Wednesday, June 01, 2005

Disparate Impact in the Lending Industry

It is well documented that minorities, especially African Americans, receive sub-prime loans more often than whites regardless of income. Some studies documenting this phenomenon are here, here, and here.

While there has been much study and discussion of this problem, there has been little in the way of enforcing lenders to provide prime loans to African American and other minority borrowers. Primarily, this seems to be due to the idea that mortgage underwriting is a neutral practice that only takes into account the financial health of a borrower.

This reminds me of the arguments made by the insurance industry defending their policies from discrimination lawsuits in the 1990s. Many African Americans were not offered the most comprehensive and safe type of homeowners insurance -- guaranteed replacement cost insurance -- nor were they offered the next best insurance -- replacement cost insurance. Instead, African Americans were disproportionately offered market value insurance on their homes.

Market value policies do not cover a homeowner as completely as replacement policies do. They offer the market value for losses instead of replacements. And, the values of market value policies are less the values of replacement cost policies in most places. For instance, in Toledo a home in an African American neighborhood in the 1990s could be purchased for, say, $60,000. But, it would cost approximately $100,000 to replace it if it burned to the ground. African Americans were only offered market value policies because insurance companies wouldn't give replacement cost policies to homes with that large a difference between the two values. Often these differing values were (are) due to segregation and stereotypes. It was found in case after case (most of which settled out of court) that this "neutral" practice had a disproportionate effect on African Americans. Thus, the policies violated the Fair Housing Act.

Today, the lending industry works in a similar manner. The lending industry claims that it has neutral criteria to determine what type of loan can be offered to borrowers. Yet, African Americans are disproportionately offered sub-prime loans. A big part of this has to do with credit scoring. African Americans disproportionately score worse than whites. Consequently, they are offered sub-prime loans instead of prime loans. There is anecdotal evidence that lenders also tend to counsel white borrowers about their options (waiting to clean up their credit, finding more money to pay up front, etc.) more often than they counsel African Americans.

It seems plain as day to me that the lending industry is negatively affecting African Americans with theses policies. And, that this disparate impact is a violation of the Fair Housing Act. We just need to provide the cases to take to court.