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ARMed and dangerous.


Until fairly recently, mortgage lenders' principal concerns with the Truth in Lending Act (TILA) involved disclosure requirements that were based on information known at the time the loan was originated. When TILA was enacted some 20 years ago, it focused on initial disclosures based on known information.

TILA's focus carried over into the disclosure rules for variable-rate or adjustable-rate mortgages (ARMs). Because the actual adjustments could not be predicted at the time the loan was taken out, TILA assumed, for upfront disclosure purposes, that the adjustments would remain the same. Therefore, in the case of an ARM transaction, the TILA disclosures were based on the interest rate (annual percentage rate, or APR), finance charge, total of payments and payment schedule known at the time of closing, despite the fact that the information disclosed would certainly change and might not even be representative of the true information throughout the life of the loan. To remedy this somewhat, Regulation Z, which implements TILA, provided that some information could be indicated as estimates, and it required certain generic disclosures for variable-rate disclosures.

Because of TILA's focus, there was a certain expectation, particularly in closed-end transactions, that if the lender got the information right at closing, it had little more to worry about in terms of disclosures. As every consumer lender should know by now, and as this article discusses, Regulation Z was amended, effective October 1, 1988, to require certain periodic disclosures in ARM transactions. The same amendments also require certain disclosures to be given at the time an application form is provided to a consumer or before the consumer pays a non-refundable fee, whichever is earlier. The new requirements resulting from these amendments have caused lenders to update certain information concerning their ARMs.

The amended Reg Z disclosure requirements may be the least of lenders' problems with ARMs. The bigger problem appears to be that many lenders failed to appreciate the fact that whether or not TILA required periodic disclosures, an ARM is, by its very nature, a constantly changing transaction. ARM adjustments must reflect the agreement between the lender and the borrower. That seems simple and self-evident, yet numerous recent audits of ARM portfolios have revealed that adjustments often have not been made in accordance with the promisory note and other mortgage documents.

It may be that with all the TILA focus on disclosures given at the time of consummation, lenders have given too little thought to ensuring that the adjustments in their ARM loans reflected the terms of their agreements with their borrowers. Whatever the reason for this problem, beginning last summer, lenders' errors in ARM adjustments have been the focus of nationwide attention. That attention has come from important sources: plaintiffs' lawyers bringing class-action lawsuits, the press, Congress and (now feeling lots of heat) the federal regulators who will examine more closely for these kinds of errors.

This article studies some of the possible causes of errors in ARM adjustments, discusses some of the legal liabilities and indicates some alternatives available to lenders when they discover that their ARM portfolios contain widespread errors.

Origins of ARM errors

Mortgage Dynamics Inc. (MDI), a management consulting firm based in McLean, Virginia, has audited a number of ARM-loan portfolios as part of due-diligence reviews for clients buying servicing and loan portfolios during the past three years. Based on these reviews, MDI has discovered the following types of ARM errors: * mistakes in the original loan set-up

process; * lack of agreement between terms

disclosed to the borrower and information

on the note and rider; * selection of the wrong index value

and, in some cases, the wrong

index; * selection of an index on the wrong

date; * failure to adjust in some years; * improper rounding or rounding the

rate when none is called for; * failure to reflect a loan modification

in the system; * miscalculation of the payment

amount; * incorrect allocation of the payment

amount between interest and principal;

and * incorrect posting of curtailments to

the month after received; thus creating

an overcharge of interest for the

following month.

There are some common threads running through the errors on this list. The nature of these ARM errors indicate three likely sources: a computer system/program that is unsuited for or incapable of handling the lender's ARM programs; inadequately trained or supervised staff who fail to understand the provisions of the promissory note or other loan agreements; and mechanical human errors in entering ARM data into a computer system. Unintentional, isolated "bonafide errors" under TILA, such as clerical, calculation, computer malfunction or printing errors, may not cause much of a problem, but systematic miscalculations or similar errors may create significant liability for lenders and those who acquire loan portfolios containing pervasive ARM errors.

Legal liability from ARM errors

The ARM errors listed above all involve situations where the loan adjustments were not made according to the terms contained in the promissory note or other loan documents. If the adjustments do not reflect the agreement between the lender and the borrower, the lender may be liable for damages resulting from breach of contract. If the ARM errors result in the borrower being charged more than he or she should have been under the terms of the agreement, the borrower may recover the difference between what should have been charged and what he or she was, in fact, charged.

The ARM errors might also involve TILA violations. This is more likely to be the case if the transactions were entered into after October 1988. Prior to that time, as indicated above, the principal disclosures required under that act were made only at the time of consummation, or prior to the loan closing if the transaction was subject to the requirements of the Real Estate Settlement Procedures Act (RESPA). In any event, these disclosures focused only on the information known to the lender at the time of consummation. Even though the information would certainly change, the lender did not have to take any further action. If the initial TILA disclosures complied with the law's requirements, as far as TILA was concerned, it did not matter whether or not the lender subsequently adjusted the ARM transaction according to the terms of the agreement.

