AVMs and the “Fifth Factor”

QUESTION

We have a question that involves appraisals and AVMs. Our concern is about the new proposals coming out of the CFPB about computer models influencing home valuations. As we understand it, their view is that these models could cause fair lending violations. 

We’ve read whatever we could about this proposal. However, it still is a bit confusing because computer models are simply not something that we know anything about. It makes us feel that this is a potential blind spot that could expose us to fair lending risk. 

It would be great if you’d explain the CFPB’s proposal in layman’s terms. 

How does the CFPB’s proposal about AVMs and computer models potentially cause fair lending violations? 

ANSWER

I know how you feel. Sometimes it seems like you have to be a computer wiz to stay current with the latest and greatest digital improvements used to originate loans. I’ll explain the CFPB’s proposal. Hopefully, it will give you a better understanding. 

The proposal involves potential requirements to prevent “algorithmic” bias in home valuations. The word “algorithmic” just means a set of concise rules that must be followed, for instance, in doing calculations. It has come to be associated with computer science, but it’s actually a term used in many disciplines. 

Let’s refer, then, to the proposal as involving “Algorithmic Bias,” which, in fact, is the CFPB’s terminology. The Bureau's proposal is entitled Consumer Financial Protection Bureau Outlines Options to Prevent Algorithmic Bias in Home Valuations.[i] 

Categorically, the proposal involves compliance management, ECOA (Regulation B), fair Lending, Fintech (Financial Technology), and Real Estate Appraisals. You can comment on the proposal at the CFPB. All potentially affected entities will have the opportunity to comment once these new AVM rules are proposed. 

In essence, the CFPB announced an initiative to ensure that computer models used to help determine home valuations are accurate and fair. Thus, the Bureau outlined the options it is considering in connection with future rulemaking on quality control standards for automated valuation models (AVMs). 

First, some background and then an explication of where this all goes. 

According to the CFPB,[ii] 

“When underwriting a mortgage, lenders typically require an appraisal, which is an estimate of the home’s value. While traditional appraisals are conducted in person, many lenders also employ algorithmic computer models. These models use massive amounts of data drawn from many sources to value homes. The technical term for these models is automated valuation models. Both in-person and algorithmic appraisals appear to be susceptible to bias and inaccuracy, absent appropriate safeguards.” 

The CFPB claims that 

“AVMs can pose fair lending risks to homebuyers and homeowners. [It] is particularly concerned that without proper safeguards, flawed versions of these models could digitally redline certain neighborhoods and further embed and perpetuate historical lending, wealth, and home value disparities.” 

This claim leads the CFPB to conclude that “computer models and algorithms…[used in] AVMs can pose fair lending risks to homebuyers and homeowners.” 

The CFPB’s oversight of these computer models is multifold, including: 

·       Ensuring a high level of confidence in the estimates produced by automated valuation  models;

·       Protecting against the manipulation of data;

·       Seeking to avoid conflicts of interest;

·       Requiring random sample testing and reviews; and

·       Accounting for any other such factor that the agencies determine to be appropriate. 

Where is this all going? 

It is going to the Fifth Factor. 

The CFPB is considering including an AVM nondiscrimination quality control factor, referred to as the “Fifth Factor.” Under this option, entities would be required to adopt policies and procedures specifically designed to mitigate fair lending risk in the use of AVMs. This would be an obligation independent of the preexisting obligation to comply with federal nondiscrimination requirements. 

There are two alternative compliance approaches the CFPB is considering. 

Under the first approach, entities would have the flexibility to design the relevant, fair lending policies, practices, and control systems in a manner that is tailored to their business models and commensurate with the institution’s risk exposures, size, and business activities. 

Under the second approach, the CFPB is considering whether compliance with applicable nondiscrimination laws for AVMs is already encompassed within the first Four Factors; specifically, the factors requiring: 

Factor 1: A high level of confidence in the estimates produced by AVMs; 

Factor 2: Protection against the manipulation of data;

Factor 3: Avoidance of conflicts of interest; and 

Factor 4: Random sample testing and reviews.

