The mortgage market will undergo radical change on Jan. 10, when virtually every aspect of home financing will be commandeered by the Consumer Financial Protection Bureau. The consequences of government overreach for creditors and borrowers will be all too predictable—more costly products and services, fewer options and, worst of all, the erosion of economic freedom.

The cornerstone of this new Dodd-Frank regime is a lender obligation to ensure that borrowers have the “ability to repay” a mortgage. This provision is also the basis of an expansive, new consumer right to sue creditors for miscalculating their financial fitness for a loan. Dozens of new servicing dictates also loom.

The costs of the regulations have been mounting for months, as creditors reconfigure policies and procedures, reprogram loan origination systems, retrain personnel—and hire consultants and lawyers to navigate 3,500 pages of rules. Even more daunting is the prospect of a further tightening of credit, which will reduce creditors’ revenue, undermine recovery of the housing market, and raise a barrier to the wealth creation associated with property investment.

The CFPB has issued some specific criteria for calculating a borrower’s ability to repay, but the bureau is also allowing some underwriting flexibility. This is both a benefit and a bane to creditors. On the one hand, lenders will enjoy some independence in designing ability-to-repay procedures. But it also means that there is no fixed compliance standard to follow, which invites arbitrary enforcement actions. As it is, the CFPB ranks among the most powerful—and unaccountable—agencies ever created.

Dodd–Frank offers a “safe harbor” from potential ability-to-repay litigation through a “qualified mortgage,” which entails loan limits, fee caps, and prescribed payment calculations, among other constraints. Of particular note is the QM requirement that mortgage payments will not increase the borrower’s debt-to-income ratio above 43%.

Although this ratio falls within the range of industry standards, there is infinite variety among borrowers’ circumstances that bankers could otherwise take into account. The DTI restriction will increase the number of applicants who will be rejected for loans they could afford. Some surveys also indicate that non-QM loans—those that might better serve buyers’ needs—will be difficult to come by. 

Young adults will be among the hardest hit. As first-time homebuyers, they may have limited income and college debt, pushing their DTI above “qualified” status. But they are the very buyers who prompt churn in the market.

Creditors lobbied hard for the QM “safe harbor” as protection from the heightened litigation risk—which exists only because Congress created the new liability scheme to begin with. But there is also recognition that the safe harbor will not eliminate litigation risk altogether. Consumers will still be able to file lawsuits; only the scope of the litigation will be delimited. Meanwhile, a new prohibition on pre-dispute arbitration also is expected to increase litigation between borrowers and creditors.

The threat of litigation will understandably breed greater caution among lenders and thus further restrict the availability of credit. The impact will be particularly hard on smaller community banks that lack the capacity to increase their compliance staff or to hire consultants. Some are simply leaving the mortgage market.

The risks to lenders may be mitigated to some degree by meticulous compliance with the ability-to-repay procedures. But even the most vigilant lender will remain vulnerable because the regulatory parameters are fluid.

Even if a lender ultimately prevails in a legal challenge, it will not be spared the costs of litigation. The average cost to secure a motion to dismiss runs an estimated $26,000; summary judgment, $84,000; and trial, $155,000.

Creditors also face stiff penalties if their pool of borrowers is, by government standards, insufficiently “diverse.” But the QM rule, with its inflexible loan parameters, increases the likelihood that less affluent borrowers—and, consequently more minority borrowers— will not be eligible for a qualified mortgage.

In many ways, Dodd–Frank and the mortgage finance regulations it spawned resemble Obamacare. Both are attempts by Washington to control a complex and dynamic sector of the economy. If left unchanged, both will produce far more harm than benefit.

 - Diane Katz is a research fellow in regulatory policy at the Heritage Foundation in Washington.