On July 22, 2010, the Fifth Circuit affirmed a Western District of Texas opinion in favor of a lender and loan servicer in a lawsuit brought by mortgagors who alleged that the terms of their home equity loan violated the Texas Constitution. Cerda v. 2004-EQR1 LLC and Barclays Capital Real Estate Inc., — F.3d —-, 2010 WL 2853651 (5th Cir. July 22, 2010) (King, J.). Applying Texas law in a diversity action, and with one judge dissenting on one issue, the Fifth Circuit declined to certify the issues presented to it to the Texas Supreme Court and instead interpreted Article XVI, Section 50 of the state constitution in accordance with past Texas Supreme Court decisions, reliance on agency determinations and textual interpretations, and at one point an “Erie guess.”

The Cerdas owned a home and a 5-acre lot in San Antonio and in April 2002 applied to refinance a home equity loan in order to obtain a lower interest rate and pay property taxes. They applied telephonically to a mortgage broker and the broker prepared a Good Faith Estimate (GFE) which reflected a principal amount of $344,000, a fixed interest rate of 8.5%, closing costs of $8,600, and cash to the Cerdas at closing of $10,400. About a month after signing the GFE, a truth-in-lending statement, and a notice concerning extensions of credit as required under Section 50(a)(6), Article XVI of the Texas Constitution (“Section 50(a)(6)”), the Cerdas closed on the loan. At the closing, the Cerdas signed a written Uniform Residential Loan Application and executed a promissory note with the following terms: principal sum of $367,500; a variable interest rate starting at 8.99% for two years and variable semi-annually thereafter up to a maximum of 15.99% with a maximum increase for each period of 1.5%; and fees and advanced interest to the lender and broker totaling $21,000. The Cerdas never made any payments on the note and eventually Defendants began foreclosure proceedings, precipitating an avalanche of litigation by both sides.

Ultimately the case landed at the Fifth Circuit following the granting of partial summary judgment and then judgment in Defendants’ favor at a bench trial. At the outset, the Fifth Circuit acknowledged that home equity loans are of “relatively recent vintage” in Texas because of the state’s long history in protecting homestead property from foreclosure, and that even that they are now permitted, Section 50(a)(6), sets certain limitations on them. Nevertheless, the court rejected each of Plaintiffs’ three arguments: (1) that the waiting period between the time they applied for the loan and the closing was not sufficient to create a lien on their homestead; (2) that their loan payments were not “substantially equal” due to the variable rate of their loan; and (3) that certain charges that they paid at the closing were improperly characterized as interest rather than fees subject to a 3% cap of the principal amount of the loan.

The court disposed of the first timing argument based on a textual interpretation of competing Constitutional provisions in effect in 2002 (since amended), but turned to legislative history for the second and third points. The court noted that Section 50(a)(6)(L) required as of 2002 that a home equity loan must be paid in substantially equal successive monthly installments, whereas Section 50(a)(6)(O) authorized variable interest. The Plaintiffs argued that any interest rate increase must be met with an increase in the extension of the term so as to keep the payments the same. The court, however, accepted Defendants’ position that the scheduled payments need only be substantially equal between payment increments (in the Cerdas’ case, for each six-month period before the interest rate could vary), and that the purpose of these provisions as drafted was to prevent lenders from requiring balloon payments that would force a mortgagor to have to pay or refinance a large amount at the end of the loan term.

The court also accepted Defendants’ argument that the “yield spread premium” – the amount paid to the broker by the lender for selling a loan with an interest rate greater than the market rate (but ultimately charged to the mortgagor in this case) – was not subject to the 3% fee cap within the meaning of Section 50(a)(6)(E) because it was an indirect payment from the mortgagor to the lender and ultimately the broker. Additionally, because there were only conflicting appellate court decisions on whether discount points should be characterized as fees or interest, the court ventured an “Erie guess” as to how the Texas Supreme Court would rule and held that discount points applied to the Plaintiffs’ loan were appropriately characterized as interest and therefore did not apply toward the fee cap either. 

In a partial dissent, Judge Haynes argued that the question of whether the payments on a variable-rate loan were substantially equal should have been certified to the Texas Supreme Court because of the harsh consequences that follow from Section 50(a)(6)’s violation (including the forfeiture by lenders of all principal and interest if they fail to cure violations of their obligations) and from the far-reaching effect of the court’s ruling on “thousands” of borrowers with variable-rate loans, including the Plaintiffs whose payments could range from $2,950 to almost $5,000 per month, who might suffer “payment shock” as a result of fluctuating interest rates.