General

Appraisal Values And Lender Liability: Art, Science, Or Gamble? – Finance and Banking – United States – Mondaq News Alerts

Executive Summary

While the mortgage industry continues to evaluate the nature and
extent of bias in the home appraisal process, no one has yet come
up with a solution for detecting and addressing it. Our Financial
Services & Products Group highlights the tension between the
purpose and design of the appraisal process and its effect on
borrowers and communities of color.

  • How can a lender ensure that its loans are supported by
    adequate collateral while being mindful of potential appraisal
    bias?

  • What steps can a lender take to eliminate fair lending risk,
    while working within the current appraisal framework?

  • How can the mortgage industry work together to eliminate
    potential bias via conscientious enhancements to the appraisal
    process?

As part of the Biden Administration’s stated focus on
narrowing the racial gap in wealth and homeownership, federal
agencies launched an Interagency Task Force on Property Appraisal
and Valuation Equity (PAVE), with the goal
of “addressing the persistent misvaluation and undervaluation
of properties experienced by families and communities of
color.” More recently, on February 14, 2022, the U.S.
Department of Justice (DOJ) issued a statement that
“combatting housing discrimination, including bias in
appraisals, is a high priority across the federal government.”
And on February 22, 2022, Representative Maxine Waters (D-CA),
chairwoman of the House Financial Services Committee, announced that
she would be “introducing legislation to address systemic
appraisal discrimination” and asked that the U.S. Department
of Housing and Urban Development (HUD) “initiate a systemic
fair housing investigation into housing valuation
discrimination.”

While these federal efforts are commendable, the concept of
appraisal bias is far from novel.
Indeed, as early as the 1930s, property valuation – a service
performed by the federal government pursuant to its Home
Owners’ Loan Corporation (HOLC) program – deliberately
and effectively “institutionalized in a rational and
bureaucratic framework a racially discriminatory practice that all
but eliminated Black access to the suburbs and to government
mortgage money.”

Under the HOLC program, “government agents methodically
included in their procedures the evaluation of the racial
composition or potential racial composition of the community,”
deeming undesirable and relegating to the lowest category those
communities that “were changing racially or were already
black.” Even as recently as 2016, HUD explicitly
required
 its rostered appraisers to evaluate the
“desirability” of a neighborhood by giving “special
consideration” to the “positive and negative effect on
value of gentrification.” Thus, while many describe the
appraisal process as an “art, not a science,” racial and
ethnic minorities may feel they are playing a rigged game.

Playing the Real Estate Market

The real estate industry has been described much like betting,
with a rising housing market commonly referred to as
“hot” (as opposed to the “bust” associated with
low housing prices and decreased demand) and an unsupported housing
market likened to a “house of cards.” Indeed,
appreciating housing values resulting from subprime lending and
inflated appraisals began to slow in 2006 and came crashing down
shortly thereafter.

By the time the Board of Governors of the Federal Reserve System
proposed amendments to Regulation Z (then codified at 12 CFR Part
203) to protect borrowers of subprime (i.e., higher-priced)
mortgage loans, it had become apparent that
“[a]verage loss amounts today are rising because the damage
caused by collateral value inflation at origination is being
compounded by severely depreciating real estate market
values.” The Federal Reserve Board reasoned that
“[a]n inflated appraisal also may lead consumers to believe
that they have more home equity than in fact they do, and to borrow
or make other financial decisions based on this incorrect
information.” For example, “a consumer also may take out
more cash with a refinance or home equity loan than he or she would
have had an appraisal not been inflated.” Such a consumer, if
saddled with “substantial unsecured consumer debt,” may
be “especially vulnerable” because “they may find a
cash-out refinance offer attractive.”

Ultimately, leading
up to the 2008 financial crisis, “borrowers in black
neighborhoods [were] five times as likely to refinance in the
subprime market than borrowers in white neighborhoods,” even
when controlling for income. These statistics indicate that racial
and ethnic minorities were acutely affected by inflated appraisals
and the resulting housing market crash. To that end,
“[w]hile the foreclosure crisis has had vast consequences
throughout the United States, it has had a disproportionate impact
on persons of color,” even when considering that homeownership
rates for Black / African American and Hispanic/Latino borrowers
had been at their lowest levels in over a decade and would drop
even further.

