Did the Community Reinvestment Act (CRA) Lead to Risky Lending?

Yes it did:

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 tractmonth 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.

This should not be contentious or surprising or controversial.

The government wanted to increase the home ownership rate among US citizens.  The government created conditions that would increase that rate.  Such conditions led to practices that helped that increase.

In short; riskier lending.

And at the heart of it all?  The usual suspects; Fran and Fred:

To satisfy CRA examiners, “flexible” lending by large banks rose an average 5% and those loans defaulted about 15% more often, the 43-page study found.

The strongest link between CRA lending and defaults took place in the runup to the crisis — 2004 to 2006 — when banks rapidly sold CRA mortgages for securitization by Fannie Mae and Freddie Mac and Wall Street.

CRA regulations are at the core of Fannie’s and Freddie’s so-called affordable housing mission. In the early 1990s, a Democrat Congress gave HUD the authority to set and enforce (through fines) CRA-grade loan quotas at Fannie and Freddie.

It passed a law requiring the government-backed agencies to “assist insured depository institutions to meet their obligations under the (CRA).” The goal was to help banks meet lending quotas by buying their CRA loans.

But they had to loosen underwriting standards to do it. And that’s what they did.

Oh boy, this won’t play well in the press.

One response to “Did the Community Reinvestment Act (CRA) Lead to Risky Lending?

  1. Helpful context re: that Agarwal et al paper can be found here: http://www.ritholtz.com/blog/2012/12/what-does-the-new-community-reinvestment-act-cra-paper-tell-us/ and here: http://noahpinionblog.blogspot.com/2012/12/did-risky-mortgage-lending-cause.html

    From Ritholtz:

    The first question is how much compliance with the CRA changes the portfolio of lending institutions. Do they lend more often and to riskier people, or do they lend the same but put more effort into finding candidates? The second question is how much did the CRA lead to the expansion of subprime lending during the housing bubble. Did the CRA have a significant role in the financial crisis? There’s a new paper on the CRA, Did the Community Reinvestment Act (CRA) Lead to Risky Lending?, by Agarwal, Benmelech, Bergman and Seru, h/t Tyler Cowen, with smart commentary already from Noah Smith. (This blog post will use the ungated October 2012 paper for quotes and analysis.) This is already being used as the basis for an “I told you so!” by the conservative press, which has tried to argue that the second question is most relevant. However, it is important to understand that this paper answers the first question, while, if anything, providing evidence against the conservative case for the second. …
    “the very small share of all higher-priced loan originations that can reasonably be attributed to the CRA makes it hard to imagine how this law could have contributed in any meaningful way to the current subprime crisis.” …

    From Smith:

    the CRA existed since 1977, and the U.S. housing bubble only began in the 2000s. If three decades was not enough for the financial market to figure out that CRA mortgages are riskier than other mortgages, then the market is grossly inefficient, and crises will tend to form even with no CRA. And if in those three decades the market did figure out that CRA mortgages were riskier, then the CRA risk described in the paper was properly priced into all the MBS, CDOs, CDS, asset-backed commercial paper, etc.

    In other words, the CRA made have caused more risky mortgages to be born, but the banks should have known that and hedged their bets accordingly. Either they did, and the root cause of the financial crisis was the mispricing of non-CRA risks (I suspect this is the case), or else they didn’t, and thus the financial system was broken for a long, long time.

    Either way, we shouldn’t blame the CRA.

    Update: Yes, I know there are reasons to doubt this study, and to think that the CRA didn’t even cause much of the increase in risky lending. But the point of this post is: Even if it did, that doesn’t mean it contributed to the financial crisis!

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