There is a narrative – a fairy tale if you will – which has been promoted about the housing market bubble which was the first domino in the economic collapse that pushed America into the economic malaise we’ve been in for the last five years. That narrative holds that the housing bubble was caused by unfettered capitalism.
The American public has been inundated by self-assured demagoguery from politicians and smirking celebrities that it was “deregulation” which allowed greedy capitalist wolves loose in the American public, and that the solution to ensure that such a collapse never happens again is to put Wall Street on a short government leash.
To be sure, greed among Wall Street types was absolutely a factor, but the rest of the story just doesn’t pass the smell test. Bankers, even greedy bankers, make profits by lending money to people who pay them back. The subprime mortgage crisis was created when banks started lending to people who couldn’t pay their loans back.
So why did banks start making subprime loans? Maybe because the government, by and through policies such as the Community Reinvestment Act, incentivized such loans and even strong-armed more reticent banks into making them.
Which is exactly what a new study from National Bureau for Economic Research concludes. “Did the Community Reinvestment Act lead to risky loans?” the study asks:
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.
Investor’s Business Daily puts the impact of the CRA into graphical form (above) and adds this anecdote illustrating the pressure for subprime lending the federal government was putting on banks:
“We want your CRA loans because they help us meet our housing goals,” Fannie Vice Chair Jamie Gorelick beseeched lenders gathered at a banking conference in 2000, just after HUD hiked the mortgage giant’s affordable housing quotas to 50% and pressed it to buy more CRA-eligible loans to help meet those new targets. “We will buy them from your portfolios or package them into securities.”
She described “CRA-friendly products” as mortgages with less than “3% down” and “flexible underwriting.”
From 2001-2007, Fannie and Freddie bought roughly half of all CRA home loans, most carrying subprime features.
What’s interesting is that the study’s authors actually admit that they may be underestimating the impact of the CRA and federal pressure for subprime lending. “If adjustment costs in lending behavior are large and banks can’t easily tilt their loan portfolio toward greater CRA compliance, the full impact of the CRA is potentially much greater than that estimated by the change in lending behavior around CRA exams,” write the researchers in their conclusion.
Put more simply, they believe banks finding it difficult to hit federal goals for CRA compliance may have moved toward more risky loans overall to please politicians and regulators who were looking for a specific lending philosophy which was more loans for subprime borrowers.
Free markets operate on mutually beneficial transactions. Banks profit only when their customers can repay their loans on time. Lending markets are inherently self-regulating. It was federal policies aimed at promoting home ownership (because, with typical political logic, politicians felt owning homes would make for better citizens) that distorted the market and created a disastrous bubble the fallout of which we’re still living with today.
And then, when everything fell apart, the politicians pointed sanctimonious fingers at Wall Street and decried “deregulation” and “predatory lending” as if the whole thing wasn’t their idea in the first place.