Yes, The Community Reinvestment Act Did Cause The Crash

Joe and I were trading emails yesterday and I told him that I’ve noticed how robotic, ignorant and stale the arguments from the left have become. Maybe they have always been that way – but recently I tried to comment on the Panama City newspaper site and I realized that I could just cut and paste a refutation to every argument these simpletons were making with absolutely no thought required, just access to the posts here at TRNL and a mastery of a couple of keys…

I’ve also grown tired of refuting the moronic two word cause that the liberals use for the economic crash – Bush’s Fault. In their minds it means Republican deregulation of the “banks”, greedy “Wall Streeters” and the Bush tax cuts.

For several years it has been an article of faith on the right that the mortgage bubble was inflated by the Community Reinvestment Act and the subsequent crash was triggered by bad loans that the banks were “encouraged” by government to make and vacuumed up by Fannie and Freddie. Now there is a credible study, conducted by researchers at the University of Singapore, Harvard, MIT and the University of Chicago, that answers the question: Did the CRA cause the economic collapse?

Yes, it did. We use exogenous variation in banks’ incentives to conform to the standards of the Community Reinvestment Act (CRA) around regulatory exam dates to trace out the effect of the CRA on lending activity. Our empirical strategy compares lending behavior of banks undergoing CRA exams within a given census tract in a given month to the behavior of banks operating in the same census tract-month that do not face these exams. We find that adherence to the act led to riskier lending by banks: in the six quarters surrounding the CRA exams lending is elevated on average by about 5 percent every quarter and loans in these quarters default by about 15 percent more often. These patterns are accentuated in CRA-eligible census tracts and are concentrated among large banks. The effects are strongest during the time period when the market for private securitization was booming.

Bush tried for six years to reform Fannie and Freddie, 17 times in 2008 alone. The Democrats blocked the reforms, with Barney Frank being quoted in the New York Times saying:

”These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis,” said Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee. ”The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.”

And yet, the liberals deny history and their own culpability to call it “Bush’s Fault”.

In June of 2012 in a post called “It’s The Economy Stupid”, I explained why it wasn’t “greed” but capitalism that drove the banks to do what they did within the rules given to them by the forces in government – companies in a free market do not act against their best interests. They essentially conformed to the policies and the regulations that drove them to conduct business in a way to maximize returns to the shareholders and since Fannie and Freddie were willing receptors for the higher risk, we got risky loans to people who couldn’t pay as a result.

My post:

Wise words from James “Snakehead” Carville.

Much has been made of the mortgage companies and the finance industry causing the housing boom and bust and the resulting crash in the financial sector.  Democrats claim that the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Community Reinvestment Act (CRA) had nothing to do with it.

It appears that they did.

Mortgages are an exercise in an investment process – a mortgage is nothing but a securitized debt instrument that yields interest (just like a government bond or commercial paper) and can be bought and sold by the holder of the debt. Basically, a chartered bank, an investment bank or a mortgage bank will give you the cash to buy a house, then either keep the debt or package it with other similar debt to back mortgage securities, which are sold to investors. When they make loans with the intent of selling them, that act is called origination.

Originators take a fee or “points” of the loan as payment for handling the loan, that is how they make their money, the subsequent transfers are facilitated by a “discount” against the value of the note over time, the seller gets their cash and a share of the future value of the note and gets out, the end buyer is in it for the payments over time to recover interest and principal. Sounds like a losing proposition but a $180,000 note at 6% for 30 years will yield a total of $347,047 in interest, making for a total repayment of $527,047. If you can hold it, you can double your investment, if not, take it to the debt market and sell it for a lower, but faster return.

The thing about businesses and corporations are that they are not in business to lose money. Even Liberals recognize this when the decry companies that “make too much money”. While it was convenient to blame the greed of financial community for the financial crisis, the fact of the matter is this: If there was no money to be made by originating and selling sub-prime mortgages, they would not have done it. If they did not have a willing buyer of the subprime paper, there is no way that they would have been in the business. Business is all about the assessment of risk and reward, only when the reward is greater than the risk will a business in a free market act. A transaction only occurs when a seller is willing to sell and a buyer is willing to buy.

