Fair Lending: Where is it Headed?

Whether measured by the Fair Housing Act or the ECOA, fair lending is more than a quarter of a century old. In that quarter century, fair lending has passed through a number of stages. As we can learn from history, we can learn from the evolution of fair lending.

At ABA's Regulatory Compliance Conference, Paul Hancock laid out the history and made some projections for future enforcement activity. Hancock is one of the few (along with this editor) whose fair lending feet were dampened during the early enforcement attempts.

Hancock laid out the history of ECOA and Fair Housing activity on discrimination based primarily on race. He noted that the addition of HMDA and CRA to the formula added the dimension of geographic measurements for discrimination. Redlining cases were among the early efforts of the Department of Justice.

In the 1990s, most of the cases were based on geography or underwriting. By the mid-1990s, flexible underwriting had became the watchword of the day. Noting that the Department of Justice has not brought an underwriting case in some time, Hancock advised the audience that the enforcement emphasis has shifted again, this time to pricing and terms.

Hancock predicts an enforcement approach that mixes pricing and terms with the concepts of unfairness and deception. In the context of fair lending, the question is not merely unfairness, but whether the unfairness occurs on the basis of race or national origin - or other prohibited basis. The issue will be how loans are being priced.

Pricing lies at the heart of the unfair or deceptive acts or practices ("UDAP") debate. Needless to say, pricing questions will be fueled by the release of 2004 HMDA data which, for the first time, provides some pricing information.

Examinations on fair lending are likely to start with pricing questions, and this is precisely where the compliance challenge lies. Can you or someone in your institution explain all pricing decisions on loans made? The examination issue will be: how are loans being priced? Who makes pricing decisions? What impact do pricing decisions have when the impact is measured by a prohibited basis?

The big question is the extent to which minorities are disproportionately present in the higher priced loans. This is the first question that will be asked by any investigator, whether that is your examiner or an attorney general looking for a hot issue.

There are likely to be differences found when the only factor considered is price. What financial institutions must do is reach and consider all of the factors that result in the pricing. If the pricing is not discriminatory, you will have to prove it. This means that loan policies must have more than lending authority and a pricing matrix; they should have risk considerations included in the pricing decision.

In the coming years, Hancock predicts that a financial institution's greatest fair lending risk is discretionary loan pricing. In his experience, the risk is greater for prime lenders than for subprime lenders. Subprime lenders generally work off of a strict risk-based pricing grid. As a result, pricing decisions are fairly consistent. However, prime lenders generally have more pricing discretion and therefore more risk of differential treatment.

Prime lenders tend to allow their lenders discretion in pricing without considering the impact of pricing decisions in the lenders' compensation. Lenders are allowed to exercise business judgment in making pricing decisions, especially in imposing or waiving fees related to the loan. Hancock defines discretionary pricing as pricing that is outside of or independent of creditworthiness. This is very different from risk-based pricing.

When lenders are allowed to adjust pricing with only their compensation in mind, the lenders may be motivated to treat customers differently based on perceptions. In short, the loan officers may be tempted to discriminate.

Hancock recommends that self assessments look at pricing practices. In particular, he suggests that the analysis should consider the pricing elements for which discretion is allowed. The areas for discretion are the areas of vulnerability.

Demonstrating compliance may come down to documentation. Institutions must be able to show why prices were higher for one applicant than another. This may be the result of extra time and effort needed to work with a new borrower. Lower prices may be the result of effective rate shopping and comparison by the applicant. These reasons must be documented and available to investigators. Hancock finds that often these reasons are placed on sticky notes that are lost when the files are imaged, so be sure that the documentation is official - and saved.

ACTION STEPS

Pull together all pricing information on different loan products. If a pricing matrix for lending authority doesn't exist, put one in place.
Determine who has the authority to set loan prices.
Determine how much pricing latitude loan officers have. Take into account the specific ways that pricing may be adjusted and compare these terms only.
Next, compare loan pricing by loan officer. Also compare each loan officer's pricing decisions to the official pricing matrix.
Now compare your findings with the demographics in your market as a whole and the market served by loan officers who impose the highest prices.
Review documentation for loan pricing and determine whether the documentation is adequate.