CRA is Not Subprime

by Stephen C. Franco

As the cost of the U.S. financial rescue plan hurtles toward $1 trillion, journalists, commentators, and politicians have been assigning blame to various parts of the government apparatus. With the benefit of hindsight, it is clear that regulation was lax and the recent direction encouraging Fannie Mae and Freddie Mac to increase their investments in subprime mortgages was ill-advised. But fingering the 30-year-old Community Reinvestment Act as a key enabler of the surge in mortgage delinquencies is misguided and inaccurate.

The Community Reinvestment Act (CRA) was instituted in 1977 to encourage banks to lend to underserved businesses and homebuyers in the communities in which they take deposits. The law also prevents banks from “redlining” certain communities of lower income consumers and refusing to lend to them. Banks are specifically discouraged from using “high priced” loans to lower income borrowers (i.e., subprime) to meet their CRA requirement. Instead, banks lend to credit-worthy small businesses and homeowners in lower-income neighborhoods at competitive market rates. Banks are graded regularly on their compliance with CRA guidelines. Community groups have used low CRA ratings as leverage to block banks from opening new branches or acquiring other banks, two activities that require regulatory approval. Unfortunately, performance data for CRA loans is not readily available, so it is difficult to objectively assess the program’s role in the recent subprime crisis. Nonetheless, here are some facts that strongly build a case in favor of the CRA program:  

• Enforcement of CRA was loosened in 2005, just as the subprime market was reaching a fever pitch. Many banks and thrifts subsequently increased their subprime lending activities in order to cash in on a seemingly profitable product with less regulation.

• Nonetheless, according to a Federal Reserve study, 75 percent of subprime loans between 2004 and 2006 were made by independent mortgage banks and brokers that were not federally regulated and thus not subject to CRA requirements.

• According to a recent study by New York City-based law firm Traiger & Hinckley, regulated banks had significantly lower market share of subprime loans than their overall loan market share (11 percent vs. 23 percent) in the communities they served.

• When regulated banks did originate a subprime loan, the rates charged were typically 74 basis points lower (4.81 percent vs. 5.55 percent) than rates charged by other lenders. There is a very strong statistical correlation (0.816) between high-cost mortgages and foreclosure rates, so CRA lenders were less likely to demonstrate predatory behavior. (Traiger & Hinckley)

• The most egregious lenders during this period likewise were not subject to CRA regulation: 167 of the 169 lenders that failed in 2007 were independent mortgage banks.

• Regulated banks are twice as likely to keep mortgages on their own balance sheet as to sell them off in securitization programs. These lenders thus maintain an economic interest in their loans and are more likely to conduct thorough underwriting. (Traiger & Hinckley)

• Foreclosure rates are lower in communities that are served by bank branches. Regulated banks, by CRA mandate, are lending in the communities in which they maintain branches. People in communities that are underpenetrated by bank branches were more likely to use unregulated mortgage banks or brokers and thus more likely to foreclose. (Traiger & Hinckley)

At Walden, we actively seek out banks with strong CRA lending records and a conservative risk culture. We find that smaller banks active in CRA lending have a more community-focused, service-based strategy that allows them to compete effectively against their larger peers. Recent results support the efficacy of this strategy: Representative small cap portfolio holdings Bank of Hawaii, Dime Community Bancorp, Independent Bancorp, Southside Bancshares, and Wainwright Bank all have outstanding CRA ratings and have experienced loan losses far below peer banks over the past 12 months. Not surprisingly, the average year-to-date return as of November 30 of this group of banks is -8.7 percent vs. -20 percent for small cap bank peers.

There is plenty of blame to go around as the inner workings of our entire financial system are called into question. Bad actors among lenders, brokers, traders, borrowers, and investors certainly had an outsized impact on the financial market meltdown. But assigning blame to a 30-year-old law that was neutered during the worst of the subprime lending spree is way off the mark.