Mortgage Lending Discrimination and Differential Volatility in Neighborhood Property Values

Observations of significant differences in loan terms between demographically distinct groups of borrowers are often interpreted as evidence of demographic discrimination. The competitive nature of mortgage lending undermines explanations of such differences based on managerial preferences for certain demographic groups while the ease and accuracy of measuring credit risk render common theories of lending discrimination based on exogenous asymmetric information increasingly implausible. Statistical procedures lacking economic foundations may also expose empirical tests for discrimination to model risk. Seeking the simplest possible explanation for these observations, we consider the valuation of secured mortgages by lenders in a classical asset-pricing model having complete markets, common knowledge and arbitrage-free valuation. Using both analytical and numerical solutions, we show that the effect of neighborhood variations in housing price volatility and the irretrievability of the value of housing services on the strategic exercise of the options embedded in common mortgage contracts induce rational lenders to offer different loan terms and balances to borrowers who exhibit identical measures of credit risk and are distinguished only by observable demographic traits.

Author (s) Details

Dr. David Nickerson
Ryerson University, Canada.

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