How CRA led to the Crisis

“Some people look at subprime lending and see evil. I look at subprime lending and I see the American dream in action. My mother lived it as a result of a finance company making a mortgage loan that a bank would not make.”
-former United States senator Phil Gramm

What Were Subprime Loans Modeled On

Even after the CJR demolished it, John Cagney lays out his full theory on how the CRA caused so many subprime loans here. I think this is an important point to clarify, as it’s going to float out there in the popular consciousness. It’s a good question why so many people gave out so many questionable loans, and it is natural for people to think someone made them; I think Megan concedes the argument but still wants to see the CRA dismantled. I think the CRA is worth defending, so let’s look at the argument closer.

Cagney acknowledges two key points: (1) CRA loans were very profitable for the banks in question and (2) most subprime loans were from places with no CRA coverage. He thinks that CRA loans looked so profitable that subprime lenders wanted in on that, so they duplicated their efforts but to no avail.

A subprime loan is not a slightly worse CRA loan.

Subprime loans aren’t like CRA loans. Cagney focuses a lot on the LTV numbers, but that is only one characteristic of a subprime loan. My favorite chart of the subprime data (click to enlarge):

80% of the subprime mortgages expired in 30 months; they perpetually had to be refinanced. 75%+ of subprime mortages had a prepayment penalty. This is not at all what CRA loans looked like. CRA rooted for solid, longer-term mortgages. If they ever rooted for a lot of prepayment penalties and fees to get tacked onto their loans, I’ve never seen it.

Another important statistic – in Massachusetts 60% of subprime defaults were originated in prime mortgages. So a large chunk of subprime loans were really prime loans that were collapsing. Either the breadwinners were experiencing “income volatility” or their spending was out of control or whatever. Capturing the disintegrating middle-class on terrible terms is not an objective of the CRA.

I’m going to go into some new research about a favorite topic around here, the roles the consistent refinancing, prepayment penalties and fees did to change the mortgage market, and how a consumer’s bill of rights that took us back to 1982 would be a great move. In case you don’t trust a pseudonymous blogger with a free wordpress account, it’s where the elite research is going to converge when discussing this in my humble opinion. Here’s Did Prepayments Sustain the Subprime Market? by Bhardwaj and Sengupta from the St. Louis Fed:

Using loan-level data on subprime mortgages, we present evidence on the uniqueness of subprime mortgage design. We show that the viability of such products was predicated on the appreciation of house prices. In a regime of rising house prices, a borrowers avoided default by prepaying the loan…Gorton (2008) argues that lenders designed subprime mortgages as bridge-financing to the borrower over short horizons for mutual benefit from house price appreciation…Subprime mortgages were meant to be rolled over and each time the horizon deliberately kept short to limit the lenderís exposure to high-risk borrowers.

The rationality is nothing like that of a CRA loan. It was something new, something about consistent refinancing with a huge amount of fees and penalties, using jumps in the interest rate to force prepayments. They were bad-faith loans, loans that were not meant to be repaid, unlike a CRA loan.

“Wait, Mike. I’m getting a weird sense of déjà vu. I feel like I’ve heard this before.”

Really, where?

“A loan that wasn’t really meant to be paid off. but instead to be paid off enough with high interest rates with higher jumps to force additional payments to occur, and with a lot of the value coming from fees and penalties.”

That does sound familiar.

“Hey wait – that’s how credit cards work!”

Good metaphor. Indeed, the logic of a subprime loan looks disturbingly like the logic of a credit card. If we had to backwards out what motivated someone to go ahead and try to make these subprime loans, you’d have to say they looked at the profitable credit card market and said “ya know what, let’s design a mortgage that looks exactly like that.” The credit card model is about as far away as you can get from the CRA model – and it is very easy to imagine subprime lenders licking their lips at the sweet profits the credit card companies were making moreso than the tiny CRA market.

 

A Community Reinvestment Act Reader
We still have to debunk this myth?

http://www.cjr.org/the_audit/a_community_reinvestment_act_r.php

Felix Salmon takes John Carney of Clusterstock to task for latching on to the right-wing effort to blame the housing bubble and financial crisis (or at least a good part of it) on the Community Reinvestment Act, a law passed in the year of my birth thirty-two years ago.

