Wall Street Journal
By Rachel Louise Ensign and Ryan Tracy

When Steven Mnuchin looked to sell his OneWest Bank for $3.4 billion in 2014, a community group with an $800,000 budget tried to block the deal. That led to a nine-hour public hearing where speakers compared the bank’s executives to the ebola virus and called for their imprisonment. Others voiced support.

Afterward, Paulina Gonzalez, the head of the community group leading the charge, approached Mr. Mnuchin seeking a truce that included the bank setting aside billions of dollars more for lower-income communities, under a law called the Community Reinvestment Act, or CRA. “I hope we can figure this out,” she said.

“No. We’re done,” Ms. Gonzalez recalls Mr. Mnuchin telling her before walking away. A spokeswoman for Mr. Mnuchin says he disputes saying that.

Four years later, Mr. Mnuchin is the Treasury secretary and his fellow executive at the bank, Joseph Otting, is now comptroller of the currency. And one of their big agenda items is an overhaul of the CRA, a law passed in 1977 to combat redlining, a practice where banks wouldn’t lend in lower-income communities.

In the years since the law’s passage, such lending grew, but so too did a thicket of rules and regulations related to the law. In the process, the CRA became a weapon for community groups looking to force banks to commit even more funds to poorer areas. Banks grumbled, but they usually paid up, sometimes giving money to the community groups themselves. Messrs. Mnuchin and Otting were the rare bankers to fight back.

Community groups agree the regulations need to be updated, but worry changes could mean lower-income borrowers would have less access to loans and banking services. Ms. Gonzalez, executive director of the California Reinvestment Coalition, says the plans are driven by the two officials’ personal experience.

“It’s very much done through the lens of two bankers who came out of California and a battle with communities in which they always put their needs last,” she says.

Bankers view the CRA as outdated and overly subjective, and support the proposed revamp, which is expected to include changes to many aspects of the rules. Mr. Otting cites his personal experience in his drive to change the law and says that will help him develop changes that make the rules work “better, both for banks and those nonprofits.”

“I went through a very difficult period with some community groups that didn’t support our community, who came in at the bottom of the ninth inning, that tried to change the direction of our merger,” he said at a banking conference in April. “And so I have very strong viewpoints.”

Part of their plan, Mr. Otting said earlier this year, would make it harder for community groups to “pole vault in and hold [bankers] hostage” when deals are up for regulatory approval.

At a congressional hearing in July, Mr. Mnuchin said his time running a bank motivated him to revise CRA rules. He said the effort wasn’t “about weakening CRA in any way,” but about “making it more effective for communities.”

The changes being outlined by Messrs. Mnuchin and Otting have both sides girding for battle.

Late last month, Mr. Otting, who runs the Office of the Comptroller of the Currency, started the process of changing the rules on his own without fellow regulators the Federal Reserve or Federal Deposit Insurance Corp. It is unusual for one regulator to alter CRA rules unilaterally, although the Fed and FDIC could join the OCC effort at a later date.

Regulators conducting CRA exams evaluate dozens of variables, including the percentage of mortgages a bank makes to lower-income borrowers—those earning less than 80% of the area’s median income—whether it invests in affordable-housing vehicles and if it has branches in poorer neighborhoods. Each exam results in a final grade ranging from “substantial noncompliance” to “outstanding.”

Banks developed methods for fulfilling huge CRA promises and ticking the boxes on the law’s requirements. They counted loans they would have made anyway toward their CRA goals, such as mortgages to affluent home buyers in gentrifying areas. They bought loans from other lenders. They put branches in areas deemed lower-income by regulators that don’t outwardly appear as such, including a portion of Midtown Manhattan with a Ferrari showroom.

Because the exams are administered infrequently, the grades are often years out of date. If a bank wants to do a deal, though, regulators must evaluate compliance at that moment and the bank’s promises for the future.

Members of a community are invited to weigh in on the CRA performance of banks pursuing a merger. That provides community groups with an opportunity to step in with demands, no matter the bank’s earlier exam grade. If banks don’t accede to the demands, the community groups, many operating on shoestring budgets, circulate petitions and mount protests outside bank headquarters that garner publicity.

In the years before the regulations became more stringent, says CRA consultant Ken Thomas, if you were doing a deal, “you’d call your investment banker and the Federal Reserve. Now, the first thing you do is call the community groups to see how much this will cost you. It has almost become an unwritten law.”

Ms. Gonzalez was at the center of Messrs. Otting and Mnuchin’s standoff with community groups in 2014 and 2015 over the sale of OneWest.

OneWest was born of the financial crisis, after shoddy mortgages led to a run on California lender IndyMac Bank in the summer of 2008. The FDIC seized it in one of the biggest bank failures ever. Sensing opportunity, Mr. Mnuchin put together a group of investors, including George Soros and hedge-fund manager John Paulson, and bought IndyMac for $1.5 billion. Their goal was to rebuild the bank, then sell it or take it public.

Mr. Mnuchin, who had worked at Goldman Sachs Group Inc., hired Mr. Otting, an affable Iowa native who became the public face of the bank they renamed OneWest.

The two tried to turn the bank into a business lender that made few mortgages. But it still handled thousands of troubled IndyMac mortgages. In 2011, demonstrators gathered outside Mr. Mnuchin’s Bel-Air mansion to protest foreclosures.

In 2014, Mr. Mnuchin’s former Goldman colleague John Thain, who was running CIT GroupInc., offered to buy OneWest for $3.4 billion. OneWest investors would turn a profit of more than $3 billion, including dividends.

