Pub. 1 2020 Issue 5

www.cbak.com 18 In Touch HANDLE ARM ADJUSTMENTS WITH CARE BY WILLIAM J. SHOWALTER, CRCM, CRP SENIOR CONSULTANT; YOUNG & ASSOCIATES, INC. ; KENT, OHIO A djustable-rate mortgages (ARMs) have not been much of an issue for many banks and thrifts in recent years since fixed rates have been so low. But they are still an important tool for serving those customers who cannot meet the secondary market qualifications applied to most fixed- rate loans. Also, many institutions have a portfolio of existing ARM loans that they service. One potential complication for some lenders is the impending discontinuance of the LIBOR index, requiring them to find another comparable index for their ARMs. ARMs were in the spotlight over 10 years ago because of problems in the subprime market. Many subprime products have variable interest rates, which shift the interest rate risk from lender to borrower. Besides the issues raised then over putting borrowers into inappropriate products, there also are concerns over errors in ARM rate changes. Do an internet search for “ARM errors” or similar terms, and you will come up with numerous firms offering loan audit and information services to borrowers. These firms tell borrowers that their companies can correct ARM errors, bring loans into compliance and get the borrower a mortgage refund. Background The initial furor over these mistakes arose over a report on ARM adjustment errors prepared by a former Federal Savings and Loan Insurance Corporation employee in 1989. His assertions sent a tremor through the mortgage industry. The report concluded that miscalculations in periodic adjustments to rates on ARM instruments resulted in significant overcharges. He found ARM adjustment errors in about 50% of the loans he sampled. From these results, he estimated the potential overcharges to be up to $15 billion for ARMs nationwide at the time. This figure has been estimated as high as $50-60 billion in recent years. The controversy was further stoked by a study from the Government Accountability Office (GAO), released in September 1991, which found between 20-25% of the ARM loans at the time contained interest rate errors. Such errors occurred when the related mortgage servicer selected the incorrect index date, used an incorrect margin or ignored interest rate change caps. The damaging studies kept coming. In July 1994, Consumer Loan Advocates, a non-profit mortgage auditing firm, announced that as many as 18% of ARMs have errors costing the borrower more than $5,000 in interest overcharges. Also, another government study in December 1995 concluded that 50-60% of all ARMs contain an error regarding the variable interest rate charged to the homeowner. The study estimated the total amount of interest overcharged to borrowers was in excess of $8 billion. Inadequate computer programs, incorrect completion of documents, and calculation errors were cited as the major causes of interest rate overcharges. Even though no other government studies have been conducted into ARM interest overcharges to date, the potential issue continues to simmer below the surface, and lenders need to be vigilant so that it does not erupt into a veritable supervolcano of enforcement actions and lawsuits. Types of errors The kinds of errors lenders are said to make in implementing ARM rate and payment adjustments run the gamut from calculation mistakes to carelessness, including: • Mistakes in the original loan setup/ data input • Miscalculation of the payment amount • Improper allocation of payments between interest and principal (amortization) • Use of the wrong index • Selection of an incorrect index value • Application of incorrect interest rate caps • Failure to adjust in some years • Use of incorrect margins • Improper rounding methods (e.g., rounding up instead of rounding to the nearest 1/8th of 1 percent) • Math mistakes causing an incorrect rate • Use of an incorrect loan balance Banking regulators point out that these errors may be considered breaches of contract and could expose the financial institution to legal action. Extent of errors Since ARMs involve changing index values periodically and complex computer calculations, they seem to attract human and software errors. Mortgage audit firms point out that leading publications such as The Wall Street Journal, MONEY, Forbes and Newsweek have warned borrowers about miscalculations occurring in up to 50% of ARMs.