The CRA and Subprime Lending

1. 82

   Shawn McIntyreposted 10 years ago

   The following question was asked on one of my articles (Economics For Beginners: The Subprime Mortgage Crisis). It's a great question, and one deserving of an answer, but an article designed for beginners simply wasn't the place. So I've invited Freeway Flyer here to the forums for a more comprehensive discussion. I invite anyone who's interested to join in.
   
   The Question:
   
   
   As to your question: "can you please reference the piece(s) of legislation passed by the federal government that compelled financial institutions to start issuing subprime loans."
   
   To answer this, we have to look at the structure of the legislation itself.
   
   The law required any bank that received FDIC insurance to maintain certain levels of CRA compliance (Sec 802), and that this compliance would be taken into account when issuing future banking charters (Sec 804).
   
   For those who are following along, what this meant was that banks had to loan a certain percentage (which differed from branch to branch, and year to year), of the money they collected from customers, in the communities where the branch existed. This meant that banks in black neighborhoods had to have a certain percentage of their loans issued to those neighborhoods, essentially keeping the money in the community where it originated.
   
   To return to the answer, the problems started in 1993 when President Clinton pushed for CRA reform. He wanted to increase the percentages required to maintain CRA compliance. This culminated in 1999 with the unmitigated disaster that is the Grammâ��Leachâ��Bliley Act (GLB), it tied CRA compliance to mergers and acquisitions for Investment and Commercial Banks (12 USC �§ 2903). This is the framework for the Subprime Lending Crisis.
   
   The government was essentially telling banks: "If you want to be able to do business, you're going to need to loan money to the people in your community regardless of risk". Now most people will point to Sec 802, specifically the part that mentions doing business: "consistent with the safe and sound operation of such institutions", and say: "See, the banks didn't have to make subprime loans". The problem is, Congress never actually defined what consistent with the safe and sound operation of such institutions constituted. This meant that it was entirely up to the discretion of the regulators at the time of review.
   
   As to your second point, concerning "mortgage securities" [sic], MBS and CDOs were the key parts of the Financial Crisis which came after (and was exacerbated by) the Subprime Mortgage Crisis. Granted they both happened within  a few months of each other, and both directly contributed to the Great Recession (not to mention making 2007 a pretty crappy year for investors), but they were two separate and distinct events.
   
   Hoped this help answer some of your questions.

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   1. 89

      peoplepower73posted 10 years agoin reply to this

      Good job Shawn:
      
      I'm chomping at the bit to say more about CDO's, MBS', and Credit Default Swaps because they are the next part of the story when  AIG enters the scene.  But I won't steal your thunder. I'll wait for the next issue in your series. Besides, I'll be out of town for the next two weeks.

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      1. 82

         Shawn McIntyreposted 10 years agoin reply to this

         Lol, I'm writing the rest of the series as we speak.
         
         Have a safe trip.

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   2. 82

      Freeway Flyerposted 10 years agoin reply to this

      Shawn, thank you for your explanation. I have found that most people on Hubpages or anywhere else online are unable or unwilling to try and back up their statements with direct references to facts, so this is refreshing.
      
      However, your post brings up a few questions/comments for me:
      
      1) I imagine that banks are not disproportionately located in poor areas. If anything, they may tend to be located in more affluent places. So I'm wondering how such a far-ranging problem as the Mortgage Crisis can be explained by reference to a law that only applied to limited areas. How could the CRA have anything to do with the large number of foreclosures that took place in middle-class neighborhoods?
      
      2) Many sub-prime loans, particularly  with borrowers who were ethnic minorities, were given to people who could have qualified for more traditional, fixed rate loans. This created additional, unnecessary risks.
      
      3) I can see your point that the CRA did not give a clear definition of reasonable risk. Wasn't this the case for loans in general, whether initiated due to the CRA or not? And is their evidence of higher foreclosure rates for loans initiated due to the CRA than other loans?
      
