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Unintended Consequences of Risk Based Pricing: Racial Differences in Mortgage Costs

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Abstract

The following analysis focuses on the role that risk pricing has had in the allocation and access to mortgage funds, specifically how it results in cost differences by race. Using a sample of fixed-rate first lien mortgages, we control for the risk characteristics of borrowers and assets. We find that borrowers with comparable credit quality experience significantly higher costs for mortgages in neighborhoods with a high density of minority households. Further, when the pricing differential is controlled for in a model of mortgage default, there is no support for neighborhood price differences. This finding illustrates a potential inequity that results from efficient/risk pricing in mortgage underwriting.

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Notes

  1. In Yezer et al. (1994), θ is variable throughout the application process.

  2. The threat of prepayment is typically not under the lender’s control in residential mortgages.

  3. As Ambrose and Buttimer (2000) report, numerous studies that examine the time-to-default indicate that borrowers’ characteristics have a limited impact on predicting default three years after origination (von Furstenberg and Green 1974; Williams et al. 1974).

  4. The data were made available via the author’s research affiliation with the Federal Reserve Bank of Richmond and an access agreement between the author and LPS Analytics Inc.

  5. We experimented with estimating the spread using the cost of funds (mortgage interest rate) and the prevailing risk free Treasury rates of various maturities. The results are insensitive to these permutations.

  6. A number of socioeconomic controls were considered and/or tested with no significant alteration in the model outcomes or coefficient estimates.

  7. The U.S. Office of Management and Budget’s definitions for race are used in the 2010 Census. The definition of Hispanic or Latino used in the 2010 Census refers to a person of Cuban, Mexican, Puerto Rican, South or Central American, or other Spanish culture or origin regardless of race. Black or African American refers to a person having origins in any of the black racial groups of Africa. It includes people who indicated their race(s) as black, African Am., or Negro or reported entries such as African American, Kenyan, Nigerian, or Haitian. The Census Bureau defines a linguistically isolated household as one in which no one in the house, 14 years old and over, speaks English or speaks English “very well” as a second language. In other words, all members of the household 14 years old and over have at least some difficulty with English. This variable serves as additional evidence of the concentration of the Hispanic population in the observed zip codes.

  8. The variable TERM denoted by the 20-year T-bond compared with the 30-day T-bill serves as a measure of the term structure comparing short- and long-term interest rates at the time of origination and exhibits a significant range in the short- and long-term spread over the observation period. We use the TERM spread as an external control where a positive TERM spread indicates an upward sloping yield curve and indicates a positive likelihood that economic activity will be expanding.

  9. This is a static entry provided by LPS. It should be noted that this entry only applies to reported action or intent of the lender at origination. For example, if the loan is held in portfolio and in a year sold on the market, the eventual sale to the secondary market is not observed.

  10. As most readers are aware, this was a period of initially low overall interest rates (2004) and then a series of events triggered inflation concerns and overheated markets. That marked a period when the U.S. Federal Reserve (Fed) and counterparts to the Fed in other nations began a systematic increase in interest rates through announcements and open market actions.

  11. A number of different quantile breaks were tested with all yielding similar conclusions.

  12. Because many of the condos are second homes, it is important to note that the mortgages on second homes average 25 to 50 basis points higher than the first mortgages.

  13. For illustrations see, Dehejia and Wahba (1999), Heckman and Hotz (1989), LaLonde (1986), Rosenbaum and Rubin (1983), and Smith and Todd (2001).

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  1. Snead Hall, 301 W. Main Street, Box 844000, Richmond, VA, 23284-4000, USA

    Brent C Smith & Kenneth N. Daniels

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  1. Brent C Smith
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Correspondence to Brent C Smith.

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Smith, B.C., Daniels, K. Unintended Consequences of Risk Based Pricing: Racial Differences in Mortgage Costs. J Financ Serv Res 54, 323–343 (2018). https://doi.org/10.1007/s10693-017-0274-5

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