May 26, 2015
Assessing the Community Reinvestment Act's Role in the Financial Crisis
Neil Bhutta and Daniel Ringo
An important question arising out of the financial crisis is whether the Community Reinvestment Act (CRA) played a significant role in the subprime mortgage boom and bust by pushing banks to make loans to risky borrowers.1 The CRA directs federal banking regulators to encourage banks to "help meet the credit needs" of their communities, particularly low- and moderate-income neighborhoods. Thus, a number of observers have argued that the CRA may have compelled banks to take excessive risk in order to expand their lending to lower-income communities and comply with the act.
In this note, we assess the strength of this argument by discussing how the CRA is enforced and by examining the available empirical evidence on the link between the CRA and risky lending. Overall, there appears to be little reason to believe that the CRA was an important factor in the subprime boom and subsequent crash. Not only is the law explicitly written and enforced to avoid pushing banks too far, but empirical research, by and large, also finds little connection between the CRA-related activities of banks and the expansion of risky or subprime mortgage lending.
Passed by Congress in 1977, the CRA directs the federal banking regulatory agencies--including the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency--to use their supervisory authority to encourage insured depository institutions to help meet the credit needs of all segments of their local communities. Local communities in this context are those areas, including low- and moderate-income areas, where banking institutions have a physical branch office and take deposits (also known as their CRA assessment areas). To the extent that lower-income areas are underserved by financial institutions as a result of possible market failures, the CRA may help correct these failures.2
The federal banking regulatory agencies periodically evaluate the performance of banks in serving their local communities, including their patterns of lower-income lending.3 These assessments are taken into consideration when regulatory agencies review bank applications for mergers, acquisitions, and branches, and applications can be denied on CRA grounds.
The CRA emphasizes that banking institutions fulfill their CRA obligations within the framework of safe and sound operation. Although CRA performance evaluations have become more quantitative since regulatory changes in 1995, and now focus on actual lending and investment patterns, the CRA does not stipulate minimum targets or goals for lending. While it is fair to say that the primary focus of the CRA evaluations is the number and dollar amount of lending to lower-income borrowers and neighborhoods, the federal banking regulatory agencies instruct their examiners to determine an institution's capacity to extend credit to lower-income groups and assess local economic and market conditions that might affect the income and geographic distribution of an institution's lending and to judge banks' performance within this context.
Community Reinvestment Act Commitments
Because merger applications can be delayed or denied on CRA grounds (for example, a merging bank may have had a poor CRA evaluation, or community groups may oppose the merger), the merger boom of the late 1990s that followed interstate bank deregulation, coupled with the CRA regulatory changes notes above, may have made banks more sensitive to CRA. Pinto (2010), Wallison (2011), and Calomiris and Haber (2014) point out that banks began promising large dollar amounts of future lending for CRA purposes as mergers became more frequent. These promises included both direct agreements with community groups and unilateral public pledges. The National Community Reinvestment Coalition reports that approximately $4 trillion in CRA commitments was promised between 1997 and 2005.
While Pinto (2010), Wallison (2011), and Calomiris and Haber (2014) claim the commitments data is strong evidence that the CRA caused an expansion in risky lending, in our view this argument is not compelling. First, these commitments generally lack any enforcement mechanism and, to a large extent, may not represent increased lending or, surprisingly, even consist of CRA-targeted loans. For example, a Citigroup managing director testified to the Financial Crisis Inquiry Commission (FCIC) that most CRA commitments "would have been fulfilled in the normal course of business" (Financial Crisis Inquiry Commission, 2011, p. 99). The FCIC report also found that less than one-fourth of the loans pledged in the largest-ever CRA commitment ($800 billion by JPMorgan Chase) were to the lower-income borrowers and neighborhoods targeted by the CRA (Financial Crisis Inquiry Commission, 2011, p. 97).
Second, CRA loan programs that might result from such commitments are not necessarily high risk. As documented in Avery, Bostic, and Canner (2000), many banks work with nonprofits to develop special programs with additional borrower screening and financial counseling, which can help mitigate credit risk. A recent study shows that loans originated from 2003 to 2006 through a major CRA-related lending program performed almost as well as prime loans and far better than the average subprime mortgage during the housing bust (Ding et al., 2011). In sum, the growth in banks' announced CRA commitments is not reliable evidence of a link between CRA and the growth in risky lending. In the next section, we discuss more-direct evidence on this question.