Notably, neighborhoods with populations of color of less than
10% in 2000 saw an increase in foreclosures of 215%, while
neighborhoods with 90% or greater minority populations experienced
an increase of 544%. Overall, the bursting of the housing market
bubble took a far greater
toll
 on the wealth of minorities than whites.

Tightening the Appraisal Rules

In 2008 and in response to the increase in foreclosure rates,
which threatened significant credit loss to government investors,
Freddie Mac, Fannie Mae, and the Federal Housing Finance Agency
(FHFA) entered into a settlement with the New York State Office of
the Attorney General, resulting in a Home Valuation Code of
Conduct
 (HVCC) to protect against inflated appraisals
caused in part by lender influence. At around the same time, the
Federal Reserve Board exercised its rulemaking authority under the
Home Ownership and Equity Protection Act by amending Regulation
Z
 to provide for several new protections for consumer
mortgages, including appraiser independence requirements designed
to ensure the integrity of real estate appraisals.

Subsequently, Congress enacted the Dodd–Frank Wall Street
Reform and Consumer Protection Act, which sunset the HVCC and
codified the Regulation Z appraiser independence provisions via a
new Section 129E of the Truth in Lending Act (implemented by the
valuation independence requirements in current 12 CFR §
1026.42).

From here, the government-sponsored entities (GSEs) followed
suit, issuing their Appraiser Independence
Requirements
, which imposed heightened obligations on lenders
to maintain separate and independent functions for their loan
production and appraisal-related services. Further, various federal
government agencies, including the Office of the Comptroller of the
Currency, Federal Reserve System, and Federal Deposit Insurance
Corporation, updated their existing Interagency Appraisal
and Evaluation Guidelines
 to “reflect developments
concerning appraisals and evaluations, as well as changes in
appraisal standards and advancements in regulated institutions’
collateral valuation methods,” while reemphasizing that
appraisals must “support an institution’s decision to
engage in the credit transaction.” And, effective January 1,
2010, HUD imposed heightened requirements
on lenders that order appraisals in connection with loans insured
by the Federal Housing Administration. In addition, and to further
protect against overvaluation bias, the GSEs and various private
vendors developed automated valuation models (AVMs) for lenders to
use in evaluating borrower collateral.

Another Rising Housing Market

The various enhancements to the appraisal process served to
fine-tune the industry’s risk assessment and management
abilities overall and succeeded in reducing expected mortgage
default rates, particularly for refinance transactions. Indeed,
after controlling for factors such as loan-to-value ratio, credit
score, debt-to-income ratio, interest rate, and loan balance,
it appears that
cash-out refinance transactions during 2010–2017 were
“only” 55% riskier than purchase transactions, as opposed
to 96% riskier before the tightening of appraisal standards. While
this tightening of standards has resulted in
almost half of cash-out refinance loan applicants receiving
lower-than-desired appraisal values, the refined process suggests a
safer bet for consumers.

However, over the last 18 months, housing prices once again have
been on the rise due to record-low mortgage rates and flexible
work-from-home policies that allowed buyers to expand their home
search. As for those homeowners staying put, they extracted more
cash
 from their homes through cash-out refinances in 2020
than in any year since the financial crisis, assured by more
stringent underwriting and appraisal standards than were available
before the financial crisis. As the rate of cash-out
refinances continues to rise,
will increased housing values remain sustainable? Industry
predictions suggest that housing prices will
decelerate
 each month of 2022 and steadily temper the
rapid home price acceleration seen in 2021. However, the extent of
any deceleration or potential decline in the housing market remains
to be seen.

Precisely because of such market volatility, the existing
appraisal framework is designed not only to protect borrowers from
taking on more debt than their property is worth but also to limit
the investor’s risk of loss in the event of borrower
default. Fannie Mae, for
example, emphasizes that, to be eligible for delivery, the loan
must be “secured by a property that provides acceptable
collateral.” To that end, Fannie Mae cautions lenders to
“pay particular attention and institute extra due diligence
for those loans in which the appraised value is believed to be
excessive or when the value of the property has experienced
significant appreciation in a short time period since the prior
sale.”

