Opinion: The larger risk from a barely noticed CFPB lawsuit

In CFPB vs NCSLT, the CFPB is attempting to assert that a trust has liability for the mistakes of a servicer

As all participants in the mortgage industry know, securitization is a critical tool for making loans to homeowners at affordable rates. The process of bundling loans and separating risks makes available fixed-rate mortgages that are fully prepayable at borrowing costs well below other forms of debt. To say that securitization is critical to American homeownership is, to say the least, a massive understatement.

There are many reasons why securitization works so well and why the ability to originate and finance a loan is as reliable as turning on your tap and knowing it will produce water. In both cases, it’s because of plumbing. That is, a network of connectivity hidden behind the walls that we typically take for granted.

In securitization, just like in your kitchen, if you mess with the plumbing, you mess with the whole system. Tinkering with that plumbing must be done on occasion, but it also must be done very carefully. (I learned this once trying to fix a dishwasher.)  

It’s not just about student loans

To wit, a barely noticed case in the world of student loan securitization is currently working its way through the court system. It involves the Consumer Financial Protection Bureau (CFPB) taking actions that would make fundamental adjustments to the plumbing of securitization. Make no mistake — this is not going to be just about student loans. If the case of the CFPB vs. the National Collegiate Student Loan Trust (“NCSLT”) lands the wrong way… well, let’s just say it will be harder to fix than my dishwasher.  

One of the critical mechanisms of securitization is the separation of the underlying assets from the bankruptcy risk of the mortgage bond issuer. This separation is important for the market. In essence, it means that the investor in a securitization deal is analyzing two things — one, the credit worthiness of the underlying assets and, two, the operational capacity of the deal structure to collect and remit according to the outlined requirements.  

It’s the credit of the underlying borrower that matters

The end investor does not, for example, need to price the risk that the bond issuer itself becomes insolvent. It is the credit of the underlying borrower that matters. To achieve this, a trust is established that legally separates and protects the mortgage loans collateralizing the investors’ bonds from any bankruptcy of the bond issuer or other participants. These trusts operate via a special purpose vehicle, which has no employees and makes no subjective decisions. They fulfill cash flows.

This legal construct is critical. Absent this mechanism upon which investors rely, all securitizations would need to be evaluated for a myriad of additional credit risks, so many that investing in them could be altogether impossible.  

In the NCSLT case, the CFPB is challenging the very core of this structure. Specifically, in CFPB vs NCSLT, the CFPB is attempting to assert that a trust has liability for the mistakes of a servicer. In the facts of the case, the CFPB alleges that a student loan servicer made errors in collections and borrower communication and that the servicer was subject to CFPB oversight. Fine, that is something for which the market is built. But the CFPB is taking the case one step further to say that the trust itself is also liable. This is a sea change to the entire market.

Should passive securitization trusts be accountable for servicing errors?

Dating back to 2017, this case has been working its way through the court system, undergoing a variety of twists and turns. As recently as last year, a district court expressed skepticism at the bureau’s attempt to hold passive securitization trusts accountable for servicing errors or that securitization trusts under the plain language of the statute are a “covered person.”

Late in 2021, however, a new judge in the case found that these passive trusts were “covered persons” under the Consumer Financial Protection Act and therefore under the bureau’s enforcement authority.

No one is or would argue against servicers having responsibility to comply with all consumer protection laws. In fact, market participants demand it. Without accountability for the servicers, investors would not be able to rely on the cash flows of their investments. But if the CFPB’s suit is successful, the entire edifice of securitization is at risk because if every party is responsible for every other party’s operations, the structure cannot function.

Again, this is not just about student loans. The ruling will likely establish precedent for other consumer asset classes. Once established, the plumbing of securitization begins to crack across consumer sectors. Investors in everything from auto loan asset-backed securities to residential mortgage-backed securities will have to somehow assess these foundational changes to risk allocation from the party responsible to the innocent fixed income bondholders.

Conceivably, the government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac — who also establish trusts as part of their securitization mechanism — would suddenly have securitization vehicles subject to substantial liability. The same would hold true for all fixed-income investments made in collateralized securitizations held across Americans’ 401(k), pension, or other savings vehicles.  

None of this is contemplated in the markets, and as far as we can tell, none of this was contemplated in the creation of the CFPB’s authority.

Everyone involved in these markets — consumers, investors, and the whole architecture in between — should take notice of this situation. While we are hopeful the right outcomes will prevail, the risks to the economy are real.  

If a securitization participant makes mistakes, they are subject to liability. To return to my original metaphor, if your faucet leaks, you should get it tightened. But opening the wall and taking a sledgehammer to the plumbing usually creates a larger, more costly problem that will take much longer to fix. And it rarely works out the way you want. 

Michael Bright is the CEO of the Structured Finance Association.

This column does not necessarily reflect the opinion of HousingWire’s editorial department and its owners.

To contact the author of this story:
Michael Bright at [email protected]

To contact the editor responsible for this story:
Sarah Wheeler at [email protected]

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