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 probabilities. 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 importance 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, the results of the analysis Low- or no-documentation is associ- the yield on a U.S. Treasury security of suggest that for many types of loans, ated with a statistically significant comparable maturity if the spread was African Americans and Latinos are higher probability of foreclosure for three percentage points or higher. By more likely to receive a higher-priced refinance loans of either type and a matching these data to a proprietary loan compared to non-Latino white statistically significant lower probabil- database on subprime lending, the borrowers with similar characteristics. ity of foreclosure for purchase fixed- authors are able to address a signifi- For example, the authors estimate that rate mortgages, and is not significantly cant weakness of earlier studies of race African Americans are 1.84 times associated with the probability of and loan pricing, namely, the inability and Latinos are 1.7 times more likely foreclosure for purchase adjustable-rate to control for the risk characteristics to receive a higher-rate fixed-rate mortgages. Rose also examines the of the borrowers and loans at the purchase loan with prepayment penal- impact of combinations of the three time of origination. In particular, the ties, all else equal, than a non-Latino loan characteristics often considered proprietary data allow them to control white borrower. These estimates are characteristics of predatory loans. In for a borrower’s FICO score, loan-to- statistically different from one at the 1 most, but not all cases, the results value ratio, and whether the loan was percent and 5 percent levels, respec- indicate that the effect of the combi- covered by private mortgage insurance. tively. nation on the predicted probability of The resulting data set contains over It is beyond the scope of the paper foreclosure is greater than the sum of 177,000 subprime loans originated in to identify the causes for such a dispar- the individual impacts. 2004. ity in pricing. It could be that even Based on the analysis, Rose con- The analysis covers subprime the better measures of borrower risk cludes that the relationships between loans that have been securitized where that are used in the analysis still do foreclosures and loan characteristics the loans are secured by first liens not completely control for differences often cited as predatory are much more on owner-occupied properties, and in risk. However, the results suggest complex than previous analysis sug- excluding loans secured by manufac- that other explanations must also be gests, and that prohibitions on these tured housing units, backed by private considered, for example, are minor- loan characteristics may not have the mortgage insurance, those with ity borrowers steered to higher-priced desired effects intended by legislators. nonstandard amortization schedules, loans? The authors suggest some This suggests the need for a model and those with origination amounts enhancements to the HMDA reports of borrower and lender behavior to above the Fannie Mae and Freddie that would aid in further research, for better understand the consequences of Mac limit (which was $333,700 in example, including information on restricting various loan characteristics 2004). Separate analyses are performed loan-to-value and credit scores, and on the supply and demand for these on six different subgroups of loans, also on the type of originator. types of credit. defined by whether the loan is fixed or Alan White of Community Legal The association between subprime variable rate, included a prepayment Services, Philadelphia, discussed the lending and minorities is the focus penalty or not, and was for purchase or Rose and the Bocian et al. papers. In of “Race, Ethnicity, and Subprime for refinancing. Following a method of his view, both papers provide further Home Loan Pricing,” by Debbie Ambrose et al. (2004), the authors use evidence on the harm to consumer Gruenstein Bocian, Keith Ernst, and three-stage least squares to estimate welfare caused by deregulation of Wei Li. The paper examines whether a logistic model relating the prob- mortgage markets. He thinks there African-American and Latino bor- ability of receiving a loan designated has been little empirical work docu- rowers receive a disproportionately as a higher-rate loan in the HMDA menting the welfare benefits of the

36 Q1 2008 Business Review www.philadelphiafed.org expansion of the subprime lending prepayment penalty mitigates some variable-rate, and hybrid mortgages market. Although their existence ap- of the prepayment risk faced by the with a 30-year term to maturity. A pears to be the received wisdom, he is lender. However, studies have yielded three-equation simultaneous equation skeptical that on balance such benefits conflicting results about whether the system is estimated, with loan rate pre- outweigh the costs. Indeed, he pro- rates that borrowers pay are lower mium (the difference between the loan poses two alternative hypotheses: that for loans that include prepayment rate and the rate on a Treasury secu- subprime loans have displaced other penalties. Elliehausen et al. advance rity of comparable maturity), loan-to- credit products, like FHA loans, and the existing literature by examining value ratio, and presence of a prepay- that subprime lending has expanded the relationship between prepayment ment penalty as dependent variables. credit not by bringing in more borrow- penalties and loan rates using Loan-to-value and prepayment penalty ers, but by increasing the amount of funding available to individuals who had access to credit before the rise of Previous research has indicated that loans the subprime market. Regarding dis- criminatory pricing, White suggested with prepayment penalties have higher value that researchers evaluate whether the to lenders, and the prepayment penalty loan-pricing matrices used by lenders mitigates some of the prepayment risk faced to match risk factors with price are correctly calibrated. Do minority bor- by the lender. rowers pay higher prices because their cost to the lender is higher? White also underscored one of the lessons simultaneous equation estimation are included as explanatory variables from Rose: the subprime market is techniques, which recognize that in the loan rate premium equation; very heterogeneous — subprime loans prepayment penalty, loan rate, loan rate premium is included as an that were made in 2000 are different and loan-to-value ratios are set explanatory variable in the loan-to- from subprime loans that were made in simultaneously by the lender. Previous value and in the prepayment penalty 2006, and loans made for purchase and studies have failed to recognize this equation. Loan characteristics includ- loans made for refinance are different, endogeneity and so have potentially ed in the model as controls are loan with the latter often better thought of produced biased estimates of the effect amount, home value, loan-to-value, as a consumer credit product rather of a prepayment penalty on the loan and whether the loan was a low-doc- than as a mortgage. rate. umentation loan. Borrower character- This study uses the subprime istics included are borrower income, SESSION 2: ARE LEGISLATIVE mortgage database of the Financial FICO risk score, and whether the REMEDIES TO LIMIT Services Research Program, which home is owner-occupied. The analysis PREDATORY LENDING contains data on all originations of also controls for whether the mortgage REALLY REMEDIES? the subprime subsidiaries of eight large was originated by a mortgage broker “The Effect of Prepayment financial institutions from 1995Q3 and whether the loan was used for Penalties on the Pricing of to 2004Q4. This database covers refinancing. Instruments are used to Subprime Mortgages,” by Gregory nearly one-quarter of loans reported identify the system. The prepayment Elliehausen, Michael Staten, and as higher-priced mortgages made for penalty equation is a probit equation Jevgenijs Steinbuks, also investigates purchase or refinancing of owner-occu- used to predict the probability that the prepayment penalties on subprime pied homes in the 2004 HMDA data. loan includes a prepayment penalty. loans. Similar to Rose’s research, The analysis includes close-ended first This predicted value is included in the the results of this paper suggest that mortgages with loan-to-value ratios of loan rate premium equation and then restricting certain loan characteristics, 90 percent or less. The average loan the interest equation and loan-to-value in particular prepayment penalties, amount for these loans in 2004 was equations are estimated by two-stage may have unintended consequences. $130,000. least squares. Previous research has indicated that Because pricing schedules differ by The empirical results show that loans with prepayment penalties loan type, the authors estimate sepa- controlling for potential endogene- have higher value to lenders, and the rate loan pricing models for fixed-rate, ity is important: The single equation

