Community Reinvestment Act (CRA)

 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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[1] The practice of geographic discrimination in the granting of credit to qualified, though low- or moderate-income applicants, in certain neighborhoods (Have Banks, 2002)

[2] With Credit score of 620 or bellow

Credit Risk Management Analysis of Canadian Imperial Bank of Commerce (CIBC)

I. Executive Summary

Canadian Imperial Bank of Commerce (CIBC) is one of the leading North American financial institutions. It has over 140 years of serving clients in Canada and around the world. Through its two distinct business lines, the CIBC Retail Markets and the CIBC World Markets, CIBC provides a full range of products and services to almost 11 million individual and small business clients and meets the financial needs of corporate and institutional clients. In 2007, revenue was $12.1 billion and net income was $3.3 billion. At year-end, market capitalization was $34.2 billion and its Tier 1 capital ratio was 9.7%” (CICB Annual Accountability Report, 2007).

However, as of January of 2008 several investors of CICB are bailing out $2.75 billion cash injections to infuse the bank with the necessary capital to survive the global credit crunch. It has also caused significant drop in the bank’s stock price. According to the bond rating service, CIBC’s rating is under review with negative implications because of its risk management processes. On the other hand, there are also major criticisms on the management of CICB by its chief executive Gerry McCaughey (Silcoff, 2008) and other top management officers who should not be in the risk committee.

Upon review of the risk management of CICB, particularly the new Base II, it is more likely that the present problem of the CICB due to subprime loan is not caused by the mere policies and procedures of CICB risk management but by the few individuals who should not be part of the risk committee.

II. Introduction

CIBC announced a US$2 billion writedown due to the subprime losses (Corporate News, 2007). CIBC suffered in the same way as the banks in the US. Several top executives, including its chief executive of World Markets and Chief Risk Officer were fired because of the subprime write-downs of about US$3.3 billion (Duncan, 2008). Other Canadian banks were not affected since by the subprime crisis of the United States. Many blames the Canadian Imperial Bank of Commerce chief executive Gerry McCaughey's and believe that he should be one of the top executives to go (Silcoff, 2008).

The changes in top management have earned several criticisms from the financial industry except for the recruitment of director Nick Le Pan and chief financial officer David Williamson (Silcoff, 2008). Changes in the Risk Management of CIBC have also been implemented since December of last year. Both these factors may greatly affect the outcome of CICB in terms of the problems of subprime loans in the US.  

            At present, CICB manage risks by following the guidelines and tolerance levels established by their Risk Management (RM) Committee and Board of Directors. This is done by following the set of procedures and standards set by the committee and the Board. The RM assists the Board in identifying, measuring and controlling the business risks of CIBC.

The policies for key risk management are approved or renewed annually by the Risk Management (RM) committee. It also measures, monitors and control the risks by evaluating the risk if it is in accordance with the risk tolerance limits.

According to the management guidelines of CIBC, stated in their Annual Accountability Report 2007, the main priorities of the RM is the management and re-allocation of risk resources to achieve the goals of CIBC; and to measure, monitor and control the credit risks, market risks, liquidity risks and operational risks. This also includes the legal risks of CIBC and its reputation (CIBC Annual Accountability Report, 2007). 

            As of 2007, the RM reported that it has achieved its target client satisfaction and financial results by continuously enhancing the CIBC’s risk infrastructure. The RM is also responsible in the implementation of Base II program of CIBC.

            The different RM groups and other groups of CIBC are also involved in the management of risks. These are the treasury, Credit and Investment Risk Management Group, Market Risk Management, Operational Risk Management, Balance Sheet Measurement, and Monitoring and Control.

            The Treasury provides the funding and asset/liability liquidity, cash and collateral management for the particular risk. It ensures that CIBC is fully capitalized and it also manages the capital in legal entities, affiliates and subsidiaries. The Credit and Investment Risk Management group provides the oversight of the adjudication, monitoring and management of the global credit risks. It uses market based techniques in measuring, monitoring and controlling of risks. The Market Risk Management (MRM) provides oversight on management, monitoring and control of the trading credit risk and trading and non-trading market risks. The Operational Risk Management identifies, measures, monitors and controls the CIBC’s operational risks.

The Balance Sheet Measurement, Monitoring and Control provide oversight on measurement, monitoring and control of the balance sheet resources, model risk and economic capital. It is also responsible in overseeing the balance sheet resource allocation process.

            On November of 2007 CIBC adapted a new framework for the management of its capital, the Base II Framework. This framework is designed to enhance the risk sensitivity of regulatory capital (CIBC Annual Accountability Report, 2007). The Basel II Framework consists of three pillars: Pillar 1 prescribes the risk-focused regulatory capital requirements, Pillar 2 deals with supervisory review, and Pillar 3 with market disclosure (CIBC Annual Accountability Report, 2007).

            The Base II Framework allows for wider discretion for the individual banks in increasing or decreasing the capital requirements. This allows for more transparency of risk management in terms of capital adequacy and the risk.

