How Dodd-Frank Is Squeezing the Middle Class

SMITH BRAIN TRUST – The 2010 Dodd-Frank regulatory overhaul was supposed to create a level playing field among home buyers. But a new study from researchers at the University of Maryland’s Robert H. Smith School of Business shows the sweep of new rules actually squeezed middle-class home buyers, while giving a boost to wealthy borrowers. 

Assistant Professor of Finance Francesco D’Acunto and Finance Professor Alberto Rossi, in a working paper, find that financial institutions reduced their lending on medium-sized mortgages 15 percent in 2014, even while piling on 21 percent more of its so-called jumbo mortgage offerings.

“This will have a lot of implications on consumer consumption,” D’Acunto said in an interview. Indeed, the report comes as economists have been puzzling over why America’s middle class has not resumed spending at pre-recession rates. 

D’Acunto and Rossi obtained data on mortgage originations – about 40 million of them – to compile their report, “Ditching the Middle Class with Consumer Protection Regulation.” They found that in the wake of Dodd-Frank, “middle-class households did not obtain cheaper mortgages, but were cut out of the mortgage market altogether.”

“This was a huge change," Rossi said. "These guys started lending only to richer people." 

How did it happen?

Dodd-Frank imposed a 3% cap on mortgage-related service fees, such as title searches, home inspections, and closing costs. The cap, which applies to all mortgages in excess of $100,000, sought to force institutions to reduce fees overall, and to make sure that smaller borrowers weren’t facing outsized fees, relative to their loans. But what it actually did was make the cost of originating jumbo loans a comparative bargain for lenders, the authors say. So, smaller loans started to be rejected or saddled with higher interest rates, the researchers found.

The 2,300-page Dodd-Frank Wall Street Reform and Consumer Protection Act also mandated a costly process for verifying a borrower’s income – a step aimed at avoiding a repeat of the abuses and pitfalls that helped drive the housing bubble and credit crisis. Leading into the financial crisis banks were extending loans to unqualified borrowers with little or no proof that they could pay the money back, knowing the lenders could offload the risk by bundling the bad loans and selling them off. When borrowers began to default on loans, the spinoff effect proved disastrous, provoking the steepest U.S. real-estate crash in history.

The process that’s in place now for verifying an applicant’s income carries a set cost – generally between $300 and $1,000 – regardless of the size of the mortgage, so it eats into the lender’s per-loan returns more on a smaller loan than on a jumbo. As a result, lenders slashed the number of loans they created near the median house price, and ramped up lending at the higher end of the price spectrum, an effect that shows up in data beginning in 2011, the year after Dodd-Frank went into effect, the research finds.

“If you are going to have more expensive underwriting, you are going to want to choose the more profitable loans,” said Finance Professor Elinda Kiss. That’s because every piece of regulation added makes a loan more costly, she said. 

Of course, the big banks are everywhere, and that makes it easy for them to grab up jumbo loans everywhere, leaving smaller loans to smaller, local peers. 

“Often regulation – as was the case with Dodd-Frank – is implemented at a time when officials are under high pressure from the media and from the public, and without a lot of thought about consequences,” D’Acunto said. “I think now we are able to see some of the consequences.”

The researchers found that income standards also appeared to be stricter for borrowers who wanted a smaller-sized mortgage. Analyzing the Home Mortgage Disclosure Act (HMDA) dataset from the years 2007-2014, the researchers found that in areas where there is competition among big lenders, the average income per loan amount increases between $100,000 and $417,000, and then slides downward above the $417,000 jumbo loan limit.

“This result suggests that, after Dodd-Frank, large lenders might have applied stricter standards than small lenders to approve mortgages in the middle of the size of the distribution, and more lenient standards to approve large mortgages,” the report says. 

Jumbo loans can’t be sold to government-sponsored enterprises (GSEs), like Fannie Mae and Freddie Mac, so lenders must either keep them on their balance sheets or sell them to private counterparties, which often set conditions that make such a move unfavorable. Larger institutions can keep more jumbos on their balance sheets, because they have a larger number of deposits. 

The top 20 U.S. lenders were 44% more likely to keep the jumbo loans they originated on their balance sheets, than its smaller-lender peers, according to the report. The top 20 lenders kept an average 66.4% of the jumbo loans they originated on their balance sheet. Lenders outside the top 20 kept only 61.3% of the jumbo loans they originated. 

Rossi and D’Acunto found that big lenders are more aggressive in setting lower rates for jumbo loans – perhaps in hopes of offering those wealthy customers a wider suite of financial services – including wealth management, brokerage accounts, and credit cards. “Acquiring wealthy customers is more profitable to them,” the researchers said.

With interest rates lingering near historic lows, Kiss said, cross-selling financial products to customers has become a central focus. “Lending, in general, has become much less lucrative, so they want to make it up with cross-selling,” she said.