Usury Laws Are Dead. Long Live the New Usury Law. The CFPB's Ability to Repay Mortgage Rule
[Updated 1.14.13] The CFPB has come out with its long awaited qualified mortgage (QM) rulemaking under Title XIV of the Dodd-Frank Act. The QM rulemaking is by far the most important CFPB action to date and will play a crucial role in determining the shape of the US housing finance market going forward. The QM rulemaking also represents a return in a new guise of the traditional form of consumer credit regulation—usury—and a move away from the 20th century’s very mixed experiment with disclosure.
The Dodd-Frank Act requires that mortgages be underwritten based on the borrower's ability to repay. Failure to do so is an absolute defense against foreclosure. There is an execption allowed, however, for Qualified Mortgages. The CFPB rulemaking defined the term Qualified Morgage. Oversimplifying (but only slightly), a QM is defined as a mortgage that meets the following six criteria
- regular payments that are substantially equal (ARMs and step-rate mortgages excepted) and always positively amortizing
- term ≤30 years
- limited fees/points (caps vary with mortgage size)
- underwritten using the maximum interest rate in the first five years to ensure repayment
- income verified
- backend DTI ≤43% (including simultaneous loans)
Significantly, the CFPB rulemaking distinguishes between regular QMs and high-cost QMs (150 bps over prime for first liens, 350 bps over prime for junior liens). Thus, the mortgage world is now like Gaul, divided into three parts: non-QM, high-cost QM, and regular QM. Non-QMs lack a safe harbor for ability to repay. High-cost QMs have a rebuttable safe harbor for ability to repay. And regular QM have an irrebuttable safe harbor for ability to repay. The result of all of this is to increase the risk of making non-QMs or high-cost QMs relative to the situation that exists today. That means there is no change in the law for regular QMs, as failure to ensure ability to repay has not previously been a defense to foreclosure.
Much of the commentary to date has been about the scope of the safe harbor, which is wider than consumer groups had wanted/banks had feared. I think it all kind of misses the point, as the QM rulemaking represents a significant expansion of lender liability and is a major step forward in creating a fair and stable housing finance market.
QM as a Usury Law
What I find interesting about the QM rulemaking is that it represents a return to the traditional mode of consumer credit regulation—usury, and eschews the 20th century’s disclosure-based regimes, including its behavioral economic tweaks. Indeed, the influence of behavioral economics is virtually undetectable in the rulemaking with one very small exception.Now before I write anything more here, let’s be clear. The QM rulemaking is not a usury law as traditionally understood. Indeed, the CFPB is expressly prohibited by statute from enacting usury regulations. Mind you, Congress never defined what a usury law is, but I don’t think anyone could reasonably characterize QM rulemaking as a usury regulation of the sort Congress prohibited.
Yet the basic thrust of the QM rule—distinguishing in the legality of high cost and low cost QMs is the same move as usury laws: high cost products prohibited, low cost products allowed. This is a new 21st century style usury law that represents a type of back-to-the-future move in consumer finance, much like the CFPB itself (which picks up on the vigorous FTC and CPSC of the 1970s--recall that the title of Elizabeth Warren's Unsafe at Any Rate was an homage to Nader's Unsafe at Any Speed) and the "abusive" part of the CFPB's UDAAP power, which harkens back to the FTC's pre-1980 definition of "unfair," which was based on equity and ethical considerations among other factors. (This definition was known as the "Sperry-Hutchinson test," and reputedly originated in the work of a 25-year old attorney-advisor named Richard Posner regarding cigarette advertising.) In some ways the CFPB is going back and picking up the spirit of consumer credit regulation from the 1970s, but doing so in a much smarter, 21st century way. In other words, key parts of the Reagan (and late-Carter) deregulation is being excised from regulatory world.
A Brief and Incomplete History of Usury Regulation
To wit (feel free to skip my historical excursion): historically, the major form of consumer credit regulation were usury laws. Disclosure regulation in consumer finance was basically unknown prior to the mid-20th century. The common law of contracts and torts substituted for disclosure by prohibiting misrepresentation and in some cases concealment, but the form and content of disclosures were not prescribed. Similarly, banking regulation for safety-and-soundness placed some limits on lending, such as maximum loan-to-value ratios, but these were not done for consumer protection purposes. To be sure, in a originate-and-hold business model, the incentives of the lender and the borrower are closely aligned; the borrower's default means a loss for the lender. Obviously not so for the originate-to-distribute model (e.g., broker loans and securitization). The major type of consumer protection regulation was usury.
