the Future of Change

In a recent post in the American Banker, Rep. Jeb Hensarling (R-TX), Chairman of the House Financial Services Committee, once again trotted out a favorite saw of those who think too much regulation caused the Financial Crisis of 2008.  In addition to blaming Too Big To Fail bailouts and the Government-Sponsored Entities (GSEs) for the financial crisis, which certainly raises legitimate questions, he also criticizes the Community Reinvestment Act for helping to lead to risky lending:

One of the most damaging of those initiatives has been the Community Reinvestment Act, which was undertaken with good intentions but is today in need of repeal. Proponents of CRA-like mandates have maintained that only a small portion of subprime mortgage originations are related to the CRA. However, though they may be small in volume, CRA loan mandates remain large in precedent. They inherently required lending institutions to abandon their traditional underwriting standards to comply with this government mandate. CRA implicitly put the government’s “Good Housekeeping Seal of Approval” on such loans.

In order to assess this statement, one needs to know how the law works, and how it worked in relation to subprime lending during the height of the subprime frenzy of the last decade.

First, the CRA, passed in 1977, requires only that federal bank regulators assess certain financial institutions’ records of meeting the banking needs of low- and moderate-income communities.  The regulators give grades to banks covered by the law in periodic reviews, and then the regulators are supposed to take these grades into account when considering requests by covered banks to engage in certain transactions, like to merge with another bank.  Nearly ninety-nine percent of bank grades are passing, and less than one-tenth of one percent of bank applications are rejected on grounds related to the CRA.  Given this reality, it is hard to argue that the law is a significant threat to banks, given that regulators are hardly aggressive in handing out failing grades or reining in bank behavior through the regulatory enforcement mechanisms of the law.  What’s more, during the height of subprime lending in the mid-2000s, the overwhelming majority of this type of lending took place outside the purview of the CRA.  Even putting aside the way the law has traditionally been enforced (i.e., not that aggressively), the CRA only covers depository institutions, and it only looks at those institutions’ activities in low- and moderate-income communities.  What’s more, non-depository subsidiaries of banks (think Countrywide and Bank of America), are covered by the CRA only at the discretion of the parent bank.  So, stand-alone mortgage banks, many subprime subsidiaries, and bank lending outside of low- and moderate-income communities are not even within the regulators’ review of bank practices under the CRA.  Because of these features of the law, ninety-four percent of subprime lending during the mid-2000s was beyond the CRA’s reach.  (For more on the scope of the CRA and its role in the Financial Crisis, read here and here.)

Thus, Hensarling is correct in stating that CRA-related loans are, in fact, “small in volume.”  It’s not quite clear what “large in precedent” means and whether, as Hensarling argues, the CRA “inherently required lending institutions to abandon their traditional underwriting standards.”  If there is any factual support for this position, i.e., that banks engaged in any lending in accordance with the CRA’s terms outside of the its narrowly drawn geographic and demographic requirements, Rep. Hensarling should come forward with it.  The problem is, none exists.  Like the arguments of others who have asserted that the CRA is to blame for encouraging banks to engage in risky lending, Hensarling’s statements are simply unsupported by the facts.