Volume 108

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

by Patricia A. McCoy & Susan M. Wachter

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. 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, which argued that the rule will fail to limit bubbles because mortgage lenders will underestimate their liability exposure when home prices are rapidly appreciating and ignore the rule as a consequence. On the contrary, we argue that the ability-to-repay rule acts as a circuit breaker that will help prevent poorly underwritten loans from fueling a future bubble in housing prices that creates the risk of financial collapse.

Without the ability-to-pay rule, loan-to-value limits are not enough to curb property bubbles. Although loan-to-value limits are important to constraining risk, the denominator—the value—will become artificially elevated during a bubble and will only fall after the bust is underway, shrouding the elevated default risk at origination and giving false confidence that mortgage risk is contained. Moreover, we know from the crisis that the inability to repay exacerbates default risk, along with the resulting further depression in housing prices. The ability-to-repay rule is a collective-action solution to this source of systemic risk and a vital mainstay of financial stability.

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