Wednesday, January 9, 2013

Is the CRA responsible for the crisis?

An important component, if not reason, of the last recession has been the run-up in sub-prime mortgages until 2007. There has been much speculation what could have triggered this, for example distorted incentives in the supply of mortgages, poor evaluation of risk, or predatory lending practices. Also mentioned has been the Community Reinvestment Act, which was implemented to reduce discrimination of lending in poorer neighborhoods and, as its title indicates, encourage mortgage holding in these areas. Could the CRA be the big culprit?

Sumit Agarwal, Efraim Benmelech, Nittai Bergman and Amit Seru claim the CRA did lead to more risky lending. This is based on the fact that mortgages given around the time of CRA examinations were 15% more likely to default. That is not that much a surprise as poorer neighborhoods do have riskier mortgage holders and banks had incentives to lend more during those exam periods. The real question is whether the risk was assessed and priced correctly.

The paper is still of interest. It shows that the effect was the strongest among the large banks (those that got bailouts...) and was more important while mortgage securitization was booming. Banks thus are not clean here.

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