The Credit Crisis and Working Americans

s p e c i a l

r e p o r t

The Credit Crisis and working america

a special report with articles by Robert Kuttner, Janneke Ratcliffe, Kai Wright, Edmund Mierzwinski, Ellen Seidman, Adam Serwer, Tim Fernholz, Tamara Draut, John Taylor, Mark A. Willis, and Barry Zigas

contents

a2 Reforming Credit by robert kuttner a4 A Bridge to Somewhere by janneke ratcliffe a7 The Assault on the Black Middle Class by kai wright a11 Regulation as Civic Empowerment by edmund mierzwinski a15 Don’t Blame the Community Reinvestment Act by ellen seidman a18 Banks as Heroes by adam serwer 20 When Creditors a are Predators by tim fernholz a23 Financial Product Safety by tamara draut 24 Reversing the Damage a by john taylor 26 Community Reinvestment: a The Broader Agenda by mark a. willis 29 What Does Financial a Capital Owe Society? by barry zigas

Illustrations by Peter and Maria Hoey

this special report was made possible through the generous support of the Ford Foundation.

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Reforming Credit Our financial system needs to work for consumers at all income levels. A guide to the crisis, its causes, and cures by ro be rt Kut t ner

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merica’s financial crisis and the related recession are not hitting everyone equally. While many well-to-do investors have lost wealth in the plunging stock market, lower-income Americans were the first victims of the calamity, taken in by rapacious sub-prime mortgages and other predatory forms of consumer credit.

As many as 10 million families will lose their home before this crisis is resolved.

Tens of millions more are finding that their home equity, the fruit of many years of faithful monthly mortgage payments, has shriveled up because of declining housing values.

Meanwhile, other forms of consumer credit are also in disarray. Moderateincome Americans, who faced decades of declining job and income security, found themselves relying on home-equity withdrawals or exorbitantly priced credit-card borrowings as a substitute for adequate income and decent social protections.

Tamara Draut has called this the plastic safety net. But with banks tightening credit requirements and home equity plummeting, that personal financial strategy is no longer available; it was always a precarious cloak for shameful levels of inequality and insecurity. So hardship continues, and it is no more equally distributed than anything else in America.

This financial bubble and collapse had a wholesale dimension and a retail one.

At the wholesale level, a series of highly speculative, complex, and opaque business strategies by financial giants like Citigroup, Countrywide Financial, Lehman Brothers, Bear Stearns, American International Group (AIG), and others bid the prices of assets up to levels well beyond their sustainable value. These bets were indulged by weak, captive, corrupted, or ideologically compromised regulatory agencies. When the bets went

bad, America’s largest financial institutions, some of which had quite literally bet the company on these gambles, were revealed to be insolvent. Government had to come to the rescue with a $700 billion bailout package and trillions more in loans and loan guarantees by the Treasury and the Federal Reserve.

And the crisis is far from over.

At the retail level, this system depended on a far-flung industry to create those assets, which involved deceptive products like sub-prime loans, hidden credit-card charges, and predatory forms of consumer credit such as payday loans with annual interest rates in excess of 400 percent. The retail abuses were connected to the wholesale collapse most explicitly through the whole sub-prime loan system: Mortgage companies marketed loans to moderateincome consumers on terms that would become unaffordable after a brief period of “teaser” rates. These retail loans were connected to the wholesale part of the system through an elaborate web of overlapping relationships. The mortgage companies were bankrolled by big Wall Street investment banks; the loans were bundled into high-risk securities; packages of those securities were then blessed with triple-A ratings by corrupt rating agencies; big commercial banks bought some of the securities through off-balance-sheet affiliates; and some of these securities were insured by firms like AIG. When the retail loans began going bad, the entire system collapsed, bringing down the giant w w w. p ro s p ect. o rg

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gary c . c a skey / upi / l andov

banks and investment banks whose bets on these loans were very highly leveraged.

The sub-prime circuit provides a snapshot of the rot in the entire system.

while the wholesale dimension of the financial crisis has received the most attention, this Prospect special report is about the retail part of the crisis, as it has affected people of modest means.

What were the abuses? What were their connections to the larger crisis? Who got hurt? And what are the remedies? The authors include journalists, experts, and advocates who are fighting these battles on the front lines.

Reform will require a top-tobottom remaking of American finance, wholesale and retail, based on far more stringent regulation. At the wholesale level, that project will entail assuring that no institution with the capacity to create credit is exempt from regulation. It must include supervision and examination of many financial products that ordinary Americans never encounter. These are arcane inventions such as creditdefault swaps and diverse forms of securitized credit that were largely the province of insiders and speculators. But these obscure products contributed to the crash of the entire system in a fashion that reduced the incomes and the security of regular people who had never heard of them, much less invested in them.

At the retail level, we also need a radical overhaul of basic consumer protection.

Three decades ago, most financial products came in one flavor—vanilla. The standard mortgage was a 30-year loan with a fixed rate and a down payment. There were no sub-prime loans; variable-rate loans were in their infancy. Usury laws, until overturned by a Supreme Court decision in 1978, provided universal protection against exorbitant interest charges.

Three decades ago, there were of course abuses, but because the system’s products were relatively standard, the abuses were fairly easy to remedy as a technical matter. The hard part was the political will.

However, from the early 1960s to the late 1970s, until Reaganism intruded, a

robust consumer and civil-rights movement persuaded allies in Congress to pass more than a score of reform bills.

The abuses of that era included overt discrimination against women and minorities. Until the 1960s, it was entirely legal to deny a black family a mortgage because they were black, or to refuse to count a wife’s income in a mortgage application on the premise that she might become pregnant. The 1968 Fair Housing Act made overt lending discrimination illegal. The 1977 Community Reinvestment Act added an affir-

mative obligation for lenders to reach out to formerly redlined neighborhoods.

On the consumer-credit front, the Truth in Lending Act of 1968 required the true interest cost of a loan to be stated in simple and transparent terms. The Fair Credit Reporting Act of 1970 allowed consumers access to their credit reports with the ability to correct mistakes. Although the industry kicked and screamed about the costs of these and other protections, the consumercredit system of that era was well on the way to greater transparency, and access to affordable credit continued to expand.

This era of reform demonstrated that when political constituencies are mobilized, proconsumer regulation is possible. after 1980, however, the financial industry responded by making its products and business strategies ever more complex and opaque. The industry did end runs around nearly all of the regulation, creating new gimmicks that regulators declined to track. Some forms of regu-

lation, such as the 1933 Glass-Steagall Act separating commercial banking from investment banking, were explicitly repealed. Others, such as the Home Ownership Equity Protection Act of 1994, which had been opposed by the Federal Reserve, were simply ignored by corrupted regulators. The current financial collapse is the logical result of this pattern of allowing finance to run wild.

Now, we must fight these battles all over again. At the retail level, we have seen modest progress with a credit-card reform bill signed into law by President Barack Obama on May 22. The law prohibits the most extreme predatory abuses such as deceptive rate increases and hidden fees. The president also issued an important executive order, reversing a Bush-era policy of encouraging federal regulatory agencies to preempt stronger consumer protections at the state level. Still to come are battles over such questions as how to modernize the Community Reinvestment Act; how to stop the escalating spiral of home foreclosures; how to expand access to normal financial services for low- and moderate-income communities; and whether to enact a Financial Products Safety Commission.

Wholesale reform of regulation has only begun, and the struggle will be uphill. Wall Street has been disgraced by this crisis but not yet dethroned as a political force. The big banks, hedge funds, and private-equity companies are fiercely resisting efforts to put them back in harness so that they are servants of the real economy rather than masters.

But protecting consumers and borrowers will also require building new institutions, rooted in communities and dedicated to the public mission of expanding economic security and opportunity.

This Prospect special report is designed as a guide to these several interrelated issues. It begins with an assessment of how ordinary people fell victim to the abuses of a predatory system and then moves into several takes on regulatory remedies. We thank the Ford Foundation for making our report possible. tap the american prospect

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A Bridge to Somewhere The road from predatory lending to good financial services for all Americans by ja nneke Ratcl i ffe

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or most Americans, the banking system is a tool to manage our money and build security. Through an array of competitively priced financial products, we can cheaply and easily convert income into assets, make payments, store and invest money, and borrow for consumer purchases, homes, and businesses. To the extent that we flourish, so too do the institutions within this system.

Unfortunately, lower-income consumers operate within a separate and decidedly unequal system. Mainstream providers have little interest in competing for this high frequency/low-balance business, forcing lower-income families to rely on check cashers, payday lenders, pawn shops, automobile-title lenders, high-priced credit cards, tax refund advance lenders, and predatory mortgage lenders.

Given the premise that low-income people are a meager source of business, the scale of the sector is mind-boggling. Today, check-cashing and payday-lending outlets in America outnumber all the McDonald’s, Burger Kings, Targets, Sears, JCPenneys, and Wal-Marts combined (33,000 versus less than 29,000, respectively, in 2004).

Add in all the other alternative service providers, and you have a vast and often rapacious network offering easy access to the financially strapped.

Excess fees and interest charged by these fringe services drain resources from vulnerable communities. They erode the value of modest paychecks and of federal programs seeking to lift people out of poverty. For example: $2 billion is stripped off the Earned Income Tax Credit benefits for the working poor annually by tax providers and their refund-advance products.

Check-cashing fees can cost two weeks’ salary over the course of a year. Payday loans extract more than $4 billion a year in fees. With the lure of small weekly pay a4

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ments, rent-to-own businesses (RTO) offer appliances, furniture, and electronics at prices many times retail. For example, a computer retailing for $851 can be obtained at an RTO shop for only $49 a week; after 91 payments (that’s 21 months) it will be all yours for just $4,449; miss a payment and you risk forfeiting the item and all payments made.

At their best, these services address basic needs at exorbitant fees, but without features that help build financial security. Use of fringe financial services doesn’t build credit histories or moneymanagement tools, and savings vehicles are almost unheard of.

In their worst forms, alternative financial services compound low-income families’ economic hardships. The standard payday loan has a 400 percent annual interest rate. A typical sub-prime credit card with a $300 limit arrives with $250 in fees already charged against it.

Or consider the mainstream banking alternative—courtesy overdrafts. This benevolent-sounding service earns banks more in fees ($17.5 billion a year) than the amount of funds actually covered ($15.8 billion). In 2006, it accounted for 74 percent of banks’ total consumer-fee income, subsidizing the cost of serving other consumers.

Defenders of such practices assert that these products help lower-income people meet urgent needs and that, when used correctly, they make sense. They further extol the virtues of consumer choice. But the profits made in the predatory economy are disproportionately derived from people who don’t use the products “correctly” and don’t have any choice. Who, given a full range of options, would choose usurious interest rates and late charges?

Debtors are at the mercy of creditors.

A typical payday-loan customer has no

more money at the next payday and must pay to renew. Card holders’ fees and punitive interest rates pile on, cross-subsidizing those who use credit cards for free. Nearly half of all overdraft, or “NSF,” fees are incurred on small debit-card and ATM transactions; thus the typical NSF debitcard purchase of $20 results in an NSF charge of $34. The vast majority of banks simply let these go through without warning—even at the ATM machine. And when you check your balance at some ATMs, the figure includes the overdraft cushion. In the mortgage market, lowand moderate-income borrowers given sub-prime loans were several times more likely to default than like borrowers under similar conditions who took out prime mortgages. what possesses lower-income people to take on such high-cost debt? Commonly cited suspects are lack of impulse control, financial illiteracy, and naiveté.

While a small percentage of households might use fringe services because of ignorance or profligacy, the majority of households resort to parasitic lenders for one reason: They don’t have enough money to make ends meet.

Between 2001 and 2007, the median income of the bottom 40 percent of earners rose only $300 in the face of rapidly rising costs for housing and health care.

Today, in Charlotte, North Carolina, home of Bank of America and Wachovia, a single parent with two children must make $3,479 a month to pay for necessities; some three times minimum wage.

The social safety net has frayed and economic risk is increasingly weathered at the individual household level. The highcost debt industry is thriving because people can’t afford to meet basic needs and because institutions refuse to extend w w w. p ro s p ect. o rg

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them credit under the more reasonable terms that the better-off enjoy.

Once overwhelmed by this debt, they are judged to be irresponsible. Thus debt has the pernicious effect of masking class inequality by increasing the short-term purchasing power of the poor, while at the same time reinforcing it by decreasing their long-term economic prospects.

prises. Better products can safely enable users to direct, track, and manage money while avoiding high-cost traps. There is no shortage of promising approaches in various stages of commercialization: Basic accounts that are no frills, low-cost, bounce-free, or rely less on branches and more on technologies such as lifeline, second chance, and express checking accounts; specially tailored bank branches; banking kiosks; mobile and online banking; employerbased banking; and even bank-less bank accounts in the form of stored value and payroll cards. The Center for Financial Services Innovation is dedicated to this effort.

Make savings pay.

solving these complex problems requires that we acknowledge the massive power advantage wielded by the financiers. It necessitates that we put more financial power in the hands of consumers and put an end to the most abusive (and lucrative) lending practices and that we expand mainstream credit services into low-income communities. With ethical behavior on the part of lenders, and a modicum of financial education, lowincome people can be responsible users of credit, and financial institutions can earn reasonable returns serving them.

Provide true financial knowledge.

Financial education and better disclosures are oft-cited solutions, but these must go beyond dressing broken windows. A full financial curriculum must take its rightful place in the K-12 system.

Economist Robert Shiller calls for the government to subsidize a network of independent financial advisers. The federally subsidized Neighborhood Housing Services/NeighborWorks America network, for example, combines counseling with mortgage finance. Its 230 organizations helped over 240,000 families in 2007, but it would have to be greatly expanded to fill the national need.

Offer control, transparency, and no sur-

Alternative financial-service providers form a vast and often rapacious network offering easy access to the financially strapped.

Many Americans are richly rewarded for saving through deferred taxes, tax credits, and employer matches on retirement savings, but low-income households have less access to these mechanisms and benefits. Numerous experiments have demonstrated that the poor want to save, and, if given mechanisms and inducements, will do so. But low yields on basic savings accounts may not even cover fees, and public-assistance benefits are cut for those who save too much.

This backward incentive structure can be rectified by matching savings by the poor or extending savings-related tax benefits to lower-wage workers.

Make debt repayable. People should be sold loans that they can repay. The more institutions charge on debt and the longer they can reap these returns, the less they worry about repayment of initial principal. The opportunity to thrive on consumer indebtedness diverts institutions from making “an honest living.” In addition to current movements to clamp

down on abusive mortgage practices, Congress is considering an across-theboard 36 percent rate cap on consumer loans. But let’s not kid ourselves that implementation of these reforms will go smoothly: the recent failure in Congress to extend bankruptcy protection to home mortgages warns us that lending reform faces a steep uphill battle.

Institutions Matter. This is especially true in poorer communities. Communitydevelopment financial institutions and community-development credit unions (CDFIs and CDCUs), which serve the banking needs of low-income communities, are enjoying more than a doubling in federal support in the stimulus bill and the new budget. But the CDFI scale remains relatively small, as can be seen by comparing CDFI funding—$400 million over two years—to the hundreds of billions invested to stabilize the nation’s banks.

For some, credit unions hold a solution.

