What We Know About Mortgage
Lending Discrimination In America

A Look at the Process from a Lender's Perspective

It is intriguing that neither the Decatur Federal Savings and Loan nor Boston-area mortgage lenders apparently believed that discrimination would be found in the investigations of their practices. If they had, they might not have cooperated so fully, in the first case with the Justice Department and in the second case with the Boston Fed survey. But the evidence reviewed here strongly suggests that their belief that they were not discriminating was false. Is it possible that lenders discriminate unknowingly? Can discrimination occur in the mortgage lending process even when people believe they are treating all applicants fairly? The answer to this question is vitally important in the quest for strategies to eliminate discrimination in home mortgage lending.

In an effort to shed some light on the issue, this project assembled a site visit team and conducted in-depth, structured interviews about the mortgage lending process to determine what role employees played in decision making, whether they were aware of fair lending requirements, how they perceived fair lending issues, and how they were monitored by their company for fair lending compliance. After the interviews, the impressions of our site-visit team were compared with standard HMDA indicators of the lender's fair housing performance.

Profile of a Mortgage Lender

The lender in question is a mortgage company, fully owned by a builder who develops housing for low- and moderate- as well as middle- and upper-income households. The lending institution has 31 employees and currently originates mortgages worth about $70 million a year. Its loans are almost all for home purchases rather than refinancing, and it processes more minority applications than the average for its metropolitan area. The loan origination staff includes six loan counselors responsible for meeting with prospective customers and taking applications, and four loan processors responsible for collecting the documentation needed to complete the applications. The branch manager of the company supervises both these groups. The company also has an underwriter who is responsible for assessing completed applications for government-insured loans (conventional loans are underwritten by an outside firm). The branch manager and the underwriter both report directly to the company's president.

The case-study lender posts a description of fair lending laws in its office and has a one-paragraph fair lending statement, written by the president, in its procedures manual. This statement describes the company's mission as extending credit to all qualified borrowers. Two of the six loan counselors currently on staff are Hispanic; none are African American. When new loan counselors are hired, they receive an orientation session and extensive on-the-job training. But none of these training procedures explicitly addresses fair lending issues or requirements. All new employees receive a copy of the fair lending statement in their procedures manual. Most said they had not read it.

The research team was impressed by the high level of personal satisfaction that the lender's staff received from their jobs. All of the staff members who were interviewed expressed great pride in their ability to work with borrowers who have problematic loan applications. Staff said they frequently originate loans to applicants who may at first appear to fail a number of underwriting guidelines, and expressed great satisfaction from helping people achieve the dream of homeownership. All of the lender's staff expressed a strong commitment to fair lending, which they defined as treating everybody the same. Staff also expressed admiration and respect for the institution's president; according to one respondent, "She is my role model."

The Lender's Origination Process

Exhibit 3 outlines the mortgage review process implemented by our case study lender. Because most applicants already have a purchase contract on a house built by the owner of the mortgage company, all respondents said that they have a strong incentive to originate as many mortgages as possible, irrespective of race or ethnicity. As a result, there are no pre-qualification assessments. Every customer completes a hard-copy loan application, and the information from this application is then entered into an electronic version of the form. The mandatory information on race is only entered on the electronic form, in an area that is not visible on the initial computer screen. None of the loan counselors ever predicts the outcome of the application review process for the customer.

Once a customer leaves, the loan counselor adds comments to the computer-version of the loan application. None of the respondents said it was acceptable to enter subjective "feelings" about an applicant. Instead, comments are factual in nature and relate to the applicant's employment history, credit history, income and whether the loan is government-insured or conventional. Because these comments are entered on the electronic version of the application, they are accessible to everybody in the company and provide information to the underwriter and branch manager about any issues that warrant attention. The rest of the origination process includes multiple reviews, so that no single employee can unilaterally make a decision about any loan application. The status of every pending loan application is discussed at weekly staff meetings, which are attended by the loan counselor, the processors, and the branch manager. An applicant who meets all the underwriting guidelines will receive a mortgage subject only to the receipt of an appraisal report. Borrowers who fail some underwriting guidelines have to comply with specified conditions. Even very complex and hard-to-fulfill conditions do not preclude an applicant from receiving a mortgage from the lender, however. In fact, the lender sometimes originates mortgages to applicants a full year after the application was initially processed. Many staff members

Exhibit 3. Lender's Origination Process

said the company originates a lot of loans to applicants who would not have received mortgages from other companies where staff are less dedicated to working with marginal borrowers. Most of the time, the branch manager sends applications directly to the underwriters for review. Applications that fail more than one underwriting guideline are sent directly to the president of the company. No application is denied without having been personally reviewed by the underwriter and the president (who together constitute a "loan committee").

