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may foster misunderstandings, miscommunication, and mistrust. In addition, perceptions of the expected behavior of a group of people may subtly affect the way in which information is evaluated or a particular loan is processed.

*Perceptions influence lenders' judgements.

Deals they would otherwise make aren't done due to these perceptions."

-Detroit lender

Based on comments made in the focus groups, attitudes do appear to exist within the lending community that have the effect of disadvantaging some potential minority borrowers and advantaging others. It

is clear that some, though not all lenders hold definite and preconceived views about the expected behavior of people from different racial and ethnic groups. For example, some characterized Asians as hardworking people who save their money; Hispanics as less likely to default on a loan because of close family ties and the importance of the home in their culture; and blacks, regardless of income, as having a higher incidence of credit problems. When asked to differentiate between black and white neighborhoods that looked similar based upon location, age of the housing stock, and income of the residents, some lenders fell back upon phrases like differences in "pride of ownership" and 'homeowner mentality."

It is possible that such cultural sterotypes affect lenders assessments of individual borrowers, with presumptions about the group inappropriately applied to the individual applicant on either a deliberate or unconscious basis. Lenders' characterizations of different racial and ethnic groups suggest that prospective borrowers who are black may face the most difficulty in obtaining financing, a conclusion which is at least consistent with available data. In several cities with significant black and Hispanic populations, loan activity was highest in non-minority neighborhoods, next highest in Hispanic neighborhoods, and lowest in black neighborhoods.

It is also possible that minority borrowers are disproportionately affected by the challenges that lenders face in making community loans. Much of the discussion exploring racial differences in lending patterns ultimately focused on these challenges, which relate to a host of institutional, market, and economic factors that make it more difficult for some low and moderate income borrowers to obtain a mortgage. The remainder of this report examines these factors in more detail and identifies ways that the secondary market could better facilitate community lending activities. To the extent that minorities are more likely to be affected by the challenges posed by community lending, initiatives on the part of the secondary market could help to reduce any racial differentials that may exist regarding the availability of mortgage credit to qualified borrowers.

THE CHALLENGES OF COMMUNITY LENDING

In discussing the challenges of community lending, lenders generally distinguished between two types of loans:

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investment quality loans which, despite being sound loans, are more difficult to process and less profitable to mortgage originators and secondary market institutions; and

higher risk loans which, in addition to greater processing costs, have higher default costs and require special underwriting criteria, borrower education, and in some instances, public subsidies.

While many lenders acknowledged that it is often difficult to distinguish between these two types of mortgages arguing that relatively little is known about the performance of community loans at the national level lenders generally believed that both types of lending activity are required in order to meet established CRA objectives. The special requirements associated with each type of loan are summarized in Exhibit 3.

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Exhibit 3

Two Types of Community Loans

INVESTMENT QUALITY LOANS are sound loans but are less profitable to
originate and service. They require:

One of the most consistent themes of the focus groups was the sense that most community loans are not 'plain vanilla" mortgages. Lenders use this term to depict a mortgage that easily meets the standard underwriting guidelines created by secondary market institutions to represent a typical "investment quality* loan. Such guidelines serve to identify a number of key elements relating to the borrower's willingness and ability to repay the debt, as well as the property's ability to cover the loss in the event that the borrower defaults.

Lenders generally felt that secondary market underwriting guidelines are good national standards that are easy to apply to middle income borrowers and neighborhoods, but provide challenges for community lending. While underwriting standards are meant to be guidelines as opposed to absolute rules, many lenders believed that the secondary market's guidelines create a mindset that a borrower, property, and neighborhood must meet a particular set of criteria in order to constitute an acceptable risk.

Lenders pointed out a variety of factors that tend to make community loans different from other mortgages. While these characteristics are described in detail below, they encompass a range of issues related to the borrower, the property, and the neighborhood. Lenders must weigh deviations from standard guidelines with a great amount of care in order to assess the extent to which 'compensating factors serve to offset any increased risk. As a result, community loans tend to require a greater knowledge of local markets and more flexibility, judgment and expertise in applying underwriting guidelines.

