Wednesday, October 22, 2014

Did the Bankers Do It?

NEW DELHI – Few areas of economic activity in the United States are more politicized than housing finance. Yet the intellectual left has gone to great lengths to absolve regulators, government lending mandates, and agencies like Fannie Mae and Freddie Mac of any responsibility for the housing boom and the subsequent bust.

The rationale is clear: if these officials, institutions, and policies were held accountable, the reform agenda would necessarily shift from regulating greedy bankers and their bonuses to asking broader questions. Might government mandates contribute to bad behavior by private players? Can regulators be trusted to make appropriate trade-offs between financial stability and mandates that have wide political support? Indeed, can central bankers be truly independent? Unquestioning acceptance of a greater government role in taming markets would, in short, give way to asking whether that role can sometimes be part of the problem.

The left has had an easy task in dominating the debate, partly because the intellectual right’s attempt to place all the blame for the crisis on government is thoroughly implausible. It is far more defensible and correct to argue that everyone – bankers, households, regulators, and politicians – contributed to (and took credit for) the boom while it lasted, only to point fingers at one another when it collapsed.

But bankers’ political tin ear in the aftermath of the crisis – first taking public bailouts and then paying themselves huge bonuses as if nothing had changed – ensured that they got the lion’s share of the blame, with everyone else willing to pose as their unwitting victims. As a result, the public-policy response has been dominated by “the bankers did it” narrative. The risk is that this approach is incomplete – and thus unlikely to be effective.

It is therefore refreshing to see a careful econometric study take on an assertion by Paul Krugman, perhaps the most influential left-leaning US economist, that “the Community Reinvestment Act of 1977 was irrelevant to the subprime boom.” The CRA instructs federal financial supervisory agencies to encourage the institutions that they regulate to help the communities in which they are chartered to meet their credit needs, while also conforming to “safe and sound” standards. In practice, regulators measure the volume of lending to CRA target tracts – poor areas with median income less than 80% of the median income of the local community – as well as to low-income and minority borrowers in non-CRA tracts to verify compliance with the Act.

The left has dismissed any claim that the CRA played a role in the housing boom by pointing out that it was enacted in 1977, while the subprime boom played out in the early 2000’s. But this ignores the possibility that regulators may have started to enforce the CRA rigorously only later.

To enforce the statute, regulators periodically examine banks for CRA compliance. To hone in on the “regulatory enforcement” effect, the recent study compares the behavior of banks that are undergoing examination (which takes place over several quarters) to that of banks that are not undergoing examination in a particular tract in a particular month.

The findings are clear. Compared to banks that are not undergoing examination, the volume of loans by banks in the six quarters surrounding a CRA examination is 5% higher, and these loans are 15% more likely to be delinquent one year after origination. In other words, banks undergoing examination lend more and make riskier loans – and these findings are even more pronounced in CRA-eligible tracts.

Good econometric studies examine secondary effects to persuade readers that the main effect is what it is. Regulators’ primary tool to enforce compliance was their authority to reject non-CRA-compliant banks’ requests for new branches or mergers. During the subprime boom, large banks were more likely to want to expand, and thus had greater incentive to comply. The study finds that CRA lending by larger banks does indeed respond more to a CRA examination.

At the height of the lending frenzy (2004-2006), the study finds that banks loaned even more in response to an examination, and that the outcomes were even worse. The authors speculate that easier loan securitization may have made risky CRA-compliant loans seem less costly. Finally, like all good studies, this one explains why the authors more careful analysis produces results that differ from those in previous studies.

Because of the way it is structured, the study only suggests a lower bound on the effects of CRA compliance. It focuses on the differential impact of the CRA on banks undergoing examination and those not undergoing examination. In fact, all banks are likely to have upped their CRA-compliant lending. The study cannot measure this increase.

There is room in economics for grand speculation – some part intuition, some part common sense, and some part ideology. If economists were to wait for careful studies before offering opinions about policy, we would never have anything timely to say. And it is certainly better to have some economic intuition guiding policy than none at all.

But there is a danger that the public mistakes speculation for truth, only because of the speculator’s credentials and assertiveness. Studies like this one are useful in setting the record straight.

More broadly, the study suggests that we should move beyond blaming the bankers. We must recognize that in the desire to broaden home ownership, essential checks and balances broke down. Households, politicians, and regulators were also complicit. As we go about the process of reform, we should bear in mind that the only thing worse than fighting the last war is fighting the wrong last war.

