Judge’s ruling will put PLS trusts under the thumb of the CFPB

If not reversed on appeal, private-label deals will face expanded liability exposure

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A recent judge’s ruling in pending litigation involving student-loan securitization trusts could have far-reaching legal and financial implications for the private-label securities market.

In the federal court case, “Consumer Financial Protection Bureau v. National Collegiate Master Student Loan Trust et al.,” a group of 15 student loan trusts find themselves the target of litigation filed by the U.S. Consumer Financial Protection Bureau (CFPB). The litigation was lodged after loan servicers on behalf of the securitization trusts filed multiple allegedly flawed lawsuits in state courts to pursue loan defaults against borrowers.  

The servicers in their state-court litigation allegedly “executed and notarized deceptive affidavits” and “filed … collections lawsuits lacking” important evidence, according to pleadings in the pending federal case — filed in U.S. District Court for the District of Delaware.

“The trusts say the CFPB lacks authority to sue them because they are not ‘covered persons’ under the Consumer Financial Protection Act,” the judge in the case wrote in his recent precedent-setting ruling. “But they ‘engaged in’ servicing loans and collecting debt through their contractors [the loan servicers], so they fall within the statute. I must thus let the CFPB’s case proceed.”

Michael Bright, CEO of the Structured Finance Association, who served previously as the chief operating officer of the government-sponsored enterprise Ginnie Mae, said the U.S. District Court judge’s ruling in the student loan case, if not reversed, would have major ramifications for the private-label securities (PLS) market, which makes use of similar securitization trusts in its offerings.

“If trusts are ‘covered persons’ in student loan securitizations,” Bright said, “they would be in PLS as well.” 

“It’s difficult to see how the market would evolve around such a dynamic,” he added. “Unless overturned, the ruling would establish a precedent that securitizations trusts are ‘covered persons’ and, therefore, they fall under the enforcement authority of the CFPB.”

A motion by the defendant securitization trusts seeking permission from the court to file a rare interlocutory appeal has been approved by the judge. The appeal, if accepted, will be reviewed by the U.S. Court of Appeals for the Third Circuit. Bright added that if the judge’s ruling is allowed to stand, the PLS market would have to “adapt pretty substantially.”

“Investors will need to quantify and charge for the risk that they will be held accountable for [with respect to] the acts of third-party servicers …,” he said. “It completely upends the construct of securitization.”

Into the Weeds

The 15 trusts being sued by the CFPB were set up to securitize a total of 800,000 student loans, according to the original complaint filed by the federal watchdog agency. Because the trusts are administrative entities and have no employees, they collect and service the debt in the securitized loan pools through third-party servicers. Mortgage securitizations in the PLS market mirror that approach as well.

As part of the efforts to collect on defaulted private student loans, the CFPB complaint alleges that the servicers, on behalf of the trusts, filed multiple lawsuits in state courts around the country. To support the litigation, the servicers — in practices reminiscent of those employed during the subprime mortgage crisis some 15 years ago — allegedly “executed and filed affidavits that falsely claimed personal knowledge of the account records and the consumer’s debt,” the CFPB complaint claims. 

In addition, defendants’ servicers on behalf of [the trusts] filed at least 2,000 collections lawsuits without the documentation necessary to prove trust ownership of the loans or on debt that was time-barred,” the CFPB pleadings charge. “Finally, notaries for [the trusts’] servicers notarized more than 25,000 affidavits even though they did not witness the affiants’ signatures.”

The CFPB sued the student loan trusts in 2017, claiming they engaged in prohibited debt-collection and litigation practices. 

“Now the trusts move to dismiss,” the U.S. District Court judge in the case, Stephanos Bibas, states in a ruling lodged in late December of 2021. “The trusts say the CFPB lacks authority to sue them because they are not ‘covered persons’ under the Consumer Financial Protection Act. 

“But they ‘engaged in’ servicing loans and collecting debt through their contractors, so they fall within the statute. I must thus let the CFPB’s case proceed.”

Late last month, however, Bibas granted the student loan trusts’ motion for an interlocutory appeal. 

“Ordinarily, parties cannot appeal until a district court enters a final judgment,” Bibas writes in his ruling on the defendants’ motion. “But if their case raises important and dispositive legal issues, they may seek permission to appeal early. This enforcement action falls into that rare category.”

The questions on appeal, according to the pleadings, are whether the student loan securitization trusts — and by extension PLS trusts — can be considered “covered persons,” subject to the authority of the CFPB. The other question on appeal is if the statute of limitations has run out on the CFPB’s lawsuit because it was initially filed “while the [CFPB’s] director was improperly insulated from presidential removal.” 

That second question stems from a constitutional controversy settled by the U.S. Supreme Court during the waning months of the Trump administration that reversed a congressional restriction on the president’s power to remove the CFPB director. The CFPB’s lawsuit against the trusts was approved by CFPB leadership and filed in federal court prior to the U.S. Supreme Court’s ruling in 2020. A new CFPB director, removable by the president, later ratified the lawsuit to cure any potential statute-of-limitations defect — a move now being challenged on appeal. 