I thought we had dispensed with this discredited argument, but Carney brings it up, so here’s his smackdown.

First, if you must, read Carney’s posts here, here, here, and here.

Salmon’s posts are here and here. He says at one point:

The fact is that the CRA did not encourage banks to extend the kind of toxic loans which ended up being such an important component of the financial crisis. Indeed, most of those loans weren’t made by banks at all — they were made by unregulated subprime lenders who had no CRA responsibilities whatsoever.
Salmon does a good enough job of demolishing Carney’s argument, but let’s see how deep we can bury it.

Barry Ritholtz of The Big Picture goes off on Carney here with a “CRA Thought Experiment”:

In reality, the precise opposite of what a CRA-induced collapse should have looked like is what occurred. The 345 mortgage brokers that imploded were non-banks, not covered by the CRA legislation. The vast majority of CRA covered banks are actually healthy.


The biggest foreclosure areas aren’t Harlem or Chicago’s South side or DC slums or inner city Philly; Rather, it has been non-CRA regions — the Sand States — such as southern California, Las Vegas, Arizona, and South Florida. The closest thing to an inner city foreclosure story is Detroit – and maybe the bankruptcy of GM and Chrysler actually had something to do with that.


Ritholtz, fairly, asks for one bit of evidence that CRA is responsible in any significant way for the bubble and resulting crisis.

Daniel Gross took a whack at the CRA speciousness back in October over at Slate.

The Community Reinvestment Act applies to depository banks. But many of the institutions that spurred the massive growth of the subprime market weren’t regulated banks. They were outfits such as Argent and American Home Mortgage, which were generally not regulated by the Federal Reserve or other entities that monitored compliance with CRA. These institutions worked hand in glove with Bear Stearns and Lehman Brothers, entities to which the CRA likewise didn’t apply. There’s much more. As Barry Ritholtz notes in this fine rant, the CRA didn’t force mortgage companies to offer loans for no money down, or to throw underwriting standards out the window, or to encourage mortgage brokers to aggressively seek out new markets. Nor did the CRA force the credit-rating agencies to slap high-grade ratings on packages of subprime debt.
And it must be said:

These arguments are generally made by people who read the editorial page of the Wall Street Journal and ignore the rest of the paper—economic know-nothings whose opinions are informed mostly by ideology and, occasionally, by prejudice.
Here’s Federal Reserve Governor Elizabeth A. Duke talking to the American Bankers Association in February, noting that a tiny minority of loans were under the CRA:

I would like to dispel the notion that these problems were caused in any way by Community Reinvestment Act (CRA) lending. The CRA is designed to promote lending in low- to moderate-income areas; it is not designed to encourage high-risk lending or poor underwriting. Our analysis of the data finds no evidence, in fact, that CRA lending is in any way responsible for the current crisis…. In fact, the analysis found that only 6 percent of all higher-priced loans were made by CRA-covered lenders to borrowers and neighborhoods targeted by the CRA. This very small share makes it hard to imagine how CRA could have caused, or even contributed in a meaningful way, to the current crisis. Further support for this conclusion comes from our finding that serious delinquency rates for subprime loans are high in all neighborhood-income categories, not only those in lower-income areas, as might be thought if the CRA were a contributing force to the subprime crisis.
One problem with the CRA-is-bad thesis is that the act was passed in 1977. Carney and other anti-CRAers say it wasn’t really enforced until Clinton refined it in 1995. But CRA enforcement was gutted by George W. Bush during the 2000’s—aka “the bubble.” Paul Krugman quotes from the administration’s new white paper on financial reform:

Some have attempted to blame the subprime meltdown and financial crisis on the CRA and have argued that the CRA must be weakened in order to restore financial stability. These claims and arguments are without any logical or evidentiary basis. It is not tenable that the CRA could suddenly have caused an explosion in bad subprime loans more than 25 years after its enactment. In fact, enforcement of CRA was weakened during the boom and the worst abuses were made by firms not covered by CRA.
Aaron Pressman of BusinessWeek had a good roundup back in September of evidence against a CRA role, and he mentioned the Bush-era laxity (emphasis mine):

Finally, keep in mind that the Bush administration has been weakening CRA enforcement and the law’s reach since the day it took office. The CRA was at its strongest in the 1990s, under the Clinton administration, a period when subprime loans performed quite well. It was only after the Bush administration cut back on CRA enforcement that problems arose, a timing issue which should stop those blaming the law dead in their tracks. The Federal Reserve, too, did nothing but encourage the wild west of lending in recent years. It wasn’t until the middle of 2007 that the Fed decided it was time to crack down on abusive pratices in the subprime lending market. Oops. (more)

 

The problem with the CRA defenses is that while I agree that you cannot find evidence in the later stages of the bubble, it's influence is all over the beginnings. Examine any bubble, the ending stages will not look like the beginning stages. It is only later that the frothy vultures take over, but something has to start it all and that's what I'm interested in.

