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November 1995
(Combines November 1 and November 15 issues*)

Federal Reserve Bank of Cleveland

Rooting Out Discrimination
in Home Mortgage Lending
by Stanley D. Longhofer


racial justice is a fundamental social
goal in the United States, making enforcement of fair lending laws an important function of the Federal Reserve and
other regulators. Despite nearly three
decades of effort, however, discrimination in the home mortgage market
remains a vexing problem.
Ultimately, the most effective way to
combat mortgage discrimination
depends on its underlying source. Lawmakers, however, tend to ignore root
causes when forming antidiscrimination
policies, which are consequently less
effective and more costly than they
could be. Our inability to deal satisfactorily with discrimination may result
largely from this failure to understand
why it arises in the first place.
Discrimination's persistence in the home
mortgage market has received renewed
attention recently because of data made
available through the Home Mortgage
Disclosure Act. These data show that
blacks and Hispanics are denied loans
more frequently than are whites. For
instance, in 1994 (the latest year for
which data are available), 33.4 percent of
all black and 24.6 percent of all Hispanic
mortgage applicants were denied loans,
compared to 16.4 percent of whites.1

ISSN 0428-1276

Some of these disparities can be explained by differences in minority applicants' income, wealth, and credit histories—all pivotal factors in the mortgage
lending decision. Nonetheless, according to a recent influential and controversial study by economists at the Federal
Reserve Bank of Boston, such factors
account for only part of the difference in
denial rates. In the end, they found that
if minorities in the Boston area had the
same characteristics as whites, they
would be denied loans 17 percent of the
time, compared to only 11 percent for
This Economic Commentary discusses
several possible sources of discrimination in the home mortgage market, outlines how each would manifest itself, and
briefly considers the solution most appropriate for each. Before continuing,
however, it is important to distinguish
between discrimination—the act of treating an individual differently because of a
personal characteristic such as race—and
bigotry, which is only one possible cause
of discrimination. Unfortunately, much
of the public discourse about this problem implies that all discrimination results
from bigotry. Such rhetoric is counterproductive. Since discrimination can also
arise from more benign intentions, indiscriminately impugning all lenders' integrity by labeling them bigots only
serves to close their minds to the genuine
problems that do exist.

To combat discrimination in the
home mortgage market effectively, it
is essential to understand its origins.
Although bigotry is the most conspicuous cause of discrimination, others
are perhaps more likely and more difficult to prevent. Statistical discrimination can arise if race is correlated
with some hard-to-measure determinants of creditworthiness. Alternatively, cultural affinity problems
might make lenders less able to accurately determine a minority applicant's true creditworthiness. Each of
these problems can result in illegal
discrimination, but their solutions
may be quite different. By channeling
resources toward the appropriate
remedy, policymakers can reduce
discrimination by more than would
be possible through sole reliance on
enforcement of fair lending laws.

* The Economic Commentary series will contain 20 issues starting this year. The sequence will remain semimonthly EXCEPT during June, July, November, and December, when we will publish a single
issue for the month.



One obvious source of discrimination in
credit markets is bigotry. Nobel laureate
Gary Becker developed an economic
framework for analyzing bigotry, or what
he calls "tastes for discrimination."3
According to this theory, lenders do not
maximize profits, as is the usual assumption in economics. Instead, they maximize their "utility," taking into account
both the profits they earn and the satisfaction they get from discriminating
against minorities. A bigoted lender,
then, would forgo some marginally profitable loans to minorities in order to satisfy his or her taste for discrimination;
the amount of profit forgone depends on
the strength of this taste.
This theory has two distinct implications. First, since a loan's profitability is
positively related to the creditworthiness
of the borrower, a bigoted lender would
hold minorities to a higher credit standard than whites. This would translate
into minorities being denied loans more
frequently, even if the creditworthiness
of the two groups were the same. Second, since marginal minority borrowers
(the least creditworthy minorities given
loans) had been held to a higher standard, their default rate would be lower
than that of marginal white borrowers.
These predictions are based on the
assumption that lenders face no outside
regulatory constraints. Under fair lending laws, however, bigoted lenders
would lower the credit standard required
for minorities and raise the standard for
whites, in order to reduce the chance of
being caught discriminating. As a result,
the difference between the default rates
of marginal white and marginal minority
borrowers would be less than in an
unregulated environment.