      4) I don't think that you can merely view the problems with MBS and CDOs as a product of the sub-prime crisis. Instead, the packaging of mortgages played an important part in creating the crisis. Because loans were sold off by those who originated them to financial firms that packaged them into securities, there was no incentive for brokers to do any careful underwriting. They received their fees and dumped the loans onto someone else who ultimately dumped them on to investors. Without this packaging of mortgages, there would not have been so many bad loans in the first place.
      
      5) Your original hub talked about basic principles of economics. The problem with economics in theory is that it is often based on the proposition that people act rationally, and that businesses act in their own best interest. In this case, however, large numbers of people were only concerned with short-term profits, not with the long-term viability of this house of cards that was being created. Originating and packaging mortgages made a lot of money for certain individuals in the short-term. And by the time it crashed, the smart ones had already took the money and ran, and the really smart ones bet on its failure. Meanwhile, the AIGs and Fannie Maes of the world were left holding the bag, with either the taxpayers or, more importantly, the Federal Reserve stepping up to bail the system out.
      
      Now you might argue that many big financial institutions paid the price by going under or being absorbed. But many of the employees of these places made a lot of money when the bubble was being created, and as far as I know, they haven't been asked to give it back. So they might be out of a job now, but if they were smart, they put enough away when times were good to make it worthwhile.
      
      So in other words, the interests of employees did not necessarily coincide with the interests of the firms that they worked for.

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      1. 82

         Shawn McIntyreposted 10 years agoin reply to this

         Thanks Freeway Flyer. One of the main reasons I began writing here on HubPages, is to try and do my part (however small it may be) to help clear up some of the general confusion that seems to surround so many economic issues these days.
         
         In the interests of keeping things easy to follow, for others who may be reading our discussion, I'm going to respond on a point-by-point basis. 
         
         
         
         This is actually a pretty common question, the best way to answer it is with an example:
         
         Let's say we have three neighborhoods:
         Neighborhood A: Upper-Middle Class
         Neighborhood B: Middle Class
         Neighborhood C: Inner City
         
         What the CRA did was tell banks in Neighborhood C, that they couldn't take deposits from Neighborhood C and then only loan money to Neighborhoods A & B anymore, they had to loan a certain percentage to customers in Neighborhood C.
         
         The downside was, too many of the people in Neighborhood C who got those loans, used the money to buy houses in Neighborhoods A & B. This had two problems: first of which was that they generally couldn't afford the houses they were buying, and second, the banks no longer got CRA credit for the loans, since the customers were no longer in Neighborhood C. 
         
         
         
         The ARM loans and the predatory lending that followed were byproducts of a problem that already existed. Since banks knew that they were going to have to make subprime loans in order to maintain CRA compliance, they quickly found a way to capitalize on the practice. Never underestimate a banks ability to profit from an apparent no win situation. These are the same people who were trying to short United stock on the morning 9/11.
         
         
         
         Yes and no, loans in general only had to satisfy the conditions set by the lender, there was no compelling third party (in this case the government) requiring them to make the loans. It was purely from a profitability stand point.
         
         As for evidence of higher foreclosure rates, it would be anecdotal at best, since it deals with information that covered by privacy laws, and not readily available to the public.
         
         
         
         We're talking about two different things. The Subprime crisis and the Housing Bubble are linked; they're two sides of the same coin. The Financial Crisis, which was a byproduct of the Subprime/Bubble, was a separate issue. The biggest culprit there wasn't the MBS and COD's (even though they certainly didn't help any) it was the Credit Default Swaps (CDS). In my opinion, those are the single most destructive invention since the nuclear bomb, and should be outlawed A.S.A.P..   
         
         
         
         This is the problem inherit with having a FINO (Free In Name Only) market system. The government needs to get out of the business of trying to manipulate and control the market, period. They need to just set the ground rules, and then stay the hell out of the way, only stepping in when someone violates said rules. As I explained to a friend of mine recently during a similar discussion:
         
         The New York Yankees may spend nearly 10 times as much on payroll as the Houston Astros, but when the game starts, they both have to play the same game, by the same rules. 
         