Unless the market is distorted by another force.

There is a concept in the finance and investment world called a “market maker”. In the investment world, a “market maker” is a broker-dealer firm that accepts the risk of holding a certain number of shares of a particular security in order to facilitate trading in that security. In other words, the firm creates a market by facilitating trades with securities that they hold.

Who was the “market maker” for subprime mortgages?

Fannie Mae and Freddie Mac.

How do we know? We know because of this information from the Associated Press of Friday , May 6th, 2011:

Fannie Mae asked the government Friday for an additional $8.5 billion in aid after declining home prices caused more defaults on loans guaranteed by the mortgage giant.

The company said it lost $8.7 billion in the first three months of the year. Those losses led Fannie to request more than three times the federal aid it sought in the previous quarter. The total cost of rescuing the government-controlled mortgage buyer is nearing $100 billion – the most expensive bailout of a single company.

Combined with the bailout of sibling company Freddie Mac, the government expects their rescue to cost taxpayers about $259 billion. That money will cover the mortgage giants’ losses on soured loans made in the midst of the housing bubble.

Fannie and Freddie – and the American taxpayers are left holding the bag. Note that the AP states that this is “the most expensive bailout of a single company.”, dwarfing anything on Wall Street or with GM. The insidious thing is that this is taxpayer funded loans being bailed out by yet more taxpayer funds. A double dip.

Looking all the way back to 1998, even during the Clinton administration there were warnings. Former Senator Don Nickles (R-OK), said this on the floor of the Senate in support of a bill to strengthen the basic requirements of loan guarantees from the FHA:

Is FHA doing such a great job? They have three times the default rate of conventional loans. They are not doing that great if they have a default rate running at 8.4 percent, three times the national rate for conventional loans.

They have a smaller downpayment, which means a much greater risk. If you have a loan with FHA, I believe the loan to value ratio is 96 percent. That is far lower than conventional loans, so you have a lot more risk and three times the default rate.

[Page 15,694 of the Congressional Record, July 16, 1998]

Financial companies would only make these risky loans if they knew that they had some way to mitigate the risk – somewhere to park the loans. That somewhere was facilitated by the Community Reinvestment Act and the trio of Democrats Chris Dodd, Barney Frank and a cadre of Republicans in name only. The CRA has been around since Jimmy Carter, but it never had been used to pressure financial firms the way that Dodd, Frank and the “go along to get along” RINOs did from their respective seats in the banking and finance committees in Congress. In 2009, Forbes noted:

The low interest rates of the early 2000s may explain the growth of the housing bubble, but they don’t explain the poor quality of these mortgages. For that we have to look to the government’s distortion of the mortgage finance system through the Community Reinvestment Act and the government-sponsored enterprises (GSEs) Fannie Maeand Freddie Mac.

In a recent meeting with the Council on Foreign Relations, Barney Frank–the chair of the House Financial Services Committee and a longtime supporter of Fannie and Freddie–admitted that it had been a mistake to force homeownership on people who could not afford it. Renting, he said, would have been preferable. Now he tells us.

Long-term pressure from Frank and his colleagues to expand home ownership connects government housing policies to both the housing bubble and the poor quality of the mortgages on which it is based. In 1992, Congress gave a new affordable housing “mission” to Fannie and Freddie, and authorized the Department of Housing and Urban Development to define its scope through regulations.

Shortly thereafter, Fannie Mae, under Chairman Jim Johnson, made its first “trillion-dollar commitment” to increase financing for affordable housing. What this meant for the quality of the mortgages that Fannie–and later Freddie–would buy has not become clear until now.

