Friday, December 28, 2012

Community Reinvestment Act’s Problem

Conclusion leapers have blamed the Great Recession and Crash of 2008 on the greed of real estate lenders and speculators, but that does not explain the timing, and does not explain why individual follies coincided. When the whole economy is disturbed, the government is usually the cause, because only government can use systemic force.

In physics, the equation for force is F=MA, where F is force, M is mass, and A is acceleration. Applied to the economy, force consists of laws, taxes, and subsidies. Mass is assets and liabilities. Acceleration is a change in momentum.

Momentum is mass times velocity: MV. Suppose the mass of the economy is moving at some constant velocity, i.e. speed and direction. Then a force causes a change in the velocity, i.e. the mass accelerates by changing speed or direction or both.

One of the acts of force the U.S. federal government initiated is the Community Reinvestment Act of 1977 (title VIII of the Housing and Community Development Act of 1977) and its enhancement in 1995.

A major expansion of CRA-based loans began in 1995. There were economists who warned that this would cause major trouble. As stated in the Wikipedia article on the CRA:
“During one of the Congressional hearings addressing the proposed changes in 1995, William A. Niskanen, chair of the Cato Institute, criticized both the 1993 and 1994 sets of proposals for political favoritism in allocating credit, for micromanagement by regulators and for the lack of assurances that banks would not be expected to operate at a loss to achieve CRA compliance. He predicted the proposed changes would be very costly to the economy and the banking system in general. Niskanen believed that the primary long term effect would be an artificial contraction of the banking system. Niskanen recommended Congress repeal the Act.”

From 1995 to 2008, CRA loan commitments leaped from a few billion dollars to 6.1 trillion dollars. Some economists have not believed that the economy had CRAP - a Community Reinvestment Act problem. But now the prestigious National Bureau of Economic Research (the organization that officially designates the dates of recessions) has published a study that concludes that the CRA indeed was a major contributor to the Depression of 2008.

The title of the NBER publication is the question, Did the Community Reinvestment Act (CRA) Lead to Risky Lending? The answer of the authors is conclusive: "Yes, it did. ... We find that adherence to the act led to riskier lending by banks."

In 2000, the federal Housing and Urban Development department increased the quota of “affordable housing” for Fannie Mae, the government-sponsored mortgage-buying company, by fifty percent. Fannie Mae and its sibling Freddie Mac buy mortgages from banks, enabling them to provide more mortgages without limit. In a banking conference in 2000, Fannie’s Vice Chair described "CRA-friendly products" as mortgages with less than "3% down" and "flexible underwriting." Flexible lending includes what bankers called “liar loans,” loans for which the banks did not verify the claimed incomes and other data of the borrowers. According to an article in Investors Business Daily, Fannie and Freddie bought half the CRA loans.

Several economists had previously blamed the CRA for the housing crash, including Thomas Sowell in his 2010 book The Housing Boom and Bust. In my review of that book for Choice, a journal for librarians, I summarized Sowell’s proposition on the origins of the housing bubble as, first, restrictions on development that made land values rise rapidly in some areas such as California, and secondly, the Community Reinvestment Act, which coerced banks to provide mortgages to low-income and minority borrowers. Sowell argues that the anti-discrimination rationale that promotes home ownership for minorities is based on faulty analysis, and was futile as low-income lost their homes after 2007.

However, there is a more fundamental cause of the Depression of 2008, a governmental force that caused all the major depression of the USA along with those of other countries. There is a force that has periodically disturbed the economic space-time continuum. Applying F=MA, that governmental force has caused the mass of the economy, particularly land values and investments in real estate construction, to periodically accelerate and decelerate. The force that has disrupted the economy for the past 200 years is: massive subsidies to land values.

Government’s public goods and welfare subsidies make territory more attractive and productive, generating greater land rent and higher land values. The subsidies are implicit in artificially low interest rates due to money expansion, and the fiscal subsidies of taxing mostly labor and goods rather than having landowners paying back the rents generated by the public services.

As the economy expands, the higher land values induce “malspeculation,” the purchase of land based on the expectations of ever higher prices. At the peak, the most optimistic speculators are the ones left holding the land bag, as real estate crashes, bringing down with it the financial infrastructure. The high acceleration of economic mass near the peak of the boom is followed by a swift and severe deceleration, the crash and depression.

We are now into a new cycle, in which once again the Federal Reserve has expanded the money supply, this time more massively than ever before, to keep interest rates low, again a subsidy to real estate, which is again reviving, and will again a decade from now, crash. The next crash will be even worse than that of 2008, since there will also be a fiscal crisis from the ever growing federal debt, as the government will no longer be able to borrow funds cheaply.

As the philosopher Hegel wrote, governments do not learn from history, and that is why the cycle is repeating again. The basic cause of the boom-bust cycle is not the CRA, but the subsidy to land values, because if not for that subsidy, land would be cheap to buy, enabling less affluent buyers to not need so much credit for the purchase of a home.


"Community Reinvestment Act." Wikipedia.

Paul Sperry. 20 Dec. 2012. New Study Finds CRA 'Clearly' Did Lead To Risky Lending.

Sumit Agarwal, Efraim Benmelech, Nittai Bergman, Amit Seru. 2012. Did the Community Reinvestment Act (CRA) Lead to Risky Lending? NBER Working Paper No. 18609.

Study Says Community Reinvestment Act Induced Banks To Take Bad Risks.
by J.D. Tuccille, 21 Dec. 2012.

Thomas Sowell. 2010. The Housing Boom and Bust. New York: Basic Books.


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