CRA loans per se are not the only story here, it was political climate surrounding CRA in the 90's that pushed people to find ways to make a purse out of a sow's ear. Why should we be surprised that when political motivations push people to make loans they would not normally make, they will find a way to make cash out of it? I saw it happen in the area of government housing. Politicians were looking for market solutions to their social projects, people who jumped in early on buying up housing proects made a lot of cash, later those entrepeneurs are blamed for being greedy.

The key cog in the machine was securitization which was a natural outcome of risky lending. Fannie and freddie pushed it and in fact guaranteed some of it, Clinton pushed it, interest rates were low, the mortgage cap gains law was passed, so suddenly this new market was created out of nothing with apparent low risk. The gold rush was on and later it exploded way beyond anything to do with CRA type lending. Looking at the later stages for CRA evidence is not useful.

Selling half million dollar homes in Vegas to bus drivers with no money down was not a CRA loan I agree, however it was viewed politically as a good outcome. The american dream was available to anyone who could sign an x on a loan document, CRA was no longer needed by then.

I have no idea why brokers are brought up, they ae not subject to CRA because they are middlemen, not banks.

 

"Beware folks, the same type of thinking that gave us the CRA garbage is now in power full force. Obama is setting up mortgage crisis x 10 with his leftist/multiculturist/tear-down-mean-white-america agenda."

Is pretty weak, not to say kind of ignorant. After all, I don't see anything "tear down mean white america-ish" when I look to who profited from lax lending, who crashed the economy, and who got bailed out the most as a result.

The answer as to who profited? Who was bailout out the most?

Wouldn't that be whitey? Is that a "tear down white america" policy? Obama has done more for white banksters than he has done for inner city blacks.

You can't have it both ways. You can't call a policy a failure of reverse rascism when it really benefits a few old white bankers. (Stan O'Neil, of course, is the exception, not the rule.)

Mith, I am referring to the new agenda here, not subprime. These white bankers will soon be pressured to steer money to Obamas liberal projects since he will own them.

Who profited the most? Brokers I would imagine, along with bus drivers sitting in $500K homes and not paying mortgages.

 

I suppose this is about the specific instance of the mechanics of the current bubble.

The source of bubbles in general though, seems to be loose monetary policy and the mal-investment it causes.

The specifics of particular mal-investments, whether internet stocks, subprime mortgages, or tulips will be traced back to the individual circumstances of each bubble, but it seems the common denominator is a sh!tload of cash and credit looking for a fat, juicy return somewhere - anywhere, even where a legitimate one doesn't exist.

 

You left out the ratings agencies lke Moody's Standard & Poors, and Fitch.

You also left out the "Commodity Futures Modernization Act of 2000" that was spearheaded by Texas Republican, Phil Gramm that created the unregulated CDS "market".

 

The "Commodity Futures Modernization Act of 2000" was passed by the house and senate and signed into law by democrat President Bill Clinton.

 

Ratings and Li's algorithm are most likely connected. Ratings people sort of shrugged and went along because I don't think many people understood the damn thing.

 

Larry Summers, Obama's chief economic advisor, was Bill Clinton's treasury point man that worked congress hard to ram through this legislation.

And, of course, you are well aware of this as you continually disparage Phil Gramm.

 

You really don't have much of a clue, do you?

The Act sailed quickly through the House, but stalled in the Senate due to Gramm's insistence of stricter deregulatory language.

Gramm opposed any language that could provide the SEC or CFTC with any hope of authority in regulating or oversight of financial derivatives and swaps. In fact, Gramm's opposition held the Bill in limbo until Congress went into recess for the 2000 election.

But leave it to you to hold Gramm in such high esteem.