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Community Reinvestment Act Induced Banks To Take Bad Risks, Economic Study Finds

The Community Reinvestment Act, which "prods banks to make loans in low-income communities,” encouraged banks to make riskier loans, concludes a recent study from the National Bureau of Economic Research.

As J.D. Tuccille at Reason notes, the federal government played

a role in inducing, even strong-arming, banks to take risks they otherwise would have avoided. Specifically, the Community Reinvestment Act and related policy pressures are pointed to as culprits, part of a government effort to extend home-ownership in lower-income neighborhoods. Now comes a new study from the National Bureau of Economic Research that says, quite bluntly. that the CRA played a major role.

In the academic world, mealy-mouthed delivery of even powerful conclusions is the norm, so it's refreshing to see authors Sumit Agarwal, Efraim Benmelech, Nittai Bergman, Amit Seru answer the title's question, "Did the Community Reinvestment Act (CRA) Lead to Risky Lending?," with the clear, "Yes, it did. ... We find that adherence to the act led to riskier lending by banks." The full abstract reads:

Yes, it did. We use exogenous variation in banks’ incentives to conform to the standards of the Community Reinvestment Act (CRA) around regulatory exam dates to trace out the effect of the CRA on lending activity. Our empirical strategy compares lending behavior of banks undergoing CRA exams within a given census tract in a given month to the behavior of banks operating in the same census tract-month that do not face these exams. We find that adherence to the act led to riskier lending by banks: in the six quarters surrounding the CRA exams lending is elevated on average by about 5 percent every quarter and loans in these quarters default by about 15 percent more often. These patterns are accentuated in CRA-eligible census tracts and are concentrated among large banks. The effects are strongest during the time period when the market for private securitization was booming.

Investor's Business Daily does a very nice job of summarizing the nature of the pressure brought on lenders . . .“‘We want your CRA loans because they help us meet our housing goals,' Fannie Vice Chair Jamie Gorelick beseeched lenders gathered at a banking conference in 2000, just after HUD hiked the mortgage giant's affordable housing quotas to 50% and pressed it to buy more CRA-eligible loans to help meet those new targets. 'We will buy them from your portfolios or package them into securities.' She described 'CRA-friendly products' as mortgages with less than "3% down" and "flexible underwriting. "From 2001-2007, Fannie and Freddie bought roughly half of all CRA home loans, most carrying subprime features."

Tuccille is correct that beginning the article abstract with the certainty of "Yes, it did" is unusual for generally cautious academics. The conclusion is also worth highlighting, as the authors note their estimated impact of the CRA on lending risk "provide[s] a lower bound to the actual impact of the Community Reinvestment Act. If adjustment costs in lending behavior are large and banks can’t easily tilt their loan portfolio toward greater CRA compliance, the full impact of the CRA is potentially much greater than that estimated" in their study.

The 2010 Dodd-Frank Act makes enforcement of the Community Reinvestment Act even more onerous and rigid by taking  enforcement away from non-ideological bank regulators who had an interest in safeguarding banks' financial health and giving it to the Consumer Financial Protection Bureau, which gives little thought to the effect of its actions on the stability of the financial system. The Community Reinvestment Act was enacted in 1977, but it was not enforced  stringently until regulations dramatically expanded its reach in the 1990s. It then became one of the factors that contributed to the financial crisis. The Obama administration and Congress responded to the financial crisis by making the financial system even worse and encouraging more of the risky lending that helped spawn the crisis.

One  rationale for creating the Consumer Financial Protection Bureau in 2010 was to make enforcement of the Community Reinvestment Act even more rigid and onerous, by discarding any consideration of how its enforcement could undermine the health of banks and the financial system. In explaining why there was supposedly a need for this new agency, when other agencies already enforced the Community Reinvestment Act, the Obama administration's regulatory blueprint complained that “State and federal bank supervisory agencies’ primary mission is to ensure that financial institutions act prudently, a mission that, in appearance if not always in practice, often conflicts with their consumer protection responsibilities” (p. 54). In other words, the Obama administration thought the power to force banks to make low-income loans should be given to an agency that has no interest in prudent lending and gives no thought to whether such imprudent loans could harm banks and America's financial stability. The CFPB, which is extremely powerful and largely unaccountable to anyone (Congress has no control over its budget, it has a sweeping grant of authority over the financial sector, and its director, once appointed, can’t be replaced by a succeeding president who disagrees with his policies) is being challenged in court.