Jonathan Foxx, Ph.D., MBA
Chairman & Managing Director 

Lenders Compliance Group

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[i] Consumer Financial Protection Bureau Outlines Options to Prevent Algorithmic Bias in Home Valuations, Consumer Financial Protection Bureau, Newsroom, February 23, 2022 https://www.consumerfinance.gov/about-us/newsroom/cfpb-outlines-options-to-prevent-algorithmic-bias-in-home-valuations

[ii] Idem, this and following quotes.

Short Reset ARMS: The Special Rule

QUESTION 

I have a question about the annual percentage rate (APR) that needs to be calculated for adjustable-rate mortgages. 

Our adjustable mortgages can change the rate during the first five years after the first payment is due. You may have heard of these types of loans. They are called “short reset ARMS.” 

We price these QMs by using the General QM rule to calculate the APR. 

When we reviewed our loan servicing system, the auditor found that the programming rules for calculating prepaid interest were not explained in the rule descriptions stated for each rule. So, we need to have those descriptions. 

What is the interest rate used for calculating prepaid interest under the General Qualified Mortgage (QM) annual percentage rate (APR) calculation rule for certain adjustable-rate mortgages (ARMs) and short reset ARMs? 

ANSWER 

Your question obviously pertains to price-based General QMs. If you want to make a QM loan under the price-based General QM definition, you must calculate the APR to determine whether the loan satisfies the price-based General QM definition. 

Let me explain. The priced-based General QM definition contains a special rule for calculating the APR for loans where the interest rate may or will change within the first five years after the date on which the first regular periodic payment will be due. These loans are sometimes referred to as short-reset ARMs and step-rate loans. 

For loans with this characteristic, the creditor must treat the maximum interest rate that may apply during those five years as the interest rate for the loan's full term when determining the APR for purposes of the price-based QM definition. 

The special rule also applies for the purpose of determining whether the loan receives a conclusive or a rebuttable presumption of compliance with the ability-to-repay (ATR) requirement. 

For a loan to satisfy the price-based General QM definition, the loan APR cannot exceed the average prime offer rate (APOR) for a comparable transaction by the amounts set forth in the rule as of the date the interest rate is set. 

The difference between the loan’s APR and APOR – the “rate spread” – is also used to determine whether the loan will receive a conclusive or rebuttable presumption of compliance with the ATR requirement.

Now, concerning the interest rate to use for calculating prepaid interest under the special rule of General QM ARMS, per Regulation Z, the APR includes any prepaid interest, sometimes referred to as “odd-days” or “per diem interest.” Typically, mortgage interest is paid one month in arrears. 

For instance, if the first scheduled periodic payment due is on November 1, it will cover interest accrued in the preceding month of October. Thus, if the borrower consummates the mortgage loan on September 20, interest starts to accrue on September 20, and at consummation the consumer will typically prepay interest for the 11-day period through the end of September. That amount is prepaid interest. 

Sometimes, a creditor may provide the borrower a prepaid interest credit, often referred to as “negative prepaid interest.” Negative prepaid interest can result if consummation occurs after interest begins accruing for periodic payments. 

Thus, to apply negative prepaid interest to the example above, if the borrower instead consummates the mortgage loan on October 4, but the first scheduled periodic payment is due on November 1 and will cover interest accrued in the preceding month of October, then at consummation the creditor will typically credit the consumer for the preceding three days in October to offset some of that first scheduled periodic payment. That prepaid interest credit is also a component of the APR. 

Finally, take note, for purposes of calculating the APR for the General QM ARM’s special rule, the maximum interest rate that may apply during the five-year period after the date on which the first regular periodic payment will be due is used to calculate prepaid interest and negative prepaid interest. 

A creditor must use the maximum interest rate in the first five years for calculating the APR for purposes of the special rule, even if the creditor will use a different rate for calculating prepaid interest due at consummation.

Jonathan Foxx, Ph.D., MBA

Chairman & Managing Director

Lenders Compliance Group

"Catch-All" Provision in RESPA

QUESTION

We are a servicer licensed in all states. As the company’s Associate General Counsel, I am tasked with monitoring the legal implementation of federal and state laws pertaining to mortgage servicing. 

One of my concerns is the “catch-all” provision in Regulation X because it appears to offer borrowers a means to allege that we may implement proper error resolution procedures but still be held liable for violations of RESPA. 

