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Usury Lawsuits Put Future of a $563 Billion Bond Market at Risk

Claire Boston

(Bloomberg) -- A pair of lawsuits targeting entities that JPMorgan Chase & Co. and Capital One Financial Corp. use to bundle credit-card loans into bonds could threaten the future of the $563 billion market for debt backed by consumer obligations.

At issue is whether credit card interest rates can be considered usurious. A Civil War-era piece of legislation has long shielded national banks from having to comply with state regulations, some of which cap the maximum rate on loans at as little as 5%. But borrowers are arguing that the packaging of credit-card debt into notes to sell to investors removes it so far from a bank that the shield shouldn’t apply.

The defendants say the suits are baseless because banks still maintain customer relationships and charge interest -- even if they’ve bundled rights to receive the interest into securities.

Should the plaintiffs prevail, the ruling would chill the market for bonds tied to consumer loans, industry groups say, forcing banks to keep more risk on their balance sheets and stifling their ability to extend credit. The fallout could ultimately extended to the $9 trillion mortgage-backed securities market, causing home loans to fall under a patchwork of state regulations, they warn.

“Is it something that people worry about? Absolutely,” said Scott Cammarn, co-chair of the financial services group at Cadwalader, Wickersham & Taft in Charlotte, North Carolina. “It’s worried about by originators. It’s worried about in the secondary market.”

The plaintiffs -- a group of New York credit-card users paying interest rates on their balances in excess of the state usury limit of 16% -- are seeking class-action status for the cases. U.S. consumers pay an average interest rate of 17.1% on their credit-card debt, according to the Federal Reserve.

In 2015, the Second Circuit Court of Appeals -- which hears cases from New York, Connecticut and Vermont, ruled that banks’ shield from usury laws doesn’t apply if a lender writes off bad credit card loans and sells the accounts to a non-bank debt collector.

The cardholders are arguing that the process of bundling credit card loans into bonds -- which requires a bank to sell the debt into a separate bankruptcy-remote vehicle -- is effectively the same type of transfer, making the credit-card rates usurious under state law and therefore uncollectable.

A favorable ruling for the plaintiffs would apply to securitized bonds containing credit-card loans made to borrowers residing within the Second Circuit’s jurisdiction. But market participants say it would likely only be a matter of time before similar cases popped up elsewhere, tied to other types of debt.

‘Securitization Scheme’

JPMorgan and Capital One themselves aren’t being sued. Rather, it’s the entities set up to help issue the ABS, along with the companies that help supervise the trusts on behalf of investors.

“Through this securitization scheme, defendants have engaged in a standard practice and policy of charging, collecting, receiving and attempting to collect interest from plaintiffs and class members in excess of the permissible interest rate,” lawyers for the plaintiffs wrote in a June 6 filing against the JPMorgan-linked entities. “Non-banks cannot charge usurious interest rates merely because they purchased or were assigned loans by national banks.”

Spokeswomen for JPMorgan and trustee Bank of New York Mellon Corp. declined to comment, while representatives for Capital One and trustee Wilmington Trust didn’t immediately respond to requests for comment.

The plaintiff “entered into a written cardmember agreement with JPMorgan Chase Bank, which remains in force,” the defendants argued in an Aug. 6 filing. The plaintiff “equates JPMorgan’s securitization of his receivables with the outright sale of his credit-card account. Courts have consistently and repeatedly rejected that equation.”

A court decision that the bundled debt can be held to state-level restrictions could “dramatically upset” the lending industry, according to trade groups the Bank Policy Institute and the Structured Finance Association.

Securitization helps banks limit lending risks and reduce borrowing costs, which are passed on to consumers and businesses in the form of lower interest rates. The structures allow banks to lend to riskier people, the pair wrote in a Aug. 13 brief.

MBS Risk

Credit-card and other asset-backed securities make up about $563 billion of the broader market for securitized bonds. But the trade groups argue that a court decision favoring the plaintiffs could have implications for a much larger universe of debt, including $9 trillion of mortgage-backed securities.

That’s because of the structural similarities between ABS and MBS. When banks take bundles of consumer credit card loans or mortgages and package them into bonds, they sell the debt to bankruptcy-remote vehicles, helping investors get exposure to pools of individual borrowers without having to worry about the financial health of the bank that made the loans.

The banks maintain the lending relationship with consumers, but pass on the right to receive interest and principal payments to the bond investors. In many cases, banks also hold onto a slice of the securities as a form of “skin in the game.”

Still, if the plaintiffs prevail, it’s unlikely that the securitization market would dry up overnight. For one, the litigation only affects borrowers in select states. And while credit card and auto loan interest rates for borrowers can climb well into the double-digits, mortgage rates are typically much lower, often below the most stringent usury definitions. The average 30-year mortgage rate currently sits at about 3.56%, near a historical low.

The plaintiffs have until Sept. 17 to respond to the motion to dismiss the Chase case. In the Capital One litigation, defendants have until Sept. 27 to serve a motion to dismiss the suit.

To contact the reporter on this story: Claire Boston in New York at cboston6@bloomberg.net

To contact the editors responsible for this story: Nikolaj Gammeltoft at ngammeltoft@bloomberg.net, Boris Korby, Shannon D. Harrington

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