Federal Agencies Propose Quality Standards for the Use of Automated Valuation Models in Real Estate

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 fear that, without appropriate care, deployment of these technologies can lead financial institutions to operate out of compliance with applicable laws (to protect the organizations and consumers) and to take on unnecessary risk to their safety and soundness.

On June 1, 2023, the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, 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 that seeks comment on their proposed rule governing the use of AI and other algorithmic systems in appraising home values. 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.

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 also may be directly or indirectly subject to the proposed rule, based on the Bank Service Company Act and Interagency Guidance on Third-Party Risk Management.

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 (including to deny a loan) or securitization determination regarding a mortgage or mortgage-backed security with certain exceptions, including use of AVMs in the development of an appraisal by a certified or licensed appraiser.

What Are the Proposed Requirements?

Covered Institutions would need to adopt 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.

The fifth factor — compliance with applicable nondiscrimination laws — is not specified in Section 1125 of the Dodd-Frank Act. Section 1125 expressly gives the Agencies discretion to add additional factors, however. 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 historical patterns of discrimination may tend to yield discriminatory results. The Agencies’ choice to make compliance with applicable nondiscrimination laws an express factor 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

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 are the advantages and disadvantages of specifying a fifth quality-control factor on nondiscrimination? What, if any, alternative approaches should the Agencies consider?
3. How might a rule covering only AVM usage by mortgage originators and secondary-market issuers disadvantage those entities vis-à-vis their competitors?
4. To what extent do secondary-market issuers use AVMs to determine collateral value in securitizations?
5. What are the advantages and disadvantages of exempting federally backed securitizations from the AVM quality-control standards?

Companies and trade associations concerned that the rulemaking’s outcome might challenge their (or their members’) business models should consider submitting comments, which will be due 60 days after publication of the proposed rule in the Federal Register.

For those interested in learning more, be on the lookout for our forthcoming Advisory on the proposal rule, as well as the proposed Interagency Guidance on Reconsiderations of Value of Residential Real Estate Valuations. And for any questions about the proposed rule, contact any of the authors listed here or your usual Arnold & Porter contact.

© Arnold & Porter Kaye Scholer LLP 2023 All Rights Reserved. This blog post 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.