For lenders with a portfolio of adjustable-rate mortgages that are concerned about the problem of erroneous adjustments to interest rates charged on the loans, the litigation involving Northeast Savings provides a cautionary tale.
Industry concern about misadjustments is well founded. For example, an Oct. 30, 1990, letter from the General Accounting Office to Sen. Richard G. Lugar, R-Ind., cites studies estimating that 20% to 35% of all adjustables nationwide have adjustment errors.
Northeast Savings attempted to exit the California residential lending market in 1994 and has been swept up in the banking industry's merger mania. Its parent company, Northeast Federal Corp., was acquired by Shawmut National Corp. in June 1995, and now Shawmut and Fleet Financial Group have merged. But Northeast remains involved in two lawsuits concerning an adjustable-rate loan secured by California real estate.
First, Northeast's appeal of a decision by a U.S. district court in Los Angeles is waiting to be scheduled for oral argument early next month before the U.S. Court of Appeals for the Ninth Circuit. In that case, the district court ruled that Northeast overcharged interest by $4,804.92 on an adjustable-rate loan and, as a result, breached the terms of the loan and violated section 6(e) of the Real Estate Settlement Procedures Act. Lawyers' fees of $24,900 also were awarded to the borrower.
Second, the federal case also gave to a state court action by the borrower to quiet title in the real estate that secured the loan. The borrower said that Northeast violated California's one form of action rule regarding the collection of debt secured by real estate, because Northeast obtained a judgment in the federal case that allowed Northeast to offset the amount of the overcharge against delinquencies owed under the loan.
California's one form of action rule, which is contained in one of the state's debtor protection statutes, provides that the only "action" permitted to enforce a debt secured by real estate is foreclosure and that any other "action" is a violation of the rule that invokes severe sanctions.
In October, the California Court of Appeals ruled that Northeast's offset was an "action" that violated California's rule and sent the case back to the trial court where the parties will litigate the issue of what is the appropriate remedy for such a violation.
If Northeast "inadvertently" took the offset, then returning the amount of the offset might remedy the violation. Conversely, if the offset was not "inadvertent," then Northeast may have forfeited the right to collect the balance of the debt or forfeited its security interest in the real properly collateral - a costly misstep on a loan with a balance of about $687,000.
Regardless of the outcome at the trial court, the California Court of Appeals decision means that Northeast and other California lenders that have erroneously adjusted a loan may not offset the amount of overcharged interest against amounts owed under the loan without risking forfeiture of the debt or their security interest in the real estate collateral.
Although the federal case involved the erroneous adjustment of only one loan, that case may have a broader significance as precedent applicable to other adjustable-rate loans that Northeast serviced.
The error found by the U.S. district court involved the choice of the wrong month's index when Northeast calculated the new interest rate. The adjustable rate was calculated by adding a margin to an 11th district cost- of-funds index.
The court ruled that in making the biannual adjustments in the loan's interest rate, the terms of the loan required Northeast to use a more recent index value than the one it used. The effect of using the older index value was to overstate the interest rate for the period from September 1989 through March 1994.
One of Northeast's briefs even asserted that "Northeast is a servicer of several thousand notes, and the impact of the court's order would be substantial ..." Even though Northeast Savings sold $800 million in single- family ARMs secured by California real estate in March 1994, it still may have liability to any borrowers who were overcharged interest while Northeast serviced those loans.
In the case pending before the ninth circuit, the overcharge amount of $4,804.92 equaled about 0.7% of the loan balance. Assuming all of Northeast's California adjustables portfolio used the same loan documents and were subject to adjustment errors of similar proportion, then the total amount overcharged could reach about $5.6 million.
Consequently, Northeast has a lot riding on obtaining a reversal from the Ninth Circuit. The irony for Northeast is that the litigation could have been settled in its entirety for $17,000 in April 1994.
Mr. Maurer is a principal of Friedemann & Maurer, a law firm in Marina del Rey, Calif.
