The high cost of segregation: exploring racial disparities in high-cost lending.

• Author: Been, Vicki

Introduction I. Racial Disparities in Subprime Lending II. Causes of Racial Disparities in Subprime Lending and the Role of Segregation A. Underlying Economic Inequality B. Geographic Differences and Borrower Behavior C. Racial Discrimination, Steering, and Targeting D. The Role of Segregation III. Prior Investigations of the Relationship Between Segregation and Subprime Lending IV. Empirical Analysis A. Methodology 1. Metropolitan Area Segregation and Lending 2. Neighborhood Racial Composition and Lending: The Case of New York City B. Results of Regressions 1. Metropolitan Area Segregation and Lending 2. Neighborhood Racial Composition and Lending: The Case of New York City Conclusion Appendix INTRODUCTION

The current foreclosure crisis has devastated many predominantly black or Hispanic communities, in part because blacks and Hispanics were disproportionately likely to finance their home purchases or refinance existing mortgages with subprime mortgages, which enter foreclosure at far higher rates than prime mortgages. Across the nation, blacks were almost three times more likely to receive a subprime first lien home purchase mortgage than whites, and Hispanics were 2.6 times more likely than whites to receive such loans. There are a variety of explanations for these stark racial disparities in subprime lending, ranging from underlying income and wealth inequalities between whites, blacks, and Hispanics to intentional discrimination in lending practices.

Efforts to determine which of these explanations are most apt and to craft appropriate policy responses to the racial disparities in the share of subprime mortgages should take into account the relationship between existing levels of residential segregation and the racial disparities in the types of mortgages homeowners received. Residential segregation may make discrimination more likely by providing easy geographic markers for the targeted racial groups, for example. Residential segregation may also exacerbate the exclusion of blacks and Hispanics from more competitive financial markets and from other consumers who are more sophisticated about mortgage products. Understanding the relationship between segregation and racial disparities in subprime lending may thus help elucidate the causes of those disparities. Similarly, understanding the relationship may help policy-makers develop better solutions to the racial disparities in the mortgage market. If levels of segregation are highly correlated with racial disparities in lending, policy-makers may need to devote more resources to ensuring that minority communities are not targeted by subprime lenders or deserted by prime lenders. If levels of black-white segregation are more highly correlated with racial disparities in lending patterns than levels of Hispanic-white segregation, policy-makers may need to fine-tune programs to take into account differences between highly segregated black and Hispanic communities.

This Article explores the relationship between residential segregation in about 200 metropolitan areas across the country and the propensity of borrowers within those areas to receive subprime loans. It also examines how borrowers of all races who live in highly segregated minority neighborhoods fare in the mortgage market, compared to those who live in more heterogeneous communities.

Part I reports the stark racial disparities in the percentage of subprime mortgages received by members of different racial groups. Part II explores the various mechanisms that might explain those racial disparities, and assesses whether and how a higher level of segregation in a metropolitan area might magnify them. Part III reviews what we know--and do not know-from earlier studies about the relationships between subprime lending and neighborhood segregation. Part IV describes our study methodology and reports our findings.

1. RACIAL DISPARITIES IN SUBPRIME LENDING

   Prior research on the mortgage market has found persistent racial disparities in the incidence of subprime and high-cost lending. (1) Across the United States, larger shares of black and Hispanic borrowers originated high-cost loans in 2006 relative to white borrowers (2) (see panel A of Table 1 (3)). (4) That year, 53.3% of first lien home purchase loans issued to black borrowers were high-cost, and 46.2% of first lien home purchase loans issued to Hispanic borrowers were high-cost, compared to only 17.7% of loans issued to white borrowers. (5) The rates of high-cost refinance loans follow a similar pattern: over half of refinance loans issued to black borrowers in 2006 were high-cost, compared to over a third of refinance loans issued to Hispanic borrowers, and only a quarter of those issued to white borrowers. (6)

   Although the rates of high-cost lending in the mid-2000s were lower in New York City than for the nation as a whole for all racial groups, in New York the racial disparities remained wide (see panel B of Table 1). Pooling New York City loan origination data from 2004-2007, (7) we find that less than 8% of the first lien home purchase loans issued to white borrowers were high-cost, compared to over 40% of the loans issued to black borrowers, and over 30% of the loans issued to Hispanic borrowers. The shares of high-cost refinance loans issued to blacks and Hispanics (37.3% and 30.1%, respectively) were approximately twice as large as the high-cost share issued to whites (17.5%).

