In this new American Game of Bank Bargains, populism continued to play a central role in determining the allocation of credit and profit. However, by the late twentieth century, the center of populist power had shifted from rural areas to big cities. In 1977, Congress passed the Community Reinvestment Act to ensure that banks were responsive to the needs of the communities they served. The CRA required banks that wanted to merge with or acquire other banks to demonstrate that responsiveness to federal regulators; the requirements were later strengthened by the Clinton administration, increasing the burden on banks to prove that they were good corporate citizens. This provided a source of leverage for urban activist organizations such as the Neighborhood Assistance Corporation of America, the Greenlining Institute, and the Association of Community Organizations for Reform Now, known as ACORN, which defined themselves as advocates for low-income, urban, and minority communities. Such groups could block or delay a merger by claiming that the banks were not in compliance with their responsibilities; they could also smooth the merger-approval process by publicly supporting the banks. Thus, banks seeking to become nationwide enterprises formed unlikely alliances with such organizations. In exchange for the activists’ support, banks committed to transfer funds to these organizations and to make loans to borrowers identified by them. From 1992 to 2007, the loans that resulted from these arrangements totaled $850 billion. From the point of view of an ambitious banker who was seeking to create a megabank of national scope, making such loans, which represented risks that the banks might not otherwise have taken, was simply part of the cost of doing business.
The alliance between megabanks and urban activist organizations became even more ambitious as it drew in a third set of partners: the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation, commonly known as Fannie Mae and Freddie Mac. CRA-mandated loans posed higher levels of risk to banks than more traditional mortgage loans. To reduce the potential harm to the their bottom lines, banks made it clear to their activist partners that there was an upper limit on how much credit they would extend. In response, activist groups successfully lobbied Congress to require Fannie Mae and Freddie Mac to repurchase the mortgage loans that banks had made to low-income and urban constituencies to meet the obligations of the CRA. After Congress enacted those requirements in 1992 — and especially after the Clinton administration progressively increased the proportion of Fannie Mae and Freddie Mac loan repurchases that met the low-income or urban criteria — even more credit could be directed to targeted constituencies at less cost to the banks. The banks were now able to resell some of their CRA-related mortgages to Fannie and Freddie on favorable terms.
The government mandates on Fannie and Freddie were not vague statements of intent. They were specific targets, and in order to meet them, Fannie and Freddie had little choice but to weaken their underwriting standards by permitting higher leverage, weaker mortgage documentation, and lower borrower credit scores. By the mid-1990s, Fannie and Freddie were agreeing to purchase mortgages with down payments of only three percent, compared with the 20 percent that had long been the industry standard. By 2004, they were purchasing massive quantities of “liar loan” mortgages, made to borrowers who were not required to document their incomes or assets at all.
Fannie and Freddie, by virtue of their size and their capacity to repurchase and securitize loans made by banks, set the standards for the entire industry. When Fannie and Freddie weakened their underwriting standards in order to accommodate the partnership between megabanks and urban activist groups, their weakened underwriting standards ended up applying to everyone. Thus, when Fannie and Freddie started taking huge risks, they changed the risk calculus of large numbers of American families, not just the urban poor. Middle-class families could now borrow heavily and buy much bigger houses in much nicer neighborhoods than they could have bought previously. The result was the rapid growth of mortgages with high probabilities of default for all classes of Americans — and the widespread effects of the subprime crisis. By distorting the incentives of bankers, Fannie and Freddie, government agencies, and large swaths of the population through implicit housing subsidies, the new American Game of Bank Bargains led to a crisis of phenomenal proportions. For a while, almost everyone who played was a winner. When the bubble burst, of course, almost everyone — most particularly and tragically the urban poor — became a loser.
That’s Charles Calomiris and Stephen Haber writing in the latest Foreign Affairs ($). Read the whole thing if you can.