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Prepared Testimony of Michael S. House of Representatives Hearing On "The Community Reinvestment Act: Thirty Years of Accomplishments, But Challenges Remain" February 13, 2008 Chairman Frank, Ranking Member Bachus, and distinguished Members of the Committee, it is an honor to be here today to discuss the Community Reinvestment Act (CRA). The Community Reinvestment Act has helped to revitalize low- and moderate-income communities and provided expanded opportunities for low- and moderate-income households. Going forward, CRA could be strengthened in several ways to ensure its continued role in encouraging sound lending, investment and services in low- and moderate-income communities. At the same time, CRA cannot be expected to resolve the range of financial problems facing low- and moderate-income communities today. This Committee has already taken strong leadership to clean up the mortgage business and drive out abuses, and I am confident that the Committee will continue to lead in resolving the subprime mortgage crisis we face today. The Community Reinvestment Act The Community Reinvestment Act of 1977 (CRA) encourages federally insured banks and thrifts to meet the credit needs of the communities that they serve, including low- and moderate- income areas, consistent with safe and sound banking practices. Federal banking agencies examine banks periodically on their CRA performance and rate the institutions. Regulators consider a bank's CRA record in determining whether to approve that institution's application for mergers with, or acquisitions of, other depository institutions. Banks and thrifts must have a satisfactory CRA record if they, or their holding companies, are to engage in newly authorized financial activities, such as certain insurance and securities functions. Changes to CRA regulations issued in 1995 focused evaluations on objective performance measures rather than previously used process-oriented factors. 1 These regulations require large banks and thrifts to disclose information about their small-business, small-farm, and community- development lending. The regulations provide for tailored examinations of large banks, small banks, and wholesale or limited-purpose institutions that more closely align with the business strategies of each institution type. Large banks are evaluated on a three-part test of their lending, investments, and services, while small banks undergo a streamlined review of lending. For large banks, the lending test accounts for 50 percent of the bank's CRA rating and evaluates its performance in home mortgage, small-business, small-farm, and community- development lending. Examiners consider the number and amount of loans to low- and moderate-income borrowers and areas, and "innovative or flexible lending practices." Under the investment test, which accounts for 25 percent of the bank's CRA grade, the agency evaluates Page 2 the amount of the bank's investments, innovation, and responsiveness to community needs. Under the service test, which makes up the remaining 25 percent of the bank's evaluation, the agency analyzes "the availability and effectiveness of a bank's systems for delivering retail banking services and the extent and innovativeness of its community development services." The agency assesses an institution's record under these three tests in light of the "performance context" in which the institution is operating, including economic and market factors; the bank's capacities, constraints, and business plans; and "the performance of similarly situated lenders." Since enactment, CRA has been, and remains today, the subject of extensive debate. Many scholars vigorously question the theoretical and empirical claims that motivated CRA, and many also advocate eliminating the law. 2 These critics argue that CRA is trying to address a nonexistent problem, and that even if intervention is warranted, CRA is an inappropriate avenue. Many critics also suggested that CRA was having little, if any, positive effect, and at a high cost. However, in earlier work, I have systematically rebutted these prior criticisms of CRA and laid a solid theoretical and empirical foundation for the Act. 3 Those findings are summarized here. CRA Reasonably Addresses Market Failures in Low-Income Communities At its core, CRA helps to overcome market failures in low-income communities. By fostering competition among banks in serving low-income areas, CRA generates larger volumes of lending from diverse sources, and adds liquidity to the market, decreasing the risk of each bank's loan. Encouraged by the law, banks and thrifts have developed expertise in serving low- income communities, and they have created innovative products that meet the credit needs of working families and low-income areas with manageable risks. These market innovations have taken several forms. Banks and thrifts have engaged in special marketing programs to targeted communities; experimented with more flexible underwriting and servicing techniques to serve a broader range of households, and funded credit counseling for borrowers. Many larger institutions have developed specialized units that focus on the needs of low- and moderate-income communities. Others have formed partnerships with community-based organizations and community development financial institutions (CDFIs). CDFIs provide local expertise and financial education, and assume portions of risk that banks do not want to bear. Spurred in part by the CRA investment test, banks have invested in CDFIs in record numbers, strengthening their ability to serve low-income markets. CRA also facilitates coordination among banks to reduce information costs. Because the law requires all insured depositories to lend in their communities, it reduces "free rider" problems. It has spurred the development of multi-bank community development corporations and loan consortia to serve low- and moderate-income communities more effectively. Moreover, banks get CRA consideration for both originating and purchasing loans, creating a trading system. Institutions can also get credit under the CRA investment test for purchasing loan securities. The development of this secondary market has increased liquidity and transparency. A positive lending cycle thus began in many communities once ignored by mainstream lenders. Under CRA, lenders know that other banks will be making loans to a community, reducing all institutions' liquidity risk, speeding the gathering and dissemination of information, 2 Page 3 and producing positive information externalities. Increased lending by responsible originators to low-income communities has occurred under CRA and such responsible lending has not led to the kind or extent of excessively risky activity under taken outside of CRA's purview. Studies have found that CRA improved access to home mortgage credit for low-income borrowers during the 1990s, as CRA regulatory intensity increased. 