Poor Math Skills May Have Fueled Mortgage Crisis

By Ross Pomeroy

Everybody knows that the economic downturn of 2008, popularly known as "The Great Recession," was bad, so I'll refrain from imparting the gory statistics; you've probably heard them anyhow. Suffice it to say, almost five years later, housing prices have not recovered, government deficits persist in the hundreds of billions, and millions of Americans remain out of a job.

Giving rise to the Great Recession was another crisis: the subprime mortgage debacle. Here's the layman's explanation: In order to own a home, hundreds of thousands of consumers accepted risky mortgages that many had almost no hope of paying off. Offering these deals were greedy lenders, who financed them by the bucket-load. Concurrently, large banks bought into securities that owned these risky mortgages. When housing prices plummeted in 2006, the whole scheme came apart in a tumultuous cascade. A high percentage of subprime mortgages had adjustable interest rates, and when those higher rates kicked in, the homeowners defaulted on their loans, which caused the securities to fail, which resulted in large, billion-dollar banks going bankrupt.*

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It's widely believed that financial institutions, regulators, credit agencies, government housing policies, and yes, the consumers, themselves, share in the blame for what happened. To defend against something like this ever happening again, the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law on July 21, 2010. But despite 800 pages worth of regulation, the legislation has been criticized as relatively toothless and ineffective.

Is there a better, simpler solution to guarding against the perils of mortgage default? In a new study published in the Proceedings of the National Academy of Sciences, an international trio of economists suggests that there may be an answer: teaching borrowers basic math.

Before reaching that conclusion, the team -- Kristopher Gerardi of the Federal Reserve Bank, Lorenz Goette of the University of Lausanne, and Stephan Meier of Columbia University -- first obtained an extensive data set of New England borrowers that took out subprime mortgages in 2006 and 2007. The researchers contacted 339 of these borrowers and conducted telephone interviews, which included questions tailored to gauge cognitive and numerical abilities.

After completing the interview process, the researchers classified respondents into four levels of numerical ability, with one being the lowest and four being the highest. What did they find?

"Borrowers in the lowest numerical ability group on average spend almost 25% of the time in delinquency, whereas those in the highest group spend on average only 12% of the time in delinquency."

Controlling for an impressive host of potentially confounding variables, including ethnicity, age, sex, education, credit score, household income, general cognitive ability, family size, and marital status, the researchers found that weak math skills were strongly correlated with the fraction of time borrowers spend in delinquency, as well as the frequency of foreclosure. Amazingly, the researchers also found that the correlations held even when comparing borrowers with near identical mortgage contracts! People who were poor at basic math could simply not keep up with their debts.

"Numerical ability must influence mortgage default through behavior that occurs after the choice of the mortgage contract," the researchers inferred.

A key limitation of the study was that the process of measuring numerical ability was conducted via a telephone interview. This introduces the potential for response selectivity to muddle the data. In other words, the individuals who responded may be different than those who did not. But examining their extensive data set, the researchers found that the people who chose to be interviewed were no different in all key measures than those who declined.

Additionally, though the data is associative, the researchers contend that reverse causality can be ruled out.

"It is implausible to argue that falling behind on one's mortgage could impair one's ability to perform simple mathematical calculations."

With this in mind, and a host of confounding abilities controlled for, we are left with a very strong link between math skills and dutiful borrowing habits. This possibility may open the door to implementing policies and initiatives with the purpose of boosting borrowers' financial skills and mathematical abilities.

"If financial education can reduce suboptimal financial decision making, this could have profound effects on household behavior," the researchers claim.

The economists even suggest a perfect follow-up to the current research: "a randomized study, offering financial education to some homeowners, but not to others, and subsequently tracking their performance."

Source: Kristopher Gerardi, Lorenz Goette, and Stephan Meier (2013) Numerical ability predicts mortgage default. PNAS. www.pnas.org/cgi/doi/10.1073/pnas.1220568110

*Sentence slightly adjusted to clarify the affect of housing prices on homeowners' interest rates.

Steven Ross Pomeroy is the assistant editor of Real Clear Science. Follow him on Twitter @SteRoPo.