The underwriter does not use an automated underwriting system, nor does she use credit scores. Rather, she judges each application by evaluating all the relevant information in the file, without considering race or ethnicity, according to her responses to us. She does not receive any information about the race of the people who receive loans, and could only provide a guess as to the percentage of minorities who receive loans from the company. She did show us some of the letters submitted by applicants explaining past instances of derogatory credit, however, to illustrate the types of credit problems she had to evaluate in making her underwriting decisions. Some of these were handwritten and we asked her who sends those: "Mainly the minorities," was the answer. She added that poorly written credit letters did not invalidate an applicants' reason for a derogatory credit episode.

The loan counselors and processors all receive base salaries along with a small commission (10 basis points per loan) on the dollar volume of loans they help process. Because commissions are small relative to base salaries, this payment structure does not appear to create disincentives for employees to work on small loans or applications that take extensive time to process. Moreover, every loan counselor is assigned to a mix of housing developments, including some targeted to lower- and moderate-income homebuyers and some targeted to middle- and upper-income buyers.

Potential for Discrimination

Over the course of a two-day site visit, the research team scrutinized the process used to assess applications, and was favorably impressed by the combination of a highly transparent review process, a strong commitment to qualifying marginal applicants, and the genuine belief by all staff that their process is color-blind. The team's strong expectation was that the lender's HMDA data would show a relatively small denial disparity between white and minority applicants. But that did not turn out to be the case.

The lender's denial rate for minorities is lower than average for its metropolitan area, indicating that it does a good job of qualifying marginal minority applicants (and/or attracts minority applicants with above-average qualifications). But disparities between its denial rates for whites and for minorities are high, compared to metro-area averages (see Exhibit 4). Overall,

the lender denies loan applications from blacks 28 percent of the time, compared to only 10 percent for whites. Thus, the white-black denial disparity for this lender is 28/10 or 2.8. On average, lenders in the metro area as a whole deny 39 percent of black applications and 25 percent of white applications, yielding a white-black denial disparity of only 1.6. In other words, the case-study lender's denial disparity rate is almost twice as high as the average rate for lenders in the same metro area. The same pattern holds when denial disparities are broken down by income categories. For example, among moderate-income applicants, the lender's loan denial rate was 2.7 times as high for blacks as for whites, compared to an area average of 1.1. For middle-income applicants, the lender's loan denial rate was 3.1 times as high for blacks as for whites, compared to an area average of 1.2. Relative disparities for Hispanic applicants were on the same orders of magnitude.

Because so many of its customers have less-than-spotless credit and few resources for a downpayment, most of the lender's originations are for government-insured loans. Further, these are the only loans that go to the firm's underwriter, while conventional loan applications are sent to a third-party underwriter. Therefore, we dropped conventional loan applications from the denial disparity comparison to get a better idea of how the firm did in its primary loan area. The case-study lender's denial rates still showed significant racial disparities. Income-adjusted averages reveal that the lender's denial rates for government-insured loans are consistently higher than the area averages for black and Hispanic applicants and lower for white applicants.

How can we reconcile these disparities with the lender's strong belief that its loan origination process contains absolutely no discriminatory treatment of minority borrowers? There are three possible explanations:

• A large share of the lender's minority loan applicants may actually be poor credit risks. It is possible that because the case-study lender serves more minority customers than other area lenders, these customers may be less creditworthy--on average--than minority loan applicants in the metro area as a whole. If so, the case-study lender's high denial disparities (relative to metro-wide averages) may reflect the diversity of its customer base rather than the possibility of discrimination. However, this explanation seems inconsistent with the evidence that the case study lender approves a larger share of applications (from both minorities and whites) than the average for mortgage lenders metro wide.
• The case-study lender may be applying underwriting standards that have a disparate impact on minority borrowers. In other words, minority customers may be denied at relatively high rates because some of the underwriting standards applied by the case study lender have a disproportionate effect on minorities, and do not serve a clear business necessity. This explanation seems inconsistent with the fact that denial disparities between whites and minorities are significantly lower among other lenders in the metropolitan area.
• The lender's staff may be providing preferential treatment to white customers without realizing it. Our case study indicates that loan counselors work hard with customers to overcome problems in their applications. It is possible that the counselors are more at ease with white customers than with minorities, find it easier to communicate and sympathize, or feel more comfortable spending time with whites to solve credit problems. If this is the case, then minorities would be at a disadvantage, not because they were treated badly but because whites were treated better.