Statistical Discrimination

Under Becker's theory of discrimination, bigots must earn relatively higher
returns on loans to people they dislike.
Alternatively, lenders might truly be
profit maximizers, willing to make loans
to any creditworthy individual. Race,
however, is correlated with many factors,
some difficult and costly to observe,
which may affect a loan's profitability.
If lenders use an applicant's race as a

proxy for these factors when making
lending decisions, they practice what is
called statistical discrimination.
If, even after controlling for easily measured determinants of creditworthiness,
minorities are more likely to default than
whites, profit-maximizing lenders might
want to "discount" any minority applications they receive.4 As a consequence,
they would hold minorities to a higher
credit standard than whites. In contrast
to bigotry's hurdle, however, this higher
standard would not be set because
lenders needed higher profits to make
them willing to lend to minorities.
Rather, this standard would be designed
to ensure that they earned the same
profit from loans to each group. As a
result, marginal minority and marginal
white borrowers would default equally
often.5 In the presence of fair lending
laws, lenders would likely lower their
standard for minority applicants and
raise their standard for whites, with the
result that marginal minority borrowers
would default more frequently than their
white counterparts—an implication
opposite to that produced by bigotry.
This type of statistical discrimination
does not necessarily arise because lenders are lazy or mean-spirited; some information that affects a loan's profitability may not be easy for them to discover.
For example, a lender can readily verify
an applicant's current employment status
and income. But if job-market discrimination makes minorities more likely than
whites to lose their jobs, lenders might
require minorities to have a higher income or more assets to qualify for a particular loan. Nonetheless, such behavior
constitutes discrimination under the law.


lack of "cultural affinity" between
lenders and minorities.6
For questionable loan applications (that
is, for those on the margin between being
accepted or rejected), lenders must make
subjective judgments about an applicant's creditworthiness by considering
"compensating factors." If some of the
signals lenders use to evaluate a person's
character are culturally dependent, then
lenders may be less able to interpret the
signals they receive from minorities,
especially if they process relatively few
minority applications. Lenders' inability
to determine which minority applicants
are good credit risks and which are not
would cause them to make more mistakes; in other words, they would accept
more "bad" minority applicants and reject more "good" ones, relative to whites.
If cultural affinity were a serious problem in home mortgage lending, the consequences would be similar to those of
more direct statistical discrimination.
Lenders would hold minorities to a
higher credit standard than whites, but
only to ensure that loans to both groups
were equally profitable. Hence, the
default rate of the marginal applicant
would be the same for both groups.7 In
the face of fair lending laws, lenders
would tend to lower the cutoff for approving minority loans and raise the
standard for approving white loans. As a
consequence, the default rate of marginal minorities would rise and that of
marginal whites would fall, creating a
gap between the two. In contrast to the
results of the statistical discrimination
already discussed, this would occur even
if there were no inherent difference in
the creditworthiness of minority and
white borrowers.

Cultural Affinity

The statistical discrimination just
described can arise only if marginal
minority borrowers are more likely to
default than whites, even after information like the applicant's income, credit
history, and net worth is taken into
account. Alternatively, if lenders are less
able to accurately evaluate minority loan
applications, statistical lending discrimination can occur even when minorities
and whites are equally creditworthy on
average. This problem can arise from a


What to Do?

