How to spread false conclusions from a simplified representation of the facts.

Claims exist that the subprime lending crisis has nothing to do with the community reinvestment act (CRA). Such claims should be closely examined, because it is easy to present half-complete facts and draw incorrect conclusions from them. Let us examine one particular blog post. This post is entitled Community Reinvestment Act had nothing to do with subprime crisis and was posted by Business Week’s Aaron Pressman on Septmeber 29, 2008 at We chose this post because of the clear claim in the title and because it ranks highly in some search engines.

The original post can be found here. If the post has moved, you may obtain a local copy here (accessed 11-01-2008).

If you are unfamiliar with the terminology and the evolution of the events that led to the subprime mortgage crisis, you might want to check out this article first and return here with your browser’s back button.

Let us look at the post section by section. Let us skip the first paragraph for now and look at the first claim of the blog post:

The Community Reinvestment Act, passed in 1977, requires banks to lend in the low-income neighborhoods where they take deposits. Just the idea that a lending crisis created from 2004 to 2007 was caused by a 1977 law is silly.

The article omits to mention that a stricter version of the 1977 CRA was enacted by Bill Clinton in 1995. This renewed and toughened CRA gave federal regulators the authority to severely curtail the activities of a bank if the bank fails to follow this act. The next tightening step occurred in 1999, when Bill Clinton signed into law the Gramm-Leach-Bliley Act which further expanded the reach of the CRA. From 1995 to 2004 it is a mere 9 years. A large majority of the subprime loans was granted under APR mortgage terms. That is, a very low interest rate is offered for the first five years of the loan. After these five years, the interest rate is no longer fixed and rises sharply. The inital low interest rate was necessary for the banks to sell enough subprime loans and not get criminalized under the CRA. The house owners usually get in trouble when the interest rate rises and they can no longer afford the loan. Therefore, there was a five-year lag after the introduction of the tightened CRA before the first problems started to appear. Furthermore, new loans were granted over many years, and the remaining four years after subtracting the lag do not appear that long anymore. When the tightened 1995 CRA by Bill Clinton is considered, the notion that the CRA is the root cause of the subprime mortgage crisis no longer appears silly.

Next, the article claims

… that 50% of subprime loans were made by mortgage service companies not subject comprehensive federal supervision and another 30% were made by affiliates of banks or thrifts which are not subject to routine supervision or examinations.

Please consider the exact wording. No comprehensive federal supervision. Does this mean that the CRA law still applies and is just not supervised and enforced? What about the banks and thrifts which are not subject to routine supervision or examinations? Do they act unlawfully just because of a lack of supervision? Is this the path recommended by the author? First, the text of the CRA applies to all regulated financial institutions – these are banks, insurance companies and their subsidiaries.

Second, please note that no real statistics are provided: How many loans were granted under the compulsion of the CRA? This is, in fact, the only number that counts. Looking at these numbers, there is not much change: the share of loans given to low- and medium income borrowers rose from 25% (1993) to 28% (1998). However, the investment portfolio mix of many banks changed. So did the number of variable-interest loans. In 1995, Fannie Mae started with a $1 Billion investment in subprime (Alt A) mortgages, a number that rose to over $30 Billion cumulatively by 1999. In 2000, Fannie Mae purchased another $2 Billion of “MyCommunityMortgage” loans. The number of loans with variable interest rate rose to 40% by 2005. Out of the subprime loans in the Fannie Mae portfolio, 92% were adjustable-interest (APR) loans. It was only 2005 that thrifts with over $1 Billion in assets were considered to have met their CRA obligations without regard to investments in their communities. We need to take another look at the high percentage of APR loans later, because they are a key element in the development of the crisis.

Eventually, we read that the Bush adminstration is to blame for the crisis:

Finally, keep in mind that the Bush administration has been weakening CRA enforcement and the law’s reach since the day it took office. The CRA was at its strongest in the 1990s, under the Clinton administration, a period when subprime loans performed quite well. It was only after the Bush administration cut back on CRA enforcement that problems arose, a timing issue which should stop those blaming the law dead in their tracks. The Federal Reserve, too, did nothing but encourage the wild west of lending in recent years. It wasn’t until the middle of 2007 that the Fed decided it was time to crack down on abusive pratices in the subprime lending market. Oops.

