CRA and the Collapse Part 2

The Community Reinvestment Act of 1977 is often tossed around these days as the source of the economic collapse we are still experiencing in this country. If you think it sounds a little strange that an act passed in 1977 caused an economic collapse in 2008 you are correct. It would be strange if that is what happened but the truth of the matter is that it isn’t that strange because that is not what caused the recent collapse no matter what Sean Hannity and Rush Limbaugh would have you to believe. In my last post, I pointed out that the actual numbers concerning the real estate mortgage industry didn’t add up to the collapse we experienced and I will go further into what actually happened in later posts on this subject but I thought it would be worthwhile to look at what actually did happen to the real estate market first.

The Community Reinvestment Act was passed with the express intent of eliminating unfair lending practices in inner cities. As far back as the thirties when the government became involved in assistance for home mortgages the mortgage industry has discriminated against one factor, perceived risk. In the early years of government involvement there were maps drawn up wherein were lined off with colored lines based upon the projected amount of risk associated with mortgages in different areas. Historically, the inner cities which were largely populated by minorities were “redlined” or outlined in red as the highest risk areas to loan money. Up until the early sixties such maps were the rule in the industry and it was very hard to convince mortgage companies and banks to loan money in these areas for the simple reason that there were plenty of other areas considered less risky in which to loan their money.

In 1968 the Fair Housing Act was passed to fight this problem. This act prohibited the policy of redlining areas based upon race, religion, gender, familial status, or ethnic origin. While the act was aimed at specifically limiting the ability of lending institutions to discriminate based upon these criteria the industry continued to be slanted away from lending in these areas because of perceived risk. While the Fair Housing Act specifically made it illegal to discriminate based upon these factors the lending institutions simply had to avoid having it proved that their bias was based upon these factors to fall outside of the control of this act.
The Community Reinvestment Act was passed to encourage investment in these areas. What the act does in effect is to require banks under the FDIC to maintain equal opportunity for loans in all areas where they are chartered to do business including lower income areas. In other words, if a bank has depositors in low income areas it is required to offer equal opportunity for loans in these same areas. There were no specific requirements to how this was to be effected but it was to be enforced by the same FDIC auditors who take care of making sure that such banks do safe and legal business under the protection of the FDIC. The Act specifically states that all such banks are to maintain due diligence and follow accepted criteria for determining that loans made under this act are fiscally sound. As with the other constraints in the act, these decisions are to be audited and enforced by the FDIC auditors.

The teeth of the enforcement of the act came from the FDIC’s recommendations as to how member institutions were graded according to their compliance with the provisions of the act. In other words, the FDIC would either give thumbs up or thumbs down to member institutions who applied for mergers and acquisitions with other banks based upon their compliance with the CRA. A good rating for compliance was the carrot on the end of the stick and member banks were to respond accordingly. The specific regulatory agencies who made these judgments were the Office of the Comptroller of Currency, the Office of Thrift Supervision, and the FDIC. The Federal Financial Institution Examinations Council was charged with coordinating these reports and publishing the findings for a bank’s compliance with CRA regulations.

While that Act itself was aimed at increasing the ability of people in lower income areas to attain financing for buying homes in these areas it was not very successful in changing the status quo. The Act itself was continuously modified to make it more effective. Changes in 1989, 1992, 1994, 1995, 1999, and 2005 were made to the Act to make it more effective in increasing this ability by giving the regulatory agencies more teeth in enforcing the act. Still, as late as 2007 there were conversations in government about further strengthening the Act to increase the amount of access to such loans for the simple reason that it never successfully impacted the markets in large numbers.

According to independent studies by the Cato Institute, and the Competitive Enterprise Institute the Act itself could never be shown to improve home ownership in low income areas. There are those who disagree of course but the reality is that the Act itself played a very small part in the growth of loans in low income areas. The overwhelming consensus of such studies is that the loans that were made under the CRA were loans that to a large extent held to term and were much less likely to threats of foreclosure than those made by private entities which were not under the jurisdiction of the CRA. As a matter of fact, some 80% of the loans that came into foreclosure during the 2007 crisis and later were made by private mortgage companies that were not in any way associated with the Community Reinvestment Act because they were not under its jurisdiction in any form.

