Credit risk and the provision of mortgages to lower-income and minority homebuyers.

Glenn B. Canner and Wayne Passmore, of the Board's Division of Research and Statistics, wrote this article. Mark A. Peirce, of the Division of Research and Statistics, and Gary G. Myers and Keith Phipps, of the Division of Information Resources Management, provided assistance.

A core function of mortgage lenders, as of other financial businesses, is the measurement, acceptance, and management of risk. The key risk for mortgage lenders is credit risk, which arises from the possibility that borrowers may fail to pay their loan obligations as scheduled. The institution that bears the credit risk in mortgage lending is critical because, without such a participant, a mortgage cannot be made.

The credit risk associated with a mortgage is accommodated through a variety of financial arrangements and institutions. Some institutions, such as mortgage companies, mainly originate loans for sale to third parties. To facilitate this process, mortgage companies often transfer to a mortgage insurer much or all of the credit risk associated with holding the loans, thereby reducing the loss the loan purchaser would suffer in the event of default by a borrower. Other institutions, mainly depositories, keep in their portfolios many of the loans they originate. Like a purchaser of mortgages, however, a depository institution that holds a mortgage may not bear the full risk of default associated with it but may instead share the risk with a mortgage insurer.

Although; a considerable amount of information is available about which institutions hold mortgages, less is known about which bear the credit risk. To assess the distribution of mortgage credit risk, we have combined data collected in conjunction with the Home Mortgage Disclosure Act (HMDA) with data submitted by private mortgage insurers about the mortgages they insure. With this unique database, we have obtained a rough gauge of which institutions bear the credit risk of mortgages. In addition, because of the strong public interest in the provision of credit to lower-income and minority homebuyers, we have measured the distribution of credit risk across institutions by the income and race or ethnic group of the borrower and by characteristics of the neighborhoods in which mortgage boffowers reside.(1)

Mortgage Underwriting 

and Mitigation of Credit Risk

When scheduled payments on a mortgage are not made, a lender typically does not know whether the borrower intends to delay payments only temporarily or to stop them altogether. The borrower is considered "delinquent," but the lender's initial expectation is that the payments will resume. If scheduled payments continue to be missed, the lender may perceive that the borrower does not intend, or is unable, to repay the loan fully.

A lender may take actions against a delinquent borrower by imposing late fees and, in cases of numerous missed payments, by foreclosing on the mortgage and forcing a sale of the property securing the loan. But foreclosure is ordinarily quite costly to the lender, who can expect to incur a variety of expenses during the process: interest accrued from the time of delinquency through foreclosure, legal expenses, costs to maintain the property, expenses associated with the sale of the property, and the loss that arises if the foreclosed property sells for less than the outstanding balance on the loan. A sale for more than the outstanding balance will offset some or all of the lender's expenses, but generally a substantial portion of the costs are not recovered by the sale of the property.

Because foreclosure is costly, a lender often chooses to work with the borrower to acquire payments on the delinquent loan. For instance, a lender may provide credit counseling, establish a repayment plan to bring the loan payments back on schedule, or renegotiate the original terms of the loan. Working with delinquent borrowers to avoid default, however, can also be costly to the lender, who must provide the resources for these activities.

To mitigate credit risk, lenders take many steps - the most important of which is requiring borrowers to meet certain standards before extending credit. The process of creating and implementing these standards and applying them to the borrower is called mortgage underwriting. In assessing the risk of a prospective borrower, lenders evaluate both the ability and the willingness of the borrower to repay the mortgage loan. They examine sources of income, debt-payment-to-income ratios, asset holdings, employment history, and prospects for income growth. Lenders also review the credit history of the borrower, including records of payments for rent and utilities when the applicant is a first-time homebuyer or has no record of loan payments to evaluate.

Assessing credit risk also requires an evaluation of the property securing the mortgage and the proposed use of the property. For example, loans extended for condominiums, manufactured homes, and properties with two, three, or four dwelling units are generally perceived as riskier, and thus are treated more stringently, than single-family detached dwellings.

Lenders also consider the characteristics of the mortgage itself and adjust the price of the loan accordingly. The loan-to-value ratio on a mortgage is one of the primary indicators of default risk; the higher the ratio, the greater the risk of default and loss. Thus, lenders will set higher interest rates on mortgages with high loan-to-value ratios, or more often, they will require that boffowers in such cases purchase mortgage insurance, which also raises the cost of the loan to the borrower.

Lenders pursue different business strategies, and their underwriting practices and standards reflect those strategies. Some lenders choose to underwrite mortgages very strictly and thus limit their exposure to losses. Others accept more credit risk and attempt to recoup their higher expected losses by charging more for a mortgage. Still others may choose not to extend a particular type of mortgage contract or a mortgage secured by a specific type of property, ceding that business to competitors.

Risk-sharing relationships also influence or limit the extent of credit losses. First and most important, the lender almost always shares the risk of the mortgage with the boffower by requiring the borrower to make a down payment toward the purchase of the home and by requiring monthly payments that fully amortize the loan over a fixed period. The bigger the down payment, the more the house value exceeds the loan balance, a difference that gives the lender a cushion in case of default. Second, lenders often share their credit risk on a loan with either a private mortgage insurance company or a government agency. Finally, lenders may sell the mortgage to a government-sponsored enterprise, such as the Federal National Mortgage Association (Fannie Mae) or the Federal Home Loan Mortgage Corporation (Freddie Mac), or to another secondary market institution under terms in which they shed the credit risk associated with the mortgage - that is, the secondary market institution will have no recourse to the seller in the event of default by the borrower. Other techniques to limit credit risk include credit counseling, homebuyer education, and early intervention with delinquent borrowers.

Transfer of Credit Risk

through Insurance or Loan Sales

Compared with home mortgages that have high down payments, those that have low down payments are more likely to go into default, and losses on such defaulted mortgages are typically more severe.(2) Mortgage lenders customarily require a down payment of at least 20 percent of the appraised value of a home, but they will accept a smaller down payment if repayment of the mortgage is insured by a public or a private entity. Such insurance allows the lender to share the risk of loss on a mortgage with the insurance provider.(3)

Private Mortgage Insurance

Most borrowers purchase homes or refinance an existing mortgage without mortgage insurance because they generally want to avoid the added costs of the insurance. Many borrowers, however, have few assets available for a down payment and closing costs and thus can ordinarily qualify for a mortgage only with a high loan-to-value ratio and mortgage backing. Other borrowers prefer making a small down payment toward a mortgage even if they have the funds for a larger down payment, and they, too, are normally required by the lender to purchase mortgage insurance.

One type of insurance is private mortgage insurance (PMI), which affords some protection to the lender if a homeowner defaults on a conventional mortgage.(4) PMI reduces a lender's credit risk by insuring against losses associated with default up to a contractually established percentage of the claim amount.(5) Because defaults may result in a loss to the insurer, PMI companies assess and manage credit risk.(6) In determining whether to insure a particular loan, a PMI company acts as a review underwriter, evaluating both the creditworthiness of the prospective borrower and the adequacy of the collateral offered as security on the loan. This review process results in the denial of insurance to prospective borrowers who are judged to impose undue credit risk on the insurer and lender. Lenders are free to extend credit to such borrowers, but they must do so without the protection of PMI.

Some information is available about the activities of the PMI industry in the aggregate as well as about the financial condition of individual insurers; much less is known about the experiences of individual home loan applicants who seek PMI-backed loans. Recently the private mortgage insurance industry made available information on the disposition of applications for mortgage insurance and the characteristics of the households seeking PMI-backed loans in 1994 (see the appendix).

Government Mortgage Insurance

Another type of insurance common in the mortgage market is provided by the government, primarily through programs administered by the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA).(7) Under these programs, the federal government bears most of the credit risk associated with a loan. The FHA is limited in the aggregate amount of credit risk it can take by budgetary requirements imposed on its ongoing business, by size limits on the mortgages that it can insure, by its inability to lower insurance premiums without congressional approval, and by a congressionally imposed limit on the aggregate amount of insurance that may be written each year.(8)

The FHA's largest insurance program is the single-family Mutual Mortgage Insurance Fund. In 1994, the FHA insured 686,000 new mortgages for the purchase of single-family homes. This program requires a uniform and substantial premium for the insurance, and it relies on lower-risk borrowers to cross-subsidize the costs imposed by higher-risk bortowers. As a consequence, lower-risk borrowers who can qualify for privately insured loans tend not to use FHA programs because they can often pay less for private mortgage insurance.

