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Adjusting to the perils of ARMS.

Adjusting to the Perils of ARMs

Not since its advent in the late 1970s has the adjustable-rate mortgage (ARM) been the focus of attention equivalent to what it is now getting from the mortgage lending community, the press, consumers and, increasingly, the courts and federal regulators. The focus today, however, is not on the initial interest rate, as it was in the heyday of the teaser-rate ARM, but is rather on the accuracy of lender's calculations in making subsequent adjustments to that rate.

ARM loans take off

Extraordinarily high interest rates in the early 1980s spurred the growth of ARMs; thus, they became a viable alternative to fixed-rate mortgages. The Mortgage Bankers Association of America (MBA) estimates that about 26 percent of the dollar amount of one-to four-family mortgage debt outstanding at the end of 1990 was ARM debt--nearly a sixfold increase from the 1982 level.

Early ARM products carried higher risks for borrowers; deeply discounted initial interest rates and no interest rate caps were common. The major secondary mortgage market agencies--Fannie Mae and Freddie Mac--have been instrumental in standardizing ARM products by promoting the use of readily identifiable indexes and standard adjustment periods. Even so, Fannie Mae currently purchases more than 60 different ARM products. Furthermore, early ARM loans that have not been converted to a more standard ARM product continue to be serviced and finally, require an understanding of and facility with the technology used to set up and adjust the borrower's interest rate/payments.

Thus, the proliferation and complexity of ARM products requires careful attention to borrowers' legal documents, timely reference to outside sources of information on index values and expertise with the technology used to set up and adjust the borrower's interest rate and payments. Additionally, the advent of these products have also brought about federal laws regulating disclosures and proper adjustment notice provisions.

The error scare

Although mortgage lenders have been originating and servicing ARMs for more than 10 years now, widespread doubt about the accuracy of the calculations used in adjusting borrowers' interest rates surfaced only as recently as 1989. John Geddes, a former employee of the Federal Savings and Loan Insurance Corporation (FSLIC), in a report released in October 1989, claimed an error rate of more than 50 percent in an audit of 7,000 adjustable-rate loans originated by thrift institutions located primarily in the Midwest. Geddes approximated that 35 percent of all loans nationally had some error in their adjustments and charged that incorrect adjustments by thrifts had resulted in $8 billion in overcharges to consumers from 1979 to early 1989.

Geddes contacted Senator Richard Lugar (R-IN), in whose state many of the surveyed ARM loans were originated and/or serviced. In July 1990, Lugar requested that the General Accounting Office (GAO) review Geddes' report and determine whether or not consumers could be reimbursed for overcharges.

The GAO did look into the Geddes survey and in October, issued a report in response to Senator Lugar's request. The GAO review of the study and the results of its own analysis indicated that Geddes' estimate of the error rate was too high. Two GAO analysts placed the error rate at between 20 to 25 percent and another estimated it to be 31 percent. In addition, the GAO's review indicated that Geddes' analysis included adjustable-rate loans other than mortgages and that the data used in the study may not have been representative of the nationwide situation, because ARMs are less common in the Midwest than in other regions of the country. The GAO's analysis revealed that it was unable to estimate what proportion of all outstanding ARMs were misadjusted or the aggregate costs of any misadjustments. It was also unable to determine if existing state and federal laws required lenders to reimburse borrowers for overcharges.

Class-action lawsuits

Before the issuance of the October 1990 GAO report, a class-action lawsuit was brought in federal court in Indiana alleging violations of the Truth-in-Lending Act (TILA) and breach of contract.

In the complaint filed against Workingmen's Federal Savings Bank, Bloomington, Indiana, plaintiffs alleged that the institution's failure to adjust the plaintiff's ARM interest rates in accordance with their TILA and Regulation Z, which implements TILA. As a result, the defendant was required to make all the credit-term disclosures required under TILA, including disclosure of the circumstances under which an interest rate adjustment would be made. Plaintiffs alleged that the savings bank's failure to make the required disclosures before consummation of the transaction violated TILA and Regulation Z, thereby entitling the borrowers in the suit to compensation for actual damages and other relief provided by TILA.

Under the breach-of-contract claim, plaintiffs alleged that they had performed all the terms and conditions on their part to be performed under the terms of their ARMs.

In support of the defendant's motion for summary judgment, the defendant institution stated that it was entitled to summary judgment because "only a refinancing is a new transaction requiring new truth-in-lending disclosures" and that a refinancing occurs in a closed-end credit transaction only when the existing obligation is satisfied and replaced by a new obligation. According to the brief, a refinancing did not take place.

