Financial Literacy and the Subprime Crisis

A new working paper from the Atlanta Fed identifies a key reason why some subprime mortgage borrowers have defaulted and some haven’t: differences in numerical ability (ht: Torsten S.).

In “Financial Literacy and Subprime Mortgage Delinquency,” Kristopher Gerardi, Lorenz Goette, and Stephan Meier examine how the financial literacy of individual subprime borrowers (as measured through a survey) relates to mortgage outcomes. They find a big effect:

Foreclosure starts are approximately two-thirds lower in the group with the highest measured level of numerical ability compared with the group with the lowest measured level. The result is robust to controlling for a broad set of sociodemographic variables and not driven by other aspects of cognitive ability or the characteristics of the mortgage contracts.

20 percent of the borrowers in the bottom quartile of our financial literacy index have experienced foreclosure, compared to only 5 percent of those in the top quartile. Furthermore, borrowers in the bottom quartile of the index are behind on their mortgage payments 25 percent of the time, while those in the top quartile are behind approximately 10 percent of the time.

Interestingly, this effect is not due to differences in the mortgages that borrowers selected (e.g., it’s not that the less-numerically-able chose systematically bad mortgages*) or obvious socioeconomic factors (e.g., it’s not that the less-numerically-able had lower incomes).

Instead it appears that the less-numerically-able are more likely to make financial mistakes once they have their mortgages. As the authors note, this conclusion is consistent with other studies that examine how financial literacy relates to saving and spending choices over time. All of which is further evidence of the potential benefits of better financial (and numerical) education.

* The authors note one caveat on the conclusion about mortgage terms: The survey covered “individuals between 1 and 2 years after their mortgage had been originated,” but many subprime defaults happened more quickly than that. As a result, their results don’t address whether financial literacy played a role in determining which borrowers ended up in mortgages that blew up very rapidly.

About Donald Marron 294 Articles

Donald Marron is an economist in the Washington, DC area. He currently speaks, writes, and consults about economic, budget, and financial issues.

From 2002 to early 2009, he served in various senior positions in the White House and Congress including: * Member of the President’s Council of Economic Advisers (CEA) * Acting Director of the Congressional Budget Office (CBO) * Executive Director of Congress’s Joint Economic Committee (JEC)

Before his government service, Donald had a varied career as a professor, consultant, and entrepreneur. In the mid-1990s, he taught economics and finance at the University of Chicago Graduate School of Business. He then spent about a year-and-a-half managing large antitrust cases (e.g., Pepsi vs. Coke) at Charles River Associates in Washington, DC. After that, he took the plunge into the world of new ventures, serving as Chief Financial Officer of a health care software start-up in Austin, TX. After that fascinating experience, he started his career in public service.

Donald received his Ph.D. in Economics from the Massachusetts Institute of Technology and his B.A. in Mathematics a couple miles down the road at Harvard.

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