4 Between 1993 and 1999, depository institutions covered by the CRA and their affiliates made over $800 billion in home mortgage, small business, and community development loans to low- and moderate-income borrowers and communities. 5 The number of CRA-eligible mortgage loans increased by 39 percent between 1993 and 1998, while other loans increased by only 17 percent. Even excluding affiliates, banks increased their lending to low- and moderate-income borrowers and areas by 10 percent over this period, compared with no growth at all for these lenders in their other markets. As a result, the share of all mortgage lending by CRA-covered institutions and their affiliates to these borrowers and areas increased from 25 to 28 percent. A series of factors beyond CRA also contributed to these gains. Strong economic growth and low inflation during the 1990s led to rapid income growth, low unemployment rates, and low real interest rates. Innovation helped drive down the costs of lending. Consolidation in the financial services sector enhanced competition among national players with economies of scale and scope. And other laws-such as fair lending and secondary mortgage market regulations- operated in intensified ways during this period. Controlling for the effects of these factors, however, CRA lenders increased their CRA- eligible home purchase lending faster than those not regulated by CRA from 1993 to 1999. 6 The Joint Center for Housing Studies at Harvard University concluded: "CRA-regulated lenders originate a higher proportion of loans to lower-income people and communities than they would if CRA did not exist." 7 By one estimate, the Joint Center found that CRA's effect on increasing home mortgage lending to low-income borrowers was equivalent to a 1.3 percentage point decrease in unemployment. Another study found that CRA boosts the number of small businesses that can access credit by four to six percent, increasing payrolls and reducing bankruptcies-without crowding out other financing available to small businesses or adversely affecting bank profitability or loan performance. 8 In sum, recent evidence shows that CRA provides important benefits to low-income communities. Critics of CRA assert that it leads to unprofitable lending. But the weight of evidence suggests otherwise. In a Federal Reserve Board survey of CRA-covered institutions, most responded that CRA lending was profitable or marginally profitable, and not overly risky. 9 Pushing further into low-income markets under CRA has not weakened banks' profitability and soundness. In the small "special programs" that serve as banks' CRA laboratories, employing new and innovative strategies, most institutions reported low delinquency and charge-off rates. In fact, most institutions surveyed reported a net charge-off rate of zero for these programs. Reforms put into place in 1995 reduced compliance costs for all banks and streamlined CRA regulations even further for the smallest institutions. Evidence suggests the reforms worked. In 2002, the Independent Community Bankers of America surveyed its membership about the cost of CRA regulation. 10 Although the study is designed to highlight the high compliance costs of 3 Page 4 CRA, the data reported in the study suggest otherwise. The mean employee cost for CRA compliance was $84,445 per year for small banks (average assets of $216 million) and about $30,000 more per year for larger "community" banks (average assets of $666 million). Average CRA employee costs as a percentage of assets were thus negligible-0.017 percent for larger "community" banks, and 0.039 percent for small banks. These costs seem manageable. CRA Should Have Done More to Combat Abuses in the Subprime Market Despite the fact that CRA appears to have increased bank and thrift lending in low- and moderate-income communities, such institutions are not the only ones operating in these areas. In fact, with new and lower-cost sources of funding available from the secondary market through securitization, and with advances in financial technology, subprime lending exploded in the late 1990s, reaching over $600 billion and 20% of all originations by 2005. More than half of subprime loans were made by independent mortgage companies not subject to comprehensive federal supervision; another 30 percent of such originations were made by affiliates of banks or thrifts, which are not subject to routine examination or supervision, and the remaining 20 percent were made by banks and thrifts. Although reasonable people can disagree about how to interpret the evidence, my own judgment is that the worst and most widespread abuses occurred in the institutions with the least federal oversight. The housing crisis we face today, driven by serious problems in the subprime lending, suggests that our system of home mortgage regulation, including CRA, is seriously deficient. We need to fill what my friend, the late Federal Reserve Board Governor Ned Gramlich aptly termed, "the giant hole in the supervisory safety net." 11 Banks and thrifts are subject to comprehensive federal regulation and supervision; their affiliates far less so; and independent mortgage companies, not at all. Moreover, many market-based systems designed to ensure sound practices in this sector-broker reputational risk, lender oversight of brokers, investor oversight of lenders, rating agency oversight of securitizations, and so on-simply did not work. Conflicts of interest, lax regulation, and "boom times" covered up the extent of the abuses-at least for a while, at least for those not directly affected by abusive practices. But no more. As has become all too evident, the subprime market has been plagued by serious problems. Some subprime borrowers who could have qualified for loans from prime lenders end up in the subprime market, paying higher rates: Preliminary research suggests up to 35% of subprime borrowers could qualify for prime mortgage loans. 12 Some minority borrowers may have been improperly "steered" to higher cost lenders by brokers or real estate professionals. Even after accounting for neighborhood and borrower characteristics that influence lending decisions, there is "a strong geographic concentration of subprime lending in those neighborhoods where there is a large population of African American homeowners" and "African-American borrowers, regardless of the neighborhood where they are located, have relatively high likelihood of obtaining a subprime compared to a prime loan." 13 Moreover, studies have documented abusive practices in the subprime sector. 