Evidence of the Community Reinvestment Act's Effect on Risky Lending
A number of researchers have investigated whether the CRA could be responsible for the subprime boom and riskier lending in general. Three key findings suggest the CRA did not have an important role in the subprime mortgage boom, either through banks' direct originations or their secondary market purchases.
First, Bhutta and Canner (2009) analyze 2005–2006 mortgage origination data from the Home Mortgage Disclosure Act (HMDA) and find that just 6 percent of all higher-priced loans (a proxy for subprime loans) were "CRA-related"--that is, were originated by depositories to either lower-income borrowers or lower-income neighborhoods in the banks' CRA assessment areas. The small share of subprime lending in 2005 and 2006 that can be traced to the CRA suggests that the CRA is unlikely to have played a substantial role in the subprime crisis.
Second, in follow-up work using loan performance data matched to 2006 HMDA origination records, Bhutta and Canner (2013) find that CRA-related loans experienced a delinquency rate that was less than half the overall rate for loans in lower-income neighborhoods and was actually lower than the overall delinquency rate across all 2006-vintage mortgages.4
Avery and Brevoort (forthcoming) and Ghent et al. (forthcoming) also find no evidence that the CRA drove up mortgage default rates during the housing bust, showing that default rates in neighborhoods that just meet the CRA definition of "lower-income" are nearly identical to those in neighborhoods just outside the lower-income definition.5 Relatedly, in preliminary work, Ringo (2015) finds that the CRA increased refinancing opportunities in lower-income neighborhoods that were added to a bank's assessment area by the Office of Management and Budget's redefinition of statistical areas between 2003 and 2004. By lowering homeowners' mortgage payments, the increase in refinancing reduced default rates.
Third, Ghent et al. (forthcoming) examine the prospectuses of 100 randomly selected private-label nonprime mortgage-backed securities (MBS) representing more than $100 billion of mortgage debt from Florida and California from 2004 to 2006 and find that not one prospectus mentioned CRA eligibility as a salient feature. Moreover, few, if any, of the MBS pools met CRA qualifications based on the incomes of the borrowers in those pools. Although banks can be credited in their CRA exams for MBS purchases, this potential incentive does not appear to have been a driver in the growth of the subprime MBS market and the loans it funded.
Notably, a study by Agarwal et al. (2012) has garnered considerable attention from critics of the CRA, including Calomiris and Haber (2014), who claim it supports the contention that the CRA caused risky lending. The study reports higher approval rates on mortgage applications in the six-quarter window around banks' CRA exams, and elevated delinquency rates on such "CRA-induced" mortgages. However, one criticism of this paper is that there is little incentive for banks to ramp up lending near the exam date, because examiners focus on lending done well before the exam (Foote, Gerardi, and Willen 2013). Indeed, Agarwal et al. (2012) also report increased lending to higher-income borrowers and neighborhoods, suggesting there may be some confounding factor driving the results. Regardless, the magnitudes of the estimated effects in Agarwal et al. (2012) appear moderate: a few percentage point increase in approvals and a 0 to 2 percentage point increase in delinquency rates.
The CRA provides an incentive structure that could plausibly have motivated banks to originate or purchase loans they would have otherwise considered too risky. However, empirical research indicates that CRA-related loans were a small fraction of the subprime market during the mortgage boom. The literature estimating the effect of the CRA finds small increases in originations--if any at all--and effects on delinquencies that are small or even negative. While we do not have a good estimate of the net costs or benefits of the act, the current best evidence suggests that the CRA was not a significant contributor to the financial crisis.
Agarwal, Sumit, Efraim Benmelech, Nittai Bergman, and Amit Seru (2012). "Did the Community Reinvestment Act (CRA) Lead to Risky Lending?" NBER Working Paper Series 18609. Cambridge, Mass.: National Bureau of Economic Research, December.
Avery, Robert B., Raphael W. Bostic, and Glenn B. Canner (2000). "CRA Special Lending Programs," Federal Reserve Bulletin, vol. 86 (November), pp. 711–31.
Avery, Robert B., and Kenneth P. Brevoort (forthcoming). "The Subprime Crisis: Is Government Housing Policy to Blame?" Review of Economics and Statistics.