www.philadelphiafed.org Business Review Q1 2008 37 ordinary least squares results and the Protection Act (HOEPA), passed in predatory lending laws, both pre- and three-equation system results differ. 1994, is a federal law that regulates post-HOEPA, and finds an additional Results for the three-equation system loans considered to be “high-cost 16 state laws that previous studies indicate that the presence of a prepay- loans.” The act defines these as first in the literature have not identified. ment penalty is associated with lower mortgages with an annual percentage Building on previous research (Ho and loan rates: 38 basis points lower for rate at origination 8 percentage points Pennington-Cross, 2006), the authors fixed-rate loans, 13 basis points lower or more above the yield on Treasury create two variants of a legal index for variable-rate loans, and 19 basis securities of comparable maturity; that measures the breadth of coverage, points lower for hybrid loans. The subordinate liens with a spread of 10 type and severity of restrictions on authors report that these interest rate percentage points or more; or loans loan terms, and enforcement mecha- reductions are similar to those found with total points and fees that exceed nisms. Higher values of the index in lenders’ wholesale loan pricing rate correspond to laws with broader cover- sheets. This result raises the possibility age, more stringent restrictions, and that a restriction on the use of prepay- The Home Ownership stronger enforcement mechanisms. ment penalties may have the unintend- The authors use 2004 and 2005 ed consequence of raising loan rates. and Equity Protection HMDA data. They identify subprime “State and Local Anti-Predatory Act (HOEPA), passed loans in two different ways. For 2004 Lending Laws: The Effect of Le- in 1994, is a federal and 2005, they designate loans as sub- gal Enforcement Mechanisms,” by prime if they are reported on HMDA Raphael Bostic, Kathleen Engel, law that regulates as having an annual percentage rate Patricia McCoy, Anthony Penning- loans considered to in excess of the rate on a Treasury ton-Cross, and Susan Wachter, takes security of comparable maturity of another look at anti-predatory lend- be “high-cost loans.” 3 percentage points or more. This ing laws and their effect on subprime information is available only on loan mortgage lending. On the one hand, originations and not on applications such laws could restrict the availability the greater of 8 percent of the loan for loans that were not originated. For of this credit and raise its price. On amount or $400 (subject to annual 2004, they also had a list of subprime the other hand, they could allay con- indexing). While HOEPA imposes lenders that was generated by the U.S. sumer concerns about predatory lend- significant restrictions on the credit Department of Housing and Urban ing by raising the cost to lenders that terms of these loans, it is estimated to Development (HUD) through indus- engage in abusive practices, thereby cover only a small portion of subprime try trade publications, HMDA data increasing the demand for this credit. mortgages. Several states have passed analysis, and phone calls to determine The authors’ analysis shows that in their own laws; many of these lower the extent of the institutions’ subprime order to understand the effect of these the HOEPA pricing triggers, thereby lending. Thus, for 2004 they were able laws, it is important to look at the indi- expanding coverage. The laws differ to repeat their analysis for this defini- vidual provisions, including the types in enforcement mechanisms: Some tion of subprime, which also allowed of mortgages covered, restrictions on allow only government enforcement, them to investigate applications for pricing, and enforcement mechanisms. and others allow borrowers to sue subprime loans, as well as originations. The study finds that these components particular parties, with some restrict- To focus on the effect of anti- have independent effects on the supply ing private lawsuits to compensatory predatory lending laws on the market of and demand for subprime mort- damages only. and to help control for other factors gages. In particular, broader coverage, Bostic et al. examine the impact that might affect loan markets, the which was a provision in the newer of anti-predatory lending laws on the analysis includes only loans that were anti-predation laws, and enhanced three different outcomes: the prob- made in counties along a state border, enforcement are associated with a ability of applying for a subprime loan where at least one of the states has greater likelihood of subprime origina- relative to a prime loan, the probability an anti-predatory lending law. The tion, while restrictions on pricing are of originating a subprime loan relative authors then estimate three separate associated with a lower likelihood of to a prime loan, and the probability of logit regressions to predict the three subprime origination. a subprime loan’s being rejected. The outcomes described above (the prob- The Home Ownership and Equity analysis includes all types of anti- abilities of applying for, originating,

38 Q1 2008 Business Review www.philadelphiafed.org or being rejected for a subprime loan market. There is weak evidence that prepayment penalties in Elliehausen relative to a prime loan), as a function stronger enforcement is associated with et al. are not large enough to offset of the legal index, a fixed effect desig- higher probability of subprime origina- the cost of the prepayment penalty nating the state border pair in which tion and lower probability of rejection for many subprime borrowers with the loan is located, controls for bor- of a subprime application. Similar to hybrid adjustable rate mortgages. He rower characteristics, such as borrower the Rose and Elliehausen et al. papers also suggests that loans that are more income (but not borrower FICO score, discussed above, one conclusion to profitable for the broker to deliver are which is not available in the HMDA be drawn from the paper is that the not necessarily the best deal for the data), and location characteristics such impact of laws intended to improve the borrower. Calhoun also suggested that as county unemployment rate. They functioning of the subprime mortgage it is important to consider the mort- also include a control for whether the market can be complex, resulting in gage delivery system when assessing institution is regulated by the Office unanticipated outcomes. anti-predatory lending laws as in Bostic of the Comptroller of the Currency Michael Calhoun of the Center et al. In Calhoun’s view, the HOEPA (OCC), since the OCC has interpreted for Responsible Lending discussed triggers for high-cost loans may be too the National Banking Act as exempt- the Elliehausen et al. and Bostic et al. narrow, as they do not include prepay- ing national banks from state and local papers. In Calhoun’s view, the mort- ment penalties or payments to brokers anti-predatory lending laws. gage delivery system is an important for delivering loans with rates above The empirical results indicate component of the subprime mortgage the lender’s minimal acceptable rate. that the existence of a state anti- market, and he focused several of his Several states now include a broader predatory lending law has little effect comments on the research results con- definition of high-cost loans in their on credit flows in the subprime cerning mortgage brokers. One of the anti-predatory lending regulations. mortgage market: It has no effect on many findings in Elliehausen et al. is The luncheon speaker on the the odds of applying for or entering that loans from brokers are significant- first day of the conference was Mary into a subprime loan, but it reduces the ly more likely to carry a prepayment Lee Widener, president and CEO of odds of being rejected for a subprime penalty, all else equal, than loans from Neighborhood Housing Services of loan by 7 percent. However, the results retail lenders. Calhoun pointed out America, Inc. (NHSA). In her presen- also show that individual components that this is consistent with a hypoth- tation, Widener said she expected the of the laws can have significant and esis discussed in Ernst (2005), namely, fallout from the current problems in sometimes offsetting effects. Although that brokers may be more likely to the subprime market to be widespread the effects differ somewhat across year place borrowers in subprime loans but noted that credit markets have (2004 vs. 2005) and subprime