The CRA (Community Reinvestment Act) Talking Point

As the public strives to understand the root causes of the economic crisis, politicians and partisan media have refined their talking points. Unfortunately, many are quite focused on creating a wedge political issue, truth be damned. The most reprehensible talking point, pushed recently by such commentators as Charles Krauthammer, Neil Cavuto, and Rush Limbaugh, attributes the crisis to the Community Reinvestment Act, passed during the Carter administration. The CRA sought to increase home ownership among low income American. Undoubtedly, CRA placed pressure on commercial banks and thrifts to extend loans that they would have otherwise avoided. However, for a variety of reasons, this talking point is factually wrong, intellectually dishonest, and is designed to create divisions among Americans during one of our most challenging periods as a nation.

As the story goes, the Clinton administration is the the true culprit, pushing the poor financial institutions into an untenable situation. If only these multibillionaire bankers had not been forced into this supposedly risky lending, they would be in business today and things would be fine. As a side note, it is worth considering who else has been pushing for an “ownership society” (courtesy of Barry Ritholtz at The Big Picture):

“One other thing I’ve done, is I’ve called on private sector mortgage banks and banks to be more aggressive about lending money to first-time home buyers. And the response has been really good. There’s a lot of people in this — our communities around the country that deeply care about the issue of homeownership, and they’ve been responsive.”

- George W. Bush, U.S. President, March 26, 2004.

As Ritholtz goes on to explain, Clinton and Bush certainly deserve a portion of the blame, but probably not for the reasons cited.

Blaming the CRA and Fannie/Freddie is a total misunderstanding of how the problem occurred, and what we need to do to fix it now, and avoid doing it again in the future.

To repeat my prior arguments, the proximate cause of the Housing crisis were 1) Ultra-low rates; and 2) Abdication of traditional lending standards, thanks to 3) originators ability to resell mortgages for securitization purposes, and hence, 4) not have to worry about loan defaults.

The credit crisis was caused by 1) the above securitized mortgage paper, that was 2) rated triple AAA by Moody’s and Standard & Poors, which then 3) Which was then “insured” by credit default swaps (CDS) — the unreserved for, shadow insurance products 4) whose exemption was made possible by the Commodities Futures Modernization Act. That legislation exempted these derivatives from any supervision or regulation. The lack of reserve requirements is why there is now $62 trillion in CDS, many of which will never pay their counter parties the promised insurance.

If you are going to blame Fannie/Freddie/CRA, or George Bush or Barney Frank, you are missing the big picture.

As I was researching this post, I came across this little gem from last March: Lehman Brothers Moves to MBS Overweight. In other words, Lehman was saying mortgage-backed securities were a good investment as recently as March. We all know how well that worked for them. If you have any blame about where the blame lies, consider this prescient video by Mr. Mortgage (I linked to this back in April, but it is worth watching again):

Essentially, lenders made a bet that housing prices would continue to go up, and therefore their lax lending standards, and their highly-leveraged positions, would pay off in the end. When housing prices started to decline, the leverage is what brought system failure. Reggie Middleton put it in terms an investor can understand:

You, as a super smart banker, buy a million shares of Yahoo Stock on margin for $122 per share, using only $50 per share of your money since you are so smart, of course. Your plan is to take these shares, turn around and flip them to your clients for a profit, but all of a sudden the market drops and you are stuck with the product on your balance sheets.

Well, you tell your clients that the market is acting irrational and will return, we just have to wait it out. So, you have $61,000,000 of your capital tied up in $122,000,000 of this tech stock waiting for the market to return. In the mean time, the market drops the price to $15 by the end of the year, effectively wiping clean all of your equity and forcing you to recieve the margin call from hell. But wait, you told your clients, accountants, lawyers, investors and regulators that this was temporary blip and values will return back to pre-bubble times. You see, that was Freudian slip. The asset values did return back to pre-bubble levels, but you bought your assets at the peak of a bubble, and leveraged up on top of it. When that return to the mean comes, it will devastate those who used leverage. This scenario is only using 50% leverage, or 2:1. The banks on my Doo-Doo list are using leverage above 6:1 to 11:1.

