Topic: Finance, Banking & Monetary Policy

Does CRA Undermine Bank Safety?

A recent policy forum here at Cato discussed the role of the Community Reinvestment Act (CRA) in the financial crisis.  While the forum focused on the federal push for ever expanding homeownership to marginal borrowers, the analysis did not touch directly upon the question of whether CRA lending undermines bank safety.

Fortunately this is a question that one economist at the Federal Reserve Bank of Dallas bothered to ask.  While his research findings were available before the crisis, they were clearly ignored.

In a peer-reviewed published article, appearing in the journal Economic Inquiry, economist Jeff Gunther concludes that there is “evidence to suggest that a greater focus on lending in low-income neighborhoods helps CRA ratings but comes at the expense of safety and soundness.”  Specifically he finds an inverse relationship between CRA ratings and safety/soundness, as measured by CAMEL ratings.

In another study Gunther finds that increases in bank capital are associated with an increase substandard CRA ratings.  Apparently bank CRA examiners prefer that capital to be lend out, rather than serve as a cushion in times of financial distress.

Given the current attempts in Washington to expand CRA, it seems some people never learn.  One can always argue over how CRA should work, but the evidence is quite clear how it has worked, once again proving: there’s no free lunch.

One Thing Greenspan Got Right and Bernanke Didn’t

While both Greenspan and Bernanke merit considerable blame for helping to inflate the housing bubble, it is worth mentioning what Greenspan did get right:  bringing to the attention of Congress and the public the risk posed to our financial system from Fannie Mae and Freddie Mac.

During Bernanke’s confirmation hearing last week, Banking Committee Chairman Chris Dodd criticized the Fed for not doing enough to warn Congress on systemic risks facing the economy.  Given Dodd’s attendance record, both as Chair and before, he can perhaps be forgiven if he missed one of Greenspan’s many appearances before the Banking Committee.

To help remind us, on Feb. 24, 2004, Greenspan told the Banking Committee:

Concerns about systemic risk are appropriately focused on large, highly leveraged financial institutions such as the GSE’s…to fend off possible future system difficulties, which we assess as likely…preventive actions are required sooner rather than later.”  In Greenspanspeak, that translates to “do something now.

Again on April 6, 2005, Greenspan warned the Banking Committee:

When these institutions were small, the potential for such risk, if any, was small.  Regrettably, that is no longer the case.  From now on, limiting the potential for systemic risk will require the significant strengthening of GSE regulation.

These are just a few of Greenspan’s many warnings to Congress on the risks posed by Fannie and Freddie.  In addition, economists at the Fed published numerous studies, during Greenspan’s tenure, on the nature of Fannie and Freddie.

Sadly, upon taking over as Chair of the Federal Reserve, Ben Bernanke scaled back these efforts.  Gone was the published economic research on GSEs.  Gone was the loud voice of authority from a Fed Chairman on GSE policy.  Instead, Bernanke choose to appease the GSE’s protectors in Congress.

While the Federal Reserve does not maintain primary regulatory authority over Fannie and Freddie, the Fed has long been viewed as the most credible voice in Washington on issues of systemic risk.  When faced with the choice of protecting the Fed, or protecting the financial system, by raising the pressure on GSE reform, Bernanke punted.  How he can be trusted to find the courage to taken on the next “Fannie Mae” is beyond me.

Here We Go Again

In the early 1990s, two Federal Reserve studies on mortgage lending were held up by proponents of interventionist government as proof that banks were discriminating against minorities. The government swung into action with lawsuits against allegedly discriminatory lenders, HUD started pressuring Fannie Mae and Freddie Mac to target the “underserved,” and the Community Reinvestment Act was enhanced to pressure lenders into lowering their lending standards. A decade later, the housing bubble, which was fueled by short-sighted government policies, burst and the financial well-being of many minority families crumbled along with it.

In a bad case of déjà vu, it’s being reported that “regulators will be bringing pressure on banks to make greater efforts to serve poorer communities after an FDIC survey showed that more than a quarter of U.S. households have little or no financial activity through banks.” This language is eerily similar to language employed in the 1990s that fueled liberal housing loan practices we now know were downright foolish. The recent news report continues:

The survey, conducted through the Census Bureau, found that 25.6 percent of the nation’s households – representing some 60 million adults – are ‘unbanked’ or ‘underbanked’… minorities, particularly African Americans, are disproportionately part of this group. More than half the black households fell into the two categories.

‘Access to an account at a federally insured institution provides households with an important first step toward achieving financial security – the opportunity to conduct basic financial transactions, save for emergency and long-term security needs, and access credit on affordable terms,’ FDIC chairman Sheila Bair said in a statement.

It used to be the “undeserved” in the housing market who supposedly needed the government’s help. Now it’s the “underbanked.” We were told that government involvement was necessary to make housing more “affordable.” Now the government is saying access to credit needs to be more affordable.

A lot of establishment analysts oppose term limits on Congress because they claim that we need experienced leaders to deal with today’s complex policy problems. But government officials stubbornly refuse to learn from their own mistakes, as we’ve seen over and over since the housing bust.