Government pressure on banks to make low-income loans was a key reason for the mortgage meltdown and the financial crisis. Yet, the Dodd-Frank Act reinforced the status quo by mandating more risky, low-income loans in several ways, not just through the CRA.  The Obama administration pushed for more onerous CRA enforcement even though many already had argued the Community Reinvestment Act was a key contributor to the financial crisis -- along, of course, with government-sponsored mortgage giants Fannie Mae and Freddie Mac, and by federal affordable-housing mandates.

The liberal Village Voice previously chronicled how Clinton administration housing secretary Andrew Cuomo helped spawn the mortgage crisis through his pressure on lenders to promote affordable housing and diversity:

Andrew Cuomo, the youngest Housing and Urban Development secretary in history, made a series of decisions between 1997 and 2001 that gave birth to the country’s current crisis. He took actions that—in combination with many other factors—helped plunge Fannie and Freddie into the subprime markets without putting in place the means to monitor their increasingly risky investments. He turned the Federal Housing Administration mortgage program into a sweetheart lender with sky-high loan ceilings and no money down . . . Three to four million families are now facing foreclosure, and Cuomo is one of the reasons why. (See Wayne Barrett, “Andrew Cuomo and Fannie and Freddie: How the Youngest Housing and Urban Development Secretary in History Gave Birth to the Mortgage Crisis,” Village Voice, August 5, 2008.)

Banks and mortgage companies have long been under pressure from lawmakers and regulators to give loans to people with bad credit, in order to provide “affordable housing” and promote “diversity.” That played a key role in triggering the mortgage crisis, judging from a 2008 story in The New York Times. For example, “a high-ranking Democrat telephoned executives and screamed at them to purchase more loans from low-income borrowers.” The executives of government-backed mortgage giants Fannie Mae and Freddie Mac “eventually yielded to those pressures, effectively wagering that if things got too bad, the government would bail them out.” But they realized the risk: “In 2004, Freddie Mac warned regulators that affordable housing goals could force the company to buy riskier loans.” Ultimately, though, Freddie Mac’s CEO, Richard F. Syron, told colleagues that “we couldn’t afford to say no to anyone.”

As a Washington Post story shows, the high-risk loans that led to the mortgage crisis were the product of regulatory pressure, not a lack of regulation. In 2004, even after banking officials “warned that subprime lenders were saddling borrowers with mortgages they could not afford, the U.S. Department of Housing and Urban Development helped fuel more of that risky lending. Eager to put more low-income and minority families into their own homes, the agency required the two government-chartered mortgage finance firms purchase far more ‘affordable’ loans made to these borrowers. HUD stuck with an outdated policy that allowed Freddie Mac and Fannie Mae to count billions of dollars they invested in subprime loans as a public good that would foster affordable housing.”

Lenders also face the risk of being sued for discrimination if they fail to make loans to people with bad credit, which often has a racially-disparate impact. The Justice Department is now extorting multimillion dollar settlements from banks, by accusing them of racial discrimination because they use traditional, non-racist lending criteria that minority borrowers are, on average, less likely to satisfy, such as having a high credit score, or being able to afford a substantial downpayment. Its Civil Rights Division chief, Tom Perez, “has compared bankers to Klansmen.” The “only difference, he says, is  bankers discriminate ‘with a smile’ and ‘fine print,’” calling their lending criteria “every bit as destructive as the  cross burned in a neighborhood.” Investor’s Business Daily chronicles this attack on small banks in “DOJ Begins Bank Witch Hunt,”

Such lower lending standards can have disastrous results. A recent book co-authored by The New York Times' Gretchen Morgenson chronicles how federally promoted lower lending standards spawned the financial crisis and put minority borrowers into homes they could not afford:

“This is a story, the authors say, ‘of what happens when Washington  decides, in its infinite wisdom, that every living, breathing citizen  should own a home.’  Encouraged by politicians to expand home  lending—not least to minorities and to households with few  assets—[government-sponsored mortgage giant Fannie Mae] ignored reasonable standards of underwriting and piled  up fugitive profits almost as fast as it increased risk to taxpayers.   The disaster is now measured in the hundreds of billions of dollars. As  for the borrowers who were supposedly to benefit from Fannie’s  mortgage-industrial complex, Ms. Morgenson and Mr. Rosner write that  home ownership ‘put them squarely on the road to personal and financial  ruin.’”

A recent study by Peter Wallison, who had prophetically warned about Fannie and Freddie, found  two-thirds of all bad mortgages either were  “bought by government agencies or required to be bought by private companies under government pressure,” a finding echoed by other recent studies.