The collapse of the housing bubble in 2008 triggered a deep recession from which the market is just now recovering. The bubble was fed by artificially low interest rates, government subsidies for risky loans, and federal quotas for lending to low-income homebuyers. In response, Congress hastily enacted the Dodd-Frank legislation, which imposed a massive regulatory framework upon the entire financial system. It also further empowered the very regulatory establishment that fueled the crisis and then failed to contain it. Since its passage in 2010, Dodd-Frank has weighed down the housing industry with thousands of pages of new regulations that raise lending costs and restrict credit options.
Lenders and Litigation: The cornerstone of Dodd-Frank’s mortgage rules is a new requirement imposed on lenders to ensure that borrowers have the “ability to repay” a mortgage. This provision requires lenders to “make a reasonable and good faith determination based on verified and documented information that the consumer has a reasonable ability to repay the loan according to its terms.” In turn, borrowers gain the right to sue lenders for misjudging their financial fitness. The obvious consequence of this new cause of action will be more litigation, which in turn limits the availability of credit.
The ability-to-repay provision upends the principles of accountability which long prevailed in the mortgage market. This perversion of credit principles presumes that consumers are incapable of acting in their own interests. Also troubling is the wide, discretionary authority granted to the Consumer Financial Protection Bureau to determine whether lenders properly determined a borrower’s “ability to repay.” In theory, this flexibility would give lenders space to evaluate buyers’ credibility based on a variety of factors. But in reality, a new government agency retains the final right to determine whether the belief in a borrower’s “ability to repay” was reasonable and in good faith. This makes the CFPB the final enforcer of a shifting and arbitrary standard. Its unpredictability can only cause lending agencies to tighten their restrictions on credit.
The CFPB thus exercises immense powers over lenders, which robs them of the discretion they once enjoyed to evaluate a prospective borrower. Though designed to protect homeowners from so-called “predatory lending” practices, the regulation actually harms them by removing mortgage options from the market.
“Safe Harbors” and Fewer Options: Recognizing the potential for significant litigation posed by the new rules, the CFPB created a so-called “safe harbor” provision for lenders. The bureau created a category of “qualified mortgages” (QMs), with standardized loan limits, fee caps, and prescribed payment calculations that satisfy the ability-to-repay criteria. Although the QM regime can help protect lenders from a problem of Dodd-Frank’s own making, it also restricts options for prospective homebuyers by incentivizing banks to focus exclusively on mortgages that satisfy the narrow QM requirements.
Hardest hit are first-time homebuyers. The QM requirements include a strict debt-to-income ratio of 43 percent, which is difficult for young adults with college debt to meet. But these are the very homebuyers needed to prompt churn in the market, allowing current homeowners to shift their equity to a higher-priced house—fueling upward mobility in the property chain. Cutting them off from the market causes stagnation.
Many common loans do not meet the QM standards. But an array of mortgage options is necessary to meet the diverse needs of homebuyers. Instead of creating a healthy and diverse market that pairs buyers with the best mortgage to fit their needs, Dodd-Frank imposes a one-size-fits-all approach that stifles credit overall.
A Contradictory Standard: Dodd-Frank leaves in place conflicting mandates that incentivize lending to high-risk borrowers. Beginning in 1992, Congress has required Fannie Mae and Freddie Mac to back mortgages to low-income and moderate-income borrowers, many of which fall into the sub-prime category. Though government-mandated sub-prime lending ultimately caused the enterprises to fail, and was a major factor in the housing bubble, Fannie Mae and Freddie Mac have since been bailed-out and set back to the task of acquiring sub-prime mortgages. The result is a housing market that simultaneously restricts the access of qualified homebuyers to credit, while continuing risky practices that threaten the stability of the entire market.
Conclusion: Failed government policies are responsible for most of the turbulence in the housing market during the past 20 years. The 3,500 pages of new mortgage regulations make it virtually impossible for lenders to keep pace with the constant changes in market conditions. Instead, it constrains the availability of credit and increases the costs. In order to truly set the housing market on a solid footing, Congress needs to repeal the mortgage constraints in the Dodd-Frank statute and allow the market to recover naturally.