Ability to Repay, Risk-Retention Standards, and Mortgage Credit Access

Summary

Prior to the recent financial crisis, mortgage underwriting standards were relaxed to the point where many borrowers could only repay their loans if favorable financial conditions that existed at the time of origination remained intact. In other words, borrowers obtained mortgage loans that relied upon interest rates not rising or the value of the underlying collateral (house prices) not declining. When market conditions changed, however, many mortgage loans became delinquent and went into default. The mortgage defaults often translated into large losses for both the borrowers and the financial industry.

After enactment of The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act; P.L. 111-203), the Federal Reserve Board announced a proposed qualified mortgage (QM) rule that would establish “ability to repay” standards for mortgage lending. The Federal Reserve, along with other federal regulatory agencies, also jointly released a proposed risk retention or qualified residential mortgage (QRM) rule to require parties involved in a transaction in which mortgage originations are sold to retain “skin-in-the-game” or a minimum percentage of the credit risk of financial products, which would result in the sharing of any eventual losses. Adoption of ability to repay and risk-retention standards may discourage lenders from excessively relaxing lending standards even during economic boom periods, thus making loan repayment more resilient to sudden shifts in short-term economic and financial conditions.

The ability to repay and risk-retention standards, while designed to curtail the pre-crisis proliferation of risky lending practices, are likely to simultaneously reduce access to mortgage credit. Although ability-to-repay standards would encourage consistent underwriting at all times, some borrowers that benefit from lender flexibility during more favorable macroeconomic conditions are likely to face increased difficulty obtaining mortgage loans. Lenders may be reluctant to originate loans that are not in compliance with the ability-to-repay standards if this exposes them to increased legal risks. Likewise, risk-retention standards that translate into more stringent qualification requirements for borrowers are likely to increase barriers to homeownership for both creditworthy and disadvantaged borrowers.

The 112th Congress is overseeing the rulemaking stemming from the Dodd-Frank Act. This report examines the developments associated with the implementation of mortgage lending reforms. After summarizing the proposed ability to repay and risk-retention standards, a description of risky underwriting practices that occurred prior to the mortgage crisis is presented, followed by a discussion of possible effects on mortgage credit accessibility.

The Consumer Financial Protection Bureau (CFPB), which will prescribe final regulations on QM rule, has re-opened the comment period to seek further comments on the litigation risks that could potentially arise from the new requirements. The comments, however, should be narrowly focused and based upon analysis that uses mortgage data provided by the regulator of Fannie Mae and Freddie Mac. The closing date for comments will be July 9, 2012.