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Article Excerpt
INTRODUCTION
Traditionally, policymakers, communities, and industry have regarded the Community Reinvestment Act ("CRA") (1) as a positive mandate for banks and thrifts (2) to do good by increasing investment in low- and moderate-income ("LMI") neighborhoods. (3) The specific purpose of CRA is to encourage federally insured depository institutions "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." (4)
When Congress enacted CRA in 1977, it was in response to the prevailing belief that under-investment was a root cause of blight in LMI neighborhoods. Congress hoped to reverse this blight by creating incentives for banks to increase their lending activities in low-income communities. At the time, it was inconceivable that LMI neighborhoods might eventually have too much credit in the form of abusive mortgages that would trigger a surge in foreclosures and force homeowners to forego heat and medical care to pay their mortgages and thus keep their homes. However, by the late 1990s, the unimaginable had happened. Predatory mortgages (5)--exploitative high-cost loans to gullible borrowers--were ravaging inner cities and newspaper headlines across the country were carrying accounts of foreclosures against low-income people of color and the elderly.
In this article, we seek to understand the intersection between CRA and predatory lending by answering the following questions:
does CRA reward banks for engaging in predatory lending or activities that indirectly support predatory lending? do federal subsidies indirectly support predatory lending? should CRA create disincentives to banks that engage in or provide indirect support for predatory lending? should CRA be extended to impose anti-predatory lending provisions on non-bank lenders, (6) including non-bank affiliates and subsidiaries of banks? is there a role for CRA to play in rewarding bank activities that combat predatory lending?
In examining these questions, we are mindful that CRA is a limited and imperfect tool for achieving community reinvestment. In particular, CRA raises controversial issues, regarding the efficient allocation of credit, competitive parity, safety and soundness, and regulatory taxation. (7) Despite its flaws, CRA has established a beachhead for community development finance across the country and has become institutionalized at major banks. Furthermore, having survived the enactment of the Gramm-Leach-Bliley Act of 1999 intact, albeit modified, CRA is here to stay for the time being. (8)
Just as there are challenges to the utility of CRA in general, there are some who contend that CRA is an inappropriate tool to combat predatory lending. Thus, a threshold question is whether there are legitimate justifications for using CRA to address predatory lending. We have identified two such justifications that we develop more fully infra. The first justification stems from the CRA's goal of encouraging banks to serve the credit needs of their communities. If CRA is creating incentives for banks to engage in predatory lending, then CRA is actually defeating one of its stated goals. Our second justification arises from the fact that banks are the recipients of special government privileges in the form of exclusive charters, federal deposit insurance and so forth. These subsidies are considered part of the rationale for imposing CRA obligations on banks. (9) If banks use these privileges to harm the communities they serve, there is a role for CRA in scrutinizing bank activities. (10)
We divide this article into three parts. In Part I, we outline the relevant provisions of CRA. In Part II, we consider how CRA-covered lenders may enable predatory lending, either directly or indirectly. We also discuss the relationships among CRA, federal subsidies and predatory lending. In Part III, we address whether there are sufficient justifications for employing CRA to penalize lenders that engage in predatory lending. Ultimately, we conclude that CRA involvement is justified and make specific recommendations.
I. APPLICABLE PROVISIONS OF THE COMMUNITY REINVESTMENT ACT
CRA requires federal banking regulators "to encourage [federally insured depository] institutions 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." (11) CRA has two principal enforcement mechanisms: CRA examinations and regulatory review of applications for expansion.
The first enforcement mechanism consists of CRA examinations. In CRA, Congress directed federal bank examiners to "assess an institution's record of meeting the credit needs of its entire community, including low- and moderate-income neighborhoods, consistent with the safe and sound operation of such institution." (12) Federal examiners evaluate a bank's community reinvestment efforts in three separate areas: lending (the "lending test"), investments in community development (the "investment test"), and retail depository services (the "service test"). (13) Institutions receive CRA ratings that can range from "outstanding" or "satisfactory" to "needs to improve" or "substantial noncompliance." (14) Those examination ratings, plus the "public" section of the examination report, are available to the public. (15) Unlike depository institutions, non-bank affiliates of banks do not undergo CRA examinations unless they volunteer to do so.
