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Toward a Universal Ability to Repay Requirement

posted by Adam Levitin

The latest consumer financial product to come under the regulatory microscope is subprime auto lending, which has seen a boom in the last few years.  The subprime auto market's boom underscores a real problem in consumer financial regulation: different consumer financial products have developed different substantive regulatory regimes that are not justified by differences in the products. Most fundamentally, we have an ability-to-repay requirement for mortgages, a different ability-to-pay requirement for credit cards, and nothing else for other products. In light of the changes in all consumer finance markets, in which securitization and sweatbox lending have undermined the traditional lender-borrower partnership that encouraged responsible lending, it is time to consider a universal ability-to-repay requirement for consumer credit. 

We have, in general, much more developed substantive regulatory requirements for mortgages and credit cards than we do for other consumer financial products.  The reasons are historical: the consumer finance regulatory regime had one single original rational design moment and all subsequent amendments have been piecemeal responses to specific crises.  

When the federal government first started regulating consumer credit in 1968, the law did not impose meaningfully different substantive requirements for different types of loans.  If an extension of credit was covered by the Consumer Credit Protection Act (the Truth in Lending Act being Title I of that Act), then it was in for pretty much the same treatment.  

Over the course of the past half century, this has changed.  We now have real substantive differences in the way we regulate different types of consumer credit:  mortgages and credit cards each have their own regime, which is different from everything else (car loans, overdraft, other short-term/small-dollar products, student loans, etc.).  Mortgages and credit cards have sensibly gotten special love from the regulatory system because they are the biggest consumer finance markets. Student lending has always had special concerns because of the government's role in that market, but auto lending, despite being another huge market, has generally fallen through the cracks. (This is not just an issue for Congress/regulators--I can't think of an academic who has written about the auto lending market in recent years.) 

While there are important differences between the mortgage and credit card regimes, they both contain an ability to pay (or ability to repay) requirement.  The Credit CARD Act of 2009 created an ability to pay requirement for credit cards, and the Dodd-Frank Act of 2010 created an ability to repay requirement for mortgage loans.  The CARD Act's ability to pay requirement is pretty weak--it only requires ability to make minimum payments (around 2% of the outstanding balance)--not to pay off the balance in full within a reasonable time period. The Dodd-Frank Act's requirement (with its Qualifed Mortgage or QM safeharbor) is more muscular. But both underline a fundamental principle that should be reflected for all types of consumer credit, but isn't:  consumers should not be able to get loans without the lender taking reasonable steps to ensure that the consumer has the ability to repay.  

Historically there was no need for an ATR requirement.  The traditional lender-borrower relationship was a sort of partnership:  the lender needed and wanted the borrower to succeed in repaying the loan because that was how the lender would make money.  Lenders that loaned beyond borrowers' ability to repay were kissing their money goodbye.  On top of this, usury laws prevented lenders from getting too aggressive in terms of the return they could receive, so lenders had no incentive to assume greater risk on more marginal borrowers, and even without usury laws, lenders' informational disadvantages likely resulted in credit rationing that used borrower willingness to accept high interest rates as a proxy for borrower risk.  Thus, in the traditional lending world, ability to repay was built into the system without an explicit legal requirement.

There is still plenty of good old fashion Lenders had skin in the game.  But the world of consumer lending has changed considerably since federal regulation of consumer finance began in 1968. The advent of securitization and the sweatbox business model have broken the lender-borrower partnership.  When TILA was enacted, there was no securitization, and the sweatbox business model existed only in Faulkner novels. 

Securitization raises a moral hazard problem, in which the original lender does not care about the borrower's ability to repay beyond its effect on the lender's ability to sell the loan. While reputational sanctions and investor diligence and lender skin-in-the-game requirements have sometimes kept moral hazard in check in securitization, we have seen the system breakdown spectacularly in mortgage securitization and sometimes in credit card securitization.  While the moral hazard problem in securitization is an investor concern, it also has consumer implications because the moral hazard undermines lenders' interest in ensuring the borrowers can repay. Instead, the moral hazard of securitization encourages lenders to find more borrowers, not just good ones. And this means borrowers getting credit that they cannot handle, with investors picking up the tab. TILA, RESPA, and the FDCPA have still not been sufficiently updated to deal with the world of securitized consumer debt.

The sweatbox model involves a lender that is willing to treat the loan's principal as a loss leader:  if the lender collects enough in interest and fees over time, the lender may still make a profit even with the loss of some of the principal.  For the sweatbox model to work, the consumer has to be turned into an annuity, making small payments of interest and fees for a long time, while making little dent in the principal.  Thus Faulkner's Old Man Snoopes woul loan out a nickel to a sawmill worker and never ask for repayment of the nickel; he'd preferred collect a penny of interest every week indefinitely. 

The sweatbox model has been well developed in the credit card space. Credit issuers lowered monthly minimum payment requirements to the point that some were negatively amortizing in the 2000s.  Likewise, teaser rates encouraged balance transfers and account openings, but card issuers' payment allocation rules were designed to pay off the low rate balances first, leaving consumers stuck with the higher rate balances.  

The CARD Act addressed some aspects of the sweatbox in the credit card space, but the sweatbox is hardly limited to credit cards or revolving lending. The sweatbox has also shown up in certain forms of short-term, small-dollar lending, where the lender can make a profit as long as the borrower makes a minimum number of payments prior to default. (Full disclosure:  I'm involved in litigation about such a product.) 

The problems we're seeing in subprime auto loans underscore the broken lender-borrower relationship.  The reputational constraints that might make a captive auto finance company (say Ford Motor Credit) reluctant to burn its funding mechanism by securitizing lots of bad loans don't seem to apply in the context of some dealers and specialty subprime finance companies. To me this suggests a need to revisit ability-to-repay requirements. 

I've got some misgivings about ability-to-repay requirements.  They are paternalistic, and they add costs that are hard to amortize for small-dollar-short-term loans. Nonetheless, it is time for consumer finance regulation to internalize the changes in the way the consumer finance market works.  It's no longer enough to rely on the tradition of the lender-borrower partnership.  We've seen that partnership disappear in too many markets, and it doesn't make much sense to respond piecemeal, as it turns into a game of Whak-a-Mole®.  It's hard to see why we would have ability-to-repay requirements for mortgages and credit cards, but not car loans or other types of loans (other than student loans). It's time to think about having an across-the-board ability-to-repay requirement for consumer finance. 



I think that's fine. But you can't have a universal ability to repay requirement and at that same time require that lenders make risky loans to non-creditworthy borrowers. That's the classic Hobson's choice.

One point about the idea that "disclosure" is the be-all and end-all. Many people simply will not pay the least attention to whatever you disclose. Because "CAR!!" Perhaps paternalism is the only way to protect these people from themselves, and the rest of us from the consequences of the bad choices that they make.

Thanks for writing about this. To me focusing regulatory oversight on making sure lenders are lending based on an ability-to-repay standard is reasonable and necessary. I'm surprised this issue doesn't get more attention. Lenders ignore the ability to repay, and essentially try to maximize loan volume. This leads to credit bubbles and boom/bust cycles. It also leads to fraud, because in order to offload the bad loans lenders have to mislead investors about the risk of the securities they package them in.

As an investor, the first thing that I would look to is the business model. A lender's model that indifferent to repayment is the first and only signal needed to run the other way.

Is there a longer, maybe a little bit more academic text in which this proposal for structural change (i.e., a universal ability-to-repay requirement for the extension of any form of credit) is laid out? I'd love to assign it to my students...

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