Measuring the Impact of Dodd–Frank on Household Leverage
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Policy Finance & Accounting Dec 1, 2017

Mea­sur­ing the Impact of Dodd – Frank on House­hold Leverage

The regulation’s attempt to pre­vent peo­ple from tak­ing on mort­gages they can’t repay may not work as intended.

a family adds assets to its house

Morgan Ramberg

Based on the research of

Anthony DeFusco

Stephanie Johnson

John Mondragon

In the wake of the Great Reces­sion, even nonecon­o­mists became famil­iar with the phe­nom­e­non com­mon­ly blamed for caus­ing it: house­hold leverage.” 

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Dra­ma­tized in the 2015 film The Big Short, this bit of jar­gon describes the rela­tion­ship between a homeowner’s debt and the resources they have avail­able to pay it back. If the for­mer con­spic­u­ous­ly out­weighs the lat­ter, the house­hold is high­ly leveraged.”

This does not nec­es­sar­i­ly mean that house­hold lever­age always trans­lates into missed pay­ments, defaults, and fore­clo­sures. But in 2007 and 2008, a cas­cade of those very effects helped over­whelm the glob­al finan­cial system. 

Com­ing out of the cri­sis, there was a big reac­tion, in both acad­e­mia and pol­i­cy cir­cles, that house­hold lever­age got us into trou­ble and that we need­ed to take seri­ous steps to reg­u­late it,” says John Mon­drag­on, an assis­tant pro­fes­sor of finance at the Kel­logg School. There have been a lot of efforts, not just in the U.S. but around the world, to reg­u­late how much house­holds can bor­row in a stronger way.” 

But how do these reg­u­la­tions actu­al­ly work when put into practice? 

Mon­drag­on, along with Kel­logg col­league Antho­ny DeFus­co and Stephanie John­son, a PhD stu­dent in eco­nom­ics at North­west­ern, ana­lyzed how the U.S. mort­gage-lend­ing mar­ket respond­ed via the Dodd – Frank act to a spe­cif­ic kind of reg­u­la­tion intend­ed to pre­vent house­holds from bor­row­ing more than they could afford. 

The law pro­vid­ed lenders with a con­ve­nient way of vet­ting poten­tial bor­row­ers based on a sim­ple sta­tis­tic: the amount of debt being request­ed divid­ed by the amount of income. If this num­ber rose above a cer­tain thresh­old — and the bor­row­er end­ed up fail­ing to make their pay­ments — the law stip­u­lat­ed that the bor­row­er could then sue the lender alleg­ing that the lender extend­ed the bor­row­er cred­it they knew they would not be able to afford. The assump­tion was that this legal dis­in­cen­tive would encour­age lenders to seri­ous­ly eval­u­ate if a bor­row­er can actu­al­ly afford the mortgage. 

But what the researchers dis­cov­ered was that lenders react­ed to the reg­u­la­tion in ways that law­mak­ers may not have intended. 

The Dodd – Frank Act

When the Reces­sion hit, Amer­i­can pol­i­cy­mak­ers were eager to draft leg­is­la­tion that they hoped would pre­vent future excess­es and abus­es of house­hold leverage. 

The Dodd – Frank Wall Street Reform and Con­sumer Pro­tec­tion Act of 2010 direct­ly addressed it, by requir­ing mort­gage lenders to explic­it­ly assess a borrower’s abil­i­ty to repay” (ATR). If a bor­row­er default­ed on a loan that vio­lat­ed this ATR rule, he or she could sue the lender for dam­ages — a pro­vi­sion intend­ed to dis­cour­age preda­to­ry lend­ing practices. 

How do these reg­u­la­tions actu­al­ly work when put into practice? 

But Dodd – Frank also helped lenders, by defin­ing a sim­ple set of loan cri­te­ria, which, if sat­is­fied, meant that the loan was auto­mat­i­cal­ly in com­pli­ance with the new law.

