Friday, February 17, 2012

The Countrywide Complaint and the Capitalization of Trust

In December 2011 the Department of Justice filed suit against Countrywide Financial Corporation alleging discrimination on the basis of race and national origin in its mortgage lending operations over the period 2004-2008. The result was a record settlement for $335 million with Bank of America, which had acquired Countrywide in 2008.

The complaint was based on a review of "internal company documents and non-public loan-level data" on more than 2.5 million loans and is worth reading in full. In addition to providing evidence of disparate impact, it describes in detail the set of incentive structures under which loan officers and mortgage brokers were operating. These compensation schemes left considerable room for individual discretion in the setting of fees and rates, and for steering borrowers towards particular loan products. The manner in which this discretion was exercised had significant effects on overall levels of compensation, resulting in strong incentives for brokers and loan officers to act against the interests of borrowers.

But these incentives were formally neutral with respect to race and national origin, which raises the question of why they led to such disparate impact. In the standard economic theory of price discrimination, it is the most affluent customers, or the ones who value the product the most, who pay the highest prices. But in the case of mortgage loans it appears that the highest prices were paid by those who could least afford to do so. One possible reason for this is that this set of borrowers was poorly informed about market rates and alternatives. But this alone is not a satisfactory explanation, because such information can be sought if one considers it to be valuable. It may not be sought, however, if if a borrower trusts his broker to be providing the best available terms. I argue below, based on a very interesting paper by Carolina Reid of the San Francisco Fed, that variations across communities in the level of such trust was a key factor in explaining why the incentive structures in place gave rise to such disparate impact.

But first, the complaint:
As a result of Countrywide's policies and practices, more than 200,000 Hispanic and African-American borrowers paid Countrywide higher loan fees and costs for their home mortgages than non-Hispanic White borrowers, not based on their creditworthiness or other objective criteria related to borrower risk, but because of their race or national origin. 
Additionally... Hispanic and African-American borrowers were placed into subprime loans when similarly-qualified non-Hispanic White borrowers received prime loans. Between 2004 and 2007, more than 10,000 Hispanic and African-American wholesale borrowers received subprime loans, with adverse terms and conditions such as high interest rates, excessive fees, prepayment penalties, and unavoidable future payment hikes, rather than prime loans... not based on their creditworthiness or other objective criteria related to borrower risk, but because of their race or national origin.
But what, exactly, were these policies and practices, and how did they give rise to the alleged disparate impact? The complaint focuses on the discretion given to loan officers and mortgage brokers, and the manner in which their compensation was determined. The process for retail loans was as follows:
Countrywide utilized a two-tier decision-making process to set the interest rates and other terms and conditions of retail loans it originated. The first step involved setting the credit risk-based prices on a daily basis... including interest rates, loan origination fees, and discount points. In this step, Countrywide accounted for numerous objective credit-related characteristics of applicants by setting a variety of prices for each of the different loan products that reflected its assessment of individual applicant creditworthiness, as well as the current market rate of interest and the price it could obtain from the sale of such a loan to investors. These prices, referred to as par or base prices, were communicated through rate sheets... Individual loan applicants did not have access to these rate sheets. 
As the second step in determining the final price it would charge an applicant for a loan, Countrywide allowed its retail mortgage loan officers... to increase the loan price charged to borrowers over the rate sheet prices set by Countrywide, up to certain caps; this pricing increase was labeled an overage. Countrywide also allowed these same employees to decrease the loan price charged to borrowers below the stated rate sheet prices; this pricing decrease was labeled a shortage. Countrywide further allowed those employees to alter the standard fees it charged in connection with processing a loan application and the standard allocation of closing costs between Countrywide and the borrower. Employees made these pricing adjustments in a subjective manner, unrelated to factors associated with an individual applicant's credit risk... 
During the time period at issue, Countrywide loan officer compensation was affected by the loan officers' decisions with respect to pricing overages and shortages, as well as other factors, such as volume of loans originated. Loan officers could obtain increased compensation for overages and could have their total compensation potentially decreased for shortages. Countrywide's compensation policy thus provided an incentive for its loan officers in making pricing adjustments to maximize overages and, when offering shortages, to minimize their amount.
Very similar incentives were in place for mortgage brokers who brought loan applications to Countrywide for origination and funding through its wholesale channel. As in the case of retail loans, rate sheets were made available to brokers on a daily basis with prices specified for different loan products based on borrower characteristics. Brokers were not required to "inform a prospective borrower of all available loan products for which he or she qualified, of the lowest interest rates and fees for a specific loan product, or of specific loan products best designed to serve the interests expressed by the applicant." In fact, the manner in which broker compensation was determined created incentives to actively conceal such information, since they were paid "based on the extent to which the interest rate charged on a loan exceeded the base, or par, rate for that loan to a borrower with particular credit risk characteristics fixed by Countrywide and listed on its rate sheets."