2. CAUSES OF RACIAL DISPARITIES IN SUBPRIME LENDING AND THE ROLE OF SEGREGATION

   There are several possible explanations for the wide disparity in subprime or high-cost lending rates between white borrowers, on the one hand, and black and Hispanic borrowers on the other. These include underlying economic inequality between borrowers of different races, cultural or geographic differences between the various racial groups that lead them to rely on different sources for mortgages, and racial discrimination in mortgage marketing and underwriting. This Part describes these explanations in more detail, and addresses how the extent of segregation in a metropolitan area might affect each of these possible underlying causes.

   1. Underlying Economic Inequality

      The mortgage underwriting process is primarily an evaluation of the risk that a mortgage loan applicant will default on a proposed loan and, if there is ultimately a foreclosure, that the collateral securing the loan will be in sufficient for the lender to recoup the resulting loss. While lenders differ in how they make these underwriting calculations, (8) the industry generally relies primarily on the following measures to make this risk evaluation: the applicant's credit history; (9) the ratio of the loan principal to the home value ("LTV") that would result from the proposed loan; (10) the ratio of the proposed mortgage payments (as well as required property tax payments, insurance payments, and, sometimes, other household debt payments) to the applicant's income (the debt-to-income ratio, "DTI"); the applicant's liquid assets (beyond the down payment); and the type of documentation the applicant provides to substantiate the applicant's reported income and asset base. (11)

      A borrower with a lower credit score, higher LTV, higher DTI, lower asset base, lower amount of documentation, or a combination of these factors represents a greater presumed risk of default or foreclosure. In theory, lenders demand a higher rate of interest or higher origination fees to compensate for the additional risk posed by borrowers with these traits, or insist upon mortgage insurance or some other credit enhancement device to mitigate the additional risk. This trade-off is a key element of what is known as "risk-based mortgage pricing." (12) Although scholars contest the extent to which economically efficient risk-based pricing explains the growth of subprime lending over the last several years, (13) there is a notable correlation between underwriting criteria and the interest rate an applicant receives, or whether or not the applicant receives a "subprime" loan (the precise definition of which varies across the studies). (14)

      For multiple reasons, risk-based pricing is likely to cause disparate shares of whites, blacks, and Hispanics to receive subprime loans, given the persistent economic inequality between racial groups in the United States. First, income is a major component of DTI; in 2006 (the year the mortgages we analyze were originated), the median income for white households was 62% higher than that of black households, and 35% higher than that of Hispanic households. (15) Second, household wealth is an indicator (albeit an imprecise one) of both liquid assets and a borrower's ability to make a down payment, which is a primary determinant of LTV. Racial disparities in household wealth are even starker than those for income. (16) Finally, blacks and Hispanics are disproportionately more likely than whites to have lower credit scores or no credit score at all. (17) Underlying economic inequality is thus one important reason that racial groups have different likelihoods of receiving subprime loans.

   2. Geographic Differences and Borrower Behavior

      In addition to economic inequalities between racial and ethnic groups, several other differences between minority and white borrowers might also contribute to differential rates of subprime borrowing. First, mortgage channels--the institutional chains through which mortgages are funded--have a significant impact on the types of loans issued. (18) Thus, if racial groups use different mortgage channels, they are likely to end up with different rates of high-cost borrowing. White and minority borrowers have tended to access capital markets for home lending through different channels, with white borrowers more likely than black and Hispanic borrowers to take out loans from depository institutions, and black and Hispanic borrowers more likely than white borrowers to rely on largely...