Community Reinvestment Act responsible for banking crisis

[SgtRock]

The CRA was passed by congress during the Carter administration in 1977. The CRA was inacted to provide credit, including home ownership opportunities to underserved populations and commercial loans to small businesses. Basically poor folks who in the past could not get loans because they were a credit risk.

It was re-interpreted by the Clinton administration in 1995. They reinterpreted the CRA to politicize lending practices. Under the CRA, the feds forced banks to prove they weren't redlining by approving loans to minorities and various community groups, bad risks or not. Franklin Raines, the Clinton appointed head of Fannie Mae from 1998 to 2004, made it his top priority to make mortgages easier to get for people with poor credit, few assets and little money for a down payment.

Sen. Phil Gramm called it a vast extortion scheme against America's banks. Still, the banks were perfectly happy to pass the risky loans to Raines' Fannie Mae, which was happy to buy them up.

That's because Raines was transforming Fannie from a stable institution dedicated to making homes more affordable into a risky venture that abused its special status as a "government sponsored enterprise." Fannie bought the bad loans and bundled them together with good ones. Wall Street was glad to buy up these mortgage securities because Fannie was deemed a government insured behemoth "too big to fail." And others followed Fannie's lead.

The current crisis is in due to the fact that people who shouldn't have been buying a home, or who bought more home than they could afford, now can't pay their bills. Their bad mortgages are mixed up with the good ones. And thanks in part to new post-Enron accounting rules, the bad mortgages have contaminated the whole pile.

In 2005 the Bush administration pushed for reforms. Those reforms were rebuffed by Democrats in congress led by Christopher Dodd and Barny Franks.

Also in 2005, John McCain sponsored legislation to thwart what he later called "the enormous risk that Fannie Mae and Freddie Mac pose to the housing market, the overall financial system and the economy as a whole."

In a nut shell the Democrats trying to do what they thought was the right thing ended up causing the current banking crisis. Thats right from the Carter admin thru the Clinton admin and into the Bush admin the bleeding heart Democrats are to blame.

[SouthernDemocrat]

The Community Reinvestment Act has little to do with today's crisis.

The problem in the current crisis is that all these toxic assets were made possible by a special kind of derivative called a “Credit Default Swap”.

A Credit Default Swap is a whereby the "buyer" or "fixed rate payer" pays periodic payments to the "seller" or "floating rate payer" in exchange for the right to a payoff if there is a default[1] or "credit event" in respect of a third party or "reference entity".

If a credit event occurs, the typical contract either settles by delivery by the buyer to the seller of a (usually defaulted) debt obligation of the reference entity against a payment by the seller of the par value ("physical settlement") or the seller pays the buyer the difference between the par value and the market price of a specified debt obligation, typically determined in an auction ("cash settlement").

A credit default swap resembles an insurance policy, as it can be used by a debt holder to hedge, or insure against a default under the debt instrument. However, because there is no requirement to actually hold any asset or suffer a loss, a credit default swap can also be used for speculative purposes and is not generally considered insurance for regulatory purposes.

See the problem with AIG, Bear Sterns, and other players in the financial crisis is that they held a large number of these Credit Default Swaps. Had they been allowed to go under, and thus default on those CDS’s, financial institutions across the globe would have immediately started dumping all those toxic assets backed by those CDS’ in a panic unseen since the Great Depression. This would have turned a financial crisis into a financial catastrophe the likes of which the world may well has never seen before. That’s why the government stepped in to bail them out and it’s why the feds are now looking at setting up another Resolution Trust to buy up all that toxic paper. The point in all of this is that all that toxic paper would have never been written had it not been for an unregulated CDS market made possible by Gramm. This is important because while Obama has long been a critic of CFMA, McCain had the guy that authored it also practically write his economic policies. The fact is, McCain has long been a protégé of Gramm on economic policies, and Gramm has consistently been wrong on economic policies.
You can read more about Credit Default Swaps and their role in the current crisis here:

Stocks Plunge as Investor Fears Deepen

Bloomberg.com: Worldwide

Credit-Default Market Freezes as Risk Grows - WSJ.com

In terms of economic policy, there has probably been no one in the last 20 years that has been more consistently wrong than Phil Gramm. In fact, you should write a letter and thank Phill Gramm for all his work that made those Credit Default Swaps possible.

[SgtRock]

Its obvious that you are a democrat and I am a republican. Democrats blame CDS and Republicans blame the CRA. Both are being backed up by economist. While I agree that the CDS is partially responsible for the crisis at hand it is in my opinion the CRA that is the prominent factor which is responsible for where we are today.

Think about it. If you own a bank and the government forces you to finance clients with bad or no credit, no down payment, and without the means to pay what will be the result.

Phil Gramm was right it was in fact a st extortion scheme against America's banks.

