When we discuss the role of the Community Reinvestment Act and other fair lending rules in contributing to lax lending standards, people bent on exonerating the CRA often point out that many of the questionable loans were made by non-depository mortgage companies not covered by the CRA.
Barry Ritholtz has been a prominent critic of the theory that the CRA has some culpability for lax lending. He has pointed out that 50% of subprime loans were made by mortgage service companies not subject comprehensive federal supervision. “How was this caused by either CRA or GSEs?” Barry asked.
As much as I respect Barry’s formidable analytical powers, I’m afraid he’s taken too narrow of the view of the matter. His question is far easier to answer than he suspects. Regulations often touch those who are not directly regulated. Indeed, the regulation of one group in a marketplace will almost always wind up affecting other groups.
More concretely, there are three very specific ways in which the CRA nudged Countrywide and other mortgage companies to adopt lax lending standards.
1. The Creation Of Artificial Demand For Low-Income Mortgages. Banks that were regulated by the CRA often found it difficult to meet their obligations under the CRA directly. Long standing lending practices by local loan officers were a big problem. But as banks expanded their deposit bases and other businesses, they often found that they were at risk of regulators discovering they had fallen behind in making CRA loans.
One way of addressing this problem was buying the loans in the secondary market. Mortgage companies like Countrywide began to serve this entirely artificial demand for CRA loans. Countrywide marketed its loans directly to banks as a way for them to meet CRA obligations. “The result of these efforts is an enormous pipeline of mortgages to low- and moderate-income buyers. With this pipeline, Countrywide Securities Corporation (CSC) can potentially help you meet your Community Reinvestment Act (CRA) goals by offering both whole loan and mortgage-backed securities that are eligible for CRA credit,” a Countrywide advertisement on its website read.
2. The Threat Of Regulation Is Often As Good As Regulation. It is highly misleading to claim that just because mortgage companies were not technically under the CRA that they were not required by regulators to meet similar tests. In fact, regulators threatened that if the mortgage companies didn’t step up to the plate by relaxing lending standards they would be brought under the CRA umbrella and required to do so.
To meet their goals, the two mortgage giants enlisted large lenders—including nonbanks, which weren’t covered by the CRA—into the effort. Freddie Mac began an “alternative qualifying” program with the Sears Mortgage Corporation that let a borrower qualify for a loan with a monthly payment as high as 50 per cent of his income, at a time when most private mortgage companies wouldn’t exceed 33 per cent. The program also allowed borrowers with bad credit to get mortgages if they took credit-counseling classes administered by Acorn and other nonprofits. Subsequent research would show that such classes have little impact on default rates.
Pressuring nonbank lenders to make more loans to poor minorities didn’t stop with Sears. If it didn’t happen, Clinton officials warned, they’d seek to extend CRA regulations to all mortgage makers. In Congress, Representative Maxine Waters called financial firms not covered by the CRA “among the most egregious redliners.” To rebuff the criticism, the Mortgage Bankers Association (MBA) shocked the financial world by signing a 1994 agreement with the Department of Housing and Urban Development (HUD), pledging to increase lending to minorities and join in new efforts to rewrite lending standards. The first MBA member to sign up: Countrywide Financial, the mortgage firm that would be at the core of the subprime meltdown.
3. The CRA Distorted the Mortgage Market. With banks offering mortgages with high loan to value, delayed payment schedules and other enticing features, the mortgage companies would have quickly found themselves unable to compete if they didn’t offer similar loans. The requirement to offer risky loans from banks created a situation where other lenders found they had to offer similar products if they wanted to expand their business.
Of course, Angelo Mozillo didn’t need very much prompting on this score. He believed exactly what the CRA regulators believed: that these lax lending practices were the wave of the future, democratizing the glories of home ownership.