At the time this article went to print, the class of plaintiffs had not been certified, and cross-motions for summary judgment had been filed. Meanwhile, similar suits have been brought in other states, including California, Georgia, North Carolina, Pennsylvania and Michigan.

The Federal Reserve and FTC

The Board of Governors of the Federal Reserve System, commonly known as the Federal Reserve, is responsible for issuing interpretations of TILA provisions. Actual enforcement authority for violations of TILA by independent mortgage companies resides with the Federal Trade Commission (FTC).

The Federal Reserve amended its official staff commentary in April 1991 by adding comment 226.20(c)3, which states that disclosures required under section 226.20 shall reflect the terms of the parties' legal obligations, as required under section 226.17(c)(1). According to the Fed, the clarification arises from concerns raised recently that some creditors may not be adjusting their variable-rate loans in a manner consistent with the terms of the underlying legal obligation, resulting in inaccurate interest-rate and payment adjustments. Under section 226.20(c), disclosures about the new interest rate and payment must be based on the index type and value specified in the legal obligation.

Section 108 of TILA, titled "Administrative Enforcement," gives authority to various regulatory agencies to enforce the TILA in cases where the annual percentage rate (APR) or finance charge was inaccurately disclosed. It also gives authority for regulators to notify the lender of the disclosure error and to require the lender to make an adjustment to the account of the person to whom credit was extended. Further, under this section, regulators are able to assure that the borrower will not be required to pay a finance charge in excess of the finance charge actually disclosed or the dollar equivalent of the annual percentage rate actually disclosed, whichever is lower.

Section 130 of TILA provides for civil liability for failure to comply with the act's requirements, except that a creditor has no liability under sections 108, 112 (criminal liability for willful and knowing violation) and 130, if within 60 days after discovering an error, whether pursuant to a written examination or the creditor's own procedures, it notifies the affected borrower and makes the adjustments previously mentioned.

This 60-day provision has been interpreted by some attorneys as applying to errors in ARM adjustments, as well as to errors in the finance charge or annual percentage rate, although it is unclear whether this section was meant to apply to errors in adjusting the interest rate or only to errors in making the required disclosures. The April amendment to the Regulation Z official staff commentary may be persuasive to a state court under a breach-of-contract action, but does not represent a definitive resolution of this question, especially if unfair trade practices are alleged, according to Margaret England, vice president and counsel for Wachovia Mortgage Company, Winston-Salem, North Carolina.

Federal agency guidelines

The Task Force on Consumer Compliance of the Federal Financial Institution's Examination Council (FFIEC), which is composed of the Federal Reserve Board, Office of the Comptroller of the Currency, Office of Thrift Supervision, Federal Deposit Insurance Corporation and the National Credit Union Administration, issued interagency procedures in October 1990 for federal regulators to use in conducting examinations of ARM loans. The task force is expected to meet this summer to try to develop a uniform policy on corrective measures the agencies should follow when their examinations reveal inaccurate or untimely adjustment notices, improperly adjusted interest rates or otherwise incorrectly serviced ARMs.

"Some federal agencies have decided that when a lender makes an ARM-adjustment error that results in an overcharge, the lender should reimburse the borrower; when it results in an undercharge, the lender should eat the loss," says Paul Schieber, a compliance attorney with Blank, Rome, Comisky & McCauley in Philadelphia. "Independently, as a matter of contract law, lenders could probably recover for undercharges, but we're working in a regulatory environment, and the regulators have voiced opposition to this approach," he added.

According to Carole Reynolds, senior advisor with the FTC, issues relating to adjustment errors are being reviewed by the FTC in the context of TILA, to the extent they arise in a particular case, and in the context of the Federal Trade Commission Act, which prohibits unfair or deceptive acts or practices in commerce. The FTC expects to issue guidelines in the future.

MBA's task force--fighting the error war

In response to concerns over ARM-adjustment errors and potential lender liability, MBA formed a task force to study the issues. The task force was composed of representatives from Fannie Mae and Freddie Mac, and members of the Regulatory Compliance, Fannie Mae Liaison and Loan Administration Committees of the MBA. The objectives of the task force were to identify the sources of ARM-adjustment errors; work with Fannie Mae and Freddie Mac to determine if their ARM-servicing procedures could be revised to promote uniformity and reduce errors; and develop procedural guidelines that could be used by mortgage lenders for the initial set-up of an ARM loan and for subsequent adjustments.

