A sudden increase in the number of subprime mortgage defaults helped push the economy into a deep global recession in 2008. Economists have offered intricate explanations for what caused it. A new study suggests that it might have been as simple as not being able to perform basic math calculations.
An individual’s likelihood of defaulting on a subprime mortgage increases as his or her ability to perform basic computations goes down, according to a new paper published in the Proceedings of the National Academy of Sciences.
Economists Kristopher Gerardi, Lorenz Goette and Stephan Meier tracked down subprime mortgage borrowers who took out loans from January 2006 to August 2007 and asked them to participate in a survey, assessing their numerical ability, financial literacy, verbal skills and cognitive ability. Borrowers who were in the process of foreclosure at the time of the survey were not included.
Survey questions ranged from calculating the cost of an item on sale at half price to evaluating the effect of inflation on money. Among the categories tested, the ability to perform basic math calculations was most closely associated with mortgage default. “Our analysis raises the possibility that limitations in numerical ability may have significantly contributed to the massive amount of defaults on subprime mortgages in the recent financial crisis,” write the authors.
In total, 339 individuals responded to the survey. The economists had information such as debt-to-income ratio, terms of the loan and credit score for all subprime mortgage borrowers (even the ones who didn’t respond). Using the data at hand, the economists concluded that there was little evidence of selection bias among the sample of respondents.
Moreover, the economists observed no significant connection between borrowers with weak math skills and a specific type of loan. “We find that poor numerical ability is correlated across the board for all types of mortgages,” said Mr. Goette, one of the study’s authors, in a phone interview. “That means restricting the types of mortgages won’t solve the problem. Even if we let people buy fixed rate mortgages, there would still be defaults.”
The study also suggests that a borrower’s income is not useful for predicting mortgage default. The household income among the survey respondents varied widely with an average at $80,000. “It’s not that subprime mortgage borrowers were low-income,” said Mr. Goette. “It’s more that they had huge mortgages in comparison to their incomes.”
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