Don't Compound ARM Errors with Misguided Audits

Don't compound ARM errors with misguided audits Allegations of errors in adjustable rate mortgages pose a dilemma for lenders and servicers. Conducting an audit of an ARM portfolio may bring peace of mind. But an audit uncovering significant problems may lay the groundwork for treble damages litigation and may undermine a potential faith error defense. ARM issue. Beginning in 1990 a report on ARM errors prepared by a former Federal Savings and Loan Insurance Corp. employee sent a tremor through the mortgage industry. The report concluded that miscalculations in periodic adjustments to rates on ARM instruments have resulted in significant overcharges. These alleged errors may be caused by software that automatically calculates adjustments. Some agencies, notably the General Accounting Office, dispute the report's estimate of the scope of the problem. GAO and others also believe that errors resulting in undercharges may be as prevalent as errors resulting in overcharges. The report has nonetheless already sparked several class action suits. These may be only the tip of the iceberg. Plaintiff attorneys have peppered financial institutions with veiled threats, accompanied by offers to sell their investigative services. In addition, some federal regulators have announced that they will expand examinations to check for errors in ARMs. Although the confidentiality of exams are protected by federal regulation, the agencies may release embarrassing information to plaintiff attorneys on request - and have. Hobson's choice. In the wake of this controversy, institutions wonder how to respond. Some already know of adjustment errors in their ARM portfolios. Others may be benignly ignorant. Many attorneys appear to be counseling clients to audit their portfolios. An audit may not be the most prudent course. An investigation showing a clean bill of health may allow executives to sleep better, and a so-so investigation may prompt an institution to refund a nominal amount of overpayments. However, some institutions may find significant liability to some overcharged borrowers and are unable or unwilling, as a practical matter, to collect additional payments from undercharged borrowers. The act of conducting an audit carries import beyond whatever it discovers. The institutions may lose their ability to claim good faith ignorance if sued. These institutions may also have produced a report - at shareholders' expense - which plaintiffs may be able to obtain and use in the course of litigation. Further, once the information is made public through a suit, it could trigger repurchase obligations or termination of servicing contracts when the portfolio in question is being serviced on behalf of other parties. Banks must take many factors into account before turning over every rock in their portfolios. These considerations include the applicable causes of legal action; the availability of good faith and limitations defenses; the potential for class action treatment of errors; and the potential damages. Causes of action. State and federal law offer a mixed arsenal to a creative prosecutor or plaintiff's attorney. Breach of contract. In the context of civil law, an overcharge is a breach of contract which may be remedied through a private action for damages. A few states, like Texas, also allow an award of reasonable attorneys' fees. An award of actual damages would simply be a refund of monies the servicer was not legally entitled to in the first instance. If this were the only threat, one might think there would be little incentive to remedy past ARM errors; after all, borrowers or regulators might never uncover these problems within the period of the applicable statute of limitations. If the problem remains undiscovered, the servicer, or its investor, retains all overpayments. Moreover, discovery of underpayments may be irrelevant (except to the underpaid investor) given the likelihood that regulators or practical circumstances will prohibit the institution from collecting additional amounts. …