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AVM Regulatory Outlook

As always, changes are coming to the valuation industry. These changes have been germinating in government and industry for a long time, but they’ve made progress in the last year, and I believe that they’re likely to emerge sometime this year.  I expect that we may see more regulatory changes liberalizing the use of AVMs soon.

I think that you’ll come to that same conclusion, too, if I share a couple milestones that I’ve observed and put them together with some insights I’ve gathered from talking to industry leaders.

The first milestone I will highlight was the July 2018 Financial System report by Secretary Mnuchin, which is consistent with the administration’s new attitude towards regulation. The report is far-reaching, and it includes thoughtful commentary about the uses of AVMs (see, for example, page 103-106). It recommends updating FIRREA appraisal requirements to accommodate increased usage of AVMs and hybrids. It also advocates for increased monitoring of AVMs and the application of rigorous market standards. And, it recommends focusing the use of AVMs and hybrids on loan programs with other mitigating risk factors.

The next milestone I will highlight was the proposed change in the de minimis threshold that was put out for comment in November of last year. The change would raise the threshold below which a residential mortgage could be originated with an evaluation, utilizing an AVM in lieu of a traditional appraisal. It would be raised from $250,000 to $400,000.

To those milestones I would add a third data point.  Last November I attended the Appraisal Subcommittee roundtable entitled: “The Evolving Real Estate Valuation Landscape.” As part of the of the Federal Financial Institutions Examination Council, the roundtable brought together industry representatives and government officials (see the table below) to discuss real estate valuation.

The day was split into two sessions; the morning and afternoon sessions each began with a panel of industry experts who addressed a series of prepared questions. In addition, there was a roundtable discussion focused on quotes from the July 2018 Financial System report referenced above.

The topic for the morning discussion was “Harmonizing Real Estate Valuation Requirements Across the Federal Government.” This session focused on identifying various federal appraisal statutory and regulatory requirements and exploring opportunities to harmonize those requirements, e.g., VA, FHA, and FHFA all having differing valuation requirements and standards.

The afternoon panel discussion topic was; “The Evolution of Real Estate Valuation” which focused on evolving valuation needs in commercial and mortgage lending. A key area of this session was focused on Alternative Valuation Products inclusive of AVM’s and their increasing used by lenders and the secondary market.

The roundtable discussion started with quotes about AVMs and hybrid valuation products and focused on standards. The group also contemplated how alternative valuation techniques can impact quality and mitigate risk. Finally, one quote that focused on speeding the adoption of technology was discussed.

As I write this six months later, I see the pieces of the puzzle coming together. Obviously, there is momentum behind the increased usage of AVMs, for their independence, increasing accuracy, speed and efficiency. But there is also an implicit concern to avoid opening the door to more risk. I see this being expressed by talk about “standards,” alternative products, such as “hybrids” and increased monitoring.

As I have written elsewhere, I welcome changes that make better use of our valuable and limited resources, namely the appraisers themselves. As AVM quality improves and the number of appraisers shrinks, we should encourage appraisers to be focused on their highest and best use. Their expertise should be focused on the complex, qualitative aspects of property valuation such as the property condition and market and locational influences.  They should also be focused on performing complex valuation assignments in non-homogeneous markets. Trying to be a “manual AVM” is not the highest and best use of a highly qualified appraiser, and I expect that Treasury, the FDIC and legislators are moving in this same direction.

 

Lee Kennedy

 

Participants in “The Evolving Real Estate Valuation Landscape” Appraisal Subcommittee, Federal Financial Institutions Examination Council, 2018
Government Trade Organizations Industry Participants
The Appraisal Foundation (TAF) American Bankers Association AVMetrics, LLC
Association of Appraiser Regulatory Officials (AARO) American Society of Appraisers Bank of America
Consumer Financial Protection Bureau (4) American Society of Farm Managers and Rural Appraisers Clarocity Valuation Services
Federal Deposit Insurance Corporation(3) Appraisal Institute ClearBox
Federal Housing Finance Agency(4) Homeownership Preservation Foundation CoreLogic
Federal Reserve Board(5) Independent Community Bankers of America Cushman & Wakefield Global Services, Inc.
Freddie Mac Mortgage Bankers Association Farm Credit Mid-America
Internal Revenue Service National Association of Home Builders First American Mortgage Solutions
National Credit Union Administration National Association of Realtors Genworth Financial
Office of the Comptroller of the Currency (4) Real Estate Valuation Advocacy Association (REVAA) JPMorgan Chase & Company
Tennessee Real Estate Appraisers Commission State appraiser coalitions representative Old Line Bank
Texas Appraiser Licensing and Certification Board Quicken Loans
U.S. Department of Agriculture ServiceLink
U.S. Department of Justice (2)
U.S. Department of the Interior (2)
U.S. Department of Veterans Affairs
US. Department of Housing and Urban Development

