Definition of the Community Reinvestment Act
The Community Reinvestment Act encourages banks to provide loans to low- and moderate-income neighborhoods. It was enacted in 1977 to eliminate “redlining” in impoverished areas. This discrimination contributed to the growth of poor neighborhoods in the 1970s. In redlining, neighborhoods are classified as poor investments. As a result, banks would not agree to issue home loans to anyone living in those areas. It did not matter how strong the applicant’s financial situation or credit history was. Some experts pointed out that these areas were initially created by the Federal Housing Administration, which guaranteed the loans.
Implementation of the Community Reinvestment Act
Legislators used provisions of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 to enhance the implementation of the Community Reinvestment Act. They could publicly rate banks based on their success in “greening” neighborhoods. Fannie Mae and Freddie Mac assured banks that they would secure these subprime loans. These factors reinforced the law. In May 1995, President Clinton directed bank legislators to make Community Reinvestment Act reviews more focused on results and less burdensome for banks, and more consistent. Legislative bodies for the Community Reinvestment Act use various indicators, including interviews with local businesses. However, they do not require banks to meet a specific financial goal for lending. In other words, the Community Reinvestment Act does not limit banks’ ability to determine who is creditworthy. Nor does it prevent them from allocating their resources in the most profitable manner.
Community Reinvestment Act and the Subprime Mortgage Crisis
The Federal Reserve found no correlation between the Community Reinvestment Act and the subprime mortgage crisis. Its research showed that 60 percent of subprime loans went to high-income borrowers outside of Community Reinvestment Act areas. Moreover, 20 percent of the subprime loans that went to poor areas were made by lenders who were not trying to comply with the Community Reinvestment Act. In other words, only 6 percent of the subprime loans were made by lenders covered by the Community Reinvestment Act to borrowers and neighborhoods targeted by the law. The Federal Reserve found that mortgage defaults were widespread, not just in low-income areas.
What Made Securitization Possible
Both studies suggest that securitization made higher subprime lending possible. What made securitization possible? First, the repeal of the Glass-Steagall Act in 1999 under the Gramm-Leach-Bliley Act. This law allowed banks to use deposits to invest in financial derivatives. Bank representatives claimed they could not compete with foreign companies and that they would only invest in low-risk securities, thereby reducing risks for their clients. Second, the Commodity Futures Modernization Act of 2000 allowed the unregulated trading of derivatives and other credit swaps. This federal law nullified state laws that had prohibited it as a gambling practice.
The Role of Enron
Who wrote and advocated for the passage of both laws? U.S. Senator Phil Gramm, Chairman of the Senate Committee on Banking, Housing, and Urban Affairs. Enormous pressure was exerted on Gramm by Enron, as his wife, who had previously served as Chair of the Commodity Futures Trading Commission, was on the board. Enron was a major contributor to Senator Gramm’s campaigns. Former Federal Reserve Chairman Alan Greenspan and former Treasury Secretary Larry Summers also collaborated to promote the passage of the law.
How Securitization Worked
How did securitization work? First, hedge funds and others sold mortgage-backed securities, collateralized debt obligations, and other derivatives. A mortgage-backed security is a financial product whose price is based on the value of the mortgage used as collateral. Once a mortgage loan is obtained from a bank, it sells it to a hedge fund in the secondary market. The hedge fund then combines your loan with many similar loans. They used computer models to assess the value of the package based on monthly payments, the total amount owed, the likelihood of repayment, what home prices and interest rates would do, and other factors. The hedge fund then sells the mortgage-backed security to investors.
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Because the bank sold your mortgage, it can make new loans using the funds it obtained. It may continue to collect your payments, but it sends them to a hedge fund, which sends them to their investors. Of course, everyone takes a cut of the money along the way, which is another reason it became popular. It was an almost risk-free process for the bank and the hedge fund.
The Need for More Mortgages
A mix of real estate-backed derivatives and insurance was very profitable! But it required more and more loans to support the securities. This increased the demand for mortgages. To meet this demand, banks and mortgage brokers offered home loans to almost anyone. Banks offered subprime loans because they were making a lot of money from the derivatives, not from the loans.
Banks were in desperate need of this new product, thanks to the recession that began in March and continued until November 2001. In December, Federal Reserve Chairman Alan Greenspan lowered the federal funds rate to 1.75 percent. He cut it again in November 2001 to 1.24 percent to combat the recession. This lowered interest rates on adjustable-rate loans. Payments were cheaper because interest rates were based on short-term Treasury bond yields, which depend on the federal funds rate. Many homeowners who could not afford traditional loans were very happy to agree to these interest-only loans. Many did not realize their payments would rise significantly when the interest was reset in three to five years or when the federal funds rate increased.
Increased Subprime Loans
As a result, the percentage of subprime loans increased from 10 percent to 20 percent of total loans between 2001 and 2006. By 2007, it had turned into a $1.3 trillion industry. The creation of mortgage-backed securities and the secondary market is what pulled us out of the recession in 2001. It also created a bubble in the housing market in 2005. The demand for mortgages increased, and homebuilding companies tried to meet this demand. With cheap loans, many bought homes not to live in or even to rent, but just as investments to sell at a higher price.
Sources:
– Federal Reserve. “Evaluating the Role of the Community Reinvestment Act in the Financial Crisis.”
– Budget
Source: https://www.thebalancemoney.com/community-reinvestment-act-3305681
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