How did the Community Reinvestment Act help trigger the sub-prime lending crisis, and the economic crisis of 2008 in the United States?

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Answered by: Forrest, An Expert in the News, Views and Matters Category
As the United States heads toward 2011, it struggles with a crisis and destruction of wealth that can be said to be never before witnessed in human history. A large portion of this economic distress was caused by the housing bubble bursting. This bubble was caused, as most are, by government intervention in the free market. One of these interventions was the Community Reinvestment Act. Even though it gave access to home loans for more Americans, the failure of the Community Reinvestment Act has contributed heavily to the recession in the United States.



     Some people believe that the Community Reinvestment Act has proved beneficial to underprivileged minority communities in the United States. Simone Flynn states that, “ Minority communities in the United States have experienced unequal and lagging economic growth and development throughout the twentieth century. The economic inequality experienced by minority communities, in part, was created or exacerbated by the unwillingness of banks to fully service minority communities” (2010, para.1). What this view fails to recognize is the changing composition of these communities throughout the twentieth century. Many of these groups are no longer considered minorities, are assimilated and have become more affluent. These groups; such as the Irish, Italians, Jews, Germans, Catholics, Cubans, and many other ethnic and religious groups who entered this country succeeded without the Community Reinvestment Act. This statement reflects a historical disconnect, which is disconcerting.

     Flynn goes on to point out that the banks pulled money out of these communities and reinvested that money in more affluent communities(2010, para.2). This is a statement less than true. The lending institutions are companies with shareholders who must produce a profit. That these institutions could not loan to persons incapable of paying back the loans, is a very clear principle. For these organizations to do so would be criminal, and their board of directors would be facing criminal prosecution for such business practices. Also, these institutions did not take the deposits away from the people. They reinvested the money to produce interest to pay the depositors no matter what community they were from. This money did not disappear, but it returned to the community as interest.



     The Community Reinvestment Act was intended to end the practice of redlining or not lending to certain low and middle income parts of the community. It forced banks to loan to people who could not pay back these loans. The government used the threat of blocking expansion or mergers of the banks that did not meet the criteria of the Community Reinvestment Act. This gave organizations such as ACORN the ability to black mail the banks. The tactics used by these community groups is to sue a bank claiming that the bank is in violation of the Community Reinvestment Act. The bank settles out of court to avoid damage to their reputation, and the community group uses that money to buy political influence. There is an enormous level of corruption that has taken root because of this aspect and use of the Community Reinvestment Act. These tactics are an example of the unintended consequences of government intervention in the free flow of the market.

      The testimony of Calvin Bradford, a board member of the National People's Action Committee, before Congress on April 15, 2010 is a good example of how the community organizations have attempted to use the Community Reinvestment Act to gain political power and rewrite history. Their goal is to continue the ruinous practices of the Community Reinvestment Act. Mr. Bradford sat before the committee and blamed the greed of Wall Street for the collapse of the housing market (Bradford, 2010), when the banks were only doing what the United States government had forced them to do. If the banks had used sensible criteria for loans the sub-prime market would never have developed as it did. From Census data, sub-prime mortgages are much more likely to default. It is nonsense to allow the practice of forcing banks to make these risky loans. This data gathered confirms that over an 18 year period the sub-prime defaults were on a steady rise, and the default rate exploded in 2008.

( United States Census Bureau, 2010).

     A steady rise of sub-prime mortgage defaults over an 18 year period can be confirmed from the data. In 1990 the sub-prime market was so insignificant that the statistics were not recorded. Then as the decade progressed, and new rules were added to the Community Reinvestment Act, the defaults climbed steadily. In this 18 year period the default rate for sub-prime mortgages was always higher than the other types of mortgages but in 2008 the default rate exploded as the bubble burst.

     The Community Reinvestment Act started out as a way to assist poor minority communities, but as with all government programs it developed into a monstrosity that went beyond its original intent. Every year the Congress added more and more groups and income classes that were eligible to receive these loans. By the late nineties the legislation had nothing to do with the original Community Reinvestment act. In 1999 President Clinton signed into law the Gramm-Beach-Lilley Act, which allowed banks to enter into investment, commercial banking, and insurance. This act repealed part of the Glass-Steagall Act that had been enacted after the market crash of 1930 to prevent such a crash from happening again. This allowed banks to provide investment banking services, exposing the banks to these risks again.

     The Gramm-Beach-Lilley Act opened the door to a practice that proved to be catastrophic. This practice is called securitization, where the bank essentially sells the mortgage that they underwrote to an investment bank allowing the bank to underwrite another mortgage instead of holding the original mortgage to maturity. This turn over allowed the banks to increase revenues by allowing more transaction fees to be collected. Because of the fact that these very same banks could act as investment banks, it led to the double exposure of the banks. Banks began making risky loans because they knew that these risky loans would be bundled and sold on to someone else as a solid package. The investors that bought these bundled loans, were led to believe that the government owned mortgage security companies Fannie-Mae and Freddie-Mac would back these questionable loans with the good faith and credit of the United States. These investors were not just risk takers, but pension plans, banks(foreign and domestic), investment banks, and hedge funds.

     The practice of securitization with the implied backing of the United States government led to money flowing into the United States housing market from around the world. This combination of low interest rates and easily available money caused increased demand for real estate. Scarcity was driving housing prices up at an unnatural rate leading to speculation by banks and homeowners. These factors created the housing bubble.

     As the market grew an aspect of the sub-prime market developed known as the credit default swap. This is practically an insurance for the mortgage backed securities being sold to investors. As the market started to collapse, it became apparent that the entities providing these credit default swaps would have to pay out. This caused even more uncertainty in the market, and this is what caused the problems at AIG, one of the biggest insurers on the planet. The mortgage crisis affected every level of the financial markets throughout the world. To say that the Community Reinvestment Act had no effect on financial markets is to deny that the meltdown ever happened. The financial uncertainty has led to massive unemployment because companies are slimming down to weather the financial storm.

