I applaud Mike at Rortybomb, among others, for being able to take John Carney’s criticisms of CRA lending seriously when Carney says

Banks making CRA loans initially expected that defaults would be higher due to lax lending standards. When they discovered the low-income borrowers had an unexpected propensity to pay their mortgages. After years of data poured in showing that borrowers were paying mortgages despite high LTVs, low down payments and unconventional income measures, bankers began to believe that many of the traditional measure of credit worthiness were overly conservative.

So here is Carney’s story

1) Government suggests that low income borrowers are being unfairly overlooked and pushes banks to extend loans to them under the CRA

2) Banks extend those loans and to the banks’ surprise the loans are good

3) CRA = FAIL

What?

To be fair to Carney he suggests that the CRA data was misleading. Other financial institutions looked at these good CRA loans and thought, hey why not throw out all the rules. In this way CRA surved as the seed of the crisis.

I am doubtful about this part of the story. I think the spread more has to do with widespread increases in risk taking in all credit products. This risk taking was the result of innovations in the way loans were cut-up and sold. However, lets assume that Carney is right. How is that the fault of the policy? The policy says “banks try to do X because we think it’s not as bad as you think.” It turns out not to be as bad as the banks think. This is an amazing success, given the hubris involved in the government suggesting loans to banks. (As a side note Ben Bernanke had a first-mover disadvantage theory as to why such a policy might work.)

The fact that other financial institutions, in attempt to maximize profits, incorrectly used existing data is not the fault of the policy that created the data. At its core the problem is that profit-maximizing institutions engaged in practices which increased aggregate risk. I still suspect that in a world where there was only one subprime lender things would have turned out much better for that institution. Perhaps not on net profitable, but not a wild risk.

My own conjecture is that when one lender engages in this type of lending it increases the risks to other lenders because it distorts home prices both on the way up and on the way down. That is, subprime and other exotic lending leads to over-valued homes, which in turn leads to loans that are larger than the long term equity in the house. Subprime and exotic loans also increase the risk of foreclosure which artificially depresses home values and restricts the ability of troubled borrowers to refinance. In short, each individual lender contributed slightly to a bubble that increased risk for all lenders.

I know Mike and others have a less charitable view. Hopefully a detailed post-mortem can figure out who’s right but so far I have seen no compelling evidence in favor of the CRA theory.

About these ads