Why I Changed My Mind On The Community Reinvestment Act

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I changed my mind about the Community Reinvestment Act.

For a long time I regarded the shouting about the the CRA as a distraction. I understood that the 1970s-era law pushed banks to lend to low-income households, but the attempts to link it to the current crisis seemed far-fetched. Much of the “blame the CRA” talk sounded to me like a partisan attempt by Republicans to cover up their party’s role in creating the housing mess. In particular, it was galling to read the Bush administration hacks complaining about the CRA when the administration had gone whole hog for the program to expand home ownership. Bush made speeches on expanding home ownership that would have made Angelo Mozilo blush.

But the case for exonerating the CRA doesn’t stand up to the evidence. Regulators charged with enforcing the CRA’s required banks to adopt many of the loan practices that turned out to be toxic. Everything from 100 per cent loan-to-value ratios to no down payment loans were part of the package that banks used to satisfy the demand of regulators.

Could the banks have used other lending methods to meet CRA requirements? Perhaps. But no one can say for sure that these would have made regulators happy or have produced enough loans to low-income and minority borrowers. What worked was what the banks actually did, and so they kept doing it. The lax lending standards were a proven method of satisfying regulators, and they were fully approved by regulators. More than approved. The regulators lavishly praised banks that adopted these innovative lending strategies.

The Federal Reserve Bank of Minnesota attempted to absolve the CRA by claiming that only a small percentage of subprime loans were related to the act. But this is just academic hooey. In reality, once banks lowered lending standards to attract CRA borrowers, they found that they had to lower lending standards across the board. It simply wasn’t possible or legal (thanks to anti-discrimination laws) to offer the lax standard loans only to the targeted borrowers. In short, if a bank wanted to raise the number of CRA loans, it had to lower standards across the board. The broader subprime market was basically a creation of the CRA.

The way the CRA was enforced guaranteed that the bad lending practicies would spread like wildfire across the country. Banks that were found to be in compliance with the CRA were granted permission to acquire other banks. Banks that were not in compliance could not make acquisitions, which often meant they couldn’t grow at all. The only known method of compliance was lax lending standards. This means that banks that lowered their lending standards grew through acquisitions, while banks that kept their standards high got acquired or stayed small. This process went on for years, creating a kind of perverted financial Darwinism. It was survival of the lax-ist.

The same dynamic operated on the levels of individuals. If you were a sceptic about the lax lending practices, you would find that you couldn’t get a job at the bigger banks or lenders. Your career potential was limited. If you were an enthusiast for lax lending, you could move from Countrywide to Shawmut Bank to Fleet Financial to Bank of America. The entire system was rigged to reward those who truly believed there was little risk in making mortgages that required scarce income information and no money down.

When market processes began to counter-act this regulatory Darwinism, the politicians stepped in to keep it going. The basic check on regulatory Darwinism was the riskiness of the loans, many of which couldn’t be securitized because Fannie and Freddie wouldn’t touch them. But once the proper political pressure was brought to bear, Fannie lowered its own standards and we got securitized subprime. Now banks could meet their CRA obligations while passing off much of the risk to others.

These days I’m a bit embarrassed for people continue to deny the CRA encouraged crappy lending practices. The evidence is unequivocal.

The point I made earlier this week about Sonia Sotomayor point is related to this argument about the CRA. She advocated a policy that was eventually adopted on a national level to disastrous effect. And while she never intended that home ownership for low income people be built upon terrible lending, this was the unintended consequence of the policy. It’s very important that we not lose track of the fact that the program to extend home ownership to the poor was not something created by predatory lenders alone. They operated in cooperation with do-gooders who believed traditional lending standards were unwarranted and operating to prevent deserving people from buying homes.

Importantly, none of this proves that the entire boom-bust in housing should be blamed on the CRA. As I said yesterday: “This doesn’t absolve the greedy and often corrupt lenders, the bubble-headed securitizers, the blundering ratings agencies or the careless MBS investors. But it does show that the government, through the CRA, had a strong hand in creating the kind of mortgage products we now regard as part of the problem. Back then, they were regarded as part of the solution.” In retrospect, I should probably have added low interest rates, oil prices, Chinese savings, terrorism and the dot com bust fueling the mortgage problem.

Why should we care about this? Because we’re now trying to figure out how to adjust the way we regulate Wall Street. If we don’t pay attention to how certain schemes to improve the operations of the financial sector went awry in the past, we’re doomed to screw things up again.

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