16 May 2010

Don't Sign If You Can't Do The Math

A recent research paper found that there was a strong correlation between basic understanding of numbers and ability of subprime borrowers to keep their homes. People who understood percents, discounts, and compounding were much more likely to be able to avoid default, even compared to less numerate people in similar economic circumstances. Math skills pay.

Here is the first numeracy question they used:
1. 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?
graph from http://www.frbatlanta.org/documents/pubs/wp/wp1010.pdfThe study was published by the Federal Reserve Bank of Atlanta (abstract and full study here). It found "a large and statistically significant negative correlation between numerical ability and various measures of delinquency and default." The authors even say "Our results raise the possibility that limitations in certain aspects of financial literacy played an important role in the subprime mortgage crisis."

People with limited math skills caused the global meltdown?? It might be fairer to say that by lending to people with unstable or inadequate income and bad math skills lenders were lending to people likely to default, and probably knew it. It should have been no surprise when those loans went bad. If the risk hadn't been multiplied by layers of collateralized debt obligations and credit default swaps we wouldn't have had a global financial meltdown. But that's another story.

The interesting thing is that similar subprime borrowers with somewhat more robust financial math skills were much less likely to default, even controlling for socioeconomic factors. "We find a large and statistically significant negative correlation between financial literacy and measures of mortgage delinquency and default, and the finding is robust to the inclusion of controls for income, education, risk aversion, and time preferences, thus ruling out a broad set of potential biases from omitted variables. 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." "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."

Same income, same mortgage provisions, same problems, but moderate math skills: much lower likelihood of default. Paying attention in math class, or maybe just having a half-way competent math teacher in 7th grade, really paid off for some borrowers. "We include as control variables measures of other aspects of financial literacy and a general measure of cognitive ability, but find that the correlation is highly specific to one aspect of financial literacy: numerical ability."

To see the degree of numerical literacy we are talking about, try this quiz put together by The Economist. It uses the same five questions posed by the researchers. Here is the Economist article on the research findings. The abstract of the study is here (with access to the whole paper in PDF).

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