New Cars, Mortgages, and Race

Like most forms of hardship in our society, the foreclosure crisis is disproportionately affecting minorities. The New York Times conducted a study of foreclosures in the New York area and found, among other things:

Defaults occur three times as often in mostly minority census tracts as in mostly white ones. Eighty-five percent of the worst-hit neighborhoods — where the default rate is at least double the regional average — have a majority of black and Latino homeowners.

Well, that might simply be a function of poverty: statistically speaking, minorities are more likely to be poor, and therefore more likely to become delinquent on their mortgages. But I don’t think it’s that simple.

First, whether you are likely to go into default is a function not just of your income, but of both your income and the size of your mortgage. As Tanta wrote,

The belief that subprime borrowers are “poor people” has taken root so deeply that you need a jackhammer to rip it out. The capacity C of traditional underwriting was, of course, always relative to the proposed transaction. A lower-income person buying a lower-priced property was, you see, not a case of subprime lending; assuming a reasonable credit history, it was a prime loan.

Let’s say you start out with a middle-income person who, like most, might be vulnerable to an economic downturn. There are a couple things you can do that will make him more likely to go into default when the downturn (or an illness, or a divorce) hits. You can push him into too big a mortgage. In Tanta’s words,

The trouble with the low-income prime loan was that it was a small prime loan. And that there were, in many market areas, more lower-income people than lower-priced properties. Both industry greed—wanting to make the biggest loans possible to make the biggest profits possible—and industry overcapacity, combined with ever less-affordable housing in the employment-rich population centers, brought us to a situation in which we might not have started with poor people, but they were certainly poor by the time we got done putting them into too much loan to buy too much house. There are subprime borrowers you find. There are those you create.

You can also give him a higher-rate mortgage than he could otherwise qualify for. According to the Times article:

Roughly 33 percent of the subprime mortgages given out in New York City in 2007, [Secretary of HUD Shaun] Donovan said, went to borrowers with credit scores that should have qualified them for conventional prevailing-rate loans.

In general, high-rate mortgages account for a larger proportion of mortgages in minority communities, even after taking median income into account. According to sociologist Gregory Squires,

We see these loans heavily concentrated in poor neighborhoods and targeted to minority neighborhoods. There is some evidence that these neighborhoods were actually targeted — that lenders have gone after people whom they think are less sophisticated borrowers, including single women and the elderly. . . .

Credit rating and income would and does explain some of the patterns. But when you control for those, segregation is also a factor. . . . In those metro areas where segregation is highest, the share of loans that are subprime goes up.

If you are disproportionately steering minority borrowers into higher-rate mortgages, then of course they will suffer a higher rate of defaults and foreclosures than you would predict solely from their other characteristics (income, credit rating, etc.).

But why would you do this? I mean, it’s obvious why an individual broker would: higher commissions. But why would a competitive industry as a whole do this?

In principle (by which I mean first-year microeconomics textbook principle), the free market should eliminate most forms of commercial racism. If a minority homebuyer is a good risk at 6%, then Good Bank willing to lend at 6% will get his business, and Bad Bank who insists on 9% will lose his business; over time, Good Bank should drive Bad Bank out of business. There are probably some doctrinaire free-market people who would insist that this in itself proves that racism does not occur: if banks are charging higher rates to minorities, then the existence of the free market proves that those minorities are higher risks.

But there is ample evidence of racism in areas where the correlation of race and credit risk is not an issue. Almost fifteen years ago, in “Race and Gender Discrimination in Bargaining for a New Car,” Ian Ayres and Peter Siegelman sent pairs of testers into auto dealerships, armed with identical back stories and identical bargaining scripts, and even wearing similar clothing. (All testers said they would provide their own financing for the car.) Black men were initially offered twice the initial markup (price minus dealer’s cost) as white men; after negotiation, black men ended up paying three times the markup of white men.

Ayres and Siegelman discuss two sets of theories why racism might occur. The first set is based on animus: car dealers don’t like minorities and therefore treat them worse, even though it is bad for their bottom line. The second set is based on statistical inference: car dealers might think that being a minority is likely to be correlated with higher search costs or lower access to information, either of which might make the buyer more likely to accept a high asking price.

In the case of mortgages, search costs might have been a factor. Perhaps an equilibrium developed where minority neighborhoods were dominated by high-interest lenders, so if you were going to enter that neighborhood, it made more sense to charge the going rate and split the high profits with your competitors than to undercut them and trigger a price war. Or perhaps there are information disparities that correlate with race, even after controlling for income. Taking advantage of people because they are poorly informed, as far as I know, is completely legal.

In retrospect, this seems like an area where better consumer education could have played a role. Back to the Times:

Upper-income black borrowers in the region are more likely to hold subprime mortgages than even blacks with lower incomes, who often benefit from homeownership classes and lending assistance offered by government and nonprofits.

Maybe the economic debacle we are all living through will lead to better personal finance education, both in school and for adults. That’s one silver lining to hope for, since an end to racism is almost certainly far off.

• Become A Funded Futures Trader