Sunday, September 28, 2008

The Community Reinvestment Act's Role in the Economic Upheaval

The Community Reinvestment Act was passed in 1977 as a response to discriminatory lending practices of banks and investment institutions. It was apparent that being a minority automatically lowered your credit rating and something had to be done to address it. The act tied the performance of banks in meeting the lending needs of the communities they served to access to deposit facilities and approvals for mergers and acquisitions. Mortgages could be insured through and sold to government sponsored entities, The Federal National Mortgage Association (Fannie Mae) and The Federal Housing Finance Agency, (Fannie Mae).

In 1995 the bill was revised to encourage more lending to low and moderate income borrowers. Freddie and Fannie were permitted to hold back just 2.5% of their investment outlays as collateral, vs the 10% requirement for banks.

The scheme as a whole set up a system whereby I could make a loan to you today, sell it to Freddie later, and be off the hook should you default on the loan. This of course encouraged lots of new lending, lax standards and less effort on validating borrowers claims on income, employment and assets. Institutions that were not covered under the CRA saw the massive amounts of cash flow being generated and followed suit, even though they had no implicit guarantee of a government bail out should things go south.

The pickle we're in now isn't the result of increased lending to minorities. It's the result of across the board lack of due diligence in lending encouraged by a bogus guarantee against failure. The problem was real, but the solution was flawed. Instead of developing real anti-discrimination standards that could be objectively measured by comparing approval rates of individuals in similar income, and asset brackets, discrimination was determined by how much money you invested in a particular neighborhood. The proponents tried to dilute the risk by having government sponsored entities buy, repackage and sell the loans in the market. I guess the idea was that if it all came crashing down, one could blame greedy Wall Street investors, since that's who the ball would ultimately be passed off to.

It's a government mentality similar to the thinking behind Social Security and soon, government health care. Of course the math doesn't work, but by the time the general public catches on, it will be "too big to fail". They'll get on board a massive government cash infusion (which will ultimately cause rampant inflation) and everything will be hunky dorey (at least until the authors are long gone).

I hope we learn the lesson that injustice and incompetence cannot be remedied by simply throwing money at them. Real, objective, measurable solutions must be developed that actually address the problem.


softwareNerd said...

Here's a very well-written article from eight years ago, that gives some insight into the players in the CRA mess.

Captain Capitalist said...

Very prophetic. And it's going to get worse. They're still looking the other way and blaming Wall Street. They even tried to get Acorn a cut of this bail out deal.