ARM transactions entered into after October 1988 are subject to new TILA rules that require periodic disclosures. These disclosures must be made at least once a year if an interest rate adjustment does not result in a changed payment amount. If there will be a new payment amount, disclosures must be made within a certain number of days before the new payment amount is due. The new disclosures must reflect the current and prior interest rates; the index values on which these interest rates were based; the extent to which the interest rate caps (in ARM programs permitting carryovers) have limited the amount of the increase; the effects of the adjustment on such things as the payment amount and a statement of the loan balance; and the payment amount that would be required to fully amortize the loan over the remaining term (if the loan involves negative amortization).

If any of the disclosures required under the new TILA rules do not comport with the actual adjustments on the ARM transaction, there may be TILA violations. Current violations may be more widespread than allegations in present lawsuits would indicate. Remember that these requirements went into effect less than three years ago. The periodic disclosures are required one year after the ARM transaction is consummated. Therefore, if there are errors in adjustments that render the periodic TILA disclosures inaccurate, it may take some time for these violations to become apparent.

If a lender's errors in its ARM adjustments do involve TILA violations, the lender may be subject to liability in an individual or a class-action lawsuit. If the borrower prevails in such a suit, the court may award actual damages. (Those would probably be similar to damages for breach of contract discussed above: the difference between what the borrower contracted to pay and what he or she actually paid.) In addition, in an individual action, if the court finds a violation of certain TILA disclosure requirements, it must award penalties amounting to twice the amount of the finance charge or $1,000.00, whichever is greater.

In a class-action lawsuit, the lender's maximum liability for TILA violations is the lesser of $500,000 or 1 percent of its net worth. The court has more discretion in making an award in a class-action suit. TILA requires the court to consider the following factors: the amount of any actual damages, the frequency and persistence of the violations, the lender's resources, the number of persons adversely affected and the extent to which noncompliance was intentional.

The TILA liabilities discussed above mention actual damages. Suppose, however, that in an individual case, the ARM-adjustment errors were in the borrower's favor. In that case, if the errors also involve TILA violations, the borrower may still recover the automatic penalty. Recovery of that penalty does not require that the borrower suffer any loss from the TILA violation. That is important to remember in assessing liability for ARM-adjustment errors.

Whether or not lenders' ARM-adjustment errors involve TILA violations, there is additional potential liability for lenders resulting from such errors. Many states have enacted what are often referred to as "little Federal Trade Commission Acts," or "little FTC Acts." These laws are based on a provision of the Federal Trade Commission Act that prohibits "unfair or deceptive acts or practices." Many state FTC acts provide that the acts will be interpreted in accordance with the Federal Trade Commission's interpretation of its own act. The FTC has found that a breach of contract may constitute an "unfair or deceptive act or practice" and has also found that TILA violations may involve "unfair or deceptive acts or practices."

If a borrower can prove that a lender's ARM violations constitute a violation of a state little FTC act, the lender may be liable for treble damages, as well as attorney's fees and court costs. Many little FTC acts so provide.

In some cases involving unfair or deceptive acts or practices and TILA violations, the plaintiffs have alleged fraud or fraudulent concealment. Errors in ARM adjustments often appear to be unintentional. For this reason, plaintiffs might not prove fraud or fraudulent concealment in court, but these allegations could nonetheless be raised.

Allegations of fraud or violations of state little FTC acts might be pled in order to increase the time period within which a plaintiff could sue based on ARM-adjustment errors. Under TILA, plaintiffs have one year from the date of the violation within which to sue. (However, a borrower may raise a TILA violation at any time as a counterclaim in the lender's action to collect the debt, unless a state law would not so permit.) A state little FTC act might provide for a longer period of time within which a plaintiff could sue for such violations. In addition, a lawsuit based on fraud, especially on a theory of fraudulent concealment, might enable a plaintiff to recover for a longer period of time.

In addition to potential liability in lawsuits brought by borrowers' lawyers, lenders subject to the jurisdiction of one of the federal financial institution regulatory agencies may have to worry about liability arising as a result of an examination. As noted, the federal agencies are feeling the heat to reduce the incidence of ARM errors, and they have publicly stated that they will be giving ARMs closer scrutiny during their periodic examinations. If ARM-adjustment errors are discovered during the course of a federal examination, the regulatory agency may be able to order restitution. Restitution may not be available for all errors. Moreover, unless the violations are intentional, the agencies have some flexibility in terms of the amount of restitution to be ordered. In any event, the period for which the lender may be liable begins with the date of the prior exam (unless errors identified in a prior exam have not been corrected).

