Community Reinvestment Act of 1977

How the Community Reinvestment Act of 1977 Helped Contribute to Failures in the Housing Market by Encouraging Excessively Liberal Lending Standards

The Community Reinvestment Act of 1977, or “CRA”, had an important role in the crumbling of the housing market over the past few years. It is critical for me to emphasize that I in no way believe that the CRA was solely responsible for the housing catastrophe. However, I do believe that the CRA directly contributed to the housing market’s demise by encouraging excessively liberal lending standards. In this article I will exclusively explore how the CRA adversely affected the housing market. Some facts may be excluded (intentionally or otherwise), but I will still strive to make a very compelling argument without presenting an “ideologically lopsided” position.

A Brief History of the Community Reinvestment Act of 1977

The CRA is actually part of a broader piece of legislation entitled “Housing and Community Development Act of 1977.” The purpose of the CRA, as stated by the bill, is threefold:

  • to require financial institutions “to demonstrate that their deposit facilities are [serving] the convenience and needs of the communities in which they are chartered to do business”
  • to define “convenience and needs” as “credit and deposit services”
  • to establish that financial institutions have a “continuing and affirmative obligation to help meet the credit needs of the local communities in which they are chartered”

The bill goes on to say that government supervisory agencies will “encourage such [financial] institutions to help meet the credit needs of the local communities in which they are chartered consistent with the safe and sound operation of such institutions.” Interestingly, there seems to be an “implicit assumption” that regulators are at least as capable as banks in determining whether or not a loan is “safe and sound.”

A primary enforcement mechanism of the CRA is the “Written Evaluation”, which has both public and confidential parts. The public part of the Written Evaluation essentially scores each financial institution with a rating of “Outstanding”, “Satisfactory”, “Needs to improve” or “Substantial noncompliance.” The scores indicate a bank’s level of “meeting community needs” according to either the Comptroller of the Currency, the Federal Reserve, or the Federal Deposit Insurance Corporation. Particulars such as names and information deemed to be too “sensitive and confidential in nature” are considered confidential and not released as part of the public report.

The CRA specifically required banks to extend credit to low- and moderate-income (“LMI”) individuals, defined as earning 50% and 80%, respectively, of the median income for their particular geographic region, and to individuals within LMI neighborhoods. Special attention was later given to minorities during the 1990’s, however I will discuss that issue later in the article.

There are a number of ways that banks can fulfill their LMI lending requirements, including but not limited to: mortgages, small business loans, education loans or any loan in which “the bank expects to make a profit.” It seems natural that if a bank were going to make a profit on a loan, they would certainly make it. So, the question remains why weren’t banks making loans to these groups? The Federal Reserve explains that the issue was partially due to imperfect information. The Fed posits that banks likely believed that there were “important, but unknown differences” between LMI credit markets and others.

The CRA was also part of an effort to prevent what was referred to as “redlining.” Redlining refers to the practice by bankers of literally drawing a red line around certain areas (typically LMI neighborhoods) on a map and declaring that no loans or mortgages will be made that originate from the redlined area. The issue was that many financial institutions that redlined certain areas took deposits from these areas, effectively using the deposits of the poor to fund credit for the rich. Therefore, in combination with the Home Mortgage Disclosure Act of 1975 or “HMDA”, Congress passed the CRA and regulators began seeking out redlining and stopping it.

The CRA Boom of the 1990’s

The 1990’s were an interesting decade marked by bizarre cigar antics and the massive boom and subsequent bust of dot coms. It was during the 1990’s that the CRA really gained power and began affecting the entire housing market. The scope and authority of the CRA was extended by numerous pieces of legislation and more specifically by regulators in the Clinton administration who were tirelessly enthusiastic about eradicating what they perceived as racism in the lending markets.

Perhaps the most significant piece of legislation affecting the CRA was the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, which made CRA performance evaluations a major determinant in whether or not the government would approve bank mergers, acquisitions, and the opening of new branches. Essentially, when a bank wanted to expand via one of the aforementioned processes the Federal Reserve – though possibly another agency – would complete a CRA evaluation of the bank. The CRA evaluation would then be presented to the public and community organizers, such as ACORN, would have the ability to review the CRA evaluations. If a bank was underperforming in the eyes of the government or the community organizers, either party had the ability to object to the merger/acquisition/new branch. Such objections have a very high potential to halt a bank’s expansion. So, any bank within CRA areas had to be sure to carefully follow CRA rules or else their ability to expand would be seriously impeded.

One of the first uses of CRA requirements to block bank expansion came just before the Riegle-Neal Act, in November of 1993. A New England company by the name of Shawmut was told that it did not satisfactorily fulfill its obligations under the CRA. Because of Shawmut’s alleged defiance of CRA guidelines, its merger was blocked. Essentially, regulators told Shawmut that their lending standards were too high to accommodate LMI individuals and neighborhoods. The government did not prescribe a solution, so Shawmut had no choice but to develop one on its own. Not surprisingly, the only ways Shawmut could get LMI mortgages approved was to lower the down payment to only 2.5% of the home price and by using “more flexible income criteria.”