loan with prepayment penalties in order to faced and handled large challenges in definition (HUD list vs. HMDA price maximize their own compensation. the past. There are likely lessons to be criteria), in general, the results suggest Calhoun discussed three sources of learned from the current experience that tighter loan-term restrictions do compensation for brokers: They can be to help borrowers, lenders, commu- not have a significant effect on the (but rarely are) paid in cash from the nity development organizations, and probability of a subprime loan applica- borrower, their fees can be financed policymakers handle future challenges. tion’s being made but do increase the into the loan amount, and they can In Widener’s view the most important odds of a subprime loan application’s receive a payment from the lender for factors for advancing community de- being rejected, and they reduce the placing a borrower with a higher inter- velopment financing are collaboration, odds of subprime loans’ being origi- est rate than the lender requires to affordability, and borrower support. nated. These effects are somewhat compensate it for the given borrower’s Collaboration between community offset by provisions resulting in broader risk profile. The lender will be more development organizations, regulators, coverage of the laws. Broader cover- likely to make such a payment if the policymakers, and lenders was essential age is associated with lower odds of loan includes a prepayment penalty, for eliminating redlining, a com- subprime loan applications but also which helps to ensure that the bor- mon practice in the 1960s and 1970s. with lower odds of rejection and higher rower remains in the loan long enough Development of fair lending practices odds of origination. This is consistent for the lender to recoup this payment. followed, taking more collaboration. with the hypothesis that anti-predatory Calhoun calculates based on typical By the mid-1980s, the Community laws help reassure potential borrow- prepayment penalties that the interest Reinvestment Act had resulted in ers, thereby attracting them to this rate reductions found for loans with hundreds of local partnerships between

www.philadelphiafed.org Business Review Q1 2008 39 lenders and nonprofits and local SESSION 3: WHAT DETER- tage over multinomial logit, which is governments that delivered capital into MINES WHO DEFAULTS OR often used to investigate such multi- many local communities. Collabora- GOES BANKRUPT AND HOW choice situations. The multinomial tion with private-sector lenders was DO THEY FARE? logit model requires that the ratio of important for achieving affordability, “The Delinquency of Subprime the probabilities of any two alternative and affordability included responsible Mortgages,” by Michelle Danis and choices (that is, the odds ratio between underwriting so that borrowers could Anthony Pennington-Cross, analyzes the two alternatives) be independent meet the long-term obligations of their the dynamics of the payment behavior of any other alternative. This makes mortgages. Borrower support was also of subprime mortgage borrowers using estimation easier but is often not a needed — both pre-purchase and more sophisticated econometric tech- good description of behavior. For post-purchase counseling. In Widener’s niques than have heretofore been used example, the multinomial logit model view lenders’ commitment to forbear to study this issue. Payment dynamics would imply that if prepayment were and not foreclose when temporary are an important determinant of loan taken away as an option, we’d see life events interrupted the borrower’s pricing. For example, delinquencies proportionate changes in the probability to repay loans was also an will increase the price of these loans abilities of all other alternatives. But important element in helping families to borrowers by increasing the cost of the nested logit model would imply in low-income communities remain servicing these loans and of guarantee- that any change in the probabilities of homeowners. Further advancements in ing timely payments. The paper’s goal delinquency is evenly distributed over the low-income mortgage market were is to identify the key factors that drive 30, 60, or 90+ days, but there would made by NHSA through its collabora- delinquency. not need to be proportionate increases tion with the mortgage insurance in- At any point in time a mortgage in the probabilities of the remaining dustry, the secondary market through can be current, delinquent, or termi- alternatives in the other nests (that is, Freddie Mac and Fannie Mae, and the nated. Within each of these branches default and current). Thus, the nested rating agencies. This allowed loans to of possibilities, there are further alter- logit model is less restrictive, and the low-income borrowers to be financed natives (called nests). If delinquent, the authors present tests indicating that through the capital markets. mortgage can be 30, 60, 90, or more the more restrictive multinomial logit Widener explained that several days late. Termination can be due to model is rejected for their data. challenges remain. One is trying to either prepayment or default (that is, The authors’ loan data are from overcome the reluctance of many foreclosure). Notice that the status of LoanPerformance, which provides data communities to allow development of the mortgage is the result of actions on pools of nonagency, publicly placed affordable housing. Another challenge of both the borrower and the lender. securitized loans. They use monthly is making the borrower support and To capture the multiplicity of possible data on the payment status of single- development systems sustainable. One outcomes, the authors estimate (via family 30-year fixed-rate subprime aid to doing this is showing that loans full-information maximum likelihood) mortgages on owner-occupied property to low-income borrowers with proper a nested logit model of loan outcomes originated between January 1996 and support systems perform better than as a function of explanatory variables, May 2003. Over 97,000 loans are is commonly thought, which is what including loan characteristics (age of included in the analysis. State-level NHSA has experienced. The subprime loan, loan-to-value, whether the loan data on house price level, house price lending market poses another chal- is a low-documentation loan, whether volatility, and the unemployment rate, lenge. When the terms under which the loan is a no-documentation and national prime mortgage rates are subprime lending is available become loan, and whether the loan includes matched to the loan data. However, predatory, such lending has a nega- a prepayment penalty), borrower’s the time period is too early to cover tive impact on communities. Better FICO score at time of origination, the recent period of sharp increases consumer education and development and variables controlling for economic in subprime mortgage delinquencies. of alternative loan products better conditions in the state in which the The authors present estimates of the suited to lower-income borrowers can property is located (change in house change in the probability of the out- help. Widener discussed several such prices, volatility in house prices, come associated with a one-standard- products that have been developed via unemployment rate, and mortgage rate deviation increase and one-standard- collaborations among NHSA, other change (which does not vary by state)). deviation decrease in an explanatory nonprofits, and the private sector. The nested logit model has an advan- variable, holding the other variables