“The stakes are high — if I am wrong about either issue, this litigation must end now,” Bibaswrote in his recent ruling. “So, I certify both questions for interlocutory appeal.”

Moody’s Take

Moody’s Investors Service, which rates many residential mortgage-backed securities offerings each year, prepared an analysis of the potential fallout in the consumer securitization sector, including the PLS market, should Bibas’ ruling granting the CFPB standing in the lawsuit against the securitization trusts survive appeal. The takeaway: “The sector will likely face increased litigation and settlements from the CFPB and state attorneys general (AGs) based on servicer and, potentially, originator actions.”

“[It] will expose deals to costs and damages, with securitizations backed by loans to riskier borrowers and with financially weak servicers most vulnerable to lawsuits,” the Moody’s analysis states.

Yehudah Forster, senior vice president of structured finance legal review at Moody’s and a co-author of the firm’s report, said that when friction develops between servicers and borrowers, often due to loan defaults, “there’s going to be complaints.” He added that it’s possible, should the judge’s ruling survive appeal, that the CFPB could seek to expand the scope of covered entities to loan originators as well.

“To the extent trusts engage originators in providing financial products, such as buying loans … then possibly the CFPB could extend [its reach] into originator actions,” Forster said.

He added that in situations where lawsuits are filed, there obviously will be increased costs for the litigants, including the PLS trusts, and ultimately the bondholders. For residential mortgage-backed securities transactions that are not the targets of litigation, however, Forster said the added costs will come in the form of the adjustments made to deals to address the increased liability exposure.

Prior to the judge’s ruling in the pending student loan trust case, the Moody’s report notes, authorities typically brought legal action only against the servicer or originator accused of violating the law. If the judge’s ruling in the current case is not reversed, the Moody’s report predicts that the CFPB and state attorney generals will be more likely to pursue litigation against “trusts over servicers that run afoul of consumer protections.”

Trust expenses will rise to cover litigation fees, and suits will potentially result in significant damages, all of which risk causing losses,” the Moody’s report states. “Suits will potentially lead to credit negative requirements, such as servicing restrictions and writing off securitized loans.” 

In addition, if the judge’s ruling remains in force, trusts and investors will be more likely to agree to unfavorable financial settlements and servicing restrictions in the future to avoid engaging in drawn-out legal battles, the Moody’s report notes. 

“A single settlement risks encouraging the CFPB and state AGs to file additional suits against other trusts, knowing that at least some will likely settle to avoid litigation costs and uncertainty,” the reports states.

Another potential fallout from the ruling being left unchecked, the report adds, is that securitizations backed by financially weaker or less-experienced servicers or deals involving loans to the riskiest borrowers may be more heavily scrutinized by the CFPB and state AGs. 

Michael Carnes, managing director of the MSR valuation group for New York-based Mortgage Industry Advisory Corporation (MIAC), recently told HousingWire that there are many players active in the mortgage servicing rights market now, including newer participants like private equity funds. In addition, as the mortgage market moves toward a purchase-dominate cycle in the year ahead, the opportunity for expanded lending in the non-QM space increases as well, according to industry experts — and a slice of the loans in that basket are designed to serve riskier borrowers

“When you’re talking about more risky loans, they can be in the crosshairs for a number of reasons,” Forster said. “There could be allegations of predatory lending, for example. “

The End Game

The Moody’s report adds, however, that should securitization trusts be put under the thumb of the CFPB, authorities will be less inclined to target those trusts that contract with larger, more experienced servicers that have sufficient funds to cover significant damages, or which have stronger servicer oversight procedures in place.

“Furthermore, even if the CFPB or AGs sue the trusts, contractual provisions will require the servicer to indemnify the trust under certain conditions,” the Moody’s report states. “For example, if a trust suffered losses because of servicer actions that violate law or contractual obligations, deal documents will typically require the servicer to indemnify the trust for costs and damages.”

“What kind of adjustments, if any, will be made to deals in terms of only choosing certain kinds of servicers, or putting in more servicing oversight … those things could add additional expenses,” Forster added. 

Forster stressed, though, that even if the judge’s ruling stands, it’s not likely to create an overall chilling effect on future PLS deals, given the student-loan trusts case at the heart of the current ruling represents the most extreme example of alleged consumer-protection legal transgressions.

“It really depends on whether service providers are doing things responsibly … if they’re servicing it properly,” he added. “Just because you’re making riskier loans, doesn’t automatically make you a target under the law.”

Bright, of the Structured Finance Association, said he expects the appellate court to “take a significant amount of time” to reach a decision on interlocutory appeal, “if they take up the request.” He expects a decision will be forthcoming soon on whether the appeal will be heard by the higher court. 

“We have and will continue to file amicus [friend of the court] briefs in each stage of the proceedings,” he added. “In the meantime, we are educating legislators and participants in markets outside student loans of the potential ramifications of this.”

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