Recently, a borrower has retained counsel, and the “catch-all” provision was cited in the counsel’s letter to us. I don’t want to get into litigation with the borrower. 

Is there some guidance you can provide about the “catch-all” provision that will help me decide how to resolve this matter quickly? 

ANSWER

Your question did not contain specific information about the loan or the particular procedures you follow for error resolution. So, I will provide generalized guidance and use actual litigation to demonstrate the legal effect of the “catch-all” provision in RESPA. 

The Real Estate Settlement Procedures Act (RESPA) includes error resolution procedures for mortgage loans. RESPA establishes “qualified written requests” or QWRs as part of its error resolution standards. Regulation X, RESPA’s implementing regulation, breaks QWRs into two categories: Notices of Error (NOEs) and Requests for Information (RFIs).[i] 

Let’s list what an error is and what it is not. 

Regulation X defines the term “error” by including a list of qualifying instances: 

•          Failure to accept a payment that conforms to the servicer’s written requirements for the borrower to follow in making payments. 

•          Failure to apply an accepted payment to principal, interest, escrow, or other charges under the terms of the mortgage loan and applicable law. 

•          Failure to credit a payment to a borrower’s mortgage loan account as of the date of receipt. 

•          Failure to pay taxes, insurance premiums, or other charges, including charges the borrower and servicer have voluntarily agreed that the servicer should collect and pay in a timely manner, or to timely refund an escrow account balance. 

•          Imposition of a fee or charge that the servicer lacks a reasonable basis to impose, such as a late fee for a payment that is not late, a default property management fee for borrowers not in a delinquency status, or a charge for force-placed insurance in a circumstance not permitted by Regulation X. 

•          Failure to provide an accurate payoff balance amount upon a borrower’s request. 

•          Failure to provide accurate information to a borrower regarding loss mitigation options and foreclosure. 

•          Failure to transfer accurate and timely information relating to the servicing of a borrower’s mortgage loan account to a transferee servicer. 

•          Making the first notice or filing required by applicable law for any judicial or non-judicial foreclosure process in violation of Regulation X. 

•          Moving for foreclosure judgment or order of sale, or conducting a foreclosure sale in violation of Regulation X. 

•          Any other error relating to the servicing of a borrower’s mortgage loan (sometimes referred to as the “catch-all” provision). (Note my emphases in bold and italics.) 

Regulation X offers several examples that are not “errors” subject to the NOE procedures: 

•          An error relating to the origination of a mortgage loan. 

•          An error relating to the underwriting of a mortgage loan. 

•          An error relating to a subsequent sale or securitization of a mortgage loan. 

•          An error relating to a determination to sell, assign, or transfer the servicing of a mortgage loan, not including an error relating to the failure to transfer accurately and timely information relating to the servicing of a borrower’s mortgage loan account to a transferee servicer. 

To illustrate how the catch-all qualifying instance of an error is applied in litigation, consider the case of Naimoli v. Ocwen Loan Servicing, LLC.[ii] It is a recent decision by the U.S. Court of Appeals for the 2nd Circuit. 

Here’s what happened. 

1.       Naimoli obtained a mortgage loan from IndyMac Bank to finance the purchase of her home. She then defaulted on her mortgage payments. To avoid foreclosure, she requested a Home Affordable Modification Program (HAMP) loan modification from her servicer, Ocwen Loan Servicing. 

2.       Ocwen approved her for a trial period mortgage loan modification plan, stating 

“if you successfully complete the TPP [trial period plan] by making the required payments, you will receive a modification with an interest rate of 3.50000%, which will be fixed for 40 years from the date the modification is effective.” 

The plan indicated that if Naimoli timely submitted her three payments, Ocwen would issue a permanent modification agreement for her to sign. 

3.       During the trial period, Ocwen told Naimoli that it could not implement the permanent modification agreement until she re-executed the mortgage and note that IndyMac (her lender) had failed to record and apparently lost.

Russian Sanctions: Filing the Suspicious Activity Report

QUESTION

We have just gotten our first potential SAR filing obligation triggered by the Russian sanctions. We contacted other financial institutions in our area, and they are starting to get a few transactions affected by these sanctions. 

Our legal team says we should be filing the SAR, but they have no idea what information should be filed specific to the Russian sanctions themselves. 

