A knowing standard: HUD issues final rule clarifying lenders' accountability for faulty FHA appraisalsPhil Schulman and Emily J. BoothHUD,FHA,Compliance
On July 20, 2004, the U.S. Department of Housing and Urban
Development ("HUD" or "Department") issued a final rule ("Rule")
codifying the Department's position regarding lender accountability
for faulty appraisals.
The Rule, which follows HUD's issuance of a proposed rule
("Proposed Rule") on Jan. 13, 2003, amends Parts 25 and 203 of
HUD's regulations to provide that a mortgage lender will be held
responsible, along with the appraiser, for the quality of an
appraisal in a Federal Housing Administration ("FHA") insured
mortgage loan transaction. While the Proposed Rule suggested that
lenders would be held strictly liable for the quality of appraisals
performed by independent appraisers in FHA transactions, the
preamble to the final Rule clarifies that a lender will be held
responsible only to the extent the lender knew or should have known
of deficiencies in the appraisal. The Rule became effective on Aug.
19, 2004.
The following is a summary of the final Rule and reviews the
effects of the Rule in light of the Department's existing
regulations and guidelines.
The Final Rule
The Rule amends three provisions of HUD's regulations.
First, the Rule amends 24 C.F.R. § 25.9(ee) to provide that
the Mortgagee Review Board ("MRB") may take administrative action
against a mortgage lender that submits an appraisal that fails to
comply with FHA guidelines. A mortgage lender will now be subject
to administrative action for: "Submitting, or causing to be
submitted, with an application for FHA mortgage insurance an
appraisal, valuation condition sheet, or any other documentation
relating to an appraisal that does not satisfy FHA requirements."
Note that the MRB has authority to take various types of
administrative action against a mortgage lender, including:
issuance of a letter of reprimand; placement of the lender on
probation; suspension or withdrawal of a lender's FHA approval;
imposition of civil money penalties; and execution of a settlement
agreement.
Second, the Rule adds the following language to the end of
Section 203.5(e)(1): "A mortgagee must select and appraiser whose
name is on the FHA Appraiser Roster, in accordance with 24 CFR part
200, subpart G."
Third, the Rule adds Section 203.5(e)(3), which provides:
"A mortgagee and an appraiser must ensure that an appraisal and
related documentation satisfy FHA requirements and both bear
responsibility for the quality of the appraisal in satisfying such
requirements. A Direct Endorsement Mortgagee (and any of its loan
correspondent lenders) that submits, or causes to be submitted, an
appraisal or related documentation that does not satisfy FHA
requirements is subject to administrative sanction by the Mortgagee
Review Board pursuant to 24 CFR part 25 and part 30."
These amendments are identical to those set forth in last year's
Proposed Rule, except that the new Section 203.5(e)(3) states that
both the lender and appraiser "bear responsibility" for the quality
of the appraisal, whereas the Proposed Rule had stated that the
lender and appraiser "shall bear equal responsibility" for the
quality of the appraisal.
The Proposed Rule focused on the conduct of unscrupulous
appraisers and lenders that force appraisal computations to match
sales prices in order to ensure that homes sell and mortgage loans
close. It referenced predatory lending practices and property
flipping schemes to inflate home prices and generate excessive fees
to buyers and sellers, which could have been prevented by
underwriters' proper review of appraisal reports. The final Rule
reiterates the Department's goals underlying the issuance of the
Proposed Rule, which are:
†To protect the FHA Insurance Fund;
†To avoid unexpectedly and costly repairs to properties
that often result in default and foreclosure;
†To clarify HUD's regulations concerning the
responsibilities of lenders in assuring the quality of FHA
appraisals;
†To promote better compliance with appraisal standards;
and
†To ensure that homebuyers receive an accurate statement
of appraised value.
