Whose American dream?

The roots of ‘risky’ lending

Maurice Jourdain-Earl has lived the legacy of housing discrimination in the United States.

Jourdain-Earl, co-founder and managing director of ComplianceTech, a home mortgage data analysis firm, grew up in segregated housing on the South Side of Chicago, where his mother settled after leaving Mississippi during the Great Migration. His grandfather was a sharecropper.

The roots of modern-day lending discrimination can be traced to federal policies that began toward the end of the Great Depression, and flourished in the 1950s. A federal agency, the Home Owners’ Loan Corporation, created maps beginning in the 1930s that used a color code scheme to determine whether banks could make home loans there. Neighborhoods with immigrant, Black or Latino populations were colored red, and thus redlining was born.

“Growing up abjectly poor, I had a goal of being a millionaire,” said Jourdain-Earl, who was the first in his family to go to college, graduating from DePaul University when he was 20. To reach that goal, he said, “I focused on working in environments where money was being made.”

His first professional job was checking buy and sell orders with a municipal bond brokerage; he worked his way up in the banking and finance industry to brokering bonds on his own and packaging mortgage-backed securities. In 1992 he founded ComplianceTech, the first tech company of its kind to analyze lending data collected by mortgage lenders under the Home Mortgage Disclosure Act of 1975.

That law was designed to identify lending patterns that lead to redlining and other forms of discrimination, and Jourdain-Earl said that minorities are more often steered into loans insured by the Federal Housing Administration, the Department of Veterans Affairs or the U.S. Department of Agriculture’s Rural Housing Service.

Those loans are insured and are designed to be available to lower-income borrowers, featuring lower down-payment and credit score requirements and higher debt-to-income ratios. But these so-called nonconventional loans are also more expensive, and tend to have higher interest rates and insurance premiums.

The difference between a “conventional” and non-conventional loan is that conventional loans adhere to standard underwriting guidelines set by mortgage finance giants Fannie Mae and Freddie Mac, collectively known as the government-sponsored enterprises. The schism between the costs and conditions of conventional versus nonconventional loans is a driving force that keeps homeownership out of reach for many minority borrowers, Jourdain-Earl says.

Though FHA loans typically have lower interest rates, they can be more expensive over the life of a loan because borrowers typically must pay both annual and monthly mortgage insurance premiums. The current upfront premium is 1.75% of the loan amount, which is added to the cost of the loan.

“The system we have now is a dual mortgage market — one white, one Black. Separate and unequal,” Jordain-Earl said.  “It throws all people of color in a box that says they are poor, which is just not true today.”

Jourdain-Earl has found that 80.8% of GSE loans were made to white borrowers, compared with 3.6% to Black and 7.7% to Hispanics. For FHA, VA and Rural Housing loans, 71.8% went to white borrowers, 11.5% to Black borrowers and 13.3% to Hispanics, the data shows.

“Fannie Mae and Freddie Mac predominantly serve the finance needs of whites and Asians,” Jourdain-Earl said. “Many minority subprime and FHA borrowers could qualify for lower-cost conventional loans purchased by Fannie and Freddie. But that hasn’t happened, even when the GSEs offer loan programs with flexible terms designed to compete with FHA.”

Homeownership preservation is another major problem. During economic downturns such as the 2008 recession, and more recently the COVID pandemic, the government has leaned on the GSEs to help Americans stay in their homes. The result is more white homeowners getting relief.

“There’s a problem of inequality in the lending industry with underwriting disparities, pricing disparities and redlining,” Jourdain-Earl said. “Some of the issues are repercussions from slavery and 150 years of Jim Crow that still exist today.”

The absence of a down payment is one of the biggest impediments to homeownership for low-and moderate-income Americans, particularly for Black and Hispanic homebuyers, said Perry. The median down payment among Black and Hispanic homebuyers is 3.5%, compared with 10% for all homebuyers in 2018.

A big driver for those racial disparities in down payment — and, by extension, the driver for how these disparities in successful homeownership remain so firmly entrenched — is the presence or absence of intergenerational wealth.

Intergenerational wealth

Perry recalled working at Freddie Mac in 1994 and chatting with a top economist about how much trouble minorities had in obtaining mortgage credit. Her colleague said he couldn’t understand why anyone would ever take out a car loan, and went on to explain that he had purchased his first car with money in a trust fund established by his grandparents.

“He honestly was trying to figure out why people would be so stupid to take out a car loan. And I said, ‘What about people who don’t have trust funds?’” said Perry. “And he shrugged it off and said, ‘Well, they should save.’

“At that moment I realized that the people responsible for policy analysis had absolutely no clue — there was a complete lack of understanding,” she said. “From that moment on, I dedicated myself to exposing these real issues and the problems of real people with respect to wealth-building.”

Wealth confers benefits — this is as true today as it has ever been. And wealth obtained through homeownership tends to confer benefits not only in one’s own lifetime, but for generations to come. A recent study by the Urban Institute found that having a parent who owns a home increases the likelihood that a young adult between the ages of 18 and 34 will also become a homeowner.

The study also found that parents who remained homeowners from 1999 to 2015 — through the crucial years of the 2008 housing crisis — tended to accrue enough home equity to pass on to the next generation. During that period, 71.5% of white parents remained homeowners, while only 31.4% of Black parents did, the study found. What is more, the study found that young adults were more likely to become homeowners if their parents’ wealth was $200,000 or more. While more than 50% of white parents met that threshold, only 10% of Black parents did.

