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August 5, 2002, Revised
October 14, 2005
Adjustable rate mortgages (ARMs) pose the greatest challenge to a disclosure
system because of their complexity, the wide array of different types, and the
frequency with which they mutate. New types of ARMs appear frequently, and old
types disappear.
ARM disclosure under Truth in Lending is corresponding complex. The theory is
that ARM disclosure should begin with general education and become progressively
more pointed as the borrower focuses on a specific type of
ARM. This generates three types of disclosures, ranging from the most
general to the most specific.
While there is nothing wrong with this general approach, the disclosures never
get specific enough to be really helpful. Even after the borrower has committed
to one particular ARM program, the prices disclosed about that program are not
(except by chance) the actual prices the borrower is contracting to pay on that
ARM.
The �Charm Booklet�
ARM disclosure occurs at three levels, of which the earliest and most general is
provision of a Consumer Handbook on Adjustable Rate Mortgages, sometimes
referred to as the "Charm Booklet." The handbook isn�t bad, although today much
better and more current materials are available on-line. I have serious doubts
about Government involving itself in general education, but borrowers are free
to ignore it, which most do, and it imposes little cost on lenders.
Specific ARM
Program Information
The next level of ARM disclosure is a list of items that must be disclosed "for
each variable-rate program in which the consumer expresses an interest." These
are provided to the borrower with the application form.
Each ARM lender must develop a library of ARM disclosures, and 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. Those that combine more than one type of ARM in a single
disclosure document, which the regulations allow, are typically the worst.
But even borrowers capable of understanding the disclosures receive little help
from them because the ARM prices (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. Hence, as part of the disclosure regulation,
the lender must remind the borrower to ask about rate, margin and maximum rate.
Note: the margin is the amount added to the interest rate index to determine the
ARM rate.
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, which today comprise
a significant part of the ARM market, the margin is the price. Yet the best the
regulations can do is require the lender to remind the borrower to ask about it.
Shameful.
Historical and Worst-Case Examples
The third level of ARM disclosure, designed to provide a quantitative feel for
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 good stuff if the ARM involved in the exercise was the one the
borrower was contracting for, but it isn�t. The historical example uses a
�representative� margin while the worst case example uses the margin in effect
when the disclosures were developed.
Why not the actual margin on the loan at issue? The lenders evidently sold the
Federal Reserve on the notion that the disclosures had to be developed in
advance to make it feasible, but this is nonsense. The technology for producing
these kinds of disclosures at the point of sale has been available for at least
15 years.
ARM Disclosures in Perspective
A
fact of life is that borrowers have a limited capacity to absorb difficult
information. Since I began writing my column in 1998, I have received hundreds
of letters from borrowers asking "Why wasn�t I told about�?" to which I have
replied "You were told, it�s a mandated disclosure!" It took me awhile
before I realized that, for all practical purposes, they weren�t told because
they had been exposed to information overload.
When borrowers confront more information than they can handle, their brains
disengage, and they sign at the bottom without having a clue as to what they are
acknowledging. Disclosing everything is much the same as disclosing nothing, it
just takes longer.
Government agencies with responsibility for disclosure are extremely reluctant
to recognize this. If they did, they would be obliged to determine what was
truly important. They could no longer compromise divergent views about what to
include by including everything.
Lenders don�t make this mistake. They know they can�t sell an ARM (or anything
else) by overwhelming the customer. They tend to focus on a single theme or
hook � an easy to understand
ARM feature that is appealing. For example, they sell COFI ARMs based
on the stability of the COFI index, and they sell option ARMs based on very low
initial payments.
ARM disclosures would be a useful counterweight to lender sales pitches if they
were limited to critically important information and presented clearly. Instead,
we have extensive and complex disclosures that leave out what is most important.
If the Federal Reserve replaced all existing ARM disclosures with a
requirement that lenders disclose the margin and maximum rate on the loan at
issue, borrowers would have more useful information than they have now.
Copyright Jack
Guttentag 2005
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