40 Q1 2008 Business Review www.philadelphiafed.org constant at their means. (The changes probability of prepayment increasing Chapter 7, filers turn over all of their are not symmetric for increases and de- as mortgage rates decline. But the assets above an exemption level that creases in explanatory variables.) They probability of prepayment is fairly un- varies by state in exchange for having are unable to report standard errors responsive to changes in house prices, their debts discharged. Under Chapter for these elasticity estimates, which which is an unexpected result. 13, filers need not turn over their as- are highly nonlinear functions of the An interesting finding is that sets but must complete a plan that in- explanatory variables and coefficients. factors that imply increased probabil- dicates how they will repay their debts However, most of the coefficient esti- ity of delinquency do not necessarily out of future income. The repayment mates are significantly different from imply increased probability of default. plan under Chapter 13 must propose to zero at the 5 percent or better level. For example, higher loan-to-value at pay at least as much as the value of the The empirical results show that origination implies a higher probabil- assets creditors would have received some of the relationships between the ity of delinquency but not of default. under Chapter 7. explanatory variables and the probabil- The Bankruptcy Abuse Preven- ity of delinquency, default, and prepay- tion and Consumer Protection Act, ment are as expected but others are enacted in 2005, introduced a means not. A borrower’s credit score appears An interesting finding tests on filers, whereby filers deemed to be a robust predictor of default and is that factors that to have sufficient income would be delinquency, with higher credit scores required to file under Chapter 13. The associated with lower likelihood of imply increased act presumes that higher-income filers delinquency or default. The estimated probability of will end up paying off more of their probability of 90-day or more delin- delinquency do not debt under Chapter 13, while at the quency is 0.75 percent for a borrower same time receiving a fresh start. But with a FICO score at the mean 649; necessarily imply there is little, if any, empirical evidence it is 1.89 percent for a borrower with increased probability about how debtors and their creditors a FICO score one standard deviation actually fare under Chapter 13. This lower, at 579. of default. paper provides such evidence using a The empirical results also show data set that the authors painstakingly that for borrowers with credit scores constructed from public court docket below 630, higher credit scores are This is a reminder that movement records of all Chapter 13 bankruptcy associated with higher likelihood of from delinquency to default is partly filings between 2001 and 2002 in prepayment. This might reflect the determined by actions of the lender. Delaware. The analysis, based on data borrowers’ ability to migrate to prime Another surprise is that higher state from over 900 filings, casts doubt on loans as their credit scores improve. unemployment rates do not seem to the success of Chapter 13 filings. However, for scores above 630, an in- trigger higher probability of delinquen- The authors approach their crease in credit score is associated with cy or default in the authors’ data. The investigation by constructing a a lower probability of prepayment. This interaction between local economic theoretical model of the bankruptcy seems counterintuitive. The authors conditions and loan performance decision. Debtors, when considering suggest this might reflect something presents an interesting avenue for bankruptcy, decide first whether to file unique about these borrowers that is future research and is one of the issues under Chapter 7 or Chapter 13. The not controlled for in the estimation – addressed in the Grover et al. paper authors do not model this decision and these borrowers seem to have credit discussed below. focus only on the decisions filers make scores that would qualify them for “The Anatomy of U.S. Personal after they have chosen Chapter 13. prime mortgages, yet they have taken Bankruptcy Under Chapter 13,” These Chapter 13 filers must decide out subprime mortgages. by Hülya Eraslan, Wenli Li, and on the length of the repayment plan to Prepayments on mortgages are Pierre-Daniel Sarte, analyzes the propose (typically three years or five known to be difficult to predict, and performance of consumers who file for years). Once the plan is proposed, the the paper’s results do not contradict personal bankruptcy under Chapter court-appointed trustee must decide this. As expected, the probability 13, one of two chapters of the U.S. whether to recommend that the court of prepayment is very responsive to bankruptcy code under which house- confirm the plan or dismiss it. If the changes in interest rates, with the holds can file for bankruptcy. Under plan is dismissed, the creditors can re-

www.philadelphiafed.org Business Review Q1 2008 41 sume debt collection measured against a time when these filers were volun- perspective, one must decide what a the filer. If the plan is confirmed, the tarily choosing to file under Chapter tolerable level of failure is and then filer begins making payments accord- 13 instead of Chapter 7. determine how one might respond to ing to the plan. Over time, the debtor The authors’ estimation results failure, be it via bankruptcy relief, gov- may experience unexpected changes in indicate that the amount that creditors ernment or private aid, or restrictions income and the plan can be modified. ultimately recover from borrowers that on the availability of credit. If the debtor completes the (perhaps file for Chapter 13 is significantly re- Porter suggested that it is not modified) plan, any remaining debts lated to whether debtors are experienc- altogether obvious how policymakers are discharged. If for some reason the ing bankruptcy for the first time, the should treat certain trigger events. debtor cannot or will not complete amount of their past-due secured debt For example, who should bear the the payments according to plan, the at the time of filing, and the amount responsibility for medical problems or case is dismissed. The debtor might of income they have in excess of what job problems that might trigger bank- try to convert the case to Chapter 7 ruptcy? In most cases, family income or go back to face his or her creditors plays a primary role in determining the without the protection of the bank- Who should bear success of any type of remedy. But both ruptcy provisions. The authors use the level and the stability of income maximum likelihood techniques to the responsibility for have been shown to be important to estimate their structural model relating medical problems successful outcomes under Chapter several outcomes — the choice of plan 7 in previous research and under length, whether the plan is confirmed or job problems Chapter 13 in the Eraslan, et al. paper. or dismissed, the creditor recovery rate that might trigger Porter suggested that further investiga- under the plan, and whether the plan bankruptcy? tion into the effect of income stability is brought to conclusion — to exog- on outcomes might prove to be fruitful enous debtor characteristics. in furthering our understanding of the The Chapter 13 filers in the is required for basic maintenance. bankruptcy process. sample have significantly more debt Also, changes in the debtors’ financial but fewer assets than nonfilers — filers’ conditions while in bankruptcy affect SESSION 4: WHAT SHOULD median total debt is about $121,000, their outcomes under Chapter 13. The AND CAN BE DONE TO about 6.6 times the national median, authors perform some policy experi- ENHANCE BORROWERS’ while the median value of their total ments using their estimated model. KNOWLEDGE OF THEIR assets is about $103,000, less than half One of the provisions of the new law CREDIT RISK? the national median. The filers are prohibits debtors with income above “Targeting Foreclosure Inter- somewhat less likely to be unemployed the state median to file a plan with less ventions: An Analysis of Neighbor- than the average Delaware resident, than five years’ duration. Their model hood Characteristics Associated but their average monthly income is suggests that this provision will likely with High Foreclosure Rates in Two about 30 percent less than Delaware’s result in only a minimal increase in re- Minnesota Counties,” by Michael average adjusted gross income and covery rates for creditors but may lower Grover, Laura Smith, and Richard they experienced a significant decline the likelihood that filers emerge from Todd, examines the predictability of in income prior to filing. The median the bankruptcy process with a fresh outcome – in this case, the probability credit recovery rate under Chapter start and their cases discharged. that a mortgage moves into foreclosure 13 is quite low, about 12 percent of Katherine Porter of the Universi- – based on neighborhood characteris- total debt; the mean recovery rate is ty of Iowa College of Law discussed the tics. If one can predict which neighbor- about 28 percent; and a relatively small Danis and Pennington-Cross and the hoods are likely to have a high rate fraction of Chapter 13 filers are actu- Eraslan et al. papers. Two key ques- of foreclosure, programs designed to ally successful in getting their cases tions important to these papers are: help sustain homeownership could be discharged. Moreover, 20 percent of How do we define success in lending targeted to neighborhoods with the the debtors who want to file under markets, and what enables this suc- greatest need. Chapter 13 are never successful in get- cess? As Porter pointed out, the defi- The paper uses public data on ting their repayment plan approved by nition of success will likely differ for foreclosures in two counties in Minne- the bankruptcy court – and this was at creditors and for debtors. From a policy sota, Hennepin and Ramsey, in 2002.

