Charges of predatory lending--intentionally targeting those who could ill-afford financial adversity--still fly fast and furiously. Cities with concentrations of low-income and protected class borrowers (such as Cleveland and Baltimore), still speak about sleezy lenders and others. Fingers point at bankers, appraisers, the Wall Street investment bankers and rating agencies.
But is this really the whole, or even the most important part, of the story? Are we mesmerized by the fire and forgetting to look for the matches?
The irony in the predatory lending story is that, not much more than a decade ago, the popular, political view of mortgage lenders was very different. In the 1980s and 1990s, the widely-held view was that mortgage lenders discriminated against the poor and stifled urban redevelopment by refusing to lend in run-down neighborhoods. It was widely alleged that mortgage lenders discriminated against women and minorities, and against central city neighborhoods. (The latter form of alleged discrimination was called "redlining".) Indeed, the Community Reinvestment Act, passed in 1977 at President Carter's urging, memorialized these suspicions in law.
Was the CRA the First Match that Lit the Great Recession?
Later in the 1990s, in pursuing alleged violators of the CRA, President Clinton was so convinced of lender bias that he even dispatched "testers" to pose as vulnerable home buyers to catch the bankers in the act of discrimination. His Comptroller of the Currency, Eugene Ludwig, sent fleets of inspectors into banks, looking for disproportionate patterns of lending. I, personally, defended a prominent west coast against these allegations. Not only was their no evidence off discrimination against protected classes, I found evidence the white buyers were statistically underrepresented once we could the full details in individual claims. Ludwig ultimately, as I understand it, apologized in front of the Bank's board.
Note that it is exactly the borrowers whose gains are ascribed to CRA who, subsequently, suffered the greatest financial distress. The Office of the Comptroller of the Currency itself summarized the effect of the CRA as follows:
Under its impetus, banks and thrifts have opened new branches, provided expanded services, adopted more flexible credit underwriting standards, and made substantial commitments to state and local governments or community development organizations to increase lending to underserved segments of local economies and populations. (Emphasis added.)
A later retrospective study of CRA's effect, done by Federal Reserve System economists, confirms that CRA regulation had an effect: "...a majority of surveyed institutions engaged in some lending activities that they would not have in the absence of the CRA.." However, the same study found that a "significant minority of institutions incurred losses conducting some of their marginal CRA-related lending activities." In other words, lending to marginal borrowers under pressure of CRA was not financially viable.
Today, most economists believe that the mortgage discrimination assumed by the CRA was never a demonstrated reality. If one accepts this view, the CRA and its implementing regulations thus constituted a selective tax on the profits of regulated mortgage lenders. The special sanctions and additional costs imposed on regulated mortgage lenders undoubtedly provided some impetus for lending to move into unregulated capital markets. It also provided impetus for their efforts to package the mortgages for the market in a way that might dilute the risk of the poor quality mortgages being generated by the industry.
Did the Fed Light the Second Match?
The Fed lit the second match via the steep yield curve that lasted nearly four years (a policy period referred to as the "Greenspan Put"). Low cost credit, and rising home prices, made buyers, lenders, investment bankers, rating agencies, and investors alike, complacent.
The securitization of a pool of mortgages provides investors in those securities with credit risk diversification, but not protection from systematic risk. That is, if the odd borrower defaulted, or a housing market got weak her or there, mortgage-backed securities would buffer the bad loans with the good, the weak markets with the strong. It was clear that there was a systematic bias of toward lending money to households with poor credit; the home-ownership rate ballooned. If something affected all markets in the same direction, the values of the underlying mortgages, their housing asset security and securities backed by the mortgages would move synchronously--down.
The shock that did it was the abrupt end of the Greenspan Put. The Fed Funds rate was raise as quickly and as far as it had been depressed after 2000. By 2005-2006, the yield curve was flat or negatively sloped, and the short-long borrowing and investing opportunity was gone. In addition, the advantage of a security backed by a diversified pool of weak credits became a liability. Diversity become synchrony, and the pooling and stripping of the mortgage credits became a source of opaqueness.
The Third Match
Thus, there were policies that, in my view, constitute the two "matches" in this scenario. One is the intervention of the CRA regulations, These regulations were tantamount to a mandate to make low-quality loans and were amplified by the Clinton and others' do-gooding belief that the market was discriminatory. The third match was the see-saw monetary policies of the Federal Reserve. The tendency of the Fed, under Greenspan, to manage soft landings, and to engineer real-sector recoveries, is a mistaken policy.
Greenspan understood that the "democratization" of mortgage credit carried risks. He expressed his concern a speech in San Francisco as early as 1997, he expressed concern about subprime mortgage trends. Unfortunately, like so many in the regulatory environment, the political correctness of CRA and lending to weak credits, coupled with the Fed's focus on micro-managing the economy, apparently made him turn a blind eye.
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