Investor confidence in the market for CDOs and all mortgages was shaken during the recession of the big housing bubble and rightly so. Investors lost huge sums and no one clearly understood why. There was a widespread belief that these losses were caused by some factor rather than a systemic problem triggered by lenders and investors themselves.
In order for investor confidence to return to this market, investors must first establish a more accurate assessment of potential losses due to mortgage defaults. This requires an accurate assessment of the fundamental value of residential properties that serve as collateral for the mortgages that include the CDOs. Since the basic value of residential properties, the value at which prices ultimately fall below a price drop, is determined by the potential for rental income from the property, a revaluation of properties using the income method will provide a more accurate measurement of the mortgage value note and thus CDO.
The rating agencies that evaluate the various tranches of CDOs must use the valuation method using the lower value of the income method and the comparative sales method. The rating agency's recommendations and ratings carry considerable weight with investors, and the rating agencies clearly made a tragic mistake in their ratings of CDOs during the big housing bubble. If credit rating agencies correctly assess the underlying collateral that backs up the mortgages pooled in a CDO, investors will regain confidence in ratings and the money will return to the secondary market. If investors in CDOs recognize the value chain as described, they would be reluctant to buy CDOs that are valued according to other methods. If investors are not willing to buy CDOs where the underlying collateral value is measured using the comparative sales method and instead require a valuation based on the income method, the CDO indicators will be forced to respond to the investors' demands, otherwise they will not be able to sell their syndicates. Investors and credit rating agencies can mandate a new valuation method for home mortgages.
In September 2008, the Federal Government took over the "conservatory" of the GSEs responsible for maintaining the secondary mortgage market. With the collapse of asset-based securities markets and CDOs, GSE swaps were the only sustainable mortgage market. This provides a unique opportunity to change market dynamics with limited government intervention. If the government, in its role as conservator, were to decide to impose a change in valuation methods, the secondary market would be forced to accept this change house project. Like any radical change in methodology, it can be phased in over time to properly train appraisers and elaborate the details of implementation. If the GSEs lead, the rest of the market will follow.
The main objection to the income method is the difficulty of evaluating market rents, especially in markets where there may not be many (or any) comparative properties for rent in the market. This is an old problem that has been investigated in detail by the Department of Labor Bureau of Labor Statistics. Comparative rents have been charged by the DOL since the early 1980s as part of their calculation of the consumer price index. The problem of irrational abundance in the late 1970s in coastal markets, particularly California, caused the consumer price index to rise rapidly. As CPI is widely used as an index of cost of living adjustments, volatility in this measure caused by the resale market should be addressed as soon as possible. After more than ten years of research, DOL decided to value the change in housing costs using a comparative rental method rather than a change in the previously used selling price method. This leveled the index and reduced volatility because the consuming aspect of housing services was tied to rents and income rather than being exposed to the volatility caused by irrational abundance in the housing market.
The Department of Labor Bureau of Labor Statistics measures the market rental rate in markets throughout the United States. It breaks down the market into subcategories based on the number of bedrooms, and it does a good job of estimating market rents in the various subcategories. These figures are updated every year. The figures from DOL will serve as a basis for assessing market rents, and this may be the only basis in areas where there are few rents.
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