The effects of the final rule: A knowing
standard
When HUD issued the Proposed Rule in January of 2003, it
appeared that the Department was seeking to impose strict liability
on lenders for deficiencies in FHA appraisals performed by
independent third parties. The proposed regulatory language stated
that a lender would "bear equal responsibility" with the appraiser
for the quality of an appraisal, and the Summary of the preamble to
the Proposed Rule indicated that lenders would be held "strictly
accountable" for FHA appraisals. It, therefore, was believed that
lenders ultimately would be required to guaranty the performance of
independent appraisers without any finding of fault on the part of
the lender. Over the past year and a half, however, the Department
has considered industry comments on the Proposed Rule, and the
final Rule clarifies that "lender accountability does not mean a no
fault liability" and that lenders will not be subject to a strict
liability standard. This position is consistent with the
Department's existing guidelines, though it does raise certain
concerns for loan correspondent lenders.
A. Public comment on the proposed rule
The Department received 34 public comments on the Proposed Rule,
including comments from the Mortgage Bankers Association of America
and from some of the largest mortgage lenders in the nation. These
comments raised several concerns with the proposed regulatory
changes. For example, commenters suggested, among other things,
that:
†HUD should enforce its existing requirements more
strictly rather than imposing new regulations because there are
already several existing statutory and regulatory systems in place
to safeguard the integrity of FHA appraisals;
†The Proposed Rule conflicted with the purpose of the FHA
Appraiser Roster because an appraiser's placement on the Roster
constitutes tacit approval by HUD of the appraiser and it is both
unfair and unreasonable to hold lenders liable for faulty
appraisals performed by appraisers on the Roster; and
†The proposed changes would increase costs to homebuyers,
discourage lenders from participating in FHA loan programs and
negatively impact the quality of appraisals.
Most of the public comments, however, criticized the Proposed
Rule's apparent intent to hold lenders strictly liable for the
quality of third-party appraisals. Commenters stated that lenders
are not trained in the intricacies of the appraisal process and
cannot identify inaccuracies resulting from appraisers' on-site
reviews. They also suggested that HUD lacked legal authority to
hold lenders strictly liable for the quality of appraisals
performed by third parties.
B. HUD rejects strict liability for a knowing
standard
HUD diligently considered the public comments that it received
on the Proposed Rule and responded to the industry's concerns in
the final Rule. Although the regulatory language in the Rule is
substantially the same as that in the Proposed Rule, the Department
has clarified that lenders will not be subject to a strict
liability standard and that the standard for administrative action
will be the same as that contained in Part 30 of the Department's
regulations for civil money penalties, which require a knowing and
material violation.
Specifically, the Department explains in the Rule that the
standard for accountability "is one of knowing (actual knowledge)
or had reason to know." When HUD identifies deficiencies in an
appraisal submitted to the Department with a loan for FHA
insurance, HUD will not look solely to the appraiser as the
responsible party, but will consider whether the lender knew or had
reason to know the appraisal was deficient. Where it is determined
that a lender knew or should have known of appraisal deficiencies,
the lender will be subject to administrative sanctions and civil
money penalties by the MRB under Parts 25 and 30 of the
Department's regulations. The Rule states that, "if an appraisal is
determined to be faulty and/or non-compliant with FHA requirements,
HUD may seek administrative sanctions against either or both of the
parties, depending upon the particular circumstances of the
case."
The knowing standard set forth in the Rule is consistent with
the Department's existing regulations and guidelines. The
Department's pre-existing regulations, as well as several HUD
Handbooks and Mortgagee Letters, already require mortgage lenders
to review and analyze appraisal documentation to verify data
integrity and ensure compliance with FHA standards. For example,
the existing guidelines require a lender to review the factual
information in the appraisal report, assess the reasonableness of
the appraiser's conclusions based on the information contained in
the appraisal report, determine whether the conclusions in the
appraisal report are consistent with other file documentation, and
certify that the underwriter has personally reviewed the appraisal
report and that the loan complies with FHA requirements. The final
Rule merely codifies the Department's intent to hold lenders
accountable for their failure to adhere to the existing
requirements and/or their knowing submission of deficient
appraisals to HUD. Such a standard would not appear to raise
objections within the lending community. In fact, codification of
the Department's position in the Rule could prove helpful to
mortgage lenders. For instance, over the past several years, some
of the HUD Homeownership Centers have taken an aggressive stance
regarding lender accountability for faulty appraisals and have
attempted to hold lenders accountable for deficiencies that they
could not have detected. For example, HUD field personnel assigned
to various Quality Assurance Divisions have requested that lenders
fund property repairs and/or indemnify HUD when an appraiser
neglected to identify necessary repair items or included inaccurate
information in the appraisal report, despite the fact that the
lender could not have known of such deficiencies. The Rule's
clarification that lenders will be held only to a knowing standard
will assist the industry in ensuring that strict liability does not
exist.