CRA's other enforcement mechanism consists of applications for expansion. These applications are divided into two types: (1) applications for deposit facilities; and (2) applications to become financial holding companies and applications by financial holding companies and national banks to commence new financial activities or acquire companies engaged in financial activities.
Applications for deposit facilities include applications for a bank charter or deposit insurance; applications to open or close a branch; applications to relocate a home office or a branch; applications for a merger, acquisition or consolidation; applications to acquire another bank's liabilities; and applications to acquire an insured bank. (16) When reviewing applications for deposit facilities, (17) federal bank regulators must take institutions' CRA performance into account. The public may lodge CRA protests and agencies have discretion to deny applications or place conditions on approval due to CRA concerns. (18) The public does not have standing to sue to enjoin bank mergers or other applications on CRA grounds. (19)
Applications to become financial holding companies and applications by financial holding companies and national banks to commence new financial activities or acquire companies engaged in financial activities receive different CRA treatment. Under the Gramm-Leach-Bliley Act of 1999, such applications must be denied where any of the holding company's banks or thrifts has a CRA rating of less than satisfactory. (20) Conversely, where a parent company's depository institutions all have CRA ratings of at least satisfactory, such applications cannot be denied on CRA grounds. (21) Regulators have no discretion and CRA does not allow protests by members of the public to such applications.
II. DEFINING THE PROBLEM
A. Direct Involvement by Banks in Predatory Lending
Banks can directly participate in predatory lending by originating or brokering predatory loans. Currently, both origination and brokerage activities may qualify for CRA credit even when they involve predatory lending.
There is a great deal of uncertainty regarding the extent to which banks originate predatory loans. (22) As we discuss infra, banks have significant disincentives to originating subprime, including predatory, loans. (23) Although theoretically the disincentives outweigh the incentives, there is anecdotal evidence that certain regulated depository institutions have originated predatory loans. For example, numerous borrowers have sued the failed subprime lender Superior Bank, (24) alleging that the bank engaged in predatory lending. (25) The plaintiffs have alleged that Superior encouraged them to assume loans they did not need or could not afford, and engaged in various forms of fraud. (26) If Superior was making predatory loans, it could have received CRA credit for these loans under the lending test.
When banks serve as loan brokers, they take borrowers' applications and perform various settlement functions, without assessing the creditworthiness of the applicants. Sometimes broker banks fund subprime loans for a brief period before assigning the loans to the originating lenders. Other times the broker banks do not fund the loans at all. (27) For the purpose of the CRA lending test, banks can ask examiners to take into account the loans that they brokered and briefly funded. Likewise, banks whose brokerage activities are limited to accepting applications and performing settlement functions can include these activities under the CRA service test. Lastly, banks can ask that their mortgage brokerage services be considered part of their community development service. (28)
B. Indirect Involvement by Banks in Predatory Lending
There are numerous ways in which banks can indirectly support predatory lenders. They can purchase predatory loans as investments, either as assignments of loans originated elsewhere or by buying securities backed by predatory loans. (29) If and when banks purchase predatory loans, they may be entitled to CRA credit under the lending test if the loans fall within CRA guidelines. (30) Similarly, when banks purchase securities backed by predatory loans made to LMI borrowers, they may receive credit under the investment test. (31)
Banks also finance non-bank subprime lenders, through warehouse lending facilities and other working capital loans (32) and through loan guarantees in the form of letters of credit. In addition, banks serve as underwriters, trustees, registrars and paying agents for securitizations of subprime loans, some of which may be predatory. (33) These bank activities raise CRA implications because some of the activities receive explicit federal guarantees, while others may benefit more generally from federal subsidies. Explicit subsidies arise, for example, when subprime lenders obtain financing through commercial paper placements guaranteed by letters of credit issued by banks. (34) Conventional letters of credit issued by insured banks qualify for up to $100,000 in federal deposit insurance. (35) Past failed bank resolution methods that protected uninsured creditors in bank insolvencies, send an additional signal that the uninsured balances of bank letters of credit may receive de facto protection as well. (36) Banks can accordingly charge lower fees for those letters of credit. The possibility that banks are receiving CRA credit for indirectly supporting predatory lending, and that federal subsidies may be facilitating predatory lending, requires that we consider utilizing CRA to deter abusive lending practices.
