The Community
Reinvestment Act (CRA) was enacted to give credit to all market groups
including the low and moderate-income groups or communities and the minorities.
Throughout its long history the CRA has been criticized as not having been able
to enhanced access to credit to these groups at low cost. Critics of the CRA
have even argued that it is ineffectual and lawless. Moreover, others argued
that CRA is a great load to bear for the financial institutions since they are
forced to comply with the requirements, which in effect forces them to lend to
uncreditworthy lenders. As the financial institutions lend to unworthy lenders,
this then creates the present subprime mortgage crisis. This paper aims to
analyze the Community Reinvestment Act as the main cause of the present
subprime mortgage crisis and to find possible solution to the crisis.
Community Reinvestment Act
The
Community Reinvestment Act (CRA) was enacted in 1977 by the United States
Congress to “encourage depository institutions to help meet the credit needs of
the communities in which they operate” (CRA, 2008). In other words, the CRA was
enacted to prevent redlining[1]
and to encourage the banks to extend credit to all the segments in their
community, including the moderate and low income neighborhoods. Under the Act,
the federal financial institution regulators, the Office of the Comptroller of
the Currency, Board of Governors of the Federal Reserve System, Federal Deposit
Insurance Corporation and Office of Thrift Supervision, assess the record of
the banks and thrifts in helping their community in terms of the aims of the
act. At he same time, the assessment of records are considered in evaluating
the applications of the banks and thrifts for bank mergers, branch openings and
acquisitions (Community Reinvestment Act Information, n.d.). The Act applies to
all federally insured depository institutions, thrifts, national banks and
state chartered commercial and savings banks.
In
1995, the revision to the Act included increasing the amounts of loans to small
business and to the low and moderate income borrowers for their home loans.
This created the subprime mortgages which now have escalated into a crisis.
A
subprime loan is the loan “offered at a
rate greater than the prime rate”. This is offered to those who do not qualify
for prime rate loans[2]
(Smith, 2007). For those who do not qualify for the prime mortgage loan, the
banks are then forced to give out subprime mortgage loan in order to comply
with CRA.
Community Reinvestment Act and Subprime
Mortgage Crisis
The Community Reinvestment Act and
its subsequent revisions force banks to give out loans to low income borrowers
and “communities of color” even though they would have otherwise failed on the
basis of capacity to pay (DiLorenzo, 2007).
The lobbyists of the CRA were the
community groups or “neighborhood organizations” such as the ACORN (Association
of Community Organizations for Reform Now). These community groups benefited
from the CRA since any protest from the community group on a certain bank can
postpone or stop the bank’s merger, expansion and creation of new branch. This
gives the community groups leverage over the bank and uses it to force the bank
to give them undeserved loans.
Thus, the banks had no choice but to
accept bad loans, the ones from the subprime properties, the “subprime loans”.
Now, to compensate for these bad loans, the banks increased their lending fees
or charged higher rates on those they deem riskier loans. The community groups
then complained and several price control lending laws were passed in many
states. This caused the many mortgage lender bankruptcy in the past years.
To add to the problem of subprime
mortgage, the Fed’s monetary policy caused an increase in real estate values in
almost all the cities in the US
in the past decade. Thus the subprime borrowers, in order to qualify for
mortgage loans, they took out adjustable rate mortgages. This rate offers low
first year rates but higher rates on the succeeding years. Thus, as soon as the
first few years are over the subprime borrowers can no longer afford to pay
their higher mortgages. This then creates foreclosure of the property (Smith,
2007).
Cleveland exemplified the subprime crisis
being experienced by many states at present. Cleveland is a poor working class city which
due to the decline of manufacturing and racial divisions was recently hit
economically. Now, the mortgage brokers offered these subprime mortgages to the
working class black areas. Most of them already had homes but the brokers told
them that they can refinance their homes and get cash.
These
brokers did not explain the resetting or increase of rates of their mortgages
in after 2 years. As a result, the city experienced repossessions which
devastated the neighborhoods in the city and the suburbs. By 2007, 1 in 10
homes in Cleveland
have been repossessed by the Deutsche Bank Trust (The US sub-prime, 2007).