Even still, what prompted the seemingly sudden enforcement of the CRA during the 1990’s? Most certainly, it was the availability of new mortgage data. In 1989 Congress passed the Financial Institutions Reform, Recovery and Enforcement Act or “FIRREA” that amended the HMDA, which was mentioned earlier as an act that sought to prevent redlining. The FIRREA amendments to the HMDA coupled with a revision of a rule made by the Federal Reserve know as Regulation C, required that all new loans report the following data to government regulators: “race, sex, and income of loan applicants and borrowers…the class of purchaser for mortgage loans sold and….[an explanation of] the basis
for their lending decisions.” As this data began to pour in over the subsequent years, regulators and politicians became armed with all the information necessary to begin pushing harder for CRA compliance.

Before I proceed it is of utmost importance that I note the obvious shortfall of the FIRREA. To begin, the data has absolutely no representation of an applicant’s credit worthiness, such as the FICO score. The implications of the exclusion of such data are immense. As a student of Economics it is quite easy for me to envision a situation where two applicants, one black and one white, apply for a mortgage. If we assume that they are both males and have equal salaries, yet the black applicant is declined, we may believe to be witnessing racism in lending. However, if we knew the applicants’ credit scores and they were significantly different, we may not be surprised at all by the decision to deny the loan. Nevertheless, for reasons unknown to sensible folk, measures of credit worthiness were excluded from the data set and have never been accounted for. Former Federal Reserve Governor Edward Gramlich pointed out in a 1998 speech that only knowing race, sex and income statistics would produce a form of “statistical discrimination.” Granted he was referring to banks assessing the ability of a lender to repay a loan, but it seems that he realized that such limited data is woefully insufficient to make any sort of judgment whatsoever.

The new data from FIRREA showed that blacks, whites and Hispanics had very different loan approval rates. For some reason, Janet Reno and other government regulators in the 1990’s (and many still today) assumed that because there were statistical differences between the three races’ loan approval rates, discrimination was going on. Therefore, Reno “threatened legal action against lenders who raised her suspicions.” In order to effectively force banks to approve more blacks and Latinos, Reno pressured regulators to give unfavorable CRA reviews to banks whom she defined as approving an unsatisfactory number of minorities. Once again, banks had to adapt to the new circumstances by lowering down payments and altering income requirements.

The Demonstration Effect

I have pointed out the numerous ways in which the CRA has changed over the years and the fact that it really began being enforced during the 1990’s. Now it is mandatory that I explain exactly how the CRA affected lending standards. The mechanism through which the CRA affected the market is called the “demonstration effect.”

Remember, the recipients of CRA loans are either LMI individuals or possibly middle- to high-income (MHI) individuals who reside within LMI neighborhoods. In the case of MHI individuals residing in LMI neighborhoods, it seems to be generally assumed throughout the CRA literature that the CRA protects them from redlining (in other words they qualify in all other ways except location). In the case of LMI individuals, however, the problem was not as much where they lived but rather that they were personally deemed too much of a risk. Theoretically, the CRA helped LMI individuals by forcing banks to rethink their risk assessment algorithm by focusing away from down payment and income constraints. This is where the demonstration effect begins.

The first important question to ask is “What was the banking industry’s response to the CRA?” The first fact to point out is that between 1985 and 1999 there were only 65 mergers/acquisitions/new branches that were blocked on CRA grounds out of over 1,000. This appears to be evidence that the CRA did not have as big an effect as many assert (myself included). There is a very easy explanation for this: banks want to expand. It is extremely easy to believe that as hard as regulators work to find CRA discrepancies, banks work equally hard to make sure that none exist. Many financial institutions have entire divisions whose sole purpose is the management of CRA projects and loans. Additionally,
many banks were finding that CRA loans were actually profitable and were thus enthusiastic about making the loans. Therefore, CRA banks were following CRA guidelines, expanding and making profit.

To understand the demonstration effect, we must look at the CRA from the standpoint of a non-CRA institution. First, throughout the 1990’s regulators and legislators were getting significantly more serious about extending credit to LMI individuals/areas. Second, for banks in CRA areas who were deemed unsatisfactory there were significant consequences in terms of both economic and reputation. Third, banks were making healthy profits off of CRA loans. Now, I understand that this may be pure speculation but it seems that if I were a non-CRA bank or lender I would wonder how soon the law would begin applying to me. Further, it seems that a rational agent would seek to eliminate possible
future regulation issues (not to mention allegations of discrimination) by voluntarily complying with the CRA. Former Federal Reserve Governor Edward Gramlich alludes to this fact when he says, “having been shown the way by banks, a number of non-financial corporations are now getting into the community lending business.” What is community lending? Overwhelmingly it is allocating mortgages to LMI individuals and areas. Gramlich does go on to say that it is possible that subprime lending would have occurred without the CRA, but that is highly suspect because of subprime lending’s relative absence prior to more strict enforcement of the CRA.

