As a part of the sweeping legislation that has become known as the Financial Modernization Act, a compromise between the House and Senate has been reached. However, the largest part of the compromise was a debate over the future of the Community Reinvestment Act.
The original CRA, which was passed in 1977, required financial institutions to extend loans to low- and moderate-income families and minorities in cities where the banks were located. This encouraged these families that home ownership was a possibility. These institutions have since revised many of their underwriting practices and made lending standards more flexible.
However, with the new bill scheduled to be voted on by Congress within two weeks, it hasn't been clear the exact role the CRA would play in the new legislation. The act, which would allow banks, securities brokerages, and insurance companies to perform services all three businesses, would repeal the Glass-Steagall Act of 1933, which separated the services of financial institutions.
The final outcome of the CRA was a compromise between Sen. Phil Gramm (R., Texas) and the White House. It stated that in order for a bank to acquire or be acquired by a securities brokerage or an insurance company, it must have a satisfactory CRA rating.
A bank must also have a satisfactory rating if it wishes to expand into the securities and/or insurance business on its own. For smaller banks, a CRA examination would be conducted every four years, and those rated outstanding would be examined every five years. Also, disclosure of all CRA agreements between banks and community groups is required.
Rich Ruffer, a managing director at Bear, Stearns & Co., said that while maintaining a satisfactory CRA rating was not always a written law, institutions still tried to achieve it. "People always shot for that anyway," he said. "It made the [merger] process easier."
Since the inception of CRA loans, they have become securitized into mortgage-backed securities pools. They generally had a significantly higher average coupon and were much riskier than those elsewhere in the market.
Many investors are now saying that the new, weakened CRA should not have any effect on their value or stature in the marketplace, because of Treasurys "basically being better than 100 basis points over this point last year," said Ned Brown, president of Financial Modeling Concepts.
"The big banks that generate most of the volume on CRA loans will continue to make the same types of loans in the same way that they've always done," he said. "The smaller banks that Gramm helped get off the hook on CRA, maybe a few less loans, but in the scheme of things it's not the big volume stuff."
Ruffer agreed. "I don't foresee a large impact on the securitization side," he said. "If you look at time extensions for banks with an outstanding, they have an outstanding because they're active in it, so I would suspect they stay active." Bear Stearns is a long-time major player in CRA loans and securities.
However, the type of loans that are making up the pools have significantly changed since they began being securitized. Brown noted that at one time 80% of CRA loan issuance was nonconforming to GSE standards, and now that has reversed "because the GSEs have become more relaxed than what they're looking for in their requirements and the banks are just making more conforming loans," he said.
One reason for CRA loan issuance to remain relatively unchanged is the changing demographics in the U.S. population, fueled by an influx of immigrants.
Homeownership among whites is close to 80%, with blacks being around 40%, Hispanics around 30% and Asians at 12% to13%. The fastest growing segment of lenders such as Countrywide and Norwest is in the lower income and minority families. "They will continue to do it, because that's who they're going after out there," said Brown.
CRA loans have also become very attractive to institutional investors, and Brown sees no change in their value if the act should be signed into law.
The one difference between CRA MBS and traditional MBS is the prepayment speeds. CRA MBS have a 20% to 30% lower prepayment rate. "If you're an institutional investor buying the triple-A paper, the stuff that's guaranteed by the GSEs, it's the best of all worlds," Brown said. "You've got slow prepayment speeds and triple-A paper, so that's the attractive face of it."
He also added that there are no downsides to the new Financial Modernization Act in terms of CRA securities. "You have your institutional investors that want to buy the triple-A paper, and then people like C-BASS that were buying the first loss piece, because they were basically playing the arbitrage spread," he said. "They kind of figured what the loss was going to be on it and how the paper was being discounted at the bottom to buy it."