Adjustable and variable rate mortgage loans became the most popular lending contracts in the late 1970s and 1980s as the result of several unique circumstances. In a phenomenon known as disintermediation, savings and loan associations lost deposits when the Federal Reserve Bank reduced its minimum savings deposit from $100,000 to $10,000 for accounts that paid higher interest than those of the S&Ls. Regulatory changes permitted the S&Ls to fund commercial developments and realize high interest rates on residential mortgages during this hyperinflationary period that also spurred the development of adjustable rate mortgages. A fast paced real estate and construction market in many areas of the country magnified the impact of these revolutionary changes in the lending industry.

The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) created the Resolution Trust Corporation which was responsible for closing over 200 thrift institutions. ARM/VRM loans were originally designed as portfolio product that could be balanced against certificates of deposit and local market conditions.

The RTC forced the liquidation of many ARM/VRM loans from the closed thrift institutions. Prior to that time, there was virtually no secondary market for ARM/VRM(RTC) loan product. Billions of dollars of residential and commercial ARM loan assets created a need for a new, secondary market. Many loans were sold at auction, and Wall Street scrambled to create new markets and securitizations. The eventual servicers of these loans have had to work with missing documents and incomplete or missing payment histories.

New ARM loan originations were up substantially in 1996 but ARM activity has declined in recent years of declining interest rates. ARM activity between 1989 and 1996 generated competition which, in turn, created a vast new array of highly complex loan products. With a secondary market in place and experience in securitization of ARM product, loan servicing issues became much more complex. Many of these newer concept products outpaced the ability of servicing agents and systems to correctly compute the loans, and many servicers still must calculate a significant number of loans manually. Errors in servicing continue to plague the industry and national statistics remain constant indicating an average error rate of 30% within any given servicing portfolio. Errors average 50/50 in terms of overcharges and undercharges; consequently, both investors and borrowers should have some concern.

Several years ago, the GAO estimated error rates in servicing ARMs to be 25% to 35%. The Wall Street Journal in 1994 cited 68%. Our firm’s experience is 30% average with high of 90% and low of 15%. Intentional wrongdoing by servicers has never been an issue and is supported by the fact that errors tend to be equally divided between under and over charges.

Dollar amounts can be significant. Paying too high an interest rate is obvious but if the loan is amortizing, the amount of payment dedicated to principal is less, interest accrues on a higher balance and the loan continues to be in error even if the error is corrected. This "cascade effect" further complicates auditing and future servicing.

Borrowers have been reimbursed millions of dollars for discovered errors, and there have been significant class action lawsuits against major servicing companies. Thus far, there has been little or no attempt by servicers or investors to recover undercharges from borrowers. Experts cite customer relations, waiver and estoppel as deterrents.

If an investor contracts with a servicing agency, there may be a basis for recourse against the servicer for the servicer's errors. Investors in securitized ARM funds may also have recourse against servicers. Consider the following example: a $1 million loan amortized over 360 months with a balloon at fifteen years. If the loan is consistently serviced one-half percent below the correct rate (9% versus 9.5%, for example) the loss of interest over the fifteen year period would be $77,154.61. Because the lower interest rate generates accelerated runoff, the balloon payoff amount would be $11,937.74 less than anticipated. The total combined loss would be $89,092.35 on a million dollar loan due to a one-half percent error. This is an example of a "fixed" rate loan; ARM /VRM complexities hold the potential for much more erratic results. The message is clear: whether borrower, investor or servicer; the "lurking liability" is sufficient to answer to the opening question; Why Audit Loan Servicing?