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December 5, 2005
"What grade would you give the Federal
Government in establishing disclosure rules for adjustable rate mortgages (ARMs)?"
F for "flunk", because the mandated disclosures
exclude the essential information borrowers need to make decisions.
What ARM Borrowers
Ought to Know
Borrowers contemplating an ARM ought to know: 1)
how long the quoted rate will last, 2) what might happen to the rate and payment
when that initial rate period ends, and 3) what might happen to the rate and
payment in subsequent adjustments after the first one?
Most ARM borrowers know the answer to the first
question, but many are at sea regarding the second and third question. To answer
them, they need to know a) the rate index used by the ARM; b) the margin that is
added to the index to determine the rate; c) the adjustment cap which may limit
the first rate adjustment; d) the rate adjustment interval after the first
adjustment; e) the adjustment cap on rate changes after the first change; and f)
the maximum rate allowed by the ARM contract.
None of this information is a mandated
disclosure. [Note: Borrowers shopping negative amortization ARMs require even more information, see
Information
Needed to Evaluate an ARM.]
Mandated ARM
Disclosures: The Charm Booklet
Mandated ARM disclosures occur at three stages.
The earliest and most general is provision of a Consumer Handbook on Adjustable
Rate Mortgages ("Charm Booklet"). The handbook isn�t bad as a general education
tool, but the checklist it provides for comparing two ARMs is incomplete and
confused.
Mandated ARM
Disclosures: Program Descriptions
The next level of ARM disclosure, provided to
the borrower with the application form, is a list of items that must be
disclosed "for each variable-rate program in which the consumer expresses an
interest." To comply, each ARM lender develops a library of ARM disclosures.
I have read many, which range in quality from
excellent to execrable. There are no requirements for comprehensibility, and
perhaps half of them would be beyond the capacity of most borrowers. But even
borrowers capable of understanding the disclosures receive little help because
the rate, margin and maximum rate in the disclosures don�t apply to the
borrower�s loan. The description is of the same type of loan, not the same loan.
It is difficult to grasp how ridiculous this is
unless you come into contact, as I do quite often, with ARM borrowers who close
their loans without ever knowing what their margin is. Especially on option ARMs
and HELOCs, on which the initial rate usually holds for one month only, the
margin added to the index is the price for the next 359 months. Yet the best the
regulations can do is require the lender to remind the borrower to
ask about it. Shameful.
Mandated ARM
Disclosures: Historical and Worst Case Examples
The third level of ARM disclosure, designed to
quantify the risks inherent in an ARM, require either historical or worst case
examples. The historical example shows payments and balances on a $10,000 loan
for 15 years starting in 1977, the year preceding a marked rate increase. The
worst case shows initial and maximum rates and payments on a $10,000 ARM if the
rate rose by as much as the contract allowed.
This would be useful if the ARM involved in the
exercise was the one the borrower was considering. It would even provide a
rationale for not mandating the disclosure of the individual ARM features cited
earlier. If the borrower knows how his mortgage would fare in a worst case
scenario, not knowing the ARM features is not that serious.
But neither the historical nor the worst case
example applies to the borrower�s loan! The historical example uses a
"representative" margin while the worst case example uses the margin in effect
when the disclosures were developed by the lender.
The full absurdity of this is also difficult to
grasp. An analogous situation would be a consumer shopping for an automobile who
asks about how the car fared in the Government�s rear-end collision test. In
response, the salesman provides the information for the model they were selling
5 years ago!
Why not the actual margin on the loan at issue?
Lenders evidently convinced the Federal Reserve that the disclosures had to be
developed in advance to make them feasible, but this is nonsense. The technology
for producing these kinds of disclosures using live price data at the point of
sale has been available for at least 15 years.
The sad conclusion is that the mandated
disclosures try to do too much and end up accomplishing little or nothing. If
all existing ARM disclosures were replaced with a requirement that lenders
disclose the margin and maximum rate on the specific loans being offered,
borrowers would receive more useful information than they get now.
Copyright Jack Guttentag 2005
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