Information Externalities, Neighborhood Characteristics, and Home Mortgage Pricing and Underwriting

Abstract

Theories of rational redlining suggest a low housing sales volume should lead to greater uncertainty in house price appraisals, making the mortgage loan riskier, less attractive to lenders, and consequently more likely to be denied or charged a higher price. Previous empirical tests of this “information externality” theory are limited solely to the denial decision, and are based on US data from the 1990s. The mortgage bubble of the early 2000s offers a unique framework for revisiting the topic. First, widespread securitization enabled banks to sell their loans, making them unaccountable for loan riskiness. Second, underwriting was extended to applicants previously deemed too risky, with pricing serving as the mechanism of compensating investors for the increased risk. Using rich loan-level data from US banks, we test whether the effect of information externalities (if any) shifted from underwriting to pricing during the mortgage bubble. We also test for any evidence of discriminatory redlining. The information externality theory has important policy implications. It can justify government intervention even if discriminatory redlining is absent. Additionally, it implies that if low sale volume areas have higher minority concentrations, omission of information variables may lead to the misidentification of economically rational redlining as discriminatory redlining. Our findings provide evidence of a shift of the importance of information externalities from underwriting to pricing decisions, although even in pricing the economic importance of information externalities is small for a majority of borrowers. We find no evidence of discriminatory redlining, and strong evidence of the importance of individual creditworthiness factors.