Managing the risk of ARM errors.
As mortgage rates continue their slow rise and market competition becomes ever keener, mortgage lenders are introducing new and more-complex ARMs.
Among the more recent wave of ARM product developments, we have seen the movement east of cost of funds - indexed (COFI) ARMs tied to the popular Federal Home Loan Bank 11th District Cost of Funds Index. Also, making a renewed showing are LIBOR ARMs tied to the London Interbank Offered Rate and 10:1 ARMs with rates that remain fixed for 10 years and then adjust annually.
Customers are responding to the appeal of lower start rates on ARMs and continuing to switch to the instrument that bolsters their purchasing power in the face of rising long-term interest rates. While the still-predominant Treasury-indexed ARMs as well as new offerings can provide a much-needed boost to mortgage production, the adjustable-rate mortgage can be difficult to service and creates more opportunities for errors in the way monthly payments or interest rates are set or adjusted.
Lenders have become more sophisticated in managing the risk of ARM error adjustments. ARM audits are being done on portfolios to discover initial errors in the way that ARM loans are set up in the servicing system. Also, new sophisticated software is available to help avoid some of the ARM problems that spurred class action lawsuits a few years ago.
Even so, this area remains one that requires vigilant management and safeguards. Along with the introduction of more-complex ARMs that are more subject to errors, increasingly savvy customers are no longer willing to assume that the calculation of their monthly ARM payment and/or interest rate is correct. Moreover, the threat of lawsuits remains, as attorneys and clients have seen that overcharges on ARMs and home equity loans is an area where legal action has been effective in the past.
This high level of interest in ARM adjustment errors can cost a bank or other mortgage lender hundreds of thousands of dollars if corrections are not handled properly. This fact, plus the desire to maintain positive customer relations, has prompted many mortgage lenders to actively investigate their ARM portfolios for errors on their own.
Further impetus for mortgage lenders to actively address this topic came from a set of guidelines issued earlier last year by Fannie Mae. Fannie Mae Announcement 94-04 set down for the first time specific guidelines for correcting mistakes that can occur with ARMs. It spells out what an institution should do if it discovers errors in its ARM portfolio and what mortgages the agency will (and will not) consider for purchase. Fannie Mae clearly spells out what it considers to be its liability should legal action be taken against an institution and/or itself as a result of these mistakes.
Should a servicer commit an error in the adjustment of one or more of its mortgages and be subject to legal action, Fannie Mae says the servicer will be fully responsible for litigating the suit and for any and all losses if not successful. This means that if Fannie Mae also is named as defendant in any lawsuit, the servicer will be responsible for reimbursing the company for any and all expenses.
While the need for conducting ARM audits has been well documented, three issues make an audit all the more critical today. First, now that Fannie Mae Announcement 94-04 has been issued, the industry has some official guidance to follow. Second, consumers have become more aware of the potential for ARM adjustment problems, and an increasing number of borrowers today recognize the opportunity exists to successfully bring suit. The result is increasingly high-profile attention to ARM errors. Third, ARMs are increasing in popularity and complexity, fueling the possibility of increased errors.
Today, as short-term rates rise, the potential for the problem to heat up increases. As ARM borrowers see their payments rise, the pressure on lenders to make correct adjustments grows. Who knows how many disgruntled ARM borrowers with payment shock might be tempted to seek out an attorney to see if they have grounds to sue because their lender hiked their payments too high? Furthermore, rising rates create opportunities for adjustment errors that produce undercharges as well as overcharges. Both hurt the lender.
Prior to the Fannie Mae announcement, guidelines found in the Truth-in-Lending Act and Section 941 of the Cranston Gonzalez Affordable Housing Act of 1990 addressed procedures for handling consumer inquiries and penalties for noncompliance. Section 941 gave federally regulated lenders 20 days to respond in writing and 60 days to make corrections to ARMs. However, it did not define the process for making those corrections.
Fannie Mac 94-04 incorporated previously established consumer response procedures and established a set of practices for servicers to follow when they review adjustments for Fannie Mac ARMs.
The Fannie Mae announcement does not require servicers to reaudit their ARM portfolios using its procedures if they recently completed an audit or have one under way. However, it does stipulate that all future audits be conducted using the new guidelines. The review can be undertaken as part of a full audit, a routine spot-check or as the result of an inquiry from a third party.
Fannie Mae cannot require servicers to perform audits on their own portfolios. However, in the absence of any other specific regulatory guidelines, the Fannie Mae procedures represent a blueprint for a prudent course of action.
Older ARMs cause trouble
Until the recent wave of more-complex ARM variations, the procedures for adjusting interest rates and monthly payments had become increasingly standard over the past 10 years. Yet the number of variables that must be taken into account on older ARM instruments continues to plague many servicers. This situation is particularly problematic when the portfolio contains hybrid ARMs that may have internal cost-of-funds indexes, implied as opposed to stated margins, interest rate floors or nonstandard forecast days. For example, one of our clients had written simple interest ARMs indexed to the six-month average of the one-year Treasury auction rate. Another had significant numbers of biweekly ARMs with odd-day (i.e., not first of the month) adjustment dates. Such features only exacerbate the potential for error.