Further, when using automated valuation tools, the federal
agencies expect lenders to “establish a level of acceptable
core accuracy and limit exposure to a model’s systemic tendency
to over value properties.” Fannie Mae’s own valuation
tool
 issues “flags and messages that signal
heightened risk of overvaluation.” Similarly, other government
investors require a lender to ensure that an appraisal value
adequately supports the loan to be guaranteed or insured.

But government investors acknowledge that there is no one
“right” property value. For example, the Department of
Veterans Affairs (VA) requires the appraisal value to be
“reasonable,” Fannie Mae and Freddie Mac refer to it as
an “opinion” of value, and HUD acknowledges it is an
“estimated” value. Similarly, the federal banking
agencies note that an appraisal is “an opinion as to the
market value” of a property on a particular date. Most
importantly, the Uniform Standards of Professional Appraisal
Practice (USPAP) definition of an appraisal, which all appraisers
must comply with, recognizes that the “opinion of value”
may be numerically expressed “as a specific amount, as a range
of numbers, or as a relationship” to a prior value or
benchmark.

These nebulous characterizations are not surprising, given that
the appraisal process relies on the professional judgment and
expertise of the appraiser and permits the appraiser to employ
subjectivity. For example, HUD
acknowledges
 that factors of location, site, view, design,
quality of construction, age, condition, and functional utility
“are all subjective factors that require subjective
adjustments.”

Prohibition on Appraisal Discrimination

Yet, while subjectivity is expected, consideration of a
prohibited factor such as race or ethnicity is prohibited and
constitutes unlawful discrimination. The Fair Housing Act prohibits
discrimination in “making available [a residential real
estate-related] transaction, or in the terms or conditions of such
a transaction,” by a person or entity “whose business
includes engaging in residential real estate-related
transactions.” For purposes of the Act, a “residential
real estate-related transaction” includes “the making or
purchasing of loans or providing other financial assistance –
(1) for purchasing, constructing, improving, repairing, or
maintaining a dwelling; or (2) secured by residential real
estate” (i.e., a mortgage loan transaction), as well as
“the selling, brokering, or appraising of residential real
property.” Fair Housing Act claims against lenders are often
brought to HUD by community organizations that receive annual
grants from HUD under the agency’s Private Enforcement
Initiative and commit to finding and referring discrimination
complaints for investigation and conciliation.

In addition to antidiscrimination laws, the USPAP explicitly
prohibits an appraiser from relying on “unsupported
conclusions relating to characteristics such as race, color,
religion, national origin, sex, sexual orientation, gender, marital
status, familial status, age, receipt of public assistance income,
disability, or an unsupported conclusion that homogeneity of such
characteristics is necessary to maximize value.” Further, for
every appraisal report, the appraiser must certify that the report
contains their “personal, impartial, and unbiased professional
analysis” and that the appraiser “had no bias with
respect to the property or the parties involved” in the
appraisal assignment.

Unfortunately, there is no bright-line rule for determining
whether an appraisal is discriminatory. It is the position of
numerous advocacy groups and public policy organizations that the
“widespread presence of anti-black bias” and “even
outright discrimination and racism” has directly contributed
to the devaluation of black assets in the housing market,
suggesting that the discriminatory conduct should be apparent on
the face of the appraisal report.

Yet, absent explicit references to a homeowner’s race or
ethnicity, or statements regarding the demographic composition of
the neighborhood, how can a lender know or verify that an appraiser
chose valuation factors based on professional judgment and
expertise rather than a prohibited characteristic such as race or
ethnicity? Of course, an appraisal value that is lower than desired
by the borrower or needed to support the loan is not itself
evidence of discrimination.

Not only are lenders prohibited from increasing an appraisal
value or ordering another appraisal absent a determination that the
appraisal is deficient, but they also must employ their own
licensed or certified appraisers if they perform a substantive
review of the appraisal report. And neither the law nor government
agency guidelines require a lender to perform a substantive review
of the appraisal before relying on it to make a loan. Rather, the
expectation is that the lender will confirm that the appraisal was
performed by state-certified or licensed appraiser, contains
sufficient information and analysis to support the
institution’s decision to engage in the transaction, and
includes a certification that the appraiser complied with the
USPAP. Ultimately, through the appraisal process, the lender
“is responsible for ensuring that the subject property
provides adequate collateral for the mortgage.”

