Introducing the Fifth C of Underwriting

Most of us know all too well the four Cs of underwriting: capacity, character, collateral, and credit. The four Cs have in many ways defined risk-based pricing on mortgages for decades, and are a convenient way to segment the myriad failures that led our economy to the precipice, as well. I can’t help but wonder, however, if it’s finally become time in this country to add a fifth C to the mix. Call it “calculation”—as in a borrower’s ability to understand basic math. Picture the following scenario: Want a mortgage on that gorgeous three bedroom Spanish Mission-style stunner you’ve had your eye on? Great! Before I draw up the papers and quote you a mortgage payment, I just need you to answer five questions for me: 1. What’s half of 300? 2. What’s 10 percent of 1,000? 3. 6,000 is two-thirds of what number? 4. What’s 2 million divided by five? 5. Let’s 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? Call it the Mortgage Aptitude Test, or MAT. After all, the SAT, GMAT, LSAT and other proficiency exams are all prerequisites to the pursuit of higher education—yet we don’t test applicants on their basic math skills before handing them the single largest debt they will ever be asked to manage in their lifetime? The five questions above, by the way, aren’t random. Nor are they part of some post-graduate educational hangover I may have. They’re taken from a 2007 study, and used in academic research to assess an individual’s degree of financial literacy; I stumbled across them again in a recent Federal Reserve Bank of Atlanta working paper led by Columbia University assistant business professor Stephan Meier (hat tip here goes to Bob Tedeschi at the New York Times, as well). Here’s what the 5 questions can tell you, depending on how people answer each. Those with the lowest level of numerical aptitude answer 1, 2, or 3 incorrectly or answer question 1 correctly but miss on 2, 3 and 4. The next lowest level is comprised of those people who answer any of the first four questions incorrectly, followed by the group that answer the first four correctly, but miss on question 5. Of course, those with the highest level of aptitude answer all 5 questions correctly. The Atlanta FRB paper is a fascinating read—what Meier and his colleagues find in a study of borrower behavior is that (gasp!) those subprime borrowers with poor analytical aptitude (those in the lowest group described above) are roughly three times more likely as other subprime borrowers to go into foreclosure. Those subprime borrowers with high analytical skills? An incredibly lower likelihood of foreclosure. What makes the study most interesting to me is that this trend of analytical aptitude affecting foreclosure likelihood holds true even when the authors control for all sorts of extraneous factors usually thrown around as explanations for default risk— including socio-economic characteristics, consumer preferences, household financial status, employment history and status, FICO score, and loan-level characteristics. Here’s the real kicker: across numerous studies using the above questions to assess analytical aptitude, roughly 16% of Americans tend to fall into the lowest-level analytical category. It’s certainly not an insignificant number. Think of 10 of your friends; and then realize that it wouldn’t be surprising if 2 of them fit the bill here. Most of us, BTW, fall into group two—those that answer at least one of the first four questions incorrectly. Meier and his colleagues conclude their analysis with the following missive: The results suggest that the correlation between mortgage delinquency and financial literacy is not due to financially illiterate borrowers taking on too much debt, or choosing excessively risky mortgages. We are able to control for many details of the mortgage contracts, but find that the correlation is not sensitive to their inclusion in the econometric models. This suggests that limited numerical ability might lead to other mistakes over the course of time, like too much spending, too little savings, or inappropriate reaction to income and/or consumption shocks. Remind me again why we aren’t administering something like a MAT prior to the decision to lend? Especially if aptitude in analytics is a direct predictor of default behavior that transcends the lending instrument, job status, even FICO scores—all of our usual risk indicators? The questions this research brings about, too, are fascinating: would a more effective focus on math programs in our school systems actually help drive better borrower behavior later on in life? Are those students that are denied an education in basic math being set up for later failure? Is analytical aptitude something that is truly a function of the quality of education, something that can be taught if enough people are given access? Frankly, I know I’d much rather see a debate around these sort of issues than read another press statement from ___(insert Congressperson looking for a vote)___ about how we need to change the GFE and HUD-1 forms to make them easier for consumers to understand. Because this study makes it damn clear that bar is going to be set pretty low, if so. After all, if someone doesn’t know that 150 is half of 300, any number on any form is likely one number too many. Paul Jackson is the publisher of HousingWire.com and HousingWire Magazine. Follow him on Twitter: @pjackson