Lenders should also be aware that ARM-adjustment errors could present problems if they seek to sell their servicing rights or their loan portfolios. Purchasers will undoubtedly insist on any necessary corrective action, including restitution, for errors detected during due diligence.

Options for addressing ARM errors

If a lender discovers that it has committed ARM errors in the past, it will obviously want to take steps to ensure that these types of errors do not reoccur. The lender will also have to address its potential liability for past errors. TILA does shield a lender from liability for violations if the lender takes corrective action. Within 60 days of discovering an error, and before a lawsuit is filed based on the error, the lender can avoid liability if it notifies the borrower of the error and makes whatever adjustments in the borrower's account are necessary to ensure that the borrower will not be required to pay an amount in excess of the disclosed finance charge or the disclosed annual percentage rate, whichever is less. Correcting ARM-adjustment errors should also help the lender avoid liability for damages resulting from breach of contract and could alleviate liability under state little FTC acts.

It is important to understand that TILA does not require lenders to adjust past errors. Although it is a means of avoiding liability, it may also be an expensive option. Lenders facing potential liability because of ARM-adjustment errors should consult with counsel as to their best options under the circumstances.

In reviewing these options, the lender should be aware of several questions that have arisen for other lenders in correcting ARM errors. These questions include: * If the corrections result in refunds

to borrowers for overcharges,

should the lender pay interest? * If the ARM errors have resulted in

undercharges to a particular buyer,

should the lender seek to recover

those undercharges? * If, within an individual portfolio,

there are both undercharges and

overcharges, should the lender attempt

to "net out," or offset, the

amount of the borrower's overcharges

by the amounts that have

been undercharged?

In determining the best choices, it is important to understand that there is a paucity of reported case law dealing with lenders' actual liability and the borrower's potential recovery for ARM-adjustment errors.

The lender's best options will depend to some extent on the circumstances under which it is making corrections. For example, is a federal regulatory agency insisting upon correction? Is a prospective purchaser of the loan portfolio insisting upon it, or is the lender facing a possible lawsuit? In each of the above situations, there may be some room for negotiation.

The recent Federal Trade Commission consent agreement involving Guild Mortgage Company (In the Matter of Guild Mortgage Company, Federal Trade Commission Docket No. C-3320, December 31, 1990) may illustrate effective negotiations in limiting the amount of restitution to be paid for TILA violations. Guild Mortgage offered an initial discounted rate, followed by an adjustable interest rate based on an index and margin. In calculating the APR, Guild Mortgage used only the initial discounted rate and, therefore, consistently understated the true APR and overcharged its borrowers by that amount.

In making restitution of the overcharges, Guild was allowed to take advantage of TILA's tolerance for errors in APR calculations and to make restitution only in the amounts by which its APR errors exceeded that tolerance. The section of the TILA under which federal agencies may order restitution is silent as to whether there is any tolerance for APR errors in such orders. The FTC or a court might have concluded that TILA's tolerance for APR errors only applies in determining whether there is an error, not in deciding how much restitution is appropriate when there have been errors, especially when the errors were attributable to apparent mistakes as to the basis for the APR calculations, rather than mistakes in APR computations. Apparently, Guild Mortgage persuaded the FTC staff and all but one FTC commissioner that it should be given extra tolerance in making restitution. The commission voted four to one to accept the consent settlement.

Although the Guild Mortgage case did not involve ARM-adjustment errors, it is an important precedent for lenders faced with some difficult decisions when they discover ARM-adjustment errors in their loan portfolios. The lesson from Guild Mortgage is that there may be room for negotiation in correcting TILA errors.

In the case of ARM errors, whether or not they involve TILA violations, there may be circumstances benefiting the lender's negotiations. First, as the above information from Mortgage Dynamics and other sources indicates, although ARM-adjustment errors may be widespread, they are usually the result of misunderstandings, mistakes or carelessness. They may be serious, but they are rarely the result of intentional wrongdoing. ARM transactions can be very complex. TILA and similar legal requirements can be difficult to follow. The complexity of the law and of ARM transactions, coupled with the lack of intentional wrong, may help a lender in negotiating a fair settlement for past ARM errors. That is the good news in an area of continued difficulty and risk for mortgage lenders.

Anne P. Fortney is a partner in the Washington, D.C., office of Carlsmith Ball Wichman Murray Case Mukai & Ichiki. Formerly director of the Federal Trade Commission's Division of Credit Practices, Ms. Fortney has more than 15 years' experience in consumer credit, mortgage lending and financial services law.
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Title Annotation:errors in adjustable rate mortgages adjustments
Author:Fortney, Anne P.
Publication:Mortgage Banking
Date:Jun 1, 1991
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