Subprime loans first surfaced in communities with minorities

In the last two decades Subprime lenders – those who offer loans to risky borrowers – have been under scrutiny due to a variety of reasons. This includes concerns about stability in the financial market and precarious lending practices towards minorities. 

Even though these issues are present that have been a part of the rise of subprime lending throughout the US and across the globe the belief that was prevalent from the early 1990s was that these lenders provide credit to communities that have the highest chance of not receiving the credit from lenders that have fewer risks ( Collins et al. 2004). If you are looking for a legit lender for same day loans, you can visit bridgepayday.com.

The subprime lending community

In our most recent report ( Jakucionyte and Singh 2021) We dispute this idea by examining the origins of subprime lending in the communities of minorities in the US in the 1990s. 

We argue that the growth of subprime lenders in neighborhoods of minority communities was due to advances in technology for lending and the policies that were endorsed by those who manage the US GSEs which are government-sponsored entities (GSEs) Fannie Mae and Freddie Mac.

The graph plots on the scale of the neighborhood the proportion of subprime loans versus the Black proportion of residents over two-time frames between 1997-2000, and 1993-1995. Between 1993 and 1995, there wasn’t a relationship between the proportion of subprime loans and the share of Black residents living in the neighborhood. However, the correlation does improve between 1996 and 2000.

The distinction between the two periods between 1993-1995 and 1996-2000 can be due to a specific change that occurred in 1995. Before the year 1995 US loans to homeowners were conducted by hand and were slow and inefficient and was is believed as being influenced by prejudices of the underwriters’ personnel. In 1995, Fannie Mae and Freddie Mac have introduced two changes to deal with the problem. They first made efforts to automatize mortgage loan approvals.

Then, they sent letters to lenders affiliated with them, informing them to utilize FICO credit score as an accurate and objective indicator of the creditworthiness of a borrower. They also provided specific cut-offs for credit scores and provided guidance for lenders on what they should do when they find credit scores that are either above or below the thresholds they have specified ( Foote et al. 2019).

Credit scores endorsement

If an applicant’s credit score is below the threshold specified for an application, it will need an exhaustive exam by the underwriter prior to selling the application to GSEs. The GSEs have explicitly declared that credit scores could influence the chances of securitization’s success.

Furthermore, credit scores are endorsed credit scores by the GSEs. the issuance of certain cut-offs only affected a small number of credit providers – the major lenders. In the 1990s, subprime loans were securitized in the private security market ( Temkin et al. 2002).

The structure of the market for securitization is vital for understanding the differences in lending that took place after 1995. Because communities with minorities tend to be poor creditworthy, GSE’s policy will increase the costs of securitization in communities that have minorities. So, prime lenders may be enticed to relocate into non-minority regions or communities that have a greater proportion of borrowers who are low risk. Subprime lenders were not directly affected by the new rules However, they could be able to join areas that are predominantly minority because they are less competitive than the principal lender.

There are differences in local mortgage markets across the US

Analyzing the differences in local mortgage markets in the US we can see that the share of loans that are subprime in Black communities significantly increased in the years following 1995. In a specific regression framework, called difference-in-differences, we find that relative to the pre-1995 period, the difference between the share of subprime lending in minority neighborhoods and non-minority neighborhoods increased by five percentage points.

The number of subprime loans increased after 1995, as prime lenders reduced lending to areas that have an underrepresented population compared to those who aren’t minorities. These lenders are increasing lending to minority communities as compared to other situations. However, the decline in lending to neighborhoods with minorities was prior to the increase in subprime lending. It was much larger and suggests that primary lenders were the first to make the move.

To connect our findings towards endorsements for credit scores We also look at the lending practices of lenders with weak or strong relationships with Fannie Mae and Freddie Mac. The prime lenders that securitize more loans with the GSEs will likely be the most affected by changes in policy. They could move away from areas that have minorities more than lenders who have more traditional approaches that tend to securitize the smallest portion of mortgages.

It is evident that prior to 1995 the prime lenders with greater ties with GSEs were able to obtain the same percentage of loans in the two neighborhoods. However, in the years following 1995, the proportion of loans granted by principal lenders with established relations with GSEs decreased in those communities that were minorities, compared with minorities. Prime lenders with less favorable relationships did not change their percentage of loans across every community.

The essence of our study is to present our findings that the endorsement of credit scores and the adherence to specific guidelines have led to an unintended result. Acceptance of credit scores in mortgage underwriting has led to the growth of subprime lenders in minorities-dominated communities, and the decline of prime lenders.

These results suggest that conditions for borrowing are shifting too. This means that the time when minorities were more vulnerable to lenders who were subprime or subprime They could have been more likely to obtain costly loans even though they had similar credit scores to a non-minority borrower. Analyzing the effects of lender sorting more closely can provide important insights into the financial security of minorities, as well as the varying levels of inequality within communities.