Barr, Michael S. (2005). "Credit Where It Counts: The Community Reinvestment Act and Its Critics," New York University Law Review, vol. 80 (May), p. 513.
Bhutta, Neil (2011). "The Community Reinvestment Act and Mortgage Lending to Lower-Income Borrowers and Neighborhoods," Journal of Law and Economics, vol. 54 (November), pp. 953–83.
Bhutta, Neil (2012). "GSE Activity and Mortgage Supply in Lower-Income and Minority Neighborhoods: The Effect of the Affordable Housing Goals," Journal of Real Estate Finance and Economics, vol. 45 (June), pp. 238–61.
Bhutta, Neil, and Glenn B. Canner (2009). "Did the CRA Cause the Mortgage Market Meltdown?" Federal Reserve Bank of Minneapolis Community Dividend, March 1.
Bhutta, Neil, and Glenn B. Canner (2013). "Mortgage Market Conditions and Borrower Outcomes: Evidence from the 2012 HMDA Data and Matched HMDA-Credit Record Data," Federal Reserve Bulletin, vol. 99 (November).
Calomiris, Charles W., and Stephen H. Haber (2014). Fragile by Design: The Political Origins of Banking Crises and Scarce Credit. Princeton, N. J.: Princeton University Press.
Ding, Lei, Roberto G. Quercia, Janneke Rattcliffe, and Wei Lei (2011). "Risky Borrowers or Risky Mortgages: Disaggregating Effects Using Propensity Score Models," Journal of Real Estate Research, vol. 33 (2): pp. 245–77.
Financial Crisis Inquiry Commission (2011). The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States. Washington: U.S. Government Printing Office, February 25.
Foote, Chrisopher, Kristopher Gerardi, and Paul Willen (2013). "Government Policy and the Crisis: The Case of the Community Reinvestment Act," Real Estate Research, blog. Atlanta: Federal Reserve Bank of Atlanta, August 1.
Ghent, Andra C., Rubén Hernández-Murillo, and Michael Owyang (forthcoming). "Did Affordable Housing Legislation Contribute to the Subprime Securities Boom?" Real Estate Economics.
Laderman, Elizabeth, and Carolina Reid (2008). "Lending in Low-and Moderate-Income Neighborhoods in California: The Performance of CRA Lending During the Subprime Meltdown," Community Development Working Paper Series 2008-05. San Francisco: Federal Reserve Bank of San Francisco, November.
National Community Reinvestment Coalition (2005). CRA Commitments: 1977-2005 . Washington: National Community Reinvestment Coalition.
Pinto, Edward (2011). "Government Housing Policies in the Lead-Up to the Financial Crisis: A Forensic Study," ; working paper. Washington: American Enterprise Institute, February, .
Ringo, Daniel R. (2015). "Refinancing, Default and the Community Reinvestment Act," unpublished paper. Washington: Board of Governors of the Federal Reserve System, January.
Wallison, Peter J. (2011). Dissent from the Majority Report of the Financial Crisis Inquiry Commission. Washington: American Enterprise Institute, January.
1. A similar question surrounds the Affordable Housing Goals, which apply to the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. The GSE goals, however, which came out of financial reform in 1992, are distinct from those of the CRA. While the CRA applies only to insured depository institutions, the GSE goals provide specific numeric targets for the GSEs' secondary market mortgage loan purchases--namely, that a specific percentage of their loan purchases should be of loans to lower-income and minority neighborhoods and households (see Bhutta, 2012, for more background and an analysis of whether the goals influence credit availability). In this note, we confine our analysis to the CRA. Return to text
3. "Lower-income" refers specifically to census tracts with a median family income that is less than 80 percent of the metro or broader area's median family income and to borrowers with incomes that are less than 80 percent of the metro or broader area's median family income. Return to text
5. Bhutta (2011) employs the same research strategy of comparing tracts just above and below the CRA lower-income threshold to test whether the CRA led to more mortgage lending. He finds that the CRA caused a modest (3 percent) increase in mortgage lending from 1997 to 2002; from 2004 to 2006, when lending to lower-income neighborhoods soared, there is no evidence that CRA had an effect on lending. Return to text
Disclaimer: FEDS Notes are articles in which Board economists offer their own views and present analysis on a range of topics in economics and finance. These articles are shorter and less technically oriented than FEDS Working Papers.