What caused the mortgage mess?
By Holden Lewis • Bankrate.com

Some people blame a fair-lending law for the mortgage meltdown and the resulting global financial crisis. Evidence shows otherwise.

The Community Reinvestment Act, passed in 1977, requires banks to extend loans where they accept deposits. It was conceived as a way of fighting redlining -- the practice of denying loans to residents of minority neighborhoods. Conservatives have periodically criticized the fair-lending law, saying, for example, that it discourages banks from opening branches in poor districts. The latest salvo from conservatives began via a Sept. 15 editorial in Investors Business Daily, titled "The Real Culprits in This Meltdown."

"Tough new regulations forced lenders into high-risk areas where they had no choice but to lower lending standards to make the loans that sound business practices had previously guarded against making," Investors Business Daily said in the editorial.

The newspaper didn't get the name of the law right, initially calling the target of its ire the Community Redevelopment Act. Its editorial blamed President Clinton for today's mess because, by encouraging minority homeownership, "he helped create the market for the risky subprime loans that he and Democrats now decry as not only greedy but 'predatory.'"

A week later, The Wall Street Journal editorialized that the CRA "compels banks to make loans to poor borrowers who often cannot repay them." On Sept. 25, U.S. Rep. Michele Bachmann, R-Minn., told the House Financial Services Committee that because of the CRA, "loans started being made on the basis of race, and often on little else." The blaming of the CRA for the mortgage mess continued up to the election.

The critics are wrong, experts say.

"It certainly wasn't the CRA," says Kenneth Thomas, author of two books about the law ("Community Reinvestment Performance" and "The CRA Handbook"). Thomas says you could just as easily blame the Sept. 11 terrorists (because the Fed slashed short-term interest rates afterward), or the Chinese (for buying so many bonds during the subprime boom). In other words, he thinks it's a huge stretch to blame the CRA on lenders' bad decisions.

There are three reasons to exonerate the Community Reinvestment Act in the mortgage meltdown.

Why CRA is not to blame

• The CRA applies to banks. Most subprime mortgages came from lenders that were not banks -- so the CRA did not cover them. • The nonbank lenders made more reckless lending decisions than banks did. • Regulations didn't drive the subprime lending boom. The pursuit of profits did.

"How people can think that a law that's been on the books for 30 years somehow precipitated or caused the subprime crisis is beyond me," says Ellen Schloemer, director of research and communications for the Center for Responsible Lending, a nonprofit group that fights predatory lending practices.

Most subprime lenders weren't even governed by the CRA because they weren't banks, Schloemer says, mentioning two nonbank lenders that went belly-up early in 2007: Ameriquest and New Century.

Of the roughly 300 failed institutions listed on the Mortgage Lender Implode-O-Meter site, the vast majority were not chartered banks. Because they weren't deposit-taking banks, they didn't have to abide by CRA rules. Time after time, lenders closed their doors because they couldn't afford to buy back the bad loans they had originated and quickly sold on the secondary market. (Like a grocer selling spoiled milk, if a lender sells a loan that goes bad right away, they have to buy it back.)

Some lenders advertised their lending policies in their names. What did customers of No Red Tape Mortgage expect? How about Right-Away Mortgage? Is anyone surprised that both Southern California-based lenders went under in June 2007, a few months into the subprime debacle?

In February 2004, Fed Chairman Alan Greenspan endorsed alternative mortgages in a speech at a conference of the National Credit Union Association. "American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage," Greenspan said. Soon stated-income loans and subprime piggyback mortgages flooded the market as profit-hungry lenders offered "creative" home financing.

"When people talk about 'creative' or 'creativity' in credit, it usually means lower credit standards," says Alex Pollock, a resident fellow at the American Enterprise Institute. He says this is a lesson "which we rediscover periodically."

One place to point the finger
For his part, Thomas believes he knows where to place most of the blame on the mortgage mess. "The real answer is in two acronyms associated with former Fed Chairman Alan Greenspan: TLTL and LTMR," he says.

TLTL stands for "too low, too long," and refers to the 2003-2005 period when Greenspan kept the federal funds rate so low that the real or inflation-adjusted federal funds rate was below zero. The federal funds rate was 2 percent or lower from November 2001 to December 2004. That roughly coincides with the most inflationary period of the housing bubble.

LTMR stands for "let the markets regulate." Greenspan was an ardent proponent of self-regulated markets, but he told Congress in late October that "this breakdown of the central pillar of competitive markets" in mortgages requires "additional regulatory changes." But he added that any new regulations "will pale in comparison to the change already evident in today's markets."