Did anti-discrimination efforts lead to the sub-prime mortgage bubble?

Question

In this article on Bloomberg, it seems clear that the goverment is forcing banks to issue risky loans.

Is the government really being this stupid, or is there more to it that this article does not mention?

Edit: Clarify: The article seemed to show that the government was again trying to force banks to make risky loans. That sort of activity was one of the things many people pointed to as a cause of the meltdown. Can anyone could show that the gov't wasn't being as imprudent as the article seemed to indicate? Maybe someone could show me that the gov't was just telling them to go into low income or minority areas but still use sensible lending techniques.

Answer 1

There are a couple of points to be made here:

1. Yes. The government did, indeed, force the lenders to make riskier loans in the name of combating real and/or perceived discrimination. The most relevant example is the Community Reinvestment Act (CRA) - most notably, the 1993-1995 changes driven by President Clinton's administration.

   Please note that "riskier" here is a technical financial term. While I don't have a public cite, I have seen first hand reports that showed higher risk on the loans specified to be in red-line zones vs outside them, with all other loan factors being equivalent.

2. No, CRA did not have any direct major contributions to the 2008 meltdown.

   The most relevant reference is a paper by a former Fed Governor Randall Kroszner titled "The Community Reinvestment Act and the Recent Mortgage Crisis". Too much to cite (and most of it relevant), so only a small quote here:

   We found that the loans that are the focus of the CRA represent a very small portion of the subprime lending market, casting considerable doubt on the potential contribution that the law could have made to the subprime mortgage crisis.

   Second, we asked how CRA-related subprime loans performed relative to other loans. Once again, the potential role of the CRA could be large or small, depending on the answer to this question. We found that delinquency rates were high in all neighborhood income groups, and that CRA-related subprime loans performed in a comparable manner to other subprime loans; as such, differences in performance between CRA-related subprime lending and other subprime lending cannot lie at the root of recent market turmoil.

3. Interestingly enough, outside of subprime metdown effects question, CRA may not have actually had ANY measurable effect in the first place.

   In a 2003 research paper "The Effects of the Community Reinvestment Act on Local Communities", economists at the Federal Reserve could not find clear evidence that the CRA increased lending and home ownership more in low income neighborhoods than in higher income ones.

   Federal Reserve chair Ben Bernanke has stated in "The Community Reinvestment Act: Its Evolution and New Challenges" that an underlying assumption of the CRA – that more lending equals better outcomes for local communities – may not always be true and is hard to measure:

   The CRA is clearly far from perfect. Although its objectives are broad and ambitious, its net effects on lower-income neighborhoods are difficult to measure with precision.

4. Interestingly enough, that second reference (Bernanke speech) also notes that at least in some instances:

   "the CRA has served as a catalyst, inducing banks to enter under-served markets that they might otherwise have ignored".

   However, there's no data in that speech to indicate whether that catalyst effect may or may not have had anything to do with the bubble (the speech is from 2007).

5. However, the anti-discrimination angle contributed to preventing the government from strongly pushing to STOP the proliferation of sub-prime loans by all actors, CRA related or not (as such an effort, pre-2008 crisis, would have had really bad political optics).

   Would such an effort have prevented the crisis? Likiely no - there were many other factors to the meltdown (too many and too far off-topic for the question to list).

   Would it have made the crisis smaller? It would have. Subprime and derivatives based on it were a major driver in the speed of the meltdown - with less of them unwinding the bubble would have been cheaper/easier.

   Would such an effort have been made had the anti-discrimination angle not been in play? Pretty hard to answer objectively.