In 2000, the Treasury Department issued a report titled “The Community Reinvestment Act After Financial Modernization: A Baseline Report.” This report was required by the Financial Modernization Act of 1999 (FMA) and was intended to measure the “impact on the provision of adequate services as intended by the…CRA.” In fact, it is this very report that talks, albeit briefly, about the demonstration effect of the CRA. The report concludes that “the fact that both lenders covered and not covered by the CRA recorded gains in mortgage lending to LMI borrowers and areas from 1993 to 1998 suggests that CRA and a variety of other factors have helped to expand mortgage credit to LMI
borrowers and areas over the 1990s.” Some of the “other factors” include: a strong economy, lowering of lending standards by the FHA and GSEs, increased merger activity among banks and the data made available under the HDMA.

The report further explains that “the rapid growth in lending to LMI borrowers and areas by CRA- covered lenders and their affiliates, coupled with their increasing share of the market for prime loans to LMI borrowers and areas, suggests that the CRA has contributed
to the recent increase in mortgage lending to such borrowers.” If you carefully dissect the wording it becomes clear what is happening: CRA institutions are lending to LMI individuals and neighborhoods both inside and outside of their CRA areas. In essence, CRA banks had such a high demand to make loans to LMI individuals and neighborhoods because of pressure to do so from regulators, that they were lending outside of their area to fulfill their CRA obligations.

Summing up the demonstration effect is quite simple: non-CRA institutions saw what CRA institutions were doing and wanted a piece of the action. Unfortunately, the prime loans were being eaten up faster than Rosie O’Donnell with a palette of Ho-Hos. So, the non-CRA institutions decided to get even more creative on loan requirements and begin lending to near- and subprime LMI (and MHI in LMI areas) individuals. After all, as far back as 1998 regulators such as Federal Reserve Governor Laurence Meyer were lauding “new mortgage products” that were “targeted toward LMI individuals.” In a speech titled “Community Reinvestment in an Era of Bank Consolidation and Deregulation” Meyer expressed elation with the fact that companies were giving out 100% loan to value mortgages. It seems that Meyer and other regulators believed that because credit was available, it should be given out. In my opinion it is exactly this mentality that eventually
pressured non-CRA institutions into massive amounts of subprime lending.

After reading “CRA Lending During the Subprime Meltdown” by Laderman and Reid of the San Francisco Federal Reserve it became fairly clear that the demonstration effect story fits very well to explain the effect the CRA had on subprime lending. The report shows that CRA covered institutions were less likely to make loans to LMIs that end in foreclosure (7% vs 12%), although CRA institutions were responsible for more total foreclosures. I posit that the relatively low foreclosure rate is a product of the push by the regulators to force CRA banks to lend to LMIs. The problem, as I have previously stated, is that CRA banks aggressively pursue prime LMI mortgagors leaving a large proportion of near- and subprime individuals. In an effort to voluntarily comply with the CRA, non-CRA institutions lend to less qualified individuals, as evidenced by their relatively higher foreclosure rate.

Lastly, the Laderman and Reid paper, like many papers, seems to focus on what CRA lending institutions did compared to non-CRA. I think that type of comparison is shortsighted because it focuses on comparison and not the cumulative effects of legislation. As far as I know there are no studies that attempt to determine with empiricism whether the CRA had an affect on all financial institutions. I think that the Federal Reserve has a very substantial incentive to prove that the CRA is effective because they enforce it and receive very significant funding to do so. It seems that this issue will likely never be resolved because of the very unsavory results that will come from it.


Was the CRA a bad piece of legislation? In its original form, no it wasn’t. It was intended to stop blatant discrimination against the poor. It wasn’t until the 1990’s that the CRA gained an enormous amount of importance and power through acts like the HMDA and FIRREA. Once regulators had the legal authority to pressure banks into making loans to LMI individuals and neighborhoods, they took full advantage of it. Were the loans made by CRA institutions poor loans? Yes and no. ACORN [reluctantly] recognizes that CRA institutions were responsible for nearly half of all subprime loans. At the same time, the CRA had ample successes that actually did expand credit to LMI individuals who truthfully deserved it.

The CRA underwent numerous changes starting in 1989 with the Home Mortgage Disclosure Act, again in 1994 with the FIRREA and yet again in 1999 with the Financial Modernization Act. During the 1990’s regulators began to pressure CRA banks into making LMI loans. CRA banks made the loans and were surprised to see that the loans were, in point of fact, profitable. Non-CRA institutions noticed that not only was the government encouraging loans to LMI individuals and neighborhoods, but the government was also lauding innovation in mortgage instruments that allowed the poor to own homes. Since banks covered by the CRA were targeting prime customers, non-CRA institutions had no choice but to lend to near- and subprime individuals. Other factors such as GSEs purchasing near-prime mortgages, the securitization of mortgages, a relatively good economy, skyrocketing home values, non-CRA banks’ desire to profit from LMI loans and their need to have an image of being non-discriminatory certainly exacerbated the situation. But, in the end it was the CRA and the regulators’ enforcement thereof that ultimately led to lending standards being so low that asinine loans were made.

I hope that this article has at least provided a basic outline of my argument against the CRA. I was severely limited in my ability to succinctly lay out an argument because of the sheer complexity of the legislation, rules and time span of the matter. It is my contention that significant amounts of work still need to be done in order to empirically prove either the success of failure of one the most important pieces of legislation ever passed related to the current housing issues.