Anti-Redlining Rule Helps Banks But Not Lower Income Communities, Fed Paper Finds

A rule designed to combat redlining of lower income and minority neighborhoods by banks did not encourage lending in those areas but did benefit banks, according to a new research paper by a Federal Reserve economist.

The paper finds that allowing banks to meet community lending requirements by purchasing loans made by others did not have its intended effect of increasing credit availability in low income and minority communities. Instead, banks purchase loans that would otherwise have been purchased by government mortgage enterprises, like Fannie Mae and Freddie Mac. Those loans often later get sold to Fannie and Freddie.

The effect is that those loans are temporarily diverted from Fannie and Freddie, prividing little benefit to the communities the Community Reinvestment Act is meant to help, the paper by economist Kenneth Brevoort of the Federal Reserve Board finds.

The Community Reinvestment Act, or CRA, was enacted in 1977 to combat redlining, the practice banks are frequently alleged to employ to cut off low-income and minority communities from access to mortgage credit. The law sought to prevent banks from accepting deposits in low-income areas and then using those to fund loans in higher-income areas, which its proponents claimed was causing capital flight from distressed communities and contributing to urban decay, by implementing exams by banking regulators to check if banks were meeting local credit needs.

A key part of the CRA exams for large banks has been a retail lending test that evaluates each bank’s record of lending to low-to-moderate income (LMI) borrowers and neighborhoods. From its inception, bank regulators have allowed banks to satisfy their requirements by either originating compliant loans or purchasing complaint loans. The idea was that allowing banks to purchase loans made by others would increase the liquidity of the low-to-moderate income lending market and encourage more lending.

Brevoort’s paper finds that giving banks credit for purchased mortgages did increase liquidity but did not encourage more lending.

Banks did significantly increase their purchases of loans that could meet CRA goals, Brevoort finds. The additional liquidity these purchases created conveyed no boost in lending in the targeted communities.

Part of the problem appears to be an overlap or redundancy between the CRA goals and the affordability goals of Fannie Mae and Freddie Mac, government-sponsored enterprises (GSE) that do not originate loans but purchase them, repackage them as guaranteed securities, and sell them into the secondary market. Often, banks themselves are investors in Fannie and Freddie securities. The overlap between the goals means banks are often purchasing mortgages that would otherwise have been purchased by Fannie and Freddie—and then selling them to the GSEs a few months later.

“The data examined in this paper are consistent with CRA having increased the liquidity of LMI loans but find no evidence that CRA-induced purchases have had any effect on credit availability in LMI communities. Instead, banks within their assessment areas appear to purchase loans that would otherwise be sold to the GSEs and that the GSEs ultimately acquired after a delay of less than 4 months,” the paper finds.
Brevoort finds that the main beneficiary of the rule allowing purchases to meet CRA goals is the banks.

While allowing lenders to meet their CRA obligations by purchasing loans appears to confer little benefit to LMI communities, the same cannot be said of banks. LMI shares calculated using purchases are notably higher for banks within their assessment areas than are originations-only shares, with the largest increases at banks whose originations-only LMI shares are lowest. While it is difficult to determine how much these purchases aided banks on their CRA exams, the fact that they chose to make these purchases implies they saw value in them.

While the purchase rule appears to provide no benefit, it is difficult to assess whether it exacts a cost on the communities the CRA is meant to protect. Without the rule, banks might have reduced their purchases but that would not necessarily have meant increased mortgage origination, Brevoort points out.