On a parallel track was the Community Reinvestment Act. New CRA regulations in 1995 required banks to demonstrate that they were making mortgage loans to underserved communities, which inevitably included borrowers whose credit standing did not qualify them for a conventional mortgage loan.

To meet this new requirement, insured banks–like the GSEs–had to reduce the quality of the mortgages they would make or acquire. As the enforcers of CRA, the regulators themselves were co-opted into this process, approving lending practices that they would otherwise have scorned. The erosion of traditional mortgage standards had begun.

This is just the most recent example of how a government intervention skews and distorts a market that otherwise would have corrected itself. Fannie and Freddie removed the risk on subprime mortgages from the market and transferred it to the taxpayer and with this artificially low risk, opened a market that otherwise would not have existed. Had the financial community been playing with their own money and motivated by rate of return, money would never have been lent to people who couldn’t afford to pay it back – it is that simple. The government basically attempted to achieve a social goal by stretching the mortgage market to one side like a rubber band and when it snapped back (as free markets always do – they correct themselves), it took out the financial community and hit the taxpayer smack in the face.

This should be a dire warning to those who seek greater intervention by government in a free enterprise system. Behaviors like this can never stand. Rational markets always seek equilibrium. Take them too far out of balance or prevent them from correcting and the result is disaster.

11 thoughts on “Yes, The Community Reinvestment Act Did Cause The Crash

  1. I hope you don’t mind that I shared this to Facebook; your explanation of why this type of government intereference in markets has universally deleterious effects is far more eloquent than what I’ve been able to construct. Thank you, and peace be with you — Kelly

    • Thanks for sharing it. I make no pretenses about being a writer, I am always pleased that someone thinks highly enough our work to share it. That is what gives it value.

  2. I, too, borrow from the RNL. The problem I have is trying to remember what post I read it from. I don’t know how you boys do that. I got a lot of great stuff from Texas last week. I’ll have to tell him.

    Well, two Kellys like you! It’s your lucky day!

  3. “Companies in a free market do not act against their best interests” I remember arguing about the Community Reinvestment Act with a local minority politician when this mess was forming. It was clear in CA even then that a large percentage of these home loans were not going to have happy endings.

    I remember one young man coming to me to ask my opinion about buying a house. Went through the numbers with him, it was clear he could not afford a house, but he got a large loan anyway. I remember wondering why anyone would give him a loan because banks don’t usually make loans that don’t have much chance of getting paid back. Shows how much attention I wasn’t paying at the time, but eventually young man lost house, ended up back living with parents.

    Today in CA if you try to discuss sub prime mortgages all you hear is that it was Bushes Fault. No mention of Fannie, Freddie, Barney Frank or the Community Reinvestment Act! Seems clear if CA can’t admit what the problem actually was they will probably repeat it.

    What happened to the frugal American who saved to buy their first house, who didn’t take a mortgage they had no way to pay back? This was such an avoidable mess, I’m just stunned at how many people fell for it.

  4. Ive been explaining this since the bubble burst.

    The statists know and/or don’t care.

    Economics in a worldwide system is well settled and well known.

    The LIARS in Congress who purchased votes with taxpayer monies.



    Willing accomplices in media blame Bush, or Reaganomics, etc. The dupes repeat the story and get angry when “we” explain and call us mean spirited or racists.

    Meanwhile the statists win, stealing wealth and giving to their friends while fiscally collapsing our government.

  5. “I realized that I could just cut and paste a refutation to every argument these simpletons were making with absolutely no thought required”

    I think the libs have a secret database for that somewhere. They just cut and paste, it doesn’t even have to be on point.

    So how is CRA different from Obamacare? Doesn’t the ACA force insurance companies to insure people who can’t afford insurance? Isn’t that coercion into another bad investment? Can we predict another bubble?

  6. Pingback: The Bush Tax Cuts Caused Obama’s Budget Woes… | The Rio Norte Line

  7. Pingback: Joe Bakanovic: Speaker of Truth | The Rio Norte Line

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