Redlining in the US Housing Market and the Early Stage of the Housing Bubble

Project Start:03/2014
Researchers:Vahid Saadi, Vahid Saadi
Category: Financial Intermediation
Funded by:LOEWE

Topic and Objectives

The credit and housing boom of the early 2000s in the US set the stage for the biggest financial crisis since the great depression. To understand the underlying causes of this boom, economists have offered a multitude of insights as to why markets, especially the banking sector, behaved as it was witnessed. Many argue that credit market conditions were such that they incentivized banks to take on too much risk. Furthermore, bank branching deregulation, securitization and finally, inflow of foreign capital, especially from the Asian markets to the US are the other factors which fueled the credit boom. There is however much less discussion about the role of the US government policy towards homeownership in this regard.

This project aims to close this gap. In particular, it studies the role of the Community Reinvestment Act (CRA) in the US mortgage and housing markets in the early 2000s. The CRA was originally enacted in 1977 to address potential discriminatory credit practices against households in low- and moderate-income neighborhoods (a practice called redlining). However, this act was not fully enforceable in the first two decades after its passing. The lack of objective and measurable criteria for assessing banks' compliance, and credible sanctions against noncompliant banks rendered the act ineffective in its original form. It was only in the 1990s that the CRA started to be credibly enforced. A major amendment was introduced to the act in 1995 with the purpose of boosting compliance rates of financial institutions by designing objective and formal criteria to assess banks' CRA performance. Moreover, for the first time noncompliance became punishable in that the regulator could decline violating banks' applications for any sort of expansion or merger.

The main purpose of this project and SAFE Working Paper No. 155 is to document the contribution of this enhancement in the CRA enforcement to the recent boom-bust cycle in the US housing market.

Key Findings

  • The results show that banks subject to the CRA increased their lending significantly after 1998. The annual growth rate of mortgage lending by such banks increased by 7.7 percentage points after 1998.
  • Housing prices react positively to increased mortgage supply. Theory suggests that laxer lending standards or lower interest rates enable credit-constrained borrowers to enter the market and increase demand for housing. On the other hand, it reduces unconstrained borrowers’ incentives to bargain on prices which allows housing prices to rise further. The paper shows that these channels are in effect: for every one percentage point higher annual mortgage growth rate, generated only through supply factors, annual housing price growth rate increases by 0.3 percentage points.
  • The boom in US housing prices was magnified partly due to the CRA.
  • The bust in housing prices from 2007 to 2010 was also sharper in neighborhoods which were eligible for CRA mortgages.
  • The CRA not only enforced banks to supply more mortgages, it turns out that such mortgages were also significantly riskier: CRA-induced mortgages went to borrowers with lower credit scores and carried higher interest rate.

Policy Implications

The paper documents a clear example of unintended consequences of well-intentioned government policies through interventions in the banking sector. The case becomes even more important if we take into account the second-order effects of such policies. Most importantly, altering mortgage and housing market policies can distort decisions regarding investments and labor and hence affects the real economy.

Related Working Papers

No.Author/sTitleYearProgram AreaKeywords
155Vahid SaadiMortgage Supply and the US Housing Boom: The Role of the Community Reinvestment Act2016 Financial Intermediation The Community Reinvestment Act, Mortgage supply, House prices, Homeownership