 

The Wild, Wild West of Automated Valuations

Recently the OCC, FDIC and the Federal Reserve proposed raising the de minimis threshold for residential properties below which appraisals are not required to complete a home loan. Currently, most homes transacting at $250K and above require an appraisal, but Federal regulators propose to raise that level to $400K. A November 30th Wall Street Journal article raises some interesting issues about the topic. They reported that the number of appraisers is down 21% since the housing crisis, but more homes require an appraiser, since more and more homes exceed the threshold each year. The article also states that these factors open the door for cheaper, faster and “largely untested” property valuations based on computer algorithms, also known as Automated Valuation Models (AVMS).

At AVMetrics, we have been continuously testing AVMs for over 15 years, so we’ve seen how they’ve performed over time. As an example, the accompanying chart shows model performance accuracy as measured by mean absolute error, a statistical metric of valuation error.  We utilize many statistical measures of evaluating model accuracy and precision, and they all show significant improvement in AVMs over time. And, as these automated tools get better and the workforce of appraisers continues to shrink, the FFIEC members’ proposed change seems warranted, but that doesn’t mean they don’t have their critics.

Mean Absolute Error of all tested AVM models for the last 10 years

Ratish Bansal of Appraisal Inc was quoted in The Journal describing the state of AVMs as “a wild, wild West,” inviting, “abuse of all kind.” Furthermore, he contrasts that with the voluminous regulatory standards covering the use of appraisals.

We note much of those voluminous standards represent nearly the same quality control that was in place before the Credit Crisis.  In other words, appraisals are not a guarantee against collateral risk.  They are simply one tool in the toolbox – an effective, but comparatively time consuming and expensive tool. Also of note, far from being the “wild, wild west,” AVMs are also governed by regulators, most notably, Appendix B of the Appraisal and Evaluation Guidelines (OOC 2010-42) and Model Risk Management guidance (OCC 2011-12). These regulatory guidelines require that AVM developers be qualified, users of AVMs use robust controls, incentives be appropriate, and models be tested regularly and thoroughly with out-of-sample benchmarks. They require documentation of risk assessments and stipulate that a Board of Directors must oversee the use of all models. In other words, if AVMs were the “the wild, wild west” they would be rooted in a town with oversight of the legendary Wyatt Earp.

My strong feeling is that appraisals should not be a sole and exclusive tool when evaluations can be effectively employed in appropriate, lower-risk scenarios. Appraisers are a valuable and limited resource, and they should be employed at (to use appraisal terminology) their highest and best use.  Trying to be a “manual AVM” is not the highest and best use of a highly qualified appraiser.  Their expertise should be focused on the qualitative aspects of property valuation such as the property condition and market and locational influences. They should also be focused on performing complex valuation assignments in non-homogeneous markets.  AVMs do not capture and analyze the qualitative aspects of a property very well, and they still stumble in markets with highly diverse house stock or houses with less quantifiable attributes such as view properties.

However, several companies are developing ways of merging the robust data processing capabilities of an AVM with the qualitative assessment skills of appraisers.  Today, these products typically use an AVM at their core and then satisfy additionally required evaluation criteria (physical property condition, market and location influences) with an additional service.  For example, a lender can wrap a Property Condition Report (PCR) around the AVM and reconcile that data in support of a lending decision.  This type of “Hybrid valuation” is on the track we’re headed down.  Many companies have already created these types of products for commercial and proprietary use.

