An Obama Settlement that Destroys Black Opportunity

It was well-intentioned no doubt, but the recent consent order the Department of Justice entered against two mortgage lenders, AIG Federal Savings Bank and Wilmington Finance, will hurt poor and black homebuyers and help no one except a few government lawyers.

Under the settlement these two companies (both, importantly, subsidiaries of AIG) will have to pay $6.1 million to 2,500 African-American borrowers who the DOJ claims suffered from discriminatory high prices and fees for their mortgages (they will also have to pay $1 million towards general financial education. First lesson: don't piss off the government). The real rub here is that these companies did not originate these discriminatory mortgages, but only bought them from local brokers who themselves were putatively discriminating. The settlement is the first to argue that national mortgage lenders are liable for the policies of these entirely independent brokers. DOJ claims that the lenders should have monitored these brokers and used "statistical analyses" to make sure they were not unwittingly discriminating against minorities.

The whole case suffers from false and anachronistic reasoning.

Before branch banking deregulation (implemented gradually by states in the 1980s, and across state lines with the 1994 Riegle-Neal Interstate Banking Act) many areas did have only one or two small community banks. These banks had short hours, conservative lending policies, and almost no competition. State and national rules against establishing branch banks meant they had a kind of de facto monopoly for their target area, and the profit cushion that arose from that monopoly meant they could comfortably ignore loans in poor and minority areas and focus mainly on high-quality white mortgages. This was the era of what was called 3-6-3 banking. Namely, borrow at 3 percent, loan out at 6 percent, and be on the golf course by 3 o'clock. Today, as evidenced by these subsidiaries of an international conglomerate, mortgage brokering is a worldwide affair, and everybody must compete to originate mortgage loans. The open market means that if one bank tries to discriminate against blacks by offering too high prices, then another can jump in and make the profit on a lower-priced loan. If all lenders in a market are discriminating, someone else can start making loans to minority borrowers. This is a classic example of how, as Nobel Prize winner Gary Becker has shown, competition decreases racial discrimination, because it makes discriminating both more expensive and less enforceable.

So what about DOJ claims that blacks suffered higher mortgage rates and fees despite having similar incomes? Unfortunately, years of scholarship have shown that blacks tend to default at significantly higher rates than whites with similar incomes. A September 1999 study by Freddie Mac showed that blacks with approximately $70,000 a year in income have worse credit histories than whites with around $25,000 a year income. Gary Becker himself showed that if banks were discriminating in mortgage lending, one should see lower default rates and higher profitability among loans to blacks, because banks would pick only the most credit-worthy minority applicants. Instead you see the reverse, high default rates and lower or equal profitability among loans to blacks.

The reasons for high black default-rate are legion. Less saved wealth, more variable job histories, and the relative absence of two-earner (and two parent) families all contribute. And all of this is, in some way at least, certainly the end result of years of racial discrimination and segregation. But it definitely does not show that mortgage bankers today are actively discriminating against minorities. Interestingly, nobody in the DOJ or elsewhere seems to argue that these well-educated bankers and mortgage brokers bear a particular animus against blacks that somehow manifests itself through charging them slightly higher fees on loans. Most people today would rightly say that that is ridiculous (yet this kind of assumption lies behind the endless press reports on mortgage discrimination and the housing crisis). Instead, the contemporary enforcers of racial housing laws claim that "cultural affinity problems," or some other unstated mechanism, cause bankers to underestimate black credit-worthiness and therefore overcharge for loans. Of course this doesn't explain why Asians have lower default rates or why black-owned banks appear to practice similar "discrimination" against black borrowers as white-owned banks, but no government lawyer appears interested in explaining this, and of course they don't have to because these cases never make it in front of jury. It almost always makes sense for accused companies to just settle and make nice with the government which regulates them and can cause them even more trouble in the future if the want to get fiesty. In this case it makes particular sense because these two companies are directly owned by AIG, and are therefore directly owned by the government that is supposedly suing them. Settlement in this case was a foregone conclusion.

This brings to mind the arm-twisting that accompanied the auto bailout, where then TARP-controlled banks caved into Obama's demands that they write off billions of dollars in secured loans on the GM and Chrysler debt so that the Democratic-friendly unions could get a bigger cut of the pie that emerged from bankruptcy (UAW illegally got 17.5% of GM and 55% of Chrysler). It also brings to mind Obama's consent decree with Westchester county, where the administration explicitly used the threat of removing HUD funds to force them to sign a decree that now forces counties across the country to allocate affordable-housing funding based on race. The administration knows that its discretionary power over federal funds allows them to force new policies sub rosa without enacting new laws. Of course, this is exactly why untrammeled political discretion over the economy is dangerous: it forces citizens and companies to bow to demands which help political friends but hurt the broader public and the rule of law. Unfortunately in the mortgage discrimination case, the effect may be even more destructive in the long-run than any of these others, because this forced settlement (with a government-owned bank subsidiary) will allow the DOJ to browbeat the rest of the private-sector with a nice signed and certified consent order in its hands. All mortgage lenders using independent brokers now exist under the Sword of Damocles.

I of course agree with these DOJ lawyers that banks should not be allowed to explicitly use race as a factor in making loans, but the problem is today almost any metric that can somehow be correlated with race ends up being a potential liability for the companies that use it. If zip-codes or job histories or credit scores correlate with race, the racial discrimination squad can use a couple easy regressions and show how a mortgage lender is secretly out to destroy black homeowners. The end result is that almost any measurement used to calculate loan rates is subject to lawsuit, and now this is true even if an independent broker makes a non-discriminatory loan without any broader statistical background. Just the gathering of such loans together in a company is dangerous, trying to rate them by chance of default is even more so. In this way this settlement works much like the recent credit-card bill, which also operated under the assumption that most borrowers were equal and banks should use fewer measurements to determine credit risk. Of course, in both cases this will lead the banks to raise rates for everyone and cut off credit to the poor. This is also the exact same logic that caused our nation's housing crash. Despite all the platitudes about learning from history, the administration is now forcing more bad, under-priced loans on banks, telling them its all for the best in the long run. But intentionally making banks dumber about the loans they make is not a path to credit stability.

In my mind though, the greatest tragedy of this settlement will be inflicted on the black homeowners it was designed to help. The increasing dangers of liability will cause more and more lenders to retreat from making loans in minority areas, ironically causing exactly the sort of redlining these laws were originally designed to prevent.

It's the same old law of unintended consequences.

(PS For those few people following this blog, I apologize for the long absence. I should return to making more regular posts during the next few months).