They’re coming to get you Barbara…

Why is it that when I think of people who still continue to argue that the Community Revinvestment Act (“CRA”) played some role in the financial crisis, I think of zombie movies?  This, however, has a bit of a twist.  Any aficionado of zombie movies knows that when you shoot a zombie in the head, you kill it.  Dead. Done. Over.  Unfortuneately, the CRA zombie has been shot in the head and many people have done it.  However, the freaking thing still keeps coming back.  Come to think of it, perhaps the zombie movie comparison is not the best one and this should be compared to Friday the 13th Part 3,125 (how many ways does Jason have to be killed before he’s dead for good).  However, if I did that, I couldn’t use my catchy title.  Anyway, to business…  

I’ve mentioned before that I no longer have patience for people trotting out the Community Reinvestment Act as a cause of the financial crisis.  Whatever initial curb appeal the CRA had as a proximate cause given the Act’s goals, any serious inquiry into the causes of the crisis should rule this out without question for reasons that should be burned into the public’s brain.  Reasons include:

1)  The majority of subprime lending that took place during the peak years (2003-2007) was being originated by nonbank lenders or banking subsidiaries that were not subject to the same CRA requirements as depository lenders (Daniel Gross here).

2)  Evidence that the CRA in practice imposed the sort of onerous requirements on banks is non-existent (Barry Ritholtz here and Felix Salmon here).

3) The amount of subprime loans being originated pursuant to the CRA was a whopping 6%.

4) Related to (3) above, banks underwriting loans per CRA were less likely to make the sort of risky loans that were commonplace amongst the unregulated mortgage companies (a study here)

5) Enforcement of the CRA was extremely favorable to lenders (maybe gutted is the appropriate term) during the subprime boom (Rortybomb here, Ryan Chittum here).  The rules under the Clinton Adminstration no longer applied.

In my opinion, those who look at the CRA in any capacity and want to make the claim that the relaxation of lending standards that took place per the CRA ultimately brought us to the financial crisis (i.e. Megan McCardle) have a burden-of-proof issue.  Not only is it next to impossible to prove that lenders not subject to the CRA were lending aggressively to keep regulators off their backs (especially in a regulatory environment favorable to lenders), but to claim that lenders reduced their lending standards the way they did because of the CRA requires one hell of an imagination because CRA loans and non-CRA subprime loans are based on two completely different business models.  In a brilliant post by Rortybomb, he makes the convincing case that subprime lending is modeled more on the credit card business than the real estate business:

80% of the subprime mortgages expired in 30 months; they perpetually had to be refinanced. 75%+ of subprime mortages had a prepayment penalty. This is not at all what CRA loans looked like. CRA rooted for solid, longer-term mortgages. If they ever rooted for a lot of prepayment penalties and fees to get tacked onto their loans, I’ve never seen it.

Another important statistic – in Massachusetts 60% of subprime defaults were originated in prime mortgages. So a large chunk of subprime loans were really prime loans that were collapsing. Either the breadwinners were experiencing “income volatility” or their spending was out of control or whatever. Capturing the disintegrating middle-class on terrible terms is not an objective of the CRA.

I’m going to go into some new research about a favorite topic around here, the roles the consistent refinancing, prepayment penalties and fees did to change the mortgage market, and how a consumer’s bill of rights that took us back to 1982 would be a great move. In case you don’t trust a pseudonymous blogger with a free wordpress account, it’s where the elite research is going to converge when discussing this in my humble opinion. Here’s Did Prepayments Sustain the Subprime Market? by Bhardwaj and Sengupta from the St. Louis Fed:

Using loan-level data on subprime mortgages, we present evidence on the uniqueness of subprime mortgage design. We show that the viability of such products was predicated on the appreciation of house prices. In a regime of rising house prices, a borrowers avoided default by prepaying the loan…Gorton (2008) argues that lenders designed subprime mortgages as bridge-financing to the borrower over short horizons for mutual benefit from house price appreciation…Subprime mortgages were meant to be rolled over and each time the horizon deliberately kept short to limit the lenderís exposure to high-risk borrowers.

The rationality is nothing like that of a CRA loan. It was something new, something about consistent refinancing with a huge amount of fees and penalties, using jumps in the interest rate to force prepayments. They were bad-faith loans, loans that were not meant to be repaid back, unlike a CRA loan…

…Indeed, the logic of a subprime loan looks disturbingly like the logic of a credit card. If we had to backwards out what motivated someone to go ahead and try to make these subprime loans, you’d have to say they looked at the profitable credit card market and said “ya know what, let’s design a mortgage that looks exactly like that.” The credit card model is about as far away as you can get from the CRA model – and it is very easy to imagine subprime lenders licking their lips at the sweet profits the credit card companies were making moreso than the tiny CRA market.

This confirms much of my  understanding of how things transpired in the mortgage business.   Nonbank lenders and mortgage brokers generated their revenues based on the volume of loans they originated.  They took little to no risk that the underlying loans would default (I think the window was 90 days tops).  Once they were sold off to Wall Street or to investors, the risk was someone else’s problem.  That said, because it was (is) a fee-driven business, the only way to maintain revenue growth is to generate more loans.  As Rortybomb correctly notes, the loans they were selling to borrowers essentially forced prepayments (I suspect borrowers were basing their own affordability based on the initial teaser rate as well as assuming the loan could be refinanced when interest rates reset).  In a market with house price appreciation and widely available credit, this is an easy selling point for someone and many borrowers bought off on it.  While this was taking place, defaults were low and when defaults occured, losses were minimal because the collateral held its value.  When the market turned the other way, it was a recipe for disaster.  It is beyond me that someone could reasonably evaluate the lending of banks as they maintained compliance with the CRA and assume that subprime lenders followed suit and embraced this model because they felt the need to keep up with the Joneses.   No way.

The reason for all of this is that John Carney, who blogs over at  Clusterstock, has spent a considerable time recently taking the opposite position.  However, he seems more willing to dismiss his critics, dismiss evidence contrary to his argument without providing any tangible evidence (as far as I’m concerned, the 1990’s don’t count), ignore regulatory capture and fill us full of abstract anecdotes than he is providing tangible evidence to his claims.  Maybe he’ll prove me wrong and provide some substance to his points (which I think would re-ignite this debate assume such evidence exists).  However, I’m skeptical and so is Barry Ritholtz, so much so that he’s willing to put up a significant amount of money to debate the issue ( Barry’s main criticism of Carney’s work is here – RECOMMENDED). 

Will we see an honest intellectual debate?  My guess is no.