Congress Should Expand the Community Reinvestment Act
Posted on September 30, 2008
Congress thinks it's about to "solve" the nation's deepening financial crisis with a $700 billion bailout of Wall Street. What's being overlooked is that one of the fundamental causes is the erosion of place-based investing. And a fundamental solution has to be an expansion of the Community Reinvestment Act (CRA).
There's no shortage of villains here. Mortgage companies pushed predatory adjustable-rate loans on the gullible poor. Regulators loosened standards in the name of the free market. Finance companies created exotic securities and derivatives that effectively hid risk. And many of these players fraudulently misrepresented or withheld critical pieces of information. Yet, at its core, this entire mess is about the delinking of investment from place,
Anti-Community Redlining and the Community Reinvestment Act
For most of human history people used their savings to invest in their own businesses, their children, and their community. They knew the beneficiaries, understood the risks, and appreciated that even if the investments didn't hit pay-dirt, the activities financed – a new local business, a college education, more roads and bridges – would have other social and personal payoffs.
Over the last century, however, modern capitalism has steadily separated savers from investors. Some of these innovations, of course, were sensible. Creating securities and markets for exchanging them enabled savers to hedge risks by diversifying their investment portfolios, and to buy and sell stocks whenever they needed to. Setting up secondary markets enabled community banks to replenish their lending capital and provide mortgages to more people of modest means.
But even the best of these innovations introduced new risks. The more anonymous the transactions, the less a lender or investor could know about the recipient of the funds. And the more distant the ties between a lender and a borrower or between an investor and a business, the less likely the new economic activity could benefit the lender’s or investor's community.
The globalization of capital also resulted in huge inequalities. Communities and companies that were already successful were naturally deemed the safest places for investors to park their money. They were net gainers. Most communities saw their savings sucked elsewhere and became net losers. And some communities, such as those that were poor and nonwhite, were redlined altogether out of bankers' and investors' portfolios.
The Community Reinvestment Act addressed some of these injustices in 1977. It outlawed redlining and forced banks and thrifts to make quarterly reports about the percentage of its lending that went back into their community, especially low and moderate income neighborhoods. Banks with low levels of community reinvestment would have difficulty receiving federal approval for merging with other banks and for opening and shutting new branches. Though actual enforcement has been scattershot, just the threat of enforcement has led to more than $1 trillion of investment in distressed communities since the CRA was passed.
Back to the Future: Causes of the Current Credit Crisis
Some conservative activists are now arguing that the CRA is responsible for the present financial meltdown, because it supposedly forced banks to make risky loans to unworthy, low-income borrowers. This is absolute nonsense. The CRA operated just fine for a generation without any problems, and in the recent years in which bad lending accelerated the Bush Administration actually reduced enforcement. Most CRA loans never enter the secondary market and are irrelevant to the current crisis.
Most importantly, nothing in the CRA requires a bank to provide loans to individuals with low credit scores. A bank simply cannot exclude poor or nonwhite neighborhoods. Providing local loans to low-risk residents in these neighborhoods is enough for a good CRA grade.
Let's get serious: Predatory loans by companies like Countrywide were undertaken not to gain CRA credit but to pocket huge profits. More than half of issuing lending institutions were never subject to the CRA. Ditto for those who securitized and resold these loans.
In fact, there's strong evidence that community friendly banks generally make fewer risky loans. A 2008 study by Traiger & Hinckley LLP found that "without the CRA, the subprime crisis and related spike in foreclosures might have negatively impacted even more borrowers and neighborhoods. Compared to other lenders in their assessment areas, CRA Banks were less like to make a high cost loan, charged less for the high cost loans that were made, and were substantially more likely to eschew the secondary market and hold high cost and other loans in portfolio. Moreover, branch availability is a key element of CRA compliance, and foreclosure rates were lower in metropolitan areas with proportionally greater numbers of bank branches."
Any community friendly bank that lends exclusively to local homeowners, students, and entrepreneurs and does not to resell those loans on a secondary market has to be exceedingly careful that the loans are sound. A bank that quickly sells its loans on a global secondary market, in contrast, can essentially dump responsibility for its mistakes onto global investors. Local loans are more likely to be informed by a personal relationship between a lender and a borrower, which typically lends itself to sounder decisions about creditworthiness than the mechanical credit scores relied upon by global banks.
The underlying cause of today's market failure is that global finance has eviscerated any identifiable relationship between a loan and an investor. Like the children's game of telephone, the introduction of each "intermediary" means that valuable information about risk and return is distorted or lost, especially since each link in the chain has the incentive to "move" the transaction along for a quick profit.
The key to restoring health and stability back to the finance system is to re-localize – to reintroduce real relationships between lenders and borrowers and between entrepreneurs and investors. Congress would be smart to toughen enforcement of the CRA, especially on any financial institution seeking federal help under the bailout.
Historically, the CRA has only applied to banks and thrifts, which means it covers only about one in seven dollars in the U.S. financial universe. The CRA has never applied to other mortgage makers, pension funds, insurance funds, hedge funds, and most other major investors. Congress should extend the CRA to apply to every one of these financial institutions, especially if they are seeking federal aid.
Those of us with our life savings on the line have a right to know where our money is going, and an opportunity to place it in funds that reinvest in our own communities. An expanded CRA would provide needed incentives to develop more creative mechanisms of local investment, such as small intrastate stock trading. Moving trillions of dollars out of unknown global companies and the unknowable derivatives linked to them, and back into Main Street businesses, would give communities across the country a desperately needed economic boost. Simply feeding more federal dollars to institutions that ignore local investment, as the current bailout does, is exactly the wrong approach.