42 Q1 2008 Business Review www.philadelphiafed.org (Minneapolis is located in Hennepin credit score is singly the most accurate suggestion is beyond the scope of the and St. Paul is located in Ramsey.) in identifying census tracts with the paper. Data on 1,178 foreclosed properties highest foreclosure rates, which is con- Several papers in this volume were used in the analysis. Street ad- sistent with the Danis and Penning- have found that a borrower’s credit risk dresses of the properties involved were ton-Cross findings, discussed above. score at origination is associated with matched to their census tract, so that In particular, the 1999 neighborhood mortgage outcome, with lower scores Census Bureau data from 1990 and credit score correctly ranks 36 of the associated with higher rates of delin- 2000 could be matched to the foreclo- 50 tracts with the highest foreclosure quency and default. An interesting sure data. Additional data on lender, rates and its correlation with the question is whether borrowers have an interest rates, and mortgage riders and foreclosure rate is 0.64. The authors accurate assessment of their own credit conditions were obtained from the also perform a multivariate analysis of score and whether the accuracy of property-records departments of the the association of foreclosure rate with their assessment varies with the level two counties. Census-tract level credit variables available in advance of or of their score. If higher risk borrowers score data were obtained from PCI concurrently with foreclosure. They have less accurate perceptions of their Corporation and CRA Whiz; HMDA estimate a logit model that predicts own credit risk, they may be more data were also used. The authors found the probability of foreclosure with likely to enter into loan contracts for that it was very difficult to determine census-level variables measuring credit which they are not well suited (if such from the mortgage documents whether risk, minority homeownership transi- contracts are offered to them), and this the loan was for home purchase or tion, and other demographic factors. could partly explain the higher rates of for refinancing, and it was sometimes Because foreclosure is a relatively rare foreclosure and delinquencies seen for difficult to determine the lender. The event, to accurately predict the prob- these borrowers. painstaking nature of the data collec- ability of foreclosure, one needs a large “Consumer Credit Literacy: tion limited the analysis to one year number of mortgaged units. Since What Price Perception?” by Marsha and two counties. In the authors’ data the number of mortgaged units varies Courchane, Adam Gailey, and Peter set, foreclosed mortgages are dispro- considerably over the census tracts in Zorn, tackles this interesting question. portionately of recent origin, with a the sample, the variance of prediction The authors use data provided to them median duration from origination to error might vary systematically with by prime and subprime lenders on 1.2 foreclosure sale of 2.6 years. Com- the number of mortgaged units in the million mortgage loans originated in pared to other mortgages originated census tract. To allow for this po- 2004 and from a consumer survey con- in the same neighborhood during the tential heteroscedasticity in the error ducted in 2000 by Freddie Mac. The same period, the foreclosed mortgages term, the authors estimate the logit loan data include variables collected tended to have higher interest rates regression using the minimum chi- under HMDA and loan-level variables and smaller loan amounts and were squared estimator. used in underwriting and pricing the more likely to have been originated This multivariate analysis loans, such as FICO score, loan-to- by a nonbank or subprime lender and indicates that the percentage of value ratio, and debt-to-income ratio. to have had another mortgage on the neighborhood adults with very low The survey includes information about property. Reflecting strong house credit scores and the change in consumers’ financial knowledge and price appreciation in the time period the share of minority homeowners credit outcomes such as whether they studied, the data also show that the between 1990 and 2000 (a measure have been denied credit, been evicted, sheriff’s sale typically brought in more of neighborhood transition) are the had utilities turned off, or property than the outstanding mortgage bal- strongest predictors of foreclosure repossessed. The survey also asked ance. Thus, had borrowers chosen to rate; both are positively associated respondents how they would rate their sell their homes before defaulting, they with foreclosure rate. Based on their current credit record. could have paid off their mortgages findings, the authors suggest that there The empirical results suggest and gotten some equity. It remains an may be social benefits from making that inaccurate self-assessment is not interesting research question as to why mortgage and foreclosure records and always associated with bad financial borrowers did not do this. credit scores by neighborhood more outcomes (which might include higher The authors’ analysis indicates readily available to the public and likelihood of being denied credit, being that of seven variables available in foreclosure mitigation practitioners, evicted, or declaring bankruptcy) and advance of foreclosure, neighborhood but a cost-benefit analysis of this that the direction of the inaccuracy

www.philadelphiafed.org Business Review Q1 2008 43 matters. The authors use locally with lower values of the alternative tors that disrupt income flows or lead weighted polynomial regressions to credit score (that is, higher risk). to unexpected expenses might lead examine the relationship between the The authors interpret the results to foreclosure. A trigger event might percent of respondents experiencing a of their research as supporting the also be a factor that could affect the bad financial outcome and credit-risk value of financial literacy programs to accuracy of a borrower’s assessment score as measured by FICO score, with the extent that these programs help of his or her own credit risk. Canner separate analyses for respondents that educate consumers about not only discussed other factors that could af- correctly assessed their credit score their credit scores but also a broader fect self-assessment accuracy, including and for those who did not. They also set of factors that are important for expectations about one’s job prospects use probit regressions to investigate assessing their credit risk. An alterna- and future income, financial literacy, this relationship when controlling for tive interpretation, which differs from experience in obtaining credit, the rea- other factors, including income and the authors’, is that consumers do not son a payment was missed (a one-time net worth. Both analyses indicate that need (or no longer need) these pro- event or a more habitual problem), and consumers who assess their credit score grams, as they appear to be accurate in changes in one’s credit score over time. to be lower than it actually is (that assessing their credit risk. Charles Plosser, president of the is, are pessimistic about their credit In his discussion, Glenn Canner Federal Reserve Bank of Philadelphia, record) are more likely to experience a of the Federal Reserve Board staff opened the second day of the confer- bad financial outcome than those who noted that concerns about foreclo- ence by discussing the theme that accurately assess their credit score, but sures have increased over time as the brought together the diverse group of consumers who assess their credit score credit-quality of the borrower pool has individuals, including government poli- to be higher than it actually is (that is, widened, new types of mortgages have cymakers, academic researchers, com- are optimistic) are less likely to have emerged, short-term interest rates have munity leaders, consumer advocates, bad financial outcomes than those risen, and house prices have flattened and financial service providers. The who correctly assess their score. or begun to fall. He agreed that it was theme he discussed was that to ensure One possible explanation is that important to try to identify leading opportunity for the economically there is reverse causality in the survey indicators of neighborhood foreclosure distressed and to promote economic data. That is, a bad financial outcome sales, given the adverse effects foreclo- development, we must be guided by might have caused the accuracy of the sures can have on individuals and their accurate information, careful research, self-assessment of credit score rather neighborhoods. and sound policy