LATENT PROBLEMS IN LOAN SERVICING

Or

“WHAT POSSIBLY COULD GO WRONG?”
William G. McCanne, Senior Vice President, Secretary and General Counsel
Mortgage Analysis Computer Corporation - MACC-TRAC

For more than ten years, loan servicers have retained us to review the accuracy of their servicing operations.  Over that time span, we have reviewed more than $60 billion of loans. These reviews included scrutiny of the loan documents as well as the payment histories recorded by the servicers and the servicers’ allocations of payments between principal and interest.  The error rate ranged from as low as two percent of loans serviced to as high as 85 percent, with an average among all servicers of approximately 30 percent. 

Most of us can imagine how an allocation between principal and interest could be made incorrectly, especially if we’re dealing with an adjustable rate mortgage loan with frequent changes in the interest rate and a complicated calculation formula with several variables.  The potential for errors is fairly obvious.  However, what is not obvious is that there is a minefield of possible pitfalls lying in wait for a servicer, pitfalls that the senior management of a servicing organization may have never imagined!  What Possibly Could Go Wrong? 

DOCUMENTATION ISSUES:  Consider the following anecdotes, all illustrating documentation problems: 

1. A lookback clause that states “the interest rate will be based on an index as of the last business day of the second month preceding a change date.”  How many loan servicing personnel, who typically have no more than a high school education, will select the correct date? 

2. A change date clause that states, “on the first day of 3/22/97.”  Will the loan servicing person choose the first or twenty-second day of March each year as the annual change date?  It’s a toss up.  What effect will it have on the amount of interest charged to the borrower over a thirty-year amortization period? 

3. A first change date interest rate cap and floor that state, “the interest rate on the first change date will not be greater than 9.35 percent or less than 9.95 percent.”  If a computer performs the servicing, this input will probably cause some kind of a rejection by the computer program.  What happens then?  What does the loan servicing person do when this happens? 

4. A conflict between the date of the promissory note and the due date of the first payment arose when the date of the promissory note was November 30, 1996 and the due date of the first payment was January 5, 1996.  Did the servicer have an established policy and procedure identifying who was responsible for correcting this error and what the proper procedure was for correcting it? 

A similar example from another promissory note stated “I will pay principal and interest on the first day of each month beginning on December 30, 1994.” 

5. One of the largest financial institutions in the United States included the following clause in a “Waiver of Borrower’s Rights:”  “Grantor expressly waives any and all rights which Grantor may have under the Fifth and Fourteenth Amendments to the Constitution of the United States.”  Is this Constitutional?  Is it ethical? 

6. In the paragraph prescribing the “Limits on Interest Rate Changes” in a promissory note, one clause stated, “My interest rate will never be greater than 0.000 %.”   Would you like to sign a promissory note with that clause? 

7. A $410,000 adjustable rate mortgage note contained the following clause: “Principal and interest shall be payable in consecutive monthly installments in an initial amount of Four Hundred Ten Thousand and 00/100 ($410,000.00) commencing on April 1. 1990.” 

8. Self-contradictory clauses are not uncommon.  An example from an Adjustable Rate Rider was a clause that stated, “The Note Holder will then round up the result of this addition to the nearest one-eighth of one percentage point (0.25%).” 

Another, similar example was a clause in a promissory note that stated, “Such increases and decreases shall be effected in such manner as to maintain a margin of TWO AND THREE-SEVENTHS (2.37) percentage points above the last published index.” 

Another self-contradictory example was, “Before each Change Date, the Note Holder will calculate my new interest rate by adding two and one-half (2 ½) percentage points (.025%) to the Current Index.” 

Another self-contradictory example was, “Before each Change Date, the Note Holder will calculate my new interest rate by adding 0.3500 percentage points (3.500%) to the Current Index.” 

Another self-contradictory example was, “Before each Change Date, the Note Holder will calculate my new interest rate by adding Two Hundred percentage points (200%) to the Current Index.” 

Another self-contradictory example in a Commercial Mortgage Note dated February 9, 1990 stated, “The (11.5%) Fixed Rate will be in effect for the first year of the loan.  Commencing on February 9, 1990 (the ‘First Change Date’) I will pay interest at the variable rate below for 25 years.”  The same loan required 300 monthly payments but stated that a final payment of $2,032.94 would be due on the 180^th month.  No consideration was made for the effect of the variable interest rate on the monthly payment amount or on the final amount due, nor was there any language to indicate that a balloon payment of the remaining principal balance would be due on the 180^th month. 