[SouthernDemocrat]

Its obvious that you are a democrat and I am a republican. Democrats blame CDS and Republicans blame the CRA. Both are being backed up by economist. While I agree that the CDS is partially responsible for the crisis at hand it is in my opinion the CRA that is the prominent factor which is responsible for where we are today.

Think about it. If you own a bank and the government forces you to finance clients with bad or no credit, no down payment, and without the means to pay what will be the result.

Phil Gramm was right it was in fact a st extortion scheme against America's banks.

Lets just look at the facts.

The CRA was enacted in 1977.

The CRA was reformed in 1995.

The Commodities Modernization Act was signed into law in 2000.

The vast majority of bad loans underlying the current financial crisis were written 2001 on. Moreover, the Bush Administration gutted CRA in 2004, yet huge numbers of toxic loans were still being written. Also its very questionable to equate subprime loans with inner city depressed areas. There are plenty of families earning a 100k a year buying 600k loans with a subprime mortgage or other creative financing, all of which is outside of CRA. Finally, CRA certainly is not responsible for the global housing bubble, that can only be made possible by instruments like Credit Swaps.

You have some ideologues desperately trying to pin this on CRA, but it just doesn't hold up under any sort of scrutiny.

[obvious Child]

From the WSJ:

in 2002, the Bush administration charted a more aggressive course by pushing for lower down payments and touting vouchers that would allow public-housing tenants to one day own homes.....

In 2004, President George W. Bush campaigned on lower barriers to homeownership as part of the domestic agenda for his second term. The Republican Party platform that year singled out the down payment as the "most significant barrier to homeownership."

Homeownership Push Is Rethought - WSJ.com

Who's fault is the current crisis again?

Do we need to run another timeline as to when this crisis originated?

[Suzy]

I am an economist by training and spent 25 years in the banking industry. I have personally sat in loan committee meetings and had bank examiners demand that we "not discriminate against low and moderate income borrowers". Never mind that the reason they are low and moderate income in the first place is their inability to make good financial decisions...like establishing a steady work history, paying bills on time, living within their means, obeying the law, buying insurance to guard against catastrophic illness or property loss, (women) having multiple children with multiple men. and on, and on.
The CRA was well intentioned, and lawmakers from both sides of the aisle rightly noted the positive effects that homeownership can have on a society. The problem was, these middle and upper class lawmakers made the erroneous assumption that if you put poor people in houses, they would suddenly start behaving like financially responsible middle class people. All of a sudden lawnmowers would replace lottery tickets and backyard barbeques would take the place of drive by shootings. Alas, these hopes for change were empty promises as they always are, and borrowers who had to get their down payments from "third party non-profit agencies" (by the way, someone always makes a profit, otherwise why are they in it) had nothing to fall back on when the hot water heater broke or the roof leaked. The houses fell into disrepair and by the time the foreclosure papers were posted, the occupants and hopes of any recovery by the lender long gone. But the originating lender didn't care...the loan had been sold, not their problem any more!
There is more blame to go around...mortgage companies and builders soon realized there was money being printed and there sprung up sompanies that specialized in getting subprime borrowers into low cost (and low quality) housing. You probably heard them advertising on the radio and saw the ads in the Sunday paper. Did you ever wonder what kind of people would need a no-doc loan? And who would be stupid enough to make such a loan? I think we all know the answer to that now...the ultimate lender was of course Fannie Mae or Freddie Mac, the original loan having long since been sold by the originating bank. All that bad paper, and Franklin Raines out the back door with his suitcase full of money...

[SgtRock]

I am an economist by training and spent 25 years in the banking industry. I have personally sat in loan committee meetings and had bank examiners demand that we "not discriminate against low and moderate income borrowers". Never mind that the reason they are low and moderate income in the first place is their inability to make good financial decisions...like establishing a steady work history, paying bills on time, living within their means, obeying the law, buying insurance to guard against catastrophic illness or property loss, (women) having multiple children with multiple men. and on, and on.
The CRA was well intentioned, and lawmakers from both sides of the aisle rightly noted the positive effects that homeownership can have on a society. The problem was, these middle and upper class lawmakers made the erroneous assumption that if you put poor people in houses, they would suddenly start behaving like financially responsible middle class people. All of a sudden lawnmowers would replace lottery tickets and backyard barbeques would take the place of drive by shootings. Alas, these hopes for change were empty promises as they always are, and borrowers who had to get their down payments from "third party non-profit agencies" (by the way, someone always makes a profit, otherwise why are they in it) had nothing to fall back on when the hot water heater broke or the roof leaked. The houses fell into disrepair and by the time the foreclosure papers were posted, the occupants and hopes of any recovery by the lender long gone. But the originating lender didn't care...the loan had been sold, not their problem any more!
There is more blame to go around...mortgage companies and builders soon realized there was money being printed and there sprung up sompanies that specialized in getting subprime borrowers into low cost (and low quality) housing. You probably heard them advertising on the radio and saw the ads in the Sunday paper. Did you ever wonder what kind of people would need a no-doc loan? And who would be stupid enough to make such a loan? I think we all know the answer to that now...the ultimate lender was of course Fannie Mae or Freddie Mac, the original loan having long since been sold by the originating bank. All that bad paper, and Franklin Raines out the back door with his suitcase full of money...

