Civics Notes page #1:
Causes of the Mortgage Meltdown & Great Recession: Not CRA
This is a nearly "raw" page of notes on one issue raised in a letter to editor to El Dorado Hills Village Life, published in May, 2010. This provides more detail than the responding letter to editor, plus a list of web references. Part
of these notes are structure as annotations to excerpts from the
earlier letter to editor, which blamed the Community Reinvestment Act
and other actions claimed to be regulatory for the subprime crisis and
its consequences. It suggested government greed, excessive regulation,
and a general objection to regulatory measures expected to be adopted
soon by Congress.
Below
this point text excerpted from the original May letter to editor is
left-adjusted and rendered in black. Notes present only on this
SierraFoot web page are indented and are rendered in blue boldface.
The problem in question involved mainly business greed and borrower greed, not government greed.
Wikipedia has pages on several interrelated topics. The best single page for reference with respect to the LTE is Wikipedia page on the Community Reinvestment Act.
That
web page includes references to 119 other source documents available on
the Web. The Wikipedia page itself probably would pass peer
review for publication in a scientific journal if its references were
also in peer-reviewed work.
Clear
causes of the housing bubble crisis include the Fed's continuance
of exceptionally low Federal Fund Rates, increased leveraging by very
large investment banks (especially in derivatives, and specifically
Credit Default Swaps), predatory lending and weaker underwriting,
predatory borrowing, business policy dependence on continuing increase
of real estate values over time, and securitization of mortgage debt.
Almost
all of this was enabled by a chain of Federal actions which
substantially deregulated finance and real estate business practices.
The most important of these probably were the Gramm-Leach-Bliley Act of
1999, which repealed the Glass-Steagall Act of 1933, the Commodity
Futures Modification Act of 2000, relaxation of SEC rules in 2004, and
maintenance of the Federal Funds Rates at an artificially low rate
following recovery from the dot-com bust a decade ago.
CRA was
not the cause. CRA operates by giving lenders a business incentive
rather than direct regulation. It defined rules for Federal
regulatory agencies (not for businesses) to evaluate how well lenders
serve all segments of their communities, with a goal of increasing
lending to low and moderate income borrowers while stating that
loans were to be "consistent with the safe and sound operation of such
[lending] institutions". The business incentive is that CRA evaluation
results are considered in applications for banking business growth by
merger, acquisition, or branching.
CRA research citations include [cited in BusinessWeek]
http://www.traigerlaw.com/publications/traiger_hinckley_llp_cra_foreclosure_study_1-7-08.pdf
Findings include CRA market share: 22.8% of all loans in 2006 were by CRA banks, 77.2% by non-CRA banks.
For high cost loans, 9.2% were by CRA banks, 90.8% by non-CRA banks.
Cites related 2009 report: The Community Reinvestment Act of 1977: Not Guilty
http://traigerlaw.com/publications/The_community_reinvestment_act_of_1977-not_guilty_1-26-09.pdf
For 2006 loans to Low-Moderate Income borrowers by CRA banks in 15 most populous service areas accounted for 16.9%
of the total. 83.1% were to higher income groups.
=> 3.85% of total loans were CRA to low/low moderate income
borrowers
Having
been in the mortgage banking business since 1967 I had the opportunity
to watch the effects of the Community Reinvestment Act of 1977
(CRA).
Banks that were likely redlining were now caught and had to begin
making more marginal loans in communities heretofore avoided. Mortgage
servicing companies were only marginally impacted by this decision.
Even with the market turndown in 1990-95 there were not an inordinate
number of foreclosures or short sales and the term “loan modification”
did not yet exist. What happened?
CRA did not require banks to make more marginal loans.
It
introduced no new regulatory requirements. Instead, it sought to reduce
credit discrimination against low and moderate income areas through
incentives to business, with those incentives supported by requirements
on Federal regulatory agencies. The Act itself summarized this in Section 802(b):
"It is the purpose of this title to require each appropriate Federal
financial supervisory agency to use its authority when examining
financial institutions, to encourage such institutions to help meet the
credit needs of the local communities in which they are chartered
consistent with the safe and sound operation of such institutions."