     A market will adapt to its environs, and the banks were no exception. Executives in the finance industry receive bonuses for performance. This is a large part of their pay. For the executives it was a question of increasing the rates of return to increase their bonuses, and mortgage backed securities were an easy way to do this. These executives also faced clamoring shareholders that wanted the returns on investment that other investors were receiving. The Gramm-Beach-Lilley Act allowed banks that could not enter the securities markets before to now do so. The promise of huge profits was irresistible. No one wanted to see that the markets don't just go up, they also go down.

     After the housing bubble burst in 2008 there were still voices raised to continue these practices. Congressman Luis V. Gutierrez, Democrat, Illinois, Chair Subcommittee on Financial Institutions and Consumer Credit Committee on House Financial Services Subcommittee on Financial Institutions and Consumer Credit claimed in a statement in April, 2010 that the Community Reinvestment Act had no effect on the current economic situation in the United States. He also stated that the law did not go far enough (Gutierrez, 2010).

     It is common knowledge that the mortgage crisis led to the economic crisis in the United States and the world. The Community Reinvestment Act created the groundwork for the crisis. He is correct that the Community Reinvestment Act did not create the crisis, but it did make the crisis possible by creating the sub-prime loan market. Banks simply took advantage of the new ground rules to earn money quickly, and regulators turned a blind eye because what the banks were doing fit the agenda of Washington D.C. elites.

     One of the people who presided over the collapse was Representative Barney Frank, Chairman of the House Committee on Financial Services. Mr. Frank stood on the floor of the House of Representatives in 2005 and made a speech expressing the opinion that there was no need for concern about a possible housing bubble, and a year later he became Chairman of the House Committee on Financial Services. In 2003 and 2006 Representative Frank led efforts to block the reform and regulation of Fannie-Mae and Freddie-Mac. These two government entities were buying up these loans , and then selling them as investment on the open market. He claimed there was nothing to worry about in the housing market. He and Senator Shumer have fought any attempt to regulate Fannie-Mae and Freddie-Mac even though the level of impropriety at these two organizations has been enormous. These failures in judgment because of ideological beliefs have cost the United States taxpayer trillions of dollars, and the downturn in the housing market has destroyed capital that could have been used for investment and job creation.

     The two organizations in question, Freddie Mac and Fannie Mae, are entities that should not exist according to a strict interpretation of the Constitution of the United States. They are government sponsored enterprises. This means these two entities are backed up by the good faith and credit of the United States. The United States government, therefore the taxpayer, is responsible for any financial losses these organizations produce. The Fannie Mae website states,

      Fannie Mae is a government-sponsored enterprise (GSE) chartered by Congress with a mission to provide liquidity, stability and affordability to the U.S. housing and mortgage markets

     Fannie Mae operates in the U.S. secondary mortgage market. Rather than making home loans directly to consumers, we work with mortgage bankers, brokers and other primary mortgage market partners to help ensure they have funds to lend to home buyers at affordable rates. We fund our mortgage investments primarily by issuing debt securities in the domestic and international capital markets (About Us, para. 1).

     As the Fannie-Mae website states, This organization is responsible for the securitization of Mortgages. Freddie Mac is the same type of entity with the same charter as Fannie-Mae(Freddie Mac, 2010). These two organizations are the only Fortune 500 companies to be exempt from regulation (Berlau, 2010), and it is documented that the executives at Freddie-Mac were caught altering the books in 2003 to provide for large bonus payouts to the executives of Freddie-Mac by hiding losses.

     The sub-prime crisis alone did not cause the recession. The loss of confidence by investors and the consumer were also a factor. The investors pulled money out of the market, and the consumer stopped spending because they did not know what was on the horizon. Lack of demand and uncertainty caused Companies to began letting workers go to keep up profitability and maintain their book value. This created high unemployment. The pullback caused a snowball affect that almost destroyed the economy.

     It is uncanny that the United States government continues to support sub-prime lending, and keeps funding the financial ineptitude of Fanni Mae and Freddi Mac. The United States government is the largest loan guarantor in the world. The only reasonable choice is to stop guaranteeing these bad loans and allow the market to correct itself to avoid future crises. As the market normalizes housing prices will stabilize and slowly increase to a true market value, eliminating the bubble.

References

Berlau, J. (2010). Mortgage Giants May be in Trouble. Bnet, CBS Business Network, CBS      News. Retrieved from http://findarticles.com/p/articles/mi_m1571/is_2003_July_8/ai_104842029/

Calvin, B., Board, M., & National People`s, A. (n.d). Community Reinvestment Act. FDCH      Congressional Testimony, Retrieved from Masterfile Premier database.

Fannie Mae. (2010). Fanniemae.com. Retrieved from http://www.fanniemae.com/kb/index?      page=home&c=aboutus

FDIC: Federal Deposit Insurance Corporation. (2010). FDIC: Federal Deposit Insurance      Corporation. Retrieved from http://www.fdic.gov/index.htm.

Flynn, S. (2008). Community Reinvestment. (p. 1). Great Neck Publishing. Retrieved from Research      Starters - Business database.

Freddie Mac. (2010). Our Mission - Freddie Mac. Retrieved from      http://www.freddiemac.com/corporate/company_profile/our_mission/index.html

Gutierrez, L. G., Chair, & Subcommittee on Financial Institutions and Consumer, C. (n.d). Community      Reinvestment Act. FDCH Congressional Testimony, Retrieved from Masterfile Premier database.

House Committee on Financial services. (2010). House Financial Services Committee. Retrieved from           http://financialservices.house.gov/index.shtml.

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