A quarterly magazine of urban affairs, published by the Manhattan Institute, edited by Brian C. Anderson.
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The Financial Crisis and the CRA
A generation ago, the government began forcing banks to make bad loans.
30 October 2008
While opinions vary on how long the current crisis in our housing and financial markets will last, its principal causes are clear. Exceptionally low interest rates, high levels of available capital, and the advent of mortgage securitization combined to spur overinvestment in housingand underinvestment in the sort of due diligence that once typified lending. But as with most events of such magnitude, a long chain of subsidiary causes also played a part. The once-obscure Community Reinvestment Act, passed during the Carter administration, has recentlyin part because of my reportingbecome a bogeyman for Republicans, some of whom have proposed its repeal. Liberal Democrats have defended it as unrelated to the meltdown. The truth lies somewhere in between. While its a long way from the late-seventies world of the original Act to the twenty-first centurys housing crisis, the CRAs role was important.
At the time of the CRAs passage, the world of banking was, as Monty Python would put it, something completely different. Banking was largely a local industry; indeed, interstate branch banking wasnt legal yet. Mortgage lending, moreover, was largely the province of just one sector of the banking industrythe so-called thrift or savings and loan institutions, which had a long-standing deal with government. They would pay relatively low rates of interest to their many small depositors in exchange for charging relatively low interest rates for home loans. The limited earnings spread strongly discouraged risk and, combined with the lack of bank competition, undoubtedly limited many neighborhoods access to credit. This came to be known as redlining, which led many advocates for the poor to conclude that only a legislative mandate could guarantee that those of modest means, living in struggling urban areas, had access to credit. (Back then, I was a crusading left-wing journalist pushing for just this kind of regulation.)
Until the Clinton years, CRA compliance wasnt a difficult matter for banks, which could get an A for effort simply by advertising loan availability in certain newspapers. Then the Clinton Treasury Department changed matters in 1995, requiring banks that wanted outstanding CRA ratings to demonstrate statistically that they were lending in poor neighborhoods and to lower-income households. But this new era of strict enforcement came about in response to conditions that no longer existed. The bank deregulation of the 1980sinitiated not by Republicans, but by the Carter administrations federal Depository Institutions Deregulation and Monetary Control Actpaved the way for sharp competition among mortgage lenders. The CRA may not be needed in todays financial environment to ensure all segments of our economy enjoy access to credit, argued a 1999 Dallas Federal Reserve Bank paper called Redlining or Red Herring?
But banks, engaged in a frenzy of mergers and acquisitions, soon learned that outstanding CRA ratings were the coin of the realm for obtaining regulators permission for such deals. Further, nonprofit advocacy groupsincluding the now famous Acorn and the Neighborhood Assistance Corporation of America (NACA)demanded, successfully, that banks seeking regulatory approvals commit large pools of mortgage money to them, effectively outsourcing the underwriting function to groups that viewed such loans as a matter of social justice rather than due diligence. Our job is to push the envelope, Bruce Marks, founder and head of NACA, told me when I visited his Boston office in 2000. He made clear that he would use his delegated lending authority to make loans to households with limited savings, significant debt, and poor credit histories. The sums at his groups disposal were not trivial: when NationsBank merged with Bank of America, it committed $3 billion to NACA. The housing arm of Acorn received a $760 million commitment from the Bank of New York.
Sizable pools of capital came to be allocated in an entirely new way. Bank examiners began using federal home-loan databroken down by neighborhood, income, and raceto rate banks on their CRA performance, standing traditional lending on its head. In sharp contrast to the old regulatory emphasis on safety and soundness, regulators now judged banks not on how their loans performed, but on how many loans they made and to whom. As one former vice president of Chicagos Harris Bank once told me: You just have to make sure you dont turn anyone down. If anyone applies for a loan, its better for you just to give them the money. A high denial rate is what gets you in trouble. Its no surprise, then, that as early as 1999, the Federal Reserve Board found that only 29 percent of loans in bank lending programs established especially for CRA compliance purposes could be classified as profitable.
As I contended in City Journal back in 2000, this was exceptionally poor social policy. Extending lines of credit based on noneconomic criteria hurts low-income neighborhoods much more than it hurts banks or other lenders. In a February 2003 study, Congressional Budget Office analysts Charles Capone and Albert Metz wrote: Once a neighborhood foreclosure cycle starts . . . it becomes progressively harder for other households to sell their homes. Abandoned properties and blight can destroy neighborhoods where low-down payment affordable housing programs are prevalent (emphasis added). In 2003, a homeowner in Chicagos blue-collar Back of the Yards neighborhoodwhere the first wave of subprime foreclosures had already beguntold me: That hurts values right there. You try to show people that theres hope for the block and then you get slapped right back down again. Collateral damage is greatest for lower-income households that pay their bills on time but find themselves living next door to a house in foreclosure.
