Prior to the recent financial crisis, mortgage underwriting standards were relaxed to the point where many borrowers could only repay their loans if the favorable financial conditions that existed at the time of origination remained intact. In other words, borrowers were able to obtain mortgage loans that relied upon interest rates not rising or the value of the underlying collateral (house prices) not declining. When market conditions changed, however, many mortgage loans became delinquent and went into default. The mortgage defaults often translated into large losses for both the borrowers and the financial industry. "Irrational exuberance," a term coined by then-Federal Reserve Chairman Alan Greenspan, arguably captures the essence of the academic work of Hyman Minsky and has been used to illustrate the dynamics that contributed to the recent financial crisis. According to Minsky, when lenders grow excessively optimistic, they increase credit availability as if the ideal economic and financial market conditions will persist. Lender optimism during the height of a business cycle can translate into a substantial increase in debt accumulation or "leveraging" by the private sector. Moreover, leveraging in response to a particular asset market bubble can result in overinvestment into a particular sector (such as housing) as well as numerous financial portfolios lacking diversification outside of one broad asset class. A "Minsky moment" subsequently occurs when assets are unable to continue generating the level of revenues necessary to repay the loans that were used to purchase them. In other words, the expected future value of the collateral used to secure the loan fails to increase and may even decline, and the borrower lacks the income stream or the ability to sell the asset to repay the outstanding loan balance. Recessions that occur after individuals have accumulated large levels of debt, therefore, are likely to be more severe than those characterized by lower debt levels. An escalation of defaults is likely to occur after a proliferation of leveraged investments have gone sour, which debilitates the banking system and impedes any subsequent lending necessary to stimulate recovery. Rulemaking is now taking place to implement "ability to repay" and risk-retention standards as mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act; P.L. 111-203 ). Under the Dodd-Frank Act, mortgage originators are required to make a good faith determination that a borrower has a reasonable ability to repay the loan regardless of the prevailing financial conditions. In addition, parties involved in a securitization transaction must retain "skin-in-the-game" or a minimum percentage of the credit risk, which would further encourage greater due diligence given the sharing of any eventual losses. Hence, the ability to repay and risk-retention measures address some risky financial practices that arguably contributed to recent excessive mortgage debt accumulation and subsequent financial crisis. The ability to repay and risk-retention standards would dampen any future periods of rapid mortgage debt accumulation by encouraging lenders to adopt qualification standards higher than those that existed prior to the financial crisis. Although some borrowers may qualify for loans when underwriting criteria are relaxed, which typically may occur at times when housing and macroeconomic conditions are more favorable for repayment, lenders may be reluctant to originate those that fail to comply with qualification standards that would reduce their exposures to legal risks. Hence, some creditworthy borrowers may be unable to obtain mortgage credit. The 112 th Congress is monitoring the rulemaking stemming from the Dodd-Frank Act. This report examines the developments associated with the implementation of mortgage lending reforms. The report begins with a summary of proposed ability to repay and risk-retention standards. Next, the report describes risky underwriting and financing practices that occurred prior to the mortgage crisis, followed by a discussion of how access to mortgage credit might be affected. This section provides an overview of the proposed rules having to do with the ability to repay and risk-retention standards. Regulatory reforms will require creditors to consider whether borrowers have the ability to repay loans, and loan originators will also have to adhere to stricter underwriting or borrower qualification standards if they choose to sell loans to securitizers. Ability to repay and risk-retention standards are designed to provide lenders and securitizers with legal protection when they refrain from lending practices that weaken overall financial stability as well as to protect borrowers from assuming mortgage obligations that are affordable only under certain circumstances. Title XIV of the Dodd-Frank Act is entitled the Mortgage Reform and Anti-Predatory Lending Act; Section 1411 is entitled "Ability to Repay" and says, In accordance with regulations prescribed by the (Federal Reserve) Board, no creditor may make a residential mortgage loan unless the creditor makes a reasonable and good faith determination based on verified and documented information that, at the time the loan is consummated, the consumer has a reasonable ability to repay the loan, according to its terms, and all applicable taxes, insurance (including