Federal banking regulators recently began adopting a final rule that requires, among other things, supervised mortgage originators and secondary market issuers to ensure that automated valuation models they use follow quality control standards, including a requirement that they comply with nondiscrimination laws. The final rule will be effective on the first day of the calendar quarter following the 12 months after publication in the Federal Register.
The Dodd-Frank Act requires the agencies, including the CFPB, the OCC, the FDIC, the FHFA, the NCUA and the Federal Reserve Board, to issue quality control standards for automated valuation models (AVMs). The final rule applies to the use of AVMs by mortgage originators or secondary market issuers in determining the value of collateral for a loan to be secured by the consumer’s principal dwelling in connection with making a credit decision or covered securitization determination regarding a mortgage or mortgage-backed security. The rule applies regardless of whether the loan is primarily for consumer purposes or business purposes, and whether the credit is closed-end or open-end.
For purposes of the final rule:
- The definition of “mortgage originator” is based on the definition set forth in section 103 of the Truth in Lending Act (TILA), with modifications. (The agencies originally proposed to simply incorporate the TILA definition by reference.) The initial part of the definition provides that a “mortgage originator” is any person who, for direct or indirect compensation or gain, or in the expectation of direct or indirect compensation or gain (i) takes a mortgage application, (ii) assists a consumer in obtaining or applying to obtain a mortgage, or (iii) offers or negotiates terms of a mortgage.
- A “secondary market issuer” means any party that creates, structures, or organizes a mortgage-backed securities transaction.
- A “covered securitization determination” means a determination regarding:
- Whether to waive an appraisal requirement for a mortgage origination in connection with its potential sale or transfer to a secondary market issuer; or
- Structuring, preparing disclosures for, or marketing initial offerings of mortgage-backed securitizations.
- “Credit decision” means a decision regarding whether and under what terms to originate, modify, terminate, or make other changes to a mortgage, including a decision whether to extend new or additional credit or change the credit limit on a line of credit.
Significantly, and consistent with the proposed rule, under the final rule when a secondary market issuer, such as Fannie Mae or Freddie Mac, uses an AVM to offer an appraisal waiver, the secondary market issuer must comply with the final rule, and not the mortgage originator.
With regard to the use of third party AVMs by lenders, the agencies noted that “A banking organization’s use of third parties does not diminish its responsibility to meet these requirements to the same extent as if its activities were performed by the banking organization in-house.”
In addition to discrimination, the quality standards also address several other issues.
“The final rule requires supervised mortgage originators and secondary market issuers that engage in credit decisions or covered securitization determinations themselves, or through or in cooperation with a third-party or affiliate, to adopt and maintain policies, practices, procedures, and control systems to ensure that AVMs used in these transactions adhere to quality control standards,” the agencies said.
Those standards must:
- Ensure a high level of confidence in the estimates produced;
- Protect against the manipulation of data;
- Seek to avoid conflicts of interest;
- Require random sample testing and reviews; and
- Comply with applicable nondiscrimination laws.
For purposes of the final rule, “control systems” is defined as “the functions (such as internal and external audits, risk review, quality control, and quality assurance) and information systems that are used to measure performance, make decisions about risk, and assess the effectiveness of processes and personnel, including with respect to compliance with statutes and regulations.”
The first four factors are set forth in Dodd-Frank, and the agencies added the fifth factor based on authority in Dodd-Frank to “account for any other such factor that the agencies . . . determine to be appropriate.” The inclusion of the fifth factor in the proposed rule drew numerous comments, both supporting and raising concerns about the inclusion of the factor.
The agencies set forth their reasons for including the fifth factor in the preamble to final rule, and make the following statement:
“As with models more generally, there are increasing concerns about the potential for AVMs to produce property estimates that reflect discriminatory bias, such as by replicating systemic inaccuracies and historical patterns of discrimination. Models could discriminate because of the data used or other aspects of a model’s development, design, implementation, or use. Attention to data is particularly important to ensure that AVMs do not rely on data that incorporate potential bias and create discrimination risks. Because AVMs arguably involve less human discretion than appraisals, AVMs have the potential to reduce human biases. Yet without adequate attention to ensuring compliance with Federal nondiscrimination laws, AVMs also have the potential to introduce discrimination risks. Moreover, if models such as AVMs are biased, the resulting harm could be widespread because of the high volume of valuations that even a single AVM can process. These concerns have led to an increased focus by the public and the agencies on the connection between nondiscrimination laws and AVMs.”
In explaining the need for the rule, the agencies said that while computer models can provide critical information for sellers, buyers and lenders, they cannot be inaccurate or discriminatory.
“It can be tempting to think that computer models can take bias out of the equation, but they can’t,” they said.
The Biden Administration has highlighted allegations of appraisal bias as a major issue that must be addressed. The administration formed an Interagency Task Force on Property Appraisal and Value Equity, known as the PAVE Task Force to focus on the problem.
As was the case with the proposed rule, with regard to the final rule the agencies addressed not adopting a more prescriptive set of standards. The agencies advised that “[d]ifferent policies, practices, procedures, and control systems may be appropriate for institutions of different sizes with different business models and risk profiles, and a more prescriptive rule could unduly restrict institutions’ efforts to set their risk management practices accordingly.”
In continuing its criticism of artificial intelligence, the CFPB in announcing the rule stated:
“The new rule approved today is also another example of the CFPB’s work to use existing laws on the books to police potential pitfalls when it comes to artificial intelligence. We’ve terminated the program that handed out special legal immunities and favors to individual AI companies that they could exploit to gain an unfair advantage. We’ve issued guidance and reports to make clear that there is no “fancy technology” exemption in our nation’s consumer financial protection and fair lending laws. We’re also building more capacity at the CFPB to address new and emerging technologies.”