Usury laws have changed over time. Prior to the 16th century, usury laws simply forbade lending money on interest. The first modern usury law "An Act Against Usurie" (37 H.viii 9) was enacted in 1545, late in the reign of Henry VIII during the Great Debasement. It permitted lending at up to 10% interest (no mention of simple vs. compounded, etc.) No scholarly work appears to have been written on the statute’s history, but it’s hard to believe it wasn’t connected with the Great Debasement, although there might have been the influence of Swiss Protestant thinkers on the law and a slightly earlier law from the Spanish Netherlands permitting interest in commercial loans.
From the time of Henry VIII up until the present, most usury laws were blunt instruments. They picked a rate cap and made any loan over that rate cap void or voidable. To be sure, there could be lots of complications as to how to calculate the rate of the loan, but the basic idea was pretty simple. (Roman-Dutch law has a more nuanced approach, the so-called in duplum rule, that limits interest and fees to twice the principal outstanding).
Small loan laws in the early 20th century started to nibble at usury proscriptions, but the first major bite out of usury laws came with the Home Owners Loan Act of 1932. This statute preempted state usury laws for federally chartered S&Ls. It doesn't make a lot of sense, however, to read HOLA standing alone. HOLA was part of a major transformation of the US housing finance system, that also included the creation of the FHA in 1934. The FHA would not insure mortgages that had an interest rate of above 5% (the rate cap varied slightly overtime). In other words, state usury laws were preempted, but were replaced by what functioned as a federal usury cap for a sizeable part of the market, and the presence of the usury cap for FHA (although never called that), kept rates down elsewhere in the market.
What was left of usury laws were largely gutted between 1978 and 1982. First, the Supreme Court's notorious Marquette decision enabled national banks to export the usury cap of their home state to other states. Then states followed up with parity laws to protect their own lenders and compete for bank chartering. The FHA rate cap was removed in the early 1980s (I think) and the Depository Institutions and Monetary Control Act of 1980 and the Alternative Mortgage Transactions Parity Act of 1982 got rid of a most of the remaining state usury and associated laws at least as applied to mortgage lending.
Perspective on the Demise of Henrician Usury Laws
In hindsight, the move away from blunt, Henrician usury laws in the late 1970s and early 1980s made a lot of sense--these laws were poorly suited to a time of rapidly rising interest rates. If risk free rates rise too high, it will be impossible for consumers to get credit. Indeed, any usury law acts as a restriction on credit availability. If there is risk-based pricing, then higher-risk consumers will find themselves unable to get legitimate credit, while if risk-based pricing is not possible, then there will be credit rationing, with lenders themselves adopting rate ceilings as underwriting proxies (so as long as the usury rate is sufficiently high, it should not matter).
Yet for all these problems, we may have thrown out the baby with the bathwater when we jettisoned the Henrician usury laws. A fixed rate usury law is pretty clearly a bad idea. But it doesn't follow that all usury laws are equally problematic. A floating rate usury law avoids the potentially disasterous problem of the Henrician statutue in no one can get a legal loan when risk-free rates rise too high. For a floating-rate usury law, however, there is still the problem of restricting legitimate credit to higher-risk borrowers, who may turn to illegal sources of credit as a substitute. (N.B. we really do not know how much credit substitution would occur and whether it would be to loan sharks or family and friends or whether high risk consumers would simply borrow--and consume--less.)
Some Justifications for Smart Usury Laws
While floating rate usury caps will limit credit, this is kind of the point. Usury laws are a paternalistic move, and they are roughly tailored. Some people should avoid high cost loans, while others might benefit from them, and unfortunately, people frequently do not (and cannot) sort themselves properly. The costs of the failures are socialized, while the benefits of success are private (basically Eric Posner's argument about usury in a welfare state). There are other arguments that can be made for usury laws, such as that they represent a form of Hayekian social learning that should be abandoned only with great trepidation (Jeffery Gordon's tongue in check argument that no one at the Federalist Society was buying).
But most convincing to me is another argument: certainty and administratibility. Usury laws are bright line rules that allow for business planning. We can try to police the same problems on an ad hoc equitable basis using doctrines like unconscionability, but these fuzzy standards make it very hard for businesses to know what is allowed and what isn't. It might chill socially beneficial behavior, and it might also result in inconsistent results. While a business might prefer to operate with zero regulatory constraints, as between a bright line rule and a fuzzy standard with substantially the same substantive result, I would think that the bright line rule would be preferred.