Even sophisticated software does not guarantee freedom from error. The original loan setup, or a conversion from another system, could have resulted in an incorrect index, margin, per-adjustment cap or life-of-the-loan cap. In addition, the software may be designed to round all interest rate adjustments to the nearest eighth of a percent, but the bank may have older loans in its portfolio that either have no rounding requirement or round to the nearest quarter of a percent.
Many servicers have acquired loan portfolios and/or servicing originated by others without undertaking an audit or requiring seller warranties that the loans were serviced correctly. Regardless of how well buyers may service, they have assumed the liability of any errors made prior to the sale. In addition, if the servicing was acquired from an institution that subsequently failed, there is effectively no recourse.
Despite the Fannie Mae announcement and industry estimates that one-half to two-thirds of ARM portfolios contain some kind of error, no dramatic rush has occurred to conduct ARM audits. Some servicers are skeptical of these percentages. Still others don't feel they can afford the cost of an audit.
Yet, not investigating your ARM portfolio can backfire. Incorrect rate adjustments that result in overcharges clearly create liability and the potential for damages that can greatly exceed the amount of the overcharge. Interest undercharges, which statistically should occur as often as overcharges, can result in substantial lost income if not discovered. An audit at one large New England bank uncovered projected undercharges of $17 million over three years.
As the CEO of another New England bank says, "Fannie Mae has taken a prudent step. The issuance of these guidelines won't necessarily prompt action on the part of many banks - although it should." As a result of a single customer complaint, it conducted an audit of its entire portfolio and found numerous errors in how rates were being rounded. By taking a proactive approach, it avoided the legal and public relations nightmare that could have occurred had it just corrected the one loan.
As Lawrence Powers, president of Consumer Loan Advocates (CLA), Lake Bluff, Illinois, puts it, "It is far better to spend the time and money now, to see exactly what's in your ARM portfolio, than it is to discover it later when a class-action suit is filed against you." The nonprofit mortgage auditing firm claims that error rates on ARMs can run 40 percent or more.
CLA plays the role of consultant to consumers. Formed in 1990 by Powers and John Geddes, president of the company's analysis division, the organization's charter evolved from Geddes' early research and findings on the extent of the ARM problem. Testifying before the U.S. House of Representatives, he cited error rates of greater than 50 percent found in ARM portfolios he examined while employed by the now-defunct Federal Savings and Loan Insurance Corporation (FSLIC).
At the time of his testimony, much industry controversy existed over his error-rate findings and questions about whether they could be extrapolated to the industry as a whole or if they magnified the problem due to weaknesses unique to the thrift institutions he studied.
Nevertheless, Geddes went into the private sector and continued to work in the field of ARM adjustment errors. Early in 1994, his company entered an alliance with ARM Consultants International (ACI), Joliet, Illinois, to train qualified ARM analysts - including bank professionals, certified public accountants, lawyers and other professionals - using CLA's proprietary software and industry expertise. A CLA for-profit subsidiary also performs analyses for commercial entities and today counts a few bank lenders among its customers.
According to Powers, "One of the largest S&Ls in the country discovered a 19 percent error rate after conducting its own internal audit. But they were only auditing for overcharges," he adds.
Some ARM lenders are error free
ARM errors are not necessarily universal. "Some [lenders], for whatever reason, do it right," notes Powers. "Maybe it's because they hold most of the paper they originate."
More experience servicing ARM loans and more standardized ARM products also have helped the industry establish a better track record in making ARM adjustments. Technology has also played a part in making errors less prevalent.
"Over the last few years, many lenders have cleaned up much of their act, and we are finding fewer and less obvious problems than were apparent with the previously failing S&Ls," Powers says. "Now with interest rates going up rather than down, however, we are finding a swing from [discrepancies resulting in] just overcharges to undercharges."
Powers predicts that more and more ARM servicers will conduct thorough analyses to detect adjustment errors. "The only way to be sure that ARM adjustments are correct is through a complete portfolio analysis," he says.
Christian G. Koelbl III who chairs the financial services department of Hodgson, Russ, Andrews, Woods & Goodyear, a large law firm based in Buffalo, New York, agrees. "The incidence of mistakes in ARM portfolios is probably more widespread than some bankers would like to admit," he says. Koelbl, who spends a substantial portion of his time advising commercial banks on compliance matters, including how to handle ARM portfolio corrections, also says that "although federal bank regulatory agencies drafted guidelines on the matter early on, they were never issued. It's probably because the regulators concluded the matter involved breaches of contract rather than violations of regulations such as Truth-in-Lending."