Since the 1700s, people have set up lending cooperatives in times when fairly priced credit was unavailable and abusive lending, rampant. Modern credit unions are nonprofits serving 85 million members with such advantages as low credit-card interest-rate caps for federal credit unions, and pioneering affordable alternatives to payday lending. Yet, their total assets are one-seventeenth those of banks, while the size of any individual institution is limited by the available pool of member resources. Moreover, limited geographic coverage and membership eligibility constraints mean that not everyone can access these institutions. While expanding and invigorating the credit-union movement could build on the promise this industry holds, major impact on the financial-services landscape would be a long way off and would require firm political resolve to overcome the objections of the powerful banking industry.

Clearly, then, we must look to our mainstream banking sector, whose relithe american prospect

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ance on taxpayer backing is now painfully evident and whose duty to serve the credit needs of its communities was confirmed in the Community Reinvestment Act of 1977 (CRA). all of these measures must be complemented by systemic financial regulation, for as long as profiteering is sanctioned, it will be pursued at the expense of innovation and sustainability. True, even a well-regulated financial system wouldn’t replace the frayed social safety net or make the poor rich. But there are tools available to enable low-income people to control their finances, keep more of the money they earn, and use that money to build financial capacity. Beyond its benefits to consumers, such a system could provide profits to banks. Here are some key principles: Make basic financial services available to low-income consumers. Given the millions paid to check cashers, it is clear that consumers can tolerate fee-based accounts, though such products should be structured to minimize costs and therefore the need for fees. How? Electronic banking

example) serves competing preferences for resisting temptation yet maintaining access to one’s limited resources. Another variant, which builds on the target market’s penchant for lotteries, is prize-based savings, like those being developed by the D2D Foundation, a fund that emerged from the research of Harvard Business School’s Peter Tufano; here, the more you save and the longer you save it, the better shot you have at a windfall.

A comprehensive savings policy requires a more concerted public-sector commitment. Imagine, for example, workers automatically enrolled in employer-based, payroll-deduction savings plans and tax benefits extended to lower-wage earners. (The Obama administration proposes a 50 percent match of the first $1,000 saved with a goal of bringing 80 percent of low- and middle-earning workers into retirement savings.) Similar benefits would apply to savings in enhanced 529 college-savings accounts, savings bonds, and certificates of deposit. Tax filers could also direct portions of their refunds to this range of savings options. Early savings habits would be forged through tax pref-

Government policies like automatic enrollment in payroll savings plans and subsidies or matches will help low-income savers. can lower banks’ costs, while simultaneously giving customers easy access to account information. For customers with past credit problems, carefully managed “second chance” checking accounts could be made more available. For those not ready for or interested in bank accounts, prepaid cards that act as virtual bank accounts might be the perfect option. The inability to overdraw prepaid cards is particularly appealing to those consumers with past overdraft problems, and early innovators are now exploring ways to add such features as a savings mechanism.

Promote savings for low-income people.

Many lower-income customers report preferring automatic, regular, small deductions from their wages. Builtin “stickiness” (limited withdrawals or small matches to leave savings alone, for a6

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erenced youth savings accounts or publicly subsidized universal child-savings accounts, as in the U.K. Make available affordable and responsible credit. Low-income consumers do need access to small, occasional loans.

How might these be provided? Consumers indicate strong preferences for loans that are repayable in installments.

Surely banks and other depositories can serve many customers with alternatives priced well under the price umbrella of current services, and even within the proposed 36 percent–rate caps. Several credit unions currently offer low-cost payday-loan alternatives, some of which wrap in a savings device; for example, the North Carolina State Employees’ Credit Union (SECU) profitably offers its 1.5 million members a 12 percent annu-

al percentage rate salary advance loan, where borrowers must deposit 5 percent into savings at each renewal. By early 2008, SECU customers had avoided $145 million in payday loan fees and instead put $13.2 million into savings accounts.

Another important part of the solution is safer, more responsible credit cards that consumers can manage to repay.

One concept proposed by Angela Littwin, assistant professor at the University of Texas School of Law, is a “self-directed credit card,” with built-in discipline— firm credit limits, low transaction limits, and/or fixed monthly payments.

Assure that housing and education loans are safe and affordable. Homeownership and education remain indispensable levers for long-term economic advancement, and system-wide reform of both of these industries is critical. Some have proposed that every borrower get a safe, standard-issue mortgage product, unless the customer explicitly chooses a riskier product, with full knowledge of the risks (which would carry greater liability for the lender as well).

Approaches like these illustrate what a viable and productive financing system for low-income households and communities could look like. It’s not that hard to envision, because it looks a lot like what many of us already have and, until recently, have taken for granted. The change called for in this article won’t come from within the industry. CRA , NeigborWorks, CDFIs, and credit unions all have their roots in community action and empowerment. Today, victims of the system may be silenced by the stigma that surrounds financial problems, but those who are speaking out are compelling lawmakers to act to protect us all. Meanwhile, complacent beneficiaries of this system need look no further than the far-reaching effects of the sub-prime mortgage crisis to realize that our separate financial systems really aren’t that distinct after all. Each of us has reason to fight for the necessary marketplace and policy changes that will ultimately serve us all. tap Janneke Ratcliffe is associate director for the University of North Carolina’s Center for Community Capital. w w w. p ro s p ect. o rg

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The Assault on the Black Middle Class Sub-prime lending was racially targeted and demolished decades of progress made by America’s most diligent and striving people of color. How will America make amends?

by Kai W right

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hen my mom describes it all now—10 months after she walked away from her house of 14 years—she sounds sort of crazy to me. I make her explain again and again, because the depth of her denial about the situation she faced is hard for me to understand. But that’s the thing about losing stuff. Whether it’s your keys or your life savings, it’s tough getting to that moment when you realize something’s gone for good.

My mother, Carolyn White, and her husband, Earl, spent the first eight months of 2008 haggling with Countrywide Financial (now acquired by Bank of America), trying and failing to get their sub-prime loan modified into something they could pay. She and Earl, like so many other casualties of the sub-prime disaster, had refinanced their home to take out equity. Then the rate exploded, increasing their monthly payment by hundreds of dollars.

“It was like talking to a brick wall,” she complains with a resigned if annoyed tone, which once rang with fury instead. Several months into the effort, when it became clear things weren’t going to work out, they started looking for a rental. “Earl had gotten to the place where it didn’t matter to him,” my mom explains. “But I was fighting it tooth and nail to the end. Even when I was packing to move, I was thinking, ‘Well, they’re going to come up with something, and we can just unpack.’”

She’d already picked out a townhouse in her same neighborhood, on Indianapolis’ solidly middle-class northwest side.

She’d dutifully selected three favorites, actually, ranking them and putting in applications. Yet, she never expected to move. Even after they’d finally walked, my brother had to shout her down to keep

her from going back and tidying up the prime loans but that 44.9 percent of property she’d abandoned. “I just couldn’t Hispanics and 52.5 percent of African see myself leaving my house,” she says.

Americans took out sub-prime loans.

At age 63, she’s starting over on her Blacks like my mom, who could qualify American dream. A rented townhouse. for conventional loans, were targeted for New, smaller furniture. Family pho- sub-prime ones, which generated higher tos edited down and re-hung. A few fees for the lender and higher costs and framed wildlife prints as reminders of risks for the borrower.

Many of the places hit hardest by the the Wyoming retirement home that had once felt within reach. They’re middle- first foreclosure wave—south Florida, aged grandparents and middle-class by all outward appearances. But they’re facing life like a couple of hard-pressed newlyweds.

They’re of course not alone. More than 10 percent of all mortgages were in default as 2008 ended. We logged more than 800,000 foreclosure filings in the first quarter of 2009, according to the Center for Responsible Lending, which projects 2.4 million this year.

These are big, dauntNo More Evictions: Demonstrators from ACORN’s Home Defenders rally ing number s w it h outside a foreclosed home in Elmont, New York, in April. which we’re all becoming drearily familiar. But less familiar the urban Midwest, cities like Oakis the fact that this carnage has dispro- land, Phoenix, Atlanta, and Detroit— portionately hit people of color, particu- had dense pockets of black and Latino larly those who were old enough to have homeowners, where slowly accumubuilt up some equity when the sub-prime lated equity could be stripped away in boom exploded. ill-conceived refinances. As a result, one In 2006, African American borrow- in 10 black borrowers is expected to foreers at all income levels were three times close, compared to one in 25 whites. And as likely to be sold sub-prime loans than a United for a Fair Economy study last were their white counterparts, even year estimated that black and Latino those with comparable credit scores. borrowers will absorb at least $164 bilThe Pew Hispanic Center reports that lion in losses, or about half the nation’s 17.5 percent of whites took out sub- overall foreclosure toll. the american prospect

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As devastating as those realities are in individual lives like my mom’s, they also point to a broader, perhaps more lasting damage that’s gone largely unexplored among policy-makers: The mortgage crisis has further deepened racial inequality in America and should finally reshape our understanding of the relationship between race and class. homeownership has been a crucial building block of middle-class wealth ever since Jefferson promoted landtenure laws that favored freeholders and Lincoln signed the Homestead Act. Today, housing represents nearly two-thirds of all middle-class wealth.

That reliance on real property always underscored the racial chasm, first in the agricultural era, when blacks were slaves and then sharecroppers rather than landowners, and then later when decades of lending bias created a massive racial disparity in homeownership rates. Before the housing boom, in the early 1990s, 69 percent of whites owned homes compared to just 44 percent of blacks and 42 percent of Latinos.

By 2004, the housing boom had improved those numbers. Fully threequarters of white families owned homes, as did nearly half of both black and Latino families. As the homeownership picture improved, so too did the wealth picture, though at a glacial rate. The racial disparity in net worth is among the most astounding statistics in modern economics. For every dollar of wealth the median white family held back in 2002, similar black families had just 7 cents, while Latinos had just 9 cents. By 2007, black families had a dime for every dollar of white family wealth, and Hispanics, 12 cents. This was progress, if glacial.

Then came the bust. The housing boom proved to be just another trapdoor in a centuries-long game of Chutes and Ladders for black and brown strivers.

By 2007, the black homeownership rate had plunged nearly three points, to 47 percent, a larger drop than among any other group, and is probably lower today.

Worse, the damage is concentrated in what were once sturdy black middle-class neighborhoods. a8

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in 21st-century America—a society that boasts equality under the law, African American CEOs, and Barack Obama—the black middle-class story is widely understood as a congratulatory tale of uniquely American success. As Obama declared in his first words as president-elect, “If there is anyone out there who still doubts that America is a place where all things are possible … tonight is your answer.”

Perhaps. It’s clear that at all stages of life—from education to workplace to life expectancy—success still tracks closely with race. And the massive black underclass—nearly a quarter of all black households live in poverty, according to the Census Bureau—is proof of lasting structural inequality. But to truly understand the relationship between race and opportunity in modern America, you must take a real look at the seemingly vibrant black bourgeoisie.

Doing so means fundamentally chang-

income adults in 1970 to 13 percent in 2006—the largest increase among any race or ethnic group. They also saw a 17 percent spike on the Pew Hispanic Center’s income index, compared to just 6 percent for whites. The American middle-class may still be awfully white, but it’s sure gotten some color in my mother’s lifetime.

There are, of course, significant qualifiers to all of this. Most important, the gap between black and white rates of achievement in all three areas—occupation, income, and education—has not improved nearly as much as the absolute number of blacks meeting the given standard. But the conventional measures of middle-class status share a much more damning flaw.

They all fail to consider the more nuanced characteristics of middle-class life that most everyday families would identify as their most prized treasures: long-term security, social stability, and the ability to

The housing boom proved to be just another trapdoor in a centuries-long game of Chutes and Ladders for black and brown strivers. ing the way we measure class. For years, scholars have primarily turned to one of three measures to identify the middle class: occupation, income, and educational achievement. If you’re a professional or a manager, if your income falls in the middle 60 percent of the national bell curve, or if you’ve graduated college, you fit into one or another researcher’s definition. And by any of those three measures, my mother’s generation posted remarkable gains for people of color.

In 1960, as my mom was entering high school, around 750,000 blacks had middle-class jobs. By 1995, nearly 7 million blacks had such jobs. That’s a growth of more than seven fold in one adult lifetime.

And the explosion of college-educated blacks is equally impressive. As my mom was finishing college in 1967, just 4 percent of blacks over the age of 25 had matched her achievement; in 2007, 18.5 percent had done so.

Latinos born in the United States went from making up just 3 percent of middle-

pass both on to your kids in greater portions than you’ve enjoyed them.

These things aren’t measured just by how much money you make or by what degree and job title you hold; they’re measured by how much wealth you can draw upon when times get tough or an opportunity comes around, and how much you can pass along to give your kids a head start. The upper middle class helps its children with everything from college tuitions to down payments. That wealth cushion is built on financial savings and investments for some. For most, it’s equity in a home. the idea of viewing economic progress through the lens of wealth rather than income emerged in the mid-1980s. It allows researchers to calculate what’s been called the “asset poverty line”—or being able to maintain a standard of living above the federal poverty level for at least three months without income.

When you lose a job or get hit with a w w w. p ro s p ect. o rg

the credit crisis huge hospital bill or, well, get socked by a foreclosure, can you cushion the blow while getting a fresh start? Do you have strong enough bootstraps to pull yourself back up, as it were?

The answers are sobering. One in five families that were middle class in 2004 couldn’t make it three months on assets alone, according to a Corporation for Economic Development analysis of Census data. In other words, when you look at wealth, the income-based poverty rate doubles. And that was before the housing bubble burst.

If you then apply a racial lens to these

make it through the early-century tough times. Many likely got expensive, subprime refinances like the one my mom and Earl took out. my mom won’t let on about it now, but she always liked saying “my house.” She was a renter from the time she and my father divorced back in the mid-1980s until she and Earl bought their house in 1994. I was away at college at the time, and whenever I visited Indy, she’d made some tinkering improvement. Even as she packed last summer, she gamed out how she’d pull up the living room carpet—it

the building block of middle-class wealth Homeownership rates by race and ethnicity (1994–2008)

74.9% 70%

white

70.0%

59.1%

60%

51.3%

asian

48.9%

50%

42.3%

47.5%

black 40%

hispanic

41.2%

c h a r t d ata : u . s . c e n s u s b u r e a u , p e w h i s pa n i c c e n t e r

1994

1996

1998

2000

asset-based measures, the disparities are awesome. Roughly 40 percent of both blacks and Latinos lived below the asset poverty line in 2004. As pioneering sociologist Thomas Shapiro sums it up in a 2006 paper, “Two families with similar incomes but widely disparate wealth most likely do not share similar life trajectories.”

The 2001 recession proves the point.

Everybody gained some ground in the roaring 1990s, but not everybody took the subsequent slowdown the same.

While the median white household emerged in 2002 with a modest 2 percent increase in net worth, according to the Pew Hispanic Center, Latinos lost more than 25 percent of their wealth between 1999 and 2001. People of color, Shapiro explains, burned through their meager assets and piled on extra debt to

2002

2004

2006

2008

was too much to keep clean—and how she’d put in a backyard deck. “I had wanted that since we moved in,” she says.