         It should be no different with the economy: let the government set the rules, let businesses do the rest, and let the chips fall as they may.
         
         
         
         This was always a "take the money and run" operation, and believe me, the firms knew it all along. I have a degree in economics from the University of Florida (GO GATORS!) and I saw this coming; you can't tell me that these guys, some of the brightest economic minds on the planet, people who not only studied, but who taught at places like Harvard, Yale, Oxford, and such, didn't know what they were getting themselves into.
         
         Again, these were all really great questions, and I hope I answered them all for you.

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         1. 82

            Freeway Flyerposted 10 years agoin reply to this

            Does the CRA dictate the neighborhood to which the money must be loaned or the people to whom it must be loaned? Your explanation seems to go back and forth between the two.
            
            Weren't many of the CDS that caused problems sold to insure the various types of mortgage backed securities?

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            1. 82

               Shawn McIntyreposted 10 years agoin reply to this

               Therein lies the problem. By failing to have set standards, and clearly defined guidelines, Congress left it up to the individual inspectors to make that determination. It could change from inspector to inspector, and month to month.
               
               
               
               The Credit Default Swaps were used to "secure" the junk CDOs that were being dumped on the market.
               
               You had companies that were selling worthless Collateralized Debt Obligations (which is what CDO stands for, for those following along), and then taking out billions in Credit Default Swaps (CDS) knowing that the CDO's were going to fail.
               
               For those following along, a Credit Default Swap is essentially an Insurance Policy (although they never, ever want you to call it that) on a debt.

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               1. 82

                  Freeway Flyerposted 10 years agoin reply to this

                  But home loans, as I understand them, are issued so a person can buy a specific property. So were people in poor areas loaned hundreds of thousands of dollars and told to just go and buy whatever home they wished? Why would a bank seeking to comply with the CRA do that, especially if the loan would not count for compliance if the home was bought out of the bank's neighborhood?
                  
                  From my point of view, the government's primary mistake in this was negligence, not pushing banks into bad loans. The CRA is brought up as a major factor by people who do not want to face the fact that private industry could act so irresponsibly. Of course, bank failures have been common in the US for 200 years, and through much of this time, banks were not regulated much at all.

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                  1. 82

                     Shawn McIntyreposted 10 years agoin reply to this

                     Most of the loans actually were under a "pre-approval basis", meaning that, yes, the lenders would approve a certain dollar amount. Congress could have easily solved this by adding a base standard, but this was a problem that apparently no one saw coming.
                     
                     
                     
                     The Governments mistake was thinking that it was smarter than the banks, it's not, and it never will be. This mess was a lot of things, but negligence isn't one of them, this was entirely deliberate. Only the specific laws and regulations that needed to be changed, in order for this to happen, were changed, and in the exact order that they needed to be changed in; Vegas wouldn't even give odds on a coincidence like that.
                     
                     This was intentional from start to finish. I won't go so far as to say that Congress and the President knew that things could get this bad when they made these changes, but a lot of people on Wall Street certainly did. 
                     
                     
                     
                     No one is suggesting that private industry didn't make a bad problem much, much worse, it just wasn't responsible for the subject of my article. Now in the article I'm currently writing on the Financial Collapse, private industry plays a staring role.

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2. 82

   Freeway Flyerposted 10 years ago

   Were the laws changed because government officials decided to change them, or did financiers lobby to have them changed? As you said, bankers know their industry better than politicians, and if you tell a bunch of politicians that these changes will get more poor people into homes, then they will happily play the part of housing advocates. Bankers prefer as little oversight as possible, as we see in their efforts today to gut the recent financial reform bill and strip it of any significant changes.

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   1. 82

      Shawn McIntyreposted 10 years agoin reply to this

      To be honest, it was a little bit of both. The Government wanted the political points for increasing home ownership and strengthening the middle class, and the banks just wanted the money.
      
      The rest was all a product of the law of unintended consequences.

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      1. 82

         Freeway Flyerposted 10 years agoin reply to this

         Yes, I guess that there was plenty of blame to go around.
         
         Let me know when you finish your next installment.

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