mortgage guarantee insurance), and assessments. Minimum standards for residential mortgage loan originations, which consist of factors that creditors are required to consider during the underwriting process, are established beginning in Section 1411 and subsequent sections of the Dodd-Frank Act. On April 19, 2011, the Federal Reserve, as mandated by the Dodd-Frank Act, announced a proposed rule that would require all creditors or lenders to make a good faith estimate that a borrower has a reasonable ability to repay. The rule would also establish minimum mortgage underwriting standards. The rule would expand ability-to-repay standards to cover all residential mortgage loans. The Dodd-Frank Act transferred the authority to prescribe final regulations to the Consumer Financial Protection Bureau (CFPB) on July 21, 2011, and the closing date for comments was July 22, 2011. The CFPB has re-opened the comment period to seek further comments on the litigation risks that could potentially arise from the new requirements. The comments, however, should be narrowly focused and based upon analysis that uses mortgage data from the portfolios of Fannie Mae and Freddie Mac, which are discussed in more detail below. The closing date for comments will be July 9, 2012. CFPB final rulemaking would not necessarily be bound by the Federal Reserve's proposed regulation. The proposed rule provides four methods in which a lender would be able to comply with the ability-to-repay standards. First, the originator can meet a general ability-to-repay standard by considering and verifying the following criteria: income or assets, current employment status, the size of the monthly mortgage payment, any monthly payment of subordinate or junior mortgages, the monthly payments of related mortgage expenses, other debt obligations, the monthly debt-to-income ratios, and credit history. In addition, creditors would be required to calculate the mortgage payment using the fully indexed rate. In other words, even if the borrower selects a nontraditional mortgage product with an initial lower interest rate, the adjustable interest rate plus the margin (the "mark-up" over the short-term interest rate index or constant amount added to the variable interest rate) must be used during underwriting. This compliance option does not place restrictions on the loan features, terms, or points and fees. Second, a lender can be in compliance by refinancing borrowers out of nonstandard and into standard mortgage products. Standard mortgage products are defined as those without negative amortization features, interest-only payments, or balloon payments. They also have limits on points and fees. This compliance option allows for streamlined refinances that can quickly move borrowers out of higher risk mortgages and into ones with more stable payments. In addition, lenders would not have to verify the income and assets for borrowers being switched into standard mortgage products as long as their new monthly payments will be lower and they have not experienced delinquencies while paying their existing mortgages. The third compliance option reduces regulatory burdens and legal liability exposure for originators and assignees holding "qualified mortgage" (QM) loans. The Federal Reserve proposed two alternative definitions for QMs given the inability to determine whether Congress intended the legal protection to be in the form of a safe harbor or a rebuttable presumption . The first definition, Alternative 1, operates as a safe harbor , which means that borrowers would not be able to assert that creditors failed to comply with any of the required underwriting criteria described below. The second definition, Alternative 2, operates as a rebuttable presumption of compliance, which allows borrowers to provide evidence that may possibly overturn a presumption of lender compliance even if the required procedures were followed. The definition of a QM loan under Alternative 1 excludes mortgages with negative amortization features, interest-only payments, balloon payments, or terms that exceed 30 years. In addition, the total points and fees cannot exceed 3% of the total loan amount (for loans of $75,000 or more). The income and assets of the borrower must be verified. The underwriting of the mortgage must be based upon the maximum interest rate that might occur during the first five years, use a fully amortizing payment schedule, and incorporate other mortgage-related obligations such as escrows for property taxes. Under Alternative 2, lenders must still comply with all criteria listed under the first definition. In addition, employment status, credit history, debt-to-income ratio, and other debt repayment obligations must be considered during underwriting. The final compliance option allows a lender to originate a balloon-payment QM in predominantly rural or underserved areas. A mortgage with a balloon payment is one in which regular payments are made for a period of time; but given that the payments include only partial or no amortization of the principal balance, the final payment that includes the remaining balance may be considerably larger. A balloon loan can be a QM as long as it is not a higher-priced loan, has a minimum term of five years, and the borrower must be qualified on the maximum possible payment that could occur over the first five years of the loan.