They bought the house for around $120,000, she says, with a fixed-rate, 30-year loan. It’s the sort of mortgage that the GI bill and Federal Housing Administration spurred into existence back in the postwar years in order to broaden the American homeownership dream. And it’s the sort of loan black families couldn’t get for decades, due to banks’ redlining of black neighborhoods. Epic fair-lending battles put an end to codified discrimination, and by the time my mom and Earl went looking for money to buy their home, they didn’t have trouble finding it.

Nor did they have a problem in 1996, when they first took out some equity,

in an effort to catch up on less-sensible debt. Their payments went up a bit, but they got the money out and paid some things off and, all things considered, were rolling along. They started vacationing out West, discovered their shared love of the peaceful dessert landscape, even bought a gas-guzzling RV to travel back and forth. They still subscribe to a Jackson Hole, Wyoming, newspaper.

The problems didn’t start until they got a second refinance as the 2001 recession waned. Earl had hoped to use the equity to make some new investments, make their money grow in slow times. But a few years later, their rapidly inflating loan payments were eating their monthly budget. It was a steep, rapid decline from there to zero equity, re-accumulated debt, and a delayed retirement.

Their experience and those of millions of others point to a confounding irony that home equity has presented for efforts to close the racial wealth gap.

On the one hand, because homeownership was key to 20th-century wealth, the huge racial disparity in ownership rates helped drive the disparity in wealth, too.

On the other hand, the wealth blacks and Latinos have managed to accumulate is dangerously dependent on home equity alone, leaving them vulnerable in times like these. According to Shapiro and his research partner, Melvin Oliver, while homeownership accounts for 63 percent of average black net worth, it accounts for just 38.5 percent of average white net worth. We cannot afford the $1.19 trillion in American home equity taken out in refinances between 2003 and 2007. if nothing else, the wealth perspective on economic progress challenges America’s creation myth of hardworking pilgrims, self-made frontiersmen, and brass-balled industrialists. In reality, our middle class looks an awful lot like an aristocracy built on inherited middleclass advantage.

For his 2004 book, The Hidden Cost of Being African American, Shapiro culled through household survey data for the early 1990s—pre-sub-prime boom—and found this gem: Just about half of all white buyers said they got the american prospect

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assistance from their parents to make a down payment, while just 12 percent of black buyers said the same. This matters. Put down more money, and you get more house, less debt, more wealth with which to start your life. In researching the book, Shapiro found the same pattern across the board on family finances: young black households were far more likely to spend resources helping out their parents and siblings, while young white ones were more likely to be receiving help from their parents.

This offers a key example of the way in which racial inequality is passed on from generation to generation—and has been shepherded along by government policy. It started with Reconstruction’s failures and has tumbled forward generation after generation.

Black abolitionists viewed emancipation as more than the end of slavery; it was also to involve the creation of economic opportunity. The idea of “reparations” seems silly 150 years removed, but the nation faced a massive debate over land redistribution following the Civil War. As

land from Native American tribes and gave it away in 160-acre plots to white settlers, to jump start the agricultural sector; for freedmen, land never materialized. More than a century later, 400 black farmers won a class-action lawsuit against the Department of Agriculture for its systematic racial bias in providing loans and other assistance to farmers throughout the 1980s and 1990s. Lo and behold, at the turn of the 21st-century, white Americans still held 97 percent of the nation’s agricultural land value.

The New Deal programs that created today’s middle class, meanwhile, are also directly responsible for today’s wealth gap. Name a massive government investment, and you’ve got an initiative that explicitly or implicitly excluded people of color. By 1965, 98 percent of the 10 million homes public money had helped buy through loans backed by the Federal Housing Administration were owned by whites. Government then spent years more ignoring private lenders’ redlining of black neighborhoods.

The proven racial bias in today’s sub-

The same investment in wealth creation must be made for people of color that has been made for generations of whites. one freedman told a reporter, “Give us our land and we can take care of ourselves, but without land the old masters can hire us or starve us, as they please.”

The administrations of first Abraham Lincoln and then Andrew Johnson, however, envisioned freed blacks as wage laborers, not landowners. When Johnson ordered Dixie’s land returned to Southern planters in 1865—and thousands of freed slaves evicted—it solidified a governing perspective that would echo forward to the modern era: People of color would receive subsistence aid, but wealth-buttressing subsidies would be limited to whites.

The examples are myriad, as Meizhu Lui of the Insight Center for Community Economic Development points out in a recent paper. The Homestead Acts of the 1860s, for instance, took vast swaths of a 10

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prime lending, then, is more normative than exceptional. As Lui wrote in a March Washington Post op-ed, “The chips on the table reflect the fact that the game was fixed. It’s time to start an honest game with a new deck.”

So how do we do that? A black president aside, the feds aren’t likely to hand out that 40 acres and a mule anytime soon.

Sadly, congressional Democrats and the White House have not yet shown enough political courage to merely stop the mounting foreclosure losses, never mind start building new wealth. They have repeatedly allowed the banking lobby to block any measure, such as loan modifications by a bankruptcy judge, that would give struggling borrowers enough leverage to demand a fair deal.

And there’s little evidence, thus far, that the billions in incentives President

Obama has begun handing the mortgage industry will spur enough real mortgage modifications to keep pace with foreclosures.

Meanwhile, even before policy-makers figure out how to slow foreclosures, communities that have been overwhelmed by them—in abandoned houses, increased crime, falling home prices, and more— are going to need significant public investment. The $6 billion Congress has allocated in the past year for “neighborhood stabilization” is clearly a mere down payment and will need to be spent creatively.

But more broadly, at some point the public sector is going to have to make the same massive investment in wealth creation for people of color that it has made for generations of whites. In some cases, that means tweaking existing policies— the home-mortgage tax deduction, for instance, is currently useless to people who don’t make enough to itemize. But it’s also going to mean recreating big, bold initiatives like those that created the wealth gap in the first place.

Whatever the plan, it will not be a small endeavor. My mom’s outlook these days reveals just how much ground has been lost—not just in dollars and cents but in the emotional toll millions of families have paid. She’s traveled all the way from denial to resignation and now wants out of the maddening ownership conversation altogether. “If I don’t get another house, I don’t really care,” she scoffs.

She’s prepared to approach opportunity like generations of black folks before her—living on the money she makes, pooling family and community resources when that’s not enough. So after retiring from 28 years of teaching grade school, she’s gone back to the classroom as a teaching aide. “I won’t say I’m happy,” she concludes, “but I’m content with it.”

The real question, of course, is whether America is equally content with the legacy of inequality this housing meltdown has deepened. If not, are we prepared to finally confront it? tap Kai Wright is a Brooklyn-based journalist and senior writer for TheRoot.com. w w w. p ro s p ect. o rg

the credit crisis

Regulation as Civic Empowerment The policing of the financial system can’t just be left to bureaucrats.

Properly designed, regulation can be a community-organizing strategy.

by Ed mund Mierzw i n s k i

pa u l s a k u m a / a p i m a g e s

I

n February 1975, a coalition of more than three dozen consumer groups paid a call on the newly installed chair of the Senate Banking Committee, Sen. William Proxmire of Wisconsin.

Proxmire, a progressive who had previously headed the subcommittee on consumer protection, had already authored several landmark laws, including the Truth in Lending Act. The coalition wanted Proxmire to sponsor a deceptively simple law, which came to be known as the Home Mortgage Disclosure Act (HMDA). The act requires banks and savings institutions to disclose, by zip code, the number and amount of loans they make in their primary service areas.

The activists, who were led by a Chicago homemaker turned activist, Gale Cincotta, and Monsignor Geno Baroni of the National Center for Urban Ethnic Affairs, wanted the information so that they could shame or pressure local banks to stop redlining urban neighborhoods.

Literally scores of neighborhood groups in dozens of cities were already several years into an anti-redlining campaign, but information was hard to come by. The only way to determine lending patterns was to look up mortgage records, one at a time, in local recorder-of-deeds offices, and then aggregate the information by bank. Mandatory disclosure under HMDA would provide the data they needed.

Proxmire was impressed with the groups’ ingenuity and the evidence that they had already assembled of pervasive redlining. He held four days of hearings and then steered the bill through the committee, onto the Senate floor, and into law, almost exactly as the groups had designed it. Two years later, armed with even more persuasive data, the groups were back to ask for legislation requiring banks to take

In It Together: Members of ACORN pray with a woman about to lose her home in Oakland, California, in May. The community-organizing group was able to delay the foreclosure by one week.

affirmative steps to make credit available to formerly redlined neighborhoods.

Once again, they were well organized and persuasive, and once again Proxmire delivered, this time with the Community Reinvestment Act (CRA).

What is notable about these two laws is that they use regulation as an organizing tool. The laws began as a strategy conceived by community organizers and then became the basis for even more effective organizing. Armed with HMDA and CRA , groups could confront lenders and demand that they change policies.

They could provide dossiers to regulators and then become their partners in policing banks. After more than three decades, while some lenders have continued to resist, others have become allies. There is now a whole generation of loan officers who pride themselves as

believing in community reinvestment.

Typically, federal regulation is the province of government bureaucrats and industry interest groups. These regulations enhanced citizenship.

The result has been a system that, according to the National Community Reinvestment Coalition (NCRC), has since 1977 leveraged over $6 trillion in reinvestment dollars through CRA agreements with banks providing credit for “affordable housing, small businesses, economic development, and community service facilities in minority and lowand moderate-income neighborhoods” in both cities and rural areas.

As a longtime activist, observer, and frequent critic of the bank regulators, my experience is that the law’s simple design and its involvement of citizens have also forced the regulators to become the american prospect

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Hitting The Street: Mark Seifert of ESOP tours foreclosed homes in Cleveland’s Slavic Village.

for example, the Cleveland-based East Side Organizing Project (ESOP) has effectively used town meetings and other tactics to bring lenders to the table and get results. In 2008, “what was originally intended to be a small gathering of home­ owners turned into a citywide event,” according to ESOP executive director Mark Seifert, resulting in the Cresthaven Development Corporation agreeing to address community concerns. According to its Web site, ESOP also “waged a successful, lengthy organizing campaign against Countrywide Financial that ultimately resulted in a valuable lenderpartnership,” which its new owner, Bank of America, is continuing.

According to Seifert, his group uses CRA tools and HMDA data in its work

Sometimes, it takes a “financial freedom” bus trip from North Carolina to New York City to send the reinvestment message. “When we got to Citigroup headquarters, the ministers, preachers, homeowners, would-be home­owners, and activists on the bus marched six times in silence around the building, then one time singing, just as in the biblical walls of Jericho story,” says Peter Skillern of the Community Reinvestment Association of North Carolina. He credits the organizing tactics with getting the group to the negotiating table with Citigroup, to promote offerings of “a full range of credit products, not just predatory loans, to the association’s members.”

Proudly featured on the home page of the Neighborhood Assistance Corpora-

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but also sometimes takes activists out to throw “thousands of small plastic loan sharks” onto the lawns of bank executive homes or against the walls of their offices, and that helps bring the banks to the negotiating table. “But what really helps, in the Countrywide and other fights, is when we take executives on neighborhood tours, so they can see why better lending is needed,” Seifert says. ESOP ’s current CRA agreements are not only to expand reinvestment lending but increasingly to fix predatory loans, do remediation, and deal with vacant lots that are the result of the mortgage meltdown.

tion of America (NACA) is a May Wall Street Journal story: “NACA ‘Terrorizes’ Bankers in Foreclosure Fight.” NACA’s promotional materials declare: “When NACA takes on a fight we take the junk yard dog approach”; “Once we grab on we never let go no matter how long it takes”; “ NACA shines a spotlight on the CEOs, executives and directors who perpetrate financial injustice.” As The Wall Street Journal reports: “In February, NACA , as it’s called, protested at the home of a mortgage investor by scattering furniture on his lawn, to give him a taste of what it feels like to be evicted.”

But NACA gets results. It counts over $10 billion in CRA loan agreements and numerous other victories. Sharing credit are such local groups as ESOP and national ones like the Association of Community Organizations for Reform Now (ACORN), the National People’s Action, and numerous other groups that meld the organizing strategies pioneered by the legendary Chicago organizer and teacher Saul Alinsky with the tools added by the CRA .

Saul Alinsky–style organizing is based on the premise that the powerless can build political power through the establishment of stable neighborhood-based organizations that achieve concrete results for their members. The CRA has helped provide a mechanism to build citizen empowerment, and it is not acciw w w. p ro s p ect. o rg

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more creative. The result has been beneficial for all parties. As the late Federal Reserve Governor Edward Gramlich said in 2001, “CRA has brought a heightened awareness of lending gaps, has led institutions to discover untapped market potential in underserved communities, and has encouraged the creation of loan products and financial services that allow low- and moderate-income borrowers greater access to credit and financial products.”

In short, CRA is not only one of the simplest regulatory laws ever passed by the Congress, it may be one of the most successful. It doesn’t impose commandand-control mandates or prescriptive rules. It does not require, nor has it generally resulted in, banks making loans at a loss.

The CRA buttresses HMDA data by providing the public with information, in the form of CRA report cards. It gives community groups the power to intervene in, or protest, proposed bank mergers on the grounds that they haven’t met their CRA requirements. That’s the relatively soft hammer (the mergers are rarely denied) that gets so much attention from the law’s critics. In practice, the CRA’s structure has worked to bring community groups into engagement with regulated banks to achieve a better outcome—win-win agreements to lend instead of challenges to lenders.

the credit crisis dental that it was conceived by Alinskytrained organizers. One person trained in the Alinsky style was a young apprentice organizer named Barack Obama.

The perceived threat of either an “unsatisfactory” CRA report card or, worse, a public merger challenge has created a better system of regulation. Banks now routinely sit down and negotiate with local community-group representatives to make sure that community needs will be met. And the regulatory agencies, which had opposed enactment of both HMDA and CRA as improper forms of “credit allocation” by government, have become believers.

In her February 2008 testimony to Congress, Federal Reserve Board’s Division of Consumer and Community Affairs director Sandra Braunstein observed that CRA and HMDA give community organizations three critical tools that most regu-

lessons for Congress and the Obama administration.

A second strong example of success based on this model is the way that worker-safety laws not only reduced worker exposure to toxic chemicals but also reduced company costs, engaged citizens, and spawned a new toxic-usereduction movement promoting alternatives and leading to community protections from toxic hazards.

The 1970 Occupational Safety and Health Act (OSHA), besides banning unsafe substances, provided workers with information by requiring management to provide materials-safety data sheets on workplace hazards. It required management to explain those hazards to workers and encouraged development of labor-management committees on occupational safety and health to reduce those hazards.

By empowering citizens, laws like CRA and Right to Know have changed the way banks think and industry behaves. lations lack, at least in adequate amounts.

First, the laws give advocates information through regular and publicly available reporting. HMDA provides empirical data on redlining; CRA provides report cards on institutions. Second, the laws encourage banks to engage directly with advocates, maybe not as equals, but at a higher level than the banks were used to.

Third, the laws provide a low-cost and effective enforcement mechanism short of litigation. While strong penalties for violations provide a deterrent against blatant corporate wrongdoing, the first goal of regulation is to get the good actors to achieve public-policy goals, not punish the bad actors. are cra and hmda anomalies? In fact, there are other examples where government either providing information or encouraging engagement between community groups and seemingly entrenched business interests resulted in better regulation and improved corporate behavior. These experiences provide ideas or

These committees forced management to engage workers, which helped reduce worker exposure to hazardous chemicals in factories. With help and encouragement from federal officials, union members and other workers were able to organize their side of those plant-based committees into local and regional committees on occupational safety and health, known as COSH groups, to share information and educate others. The labor committees formed alliances with community, women’s, and environmental groups to establish even broader networks to spread information and share ideas.

