The One-Mile Rule: Prudent Policy or Modern Day Redlining?

Throughout the history of mortgage banking and lending in the United States, underwriting policies have significantly influenced the appraisal process for home purchases and refinances. Appraisers must follow underwriter appraisal review guidelines meticulously to ensure their appraisal reports are accepted by the lender. Unfortunately, in the past, these policies became the basis for redlining, wherein certain communities were systematically denied access to mortgage credit. In this article, we delve into the historical context of underwriting policies and their influence on the appraisal process to uncover whether contemporary practices perpetuate the discriminatory legacy of redlining.

Established in 1934, the Federal Housing Administration (FHA) introduced an Underwriting Manual, setting standards for “prudent” lending decisions by banks and lenders which, alongside setting appraisal review policies, aimed to ensure sound lending practices. Unfortunately, it also contributed to the perpetuation of discriminatory practices in housing finance. Underwriting guidelines serve as the criteria for assessing a borrower’s financial health and risk level, encompassing factors such as credit score, debt-to-income ratio, employment history, down payment, and property appraisal approval, and ultimately shape mortgage eligibility and terms.

In the 1930’s, appraisers (then known as valuators) were instructed to follow a rating system. When evaluating a property’s location, they turned to Part II Section 226-289 for guidance on “PROTECTION FROM ADVERSE INFLUENCES.” This aspect was underscored as pivotal, emphasizing its significance in the rating process. Adverse influences, as outlined in the Underwriting Manual, encompassed factors such as “the infiltration of business and industrial uses, lower class occupancy, and inharmonious racial groups.” Appraisers/Valuators were tasked with gauging the level of “protection” against these adverse influences or assessing the associated “risk” they posed. (see Fig. 1)

Fig. 1

 
The 1936 FHA Underwriting Manual provides some illuminating examples of these so-called “adverse influences” including:

#228. “Deed restrictions are apt to prove more effective than a zoning ordinance in providing protection from adverse influences. Where the same deed restrictions apply over a broad area and where these restrictions relate to types of structures, use to which improvements may be put, and racial occupancy”

#233. “The Valuator should investigate areas surrounding the location to determine whether or not incompatible racial and social groups are present, to the end that an intelligent prediction may be made regarding the possibility or probability of the location being invaded by such groups. If a neighborhood is to retain stability it is necessary that properties shall continue to be occupied by the same social and racial classes. A change in social or racial occupancy generally leads to instability and a reduction in values.”

#289. “Schools should be appropriate to the needs of the new community and they should not be attended in large numbers by inharmonious racial groups.”

The FHA Underwriting Manual also incorporated “residential security maps” into their standards to determine where mortgages could or could not be issued. Developed by the Home Owner’s Loan Coalition, these were color-coded maps indicating the level of “adverse influences” for real estate in American cities, with red denoting the highest risk zones. These maps formed the foundation for what eventually became known as redlining.

The Fair Housing Act in 1968 banned discrimination in real estate and mortgage lending, including racially motivated redlining. By 1971, the Federal Reserve’s efforts included training programs for bank examiners and mandated banks under its jurisdiction to prominently display Equal Housing Lender information in their lobbies. Subsequently, in 1977, Congress enacted the Community Reinvestment Act, affirming the responsibility of federally regulated financial institutions, such as banks, to reinvest in the low- and moderate-income communities where they operated. Collectively, these reforms played a crucial role in curbing redlining as a widespread legal practice. With these regulatory changes and increased awareness, appraisers were no longer hemmed in by the “red lines” imposed by underwriter guidelines, allowing for fairer and more equitable assessments of properties across neighborhood lines.

Despite the progress made in addressing discriminatory practices during this period, recent studies indicate a concerning regression. A study titled “The Increasing Effect of Neighborhood Racial Composition on Housing Values, 1980–2015” by Junia Howell and Elizabeth Korver-Glenn, highlights this trend. The study reveals that between 1980 and 2015, home values showed decreased correlation with traditional factors like housing characteristics, construction quality, neighborhood amenities, and socioeconomic status. Conversely, the correlation between home values and neighborhood racial composition significantly strengthened during this period, increasing by fivefold.

This raises the question: What could have caused this?

To understand the origins of this issue, let’s explore the landscape of mortgage lending during the period highlighted in the study. During the 1980s, the financial sector weathered a significant period of turmoil centered around the nation’s savings and loan (S&L) industry. In response to the challenges facing S&Ls, policymakers enacted the Depository Institutions Deregulation and Monetary Control Act of 1980. They took steps to deregulate the industry in the hope that it could grow out of its problems. Unfortunately, these efforts exacerbated the industry’s problems and federal regulators found themselves ill-equipped to address the mounting losses suffered by S&Ls. In 1980, there were nearly 3,500 S&Ls holding assets of approximately $480 billion tied up in mortgage loans. This accounted for 50% of all outstanding home mortgages at that time. Over the decade spanning 1980 to 1990, 32% of S&Ls failed and were subsequently closed. Ultimately, the situation led to a taxpayer-funded bailout, compelling Congress to implement significant reform legislation in the form of the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) in 1989. This wave of bank failures and subsequent legislation reshaped the mortgage lending landscape, diminishing the significance of S&Ls in the residential mortgage market.

