Proposed Regulation for Quality Control Standards in the Use of Automated Valuation Models by Mortgage Lenders Targets Compliance With Discrimination Laws as Well as Safety and Soundness

With the greater adoption of artificial intelligence (AI) and other automated systems in the financial services industry, the federal financial regulators have shown increased interest in how financial institutions use these technologies. These systems can improve operational efficiency and customer service. However, the regulators have expressed concern that, without appropriate care, the deployment of these technologies can lead financial institutions to take on unnecessary risks that could result in the organization operating out of compliance with applicable laws and regulations, including but not limited to those related to safety and soundness and discrimination.

On June 21, 2023, the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System (Federal Reserve), Federal Deposit Insurance Corporation, National Credit Union Administration, Consumer Financial Protection Bureau, and Federal Housing Finance Agency (collectively, the Agencies) issued a Notice of Proposed Rulemaking (NPRM) that seeks comment on a proposed rule governing the use of AI and other algorithmic systems in appraising home values (proposed rule). The proposed rule implements the quality-control standards mandated by Section 1125 of the Dodd-Frank Act for the use of automated valuation models (AVMs) by mortgage originators and secondary market issuers to value single-family and one-to-four-unit multifamily homes. While four of the five proposed quality-control standards are based on those specified in the Dodd-Frank Act and are consistent with standards that are currently set forth in regulations and guidance for appraisals, the Agencies are proposing a fifth standard that AVMs comply with applicable discrimination laws.

This Advisory provides an overview of the proposed rule and includes key takeaways and other considerations for institutions that would be covered by the proposed rule.

What institutions would be covered by the proposed rule?

The proposed rule would apply generally to mortgage originators and secondary market participants and specifically to financial institutions; subsidiaries owned and controlled by a financial institution and regulated by a federal financial institution regulatory agency; credit union service organizations; and any party that creates, structures, or organizes a mortgage-backed securities transaction (Covered Institutions). Third-party service providers of banking organizations that provide related services may also be directly or indirectly affected by the proposed rule, based on the Bank Service Company Act and the newly released Interagency Guidance on Third-Party Risk Management. Similar to the Interagency Guidance on Third-Party Risk Management, the proposed rule is principle-based and does not prescribe particular quality-control standards. Unlike the guidance, however, the proposed rule would be binding and noncompliance could result in formal and informal enforcement actions against a Covered Institution for failure to have what the Agencies deem to be appropriate policies, procedures, and practices — even if there are no alleged violations of other laws or regulations. For more information about the Interagency Guidance on Third-Party Risk Management, check out our prior Advisory.

What transactions would be covered by the proposed rule?

The proposed rule would apply to transactions (Covered Transactions) that use AVMs to value collateral in connection with making a credit decision or covered securitization determination regarding a mortgage or mortgage-backed security. The term “automated valuation model” would be defined as any computerized model used by mortgage originators and secondary market issuers to determine the value of a consumer’s principal dwelling collateralizing a mortgage, even if the mortgage is primarily for business, commercial, agricultural, or organizational purposes. The proposed rule includes definitions for several other key terms, including but not limited to “control systems,” “covered securitization determination,” “mortgage originator,” and “secondary market issuer.”

What transactions would be exempt from the proposed rule?

The proposed rule distinguishes between using AVMs to determine the value of collateral securing a mortgage and using AVMs to monitor, verify, or validate a previous determination of value. Thus, the proposed rule expressly excludes the use of AVMs in monitoring the quality or performance of mortgages, reviewing already completed determinations of the value of collateral, or developing an appraisal. As such, the proposed rule would not apply to the use of AVMs in the (i) monitoring of the quality or performance of mortgages or mortgage-backed securities; (ii) reviews of the quality of already completed determinations of the value of collateral; or (iii) the development of an appraisal by a certified or licensed appraiser.

What are the proposed requirements?

Covered Institutions would need to have policies, practices, procedures, and control systems to ensure that AVMs used in the Covered Transactions adhere to quality-control standards to (1) ensure high-level confidence in estimates; (2) protect against manipulation of data; (3) seek to avoid conflicts of interest; (4) require random sample testing and reviews; and (5) comply with applicable nondiscrimination laws.

The Agencies propose to allow each Covered Institution flexibility to create its own quality-control standards that are appropriate for its size and the risk and complexity of its Covered Transactions. Accordingly, the proposed rule does not include prescriptive requirements for quality-control standards. Instead, the Agencies noted that the Covered Institutions may look to the existing guidance for assistance with compliance. The existing guidance relating to the use of AVMs includes Appendix B to the Interagency Appraisal and Evaluation Guidelines and Guidance on Model Risk Management. For institutions that use third-party service providers for AVMs and AVM services, the Agencies reminded such institutions that they remain responsible for ensuring that third parties, in performing their activities, comply with applicable laws and regulations, including the safety and soundness requirements.

