Many defaulting subprime borrowers flunked a simple numeracy test. Dare to try it?

May 13th 2010 | From The Economist online

IN AMERICA'S subprime-mortgage meltdown, why did some borrowers manage to struggle on, keeping up with their payments, while others defaulted? Subprime borrowers were all, by definition, people with poor credit histories, prone to financial problems, yet their ability to repay differed widely. A study from the Federal Reserve Bank of Atlanta has found that what makes the difference is the borrower's basic numeracy. They gave a simple quiz to a group of subprime borrowers who had similar personal circumstances and had taken out the same type of loan. They found that those who flunked the test were much more prone to defaulting than the numerate, who were much more likely to manage to keep paying.

The numeracy quiz that the study's authors gave to their sample of borrowers was hardly rocket science.

In a sale, a shop is selling all items at half price. Before the sale, a sofa costs $300. How much will it cost in the sale?
    $200
    $150
    $450
    $120

If the chance of getting a disease is 10 per cent, how many people out of 1,000 would be expected to get the disease?
    100
    10,000
    1,000
    200

A second hand car dealer is selling a car for $6,000. This is two-thirds of what it cost new. How much did the car cost new?
    $9,000
    $4,000
    $8,000
    $9,999

If 5 people all have the winning numbers in the lottery and the prize is $2 million, how much will each of them get?
    $100,000
    $500,000
    $400,000
    $200,000

Say you have $200 in a savings account. The account earns ten per cent interest per year. How much will you have in the account at the end of two years?
    $224
    $240
    $242
    $220

 

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What your score means

    0-1 Oh dear: Mr Madoff would love to meet you some day
    2-3 Not great: Best steer clear of the synthetic derivatives market
    4    Not bad: On a par with Goldman Sachs's institutional clients
    5    Perfect: We're seeking a new finance director. Care to apply?

The correct answers are highlighted below in blue.

In a sale, a shop is selling all items at half price. Before the sale, a sofa costs $300. How much will it cost in the sale?
    $200
    $150
    $450
    $120

If the chance of getting a disease is 10 per cent, how many people out of 1,000 would be expected to get the disease?
    100
    10,000
    1,000
    200

A second hand car dealer is selling a car for $6,000. This is two-thirds of what it cost new. How much did the car cost new?
    $9,000
    $4,000
    $8,000
    $9,999

If 5 people all have the winning numbers in the lottery and the prize is $2 million, how much will each of them get?
    $100,000
    $500,000
    $400,000
    $200,000

Say you have $200 in a savings account. The account earns ten per cent interest per year. How much will you have in the account at the end of two years?
    $224
    $240
    $242
    $220

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Evidence from a Survey Matched to Administrative Data

Kristopher Gerardi, Lorenz Goette, and Stephan Meier

Working Paper 2010-10  April 2010

Download the full text of this paper (428 KB)

The exact cause of the massive defaults and foreclosures in the U.S. subprime mortgage market is still unclear. This paper investigates whether a particular aspect of borrowers' financial literacy—their numerical ability—may have played a role. We measure several aspects of financial literacy and cognitive ability in a survey of subprime mortgage borrowers who took out mortgages in 2006 or 2007 and match these measures to objective data on mortgage characteristics and repayment performance. We find a large and statistically significant negative correlation between numerical ability and various measures of delinquency and default. 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. Our results raise the possibility that limitations in certain aspects of financial literacy played an important role in the subprime mortgage crisis.

JEL classification: R2, D1, D8

Key words: subprime mortgage, delinquency, default, financial literacy, cognitive ability, survey

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The authors thank Daniel Bergstresser, Chris Foote, Jeff Fuhrer, John Leahy, Robert Shiller, and seminar audiences at the Federal Reserve Bank of Boston, the 2009 meetings of the Allied Social Science Associations, Harvard Business School, Universitat Autonoma de Barcelona, and Columbia University. They are especially grateful to the Boston Fed, where the authors were employed at the time the survey was conducted and which provided the funding for the survey. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to Kristopher Gerardi, Federal Reserve Bank of Atlanta, Research Department, 1000 Peachtree Street, N.E., Atlanta, GA 30309, 404-498-8561, kristopher.gerardi@atl.frb.org; Lorenz Goette, University of Lausanne, Faculty of Business and Economics, Bâtiment Internef, 1015 Lausanne-Dorigny, Switzerland, lorenz.goette@unil.ch; or Stephan Meier, Columbia University, Graduate School of Business, 3022 Broadway, New York, NY 10027, sm3087@columbia.edu.