The Color of Credit: Mortgage Discrimination, Research Methodology, and Fair-Lending Enforcement: M

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THE SOCIAL STRUCTURE OF HIGH-COST LENDING

One case went to trial, resulting in a guilty verdict against the defendants, and just over 20 percent of the cases were still ongoing at this writing. Of the cases that did not settle and which survived a preliminary motion to dismiss to produce fuller public records, we selected four cases using an inductive strategy that deliberately sampled on the dependent variable.

We chose cases in which discrimination was well documented, thereby enabling us more readily to identify the processes by which the lending discrimination was effected during the housing boom. In making our selections, we also endeavored to capture geographic and social variation among the parties and others who offered sworn testimony in the various cases.

Iqbal , U. Our sample may therefore be skewed toward more severe cases of discrimination. In this analysis, however, we seek not to determine whether discrimination took place or how widespread it was, but to identify the institutionalized social processes and structured practices through which the discrimination occurred. Using a legal case as the unit of analysis creates the opportunity to look at the relationships among multiple actors in the mortgage process and provides a window into how discrimination took place in different contexts, from a cluster of real estate professionals working on a small scale flipping homes in Brooklyn to a large national lender in Memphis to a Manhattan investment bank securitizing subprime loans from Detroit made by a closely linked mortgage originator.

The Social Structure of Mortgage Discrimination

As with any case study, the generalizability of the findings is limited, but the focus here is on identifying the processes through which discrimination took place, as quantitative studies have already established the pervasiveness of the discrimination. The first of these cases, Barkley v. After a three-week trial, the jury found the real estate investor and mortgage companies guilty of fraud, conspiracy to commit fraud, and deceptive practices. The verdict was upheld on appeal by the United States Court of Appeals for the Second Circuit, yielding more than 25 depositions by key actors in the trial, with some interviews lasting for eight hours or more.

Both cases alleged that Wells Fargo intentionally targeted minority communities and used discriminatory and deceptive methods to steer minority customers into high-cost loans, resulting in extraordinarily high rates of foreclosure that caused local governments to lose property tax revenue and spend additional resources to maintain vacant homes. Wells Fargo , WL D. The public record in these cases includes multiple declarations made by employees from different regions and various positions at Wells Fargo and associated commercial entities.

The fourth case, Adkins et al. Morgan Stanley , was brought by black residents of Detroit who alleged that they were fraudulently steered into high-cost loans by New Century Financial Corporation, the second largest originator of subprime mortgages in the United States in The plaintiffs argued that Morgan Stanley, an investment bank that acted as a warehouse lender for New Century, encouraged that firm to issue mortgages in violation fair lending laws in order to generate large numbers of high-cost mortgages that would realize greater profits from securitization.

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The plaintiffs also alleged that borrowers were more likely to receive such high cost, high risk loans if they were African American or lived in predominantly black neighborhoods, yielding litigation that is still ongoing. Together, the hundreds of pages of depositions and exhibits provide a rich source of qualitative data about practices used within the mortgage industry during the housing boom, and they offer a unique opportunity to analyze the social processes behind the quantitative results developed to date.

To conduct our content analysis, we randomly selected a subsample of the relevant evidentiary filings yielding a dataset of pages of deposition transcripts, declarations, and exhibits from individuals in different roles in the lending industry who were knowledgeable about the alleged discriminatory practices. The majority of the depositions and declarations come from employees of the defendants, such as loan officers or investment bankers, but a substantial portion come from borrowers, appraisers, closing attorneys, and other actors in the field.

To analyze these data, we began by coding the depositions, declarations, and exhibits into three categories that we derived empirically and theoretically from an initial analysis of the data and from a broader understanding of the context of subprime lending: From this 10 percent sample, we then extracted texts coded as reflecting vertical segmentation, horizontal segmentation, and racial targeting, and assembled the relevant passages for analysis and to reconstruct the structural logic of the reported discrimination. In our analysis we seek to reconstruct the social organization of high-cost, high risk discriminatory lending as revealed by sworn statements of actors directly involved in the lending process.

We explain how the securitization of mortgages institutionalized a vertical segmentation of entities separating the investors purchasing bundles of loans and borrowers seeking credit and how this segmentation contributed to the perception among upstream financial actors such as securitization specialists and bond traders that they had no responsibility for discriminatory or irresponsible actions of those downstream in the lending process such as mortgage brokers much less the borrowers themselves.

We show how the mortgage lending industry also created a structure of horizontal segmentation in which prime and subprime lending operations were separated from one another organizationally. This organization made it difficult or impossible to transfer clients from subprime to prime lending officers and served as a one-way street channeling prime-eligible customers into higher priced and riskier subprime loans. Finally, we elucidate how loan originators within this segmented structure exploited racial segregation in order to target neighborhoods that had historically been denied credit for exploitative, high cost loans Engel and McCoy, ; Immergluck, Taking advantage of residential segregation, originators developed specialized strategies and marketing materials aimed at identifying black and Latino borrowers as subprime lending marks.

