On June 1, six Federal financial regulatory agencies[1] (Agencies) jointly issued a Notice of Proposed Rulemaking (the Proposed Rule) requiring the implementation of quality control standards for the use of automated valuation models (AVMs) to estimate the value of real estate. The standards would apply to AVMs used by mortgage originators and secondary market issuers in determining the collateral value of a mortgage secured by a consumer’s principal dwelling. The rulemaking was required by Section 1473(q) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 1473(q) amended title XI of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 to add section 1125. Section 1125, among other things, required the Agencies to establish standards to ensure confidence in the estimates that AVMs produce, protect against data manipulation, avoid conflicts of interest, require the use of random sample testing and review, and account for any other factors the Agencies may determine. 

The Agencies note that AVM usage has increased with developments in both modeling technology and the availability of larger input datasets. While the Agencies recognize that the use of AVMs can lower the cost of, and result in faster production of, valuations, the Agencies are implementing the standards to ensure the valuations produced by AVMs are credible and consistent with safe and sound banking practices.

The deadline for providing comments on the Proposed Rule is August 21, 2023.

Key Takeaways:

• The Agencies did not adopt prescriptive standards for the use of AVMs; rather, the Proposed Rule requires that institutions develop standards that are appropriate given the size of the institution and complexity and risks of the transactions for which they use AVMs.
• In addition to the statutory factors provided by Dodd-Frank, the Agencies used the authority provided by Dodd-Frank to also require that use of AVMs comply with applicable nondiscrimination laws. Their focus on concerns of bias and discrimination is consistent with recent guidance and statements by the CFPB and other federal agencies related to risks associated with the use of automated systems and AI. 
• The supplementary information leaves room for modifications in the final rule, including to provide more prescriptive requirements. However, the Agencies may be unlikely to proposed detailed control requirements since institutions have already implemented controls in line with section 1125’s mandate and existing supervisory guidance, including risk management guidance addressing the validation and testing of models.
• The Proposed Rule is focused on control standards for mortgage originators’ or secondary market issuers’ own use of AVMs. However, the Agencies are seeking comment on whether it would be feasible to require originators to have control standards to assess secondary market issuers’ use of AVMs in appraisal waiver determinations.
• The Agencies proposed that a final rule would become effective the first day of a calendar quarter following 12 months after publication of any final rule in the Federal Register but have requested comment on the proposed implementation period.

1.  What Is An AVM?

The Proposed Rule defines an AVM as a computerized model that is used by a mortgage originator or secondary market issuer to determine the value of a consumer’s principal dwelling collateralizing a mortgage.

• “mortgage originator” has the meaning provided under the Truth in Lending Act, which generally encompasses persons who (i) take a residential mortgage loan application, assist a consumer in obtaining or applying for a residential mortgage loan, or offer or negotiate the terms of such a loan for, or in expectation of, compensation or gain or (ii) represent to that public that they can or will do any of the above;
• “secondary market issuer” means any party that creates, structures, or organizes a mortgage-backed securities transaction;
• “mortgage” means a transaction in which a mortgage, deed of trust, purchase money security interest arising under an installment sales contract, or equivalent consensual security interest is created or retained in a consumer’s principal dwelling; and
• “dwelling” means residential structures containing one to four units (including an individual condominium unit, cooperative unit, factory-built housing, or manufactured home, if used as a residence), including homes purchased or to be constructed that would become the principal dwelling within the year or upon completion of building, but excluding vacation or second homes.

2.  Which AVMs Are Covered By The Proposed Rule?

The proposed requirements would apply to any AVM used in determining the value of collateral in connection with a credit decision or covered securitization determination regarding a mortgage or mortgage-backed security.

• “credit decision” means a decision whether, and under what terms, to originate, modify, terminate, or make other changes to a mortgage, including whether to extend new or additional credit or to change the credit limit on a line of credit; and
• “covered securitization determination” means a determination regarding (1) whether to waive an appraisal requirement for a mortgage origination in connection with its potential sale or transfer to a secondary market issuer; or (2) structuring, preparing disclosures for, or marketing initial offerings of mortgage-backed securitizations.

The Proposed Rule expressly excludes:

• AVMs used as portfolio monitoring tools to track the quality or performance of mortgages or mortgage-backed securities;
• AVMs used by certified or licensed appraisers when preparing appraisals under the Uniform Standards of Professional Appraisal Practice (USPAP); and
• AVMs used to review the quality of completed collateral valuation determinations.

This means that the proposed requirements would only apply when an AVM is being used to produce a new collateral value determination before originating a purchase-money mortgage or placing a loan in a securitization pool. The Supplementary Information preceding the Proposed Rule also states they would cover AVMs used in deciding whether or to what extent to reduce or suspend a home equity line of credit (HELOC). The Agencies indicated there could be some movement here by seeking comment on the extent to which financial institutions purchase or service HELOCs without engaging in mortgage originator or secondary market issuer activities. They would not, however, apply to an AVM that is used by a financial institution purely to monitor asset quality and collateral risk for its own real estate investment portfolio. The additional exclusion of any AVM whose use is limited to reviewing historical collateral valuation determinations means the Proposed Rule would not prevent institutions from using AVMs to validate a previous determination of value.

