October 14, 2011

The Community Reinvestment Act, or CRA, regulations caused the failure of the two government-sponsored mortgage investment giants, Fannie Mae and Freddie Mac, and their failure is at the heart of the housing market meltdown.

In September 2008, the federal government injected $200 billion to cover the investment losses of Fannie Mae and Freddie Mac. But it soon found that the amount was not enough. Shortly after, in February 2009, the government doubled its commitment to $400 billion for the two agencies to cover their losses. And it is still not enough either.

How did Fannie Mae and Freddie Mac, the two government-sponsored enterprises who purchase and securitize mortgages from private lenders, get into this financial mess? And how did CRA regulations contribute to their financial trouble?

In 1992, the Federal Housing Enterprises Financial Safety and Soundness Act, enacted by Congress to support the government’s affordable housing goals, required Fannie Mae and Freddie Mac to purchase a percentage of mortgages going to low and moderate income borrowers CRA eligible loans. In 1996, the Department of Housing and Urban Development set a target for Fannie and Freddie that 42 percent of their investment must go to CRA-eligible borrowers. The same target was increased to 50 percent in 2000 and then to 52 percent in 2005.

Even in 2007, just prior to the bankruptcy of Fannie Mae and Freddie Mac, Federal Reserve Chairman Ben Bernanke was suggesting to further increase the percentage of CRA loans purchased by Fannie and Freddie in order to help banks fulfill their CRA obligations. The Federal Reserve is one of the four federal regulators involved in enforcing the Community Reinvestment Act.

In 1997, the first securitization of CRA loans, by Bear Stearns, was guaranteed by Freddie Mac. Bear Stearns soon issued another $1.9 billion of CRA mortgages guaranteed by Fannie and Freddie. Fannie securitized close to $400 billion of CRA mortgages between 2000 and 2002. Fannie and Freddie were the primary drivers fueling the demand for secondary market subprime securities.

The Community Reinvestment Act was signed into law in 1977 by President Carter. The Act requires banking institutions insured by the Federal Deposit Insurance Corporation, or FDIC, to be evaluated by their federal regulators for the loans made to low and moderate income borrowers and to poor communities. The act forced banks to make these loans, which the banks would have rejected otherwise as financially unsound. Several legislative revisions to the act have been made since then.

The banks are assigned a rating for their CRA compliance, which the regulators consider when approving a bank’s merger or expansion. Several independent mortgage companies, such as Countrywide, also made CRA loans and would sell them to banks needing CRA credits.

In 1994, after the Riegle-Neal Interstate Banking and Branching Efficiency Act was passed by Congress, there was a surge of bank mergers and interstate expansions. The CRA compliance became even more important.

In 1989, the CRA ratings were first made publicly available. And in 1995, President Clinton made the CRA ratings available on a public website. With better public access to CRA ratings, community activist groups started pressurizing banks to make more of these unsafe loans.

But prior to 1992, the banks that made CRA loans had to accept the risk of those loans. Fannie Mae and Freddie Mac would not purchase these loans because the loans didn’t meet their guidelines. However, the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 changed this by requiring Fannie and Freddie to purchase CRA loans.

The CRA also resulted in lowering the lending standards in the banking industry. Not only did banks need to comply with the CRA for their expansion and growth but they also needed to compete with non-banking mortgage companies, like Countrywide. These independent mortgage companies lowered their lending standards to become more competitive with banks, as long as Fannie and Freddie would purchase these loans and these mortgage companies didn’t have to carry the loans on their balance sheets.

Several reform ideas and proposals are being considered to solve the current housing crisis that is holding back economic recovery. Repealing the CRA (currently the regulation is not justified) or decoupling the government-sponsored enterprises such as Fannie and Freddie from the CRA (similar to the regulatory system in place prior to 1992) are two alternatives to prevent another housing market meltdown.

www.bepress.com/erj/). E-mail him at floridavc@gmail.com .