Financial Services Regulation: The New Ability-to-Repay Rule
On January 10, 2013 the Consumer Financial Protection Bureau released new proposed rules related to mortgage lending standards. In effect, the agency will implement an “Ability to Repay Rule” to govern those who engage in mortgage lending.
Here’s the agency’s announcement, which offers few details.
This news report from the Wash Post’s business section is more informative.
The new rules will apply to “qualified mortgages” and are designed to keep lenders from issuing loans to borrowers who lack the means to pay them back. As the CFPB explains:
The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act created broad-based changes to how creditors make loans including new ability-to-repay standards, which we are charged with implementing. Among the features of our new Ability-to-Repay rule:
- Potential borrowers have to supply financial information, and lenders must verify it;
- To qualify for a particular loan, a consumer has to have sufficient assets or income to pay back the loan; and
- Lenders will have to determine the consumer’s ability to repay both the principal and the interest over the long term − not just during an introductory period when the rate may be lower.
Notably, lenders that follow these rules for qualified mortgages will be protected from certain types of lawsuits from borrowers. As the Washington Post article cited above explains, this was considered to be a “big win” for the lenders. What’s going on here?
As Ed and I discuss in Chapter 6 of Madmen, the players in the 2008 financial crisis are many. Importantly, the actions of economic players should not be seen as separate from those of political players. Indeed, as noted in an earlier post, a more-helpful perspective is provided in Smith, Wagner and Yandle’s paper, “A Theory of Entangled Political Economy, with Application to TARP and NRA.”
A key point from Smith, Wagner and Yandle is that there is a huge difference between, on the one hand, a dyadic relationship between a lender and a borrower under a set of political and institutional rules, and on the other hand, a triadic relationship in which political entities participate directly in market transactions.
Under the former, a lender evaluates a potential borrower with an eye for getting a return on the requested loan. Under the latter, the same may happen, but the incentives are different, and a lot more is going on.
Under a “triadic” model, the political actors — regulators, nonprofit agencies, consumer groups, etc. — do not have residual claimancy. They do, however, have interests. As the authors point out:
While political entities cannot appropriate profit directly from their activities, successful political action will nonetheless create profits to be appropriated, for profit is just another word for gain. What we have is universal competition as a feature of universal scarcity, only with the enterprises that engage in competitive activity doing so under different institutional rules of property rights that create setting of cooperation-cum-conflict that we denote as entangled political economy.
What might we expect from the continued post-crisis political negotiation? Rules to protect borrowers from lenders who would sell them unaffordable mortgages? Check. Rules to protect lenders from borrowers who sue after agreeing to an unaffordable mortgage? That, too.
Interestingly, the CFPB’s announcement talks about the former but not the latter. And it does this with anecdote:
Earlier this year, we heard from a California man named Henry, who was in the process of foreclosure. He was desperate. During the overheated years, a lender sold him a mortgage valued at more than half a million dollars. This was far more than he could afford on his annual salary of less than $50,000. He said he’d assumed that the lender knew what it was doing when he qualified for such a large loan. He’s now worried not only about losing his home, but about losing his family’s entire future.
Henry is not alone. Unaffordable loans helped cause the worst financial crisis since the Great Depression. People across the country were sold unsustainable mortgages. Some may have entered with their eyes open, seeking to ride the wave of rising housing prices, but many were led astray. For many borrowers, it appears that lenders ignored the numbers to get the loan approved. This kind of reckless lending was an endemic problem.
To put it simply: lenders should not set up consumers to fail.
The CFPB is painting a pretty clear picture of one interpretation of the causes of the 2008 financial crisis. And this interpretation, which is broadly supported by the Dodd-Frank legislation, will influence future rules.
What specific near-term rules might we expect for financial services? What would true systemic reform look like? And finally, what new way of looking at financial services — what new idea — would be necessary for such systemic reform to come about?
[Updated to correct typo on January 11, 2013.]