Government’s role in the subprime crisis

| March 19, 2012 | 5 Comments

Could a new paper published by researchers from the Federal Reserve Bank of St. Louis finally answer the question of whether affordable housing laws caused the subprime crisis? 

There are good reasons why this idea has held on for so long. While political biases may be behind its refusal to die, honest observers can also see some logic in the camp of the those who blame Uncle Sam for the subprime crisis. After all, the Community Reinvestment Act did encourage lenders to give poor people more access to credit. And Congress definitely did set explicit targets for Fannie Mae and Freddie Mac to help increase mortgage lending to areas with high levels of minorities and the poor to support affordable housing.

It doesn’t take a big leap to think that the government’s nudges may have led to mortgages being made to people who couldn’t afford to repay them. It makes for a nice, tidy explanation. And heaven knows how we love nice and tidy. But, as Rubén Hernández-Murillo, Andra Ghent and Michael Owyang show, this is actually not what happened.

Their research asks whether there’s evidence that lenders changed their behavior to meet CRA, Fannie or Freddie-mandated goals by:

  • making more subprime loans than they otherwise would have?
  • lending to riskier borrowers than they otherwise would have?
  • charging risky borrowers less than they otherwise would have?

The CRA, Fannie and Freddie have specific metrics for evaluating whether a particular loan — or a loan-turned-mortgage-backed-security — actually qualifies towards their affordable housing or credit access goals. These metrics are generally related to the racial and / or income composition of a certain census tract or individual borrower and serve as strict cut-offs in regards to program goals. For example, if a bank makes a loan to someone whose income is less than or equal to 80% of the median income for that “metropolitan statistical area” then that loan will count towards the bank’s mandate CRA target (that is, if it’s covered by the CRA; not all financial institutions are.) If their income is ever so slightly over this 80% bar, then a loan to them would not help the bank hit its CRA target.

The very presence of these kind of black-and-white thresholds allowed the researchers to use a regression discontinuity approach to see whether there were any statistically significant increases in the number of loans made to people who fell just inside of the threshold as opposed to those who fell just on the outside of it. If the banks were strongly influenced by their desire to meet affordable housing targets then they should have made more of the kind of loans that would qualify and less of the kind of loans that would not qualify. These relative changes should show up as anomalies in an otherwise continuous data pattern, but the researchers’ examinations of 722,157 securitized subprime mortgages made in California and Florida from 2004-2006 found no evidence of this.

The same held true for the other two research questions. Hernández-Murillo, Ghent and Owyang did not find that lenders gave lower (i.e. better) prices to borrowers falling inside the threshold vs. those falling outside. Nor did they find evidence that lenders lent more often to qualifying riskier borrowers (those who would go on to be seriously delinquent within the first two years after receiving the loan) than they did to riskier borrowers whose loans would not qualify.

So, to recap, the subprime story went something like this: foolish borrowers borrowed and foolish lenders lent. The evidence appears to show that lenders did not change their behavior in order to hit the affordable housing targets that the government imposed on them. While the government’s programs to encourage affordable housing may have other flaws they did not, at any rate, directly cause the subprime crisis. Myth busted.

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Category: Housing

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  • Anonymous

    Ritholtz and Yves Smith explained this quite a while ago in internet time. CRA loans likely came out better than the subprime and prime originated by private mortgage bucket shops simply because the banks subject to CRA likely did more due diligence on the CRA loans simply because there would be more scrutiny of them. Countrywide et al weren’t under CRA and simply cranked out fake loans as fast as their greedy pudgy little fingers could type in imaginary numbers.

    • Finance Addict

      Indeed, some of the researchers’ results support this theory, proving that a loan made to a borrower with income less than the median income in the Metropolitan Statistical Area was 2% less likely to default than one that did not qualify for Fannie / Freddie’s income goal.

  • David_Merkel

    “Our results indicate that the extensive purchases of risky private-label mortgage-backed securities by the GSEs were not due to affordable housing mandates.”

    That is the relatively limited finding of this paper, which examined two hot markets during the worst of the origination. It doesn’t mean that by providing a ready market for Subprime RMBS, the GSEs did not add to the crisis. It also does not mean that the GSEs did not add to the crisis by guaranteeing more & more debt against housing which with easy monetary policy, led to overborrowing against housing, helping to create a speculative bubble.

    Don’t get me wrong, I have not been in the camp that says the CRA or affordable housing mandates drove bad lending. I do think the GSEs played a moderate role in the crisis, mainly through facilitating too much seemingly normal lending as house prices rose too rapidly. Same for the Mortgage Insurers and Home Equity Lenders who allowed deposits to drop to minuscule levels.

    There’s a lot of blame to go around in the financial crisis, I think the GSEs deserve some of it, but they don’t get star billing either.

    • Finance Addict

      To expand on my Twitter comment, if the GSEs are guilty of anything than it seems to me to be more a halo effect of their general, gargantuan role in the housing market. (A role that’s being greatly debated.) If I had to describe it in my own words I’d say that the GSEs have two missions: (1) to give broad support to the housing market and (2) to encourage the fulfillment of narrow goals around providing affordable home ownership to minorities and low-income support. The research paper hones in on goal 2, but goal 1 certainly had a lot to do with the general carelessness seen in the market.

      I agree: the researchers do take a very narrow focus and this is an interesting counterpoint to the similarly narrow focus of observers who swore that there had to be a direct link between affordable housing goals & subprime. (And who may well continue to think so, despite this evidence to the contrary.)