Was there a high enough level of CRA-related lending to spark our current crisis? Not on its own, of course. The crucial link was the extension of CRA-type thinking and regulation to the secondary mortgage markets through the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which buy loans from banks in order to provide liquidity. Beginning in 1992, the Department of Housing and Urban Development pushed Fannie and Freddie to buy loans based on criteria other than creditworthiness. These affordable housing goals and subgoalsauthorized, ironically, by the Federal Housing Enterprises Financial Safety and Soundness Actbecame more demanding over time and, by 2005, required that Fannie and Freddie strive to buy 45 percent of all loans from those of low and moderate income, including 32 percent from people in central cities and other underserved areas and 22 percent from very low income families or families living in low-income neighborhoods. As one former Fannie Mae official puts it: Both HUD and many advocates in the early 2000s were anxious for the GSEs to extend credit to borrowers with blemished credit in ways that were responsible.
How were such goals to be met? Crucially, subprime loans didnt only allow banks to meet their CRA lending requirements; sold to Fannie and Freddie, they could also help the two secondary mortgage giants meet their affordable-housing targets. Not all subprime loans, or even a majority of them, were made for CRA-related reasonsthe combination of cheap money and imprudent borrowers clearly made for a tremendous bubble. But such loans, bundled into asset-backed securities, were purchased (according to a June 2007 HUD report) especially by Freddie Mac to help fulfill its affordable-housing goals. As recently as April of this year, Fannie actually boasted about mortgage products and options, which included reduced requirements for down payment and closing costs, choices for borrowers with less than perfect credit and flexibility to provide loans to home buyers with no traditional credit history. In 2005 alone, Fannie Mae purchased some 3.8 million loans that could help them achieve affordable-housing targets. Bruce Marks might as well have been in charge of federal housing policy.
Its important to note that Fannie and Freddie bought paper from all sorts of mortgage originators, not just from banks bound by the CRA. But the loans still counted toward Fannies and Freddies affordable-housing goalsand helped lead to their meltdowns. Those meltdowns were anticipated by the National Association of Realtors when in 2004 it wrote to HUD protesting the increases in the GSE affordable-housing goals: Increases in housing prices have exceeded income growth in the past few years, interest rates are on the rise and rental markets are soft. The credit scores of renters have declined significantly over time, reducing the number of qualified buyers. By insisting that such underqualified buyers be dealt into homeownership for political reasons, we helped create the financial crisis.
How many of the troubled Fannie/Freddie loans were also used for CRA purposes by banks that originated them? Its impossible to know; regulators havent done a rigorous assessment. Nor have CRA advocates pushed for any performance tracking. But they were certainly implicated in our present situation. One chief executive of a significant New York bank recently told me that Fannie Mae scooped up all of the CRA loans he originated. As economist Russell Roberts of George Mason University points out, Bank of America reported that nonperforming CRA-eligible loans were a significant drag on its third-quarter 2008 income. Its earnings report states: We continue to see deterioration in our community reinvestment act portfolio which totals some 7 percent of the residential book. . . . The annualized loss rate from the CRA book was 1.26 percent and represented 29 percent of the residential mortgage net losses. This is a far cry from the advocates standard line that CRA loans, while less lucrative than standard mortgages, are still profitable.
But the CRA advocates, including the New York Times, continue to claim that CRA-qualified loans made by regulated financial institutions performed well and shouldnt be implicated in our current troubles. They point to the results of an evaluation of CRA loans by North Carolinas Center for Community Capital, which found that such loans performed more poorly than conventional mortgages but better than subprime loans overall. What they dont mention is that the study evaluated only 9,000 mortgages, a drop in the bucket compared to the $4.5 trillion in CRA-eligible loans that the pro-CRA National Community Reinvestment Coalition estimates have been made since passage of the Act. There has been no systematic study, by either the Government Accountability Office or the Federal Reserve, of the performance of loans cited by banks in their CRA filings. Many such loans werent even underwritten by the banks themselves, which often purchased CRA-eligible loans (advertised in such publications as American Banker) and then resold them. Again, the emphasis was on showing regulators that loans were being madenot how they were performing. How could such a system not lead to problem loans and high delinquency and foreclosure rates? Eight years ago, when the national average delinquency rate was 1.9 percent, Marks told me that the rate for his organizations loans was 8.2 percent.
It seems clear that we have, as a matter of national policy, pushed too many households toward homeownership. Both political parties are guilty. Democrats were largely responsible for the Fannie and Freddie affordable-housing goals, but the Bush administration promoted the idea of letting holders of Section 8 rental-housing vouchersvery poor householdsuse their housing subsidy as a down payment on a mortgage.
Looking ahead, how should we think about our financial system as it relates to Americans of modest means? We have the tools in place for a fair and effective housing policy. Fair-housing and antidiscrimination laws must be enforced to ensure that prospective borrowers are not turned away for nonfinancial reasons. Credit scoringwhich didnt exist at the time of the original passage of the CRAallows lenders to differentiate among households of similar incomes but different levels of frugality and thrift. Lets allow these market mechanisms to operate, rather than relying on regulatory mandates and the political risk they introduce into financial markets.
Howard Husock, a contributing editor of City Journal, is the Manhattan Institutes vice president for policy research, the director of its Social Entrepreneurship Initiative, and the author of Americas Trillion-Dollar Housing Mistake.