Asset-Backed Securities Face New Risks From US Court Decision

A federal court decision has raised new legal risks for a corner of Wall Street that bundles consumer loans into asset-backed securities.

A US appeals court last week for the first time upheld the power of the Consumer Financial Protection Bureau to sue trusts that issue the securities if debt-collection companies or others they hire run afoul of the law. The trusts outsource the role of collecting on the loans that they package into bonds and sell off to investors.

The precedent could boost borrowing costs for firms that use securitizations by spurring investors to demand higher yields to compensate for the risk the trusts could be hit with lawsuits that would claw away funds. Credit rating firms may also be more cautious about assigning high grades to securities backed by debts from risky borrowers, like auto loans and subprime mortgages.

There are roughly $750 billion of US asset-backed securities outstanding and about two-thirds of that is backed by various forms of consumer debt, according to data from Barclays Plc. Much of that is owed by borrowers with lower credit scores, a segment of the industry that’s frequently drawn attention from regulators for its aggressive debt-collection practices.

“This could have big consequences for trusts that contract with servicers that don’t have rigorous and incorruptible practices,” said Steven Schwarcz, a professor at Duke University School of Law and an expert in securitization.

The decision by the third circuit appeals court stems from a 2017 lawsuit filed by the CFPB against trusts originally set up by First Marblehead, a Boston-based company that bought up 800,000 student loans from banks starting in the 1990s. First Marblehead then transferred the loans into a series of trusts, which issued bonds to investors and contracted with outside companies to service the loans. They filed thousands of lawsuits against debtors seeking to collect payment.

The CFPB sued the trusts and a debt collector for them, Transworld Systems, alleging that they relied on faulty paperwork in many of the lawsuits. The trusts have argued they’re outside the CFPB’s enforcement authority because they don’t have any staff and instead rely on separate companies known as servicers to collect money from borrowers.

A judge rejected that argument in 2021, and the trusts appealed it. Last week’s decision by a three-judge panel denied the argument that they’re exempt from the scope of the CFPB, ruling that the trusts were subject to its authority because they hired the servicers. It then handed the case back down to the lower court to let it proceed.

The CFPB declined to comment. Transworld didn’t respond to requests for comment.

Lawyers and industry groups are holding meetings to discuss implications of the case. An American Bar Association committee plans to discuss the case at its next meeting this week. And the Structured Finance Association, an industry lobbying group, on Friday held the first meeting of a task force assembled to discuss it, said Michael Bright, the group’s chief executive officer.

“We are disappointed by this ruling and are concerned about the very meaningful negative implications of it,” said Bright.

While the ramifications of the latest ruling are still unclear, ratings agencies have been following the case closely. After the lower court’s ruling, Fitch Ratings highlighted possible lawsuits as a new risk, while Moody’s Ratings warned that pools of loans to riskier borrowers could be targeted by authorities.

Photograph: The New York Stock Exchange (NYSE) in New York on Thursday, March 21, 2024. Photo credit: Michael Nagle/Bloomberg