That
section is explicit in calling for "safe and sound operation" of
financial institutions. A paraphrase of this as it could be expressed
in computer logic is
For each loan (mortgage) application received by a regulated financial institution (bank)
If the loan can be granted without undue financial risk
then the bank will be encouraged to grant the loan on its own authority
else (if the bank considers the application's risk
to be excessive) it is expected not to grant the loan.
The
incentive to provide fair service derives from a requirement for Fedeal
regulatory agencies to periodically evaluate a bank's performance with
respect to the objective. The original CRA defined 12 assessment
factors in 5 performance areas, to be evaluated and published. Results
are to be considered when the regulated bank applies for expansion by
means of merger, acquisition, or branching.
In
1995 the Clinton Administration started tinkering (new regulations
being added) with the CRA. Robert Rubin was a major tinkerer in this
plan. By 1998 regulatory tinkering created the sub-prime loan.
Actual history of revisions to CRA or to interdependent parts of law is:
1989:
Financial Institutions Reform, Recovery and Enforcement Act of
1989 was adopted to clean up the mess left by that decade's savings and
loan crisis. The most significant changes were to establish the
Resolution Trust Corporation (RTC) to close several hundred insolvent
thrifts and to moge S&L regulation from the Federal Home Loan Bank
to the new Office of Thrift Supervision. With respect to CRA, it
defined four categories for performance of CRA banks on achievement of
CRA objectives: Outstanding, Satisfactory, Needs to Improve, or
Substantial Noncompliance.
[President: George H.W. Bush Congress majority: Democrat]
1991
(December): CRA details were amended twice, once in connection with the
Resolution Trust Corporation Refinancing, Restructuring, and
Improvement Act of 1991 and once in loose coordination with the Federal
Deposit Insurance Corporation Improvement Act of 1991. The most
significant changes were in the nature of RTC-related incentives for
providing credit to predominantly minority neighborhoods.
[President: George H.W. Bush Congress majority: Democrat]
1992:
Federal Housing Enterprises Financial Safety and Soundness Act of 1992
(not directly changing CRA) required Fannie Mae and Freddie Mac to
support affordable housing through allocating a percentage of lending
to affordable housing.
[President: George H.W. Bush Congress majority: Democrat]
1993: [quoting Wikipedia text] "President Bill Clinton asked regulators to reform the CRA in order to make examinations more
consistent, clarify performance standards, and reduce cost and
compliance burden." Part of the benefit was to be paperwork reduction. (Federal agencies made corresponding changes in regulations in 1995.) [President: Bill Clinton Congress majority: Democrat]
1994: Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
repealed restrictions on interstate banking. This deregulation
measure allowed use of out-of-state CRA ratings for mergers,
acquisitions, and branching. Activity in mergers and acquisitons
increased, contributing to the later issue of whether financial
institutions are "too big to fail".
[President: Bill Clinton Congress majority: Democrat]
1995: Federal agencies made CRA-related regulation changes
in answer to President Bill Clinton's request in 1993. Changes had been
reviewed in Congressional hearings. As noted for Bill Clinton's 1993
request for changes, CRA changes were targeted toward improving
regulatory consistency and simplicity, in the stated interest of
reducing cost and compliance burdens and reducing paperwork.
[President: Bill Clinton Congress majority split -- House: Republican Senate: Democrat]
1999: Gramm-Leach-Bliley Act ("Financial Services Modernization Act")
repealed part of Glass-Steagall Act of 1933. This allowed banks to
offer a full range of investment, commercial, banking, and insurance
services. Also, smaller banks would be reviewed less frequently for CRA
compliance.
[President: Bill Clinton Congress majority: Republican]
2000: The Commodity Futures Modernization Act of 2000
exempted derivatives from regulation, including capital reserve
requirements. This allowed use of Credit Default Swaps, one form of
derivatives, to increase by about a factor of 100 in 10 years, with
outstanding CDS's estimated in 2008 to cover total debt in the range of
$33 trillion to $47 trillion. Total face (notional) value of all
derivatives was reported to be $683 trillion in June, 2008, with 8% of
that amount in Credit Default Swaps. As early as 2003 Warren Buffet
referred to derivatives as "financial weapons of mass destruction".