Comparison of PMI and Government

Insurance

From the lender's perspective, the mortgage insurance provided by private mortgage insurers and that provided by government agencies such as the FHA and the VA are similar in that both reduce credit risk. The level of protection varies, however: Whereas PMI companies typically limit coverage to 20-30 percent of the claim in a mortgage default, the FHA covers 100 percent of the unpaid balance of the mortgage to the lender as well as most costs associated with foreclosure and sale of the property. The VA provides loan guarantees, with the guaranteed proportion tied to the size of the mortgage. For marginally qualified borrowers, some lenders may prefer the added protection afforded by FHA or VA insurance, and they may encourage the borrowers to apply for these mortgages.

Lenders may have other incentives to encourage applicants to apply for one loan program rather than another. For example, FHA-insured mortgages provide lenders with greater servicing revenue than do PMI-covered mortgages. The origination of mortgages covered by PMI often requires less paperwork, however.

From the homebuyer's perspective, the costs and availability of the insurance offered by the FHA, the VA, and PMI companies can differ markedly. Households often choose mortgages backed by the FHA or the VA instead of those backed by private insurers because the agencies insure mortgages that require considerably less cash at closing and use more liberal underwriting guidelines when evaluating the creditworthiness of the applicant.(9) For example, the FHA insures mortgages that require smaller down payments and, unlike PMI companies, allows the borrower to finance closing costs. In addition, the FHA allows households to use gifts from others for the entire down payment. (In general, private insurers backing low-down-payment mortgages limit the portion of the down payment that may be paid from gifts.) Moreover, the FHA allows households that carry relatively more debt to qualify for a mortgage, an underwriting practice that is often important to lower-income and first-time homebuyers.

As noted earlier, FHA-insured mortgages are not likely to be used by lower-risk borrowers who have the resources to pay closing costs. At the same time, the PMI industry is unable to serve many of the higher-risk FHA boffowers. Because the FHA is a federal agency and thus does not have to meet the same capital and profitability requirements imposed on PMI companies by private-sector investors, its programs can reach many borrowers whom private sector companies cannot profitably serve. The FHA's lending to these higher-risk borrowers is limited mainly by federal legislation imposing limits on mortgage size and establishing criteria for the financial soundness of the FHA's Multiple Mortgage Insurance Fund.

Secondary Market Institutions

Institutions in the secondary mortgage market play a prominent role in the US. housing market, each year buying and selling billions of dollars of mortgages and of securities backed by mortgages. Secondary market institutions generally do not originate loans but rather specify the underwriting guidelines that loans must meet to be eligible for purchase or securitization. These guidelines and related limitations on the size of loans that may be purchased vary among the secondary market purchasers.(10) As a consequence, the characteristics of the borrowers and of the neighborhoods in which the properties are located can be expected to differ among the loans that these institutions purchase or securitize.

Three government-sponsored enterprises (GSEs) dominate secondary market activity - Fannie Mae, Freddie Mac, and the Government National Mortgage Association (Ginnie Mae). Fannie Mae and Freddie Mac buy mainly conventional mortgages: They hold some in portfolio and convert others into securities that they sell to investors. Ginnie Mae does not purchase loans but guarantees the timely payment of interest and principal for privately issued securities backed by mortgages insured by the FHA or the VA. Over the past few years, the GSEs have accounted for 60 percent to 72 percent of all mortgage purchases reported under HMDA.(11)

While the GSEs dominate secondary market activity, other institutions - including commercial banks, savings associations, insurance companies, and pension funds - are also active purchasers of mortgages. The non-GSE institutions buy the same types of loans purchased by the GSEs, but they also provide a market for lenders who originate nonconforming loans, such as jumbo loans, mobile-home loans, and certain types of adjustable rate mortgages.(12)

Underwriting Standards and

the Composition of Mortgage Activity

The institution that bears the credit risk of a mortgage is the one that ultimately makes a mortgage loan possible. The willingness and availability of institutions to bear credit risk influences the distribution of mortgage credit among different groups of borrowers. Because the credit characteristics of different groups of borrowers vary, the underwriting standards of institutions can potentially affect the distribution of mortgage borrowers across income groups, race and ethnic categories, and neighborhoods.

For the reasons outlined below, we expect the FHA and the VA to have the greatest involvement with lower-income and black or Hispanic borrowers, Fannie Mae and Freddie Mac somewhat less involvement, and the PMI companies the least. As for portfolio lenders - institutions that originate a mortgage and then choose to keep or sell the mortgage - it is difficult to say, a priori, where they might fall in this ranking. Our expectations are tempered by many caveats. In the following discussion, we describe the various underwriting standards and the way they can be expected to affect the distribution of borrowers, and then we review the actual distributions as calculated from the 1994 HMDA data.(13)

The FHA and the VA

The respective missions of the FHA and the VA are to promote home ownership among moderate-income homebuyers and among all veterans. The agencies achieve these goals, in part, by using government subsidies.

Because FHA and VA underwriting standards are generally less strict than those for privately insured mortgages, borrowers whose mortgages are backed by the FHA or the VA can qualify with more debt relative to income, with smaller down payments, and with weaker credit histories. The more relaxed underwriting guidelines of the FHA and the VA are often needed by families with lower incomes because, compared with families having higher incomes, lower-income families tend to carry relatively higher loads of nonhousing debt, to have a history of credit problems or no credit history at all, and to have fewer assets available to make a down payment and pay closing costs. Thus, mortgages insured by either the FHA or the VA would tend to be those of lower-income borrowers.(14) In addition, limits on the size of mortgages eligible for FHA and VA backing imply that the proportion of upper-income borrowers - who generally desire larger mortgages - will be lower for these agencies than for institutions without these size restrictions.

On average, black and Hispanic borrowers, compared with white or Asian borrowers, have lower incomes, purchase homes with lower values, and have less wealth; they also have more credit problems, higher total debt-payment-to-income ratios, and less stable employment.(15) Thus, we expect that FHA and VA mortgages would be more heavily utilized by black and Hispanic borrowers. Besides having higher proportions of lower-income borrowers and of black and Hispanic borrowers, the FHA and the VA are also more likely to back mortgages extended to borrowers purchasing homes in lower-income and predominately minority neighborhoods.(16)

GSEs and PMI Companies

Fannie Mae, Freddie Mac, and private mortgage insurers are profit oriented and thus cannot bear the same degree of credit loss as the FHA or the VA. However, Fannie Mae and Freddie Mac, although owned by private shareholders, are government-sponsored enterprises that receive important benefits from that sponsorship. One objective in the charters of Fannie Mae and Freddie Mac is to promote the availability of mortgage credit to low- and moderate-income families. In addition, the Department of Housing and Urban Development (HUD) establishes annual goals, as required by the Federal Housing Enterprises Financial Safety and Soundness Act of 1992, for the purchase of such mortgages by Fannie Mae and Freddie Mac. Thus, the expectation is that these enterprises will, to a greater extent than purely private-sector entities, promote homeownership among lower-income households.(17)

Private mortgage insurers neither receive government support nor have a government mandate to serve lower-income borrowers. To a limited extent, PMI companies can price risk by charging higher premiums to borrowers with certain credit characteristics. However, lower-income borrowers with these characteristics are constrained in their ability to pay higher premiums. Thus, we expect that PMI companies are more likely than government-sponsored institutions (the FHA, the VA, Fannie Mae, and Freddie Mac) to insure borrowers who have higher incomes, who are either white or Asian, and who are purchasing homes in higher-income neighborhoods or in neighborhoods with fewer minority residents.

