We have all heard about how the Community Reinvestment Act (CRA) is responsible for the surge in sub-prime lending, and therefore, extrapolating a touch, the financial crisis of 2008. The Act, originally passed in 1977, encourages banks to loan to lower-income and riskier borrowers who might not qualify for prime mortgage rates. The logic seems clear enough: if the government forced lenders to under-write loans for non-creditworthy borrowers, then the government must be to blame for pushing lenders into riskier mortgage products that had potentially high default rates.

While this makes some intuitive sense, it misunderstands the core drivers of the sub-prime mess. In the first place, it is worth asking how it could be that it took over 30 years for a legislative act to destroy the financial system. Surely the variable rate mortgages that drove many homeowners into default do not have ARMs that reach that far. If CRA is responsible for the mess, why did it take so long to wreak havoc? As we will see, it is not credible to blame CRA for what has happened to the housing market over the past three decades, because CRA has become less and less relevant over time.

These claims about CRA are based on two premises which turn out to be false. The first premise is that sub-prime mortgages were mostly the result of CRA-regulated banks. But most sub-prime mortgages were in fact originated by mortgage brokers that were not covered under CRA. It turns out that fewer and fewer loans since 1977 have actually been covered by CRA, because fewer and fewer of these loans originated with banks that are covered by the law (see this Harvard Joint Center for Housing Studies report). In fact, between 2004 and 2006, only 9 percent of sub-prime mortgages to risky borrowers were from institutions complying with CRA. That is, nine out of every ten sub-prime mortgages to risky borrowers had nothing to do with CRA. They were originated by independent mortgage brokers that were able to evade CRA regulations.

The second premise is that sub-prime mortgages were primarily given to non-creditworthy borrowers who could not afford prime rate mortgages. But a Wall Street Journal article from nearly two years ago has categorically demonstrated that this is not true: in 2005, 55 percent of sub-prime mortgages went to people who could have qualified at that time for a prime mortgage. Indeed, the percentage of sub-prime mortgages under-written for creditworthy borrowers steadily increased between 2000 and 2006, from 41 to 61 percent.

All of this suggests that if anything has changed since 1977 that might explain the financial crisis, it is not the increasing number of CRA-compliant sub-prime mortgages to risky borrowers. The opposite is true: fewer and fewer loans have been covered by CRA, and more and more sub-prime loans have gone to creditworthy borrowers.

What then is the driver of this increase in sub-prime and the consequent rise in defaults? It turns out that the rise in sub-prime mortgage lending was the result of the exorbitant fees that brokers and bankers could collect on securitizing such loans (through such incentives as “yield spread premiums”), as well as the potential gains from holding riskier loan portfolios that had allegedly been bundled in ways that made them virtually riskless for investors. As Michael Lewis has shown, securitizers could not originate new risky loans fast enough in order to feed the appetite of investors looking for mortgage-backed securities based on sub-prime.

It is for this reason that even after mortgages in America had been extended to every completely non-creditworthy household in America, lenders began pushing creditworthy households into sub-prime. But after every non-creditworthy and creditworthy household in America had been sub-primed and bundled off, there was still more demand. And that is how the financial system went beyond financing and began to engage in full-on, outright gambling. When there were no more mortgages to write (and in truth, even before this), the banks began creating and selling synthetic products, bundles of fictional loans that tracked actual loans and which were little more than expensive and risky side-bets by investors hungry for more risk (For more on this, see Gillian Tett's new book, Fools' Gold). Keep in mind that the packaging of synthetic products does not generate any productive investment in the economy, but is simply a way to speculate outright on the housing market. The creation of synthetic products based on bundled sub-prime loans that were pushed onto credit-worthy borrowers who could have qualified for prime loans is the single best piece of evidence that the irresponsible lending practices of major financial institutions were not caused by CRA, but by the search for speculative profit wherever it could be found.

The roots of the current crisis do go back several decades, but they are not to be found in CRA. A better place to look would be at the various crises that have occurred since the early 1980s. What these crises/scandals– savings and loan, Long-Term Capital Management, Enron–have in common is not sub-prime, but the increasingly irresponsible behavior of over-leveraged financial firms operating across a variety of markets, from junk bonds, to government bonds, to sub-prime. But more on that in a future posting.