Will Ability to Repay Rules make Reckless Lending a Thing of the Past?

The new ability to repay rules seems like a natural follow up to our story last month “Are Lenders Controlling the US Economic Recovery” . Will these new rules make reckless lending a thing of the past or will they simply spark a flurry of lawsuits to question the rules?

Qualified mortgage standards and the ability to repay rules provide a rigid framework designed to prevent lenders from irresponsibly inflating another painful housing bubble. The rules as drafted should achieve the desired effect.

The housing bubble inflated because lenders underwrote huge loans to borrowers who didn’t have the capacity to repay unless the value of the underlying collateral kept rising to bail them out. It became a massive Ponzi scheme that imploded and wiped out the housing market, the economy, and nearly our entire financial system. Regulators were wise enough to understand that much, and they were brave enough to pass the Dodd-Frank law to attempt to rein in the worst offenses. Part of the implementation of Dodd-Frank is the establishment of rules regarding the ability to repay a loan.

It’s shocking that bankers must be regulated in order to properly evaluate a borrowers ability to repay; prior to the age of securitization, lenders loaned their own money, and they lost money if they loaned it irresponsibly. In a system of originating to hold loans, lenders concerned themselves with the borrower’s ability to repay as a matter of survival; with securitization, lenders found they could pass the risk of default on to others, so they lost their concern for a borrower’s ability to repay the loan. Regulators had to restore it.

How far does a lender have to go to determine if a borrower has an ability-to-repay his or her mortgage? Yes, while the ability-to-repay rule of Dodd-Frank has standards, there’s no telling what sort of allegations will be brought up against a lender if a borrower happens to default. …

“How far does it go?” asked Anthony Sepci, partner at KPMG. “Do lenders have to go and interview the HR manager to ensure the applicant is doing well at his job, or follow someone through their rehab for their drug habit? How far do they have to dig and what’s the legal aspect?”

This is the crux of the problem with the new rule. There is no established standard of appropriateness, and there won’t be until suits are filed, and judges rule on the specifics of the cases. Only through case-law precedent will these standards be fully established.

Charles Gelinas, a partner with Dentons, said the potential for litigation is great because there’s no way of knowing what precedents the courts could set and there’s a lot open for interpretation.

Prior to January 10th, 2014, if a lender made a mortgage loan that a borrower couldn’t afford to pay back, there was no legal recourse. A borrower couldn’t file a lawsuit complaining that the mortgage couldn’t reasonably be repaid. There was no federal law against making mortgages to borrowers regardless of the borrower’s ability to repay the mortgage.

After January 10th, 2014, federal law (12 CFR § 1026.43) requires all lenders ensure borrowers have the ability to repay every mortgage loan a lender makes. If a lender fails to do so, a borrower may within three years of the loan’s origination, file a lawsuit claiming the lender failed to consider and verify the borrower’s reasonable ability to repay the mortgage loan. A successful lawsuit could result in statutory damages totaling up to three years’ finance charges and fees. Other statutory damages are available, in addition to actual damages, court costs, and attorney’s fees. A borrower may also assert a violation of the ability to repay rules (“ATR”) in a defense to a foreclosure action at any point in the mortgage’s term. The damages in this claim are limited to statutory damages totaling up to three years’ finance charges and fees.

There is no free house for a borrower if they win an ability-to-repay lawsuit, thankfully; however, the punishment is stiff enough that lenders will not want to face a rash of costly lawsuits from aggrieved borrowers either.

The big question is whether or not these rules provide a rigid enough box to prevent lenders from lending irresponsibly and creating another unstable housing bubble. Only time will tell how these provisions are enforced, but since lenders will face the wrath of millions of disgruntled borrowers rather than the impotent prods of captured regulators, I believe the qualified mortgage rules and the ability to repay rules go a long way toward keeping residential mortgage lending on the up and up.

What do you think about the ability to repay rules? We’d like to hear from you.

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