Some factors, however, suggest that PMI companies may be more likely than Fannie Mae or Freddie Mac to insure a higher proportion of mortgages extended to lower-income borrowers. For example, PMI companies focus exclusively on mortgages that have high loan-to-value ratios - mortgages that are more often used by lower-income borrowers. In contrast, Fannie Mae and Freddie Mac generally bear risk only for mortgages with larger down payments because of restrictions in their charters. Unless the mortgage carties PMI or some other form of credit enhancement, Fannie Mae and Freddie Mac generally purchase only mortgages with the lowest credit risk because they are restricted to purchasing mortgages with a loan-to-value ratio of 80 percent or less. In addition, many of the PMI companies have recently begun new programs to increase the utilization of PMI by lower-income and minority households, suggesting that PMI companies, like the GSEs, may balance the objective of profit maximization against other objectives.(18)

Portfolio Lenders

Portfolio lenders are institutions that have the capability of originating and funding a mortgage directly; among them are commercial banks, savings associations, credit unions, and some mortgage banks. Portfolio lenders can determine their own underwriting standards, and these institutions may strive to keep only their low-risk mortgages and pass the risk of their other mortgages to other institutions either by selling them or by obtaining insurance on them from a third party. A portfolio lender's tendency to keep better-quality mortgages for its own portfolio and to sell poorer-quality mortgages is referred to as adverse selection.

Profit-oriented purchasers or insurers of mortgages, such as Fannie Mae, Freddie Mac, and PMI companies, guard against adverse selection by setting stricter underwriting standards than they would if they had full information about the risk of the mortgages they buy or insure and by closely monitoring the adherence of mortgage originators to these standards. On balance, it is difficult to know, a priori, how adverse selection will affect the relative involvement of mortgage-market institutions in lending to lower-income and minority borrowers.

Holding mortgages that can be easily sold in the future improves the liquidity of a portfolio lender, and thus the degree to which such a lender wants to hold nonstandard mortgages may be limited. Portfolio lenders can, however, exploit market niches that allow them to collect better information about the risk of a particular group of mortgage borrowers, or they can specialize in the management of higher-risk mortgages more generally; under these circumstances, they may hold relatively large proportions of nonstandard mortgages, including those extended to lower-income and minority borrowers. In other words, many portfolio lenders pride themselves on knowing their community," and this knowledge can be used to better manage the credit risk of local lending. Without this specialized knowledge or without some feature that makes the mortgage nonconforming (and hence higher yielding or lower cost), a portfolio lender often will have difficulty originating and funding a mortgage loan profitably.(19)

The vast majority of portfolio lenders are depository institutions, which in turn hold almost all home purchase loans held by portfolio lenders. Depository institutions benefit from a government subsidy provided through deposit insurance and from other services available exclusively to them. In return, they bear the costs of many regulations not imposed on other firms. Among these regulations is the Community Reinvestment Act, which requires them to help meet the credit needs of their communities. This factor, combined with the limited profitability of funding confomiing mortgages, leads us to expect that mortgages held by depository institutions in portfolio without PMI generally will be underwritten with greater flexibility than mortgages that are either insured by a PMI company or sold into the secondary market.

Mortgage Activity and Loan Size

For the analysis presented below, the mortgage market is divided by loan size. The FHA cannot insure mortgages that are larger than legislated limits. In 1994, the loan size limit in most areas of the country for a single family home was $77,197. In areas where housing prices were high, the allowable limit was $152,362.

We refer to mortgages that fall within the FHA mortgage size limits as FHA-eligible. In 1994 about 67 percent of all mortgages for the purchase of owner-occupied homes were FHA-eligible (table 1).(20) In 1994 an even higher proportion of the mortgages extended to lower-income borrowers (95 percent) and to black or Hispanic borrowers (82 percent) were FHA-eligible.

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Mortgages that exceed the FHA's single-family mortgage size limits but not the limit on mortgages that Fannie Mae and Freddie Mac can purchase ($203,150 in 1994) are referred to here as "GSE-eligible only" mortgages, a term we shorten further to "GSEO-eligible." In 1994 about one-fourth of all mortgages for purchasing an owner-occupied home were GSEO-eligible. Less than 5 percent of the mortgages extended to lower-income borrowers and 15 percent of the mortgages extended to either black or Hispanic borrowers were GSEO-eligible.

Fannie Mae and Feddie Mac bear a relatively large share of the risk of GSEO-eligible mortgages. With their government backing, they are advantaged competitors that can effectively price the risk of conforming GSEO-eligible mortgages below the price set by their potential competition.(21) Typically, other bearers of credit risk take on the risk of a GSEO-eligible mortgage only if it is nonconforming or if they have some generally unavailable knowledge about the borrower or the property securing the mortgage.

Finally, a mortgage that exceeds $203,150 is referred to as a jumbo mortgage. In 1994, jumbo mortgages accounted for about 8 percent of all mortgages for purchasing a home, for less than I percent of the mortgages to lower-income borrowers, and for less than 3 percent of the mortgages to black or Hispanic borrowers.

The Distribution

of Mortgage Borrowers

by Holder of the Credit Risk

In the discussion of the influence of underwriting standards on mortgage activity, we use two special terms: mortgage credit risk holders (risk holders), which are institutions that would actually bear the loss from a mortgage default, and mortgage credit risk portfolios (risk portfolios), which are the mortgages for which a risk holder bears the credit risk, regardless of whether the risk holder actually funds the mortgages. For our purposes, the risk holders are the FHA, the VA, PMI companies, Fannie Mae and Freddie Mac, other purchasers of mortgage securities, and depository institutions. The FHA, the VA, PMI companies, Fannie Mae, and Freddie Mac do not fund all (or in some cases any) of the mortgages for which they hold the credit risk. Thus, the number of mortgages in the risk portfolios of these institutions is far larger than their actual mortgage holdings.

For a depository institution, the risk portfolio consists only of the mortgages held in the institution's portfolio that are not insured and that have not been securitized. That is, for this discussion, we assign to the insurer all the credit risk of an insured mortgage. In the case of government-backed mortgages, the assignment is essentially accurate; in the case of PMI-insured mortgages, it is less valid, but we have no way to quantify the actual shares of credit risk. Because PMI companies are bearing the preponderance of risk associated with such mortgages, assigning them all the risk is a simplification that should not be seriously distorting.

Using HMDA and PMI Data to Determine

Who Bears Credit Risk

Information about who originates, holds, purchases, or insures a mortgage in a given year is available from HMDA in combination with PMI data. But the credit characteristics of the mortgage are not included in the data. Thus, only rough comparisons are possible because we can observe only the income and race or ethnic group of the borrower and the location of the property and not key measures of creditworthiness such as the loan-to-value ratio, the credit history, or the debt-payment-to-income ratios.

Because of the limited set of information available in HMDA and PMI data, we do not attempt to adjust our measure of credit risk - the actual number of mortgages either insured or held without insurance by the institution - for the actual expected credit risk of particular mortgages. This technique allows only broad and rough inferences about the extent to which an institution bears the credit risk associated with particular income, racial, or ethnic groups. Adjustments to our measure of risk bearing would require information related to the creditworthiness of individual borrowers, which is not available from the HMDA and PMI data. We do, however, discuss the direction adjustments might take and do not believe that they would generally alter the patterns outlined below.

To conduct the analysis, we matched the individual mortgage records reported by mortgage originators under HMDA with individual records on loans insured by PMI companies reported in a manner that parallels that of HMDA reporting. The details of this matching procedure are provided in the box, "Matching HMDA and PMI Loan Records." Extracting the PMI-insured mortgages from the mortgages funded or guaranteed by an institution allows us to measure the credit risk borne by these institutions more precisely.

Accounting for PMI

Measuring the overall distribution of mortgage lending by type of risk holder without controlling for the size of the mortgage or extracting the mortgages insured by PMI indicates that depository institutions held or purchased 34 percent of the mortgages originated in 1994 (table 2, last column, sum of "Depository institution," "Bank or savings association not affiliated with a mortgage originator," and "Affiliate, from a depository institution or its subsidiary" for mortgages with and without PMI). Fannie Mae and Freddie Mac purchased about 25 percent of the mortgages, and the FHA and VA backed about 23 percent of the mortgages. The remaining mortgages were originated and held by an independent mortgage company, purchased by "other" secondary mortgage market institutions, or purchased from independent mortgage companies by affiliates.