Much of the ARM loans being written by mortgage lenders in today's market are ending up in the portfolios of commercial banks and thrifts. If a new crop of ARM adjustment errors results from this year's heavy ARM production, much of it likely will fall in the lap of bank and thrift servicers. Mortgage bankers, traditionally, have not been prone to build large ARM servicing portfolios. For this reason, professionals who advise financial institutions on compliance matters are taking the issue of ARM errors very seriously today.
"Banks with ARMs know they have a possible problem, but the ones actually taking time to audit their portfolios are in the minority," Koelbl says. When asked why these servicers may be reluctant to undertake an ARM portfolio audit he says smaller banks may feel it is too costly, while larger ones may think they have the problem under control.
"Often a bank's problem is not through its own action, but rather through portfolios acquired from failed institutions," according to Koelbl.
The problem is unlikely to disappear anytime soon. Although no industry statistics are available on the dollar volume of undercharges or overcharges, or on the number of errors discovered, we can only assume that the problems will be exacerbated as the total number of ARMs outstanding grows. From the first quarter of 1991 through the first quarter of 1994, adjustable-rate mortgages consistently accounted for less than 25 percent of the conventional mortgages written, according to the Mortgage Bankers Association of America (MBA). As of October 1994, ARM share almost doubled to 43 percent. MBA economists are forecasting the ARM share to remain above 40 percent for all of this year. MBA's forecast prepared earlier this year anticipates $600 billion in total residential originations for 1995.
Mortgage servicers cannot ignore with impunity this increasing potential for ARM errors. When deciding on whether to audit an ARM portfolio internally or engage an outside firm, consider the following:
* If you are going to conduct an external audit, consider your options carefully. Too often price becomes the only issue, when quality should be paramount. Conducting an internal audit can be like the fox guarding the hen house. Although well intentioned, the same staff who may have been the source of the problem are asked to find and correct it.
* If you are planning to conduct a sample analysis versus a complete portfolio review, keep in mind that a sampling may uncover a pattern of errors, but cannot guarantee that all mistakes are identified.
* When evaluating an outside firm, you should be shown the process the consultants will go through to conduct the audit on a step-by-step basis. Be sure they lay out protocols for your internal staff to follow after their departure.
* Finally, having the correct software is important. But remember, too much emphasis on software and not enough on training will not ensure that mistakes will not occur again. Make sure you address what caused the problem in the first place.
The key issues that will determine how to handle an ARM audit will vary from institution to institution. But the important thing is not to postpone it. If you do, you may find that you are left with a very costly problem.
RELATED ARTICLE: REVIEWING THE RULES
For those unfamiliar with Fannie Mae's guidelines for determining overcharges and undercharges on ARMs, here are the highlights.
1. For errors discovered in the interest rate and monthly payment amount, the reamortization must use the borrower's actual payment(s) and the correct interest rate(s), and compare the resulting unpaid balance to the actual unpaid balance. If the resulting unpaid balance is higher, the borrower was undercharged. If the balance is lower, the borrower was overcharged.
2. For errors discovered in the monthly payment only, the mortgage must be reamortized using the correct payment(s) and the correct interest rate, and then the resulting unpaid balance compared to the actual unpaid balance. If the resulting balance is higher, the borrower was overcharged. If the balance is lower, the borrower was undercharged.
3. For errors discovered in the interest rate only, the mortgage must be reamortized using the borrower's actual payment and the correct interest rate(s). The resulting unpaid balance is then compared to the actual unpaid balance. If the resulting balance is higher, the borrower was undercharged. If the resulting balance is lower, the borrower was overcharged.
4. The practice of netting overcharges against undercharges is permissible when multiple errors exist, for the same mortgage and all errors are related to the same borrower.
8. All corrections are subject to borrower notification requirements within 60 days of their discovery. If the error is discovered as a result of a borrower's inquiry, the mortgage servicer must send an interim response to the borrower within 20 days.
6. A servicer must correct an ARM adjustment error for a mortgage without waiting for the next scheduled interest rate and/or payment adjustment date, This requirement is applicable whether the discovery of an error is the result of
* internal audit
* audit by the servicer's regulator
* "due diligence" review by a potential transferee servicer
* notification from Fannie Mae
* inquiry directly from a borrower.
7. Borrowers must receive 25 days' advance notice before a change in payment amount is made, except when an error is discovered in the interest rate only. In that case, no advance notice is required other than the normally required Truth-in-Lending Act disclosures.
8. A servicer cannot require a borrower to make up an undercharge or change the mortgage's unpaid principal balance to correct any misapplication of monthly payments, unless it is specifically provided for under Fannie Mae procedures.
9. While the practice of netting overcharges and undercharges is permitted (see #4 above), this practice cannot be used for assumed mortgages, in which an overcharge or undercharge affecting a previous borrower would be "netted" against any overcharges or undercharges for a current borrower.
10. A servicer must give the affected borrower a cash refund or a credit for any net overcharge that totals $1.00 or more.
Jacob C. Gaffey is president of Capital Strategies Group Inc. in Providence, Rhode Island.