It said, you won’t face any legal risk as long as the loan checks these five box­es,’” explains DeFus­co, an assis­tant pro­fes­sor of finance. That cre­ates a big incen­tive for lenders to cre­ate loans that check those boxes.” 

Still, it is dif­fi­cult to mea­sure the real-world effects of a reg­u­la­tion like Dodd – Frank’s ATR rule, DeFus­co says. 

Any time you ask how the mar­ket is going to respond to some pol­i­cy, it’s dif­fi­cult to come up with the coun­ter­fac­tu­al: that is, how would the mar­ket have behaved if the pol­i­cy weren’t passed?” 

Luck­i­ly for the researchers, that data exists. The way the law was imple­ment­ed pro­vid­ed the per­fect exper­i­ment for fig­ur­ing out what this coun­ter­fac­tu­al would have been. 

Dodd – Frank’s ATR rule was only par­tial­ly imple­ment­ed in 2014 (and remains so until 2021). This split the mort­gage mar­ket in two: a reg­u­lat­ed por­tion of the mar­ket and anoth­er where the reg­u­la­tion nev­er hap­pened. The idea was to ease into the reg­u­la­tion in order to not be too heavy-hand­ed, DeFus­co explains. 

The authors focused on one met­ric for defin­ing auto­mat­ic com­pli­ance with the ATR rule, known as debt-to-income (DTI) ratio. They chose this met­ric because it was the only part of the law that explic­it­ly addressed leverage. 

With­in the reg­u­lat­ed seg­ment of the mort­gage mar­ket, any loans with a DTI ratio above 43 per­cent — which trans­lates into high­ly lever­aged house­holds — would fail to sat­is­fy Dodd – Frank’s auto­mat­ic abil­i­ty to repay” cri­te­ri­on. This doesn’t mean lenders would auto­mat­i­cal­ly be break­ing the law by grant­i­ng loans to these cus­tomers; it sim­ply means that they could poten­tial­ly be sued by default­ing bor­row­ers because their loans did not qual­i­fy for auto­mat­ic protection. 

The pol­i­cy is thus mak­ing those loans more expen­sive for lenders, in that they face extra legal risk if they do make those loans,” DeFus­co explains. 

Sur­pris­ing Lender Reactions

The researchers ana­lyzed rough­ly 1.2 mil­lion loans between 2010 and 2015 to see how lenders react­ed to this extra expense for loans that did not qual­i­fy for auto­mat­ic pro­tec­tion. They had two the­o­ries for what might happen. 

One response would be to pass that extra cost through to bor­row­ers in the form of high­er inter­est rates. The oth­er reac­tion would be to sim­ply not orig­i­nate high-DTI loans in the first place — either by exit­ing the mar­ket or by forc­ing bor­row­ers with DTI ratios above 43 per­cent to accept small­er loans, thus push­ing the DTI ratio below the 43 per­cent threshold. 

The researchers found, as expect­ed, that lenders respond­ed in both ways. 

Yet the researchers were sur­prised by how lit­tle lenders marked up their inter­est rates for high-DTI loans. A DTI ratio above 43 per­cent result­ed in the aver­age bor­row­er pay­ing between $1,200 and $2,500 more in inter­est over the life­time of the loan — not a very large num­ber,” DeFus­co says, in the con­text of a 30-year mortgage. 

But the quan­ti­ty response, he says, was pret­ty big”: when the reg­u­la­tion was imple­ment­ed, an esti­mat­ed 20 per­cent of high-DTI bor­row­ers were forced into small­er loans below the ATR thresh­old, and 15 per­cent were refused loans entire­ly. These shift­ed and lost loans rep­re­sent about $1.3 bil­lion in affect­ed mort­gages, accord­ing to the authors. 

This lop­sided response from mort­gage lenders sur­prised the researchers. 

From an aca­d­e­m­ic point of view, it’s always bet­ter to just charge the right price for some­thing than to not sell it at all and poten­tial­ly leave mon­ey on the table,” DeFus­co says. 

It also may not have reflect­ed pol­i­cy­mak­ers’ intention. 