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  1. CommentedLynn Willhelm

    I agree that only blaming one group of players is like pointing fingers at "the Bad apples" while ignoring the systemic problems. Bankers indeed didn´t hold their moral lines, but the loose regulations only made it abnormal to do so. I support Rajan´s effort to promote more awareness that the populism-driven credit-policy is unsustainable and harmful for the society.only when the public accepts that, can the regulation returns to discipline, like in Germany.

  2. CommentedU mustbejoking

    There is just so much wrong with this article that it's impossible to begin. One pities the the Indian population if their Finance Ministry is relying on Mr. Rajan's advice at this juncture.

    Leave it to someone with more heft to deal with the many levels of error built into this article:

    "Admati and Hellwig are confronting the bankers and their allies in no uncertain terms, grounding their argument in deep financial thinking, yet writing for a broad audience. Whatever else happens in 2013, we can be sure that they will not win the Goldman Sachs Business Book of the Year award. "

  3. CommentedAlexander Stingl

    Raghuram Rajan deserves applause for a thorough and insightful analysis. It should be acknowledged, all the same, that any future discussion of the role of the government and of the other forces playing a hand in economies, as well as the role of economy itself, is not only a set of discussions we must necessarily have and which will require a "generous duration", which the fast pace of election-periods, mass media cycles, and financial market "blitzkrieg" no just do not allow but are incapable of conceiving of; this discussion must, and this reflects back on the issue of duration, account for the argument which Colin Crouch has emphasized that there are not only two players (market and State) but there exists a third, which is not governed by market forces, pace Chicago School of Law: corporations. The problem is not merely the existence of these three types of entities but the intertwining and interpenetration of their three differing rationales in the reality of economies and the societies/nations/communities they are imbricated in. there is yet no serious economic or sociological model to deal with this complexity (to the power of n=3) or a model of thirdness. Because of the complex nature, it would require economists, sociologists, anthropologists, philosophers, science studies, political scientists etc. scholars (and channels to expert practitioners) to even begin to account for these problems in a genuine time-frame. Instead we are defunding higher education and the remainders are being structured by bureaucratic and/or corporate accountancy rationales. We are, in other words, destroying the actual resource we would need to improve and change the system of our thinking from binary to more complex alternatives. So who did it? We all did it, slowly but surely and with acceleration.

  4. CommentedRobert Mullen

    Of course the CRA played a role. Reading the papers during the initial Fannie Mae crisis, the use of derivatives to smooth profits, and the ensuing hearings(2003), it was clear the Democrats interest was not in driving proper regulation but in extracting commitments from Fannie to make additional loans to the underserved (i.e., the poor, the high risk, call them what you will.)
    This is a typical Washington compromise, to extort policy changes in lieu of compliance. Both sides do it and the result is lack of enforcement coupled with tainted policies.

  5. CommentedZsolt Hermann

    The article says in the last paragraph:
    "More broadly, the study suggests that we should move beyond blaming the bankers."
    I agree completely. Blaming the bankers and financial institutions carried everybody off track for a long time all over the world.
    Punishing or bailing out banks has no effect of the global crisis since it is a system problem.
    We could even say the bankers became the "innocent, lucky or unlucky celebrities" of the constant quantitative growth economic system that is heavily reliant on credit taking.
    What the global crisis is indicating is that this economic system, based on unnecessary and harmful overproduction and over consumption is self destructive, and recently it started harming the whole system including itself. It is impossible to stubbornly push an unnatural structure, model inside of a vast natural system with strict laws, without negative consequences.
    True solution will only come when people start concentrating on the real issue instead of the superficial symptoms, and however difficult it is to see at the moment in this respect the bankers are completely irrelevant.

  6. CommentedMichael Cohen

    In the run up to the financial meltdown we were failed by every important institution involved in protecting our interests.

    Congress - Eliminated Glass Steagall which lead to the creation of unmanageable, to-big-to-fail super banks. Then Congress backed by the Fed prevented Brooksley Born from regulating the tremendously destructive and destabilizing market in credit default swaps.