The fifth factor—compliance with applicable nondiscrimination laws—is not specified in Section 1125 of the Dodd-Frank Act. Section 1125 expressly provides the Agencies with the authority to account for any other factor that the agencies determine to be appropriate. The Agencies propose to use this discretion to add the fifth factor because of their concerns that AVMs may produce discriminatory valuations due to the data used or a model’s development, design, implementation, or use. For instance, models trained on data reflecting systemic inaccuracies and historical patterns of discrimination may tend to yield discriminatory results. Notably, the Agencies propose to include the fifth factor despite their recognition that compliance with applicable nondiscrimination laws may be indirectly reflected in three of the first four quality control factors. The Agencies provided in the NPRM that including the fifth factor would create an independent requirement that specifically addresses nondiscrimination.

The Agencies’ proposal fits with the Biden Administration’s increased focus on the connection between nondiscrimination laws and AVMs. Last year, the administration established an Interagency Task Force on Property Appraisal and Valuation Equity (PAVE) to examine the various forms of bias in residential property valuation practices and identify ways the government and industry stakeholders can address such bias.¹ As highlighted by PAVE, recent studies of home appraisals and the market value gap between majority-Black and majority-White neighborhoods indicate there may be appraisal bias in the U.S. housing market.² There have been lawsuits against mortgage lenders alleging violations under the Equal Credit Opportunity Act (ECOA), Fair Housing Act (FHA), and other federal and state civil rights laws related to alleged discriminatory appraisals. The CFPB and DOJ have submitted a Statement of Interest in at least one case analyzing the legal questions related to a mortgage lender’s obligations under ECOA and FHA and specifically the consequences of relying on discriminatory appraisals.³

The Agencies’ choice to make compliance with applicable nondiscrimination laws an express factor also follows the Biden Administration’s approach to AI regulation, as reflected in its Blueprint for an AI Bill of Rights, which includes algorithmic discrimination protections. For more information about Biden’s Blueprint, check out our prior Advisory.

Other Considerations for Covered Institutions

Many financial institutions and their third-party service providers rely on AVMs for efficiency and cost savings, and based on such, the Agencies are concerned that the use of AVMs may have unintended effects that would result in the Covered Institution operating in an unsafe or unsound manner or violating consumer financial protection laws. Additionally, in the NPRM, the Agencies are reminding Covered Institutions that use of third parties does not diminish their responsibility to oversee the activities of the third parties for compliance with applicable laws in the same manner as if they were conducted by the institution itself.

The Agencies are soliciting feedback on dozens of aspects of their proposed rule. Particularly important questions include the following:

1. How should the Agencies define key terms such as “mortgage originator,” “consumer,” and “credit decision”?
2. What, if any, additional clarifications would be helpful for situations where an AVM would or would not be covered by the proposed rule?
3. What are the advantages and disadvantages of specifying a fifth quality-control factor on nondiscrimination? What, if any, alternative approaches should the Agencies consider?
4. How might a rule covering only AVM usage by mortgage originators and secondary-market issuers disadvantage those entities vis-à-vis their competitors?
5. To what extent do secondary-market issuers use AVMs to determine collateral value in securitizations?
6. What are the advantages and disadvantages of exempting federally backed securitizations from the AVM quality-control standards?
7. Are lenders’ existing compliance management systems and fair lending monitoring programs able to assess whether a covered AVM, including the AVM’s underlying artificial intelligence or machine learning, applies different standards or produces disparate valuations on a prohibited basis? If not, what additional guidance or resources would be useful or necessary for compliance?

The Agencies have also issued proposed Interagency Guidance on Reconsiderations of Value of Residential Real Estate Valuations. This proposal describes the risks of deficient residential real estate collateral valuations that remain uncorrected, including those that may involve discrimination, and provides guidance on how financial institutions can create or enhance policies, procedures, control systems, and complaint-resolution processes to address those risks.

Companies and trade associations concerned that the rulemaking’s outcome might challenge their (or their members’) business models should consider submitting comments, which are due by August 21, 2023.

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Financial institutions interested in how the Agencies’ proposed rule on quality control standards for AVMs may impact their businesses may contact any of the authors of this Advisory or their usual Arnold & Porter contact. The firm’s Financial Services team would be pleased to assist with any questions about the proposed rule discussed in this Advisory or consumer finance more broadly.

© Arnold & Porter Kaye Scholer LLP 2023 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.