Subprime Crisis Gone Mad
by Rennett Stowe
Robert Avery and Kenneth Brevoort investigated the role of Community Reinvestment Act (CRA) and Government-Sponsored Enterprise (GSE) in subprime crisis trying to answer the question, Is Government Housing Policy to Blame?. They examined indirectly whether these programs were associated with worse outcomes in the mortgage market, including delinquency rates and measures of loan quality. Their findings attack general beliefs.
CRA and GSE
The Community Reinvestment Act (CRA) is a federal law designed by the U.S. to encourage commercial banks and savings associations to help meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighbourhoods. Consistent with safe and sound operations, the law was substantially revised in 1995 and updated again in August 2005.
Economist Stan Liebowitz wrote in the New York Post that a strengthening of the CRA in the 1990s encouraged a loosening of lending standards throughout the banking industry, and he charges the Federal Reserve with ignoring the negative impact of the CRA. Congressman Ron Paul also claimed that CRA forced “banks to lend to people who normally would be rejected as bad credit risks.”
Government-Sponsored Enterprises (GSEs) are privately held corporations with public purposes created by the U.S. Congress to reduce the cost of capital for certain borrowing sectors: agriculture, home finance, and education. GSEs hold or pool approximately $5 trillion worth of mortgages. Fannie Mae, Freddie Mac, and Ginnie Mae are the three main, well-known GSEs. The government’s CRA changes authorized GSE’s to buy subprime mortgages, which it began to do in 1997. Then Fannie Mae expanded home ownership for millions of families by reducing down payment requirements, and borrowing regulations were even more eased.
“Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market,“ Fannie Mae’s CEO, Franklin Raines, explained.
When specialists talk about subprime crisis, they usually blame the government policy.
However, FDIC Chairman Sheila Bair, Comptroller of the Currency John C. Dugan, Tim Westrich of the Center for American Progress, and some others object that there is no evidence that CRA caused the crises. Avery’s and Brevoort’s work agree with their objections.
Subprime Mortgage Crises
by Louisa Thomson
“Using a variety of indirect tests, we find little evidence to support the view that either the CRA or the GSE goals caused excessive or less prudent lending than otherwise would have taken place,” they said in the paper. They also didn’t find any evidence that either the CRA nor the GSE goals contributed to house prices appreciation during the 2001-2006 subprime buildup. Their analysis showed that loans purchased by CRA-covered lenders appear to have been sensitive to the definition of a CRA-favoured loan, but they probably didn’t affect the overall quality of loans originated.
However, their tests weren’t direct and thus they can’t say they proved that CRA and GSEs didn’t play significant roles in the subprime crisis. CRA made borrowing more accessible and attracted those whose credit risk was high and who would be rejected today. But were their actions strong enough to affect the whole market?
The authors added that direct evidence would be available by focusing on the performance of loans originated through these programs, but it isn’t publicly available now. Meanwhile, economists will still argue about the real causes with no exact proof.