Of the mortgages that were retained or purchased by depository institutions or their subsidiaries, roughly 17 percent were backed by PMI (derived from table 2). That most of these mortgages were not backed by PMI implies that depository institutions bear the credit risk of most of the mortgages they hold; given that depository institutions, taken together, have the largest market share for mortgages, it also implies that they are the largest holder of credit risk in the mortgage market. In contrast, Fannie Mae and Freddie Mac together had PMI coverage for about 31 percent of the mortgages they purchased.

Treating risk holders separately, depository institutions bore about 28 percent of the credit risk of home lending, whereas Fannie Mae and Freddie Mac together, the FHA, and the PMI companies each had 17 percent. Thus, measuring 1994 mortgage portfolios as risk portfolios by extracting mortgages insured buy PMI only slightly reduces the market share of depository institutions but significantly shrinks the combined share of Fannie Mae and Freddie Mac. Put another way, the distribution of mortgage originations and purchases in the 1994 market did not parallel the distribution of credit risk.

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Generally, the type of mortgage insured by the FHA or by the PMI companies is riskier than the type of mortgage for which Fannie Mae or Freddie Mac bear the credit risk. Thus, if one could "weight" mortgage loans by the actual credit risk they pose to the institutions that insure, hold, or purchase mortgages, the FHA and the PMI companies presumably would bear a proportion of the credit risk that is higher than we calculate.

FHA-Eligible Mortgages

FHA-eligible mortgages are, by definition, relatively small and are more likely to be used by lower-income borrowers. By looking at the composition of FHA-eligible mortgages in each institution's risk portfolio, one can make some inferences about which institutions provide the critical credit-risk-bearing ingredient in the extension of credit to lower-income borrowers.

The FHA and the VA

Among FHA-eligible home purchase mortgages, those actually insured by the FHA include a significantly higher proportion of lower-income borrowers and borrowers who are black or Hispanic than those held or insured by other risk holders (table 3). This result is not surprising because, as described earlier, the FHA is government backed and government subsidized and thus can use more flexible underwriting standards than a private-sector lender or insurer. The other government agency that directly backs mortgages, the VA, insured a lower proportion of mortgages extended to lower-income or black or Hispanic borrowers in 1994 than did the FHA, but it still generally carried a higher proportion of such mortgages in its risk portfolio than did many other risk holders. The VA, of course, is restricted to serving veterans, and that restriction in itself might constrain the range of household income groups it can reach.

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FHA-eligible Mortgages without PMI

As discussed earlier, lower-income borrowers in general have less wealth, more credit history problems, higher ratios of total debt payments to income, and less stable employment, and they are more likely to be black or Hispanic. These financial characteristics are traditionally used in mortgage underwriting as measures of risk. Because portfolio lenders, and depository institutions in particular, tend to be located in the neighborhoods where they make loans and often have multiple relationships with their borrowers, they have an opportunity to look beyond these traditional measures and acquire better information about the risk characteristics of individual borrowers.(22) Portfolio lenders can also exercise considerable flexibility when applying their underwriting standards if they plan not to sell or insure a mortgage. The knowledge and flexibility of portfolio lenders seems to be reflected in the income and racial or ethnic characteristics of the borrowers for the mortgages they originate.

In contrast, institutions such as Fannie Mae and Freddie Mac purchase mortgages without the benefit of the additional information that comes from familiarity with borrowers and their neighborhoods; these institutions seem to have greater difficulty bearing the credit risk associated with the mortgages extended to lower-income and black or Hispanic borrowers. This distinction is highlighted by the proportions of mortgages extended to lower-income and black or Hispanic borrowers without PMI and held by the various risk holders.

Of the FHA-eligible conventional mortgages originated and held in portfolio in 1994 by depositories, about 41 percent were extended to lower-income borrowers and 12 percent to black or Hispanic borrowers. Affiliates of depositories also purchased a significant proportion of lower-income mortgages for their risk portfolios. Fourty-four percent of their FHA-eligible mortgages were to borrowers with lower income, and 17 percent were to borrowers who live in lower-income areas; these levels are comparable to those of the FHA and the VA, suggesting that those borrowing from affiliates tend to have lower incomes than those borrowing from traditional depository institutions. Depository institutions sometimes use affiliates, such as mortgage brokers, to extend the reach of their branch networks into lower-income neighborhoods, where opening more traditional "brick and mortar" facilities may not be profitable.

Although most independent mortgage companies sell most or all of their mortgage originations to others, some hold their originations - particularly those that are nonconforming - in portfolio. The risk portfolios of these lenders and their affiliates also have relatively high proportions of mortgages extended to lower-income or black or Hispanic borrowers; the proportions may partly reflect the extensive involvement of these lenders in FHA lending, which may also generate many opportunities for extending conventional mortgages to black and Hispanic borrowers.

FHA-eligible mortgages that are not insured and that are sold either to a government-sponsored enterprise or to a nonaffiliated depository institution are more likely to be mortgages of higher-income or white or Asian borrowers. The high proportions of such mortgages sold to Fannie Mae and Freddie Mac may reflect stricter underwriting standards for mortgages without PMI, the required low loan-to-value rations on mortgages without PMI, and the difficulties these institutions face in collecting comprehensive informations about the risk characteristics of lower-income borrowers.

Similarly, a bank or savings association that is purchasing a mortgage form a nonaffiliated mortgage lender would be expected to set high underwriting standards because, as described earlier, it must guard itself against originators who may try to sell it mortgages with poorer credit risk. A depository does not generally need to rely on non-affiliated originators to generate mortgages to lower-income and minority borrowers because it can extend these mortgages directly or through its own affiliates. However, some depositories may purchase such mortgages to help them meet their obligations under the Community Reinvestment Act.

In recent years, HUD has encouraged both Fannie mae and Freddie Mac to increase the lower-income portion of their total mortgage purchases. Yet, in terms of risk holdings of such mortgages, the ranking of Fannie Mae and Freddie Mac combined in 1994 was low. Furthermore, the proportion of mortgages purchased by Fannie Mae and Freddie Mac that are for properties in lower-income or minority neighborhoods is also relatively small, a fact suggesting that some of the lower-income borrowers in the risk portfolios of these institutions actually may be households with substantial financial assets.(23)

Perhaps also surprising is the high proportions of lower-income and black or Hispanic borrowers among those whose mortgages are sold to private-sector nondepository purchases such as investment banks, life insurance companies, and pension funds (the "other" category in table 30. Like Fannie Mae, Freddie Mac, and depository institutions purchasing loans from nonaffiliates, these entities must guard themselves against mortgages with unexpectedly high credit risk and thus presumably set high underwriting standards. However, here, too, some countervailing factors exist. First, in the past couple of years investment banks have created a secondary market for mortgages that do not meet traditional underwriting standards. Securities in this market are often backed by "B" and "C" mortgages - that is, mortgages with lower credit quality than "A" mortgages, which have the highest expected credit quality.(24) Second, some of the private-sector purchasers of mortgages, such as pension funds, have also have been encouraged to increase the proportions of their risk portfolios extended to lower-income households.

FHA-Eligible Mortgages with PMI

Given that PMI companies use their own underwriting standards, for the most part regardless of who holds the mortgages, we expect that the distribution of borrower characteristics among privately insured mortgages does not vary much by type of institution. However, our expectations are not supported by the data. The distribution of mortgages extended to black or Hispanic borrowers varies. In addition, the variance does not seem to reflect a distinction between portfolio lenders and other institutions. As for mortgages extended to lower-income borrowers, the same pattern of borrower characteristics across institutions exists regardless of whether or not the mortgage is insured by PMI. Portfolio lenders and their affiliates carry the highest proportions of such mortgage, as well as relatively high proportions of mortgages extended to borrowers in lower-income neighborhoods.

