Commentary: What Can We Learn from Government Attempts to Modify the Allocation of Mortgage and Consumer Credit in the United States?

IntroductionThis commentary considers the Community Reinvestment Act (CRA) in historical context. CRA reflects one of many government attempts to influence the allocation of mortgage and consumer credit, but many of these interventions have had adverse outcomes. This commentary is written in the hope that those who are aware of history will stop repeating it. Specifically, I argue that lawmakers have been too quick to succumb to political pressures and have failed to follow basic economic principles when creating mortgage market policies. As a result, expanding access to credit has been prioritized over the safety and soundness of the housing and mortgage markets.The Legacy of Past Housing PoliciesUntil the 1990s, restrictions on banks limited their geographical expansion. The policy of not allowing interstate branching was formalized in the McFadden Act1 of 1927 and strengthened by the Bank Holding Company Act2 of 1956. Although these restrictions seem absurd today, they had important implications for mortgage finance. Because they could not branch across state lines, banks held local mortgages in their portfolios and were forced to take substantial geographic risk that could not easily be diversified away. The lack of portfolio diversification was magnified because deposits were also local. As a result, a downturn in the local economy could result in bank failure, because customers would withdraw deposits and loan performance would deteriorate. Banks could not market the poorly performing local loans, and liquidity problems would turn into insolvency.Given the political unpopularity of branching, the answer to geographic risk diversification was to get mortgages out of the portfolios of the depository institutions that underwrote and endorsed them. The National Housing Act3 of 1934, which established the Federal Housing Administration (FHA) and introduced mortgage insurance to make mortgages more marketable, accomplished this goal. In the beginning, insurable mortgages had a maximum term to maturity of 20 years and a maximum loan-to-value (LTV) ratio of 80 percent, based on strict appraisals and required property inspections. The founding of the Federal National Mortgage Association (Fannie Mae) in 1938 to purchase both FHA-guaranteed and conventional mortgages was the second answer to the problem of diversifying geographic risk. Fannie Mae enabled housing to be financed by ultimate lenders who held a well-diversified portfolio. In many cases, banks, which could not diversify geographically due to statutory limits, purchased the mortgage-backed securities back from Fannie Mae.The prohibition against branching provided a justification for federal involvement to diversify geographic risk, but it introduced other problems. Initially, FHA Section 203(b) mutual mortgage insurance was seen as a success. FHA was designed to protect homebuyers and taxpayers, but the limits on both maturity and LTV ratio crept upward as house prices rose and memories of the Great Depression faded. Redlining-which was designed to manage FHA's risk by avoiding neighborhoods where house prices were likely to decline-came under attack for discriminating against minority neighborhoods.Yet another policy was added in response: Section 235 of the Fair Housing Act4 of 1968. It relaxed lending criteria, reduced property inspection requirements (increasing the risk that mortgages were made on flawed units), and provided interest rate subsidies. The next 5 years were marked by scandal; more than 240,000 units went into default, resulting in a foreclosure rate five times that of FHA insurance. The effects of dilapidated and abandoned structures on neighborhoods turned residents against FHA and raised demands that the private sector become more involved in financing higher-risk loans. In my opinion, the primary impetus for passage of the Home Mortgage Disclosure Act5 (HMDA) of 1975 and the Community Reinvestment Act6 (CRA) of 1977 was the complete failure of Section 235, which was in turn a reaction to deficiencies in FHA Section 203(b) mutual mortgage insurance. …