An unnamed associated press writer based in Washington made an ass of him or herself this week while writing an article titled “Young people’s financial knowledge falls short”. This article reports on results from a “nationwide survey released Wednesday by the Federal Reserve” in which High School students performed poorly when asked to answer finance questions. I have no doubt that this is a real problem and serious deficiency. I do not mean to marginalize it, but clearly, the author needs to brush up on his knowledge just like the High School students. The article cites the causes of the impending/occurring recession as cause for concern at the poor showing. Then it goes on to summarize the current economic situation, for the uninformed reader with this gem of a paragraph:
When the housing market collapsed, home values fell and interest rates rose. That especially clobbered people with tarnished credit or low incomes holding more risky “subprime” mortgages. As these homeowners found it increasingly difficult or possible to make their monthly mortgage payments, home foreclosures took off, some lenders went out of business and financial institutions suffered multibillion losses as mortgage-backed investments soured.
First we have “increasingly difficult or possible” clearly those are synonyms </sarcasm>. I know I get stuff like that wrong all the time, but the author is a professional in the field of writing and should be held to a higher standard. Now, lets look at how things actually happened:
- “People with tarnished credit or low incomes holding more risky ‘subprime’ mortgages” saw their interest rates rise as their mortgage contract specified would occur years in advance.
- “These homeowners found it increasingly difficult or impossible to make their monthly mortgage payments” due to poor planning or other excuses. It’s not like it blindsided them; they knew their rates would increase. Subsequently many defaulted on their mortgages pushing their homes into foreclosure.
- This repeated a few times as each month’s worth of subprime loans lapsed beyond its below market initial interest rate and into an appropriate interest rate for the risk. This contracted and expected increase is what I take the author means by “interest rates rose.”
- As this process repeated, more and more people default and are pushed into foreclosures, which have begun to glut the market for homes driving down prices as excess supply is prone to do.
- With rising foreclosure rates banks begin to see the follies of their ways, stop offering subprime loans and raise rates on normal loans to cover the money they are losing when people default. This is the so called credit crunch. “Financial institutions suffered multibillion losses as mortgage-backed investments” dropped in price reflecting the actual amount of risk they represent. (Risky investments cost less.)
- Only now, that foreclosures have sored and all interest rates have risen does the housing market actually collapsed. This is the start of the feed back cycle where home values have become less than the amount left in mortgage payments, leading to defaults and foreclosures leading to lower home values.
- Following the collapse the Federal Reserve has stepped in a lowered interest rates significantly to stabilize the market. This is the traditional method by which interest rates fall.
So lets examine: rising interest rates (if you want to call contracted, expected increases rises) and falling home prices due to sudden oversupply were the causes of the housing market collapse, not the results of it. Granted that home prices continue to fall as a result, but it is clearly incorrect that interest rates rose as a result of the collapse — they have fallen as a result. It is not so much that these factors “clobbered people with tarnished credit or low incomes holding more risky ‘subprime’ mortgages,” as these people clobbered themselves and each other by not planning ahead for their contracted rate increases.
This writer, and many people, portray these people as the victims. I portray them as the antagonists. If subprime loan holders were able to continue to pay their contracted mortgage interest rates we would not have a housing market collapse. Some argue that it is the fault of predatory lending practices by unscrupulous banks who sucked these people into these loans. This hides the truth of the matter, which the national survey this article is about brings to the forefront: predatory lending practices do not work on a financially well educated customer. Such a customer can plainly predict that they will be unable to make payments in the future given reasonable income prospects, and seeking to not go into debt will not take the loan that is sure to bankrupt them. This shifts the blame back to the loan holders, and to this syllogism: if subprime loan holders weren’t so stupid as to hold subprime loans we would not have a housing market collapse. Now, I will grant that once the collapse occurred people who would have otherwise remained in good financial standing in line with their predictions were placed between a rock and a hard place, perhapses, despite their own due forethought. This is unfortunate; I do not mean to paint such individuals as part of the problem. The economic understanding of exactly how we ended up in this mess as presented by this unnamed author clearly demonstrates the widespread problem that is what I think actually got us into this mess. Now, why do we have this education problem? maybe something from the survey can shed some light:
In this year’s survey, only 16.8 percent correctly answered that stocks likely would offer the higher growth over 18 years of saving for a child’s education, while 37.3 percent thought a U.S. savings bond — one of the most conservative investments — would offer the highest growth.
Clearly the one with the higher rate of return over the next 18 years is a prediction, there is not a correct answer. If you study the last 18 years the answer is clear, but as they say, past performance is no indicator of future success. If one were to predict that the stock market is seriously overvalued, and that the rising specter of oil prices will, over the next 18 years, wreak havoc on the profit margins of companies leaving the stock market lower than it is today you may correctly conclude that a U.S. savings bond, with its gaurneteed rate of return, will offer higher growth. To sway the answer to the question (which asks which is more likely) you would need to attach at least a 50% probability to scenarios like this where you expect the market to grow by less than ~3% over 18 years. Of course were that the case an investment tied to the inflation rate, or in precious metals would almost certainly outperform the savings bond, which would likely acrue interest at less than the inflation rate is such damaging scenarios.
The point here is that it may not be an invalid assessment of risk to choose the savings bond. The response I have provided here, or one similar, is pretty much the only actually correct answer to that question. The fact that the questions was provided as multiple choice and did not include such a response indicates why we have such a poorly financially educated population. We fail to even attempt to educate them properly. I personally did really learn all I needed to know about this kind of stuff until my Junior and Senior years of college.