The American Mortgage System: Crisis and Reform

7. Constructive Credit: Revisiting the Performance of Community Reinvestment Act Lending During the Subprime Crisis

C h a p t e r 7 Constructive Credit: Revisiting the Performance of Community Reinvestment Act Lending During the Subprime Crisis Carolina Reid and Elizabeth Laderman In 1977, when advocates and legislators were first debating the merits of Senate Bill 406, the Community Reinvestment Act (CRA) of 1977, the key question confronting Congress was whether or not “redlining”—the practice of denying access to credit based on where one lived—was contributing to the decline of inner-city neighborhoods. Advocates argued that banks had a social responsibility to reinvest locally held deposits back into the communities where they had branches; in short, the savings of residents in the inner city should not be directed to promote homeownership in the suburbs. Evidence of geographic discrepancies in areas where local banks were lending , coupled with testimony by Ronald Grzywinski, one of the founders of South Shore National Bank of Chicago that was successfully lending in formerly redlined communities, led Senator William Proxmire to conclude that banks did have an obligation to lend in the same communities in which they were taking deposits and that this could be done in a way that would not require credit allocations or pose undue risks to the institution. In defending an attack on the proposed legislation by the American Bankers Association, Senator Proxmire noted, “What we are trying to do here is not provide for 160 Carolina Reid and Elizabeth Laderman any terrible sanction or require that you make loans that aren’t sound. Every loan should be sound. . . . All we are saying is that the job that you do in servicing community needs should be taken into consideration as one element in whether or not branching should be approved. It is a mild proposal, it seems to me” (Proxmire 1977: 323). Indeed, in both its intent and its enforcement mechanism, the CRA sought only to underscore the “long-standing obligation to an institution’s local service area implicit in existing law” and provide the regulatory agencies with the authority to enforce this principle. Three decades later, the subprime crisis has led to a renewed debate about the CRA and whether or not it somehow encouraged banks to make unsound lending decisions. Economist Thomas DiLorenzo, for instance, wrote that the current housing crisis is “the direct result of thirty years of government policy that has forced banks to make bad loans to uncreditworthy borrowers ” (DiLorenzo 2007). This “blame the CRA” story has been refuted by industry leaders and researchers. Researchers at the Board of Governors of the Federal Reserve found that the majority of subprime loans were made by independent mortgage lending companies, which are not covered by the CRA and receive less regulatory scrutiny overall (Avery, Brevoort, and Canner 2007). In addition, our previous work found that loans made by CRAregulated institutions in California performed better on average than loans made by institutions that were not covered under the CRA (Laderman and Reid 2009). While these research papers have failed to appease CRA’s most vocal critics, the intent of this chapter is not to disprove once again the idea that the CRA is to blame for the subprime crisis. Instead, a much more important question is whether or not the CRA succeeded in providing access to credit to residents of historically underserved communities. Did financial institutions covered by the CRA make loans in low- and moderate-income (LMI) communities during the subprime boom? Perhaps more important, did those loans provide constructive credit in the community—in other words, were the loans fairly priced, and did they help borrowers not only achieve but also sustain homeownership? Or did the loans contribute to the current community development crisis, in which neighborhoods are struggling not with suburban flight but rather with the negative spillover effects resulting from subprime lending and subsequent foreclosures? Simply put, during the most recent period when an explosion of private mortgage lending occurred, did the CRA perform as its authors intended? If not, what can we learn from the recent crisis for possibly restructuring the CRA? Constructive Credit: Community Reinvestment Act Lending 161 To help answer these questions, we analyze mortgage lending patterns and loan performance in three states: California, Ohio, and Pennsylvania . These states represent three distinct housing and mortgage markets. California characterizes the boom-and-bust model of the market, with a period of high price appreciation followed by severe house price declines and a rapid and dramatic...