Conclusion
As
demonstrated by effects of subprime in Cleveland,
other states are also experiencing the same crisis. In fact, the problem of
subprime crisis has already spread nationally by 2005. As of 2005 1 in every 5
mortgages are subprime. At the same
time, the mortgage rates are expected to reset to higher rate in the next
years. Thus, more foreclosures are estimated. In fact, it is estimated that
more than 2 million families will have their homes foreclosed in the next two
years (The US sub-prime, 2007). The wave of repossession or foreclosure is
expected to cause a new trend in house price. As more and more homes are
repossessed, the prices of house will crash. This will cause national decline
in house prices by 10% in the next year, particularly in the areas where there
was a boom, such as in California and Florida (The US
sub-prime, 2007).
Consequently,
as the house price crash, the US
building industry, which makes us 15% of the US economy, is expected to suffer.
It will lose about one to two million jobs and will cut its productivity or
output by half. Other industries are expected to follow and the economy is
expected to slow down by 1.5% (The US sub-prime, 2007).
At
the same time, since experiencing the foreclosure of their homes, many will be
reluctant to spend beyond their current income on credit. While at the other
side, the banks will cut back on how much credit they will give. These will
then add to the slackening of the economy, more bank losses and eventually the
collapse of the bond market. In fact, it is estimated that the losses of
financial institutions is between $220b and $45b, as the subprime mortgage
bonds of $1 trillion is revalued (The US sub-prime, 2007).
Although
there were other factors which are also instrumental to the subprime crisis,
tracing back the effects of the Community Reinvestment Act shows that it is the
main cause of the present housing problem in the US. At the same time, it created major
economic problems as other industries were eventually affected.
Recommendation
As a proposal to solve the problem,
the administration is urging the industry to renegotiate rather than repossess
(The US sub-prime, 2007). However at present many of the banks are facing cases
of foreclosure that before the negotiation takes place, millions of properties
will have been repossessed. Another proposal is the bank bail out by the
Federal Housing Administration. According to some economists, this will only create
“moral hazard” which will encourage more bad loans to be given in to
un-creditworthy borrowers (DiLorenzo, 2007).
To solve the problem of subprime
crisis caused by the Community Reinvestment Act, it is important to first
acknowledge that indeed the CRA is the root cause of the problem. Having done
so, revision of the ACT is pertinent. The ACT should be again revised to
reverse the problem it has created. More stringent rules should be applied for
housing loans and small business loans. At the same time, the mortgage rates
should be controlled so that the homeowners will be given the chance to pay for
their loans in a more realistic set up. The first two years of low rates
followed by a higher and variable rate should be revised into a fixed and affordable
rate. The banks may lengthen the years of payment to cover all the payments. As
for the losses on the banks, the Federal Housing Administration should give
loans to the banks, without interest, to cover the subprime loans. The banks
shall then pay the FHA as homeowners begin to pay their mortgages. These will then reverse the housing price
crash which creates the present economic stagnation.
Works Cited
CRA. 2008. Community Reinvestment
Act. FFIEC.
Retrieved 20
February 2008 from
http://www.ffiec.gov/CRA/
Community Reinvestment Act
Information. n.d. Office of the Comptroller of the Currency.
Retrieved 20
February 2008 from
http://www.occ.treas.gov/crainfo.htm
DiLorenzo, Thomas J. 2007. The
Government-Created Subprime Mortgage Meltdown.
LewRockwell.com.
Retrieved 20 February 2008 from
http://www.lewrockwell.com/dilorenzo/dilorenzo125.html
Have Banks, After 25 Years, Made
Peace with the Community Reinvestment Act? 2002.
Knowledge at Wharton.
Retrieved 20 February 2008 from
http://knowledge.wharton.upenn.edu/article.cfm?articleid=623
Smith, Lisa. 2007. Subprime Loans:
Buyer Beware. Investopedia. Forbes.com
Retrieved 20
February 2008 from
http://www.forbes.com/investoreducation/2007/08/27/subprime-credit-default-pf-education-in_ls_0827investopedia_inl.html
The US sub-prime crisis in graphics.
2007. BBC News
Retrieved 20
February 2008 from
http://news.bbc.co.uk/2/hi/business/7073131.stm
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