The safe harbor in the QM rulemaking is exactly this sort of bright line rule. The mortgage industry would of course prefer not to be regulated at all, but if it is to be regulated, then a clear and absolute safe harbor is far more preferable to the fuzzy one of a rebuttable safe harbor (or no safe harbor at all). Hence the industry's general approval of the QM rulemaking outcome.
The QM rulemaking is not the only place an ability to repay (or suitability) requirement appears in federal law. There is a similar requirement under the Credit CARD Act. That requirement is incredibly weak, however, as the regulatory interpretation only requires an ability to make minimum monthly payments--typically 2% of the balance--and allows this determination to be made based on models rather than actual data, so it's unlikely to be tripped by anyone, only increase compliance costs. Still, the move toward mandating suitability or ability to repay, with regulatory agencies given reign to then create safe harbors is a move that allows for the creation of function federal usury laws, even if the u-word is never used.
The QM Rulemaking and the Future of the GSEs
Perhaps the most immediate effect of the QM rulemaking is that it makes the privatization of Fannie and Freddie (always a pipedream) truly impossible. The reason for this is simple. Private risk capital is unwilling to fund the credit and rate risk on mortgages structured as QMs on a substantial enough scale to support even a fraction of the US housing market. The only loans the private, non-GSE market has only ever supported in any scale are bullet loans--short-term, non-amortizing loans. This is what the market looked like before the GSEs. (Yes, S&Ls offered some longer term, amortizing loans, but this was a fraction of the market.) And this is what the private label-securitization market of the 2000s looked like. The infamous 2/28s and 3/27s were really just 2-3 year bullet loans that had to be refinanced if they were not to explode. We have never seen the private market provide long-term, amortizing loans in large volume. The private Jumbo market is relatively small compared with the entirety of the US housing finance market, and it piggybacks off of the presence of the GSE market. And this isn't even raising the issue of fixed-rate vs. adjustable-rate; there are few places in the world where the private market provides fixed-rate loans in any scale. All of this means that as long as there is the QM rulemaking in place, it really isn't possible to eliminate the GSEs. They can and should be restructured, but the QM rulemaking will hopefully force us to be realistic about the role private risk-capital can play in the housing finance market.
Note that this is true even with the sunset provision for GSE purchase eligibility. Dragooning the GSE underwriting standards into QM seems reasonable enough while the GSEs are in conservatorship and under firmer regulatory control. But once they cease to be in conservatorship, then all the loans they will purchase or guarantee must meet the income/asset verification, underwriting, and DTI requirements of the CFPB's QM rule. Those are going to be pretty traditional looking loans.
Behavioral Economics and Plain Vanilla for Prepayment Penalities
A few other notes. I don’t see the behavioral economics bogeyman lurking anywhere in this rulemaking, despite the fears of the newly confirmed FTC Commissioner Joshua Wright. The distaste for non-amortizing mortgages long pre-dates behavioral economics and can be found at least as early as the Hoover Administration’s 1931 National Conference on Home Building and Home Ownership. The only spot I see behavioral economics clearly appearing is in regard to prepayment penalities.
The rulemaking requires a creditor that offers a consumer a mortgage with a prepayment penalty to also offer the consumer an alternative mortgage without a prepayment penalty that conforms to certain other requirements that basically make it plain vanilla. So plain vanilla--which nearly sank the CFPB as part of the Dodd-Frank Act--is back, but it's not a whole scoop. Instead, there's just a drop of plain vanilla coulis trickled on the ability to repay rule. So far the behavioral bogeyman hasn't emerged, perhaps because behavioral nudges (like default rules) and use disclosures just aren't very operative in most real world, dynamic settings.
The QM rulemaking is a smart, 21st century usury law, that is sensitive not just to interest rates, but to a range of product features. Loans aren't just interest rates. While the understanding of which features are of concern may be influenced by behavioral economics, one doesn't need Kahnemann & Twersky--as important as their work is--to understand the problems of non-amortization and rate resets, etc., just common sense. For all of the attempts we will see to reform disclosures, this style of smart substantive term regulation is, I suspect, what the new consumer finance regulation will look like, not least because we know it produces results, unlike a lot of disclosure regulation.