analysis. than the other way around. However, Canner discussed two theories In Plosser’s view, “public policy in a separate analysis that helps to of default. The trigger-events theory driven by headlines rarely turns out address this potential reverse causal- suggests that borrowers may default to be good policy” and research can ity, the authors still find that optimism when certain life-events – for example, now make a greater contribution to is associated with better financial medical problems, divorce, job loss – economic development efforts than outcomes. The authors next explore disrupt their ability or willingness to it could in the past because develop- an alternative explanation — that pay. The options theory suggests that ment efforts have been more diverse consumers are actually more accurate when a borrower takes out a mortgage and more local in nature. The efficacy in their assessments of their credit risk it is like having a put option on the of these various programs cannot be than their FICO scores reflect. Using value of the home – the borrower will discerned without the proper research. their loan and survey data, the authors choose to default when the mortgage Plosser discussed the importance of construct an alternative credit score balance exceeds the value of his or her development strategies that work with and find some support for this alterna- home. These two theories can suggest the marketplace as it tries to be more tive hypothesis: a regression of this alternative factors that Grover et al. responsive to the needs of lower-in- alternative credit score on FICO score may want to incorporate into their come households and cautions against and accuracy of self-assessment (that study of predicting foreclosures. The the law of unintended consequences is, optimism and pessimism) indicates options theory suggests that areas with that might arise if policymakers try to that holding FICO score constant, op- falling home prices or where borrow- manipulate economic outcomes. Poli- timism is associated with higher values ers have little or negative equity might cies are likely to always have some sur- of the alternative credit score (that is, show higher rates of foreclosure. The prising effects, but careful analysis of lower risk) and pessimism is associated trigger-event theory suggests that fac- proposed policies and careful monitor-

44 Q1 2008 Business Review www.philadelphiafed.org ing of implemented policies can help the relationship between wealth and the owners prior to self-employment keep such surprises to a minimum. access to financial capital over the life – the authors find that lower levels of the business. of assets among African Americans SESSION 5: DOES THE FINANC- The authors use data from several account for 15.5 percent of the differ- ING OF SMALL BUSINESSES sources, including the Census Bureau’s ence in the probability of becoming DIFFER FOR MINORITY- Characteristics of Business Owners self-employed between whites and OWNED BUSINESSES AND FOR Survey, the 1998 Survey of Small Busi- African Americans. However, a related BUSINESSES IN LOW-INCOME ness Finances, the Survey of Minority- question is whether African Ameri- AREAS? Owned Businesses, the Survey of cans are less able to raise external The last two sessions of the Business Owners, and the Current funds to start their businesses than conference turned from mortgages to Population Survey, with sample-size are whites and are thereby hampered other aspects of community lending and development. “Tracing Access to Financial Capital Among African- To ensure opportunity for the economically Americans from the Entrepreneurial Venture to the Established Busi- distressed and to promote economic ness,” by Alicia Robb and Robert development, we must be guided by accurate Fairlie, empirically investigates the information, careful research, and sound relationship between wealth, access to financial capital, and the outcomes policy analysis. from African American-owned businesses from the start-up stage through maturity. Business ownership rates for varying over the surveys and years. by undercapitalized businesses to African Americans are considerably For example, the 1998 Survey of Small start with. The authors provide some lower than those for whites. Accord- Business Finances includes about evidence consistent with this: The ing to the 2000 census data, nearly 11 3500 businesses that were not equally Characteristics of Business Owner data percent of white workers are self- owned by a minority and nonminority; indicate that African American-owned employed business owners, while less the 1997 Survey of Minority-Owned businesses have lower levels of start-up than 5 percent of African-American Business Enterprises includes over 15 capital compared to white-owned busi- workers are. In addition, African million white-owned firms and over nesses. Less than 2 percent of African American-owned businesses appear 750,000 African American-owned American-owned businesses start with to be less successful on average than firms. All the data sets confirm that $100,000 or more in capital, compared those owned by whites or Asians, with African American-owned businesses with nearly 5 percent of white-owned lower profits and higher closure rates. underperform white-owned businesses businesses, and 6.5 percent of African Understanding the sources of such and tend to be smaller in terms of sales American-owned businesses start disparities is an important step toward and employment. with $25,000 to $100,000 in capital, determining whether entrepreneurship Research on entrepreneurship compared with about 11 percent of is an effective way out of poverty for indicates that personal wealth is an white-owned businesses. The empiri- minorities. The research can also help important determinant of self-employ- cal results also show that lower start-up in determining whether government ment. The differences in net worth capital accounts for 14.5 percent of the programs offering loans to minority- between whites and African Ameri- difference in profitability of white- owned businesses can be made more cans are large: The median net worth owned and African American-owned effective or whether a new approach is of whites, at $67,000, is more than 10 businesses. However, as the authors needed. While previous studies have times the median net worth of African discuss, the amount of start-up capital found that the poorer performance of Americans, at under $6,200. Results available for investment in new busi- African American-owned businesses using the Current Population Survey nesses may be related to the predicted relative to white-owned businesses data from 1998 to 2003 indicate that performance of the business. That is, stems from low levels of start-up capi- the largest single factor explaining it could be that African American- tal, education, and business experi- racial disparities in business creation owned businesses have lower start-up ence, these studies did not trace out rates are differences in asset levels of capital because investors perceive that

www.philadelphiafed.org Business Review Q1 2008 45 their probability of success is lower. Or businesses with which to assess their a low- and moderate- vs. middle- and they could have less access to capital creditworthiness. The inability to high-income census tract or a pre- because they have less personal wealth distinguish low-credit-risk small firms dominantly minority vs. nonminority to borrow against. from high-credit-risk small firms can census tract. The authors show that some result in the rationing of credit to all The univariate analysis looks differences in racial borrowing pat- small firms. Banks, in particular local at borrower-lender distance by type terns persist even as the businesses banks, can help eliminate some of of census tract over time. Their mature. Data from the Survey of these information problems through multivariate ordinary least squares Small Business Finances indicate that repeated interactions with the firm. To regression analysis (which includes African American-owned businesses the extent that minority and low- to loans originated in the period January are less likely to have an outstand- moderate-income neighborhoods have 1992-April 2001) relates distance to ing loan or credit line and more likely less access to local financial services, indicators of whether the borrower is to have borrowed on a credit card they are potentially put at an even located in a low- and moderate-income than white-owned businesses, but the greater disadvantage at overcoming area, whether the borrower is located African American-owned firms also the imperfect information problems in a minority area, a linear time trend, have