Tuesday, October 14, 2008

The Community Reinvestment Act

The Community Reinvestment Act is a U.S. law whose objective is to encourage financial institutions to make loans in low to moderate income (LMI) geographic areas. There is a socioeconomic and racial justice angle to this, as banks might otherwise take deposits in LMI neighborhoods and loan them out in richer neighborhoods. This represents in some ways an outflow of capital from poor people to finance crap for rich people.

Banks would have their loan patterns reviewed by regulators. There were no specific penalties for noncompliance. However, CRA ratings were made public. Regulators were allowed to consider performance under the CRA when approving or rejecting merger or other expansion requests. Regulatory changes under the Clinton administration allowed community groups better access to CRA information and increased rights to protest against banks. In the US, community group protests can have significant regulatory impact. Of course, minority communities often get trampled; for example, they may be frozen out of the hearing process when an industrial or waste disposal company is attempting to clear a hazardous waste site.

The notoriously right-wing Investors Business Daily has an editorial attempting to blame US government interference in the markets on the subprime crisis. They include the Community Reinvestment Act, saying that it forced lenders to loan increasing amounts of money to people who couldn't pay it back. The corollary is that the CRA must then have contributed to the increasing number of defaults that caused the subprime crisis. One conservative commentator accused accused Congress of forcing lenders to substitute identity politics for financial prudence.

Although there is mixed information about the effectiveness of the CRA at increasing affordable loans to LMI households, I doubt that the CRA contributed in a significant way to the subprime crisis.

There is a mutual fund, the CRA Qualified Investment Fund (CRAIX) that invests in securities that support community development activities. Investments in the fund are deemed to be qualified under the CRA; CRA-subject financial institutions can invest in the fund to meet some of their CRA obligations.

Year to date as of 10/13/08, according to Morningstar data, the fund is up 1.49%, which is 9% ahead of intermediate term bond funds. In 2007, the fund was up 5.8%, which was 1.1% ahead of intermediate term bond funds. If borrowers in CRA loans couldn't pay, then we would not expect the fund to have performed so well this year. 9% ahead of its peer group is a lot, placing the fund in the 2nd percentile of peer funds this year. That means it's outperforming 98% of similar funds.

Additionally, the law firm Traigler and Hinckley has published a study on CRA loans in the 15 largest US metropolitan areas. They find that, using 2006 data, banks making loans in their CRA assessment areas were much less likely to make high cost loans, charged less on the high cost loans they did make, and were more likely to retain those loans in their portfolios. Securitization has contributed significantly to the subprime crisis; it reduced the incentive for lenders to be thorough about checking creditworthiness. As the CRA Fund demonstrates, those CRA-qualified loans that did get securitized seem to be performing well (at least, the ones the fund bought). The fact that banks are less likely to make high cost loans is also significant.

Additionally, Aaron Pressman reminds us in his blog for Businessweek that 50% of all subprime loans were made by independent mortgage lenders not subject to the CRA. Another 30% were made by subsidiaries of banks or thrifts that were also not subject to the CRA.

The burden of proof, then, is on the folks with an agenda against making affordable loans to LMI householders to show that the CRA made a significant contribution to this crisis. It's telling that at the beginning of the last Presidential debate, the candidates were asked how the bailout plan was going to affect them. John McCain, who answered first, started by criticizing Fannie Mae and Freddie Mac. These firms definitely were mismanaged, but they don't bear the lion's share of the blame and were completely unrelated to the bailout. The conservatives with an agenda will always try to shift the blame to government entities and regulations, but we shouldn't be fooled.

I'll try to say more later about the actual effectiveness of the CRA at causing affordable lending to LMI households. The data isn't quite as clear there.

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