We’re also not sure of the Red Flags to use in connection with the sanctions. We implement a risk-based, customer due-diligence program, especially since we began accepting cryptocurrency transactions late last year. 

We are desperate for guidance since the SAR has to be filed immediately. 

What types of Red Flags should we be alert to for the Russian sanctions? 

About the cryptocurrency transactions, how do we monitor them for SAR filing? 

And, how do we complete the SAR to ensure it gets recognized as a SAR involving a Russian sanction? 

ANSWER

Given the critical impasse you are at and the immediate demand for BSA compliance caused by the horrific war in Ukraine, we have moved your inquiry to the top of the FAQ list. I will provide a response that should help you procedurally. The Financial Crimes Enforcement Network (FinCEN) closely monitors SARs filed in response to the sanctions relating to Russia and Belarus (and other affiliated persons). 

If you are unsure of the filing requirements and need information, I suggest that you contact FinCEN’s Regulatory Support Section at frc@fincen.gov. If you need to expedite the filing, you should call FinCEN’s toll-free hotline at (866) 556-3974 (continuously monitored). Keep in mind that you should immediately report any imminent threat to law enforcement officials in your region. 

It is helpful that you contacted and shared your concerns with financial institutions in your area. Information sharing among financial institutions is critical to identifying, reporting, and preventing evolving sanctions evasion, ransomware and cyber attacks, and laundering of the proceeds of corruption. 

Financial institutions and associations of financial institutions sharing information under the safe harbor authorized by section 314(b) of the USA Patriot Act may share information with one another regarding individuals, entities, organizations, and countries suspected of possible terrorist financing or money laundering.[i] Indeed, FinCEN strongly encourages such voluntary information sharing. 

The financial institutions affected by the Russian sanctions include:

·       Casinos;

·       Depository Institutions;

·       Insurance Industry;

·       Money Services Businesses;

·       Mortgage Companies and Brokers;

·       Precious Metals and Jewelry Industry;

·       Securities and Futures. 

A financial institution is required to file a SAR if it - 

(A) knows, suspects, or has reason to suspect a transaction conducted or attempted by, at, or through the financial institution involves funds derived from illegal activity, or attempts to disguise funds derived from illegal activity;

(B) is designed to evade regulations promulgated under the BSA;

(C) lacks a business or apparent lawful purpose; or

(D) involves the use of the financial institution to facilitate criminal activity, including sanctions evasion.[ii] 

Furthermore, all statutorily defined financial institutions may voluntarily report suspicious transactions under the existing suspicious activity reporting Safe Harbor.[iii] 

Filing the SAR does not in itself mean that somebody is guilty of money laundering. Nevertheless, it is imperative to be attentive to efforts to evade the expansive sanctions and other U.S.-imposed restrictions implemented in connection with the Russian Federation’s invasion of Ukraine. 

In the last two months, Lenders Compliance Group has experienced a substantial increase in engagements for Anti-Money Laundering Program Tests (statutorily required), Anti-Money Laundering Program Risk Assessments, and Anti-Money Laundering Program Training (statutorily required). You must retain a recognized compliance firm whose audits, reports, and training meet a high level of regulatory scrutiny to ensure you have appropriate protection and remain in full compliance with FinCEN guidelines. 

Please get in touch with us HERE, and we’ll do our best to get your AML compliance needs into our schedule as soon as possible. 

In a recent FinCEN alert,[iv] FIN-2022-Alert001,” (sic) a set of select Red Flags were provided to identify potential sanctions evasion activity; however, the list is not meant to be exhaustive. The issuance also provides the obligations with respect to cryptocurrency, generically referred to as “convertible virtual currency” (CVC). 

Evading sanctions is nothing new for crooks. However, due to the Russian and Belarusian actions, sanctioned Russian and Belarusian actors may seek to evade sanctions through various means, such as by moving transactions through non-sanctioned Russian and Belarusian financial institutions and financial institutions in third countries. Red Flags should be taken as one of the tools to identify such transactions, but you will also need to add to the list as incidents require. 

