Credit supply has been a long-term interest to the federal government because home ownership and economic growth depend on people having access to credit. After October 2008, however, many claimed that actions by Washington to expand credit supply also expanded subprime lending. This paper focuses on whether actions to expand credit to low-moderate income borrowers helped cause the subprime crisis.

Redlining is the act of denying credit to low-moderate income neighborhoods. After the passage of the Civil Rights Act in 1964, many groups petitioned Washington to prevent redlining. These groups, like ACORN, believed that redlining was an implicit form of segregation that ghettoized urban neighborhoods. They believed it created incentives for home owners and landlords to simply abandon buildings if they could not refinance or modify their loans, which ultimately lowered property values in the area. Groups in favor of reform also argued that it was unjust for a bank to collect deposits within a neighborhood and deny loans to those same residents. In response to these concerns, Congress passed the Community Reinvestment Act (CRA) in 1977. The CRA gave the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision the authority to assess and monitor the lending practices of commercial banks.

In this paper, I seek to answer two questions regarding redlining and the CRA. Is there evidence that redlining exists? Did the CRA contribute to the growth of subprime loans prior to the 2007-2008 financial crisis? I present a literature review that debates these questions. Most literature has shown that redlining is an insignificant practice, but suggests that discrimination can still occur at the individual level. Of course, there are specific cases of redlining, but the practice is not prevalent. I also present a literature review that debates the CRA’s effect on subprime lending and whether it helped cause the subprime crisis. Although critics of the CRA tell a compelling story that connects regulations to increased subprime lending, the empirical literature suggests that the CRA did not cause the subprime crisis and may have even detracted subprime lending.

Redlining

Although the main interest of this paper is to discuss the CRA’s role in the crisis, it is best not to assume that redlining exists. The information known about the practice informs our understanding about the CRA’s construction. In this section I will discuss the history of redlining, possible causes of redlining, arguments that support the notion that redlining is an actual practice by lending institutions, and arguments that say that redlining is not a common practice. The empirics suggest that redlining is not a prevalent practice, but racial discrimination can still occur.

Many often argue that the Home Owners’ Loan Corporation (HOLC) Act of 1933 created redlining. The purpose of this act was to prevent home foreclosures during the Great Depression by refinancing mortgages. This program extended the maturity of millions of loans to 20-25 years. The new terms amortized loans so that borrowers could have more time to pay in a steady and predictable way. HOLC also issued new low-interest loans to former homeowners who lost their properties during the Great Depression. The provision of services, however, was far from perfect and paved a path for discriminatory lending practices (Massey and Denton 1993; 51).

HOLC separated urban neighborhoods into four different risk categories through a Residential Security Map. The ones considered to be most at risk of default were colored in red ink because HOLC servicers were cautious to lend in these red zones. Unfortunately, the residents in these zones tended to be low-income African Americans. Although Massey and Denton (1993) do not explicitly say that HOLC’s method was a form of racial discrimination, they imply that it was.

Some also contend that HOLC initiated racial discrimination on a wider scale. Jackson (1985; 198-199) argues that while HOLC “did not initiate the idea of considering race and ethnicity in real-estate appraisal… [it] simply applied these notions of racial and ethnic worth to real-estate appraising on an unprecedented scale”. He shows that other individuals, including realtors, applied bigotry into their decision making. Racism against African Americans was so high that people were openly antagonistic toward “the attempts of middle-class black families to escape from ghetto areas” (198). However, Jackson does not mean that HOLC changed the way people thought about blacks or black ghettos, but that it brought the practice of racial discrimination in the housing market to new level.

Considering that HOLC ended in 1950, it is clear that HOLC alone did not make redlining a widespread problem. What made redlining problematic was that national banks also adopted the method. During the 1930’s, the Federal Home Loan Bank Board circulated a questionnaire to banks and lending institutions from across the country. When asked, “What are the most desirable lending areas?” these lenders responded that “Blue” zones were the most desirable. When asked, “Are there any areas in which loans will not be made?” these lenders responded that they would not lend in “Red and most yellow” zones (Jackson 1985; 203). There is a marked difference between lending practices by these private institutions and that of HOLC. Even though HOLC established the Residential Security Maps, it was still impartial to the individual borrowers in the red zones (Jackson 1985; 202). Although HOLC’s pattern of lending was not discriminatory in practice, its underlying method helped institutionalize discrimination throughout the mortgage lending industry.