“Parents or families with more wealth can help with a down payment — so the impact is intergenerational,” said Karan Kaul, senior research associate at the Urban Institute’s Housing Finance Policy Center. “If your parents aren’t homeowners, then right away, you are less likely to be a homeowner.”

The long-term impacts of COVID-19 on homeownership are unknown, but Kaul notes that, combined with the last financial crisis and Great Recession, there is the potential “for three generations to be impacted by housing losses.”

But homeownership cannot be observed in a vacuum. Gregory Squires, a sociology professor at George Washington University, said there are many other racial disparities — in education, employment, income and health care, to name a few — that have significant implications for the minority homeowner experience, and that can profitably account for why those homeowners pass on less wealth to their heirs than white homeowners do.

“Everybody is talking about structural racism today, about homeownership, wealth and the racial gap,” Squires said. “It is the case that a high share of wealth for minorities comes from homeownership. But they also tend to purchase homes that have less value, are in minority neighborhoods where property values are depressed and buy later in life, so they have fewer years of wealth accumulation for home equity.”

“The notion that housing is the solution to inequality and wealth disparities is a problem,” he said. “There are all these other areas — education, criminal justice, labor markets — that affect different groups of people differently. Housing alone isn’t going to eliminate all those other problems. We have probably focused too much on homeownership as the solution to structural inequality.”  

Fixing the post-2008 fixes

The experience of Perry, Jordain-Earl and others who have studied homeownership trends also illustrates the complicated relationship between lending institutions, minorities and the federal government.

If you’re reading American Banker, there’s a good chance you know there’s a difference between an FHA loan, a VA loan and a GSE conventional loan. But most homebuyers don’t understand those distinctions and the differences that they represent in cost. And the policies that end up steering minority borrowers away from conventional loans and toward costlier loans were largely a byproduct of the housing bubble and policies put in place by the Obama administration in its wake.

“FHA is in a position to take a little more risk than private lenders, as part of the government. They are supposed to do that, but not to lose money in the process,” said Weicher.

Banks have also largely vacated the FHA loan market since the 2008 financial crisis, going from roughly 50% of FHA originations pre-crisis to less than 10% post-crisis.

That exodus began after President Obama took office, when the Justice Department initiated False Claims Act investigations against banks for allegedly certifying FHA loans that were eligible for federal mortgage insurance. Lenders were required to conduct quality control reviews of loans that defaulted within the first six months to ensure they complied with the FHA’s guidelines.

The Justice Department’s approach made both legal and political sense; the department said in a November 2014 statement that the False Claims Act investigations were meant to fulfill “the administration’s priorities to hold the financial industry accountable for its part in the gross misconduct that led to the housing and mortgage crisis.”

By 2014, more than $4.6 billion had been collected in False Claims Act settlements from a number of banks, including Bank of America, JPMorgan Chase, SunTrust and U.S. Bank. Many banks learned the lesson that FHA loans — which already brought in marginal profits — weren’t worth the trouble.

“The real question for me is should we be in the FHA business at all,” Jamie Dimon, the CEO of JPMorgan Chase, said in 2014.

The Obama administration also oversaw a wholesale revision of how regulators evaluate banks’ capital adequacy, and the Fed’s stress testing regime in particular has had dramatic implications for what kinds of loans banks will hold on their books. Residential mortgages — previously thought to be risk-free — faced dramatic loan losses in the stress tests, especially for riskier loans. The result is fewer institutions willing to offer riskier mortgage lending products.

“If we tell banks that we want them to do well in a crisis and that we are protecting the public against another bank failure by performing stress tests , that’s a reason why banks don’t make loans to certain borrowers,” said Jeff Naimon, a partner at the Buckley law firm.

The stress tests increased capital requirements for mortgages because those assets drove the 2008 financial crisis, and loosening them might stoke fears that regulators are inviting a similar result. But that crisis, Petrou said, was driven more by well-heeled borrowers leveraging their equity than subprime borrowers obtaining mortgage credit.

“The whole assumption of the current risk-based capital system is that subprime borrowers are more risky, but none of the evidence supports that,” she said. “There is a growing body of research showing that it was prime borrowers who really drove losses during the financial crisis by leveraging their houses as ATMs.”

If lowering capital retention requirements were targeted to lower-value homes, it would provide meaningful benefit to families seeking to enter the housing market for the first time without setting the stage for another housing bubble, Petrou said. The incoming administration will have to find a way to balance the interests of expanding mortgage access against systemic risk, she said, but focusing on lower-value homes is a profitable place to start.

“There needs to be some policy initiatives — including incentives for low-balance loans for banks to originate home loans of $150,000 or less," she said.

The ultra-accommodative interest rate policies put forward by the Fed since 2008 — and especially since the onset of COVID — has also had a secondary effect of making it harder for lower-income earners to make low-risk interest gains on their savings, she said. That means it is taking longer for many BIPOC savers to generate sufficient savings for a down payment, she said.

"You can never regain equitable ground as long as interest rates are as low as they are and no one can save for a down payment," she said.

If the Biden administration wants to make the American Dream as real for nonwhite Americans as it has been for white Americans, it has its work cut out for it. But a significant part of closing that disparity of experience means finding sustainable ways to make homeownership more available and more profitable for nonwhite borrowers — and banks.

“FHA doesn’t have to be the main option for Black and Hispanic borrowers,” said Perry. “If we know that credit scores and debt-to-income ratios are nothing but measures of wealth disparities that reflect discrimination, then there are  ways to enhance access to credit and homeownership opportunities for people of color.”