Table of Contents I. Introduction II. The Nation's Dual Credit Market Rooted in Discrimination A. Overt Historical Discrimination B. Subprime Lending and Its Long-Term Discriminatory Effects C. The Proliferation of Fringe Lenders in Communities of Color III. Credit Scoring Has a Discriminatory Impact and Is Not the Best Measure of Risk A. Limited Scope, Quality, and Transparency of Credit Information B. Disparate Impact of Credit-Scoring Factors 1. Payment History: 35% of FICO Score 2. Amounts Owed: 30% of FICO Score 3. Length of Credit History: 15% of FICO Score 4. New Credit: 10% of FICO Score 5. Types of Credit Used: 10% of FICO Score C. Existing Credit-Scoring Systems Do Not Adequately Predict Risk D. Risky Loan Products and Unsafe Lending Environments--Not Borrowers--Were Clearly the Culprit IV. Why the Federal Government and Lenders Have an Obligation to Change the System V. Policy and Enforcement Solutions to Improve Credit-Scoring Systems A. Broaden the Scope of Financial Data Utilized by Underwriting and Credit Scoring Models B. Improve the Quality of Data C. Make the System More Transparent D. Adequately Assess the Impact of Credit-Scoring Mechanisms on Underserved Groups E. Reduce the Overreliance on Credit-Scoring Mechanisms F. Evaluate Product Risk G. Fix Credit Scores for Victims of Discrimination VI. Conclusion I. INTRODUCTION
Our current credit-scoring systems have a disparate impact on people and communities of color. These systems are rooted in our long history of housing discrimination and the dual credit market that resulted from it. Moreover, many credit-scoring mechanisms include factors that do not just assess the risk characteristics of the borrower; they also reflect the riskiness of the environment in which a consumer is utilizing credit, as well as the riskiness of the types of products a consumer uses.
Until only a few decades ago, communities and people of color were explicitly excluded from access to low-cost government and other mainstream loans. In the 1930s, the Home Owners Loan Corporation (HOLC) used blatant discriminatory rating systems and "residential security maps" to deem communities of color to be high risk. (1) The Federal Housing Authority (FHA) and Veterans Administration (VA) continued this discrimination into the 1950s. (2) Banks, real estate agents, appraisers, and others also perpetuated redlining and segregation in the housing markets. The passage of the federal Fair Housing Act of 1968 improved conditions, but federal regulatory agencies refused to acknowledge their enforcement responsibilities under the Act until the mid 1970s. It was not until civil-rights groups sued the agencies that the federal government began to collect information on the mortgage-lending practices of the institutions it regulated, and to establish and implement fair-lending examination procedures.
Because of this history of racial discrimination, segregated neighborhoods formed and people of color had limited access to affordable, sustainable credit. Instead of accessing mainstream credit available to white borrowers and white neighborhoods, people of color were relegated to using fringe lenders and paying much more than they would have had to otherwise. While segregation and housing discrimination have abated somewhat, we still live in an extraordinarily segregated society. (3) Access to credit is even now often based on where we live rather than our individual ability to repay that credit. As this Article will explore, people of color were steered to subprime loans even when they qualified for prime loans, contributing to the fact that the foreclosure crisis has hit communities of color worse than the rest of the country. (4)
Credit-scoring systems in use today continue to rely upon the dual credit market that discriminates against people of color. For example, these systems penalize borrowers for using the type of credit disproportionately used by borrowers of color. Even fair-lending defense attorneys who represent major banks readily admit that credit scoring has a differential impact on people of color. In a recent article, attorneys at K&L Gates asserted "even the most basic lending standards, such as credit scores and [loan-to-value] requirements, 'impact' racial and ethnic groups differently." (5) While some in the financial industry have recently discussed the existence of the disparate-impact theory under the Fair Housing Act and other long-established laws, all eleven circuit courts that have considered the matter recognized disparate impact as a legally acceptable means by which parties can assert claims under the Act. (6)
As we all look for solutions to the foreclosure crisis, lenders, regulatory agencies, and policymakers promote tighter underwriting standards as a solution to improving the quality of loan performance and strengthening the economy. What they mean in part, however, is requiring higher credit scores for the best and most affordable products. This, of course, places the focus of improving loan performance on borrowers. But many studies and analyses have demonstrated that inappropriate loan products and their components were key factors driving the subprime crisis. (7) Factors including product type, presence of a yield-spread premium, distribution channel, inflated appraisals, and prepayment penalties helped significantly to predict whether a loan would fail. Even major credit repositories and credit-scoring companies, including VantageScore and FICO, admit that credit scores declined in predictive value leading up to and during the foreclosure crisis. (8) So why are some looking to increased reliance on credit scoring as a way of originating well-performing mortgages and solving the crisis?