Prior research suggests that Latino immigrant households seeking to purchase a home were more susceptible, via Spanish-speaking intermediaries, to high-risk loans and subsequent foreclosures than were white, black, or Asian households Allen ; Rugh ; Rugh and Hall Black and Latino borrowers were also vulnerable to targeted subprime refinance lending, especially older borrowers and those in older homes; overall such targeted refinance lending tended to affect those in in racially isolated African American communities the most Botein ; Hyra et al.

To gain the trust of those borrowers, originators worked through local social structures and interpersonal networks to enlist trusted intermediaries such as religious leaders, small business owners, and personnel in community-based organizations. As has been documented e.

Profits for loan originators and financiers depended largely on transaction fees and most critically on the size of the gap between the interest rate prevailing at the time of origination and that paid by borrowers. The depositions we reviewed indicate that, unsurprisingly, this incentive structure led investment bank employees to encourage mortgage originators to generate ever more loans with high or adjustable interest rates Kaplan, a ; Vanacker, Specifically, financial firms specializing in securitization sought to place the risk of future interest rises onto borrowers by steering them into adjustable rate mortgages, thereby guaranteeing investors a stable rate of return over the U.

Treasury rate while placing individual borrowers at risk of financial stress because of increased payments Shapiro, ; Vanacker, When faced with borrowers who were unlikely to be able to repay a loan, some loan officers were encouraged by supervisors to find ways to lower the initial monthly payment through innovations such as hybrid adjustable rate mortgages. These loan packages made use of temporary low teaser rates, interest only mortgages, or mortgages with 40 year payment terms that ballooned in later years. The demand for investment grade securities constructed from bundles of mortgages was satisfied through a hierarchically segmented lending market in which investors paid investment banks to oversee the formation of pools of loans from banks and non-bank lenders and their conversion into a security that generated a steady revenue stream and then purchased those securities.

In theory, the investment banks securitizing the loans were separate from the lenders originating them.

In practice, many banks established close relationships with loan originators and influenced the terms of the loans they made. This vertical segmentation between investment banks and loan originators allowed investment banks to exercise significant control over the lending process while still eschewing liability and ethical responsibility for practices with discriminatory impacts. Although the separation of mortgage origination from mortgage investment and its implications for the stability of housing markets has been extensively discussed e.

Lewis, ; McLean and Nocera, , this research highlights the way in which this segmentation was also used by investment banks to influence the types of loans that were originated while displacing responsibility for practices that had foreseeable discriminatory effects. Depositions, for example, describe how investment banks issued bid stipulations to specify the types of loans that they would buy from pools of already originated loans, thus shaping the types of loans that would be originated in the future by sending signals about what loans would be purchased Kaplan, a ; McCoy, Morgan Stanley, for instance, had a close relationship with New Century Financial, which was the second largest subprime lender by market share in the United States in We seek to maximize our premiums on whole loan sales by closely monitoring requirements of institutional purchasers and focusing on originating or purchasing the types of loans that meet those requirements and for which institutional purchasers tend to pay higher premiums.

Given its dominance as a buyer, Morgan Stanley was in a strong position to encourage New Century to originate high-cost loans. Indeed, investment bankers at Morgan Stanley told New Century that they would refuse to buy a loan pool if it had too many fixed rate and too few adjustable loans Vanacker, , p. And in fact the same people who buy our loans generally finance them; they provide us our short-term warehouse line. So we absolutely have to answer to them in terms of that criteria. As one of the deponents in the Adkins case revealed, investment bankers at Morgan Stanley were aware that high-risk, non-conforming loans were being made by New Century, and that many of those loans came disproportionately from cities populated by people of color, such as Detroit.

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Nonetheless financial officers at Morgan Stanley portrayed themselves as not responsible for any discriminatory lending that might be taking place downstream in the lending process. Morgan Stanley itself did not originate the loans even if in reality it set the terms of lending Davis , — These contract provisions bolstered the perspective of those at the top of the lending hierarchy that were not responsible for any discrimination by loan originators, even if it was foreseeable.

The rise of subprime lending is well documented e. Shiller ; Immergluck ; Aalbers Yet the way in which the segmentation of loan origination into separate prime and subprime lenders enabled discrimination has not been adequately addressed. As discussed below, loan originators tended to specialize in either prime or subprime loans but not both and some subprime lenders targeted neighborhoods with large shares of black and Latino residents. Even if a subprime lender working in a community of color was inclined to provide a prime loan to a qualified borrower, the lender was unable to.

And indeed, in some cases where banks did have both prime and subprime lending operations in the same bank, internal controls were designed to drive potential borrowers towards subprime loans but not the other way around. Compensation for loan originators was based primarily on commissions from the loans they completed and thus depended on the number of loans, their size, and the fees and interest rates that could be extracted from borrowers Jacobson, ; Unger, Under these circumstances, it was more profitable for lenders and originators to place a customer in a high-cost subprime loan than in a conventional loan, even if the borrower qualified for a lower-cost prime loan Jacobson, , p.

