How would a behavioral economist look at the sub-prime mortgage crisis?
How would a behavioral economist look at the sub-prime mortgage crisis in any way that is different from a rational economist?
Here is my perspective on the sub-prime mortgage crisis: When the housing market was hot, all the bankers that gave out loans assumed that their customers didn’t want their house to go into foreclosure, and that they would act accordingly.The first assumption was correct-no one wanted their house to go into foreclosure. But the second assumption, that consumers knew what to do in order to make sure they didn’t lose their house, was wrong, very wrong. The basic problem is that it is extremely difficult to calculate the optimal amount that any of us should borrow on a mortgage. Think about it: If you had to get a new house right now, what is the ideal amount to spend and how much of it should you take as a mortgage?
On top of that, the smart bankers introduced interest-only mortgages. From a standard economics perspective these mortgages are wonderful because they allow for extra flexibility. At the time when these mortgages became popular, I was working on research at the Federal Reserve Bank in Boston and I got into a debate with a local economist. He maintained that interest only mortgages were a great idea because they provided much flexibility; people could pay only the interest and use the rest of the money to pay other expenses such as credit card debt, or health related expenses. Of course they could always use the money to pay down the principal on the loan. But from my perspective these loans would be ideal only if people were purely rational. But we’re not.
To begin with, when deciding on a mortgage, borrowers were told by the banks and by any mortgage calculator the maximum amount that they could borrow and not the optimal amount that they should borrow. So given a borrowing max of $400,000 with a regular mortgage or a borrowing max of $650,000 with an interest-only mortgage, would the average consumer borrow $400,000 with the interest-only mortgage and this way gain flexibility, or would they borrow to the new max?
Unfortunately, since we have a hard time figuring out how much we should borrow people often borrow to the max, gaining no flexibility and in the process exposing themselves to a much higher risk in the real-estate market.
My latest book, The Upside of Irrationality, explores some positive and some negative ways that irrationality plays out in our lives.
I am sorry sir… but how can we call the behavior of home-owners as irrationality? It may be irrational to a rational person, but there is a perfectly good word called “Greed”. People were Greedy to buy houses that they could not afford.
Borrowers’ and bankers’ pendulums are swinging now in the “opposite” direction; as of Sep 30, total consumer debt was falling at an annual rate of 3.7%. This is the first time the pendulum swung in the opposite direction. Will it go to far this way? Can it go too far this way?
Over the last few in Australia I have noticed a trend in home ownership. People are buying much larger houses. Much larger than they need either at the time or probably ever. 30 squares, 3 bathrooms, 5 bedrooms, lounge,dining, family and rumpus room. And of course they cost more, a lot more. The level of housing debt used to be about 3 to 4 times a persons wage but is now more like 7 times going by the latest figures.
Unlike PJ I am quite sure this is not overt greed. It is simply people aiming to match what is being depicted in the media, newspapers and magazines as normal. Most families now have two bread winners and so this level of debt seems to be manageable , especially before kids come along and while interest rates are low. And when talking to bankers, as I did when buying my first and only house 18 years ago, the emphasis was on ‘maximum loan’. Even 4 times my income seemed too large. Anything higher the Gen Y’ers have got into must be truly scary however poor financial planning and the lack of a historical context does not make for greed.
I think there is a lot more human incompetence than greed.
Thanks for your insights. It’s confusing to think about mortgages these days, so it’s good to have opinions from professionals.
I put this one on both parties. The consumer is ignorant to borrow the max amount and not take into account his own financial risk at being mortgaged to the hilt.
The mortgage broker is also at fault for not forcing the ignorant consumer to see the TOTAL cost of his loan through the life of the mortgage. He should also show worst case scenarios to his client to ensure he is prepared for bad times.
The mortgage broker is in the business of selling mortgages. So, I would place more blame on the consumer for not examining worst case scenarios and purchasing larger mortgages than they could afford under those scenarios.
I think we all need to keep in mind that depending on where one lies on the socioeconomic/credit-worthiness ladder, rational for one person may not equate to rational for another.
In the case of sub-prime borrowers, maybe they were exhibiting “rational” behavior. In normal times, they would never be considered for a $250,000 no-money-down interest-only loan. And aware of their past poor credit history and hopelessly resigned that they will only continue such bad behavior in the future, they might rightfully conclude that if they don’t accept the generous loan now, they might not get it in the future. Even if it means they can’t afford it and will foreclose within 12 months or so….at least for 12 months they can live a lifestyle that they will “never” be able to afford (assuming they plan on continuing their behavior of uncreditworthiness).
Very excellent photo was got.