Recession is a terrifying thing: it destroys industries, communities, and families on a global scale. With the stakes so high, it’s natural that all the major players would start searching desperately for a place to lay the blame–preferably, a place as far away from theirs as possible. One possible cause for our current recession that has been bandied about is the Community Reinvestment Act (CRA), a 1977 law that requires federally-insured banks to make loans to their entire service areas, not just the most affluent parts. Placing the blame here is misguided–in fact, it’s been convincingly argued that the CRA actually counteracted some of the most destructive forces driving the recession–and deflects attention from the larger causes.
The CRA was passed in response to a practice called “redlining,” where banks would not give loans to minority or racially-changing neighborhoods; once a neighborhood was determined to be “hazardous” to development, bankers would literally draw a red line over the area on a map and business loans and mortgages would not be granted within that service area. The decision to redline was often not made by any systematic assessment of the creditworthiness of the neighborhood, but by negative assumptions about racial minorities. Since no one could get mortgages within those areas, homeownership was chronically low and development was stagnant, thus pushing the neighborhoods further into poverty and farther away from an ideal investment environment. The CRA made it illegal for banks to systematically write off entire service areas, opening up lines of credit and paths to homeownership to minorities and the low-income. So what’s the problem?
One factor behind the recession was the collapse of subprime loans, or loans made to borrowers generally regarded as subprime: those who have a high risk of defaulting, or who have a history of bankruptcy. The loans were usually made at low teaser rates that ballooned after two or three years. Often, borrowers could not afford the new payments and ended up defaulting and going into foreclosure.
Critics of the CRA say that the law creates strong incentives for banks to lend to subprime borrowers. A good CRA score is important to any bank since their CRA compliance is periodically reviewed by regulators; the score is examined when a bank wants to open new branches, acquire other banks, or merge. According to critics like the Washington Post’s Charles Krauthammer and University of Texas economist Stan Liebowitz, this gave banks the incentive to lower their standards and give loans to those who couldn’t afford them in order to have a good CRA score. The crux of this argument is that the CRA requires that banks loan to minority neighborhoods; minorities aren’t creditworthy; so CRA requires that banks loan to the uncreditworthy, which caused them to default on their mortgages, and so on until financial Armageddon.
Aside from originating from the same race-based assumptions that drove redlining in the first place, that argument simply doesn’t stand up to the numbers. A 2008 report by Traiger & Hinckley LLP found that banks subject to CRA rules were “substantially less likely than other lenders to make the kinds of risky home purchase loans that helped fuel the foreclosure crisis”–non-CRA financial entities made about seventy-five percent of subprime loans, while CRA banks issued the other twenty-five percent, according to testimony by University of Michigan law professor Michael Barr. When CRA banks did make risky loans, their rates were much less exorbitant than non-regulated ones and their borrowers were less likely to default. In Illinois, CRA banks were fifty-eight percent less likely to make high-cost loans than non-CRA institutions.
Secondly, the CRA only applies to financial institutions that are backed by federal insurance. People have an incentive to choose banks over uninsured financial services because they know their money will be backed up and that banking practices are subject to supervision; federal insurance gives regulated banks a competitive advantage in attracting customers. The CRA is a responsibility that comes along with that substantial privilege. Increased regulation comes along with federal insurance, too, so the government is checking on banks to make sure they aren’t making bad loans; banks subject to the CRA are also subject to more quality-control and supervision than unregulated financial services. Far from contributing to the loan crisis that caused the recession, the regulation that comes along with the CRA actually deterred bankers from making those high-cost loans.
Finally, the originate-to-distribute system, which allows mortgagers to sell loans out of their portfolios and thus migrate much of the risk to another institution, creates lax incentives for good underwriting. Non-CRA lenders engage in this practice at a much higher rate than CRA banks do. Federal Reserve Chairman Ben Bernanke described the process in testimony before the House of Representatives: “When an originator sells a mortgage and its servicing rights, depending on the terms of the sale, much or all of the risks are passed on to the loan purchaser. Thus, originators who sell loans may have less incentive to undertake careful underwriting than if they kept the loans. Moreover, for some originators, fees tied to loan volume made loan sales a higher priority than loan quality. This misalignment of incentives, together with strong investor demand for securities with high yields, contributed to the weakening of underwriting standards.” The Traiger report found that CRA banks retain originated loans more than twice as often as unregulated banks.
The CRA did not get us into this recession, but it can help get us out of it. In Illinois, foreclosures jumped by twenty-four percent in the month of October alone. Janet Yellen, President of the Federal Reserve Bank of San Francisco, described the effects of foreclosures on communities in a speech to the Community Reinvestment Conference: “Studies of cities like Baltimore, Chicago, and Cleveland have found that low-income and minority communities have been the hardest hit by concentrations of foreclosures. The rise in foreclosures may have other negative implications as well, such as reducing neighborhood property values and increasing crime. Furthermore, as declining property taxes and transfer fees shrink local government revenues, vital services to low- and moderate-income families may also suffer.” Preventing avoidable foreclosures should be a high priority because of the “domino effect” they cause across an entire community–for every house that’s foreclosed on, that’s one more abandoned house that turns into an eyesore, lowers property values, and attracts crime. The CRA can incentivize banks to work with their customers to avoid foreclosure by refinancing their loan or adjusting the loan terms.
Here on the South Side, one bank is doing just that. ShoreBank, the community development and environmental bank founded by the only banker to testify in favor of the CRA, introduced their Rescue Loan program in response to the mortgage crisis. The program offers “fixed-rate loans at competitive market rates to qualified home owners or new home buyers with credit scores of 520 or better, and not more than 90 days delinquent,” according to a recent press release. Their bankers, with a long history of making affordable loans to low- and moderate-income communities, have identified 10,000 people on the South and West Sides and the suburbs in high-risk mortgages and have launched a massive outreach campaign to get them to refinance into affordable loans before their rates go up and it’s too late. “Don’t wait,” advises Brian Berg, Vice President of Corporate Communications. “Once you get to a certain point, which is usually about ninety days, it’s hard for any institution [to provide refinancing]. As much as it’s our mission to help these folks, we’re not going to violate or jeopardize our standard underwriting.” Although ShoreBank conducts most of its activity in areas that may scare off other bankers, they have proven that community reinvestment doesn’t have to be the enemy of sound underwriting: “We know that, historically, Shore Bank has had loan losses at or below our industry peers,” says Executive Vice President for Consumer and Community Banking Jean Pogge. “Those were loans that other banks might view as very risky, and we’re quite proud of that.”
As Pogge points out, “The CRA is really about encouraging responsible lending.” There’s no reason it has to be bad business–the law itself has no quotas and requires that CRA practices “be consistent with safe and sound operations”–and ShoreBank is consistently profitable with $2.4 billion in assets. But more importantly, as Janet Yellen reminds us, “We should not view the current foreclosure trends as justification to abandon the goal of expanding access to credit among low-income households, since access to credit, and the subsequent ability to buy a home, remains one of the most important mechanisms we have to help low-income families build wealth over the long term.”