Community Reinvestment Act - Part Three

All of this comes from Wikipedia. I've just changed the words a little and added comment.

There were arguments against the CRA by such people as William A. Niskanen, chair of the Cato Institute. He said there was no assurance that banks would not be expected to operate at a loss, and recommended Congress repeal the Act during March 1995 congressional hearings. In my personal research, I couldn't find where the Government was guaranteeing these CRA loans in any way, shape, or form.

So now we've got the government pressuring banks to make loans to people who will most likely default, and then, in essence, telling the banks they're out of luck if they think the government's gonna help them when these people do default. That's the way I see it anyway.

Of course all the reports from the government side of things were that there'd be (had been no) problems with CRA loans. Significant to me is that now we're talking about mortgages - " ... lower-income neighborhoods...with lower-income borrowers appear to be as profitable as other mortgage-oriented commercial banks".

In my opinion, "CRA-covered lenders" and "CRA-eligible institutions" = banks who were pressured to make bad loans. Having said that:     The Treasury Department said that between 1993 and 1998, $467 billion in mortgage credit flowed from [banks who were pressured to make bad loans] to low- and medium-income borrowers and areas. ...The total number of loans to poorer Americans by [banks who were pressured to make bad loans] rose by 39% while loans to wealthier individuals by [banks who were pressured to make bad loans] rose by 17%. The share of total US lending to low and medium income borrowers rose from 25% in 1993 to 28% in 1998 as a consequence.

In October 1997, First Union Capital Markets and Bear, Stearns & Co launched the first publicly available securitization of Community Reinvestment Act loans, issuing $384.6 million of such securities. The securities were guaranteed by Freddie Mac and had an implied "AAA" rating.

I asked what this meant at Hunter's Campfire. My thanks to Southerntier8 who told me "Securitization means they bundled together the payments coming in from a collection of peoples mortgages and sold them as one security. It is the same idea as a corporate bond except the payments come from the collection of homeowners rather than a corporation. ... Fannie and Freddie would have been the original lenders. Bear Sterns and First Union (investment banks) would have brokered the deal. Probably they were sold on the bond market to large institutions i.e. insurance companies, pension funds, etc."

My thanks also to Mike762 who told me, "Essentially you take a bunch of mortgages made by different banks and mortgage brokers, and bundle them into a "bond". Then you take this "bond" and get one of the ratings agencies such as Standard and Poor's, Fitch, or Moody's to rate the risk of the bond. The lower the risk of default, or failure to perform, the higher the rating. A AAA rated bond is essentially default proof - at least that's how it's supposed to be. Think US Treasury Bonds.

These are then called Collateralized Debt Obligations or CDO's, or Mortgage Backed Securities or MBS's. The kicker is that these bonds are rated on the senior, or most credit worthy tranche (slice), and not on some of the less credit worthy tranches, because the idea was that the senior tranche would always perform, making up for the losses of the more junior or riskier segments, thus paying the dividend, and keeping the risk of default at nil. It obviously didn't work out that way."

Investopedia offers a good definition of "tranche": "Tranche" is actually a French word meaning "slice" or "portion". In the world of investing, it is used to describe a security that can be split up into smaller pieces and subsequently sold to investors. Mortgage-backed securities (MBS), such as a collateralized mortgage obligation (CMO), can often be found in the form of a tranche. These securities can be partitioned based on their MATURITIES and then sold to investors based on their preferences.

For example, an investor might need cash flows in the short term and have no desire to receive cash in the future. Conversely, another investor could have a need for cash flows in the long term but not right now.

To take advantage of this selling situation, an investment bank could split some security or asset, such as a CMO, into different parts so that the first investor receives the early cash flows of a mortgage and the second investor has the right to receive the latter cash flows. With the creation of these tranches, a security or issue that was once unattractive may enjoy some new found marketability."


So finally, in 1997, banks had a way to...get rid of these bad loans. That's what it looks like to me anyway. Everybody's happy now. The government is forcing the banks to make bad loans to bad risks, so the government's happy. I'm assuming the banks, along with Freddie and Fannie, now had a way to get rid of the risky loans, so they're happy. The investment banks who brokered the deals made a bunch of money selling these bad loans on the stock market to unsuspecting suckers; so the investment banks are happy. The unsuspecting suckers? They're not so happy right now.