Monday, July 13, 2009

Financial Literacy and the Financial Crisis

Nearly 7,000 high school seniors completed the latest financial literacy survey in 2008. The results were not encouraging. The average score was 48%, representing a solid failure and the worst performance of high school seniors to date (Source: Jump$tart Coalition).

When we also consider the students that drop out and never make it to senior year, we can clearly see that well over half of our young people entering adulthood are unprepared to effectively manage their own finances and make informed financial decisions. This cannot be good. It would be naive to think that the dismal state of financial literacy among today's young adults does not have wider economic consequences.

The most obvious consequence that comes to mind is the current financial crisis. Blame for the collapse of the financial markets has been laid at the feet of many people, groups, agencies and organizations, including: Wall Street financiers, members of the executive and legislative branches of government, mortgage lenders, mortgage guarantors (like Fannie Mae), and even borrowers. Certainly a strong case could be made against each of these potential culprits.

Lurking beneath all of these causes, however, is the most insidious one of all - financial illiteracy. With so many of America's young people unable to pass a basic financial literacy test, is it any wonder that they became victims of questionable lending practices?

Few would argue with the fact that it was the subprime mortgage crisis that started the financial chain reaction that ultimately resulted in our current economic situation. But what caused the subprime mortage crisis? The subprime mortgage industry owes its existence to the Community Reinvestment Act (CRA) which was originally created in the 1970's. Its purpose was a noble one - to help encourage more widespread home ownership by disadvantaged households that might normally have difficulty qualifying for mortgage loans. These mortgage loans given to people who would typically be denied due to credit risk issues are called subprime loans.

As long as the subprime market remained relatively small, there was no danger to the overall economy. In the last ten years, however, these loan programs were heavily pushed by groups like Fannie Mae, who would buy up the questionable loans, guarantee them, and then package and sell them off to Wall Street at a profit. They were making lots of money doing it, and heavily lobbied both Republicans and Democrats in Congress to make sure they could continue the practice unrestrained.

But who were the borrowers? For the most part, they were the financially illiterate, who due to lack of financial education, were unable to make informed decisions about how much house they could really afford, if any. Since they lacked the tools to understand the level of risk they were taking, they were inclined to believe whatever they were told by their lender, missing the obvious fact that as soon as their adjustable rate started to increase, they would be forced into mortgage default.

The supply of subprime loans was high during this period due to the fact that the loans could be easily sold by lenders to Fannie Mae at a profit (and with no risk to the lender). It was so profitable that any lender would have been doing a disservice to their stockholders by NOT participating.

The demand for subprime loans, however, was driven by financial illiteracy. If as a society we had done a better job educating our young people in basic financial principles and budgeting, then there would have been many fewer borrowers willing to enter into these excessively risky mortgage contracts.

Free markets work very well when all parties are well-informed and educated. Prosperity inevitably follows a well-functioning free market. As such, financial illiteracy represents perhaps the greatest threat to capitalism that we have yet encountered. It is therefore incumbent upon parents, businesses, teachers and local officials to ensure that the next generation is better educated than the current generation to make wise personal finance decisions.

No comments:

Post a Comment