www.hudclips.org U. S. Department of Housing and Urban Development Washington, D.C. 20410-8000 July 10, 1996 MORTGAGEE LETTER 96-34 TO: ALL APPROVED MORTGAGEES SUBJECT: Single Family Loan Production - Automated Underwriting Systems In Mortgagee Letter 95-7 (ML 95-7), we announced that FHA would permit lenders to use automated underwriting systems (AUS). Although FHA did not approve or endorse these systems per se, lenders could request permission to use them for underwriting FHA mortgages. While FHA will continue to approve such requests, under the conditions described below, we will now also offer direct approval of individual AUS with lenders permitted to simply register their use of an approved AUS and agree to any required conditions. Since the issuance of ML 95-7, we have observed the continuing refinement and acceptance in the marketplace of various automated underwriting systems and their potential for expanding access to new borrowers, streamlining processing, and enhancing risk management. We also recognize that there are concerns about how the introduction of this technology will affect service to certain market segments, particularly those borrowers who have traditionally been underserved by the mortgage market. FHA has developed a process by which it would consider approval of automated underwriting systems themselves. This process will allow FHA to ensure that the use of any approved system will meet FHA's policy objectives: To identify and approve credit-worthy borrowers that would have been excluded from homeownership under current FHA credit guidelines; To ensure that credit-worthy borrowers meeting existing FHA underwriting guidelines are not excluded from homeownership; To expand access to mortgage credit for low- and moderate-income borrowers and to prevent unlawful discrimination against borrowers protected by the Fair Housing Act and the Equal Credit Opportunity Act; To reduce the cost and time associated with originating FHA-insured mortgages; and To enhance our ability to assess risk and manage FHA's mortgage insurance fund. This mortgagee letter sets forth basic requirements of an acceptable AUS and describes the process that we intend to follow in reaching a decision whether to approve an automated underwriting system. Automated systems come in various forms. Some automate the rules that are embodied in underwriting criteria. Others are based on custom mortgage scorecards that are empirically-derived predictors of the risk of default based on selected components of the loan application. Some are a combination of both. Others use neural networks or case-based reasoning to enhance decisionmaking. With these systems, a provider of credit can offer additional underwriting flexibilities and lessen documentation requirements. In addition, portfolio analysis and lender credit risk profiles can be made more accurate through such systems. Equally important, since loan performance is a combination of underwriting and servicing, automated underwriting/risk assessment systems allow lenders to concentrate their servicing activities on those loans where quick intervention may cure a default or mitigate loss. Under the terms and conditions described below, FHA will approve automated underwriting systems that it concludes will help FHA to achieve its policy objectives. For those systems that demonstrate the predictive power of an empirically-based scorecard, we will also consider credit policy revisions as well as documentation reductions. FHA may impose different requirements on lenders using an approved system than on those who use traditional FHA underwriting. Approval will only be granted to those automated systems that meet these terms and conditions and, at this time, these approvals will relate only to mortgage scoring, not separate collateral assessment tools, but FHA reserves the right to consider such tools at a later date. AUS Screening Process: Only viable, operational automated underwriting/risk assessment systems that survive an initial review will be evaluated. To qualify for evaluation, a sponsor or developer of an AUS must provide to FHA's Office of Single Family Housing in Washington, D.C., the following: System and development process description. The system developer must first demonstrate an expertise in automated underwriting or mortgage scoring model development and explain the development process, how it tests validity, how often it refreshes data, adjusts its scorecard, etc. The developer must provide a detailed description of the system, including whether it is rules-based, relies on statistical modeling, uses neural networks or case-based reasoning, or uses combinations of these. Information provided by the system developer will be designated as confidential and will not be made available beyond the Department unless required by law. Market acceptance. The AUS must be used by a substantial number of FHA- approved lenders (even if only used on conventional mortgages). Only those that have gained wide acceptance by mortgage lenders and are available for use throughout the nation will be considered. Exclusion of rejecting systems. FHA will not consider for approval any system whose intended use would allow the system to make the decision to reject an application for an FHA-insured loan. The AUS must only result in mortgage approval or referral to a human underwriter. AUS Evaluation Process: Those systems that survive the initial screening will be subjected to an evaluation by FHA. During this process, the systems sponsor must demonstrate to FHA that the AUS is an effective predictor of the risk of default of a FHA loan and that its predictive capacity is strong for various different cohorts of borrowers. This process includes: Provision of FHA loan-level data. FHA will consider written requests to provide loan-level data to the system sponsor for the purpose of developing and validating any mortgage scorecard. In exchange for the data, the sponsor must agree to certain terms and conditions including sharing of any information