Why the Ability-to-Repay Rule is Vital to Financial Stability

Abstract

Following the 2008 financial crisis, Congress required residential mortgage lenders to make a reasonable determination of borrowers’ ability to repay before extending credit. Most regard this ability-to-repay rule as a consumer protection provision. But what is less well appreciated is the rule’s importance in protecting financial stability.

We respond to a landmark 2015 critique in the University of Pennsylvania Law Review arguing that the rule will fail to limit bubbles because mortgage lenders will ignore it when home prices are rapidly appreciating by underestimating their liability exposure. On the contrary, we argue that the ability-to-repay rule acts as a circuit breaker that helps prevent poorly underwritten loans from fueling a future bubble in housing prices, with the risk of financial collapse.

Without that rule, loan-to-value limits are not enough to curb property bubbles. While loan-to-value limits are important to constraining risk, the denominator — the value — will be artificially elevated during a bubble, and will only fall after the bust is in process, failing to provide information at origination of the elevated default risk, and giving false confidence that mortgage risk is contained. Moreover, we know from the crisis that it is the inability to repay that makes foreclosure and the resulting further depression of housing prices inevitable. The ability-to-repay rule is a collective action solution to this source of systemic risk and a vital mainstay of financial stability.

Keywords: financial stability, systemic risk, housing bubbles, ability-to-repay rule, mortgages, Dodd-Frank Act, sectoral tools

JEL Classification: G01, G02, G18, G21, G28, K23, K42