We at AVMetrics believe in using the right tool for the job, and we believe there is a place for automated valuations in prudent lending practices. We think the smarter approach would be to marginally raise the de minimis threshold, but simultaneously to provide additional guidance for considering other aspects of a lending decision, specifically, collateral considerations and eligibility criteria for appraisal exemptions such neighborhood homogeneity, property conformity, market conditions and more.

Raising the De Minimis Threshold – Fear Not!

Background

There is a lot of controversy about appraisals and Appraisers these days, and the FFIEC proposed rule change – increasing the de minimis threshold to $500,000 – allowing for an appraisal exemption and the use of an evaluation in lieu of an appraisal – has sparked anxiety in the world of collateral risk.  Our colleagues at the Collateral Risk Network (CRN) expressed their opposition to the proposal. Not surprisingly for a group of its size, there are diverse opinions at the individual membership level of the group.  Our opinion is that the change – far from being the catastrophe imagined – will in fact have some important benefits.

A Place for De Minimis

While the CRN and certain appraiser blogs expressed skepticism – to put it mildly – we believe that there is a place for an appropriate de minimis level, even the $500,000 level now being considered.  On low risk transactions, evaluations (as opposed to full appraisals) can be appropriate and even beneficial for risk management of the overall lending system.

Here’s why.  Lending volumes tend to scale up and down faster than the supply of appraisers.  As a result, boom cycles in the lending business can place extreme pressure on appraisers.  This scenario makes quality control extremely challenging.  The option to leverage efficient evaluations on low risk transactions can improve the risk management of the entire system by devoting limited appraisal resources to their highest and best use.  In other words, when you place strain on a system, something has to give, and raising the de minimis threshold enables lenders to focus scarce resources on the riskier transactions.

Evaluations and the Credit Crisis

The CRN expressed concern about allowing the mistakes of the recent Credit Crisis to be repeated, and we could not be in more agreement.  However, their letter insinuated that evaluations (specifically BPOs and AVMs) were to blame for inflated valuations.  Of the vast number and type of quality problems experienced during the credit crisis, evaluations were not a major contributing factor.  In fact, we are not aware of any reported cases of AVMs being blamed for the quality problems experienced during the credit crisis.

Appraisals as a Source of Market Analysis

Strangely, the CRN comments suggested that reviewing individual appraisals is an important source of market trend analysis for investors during overheated markets.  We find this highly improbable.  The typical single-family appraisal may contain microanalysis of neighborhoods or small markets that lenders may find informative, but most Investors already access market and economic trend data via other sources, including their own or 3rd party economic analyses and risk management tools.

Existing Quality Control Infrastructure for Appraisals

The CRN letter makes the case that appraisals benefit from an extensive regulatory framework and quality control infrastructure surrounding their use, making them inherently safer for the industry to rely upon.  We note that much of the same quality control infrastructure and practices were in place before the last crisis.  Much of that appraisal quality control depends on the same people and practices – e.g., “desk appraisals” performed by other appraisers – making them subject to similar risk factors.  In other words, appraisals are not a guarantee against risk.  They are simply one tool in the toolbox – an effective and comparatively expensive tool – but they should not be an exclusive tool when evaluations can be effectively employed in lower-risk scenarios. .

Application of Evaluations

We believe in using the right tool for the job, and we believe that there is a place for evaluations in prudent lending practices. Relying on additional risk measurements, rather than just focusing on a one size fits all de minimis level can provide a formula for better risk management.  For example: A $350,000 transaction at a 40% LTV for a pay stub borrower has less need for an appraisal; an evaluation might be able to suffice.  Better to allocate that valuable appraisal resource to a $225,000 transaction at 90% LTV.  Raising the de minimis, while providing additional guidance for other measures, provides lenders and investors more flexibility to make smarter risk management decisions, and it releases valuable appraisal resources to be used where they can have the most benefit.

Now that the FFIEC has recently closed its commentary period regarding the proposed de minimis lending threshold of $500,000, we expect to receive final communication from the FFIEC during 2016.
We anticipate that lenders will adapt to the new regulations incrementally, with quality controls designed for the new thresholds, not discarded with the bathwater.

Lee Kennedy & Mike Coyne,

AVMetrics, LLC.