The PMI-covered portions of each holder's risk portfolio had a greater proportion f higher-income and black and Hispanic borrowers than did the portions not covered by PMI. Interpreting these differences is problematic. One possible explanation is that PMI companies, when insuring the risk of mortgages with high loan-to-value ratios, provide the best value for individuals with higher-incomes (but little wealth). Blacks and Hispanics at all incomes have, on average, less wealth than whites with similar incomes, suggesting that black and Hispanic borrowers who have higher incomes and meet traditional underwriting standards but lack the wealth for a down payment may find their lowest-cost option is a mortgage with PMI.(25)

The Market Share of FHA-Eligible Mortgages

An institution's underwriting standards and business strategy influence its presence in a particular market. An institution aggressively seeking mortgages with a variety of credit qualities may have a significant presence in all markets but have a lower proportions of higher-risk mortgages than an institution that only rarely accepts higher-risk mortgages. For example, an institution may actually make most of the FHA-eligible mortgages extended to lower-income borrowers, but such mortgages may account for a small percentage of its portfolio because it makes many mortgages overall.

The credit risk or the majority of FHA-eligible mortgages extended to lower-income or to black or Hispanic borrowers is carried either by the FHA or by depository institutions (or their affiliates) who are not using PMI for such mortgages (table 4). Together, thee institutions for about 56 percent of the FHA-eligible mortgages extended to lower-income borrowers, Fannie Mae and Freddie Mac taken together are the third largest risk holder in this market, with a 15.2 percent share of the market, whereas PMI companies as a group bear the risk of 12.3 percent of these mortgages.

The FHA and depository institutions (including affiliates) accounted for about 60 percent of the FHA-eligible mortgages extended to black or Hispanic borrowers, PMI companies accounted for about 14 percent, and Fannie Mae and Freddie mac accounted for about 10 percent. In addition, the FHA and depository institutions that are not using PMI hold the majority of the mortgages extended to borrowers in lower-income neighborhoods or in neighborhoods with high proportions of minority residents, a finding that suggests that these borrowers have limited financial resources.(26)

GSEO-Eligible Mortgages

In 1994 the number of GSEO-eligible mortgages was roughly 38 percent of the number of mortgages that are FHA-eligible (derived from table 1). Furthermore, among GSEO-eligible mortgages, only 5 percent were for lower-income borrowers, an 4 percent were for borrowers purchasing properties in lower-income neighborhoods. Roughly 8 percent of the borrowers in this category were black or Hispanic, and about 4 percent of the GSEO-eligible mortgages were for properties in minority neighborhoods. Thus, institutions that focus on GSEO-eligible mortgage lending are limited in the extent to which they can serve lower-income or black or Hispanic borrowers.

Among risk holders of GSEO-eligible mortgages, the FHA and VA have higher proportions of such mortgages extend to lower-income or black or Hispanic borrowers and relatively high proportions of such mortgages extended to borrowers purchasing homes in lower-income and minority neighborhoods. Thus, among large mortgages as well as FHA-eligible mortgages, the FHA and VA underwriting standards, which qualify higher-risk borrowers for mortgages, seem to serve larger proportions of lower-income or black or Hispanic borrowers than do the underwriting standards of other lenders.

In contrast to patterns found among FHA-eligible mortgages, Fannie Mae and Freddie Mac hold in their combined GSEO-eligible risk portfolio a higher proportion of lower-income mortgages without PMI than do depository institutions. The proportion of such mortgages in their risk portfolio that is extended to black or Hispanic borrowers with no PMI is also somewhat higher. For Fannie Mae and Freddie Mac, the proportion of borrowers in lower-income neighborhoods is smaller than their proportion of lower-income borrowers, suggesting that some of the mortgages to lower-income borrowers may not actually be to those with limited financial resources.

Together, Fannie Mae and Freddie Mac purchased, and depository institutions purchased or originated, the majority of GSEO-eligible mortgages made to lower-income borrowers without mortgage insurance. These institutions also purchased

Matching HMDA and PMI Loan Records

To evaluate the respective roles of the FHA, the VA, portfolio lenders in the primary market, secondary market institutions, and the private mortgage insurance companies, we compared information on individual home mortgages reported by lenders covered by HMDA in 1994 to those reported by PMI companies for that year. Conventional home mortgages (that is, those not government-backed) we identified in the HMDA data as privately insured if loan records in the two files matched. Two loan file records were deemed to match each other if they were similar for the following characteristics: purpose of loan, location of the property securing the mortgage (same state, MSA, county, census tract), race or ethnic status of borrower, sex of borrower, applicant income, and loan size. The purpose of the loan and the location of the property had to be identical for the two loan records. The race or ethnic status also had to be identical unless it was missing from the PMI record - in this case, a match was allowed if all other criteria were satisfied.

For matches on applicant income, differences of $1,000 for borrowers with incomes of less than $50,000 and differences of $2,000 for higher-income borrowers were allowed in identifying matches. For matches on loan size, differences of $1,000 for loans of less than $100,000 and differences of $2,000 for loans of $100,000 or more were allowed in identifying matches.

Among the 2,795.162 conventional home purchase loans reported in 1994 under HMDA, 454,187, or 16.2 percent, were identified as privately insured. For this article, 1,813,188 conventional mortgages for the purchase of owner-occupied homes were used, of which 393,742, or 21.7, percent were insured. The smaller number of mortgages reflects a number of restrictions, including that the property be owner-occupied, that it be located in an MSA and have a valid census tract number, and that mortgage be approved during the first ten months of 1994. The higher percentage of insured mortgages in our data likely reflects the exclusion of non-owner-occupied properties and properties outside of MSAs (often mobile homes), for which mortgages rarely carry PMI. chased or originated about 39 percent of the mortgages extended to black or Hispanic borrowers without mortgage insurance. As described above, the FHA's role was greatly diminished because of limits on the size of loans that can be FHA-insured.

In the VA's risk portfolio, the share of GSEO-eligible mortgages extended to lower-income and to black or Hispanic borrowers is greater than the share of FHA-eligible mortgages so extended because, although it is less restrictive on loan size, the VA still applies relatively flexible underwriting standards. However, the VA's share of mortgages extended to borrowers in lower-income neighborhoods is significantly smaller for GSEO-eligible mortgages relative to its share of such mortgages extended to lower-income borrowers; this finding suggests that, as with Fannie Mae and Freddie Mac, some of these borrowers may have more wealth than is typical of a lower-income borrower.

Jumbo Loans

Few jumbo mortgages were extended to lower-income borrowers or to borrowers purchasing homes in lower-income census tracts (table 1), and the lower-income borrowers that did have such mortgages presumably had substantial wealth to qualify them for the loans. Almost all jumbo mortgages for lower-income borrowers and census tracts were extended without PMI (table 4) and were sold for private mortgage securitizations (table 4, "Other") or held in portfolio by depository institutions.

Similarly, the few jumbo mortgages extended to black or Hispanic borrowers were often held by depository institutions in their portfolio; about 5 percent of jumbo loans went to such borrowers or to census tracts characterized as predominately minority (table 1). Only 0.2 percent of jumbo loans carried FHA insurance (table 2), and they were probably for multifamily properties in high-cost areas. Almost half of FHA jumbo loans were made to black or Hispanic borrowers (table 3).

Conclusion

Who bears the credit risk of mortgage lending for the purchase of owner-occupied homes? By merging HMDA data with data from PMI companies, we created a unique database that allowed us to count the total number of mortgages that were originated by institutions in metropolitan areas during 1994 as well as the number of such mortgages covered by private mortgage insurance. By identifying mortgages insured by PMI, we could more precisely assess the distribution of the credit risk of mortgage lending.

Depository institutions bore the credit risk of about 28 percent of the mortgages originated in 1994. Fannie Mae and Freddie Mac together, the FHA, and the PMI companies each bore roughly 17 percent of the credit risk. In addition, depository institutions were less likely than other private-sector entities to use PMI.

To address the question of who serves lower-income or black or Hispanic mortgage borrowers requires, by our definition, the determination of who bears the credit risk of their mortgages. Judged by the proportions of mortgages extended to these groups in an institution's mortgage credit risk portfolio (risk portfolio), as well as by the market share accounted for by an institution's risk portfolio, the FHA is a major provider of service to lower-income and black or Hispanic mortgage borrowers. This result was to be expected because the FHA generally insures the mortgages of borrowers who currently have few assets available for down payments and closing costs and who do not usually qualify for a mortgage with PMI. The FHA can reach large numbers of these mortgage borrowers because it receives the benefits of government subsidy and does not have to earn a competitive return on equity.