Although not inclusive, the errors that have been identified by the task force include the following situations:

* Documents essential to the accurate

calculation of ARM adjustments are,

in some cases, missing from loan

files and subject to a transfer of

servicing or acquisition. * The complexity and proliferation of

ARM-loan products make it difficult

for small companies with limited

staff resources, in particular, to

understand and accurately transfer

ARM requirements to computer

systems that will, in turn, make the

calculations. A related problem is that

the computer program employed by

a lender may not have the capacity

to make the ARM adjustment

according to its requirements (e.g., no

ability to handle carryover of

interest). Also, nonstandard ARM

products, which neither Fannie Mae nor

Freddie Mac accept, create

problems for servicers in developing a

format for making adjustments. * Misapplication of the index value

used in making the adjustment has

been found. As a result, lenders

may be overcharging or

undercharging borrowers by using an

incorrect index figure on which to

base the new interest rate and/or

payment. Ambiguities in ARM legal

documents may open the door to

varying interpretations.


The task force recommended that the following action be taken to address the issue of ARM errors:

* Develop procedural guidelines that

can be used by employees who are

responsible for entering the

borrower's ARM product requirements into

the computer. This checklist also

could be used by the company in

auditing its ARM servicing portfolio; * Continue to encourage the

secondary market agencies to use

constraint in the number and

complexity of ARM products being

offered to lenders in order to

promote standardization and allow

better administrative management by

lenders; * Eliminate ambiguities in the Fannie

Mae/Freddie Mac ARM notes and

instructions by, for example, more

precisely defining the "availability"

period of particular indexes; * Determine the extent of ARM-adjustment

ARM-adjustment problems related to

computer systems; and * Encourage Fannie Mae/Freddie

Mac to assist lenders in converting

borrowers' nonstandard ARM

products to standard products that can

be placed in pools or sold to the

agencies. Fannie Mae is open to this

suggestion at the lender's request.

Freddie Mac indicated that because

of its limited ARM-product offerings,

the loans sold to it and subsequently

pooled, are standard products.

Wachovia Mortgage's England, a task force member, thinks that "we [as an association] can serve the industry by providing educational materials and information through seminars regarding the source of errors and by working with the secondary mortgage market agencies to resolve ambiguities and promote standard language in their legal documents and servicing procedures."

Index ambiguities

In February 1991, Fannie Mae and Freddie Mac proposed changes to their policies regarding the availability of the Treasury indexes that are used to determine new interest rates for ARMs. They did this by instructing servicers to use the publication date (defined by Fannie Mae as a Monday) of the Federal Reserve Board's Statistical Release H.15 to determine the "latest available index" that should be used as the "current" index.

Currently, the agencies' ARM notes require that the new interest rate for an ARM will be based on the most recent index figure available as of the date 45 days before each interest rate change date (called the "current index"). Fannie Mae, for example, indicates that an index for a Treasury-indexed ARM becomes the "most recently available index" on the day following the publication date of the Federal Reserve's Statistical Release H.15 (519) (on a Tuesday).

According to England, there currently is no industry standard of what constitutes the most "recently available index." As a result, when the day for determining the index value falls on a Monday, some lenders are using the index values from the FRB's H.15 release, when the current information is released, while others are using the index values in effect for the previous week, to conform to current investors' guidelines or because the information is not considered "available" to the public until Tuesday. "There is a real split among lenders, and it is uncertain how a court would rule," says England.

The MBA has urged Fannie Mae and Freddie Mac to adopt uniform language in their procedures to avoid confusion and to reduce the incidence of error and to apply any change in the definition prospectively, thereby ensuring that the change in policy will not affect interest rate adjustments made in the past.

MBA procedures/checklist

The members of the MBA task force produced a checklist of procedural guidelines regarding ARMs errors that is available through the MBA. The guidelines were developed to aid members in complying with federal regulations governing disclosures to the borrower, understanding the parameters of an ARM loan and identifying errors in the initial set-up and subsequent adjustments. This information will be the subject of a future article in Mortgage Banking.

The MBA wishes to acknowledge, in particular, the efforts of task force members Diane Stark, vice president, Sears Mortgage Corporation, Riverwoods, Illinois, and Margaret England, vice president and counsel, Wachovia Mortgage Company, Winston-Salem, North Carolina.

Janet Badger is assistant director of regulatory compliance at the Mortgage Bankers Association of America, Washington, D.C.
COPYRIGHT 1991 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Title Annotation:adjustable-rate mortgage
Author:Badger, Janet
Publication:Mortgage Banking
Date:Aug 1, 1991
Previous Article:The factors driving wholesale.
Next Article:Lending assistance.

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