Loan Performance and Race

R. CARTER HILL [*] Recent studies find evidence of racial discrimination in mortgage markets. Although these studies explore loan approval rates for whites versus minorities, they do not specifically consider loan performance, either in the form of default rates or loan administration costs. This study considers discrimination in the used car credit market, where the collateral is not subject to location externalities, collateral value and quality do not vary as much as in real estate, and the loan terms are shorter. We find administration costs and default rates are higher for minorities than for whites, controlling for age, income, home ownership, wealth, occupation, loan terms, and geographic location. (JEL K2) I. INTRODUCTION Credit discrimination occurs whenever minorities are denied credit on the basis of race or are offered loans at terms different than the terms offered similarly situated whites. [1] Economists identify two types of discrimination: preference (taste)-based discrimination and information (statistical)-based discrimination. [2] The legal definition of discrimination makes no such distinction. In their statistical studies, Munnell, Brown, McEneaney, and Tootell [1996], Carr and Megbolugbe [1994], and Gabriel and Rosenthal [1991] find evidence of discrimination, whereas most economic theorists, such as Becker [1993], and commentators, such as Brimelow [1993] and Brimelow and Spencer [1993], argue competition will greatly reduce, if not eliminate, discrimination. In Section III, we demonstrate why, under regulation, statistical discrimination may increase with increasing competition. This anomalous result occurs because the legal definition does not distinguish between the two types of discrimination. Some economists implicitly assume credit markets are unregulated when considering the effect of competition on discrimination. Antidiscrimination regulation changes the effect of competition. In unregulated markets, taste-based discrimination is unprofitable and increasing competition will reduce this form of discrimination. If the industry's employees or white borrowers have a taste for discrimination, competition will not necessarily eliminate taste-based discrimination. When regulation is binding and the economic foundation for statistical discrimination exists, discrimination is profitable and increasing competition may increase discrimination. The effect of regulation and competition on discrimination depends critically on the information basis for discrimination (the relationship between loan performance and race). Therefore, the appropriate empirical question is Does a statistical basis for discrimination exist? This question cannot be answered by loan approval studies. Rather, it must be addressed by evaluating how loans perform after they are approved. Further, the appropriate public policy issue is Should society regulate statistical discrimination? This article is an empirical inquiry into the relationship between race and loan performance. We measure loan performance by estimating the same marginal default rates that lenders use to score credit applications and by the variables that have the most impact on loan administration costs. We find that race matters, regrettably in the fashion suggested by stereotypes. In general, minorities have higher default rates and contribute to higher administration costs. In other words, the foundation for statistical discrimination appears to exist. Section II contains a review of the extant literature. A theoretical model of credit "scoring" with both taste and statistical discrimination is contained in Section III. The data are discussed in Section IV, and the empirical models are presented in Section V. II. LITERATURE As in Arrow [1973] and Becker [1957], an individual is said to have a preference, or taste, for discrimination if he is willing to pay a price, or forgo income, in order to practice discrimination. …