Activities involving the evasion of sanctions are often conducted by various actors, including CVC exchangers and administrators within or outside Russia, given that these entities may retain at least some access to the international financial system. The money laundering pipeline consists of all manner of individuals, such as corrupt senior foreign political figures, their families, and their associates (viz., foreign “politically exposed persons” or PEPs),[v] or associated entities and financial facilitators, to evade U.S. sanctions or otherwise hide their assets.

Property Address required for a Loan Application

QUESTION 

In our compliance meeting, there was an extensive discussion about the “six pieces of information” that constitute an application. I know this is a TRID rule, but there are a few issues with this rule. 

We originate loans and use a subservicer. One issue for us is that sometimes we do not have the property address immediately, but we have everything else. We do not have a pre-approval program, and we’re careful to meet the six pieces of information for the application requirement 

But that brings up the debate as to how disclosure is provided for the property address in the first place. Eventually, we obviously get the property address, and our disclosures are updated accordingly. 

Is there an explanation for how timing the disclosure of the property address is important? 

How does the timing of the disclosure of a property address impact our originating and servicing loans? 

ANSWER 

As you likely know, in November 2013 the CFPB for the first time included a definition of “application” in Regulation Z as part of its TILA-RESPA Integrated Disclosures Rule (TRID Rule). Before then, Regulation Z had incorporated the definitions in Regulation X into its Good Faith Estimate requirements. 

The definition it included in 2013 states that for purposes of Loan Estimates, Closing Disclosures, and Special Information Booklets, an “application” consists of the submission of six pieces of information: 

(1) the consumer’s name,

(2) the consumer’s income,

(3) the consumer’s social security number to obtain a credit report,

(4) the property address,

(5) an estimate of the value of the property, and

(6) the requested mortgage loan amount. 

In developing a response to your question, I would like to approach it by discussing a recent decision of the U.S. Court of Appeals for the 3d Circuit, which specifically considered the timing of disclosure in relation to information involving the property address. The case is Nelson v. Acre Mortgage & Financial Inc.[i] 

Nelson, a retired, disabled military veteran, contracted with Classic Quality Homes to buy a house and used Acre Mortgage to obtain a mortgage loan. Nelson sued Acre, alleging that it violated TILA and RESPA by failing to disclose all material terms, improperly representing that Nelson would not have to pay property taxes, failing to make a reasonable and good faith determination of Nelson’s ability to repay, and failing to provide notice of the transfer of servicing rights to The Money Source, the servicer of the loan. 

The argument centered on a failure-to-disclose claim related to Acre’s alleged use of outdated documents. 

Let’s check the timeline. The CFPB’s revision of the regulations governing mortgage loan disclosures had an effective date of October 3, 2015. Nelson alleged that Acre improperly used the pre-October 3 disclosure forms for an application she made after that date. 

Acre moved for summary judgment, citing depositions of (1) Nelson, (2) an Acre owner, and (3) a Classic employee, along with documents including an application and disclosure forms Nelson had signed. The district court granted the motion because it found that no reasonable jury could return a verdict for Nelson on her TILA and RESPA claims. 

Not so fast, said the 3rd Circuit court! 

The 3d Circuit vacated the judgment, concluding that Acre failed to meet its initial burden to show no genuine dispute as to any material fact. While Acre had provided testimony and documents to support its own version of the events, those materials did not foreclose a reasonable jury from crediting Nelson’s contrary testimony instead and finding Acre liable. 

Now, let’s apply Regulation Z. 

According to Regulation Z,[ii] the October 3 disclosure forms apply only when “the creditor or mortgage broker receives an application on or after October 3, 2015.” Acre argued that it had properly used the pre-October 3 forms because the record showed it had received the 6 items constituting Nelson’s “application” on September 24, 2015. 

Acre claimed that: 

(1) an Acre employee testified that Classic initially referred Nelson to Acre in September regarding a mortgage loan for a newly constructed home;

(2) after speaking to Nelson by phone, Acre began preparing an application;

(3) Classic and Nelson later agreed she would instead purchase a refurbished home and Acre restarted the application process, again by phone;

(4) after Acre prepared the second application, Nelson came to the office in person;

(5) a loan application form included an attestation by Acre’s loan originator that she had collected the information supporting the second application by phone on September 24;

(6) a Good Faith Estimate reflected September 24; and

(7) disclosure forms contained Nelson’s signature and a September 24 date.