Divisions in the U.S. based on ethnic lines remain a guarded secret from the rest of the world. As a result, conspicuously absent from analyses of the subprime meltdown by international organizations and media was any mention of color or ethnicity. But, it is well-known in the U.S. that the market for financial services, and for credit in particular, is segmented along lines of color. Studies by the Center for Responsible Lending, ACORN, and the U.S. Department of Housing and Urban Development all confirm that subprime lending is disproportionately concentrated on African American and Latino homeowners. These studies also show that subprime lending is highly concentrated in minority neighborhoods (both urban and suburban). In fact, higher-income African American and Latino borrowers are more likely to receive subprime loans than lower-income white borrowers.
Commonly, subprime lending is defined as lending to people with impaired credit history. But this is a flawed definition; subprime lending is better defined as high-cost lending—loans that are more costly than prime credit. It is the segmented nature of the credit market which forces borrowers with equivalent credit histories as prime borrowers to settle for more expensive credit. A study by Freddie Mac estimated that 15 percent to 35 percent of subprime borrowers had high enough credit scores to qualify for prime credit; yet they ended up with subprime loans. It remains a fact that certain neighborhoods are not served at all or underserved by mainstream financial institutions, leaving a gap to be filled by alternative lenders that take advantage of the situation.
Sometimes market-segments may be defined by neighborhoods with older and lower-valued homes that many mainstream prime lenders avoid. Such neighborhoods tend to be minority neighborhoods. In addition to geographic redlining, some mortgage lenders discriminate against individuals of particular ethnicities. The complex and cumulative effects of various discriminatory behaviors harden the boundaries between prime and subprime credit markets.
For example, when African American homebuyers are steered as a result of housing discrimination to black neighborhoods with old and lower-valued homes, they face difficulty obtaining adequate property insurance, and they face more precarious conditions in the job-market resulting in unstable income; these factors, together, could shut them out of prime credit and leave them with no option but to accept subprime credit, often on abusive terms. When one adds to this equation, unequal educational quality (with minorities receiving worse quality education), it is easy to see how certain ethnic minorities become prime targets of abusive subprime lending.
The defaults and foreclosures contributing to the current subprime meltdown fall into a number of categories—only one of which is defaults resulting from unfair, abusive lending. It is this slice which deserves the urgent attention of policy makers. Other categories include defaults by market speculators. The defaults and foreclosures being made by borrowers who, in fact, qualified for prime credit, and who with a prime loan could easily make their monthly payments and sustain homeownership, are the entirely avoidable part of the current mortgage crisis.
The only reason these homeowners have defaulted is that they were subjected to onerous terms, often without full disclosure. George Bernard Shaw in his Pygmalion made the point that the difference between a flower-girl and a lady lies simply in the way she is treated. It would seem that this is precisely the difference between some subprime borrowers and prime borrowers. Clearly, the way they are treated—higher costs and fees—significantly affects their ability to service the loan without default. Onerous terms of credit increase the likelihood of default and eventual foreclosure. Home mortgage markets that are segmented on ethnic lines did not come into existence recently, and nor did they occur by accident. They were deliberately created through a series of federal government policies from the beginning of the 20th century. Racially integrated neighborhoods were openly and legally discriminated against by federal government institutions (such as the Home Owners Loan Corporation (HOLC), Federal Housing Administration (FHA), and Veterans Administration (VA)) till around 1950. The FHA officially recommended the use of racially restrictive covenants.
These institutions rarely made housing finance available for persons of color or to neighborhoods of color. Even after racial discrimination in housing was made illegal through legislation, unfavorable treatment of persons of color continued in one guise or another.Hence, a policy solution to entirely eliminating one slice of the current subprime crisis is to open up prime credit to qualified borrowers regardless of their ethnicity or the ethnic composition of their neighborhoods.
This can be achieved through outreach by mainstream prime lenders and vigorous enforcement of non-discrimination laws. The other solution is to protect all borrowers by eliminating fraud. In a recent interview, Alan Greenspan identified addressing fraud as the only area where he supports more government regulation because, in his words, “fraud is destructive of markets, but more importantly it's destructive of families.” These policies will strengthen our confidence in markets and also help stabilize the general economy and maintain stable world markets.
Dr. Nandinee K. Kutty is an economist and a policy consultant. She is a co-editor and contributor for a new book Segregation: The Rising Costs for America (Routledge, 2008). Her email address is email@example.com.