Note on Community Reinvestment Act

It is easy to forget, but when the financial crisis first hit, there was a pet theory being floated out by conservatives that this was all caused by the Community Reinvestment Act. The Community Reinvestment Act prevents certain banks from using redlining and other racially discriminatory lending practices. Not surprisingly, conservatives have never been big fans.

Quickly, anyone with any sense realized that blaming the CRA — a 30-year old law — was on its face absurd. So the right-wingers shifted to a slightly less absurd but still wrong theory that blamed Fannie and Freddie. That theory also met with broad scorn, but as far as I can tell it is still the leading theory on the right. Sure it’s not a very good theory and is directly contradicted by the evidence, but at least it does not point the fingers at the private financial sector.

Noah Smith has a blog post about the Community Reinvestment Act arguments today that is worth reading. In it, he makes the broad theory point as to why, by definition, the Community Reinvestment Act could not have caused the financial crisis. The short of it is that whatever extra risk the CRA created for lenders, it would have been priced into the securities, and the crisis could not have resulted. As it turns out, the financial sector almost uniformly mispriced mortgage-backed securities, which is what set the stage for the unraveling that generated the crisis.

It deserves adding here that — theoretically-necessary financial sector incompetence aside — there is actually very little empirical support for the idea that the CRA had any meaningful effect on the financial sector. There just weren’t a lot of CRA subprime loans, and they were half as likely to default as non-CRA subprime loans, as the Financial Crisis Inquiry Report points out:

The Commission concludes the CRA [Community Reinvestment Act] was not a signifcant factor in subprime lending or the crisis. Many subprime lenders were not subject to the CRA. Research indicates only 6% of high-cost loans — a proxy for subprime loans — had any connection to the law. Loans made by CRA-regulated lenders in the neighborhoods in which they were required to lend were half as likely to default as similar loans made in the same neighborhoods by independent mortgage originators not subject to the law.

Noah’s point is an especially important one though and deserves highlighting. There is an entire craft industry of people wanting to blame this or that thing on the financial crisis, all to avoid pointing fingers at the utter failures of financial industry professionals. But the fact is, whatever policies existed and however bad you might think they were, none of them forced financial firms to assume financial positions that bankrupted themselves. They did that on their own. Were they as smart as they pretend to be, they would have assessed the risks of any policies out there and priced them in. Their failure to do that — these the smartest guys in the room — is what generated the financial crisis, and that is true necessarily.