II. Credit Risk Management of CICB

            For Credit Risks[1], the Capital and Risk Committee (CRC) is the group responsible for the oversight of policies and limits which are subjected to annual review and approval of the RM. The CRC is responsible for the implementation of the policies and in overseeing the quality of credit portfolio. The senior manager repots at least once per quarter to the RMC regarding the material credit risk matters. These include the individual credit transactions, compliance with limits, portfolio trends, impaired loans and credit loss provisioning levels. The RMC and the Audit committee on the other hand are tasked to review the quarterly impaired loan balances, allowances and credit losses (CIBC Annual Accountability Report, 2007).

            Portfolio management decisions and adjudications are then done based on the evaluation of risk as reflected by the policies, standards and limits set by the committee. The risk appetite of CICB is based on the policies, standards and guidelines, processes and controls and risk concentration limits. The company’s credit risk is measured, monitored, controlled and managed according to the set of policies, standards and procedures created by the RM.

            The approval of credit is controlled centrally since all requests are submitted to the credit risk management unit or to the RMC for approval. Once it is approved, credit exposures are monitored regularly. Monitoring includes full risk assessment annually. While those that are considered as higher risks are more closely monitored and reviewed quarterly. Different groups, the specialized loan workout group and the collections group, handle the management of the higher risk loans on a daily basis.

            The business and government loan portfolios are managed against concentration limits and exposures. The concentration limits are established for individual borrowers, industry sectors, selected products or types of lending, groups of related borrowers and countries and geographic regions. These are under strict underwriting standards. Higher risks are reduced by using credit derivative hedges and direct loan sales.

            To reduce risk in lending portfolios, CIBC required third party guarantees and insurance, such as the government’s guarantee on residential mortgages. Collateral pledges ensure risk mitigation effects. Policies and standards for collateral management include valuation, verification, legal certainty, and tracking, maintenance of collateral and periodic updated valuations. Collaterals are in the form of cash or securities, charges over inventory, receivables, real estate properties and operating assets.

For Credit risk under the Base II Framework, any institution may adopt any of the two approaches in circulating regulatory capital. These two approaches are: (a) the standardized approach which uses prescribed risk weights or (b) an internal ratings based (IRB) approach which allows the use of a bank’s internal models to calculate some, or all, of the key inputs into the regulatory capital calculation (CIBC Annual Accountability Report, 2007).

            In the first approach, the standardized approach, eligible financial collateral held by the institution reduces the amount of exposure and the exposures are assigned the risk weights by the regulators. In the second approach, the IRB approach, the institution may adopt the foundation approach or the advanced approach.

            Under the foundation approach, the probability of default (PD), exposure at default (EAD) and loss given default (LGD) are determined by the use of internal estimates. Under the advanced approach, also called the AIRB, the probability of default (PD), exposure at default (EAD) and loss given default (LGD) are determined by the use of internal estimates and inputs to the calculation. This uses a more advanced methodology and is more appropriate for the more sensitive risks since it determines the needed capital requirement calculations for these risks.

III. Operational Risk Management of CICB

            Operational Risk[2] is under the Governance and Control Committee (GCC). It oversees the management of internal control framework and objectives set by the Senior Executive Team (SET). On the other hand, the SET is the one answerable to the Board of Directors, the RM and the Audit Committee in terms of internal control.

            Under the internal control framework the individual businesses have the full responsibility for the management of the risk while the RM is the one responsible for the monitoring, controlling and measuring of the operational risk. It is also the one responsible for the businesses which manages the operational risks. They have to ensure that the businesses comply with the policies and procedures set by the CRC and the RMC.

            The people and processes operational risks are moderated by the human resources policies and operational procedures. The systems operational risks are managed through technology development and change management.

            CIBC has insurance programs to reduce loses which might arise from operations risks, such as insurance against property loss, criminal activities and damage and liability exposure. Aside from insurance program, CIBC has global business continuity management program to ensure continued normal operations in the event of major disasters. This business continuity management program is subjected to regular review, testing and updating.

For Operational Risk under the Base II Framework, any institution may adopt any of the two approaches in calculating risks: the basic indicator approach, the standardized approach and the advanced measurement approach (AMA).

            The basic indicator approached is in accordance with the regulatory defined percentage applied to the annual gross income of the institution. The standardized approach is the same as the basic indicator approach except that instead of regulatory percentage, multiple regulatory percentages are applied based on the regulatory specified business line. The advanced measurement approach (AMA) is the application of qualitative and quantitative criteria on both the internal and external data and scenario analysis. On circulation of regulatory capital, CICB uses the AMA approach.

            Under the Base II operational risk measurement includes expected and unexpected losses which may arise from legal liability, client restitution, regulatory compliance and tax violations, loss or damage to assets, transaction processing errors and theft, fraud and unauthorized activities.

IV. Market Risk Management of CICB

            Market Risk[3] is under the control of the CRC. Its internal control framework includes individual market risk manager for each business. Aside from the market risk manager, a regional risk manager is assigned to all four major trading centers. This is to ensure comprehensive risk coverage.

