Predictably, adjustable rate mortgages had a higher rate of default than non-adjustable rate mortgages, given the increase in interest rates in the years before the crisis, after many borrowers took out loans during an era of unusually low, near-zero rates. But another puzzling finding was that loans below $100, 000 and loan amounts in the $250,000 to half-million range had higher interest rates than loans of a half-million and above, once again suggesting that while middle-income individuals who might otherwise appear to be 'good' risks had been targeted for loans that were not advantageous to them.
"The finding that blacks and Latinos tended to borrow more helps explain why they received a disproportionately high share of high-cost loans, but the larger amounts borrowed by Asians contradicts the hypothesis that loan amount explains the rate spread differentials the best predictor that a borrower would default is the amount borrowed" as Asians tended to borrow more than either group, but had a lower rate of default (Doviak & MacDonald 2011: 20). Other suggestions of impropriety upon the part of lenders are manifest in the fact that the interest rate on a loan originated to a black borrower was as much as 1.36 percentage points higher than a the interest rate originated to an equivalent white borrower and 0.92 percentage points for a Latino (Doviak & MacDonald 2011: 26).
Adverse selection, simply stated is the idea that market imperfections -- discrimination, lack of alternatives, etc. -- may cause individuals to make economic decisions they might not otherwise decide upon. In this instance, the statistical evidence seems clear that lenders encouraged low-risk borrowers to take subprime loans for discriminatory reasons. The reasons for this are not immediately clear...
But it is possible to speculate why this might be the case. Because of discrimination in the housing market in the past, members of historically discriminated-against groups often do not have a long-standing tradition within their families of home ownership and thus may not be familiar with the nature of what constitutes a favorable loan for a home. The determination to 'milk' the housing boom by encouraging individuals to take out mortgages on 'more home than they could afford' caused lenders to engage in unjust practices that ultimately hurt themselves in the long run as well as borrowers. "the default that progresses to foreclosure reduces the value of a lender's portfolio of home mortgages" (Doviak & MacDonald 2011: 26).
The solution to the problem delineated in the article seems clear: greater transparency and better education of borrowers. For many borrowers, finding a home they can afford and calculating how high a mortgage payment they can reasonably pay, as well as understand the different types of mortgages, can be a complicated process. Rather than seeking to help borrowers navigate unfamiliar financial territory, banks made borrowers subject to undue pressure to act against their financial interest.
Greater regulation also seems required of banks in the future. Banks must it clear to borrowers, in unambiguous language, the terms of their agreement. To deal with the current situation, the authors suggest a shift from adjustable rate mortgages to fixed rate mortgages for individuals currently in foreclosure, to help borrowers remain in their houses. This is in the best interest of society as well as the long-term financial interests of banks. The evidence presented in the article makes a compelling argument that borrowers are not…
