A court just ruled that CFPB's funding is unconstitutional, and that could be 'catastrophic' for mortgage markets

A court tossed out a regulation written by the Consumer Financial Protection Bureau for payday lenders last week, saying the agency's funding was unconstitutional and that it, therefore, lacked the ability to curb the industry.

The U.S. Court of Appeals for the Fifth Circuit voided a CFPB rule that prohibited payday lenders from debiting the accounts of customers who miss a payment without getting their consent first. While the ruling applied just to that regulation, financial service attorneys say it muddies the agency's authority and has the potential to upend all of its rules.

"The Fifth Circuit's ruling potentially calls into question every single rule, guidance and order that the CFPB has issued — as they all trace their origins to the CFPB's unconstitutional self-funding structure," regulatory attorneys Anthony DiResta and Luis Garcia of Holland & Knight wrote in a note to clients Tuesday.

If the agency's legal authority is undermined, it could have a profound affect on home lending markets — an industry that's prone to disruption when laws are murky, especially as interest rates rise.

"Anything that disrupts the mortgage market is potentially going to make it even harder for homebuyers to qualify for a loan," said Patricia McCoy, a professor of law at Boston College.

McCoy points to Georgia after the state passed a law in 2002 intended to protect consumers from predatory loans by allowing them to seek punitive damages from the loan originator and whoever bought the loan. That extended the potential damages to the Wall Street banks as well as mortgage investors Fannie Mae and Freddie Mac.

Top credit-rating agencies refused to rate residential mortgage-backed securities pools containing loans that originated in Georgia, which had a chilling effect on the MBS market. Fannie and Freddie, which buy mortgages and package them as securities to sell to investors, stopped buying mortgages in the state. The next year, the Georgia legislature changed the law, pulling back the liability provisions.

"The Fifth Circuit's decision threatens to paralyze mortgage lending in Mississippi, Louisiana, and Texas because lenders will lose certainty about what law applies to future mortgages that they make," McCoy said, referring to the states within the Fifth Circuit. She was part of the original leadership team at the CFPB during the Obama administration.

Established after the 2008 financial crisis, the CFPB created a series of rules for the mortgage industry, including standards for a 'qualified mortgage' based on a borrower's ability to repay a loan. Those two rules give mortgage investors and lenders legal protection from borrowers who claim they were deceived into taking out a loan they couldn't afford so long as it meets that standard.

If the Fifth Circuit decision is upheld, it could call into question those long-standing mortgage rules.

Many legal observers expect the decision will ultimately get appealed to the Supreme Court. While the high court is not required to take a case, this one raises significant constitutional questions. It could be a yearslong process, which may see other challenges to the CFPB's authority stopped or delayed until the case is resolved.

An appeal would take some time to play out. The Mortgage Bankers Association has been advising its members that the ruling is currently limited to the CFPB's payday-lending rule.

"We do like to settle rules that give us some safe harbors for the way that we make mortgages and we don't want that to all go away," Mortgage Bankers Association president and CEO Robert Broeksmit said Monday at the trade association's annual convention. Still, he vowed to keep fighting what he called the bureau's regulatory overreach. "Now is no time to make you hire more lawyers to try to understand what the bureau is doing."

While industry groups have filed lawsuits against several CFPB rules, losing the ability-to-repay and qualified-mortgage rules would be "devastating," said Richard Andreano, an attorney who leads the mortgage practice group at law firm Ballard Spahr.

"The loss of the CFPB mortgage regulations and the effect on the market would be catastrophic," said Andreano. He thinks the potential consequences would mean either the court or Congress would fix the situation before it would have an impact. "But it adds uncertainty, obviously, if you're in the mortgage business now," he said.

The protections provided by the ability-to-repay and qualified-mortgage rules also apply to the mortgage bond market, where home loans are packaged into securities and sold to investors. With no set guidelines, the ruling raises questions about how credit raters and mortgage bond investors would treat the loans.

"They do not want any loans in their loan pools that have a heightened risk of damages exposure because that exposure would extend to the investors who buy the securitized bonds," said McCoy.

S&P Global Ratings and Moody's Investors Service did not comment, but Fitch Ratings said it will be watching for any changes that would have an immediate effect on the mortgage market.

"Originators and servicers in the mortgage market are subject to the rules and regulations of a myriad of governing bodies at the state and federal level," said Roelof Slump, who runs operational risk for structured finance at Fitch. "Potential changes in how the CFPB are funded aren't likely to have an immediate effect on the mortgage market."

How the CFPB is funded, by the Federal Reserve instead of Congress, is the root of the problem. The design was intentional — to keep the agency free from political pressure. The court, however, said the funding was unconstitutional because the agency didn't answer to the people or Congress.

"I believe the court's decision on illegality of the CFPB funding mechanism is correct as is it's governance structure," said Bill Isaac, former head of the Federal Deposit Insurance Corp., who ran the bank regulator during the savings and loan crisis of the 1980s. "What that means in terms of the legality of past actions by the CFPB is difficult to predict."

Andreano expects the courts will find an interim solution, but that Congress will ultimately need to change the CFPB funding structure, "I do see there being a fix, but I think the lobbyists are going to be very busy for quite some time."

Jaret Seiberg, managing director at Cowen Washington Research Group, told investors earlier this week that if Republicans take control of one or both houses of Congress in the Nov. 8 elections, that could complicate efforts to fix the agency's funding.

In fact, he said the GOP could try to defund it altogether.

"We appreciate industry frustrations with CFPB, but a defunded agency could be worse as the laws would still apply, but guidance and safe harbors that financial firms rely upon as defenses to litigation may become invalid," he wrote.

The CFPB, meanwhile, said the ruling won't stop it from policing consumer lenders.

"The CFPB will continue to carry out its statutory mission enforcing federal law and protecting Americans from predatory financial institutions. Illegal practices are still illegal, and the CFPB is going to hold companies accountable when they break the law," the agency said in a statement.