The Agencies clarify that the inclusion of the decision whether to waive an appraisal requirement as a “covered securitization determination” only impacts the secondary market issuer that uses AVMs in connection with those decisions. For example, the Supplementary Information notes that both Fannie Mae and Freddie Mac have appraisal waiver programs, and when they use AVMs to determine whether to issue an appraisal waiver offer, they make a “covered securitization determination” subject to the Proposed Rule. However, mortgage originators that submit a loan to determine whether Fannie Mae or Freddie Mac will offer an appraisal waiver do not make a “covered securitization determination” and are not required to have policies, procedures, and controls in place covering Fannie Mae’s or Freddie Mac’s use of AVMs. However, the Agencies posed a question of whether it would be feasible for originators to perform quality control reviews of secondary market issuers’ use of AVMs in this context.

While the Proposed Rule specifically excludes from its coverage AVMs used by licensed appraisers, the Agencies remain concerned and focused on bias and discrimination in appraisals generally. Shortly after issuing the Proposed Rule, the OCC, Federal Reserve, FDIC, NCUA, and CFPB also issued proposed interagency guidance outlining how institutions may develop or enhance processes for the reconsideration of real estate valuations into their risk management programs. The Proposed Guidance addresses the ways collateral valuations may be deficient, including due to prohibited discrimination and to deficiencies and errors in assumptions and data used and valuation methodologies. The guidance also discusses the obligations of financial institutions if they determine an appraisal does not meet minimum regulatory or Uniform Standards of Professional Appraisal Practice (USPAP) standards. These include obligations to (i) refrain from using uncorrected appraisals that are determined not to have met minimum regulatory standards and (ii) report to state agencies an appraiser’s failure to meet USPAP or applicable ethical or legal standards.

3.  What Quality Control Standards Apply To Covered AVMs?

The Agencies have recognized through their existing supervisory guidance that institutions use a variety of valuation tools but require that the use of these tools be consistent with safe and sound business practices. Sound banking practices include the establishment and use of policies and procedures governing the selection, use, and validation of AVMs, including steps to ensure their accuracy, reliability, and independence.

The Proposed Rule would require adoption and maintenance of policies, practices, procedures, and control systems to ensure that covered AVMs adhere to quality control standards designed to:

(a) ensure a high level of confidence in the estimates produced;

(b) protect against the manipulation of data;

(c) avoid conflicts of interest;

(d) require random sample testing and reviews; and

(e) comply with applicable nondiscrimination laws.

This mirrors section 1125’s four requirements and adds a fifth factor focused on compliance with nondiscrimination laws. The Agencies indicated in the Supplementary Information that the purpose of the added factor is “to heighten awareness among lenders of the applicability of nondiscrimination laws to AVMs.” However, they acknowledge it does not create any new obligations since institutions are already required to consider nondiscrimination under the Equal Credit Opportunity Act (ECOA), its implementing Regulation B, and the Fair Housing Act. Furthermore, AVMs that reflect discriminatory biases or assumptions likely are covered by the existing section 1125 factors in that they would preclude a high degree of confidence in the estimates produced and result in data manipulation and could be the subject of random sample testing and reviews. 

The Proposed Rule does not set specific requirements for how institutions are to structure their policies, practices, procedures, and control systems to incorporate these five factors.  Instead, institutions are required to set quality control standards for AVMs that are appropriate for the size of the institution and for the risks and complexity of transactions for which they are used. The Agencies’ decision not to prescribe specific requirements recognizes the fact that institutions have been operating under section 1125’s mandate for over ten years and have structured their controls in line with the existing supervisory framework. The Proposed Rule provides flexibility for institutions to continue doing so and to consider their unique business models and risk profiles in developing risk management processes. 

The Agencies left open the possibility that the final rule could provide more detailed guidance on incorporation of these factors and alter the proposed additional factor. They posed several questions in the Supplementary Information regarding whether such guidance would promote safety and soundness and consumer protection and more effectively carry out the purposes of section 1125. They also acknowledged that institutions covered by the Proposed Rule currently operate under different supervisory guidance applicable to use of AVMs, perhaps suggesting that some uniformity may be desirable. The Agencies also questioned in the Supplementary Information whether their proposed fifth factor is necessary given the existing statutory quality control factors and whether lenders’ existing compliance management systems and fair lending monitoring programs are even able to assess whether a covered AVM applies different standards or produces disparate valuations on a prohibited basis.

[1] The proposal was issued by the Office of the Comptroller of the Currency (OCC), the Department of the Treasury, the Board of Governors of the Federal Reserve System (the Federal Reserve), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), the Consumer Financial Protection Bureau (CFPB), and the Federal Housing Finance Agency (FHFA).