    Fanny May and Freddy Mac - Lead the race to the bottom by encouraging the CRA so they could expand their business into riskier investments while still maintaining the advantage of the unwritten US backing

    The Banks - Created, sold, and profited from the toxic CDO's that they sold as AAA investments

    The Credit Ratings Agencies - Were complicit in the incompetent and probably fraudulent math that turned toxic waste into AAA assets.

    In the run up to the housing crisis mortgages were transformed from
    a) Fixed rate mortgages written and held by banks.

    into b) Complicated variable rate mortgages with low introductory rates that balloon after a few years written by store front mortgage brokers and then sold immediately.

    Any statistical process that mixes payment data between these two pools of mortgages is pure fiction.

    The Fed - Under Greenspan, the Fed was willfully negligent in its responsibility to monitor banking practices. The pathetic testimony by Greenspan after the debacle where he said he didn't understand who Banks could act against there own self interests shows how out of touch he was. The self interest of the banks was different from the self interest of the Bank executives that made their bonuses through risky investments and then left the banks in a shambles.

    So there it is, a rouge's gallery of incompetence and greed. If any one of the institutions we depend on had effectively and competently done its job, we would probably have avoided much of the economic pain we are now suffering.

  7. CommentedMichael Cohen

    In the run up to the financial meltdown we were failed by every important institution involved in protecting our interests.
    Congress - Eliminated Glass Stiegle which lead to the creation of unmanageable, to-big-to-fail super b

  8. CommentedFriedrich Böllhoff

    Good article. Interesting comments on it, albeit some of them a bit strange. The article offers a good opportunity to refute Dr. Rajan's arguments, or to try it at least. Nothing convincing is offered to readers.

    If bankers were the only problem, it could have been solved some time ago. If some nutty people are able to derail a whole economy, they should be prevented from it by proper regulation. Then the happy life could restart again after doing away with the legacy of too many debts.

    I wonder for some time now, why prospects are not a lot better in the industrialized countries, more than four years after the crisis began. If all did it right, except those bankers, we should be in a better position than we are now. I think the author is right to put the blame on all actors involved, bankers, households, regulators and politicians. (It takes two to sign a loan contract.)

    When I put finance aside and look at the “real” economy, I see a lot of overconsumption and a misallocation of resources prior to 2008, too many resources into housing. There has been too little emphasis on maintaining competitiveness. It was an unsustainable path that turned out not to could have been followed any longer.

    In fact, I still suspect that the rise in commodity prices triggered the crisis. And the end of the crisis and the continuation of our former way of life is blocked by their very high prices still. It explains much of Africa's current economic rise, by the way. Maybe we have entered a period, where the growing purchasing power of the middle class in emerging economies and the relative scarcity of natural resources forces consumers in industrialized countries to change their consumption patterns.

  9. CommentedTim Chambers

    I'm sorry, sir, but I don't buy it. Tying increased lending activity in CRA areas to bank examinations is only a small part of the picture. To imply that they were responsible for a multi-trillion dollar housing bubble that was even more prevalent in communities not covered by CRA, and especially in new luxury subdivisions beggars your credibility. The leftist analysis puts the blame squarely where it belongs, on the speculative frenzy induced by central bank lending rates, and the repackaging of loans into MBS and CDO securities and derivatives. The bankers and the hedge funds bear the lions share of that responsibility.

  10. CommentedProcyon Mukherjee

    The seminal paper, “Did the Community Reinvestment Act (CRA) Lead to Risky Lending” had tried to exploit the data on “variation in banks incentives to conform to CRA standards around regulatory exams”. The study also found that “in particular, the review cycle for smaller banks – those with less than $250 million
    in assets – is five years, whereas for larger banks the review cycle is two years”, which perhaps have led to larger banks exploiting the situation around examination periods more than smaller banks.

    But the observations around quality of loans, “we find that the reduction in loan standards associated with elevated lending around CRA exams is based primarily on unobservable characteristics. In other words, there is no meaningful change in the observable characteristics of loans made by treatment group banks relative to the control group banks around the CRA exam.” This part as covered in the fourth section would need further studies and lacks adequacy.

    We are still left with the looming question, what in the CRA’s examination actually led to the confirmatory tests on finding whether lending was “safe and sound”, which was one of the main goals.

    Procyon Mukherjee

      CommentedKen Presting

      There is good reason why Project-Syndicate carries no stories on the scandal regarding the American ambassador's death in Benghazi, Libya - There is no story. The same reasoning applies to the CRA. There is no scintilla of evidence that CRA incentives had anywhere near the volume necessary to influence the housing bubble.