One of those ideas was that local communities, as well as plant workers, had a right to know about their exposure to hazardous chemicals. In 1976, one of the COSH groups, the Philadelphia Area Project on Occupational Safety and Health began organizing for a federal right-to-know law. In 1978, it began working with the Public Interest Law Center of Philadelphia to organize a response to industrial air pollution that

the groups believed contributed to high local cancer levels. Following a 1979 “chemical killers” conference attended by over 300 labor, community, and environmental groups, a new Delaware Valley Toxics Coalition succeeded in enacting a Philadelphia right-to-know ordinance in 1981.

According to Paul Orum, now a chemical security consultant to community and environmental groups and the longtime coordinator of the Working Group On Community Right To Know, “Other COSH groups spread the word, and by the time of the Bhopal, India, chemical tragedy that killed hundreds in 1984, about half the states had enacted either worker or community right-to-know laws. Then, Bhopal helped spur passage of the 1986 federal Emergency Planning and Community Right To Know Act.” A centerpiece of that law is its Toxics Release Inventory (TRI), which requires public reporting of toxic-hazard discharges for the purpose of emergency planning. The law, and its predecessor laws that gave COSH committees the ability to engage management on toxic and other hazards in factories, have had an additional effect. They contributed to toxics-use reduction. After all, what company wants to lead its state or the nation in toxic pollution?

In short, just as CRA by empowering citizens changed the way banks think, the TRI and right-to-know laws have changed the way industrial companies think. Orum adds, “Before these laws, companies couldn’t tell you why they produce these hazards.” Now, as widely reported by community groups and by organizations such as the University of Massachusetts-Lowell Toxics Use Reduction Institute, itself founded by a state toxics-use reduction law, companies use fewer toxic inputs, both to reduce toxic exposure to workers and, later, to avoid toxic dumping and the cost, public shaming, and litigation risk that go along with it. The institute uses a variety of engagement and training seminars and even issues awards as ways to convince companies to switch to safer alternatives.

It helps that the companies have a selfinterest in their bottom line. Safer alterthe american prospect

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$64

$52

2005

$56

$51

2004

$42

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c h a r t d ata : f e d e r a l f i n a n c i a l i n s t i t u t i o n s e x a m i n at i o n c o u n c i l

2007

2006

2003

$28 2002

$25 2001

$20

$17 1999

2000

$16

$19 1997

1998

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yet another model of enlisting citizens as regulatory monitors is the CUB movement. CUB stands for citizens utility board. The idea is that utility ratepayers may voluntarily check a box on their utility bill to fund organized advocacy vis-à-vis state utility regulators, just as workers have rights to petition for similar checkoffs to fund unions to represent their interests. Rather than simply expanding or complicating regulation, government-chartered citizen groups can balance the power of regulated utilities and keep their regulators from being captured.

Wisconsin legislators established the first citizens utility board in 1979.

Then, in 1984, citizens in Oregon and elected officials in Illinois approved the establishment of their own CUBs. Following a 1986 U.S. Supreme Court decision holding that a similar mechanism for a California utility consumer group was unconstitutional, the movement stalled. The Illinois and Oregon CUBs, however, developed alternate funding that has allowed them to maintain their effectiveness. The Illinois CUB, in particular, successfully sought a legislative amendment to place its checkoff inserts in large government mailings, such as motor vehicle renewals, instead of in the utility envelopes. It claims to have saved consumers over $10 billion in refunds and blocked rate hikes.

The Oregon CUB uses intervenor funding, where a portion of utility user fees paid to the state for regulation is allocated to effective citizen groups for their participation in rate case negotia-

tions. Groups, including CUB, apply in a help seek solutions to the financial meltgovernmental process for fees to cover down wrongly blamed on the CRA . Just their legal and other costs to represent before he and his wife were killed in a their members and ratepayers in cases plane crash during his 2002 re-election campaign, Sen. Paul Wellstone filed his before the commission.

Both of these methods are more effec- last piece of legislation, to establish the tive and lower in cost than is the typical Consumer and Shareholder Protection consumer-group fundraising—direct Association, to be funded by a CUB-like mail, door-to-door canvassing, grass- checkoff on regulated financial firms. roots events—at providing the CUBs with Laws that help citizens or worka stable low-cost funding base. By giv- ers build countervailing power are an ing consumer groups the resources that underused mechanism for building they need to participate, government better, more efficient government that obtains better utility regulation than it might by hirPromoting Community Lending ing more bureaucrats.

CRA community-development lending (in billions) In the telecommunica$70 tions and media arena, the $60 twin pillars of information and engagement have helped $50 provide community groups $40 with the power to challenge media mergers and company $30 sales as well. For example, $20 radio and television stations must keep a public file docu$10 menting how much of their $0 programming is designed to meet community needs.

Citizen groups use these files (information) to challenge (power), under intrudes less into markets and achieves statutory requirements, broadcast-license better outcomes. The Wagner Act gave renewals of firms that fail to meet local workers rights to organize. The Freedom community needs as defined in the Com- of Information Act, although used by munications Act of 1934. business groups also, gives citizen groups and the media some needed information as congress reworks the financial sys- and transparency about their governtem, it could also draw on the CUB strat- ment’s operations and effectiveness. egy, by financing organized consumer All of these citizenship strategies intervention through voluntary user fees. address the same broad problem: the Despite the setback of the 1986 Supreme imbalance between the concentrated Court case, more recent cases have gener- power of affected industries and the ally upheld similar government-approved diffuse power of ordinary people. By checkoffs to business, for a variety of designing regulation so that it engages agricultural cooperatives, including the and informs citizens, facilitates organiz“Got Milk?” and “Pork. The Other White ing, and puts citizens into direct encounMeat” campaigns. Those successes, and ters with the industry as well as with the need for real financial regulatory regulators, these policies energize citireform, suggest that it is time to revisit zenship, and they begin to redress the the consumer checkoff approach. structural power imbalance. tap A good place to start would be giving consumers, depositors, small investors, Edmund Mierzwinski is consumer and taxpayers their own checkoff-funded program director and senior fellow financial-reform organization to counter for the U.S. Public Interest Research the power of the financial sector and Group, the federation of state PIRGs. 1996

natives have much lower life-cycle costs.

So, passage of laws that gave the public information and the ability to organize also helped companies reduce their use of toxic chemicals and switch to safer alternatives. This has improved worker safety, lowered costs, led to less dumping of toxic wastes into the environment and even reduced the need to spend scarce dollars protecting chemical plants against terrorists. As Orum says, “Information that is publicly disclosed empowers workers and communities to advocate for more changes.”

the credit crisis

Don’t Blame the Community Reinvestment Act Homeownership rates and CRA enforcement soared in the 1990s, but sub-prime came later. CRA shouldn’t be the scapegoat for the housing meltdown.

by El len Seidm an

T

he mortgage crisis is far from over.

Foreclosure filings in the first quarter of 2009 increased 24 percent over the already-heady 2008 levels; April filings were up 1 percent over March and 32 percent over the prior April. During 2008, foreclosure notices were filed on over 2 million properties, and banks took back more than 850,000 properties.

Delinquencies continue to climb: 7.88 percent of all mortgages on one- to four-unit buildings were delinquent at the end of 2008, the highest rate on record. For subprime loans, the rate was 21.88 percent and almost 14 percent of sub-prime loans were in foreclosure. With home prices still falling—in March 2009 prices were down 32.2 percent from their 2006 peak—and unemployment now at 9.4 percent and still rising, it is unlikely the situation will get better any time soon.

How did we get into this? There are a plethora of potential culprits. One was the unsustainable run-up in home prices fueled by a combination of low interest rates and often deceptive loan products that enabled homeowners to get deeper and deeper into debt with “low monthly payments” that quickly ballooned and ultimately proved unaffordable. An explosion in the international demand for high-yielding “safe” investments combined with financial engineering and overreliance on overly optimistic credit ratings created an insatiable appetite for mortgage-backed securities and the mortgages behind them, no matter how risky. Regulation was entirely missing in some cases—mortgage brokers and credit-default swaps come to mind— and lax in others. Finally, a public policy

that regarded homeownership for all as the key to prosperity—combined with stagnant incomes, exploding costs for necessities such as health care and education, and lack of support for affordable rental alternatives—made it highly likely that when house prices stopped going up, millions of Americans would find themselves unable to afford their mortgage payments.

But in the face of all these factors, some have fixed their attention instead on a formerly obscure 32-year-old statute, the Community Reinvestment Act (CRA). Echoing much of the conservative blogosphere, The Wall Street Journal in September 2008 assigned CRA blame for the ongoing crisis, albeit behind “the Federal Reserve,” “banking regulators,” and “a credit-rating oligopoly.” The election of President Barack Obama and subsequent revelations about the extent to which unregulated credit-default swaps and mortgage-backed securities backed by sub-prime loans played a pivotal role in the economic devastation, have tempered but not silenced the criticism.

This is ridiculous. The case against fingering CRA for the destruction of the mortgage market rests on both logic and fact. Recent work by economists at the Federal Reserve Board of Governors and the Federal Reserve Bank of San Francisco provides a strong factual rebuttal, but let’s start by understanding what the Community Reinvestment Act is and isn’t.

CRA was enacted in 1977 in response to concerns that banks were unwilling to lend in minority communities and in those in danger of “tipping.” Note that we’re talking about 1977. While one can

argue about the precise timing of the start of what ultimately became the subprime bubble, as late as 2001, 24 years after CRA was enacted, only about 9.7 percent of mortgage originations (about $200 billion) were sub-prime or Alt-A loans (Alt-A loans have weak or no documentation of income or credit records); by 2006, sub-prime and Alt-A loans were 33.5 percent of loans made and had quintupled to $1 trillion.

CRA states, rather simply, that “regulated financial institutions have [a] continuing and affirmative obligation to help meet the credit needs of the local communities in which they are chartered.” It requires the federal bank regulators to “assess the institution’s record of meeting the credit needs of its entire community, including low- and moderate-income neighborhoods, consistent with safe and sound operation of such institution,” (emphasis added) and to “take such record into account in its evaluation of an application for a deposit facility [including a merger or acquisition] by such institution.”

Although CRA and its close cousin, the Home Mortgage Disclosure Act (passed in 1975 to gather data on bank lending patterns), had some effect during the 1980s, the statutes came into their own during the 1990s. In 1989, the Federal Reserve denied a proposed merger by the Continental Illinois Corporation because of poor CRA performance, the first time any agency had used this enforcement action. Amendments to CRA in 1989 and 1994 made data more public and more useable. With its reduction in direct federal support for housing, the Reagan Revolution of the 1980s rather ironically led to the growth of the communitydevelopment movement, which included both organizations that partnered with banks subject to CRA to meet community credit needs and entities that functioned as advocates to ensure that the statute was enforced (sometimes the same community groups played both roles).

The Clinton administration made enforcement of CRA a priority. A major stimulus to this effort was the 1994 RiegleNeal Interstate Banking and Branching Act, which permitted, through merger the american prospect

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and acquisition, the nationwide banks we have today. That brought the CRA’s primary enforcement mechanism, consideration of a bank’s record of serving its community in evaluating the merger application, into play. what happened during the 1990s? The homeownership rate, which had been stagnant since the 1960s, climbed from 64 percent in 1994 to 67.8 percent in 2001, with larger increases for minorities, women, and lower-income families.

Between 1993 and 1998, CRA-covered lenders increased their home-mortgage lending in low- and moderate-income areas by 39 percent, compared to a 17 percent increase in other areas. In 2002, the Joint Center for Housing Studies at Harvard found that “CRA has expanded access to mortgage credit; CRA-regulated lenders originate more home purchase loans to lower-income people and communities than they would if CRA did not exist.” And CRA did not just expand home-mortgage lending. Testifying in 1999, Federal Reserve Chair Alan Greenspan reported that in 1997 alone, CRA loans included “525,000 small business loans worth $34 billion; 213,000 small farm loans worth $11 billion; and 25,000 community-development loans totaling $19 billion.”

What didn’t happen? An explosion of sub-prime lending. That came later. So for starters, the timing is entirely wrong for the contention that CRA caused the crisis. Nevertheless, by the end of the 1990s, bank regulators became concerned that poor lending practices were beginning to develop in the home-lending market and that some might ignore CRA’s admonition that CRA lending needed to be done “consistent with safe and sound operation.” In 1999, banking regulators issued guidance concerning sub-prime lending and made the point that CRA lending needed to be responsible—well underwritten, well priced, and understandable by the borrower.

Even efforts after 2001 to press Fannie Mae and Freddie Mac to buy sub-prime loans, as part of the Bush administration’s “Ownership Society,” do not implicate CRA . Those who scapegoat CRA a 16

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often contend that it was a reckless push for homeownership—by both the Clinton and Bush administrations—that led to the sub-prime crisis. But while homeownership increased significantly during the Clinton years, sub-prime (and also Alt-A) lending was still under 10 percent of mortgage originations when President Bill Clinton left office. President George W. Bush’s further pressure for homeownership, which included substantial pressure on Fannie Mae and Freddie Mac to purchase loans, in particular low-documentation loans, was dubious policy, but cannot be blamed on CRA .

In 2006, the height of the sub-prime boom, almost two-thirds of the high-cost loans made were for purposes other than the purchase of a home by an owneroccupant—they were mostly refinancings to extract equity. But even this over-

CRA-covered subsidiaries (15 percent),

this was a marked decline. this leads to three critical questions: What kind of lending were CRA-covered institutions doing that “counted” under CRA? How did those loans perform? And who was doing the sub-prime lending, especially in the low- and moderateincome census tracts and to low- and moderate-income borrowers, that is, subprime loans that would “count” under CRA? Three recent studies provide strong evidence that even during the boom years that led to the crisis, CRA lending that “counted” was relatively small in the context of a multitrillion-dollar mortgage market, the CRA loans were of relatively high quality, and CRA-covered loans have performed well compared to those that were not covered by CRA .

Loans made by CRA lenders were far less likely to go into foreclosure than those by independent mortgage companies. states the case against homeownership.

As the Center for Responsible Lending has demonstrated, between 1998 and 2006, only about 9 percent of sub-prime loans went to first-time homebuyers.

Note also that CRA applies only to banks and savings institutions (“thrifts”).