Do private-sector institutions, which must earn a competitive return on equity, also serve large numbers of lower-income and minority borrowers? The 1994 data indicate that depository institutions and their affiliates were as significant as the FHA in the provision of mortgages to lower-income borrowers and to boffowers purchasing properties in lower-income neighborhoods. However, the FHA reached a higher proportion of black and Hispanic borrowers and of borrowers purchasing homes in minority neighborhoods. One interpretation of this pattern is that depository institutions have had substantial success creating mortgage products for lower-income borrowers with few assets but who meet other underwriting guidelines, whereas compared with the FHA, they have had less success developing mortgages that incorporate more flexible standards for a wider range of underwriting criteria.

One of our expectations was that Fannie Mae and Freddie Mac, the government-sponsored enterprises, would promote homeownership among lower-income households to a greater extent than would purely private-sector entities. The evidence, however, indicates that in terms of risk holdings of such mortgages, Fannie Mae and Freddie Mac did not outperform private-sector entities such as depositories. The difference may arise because Fannie Mae and Freddie Mac, unlike depositories, generally have no interactions with borrowers and are not located in the neighborhoods where the mortgages are originated; thus they lack the opportunity to look beyond traditional measures of risk.

A surprising element in the data is the apparent success of nondepository private-sector mortgage purchasers in providing a method for investors to serve the mortgage needs of lower-income and of black or Hispanic borrowers. These efforts accounted for a relatively small share of the mortgages extended to these borrowers in 1994; but these risk portfolios, which seem to have been created by private-sector securitizers, had a higher proportion of such mortgages among FHA-eligible mortgages than did the risk portfolio of Fannie Mae and Freddie Mac.

Appendix:

Summary of the 1994 PMI Data

In 1993 the Mortgage Insurance Companies of America (MICA) requested and arranged for the Federal Financial Institutions Examination Council (FFIEC) to process data from private mortgage insurance companies regarding applications for mortgage insurance and to produce disclosure reports for the public.(27) The MICA request was a response to growing public and congressional interest in learning more about the activities of PMI firms as they relate to issues of fair lending, affordable housing, and community development.

To gather information for these disclosures, each PMI company records data in a loan application register for PMI applications acted on in a given period. The information covers the action taken on the application (approved, denied, withdrawn, or file closed); the purpose of the mortgage for which insurance was sought; the race or national origin, the sex, and the annual income of the mortgage applicant(s); the amount of the mortgage; and the geographic location of the property securing the mortgage. The FFIEC summarizes the information for the public in disclosure statements that have formats similar to those created for financial institutions covered by the Home Mortgage Disclosure Act.

Disclosure statements for each PMI company are publicly available at its corporate headquarters and at the central depository in each metropolitan statistical area in which the HMDA data are held. The central depository also has aggregate data for all of the companies active in that MSA. In addition, the PMI data are available from the Federal Reserve Board through its HMDA Assistance Line (202-452-2016).

This appendix summarizes the PMI data for calendar year 1994.(28) Beginning with the release of the 1995 PMI data, these types of summary tables will appear each year in the Financial and Business Statistics section of the September issue of the Federal Reserve Bulletin.

The 1994 PMI Data

For 1994, the eight PMI companies that are actively writing home mortgage insurance submitted their data to the FFIEC through MICA. In total, these companies acted on 1,483,576 applications for insurance: 1,176,044 to insure home purchase mortgages on single-family properties and 307,532 to insure mortgages for refinancing an existing mortgage (table A. 1).

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The total number of privately insured loans was only slightly lower than that in 1993, but the composition changed in that refinancings were much less prevalent. This pattern agrees with changes in loan composition evidenced in HMDA data. From 1993 to 1994 the number of applications for conventional refinancings fell nearly 51 percent, whereas the number of applications for conventional home purchase loans increased almost 23 percent (data not shown in tables).

The two largest PMI companies, Mortgage Guaranty Insurance Corporation and GE Capital Mortgage Insurance Corporation, accounted for more than half of the applications for PMI and of the policies written in 1994. By and large, the distributions of applications received and of policies written among the PMI companies for insurance to back home purchase loans and refinancings were similar, although Mortgage Guaranty Insurance and Republic Mortgage Insurance Company were somewhat more likely to receive applications for insurance for home purchase loans than for refinancings.

The large share of PMI activity accounted for by Mortgage Guaranty Insurance and GE Capital Mortgage Insurance extended across all regions of the country (table A.2). Similarly, the ranking of the four largest firms in the industry varied little by region. The four largest firms were present in all regions and seemed generally not to be focused disproportionately on any given region (memo item). (An exception was the relative concentration of Mortgage Guaranty Insurance in the Midwest - particularly the Great Lakes area).

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Smaller firms generally had a more regional orientation, with Amerin Guaranty more active in the West and Triad Guaranty Insurance Corporation and Republic Mortgage Insurance more active in the South (table A.2, bottom portion). One company, Commonwealth Mortgage Assurance Company, seemed to focus on both the West and the South. The distribution of PMI policies in 1994 followed the distribution of home sales that year (comparison of the bottom two rows of the table). However, homebuyers in the South seemed to be less likely than buyers in other regions to use PMI.

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Most applications for mortgage insurance pertained to loans of less than $150,000 (table A.3). More than 90 percent of all applications for insurance were for mortgages that were less than or equal to the loan size limits established for Fannie Mae and Freddie Mac (first memo item). The average size of the home purchase mortgages for which private mortgage insurance was sought was $115,925, and that of the refinancings was $124,407.

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Compared with all conventional home mortgage applications in 1994 (table A.3, size statistic items), those involving PMI were, on average, larger for both home purchase loans and refinancings. In particular, PMI companies handled a much smaller proportion of applications for mortgages under 50,000, partly because this category includes loans for mobile homes, which are in the conventional home mortgage totals but are rarely insured by the PMI industry.

Characteristics of Applicants for PMI

In 1994, roughly two-thirds of all applicants for PMI had incomes that were at or above the median for MSA in which the property securing the loan was located (table A.4). The distributions of PMI applicants by income differed between those seeking insurance for loans to purchase homes and those who applied for insurance to refinance an existing loan. In particular, the proportion of insurance applicants for refinancing who were in the highest income grouping (income greater than 120 percent of their MSA median family income) was significantly larger (59 percent) than the comparable proportion of insurance applicants for home purchase mortgages (48 percent). This difference probably reflects the higher proportion of first-time, and perhaps younger, homebuyers in the home purchase category.

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Like the distribution of applications for conventional home purchase loans and refinancings observed in the 1994 HMDA data, most applicants for loans backed by PMI were white (about 80 percent), and roughly half were seeking insurance for mortgages to be secured by properties located in predominantly white neighborhoods (neighborhoods with a minority population of less than 10 percent). Overall, about 60 percent of the applicants were seeking insurance to help by a home or to refinance a mortgage on a property located in the non-central city portion of MSAs.

The distribution of applications received by the individual PMI companies according to the income and the race or ethnic group of the borrower generally reflected the national distribution (table A.5). The differences among the companies were, for the most part, minor and may have partly reflected the regional orientation or the business strategy of the company. For example, Amerin Guaranty Corporation is concentrated in the West and has a business strategy of delegating the underwriting decision to the lender.(29) Both characteristics may have resulted in lending to higher proportions of lower-income and minority applicants.

Disposition of Applications

for Mortgage Insurance

PMI companies approved most of the applications for insurance they acted on during 1994 - roughly 87 percent of applications for insurance to back home purchase loans and 88 percent for refinancings (table A.6). Among the applications for insurance on home purchase loans, 9.7 percent were denied by the insurer, and 2.5 percent were withdrawn by the lender; in a relatively small percentage of cases, the application file was closed after additional information needed by the insurer to make a decision was not provided. For home refinancing applications, the denial rate was 8.5 percent, and the withdrawal rate was 2.8 percent. Compared with the PMI data for the fourth quarter of 1993, denial rates for all of 1994 were down slightly, about 1 to 2 percentage points.

