New information reported under HMDA and its application in fair lending enforcement

Federal Reserve Bulletin, Summer, 2005 by Robert B. Avery, Glenn B. Canner, Robert E. Cook, Shannon C. Mok, Caitlin G. Coslett, Patricia J. Dykes, Sylvia A. Freeland

Borrowers in the higher-priced market generally fall into one of two market segments, "near prime" and "subprime," with individuals in the latter category paying the highest prices because they pose the greatest risk of default. In practice, the dividing line between these two "nonprime" markets is becoming increasingly amorphous, as is the line between the prime (lower-price) and nonprime markets.

Estimates of the annual volume of subprime lending vary, but all sources agree that this market has grown substantially in recent years. (11) One industry source estimates that over the period 1994-2004, the annual dollar volume of subprime home loans increased from about $35 billion to more than $530 billion. Consequently, subprime lending is no longer a minor segment of the market. Subprime loans are estimated to have accounted for about 19 percent of all home-loan originations in 2004, up from less than 5 percent in 1994. (12)

As significant pricing variability has emerged in the market, so have concerns about the fairness of creditor decisions in this regard. Little information has been available to assess the merits of these concerns, and only a few fair lending investigations focusing on pricing issues have been pursued by the federal banking agencies or the Department of Justice. In its review of Regulation C that led to the 2002 revisions, the Federal Reserve Board averred the importance of gathering information to facilitate assessments of the fairness of loan-pricing decisions, particularly for nondepository institutions, which are less likely to be subject to periodic fair lending examinations. Recognizing the costs incurred by lenders to comply with such a reporting and disclosure requirement, the Board limited the scope of the regulation to the disclosure of pricing on loan originations (not loans purchased from other entities or applications that did not result in a loan origination) in the higher-priced segment of the loan market and to focus within that segment only on dwelling-secured loans subject to Regulation Z (which does not cover "business purpose" loans--including some loans to individuals who do not intend to occupy the dwelling being financed). (13)

Specifically, the 2002 revisions to Regulation C require the reporting of the spread between the annual percentage rate (APR) on a loan and the rate on Treasury securities of comparable maturity for loans with spreads above designated thresholds. The APR was selected as the measure of the loan's pricing because it was regarded as the best single measure of the "true" cost of a loan. The thresholds for reporting differ by lien status: 3 percentage points for first liens and 5 percentage points for junior liens. To calculate the rate spread, the lender uses the yield on Treasury securities as of the fifteenth day of a given month depending on when the interest rate was set on the loan. (14)

In establishing this disclosure rule, the Federal Reserve sought to select thresholds that would exclude the vast majority of prime rate loans and include the vast majority of subprime loans. The selection of specific thresholds was based on loanprice data from several sources. (15) The analysis revealed that roughly 98 percent of prime first-lien loans have APRs that would likely fall below the threshold of 3 percentage points for reporting first liens. (16) The analysis also indicated that this threshold would require reporting for about 98 percent of the subprime loans backed by first liens and that the 5 percentage point threshold would capture about 95 percent of the subprime loans backed by junior liens. Overall, data from the Annual Housing Survey covering prime, near-prime, and subprime loans suggested that, in a typical year, the thresholds would fall somewhere in the near-prime range and would require the reporting of about 10 percent of all home loans backed by first liens and about 22 percent of all loans backed by junior liens.