Thanyou, welcome to DP. Its good to have someone with experence in economics on the forum. And you are spot on pertaining to the cause of the current banking crisis.

[Onion Eater]

I am an economist by training and spent 25 years in the banking industry. I have personally sat in loan committee meetings and had bank examiners demand that we "not discriminate against low and moderate income borrowers". Never mind that the reason they are low and moderate income in the first place is their inability to make good financial decisions... The problem was, these middle and upper class lawmakers made the erroneous assumption that if you put poor people in houses, they would suddenly start behaving like financially responsible middle class people. All of a sudden lawnmowers would replace lottery tickets and backyard barbeques would take the place of drive by shootings. Alas, these hopes for change were empty promises as they always are.

Excellent first post, Suzy! Welcome aboard!

I've said elsewhere on this forum that credit limits are more important than interest rates, so I'll just paste that in:

In my Critique of Austrian Economics, Axiomatic Economics by Victor Aguilar: Critique of Austrian Economics, I write:

“Credit limits are more important than interest rates and there are many people who cannot get credit at all. Interest rates only affect how much money is being transferred. They do not affect who gets it…

“Recently, Stiglitz and Greenwald have raised the same issue. ‘That some loans are not repaid is central… Thus, a central function of banks is to determine who is likely to default, and in doing so, banks determine the supply of loans.’ (2003, p. 3). This idea, that bank loans redistribute wealth from one class of people to another, is a fundamental departure from the classical view that banks merely divide the world into those who are willing to borrow at x% but not at x.1%, without regard to who those people are, their class or their importance to the government.”

Recent events have confirmed my belief that credit limits are more important than interest rates:

Alan Zibel writes, “Lenders [who must satisfy Fannie and Freddie] are demanding bank statements, big cash reserves and second appraisals before they approve a loan to refinance a home. Mortgage rates are hovering around 6.6%, about the same level as a year ago.”

Clearly, if mortgage rates are the same as a year ago but the housing market is so much different (and worse) than a year ago, then mortgage rates are not the best measure of the market. Credit limits are.

Martin Feldstein concurs, “The dysfunctional state of the credit market means that many individuals and businesses are unable to get credit. Lowering interest rates will not stimulate demand for those who cannot get credit.”

At the macro level, most economists agree that the Federal Reserve loaning money to investment banks and holding loan auctions to avoid shaming the recipients is far more important than the fact that they lowered the discount rate. Also, the repeal of the Glass-Steagall act in 1999 is widely seen as a precursor to the current credit crisis, yet it had no direct impact on interest rates.

You [MC.no.spin] write that the Fed was forced to help Fannie Mae and Freddie Mac. Maybe, maybe not; but let’s consider why you think the issue is important in the first place. It has no direct impact on interest rates. It just makes a source of loans, the Fed itself, available to Fannie and Freddie that they were previously denied access to. In other words, it changed the credit limits that Fannie and Freddie face, but not the rates that they must pay.

This agrees with SgtRock's assessment that the "Community Reinvestment Act is responsible for the banking crisis," as this legislation affected only credit limits, not interest rates. However, SouthernDemocrat, you are not wrong when you assert that, "the problem in the current crisis is that all these toxic assets were made possible by a special kind of derivative called a 'Credit Default Swap'."

You two are falsely assuming that your positions are mutually exclusive or, at least, that one explanation must be stronger than the other. In fact, you are addressing different questions. This is the (oft-misunderstood) point of my thread, Is the collapse of the dollar inevitable?

Your [MC.no.spin] argument that the inflation threat is minimal right now misses my point. I didn't say that the inflation threat was great; I said that IF inflation threatens to turn into hyperinflation, it will be difficult to check. Whether this is a big IF or a small IF is a seperate question.

By the same token, there were two problems in the housing market that impact our current crisis:

1) Loans were made to people who didn't have any verifiable income and who didn't have a down payment.

2) Mortgages were broken up and combined into securities so it is very difficult to estimate the value of those securities now and, by extension, the strength of the companies who own them.

The former caused the crisis, the latter made it difficult to get out of.

My point is that causing a problem and making it difficult to fix are two different things. To demarcate two different things is not to diminish or exaggerate either one, it is just to say that they are two different things - don't get them confused.

So, in conclusion, SgtRock and SouthernDemocrat, don't let your partisanship lead you to assume that your positions must be in conflict. Sometimes both the Republicans and the Democrats have a bit of the truth. Though, frankly, more often they are equally clueless - only in different ways!