14 These practices have included "flipping," repeatedly refinancing a loan in a short period of time. Flipping subjects a borrower to high fees, including prepayment penalties, which diminish the borrower's home equity without providing significant benefit. Loans have been "packed" with additional products (such as credit life insurance) without the borrower understanding that the products were optional or unsuitable. 15 Loans have included fees unrelated to risk or servicing, and which are structured to disguise the loans' true costs. 16 Some brokers have made home 4 Page 5 mortgage loans without regard to the borrower's ability to repay. 17 These so-called "asset based" loans often were made by brokers who earned high fees and were less concerned about their reputations among lenders. 18 In other cases borrowers have testified that "unscrupulous mortgage brokers, lenders, home improvement contractors, appraisers, and combinations thereof" engaged in "outright fraud" as well as "deceptive or high-pressure sales tactics," and often "prey[ed] on . . . the elderly, minorities, and individuals with lower incomes and less education." 19 While credit risk is a key determinant of whether a borrower receives a prime or subprime loan, "credit risk alone may not fully explain why borrowers end up in the subprime market." 20 For example, borrowers who are older, Hispanic, or search less for interest rates are more likely to end up in the subprime market. 21 Having a subprime loan is an important determinant of refinancing with a subprime loan even after controlling for relevant factors related to risk and creditworthiness: Some 60% of subprime borrowers who refinanced did so with subprime loans rather than prime ones, 22 indicating that many subprime borrowers get stuck in that market. The higher price that borrowers pay is a function not only of using a subprime lender, but also of negotiating with mortgage brokers, who dominate the subprime market. Brokers are compensated for getting borrowers to pay higher rates than those for which the borrower would qualify. Such "yield spread premiums" are used widely. 23 In loans with yield spread premiums, there is wide dispersion in prices paid to mortgage brokers. Within the group of borrowers paying yield spread premiums, African Americans paid $474 more for their loans, and Hispanics $590 more, than white borrowers; thus, even if minority and white borrowers could qualify for the same rate, in practice minority borrowers are likely to pay much more. 24 CRA has not yet done enough to integrate the prime and subprime markets, as evidenced by these problems. 25 In some ways, CRA is well positioned to help overcome the bifurcation between the prime and subprime markets by enhancing competition from banks and thrifts. Overcoming that bifurcation would improve market efficiency, reduce racial discrimination, and speed the process of correcting other market failures. Competition from banks and thrifts can help to drive out abusive practices and improve price transparency in these markets. However, given the large role played by independent mortgage companies and brokers, bank and thrift competition under CRA is not enough, on its own, to drive out bad practices. In recent years, there was intense competition among mortgage market participants to provide harmful products. Further federal regulation is thus also necessary to combat abusive practices, prevent a race to the bottom in bad lending behavior, and restore integrity to our housing markets. We need to ensure that all participants in the mortgage process have the right incentives to engage in sound lending practices and are subject to the right kind of regulatory oversight. CRA Performance Context Should Include Affiliates of Banks and Thrifts One suggestion going forward is that it is both possible under existing law and desirable as a matter of policy to take account of affiliate activity while respecting the fact that CRA applies only to insured depositories. For example, CRA regulations already provide that evidence of illegal credit practices will affect an institution's CRA rating. 26 The laws governing such credit practices are equally applicable to banks and thrifts and non-depository creditors. Illegal credit practices of an affiliate that has been included at the option of the depository institution for purposes of a CRA examination are relevant to its rating, but so too should be the illegal credit practices of affiliates not so included. Given the cost of regularly examining all affiliates for 5 Page 6 such practices, enforcement of other credit laws should occur through risk-based examinations of affiliates. 27 In addition to direct enforcement of such credit laws, the results of such compliance examinations should be taken into account in the performance context under CRA. Banks should include activities of affiliates and bank regulators should determine whether such activities are serving the credit needs of their community. For example, some borrowers may be ending up in a bank's subprime unit, or subprime affiliate, or obtaining an inappropriate loan, when in fact they could qualify for a mortgage on better terms. The regulators now give CRA consideration for "promoting" borrowers from the subprime to the prime market, 28 and banks and thrifts should thus have in place procedures to ensure that borrowers with good credit histories get access to their prime mortgage units and products, and that all borrowers get access to the best loan for which they qualify, from whatever part of the company offers the product. In principle, the OCC considers a bank's subsidiaries' assets in determining the performance context in which a bank operates. 29 Similarly, the assets and activities of all of the affiliates of a bank should also be considered in assessing the performance context within which a bank meets its obligations under CRA. After all, a bank's affiliates are hardly irrelevant to the bank's business decisions, including how to meet the credit needs of their communities. The Gramm- Leach-Bliley Act made a financial holding company's commencement of newly authorized activities, or its merger with newly authorized entities, contingent on satisfactory CRA performance by all of the affiliate banks or thrifts. A bank's affiliates have a strong interest in ensuring adequate CRA performance by all the insured depositori
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