Aside from variation across borrowers in rates and fees for a given product, there was also variation in the types of products towards which borrowers were steered:
It was Countrywide's business practice to allow its mortgage brokers and employees to place a wholesale loan applicant in a subprime loan even when the applicant qualified for a prime loan according to Countrywide's underwriting practices... These underwriting guidelines were intended to be used to determine whether a loan applicant qualified for a prime loan product, an Alt-A loan product, a subprime loan product, or for no Countrywide loan product at all.  Countrywide's compensation policy and practice created a financial incentive for mortgage brokers to submit subprime loans to Countrywide for origination rather than any other type of residential loan product.
The incentives to increase overages, reduce shortages, and steer borrowers towards subprime products even when qualified for prime loans clearly operated against the interests of borrowers. Coupled with the incentives tied to loan volume, this compensation scheme encouraged brokers and loan officers to set terms that varied systematically across borrowers. Applicants who were more sophisticated and knowledgable, and would walk away from riskier or more expensive products, received better terms than those who were more naive. And those who were suspicious of their brokers and aware of the incentives under which they were operating secured better terms than those who were more trusting.

Hence the disparities in rates and fees identified in the complaint could, in principle, have arisen from differences across social groups in the degree to which they trusted those with whom they were transacting. Carolina Reid's paper provides some evidence for this interpretation. Reid argues that "while financial services have gone global... obtaining a mortgage is still a very local process, embedded in local context and social relations." In order to better understand this process, she interviewed homeowners in Oakland and Stockton, two areas that experienced very high rates of subprime lending prior to the crisis and correspondingly elevated rates of foreclosure subsequently. These were also areas in which a disproportionately large share of originations were mediated by mortgage brokers. Here is what she found:
One of the strong themes that emerged from the interviews was the extent to which respondents of color expressed their desire to work with a broker from their own community or background... In this sense, the interviews support Granovetter’s hypothesis that individuals are “less interested in general reputations than in whether a particular other may be expected to deal honestly with them—mainly a function of whether they or their own contacts have had satisfactory past dealings with the other.” (Granovetter 1985, p. 491) In numerous interviews, borrowers said that they turned to their social networks and relations in the neighborhood to identify a local mortgage broker who would be willing to “work with someone like me.” Part of this was driven by a lack of trust in traditional lenders, and several respondents in Oakland noted a historical distrust of banks in the community... More frequently, however, respondents noted that they didn’t think they could obtain or qualify for a loan without help from someone who was ‘like them’ but who knew the system... 
Respondents listed a wide array of ways that they received recommendations for both real estate agents and mortgage brokers: family, neighbors on the block, the local church, their jobs, the park, and parents at their kids’ school...  
The desire to be served by someone from the community was not lost on mortgage brokers, who during this time period actively created the impression that they were part of the community to help promote their business. Strategies ranged from relying on customer referrals to generate new business, to frequenting local churches, social gatherings, and businesses and by adopting local social conventions... The interviews pointed to how the respondents felt immediately connected to these brokers, “he understood my situation”, “he told me that he understands how difficult the paperwork is, especially when you have lots of jobs,” “I liked his ideas for how to brighten the kitchen,” “she seemed to understand why we wanted to move from SF, buy a house, provide for a yard for the kids, a good school.” 
In theory, mortgage brokers are well‐placed to serve as a “bridging tie” and “trusted advisor”, since they have both experience with the lending process and access to information about mortgage products and prices. Empirical research studies, however, have revealed that the during the subprime boom, yield spread premiums coupled with a push for a greater volume of loan originations provided a financial incentive for brokers to work against the interests of the borrower (e.g. Ernst, Bocia and Li 2008). In addition, since there was no statutory employer‐employee relationship between lending institutions and brokers, there were few legal protections to ensure that brokers provide borrowers with fair and balanced information. This aligns with the “trust” that social relations engender... In both Stockton and Oakland, respondents did not seem to be aware of the potential for perverse incentives on the part of brokers, and instead trusted them fully to act in their best interests. 
It is ironic that distrust of traditional lending institutions such as commercial banks led some borrowers to seek out brokers from their own communities whom they felt they could trust. But these brokers were operating under high-powered incentives to inflate rates and fees and guide borrowers towards subprime products even when they were eligible for cheaper alternatives. The trust that was placed in the brokers allowed them greater flexibility to respond to these incentives and left borrowers worse off than they would have been if they had been more suspicious or better aware of the incentive structures in place.

