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October 6, 2008

Congress's CRA Caused the Crash?

It’s recently been suggested to me that the true cause of the subprime mess is that Congress forced banks to loan to poor people (also known as “people who cannot afford to repay the mortgage”), perhaps under the guise of fairness or avoiding racism or classism or something like that.

There would appear to be some truth to this idea, but not like you’d think (surprise! it’s a complicated subject). Congress has indeed encouraged banks to loan money to poor folks, starting with the Community Reinvestment Act (CRA), enacted in 1977, under Carter’s administration. The original idea was to ban a practice known as “redlining”, which essentially was a practice of defining financial no-fly-zones. Anyone who wanted a loan who happened to live within the redlined area wouldn’t be considered by any bank. This resulted in de-facto slums, among other things. Removing the problem is a touchy one, and you’d think would require very specific rules. But rather than be very specific, the law as enacted used very vague language (apparently to pacify critics of the bill who complained that it would be a train-wreck if it required banks to lend to people who couldn’t afford it). According to Wikipedia:

Congress included little prescriptive detail and simply directs the banking regulatory agencies to ensure that banks and savings associations serve the credit needs of their local communities in a safe and sound manner.

With the Financial Institutions Reform Recovery and Enforcement Act, in 1984, the credit ratings that banks used to evaluate people’s creditworthiness was made public (using a four-tier system) and was required to contain supporting details, so that their decisions could be audited if necessary. The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 supposedly created the Housing and Urban Development (HUD) organization, and according to Fannie Mae’s website:

The Federal Housing Enterprises Financial Safety and Soundness Act (“FHEFSSA”) of 1992 modernized the regulatory oversight of Fannie Mae and Freddie Mac. It created the Office of Federal Housing Enterprise Oversight (“OFHEO”) as a new regulatory office within HUD with the responsibility to “ensure that Fannie Mae and Freddie Mac are adequately capitalized and operating safely.” OFHEO is funded by assessments on Fannie Mae and Freddie Mac and is authorized to act without HUD oversight on a range of regulatory issues enumerated in the statute. FHEFSSA established risk-based and minimum capital standards for Fannie Mae and Freddie Mac. And, it established HUD-imposed housing goals for financing of affordable housing and housing in central cities and other rural and underserved areas.

(emphasis mine) I couldn’t find all the specifics of those housing goals in a quick look through the text of the Act, but it’s long and complicated (maybe someone else will spend the time). Anyway, in an effort to finance these things effectively, Fannie and Freddie created and sold mortgage-backed securities. THIS is where the door was built (aka: the HUD), but the door isn’t yet “open.” More on this in a moment.

Because of the CRA requirements of transparency (imposed in 1984), banks were having trouble selling themselves, especially to out-of-state buyers. Not that the sales wouldn’t happen, but the sales would be slowed by CRA-based protests (I’m not sure what exactly they were protesting). So, Congress passed, in 1994, the Riegle-Neal Interstate Banking and Branching Efficiency Act, which removed the requirements that the banks had to publish the reasons why they made lending decisions under many circumstances, in order to facilitate sale of the banks. The publishing requirements were still in place if you weren’t selling your bank, though.

In 1995, Bill Clinton’s HUD made the policy decision to allow Fannie and Freddie to purchase subprime mortgage securities. Supposedly, HUD expected that Freddie and Fannie would impose their usual high standards upon subprime lenders. They did… mostly (hey, it’s still a subprime loan, after all), for a while, anyway. But this was still a bad idea (more on this in a moment).

In 1999, Congress passed the Gramm-Leach-Bliley Act, which repealed the Depression-era Glass-Steagall Act’s prohibition against banks acting as any combination of investment bank, commercial bank, and/or insurance company. Having more than one of those under one roof was a bad idea in 1929 because it creates conflict-of-interest on the part of the bankers/brokers, but apparently it’s a good idea in 1999. This paved the way for the formation of Citigroup and other investment/commercial/insurance banks. The GLB Act also reduced the number of banks to which the CRA applied, and altered their requirements so that they’d have to report on their CRA compliance less often.

In 2003, the Federal Reserve Bank of New York said:

Today, less than 30 percent of all home purchase loans are subject to intensive review under the CRA. In some metropolitan areas, this share is less than 10 percent.

This was considered bad news because it meant that the remaining 70 percent of loans were virtually un-auditable, and the reasons that loan decisions were made were untraceable. And Congressman Ron Paul made a speech predicting that these policies of increased lending to poor people would result in a credit collapse and a bailout. Spooky, eh?

What about predatory lending practices? In 2002, according to Wikipedia:

Kathleen C. Engel and Patricia A. McCoy published a study of the predatory lending implications of the CRA, noting that by the late 1990s, predatory high cost mortgages to “gullible borrowers” were leading to foreclosures against low-income people of color and the elderly.