Potential Improvements to the Appraisal Process

Given that the existing appraisal framework is designed to
prevent lender influence and protect against overvaluation of
collateral, lenders are in a difficult position to detect
discrimination and correct it. Suggestions made by federal
agencies, government investors, advocacy groups, and public policy
organizations vary widely, conflict with one another, and
ultimately reflect each entity’s own stake in the game. For
example, a study commissioned by the
Federal Financial Institutions Examination Council recommends that
the USPAP be amended “to require appraisers to identify
mortgage borrowers as ‘intended users’ of appraisals
prepared in relation to residential mortgage
transactions.”

While this suggestion would create a duty of care where none
currently exists, and therefore a private right of action for
negligence, for borrowers who believe that an appraiser has
undervalued their home, this change would conflict with existing
government investor guidelines, which emphasize that the
“intended user” of the appraisal is the lender, and the
“intended use” is to “evaluate the property that is
the subject of this appraisal for a mortgage finance
transaction.” Further, it is unclear what the intended use of
the appraisal report would be for a mortgage borrower who may not
own the property or ultimately purchase it.

Virtually all other suggestions for detecting and eliminating
appraisal discrimination or bias are directed at the appraiser and
recognize, at least implicitly, that lenders’ obligations in
the appraisal process cannot easily be changed. These suggestions include
“expand[ing] the participation of people of color in the
appraiser profession” (given that the
vast majority of appraisers are white and only 1% are black) and
prohibiting appraisers from using in their appraisal report
commentary any words or phrases that can be viewed as potential
race- or ethnicity-related red flags.

However, even these appraiser-specific recommendations are at
odds, reflecting the differing, and sometimes incompatible,
priorities among industry participants. While government investors
propose “modernizing” the appraisal process through
“better use of data, technology, and process design,”
the Consumer Financial
Protection Bureau
, much like advocacy groups, has expressed
“concerns that AVMs may reflect bias in design and function or
through the use of biased data and may introduce potential fair
lending risk.”

Nevertheless, other than recommending that lenders review the
language of appraisal reports for red-flag language, the industry
has come up empty-handed in terms of what lenders can do to detect
appraisal discrimination and correct it. While government investors
have made some updates to their
guidelines
 to require lenders to “evaluate the
appraisal and ensure it complies with … the Fair Housing Act and
other federal, state, or local antidiscrimination laws,” the
nature and scope of this obligation remains a topic of discussion
and some disagreement.

Even the nature and extent of appraisal bias – and the
steps in the appraisal process that might be the problem –
are subject to contention. On the one hand, Freddie Mac asserts that
“the topic of a potential appraisal gap is worthy of
considerable research,” while Fannie Mae, much like public
policy think tanks, notes that
“the frequency of ‘undervaluation’ [does] not have a
notable racial pattern.”

But even assuming significant bias, there is no consensus on
which legitimate alternatives could substitute for the existing
valuation process. This is no surprise, given the industry’s
use of credit scoring models for their predictive value, despite
concerns that these models may have a disproportionate and
unfavorable effect on minorities.

Indeed, the lender’s entire appraisal-related process, from
the use of automated valuation tools to the scope of appraisal
review, could very well be examined for potential discrimination,
even when the lender is performing these actions consistently in
accordance with its policies and procedures and without regard to
race or other prohibited factor. This level of scrutiny into a
lender’s involvement with a mortgage settlement service is
unprecedented. If this were a different settlement service, such as
title, inspection, or hazard insurance, there would be no
expectation for a lender to scour the results for deficiencies, or
implicit biases, that could signal discrimination. For example,
courts acknowledge that a lender would not be expected to uncover a
defect in title that a knowledgeable title company or attorney
failed to detect.

Ultimately, lenders will need to understand the expectations and
risks arising from their role in the appraisal process,
particularly once the historic run on housing prices begins to wind
down. Further, while no one has yet come up with a solution for
detecting and addressing appraisal bias, the industry might benefit
from working together to eliminate potential bias by considering
conscientious enhancements to the appraisal process rather than
burning down the house.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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