Administration Pressuring Banks to Make More Subprime Loans

Remember back in 2008 how the U.S. had a terrible financial crisis caused by too many subprime mortgages being issued by banks? Apparently, Washington doesn't. Even if you're cynical about the government's ability to learn from its mistakes, it seems unthinkable that it could be pressuring banks into making more subprime loans again. But according to a recent Bloomberg article, that's exactly what's happening.

From the article by Clea Benson:

Lawyers and bank consultants say regulators and the Obama Administration are scrutinizing financial institutions for a practice that last drew attention before the rise of subprime lending: redlining. The term dates from the 1930s, when the Federal Housing Administration drew up maps using red ink to delineate inner-city neighborhoods considered too risky for lending. Congress later passed laws banning lending discrimination on the basis of race and other characteristics. "The agencies have refocused on redlining because, in the wake of the subprime explosion and sudden implosion, they are looking at these disadvantaged neighborhoods and not seeing any credit access," says Jo Ann Barefoot, co-chair at Treliant Risk Advisors in Washington, D.C., which consults with banks on regulatory issues.

Let's start with a clear, unequivocal statement: racial discrimination is wrong and should not be tolerated. But is that really what's necessarily going on here? As the housing market struggles to find its footing, its problems have become highly localized. Even in a given county, one city might see housing price stabilize, while prices in another city continue to fall.

So if by "redlining," regulators are finding that banks are "discriminating" against certain neighborhoods because home prices there have yet to stabilize, then that seems pretty reasonable, even laudable. But if they have the minutes of a board meeting where one officer states, "Listen, no more loans to (African American/Latino/Asian/Indian/etc.) people, because I don't trust them." Then, that's not okay. Borrowers should not be using race as a credit characteristic, but they should use a neighborhood's localized housing market health as a risk factor.

The 1977 Community Reinvestment Act (CRA) requires banks to make loans in all the areas they serve, not just the wealthy ones. A Bloomberg analysis found the percentage of banks earning negative ratings from regulators on CRA exams has risen from 1.45 percent in 2007 to more than 6 percent in the first quarter of this year.

This is an interesting statistic. There's some controversy surrounding how big a role the CRA played in the subprime crisis. And yet, now that banks have tightened their lending requirements, far more are failing to comply with the CRA. This appears to imply that if banks did not have to comply with the CRA, then they would originate safer loans. Indeed, they do have to comply with the CRA but more are increasingly failing to do so anyway. They may believe penalties they face would be less costly than additional bad loans.

At the Justice Dept., a new 20-person unit dedicated to fair lending issues received a record number of discrimination referrals from regulators in 2010 and has dozens of open cases, according to a recent agency report. Potential penalties can reach into the millions of dollars. "We are using every tool in our arsenal to combat lending discrimination," Thomas E. Perez, the assistant attorney general for the Civil Rights Div., told a conference of community development advocates in Washington in April.


Let's stress this one more time. Discrimination in its broadest sense is a positive behavior on the part of a bank. If a bank didn't discriminate between borrowers, then it would give a loan to anyone and huge losses
would result. It's like if you're at the grocery store picking between two apples. If one is rotten and the other is without blemish, then you pick the good one. That's discrimination.

But not all discrimination is done in the name of logic and sound underwriting practices. As previously stated, discrimination based on race should not be tolerated, but it's not at all clear that's what's going on here. Instead, it sounds like regulators are pressuring banks to make what could very well be lots of bad loans, if they're in areas where home prices will continue to fall and borrowers do not demonstrate a clear ability to pay. And of course, since the government is backing virtually all mortgage at this time through various agencies, many of those losses will ultimately hit taxpayers.