Grand Valley State University
As a researcher and an advocate for fair lending and community reinvestment, I have shared the concerns of many over the ubiquitous use of credit scoring in the mortgage lending process. Many of my concerns have been articulated by others in earlier articles in this series. For example, in the first installment, community reinvestment consultant Cal Bradford points to the disparate impact of credit-scoring systems and questions where the threshold be set in determining whether a scoring system meets the "business necessity" test under the Equal Credit Opportunity Act and Regulation B. If lowering the threshold for approving loans reduces disparate impact but increases loan losses, what standard is to be used to determine whether such losses have increased too much? Lenders may argue that pressures for ever-increasing earnings force them to push loan losses lower and lower, therefore raising approval thresholds. Who determines how low losses need to be—the market's invisible hand? Even conceding such a market-based approach, who determines where the invisible hand has set that thresh-old—the lender or the regulator?
Previous contributors have pointed to other important issues, such as the lack of transparency in scoring models and the focus on correlation over causation. Before exploring particular issues with overrides and counteroffers, however, I feel obliged to spend a little time on a couple of issues that I feel did not receive enough attention in earlier parts of this series. First, alluded to in other essays but perhaps not addressed directly, are the problems that increasingly sophisticated lending tools pose for less-sophisticated loan applicants. As lending processes become more difficult to understand (even if there is greater disclosure, credit-scoring systems often remain more complex and mystifying than previous systems), those who have less understanding of how credit works or less-developed mathematical skills will be more confused about why they are denied credit or charged higher rates. Without such an understanding, it is unlikely that people will be able to improve their credit prospects very much. While some counseling programs do a good job of dealing with this problem, the proliferation of credit scoring has not been matched by an equivalent investment in home-buyer and home-owner counseling resources.
Another, larger issue posed by credit scoring is often referred to as the problem of paradigm shift and has been brought up more often in the context of safety and soundness concerns. Credit-scoring systems are relatively new, only having grown into common use in the mortgage market since the mid-1990s. Most have not been tested extensively during a substantial change in the business cycle (although that is likely occurring now to some degree). When a major business cycle or technological change occurs, scoring models may not do a good job at predicting behavior.
While these concerns typically have focused on the possibility of scoring systems yielding approval rates that are too high (thus causing safety and soundness problems), it is also possible that paradigm shifts cause changes in the importance of different variables in predicting loan performance—which, if not corrected, could unfairly disadvantage minority applicants. For example, some systems disproportionately penalize some minority applicants for having more credit activity with finance companies. If the regulation of finance companies were to improve significantly, we might expect the negative effect of such interactions would diminish, thus becoming a less important determinant of repayment.
An often-overlooked issue with credit scoring is its use in data-mining and marketing efforts by lenders and mortgage brokers. It is now possible to obtain data on the credit scores of residents of specific neighborhoods, enabling lenders to target specific areas with different types of products—which, in turn, can lead to increasingly segregated lending markets.
Turning now to the more specific problems of overrides and counteroffers, there are a number of issues that lenders, regulators and advocates should be particularly concerned about. First, to be clear, overrides and counteroffers are not problems in and of themselves, and they can be an important part of mortgage-lending operations. The growth in credit scoring means that such practices have become more prevalent, however, and, therefore, can create greater fair-lending risks.
As shown in the Deposit Guaranty National Bank case, where the lender was found to favor non-minority applicants in the override process, lenders must monitor such practices closely. They should look especially at aspects of the scoring system where minority borrowers may be disadvantaged (for instance, failure to consider a history of rental payments in the evaluation of credit history).
In terms of counteroffers, if above-standard pricing is used, lenders should be careful to use real risk-based pricing and should be required to document and justify this to regulators. Arbitrary risk premiums should not be tolerated. Regulators should compare the pricing and approval systems to those of other lenders.
Clearly, retail lenders must be concerned with both the fairness of overrides and the fairness of pricing in overrides. However, regulators need to clarify and enforce the fact that wholesale lenders—or lenders with correspondent relationships—are liable for any discriminatory behavior on the part of their brokers or correspondents. Because brokers are disproportionately active in minority communities, this is an important point. Effectively, lenders may attempt to "outsource" discriminatory overrides by having brokers perform the override function so that the lender itself ends up with few overrides, if any at all.
Related to this problem is the common scenario of one holding company owning several affiliates (bank and non-bank) that engage in mortgage lending. If, for example, the bank affiliate tends to make retail loans to white borrowers and the non-bank affiliate tends to make wholesale loans through brokers to non-white borrowers, then an override system that applies only to the bank may disproportionately benefit white applicants when considering all applications to the holding company and its brokers. This problem, in turn, is related to the larger need for fair-lending examinations to be conducted on a holding company basis, not just on a bank basis.
Second reviews, overrides and counteroffers can be an important part of a lender's program to adequately serve all segments of a market. Guarding against fair-lending problems requires a comprehensive system of oversight and controls and a regulatory framework that includes close and comprehensive scrutiny of the override process.
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