Looking closer into the survey results, it is not clear that redlining is the generally accepted practice among lending institutions. Did lenders follow similar practices as HOLC, where they considered both the borrower’s neighborhood and the borrower’s credit risk? Or did they simply look at the borrower’s neighborhood and the borrower’s race? These questions motivate a debate about whether redlining was even a formal practice among commercial banks.

Bradbury, Case and Dunham (1989) find evidence of redlining by mortgage lenders or real estate institutions in Boston. They partition Boston neighborhoods into metropolitan statistical areas defined by the Census Bureau, City of Boston, and neighborhood groups. The initial analysis found that much of Boston’s black population resided in the Roxbury-Mattapan corridor, while low-income neighborhoods did not have that same concentration. This result suggests that Boston contained many low-income white neighborhoods. They then determine the origin of mortgages through individual deed transfers from the Suffolk County Registry of Deeds, which contains all lending information in the county. They find that the ratio of mortgage loans to potentially mortgageable homes in predominantly black neighborhoods is lower than the ratio in predominantly white neighborhoods. Loans originated on 6.9% of owned structures in predominantly white neighborhoods, 3.5% in predominantly black neighborhoods, and 2.7% in neighborhoods where more than 80% of the population was black. However, Bradbury, Case, and Dunham are unable to determine if redlining occurs at the housing market level or at the mortgage market level.

Contrary to these findings, Holmes and Horvitz (1994) argue that lending has less to do with one’s race, and more to do with economic criteria. They draw data from 1990 census tracts in Houston and 1988-1991 mortgage data from the Home Mortgage Disclosure Act (HMDA). HMDA requires banks to report the number of loans made within a location, report data on loans denied, and detail the sex, race, and income of applicants. HMDA, like the CRA, was a response from Congress to prevent discrimination. Holmes and Horvitz use deed files from the Harris County clerk’s office to analyze defaults. After controlling for economic factors, they find “no evidence that racial composition or changes in racial composition by census tracts affects the flow of mortgage credit. The data do not support claims of racially based mortgage redlining”. In addition, they find that the leading indicator of whether a borrower will receive a mortgage and default is college education, where education is not a proxy for racial variables.

In addition, Tootell (1996) finds no evidence in redlining in Boston, but finds evidence of racial discrimination. This study draws from 1990 HMDA data. Although initial analysis of HMDA data shows that “applicants in minority neighborhoods were almost three times as likely to be denied a loan as applicants in white areas”, Tootell points out that HMDA lacks crucial economic information about applicants. It only shows the applicant’s income level, but not other factors that lenders use to determine the applicant’s credit. To compensate for this problem, the Federal Reserve Bank of Boston gathered additional information that a standard mortgage application would contain. From this new data, Tootell finds that “the race of the applicant, not the racial composition of the neighborhood, is important in the mortgage lending decision…Discrimination, not redlining or steering, appears to be occurring in the mortgage market in Boston”. These findings point to a more individualized form of discrimination. Lending discrimination has less to do with the community that an applicant resides in, and more to do with his or her appearance when sitting with a mortgage lender.

The Community Reinvestment Act

Congress passed the Community Reinvestment Act in 1977 following concerns by community organizations that banks redlined minority communities. It is important to note that even though Congress passed the CRA in response to concerns of racial discrimination, the law itself does not state that banks should increase lending to minorities. Instead the CRA encourages banks to increase lending to low-income borrowers in a safe and sound way. In addition, the CRA only covers commercial banks and thrifts, and thus does not cover all types of lending institutions, such as credit unions or non-bank mortgage lending companies. The first version of the CRA was relatively weak compared to how it is enforced today. During its first twelve years, the CRA only required banks to report how much they lent to the neighborhoods and where they collected deposits. In 1989, the CRA was amended to make that information available to the public.

Since the 1990's, Congress reformed the CRA to increase enforcement because of growing concerns that the initial version of the law did not properly restrict discrimination. New studies that used 1990 census data and late-1980's — early 1990's HMDA data found that lending discrimination was still a problem (Munnell et al. 1992). The Federal Reserve, FDIC, OCC, and OTS were given more authority to regulate banks and examine their lending practices. After assessing each bank, these agencies gave ratings on the scale of “outstanding”, “satisfactory”, “needs to improve”, or “substantial noncompliance”. The agencies then used these ratings to determine whether a bank can open or relocate offices, open new branches, merge or acquire other institutions, and apply for a bank charter.