It is clear that discrimination in the home
mortgage market can spring from different sources. One might ask whether this
really matters: Since we as a society
have decided that we don't want individuals treated differently because of their
race, why not just outlaw all discriminatory behavior and punish offenders, regardless of why they are discriminating?
Unfortunately, this solution does not
appear to have satisfactorily eliminated

discrimination. Furthermore, it can entail
large deadweight costs. In addition to
the substantial direct costs of enforcement, it may lead to undesirable changes
in lenders' activities. To avoid detection,
lenders that discriminate would make
more loans to minorities. But they might
also make fewer loans to whites, reducing the total availability of mortgage
credit. While it is possible that traditional fair-lending enforcement is the
best overall solution, by focusing
directly on discrimination's root causes
we may find more effective ways to
combat this serious social problem.
As it turns out, the most effective solution to bigotry is quite straightforward:
Increase competition in the banking
industry. Because bigoted lenders are not
maximizing profits, in a perfectly competitive market they will eventually be
run out of business. Other lenders will
grant those marginally profitable loans
and so will be able to offer either a lower
interest rate to all borrowers or a higher
rate of return to their investors. Unless
the lender's owners, depositors, and
customers have the same "tastes" as the
loan officer, this type of discrimination
cannot persist when other lenders can
enter the market.8
If marginal minority applicants are less
creditworthy than marginal whites, and
lenders use this fact to statistically discriminate against them, the problem is
more difficult. Attempts to make lenders
ignore race will encourage them to
devise other criteria, correlated with
race, on which to base their lending decisions. Since such criteria may be costly
to use and provide no useful information
to the lender, they will necessarily push
mortgage rates up. As the government's
attempts to detect discrimination and
lenders' proxies for race get more sophisticated, the deadweight costs of this
exercise escalate.
Ultimately, the only effective way to
eliminate this kind of statistical discrimination is for the relative creditworthiness of minorities to improve. When
minorities and whites are equally good
credit risks (holding easily measured
factors constant), lenders will have no
incentive to discriminate. To say this

does not absolve society of responsibility for addressing the problem. Rather,
if we are to effectively fight statistical
discrimination in lending, we must expand our efforts and resources beyond
the mortgage market. Fighting job discrimination and improving educational
opportunities, for example, would be
good places to start.
The problems of cultural affinity arise
when lenders use the wrong model to
predict minority defaults, partly because
they lack experience in evaluating
minority applicants. To solve this problem, we must lower the cultural barriers
between minorities and financial institutions. One might think that this could be
done by forcing lenders to hire more
minority loan officers. But some institutions already do this voluntarily. If the
solution is so simple, why aren't we seeing the results yet?

cial education to potential borrowers if
some of those they teach end up applying for loans at other institutions. The
expense of such programs and institutions' inability to capture their benefits
may explain why lenders have not
undertaken more of them voluntarily.
So what is to be done? The fact that
educational programs are costly, and
that the benefits of reducing discrimination accrue to society at large rather
than to individual lenders, suggests that
subsidizing financial counseling and
education programs, supporting specialized community development institutions, and encouraging lenders to
experiment with innovative underwriting criteria for low-income and minority applicants may all be appropriate
ways to reduce discrimination induced
by cultural affinity problems.

One explanation is that a lack of financial sophistication on the part of some
minority borrowers might make it difficult for any loan officer to evaluate their
creditworthiness, regardless of the officer's race. For whatever reasons, many
low- and moderate-income families,
including minorities, live in a "cash
only" society; they may not have a
checking account or credit cards, and
may pay most of their bills with cash.9
Such individuals may also lack demonstrable experience in managing credit.
This lack of experience in dealing with
financial institutions may make it more
difficult for some minority applicants to
convince a lender of their creditworthiness. Furthermore, it can be very difficult for a lender to assess the true creditworthiness of an applicant who has this
kind of unconventional financial background. Bridging these gaps requires the
education of both parties to the mortgage
transaction: Lenders may need to learn
more effective ways to evaluate applicants with atypical financial histories,
and some low- and moderate-income
minority borrowers may benefit from
pre-loan educational programs combined
with ongoing financial counseling.
Educational programs are costly, however. Furthermore, lenders may fail to
reap all the benefits of providing finan-


Some might be inclined to dismiss
efforts to understand the sources of discrimination as a pretext for delaying any
action. And from an applicant's point of
view, why discrimination has occurred is
irrelevant; his or her loan has been denied for reasons other than creditworthiness, and that is all that matters.
Nonetheless, from a policymaker's perspective, the why is vitally important.
To combat discrimination in the home
mortgage market effectively, it is essential to understand its origins. This Economic Commentary has outlined three
potential sources of such discrimination
and has suggested possible solutions to
each. The differences among these
solutions make it clear that policymakers must understand discrimination's
root causes before they can hope to
eliminate it.