worse credit histories than white- and gaining access to credit. However, interactions between type of census owned businesses, including higher the advent of new technologies, such tract and the time trend, and a set rates of delinquency and bankruptcy. as credit scoring models for small busi- of variables to control for borrower, The authors estimated a multivariate nesses, can help alleviate the problem lender, and loan characteristics at the logistic equation and found that once of lack of proximate financial services time of loan origination. credit history is controlled for, the dif- by giving lenders not necessarily physi- The analyses indicate that dur- ference in the probability of having an cally located in the local neighborhood ing the 1980s and most of the 1990s, outstanding loan is not statistically sig- the ability to distinguish more cred- borrower-lender distances tended to nificant. However, African American itworthy firms from less creditworthy be stable and shorter, on average, for owners are more likely to have been firms. These new technologies can small businesses in low and moderate- denied credit and to have borrowed on substitute for the local bank-borrower income areas and in predominately their credit card than white owners, relationship in alleviating imperfect minority areas than for those in even controlling for credit history. information impediments to lend- middle- and upper-income areas and The causes of the differences in credit ing. Indeed, several previous studies nonminority areas, respectively. By experiences of white and African have found an increase in the distance the late 1990s, however, all borrower- American business owners, the effects between U.S. small business borrowers lender distances had increased, but these differences might have on busi- and their bank lenders in recent years. those for small businesses in low- and ness outcomes, and the direction of The authors extend the previ- moderate-income areas and in predom- causality (does limited access to credit ous literature by examining changes inately minority areas had increased cause poor performance or does poor in borrower-bank lender distance more, so that the borrower-lender dis- performance lead to limited access to for low- and moderate-income areas tances are now longer for firms located credit?) are potentially fruitful avenues and predominately (that is, over 50 in these areas compared to firms in to pursue in future research. percent) minority areas. Their data middle- and upper-income areas and Indeed, “Commercial Lending are a random sample of over 27,000 nonminority areas, respectively. The Distance and Historically Under- small business loans originated by timing is consistent with the introduc- served Areas,” by Robert DeYoung, U.S. commercial banks under the U.S. tion of automated small-business credit Scott Frame, Dennis Glennon, Small Business Administration loan scoring models, and smaller loans Daniel McMillen, and Peter Nigro, program from January 1984 to April in the sample (to which these credit addresses the topic of access to credit 2001 with term-to-maturity of three, scoring models are most often applied) by small businesses located in minor- seven, and 15 years. The data include seem to be driving the results. While ity and low- and moderate-income locations for both borrower and lender, these results are suggestive, the authors neighborhoods, which have typically so the authors computed as-the-crow- cannot directly test the hypothesis been underserved by financial ser- flies distances for each pair. They then that the introduction of small-business vices. There is generally little publicly used mapping software to determine credit scoring models has allowed for available information about small whether the borrower was located in increased distance between borrower

46 Q1 2008 Business Review www.philadelphiafed.org and lender. A definitive test is an countries, there is a strong significant session, which focused on two particu- interesting topic for future research. positive relationship between the ratio lar products: payday lending and pre- In discussing the DeYoung et al. of aggregate private credit to GDP (a paid cards. As discussed in “Strategic paper, Leora Klapper of the World measure of financial development) and Pricing of Payday Loans: Evidence Bank said that two types of credit entry rates of new businesses. However, from Colorado, 2000-2005,” by Rob- scoring models are currently being empirically it is difficult to separate ert DeYoung and Ronnie Phillips, used for small-business lending. The out the effects of personal wealth and payday lending has arguably extended most common produces the personal credit history from access to capital to credit availability to more households, credit score of the business owner, determine their independent effects. but at what price? In a typical payday which measures the probability that Klapper cited some previous literature lending transaction, a customer the owner will default and is based that looked at the effect of windfall receives a specified amount of cash in on data on the owner, including the gains on entrepreneurship as a way of return for a personal check written to owner’s credit history and indebted- isolating the effect of access to capital the lender for that amount plus a fee; ness. The other model, which is growing in usage, produces a business survival score, which measures the As the financial system moves to more probability of business failure and is quantitative underwriting models, are owners based on data on the business or business’s industry, including information with limited credit histories able to obtain as on management quality and industry much credit as they did under more qualitative risk. A business survival score can be derived when owners don’t have much relationship lending by a loan officer? personal credit history, and such models are becoming increasingly used in on the self-employment decision. For the lender holds this check for a speci- emerging markets like India that don’t example, Lindh and Ohlsson (1996) fied short period, often two weeks or have credit bureaus collecting data on found that winners of the Swedish lot- less. At the end of the holding period, personal credit histories. tery are more likely to enter self-em- the transaction can be terminated by Klapper suggested that more re- ployment and remain successfully self- the lender’s depositing the check or search needs to be done to determine employed, controlling for other factors the customer can pay another fee to whether the credit scoring models are like demographics and inheritances. roll over the loan. Critics of payday actually increasing access to credit in This evidence is consistent with access lending say it is credit offered at exorbi- low-income neighborhoods. Can these to credit being an important determi- tant prices — triple-digit APRs are models substitute for bank branches in nant of entrepreneurship. not uncommon — and marketed to delivering credit to the smallest busi- Klapper suggested that as credit unsophisticated borrowers. Others say nesses? As the financial system moves scoring becomes more important in such lending fills a need for immediate, to more quantitative underwriting the delivery of financial services and short-term credit. Why borrowers use models, are owners with limited credit credit to small businesses, helping payday loans rather than alternative histories able to obtain as much credit those in low-income and minority forms of credit is not fully understood. as they did under more qualitative neighborhoods to understand their Surveys show, for example, that the relationship lending by a loan officer? credit scores and learn ways to improve typical payday loan customer has a job As Klapper pointed out, access them will likely become more impor- and a bank account, and half have a to credit by African American busi- tant in expanding their economic credit card. ness owners was a main theme in the opportunities. The paper investigates the pricing paper by Robb and Fairlie. There is a patterns of payday lenders in Colo- growing international literature that SESSION 6: CAN ALTERNATIVE rado and concludes that these lenders links access to financial services and FINANCIAL SERVICES behave strategically when setting their entrepreneurship. Aggregate level data PRODUCTS HELP THE terms and fees. The authors’ analysis show a relationship between economic UNDERBANKED? is based on information on nearly growth and access to capital. Klap- The theme of access to financial 25,000 payday loans made in Colorado per showed that based on data on 90 services was also taken up in the last between June 2000 and August 2005.