Given the information currently available, it is impossible to determine with certainty which of these explanations is correct. It is clear, however, that despite the commitment and good intentions of the case-study lender, denial rates for minority loan applicants are unusually high, relative to denial rates for white customers. And these denial disparities appear to be out of line with comparable ratios for the metropolitan market as a whole.

Improving Fair Lending Performance

Lending industry experts and fair housing advocates have identified a number of practices and procedures that lenders should implement to reduce the possibility of discrimination against minority applicants. Our case study reveals that the lender we visited has not fully implemented any of these fair lending best practices. Moreover, the research literature on organizational change contains clear lessons about "what it takes" to effectively change behavior within an institution. Taken together, the literature on fair lending best practices and the literature on organizational change suggest seven recommendations for the case study lender:

• Find out whether a problem exists. Before implementing any institutional changes, management and front-line workers must understand whether they have a real problem. There is a "chicken and egg" problem concerning the data gathering needed to determine whether a lender discriminates. To the extent that the lender does not believe it has a problem, there is no incentive to gather more data. In addition, organizations may face real disincentives to gather data on potential discrimination which might be subpoenaed or otherwise disclosed. However, without detailed information, it is impossible to determine whether discrimination may be occurring. Given the high denial disparities revealed by HMDA measures, the case study lender should conduct a careful file review (comparing outcomes for white and minority applications that had similar credit problems), and conduct paired tests of its own operations.
• Make the case for change. If there is a problem with discrimination, management must explain why change is fundamental to business success. If fair lending changes are implemented without a clear "business case," employees are likely to perceive them as "tacked on" to otherwise profit-oriented operations for "feel-good" reasons. Under these circumstances, employees may believe that the changes being implemented will actually hurt bottom-line performance, and that they will not last very long or be taken seriously. Unless all employees see fair lending as critical to business success, institutional changes are unlikely to take root.
• Create an integrated plan. A recurring theme in the literature on organizational change is the importance of creating a coherent strategy, where various management policies mutually reinforce each other. In other words, it is not sufficient to simply implement a training program or new incentive systems without examining how these changes interact with other policies, procedures, and incentives within the institution. Front-line employees should be included in the development of an integrated plan, because they often have good ideas about how different organizational policies contradict one another in practice. The plan should also include feed-back loops, which provide employees with data on their performance, and reward them as performance improves.
• Implement clear incentives. Efforts to promote fair lending within an institution are likely to run up against numerous barriers. Loan counselors may have to spend more time working with small or problematic loan applications in order to ensure equal treatment of minorities. Many lenders--including the case study lender--provide compensation based on the dollar value of loans originated. This aligns incentives with the lender's financial costs and benefits, but may not be consistent with fair lending outcomes.
• Change decision-making procedures. Fair lending efforts often involve a "second look" and other extra reviews for marginal mortgage applications, especially those of minorities. These reviews can be helpful if marginally qualified minority applications are receiving less attention and assistance than marginally qualified applications from whites. However, multiple reviews can create resentment among front-line staff who may feel that their discretion and decision-making authority has been reduced, and that fair lending is largely a matter of oppressive oversight by outsiders. Ideally, front-line employees could receive frequent feedback on their fair lending performance (along with clear incentives to provide equal treatment), so that they feel empowered to identify problems and find solutions.
• Provide fair lending and diversity training. Employees at all levels may need to gain a better understanding of the forms discrimination can take and the importance of eliminating both differential treatment and disparate impact discrimination. Training should not be presented in terms of fair lending for its own sake, but in terms of satisfying the needs of a diverse customer base as well as complying with existing laws. Programs that promote fair lending from a legalistic or "do-gooder" perspective are less likely to have a lasting impact than those that emphasize the economic rationale for effectively working with a diverse clientele.
• Recruit and retain a diverse workforce. A lender may be able to foster fair lending by creating a racially and ethnically diverse workforce. It is possible that minority borrowers feel more welcome or comfortable in an office that includes staff of their race or ethnicity. And in some cases, having bilingual staff available may be critical. Moreover, minority staff members may contribute new perspectives to ongoing fair lending efforts.

Institutional change does not happen overnight. Our case study illustrates how a lending institution might be discriminating against minorities despite its best intentions, and reflects the challenges confronting lending institutions as they try to ensure full and fair service to both minority and white customers.

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Content Archived: January 20, 2009