Financial Planning Association of Missouri and Southern Illinois, St. Louis, Jan. 9, 2008Economic conditions ; Education ; Economics

William Poole

English

Research Papers in Economics

1
Dollars and Sense
Financial Planning Association of Missouri and Southern Illinois
St. Louis, Missouri
January 9, 2008
things the Federal Reserve is doing to address
this issue. Finally, I’ll look at what we can all do
to help Americans know more about their finances
and to give them the tools to make better choices.
As financial planners, you of course have a large
stake in this enterprise and will benefit in the
long run from having better-prepared clients. I
know your organization is already involved in
some education efforts, and I applaud your efforts.
Before proceeding, I want to emphasize that
the views I express here are mine and do not
necessarily reflect official positions of the Federal
Reserve System. I thank my colleagues at the
Federal Reserve Bank of St. Louis for their com-
ments. Joseph C. Elstner, public affairs officer at
the St. Louis Fed, provided special assistance.
However, I retain full responsibility for errors.
FIVE MISTAKES
Let’s review the five major mistakes creating
the subprime mess.
First, too many borrowers took on mortgages
they could not afford. Nothing new there, except
for the number of such borrowers. How could
something seemingly so preventable happen?
One of the main culprits was the adjustable rate
mortgage, or ARM. Actually, the problem is not
the ARM itself but grossly inadequate borrower
understanding of this type of mortgage. The “Two/
Twenty-Eight” ARM called for low initial pay-
ments for two years, which would then reset to
higher levels for the remaining 28 years of the
30-year mortgage. Too many borrowers, though,
did not insist on knowing just what the “higher
level” would mean, and too many mortgage bro-
kers did not provide that information in a way
W
e are certainly living in extraordi-
nary financial times. Our nation
has enjoyed a long economic
expansion and inflation has been
relatively low. However, since last August, finan-
cial markets have been in considerable turmoil
resulting from subprime mortgage lending and
a deflating housing boom. The Federal Open
Market Committee (FOMC) is watching both
recession and inflation risks. Recession risks are
primarily a consequence of financial turmoil,
which has threatened to spread housing industry
woes to the broader economy.
Will housing sector problems push the econ-
omy into recession? It is too early to tell right now,
but what we can do is to examine the current sit-
uation closely and try to learn from it. Perhaps
“relearn” is a better word, because the mistakes
that brought us to this point have been made
before. There are no new lessons here. The lessons
are familiar ones that need to be more forcefully
driven home and incorporated in standard finan-
cial practice in the future. That is why I’ve titled
my remarks “Dollars and Sense.” The Fed is work-
ing on providing the public with better and more
useful financial information that we hope will
reduce the odds on the housing finance industry
repeating its recent financial mistakes.
My plan is to review the current situation
and examine five key mistakes by borrowers and
other market players. Although many borrowers
have little financial expertise, we would have
expected all the other players to be more sophis-
ticated and experienced. Then I’ll review where
the country stands in trying to educate Americans
in basic financial literacy and economic thinking.
As part of that review, I’ll include some of thethe borrower could understand. Other borrowers,
wanting to take advantage of low initial payments,
gave misleading or false information about their
ability to repay. It is important to emphasize that
there is nothing inherently wrong with adjustable
rate mortgages, and they make sense for many
borrowers. However, borrowers must be prepared
for interest rate resets and able to pay higher rates.
In recent years, too many borrowers were not
prepared. Borrowers also need to understand
prepayment penalties in their mortgage contracts.
These can make refinancing ARMs into fixed-rate
mortgages terribly expensive.
Second in our mistakes summary, mortgage
brokers put too many borrowers into unsuitable
mortgages. As I mentioned in a speech to a St.