Of course, part of the problem continues to be the fact that there is are no defined variables for price and risk on these MBS. Lending has dried up because there is no trust in the market, and no possible valuation of companies holding large amounts of this debt. As in, many of these companies may have no value at all.

But I digress. Coming back to the CRA talking point, we should consider the facts. Unlike Charles Krauthammer and Neil Cavuto, McClatchy has done its due diligence:

As the economy worsens and Election Day approaches, a conservative campaign that blames the global financial crisis on a government push to make housing more affordable to lower-class Americans has taken off on talk radio and e-mail.

Commentators say that’s what triggered the stock market meltdown and the freeze on credit. They’ve specifically targeted the mortgage finance giants Fannie Mae and Freddie Mac, which the federal government seized on Sept. 6, contending that lending to poor and minority Americans caused Fannie’s and Freddie’s financial problems.

Federal housing data reveal that the charges aren’t true, and that the private sector, not the government or government-backed companies, was behind the soaring subprime lending at the core of the crisis.

Subprime lending offered high-cost loans to the weakest borrowers during the housing boom that lasted from 2001 to 2007. Subprime lending was at its height vrom 2004 to 2006.

Federal Reserve Board data show that:

- More than 84 percent of the subprime mortgages in 2006 were issued by private lending institutions.

- Private firms made nearly 83 percent of the subprime loans to low- and moderate-income borrowers that year.

- Only one of the top 25 subprime lenders in 2006 was directly subject to the housing law that’s being lambasted by conservative critics.

The “turmoil in financial markets clearly was triggered by a dramatic weakening of underwriting standards for U.S. subprime mortgages, beginning in late 2004 and extending into 2007,” the President’s Working Group on Financial Markets reported Friday.

Conservative critics claim that the Clinton administration pushed Fannie Mae and Freddie Mac to make home ownership more available to riskier borrowers with little concern for their ability to pay the mortgages.

“I don’t remember a clarion call that said Fannie and Freddie are a disaster. Loaning to minorities and risky folks is a disaster,” said Neil Cavuto of Fox News.

Fannie, the Federal National Mortgage Association, and Freddie, the Federal Home Loan Mortgage Corp., don’t lend money, to minorities or anyone else, however. They purchase loans from the private lenders who actually underwrite the loans.

It’s a process called securitization, and by passing on the loans, banks have more capital on hand so they can lend even more.

Newsweek on the same subject:

Banks that sought to meet CRA requirements by indiscriminately doling out loans to minorities may have been part of the problem. But none of these issues is the cause of the problem. Not by a long shot. From the beginning, subprime has been a symptom, not a cause. And the notion that the Community Reinvestment Act is somehow responsible for poor lending decisions is absurd.

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. 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 subprime debt.

Second, many of the biggest flameouts in real estate have had nothing to do with subprime lending. WCI Communities, builder of highly amenitized condos in Florida (no subprime purchasers welcome there), filed for bankruptcy in August.

Third, lending money to poor people and minorities isn’t inherently risky. There’s plenty of evidence that in fact it’s not that risky at all. That’s what we’ve learned from several decades of microlending programs, at home and abroad, with their very high repayment rates. And as The New York Times recently reported, Nehemiah Homes, a long-running initiative to build homes and sell them to the working poor in subprime areas of New York’s outer boroughs, has a repayment rate that lenders in Greenwich, Conn., would envy. In 27 years, there have been fewer than 10 defaults on the project’s 3,900 homes. That’s a rate of 0.25 percent.

On the other hand, lending money recklessly to obscenely rich white guys, such as Richard Fuld of Lehman Brothers, or Jimmy Cayne of Bear Stearns, can be really risky. In fact, it’s even more risky, since they have a lot more borrowing capacity.

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