1. The source of these data is the Federal
Financial Institutions Examination Council.
These rates apply to conventional home purchase loan applications made at covered institutions as defined by the Federal Reserve's
Regulation C (12 CFR §203 et seq.). Interestingly, only 12.0 percent of Asians' loan applications were denied, a rate much lower than
that of whites.

2. See Alicia H. Munnell, Lynn E. Browne,
James McEneaney, and Geoffrey M.B.
Tootell, "Mortgage Lending in Boston: Interpreting HMDA Data," Federal Reserve Bank
of Boston, Working Paper WP-92-7, October
1992, table 4. The validity of these findings
has been the subject of heated debate in the
academic community. For an overview of
problems with this study, see David K. Home,
"Evaluating the Role of Race in Mortgage
Lending," FDIC Banking Review, vol. 7,
no. 1 (Spring/Summer 1994), pp. 1-15; and
Mitchell Stengel and Dennis Glennon, "Evaluating Statistical Models of Mortgage Lending Discrimination: A Bank-Specific Analysis," Office of the Comptroller of the
Currency, Economic and Policy Analysis
Working Paper No. 95-3, May 1995. See
also Lynne E. Browne and Geoffrey M.B.
Tootell, "Mortgage Lending in Boston—
A Response to the Critics," New England
Economic Review, September/October 1995,
pp. 53-78.
3. See Gary S. Becker, The Economics of
Discrimination, 2d. ed. Chicago: University
of Chicago Press, 1971.
4. Paul Calem and Michael Stutzer present a
more sophisticated model of statistical credit
market discrimination in "The Simple Analytics of Observed Discrimination in Credit

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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Material may be reprinted provided that
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Markets," Journal of Financial Intermediation, vol. 4 (July 1995), pp. 189-212.
5. Average default rates (the percentage of
loans that default irrespective of the applicant's creditworthiness) would be higher for
6. This theory was developed by Charles W.
Calomiris, Charles M. Kahn, and Stanley D.
Longhofer in "Housing-Finance Intervention
and Private Incentives: Helping Minorities
and the Poor," Journal of Money, Credit, and
Banking, vol. 26, part 2 (August 1994),
pp. 634-74. For empirical evidence consistent with this theory, see William C. Hunter
and Mary Beth Walker, "The Cultural
Affinity Hypothesis and Mortgage Lending
Decisions," Federal Reserve Bank of Chicago, Working Paper WP-95-8, July 1995.
7. As before with more direct statistical discrimination, average default rates for minorities would be higher.

9. See Glenn B. Canner and Ellen Maland,
"Basic Banking," Federal Reserve Bulletin,
vol. 73, no. 4 (April 1987), pp. 255-69, and
John P. Caskey, "Check-Cashing Outlets in
the U.S. Financial System," Federal Reserve
Bank of Kansas City, Economic Review,
November/December 1991, pp. 53-67.

Stanley D. Longhofer is an economist at the
Federal Reserve Bank of Cleveland. The
author thanks Paul Bauer, Paul Calem,
Glenn Canner, Julie Longhofer, Joao Santos,
Mark Schweitzer, Mark Sniderman, and
James Thomson for helpful comments.
The views stated herein are those of the
author and not necessarily those of the Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve

8. Because urban credit markets are generally quite competitive, bigotry is more likely
to exist in rural areas. Also, in a market with
other problems like cultural affinity, competitive pressures may take some time to eliminate bigotry. Nonetheless, the basic point—
that competition is the best preventative for
bigotry—remains true.

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