Community Reinvestment Act
Why This 1977 Law Did Not Create the 2008 Financial Crisis
The Community Reinvestment Act encourages bank lending to low- and moderate-income neighborhoods. Enacted in 1977, it sought to eliminate bank “redlining” of poor neighborhoods. That had contributed to the growth of ghettos in the 1970s. In redlining, neighborhoods were designated as not good for investment. As a result, banks would not approve mortgages for anyone who lived in those areas. It didn't matter how good the applicant’s individual finances or credit was. Some experts argued that these areas were initially established by the Federal Housing Administration, which guaranteed the loans.
The Reinvestment Act mandated that the bank’s lending record to these neighborhoods is periodically reviewed by each bank’s regulatory agency. If a bank does poorly on this review, it might not get the approvals it seeks to grow its business.
Regulators used provisions of the 1989 Financial Institutions Reform Recovery and Enforcement Act to strengthen enforcement of the Reinvestment Act. They could publicly rank banks as to how well they “greenlined” neighborhoods. Fannie Mae and Freddie Mac reassured banks that they would securitize these subprime loans. It was the “pull” factor that complimented the “push” factor of the CRA.
In May 1995, President Clinton directed bank regulators to make the CRA reviews more focused on results, less burdensome to the banks, and more consistent. The CRA regulators use a variety of indicators, including interviews with local businesses. They do not, however, require banks to hit a dollar or percentage goal of loans. In other words, the Reinvestment Act doesn’t restrict banks’ ability to decide who is credit-worthy. It doesn't prohibit them from allocating their resources in the most profitable way.
The Obama administration used the CRA to penalize banks for discrimination that had nothing to do with housing. It lowered ratings of banks that discriminated in overdraft charges and auto loans. The administration also pursued new redlining cases against banks, an issue that hadn’t been at the forefront for decades.
The Trump administration seeks to make enforcement more transparent, and return its focus to housing.
The CRA Did Not Cause the Subprime Financial Crisis
The Federal Reserve Board found there wasn’t a connection between CRA and the subprime mortgage crisis. Its research showed that 60 percent of subprime loans went to higher-income borrowers outside of the CRA areas. Furthermore, 20 percent of the subprime loans that did go to ghetto areas were originated by lenders that weren't trying to conform to the CRA. In other words, only 6 percent of subprime loans were made by CRA-covered lenders to borrowers and neighborhoods targeted by the CRA. Further, the Fed found that mortgage delinquency was everywhere, not just in low-income areas.
If the CRA did contribute to the financial crisis, it was small. An MIT study found that banks increased their risky lending by about 5 percent in the quarters leading up to the CRA inspections. These loans defaulted 15 percent more frequently. This was more likely to happen in the “greenline” areas, and were committed more by large banks. Most important, the study found that the effects were strongest during the time when private securitization was booming.
Both studies indicate that securitization made higher subprime lending possible. What made securitization possible?
First, the 1999 repeal of Glass-Steagall by the Gramm-Leach-Bliley Act. This allowed banks to use deposits to invest in derivatives. Banking lobbyists said they couldn’t compete with foreign firms, and that they would only go into low risk securities, reducing risk for their customers.
Second, the 2000 Commodity Futures Modernization Act allowed the unregulated trading of derivatives and other credit default swaps. This federal legislation overruled the state laws that had formerly prohibited this as gambling.
Who wrote and advocated for passage of both bills? Texas Senator Phil Gramm, Chairman of the Senate Committee on Banking, Housing and Urban Affairs. He was heavily lobbied by Enron where his wife, who had formerly held the post of Chairwoman of the Commodities Future Trading Commission, was a board member. Enron was a major contributor to Senator Gramm’s campaigns. Federal Reserve Chairman Alan Greenspan and the former Treasury Secretary Larry Summers also lobbied for the bill’s passage.
Enron and the others lobbied for the Act to allow it to legally engage in derivatives trading using its online futures exchanges. Enron argued that legal overseas exchanges of this type was giving foreign firms a competitive advantage.
This allowed big banks to become very sophisticated, allowing them to purchase smaller banks. As banking became more competitive, the banks that had the most complicated financial products made the most money, and bought out smaller, stodgier banks. That’s how banks became too big to fail.
How did securitization work? First, hedge funds and others sold mortgage-backed securities, collateralized debt obligations and other derivatives. A mortgage-backed security is a financial product whose price is based on the value of the mortgages that are used for collateral. Once you get a mortgage from a bank, it sells it to a hedge fund on the secondary market.
The hedge fund then bundles your mortgage with a lot of other similar mortgages. They used computer models to figure out what the bundle is worth based on the monthly payments, total amount owed, the likelihood you will repay, what home prices and interest rates will do, and other factors. The hedge fund then sells the mortgage-backed security to investors.
Since the bank sold your mortgage, it can make new loans with the money it received. It may still collect your payments, but it sends them along to the hedge fund, who sends it to their investors. Of course, everyone takes a cut along the way, which is one reason they were so popular. It was basically risk-free for the bank and the hedge fund.
The investors took all the risk of default. They weren’t worried about the risk because they had insurance, called credit default swaps. They were sold by solid insurance companies liked AIG. Thanks to this insurance, investors snapped up the derivatives. In time, everyone owned them, including pension funds, large banks, hedge funds and even individual investors. Some of the biggest owners were Bear Stearns, Citibank, and Lehman Brothers.
The combination of a derivative backed by real estate, and insurance, was a very profitable hit! However, it required more and more mortgages to back the securities. This drove up demand for mortgages. To meet this demand, banks and mortgage brokers offered home loans to just about anyone. Banks offered subprime mortgages because they made so much money from the derivatives, not the loans.
Banks really needed this new product, thanks to the 2001 recession (March-November 2001). In December, Federal Reserve Chairman Alan Greenspan lowered Fed funds rate to 1.75 percent, and again in November 2001, to 1.24 percent, to fight recession. This lowered interest rates on adjustable –rate mortgages. The payments were cheaper because their interest rates were based on short-term Treasury bill yields, which are based on the Fed funds rate. Many homeowners who couldn't afford conventional mortgages were delighted to be approved for these interest-only loans.
Many didn’t realize their payments would skyrocket when the interest reset in 3-5 years, or when the fed funds rate rose.
As a result, the percent of subprime mortgages doubled, from 10 percent to 20 percent, of all mortgages between 2001 and 2006. By 2007, it had grown into a $1.3 trillion industry. The creation of mortgage-backed securities and the secondary market was what got us out of the 2001 recession.
It also created an asset bubble in real estate in 2005. The demand for mortgages drove up demand for housing, which homebuilders tried to meet. With such cheap loans, many people bought homes, not to live in them or even rent them, but just as investments to sell as prices kept rising. (Source: "The Mortgage Mess Spreads," BusinessWeek, March 7, 2007.)