collected concerning the sample FHA loans and the results of testing of the predictive capacity of its scorecard. Default predictability. The system must be shown to be a statistically reliable predictor of the risk of default, with the validity of the system being empirically assessed through an adequate sample of FHA mortgages. If a mortgage score is used, there must be a demonstrated relationship between that score and the risk of mortgage default across various subsets of the portfolio. Scrutiny will be given to the elements used in building a mortgage scorecard and, when appropriate, consideration given to possible alternatives. "Cut-point" determination. The system sponsor must provide FHA with various analyses as requested to permit FHA to determine the appropriate level of risk it wishes to assign to different outcomes from the system (i.e., accept or refer). For a system to be approved, the establishment and adjustment of those cut-points must always be within FHA's control. Moreover, the system sponsor must be prepared to provide FHA with ongoing analyses in the form specified by FHA to monitor the appropriateness of those cut-points. Credit policy revisions. Based on analyses of the system's performance, FHA may revise credit policy and/or documentation in response to the validity and predictiveness of the system. Credit policy revisions and documentation reductions will be specific to the AUS itself, i.e., depending on the demonstrated predictability of the system, FHA may offer varying levels of documentation relief and underwriting flexibility. Mortgages underwritten by rules-based automated systems must continue to meet standard FHA credit guidelines. Compliance with Fair Housing Act and Equal Credit Opportunity Act. FHA must be satisfied that use of the AUS would comply with the Fair Housing Act and the Equal Credit Opportunity Act. System sponsors may be asked to provide information to help FHA ascertain that the development of the system was consistent with those Acts' requirements. FHA may establish requirements for the AUS to ensure that its use does not result in discrimination against, or have a disproportionately adverse impact on, minority or other classes of borrowers. AUS Demonstration Process: Systems that survive the evaluation process will be required to be subject to a demonstration of their use in the origination of FHA-insured mortgages before FHA will consider system approval. Typically, a demonstration would consist of the use of the system for a limited time period, by a limited number of different lenders, for a limited number of loans. The demonstration would be structured to gather information about whether use of the system in some or all circumstances would be consistent with FHA's policy objectives. FHA may waive this demonstration requirement if it determines that other mechanisms are sufficient to make that determination. During a demonstration, required procedures, credit policy revisions, and documentation reductions may vary among the lenders chosen to test the AUS. The demonstration will be designed to permit scrutiny of whether use of the AUS limits, maintains, or expands FHA's reach to credit-worthy homebuyers. Loan-level review of loans approved by the automated underwriting system, as well as loans referred to human underwriters, may be performed. FHA may also seek to determine how underwriter judgments may have been influenced by AUS referrals, i.e., exhibiting a decreased likelihood of approving loans that would have been made previously. Finally, interviews with lenders, counseling agencies, and others with access to the AUS may be conducted. AUS Continuous Evaluation: FHA will continuously evaluate any AUS that is approved. Once a system is approved, FHA will assign a CHUMS number identifying the AUS for loan tracking purposes. Lenders will also be required to register their use of any approved automated system, obtain a special CHUMS number and agree to whatever conditions we require in connection with that system. Approval of a system may be subject to requirements for periodic reporting and monitoring on the system, its continuing predictive power, and the results of its use. Credit policy and documentation revisions proposed by the system developer after the evaluation and demonstration process must be approved by FHA Headquarters. FHA's approval of any AUS may be revoked at any time upon notice that the AUS no longer serves FHA's policy objectives or results in unacceptable loan quality. Lender's Use of AUS: When FHA approves a particular AUS, it will establish guidelines for its use to which the lender must adhere if it intends to use the AUS in the origination of FHA mortgages. These guidelines may include the extent of credit policy and documentation waivers permitted in connection with the use of that system, as well as requirements to emphasize the lender's responsibilities to ensure nondiscriminatory use of the system. * * * FHA is committed to expanding homeownership opportunities for first-time homebuyers, low- and moderate-income families, non-traditional borrowers, minorities, women, and those that might otherwise be denied conventional financing. While FHA's current credit policies are flexible yet prudent, automated underwriting/risk assessment systems can be powerful tools in the expansion of homeownership while at the same time allowing lenders and mortgage insurers to proactively manage the risk inherent in all lending. Further, as FHA's paperwork reduction and other efforts have demonstrated, FHA seeks to make participation in FHA programs less costly for the lender as well as the homebuyer. Additional information regarding this process and the loan-level data element layouts available to systems sponsors may be obtained from James Beavers, Underwriting Branch, Home Mortgage Insurance Division, Room 9272, HUD Headquarters, 451 7th Street, Washington, DC 20410 or by calling (202) 708- 2700 Ext. 2205. Sincerely, Nicolas P. Retsinas Assistant Secretary for Housing- Federal Housing Commissioner