C. Steering of Prime Borrowers to Subprime and Predatory Loans
One of the most troubling conclusions to emerge from the research on the subprime market is that substantial numbers of customers who qualify for prime loans are steered to costlier subprime loans that should be reserved for customers with weak credit ratings. (37) Mortgage brokers have strong incentives to engage in steering due to "yield spread premiums." (38) These are premiums lenders pay mortgage brokers if they persuade borrowers to accept higher interest rates even though the lenders would, if pressed, grant the loan at lower rates. (39) Unsuspecting borrowers typically never know that they are paying these premiums. Under the Truth in Lending Act, (40) for example, lenders do not have to include yield spread premiums in the calculation of finance charges, even though the cost of the premiums is passed on to the borrowers. (41) Similarly, even when loan disclosure documents list yield spread premiums, relatively few borrowers recognize that these premiums will cause them ultimately to pay higher interest rates. (42) Similar problems are posed by overages, which are incentive payments to loan officers in the form of negotiable interest and fees over and above the minimum rates lenders would be willing to accept to close the loans. (43)
In the bank context, there are two ways that lenders can induce prime loan customers to take out subprime loans. First, banks that offer both subprime and prime loans can steer prime-eligible borrowers to inappropriate subprime products. Second, where banks make prime loans directly, but segregate subprime lending in non-bank affiliates or subsidiaries, the subprime entities may refrain from referring prime-qualified applicants to the banks where they could obtain prime loans. (44) Alternatively, banks may discourage some prime-eligible applicants from securing prime loans by, for example, imposing onerous documentation requirements. Ironically, banks can receive CRA credit for making subprime loans to LMI borrowers even when the borrowers are eligible for prime loans.
Steering by non-bank affiliates rarely even appears on the radar screen of federal bank regulators. The activities of affiliates are not subject to CRA scrutiny unless parent companies voluntarily submit to it. Although mortgage lending by non-bank affiliates (like banks themselves) is subject to the reporting requirements of the Home Mortgage Disclosure Act ("HMDA"), (45) until recently HMDA's regulations did not require reporting of annual percentage rate ("APR") data, which made it difficult to identify subprime loans, let alone steering. (46)
CRA examiners do consider steering when there are allegations that lenders have discriminated by charging higher rates to minorities or other protected groups. (47) Such discrimination claims are relatively rare, and are difficult and costly to prove. (48)
Due to heavy press coverage and in-depth studies by the agencies themselves, (49) federal banking regulators are cognizant that steering is a problem. Since December 2000 or so, the Federal Reserve has expected applicants for approval of deposit facilities to represent that they will review their subprime loan applications for prime-eligible applicants and offer those customers prime products. (50)
CRA examinations, however, are a different matter. In contrast to the Fed's new approach to deposit facility applications, federal banking regulators have not provided guidance to CRA examiners on how to curb steering. In two advance notices of proposed rulemaking, one by the Office of Thrift Supervision in April 2000 and the other by federal banking agencies jointly in July 2001, the agencies solicited public comment on how best to respond to this problem. (51)
D. The Paucity of Legitimate Subprime Lending by Banks
Although CRA-covered lenders originate the greatest number of loans in LMI neighborhoods and to LMI borrowers, these lenders focus primarily on prime lending. As a result, LMI borrowers with impaired credit often turn to non-bank lenders--some of whom are predatory lenders--for subprime loans. Between 1993 and 1998, there was a tremendous surge in lending to LMI borrowers. CRA-covered institutions accounted for eighty-three percent of the growth in prime loans to these borrowers. (52) In contrast, CRA-covered institutions were responsible for only fifteen percent of the increase in subprime loans during the same period. (53) Subprime lenders not covered by CRA accounted for two-thirds of the increase in subprime mortgages. (54) The failure of CRA-covered institutions to meet...
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