Another self-contradictory example provided, “Notwithstanding the interest rate set out in this note, the undersigned agrees that the rate of interest shall increase or decrease each calendar quarter at the rate of two and on-half percent (2.5%) per annum in excess of [the lender’s] prime rate, and the change of the rate of interest in the note shall be determined and become effective on the first day of each January and July.” (Emphasis added) 

Another self-contradictory example provided for a two percent annual interest rate adjustment cap for a loan that had a 36-month interest adjustment period. 

Another self-contradictory example had a 6% lifetime interest rate adjustment cap that was less than the initial interest rate. 

9. Sometimes the language is blatantly absurd.  Such a clause stated, “My interest rate will never be greater than 42%.”  Is a clerk obligated to take any action if he/she sees such an error?  If not, is the intent of the parties thwarted? 

Sometimes the language is probably absurd:  Such a clause stated, “Before each Interest Change Date, the Note Holder will calculate my new interest rate by adding 13.250 (13.250%) percentage points to the Current Index.”  How likely is it that a clerk will spot such an error? 

In a promissory note with a margin of 2.5%, the following limit on interest rate changes appeared: “The interest I am required to pay at the First Change Date will not be greater than 2.000% or less than 2.000%.” 

10. Some errors are obvious, but does the servicer have a policy and procedure to deal with them?  In the following example an interest rate was inserted in a blank space that required a term of years: “the Index is the weekly average yield on United States Treasury securities adjusted to a constant maturity of 9.85 years, as made available by the Federal Reserve Board. 

11. Sometimes a financial institution takes a high-handed approach and tells the borrower that we’ll let you know, when we decide, what we want you to pay.  Consider the following clause from a 1985 Mortgage Note: “The Base Rate of the Bank wherever used in this Note or any other document in connection herewith shall mean the Base Rate as determined from time to time by management of the Bank and printed, published, or circulated within the Bank as part of its internal operating procedure.” 
    
    In a similar example, a clause in a 1984 Real Estate Lien Note stated, “The holder of this note shall have the right to change the interest rate of this note to any rate of interest within the limits then permitted by law that the holder shall choose.
    
    In another example, a clause provides, “The Noteholder shall have the right during the tenth (10^th) and twentieth (20^th) loan years to adjust the interest rate due hereunder provided ninety (90) days notice of such adjustment is given to the Borrower.”  There was no method provided for calculating such adjustments, nor was there any limitation on the amount of such adjustments.
    
12. Some drafters have a flair for creativity that knows no bounds.  A 1986 promissory note had a “First Maturity Date” of January 1, 1990 and an “Ultimate Maturity Date” of January 1, 1997. 

13. Sometimes the person who completed the blank spaces on the document was merely careless.  For example, a 1989 RENEWAL OR EXTENSION AGREEMENT had a clause that stated “the original principal amount of FORTY SEVEN THOUSAND & NO/100 Dollars ($47,000.00) and bearing interest at the rate of BOR+1 percent (14.25e%) until May 9, 1992.” 
    
    In another example in a $164,000 loan, the person who completed the blank spaces on the promissory note form mistakenly typed the monthly payment amount ($1,981.91) in the blank that called for the total principal amount owed. 

14. Sometimes the language prescribes an impossibility.  For example, “payable on the 31^st of June.” 

15. Sometimes the preprinted language on a form is too difficult to deal with.  In this example, the drafter certainly didn’t want to deal with it:  “Regardless of the preprinted matter in the within note, the interest rate is to be the New York Prime Rate plus 2.75%.” 

16. In a memorandum to her attorney, a borrower stated, “[The lender] called today and advised me that the three extra payments I had made were not being credited to the next month’s payment due, but $495 (the normal monthly payment amount) would be credited to principal and the rest to interest. In other words, if I make three prepayments in one month, interest is charged three times for that month!” 

17. Sometimes the lender may get carried away with the need for documentation, such as this statement from an Affidavit of Continuous Marriage required of the borrowers: “We have been continuously married to each other, from February 5, 1993, through and including July 22, 1994, without interruption.” 

18. Sometimes the drafter of a promissory note leaves too much to chance (or to the discretion of the clerk who has to board the loan).  Consider the following clause:  “Before each Change Date, the Note Holder will calculate my new interest rate by adding or subtracting the correct percentage points to the Current Index.” Emphasis added. 