The use of credit scoring and its disparate impact go far beyond the lending sector, affecting access to many other financial products and services. Employers use credit and other scoring mechanisms to evaluate job applicants, insurers use them to determine auto, life, and homeowners insurance, and landlords use them to screen tenants. Credit-scoring modelers and companies are finding even more creative ways to broaden the use of these systems. A recent proposal in Texas would use credit scores to determine utility rates. (9) Credit scores are even being used to determine which patients are more likely to take their medication as prescribed. (10)
Consumers, civil-rights groups, and policymakers are greatly concerned by the expanded use of scoring mechanisms. For example, insurance companies use credit-based insurance scores to determine pricing. Yet, studies by the Missouri and Texas Departments of Insurance have found that insurance scoring discriminates against low-income people of color because of the racial and economic disparities inherent in scoring mechanisms. (11) The Missouri study concluded that a consumer's race was the single most predictive factor determining his or her insurance score and, consequently, his or her insurance premium. (12)
The relationship between insurance credit scores and race is so strong that even though the Federal Trade Commission (FTC) used data selected by the industry in a 2007 FTC report, it found that credit scoring discriminates against low-income people of color, and that insurance scoring was a proxy for race. (13) The FTC report also confirms that, despite growing reliance on credit-based insurance scores, scant evidence exists to prove there is a causal relationship between a consumer's score and auto-insurance losses. (14) Without the need to demonstrate such a connection, insurers could theoretically use any arbitrary consumer characteristic, such as hair color or zodiac sign, that demonstrates a correlation to a specific outcome, to price insurance products.
This Article focuses primarily on the use of credit scores by lenders, not other industries. It provides an abbreviated overview of other critical issues facing consumers in regard to credit scoring and reporting. These issues are significant and help to demonstrate the urgent need to reform this system. For example, credit-scoring systems are based on information obtained from consumer credit reports, even though credit reports are often rife with errors that are difficult to correct. Credit-scoring systems are also a mystery to consumers because credit-scoring companies maintain that their systems are proprietary and cannot be revealed. These issues are covered in great detail by recent reports by Demos (15) and the Consumer Financial Protection Bureau (CFPB), (16) and a survey by the Consumer Federation of America and VantageScore. (17)
Fixing our current credit-scoring system is not only a moral imperative consistent with our national policies and beliefs about fairness and justice; it is also a legal obligation as outlined by the Fair Housing Act and the Equal Credit Opportunity Act. We hope this Article will assist with the dialogue at this conference as well as our national dialogue on how to move forward and out of our financial and foreclosure crises.
This Article begins with a discussion of the historical discrimination that led to our dual credit market, including subprime lending and the foreclosure crisis. (18) Next, this Article contains a detailed analysis of why credit scoring has a discriminatory impact. (19) Then it discusses the legal obligations that the federal government and the financial industry have to promote fair housing. (20) Finally, it offers recommendations for how to fix our broken approach to credit scoring. (21)
THE NATION'S DUAL CREDIT MARKET ROOTED IN DISCRIMINATION
Credit-scoring systems penalize borrowers who have anything other than mainstream, prime loans. As described below, the financial industry excludes people and communities from mainstream, affordable credit based on race and national origin. (22) In the past, the federal government and private industry explicitly promoted this behavior with...