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Financing Community Development Financing Community Development: Learning from the Past, Looking to the Future Summary of the 2007 Federal Reserve System Community Affairs Research Conference BY LORETTA J. MESTER he Federal Reserve System’s 2007 Community tations and discussions did advance our knowledge and provided several in- T Development Research Conference, teresting avenues for further research.* “Financing Community Development: Jeffrey Lacker, president of the Federal Reserve Bank of Richmond Learning from the Past, Looking to the and chair of the Conference of Presi- Future,” was held in Washington, D.C., on March 29-30, dents’ Committee on Research, Public Information, and Community Affairs, 2007. This conference was the fifth in a biennial series opened the conference. He pointed that the Federal Reserve System established in 1999. out the value of careful, objective research on consumer financial mar- The responsibility for organizing the conference program kets, which have experienced much rotates among the Federal Reserve Banks. The staffs of innovation in recent years. Financial the Federal Reserve Bank of Philadelphia’s Community innovation creates opportunities but also entails risk. Lacker would like Affairs Department and Research Department took the researchers to study borrowing and lead in organizing the 2007 program. The intention of other household financial decisions from an ex ante viewpoint, that is, to the conference series is to encourage the application look at the full distribution of possible of rigorous economic analysis to issues related to outcomes and their relative prob- abilities. Otherwise, it is difficult to community development because without such state-of- know whether any particular credit the-art research, policymakers cannot hope to devise market product is beneficial on net or whether the benefits of any pro- effective economic development policies and programs. posed method for curtailing adverse In this article, Loretta Mester provides a summary of the outcomes outweigh the costs from restricting credit that the method may conference. entail. He also pointed out one of the limitations of the data collected under the Home Mortgage Disclosure The conference was organized (2) Are legislative remedies to limit Act. Even with recent enhancements, around six key questions: (1) Is sub- predatory lending really remedies? these data include information from prime loan pricing fair or predatory? (3) What determines who defaults or lenders only and do not contain much goes bankrupt, and how do they fare? information about borrowers, so Lacker (4) What should and can be done to enhance borrowers’ knowledge of their Loretta Mester is senior vice credit risk? (5) Does the financing of president and small businesses differ for minority- * Revisions of some of the papers presented at director of owned businesses and for businesses this conference have been published in a special Journal of Economics and Busi- research in the in low-income areas? and (6) Can issue of the Philadelphia ness, 60, Nos. 1-2, 2008. Part of this summary Fed’s Research alternative financial services products is taken from my introduction to this special Department. This help the underbanked? Although the issue. The conference papers are available article is available on the Federal Reserve System’s website at research did not provide definitive www.federalreserve.gov/communityaffairs/ free of charge at answers to these questions, the presen- national/2007researchconf/default.htm. www.philadelphiafed.org/econ/br/. 34 Q1 2008 Business Review www.philadelphiafed.org is pessimistic about their usefulness all straightforward. To the extent that code on median household income, for understanding the effectiveness of these factors are not associated with race, education, and adult population. credit markets. Lacker suggested that foreclosures resulting in loss of wealth Over 31,000 loans were used in the researchers try to partner with credit and tax base, the empirical basis for empirical analysis, with over 200,000 rating bureaus so that lender-supplied some of the new regulations enacted loan-quarters of observations. data can be combined with data on at the municipal and state level is ques- Rose estimates multinomial households to better illuminate bor- tionable. These laws might restrict logit models that explain for each of rowers’ credit decisions and outcomes. legitimate access to credit for low-in- four loan types (fixed-rate purchase, In his view, further research will help come borrowers without offering much fixed-rate refinance, adjustable-rate us better understand the costs and benefit. The results also suggest that purchase, adjustable-rate refinance) benefits of market practices and gov- our understanding of these loans must the probability of a loan’s entering ernment interventions. advance before effective federal legisla- foreclosure, prepayment, or remaining Indeed, turmoil in the subprime tion to limit predatory lending can be active in the quarter. Explanatory vari- mortgage market took center stage in mid-2007, underscoring the im- portance of further research on this market segment. Six papers at the The recent increase in subprime mortgage conference studied various aspects of foreclosures has prompted calls for more the subprime mortgage market, includ- regulation to curb predatory lending, and some ing pricing, possible predatory practices and policy responses, foreclosures, and municipalities and states have passed such delinquencies. legislation. SESSION 1: IS SUBPRIME LOAN PRICING FAIR OR PREDATORY? designed, and that the recent regula- ables include macroeconomic, demo- “Predatory Lending Practices tory guidelines emphasizing prudent graphic, and vintage control variables, and Subprime Foreclosures: Distin- loan terms and underwriting standards and features of the loans, including guishing Impacts by Loan Cat- may be a better approach than placing whether the loan requires a balloon egory,” by Morgan Rose, examines restrictions on loan characteristics. payment, whether it has a prepayment the foreclosure behavior of subprime Rose uses quarterly data collected penalty period longer than 36 months mortgages. While the rise in subprime by LoanPerformance, Inc. on subprime from origination, whether it is a low- or mortgage lending has increased access refinance and home purchase mort- no-documentation loan, the loan-to- to credit for some borrowers, it has gages originated in 1999Q1 through value ratio, interest rate at origination, also raised concerns about possible 2003Q2 on properties located in the the borrower’s FICO score at origina- predatory pricing practices within this Chicago metropolitan area and which tion, and, for refinance loans, whether market segment. The recent increase have been securitized into private-label the borrower withdrew cash. The first in subprime mortgage foreclosures has mortgage-backed securities. Chicago three of these loan characteristics are prompted calls for more regulation to provides a good laboratory for study, often cited as features of predatory curb predatory lending, and some mu- having experienced a significant loans. Standard errors were adjusted nicipalities and states have passed such increase in foreclosures in recent years. to allow for clustering by loans, since legislation. But distinguishing preda- Focusing on a single geographic region loans can remain in the data set for tory lending from legitimate lending is can help control for regional differenc- multiple quarters. a difficult task. Rose’s analysis indi- es in housing markets. However, the The empirical findings indicate cates that the impact of prepayment limited time period means the loans that the relationship between outcome penalty periods, balloon payments, and studied are not seasoned and many (foreclosure, prepayment, active), loan reduced documentation — charac- of the new types of mortgage instru- characteristics, and demographic vari- teristics often cited as consistent with ments, like “piggyback” mortgages, ables differs among the four loan types, predatory lending — on the foreclo- cannot be included. Rose combines making it difficult to reach a general sure behavior of subprime refinance these data with 2000 Census Bureau conclusion about whether particular and home purchase mortgages is not at data, which include information by ZIP loan characteristics or combinations www.philadelphiafed.org Business Review Q1 2008 35 of characteristics are associated with larger share of higher-rate home loans, data to borrower, loan, economic, and higher probability of foreclosure. For controlling for borrower riskiness. This geographic characteristics, allowing example, having a prepayment penalty paper uses the 2004 data collected for endogeneity between the loan-to- period longer than 36 months is as- under the Home Mortgage Disclosure value, loan amount, and loan interest sociated with a statistically significant Act (HMDA), which for the first time rate. (Unlike the Elliehausen et al. higher probability of foreclosure for included information on the costs paper discussed below, this paper does purchase fixed-rate mortgages and re- of subprime home loans. For first- not account for potential simultaneity finance adjustable-rate mortgages, but lien loans, lenders were required to between the presence of a prepayment not for refinance fixed-rate mortgages report the spread between the annual penalty and other loan terms.) or purchase adjustable-rate mortgages. percentage rate (APR) of the loan and Overall,
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