Such characteristics tend to make community lending less profitable to mortgage originators. In general, community loans are more time-consuming to process, require greater sophistication on the part of the underwriter, and as a result, are more expensive to originate. At the same time, origination fees are lower since they are based on lower mortgage amounts. These factors combine

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to make community lending less lucrative to mortgage lenders, regardless of the risk. In addition, the compensation of loan officers is typically tied to the dollar volume of mortgage originations, a structure that tends to reinforce any underlying bias towards larger and more easily processed loans.

Lenders also indicated that community loans are more likely to result in additional costs even after being sold to secondary market institutions, an outcome which may limit the volume of loans that can be originated. While neither Fannie Mae nor Freddie Mac underwrites individual loans in advance of their purchase, each organization subjects a certain proportion of its purchases to a post-purchase quality control audit. In the event that this audit uncovers significant deviations from established underwriting guidelines which cannot be resolved, the lender will be required to repurchase the loan. This can be a major issue for lenders who do not otherwise hold loans in portfolio and for smaller institutions for whom repurchase of even a single loan can cause serious problems.

Because sound community loans often do not look like "standard" mortgages and because mortgages with 95 percent loan-to-value ratios (LTVs) are audited more frequently -- lenders believe that the risk of repurchase is significantly higher for these mortgages. As a result, many lenders tend to hold them in portfolio to avoid the extra costs incurred with the auditing process and the potential cost of repurchase, as well as the perceived damage to their overall standing with the secondary market entity if there are a large proportion of repurchases. Lenders not in a position to portfolio loans may be discouraged from making them altogether. While lenders acknowledged the need for a 'national standard" to be used by the secondary market, they perceived such standards as encouraging a "cookie cutter" or "matrix" style of underwriting that is detrimental to community lending. They also indicated that less favorable pricing of 95 percent LTV mortgages by the secondary market further discourages them from making or selling community loans.

Higher Risk Loans

The above comments refer to loans which lenders believe to be "investment quality. However, lenders also believe that some community loans do in fact involve a greater amount of risk. Since lenders are also under severe pressure to assure federal regulators that their institutions are and will continue to be financially sound, they firmly believe that a cooperative public/private initiative at both the national and local levels is needed to appropriately respond to the needs of less qualified borrowers and fairly share the risk.

Higher risk community loans have all of the disadvantages associated with investment quality community loans, but to an even greater degree. In addition to these factors which again lead to considerably higher processing costs -- higher risk mortgages typically involve significant deviations in key underwriting guidelines such as lower downpayment requirements or significantly higher housing costs in relationship to borrower income. In order to offset their increased risks and greater default costs, lenders believe that such mortgages should be handled through special programs involving borrower education, public subsidies, and sharing of the mortgage risk.

The Secondary Market

The special characteristics of community loans also pose major challenges for the secondary market. Just as lenders feel caught between demands for increased financial stability and increased CRA lending, the tension between risk management and proactive community lending is no less pronounced for secondary market institutions. Indeed, given the national scope of the secondary market -- and the greater distance that this imposes between the "risk bearer and the actual loan -this tension may be more profound.

In addition, the unique features of many community loans discourage volume processing, leading to a higher processing cost per loan on the part of the secondary market entity. Furthermore, the smaller average size of such loans results in less revenue per loan, also shrinking the return to the investor. While a customized approach may be required to adequately address community lending needs, such customization is costly to implement. In the view of most lenders, without a detailed

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knowledge of the local community, its people, and its housing market, the secondary market cannot always assess the underlying riskiness of community loans.

The potential impact of secondary market institutions is also affected by the policies and practices of other actors in the lending community. For example, mortgage loans with a loan-to-value ratio greater than 80 percent must also have credit enhancement most commonly, mortgage insurance. In some instances lenders indicated that the criteria established by private mortgage insurers were more stringent than those imposed by Freddie Mac or Fannie Mae. Underwriting standards adopted by mortgage wholesalers also play a role, particularly for smaller lenders who frequently sell through an intermediary.

RECOMMENDATIONS FOR THE SECONDARY MARKET

Despite these factors that affect secondary market investment -- higher processing costs, lower revenues, stiffer underwriting criteria of mortgage insurers and wholesalers -- the majority of lenders in the focus groups believed that the secondary market can and should do more to actively encourage community lending. Such activities, in turn, could conceivably reduce the racial and ethnic disparities in lending patterns that have been found in many communities. In general, lenders' recommendations fell into four broad categories reflecting a need for:

increased awareness of the challenges of underwriting community loans,

special programs to accommodate higher risk loans,

closer communications with the lending community, and

a more active leadership role.