This was proven when they were key factors in the finance crisis of
2008 which required radical and rapid government response to avert a
chain reaction which would have produced a full scale depression
instead of "The Great Recession".
[President: Bill Clinton Congress majority: Republican]
2001: George W. Bush
took office as president. Advocating an "Ownership Society", policies
and actions throughout his administration tended to promote empowerment
of the financial industry and restraint of regulation. See the lengthy
New York Times article, "White House Philosophy Stoked Mortgage Bonfire" for a report of many details.
[President: George W. Bush Congress majority: Republican 2001-2007, Democrat 2008]
2002
& 2003: Interagency and nongovernment reviews showed that the
1995 regulatory changes had weakened CRA. By 2003 less than 30% of home
purchases were included in CRA reviews.
[President: George W. Bush Congress majority: Republican]
2004: The Securities and Exchange Commission (SEC) relaxed rules,
consequently enabling investment banks to carry higher levels of debt.
This allowed investment banks to fund higher levels of debt in
subprime loans, whose actual level of risk was being underestimated by
rating agencies covering mortgage-backed securities.
[President: George W. Bush Congress majority: Republican]
2005:
Office of Thrift Supervision (OTS) changed rules to permit CRA ratings
for companies with more than $1 billion in assets to satisfy CRA
evaluation criteria with any combination of lending, investment and
services instead of only lending. Democrats in Congress protested.
FDIC, FRB, and OCC changed their regulations to match OTS.x
[President: George W. Bush Congress majority: Republican]
2008:
Higher Education Opportunity Act requires Federal financial supervisory
agencies to change CRA rules to recognize low-cost education loans in
assessing CRA compliance.
[President: George W. Bush Congress majority: Democrat]
Overall summary:
Changes in law and regulations have generally been in the
direction of decreasing regulation of banks and other financial
institutions. Deregulation not directly related to CRA enabled unwise
business decisions in the financial sector to produce the crises
involving subprime mortgages, foreclosures, financial liquidity, new
construction, poperty values, unemployment, and budget
stress at all levels of government.
Politically, what changes happend on whose watch?
| Year | Party of president | Congress majority | Changes |
| 1989 | Republican George H.W. Bush | Democratic | Deregulatory, relatively minor |
| 1991 | Republican George H.W. Bush | Democratic | Mainly business incentives |
| 1992 | Republican George H.W. Bush | Democratic | Neutral for private sector, regulatory for Fannie Mae & Freddie Mac |
| 1993 | Democratic Bill Clinton | Democratic | Request to Congress for deregulatory action |
| 1994 | Democratic Bill Clinton | Democratic | Deregulatory, major |
| 1995 | Democratic Bill Clinton | mixed | CRA regulatory simplification reducing costs to both business & government |
| 1999 | Democratic Bill Clinton | Republican | Deregulatory, major |
| 2001+ | Republican George W. Bush | Republican | Deregulatory, varying scope |
| 2004 | Republican George W. Bush | Republican | Deregulatory, highly significant (SEC) |
| 2005 | Republican George W. Bush | Republican | Deregulatory for CRA |
| 2008 | Republican George W. Bush | Democratic | Pro-business CRA linkage with education loans |
Up until this time [1998] loans were commonly made with no down payment. They were called Veterans Administration loans.
VA
loans were in fact made with zero down. However, Federal Reserve Board
statistics for mortgage debt outstanding (currently available on the
web only for 2005 and later) show that mortgages held by the Federal
Housing Administration and Department of Veterans Affairs (including VA
loans) accounted for only .03% of all mortgage debt outstanding ($3,592
million out of $12,063,864 million, [$3.6 billion out of $12 trillion).
Also,
only 4% of FHA and VA mortgage funds were for single family homes, 96%
were for multifamily (condominium) residences. This further
suggests that VA mortgages are extremely
rare in El Dorado Hills, where almost all residences are single family
homes at property values likely to be unaffordable to younger veterans,
even with a VA mortgage.
At the time this writer and his
wife moved into El Dorado Hills (1990) the standard for minimum down
payment had dropped from 30% to 20%. Property values were high enough
to require that our first EDH mortgage was a jumbo and that we were
required to buy Private Mortgage Insurance.
