Public policy encourages risky lending? That’s CRAzy!

Since the Mayan calendar didn’t usher in an end to the Great Recession, we still have to figure out why it happened. We could boil it down to two deadly sins (greed and pride) and two groups of culprits (financiers and legislators). The typical storyline is that greedy financiers worked around too-loose regulations in creating subprime mortgages that were grouped together and packaged as mortgage-backed securities, pridefully presuming that the (at least geographically-; certainly not risk-) diversified bundles would stay afloat long enough to bring them big bucks. No less than Pope Benedict has noted the problems caused by profit-seeking to the exclusion of other considerations. So, the typical storyline is an answer to why the Great Recession happened, but it is not the only one.

Pic by Kevin McShane

Legislators, too, bear some responsibility in fostering the housing bubble. The stock answer from conservatives was that the Community Reinvestment Act (CRA) encouraged lending to less-than-creditworthy homebuyers out of an aim to promote homeownership among minorities. Legislators were greedy for votes and prideful that they could overturn truly despicable redlining and discriminatory lending practices simply by passing laws. This stock answer was of course criticized by non-conservatives (such as here and here).

A recent study published by the National Bureau of Economic Research (ungated copy at SSRN here) by authors from the National University of Singapore, Harvard, MIT, and the University of Chicago provides some pretty powerful support for criticisms of the CRA. In response to its title, “Did the Community Reinvestment Act (CRA) Lead to Risky Lending?” the abstract says bluntly “Yes, it did.”

Our empirical strategy compares lending behavior of banks undergoing CRA exams within a given census tract in a given month to the behavior of banks operating in the same census tract that do not face these exams. We find that adherence to the act led to riskier lending by banks: in the six quarters surrounding the CRA exams lending is elevated on average by about 5 percent every quarter and loans in these quarters default by about 15 percent more often. These patterns are accentuated in CRA-eligible census tracts and are concentrated among large banks.

Later in the paper, some more detail is given:

Our empirical design exploits this intertemporal variation in incentives to comply with CRA standards by comparing banks undergoing CRA exams (treatment group banks) to similar banks operating in the same vicinity but not undergoing a CRA exam (control group banks). The identifying assumption is that around the time of CRA exams, because of their increased incentive to comply with CRA standards, banks will shift their lending behavior toward borrowers that improve their CRA rating…The evidence therefore shows that around CRA examinations, when incentives to conform to CRA standards are particularly high, banks not only increase lending rates but appear to originate loans that are markedly riskier.

If you think that 5% more loans and 15% more defaults isn’t a large effect, the authors note

our estimates of the effect of CRA evaluations provide a lower bound to the actual impact of the CRA. If adjustment costs in lending behavior are large and banks can’t easily tilt their loan portfolio toward greater CRA compliance, the full impact of the CRA is potentially greater than that estimated by the change in lending behavior around CRA exams.

Perhaps politicians believe that their laws and rules fall under the principle of double-effect, that even though there may be foreseen bad consequences (including the worst recession in decades?) as long as they themselves meant well when passing such laws and rules, or as long as some minority borrowers received loans on which they did not default, the politicians should be considered righteous. But the actions of politicians, and the effects of policy, do not receive moral bonus points because they result from a democratic process.

Might it not be better policy to presume that lenders familiar with local market conditions and homebuyers would be better situated to determine appropriate interest rates and lending restrictions than legislators and bureaucrats hundreds or thousands of miles away? The critic who raises the legitimate problem of discriminatory lending needs also to address how the side effects of public policy meant to combat such lending can affect groups discriminated against. Does it help disadvantaged groups to be given loans when the default rate rises at least 15%?

I’ll file this as another example of “reverse usury.”


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