It does not apply to credit unions, independent mortgage companies, or investment banks. And banks and thrifts get credit under CRA only for lending to low- and moderate-income borrowers or in low- and moderate-income census tracts in their assessment areas, broadly the area near their branches which, for large institutions, generally includes entire metropolitan areas. This is critically important to understanding the role of CRA in the current debacle. When CRA was enacted, there were approximately 18,000 banks and thrifts, which made about 70 percent of all home-mortgage loans, and almost all loans were originated by branches and thus were covered

by CRA . By 2006, there were 8,700 banks and thrifts, with a market share of about 43 percent. Even adding the share of their

Researchers at the Center for Community Capital at the University of North Carolina tackled the performance question by comparing 50,000 loans made to lower-income borrowers and sold to SelfHelp Credit Union under the Community Advantage Program (CAP) to sub-prime loans made to borrowers with similar risk characteristics. The CAP loans, which were CRA-eligible, had low down payments and flexibility with respect to credit and debt-to-income ratios, all usually regarded as high risk factors that could result in a borrower being consigned to a subprime loan. However, they were fixed-rate loans, with no prepayment penalties, and were made through normal retail channels, that is, at a bank. The sub-prime loans, by contrast, were adjustable-rate loans, many with prepayment penalties, and usually made through brokers. The result: The 2004 cohort of CAP loans had a default rate one-sixth the rate for brokeroriginated adjustable-rate loans with prepayment penalties; the 2006 cohort had one-third the defaults. The researchers concluded: “For comparable borrowers, w w w. p ro s p ect. o rg

the credit crisis the estimated default risk is much lower with a CRA loan than with a sub-prime mortgage. … Borrowers and responsible CRA lending should not be blamed for the current housing crisis.”

Economists at the Federal Reserve Bank of San Francisco looked at all three questions for home-purchase loans made in California between January 2004 and December 2006, the height of the California sub-prime lending boom: What kinds of loans did CRA-covered lenders make, how did they perform, and who made sub-prime loans in CRA-eligible

ment areas, which receive the greatest regulatory scrutiny under the CRA , are significantly less likely to be in foreclosure than those made by independent mortgage companies that do not receive the same regulatory oversight.”

Finally, in late 2008, Federal Reserve Board economists Glenn Canner and Neil Bhutta analyzed the 2005 and 2006 Home Mortgage Disclosure Act data to understand the relationship between CRA and the sub-prime crisis.

After observing that “the [sub-prime] crisis is rooted in the poor performance of

Where credit is due

Percentage of higher-priced loans in lower-income communities (2006)

20% sub-prime

c h a r t d ata : f e d e r a l f i n a n c i a l i n s t i t u t i o n s e x a m i n at i o n c o u n c i l

Independent mortgage companies

census tracts? They found that about 16 percent of the loans made by CRA lenders were made in CRA-eligible neighborhoods, compared to 20.5 percent of the loans made by independent mortgage companies (IMCs). However, more than half the independent mortgage company loans in low-income communities were higher priced, compared with 29 percent of the loans made by CRA lenders; in moderate-income communities, 46.1 percent of the mortgage company loans were higher priced, compared to 27.3 percent of the loans of CRA lenders.

The study also looked at loan performance, controlling for a wide range of borrower, neighborhood, and loan characteristics. The researchers found that “loans made by lenders regulated under the CRA were significantly less likely to go into foreclosure than those made

by IMCs.” Even more important, “loans made by CRA lenders within their assess-

6% sub-prime

Banks within CRA assessment areas

mortgage loans made between 2004 and 2007,” Canner and Bhutta found that in 2006 “only 10 percent of all loans [were] ‘CRA-related’—that is, lower income loans made by banks and their affiliates in their CRA assessment areas.” Looking at the higher-priced loans that are a proxy for the poor-performing sub-prime loans, they observed that “only 6 percent of all higher-priced loans in 2006 were made

by CRA-covered institutions or their affiliates to lower-income borrowers or neighborhoods in their assessment areas.”

With respect to performance, Canner and Bhutta did three types of analysis. First, looking at mortgages originated between January 2006 and April 2008, they found that sub-prime and Alt-A loans originated in zip codes with incomes just below the level that “counts” for CRA purposes performed slightly better than those originated in zip codes with incomes just above the

CRA level. They also looked at the performance of first mortgages originated under the affordable-lending programs of NeighborWorks America, most of which counted for CRA purposes, and found that these loans had delinquency rates lower than sub-prime or Federal Housing Administration loans, and foreclosure rates lower even than prime loans. Finally, they noted that only about 30 percent of foreclosure filings in 2006 took place in CRA-eligible zip codes.

Based on the Canner and Bhutta study, former Federal Reserve Governor Randall Kroszner concluded, “we believe that the available evidence runs counter to the contention that the CRA contributed in any substantive way to the current mortgage crisis.” In reaching this conclusion, Kroszner and the Federal Reserve Board joined other bank regulators in affirming that CRA did not cause the mortgage-market meltdown.

Federal Deposit Insurance Corporation Chair Sheila Bair has stated, “I want to give you my verdict on CRA: Not guilty.”

Comptroller of the Currency John Dugan agrees: “CRA is not the culprit behind the sub-prime mortgage lending abuses, or the broader credit quality issues in the marketplace. Indeed, the lenders most prominently associated with subprime mortgage lending abuses and high rates of foreclosure are lenders not subject to CRA .” All of these regulators were appointed by President George W. Bush.

CRA is not perfect. In fact, the lack of coverage of independent mortgage companies and mortgage companies that are part of bank holding companies but not banks is a major failing that should be corrected. Moreover, the concept of CRA assessment area is outdated, especially for large, national institutions; it is essential that a greater proportion of the lending done by CRA–covered institutions be actually evaluated under CRA .

But these are reasons to fix CRA , not to blame it for a crisis it did not cause. tap

Ellen Seidman is a senior fellow at the New America Foundation and executive vice president, national program and partnership development, at ShoreBank Corporation. the american prospect

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Banks as Heroes Community-development banks show what financial institutions can do when they have the right motivation and the right mission.

by Adam Serwer

L

ate last summer, Gloria Stallworth, a resident of Chicago’s South Side, was hospitalized with stomach pains. The 54-year-old mother and nutritional supervisor at a local hospital was told by doctors that her pain was due to anxiety, and Stallworth knew exactly what was wrong.

She was drowning in bills; specifically, her adjustable-rate mortgage seemed to take more and more money out of her pocket every month.

“It was a nightmare,” Stallworth says.

“My mortgage was going up but my pay wasn’t moving.”

With her mortgage, assorted bills, and her daughter’s private school tuition, Stallworth considered taking a second job. Until she heard a radio story about ShoreBank, a community-development bank that was offering rescue loans for homeowners drowning in their adjustable-rate mortgages. “My rate was about to adjust again,” Stallworth says, so she picked up the phone. With ShoreBank, Stallworth was able to refinance and bring her mortgage down to a manageable 6.25 percent rate.

Stallworth’s story has a happy ending.

But the stories of millions of other minority homeowners saddled with sub-prime mortgages don’t. The sub-prime debacle hit minorities particularly hard—blacks and Latinos made up almost half of new homeowners between 1995 and 2005.

In 2005 more than half of these new homeowners who were black received sub-prime loans, and 46 percent of new Latino homeowners got them as well. The numbers cut across class but not race: even high-income minority borrowers were far more likely to get adjustable-rate mortgages than were whites or Asians. a 18

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ShoreBank, a community-development financial institution, or CDFI, didn’t start out trying to repair the fallout of subprime loans. Launched in 1973 as the South Shore National Bank, ShoreBank was founded to provide loans to Chicago neighborhoods devastated by redlining, racial discrimination, and the fallout of the riots of the late 1960s. It’s more than just a business; it’s a profitable one: ShoreBank, in fact, has been profitable since its second year. Last year it reported a profit of $2.6 million and, along with its affiliates across the United States, holds over $2.4 billion in assets. ShoreBank has purchased and renovated more than 55,000 units of affordable housing since 1973. According to the National Community Investment Fund, a nonprofit that measures the performance of CDFIs, more than 80 percent of ShoreBank’s loan originations and purchases are in low- and moderate-income communities.

CDFIs like ShoreBank give the lie to the idea that adjustable-rate or other highinterest loans are the appropriate way to deal with the risk of lending to minority communities. Aside from the fact that adjustable-rate loans were targeted at minorities regardless of credit history, ShoreBank showed that lower-income borrowers and small businesses, carefully evaluated for credit-worthiness, could pay back conventional loans at the same rate as other borrowers. ShoreBank isn’t quite as profitable as other banks— careful underwriting of smaller loans is more expensive and time consuming.

But ShoreBank’s avoidance of deceptive adjustable-rate mortgages allowed it to avoid the losses incurred by other banks when the sub-prime crisis occurred.

By 2007, ShoreBank was already

warning of the coming debacle in the subprime market. ShoreBank founder and Chair Ronald Grzywinski wrote a letter to Federal Reserve Chair Ben Bernanke warning that responsible CDFIs like ShoreBank were unable to compete with predatory lenders and that stronger regulation was necessary. A month earlier, Bernanke had dismissed calls for tougher regulation in a speech on sub-prime lending he gave in Chicago, arguing that “in the long run, markets are better than regulators at allocating credit.” Months later, ShoreBank had launched its Rescue Loan Program, serving borrowers with high-priced loans and encouraging them to refinance before it was too late. “It’s a very emotional thing where people don’t like to admit that they’re behind or do something about it,” says Brian Berg, a spokesperson for ShoreBank. “Half the people didn’t know what kind of mortgage they had signed on for.”

Located in the same communities as their lenders, CDFIs like ShoreBank have an incentive to help their neighborhood improve rather than simply collect on w w w. p ro s p ect. o rg

the credit crisis

s ta c i e f r e u d e n b e r g / a p i m a g e s

Now Offering Rescue Loans: Mary Houghton, president and co-founder of ShoreBank Corp., and Ronald Grzywinski, chair and co-founder, pose inside one of the bank’s vaults in Chicago.

residents’ loans. ShoreBank in particular highlights its “triple bottom line,” which focuses not just on profitability but on raising the value of the homes in the community and making them environmentally sustainable. ShoreBank uses its influence with borrowers to encourage them to weatherize their homes and retrofit them with appliances that use less energy, which also leaves the borrower with more money in the long run. Typically, people recoup their costs in two to four years. “The costs we’ve found from working with folks are [$2,000] to $5,000,” Berg says. “They’re reducing utility bills up to 50 percent a month, not to mention the environmental benefits.” Despite the general downturn in the market, community-development banks are still appealing investments— over the past two years, TIAA-CREF has invested more than $49 million in seven community banks across the country, including ShoreBank.

Since its creation, ShoreBank has become a model for CDFIs across the country. While devoting more than 80 percent of its loans to low- and moderate-

income communities, its loan losses in 2008 were less than 1 percent of its outstanding loans. And while many of the most prominent CDFIs began prior to 1994, the Community Development and Regulatory Improvement Act, signed by Bill Clinton, established the Community Development Financial Institutions Fund, which provides capital for and helps train CDFIs. Over 800 CDFIs are now licensed by the CDFI Fund.

By 2000, ShoreBank had established itself as a reliable institution where less affluent Chicago residents could go to get home loans. But as sub-prime lending grew, predatory lenders began poaching customers from CDFIs like ShoreBank, with disastrous results. ShoreBank watched as significant portions of Chicago neighborhoods were lost to blight and foreclosure. In the city of Chicago, the foreclosure rate increased 34 percent from the first quarter of 2008— after a substantial number of homes had already been lost.

“The investment we’ve made is being stripped away,” says Michelle Collins,

lina has spent years advocating for better lending practices and regulation. In 1998, after a local borrower came to SelfHelp Credit Union looking to refinance an adjustable-rate mortgage, the credit union was shocked at the amount the borrower was being charged in fees.

“We couldn’t believe it was legal,” says David Beck of Self-Help. The group began looking into the previous lender and realized it had expanded all over Self-Help’s home base in North Carolina.

“If this is the type of lending these guys do, they are dwarfing all of our efforts to do good,” Beck says. Working with a coalition of groups including the NAACP and the AARP, they managed to persuade North Carolina to enact stronger regulations against predatory lending, in the form of a state law that limited the amount of fees lenders can charge on refinancing or home-equity loans.

This law is now threatened by a provision in the proposed Mortgage Reform and Anti-Predatory Lending Act, which passed the U.S. House in May. That bill would preempt state regulations.

Seven years ago, Self-Help established the Center for Responsible Lending to help push for better regulation.

Since the sub-prime crisis, Self-Help

After the sub-prime crisis, Shorebank found itself in the unexpected business of aiding neighborhoods devastated by foreclosures. senior vice president of mortgage lending at ShoreBank. “Home values are plummeting; people are losing their homes.”

In the aftermath of the sub-prime crisis, ShoreBank found itself in the unexpected business of trying to repair neighborhoods devastated by foreclosure, by offering loans to borrowers like Gloria Stallworth. Since the program started, ShoreBank says it has kept over 200 Chicago families in their homes by making more than $32 million in rescue loans. shorebank isn’t the only CDFI trying to clean up the mess left behind by unscrupulous lenders. Founded in 1980, Self-Help Credit Union of North Caro-

has undertaken a number of initiatives to stem the tide of foreclosures. It received money from North Carolina’s Neighborhood Stabilization Grant program to help finance home loans and redevelopments in some of the hardesthit areas in the state. The credit union has also instituted “high-touch loss mitigation” practices—meaning that it is in frequent communication with its borrowers—in order to keep borrowers from falling behind on their payments.

“One of the problems” that exacerbated the sub-prime crisis, Beck says, “was that lenders were using conventional loss-mitigation techniques in a nonconventional market.” the american prospect

a 19

not every community-lending institution is capable of meeting all the needs of residents in communities of color. While ShoreBank offers fixed-rate loans for businesses and homes, its focus is on building appreciable wealth, so it doesn’t offer car loans, for example. The problem is that while the value of a car depreciates over time, it can often be essential to getting or keeping a job.

“It depends on how you see asset­building. A car is not a product that increases in value, but it’s definitely a necessary product to get to asset building,” says Jose Garcia, an associate director for research and policy at the New York–based think tank De¯mos. “You don’t have a reliable public transportation system in most cities.”

Other community-lending institutions, like Self-Help, do offer such loans.

But a far more significant obstacle is the lack of regulation to curtail predatory lending. “The free-marketers will say just let the market be free,” says David Beck.

“But the flip side of a free market is perfect or near-perfect information. And the fact is in any loan transaction, the borrower is almost always at a disadvantage to the lender or the broker. And in situations with vulnerable populations, it’s an extreme information disadvantage.”

Community-lending institutions are admirable, but by themselves they are no panacea. Even if sub-prime mortgage loans are gone forever, predatory lenders have a menu of options to choose from: payday loans, car loans, single-premium credit insurance, even usurious creditcard rates. Unless Congress enacts very strong pro-consumer regulation, when the market rebounds predatory lenders are likely to start circling once more.

And the need is not just rules to prevent predatory practices but also regulations to require conventional lenders to reach out to residents of low- and moderateincome communities [see Janneke Ratcliffe, “A Bridge to Somewhere,” page A4]. Only when people of color and other communities of modest means have the full range of financial services at reasonable rates will they have access to the capital they need to realize their economic potential. tap a 20

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When Creditors are Predators We need to regulate to assure that loans work— and stop the loans that work people over.

by T i m F er nh o l z

‘‘H

ow many people remember the sub-prime crisis of 1991–1993?”

William Black asked me the other day. Black is a longtime federal regulator turned economics professor.

We were talking about how the collapse of the housing market in 2006–2008 catalyzed today’s Great Recession.

“It’s a trick question,” he continued.

“The same stuff was developing, all the non-amortizing loans, all the qualifying of borrowers at the teaser rate. We killed it by regulation, and there was no crisis, period.

There were maybe two or three failures of institutions, but hardly in the way of that, either. It always starts out fairly small, and if you squash it when it’s nice and small, there is no systemic problem at all.”