Louis real estate group last July, with widely held
expectations of rising interest rates priced into
the markets throughout the 2003-2005 period, it
is difficult to avoid the judgment that these ARM
loans were poorly underwritten. It was imprudent
for mortgage bankers and lenders to approve bor-
rowers who likely could not service the loans
when rates rose. It is important to understand
that rising interest rates were not just a risk but
actually the market expectation. Poor underwrit-
ing not only jeopardized the borrowers put into
unsuitable mortgages but also the brokers them-
selves. Numerous brokers are now bankrupt, and
many survivors have suffered large losses and
sullied reputations.
Third, it is surprising to me that investment
banks jeopardized their reputations by securitizing
these mortgages when the underlying loans were
backed by inadequate or spurious information.
Damaged reputations are also casualties of the
fourth major mistake: rating agencies that placed
AAA ratings on many securities backed by sub-
prime mortgages. The rating agencies seemed to
have based their ratings on a backward look at
default experience on similar mortgages before
2006, rather than on a forward look based on care-
ful analysis of the likely ability of borrowers to
repay in less favorable market circumstances. The
reason default experience on subprime mortgages
was relatively favorable before 2007 is that hous-
ing prices were rising, permitting stressed borrow-
ers to sell their properties to repay the mortgages.
The rating agencies, apparently, did not believe
that house prices might stop rising, in which case
the music would stop.
The final entry on our major mistake list is
investors who bought those securities without
conducting an adequate analysis of the underly-
ing investments. Investors too readily accepted
the AAA ratings at face value. As financial plan-
ners, you are very familiar with the cliché that
“if something looks too good to be true, it proba-
bly is.” A reach for yield with inadequate attention
to risk is another basic lesson that apparently
cannot be relearned often enough.
It is interesting, and a bit depressing, that
investment professionals made four of the five
mistakes. I can understand the mistakes many
financially naïve borrowers made but have a
hard time understanding how so many invest-
ment professionals could have been so wrong.
Many observers point to greed, but I prefer a dif-
ferent explanation. Shortsightedness rather than
greed explains actions that led to losses of tens
of billions of dollars and the failure of many
financial firms.
AVOIDING FUTURE MISTAKES
I will now add some detail to three of these
mistake categories—borrowers who cannot repay,
mortgage brokers putting people into unsuitable
loans and investors who did not do their home-
work. Here is my question: How could better
education and financial decision-making have
helped people avoid these mistakes?
Borrowers
Too many know too little about credit and
what its costs and risks are. Starting with course-
work on credit usage in elementary and middle
schools and continuing with financial literacy
and economics in high school would go a long
way toward equipping borrowers with the infor-
mation they need, or at least give them enough
knowledge to ask the right questions about what
they can afford and what lending terms mean.
ECONOMIC EDUCATION
2Mortgage Brokers
Many have closed their doors and gone out
of business through unsatisfactory lending. In
the July realtor speech I mentioned earlier, I
emphasized that a durable stream of profits in
mortgage lending requires a continuing flow of
capital from investors willing to buy the mortgages
an originator wants to sell and securitize. Given
the difficulty any mortgage broker faces in differ-
entiating its own products, the best way to stand
out and survive over the long term is to give out-
standing service to mortgage shoppers. Turning
outstanding service into future business prospects
is precisely the role for reputation. A firm’s good
name spread through word of mouth will pay
the highest dividends over the long term. And
going the extra mile by making certain that bor-
rowers understand lending terms and are able to
service those loans can cement that reputation
and keep those doors open a long time.
Investors
Here I want to look at individual investors,
the ones you know so well. It may be true that
many if not most such investors put their money
heavily into mutual funds, reducing some of the
risk of holding individual stocks and bonds. What
would help them greatly, I believe, is a much
better understanding of what their funds hold.
Mutual funds are professionally managed, but
the subprime fallout has hit the pros hard, too.
In one example from our Federal Reserve District,
two investors in two Regions Morgan Keegan
mutual funds severely affected by subprime mort-
gage problems are suing over sharp declines in the
values of their investments. As of December 13,
2007, the Select Intermediate Bond Fund and
the Select High Income Fund were down 47 and
56 percent, respectively. News media accounts
tell of disastrous results being faced by other
investors in similar types of securities. Would
investors equipped with better knowledge have
avoided such steep losses? More organizations
should get behind efforts to improve investor
knowledge.
