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Low-income loans didn't cause the financial crisis

What caused the housing bubble and collapse of the financial system? Many fingers have pointed to a lack of regulation, financial innovation that didn't live up to its promises of risk-sharing and risk-reduction, and low interest rates from the Fed, which created an excess of liquidity.

Another cause that's often cited says the financial crisis was the result of government pressure to make subprime home loans to those at the lower end of the income scale. But recent work from the National Bureau of Economic Research provides no support for that claim.

The typical narrative is that government, through the Community Reinvestment Act (CRA) and Fannie Mae/Freddie Mac, caused lenders to reduce standards in order to make these loans. That in turn led to an abundance of loans to people who could not afford to repay them. These loans went into default in large numbers, and that fueled the financial crisis.

For instance, Rep. Scott Garrett, R-N.J., claimed in early 2007 that "The recklessness of government is the primary culprit here. For years Congress has been pushing banks to make risky subprime loans. ...Congress passed laws that said we're going to fine you and we're going to file lawsuits against you lenders if you don't make risky loans."

He was far from alone, many other Republican politicians made similar claims. Fox News also supported this argument, "Look... You go all the way back to the Community Reinvestment Act, under Jimmy Carter, expanded under Bill and Hillary Clinton -- they put the guns to the banks' heads, and said, "You have got to do these subprime loans. ...That's what caused this mess."

This is, in essence, a debate between those who claim lack of financial sector regulation caused the crisis and those who claim overregulation -- forcing banks to make loans to risky low-income borrowers -- is the culprit.

However, the new evidence from Manuel Adelino of the Fuqua School of Business at Duke University, Antoinette Schoar of the MIT Sloan School of Management and Felipe Severino of the Tuck School of Business at Dartmouth undermines this story. In their paper, "Changes in Buyer Composition and theExpansion of Credit During the Boom," the researchers found:

"While there was a rapid expansion in overall mortgage origination during this time period, the fraction of new mortgage dollars going to each income group was stable. In other words, the poor did not represent a higher fraction of the mortgage loans originated over the period. In addition, borrowers in the middle and top of the distribution are the ones that contributed most significantly to the increase in mortgages in default after 2007. Taken together, the evidence in the paper suggests that there was no decoupling of mortgage growth from income growth where unsustainable credit was flowing disproportionally to poor people."

Lots of previous evidence supports this conclusion. For example, the Financial Crisis Inquiry Commission established by Congress concluded:

"...the CRA was not a significant factor in subprime lending or the crisis. Many subprime lenders were not subject to the CRA. Research indicates only 6% of high-cost loans -- a proxy for subprime loans -- had any connection to the law. Loans made by CRA-regulated lenders in the neighborhoods in which they were required to lend were half as likely to default as similar loans made in the same neighborhoods by independent mortgage originators not subject to the law."

Thus, in the battle over whether too much or too little regulation of the financial sector played a role in causing and exacerbating the crisis, the evidence points away from those who claim overzealous government regulation was at fault.

That's something to keep in mind as Congress does its best to dismantle the Dodd-Frank law's new financial regulation.

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