Saturday, June 27, 2009

Here's How The Community Reinvestment Act Led To The Housing Bubble's Lax Lending

The following is John Carney's explanation of how he now believes the Community Reivestment Act of 1977 helped lead to the housing bubble.

Here's How The Community Reinvestment Act Led To The Housing Bubble's Lax Lending: "Contrary to my initial conclusion, the evidence is overwhelming that the CRA played a significant role in creating lax lending standards that fueled the housing bubble."

It is fairly complex piece (even if named a "quick" guide), but will give a few look-ins.

"Let's begin:

  • How could a piece of 1977 legislation be significant to the deterioration of mortgage standards 25 years later?
The CRA was not a static piece of legislation. It evolved over the years from a relatively hands-off law focused on process into one that focused on outcomes ...Regulators, beginning in the mid-nineties, began to hold banks accountable in serious ways. Banks responded to this new accountability by increasing the CRA loans they made, a move that entailed relaxing their lending standards"

Another peek:

"Regulators instructed banks to consider alternatives to traditional credit histories because CRA targeted borrowers often lacked traditional credit histories. The banks were expected to become creative, to consider other indicators of reliability.

Similarly, banks were expected by regulators to relax income requirements. Day labors and others often lack reportable income. Stated-income was a way of resolving the gap between actual income of borrowers and reported income. The problem, of course, comes when the con-artists and liars come into the game."

And lest you think this is just an attack on one political party, there is plenty of blame to go around. Note the following:

"George W. Bush was a major proponent of the kind of mortgages that banks had started making under the CRA. He urged low-to-no doc mortgages and the elimination of downpayments, just like the CRA regulators had long done. “We certainly don't want there to be a fine print preventing people from owning their home,” the President said in a 2002 speech. “We can change the print, and we've got to.”"

There is much more, but it is definitely an article that you should read. Even if you do not think you agree with all of his conclusions, it will serve all of us to see the often unintended consequences of relaxing standards.

Interestingly I have sort of gone through a similar metamorphosis. From September when people began saying this was a main cause to now I have come to realize the CRA did play more of a role than I thought. The fact that regulators evaluated banks on making these loans led to more of the loans. To me that has now become unarguable. Was it the only reason for the bubble? No, but it did play a large role. Or in Carney's words:

"Of course it wasn’t the CRA that caused everything. The CRA was a factor in lowering lending standards. This was a necessary, although not sufficient, cause for the mortgage mess"

(BTW the points he addresses are in many ways similar to those raised in academic circles that have led to grade inflation and high passing rates. But that could be a whole other topic for another day!)


JRR2OK said...

Could CRA have applied downward pressure on lending standards? Sure. But did most of the garbage upon which the bubble and the CMO/CLO/ratings fixing debacle was built get in the pipeline thanks to CRA? I have my doubts. Consider:

gatorbrit said...

Not everyone agrees with him... For example Felix Salmon has been arguing that Carney is way off base on this..

Jim said...

Interesting post. What do you think of Barry Ritholt'z post:

He tosses out some statistics which indicate that CRA was a very small part of the mess.

FinanceProfessor said...

My take is that it played a role, not the only role by any stretch (probably pay was bigger)...

I think CRA did sort of set the tone however and helped create an atmosphere where other things (incentive pay etc) could take better root.

Is CRA only to blame? No. But I agree with Carney that it did play a role. And possibly a bigger role than we (or at least I) first realized.

Just for fun I tried to put myself in their shoes..the nearest I have to a regulator is my Dept Chair. So let's consider my annual appraisal and how it impacts something similar: grade inflation.

Student's evaluations of my teaching make up a fairly small percentage of my appraisal (I think less than 10%) but it is a very visible (noisy) and current indicator. So even though officially it is given only 10% weight in annual evaluation, it actually plays a much larger role.

Similarly, by getting press coverage, by getting regulator backing, CRA likely played a role even at those firms not covered.

Was it the only cause? NO WAY. Was it a cause? Probably.

Jim said...

FP, Interesting example wrt student evaluations. Good point.