These changes paved the way for Fannie Mae and Freddie Mac, collectively known as the Government Sponsored Enterprises (GSEs), to significantly increase their acquisition of residential mortgages on the secondary market. The GSEs’ combined market share surged, doubling from around 20% in 1980 to surpassing 40% by 1990 (see Fig. 2). Their dominance persisted through the housing boom and subsequent crash of the 2000s. During this period, the policies of the GSEs, characterized by relaxed lending standards and the packaging of risky mortgage-backed securities, played a significant role in the financial crisis, necessitating substantial taxpayer assistance for their bailout. Despite this, or perhaps because of it, by 2015, the GSEs combined market share had expanded to over 70%, a figure that persists today.

Fig. 2

 
A prominent example is the “one-mile rule”As a result, the guidelines established by the GSEs emerged as the de facto standard, wielding significant influence over residential appraisal practices from 1980 to 2015, a sway that persists to this day. A prominent example is the “one-mile rule,” an informal yet widely acknowledged practice among underwriters and appraisal reviewers. This unwritten mandate restricts appraisers to selecting comparable properties within a one-mile radius of the subject property, thereby discouraging exploration beyond this arbitrary circular boundary, despite the irregular shape of most real estate markets. The prevalence of this practice is so pervasive that in 2020, Fannie Mae felt compelled to address it directly, dispelling what it termed “the myth of the one-mile rule.” (Fig. 3) While not codified, any appraiser active during this era can attest to the fact that underwriters often treat it as an unwritten decree. Remarkably, Fannie Mae has gone so far as sending complaint letters to state licensing boards if chosen comparables by the appraiser aren’t as close to the subject property as preferred by the underwriter/appraisal reviewer.

Fig. 3

In today’s mortgage landscape, underwriters increasingly rely on technological tools like Automated Valuation Models (AVMs) for appraisal review, a trend that accelerated during the COVID pandemic. The use of AVMs within the GSEs’ Collateral Underwriter (CU) system surged in 2020, when the GSEs began allowing appraisal waivers for purchase transactions based on AVM-supported values. This shift was significant, as appraisal waivers accounted for up to 40% of all mortgage transactions during the pandemic and possibly contributed to the unchecked rise in values during this time.

When appraisers are used, they often face revision requests from underwriters seeking clarification if their chosen comparables diverge from those preferred by the GSEs’ computer program. This typically occurs when the GSEs’ algorithms suggest comparables closer in proximity to the subject property than those selected by the appraiser. While it may no longer be explicitly termed the “one-mile rule,” its effect remains the same.

While it may no longer be explicitly termed the “one-mile rule,” its effect remains the same.This practice may shed light on why the correlation between home values and neighborhood racial composition strengthened again from 1980-2015, while the connection between home values and traditional factors like housing characteristics, construction quality, neighborhood amenities, and socioeconomic status weakened. This trend coincides with the acceptance of the GSE’s policies as the industry standard. When appraisers are required to operate within predefined parameters set by underwriting guidelines, whether through redlined maps or implicit “one-mile rule,” the result can be undervalued properties in historically marginalized neighborhoods.

Moreover, the increasing correlation between home values and neighborhood racial composition highlights how technological tools, intended to streamline processes and improve accuracy, can inadvertently exacerbate discriminatory practices. By emphasizing certain characteristics favored by algorithms, such as proximity to the subject property, these tools can reinforce historical biases. Addressing these unintended issues requires a multifaceted approach that acknowledges the limitations of technology in capturing the complexities of real-world contexts. It also necessitates a reevaluation of appraisal review practices and the adoption of more inclusive methodologies that account for the diverse range of factors that contribute to property values. Additionally, regulatory measures and oversight are needed to ensure that technological advancements in the appraisal industry do not perpetuate inequities but rather promote fairness and equality in housing markets.

Although Fannie Mae and Freddie Mac have been under the Federal Housing and Finance Agency’s (FHFA) conservatorship since the housing crash in 2008 due to their own mismanagement, they claim to have officially debunked the “one-mile rule” as a “myth”. However, it remains crucial for the FHFA to meticulously monitor the incorporation of proximity of comparables as a determining factor in the computer algorithms currently guiding underwriter review. Specifically, the FHFA should conduct a thorough review of Collateral Underwriter (CU), the GSEs’ algorithm-based appraisal review system, to ascertain whether it contributes to the observed correlation between home values and neighborhood racial composition. CU plays a critical role in assessing risk for property transactions and “grading” appraisers’ work, ultimately impacting consumers’ access to preferred lending options and determining which appraisers are chosen for assignments. Transparency and accountability are imperative for these public utilities, which support trillions of dollars in mortgage loans, both in their formal policies and the informal rules they enforce.

The FHFA should encourage the GSEs to make their data, including Collateral Underwriter and appraisal waiver data, readily available to researchers and academics. By providing access to comprehensive datasets, researchers can conduct independent analyses to identify and address any underlying biases in the appraisal process. This transparency not only facilitates accountability but also enables evidence-based policymaking to promote fairness and equity in the housing market. By addressing the systemic underwriting and appraisal review issues that perpetuate disparities in appraisal outcomes and access to mortgage credit, the FHFA can play a pivotal role in promoting a more inclusive and equitable housing market for all Americans.