The quan­ti­ty response is not what they expect­ed,” Mon­drag­on says. There’s a broad­er dis­cus­sion in the back­ground of all this about whether or not cred­it has become too tight and there are some con­cerns about whether reg­u­la­tion may be part of that.” 

DeFus­co adds that, because their results only cor­re­spond to a small seg­ment of the total mort­gage mar­ket, we’re not nec­es­sar­i­ly say­ing this pol­i­cy itself is respon­si­ble for the tight cred­it that’s going around now. But our results are very sug­ges­tive of the idea that as soon as you make it riski­er for lenders to do some­thing, they’re going to respond by mak­ing few­er loans instead of chang­ing their prices.” 

Is Reg­u­la­tion Pre­vent­ing Bad Loans?

So is Dodd – Frank work­ing? It depends, say the authors. 

If the point of Dodd – Frank’s ATR reg­u­la­tion was to pre­vent poten­tial­ly bad” loans from being made in the first place, one could point to the con­trac­tion in cred­it extend­ed to high-DTI bor­row­ers as a ring­ing endorsement. 

But there is a poten­tial prob­lem with that inter­pre­ta­tion: Does pre­vent­ing loans with DTI ratios above 43 per­cent actu­al­ly result in few­er loans going bad? 

The researchers ana­lyzed loan default rates for mort­gages made with high-DTI ratios between 2005 and 2008, dur­ing the run-up to the finan­cial cri­sis. They found lit­tle evi­dence that 43 per­cent is a mag­i­cal thresh­old. Loans with DTI ratios above 43 per­cent did not default sub­stan­tial­ly more often than loans slight­ly below that ratio. 

Fur­ther­more, they esti­mate that if the Dodd – Frank abil­i­ty to repay” reg­u­la­tion had been in place for the entire mort­gage mar­ket pri­or to the finan­cial cri­sis, the loan-default rate would only have been reduced by 0.2 percent. 

In real­i­ty, loans orig­i­nat­ed in 2007 default­ed at rates as high as 24 per­cent — lead­ing the authors to con­clude that screen­ing out high-DTI bor­row­ers would have had a rel­a­tive­ly small” effect on mit­i­gat­ing the Great Recession. 

The researchers cau­tion that their analy­sis only applies to how a sub­set of mort­gage lenders actu­al­ly respond­ed after 2014 to one check­box” imposed by Dodd – Frank. 

We’re only look­ing at one very spe­cif­ic part of the over­all abil­i­ty-to-repay rule, which is this DTI ratio,” Mon­drag­on says. Still, a broad­er point we make is that this tar­get — the size of your debt rel­a­tive to your income — might not be a very effec­tive tar­get [for reg­u­la­tion], because it doesn’t seem to affect loan per­for­mance that much.” 

That impli­ca­tion looms large over the ques­tion of whether reg­u­lat­ing house­hold lever­age might do any good in pre­vent­ing anoth­er finan­cial crisis. 

There was a strong intu­ition at the time that this law was being draft­ed that this [DTI met­ric] would be an impor­tant deter­mi­nant of how loans end up per­form­ing,” DeFus­co says. But the researchers’ results imply that this intu­ition may have been flawed. 

That house­hold lever­age played a cen­tral role dur­ing the finan­cial cri­sis” is not in doubt, the authors write. But mea­sur­ing it as a ratio of debt to income is only one way to look at the phenomenon. 

There’s anoth­er notion of lever­age that could be impor­tant, which is how large your loan is rel­a­tive to the val­ue of your house,” DeFus­co adds. That’s a thing our results can’t speak to, and the law doesn’t reg­u­late it any­way. But that could be anoth­er dimen­sion along which lever­age is very impor­tant and if we reg­u­lat­ed that, it could have very dif­fer­ent results.” 

About the Writer

John Pavlus is a writer and filmmaker focusing on science, technology, and design topics. He lives in Portland, Oregon.

About the Research

DeFusco, Anthony A., Stephanie Johnson, and John Mondragon. 2017. “Regulating Household Leverage.” Working paper.

Read the original

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