C. Loan Correspondent Lenders
While the Rule is consistent with the Department's existing
regulations and guidelines, it does raise a concern regarding the
accountability of loan correspondent lenders. As in the Proposed
Rule, the preamble to the final Rule states that the regulatory
changes will apply to "lenders, sponsor lenders and loan
correspondent lenders" and the new Section 203.5(e)(3) provides
that a "Direct Endorsement Mortgagee (and any of its loan
correspondent lenders)" may be subject to administrative action
and/or civil money penalties for the submission of deficient
appraisals. While a loan correspondent lender that submits an
appraisal report to its sponsor and/or HUD knowing of deficiencies
in the report admittedly should be subject to administrative
action, the Rule potentially could be applied without consideration
of the fact that appraisal review is an underwriting function that
loan correspondents are not permitted to perform.
FHA guidelines expressly define appraisal review as an
underwriting function. The Single Family Direct Endorsement Program
Handbook states: "Since loan correspondents cannot perform any
underwriting function (i.e., review of the appraisal, mortgage
credit examination or underwriting), no specific Direct Endorsement
training is required for the correspondent." Other FHA guidelines
likewise require the underwriter, not the loan correspondent, to
review an appraisal report to determine whether the appraiser's
conclusions are acceptable. While a loan correspondent may select a
HUD-approved appraiser to perform the appraisal of a particular
property, the loan correspondent is not trained in underwriting
issues and is not responsible for reviewing appraisals to determine
their acceptability. Thus, to the extent the Rule may be used to
hold loan correspondent lenders accountable for deficiencies that
the underwriter should have identified, such application of the
Rule would be contrary to the very nature of a loan correspondent's
business. It appears that the situations where a loan correspondent
would be accountable under the new Rule should be limited to those
where the correspondent knew or should have known of deficiencies
in the appraisal for reasons unrelated to review of the actual
appraisal report (e.g., the loan correspondent had reason to know
that the appraiser intended to inflate the property value, the loan
correspondent received a complaint from the borrower regarding the
appraisal or other similar situations). The Department's position
regarding this matter is unclear from the language of the Rule,
though HUD did recognize in its response to public comments that,
"under the Direct Endorsement process, the lender's Direct
Endorsement underwriter (or, in case of a loan correspondent, its
sponsor's Direct Endorsement underwriter) is already required to
review the appraisal documentation."
Although the final Rule does not appear to impose any new
requirements on FHA mortgage lenders, it does reflect the
Department's continued efforts to increase oversight of the
appraisal process and enhance lender accountability for deficient
appraisals. The Rule follows in the wake of several
appraisal-related advancements, including, among other things,
implementation of a Homebuyer Protection Plan, amendments of
Handbook requirements, designation of a sanctions matrix for
appraisers, creation of the FHA Appraiser Roster, and
implementation of the Appraiser Watch Initiative. Given HUD's
strenuous efforts to preserve the integrity of FHA appraisals and
hold lenders accountable for appraisal deficiencies, it is crucial
that lenders take their appraisal responsibilities seriously and
ensure their personnel are intimately familiar with appraisal
requirements.
For more information regarding FHA appraisal requirements,
visit www.hud.gov or www.hudclips.org.
Phil Schulman is a partner with the Washington, D.C.-based
law firm, Kirkpatrick & Lockhart LLP. He can be reached at
(202) 778-9027 or e-mail
[email protected].
Emily J. Booth is an associate partner in the Washington,
D.C.-based law firm, Kirkpatrick & Lockhart LLP. She can be
reached at (202) 778-9112 or e-mail
[email protected].
Reprinted with permission from the Kirkpatrick &
Lockhart AlertMortgage Banking Commentary, July 2004.