As a result, the FDIC decided to strongly discourage the practice of “predatory lending”. And any bank found guilty of predatory lending was considered a higher risk, resulting in a lower CRA performance rating for that bank, both of which made FDIC insurance significantly more expensive. Interestingly, this move seems to have been quite effective. A study sponsored by a New York law firm (Traiger & Hinckley LLP, whoever they are), in January 2008 found:

Our study suggests that without the CRA, the subprime crisis and related spike in foreclosures might have negatively impacted even more borrowers and neighborhoods. Compared to other lenders in their assessment areas, CRA Banks were less likely to make a high cost loan, charged less for the high cost loans that were made, and were substantially more likely to eschew the secondary market and hold high cost and other loans in portfolio. Moreover, branch availability is a key element of CRA compliance, and foreclosure rates were lower in metropolitan areas with proportionately greater numbers of bank branches.

The FDIC’s measures to prevent irresponsible and predatory lending worked, and worked really well. So, if CRA wasn’t the problem, what was? What brought down Fannie Mae?

Remember the HUD? They expected that Fannie and Freddie would buy only the best quality subprime loans. But that backfired: what that ended up doing was making the market for these loans, including the even-crappier ones, bigger. According to Patricia McCoy, teacher of securities law at the University of Connecticut, cited in a Washington Post article, “That just pumped more capital into a very unregulated market that has turned out to be a disaster.” The HUD’s policies and encouragement are probably largely to blame for that market being particularly popular. It isn’t clear where the HUD’s policies started in 1992, but by 2000 the HUD required Fannie and Freddie to use 50% of their budget for “affordable” housing (sub-prime housing is one category that is considered “affordable”). Bush’s HUD upped that requirement to 56% in 2004. Clinton’s HUD opened the door by allowing subprime investing. But for some reason, it didn’t really take hold as a preferred strategy for investing in “affordable” housing.

Consider this: between 2005 and 2008, Fannie made loans to risky (sub-prime) borrowers of more than $270 billion dollars. That staggering sum is more than three times as much as all earlier years combined. But if it was all the HUD’s fault, then between 2005 and 2008, Fannie should have only increased subprime investment by about 6%, not 300%. And this would seem to have only a tangential relationship with the 30-year-old CRA. Something happened in 2004 or 2005! (One allegation I’ve heard is that Countrywide Mortgage started strong-arming Fannie into buying more of their riskiest loans at about that point.)

According to a New York Times article, Fannie Mae’s CEO, Daniel H. Mudd, under pressure from competing banks stealing his market and from Congress members demanding that they loan more to low-income folks, was between a rock and a hard place:

So Mr. Mudd made a fateful choice. Disregarding warnings from his managers that lenders were making too many loans that would never be repaid, he steered Fannie into more treacherous corners of the mortgage market, according to executives.

For a time, that decision proved profitable. In the end, it nearly destroyed the company and threatened to drag down the housing market and the economy.

Nevertheless, folks like the venerable Wall Street Journal blame the CRA for encouraging loose lending standards:

This 1977 law compels banks to make loans to poor borrowers who often cannot repay them.

And yet somehow, the CRA’s actual effect appears to have been the exact opposite: banks that were covered by the CRA were LESS likely to make sub-prime loans than banks that had were unaffected by the CRA. Those independent mortgage companies (unaffected by the CRA) made “high-priced loans” at more than twice the rate of banks governed by the CRA, according to Janet L. Yellen, President of the Federal Reserve Bank of San Francisco. According to the congressional testimony of Michael Barr (law professor at University of Michigan), 50% of the subprime loans were made by non-CRA mortgage companies, and another 25-30% came from mortgage companies only partially regulated by the CRA—-fully CRA-regulated institutions are responsible for “perhaps” one-in-four sub-prime loans. To quote the professor: “the worst and most widespread abuses occurred in the institutions with the least federal oversight.” And even more definitively, the Bank for International Settlements (an international organization of central banks) concluded:

Contrary to some media commentary, there is no evidence that the Community Reinvestment Act was responsible for encouraging the subprime lending boom and subsequent housing bust. This Act only applies to depositories, and did not cover most of the important subprime lenders. Depositories showed a lesser tendency to write subprime loans than lenders not subject to the Act (Yellen 2008).

Weird… you mean banks behave more responsibly when someone is peering over their shoulder? Say it ain’t so!

It seems to me that a large part of the Fannie problem was the HUD, enabling large scale sub-prime investing, and encouraging Fannie and Freddie to invest heavily in “affordable” housing. But that’s not the entirety of the problem; the HUD opened the door, but cannot have been responsible for the huge increase in sub-prime investment starting in 2005. However, even minimal investment in sub-prime mortgages (that HUD was trying to create) created demand in the sub-prime mortgage-backed securities market, which drove up the cost and encouraged other folks to invest as well.

I think the real lesson to be learned here is that there is no simple answer to questions like “what caused this economic mess?”, no matter how much politicians would love to say “it’s the other guy and his party’s fault”.

About October 2008

This page contains all entries posted to Kyle in October 2008. They are listed from oldest to newest.

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