That’s when Ms. Gonzalez and the California Reinvestment Coalition, or CRC, got involved. In a recent interview, Ms. Gonzalez, the daughter of a garment worker who unsuccessfully tried to unionize his colleagues, said she viewed the pending merger as an opportunity to get the bank to give more to poor Californians.

OneWest thought it was doing enough. Mr. Otting met with local religious leaders and groups representing minorities.

The bank also opened its checkbook. In a 2012 CRA evaluation, regulators said OneWest committed $1.4 million to Los Angeles-area groups providing affordable housing and other services. OneWest received a grade of “satisfactory.”

CRC, one of the most prominent of the groups that negotiate around bank mergers, said OneWest was spending less money on CRA than peers.

The ability of community groups to use the CRA that way reflects how the law evolved. In the 1990s, CRA regulations became tougher, requiring the extensive, public exam with an overall grade. A bad grade effectively prohibits mergers.

Around that time, a rollback of laws prohibiting banking across state lines led to a wave of mergers, making good CRA grades especially important. Each deal needed regulatory approval. Community groups had clout, and it became the norm for banks to negotiate with them in exchange for support for deals—or at least dropping noisy opposition.

Former Senate Banking Committee chairman Phil Gramm called the community groups’ tactics “extortion” and, in 1999, tried to limit their influence. After the financial crisis, some conservatives also blamed CRA for the shoddy lending behind the mortgage meltdown, though Fed economists dispute this.

Since 1977, banks have made about $6 trillion in CRA commitments, according to the National Community Reinvestment Coalition, an umbrella organization.

Most of the money promised in the agreements is for profitable loans and investments, generally benefiting lower-income people or areas. Regulators require the loans to be low-risk, but they wouldn’t necessarily all be made otherwise. According to a 2000 study from the Harvard Joint Center for Housing Studies, growth of loans to lower-income communities would be 20% lower if it weren’t for CRA. Donations are often a part of the agreements, though generally a small one.

Sometimes, the agreements can lead to money going to groups connected to the organizations who lobbied for them. In August 2014, for instance, when Banc of California Inc. wanted to buy 20 Popular Community Bank branches, CRC got the acquirer to commit 20% of deposits to CRA activities. That included a $500,000 investment in NeighborWorks Orange County, a CRC member. CRC says it is up to banks to decide where to put their CRA funds.

OneWest and CIT realized early on that their merger—one of the largest since the crisis—could run into CRA problems. They invited groups including CRC to an event in California to discuss the deal. OneWest also brought along children it said had benefited from its philanthropy.

OneWest executives gave PowerPoint presentations on the bank’s mortgage modifications. They didn’t make any specific CRA commitments for the combined bank.

In the following weeks, the bankers held more meetings. At one meeting with the Greenlining Institute, another anti-redlining organization, Mr. Otting said groups opposing the merger couldn’t expect any donations from the bank, Greenlining’s director says. The group sent a public letter to then-Federal Reserve chief Janet Yellen and other top Fed officials urging them to “investigate and verify Mr. Otting’s threat.” Mr. Otting declined to comment.

Ms. Gonzalez’s group met with OneWest. CRC wanted the bank to commit more than 25% of its California deposits to CRA loans, investments and grants, or about $3.6 billion annually. It eventually cut its request to around 20% of deposits—in line with what some other banks planning mergers had committed after discussions with CRC.

Mr. Otting told the activists there was no way the bank could commit that much. OneWest executives felt they couldn’t ramp up lending volume that quickly. With no deal in sight, CRC decided to fight.

It led a group of protesters to the bank’s headquarters. CRC and other groups started petitions against the merger that got more than 22,000 signatures. Regulators started asking questions about the activists’ allegations.

Mr. Otting set up a website for people to send a form letter to bank regulators supporting the merger. About 2,100 were sent, including one from Mr. Otting’s mother.

CRC pushed regulators for a public hearing. A few weeks before it was held, the banks released a new plan promising to make $5 billion in CRA loans, investments and grants at the combined bank over four years. It was less than what the activists wanted.

Regulators eventually approved the merger on the condition the bank submit a revised CRA plan that gave more detail about how the merged operation would provide the $5 billion in funding over four years.

Later, when President Trump nominated Messrs. Mnuchin and Otting to their current government positions, CRC protested. It tagged Mr. Mnuchin the “foreclosure king” and brought borrowers to speak on a panel with Sen. Elizabeth Warren (D., Mass.).

After Mr. Mnuchin became Treasury secretary, his staff started drafting a report to set the Trump administration’s agenda for bank regulation. It initially focused on rolling back parts of the 2010 Dodd-Frank Act, people familiar with the matter say.

Mr. Mnuchin instructed staff to add a section on updating CRA rules, these people say. A later Treasury report on CRA ordered up by Mr. Mnuchin suggested changes that, among other things, could strip community groups of their leverage around deals.

Community groups and banks alike want the CRA updated, but they disagree on what the changes should be.

In public remarks and in the August document that formally began the rule-change process, Mr. Otting has outlined plans for standardized CRA scores. They would be reported regularly like other metrics, such as loans and deposits. If the scores are above a certain level, banks would be considered compliant. That could deprive community groups leverage to extract concessions.

The OCC also floated ideas for expanding the activities that qualify for CRA credit and changing the geographic scope of the tests. Such changes could transform the way banks make loans, investments and donations in lower-income areas.