Viewed in this manner, the subprime saga has some broader implications. From the point of view of a company operating in multiple local markets with a diverse customer base, the strategy of giving local employees or contractors the discretion to adjust prices can be very profitable. This is especially so if these employees appear trustworthy to their customers, but are not in fact deserving of such trust. As Groucho Marx is reputed to have said:
The secret of life is honesty and fair-dealing. If you can fake that you've got it made. 
For products involving frequent repeat purchases by the same customer, reputation effects and competition can limit the degree of price discrimination. But the purchase of a home is an infrequent transaction for most people, and the complexity of the loan product precludes easy comparison with alternatives on offer. Trust then becomes a key determinant of pricing and transaction volume, especially when strong and hidden incentives for the betrayal of trust are in place.

Betrayal also leads to the erosion of trust over time. It could be argued that trust is one of our most valuable public goods, substantially lowering the costs of transacting. In the complete absence of trust, the volume of resources that would need to be devoted to monitoring would be prohibitively large and many organizations and markets would simply not exist. Trust also comes naturally to most of us, based on simple cues such as those revealed in Reid's interviews. High-powered incentives to secure and then betray such trust are therefore costly not just to the immediate victims, but also to the broader community. This may be one of the less visible consequences of the subprime crisis. 


  1. There is an alternative explanation, a contagion effect.

    See "The Effect of Neighborhood Contagion on Mortgage Selection" from the St. Louis Fed.

  2. Rajiv - Excellent post and most illuminating.

    The level of trust one can show without being swindled all the time is one of the key differences between many of the more developed economies and some of the less developed ones. And once there is a widespread breakdown in the level of trust, it is not only extremely costly to economic productivity but it can take a long time to recover.

    Just a tangential point that I've been thinking about for a while - what we have here is evidence of a fraud-friendly environment in which the real proponents (senior managers) are almost impossible to convict on the basis of 'mens rea' or even 'wilful blindness'. They can capture the rewards without being ever liable for the consequences.

    If you add in the research on self-deception and a sufficiently selective and competitive environment, then we get an environment rife with moral hazard and fraud without any of the actors, even senior, being culpable in the normal sense of the word. In fact, everyone probably genuinely believes that they've done nothing wrong!

  3. Ashwin, thanks. Regarding your point about everyone believing they did nothing wrong, here's an extract from an interview with a broker (quoted by Reid):

    "Interviewer: In retrospect, do you wish you had done anything differently with the borrowers?
    No. I don’t think so. I helped a lot of families buy beautiful homes, where they could raise their families. Some of them couldn’t afford it. [That’s life.]"

    And some borrowers now in foreclosure still feel that their brokers had no choice with regard to setting rates and fees or selecting products:

    "Very few of the respondents were willing to openly criticize their mortgage broker, even when they were in the process of renegotiating loan terms with their lenders. “The broker just sold me what the bank was offering. He couldn’t change the terms.”

    It's sometimes hard even to face the fact that one's trust has been misplaced.

    Milton, thanks for the link, I'll take a look.

  4. Frequent lurker here.

    Just wanted to second Ashwin, I appreciate the clarity of thought and explanation on this blog.

  5. Thanks jiduthie, please keep lurking... and make sure you also check out Ashwin's excellent blog Macroeconomic Resilience. I think we're both aiming for posts with long shelf-lives.

  6. so it's just Willy from the 1959 "A Raisin in the Sun"? The poor and minorities are their own worst enemies? I tend to think the poor would've figured this out by now.

    Despite your heroic efforts to cite interviews as evidence (really, who doesn't trust people with similar backgrounds/beliefs?), the argument lacks an equilibrium. Shouldn't there be competition within the minority market? Countrywide had to compete with HSBC, WAMU, and WFC! These 'high-powered incentives' you reference should induce brokers to undercut each other, regardless of trust. If the countrywide agent had wide price discretion, then why didn't he use it to undercut the HSBC broker (and vice versa)? I doubt the poor are as simple as you suppose.

    Rather, the measure of creditworthiness likely leaves much to be desired. I think Thomas Sowell has written on this. Rather than argue metrics with a judge and face a larger loss, BofA likely thought it best to settle.

  7. Kevin, if you think my point is to suggest that the poor are their own worst enemies you've completely misread the post.

    Certainly this was not an equilibrium situation, that's why it could not be sustained. Too much faith in the powers of competition can dull one's incentives to actually make people compete. A couple of years ago energy supply was deregulated in New York state and I found myself with lots of options. I chose essentially at random, thinking that competition would ensure rough equalization of all prices. Last month I realized that I'd been paying more than twice the rate I would have paid if I'd just stayed with my local utility. Disequilibrium, yes, but it can persist for quite a while.

    I fully understand that creditworthiness measures are imperfect but there's no incentive for brokers and loan officers to raise rates for those they perceive to be higher credit risks. On the contrary, the incentive is to raise rates for everyone, to the extent that competition (and trust) allows. For some classes of borrower this worked well, for others not so much.