Did financial illiteracy contribute to subprime crisis?
It makes intuitive sense that complicated mortgage products would pose the most danger the borrowers who were least able to understand them. But did that intuition bear out in the real world? Sadly, yes. According to a new paper by Kristopher Gerardi, Lorenz Goette and Stephan Meier, “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.”
To translate that back into English, borrowers with the most financial literacy were two-thirds less likely to be in foreclosure than borrowers with the least financial literacy. That result remained even after controlling for demographic characteristics such as education and income and the specific mortgages both groups signed. Bottom line: “Twenty 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.”
What seems to be happening here is not that folks who are financially illiterate choose worse mortgages so much as folks who are financially illiterate make more financial mistakes once they have their mortgages. Either way, it’s a reminder of the extraordinary asymmetry of information that stands between borrowers and lenders. You can download the full paper here (pdf).