www.philadelphiafed.org Business Review Q1 2008 47 These loans were made after legislation temporal pricing strategy might be less or by phone wherever the network was passed that limited loan principal profitable for lenders in more competi- brand is accepted. to $500 for a term of 40 days or less, tive markets, since they face a higher The study uses transactions and limited the finance charge to a maxi- probability of losing their customers to cardholder demographic data from four mum of 20 percent of loan principal competitors before being able to make general spending prepaid card provid- up to $300 and to 7.5 percent above up for the low initial price. Perhaps ers – a random sample of 500 card- $300, and permitted only one renewal more surprisingly, the authors also find holders was drawn from each of the of the loan. The average APR on the that payday loan prices are higher in four firms, resulting in a sample of over loans is nearly 460 percent, and nearly markets with more commercial bank 1900 active cardholders. Transactions 90 percent of the loans carried the branches. This suggests that commer- for each cardholder were tracked over maximum charge allowed by Colorado cial bank products are not a substi- a 12-month period during 2005-2006. law. Because payday loan prices are tute for payday loans. Indeed, to the These data were augmented with in- constrained by the law, the authors extent that borrowers need a checking formation obtained during discussions use Tobit regressions to investigate the account to take out a payday loan, with other industry providers. The relationship between pricing, competi- commercial banking services serve as a analysis suggests that many providers tion in the market, and demographic complement to payday lending. are marketing their cards to under- characteristics of the geographic mar- While payday loans offer an alter- banked customers, a potentially sizable ket (ZIP code area) in which the loans native to other forms of credit, prepaid market. Most cardholders spend are made. Since payday lenders appear cards offer an alternative to other nearly all of the funds loaded onto in less than a quarter of the ZIP code forms of payment. “Cardholder Use their cards each month – they are not areas in Colorado and this locational of General Spending Prepaid Cards: using the cards as a store of value but choice of the lenders might be related A Closer Look at the Market,” by as a transactions method. They use to the factors included in the Tobit Sherry Rhine, Katy Jacob, Yazmin the cards mainly for point-of-sale pur- regression (for example, the income in Osaki, and Jennifer Tescher, studies chases and not to withdraw cash from the market), there is a potential sample the current and potential use of this an ATM, suggesting that the cards selection bias; that is, the sample may rapidly growing payment instrument. may be acting as a substitute for cash. not be randomly selected. The authors Traditional gift cards are typically The analysis indicates that the average correct for this using the standard two- used to make small-dollar transactions cardholder loads funds onto his card stage Heckman procedure. with specific retailers. In contrast, once a month and the average amount The analysis indicates that over general spending prepaid cards can loaded is $217. The average cardholder time, payday loan prices in Colorado hold considerable value and can be makes 3.5 point-of-sale transactions have drifted to the state-legislated used to make payments at a variety of per month, each averaging a little less price ceiling, and that this occurred establishments. For example, a firm than $40. And he withdraws funds more quickly in markets with more may offer payroll cards to its employ- from an ATM less than once a month, payday lenders where explicit collusion ees through which the firm will pay with the average amount of withdrawal was more difficult. Thus, the legislated employees their wages in lieu of direct a little more than $40. The authors’ price ceiling seems to have behaved deposit into checking accounts, which study is one of the first to document as a focal point and may have had an some employees may not have. Prepaid the usage of these types of cards. They unintended effect of facilitating im- cards have also been used to distribute suggest that one avenue for future plicit collusion. The authors’ empirical payments after natural disasters. As research is to augment their data with results also suggest that lenders take the authors explain, network-branded information from consumers about advantage of borrower switching costs general spending reloadable cards offer their motivations for using such cards. by offering lower prices on initial loans functions similar to traditional credit Victor Stango of Dartmouth than on refinanced loans (although and debit cards. Their transactions College discussed the two papers on the difference is small). Lenders that are processed using the same systems alternative financial services. As he face fewer competitors appear better as these network brands (MasterCard, pointed out, there are clearly new able to exploit relationships in this Visa, American Express, or Discover) alternatives available to the under- way; that is, they charged an even and the cards can be used to withdraw banked, but given the high cost of lower initial price than did lenders funds from ATMs, to make retail pur- these alternatives, the question is facing more competition. This inter- chases, or to pay bills in person, online, whether they are beneficial to their

48 Q1 2008 Business Review www.philadelphiafed.org users. The DeYoung and Phillips access to credit, and increase the rural areas and in disaster areas. paper discusses the high cost of payday information available to assess lending Chairman Bernanke said that the lending. Stango indicated that the patterns. The banking industry has CRA will have to continue to evolve cost of prepaid cards is also very high. undergone significant changes since to reflect changes in financial markets He estimated, based on the data in the then, with interstate banking and and in the economy. He concluded his Rhine, et al. paper, that the average branching, industry consolidation, the talk by pointing out some of the chal- cardholder has a monthly balance of rise of the secondary mortgage market, lenges that lay ahead. First, defining between $100 and $200 and pays about and securitization. Banks have gained “local community” is becoming more $20 in fees per month. Stango posed experience in underwriting loans in difficult as institutions become more some questions for future research: lower-income neighborhoods. Chair- national in scope and with the advent Why do people use these alternative man Bernanke cited a Federal Reserve of nontraditional delivery mechanisms financial services given their high cost? Do consumers have sufficient information to make informed usage decisions? The CRA affirmed the obligation of federally Are the markets for these alternatives operating as one might expect a com- insured depository institutions, which benefit petitive market to operate? from access to the financial safety net, to help The conference concluded with meet the credit needs of their communities, in Federal Reserve Chairman Ben Bernanke speaking on the Commu- a safe and sound manner. nity Reinvestment Act (CRA). As the Chairman explained, the CRA affirmed the obligation of federally study that indicated that in general, like the Internet. Second, nonbank insured depository institutions, which CRA-related mortgage lending was at institutions are becoming more impor- benefit from access to the financial least somewhat profitable and usu- tant providers of financial services to safety net, including federal deposit ally did not involve disproportionately lower-income communities. But these insurance and the Federal Reserve’s higher default rates than non-CRA institutions are not subject to CRA. discount window, to help meet the mortgage lending (Avery, Bostic, and Third, access to credit in lower-income credit needs of their communities, in Canner, 2000). communities has increased, but more a safe and sound manner. But over In 1995, the CRA regulations lending does not necessarily imply bet- the 30 years since it was enacted, the were amended to emphasize ter outcomes. Distinguishing beneficial CRA has evolved with the financial performance over process and to from harmful lending poses a chal- services industry. When the CRA lessen the compliance burden. Large lenge for regulators as they seek to en- was passed in 1977, many felt that institutions’ compliance with CRA sure that the CRA continues to assist poor conditions in American cities, would be judged based on their community economic development. and in particular in lower-income and performance with respect to lending, The presentations and discussion minority neighborhoods, were partly investments, and services, and small at the 2007 Federal Reserve System caused by limited credit availability. banks would be allowed to meet Community Affairs Research Confer- As Chairman Bernanke explained, the their requirements via a streamlined ence help illuminate several aspects of CRA and other legislation passed in examination that focuses on lending community reinvestment and devel- the 1970s, including the Equal Credit activities. In 2005, further refinements opment finance. They also suggest Opportunity Act, the Fair Housing were made, including expanding the that much remains to be learned. It is Act, and the Home Mortgage Dis- definition of community development hoped that this conference will inspire closure Act, were intended to reduce to cover activities that benefit middle- further rigorous research in this area. BR credit-related discrimination, expand income communities in distressed

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