Put quite simply, loan originators wishing to maximize profits had to convince customers with good credit to accept higher-cost, higher-risk lending products. As one Wells Fargo loan officer put it:. The commission and referral system…was set up in a way that made it more profitable for a loan officer to refer a prime customer for a subprime loan than make the prime loan directly to the customer…. Because commissions were higher on the more expensive subprime loans, in most situations the A rep made more money if he or she referred or steered the loan to a successful subprime loan officer.

Whether a mortgage was new or a refinance loan, loan originators seeking to make money could do so most successfully by steering borrowers into high-cost products, regardless of their credit history or credit score. One Wells Fargo loan officer described her role in the firm in this fashion:. When I got the referrals [from prime loan officers], it was my job to figure out how to get the customer into a subprime loan. I knew that many of the referrals I received could qualify for a prime loan. Once a loan was referred to a subprime loan officer, there was no way for that officer to make a prime loan.

The organizational structure of lending operations served as a one-way ratchet pushing customers toward higher priced loans. Once I got the referral the only loan products that I could offer the customer were subprime loans. My pay was based on the volume of loans that I completed…. In short, the horizontal segmentation of the market among—and even within the same originating or lending firm—trapped many borrowers unknowingly in high-cost loans even when they qualified for prime rates. Such quantitative data suggest that originators explicitly targeted neighborhoods with large shares of black and Latino residents for high-cost loans, yielding a very strong association between segregation and foreclosures once the market peaked Rugh and Massey The question is how and why originators came to target these neighborhoods.

One loan officer described the mindset at his office as follows: Another subprime loan officer described the same general sentiment and set of practices:. It was the practice at the Wells Fargo offices where I worked to target African Americans for subprime loans. It was generally assumed that African-American customers were less sophisticated and intelligent and could be manipulated more easily into a subprime loan with expensive terms than white customers.

To identify potential minority borrowers for high-cost home equity loans, lenders turned to data sources that were thought to indicate a lack of financial sophistication combined with a desire for credit. Loan officers were given lists of leads to solicit for subprime refinance loans, and statements by loan originators indicate that these lists did not represent a random cross-section of the local population but were disproportionately African American Dancy, , p.

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Some lists were generated from current or previous borrowers with the bank, while others were obtained by purchasing lists of customers who had financed the purchase of goods, such as furniture or jewelry, at stores in black and Latino communities Simpson, , p. Branch managers often used information from businesses located in minority neighborhoods to obtain lists of customers who had already taken out high-cost loans so that they could solicit them for additional high-cost refinancing Taylor, , p.

Eventually, in addition to purchasing lists of borrowers who both wanted credit and had short-term financial needs, banks began to create their own lists using various exploitative techniques. As one loan officers explained:. How did originators gain the trust of potential borrowers? The qualitative evidence suggests that loan originators often gained the confidence of potential borrowers through the manipulation of trusted co-ethnic intermediaries in community service organizations and churches.

To gain the confidence of borrowers, brokers and originators strategically exploited social structures and interpersonal networks within minority communities.

The Social Structure of Mortgage Discrimination

As one loan officer described it:. Homeownership and loan lending are associated, after all, because the overwhelming majority of domestic purchases are made with the aid of a personal loan personal loan. In this publication Stephen Ross and John Yinger speak about what has been realized approximately mortgage-lending discrimination lately.

They re-analyze current loan-approval and loan-performance information and devise new assessments for detecting discrimination in modern loan markets. Their research additionally finds numerous significant weaknesses within the present fair-lending enforcement process, particularly, that it totally overlooks one of many major kinds of discrimination disparate impact , misses many situations of the opposite major style disparate treatment , and insulates a few discriminating creditors from research.

Ross and Yinger devise new techniques to beat those weaknesses and exhibit how the methods may also beapplied to discrimination in loan-pricing and credit-scoring. This sequence publishes monograph size conceptual papers designed to advertise thought and learn on vital important and methodological themes within the box of human assets administration.

Closing the Gap between Research and Practice: Simply select your manager software from the list below and click on download. I offer one possible mechanism: This systematically steers lenders toward funding higher status groups even when applicants have the same financial histories. This study provides experimental evidence that status is a likely mechanism driving lending discrimination. Skip to main content. Discrimination in Lending Markets: Status and the Intersections of Gender and Race.

Vol 79, Issue 1, pp. Download Citation If you have the appropriate software installed, you can download article citation data to the citation manager of your choice. Discrimination in Lending Markets. Via Email All fields are required. Send me a copy Cancel. Request Permissions View permissions information for this article. Harkness 1 Sarah K.

Article first published online: February 9, ; Issue published: Abstract Full Text Abstract.

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