Academic journal article ABA Banking Journal

The ARMs Race: Prepare to Do Battle Again

Academic journal article ABA Banking Journal

The ARMs Race: Prepare to Do Battle Again

Article excerpt

As the latest spike in interest rates rings adjustable rate mortgages nto favor again, creditors need to brace themselves for costly new regulatory and legal battles over rate and payment adjustments.

While federal regulators may not be making as much noise about ARM adjus.t. ment errors as they are about fairleng.,jng and community reinvestment, when the first reports surface that some adjustments are amiss, lenders can expect another full assault on their ARM practices and procedures.

Lessons from the courts

During the last wave of ARMs, in the mid-1980s, consumer groups, regulators, and individual borrowers zeroed in on a poorly prepared mortgage banking industry. A number of enforcement actions and class action lawsuits led to expensive litigation and regulatory enforcement proceedings. Lessons from these various actions, as well as recent regulatory agency guidelines, form a framework for understanding how to resolve ARM issues.

Most notable among recent court cases are class action suits filed in 1990 in Indiana and men exportea to over a dozen states.

These cases claimed that plaintiffs suffered economic damages by virtue of a "common pattern of errors" made by creditors in adjusting ARM interest rates. The suits alleged that a failure to adjust interest rates as stated in the initial contract resulted in a "new" transaction under the Truth In Lending Act (TILA), but that the creditors either did not provide new disclosures as required for these transactions or provided faulty initial disclosures. The plaintiffs also alleged breach of contract, claiming that lenders failed to appropriately adjust interest rates as stated in their initial contracts with the plaintiffs.

These two issues are still valid points of concern for lenders, and of the two, the TILA infractions carry the stiffest potential penalties. Class-action TILA violations can result in statutory damages and penalties of either $500,000 or 1% of the lender's net worth, whichever is less, along with actual damages and attorney fees. A breach of contract, on the other hand, generally results only in actual damages, but no attorney fees or punitive damages.

As it relates to ARMs, truth in lending law limits statutory damages to cases where the creditor fails to comply with certain portions of the disclosure requirements, including disclosures of the amount financed, the finance charge, annual percentage rate, total payments, the payment schedule, and any security interest. Additionally, regulatory agencies allow small tolerances for understated finance charges or annual percentage rates, except when meant to mislead.

Nevertheless, the combined restitution exposure for some lenders during the last wave of ARM complaints exceeded several million dollars. Making restitution even more punishing is the fact that it can be required even when disclosure errors and violations are unintended.

Audit and verify

Problems with ARM adjustments typically involve three issues:

1. Using an inappropriate index on which to base interest-rate adjustments for the mortgage

2. Calculating improper index values.

3. Improperly rounding adjusted rates.

Recent guidelines issued by the Federal National Mortgage Association, supervisory orders from federal banking agencies, and procedures at the Resolution Trust Corp. have brought a relatively high degree of consistency to the policies and procedures required for correcting ARM adjustment errors. These guidelines apply to errors that affect either the borrower's payment or interest rate, the creditor's individual mortgage records, or the creditor's remittances and reports.

The regulatory agencies have stressed time and time again the need for creditors to have internal systems and procedures in place to verify and audit the accuracy of the ARM adjustments. While the agencies do not prescribe the exact nature of these procedures, they do require that creditors provide a routine check of all ARM adjustments and respond to errors, regardless of whether the errors are identified by an internal audit, a borrower, or a regulator. …

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