Poor quarterly results from banks across the US over the past two weeks suggest credit problems once confined to high-risk mortgage borrowers are spreading across the consumer landscape, posing new risks to the economy and weighing heavily on the markets.
US banks have raised reserves for loan losses by at least $6bn over the second quarter and by even larger amounts from last year, indicating financial executives believe consumers will be increasingly unable to make payments on a variety of loans.
Banks are adding to reserves not just for defaults on mortgages, but also on home equity loans, car loans and credit cards.
“What started out merely as a subprime problem has expanded more broadly in the mortgage space and problems are getting worse at a faster pace than many had expected,” said Michael Mayo, Deutsche Bank analyst.
“On top of this, there is an uptick in auto loan problems, which may or may not be seasonal, and there is more body language from the banks that the state of the consumer was somewhat less strong [than thought].”
In the US, making bad loans isn’t just a good idea, [url=http://en.wikipedia.org/wiki/Community_Reinvestment_Act]it’s the law.[/url]
“In the US, making bad loans isn’t just a good idea, it’s the law”
That is toxic falsehood. The Community Reinvestment Act (CRA) requires FDIC-insured banks to look for ways to serve the credit needs of the communities in which they operate, including low- and moderate-income areas. It does not require banks to make unsound loans; it does encourage banks to see if there opportunities to make good loans that might not meet traditional criteria.
Here are four examples (two historical, two more recent) of good loan opportunities that did not meet traditional criteria:
-1- During the 19th and early 20th century, most U.S. commercial banks did not want to deal with people of modest means (including immigrants and blue-collar workers). Yet savings banks and (later) credit unions prospered making loans to such people.
-2- During the 1920s, New York State, unable to eradicate loan sharks by criminal prosecution, asked big commercial banks to start making small loans to the working poor. The predecessor to today’s Citibank did so and found the business very safe and profitable. The working poor, whom the bank had previously shunned, did a good job of repaying their loans. The bank made lots of money and the poor could get credit without depending on extortionate thugs.
-3- Traditional personal-loan criteria focused on the income of the applicant and his or her spouse. Yet among Asian immigrants extended families often live together and function as economic units. Encouraged by the CRA, banks found that they could make good, profitable loans by taking account of other family members’ assets and income in evaluating an applicant’s ability to repay a loan.
-4- Take the case of someone in a poor neighborhood who wants to buy an abandoned row house for $2,000, spend $20,000 to fix it up, and do all the work himself. When he finishes, he will have a house worth $80,000 that cost him $22,000 and lots of sweat. But he needs to borrow most of the $22,000. Encouraged by the CRA, banks have found that they can make “sweat equity” loans safely and soundly.
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The Community Reinvestment Act itself declares that it seeks to encourage federally insured banks “to help meet the credit needs of the local communities in which they are chartered consistent with the SAFE AND SOUND operation of such institutions.†12 U.S. Code §2901(b). http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=browse_usc&docid=Cite:+12USC2901
The Federal Reserve Board underscores that the CRA does not require banks “to make high-risk loans that jeopardize their safety. To the contrary, the law makes it clear that an institution’s CRA activities should be undertaken in a safe and sound manner.â€
http://www.federalreserve.gov/dcca/cra/
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If the CRA were the cause of bad-loan problems, then we’d expect that mortgage brokers and mortgage bankers (not covered by CRA) would have made better loans than federally insured commercial banks and savings institutions (covered by CRA). That is not the case. We have an epidemic of bad loans because lenders and investors became insouciant about credit risk.
That’s a lovely sentiment, Iranaeus, but the reality on the ground is that banks don’t need to be pressured legally into making good, sound loans, particularly when it seems they have nearly a century of experience (pace your citations) to back up their practices.
The history of the CRA does appear to indicate a good repayment rate and in that aspect I appear to be incorrect and retract my assertion. However, it also seems that there are pernicious effects related to the CRA that harm the very people it purports to help: [url=http://www.cato.org/pub_display.php?pub_id=4976]LINK[/url]
One of the main problems is that people are greedy. The banks and credit card companies make more money with riskier investments because the interest rates are higher and if a few default on their loans, the banks are still ahead. Likewise, the poor are greedy in that they are encouraged to spend more than they can afford both in terms of capital expenditures (homes, appliances, cars, etc.) and on consumer goods and credit (luxury items). This means that when one hiccup comes along, the house of cards built by these people and the banks and credit card companies who enable them come tumbling down.
This is not just a problem of overly permissive credit institutions or of over extended consumers, but of both feeding off the greed of each other.
YBIC,
Phil Snyder
So much for the Bush economy – my grandchildren will be paying for his mismanagement & for his war of choice.
What your grandkids will be paying for the liberation of Iraq is a spit in a river compared to what they’ll be paying to keep you and the missus in slot machine coin and Flowmax, Bob. But we dare not mention those sacred cows.
We agree {surprises never cease, huh ?} on the scam that is legal gambling & the health “system”. But 6,000 wrongs do not make a right.
Jeffersonian [#3]: I appreciate your reconsidering the Community Reinvestment Act’s effect on the soundness of bank lending.
George Benston, to whose Cato Institute paper you link, assumes that the CRA is simply an anti-discrimination statute (notably aimed at race discrimination) and accordingly concludes that it serves no purpose of its own. For a rebuttal see Michael Barr, Credit Where it Counts: The Community Reinvestment Act and Its Critics, 80 New University Law Review 513-652 (2005), particularly pages 527-30 and 533-44:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=721661
[blockquote]We agree {surprises never cease, huh ?} on the scam that is legal gambling & the health “systemâ€. But 6,000 wrongs do not make a right. [/blockquote]
Since an oblique reference is too obscure for you, I was speaking of Social Security and Medicare, the two boondoggles that make Iraq look like a shopping spree at a dimestore .
Thanks, Iranaeus. As a free-marketer, color me unconvinced, but it’s not a law I spring the length of my chain to pillory. I’ll reserve that vehemence for Sarbanes-Oxley and a host of other foolish legislation.