Nobody squashed our current crisis, which has been building for nearly a decade. The tale of bad incentives and free-market profit-maximizing gone wrong is, by now, familiar: Dubious loan products created an artificial demand for buying and building homes. This all created a huge bubble in the housing market; when it inevitably popped, a financial sector, swollen by deregulation, crashed down with it, starting the self-reinforcing cycle of deep recession.

Businesses unable to obtain credit laid off workers, and workers, already overburdened with credit-card debt and stagnant income, defaulted on loans of all kinds, further damaging banks.

As the administration attempts to deal with the immediate effects of the crisis, the next task is figuring out how to realign the bad incentives in the financial industry through regulation. Rep. Barney Frank passed legislation in the House, now awaiting Senate consideration, to prevent predatory mortgage lending, and President Barack Obama has signed leg-

islation limiting credit-card practices that hurt borrowers. These efforts are a start, though consumer advocates want the government to go further. But the premise of all this legislation is relatively simple: We need lenders to profit when loans succeed, not when they fail. That idea needs to be the centerpiece of the next era of consumer regulation.

Elizabeth Warren, a Harvard law professor and the chair of the Congressional Oversight Panel that monitors the bankbailout program, has proposed a very simple way to approach the problem, analogizing financial products with consumer products (and loans are nothing if not products for consumption): A company can’t sell a toaster that has a one-infive chance of catching fire and burning down your house, but it’s perfectly legal to sell someone a loan with a one-in-five chance of destroying his or her financial independence. Warren proposes a financial products safety commission to review potentially hazardous products for safety and efficacy, rather like the way the Food and Drug Administration functions, before such products are marketed to consumers [see Tamara Draut, “Financial Product Safety,” page A23].

That insight is the key to understanding the problem of predatory lending. There’s no widely accepted legal definition of the term, but predatory lending generally means more than just exorbitant rates and fees; it usually includes some kind of deception or fraud on the part of the lender—misinformation about payment practices, failures to disclose important details, misrepresentation of hidden costs, risks, or conflicts of interest. But a broader definition might also be useful: Predatory lending occurs when the lender’s business model is based on making w w w. p ro s p ect. o rg

the credit crisis

Shaming The Sharks: Members of the Neighborhood Assistance Corporation of America (NACA) and hundreds of homeowners protest outside the home of the CEO of Greenwich Financial Services.

danielle robinson / the hour / ap photo

profits based on fees and defaults, not on the normal performance of a loan.

ordinary loans to low- and moderateincome Americans are often, by necessity, lower in profit for lenders. The lender doesn’t get the economies of scale of a large loan, and small loans to people of modest means require more careful underwriting. But mortgage lenders found another route to make money: They could make an up-front killing charging huge fees for a badly underwritten loan with a low interest rate that would later balloon, then sell the loans packaged as securities, passing off risks to the next person up the chain. That’s just the part that was legal—fraud was rampant as well.

Lynn Drysdale, a consumer attorney in Tampa, Florida, offers a deadpan list of practices she encounters when defending borrowers facing foreclosure: “Falsifying loan applications, falsifying appraisals, putting people in exotic loan products … that make it appear that they can pay, but they really can’t … telling them they can refinance within a year but not telling them there is a really high prepayment penalty.”

This system “worked” for a while. As long as housing prices rose, defaulting borrowers could simply refinance into

another, often even more punishing loan to avoid foreclosure. But the increase in housing prices was artificial; in fact, it was driven in part by the mortgage industry’s willingness to give loans to nearly anyone and lenders’ collusion with appraisers to increase home prices. Eventually, though, the bottom fell out, and the reckoning is all around us. And the same incentives are still at play in other consumer-credit markets, such as credit cards.

“It’s completely ass-backwards at this point,” Ira Rheingold, the executive director of the National Association of Consumer Advocates, tells me. “Credit-card companies make their money when people fail. Their best customers are people who are late, people who miss payments.

Credit-card companies once actually made money by offering people credit.”

For Rheingold, the key question is how to regulate credit-card practices “so that the incentive for credit-card company success matches consumer success.”

Bank and credit-card fees, as well as payday loans, place consumers in a tight spot—many second mortgages or risky refinancings were obtained to pay down other kinds of debt. In 2008, average credit-card debt alone was $8,565.

When you consider the average household income is around $50,000, you can

see where problems begin to arise. Rep. Carolyn Maloney’s credit-card legislation passed by Congress in April and signed into law by President Obama will help end some abusive practices, such as late-fee traps, teaser rates, and retroactive interest-rate adjustments; it will also increase consumer notice and require borrowers to consciously opt in to highinterest accounts instead of opting out.

Lenders typically argue that further restrictions on their practices will require them to raise interest rates or simply deny credit to low-income borrowers. The first argument isn’t supported by empirical studies; a healthy banking system doesn’t depend on exorbitant profits in any one product line. And the second is half financial blackmail—we’ll only lend if we can damage—and half a real concern: There are some borrowers who simply don’t qualify for any kind of traditional loan, yet socially responsible banks have in fact demonstrated that they can earn a normal rate of return by lending to surprisingly low-income people if they tailor loans to needs and work with their customers to use credit responsibly [see Adam Serwer, “Banks as Heroes,” page A18].

However, the typical practice has been to make loans with excessive costs to unqualified and qualified borrowers alike. The point is to reap the extra fees. Fannie Mae estimates that half of sub-prime borrowers qualified for prime loans—in part because banks paid brokers incentive fees to put borrowers into high-interest mortgages.

In the pending legislation, Congress will ban those fees, as well as require mortgage originators to ensure that borrowers can repay loans and achieve a net benefit from them; it would also make originators hold on to 5 percent of any loan they pass up the chain to ensure they have skin in the game. While all this is a step in the right direction, consumer advocates worry that overly loose standards and a lack of enforcement authority won’t give the bill much teeth—Rheingold calls it a “convoluted mess, a cockamamie scheme.” Instead, he argues that everyone on the chain, from the originator to a Wall Street investor, should be legally liable for the the american prospect

a 21

outcome of each loan—investors to borrowers, and originators to investors.

“We need to redo the securitization system so that it’s not a liability-avoidance system,” Rheingold says. “Any mortgage or any transfer of that mortgage, liability fully goes along the way so that risk goes along with that, so that everybody is worried about their liability and acts appropriately.”

More disclosure isn’t a silver bullet either, for mortgages or consumer credit.

Indeed, complicated disclosure forms are more confusing than clarifying for

loan interest—the Center for Responsible Lending believes that capping consumer loans at 36 percent interest is a “quick, commonsense” way to prevent borrowers from becoming trapped in debt, taking out one loan after another just to stay afloat. It’s a reflection of how far we’ve fallen that a 36 percent interest cap is considered progress. That used to be considered usury.

As we go to press, the Treasury is preparing to present Congress with a proposal for comprehensive financial-regulation overhaul. Several options have been float-

One regulation worth enacting would flatly prohibit loans without income verification— what the industry calls “liar loans.” borrowers who aren’t financial experts, and often end with clauses saying lenders can change the terms at anytime; for example, the recently passed creditcard reform had to prohibit the common practice of retroactively raising creditcard interest rates on past balances. For complicated mortgage products, it’s better to ensure there is legal accountability and that consumers aren’t even offered products that are likely to lead to late payments, excess fees, and defaults.

One regulation worth pursuing, so simple it will make you laugh, is to end non-verification loans—those made without any proof of income. In the industry, these were termed liar-loans. “If we had said that to get a loan you have to show a pay stub—at least one pay stub—we would not be in this mess today,” says Mark Seifert, the executive director of the East Side Organizing Project, a community group that works on foreclosure prevention.

This, too, is part of Rep. Frank’s mortgage legislation, which requires that the underwriting explicitly consider a borrower’s income and existing debt to ensure that a loan could reasonably be paid back.

The last part of the regulatory agenda is simple, too: Put a cap on the fees and interest charged on loans, whether for mortgages, credit cards, or smaller lines of credit like payday loans. It’s time to revisit anti-usury laws that used to limit a 22

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ed; one, to consolidate the four major regulators into one organization, has been quashed by congressional leaders, but it’s possible that the Office of Thrift Supervision, a notoriously lackluster regulator, will be eliminated, and the Securities and Exchange Commission and the Commodity Futures Trading Commission may be combined. All of these changes are in the interest of ensuring a systemic approach to protecting the economy from risk. Derivatives, the financial products that helped explode the financial crisis, will come under scrutiny. The administration has also apparently embraced Warren’s idea of the Financial Product Safety Commission, which would have important and welcome influence protecting consumer borrowers.

In all of these efforts, it is important that federal standards allow states the freedom to demand more from regulated institutions—reforms need to clarify that state regulators have the right to impose higher standards, as is the case with minimum-wage laws—and that the federal standard is a floor, not a ceiling.

Otherwise, pro-consumer regulators and law-enforcement officers at the state level could have their hands tied. Home loan giant Countrywide Financial, for instance, switched regulators in 2007 to gain access to broader preemption authority, thus avoiding state regula-

tors. “The feds were aggressive in only one area, and that was preempting state regulation,” William Black says. “Even though the [attorneys general] were kind of heroes in this, they were driven from the field by the preemption doctrine.”

Limiting federal preemption should go hand in hand with more funding to the moribund FBI white-collar-crimes unit and the Department of Housing and Urban Development’s near-disbanded mortgagefraud investigators to ensure that regulations are actually enforced. In late May, President Obama signed legislation championed by Sen. Patrick Leahy of Vermont that expands fraud statutes to include mortgage lenders and their agents, among other technical fixes to make it easier to prosecute lenders who make false statements. The law also appropriates funding to hire hundreds of new FBI agents and Department of Justice attorneys to focus on combating mortgage fraud. underlying the whole problem of credit for lower-income Americans is the larger challenge of asset building. Building the kind of advantages available to the wealthy can be very difficult, but the government can adopt policies, ranging from children’s savings accounts to making the first-time homebuyer tax credit refundable, that encourage saving, provide access to financial education, and develop shared equity resources. These strategies would help create an environment where credit builds wealth instead of destroying it.

“We should be more worried about giving people more disposable income, livable wages, so they have enough income that they can actually buy a house,” Rheingold says. “Instead, what we’ve seen over the last 15 or 20 years is income stagnation, but to make up for that income stagnation, we’ve made credit incredibly accessible.”

Ultimately, finding policy solutions is only part of the challenge. Now that the crisis has laid bare the perverse incentives of the financial sector, Congress and the president should take an aggressive approach toward restructuring the way lenders do business. It will take political capital, and likely plenty of real capital from consumer-advocacy organizations trying to match the millions bankers spend w w w. p ro s p ect. o rg

the credit crisis lobbying to maintain the status quo. Veterans of these battles are skeptical of the idea that progress will come easily, if at all, given the success of lenders at stymieing legislation they dislike—a bill that would have allowed bankruptcy courts to modify

home loans to make them viable failed due to lender lobbying. If some consolation is to be taken from the current recession, it is that a politician who opposes the bankers is making a very smart investment of political capital indeed. tap

Financial Product Safety The case for a new agency to put the needs of consumers first

by Tama ra Draut

c h a r t d ata : t h e j o i n t c e n t e r f o r h o u s i n g s t u d i e s

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s our nation’s economic crisis spreads and trillions of dollars are disbursed to keep the banks afloat, it’s easy to forget that the catastrophe began with the peddling of a toxic retail-credit product: adjustable-rate subprime mortgages. Fueled more by demand from Wall Street than by demand from homebuyers or homeowners, a vast army of unregulated mortgage brokers barreled through down-on-their-luck neighborhoods offering salvation via cash-out refinancing in the form of exploding adjustable-rate mortgages. Contrary to popular perception, the majority of these mortgages weren’t taken out by speculative investors or even by middle-class families fulfilling their aspirations for ever-more home on an ever-shrinking income. In many cases, the mortgages were sold to existing homeowners, who were duped into trading their affordable fixed-rate mortgage for an ultimately unaffordable adjustable one. According to The Wall Street Journal, more than half of all sub-prime loans went to people with credit scores that could have qualified them for traditional mortgages.

As early as 1998, legislative hearings on predatory lending featured testimony from advocates, government officials, and Congress members voicing concern about the dramatic increase in sub-prime loans. The warnings were steady and consistent, but regulators failed to act.

Why? First, agencies were fragmented and afflicted with conflicts of interest.

The Office of Thrift Supervision and the Office of the Comptroller of the Currency are both funded through money paid by the very institutions they regulate.

Second, agencies focused almost exclusively on the “safety and soundness” of the banks they regulated. If they sold off the sketchy loans (the case with near-

posed by Harvard law professor Elizabeth Warren, would surely have yanked these mortgage products and the brokers who sold them from the market—preventing the whole complicated chain of events that resulted in the collapse of our economy. In the pending bill introduced by Sen. Dick Durbin and Rep. William Delahunt, the commission would have the power to “ban abusive, fraudulent, unfair, deceptive, predatory, anticompetitive, or otherwise anticonsumer practices, products, or product features.”

Had the FPSC, modeled after the Consumer Product Safety Commission, existed prior to the current crisis, it would have been the first stop for consumer advocates, mayors, attorneys general, and consumers themselves to file complaints or raise concerns about predatory sub-prime loans. The FPSC would have investigated. Having found widespread evidence of loans being deceptively marketed, shoddily underwritten, and loaded with features that would eventually make them unaffordable, the FPSC would have

Taking out the cash

Home-equity cash-out refinancing, in billions The peak: $327 billion $350 $300 $250 $200 $150 $100 $50

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ly all sub-prime mortgages), the bank’s own portfolio was safe and sound. Third, agencies had authority they failed to use.

The Federal Reserve could have acted— it had the authority through the Home Ownership and Equity Protection Act— but Chair Alan Greenspan showed very little interest in consumer protection.

By contrast, a Financial Products Safety Commission (FPSC), an idea first pro-

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forced the equivalent of a recall, converting sub-prime adjustable-rate mortgages into affordable fixed-rate loans. The agency would then likely have issued new quality standards, clearly specifying the underwriting necessary to ensure home­ owners could afford the payments under the highest rate-adjustment scenario. It also would likely have issued rules prohibiting the use of kickbacks to brokers the american prospect

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for originating loans with interest rates higher than the consumer qualified for.

Moreover, toxic financial products have been aggressively marketed to communities of color. As a result, African Americans and Latinos have suffered disproportionately under deregulation.

A survey commissioned by De ¯ mos found that low- and middle-income Hispanic and African American households carried credit-card debt twice the total value of their financial assets, while white households had financial assets worth more than the amount of their credit-card debt.

United for a Fair Economy has estimated that households of color have lost between $164 billion and $213 billion as a result of sub-prime loans taken out during the past eight years. Many of these borrowers qualified for prime-rate products.

A Financial Products Safety Commission could monitor marketing campaigns to see if similarly situated borrowers are being offered different products depending on their community of residence or their race or ethnicity. By extending the collection of race data from mortgages to credit cards, auto loans, payday loans, and so on—the commission could better police the industry’s racial targeting. as the idea of a Financial Products Safety Commission gains momentum (the White House was considering the idea as this issue went to press), questions arise about whether the new agency should have direct authority or whether it should serve in an intervenor function, working with existing regulatory agencies. The current bill would give the agency direct authority. While arguments can be made for either form, if the goal is to elevate consumer protection in the regulatory scheme, creating an agency that doesn’t have direct authority to regulate financial products seems poised to produce lukewarm results.

