Abnormal brain activity during the processing of simple sounds is evident in individuals with increased genetic liability for schizophrenia; however, the diagnostic specificity of these abnormalities has yet to be fully examined. Because recent evidence suggests that schizophrenia and bipolar disorder may share aspects of genetic etiology the present study was conducted to determine whether individuals with heightened genetic liability for each disorder manifested distinct neural abnormalities during auditory processing. Utilizing a dichotic listening paradigm, we assessed target tone discrimination and electrophysiological responses in schizophrenia patients, first-degree biological relatives of schizophrenia patients, bipolar disorder patients, first-degree biological relatives of bipolar patients and nonpsychiatric control participants. Schizophrenia patients and relatives of schizophrenia patients demonstrated reductions in an early neural response (i.e. N1) suggestive of deficient sensory registration of auditory stimuli. Bipolar patients and relatives of bipolar patients demonstrated no such abnormality. Both schizophrenia and bipolar patients failed to significantly augment N1 amplitude with attention. Schizophrenia patients also failed to show sensitivity of longer-latency neural processes (N2) to stimulus frequency suggesting a disorder specific deficit in stimulus classification. Only schizophrenia patients exhibited reduced target tone discrimination accuracy. Reduced N1 responses reflective of early auditory processing abnormalities are suggestive of a marker of genetic liability for schizophrenia and may serve as an endophenotype for the disorder.