How would a behavioral economist look at the sub-prime mortgage crisis?

October 13, 2008 BY danariely

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.