Critics contend that we don’t need a new agency because safety and soundness and consumer protection are two sides of the same coin. This idea is conventional wisdom now but was considered naive for the last decade. It’s not difficult to imagine a time, say a decade from now, when the interests of consum a 24

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ers are again viewed as pesky nuisances standing in the way of bank profits.

The current patchwork system of regulators overseeing consumer financial products—some 10 altogether—are illequipped, even ill-designed, to do the job of protecting consumers. Their primary clients are banks, not consumers. Historically, much consumer protection was provided through state law and oversight.

But beginning in the late 1970s, usury protections and other credit regulations were all but nullified by legal rulings and several pieces of congressional legislation that preempted state laws. In addition, none of the agencies have the resources to tackle consumer protection adequately.

Millions of families have lost their home, jobs, retirement savings, college aspirations—as a result of toxic products pushed by unregulated mortgage lenders and brokers, who often had the full backing of capital from august financial institutions and the full approval of existing regulatory agencies. It remains to be seen if this lesson will lead to transformative change such as the establishment of a Financial Product Safety Commission, or if the lingering power of the banking industry will leave us with mere tinkering at the margins. tap Tamara Draut is vice president of policy and programs at De¯mos.

Reversing the Damage What will it take to resume credit flows to lowand moderate-income neighborhoods?

by J o h n Tay lo r

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e have committed more than $8 trillion to bailing out banks, but one common lament, from many business owners and prospective homeowners, is that the very same banks are reluctant to make loans.

We need to modernize existing laws and enact some new ones in order to restore flows of credit.

One immediate remedy is the CRA Modernization Act of 2009. This proposed law would strengthen the existing Community Reinvestment Act to make it more effective and expand CRA’s purview to financial institutions other than banks.

Had the existing CRA covered independent mortgage companies, most of the unsavory lending practices that led to millions of foreclosures and brought down the nation’s economy would not have occurred. Top economic researchers from the Federal Reserve have found that less than 7 percent of the high-cost, highrisk loans that are at the source of our economic and foreclosure calamity were made by CRA–regulated institutions.

As it turns out, regulatory oversight matters. A CRA–regulated bank would have CRA examiners looking over their loan portfolios and practices to prevent unethical, unsafe, unsound, and discriminatory lending practices. The regulatory oversight for non-bank mortgage institutions was all but nonexistent. The CRA Modernization Act of 2009 would level the playing field by treating banks and non-banks alike, while increasing average Americans’ access to credit and capital.

Here’s a list of lenders not currently covered by CRA: ■ Independent Mortgage Companies (to name a few that have disappeared: Countrywide, Ameriquest, New Century Financial Corporation, Option One, Golden West) ■ Mainstream Credit Unions (not predatory lenders but they lag behind banks in most areas in serving minorities and low-wealth borrowers) ■ Insurance Companies (try being a business and getting a loan where insurance companies refuse to issue property w w w. p ro s p ect. o rg

the credit crisis or casualty insurance in your community) ■ Securities Firms (Morgan Stanley, Bear Stearns, Charles Schwab, and others) With the expansion of CRA to other financial institutions, we not only decrease unsafe lending practices but exponentially expand the responsible credit available to low-, moderate-, and middle-income neighborhoods for small businesses, homeowners, investors, and others. Literally trillions of additional private-sector dollars would be available for reinvestment in cities and towns, and all this without government subsidies

banks, and investors who modify loans.

Yet the program is entirely voluntary for the banks. The one possible stick, proposed authority for bankruptcy judges to order modification of loan terms, was rejected by the Senate after the administration failed to press for it.

Unfortunately, the new foreclosure filings continue to escalate. New fore-

We take homes to make room for highways, city centers, schools … why not use eminent domain to help keep people in their homes?

m a r y a n n c h a s ta i n / a p i m a g e s

Couples’ Counseling: The NACA’s “Save the Dream Tour” is helping at-risk home­owners across the country by restructuring their mortgages and permanently reducing their interest rates.

(such as the $11 trillion welfare payment already appropriated for our financialservices system).

The new legislation would also improve the system for evaluating banks, so that predatory lending and racial discrimination would be explicitly penalized. It would provide far more detailed data on lending practices. Lending to small cities and towns as well as to rural areas would also be explicitly covered. but expanding cra regulation is not sufficient. The legacy of the sub-prime collapse is also an epidemic of foreclosures.

Thus far, the administration’s response has been far too feeble.

President Barack Obama’s $75 billion program, Making Home Affordable, creates financial incentives to loan servicers,

We take homes to make room for highways, airports, city centers, and schools; why not purchase securities to actually keep people in their homes?

This proposed new Homeowners Emergency Loan Program (HELP Now) would allow government purchase of these loans at a deep discount, since these mortgages have already lost sub-

closures are occurring at about 300,000 per month, with foreclosures at this level projected through all of 2009 and most of 2010. This will produce a continuing downward spiral in property values, stripping additional equity and wealth from property owners who did not get predatory or sub-prime loans.

One strategy, as proposed by the National Community Reinvestment Coalition in January 2008, would have government brake this collapse by forcing the sale of toxic mortgages, as well as mortgages that have been converted to securities, by directly purchasing them from Wall Street firms and banks. This involves using the power given Treasury under the Emergency Economic Stabilization Act of 2008 (which gave us TARP) or government’s powers of eminent domain.

stantial value. Under current market conditions, this discount would be steep enough (between 30 percent and 50 percent) so that private-sector banks would be able to immediately refinance these mortgages at terms that matched the borrower’s ability to pay.

Millions of these toxic loans could be refinanced through this mechanism without government guarantees or subsidies.

Instead, the loss the investors and banks have already suffered on paper would be converted into a gain for homeowners.

The government could then use its guarantee and subsidy programs and perhaps direct lending, as it did in the 1930s, to assist homeowners in deeper trouble.

The overriding goal is to keep people in their homes. Once a home becomes vacant, it is likely to lose even more value, dragging down the value of homes in surrounding neighborhoods.

There is some talk now within the Obama administration of creating a direct-purchasing program, although administration officials remain hopeful that their financial-incentive program will work. But the deepening collapse of our economy exacerbates the challenge. Whereas most of the foreclosures that occurred when the economy first collapsed in 2007 resulted from these exploding sub-prime loans, increasing numbers of Americans can’t pay their mortgages because of job loss. These homeowners also need mortgage relief.

Creating a direct-purchasing program now would allow millions of homeowners, who are still working, to avoid defaulting the american prospect

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on their loans. This could help lessen the foreclosure crisis and contribute to stabilizing home prices. The challenge of creating jobs, stabilizing communities, and getting banks back into the business of lending will be further undermined if the foreclosure filings continue to escalate.

So let’s tell Congress: You’ve taken care of the banks. It’s time to assure that those who elected you at least have the chance

to start or expand businesses or to become homeowners the old-fashioned way, borrowing money from a lender that is not predatory, usurious, or disengaged. tap John Taylor is the president and CEO of the National Community Reinvestment Coalition and has worked to increase economic opportunity for working-poor Americans for over 25 years.

Community Reinvestment: The Broader Agenda CRA has created a cadre of community-friendly bankers.

It’s time to bring reinvestment policy into the 21st century.

by Mark A. W ill i s

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he world of banking and of community development is very different than it was in 1977 when Congress enacted the Community Reinvestment Act (CRA). Thirty-two years ago—with cities still in an urban crisis of broad economic decline and with civilrights legislation only a dozen years old— CRA laid out an affirmative obligation for banks to expand access to credit in local service areas for “underserved” communities. Under pressure from both activists and regulators, banks significantly increased their investments in neighborhoods formerly written off, and bankers commenced constructive dialogues with community groups. In these terms, CRA has been a success.

Today, however, the regulatory tools of CRA are a poor fit with the machinery of the new world of mega-banks and mortgage finance that evolved since the 1990s, let alone the wreckage of the industry after the crash. The core CRA concept of a bank’s local service area hardly fits a Bank of America or a Wells Fargo. The three largest banks in the country now hold almost 30 percent of the nation’s total deposit base. In recent years, loosely regulated non-bank competitors such as the mortgage companies that helped a 26

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fuel the explosion of sub-prime home mortgages were able to capture significant chunks of the marketplace. CRA– regulated depository institutions’ share of household assets and consumer loans both have fallen roughly 40 percent over the last three decades.

Not only does CRA now miss a lot of the action, it has also lost some of its bite. Banks see less value in striving for an “outstanding” CRA regulatory rating.

Moreover, the CRA pressure points for advocates, such as applications for bank mergers that regulators must approve, are less potent, given the number of recent shotgun mergers sponsored by regulators to shore up weak banks in the current emergency. At the same time, the largest banks have increasingly addressed CRA goals through their mainstream business units, to the detriment of specialized units that historically have been a major source of innovations and partnerships with community-based organizations and with government. Worse perhaps, CRA also doesn’t focus enough on areas where banks could have the most impact in revitalizing and strengthening lowand moderate-income communities.

So, in this era of intended financialsector reform, what can we learn from

the past 32 years? What does an “affirmative obligation” mean in the new context?

How can CRA itself best be overhauled?

Should CRA be stretched even more by taking on additional roles such as examining discrimination and abusive lending practices? Which non-banks should also be subject to an affirmative obligation?

And what complementary legislative and regulatory changes are needed to promote the broader goal of reinvestment in underserved communities?

Affirmative Obligation— A Record of Success

While CRA may not be the sole reason that banks have made progress in serving lower-income communities, CRA has shown that an affirmative obligation can create a win-win for the institutions, their customers, and their communities. With this regulatory mandate, banks found good business opportunities, borrowers (including individuals, businesses, and real-estate development projects) gained new access to credit, and communities have been better able to develop and thrive. By following good underwriting practices, banks have demonstrated that loans in these communities can perform well, thereby helping to attract additional capital and competition, creating a virtuous circle.

CRA has created a cadre of bankers who recognize the business potential of lending to low- and moderate-income neighborhoods prudently and profitably.

They have learned how to collaborate with community-based organizations, each other, and with government to provide, for example, real-estate loans for affordable housing and community economic development, which were previously avoided due to their complexity and modest size as well as to possible discrimination. Prodded by CRA , banks helped nurture and sustain the growth of a whole new industry of communitydevelopment financial institutions (CDFIs) that use their specialized knowledge and lower operating costs to serve low- and moderate-income communities more effectively than a bank can directly.

The current financial crisis and a prolonged recession could well reverse all w w w. p ro s p ect. o rg

the credit crisis

Government Lifeline? ACORN stages a protest in front of the Federal Reserve Bank in Doral, Florida.

j . pat c a r t e r / a p i m a g e s

past progress, however. Less aff luent communities are particularly vulnerable to the combination of job losses and mortgage foreclosures. Meanwhile, banks are focused internally on cutting cost, trimming every possible product and service that cannot turn a profit, and improving the credit performance of their portfolios through much tougher underwriting standards. The need for financial-sector reform and for public policy to be responsive to the potentially disproportionate impact on these communities is urgent.

what is the best way to revamp CRA and utilize other laws with complementary policies?

Bring competitors into the fold. At their peak, over 50 percent of sub-prime home-mortgage loans were originated by non-banks, including independent mortgage banks, many of which are now gone. Regulating just the banks did not work. Bankers and community advocates agree that all the key players in the market should be subject to the same rules and regulations and to the same public scrutiny as banks. In fact, consideration should be given to including an affirmative obligation in any comprehensive legislative reform of the homemortgage markets. Taking advantage of such legislation would both ensure fair and equal coverage of all players in that market and allow CRA to focus on other areas of importance for the well-being of

low- and moderate-income communities.

Make CRA less complicated and more effective. As a regulatory process, CRA requires the grading of a bank’s performance with the two possible passing grades being satisfactory and outstand-

credit. Loans for affordable housing and community economic development only count for extra credit, and communitydevelopment services appear to have a weight of only about 5 percent toward the bank’s composite CRA score. Also, loans that are made at below-market interest rates—especially if at a rate below the bank’s internally charged “cost of funds”—should receive more credit than those made at market rates. These loans can be of particular value to CDFIs. Emphasize quality, not just quantity.

A greater emphasis on communitydevelopment lending also suggests the need to bring qualitative judgments back into the rating process. A well-intentioned CRA reform enacted in 1995 emphasizes outputs—“production over process.” But today’s greater reliance on sheer numbers has undervalued such important factors as technical assistance devoted to making deals happen and pricing concessions needed to make deals work. CRA should count the extra efforts the bank makes to

CRA misses a lot of the action because it

only covers banks. The law needs to be extended to cover banks’ competitors.

ing. Banks with lower ratings can be denied approval for business objectives such as permission to merge or make acquisitions. The CRA review also offers a target for activist groups seeking leverage on bank-lending policies. As the regulators have tried to accommodate the concerns of activists and others, the process has become more and more complicated and cumbersome with exams for a large, national bank taking 18 months or more to complete. By the time the results are in, they are often too late to have an effect on the bank’s business strategy for its next CRA exam.

Focus on community development. In addition to expanding coverage to nonbanks, CRA reform needs a better focused evaluation of banks. While communitydevelopment loans and services are critical to helping low- and moderate-income communities to thrive, they are undervalued by CRA today. They should get more

assure that credit actually flows to communities that would otherwise be underserved. Examiners need to be both trained to ascertain which loans had a significant impact on the community and would not otherwise have been done, and empowered to give these loans extra weight.

Acknowledge differences among banks.

Today, banks with only a local presence, but with assets greater than $1 billion, are examined under the same rules as national mega-banks; they are subject to the same tests on the same products and services. CRA should allow more variation in the types of skills, knowledge, and systems that are typical of banks of different sizes. For example, large national banks should get credit for investing in national funds that help improve the flow of capital to multiple local jurisdictions. Similarly, regulators should adjust criteria to local conditions.

For example, Cleveland may be more the american prospect

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U.S. Treasury has a program called First Accounts, which subsidizes the expenses of helping lower-income people who have no bank accounts to move into the financial mainstream. However, the program has been woefully underfunded. Sometimes, subsidizing the extra administrative, underwriting, and counseling costs, as well as a shallow subsidy of interest rates, is more effective than regulatory pressure in getting banks to provide services that are otherwise not costeffective for the bank.

Fix other laws that fight discrimination. Some advocates have called for the additional public disclosure of the race and gender of small-loan applicants as well as more detail on home-mortgage loans, including an applicant’s credit score. While the purpose of unmasking patterns of discrimination is laudatory, especially given the apparent persistence of racial targeting in sub-prime lending, researchers have estimated such disclosures could allow 80 percent of the personal data to be matched to a specific person by using other data sources from credit records. Strengthening and effectively enforcing existing fair-lending laws may be a better approach than adding more requirements to CRA and risking disclosures that could violate personal privacy. If the issue is affirmative obligation, then it may be better to add it to the anti-discrimination laws than to enmesh the CRA itself in the process of investigating discrimination, which often requires reviewing individual loan files, a process that seems best done on a confidential basis.