In addition, the charters of the CRA and for newly formed Government Sponsored Enterprises (GSEs), such as Fannie Mae and Freddie Mac, sought to make housing more affordable to low-moderate income people. The purpose of this program was to reduce urban poverty and increase home-ownership among the least fortunate. Thus, the CRA and GSEs aimed to increase lending in low-moderate income neighborhoods that may have residents with higher credit risk.

The correlation between these reforms and the subprime crisis is the basis of criticism from several people who believe that the CRA and GSEs created the crisis. Most notably, Wallison (2008) believes that the “most important fact associated with the CRA is the effort to reduce underwriting standards so that more low-income people could purchase homes”. Wallison asserts that the government intentionally spurred subprime lending through the CRA “at the behest of community groups and ‘progressive’ political forces”. He points to trends in homeownership since the CRA was amended in 1994. For instance, homeownership was at 64 percent for 25 years prior to 1995, but grew to 69% between 1995 and 2005 (Vlasenko 2008). Wallison also asserts that housing prices doubled between 1995 and 2007 because the CRA spurred housing demand. The final nail in the coffin is growth in subprime lending: between 2001 and 2006, subprime loans rose from 7.2 percent to 18.8 percent of total loans, while Alt-A loans rose from 2.5 percent to 13.9 percent of total loans. Through these numbers, Wallison paints a compelling narrative of how the government’s actions caused the subprime crisis.

White (2008) shares that same belief. White asserts that banks responded to the CRA amendments by joining “into partnerships with community groups to distribute millions in mortgage money to low-income borrowers previously considered noncreditworthy”. Other banks also adopted the practice of purchasing mortgage-backed securities (MBS) in order to increase their CRA ratings. The MBS contained disproportionate amounts of subprime loans that met CRA criteria and were securitized by Freddie Mac. White also suggests that the benefits of purchasing MBS in order to raise CRA ratings deteriorated underwriting standards. Thus, White concludes that the CRA bears responsibility for the “total crop of bad mortgages” and for the “increase in defaults that has come from CRA-qualifying borrowers”.

In support of White’s argument, Nichols, Hendrickson, and Griffith (2011) find evidence that the CRA encouraged banks to buy mortgage-backed securities. Using a data sample from the FDIC’s Statistics on Depository Institutions on the largest 20 metropolitan statistical areas in the United States, they identify commercial banks that operated in each area between 1999 and 2008. They conclude from their findings that “the CRA pushed bankers into risky lending that may not have occurred in the absence of regulation” because the CRA pushed bankers to participate in MBS pools.

However, others look at these arguments with skepticism. Numerous papers argue that the CRA had little to no effect on increasing the amount of subprime loans by commercial banks (Berry and Lee 2006; Avery and Brevoort 2011), and Reid and Laderman (2010) even assert that the CRA perhaps prevented banks from granting loans to subprime borrowers. Avery and Brevoort (2011) criticize Wallison’s research method: “[L]oan volume differences by themselves…are insufficient to ‘prove’ that the regulations contributed to the elevated mortgage delinquency observed during the crisis”.

Berry and Lee (2006) analyze data from the HMDA, FDIC Summary of Deposits, and the Federal Reserve’s Commercial Bank Database between 1993 and 2003. Their application of regression discontinuity analysis did not identify the CRA as a causal effect for increased low-moderate income lending. They suggest that differences in loan rejection rates “likely reflect different business practices in areas where banks have a physical presence compared to where they do not, rather than any impact of CRA”. However, Berry and Lee do not go as far to say that the CRA had no effect on increasing the availability of credit for low-moderate income borrowers. They consider that “it is possible that CRA has influenced outcomes other than loan rejection rates or that its effects have been concentrated on particular sub-populations”. Despite these other possibilities, their findings do not support Wallison’s claim that the CRA degraded underwriting standards.