            CIBC has policies for market risks and these policies includes identification and measurement of different market risks, eligibility for inclusion in trading and non trading books and establishing of limits. The policy in risk tolerance level is clear and well defined since they are measured according to the Value-at-Risk (VaR) and potential worst-cases losses.

            In determining market risk and in setting limits on the amount of risk, CIBC uses its three-tiered approach. Tier 1 limits are the overall market risk and worst case scenario limits, Tier 2 limits are in controlling the risk profile in each business and Tier 3 limits are the desk level and to monitor risk concentration and impact of book specific stress events (CIBC Annual Accountability Report, 2007).

            To ensure that only authorized activities are undertaken, daily monitoring of market risk exposures are done on approved risk limits. The daily risk and monitoring report are based in the previous day’s repot. Limit compliance reports and market summary risks are submitted weekly. These are reviewed by the RMC every quarter and by the SET every week. 

            CIBC uses different risk measurements: VaR, stress testing and scenario analysis and backtesting. VaR compares the risk in different businesses and asset classes; stress testing and scenario analysis gives insights on portfolio behavior; and backtesting validates the effectiveness of risk measurement by using actual and theoretical profit and loss outcomes (CIBC Annual Accountability Report, 2007). 

In Market Risk Analysis under the Base II, the market risks are subjected to the Market Risk Amendment to the Basel Accord provision. CIBC continues to use the Internal Models Approach (IMA) which was already approved by the Office of the Superintendent of Financial Institution. According to the CIBC Annual Accountability Report of 2007, the IMA model has 99.865% efficiency rate for perceiving liquidity of different trading portfolios.

IV. Recommendation

            With the problems created by the subprime crisis in the US, many speculate on the effectiveness of CIBC’s risk management processes. Since Gerry McCaughey took over the bank he aimed to change its reputation for the better. One of the results of his actions is the failure of CICB’s proper management of risks. 

Since the problem has emerged, CIBC has taken several steps into eliminating capital market risks. It has also created changes in its risk management procedures, as discussed above, since it was downgraded to negative ratings because of risk management failings. McCaughey himself admitted that CIBC had “underestimated the extent to which the subprime market might deteriorate and the degree to which that would impact securities that were structured to be very low risk” (Duncan, 2007).

Based on these, it is easy to assume that the failed risk management procedures of CIBC stems from the individuals who should be more in control and knowledgeable about what they are doing. The Board of Directors along with the RM committee had failed in its role of protecting the bank against this financial risk.

The first thing that CIBC should do is to understand the importance of having reliable and able chief risk officer. The chief risk officer should have financial and people skills. This is because the chief risk officers must be able to coordinate effectively his people into implementing the policies and procedures of the new risk management division. Of course, the financial skills are necessary so that he can evaluate the potential cost of the risks on the capital.

The massive layoff of top executives of CIBC only shows that the bank did not have an effective and able chief risk officer. Such massive financial loss also shows that these individuals did nothing to protect the bank on such risk. Moreover, the criticisms that the top executives were not really expert bankers are proven to be true with this billion dollar loss.

Lastly, CIBC is one of the leading banks in Canada and since it is the only bank affected by the subprime crisis, it is impossible that the bank failed on its risk management procedures alone. In conclusion, the problem of CIBC’s risk management is not its guidelines, policies and procedures but the people who are part of risk management. The Board of Directors and investors should start taking a close look on the people behind the reign and see if they are capable of fulfilling their appointed tasks.

Appendix 1

Appendix 2

Works Cited

CIBC Annual Accountability Report. 2007.  CICB.com

Retrieved 8 March 2008 from

http://www.cibc.com/ca/pdf/about/aar07-en.pdf

Corporate News Release. 2007. Micro.newswire.ca

Retrieved 8 March 2008 from

http://micro.newswire.ca/release.cgi?rkey=1512194538&view=14730-0&Start=0

Duncan Mavin. 2007.  CIBC faces more questions about subprime. Financial Post 

Retrieved 8 March 2008 from

http://www.nationalpost.com/news/story.html?id=158782

Duncan, Mavin, 2008. Investors prop up CIBC with $2.75B injection. National Post

Retrieved 8 March 2008 from

http://www.nationalpost.com/news/story.html?id=237388

Silcoff, Sean. 2008. It's McCaughey who should be gone. Financial Post.

Retrieved 8 March 2008 from

http://www.financialpost.com/analysis/story.html?id=1c9eeb01-5eec-4b6f-b1dd-36d9f1f69902&k=18323

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[1] The risk of financial loss due to a borrower or counterparty failing to meet its obligations in accordance with agreed terms (CIBC Annual Accountability Report, 2007)

[2] The loss resulting from inadequate or failed internal processes, systems, or from human error or external events (CIBC Annual Accountability Report, 2007)

[3] The potential for financial loss from adverse changes in underlying market factors, including  interest and foreign exchange rates, credit spreads, and equity and commodity prices (CIBC Annual Accountability Report, 2007)