19. Sometimes the language simply doesn’t make any sense: “The Index for a 5-year ARM loan is the weekly average rate on Treasury Securities with corresponding maturities and adjustments plus 275 basis points occurring every five years.” 

INTERPRETATION ISSUES:  There are also some interpretation problems that have not been litigated, to the best of our knowledge.  For example: 

20. If an adjustable rate mortgage loan has a rider to the security agreement and if the value of any term therein conflicts with the value of said term in the promissory note, which value governs?  It can be argued that the promissory note is the principal document and its terms govern in any case where the terms of a secondary document conflict.  Or, one can argue that since the security instrument and riders thereto are usually recorded and the promissory note is usually not recorded, it is in the public interest to recognize the value of a term of such a rider even if it conflicts with the value of the same term in the note. As public records, they protect third parties who may rely upon them.  Another argument could be made that if the parties executed the rider after the note was executed, evidence of the most recent agreement should be given recognition above that of an earlier agreement.  The problem with this argument is that the two documents are usually executed at the same time. 

21. Some lenders contend that if an adjustable rate loan has (a) a first interest adjustment cap and floor and (b) a life interest adjustment cap and floor, the first interest adjustment is not limited by the life interest adjustment cap and floor.  Alternatively, other lenders contend that it is. 

22. Some lenders contend that if an adjustable rate loan has a lookback clause that refers to a “published” index value, the pick date is the date of the publication in which it first appears as opposed to the date it is first released by the issuing organization to the public and the press.    

LEGAL ISSUES:  Is there a legal issue in each of the following circumstances?  If you think so, what do you believe is the law governing such circumstances?  Is the law different in different jurisdictions?    

23. Unilateral Change.  When a lender sends a letter to a borrower with a change of any term in the loan, is such change legally effective without the borrower’s consent?  “Yes,” “No,” or “It depends”? 

24. Conflicting Terms within a Document.  What is the effect of conflicting terms within a promissory note?  For example, if the note provides the loan amount, the interest rate, the monthly payment amount and the amortization term but the amortization term is inconsistent with the values of the first three terms, what is the legal effect?  Is an amendment required to make all the terms mathematically consistent?  What if the same term appears twice in the document but with different values?  What if the stated maturity date (7/3/96) is prior to the first payment due date (8/3/96)? 

25. Conflicting Terms in Two or More Documents.  What is the effect of conflicting terms in a promissory note and security instrument?  Does either document take precedence?  Is the servicer required to obtain written clarification from the lender and the borrower? 

26. Missing Information. What action is legally required if the servicer discovers that a blank space to be filled in when the promissory note was completed was overlooked and left blank when the note was executed?  Suppose it is an important value in determining how the loan should be serviced?  For example, a missing initial interest rate change date?  Or the missing maturity of U.S. dollar denominated deposits? 

27.  Unacknowledged Changes.  What action is legally required if the servicer discovers that a blank space on the promissory note was filled in and struck out. Then a new value was interlineated, either handwritten or typewritten, AND neither the borrower nor the lender initialed the change?  What action is required if only the lender initialed the change?
    
28. Missing Documents.  What action is legally required if the servicer cannot find the attachedaddendum referred to in the promissory note? What action is legally required if the servicer has the original security instrument and a rider thereto that, together, provide all the practical information necessary to service the loan, but it does not have the original (oreven a copy) of the promissory note?
    
29.  Illegible Value.  What action is required if the value of an important term in the loan documentation is illegible?
    
30. Rounding Conflict between Words and Numbers.  Suppose the margin is stated, “Before  each Change Date, the Note Holder will calculate my new interest rate by adding SIX AND625/10000 percentage points (6.063%) to the Current Index.”   Does the lender have an established policy and procedure for addressing this problem?
    
31. W hat effect should be given to an undated letter of modification? 
     
32. What effect should be given to a BALLOON RIDER that converted an Adjustable RateM ortgage Loan into a Fixed-Rate Mortgage Loan?
    
33. If the term in the promissory note has been obliterated but is still discernable, should the servicer recognize a different value of the same term in a rider to the security instrument?
    
34. What is the effect of an obliteration of an entered value in a blank space on a preprinted formif it has not been initialed by both parties?   Of an obliteration followed by an interlineation, neither of which have been initialed by both parties?  What if they have been initialed by one party?

What Possibly Could Go Wrong?   The list goes on and on and on.  This article is intended to encourage loan servicing enterprises to re-evaluate their policies and procedures.  It is important to involve the legal department initially; better to be proactive than reactive.