Sub Prime Mortgages and other exotic entities that actually led to the housing bubble collapse were the overwhelmingly the creation of private enterprise mortgage companies. Why? For the same reason that all such schemes are hatched; PROFIT.

In the recent past in this country the overwhelming majority of home mortgages that were made were simple financial agreements wherein one party made a loan and the other party held onto the loan as an investment. The profit was in collecting the interest rate over a long term and it was a pretty handsome profit at that. The standard rule of thumb for such mortgages is that a 30 year note usually pays off some 300% over the term of the loan. As most homeowners understand this means that a $50,000 dollar mortgage usually costs some $150,000 by the time it is paid off if it goes the full term of the loan. Obviously, a loan that defaulted was bad business for everyone. The homeowner lost his home and the money he had invested up to the point of foreclosure and the mortgage holder lost the projected profits of the long term interest payments so it was in no one’s best interest to make bad loans.

Securitization changed the whole industry in a drastic way in the late 1990’s. Just as the Dot Com collapse of the late 90’s started to crash the financial markets securitization of mortgages began to take over these markets which is basically the way we avoided an economic collapse at that time. I will go more into the details of Securitization and how it works in a later post but for now I will give the short version explanation.

Basically, Securitization involves bundling groups of mortgages into bond type instruments that are traded on the market as assets. In other words, it is a little bit of hocus pocus magic whereby a Debt in the form of a mortgage is changed into an Asset in the form of a Collaterized Mortgage Obligation (CMO). Of course the rules and regulations for this little bit of magic are hazy and open ended which is exactly why such regulations are needed but for now it is worth noting that this industry grew at an astronomical rate in the late 1990’s and early 2000’s.

Securitization instantaneously created a market for mortgages, lots of mortgages. The people producing the mortgages sold them immediately after creating them to a group who would bundle them into CMO’s and sell them again. Each transaction created a profit margin so that such mortgage bundles often actually increased in value with each trade, sometimes in margins that ended up being in the range of 50 to 100 times over the initial value. It was magic. A debt instantaneously becomes an asset and then multiplies in value and everyone was making lots of money. Of course there is really no such thing as magic. A debt is still a debt, no matter how you bundle it or what you name it but that is something we still don’t seem to recognize as a nation and another point for another post later on.

As Securitization grew mortgage companies became more and more creative with the types of loans they created. They also pushed harder for approval of higher risk loans. After all, the mortgage company wasn’t going to hold the loan to maturity and the next person in line who was doing the securitization wasn’t either. Instead of long term profit on sound loans the real money was now in short term profits on large volumes of loans and no one really cared how safe the loans themselves were. After all, as the market boomed the home values increased so that a person could always just refinance if they couldn’t pay the mortgage. It was the classic case of paying the piper later and the US economy boomed.

The Housing industry became a pyramid scheme and as long as the home values kept increasing there was no end in sight. As in most such schemes the jig is eventually up. Someone notices that the emperor isn’t actually wearing any clothes and reality starts to set in. As in all pyramid schemes that inevitably collapse the people on the bottom lose and we are seeing the effects of this one now. It wasn’t the fact that the government forced banks to make bad loans it was the fact that banks found a way to make it profitable to make bad loans. Through control of Congress and the gradual dismantling of the regulations put in effect after the last great collapse in 1929 from rampant speculation greed found a way to create even more rampant speculation in the last 15 years.

Casinos make a lot of money off of people’s belief that they can beat statistical certainty but at least most people who play in Casinos have to use their own money. The banking industry in the US has created their own Casino but they are using our money to gamble with. As long as the general public doesn’t understand what just happened to our economy we have no way to prevent it from happening again. It doesn’t really matter if the economy comes back or not if we don’t fix the problems that caused it to collapse in the first place and we simply have not done that so far.

We have allowed a system to be created where it was profitable to make bad loans and it was the pursuit of these profits that crashed the economy. Don’t expect the people who made all the money to abandon the system that was so profitable for them any time soon. It is fairly easy to just buy media outlets if you have a lot of money and spread propaganda that blames everyone but the people who created the problem. After all, most Americans are so stupid that they can be convinced that poor people buying homes they couldn’t afford crashed the world economy. Oh how those poor bankers must have anguished over being forced to make loans to people they knew couldn’t pay them back by the big bad government. As my dad used to say, “they must have cried all the way to the bank.”