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Regulation | Peer-Reviewed Research

White Picket Fences

How A Rule To Protect Consumers Reduced Access To Credit

Based on research by Stephanie Johnson

How A Rule To Protect Consumers Reduced Access To Credit

  • Post-2008 federal policy raised the cost of home loans.
  • The policy also led to a drop in the quantity and size of home loans.
  • The policy would have had little effect on default rates during the housing crisis.

In the Great Recession of 2007 to 2009, unemployment rates rose dramatically, from 5 to 10%. Men, Blacks, Latinx, young workers and the less educated were hit hardest. The economic freefall was precipitated by a deluge of lending with little consideration of borrowers’ ability to repay home loans. 

Outrage over the economic disaster led to major governmental reforms of the $600 billion U.S. consumer mortgage lending industry. In 2010, a bipartisan Congress passed the Dodd-Frank Wall Street Reform Act, designed to reduce systemic risk and prevent predatory lending. Four years later, the Consumer Financial Protection Bureau (CFPB) was charged with implementing the so-called Ability-to-Repay (ATR) Rule, which requires lenders to make a good faith effort to determine a borrower’s ability to repay. Under this rule, lenders that fail to comply and then try to foreclose on a borrower are subject to legal action. The borrower is also entitled to retaliate and sue by asserting a regulatory violation. 

As part of the consumer protection process, the CFPB also created a class of low-risk loans known as qualified mortgages. These automatically satisfy the ATR Rule because they require a debt-to-income ratio (DTI) of 43% or less. Such mortgages were designed to reduce defaults and limit the extent to which households must curb personal consumption when facing economic challenges. 

But how did these policies work in practice? In a recent study, Rice Business professor Stephanie Johnson and a team of coauthors took a close look at how these consumer protections affected the average borrower in real life. Their results were unsettling. The macro regulatory approaches meant to help avert a repeat of 2008, the researchers found, had some large unintended consequences. 

To reach their conclusions, Johnson’s team reviewed 1.2 million mortgages taken out between January 2010 and December 2015. For their data, they tapped the CoreLogic Loan-Level Market Analytics (LLMA) database. The average loan in the sample amounted to $265,000 with an interest rate of 4.3%. Borrowers had an average FICO score of 755, a loan-to-value (LTV) of 80%, and a debt-to-income (DTI) of 33%. 

The team found that the new regulations affected mortgage lending in several areas. First, because the new policies make the lender responsible for a borrower’s inability to keep up with payments, lenders typically pass the burden onto the borrower in the form of high interest rates. As a result, consumers today pay $1700 to $2600 more for access to credit over the life of the loan. The consumers most deeply affected by the regulations were those who took out so-called jumbo mortgages: loans valued at $548,000 or more.

Under the new regulations, the lending of these mortgages decreased by approximately 2%, or $600 million. This is especially striking, considering that this class of borrowers tends to have both higher FICO scores and larger down payments.

The regulations also had unintended consequences on the loan industry. Because of new legal liabilities, many lenders got out of the non-qualified mortgage business altogether. Others simply slashed the number of high-risk products they offered. If the policy had been applied to the entire market (not just jumbo loans) mortgage originations would have declined by approximately $12 billion. Fifteen percent of jumbo loans with DTIs above 43 percent disappeared entirely. In some cases, would-be borrowers simply decided against home buying. Others took out smaller loans, making buying decisions that may have then affected their quality of life.

The researchers also looked at loan performance, which is typically gauged by default rates. For this study, a default was defined as a payment that was late by 90 days or more, or if the property was repossessed within 5 years of the loan date. Of the loans the researchers analyzed, those above the 43 percent cutoff did not perform much worse than loans with moderate DTIs. In fact, the team concluded, if the regulations had been in effect pre-crash, they would have had little effect, only reducing the default rate by 0.2 percentage points. 

Designed to ward off a repeat of the 2008 economic crisis, the federal government’s new lending rule actually offered little new protection for consumers. At its core, Johnson and her colleagues found, the rule was based on a faulty premise of a strong link between DTI and default. As a result, the rule designed to protect homeowners simply reduced their access to credit – without reining in default rates.

Stephanie Johnson is an assistant professor of finance at the Jesse H. Jones Graduate School of Business at Rice University. Her research focuses on household finance and empirical macroeconomics.

Anthony A. Defusco is an Associate Professor of Finance at the Kellogg School of Management at Northwestern University.

John Mondragon is a senior economist at the Federal Reserve Bank of San Francisco. 

To learn more please see: Defusco, A. A., Johnson, S., & Mondragon, J. (2019). Regulating Household Leverage. The Review of Economic Studies. 

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