Cover other financial products and services. An affirmative obligation might also be appropriate for non-bank financial products that are critical to the wellbeing of a community. Insurance is one example often cited. For these, the same set of questions should be addressed before applying an affirmative obligation.

What particular products or services are at issue? Is the community underserved with regard to them? Would the benefits (private and society-wide) of providing them exceed the costs? If so, what would be the best way to cover all the firms playing in that particular market? If there w w w. p ro s p ect. o rg

c h a r t d ata : m o r t g a g e b a n k e r s a s s o c i at i o n / m i l k e n i n s t i t u t e

in need of replacing surplus properties ing standards even for non-depository with urban amenities (green spaces, for institutions, there would have been no instance) whereas New York continues sub-prime catastrophe. If the political to face a shortage of affordable housing. will is not present to enforce other existThe regulators could give a bank the ing laws, expanding the reach of CRA is a option of being judged under the stan- poor substitute and may backfire. dard rules or based on a set of tests that Use better and more targeted subsidies. are more locally tailored.

The rewards and sanctions of CRA may Avoid promoting destructive competi- not be enough to promote the desired tion. Overemphasis on sheer loan vol- flows of capital to credit-starved comume can cause banks to fight over market munities whether through specialized share, purely for regulatory credit. The community-development financial instigoal of CRA is to encourage banks to look tutions or via direct loans that may have harder to expand their lending opportunities in low- and loans gone bad moderate-income communities, Sub-prime adjustable-rate mortgages have the not to lower price or credit qualworst default record. ity in a desperate attempt to steal home mortgages delinquent or in foreclosure 35% market share from one another.

33.4% More generally, all of the CRA 30% examination criteria should be 25% reviewed to assure that the banks ■ Sub-prime Adjustable-rate mortgage 20% truly serve the law’s broad goal.

■ prime fixed-rate mortgage Some are not worth the trouble 15% and take limited resources away 10% from more important measures.

3.0% 5% Others have unanticipated or perverse consequences.

0 Addressing foreclosure preven1998 2008 tion. Several million American families will lose their home in the next additional risks, are more costly to serfew years, whether because of the explod- vice, and are not conventionally profiting costs of sub-prime loans or because able without additional subsidy. While of household income losses in the reces- CRA has sparked some innovation and sion. To date, the administration’s policy experimentation by banks, it has rarely, of giving financial rewards to banks for if ever, been able to induce a bank to marmodifying loan terms has had only lim- ket and produce at scale products and ited incremental impact. For CRA itself to services that lose money either because make a difference, it would have to offer of high production costs or an inability specific and significant CRA credit for to set a price sufficiently high. Nor has cooperating with the loan-modification CRA had much effect on the amount of program. Public-policy initiative may funds a bank allocates for philanthropic well need to become more robust before purposes although it may have raised the the foreclosure crisis is solved. proportion going to community development. If we want to expand the overBeyond CRA all resources available to less affluent Overburdening CRA with new require- communities in a way that succeeds, we ments and expanding it to new industries, need to recognize that this enterprise will products, and situations can, paradoxical- sometimes require direct subsidies as ly, defeat the larger purpose if the result well as regulatory carrots and sticks.

The types of incentives that CRA can is to dilute CRA’s effectiveness or lead us to ignore other needed policy tools. offer, even once strengthened, have Arguably, if the Home Ownership Equity only a limited ability to induce banks Protection Act of 1994 had been enforced, to undertake activities that do not meet with its requirement of sound underwrit- their minimum profitability hurdles. The

the credit crisis is a problem with profitability, would monetary incentives be preferable? The clearer the answers are to these questions, the more effective the legislation will be in helping communities.

The brilliance of CRA was its brevity and simplicity. It required affirmative outreach to communities and left the details to regulators and to interactions between banks and community groups.

While this approach left room for innovation, it also expanded expectations

beyond what CRA alone could accomplish. To be truly effective going forward, CRA needs more focus on community development; its regulations need more latitude with clear but flexible criteria, and laws that complement CRA should be strengthened. tap Mark A. Willis is a visiting scholar at the Ford Foundation. He previously headed community-development banking at JPMorgan Chase.

emergency aid in a crisis. These include access to credit from the central banking system, examination and certification of soundness, and deposit insurance. And in the current crisis, government has also used trillions of dollars of public funds to prop up banks’ shaky balance sheets and guarantee the institutions’ debt, while the Federal Reserve has opened its spigots to provide liquidity as necessary.

the contention that a corporation owes society something in return requires closer analysis. Some of the benefits that society expects are relatively cost-free or are spread so uniformly across business sectors that they do not impose noticeable costs. But in other cases, pursuing social goals may turn out to be less profitable or to take a measurable bite out of the company’s total return.

Many of business’ reciprocal obligations to society are fairly basic. As beneficiaries of government’s basic civil-society functions, like national defense, corporations are expected to pay taxes and follow norms of good behavior. They may not commit fraud.

We do not allow them that “there are no values, to deny employment, no ‘social’ responsibilities in any sense other than credit, or other benefits the shared values and on the basis of race, gender, national origin, age, responsibilities of individuals.” or sexual orientation.

Labor’s right to orgaCompanies, in other words, should stick nize and negotiate in its to their business. Any own interests generally is diversion erodes sharewell established, though holder value, diminishes often breached in pracfocus on what capitalists tice. Market forces alone Nothing Owed: According to freedo well, and arbitrarily market guru Milton Friedman cannot be left to assure bends private investment safety in automobiles or to pursue public goals, often without in the air. More narrowly, the Commuaccountability for either the choice of nity Reinvestment Act requires banks goals or the efficacy of their pursuit. that take deposits out of communities But corporations are creatures of to give something back, in the form of public legislation and regulation. They credit to low- and moderate-income as enjoy limited liability, certification by well as affluent borrowers. the Securities and Exchange CommisCorporations didn’t always accept sion (SEC), which helps them float stock, that these citizenship responsibilities and a variety of other public investments were theirs. Some still chafe at them. that help them do business. Banks, as But they largely are accepted, at least in specialized institutions, have an even broad principle. Some, although not all, more extensive other layer of public of these benefits impose costs on corbenefits in ordinary times, as well as porations. But they are the necessary

What Does Financial Capital Owe Society?

Corporate social responsibility is a worthy goal, but it’s no substitute for regulation, subsidy, and government sponsorship of social institutions.

by Bar ry Ziga s

eddie adams / ap images

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he idea that private enterprise should be harnessed to the creation of social capital is an old claim given new resonance by the financial crisis. After beggaring millions of people and threatening the global economy with ruin, banks and other credit providers surely have an obligation both to run their businesses soundly and to meet a higher standard of social responsibility. While some argue this could hobble, distract, or damage corporate focus on the bottom line, let’s be clear. It was not an excess of attention to social needs that caused the near total collapse of the world’s financial system but almost every other kind of excess.

Milton Friedman defined the classic position against corporate social responsibility in an oft-quoted 1970 New York Times Magazine article, where he stated flatly that a corporate executive’s responsibility is “to conduct the business in accordance with [shareholders’] desires, which generally will be to make as much as possible while conforming to the basic rules of the society.” Friedman continued

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cost of doing business in a civil society.

President Barack Obama has made clear that his administration will rely heavily both on broad business regulation and on exhortation to seek an increased level of social investment and responsibility from private interests. This is a healthy restoration of the principle of mutual dependency that was waylaid in a form of “extraordinary rendition” under the George W. Bush reign after decades of buildup dating back to the Reagan era.

For more than two decades, many have placed hopes in a movement for corporate social responsibility, or socially responsible investment, from which some of President Obama’s optimism springs. The idea is that norms of good behavior can be cultivated among entrepreneurs and rewarded by consumers who will favor such enterprises. Many corporations pride themselves in pursuing a “triple bottom line” of benchmarks on good treatment of workers and stewardship of the environment, as well as conventional profit criteria.

There has been a proliferation of selfconsciously green companies as well as mutual funds that market their services on the premise that investments in firms that have a social commitment can produce just as high financial returns as an ordinary portfolio. Recently, energy companies like Chevron and BP have launched extensive “green” advertising campaigns whose message seems to be aimed at convincing consumers that these are something other than energy companies that depend on fossil fuels for their profits. The hope is that these norms are contagious and that more and more corporate executives will appreciate that they can do well by doing good.

But as Clive Crook observed in a 2005 Economist article, “Getting the most out of capitalism requires public intervention of various kinds, and a lot of it: taxes, public spending, regulation in many different areas of business activity. … To improve capitalism, you first need to understand it.”

The problem with these efforts— sometimes sincere, sometimes just a more nimble form of marketing—is that they often are overwhelmed by larger trends a 30

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driven by the conventional bottom line.

The largest banks have recently shuttered their community-development subsidiaries. Their investments in affordable housing, accessible mortgages, and community-based financial intermediaries are all shrinking along with their market capitalization. In the same two decades that corporate social responsibility has become trendy, large corporations have more aggressively busted unions, shifted to outsourcing, and cut health and pension benefits. It turns out that what we do to constrain and contour corporate behavior as citizens—via government action—is more potent than what we can achieve as investors or consumers.

As Brookings Institution senior fellow and New York University economist William Easterly notes, “Moral exhortation has a very limited effect on most people’s behavior, much as we would wish it otherwise.” So, relying on corporate good

ments extended the government’s sponsorship in return for providing consumers and society with specific benefits, such as long-term mortgages with fixed rates.

Regulation. Sometimes, the most effective route to a social goal is regulation.

Automobile companies, for instance, were required to comply with the Corporate Average Fuel Economy standards for gas mileage long before President Obama became “auto executive of the year” through auto company bailouts.

The Community Reinvestment Act changed norms in the banking industry because it used government’s power to grant or withhold benefits sought by banks. There is a long history of government regulation, both to compensate for market failures and to prevent antisocial corporate behaviors.

Subsidy. But when government is seeking to bring private investment into specific new areas, particularly those where

"Corporate social responsibility" is trendy, yet corporations still bust unions, outsource labor, and cut health and pension benefits. citizenship is not enough. Necessary complements are subsidy, regulation, and direct government involvement or sponsorship of enterprises with public purposes.

Sponsorship. Government has long offered specific public benefits to induce private enterprises to achieve social goals. This form of sponsorship trades social capital the government has in abundance—land or its own credit, for instance—to induce private capital to create broader social value, such as railroads, and credit and liquidity in various markets. This strategy can be a powerful lever in creating social investment, particularly if the government negotiates hard in return for its favors.

Sponsorship has deep roots in the financial and credit sectors. Government bank charters have long played a critical role in helping to promote capital formation as well as savings by individuals and institutions. Guarantees of deposits, mortgages, and other financial instru-

costs are uncertain or where returns for the capital invested will be lower, sponsorship and subsidies are more appropriate. In a sponsorship model like Fannie Mae and Freddie Mac, government attracts private investment to specific activities in return for certain privileges and benefits. Part of this bargain was a requirement that the companies invest in mortgages serving lower-income people and communities, even if these provided a lower return than other mortgages.

And as the fate of Fannie and Freddie demonstrates, constant vigilance is required in public-private partnerships lest the profit motive corrupt or endanger the public purpose. Real capital was put at risk through this partnership. While shareholders profited for many years through their growth and profitability, the companies’ recent losses, driven by bad management decisions and weak oversight by their regulator as the mortgage market morphed into a carnival of crazed risk-taking, have wiped out nearly w w w. p ro s p ect. o rg

the credit crisis

all common and preferred share value.

But as their nominal owner today, the government is using them both to actively funnel subsidies in the form of cash and forbearance to beleaguered owners whose mortgages they hold. Freddie Mac in a recent SEC filing estimated the cost of these indulgences to be as high as $30 billion. Because of their hybrid heritage, both institutions have been far more active and responsive to the mortgage default crisis than any of the fully private investor trusts or Wall Street banks that created them to peddle the vast bulk of toxic mortgages.

The model has its critics. National Economic Council Director Lawrence Summers might have been channeling Friedman when he recently wrote disapprovingly about creative capitalism and the roles of Fannie and Freddie: “Inherent in the multiple objectives urged for creative capitalists is a loss of accountability with respect to performance.”

With friends like this in high office, it is even more important for progressives to focus hard on just how sponsorship, subsidy, and regulation can be applied in new, as well as old, contexts as the financial crisis abates, and where each tool is most appropriate.

the investments meet a market test of economic sustainability.

But many subsidy needs cannot be met through tax incentives, and many economists oppose them as a noxious perversion of the tax system. Tax subsidies are also wasteful, in that a large proportion of the subsidy “leaks” in the form of allowing well-to-do investors to reduce their taxes as a way of getting to serve social goals. Direct subsidies are the alternative, as when Congress gave the Department of Housing and Urban Development (HUD) new authority and cash in 2009 to invest more than $2 billion to insure completion of affordable housing projects jeopardized by the

as powerful as they are, sponsorship and regulation alone will not provide economically sustainable interventions to reduce poverty. Private capital, for instance, will not underwrite moneylosing housing investments, nor should it.

Government must provide the subsidies that make low-cost housing possible.

These subsidies can be provided either directly, through budget expenditures, or indirectly, through tax credits and other subsidies to attract capital to certain investments.

Subsidies provided through the Low Income Housing Tax Credit and the New Markets Tax Credit, for instance, have the virtue of certainty, predictability, and low bureaucratic overhead. They only work if private capital agrees that

financial crisis. Such cash investments sometimes are a more efficient way to subsidize specific activities, and often are needed to reach very low-income groups because tax incentives cannot be made lucrative enough to do so.

Community development financial institutions (CDFIs), a hybrid form of social capital, have benefited from a combination of direct social investments from private banks and subsidies from government. The Treasury Department’s CDFI fund provides seed and matching capital grants and loans to qualified CDFIs. In past years, banks also made investments at preferential terms in CDFIs, in part because such investments were favorably regarded in reviewing compliance with the Community Rein-

vestment Act, and in part because CDFIs’ seed investments in predevelopment expenses for housing, health care, and education facilities often led to opportunities for sponsoring banks to make market-rate loans and investments in the final products.

Low Income Housing Tax Credits, Section 8 housing rental subsidies, Community Development Block Grants, investments in CDFIs, and other explicit subsidy interventions acknowledge that government has a singular role in providing capital to achieve certain results that the private sector cannot provide. The partnership model seeks to maximize private investment in such endeavors but recognizes that subsidies must be provided in order to do so.

As a consequence of the financial crisis, the federal government now holds stakes worth $199 billion in more than 500 banks, has guaranteed trillions more, and functionally owns Fannie Mae, Freddie Mac, and American International Group. The old financial regulatory system and its assumptions have been swamped by decades of weakening federal capital markets regulation. As Treasury Secretary Timothy Geithner testified in March 2009, “To address this will require comprehensive reform. Not modest repairs at the margin but new rules of the game.”

These new rules will definitely include a more comprehensive acceptance of the federal government’s ultimate role in managing moral hazard and systemic risk. We need a more comprehensive and aggressive agenda for using the levers of citizenship, sponsorship, and partnership, as well as explicit regulation and subsidy, to assure that the financial system that emerges from this wreckage benefits not only shareholders and management but taxpayers who are ultimately at risk and the society in which they live. tap Barry Zigas is director of housing policy at Consumer Federation of America, in Washington, D.C. the american prospect

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THANKS TO

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THANKS TO

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