Federal Reserve Bank of Chicago President Charles Evans pointed directly to a major problem with the economic system in a speech before the Indianapolis Neighborhood Housing Partnership on Wednesday: a serious deficit in the country's financial literacy.

His solution, however is aimed less at eliminating that illiteracy than at incentivizing it in appropriate directions.

Evans spoke at the Indianapolis Neighborhood Housing Partnership (INHP) Community Breakfast on the roots of the housing crisis and current plans to end it, but his speech differed a bit form the formulaic presentation given over and over by financial and housing officials.  While others have pointed to the use of inappropriate mortgage products as one cause of the crisis, rather than vilify these products such as option mortgages or those with zero amortization, Evans made room for them at the table.

"While economists usually give great respect to individual choices," he said, "in this case it seems that many borrowers made poor choices and that at least some lenders abetted those poor choices."  Evans said that people who had no business getting exotic mortgages not only got them, but got them without any verification of their ability to pay.  There are two policy approaches to insuring that a housing meltdown does not happen again.  One would be the imposition of stringent regulations that eliminates those inappropriate products.  This would certainly prevent unqualified borrowers from obtaining them, but these products might be perfectly appropriate to certain people and certain situations, so strict regulation could have some real costs.

An alternative, he said, would be to place few restrictions on the choices available to borrowers but to better educate them about home ownership and mortgages.  "This would make borrowers better prepared to make informed financial decisions.  Such an approach might keep those who should not have exotic mortgages from getting them while leaving such mortgages available to the small group of people for whom they are appropriate. 

In effect, Evans was preaching to the choir.  INHP operates an innovative financial coaching program which has been the subject of a Federal Reserve paper on the subject, a fact which Evans alluded to in his speech.  However, he said, "The big question is whether financial education can work."

Chicago Fed staff has recently undertaken a review of studies evaluating the effects of financial education and they found that the evidence on its effectiveness is mixed.  Some programs have improved financial outcomes due to increased financial literacy however other programs are less successful.  Evans said that, while more research is needed, his own opinion is that programs must be very well designed and rigorous.  Further, he said, it is an open question as to whether effective programs can be implemented on a wide scale at reasonable cost.

The INHP program was included in that evaluation.  It is aimed at low-and moderate-income households, and designed to prepare them for home ownership.  Under the program, prospective homeowners are assigned a coach who will work with the client for up to 24 months to provide guidance and education on money management, improving credit scores, reducing debt, negotiating collection balances, and saving for a down payment on a home.  In addition to monthly meetings with the coach, the client also attends formal classes.   While the program is completely voluntary, it has strict requirements and clients who do not fully participate may be asked to leave.   Evans said an important component of the Indianapolis program is its continuation following the home purchase and involvement with the client should problems arise.

Other research had already showed that the INHP clients improved their credit scores during counseling, making them better candidates for mortgages, but the Federal Reserve study indicated that the training did indeed translate into improved loan performance.  Compared to other borrowers, the INHP clients started the program with significantly lower FICO scores and lower incomes and had accrued smaller down payments.  Yet, despite their financial condition at entry, they had a lower default rate - 3.8 percent compared to 6.4 percent - than other borrowers over the course of a year.  When researchers controlled for an array of additional influences, the differences grew.  The 12-month default rate was typically 8 to 9 percentage points lower than for comparable borrowers who had not participated in the INHP program.

However, Evans said, the success of counseling is certainly not guaranteed.  Fed researchers also looked at a counseling program in Chicago created under a mandate by the Illinois Legislature.  The law grew out of concerns that predatory lenders were taking advantage of naïve, less sophisticated borrowers in certain markets and required that mortgage applicants with low credit scores and those taking out nontraditional high risk mortgages in certain zip codes undergo a brief counseling session with a HUD-approved counselor before closing on the loan.  The session, which typically occurred a few days prior to the closing, was designed to educate the borrower about the terms of the loan and to discuss whether that product was appropriate for the applicant.  The Fed researchers found that the counseling had little effect, "perhaps unsurprising," Evans said, "given its extent and when it took place.  Increasing participants' financial sophistication is not easy."

There were, however, some positive effects from the program.  The researchers found that fewer high-risk loans were originated because some lenders preferred to exit the market rather than having their mortgage terms scrutinized by counselors and being accused of predatory lending.  Other dubious loans were not made because borrowers opted for alternatives to avoid the mandatory counseling.  "While one can argue that this decrease in the supply of mortgages had a downside in terms of decreasing borrowers' choices, the analysis found that the borrowers who were able to obtain mortgages performed significantly better than similar applicants in zip codes without the counseling requirement.

Evans pointed out that the two programs each affected the performance of loans, but they did so in quite different ways; one by affecting the behavior of potential borrowers which helped their performance on their mortgage arrangements, the other had a positive result because some lenders avoided the new environment and some borrowers choose products that did not require counseling.

"These findings fit quite well with the principles of a relatively new school of thought known as behavior economics, which recognizes that people frequently make substantial mistakes in their economic decisions," Evans said.  "In fact, these mistakes are so systematic that it is possible to alleviate many of their worst consequences by marginally adjusting the context in which the decisions are made.  The costs resulting from the adjustment may be relatively minor and less costly, for example, than the consequences of prohibiting certain products altogether. In mortgage markets, prohibitions of products intended to "protect" borrowers could result in significant reductions in the availability of credit.  This could prove costly as it would preclude some qualified customers from obtaining higher-risk mortgage products that they readily understand and can repay.

But behaviorists would also argue, he said, that mass-scale counseling could be costly and difficult.  They would instead give consumers choices, but then incentivize them to make the proper choices.  He cited the Chicago example as one type of low-cost incentive to avoid the high-risk product by "nudging" borrowers toward the low risk option which would be the "proper choice" from a policy perspective.  "We may," he said, "look to behavioral economics more often as we evaluate new policy options aimed at avoiding the mortgage market problems we have seen in the recent past."