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

66 Pages Posted: 5 Sep 2019 Last revised: 19 Sep 2019

See all articles by Patricia A. McCoy

Patricia A. McCoy

Boston College Law School

Susan M. Wachter

University of Pennsylvania - Wharton School, Department of Real Estate ; University of Pennsylvania - Finance Department

Date Written: August 16, 2019

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

Suggested Citation

McCoy, Patricia Ann and Wachter, Susan M., Why the Ability-to-Repay Rule is Vital to Financial Stability (August 16, 2019). Georgetown Law Journal, Forthcoming; Boston College Law School Legal Studies Research Paper No. 510. Available at SSRN: https://ssrn.com/abstract=3444360

Patricia Ann McCoy (Contact Author)

Boston College Law School ( email )

885 Centre Street
Newton, MA 02459-1163
United States

Susan M. Wachter

University of Pennsylvania - Wharton School, Department of Real Estate ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104-6330
United States
215-898-6355 (Phone)

HOME PAGE: http://real.wharton.upenn.edu/~wachter/index.html

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

HOME PAGE: http://real.wharton.upenn.edu/~wachter/index.html

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