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

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.”