Avery and Brevoort (2011) also argue that the CRA did not play a significant role in the subprime crisis. Their approach examines whether mortgage defaults across low-moderate income census tracts show variation with lending activity by commercial banks. They use data from Equifax to determine whether a borrower was delinquent by the end of 2008 and use HMDA data to analyze the loan sizes in each tract. Their null hypothesis is if the CRA reduced underwriting standards, they would find worse outcomes in low-moderate income census tracts that were served by CRA-covered banks than when compared to similar non-CRA tracts. Through a regression discontinuity approach, Avery and Brevoort find “little evidence to support the view that either the CRA or the GSE goals caused excessive or less prudent lending than otherwise would have taken place”. There was no evidence that tracts with low-moderate income residents who borrowed from CRA-covered banks had higher delinquency rates than tracts without CRA-covered banks.

Reid and Laderman (2010), in concurrence with Berry and Lee (2006) and Avery and Brevoort (2011), argue that the CRA did not increase subprime lending; if anything, the CRA reduced the likelihood that banks would issue subprime loans. They argue that the CRA altered lending behavior because of regulatory scrutiny. Reid and Laderman compare CRA-regulated banks to non-CRA regulated lending institutions using HMDA data. To account for whether a loan was sub-prime, they determine whether a loan was higher-priced as a proxy variable. In addition, they merge the HMDA data with Federal Housing Finance Agency housing price data in order to capture housing, mortgage market, and economic conditions in their study. They find that CRA institutions are less likely to issue higher-priced loans than non-bank institutions and do a better job aligning loan terms with borrowers’ risk profiles. These findings suggest that the CRA was a layer of consumer protection during the subprime crisis by insuring that banks met the credit needs of low-moderate income communities, but did it in a safe and sound way. This study thus concludes that commercial banks may not have been at fault for the increase in subprime loans. Instead non-bank lending institutions, such as Countrywide, may be subject to blame.

Indeed, Bhutta (2008) finds that CRA institutions initiate crowding-in of non-bank lending institutions in densely population areas. This study focuses on whether reforms to the CRA caused banks to increase their lending volumes from 2000 census tract data and information from the HMDA. Bhutta finds that the CRA had a marginal effect on lending increases, with no effect in small and moderate density areas, but a concentrated effect in large cities. He suggests that small banks that are covered by the CRA increase lending because they want to avoid low CRA ratings. If a small bank that offers services to a segmented population receives a poor rating, it may damage the business. In addition, Bhutta identifies a mechanism that may explain why non-bank lending institutions crowd-in where CRA-covered banks lend. He suggests that increased homeownership (due to the presence of CRA institutions) increases the demand to refinance and access credit. Both commercial banks and non-bank institutions will enter the market to meet that demand. An alternative mechanism proposed by Lang and Nakamura (1993) suggest that as home sales increase, more public information about neighborhood home values will also increase. These increases make real estate appraisals more precise and lead to a greater equilibrium for credit supply from both bank and non-bank institutions.

Conclusion

In sum, racial discrimination may be a problem in lending, but the evidence does not suggest that the Community Reinvestment Act led the subprime crisis. The empirical evidence indicates that the CRA did not increase subprime lending nor deteriorate underwriting standards. The research even says that the CRA was not effective in increasing loans to low-moderate income borrowers (Bhutta 2008). Thus, the growth in subprime lending may not have come from banks, but may have instead come from non-bank lenders. Institutions like Countrywide may be responsible for increasing subprime loans. Furthermore, the CRA may have limited the number of subprime loans that commercial banks issued because of increased scrutiny over whether banks were lending to low-moderate income borrowers in a safe and sound way.

This is not to say that the CRA is totally not responsible for the growth of subprime loans leading up to 2008. It is possible that the CRA could have induced subprime lending through some indirect way, such as crowding-in by non-bank institutions, but testing such indirect mechanisms would be difficult. In addition, there are problems with research data. There is currently no data available on whether banks covered by the CRA have different delinquency rates than when compared to non-bank institutions. This crucial piece of information is the missing link to determine whether the CRA increased delinquency and subprime lending. Without that data it is likely that the debate will rage on between ideologues that promote less regulation and researchers that analyze what data is available, and that data does not prove that the CRA caused the subprime crisis.

Thomas Wong works at the Office of the Comptroller of the Currency and is a graduate student in economics at American University. He writes on public policy and economic issues.

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