In later years those
standards were further relaxed and dropped, permitting business
practices which now are often considered to be predatory lending. An
additional risk is predatory borrowing, with the most common abuse
being to falsify income level for a stated income loan. Both predatory
lending and predatory borrowing in the mortgage market were enabled by
relaxation of regulations whose purpose was to protect both borrowers
and lenders.
Loans with minimum down payments were
insured by the FHA (97 percent). It was common to make 95 percent loans
saleable to FNMA. It was not the no down payment issue tha caused
the meltdown, and, please note, these loans all required “verifiable
income.” The sub-prime requirements forced the providing of 103 percent
loans with no “verifiable income,” commonly known as “stated income.”
These government regulatory requirements, made to benefit a particular
constituency, were the cause of the sub-prime meltdown. And who did
these Democrat inspired government regulations hurt the most? Yes, our
minority communities.
It's
true that drastically relaxed requirements to qualify for mortgage
loans were a major cause of the subprime loan crisis. An
additional cause was aggressive marketing, with below-Prime Rate
initial interest rates and with minimal communication to buyers that
the interest rate would increase very substantially in a later year.
Many home buyers were unaware of the later rate increases. This
resulted from a combination of deregulation and <business:
Read with your own choice of language: Business greed or
business optimization of financial results for stockholders and other
business ownersand management>.
Another factor was
securitization of subprime loans, which hid the level of risk. This was
another result of <business> management in the absence of
regulation.
The Deregulation in question is more consistent with Republican ideology than Democrat, although Democrats
The
new financial regulation bill being considered in Congress will
certainly benefit some and hurt others, depends on which side you are
on. I don’t think we need our government to have more power; again it
was government that created sub-prime. What we need to do is rescind
the regulations that created sub-prime mortgages in the first place.
After all, if there were no subprime regulations then there would have
been no subprime mortgages, no sub-prime securities, no sub-prime
derivatives, no sub-prime credit default swaps, no $85 billion bailout
of AIG and finally no need for the new financial legislation.
Most
sources attribute the primary cause of the subprime mortgage
crises to predatory lending and predatory borrowing. The lending
factors were issuance of mortgages at unsustainably low introductory
interest rates, with the a balloon (rate adjustment) to a much higher
rate after a small number of years. Often this was not disclosed
clearly to borrowers, many had believed the introductory rate would
countinue. Results were especially serious when combined with predatory
borrowing, using inflated values of stated income to secure a mortgage
loan.
Both of these practices were produced by lenders' changes
in conduct of business, enabled by relaxation of government regulations
and not by imposition of regulations. A further factor in relaxation of
regulations was securitization and mortgage-backed securities, which
produced an economic incentive for lenders to process high volumes of
mortgages without adequately managing risk. Securitization also tended
to hide risk until the consequences became evident.
It does not
follow that there lack of existence of subprime regulations would
produce lack of subprime loans. In terms of logic, this is at best a
nonsequitor fallacy or an axiomatic assertion.
Why
aren’t the 1995-98 regulations added to the Community Reinvestment Act
of 1977 creating subprime mortgages being rescinded? Because they
benefited builders, real estate interests and government control of
banking interests, to name a few.
Actually,
only the early results benefitted builders, real estate interests, and
banking interests. The end result was an economic crash for all of
these interests, as well as impacting all the rest of us.
The
harmful regulatory changes accomplished varying degrees of
deregulation, not regulation. The ultimate results dramatically
reflected short-sighted and negligent business management, with
inadequate understanding of its systemic consequences.
The
financial sector needs the equivalent of what aerospace engineering
uses: Systems for stability augmentation. Both domains need
to avoid catastrophic failures while providing a high degree of freedom
within a good range of maneuverability. If done reasonably well,
the new legislation should do exactly that for business. Engineers have
been doing it for aviation and space systems for a century.
[original letter writer's name redacted for web possting of the annotated letter]
El Dorado Hills
Selected References, web links, most from sequential listings returned by Google, excluding blog links.
Wikipedia pages appear to be the best references on this topic for understanding without extensive reading.
Each Wikipedia page has its own list of references, such as the 119 references in the first page cited below for CRA.
Approximately 20
additional references not in the list above were checked when preparing
these notes. All were located by using Google to search for different
words and phrases related to this topic.