The remainder of this paper discusses these recommendations in more detail.

Special Underwriting Issues

In general, lenders indicated that secondary market underwriting guidelines are good national standards and generally did not believe that they should be modified. Rather, they urged increased flexibility in administering the guidelines. Lenders believe that lending in general, and community lending in particular, involves making very specific judgments based on very individual circumstances. For this reason, they feel that one must look at the "total picture" rather than each criterion in isolation. Lenders perceive the secondary market's underwriting process as a "cookie cutter' process which focuses on discrete elements rather than the whole. Although written guidelines consistently state that lenders can and should be flexible, very few lenders perceive that this flexibility actually exists.

Someday someone is going to do a study
that shows that many low income people
pay their bills better than the rest of us.
St. Louis lender

Lenders also noted that the lending community in general has limited experience with the actual performance of loans that fit into the community lending category, and suggested that some of the long-standing underwriting rules may apply differently in

these circumstances. For a variety of reasons, a low or moderate income homeowner may look at their home and neighborhood in a different light than typical underwriting standards would suggest, and may be less likely to "walk away" in the face of declining property values as long as the payment remains affordable. Most lenders believe that existing guidelines do not adequately capture the housing options or probable behavior of many low or moderate income borrowers.

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include:

Areas identified by lenders that reflect the special challenges of underwriting community loans

Documentation,
Downpayments,

Income ratios,

Employment history,

Credit, and

Property and neighborhood issues.

Each is described in detail below.

Documentation. Lenders indicated that documentation is often difficult and time consuming for community loans, and stressed issues surrounding downpayment requirements and credit history. For example, some low and moderate income borrowers have a long-standing distrust of financial institutions and prefer to keep their savings at home. In some cultures, extended families pool their money. Both of these circumstances make it difficult to document assets and the source of the borrower's downpayment.

Similarly, past credit history serves as the principle method for determining a borrower's creditworthiness. Lenders expressed the belief that secondary market underwriters are as likely to be concerned about a loan if the borrower has no credit as they are about a borrower who has poor credit, even though our conversations with secondary market underwriters and review of published guidelines indicated that this was not the case. Underwriting guidelines generally allow good performance on previous rent payments and utility bills to be used to establish a credit history, but the processing forms may inadvertently undermine their use. This may have an adverse impact on certain low and moderate income minority borrowers who tend to pay with cash.

Downpayments. Low and moderate income families find it very difficult to accumulate savings. The small amount they are able to save often has to be used for emergencies that inevitably arise. Unless they receive assistance (e.g., grant, "soft loan" from the public sector or gift from a relative) many families will never be able to set aside the money for a downpayment or the two month reserve requirement.

Lenders generally agreed that "equity" in the property is critical to motivating the borrower to meet his or her financial obligations during difficult times. However, many suggested that what constitutes adequate equity for low and moderate income borrowers may be different from the standard 5-10 percent downpayment from borrower funds. For example, a low and moderate income borrower who scrimps to save $2,000 (4 percent of a $50,000 home purchase) may feel more "invested" than a higher income borrower paying a downpayment of a significantly higher percentage. While no lenders recommended a loan-to-value ratio of higher than 95 percent, many suggested that there could be some flexibility regarding the source of downpayment, especially in the context of a counseling program or a risk-sharing partnership.

Income Ratios. Secondary market guidelines generally establish two important constraints on the amount of mortgage payments that the borrower can support. The first such constraint commonly known as the "front-end" ratio generally limits the borrower's housing expenditures (including mortgage payments, hazard and mortgage insurance, and property taxes) to 25-28 percent of income. The second constraint the so-called 'back-end ratio" -- limits housing expenditures plus all other on-going obligations, including alimony, child support and other debt payments, to 33-36 percent of income.

Low and moderate income borrowers frequently spend a much larger share of their income on rent. Indeed, for some families, the monthly cost to own may be no more than and sometimes, well below what they currently pay for rent. Some lenders indicated that successful payment of rent at these levels suggests that the borrowers would be good risks, even though the front-end ratio