Lax Lending Standards: Blaming the CRA Doesn't Add Up

by: Rortybomb


John Carney has posted three ways the CRA caused lax lending. Reminds me of last fall. Barry and Felix have already responded; I want to address Carney’s points more directly:

Barry Ritholtz has been a prominent critic of the theory that the CRA has some culpability for lax lending. He has pointed out that 50% of subprime loans were made by mortgage service companies not subject comprehensive federal supervision…

2. The Threat Of Regulation Is Often As Good As Regulation. It is highly misleading to claim that just because mortgage companies were not technically under the CRA that they were not required by regulators to meet similar tests. In fact, regulators threatened that if the mortgage companies didn’t step up to the plate by relaxing lending standards they would be brought under the CRA umbrella and required to do so.

I don’t follow this. Non-depository institutions were worried about being brought under the influence of the CRA, who wanted them to make subprime loans, so they made a concession to the CRA of… creating the large majority of subprime loans?

I can easily imagine a story where the CRA forces Bank A to issue 100 subprime loans. NonBank B is not subject to the CRA so they don’t have to issue any, though the CRA is threatening to bring them under their regulation stick. So NonBank B issues 20 or 30 or 80 subprime loans to keep them off their back. But I can’t see a scenario in which they go ahead and issue 400+ subprime loans to keep the CRA off their back. (80% of subprime loans were from lenders with no regular government supervision; 50% with none at all.)

3. The CRA Distorted the Mortgage Market. With banks offering mortgages with high loan to value, delayed payment schedules and other enticing features, the mortgage companies would have quickly found themselves unable to compete if they didn’t offer similar loans.

I think this is actually a big deal – within the subprime shadow banks. Shadow bank A includes no-docs, so in order to keep their supply of mortgages to off-load up, Shadow bank B has to do the same. The worst kind of Nash equilibrium.

If Carney’s direction holds in this argument – that regulated banks took the lead in this and the shadow banks followed suit, it is a very simple quantitative argument. The data should show that Depository institutions started issuing subprime mortages earlier, and always in greater numbers, than non-depository institutions. That’s the equilibrium. The shadow banks have to “keep up” in this narrative, so they shouldn’t ever be ahead or earlier in subprime origination than depository institutions. I’ve never seen a data set that pass this hurdle. Lots of smart quants have looked at this and found the time series of originations doesn’t hold up.


1. The Creation Of Artificial Demand For Low-Income Mortgages. Banks that were regulated by the CRA often found it difficult to meet their obligations under the CRA directly.

Another narrative that is necessary is that the CRA had to be gaining, or holding steady, in regulatory power under the Bush administration. Especially during 2004-2006. I’ve been really fascinated lately with just how terrible the OTS was in its regulatory responsibility, and am writing this mostly as a way to document the following. Instead of decades old pamphlets or old stockholder speeches, let’s look at Federal Register/Vol. 70, No. 40/Wednesday, March 2, 2005/Rules and Regulations:

Office of Thrift Supervision
12 CFR Part 563e

ACTION: Final rule.
SUMMARY: In this final rule, OTS is making changes to its Community Reinvestment Act (NASDAQ:CRA) regulations to reduce burden, provide greater flexibility to meet community needs, and restore the focus of CRA to lending.
Specifically, OTS is providing additional flexibility to each savings association evaluated under the large retail institution test to determine the combination of lending, investment, and service it will use to meet the credit needs of the local communities in which it is chartered, consistent with safe and sound operations.

Sounds like in the middle of the subprime mortgage market the OTS cut the balls off the CRA when it came to big lender institutions in the name of “additional flexibility.” However this might be lawyer trickery in the language. Let’s look at how the lobbyists lined up in this action – continuing:

IV. The Comments
A. Overview
OTS received approximately 4,200 comments. The vast majority (about 4,000) came from consumer and community organizations and representatives (Consumer Comments). These included community development advocates, Community Development Corporations, Community Development Financial Institutions, housing authorities, consumer protection and civil rights organizations, faith-based organizations, and educators…These comments opposed the proposal…

In contrast, OTS received a couple of hundred comments from financial institutions and industry trade associations (Financial Institution Comments). Almost all of these supported the proposal, including the portion on assigned ratings…OTS considers the level of support significant.

So the OTS finished doing an overhaul of CRA in 2005 that community organizers protested and large banks applauded. This overhaul had probably been de facto law since Bush showed up, and in 2005 there was the talk of “The Permanent Republican Majority” so it would have likely stayed. That doesn’t sound like the CRA was something to fear during the Bush years – OTS was the best site for regulatory capture (that’s why AIGFP chose it as their regulator), and they were definitely in the business of making banks CRA free.

I think it is important to remember that the characteristics of subprime loans – high prepayment penalties, consistent and high turnover to the tune of 80% expiry within 30 months – are not consistent with the types of loans the CRA was rooting for.