      This article is much less informed than the commenters who are criticizing it. That is a sign of a highly valuable web resource, having made a bad editorial decision. Let's all step up our game, please.

  11. CommentedPaul Mathew Mathew

    If you read Raghuram Rajan`s book Fault Lines, you will quickly find out where he is coming from - he is a toady to banking interests.

    How else do you think you win Goldman Sachs FT finance book of the year.

  12. Commentedjames durante

    It is fine for anyone to "take a more balanced approach." But that is not what this apologist for the free marketeers does. A balanced approach would not simply point out one small facet of a problem that may have been overlooked. Rather it would try to weight the different factors. If one does so it seems hard to escape the fact that the historically low interest rate set by the fed coupled with an exploding demand for sub-prime mortgages, to be packaged into securities, were the most salient factors in the housing bubble.

    Additionally, I can't imagine that the bankers really mind being "blamed" for the crisis as long as taxpayers bail them out and they return to record profits. Of course they do this by taking advantage of a historically unprecedented spread between their borrowing costs from the fed and the interest rates they charge. For the average American who is left screwed and tatooed he can rest assured that "we all have to make sacrifices."

  13. CommentedElizabeth Pula

    The bankers did do it, are still doing it. The regulators plead whatever like historically forever whenever, and the taxpayers in more than one country are stuck, as historically usual, paying the tab. Same story with different dates and players.

  14. CommentedKen Presting

    I would suggest to the editors of Project-Syndicate that they reconsider accepting further submissions from this author. The present article is misleading and not a positive contribution to discussion.

    The study cited in makes no attempt whatsoever to address the issue raised by the title, and in fact is irrelevant to the question of whether illicit banking practices created the housing loan crisis. It is welcome news that the CRA motivated local banks to make loans which defaulted at a rate only 15% higher than without the CRA. It was always known that the CRA would increase banks' costs and risks. That was the whole point - to force banks to contribute to Community Reinvestment even though it was less profitable than other lending.

    However, the author's question requires us to know whether CRA-mandated activity and losses had the magnitude relevant to influence the credit bubble and eventual bust. Neither the article cited nor the author's discussion address that fundamental issue.

    It is well established that certain mortgage-backed securities were recommended by investment bankers to institutional clients, while the brokers themselves were short-selling those same securities. This has been called "the heart of securities fraud" but this author want us to forget that. Yes, the bankers did it, and the recent guilty plea by UBS shows that bankers are still doing it. There is no legitimate doubt about whether there is criminal activity in systemically important institutions. The question is how can we stop it.

    The article he cites weighs heavier against his thesis than for it. We have been seeing screeds like this for years in Forbes and the WSJ. They are persuasive only to those who would never click through to an academic paper. I expect rather better on Project-Syndicate.

      CommentedKen Presting

      My intellectual values require a quantitative comparison between putative cause and theoretical effect. None of us here want to see any rehash of either free market deification or central planning apocalypse. America's genius is of checks and balances, isn't that our working consensus?

      CommentedAnthony Juan Bautista

      Hilarious: Rajan has made propositions at variance with my values--let's censor him! You have the same absence of imagination that got us into this mess in the first place.

      Hold on for the FHA bail-out.

      Government is good. Government will save us. Government would never harm us.

  15. CommentedShane Beck

    The problem is not CRA and its effect upon sub prime lending as par se, the sub prime loan is still backed by an asset, even if it has negative equity. Furthermore the risk of sub prime loans held by banks is directly observable and can be factored into the risk management practices of the bank. The problem was packaging of sub-prime loans into CDOs. The CDOs could not be rated properly for investment purposes and there was a distinct disjunction of responsibility between the banks issuing the sub prime loan, the investment firms selling the CDOs, the rating agencies who rated them and the international investors who bought them. It was in effect a ponzi scheme where all profited until the housing bubble in the US burst. The CRA had little to do with it, the banks would have flogged those sub prime loans as much as possible regardless of the CRA since there was great profit to be made selling them as CDOs.

  16. CommentedSimon Matthew

    Rajan is flogging a dead horse here. Several European countries also had housing bubbles-where is their CRA? Also, the CRA isn't just some random boogeyman regulation, it's a principles effort to make sure that sources of credit don't discriminate by race.