In general, the relatively high approval rates for PMI are not surprising: Lenders submitting applications for insurance know the prospective borrower's credit circumstances and the credit underwriting guidelines used by the PMI companies.(30) However, the evaluation of disposition patterns for mortgage insurance applications is complicated because lenders may submit an application for insurance to more than one PMI company at a time. Multiple applications are potentially more common for PMI than for mortgages because PMI companies do not charge lenders to submit an application, whereas lenders generally charge mortgage applicants for each submission.

Overall, nearly 7 percent of the applications in the 1994 data appear to have involved multiple applications (see box "Multiple Applications"). Analysis of these applications suggests that lenders were submitting the applications primarily of marginally qualified applicants to more than one PMI company. For example, among the multiple applications, the denial rate was roughly 33 percent for insurance for home purchase mortgages compared with 8 percent for all home purchase applications excluding the multiple applications (the denial rate for all home purchase applications, 9.7 percent, is shown in table A.6).

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Although most applications for PMI were approved in 1994, there were substantial differences across metropolitan areas. In particular, applications for insurance for home purchase mortgages secured by properties located in all California MSAs and in many Florida MSAs had relatively high denial rates. In California, weak housing market conditions, combined with the aggressive pursuit of customers by mortgage originators, may have led to higher proportions of marginally qualified applicants for mortgage insurance in these markets. The explanations for high denial rates in Florida are less certain, but suggestions range from a high proportion of condominiums and second homes to a local economy that is prone to greater volatility in housing prices. In contrast, many MSAs in the Midwest and some in the South had denial rates well below the national average (for example, Minneapolis-St. Paul, 2.4 percent; Detroit, 4.1 percent; Milwaukee, 4.0 percent; and Richmond, 4.2 percent.)

Disposition by Applicant Characteristics

In general, the amount and the stability of income can be expected to affect an applicant's ability to qualify for mortgage insurance, although they are usually considered in relation to the existing and proposed debt burden rather than as absolute measures of creditworthiness. Other factors considered in evaluating creditworthiness include the amount of assets available to meet down-payment and closing cost requirements, employment experience, and credit history. On average, lower-income house holds have fewer assets and lower net worth and experience more frequent employment disruptions than do higher-income households; this combination of factors often results in a denial of an application.

The 1994 data indicate that the majority of applications for PMI were approved but that the rates of approval and denial varied somewhat wrong applicants grouped by their income (table A.6). For example, in 1994 nearly 90 percent of the applicants for insurance for home purchase loans whose incomes placed them in the highest income group were approved for insurance, compared with 84 percent in the lowest income group (income less than 80 percent of their MSA median). Approval and denial rates for applicants from middle-income groups were similar to those for the highest income group. The same patterns were found for applications for insurance of refinancings.

Examining the racial or ethnic characteristics of applicants indicates that greater proportions of Asian, black, and Hispanic applicants than of white applicants had their applications for private mortgage insurance denied in 1994. The denial rate for Native American applicants was about the same as that for white applicants. For example, for insurance for home purchase loans, 16.3 percent of Asian applicants, 18.4 percent of black applicants, 19.4 percent of Hispanic applicants, 9.9 percent of Native American applicants, and 9.3 percent of white applicants were denied. The rate of denial also generally increased as the proportion of minority and lower-income residents in a neighborhood increased.

Differences in PMI denial rates for applicants grouped by race or ethnicity reflect various factors, including the proportion of each group with relatively low income. In 1994, 19 percent of the white applicants who applied for insurance had incomes that were less than 80 percent of the median family income for their MSA (data not shown in tables). The figures for other groups of applicants in the same income category were roughly 33 percent for black, 32 percent for Hispanic, and 19 percent for Asian applicants. Differences in the distribution of applicants for insurance by income account for some of the differences in denial rates. However, within each income group, white applicants had lower rates of denial than Asian, black, or Hispanic applicants (table A.7).

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Denial rates are also influenced by differences in the frequency of multiple applications for insurance for the same applicants across racial or ethnic groups. Generally, applications by minorities are more likely to be submitted to more than one PMI company because minority applicants often have lower incomes or more complex credit circumstances. Excluding multiple applications submitted for the same individuals reduces denial rates about 3 to 4 percentage points for minorities and about 2 percentage points for whites.

The pattern of denial rates by race or ethnicity differs from the pattern in HMDA data in one notable way. In HMDA data, Asian applicants for home purchase loans have a lower denial rate than that for white applicants.(31) The high proportion of Asian applicants from California may help account for their relatively high denial rate for PMI. Among Asians applying for home purchase loans where the MSA location of the property was reported, 34 percent were seeking insurance for mortgages to buy homes in California. (Only 14 percent of all PMI applications were for loans to buy homes in California.) Slightly more than 24 percent of the Asian applicants from California were denied PMI, compared with a denial rate of only 12 percent for Asians outside California (data not shown in tables).

