Sri Lanka plans directed credit law, amid warnings of US disaster

ECONOMYNEXT – Sri Lanka is planning to enact a law to force banks to lend back an unspecified share of deposits to the same area they were raised in, Central Bank Governor Arjuna Mahendran said amid warnings that similar interventions in the US proliferated subprime lending.

"We’ve looked at credit allocationas among banks," Central Bank Governor Arjuna Mahendran told an economic forum in Delhi earlier this month.

"One interesting precedent is a bit of legislation that the Americans drafted in the 1970s – the Community Re-investment Act – which mandated that banks should  re-lend 35 percent of the deposits they derive to any particular regions."

"That is something we are looking at where we guide our banks to then give back to geographic regions in term of their deposit mobilization."

The move comes despite the experience of Fannie Mae and Freddie Mac, two agencies that guaranteed housing mortgages to keep rates down and accumulated large volumes of bad debt, and whose problems were compounded by the perverse incentives set by CRA rules when artificially low interest rates were set by the Federal Reserve.

Bear Stearns, one of the first banks to fail in the US as rates corrected, was also one of the first to securitize CRA loans.

José Viñals, Financial Counselor and Director, IMF Monetary and Capital Markets Department, recalled the case of the US.

"The United States decided to increase the housing loans for under-privileged citizens by the role of Freddie and the abuse of these led to the sub-prime crisis," he said.

Credit Bubble

The two US mortgage agencies accumulated large bad debts after the Federal Reserve fired a housing and economic bubble by keeping rates down for multiple years, the biggest bubble it had fired since the ‘roaring 20s’ boom that generated the Great Depression.





While directed credit may cause only a little harm when interest rates are market driven (starve fastest growing sectors of the economy of credit and mis-allocate resources to the whims of politicians or interventionists) state mandated credit can cause enormous harm to low income borrowers when central banks fire credit bubbles with low interest rates.

In Sri Lanka interest rates fluctuate wildly because the central bank resists the market by printing money to delay rate rises – usually to accommodate fiscal excesses such as fuel subsidies or populist spending – and generate balance of payments crises.

Sri Lanka’s attempts to enact a CRA style law comes as poor borrowers in Northern Province in particular have got in to high levels of debt as the banks and finance companies expanded into former war-torn areas where customers were not used to easy credit and had no prior default experience.

In the US, directed credit laws including the CRA wreaked havoc among low income borrowers when interest rates normalized following mal-investments fired by the Fed’s low interest rate driven asset-price bubble.

In 2001, following small recession, the US Fed cut rates from 6.25 percent to 1.75 percent. In 2003, when the economy and credit started to recover rates continued to be cut.

In 2003 rates were down to 1.00 percent, where it stayed for a year, notes Lawrence White, F.A. Hayek Professor of Economic History at the University of Missouri-St. Louis noted in a 2008 paper (How did we get into this financial mess?).

Subprime Expansion

In 2001 mortgages classified as non-prime (‘Alt – A’) were only 10 percent of the total.

"The non-prime share of all new mortgage originations rose close to 34 percent by 2006, bringing the non-prime  share of existing mortgages to 23 percent," White said.

"The expansion in risky mortgages to under-qualified borrowers was an imprudence fostered by the federal government.

"The growth of ‘creative’ nonprime lending followed Congress’s strengthening of the Community Reinvestment Act, the Federal Housing Administration’s loosening of down-payment standards, and the Department of Housing and Urban Development’s pressuring lenders to extend mortgages to borrowers who previously would not have qualified."

The Congress and the executive branch managed to push subprime lending through several ways.

The Federal Housing Authority was created in 1934 to allow borrowers with only a 20 percent down payment to get a loan, when banks were asking for 30 percent down. When banks later started to lower their own requirement towards 20 percent, FHA pushed theirs down faster.

"By 2004 the  required down payment on the FHA’ s most popular program had fallen to only  3 percent and proposals were afoot in Congress to lower it to zero," White notes.

Russ Roberts, another US academic noted that Fannie Mae and Freddie Mac were repeatedly pushed by Congress to give loans to low and moderate income borrowers.

"For 1996, the Department of Housing and Urban Development (HUD) gave Fannie and Freddie an explicit target – 42 percent of their mortgage financing had to go to borrowers with income below the median in their area," Roberts wrote in the Wall Street Journal (How the government stoked the mania).

"The target increased to 50 percent in 2000 and 52 percent in 2005.

"For 1996, HUD required that 12 percent of all mortgage purchases by Fannie and Freddie be "special affordable" loans, typically to borrowers with income less than 60 percent of their area’s median income. That number was increased to 20 percent in 2000 and 22 percent in 2005.

"The 2008 goal was to be 28 percent.

"Between 2000 and 2005, Fannie and Freddie met those goals every year, funding hundreds of billions of dollars’ worth of loans, many of them subprime and adjustable-rate loans, and made to borrowers who bought houses with less than 10 percent down."

CRA Teeth

Until 1989, the CRA was relatively harmless as it was a reporting requirement, notes White. In 1989 the law was changed to make CRA ratings public. Another change in 1995 gave it more teeth, allowing the state interventionists to deny branch applications if the CRA rating was low.

Civil organization like Association of Community Organizations for Reform Now (ACORN) pressured banks to lend to non-qualified borrowers on the threat of complaining to push the CRA rating down, White notes.

"In response to the new CRA rules, some banks joined into partnerships with community groups to distribute millions in mortgage money to low- income borrowers previously considered non-credit worthy," White says.

"Other banks took advantage of the newly authorized option to boost their CRA rating by purchasing spe-cial "CRA mortga ge-backed securities," that is, packages of disproportionately non-prime loans certified as meeting CRA criteria and securitized by Freddie Mac."

Roberts says in 1997, Bear Stearns did the first securitization of CRA loans, a 384 million dollar offering guaranteed by Freddie Mac.

"Over the next 10 months, Bear Stearns issued $1.9 billion of CRA mortgages backed by Fannie or Freddie. Between 2000 and 2002 Fannie Mae securitized $394 billion in CRA loans with $20 billion going to securitized mortgages."

The advantages politicians and interventions see in laws like CRA is that they could give cash to the vote base without raising new taxes or raising the subsidy bill, which was the way to address the issue if banks did not find eligible borrowers in a given area.

"By pressuring banks to serve poor borrowers and poor regions of the country, politicians could push for increases in home ownership and urban development without having to commit budgetary dollars," Roberts noted.

"Beware of trying to do good with other people’s money." (Colombo/Mar27/2016)

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