The Cost of Government Guarantees

John Kay’s column in yesterday’s Financial Times criticizes government guarantees to banks because they involve hidden but large costs. According to Kay:

  • Such guarantees distort competition: sheltered banks outperform rivals not because of greater efficiency, but because capital becomes cheaper to obtain.
  • Sheltered banks gain too-big-to-fail status, which creates barriers to entry for smaller, more efficient banks.
  • Relief from business risk leads to more risk taking, AKA moral hazard.
  • Cheaper private risk management incentives are reduced within and outside the bank.

Other kinds of government guarantees, such as social insurance, also involve large hidden costs. Social Security and Medicare’s guarantee of a paid holiday with medical care for the rest of retirees’ lives generates the same types of costs:

  • Labor competition is reduced because the programs induce early worker retirements, which leads to higher wage costs, on average, and lower national output.
  • Workers who believe they will receive Social Security and Medicare will engage in lower personal saving, which means less capital formation and lower economic efficiency.
  • Retirement income guarantees induce riskier personal savings portfolios, AKA moral hazard.
  • Guaranteed retirement income means poorer financial knowledge and poorer risk management.

And now, retiree political power is too big to fail as well!

How come when Kay writes about market distortions from government guarantees for banks, he gets published; but when I do the same about government guarantees for people, I get the cold shoulder from editorial page editors?

Volcker on Financial Reform and Economic Stimulus

In a recent edition of The Region magazine, published by the Federal Reserve Bank of Minneapolis, retiring Minn. Fed President Gary Stern interviews Paul Volcker on a variety of topics.  It’s an interview well worth reading, and reminds one why Volcker is one of the more thoughtful voices on economics and finance, even if he isn’t always right.

Some highlights.  On the Obama financial reform plan:

I do not share one part of the general philosophy which seemed to emerge from this, particularly the proposal that the Federal Reserve supervise directly all “systemically important” institutions. I don’t know what “systemically important” institutions are, incidentally, but I’m sure that if you picked them out, people will assume they’re going to be saved, that they’re too big to fail. At the same time, there’d be some that you don’t pick out in advance that you’d want to save under particular circumstances.  So I think that is a mistake.

Volcker also express concern that those institutions at the center of the crisis are left out of the reform.  Specifically he mentions that Obama Administration officials “haven’t said anything about Fannie Mae or Freddie Mac.”

Volcker also takes issue with the Administration’s proposal to regulate non-banks, including hedge funds and private equity.  “I wouldn’t regulate so strictly the nonbanks.  I’d like to create the impression…that there’s no automatic bailout of those institutions.”

Volcker also raises important questions about the Administration’s Keynesian stimulus actions.  As the stimulus was meant to replace a reduction in private sector demand, Volcker asks “are we really dealing with the underlying pressures in the economy without permitting a relative decline in consumption to proceed?”

Those are just a few of his comments.  Here’s to hoping the rest of the Obama Administration is listening.  They could do a lot worse than Volcker’s advice.

Remembering the Reporter Who Sued the Fed

With the Washington Post and other mainstream media outlets publishing endless defenses of “Federal Reserve independence” and proclaiming the Fed as savior of our financial system, it is all to easy to dismiss much of the media as simply defenders of the status quo.  There were many, however, willing to challenge this orthodoxy.  Standing out among them was Mark Pittman, reporter for Bloomberg.  It was Mr. Pittman who sued the Federal Reserve, winning a victory on August 24, as the Manhattan Federal Court allowed the suit to proceed.  Sadly, Mark Pittman passed away on November 25th. 

Mark Pittman and his employer, Bloomberg News, sought details on the Federal Reserve’s numerous special lending facilities.  Which firms were getting loans, and for how much and at what terms?  These were all details the American public were entitled to, yet were denied by the Federal Reserve.  We all remember the Fed’s warnings that if AIG counter-parties were named, there would be market disruptions.  Yet, after much public and Congressional pressure, those firms were named, with no adverse market consequences. 

While Mark Pittman’s efforts will be greatly missed, his suit continues, as does the efforts by Rep. Ron Paul and others in Congress, to bring transparency to the activities of the Federal Reserve.

They Never Learn

The town of Truckee, CA is an upscale community nestled in the Sierra Nevadas near Donner Summit off I-80. Housing is expensive.  Truckee’s origins were as a railroad town, so there is older housing.  In Truckee, however, downscale is funky and comes with upscale prices.  The Truckee Town Council has decided to provide “downpayment assistance” with loans at interest rates as low as 2 percent.

Those who work in Truckee often cannot afford to live there and the Truckee Town Council hopes to make housing affordable for them.  The program is thus paved with good intentions, but we know where that road leads.  Cato’s Randall O’Toole and Hoover’s Thomas Sowell have shown that land-use restrictions and zoning are principal causes of high-priced housing.  The recent housing boom and bust demonstrated how efforts to make housing “more affordable” largely made it more expensive.  And they ended up putting many into homes that they could not ultimately afford.

There are no reports that the Truckee Town Council is planning to ease land-use restrictions.  So they have done nothing to address the problem of pricey homes.  It’s supply and demand, and the Council is working the wrong side of the equation.