First, the problem aggravated by the tightened Bill Clinton version of the CRA took its time to ramp up, much like a rotting barrel that is slowly filled with water. It takes some time, and it can be filled for some time, before it finally breaks. The timing outlined here does not account for the lag. This makes the statement that the Bush administration cut back on CRA enforcement and therefore cause the crisis a bit shaky. Indeed, the subprime mortgage market appeared superficially healthy in the 1990s. This was a time when banks were still allowed to refuse mortgages to people who could be reasonably expected not to pay back the loan.

Furthermore, please consider that the Bush adminstration proposed a new oversight agency in 2003, a step that might have helped stem the crisis, but was turned down by Democrat-controlled Congress.

Most importantly, we need to point out the two most crucial (intentional?) omissions in this article apart from the 1995 revision of the CRA:

  1. The fact that house prices kept increasing with inflation since the seventies, but the increase accelerated dramatically in the 2000’s – a veritable bubble.
  2. The dynamics added to the crisis by trade in subprime mortgage packages between banks and between Fannie and Freddie.

When banks were forced to give out subprime loans, demand for houses rose artificially. In fact, house prices that rose consistently with inflation since the 1970’s exploded in the last decade, a rise that far exceeded inflation, and formed a bubble. Bubbles tend to burst – this is a mechanism of market self-correction. However, in this case, the burst of the bubble had terrible consequences. As long as the house prices were increasing, a borrower was able to sell the house, once it became unaffordable, at a reasonable price. Once the house prices started dropping, many borrowers with loans not backed by enough equity had to sell beneath the level of the loan. Those borrowers were often unable to afford a new house. The problem was magnified by the high percentage of APR loans, over 40% of all loans by 2004. But how else could the lenders meet their obligations under the CRA, except to give out loans at artificially low initial interest rates? In the same year, interest rates began to rise. By now, all APR loans provided between 1995 and 1999 had switched from fixed to variable interest rate, and monthly payment for many borrowers rose sharply. For millions of low-income borrowers, their homes became unaffordable, because they were bought with artificially low interest rates under the APR terms.

The housing market was consequently flooded with houses for sale, which further drove house prices down. None the less, since Fannie Mae and Freddie Mac were backed by the US government, politicians, government-related experts and CRA-affected institutions claimed that subprime loans were profitable. Partly for this reason, the emerging problems stayed hidden.

In this spiral, the collateralized debt obligations (CDOs, bundles of high risk securities held by investment banks) lost their value. Since these CDOs were used as part of an investment bank’s asset portfolio, the banks leverage ratio increased rapidly to the point where the bank had to declare bankruptcy. This was the height of the subprime mortgage crisis. Clearly, these dynamics have nothing to do with the frequently alleged greed. Rather, we are observing the dire consequences of too much political meddling with private market affairs.

Let us now return to the first paragraph of the blog post:

Fresh off the false and politicized attack on Fannie Mae and Freddie Mac, today we’re hearing the know-nothings blame the subprime crisis on the Community Reinvestment Act – a 30-year-old law that was actually weakened by the Bush administration just as the worst lending wave began. This is even more ridiculous than blaming Freddie and Fannie.

Unfortunately, both the hard data and the links in this blog do not help substantiate the claim that the CRA was not the cause of the credit crisis. In fact, glaring omissions give rise to the question whether the author understood the mechanisms and dynacmis that led to the credit crisis. In addition, the links provided at the end of the blog post are links to pages of similar quality and political leaning. The author would be well-advised to discuss articles of the opposite opinion as well and prove why they are wrong.

In this light, one should start to wonder about the accusation that the know-nothings blame the subprime crisis on the Community Reinvestment Act. The “know-nothings”? Such as the experts at the Heartland Institute? Those at the Cato Institute? What the article really supports, on the other hand, is the notion that a text that starts with polemics and unsubstantiated accusations should make you leery and skeptical.

Finally, we need to ask the question why the CRA and its predecessor, the Free Housing Act, are a liberal brainchild. Is it simply the usual liberal desire for more government intervention? Maybe, and maybe not. Remeber that it was left-radical Saul Alinsky who stipulated the principle that one must organize to rub raw the sores of discontent and that conflict is the basis of community organization. What better way to induce pain and discontent than by driving the masses into bankruptcy? A law that superficially seems to help the poor (to get a house that they wouldn’t be able to afford otherwise). Yet, the long-term consequence is individual bankruptcy and a large-scale credit crisis. To what ultimate terms? To make people more dependent on government largesse. Because, in the consequence, those dependent on goverment subsidies will vote for the party that promises the most largesse – the liberals. What a cynical way to grab more power.