The difference in PMI denial rates between white applicants and Asian, black, and Hispanic applicants may lead some observers to conclude that race influences the disposition of applications.(32) Although these disparities raise questions, the extent of any discrimination cannot be determined from the data submitted by the PMI companies because they provide little information about the characteristics of the properties that applicants seek to purchase or refinance or of the financial circumstances of the applicants. For example, the applicants' levels of debt, their credit histories, and their employment experiences are not disclosed. Without information about these circumstances and about the specific underwriting standards used by PMI companies, the fairness of the decision process cannot be assessed. (1.) Unless otherwise noted, all mortgages discussed were approved during the first ten months of 1994 for the purchase of owner-occupied, single-family homes located in metropolitan areas. (2.) Research has consistently found that mortgages with higher loan-to-value ratios go into default more frequently than those with lower ratios. See Roberto G. Quercia and Michael A. Stegman, "Residential Mortgage Default: A Review of the Literature," Journal of Housing Research, vol. 3, no. 1 (1992), pp. 341-79. In Freddie Mac's experience, for example, loans with down payments of 5 percent go into default twice as often as loans with 10 percent down payments and five times as often as loans with 20 percent down payments. Loss severity (that is, the loss measured as a proportion of the loan balance) is about 25 percent higher for loans with original loan-to-value ratios in the range of 91 percent to 95 percent compared with loans from 81 percent to 90 percent (Secondary Mortgage Markets, vol. 11, no. 1, 1994, pp. 15-19). The experience of the Federal Housing Administration (FHA) with the mortgages it insures has been similar to that of Freddie Mac. Among FHA-insured mortgages originated from 1986 through 1989, those with loan-to-value ratios greater than 95 percent have defaulted at a rate three to four times that of loans with ratios of less than 90 percent. See James Berkovec, Glenn B. Canner, Stuart Gabriel, and Timothy Hannan, "Race and Residential Mortgage Defaults: Evidence from the FHA-insured Single-Family Loan Program," in Proceedings of a Conference on Discrimination and Mortgage Lending (U.S. Department of Housing and Urban Development, Washington, D.C., May 1993). (3.) Some lenders will grant low-down-payment mortgages without insurance, sometimes at higher interest rates, thus effectively providing the insurance themselves. Most often such mortgages are extended as part of an affordable housing program, but lenders may self-insure other low-down-payment mortgages as well. (4.) Conventional loans are those not backed by a government agency. For a description of the PMI industry, see Glenn B. Canner, Wayne Passmore, and Monisha Mittal, "Private Mortgage Insurance," Federal Reserve Bulletin, vol. 80 (October 1994), pp. 883-99. (5.) The claim amount on a defaulted loan generally includes the outstanding balance on the loan, delinquent interest payments, expenses incurred during foreclosure, costs to maintain the property, and advances the lender made to pay taxes and hazard insurance on the property. After foreclosing and taking title to a property, a lender may submit a claim to the mortgage insurer. At this point, the PMI company has two options: (1) Pay the full claim amount and take title to the property or (2) pay the lender the designated percentage of the coverage of the total claim amount as indicated in the policy and let the lender retain title to the property. The option selected by the PMI company will depend on its estimate of the potential value of the property net of sales expenses. (6.) For further information about the risk diversification and monitoring practices of PMI companies, see Roger Blood, "Managing Insured Mortgage Risk," in Jess Lederman, ed., The Secondary Mortgage Market: Strategies for Surviving and Thriving in Today's Challenging Markets, rev. ed. (Probus, 1992), pp. 635-60. Also see John R. Hoff and Kathleen E. Valenti, "Preserving the Dream," Mortgage Banking (August 1995), pp. 77-83. (7.) Technically, the VA offers loan guarantees rather than mortgage insurance, but both guarantees and insurance are similar in function and so are referred to here as mortgage insurance. Other government agencies also provide home loan insurance, but on a much smaller scale. (8.) For a discussion of the history of the FHA's programs and its credit policies, see Susan Wharton Gates, "FHA at a Crossroads," Secondary Mortgage Markets, vol. I 1, no. 3 (1995), pp. 1, 14-21. (9.) The VA mortgage guarantee program, which is open only to veterans, is usually the program of choice for eligible households with few assets available for down payment. (10.) Basic underwriting guidelines include the allowable debt-to-income and loan-to-value ratios. Fannie Mae and Freddie Mac, as well as most other secondary market participants, establish their own guidelines for the conventional mortgage loans they purchase. In the case of the Government National Mortgage Association (Ginnie Mae), underwriting standards are established by the Department of Housing and Urban Development and the VA. (11.) For a general discussion of the HMDA data, see the appendix, pp. 91-103, to Glenn B. Canner and Wayne Passmore, "Home Purchase Lending in Low-income Neighborhoods and to Low-Income Borrowers," Federal Reserve Bulletin, vol. 81 February 1995), pp. 71-103. For a summary of the 1994 HMDA data, see the Financial and Business Statistics section of the September 1995 Federal Reserve Bulletin. (12.) Jumbo loans are conventional mortgage loans that exceed in size the maximum single-family mortgage that may be purchased by Fannie Mae or Freddie Mac. (13.) Because lenders who originate loans at the end of the year may not have an opportunity to sell the loan before year-end, when HMDA data must be reported, we have excluded from our calculations loans originated during the last two months of 1994. (14.) The importance of income, per se, in credit risk is unclear. Lower-income barrowers with good credit histories, modest debt burdens, and stable employment may be similar to other similarly situated, higher-income borrowers in terms of their likelihood of default. But, as described, income is highly correlated with other measures of creditworthiness. (15.) See for example, Alicia H. Munnell, Lynn E. Browne, James McEneaney, and Geoffrey M.B. Tootell, Mortgage Lending in Boston: Interpreting HMDA Data, Working Paper 92-7 Federal Reserve Bank of Boston, October 1992), p. 24, table 4. (16.) Many lower-income borrowers do not buy homes in low-income neighborhoods. Thus, lower-income borrowers are not synonymous with low-income neighborhoods, but the proportion of lower-income borrowers in lower-income neighborhoods is higher than the proportion in other neighborhoods. See Glenn B. Canner and Wayne Passmore, "Implementing CRA: What is the Target?" in Proceedings of the 31st Annual Conference on Bank Structure and Competition (Federal Reserve Bank of Chicago, forthcoming). (17.) Specifically, the goals require that a certain proportion of Fannie Mae and Freddie Mac purchases be mortgages extended to low- and moderate-income families and to families located in central cities. Furthermore, both institutions must purchase a specified dollar amount of mortgages extended to families residing in low-income areas or with very low incomes (this latter goal is referred to as the special affordable housing goal). For more details about these goals and their effects, see Glenn B. Canner, Wayne Passmore, and Dolores S. Smith, "Residential Lending to Low-Income and Minority Families: Evidence from the 1992 HMDA Data," Federal Reserve Bulletin, vol. 80 February 1994), pp. 79-108. (18.) The PMI industry has been promoting homeownership by providing insurance for mortgages with 97 percent loan-to-value ratios. These programs also use more flexible underwriting criteria. To offset the additional potential risk from such loans, bor-rowers are required to complete a homebuyer education course. Thus, to the extent the programs are influencing the type of mortgage that is insured or sold, we might expect to see more low-income borrowers, or black and Hispanic borrowers, with mortgages that are insured or that have been sold. In addition, PMI companies, as well as Fannie Mae and Freddie Mac, have introduced new programs targeted toward low- and moderate-income households. Joint programs among the PMI companies and the secondary market agencies, such as Fannie Mae's Community Home Buyers program and Freddie Mac's Affordable Gold program, allow the borrower to use gifts and other nonborrower sources of funds for part of the down payment on a mortgage with a 95 percent loan-to-value ratio; such sources of funds are not allowed in regular 95 percent loan-to-value ratio programs. (19.) See Joseph Blalock, "Successful Fixed-rate Lending" Savings and Community Banker February 1994), p. 38; and Wayne Passmore, "Can Retail Depositories Fund Mortgages Profitably?" Journal of Housing Research, vol. 3, no. 2 (1992), pp. 305-40. (20.) Some FHA mortgages have sizes above the mortgage limits used for the Fha-eligible category because the FHA establishes higher mortgage limits for two-, three-, and four-family properties. (21.) For additional details about Fannie Mae and Freddie Mac and their roles in the conforming mortgage market, see John L. Goodman, Jr., and Wayne Passmore, Market Power and the Pricing of Mortgage Securitization, Finance and Economics Discussion Series 187 (Board of Governors of the Federal Reserve System, March 1992). (22.) For an extensive review of the role of depository institutions in community lending, see Board of Governors of the Federal Reserve System, Report to the Congress on Community Development Lending by Depository Institutions (Board of Governors, 1993). (23.) For evidence that lower-income borrowers who purchase homes in middle- and upper-income neighborhoods may not be financially constrained, see Canner and Passmore, "Implementing CRA." (24.) For a further discussion of the role of non-agency mortgage securities, see Nancy DeLiban and Brian P. Lancaster, "Understanding Nonagency Mortgage Security Credit," Journal of Housing Research, vol. 6, no. 2 (1995), pp. 197-216. (25.) Data on wealth and income are from the Board of Governors of the Federal Reserve System, 1992 Survey of Consumer Finances. (26.) Many of the lower-income borrowers recorded in HMDA data may not be borrowers with limited financial resources. For example, retirees may have lower incomes but significant holdings of financial assets, and newly graduated professionals may have small current incomes but substantial future incomes. Lower-income borrowers who locate in lower-income neighborhoods may be more likely to have both limited income and limited financial assets and thus may be more likely to need loan programs that allow minimal down payments and the financing of closing costs. Conversely, lower-income people with wealth are less likely to locate in such neighborhoods. See Canner and Passmore, "Implementing CRA." (27.) Founded in 1973, MICA is the trade association for the PMI industry. The costs to the FFIEC for receiving and processing the data, preparing disclosure statements and other reports, and disseminating the data are being covered by the PMI companies through MICA. (28.) An analysis of the 1993 data is in Glenn B. Canner, Monisha Mittal, and Wayne Passmore, "Private Mortgage Insurance," Federal Reserve Bulletin, vol. 80 (October 1994), pp. 883-99. (29.) For example, if a lender has additional information about an applicant that is not adequately reflected in standard mortgage documentation and that causes the lender to believe the applicant is creditworthy, then the lender may use Amerin Guaranty.

Analysis of PMI activity by region of the country indicates that applicants of Hispanic origin accounted for a relatively large share of all applications for insurance to buy homes for each company in the West. However, Amerin Guaranty received a particularly large share of its insurance applications from Hispanic mortgage applicants. In 1994, nearly one-quarter of Amerin Guaranty's customers in the West were of Hispanic origin, roughly twice the proportion of Hispanic applications received by other PMI companies in this region (data not shown in tables). (30.) The approval rate for Amerin Guaranty Corporation is 100 percent because the firm delegates the decision to approve an application for insurance to the lending institution. Thus, Amerin Guaranty receives notification about applications for insurance only when a lender has selected it as the insurance provider. (31.) For example, according to the 1994 HMDA data, the denial rate for Asian applicants was 12 percent, and the denial rate for white applicants was 16.4 percent. (32.) Unlike many originators of mortgages, PMI companies do not ordinarily have direct contact with prospective borrowers and would be aware of race and ethnic identities only from application documents forwarded for their consideration.