Where does the country stand in terms of
educating our citizens in the financial and eco-
nomic basics? The brief answer is that efforts
across the nation are making progress but we
have a long way to go.
According to a 2007 survey by the National
Council on Economic Education:
• Economics, traditionally part of the social
studies curriculum, is now included in the
educational standards of all states.
• 41 states, up from 28 in 1998, now require
these standards be implemented. Sounds
good so far, but there’s more.
• Only 17 states, not including Missouri or
Illinois, require students to take an eco-
nomics course for high school graduation,
up from 13 states in 1998.
• Only 22 states, not including Missouri or
Illinois, require testing of student knowl-
edge in economics, three fewer than in
2004.
Personal finance, a newer subject in compari-
son with economics, is now included in the edu-
cational standards of 40 states, up from 21 in 1998,
with 28 states requiring these standards to be
implemented. Still, though, only seven states
require students to take a personal finance course
for high school graduation and only nine require
the testing of knowledge in personal finance.
Missouri now requires personal finance for grad-
uation and tests for knowledge; Illinois requires
a consumer education course but does not test
on the subject for graduation.
What we have, then, is a mixed bag when it
comes to preparing students to learn about money
and the choices to be made in handling it. Our
nation is making progress, but as we have seen
with the subprime mess, we as a society have a
lot more to do in equipping students and adults
with the knowledge they need to make wiser
financial decisions.
I know the Financial Planning Association of
Missouri and Southern Illinois believes in boost-
ing financial literacy. Your web site tells of the
projects you’ve undertaken to better educate your-
selves and your clients and the volunteer work
you’ve done for the community. At the Federal
Dollars and Sense
3Reserve Bank of St. Louis, and in our Branch
cities of Little Rock, Louisville and Memphis,
we’re trying to do our part, too.
We’ve got a two-pronged effort going, with
one part aimed at community development and
a complementary effort aimed at improving finan-
cial education in the schools. On the community
development side, we work on educating com-
munity groups and through those groups, their
members, about improving communities through
making better financial decisions.
Last month, for example, we hosted a seminar,
“HMDA to Home Improvement,” in St. Louis.
HMDA is the acronym for Home Mortgage
Disclosure Act. Attending were mortgage lending
experts, community group representatives, econ-
omists and government officials. Discussions
were aimed at helping homeowners avoid fore-
closures and take advantage of programs making
home improvements affordable.
The St. Louis Fed also participates in the St.
Louis Foreclosure Intervention Task Force. It’s a
collaboration of representatives of government,
financial institutions, and real estate and non-
profit organizations One outgrowth of that effort
is a hotline, 888-995-HOPE, that counsels home-
owners concerned about foreclosure. Brochures
and television appearances helped promote the
hotline. We helped in starting a similar program
in Springfield, Missouri.
In Louisville, Kentucky, our Branch staff is
involved in the Don’t Borrow Trouble Coalition,
an organization helping citizens deal with lending
issues, particularly as they relate to mortgages.
The Kentucky Predatory Lending Prevention
Committee is another organization we help sup-
port; it helps families avoid money scams and to
resolve financial problems. We’re also active in
similar efforts in Arkansas, Indiana, Tennessee
and other locations.
Besides our community development efforts,
the St. Louis Fed and other Federal Reserve Banks
work through state economic education councils,
centers for economic education and local school
districts to offer mostly free economic and finan-
cial education materials and curricula to teachers.
We do some work directly with students, but we
find we can reach many more of them by working
through their teachers. Our aim is to drop large
boulders in the education pond and to encourage
the ripples to expand.
We have a lot going on in this area too; I’ll
highlight some of the key projects.
I mentioned earlier that Missouri now requires
a one-semester personal finance course. The St.
Louis Fed’s economic education experts are
helping to train educators who will be teaching
those courses, setting up workshops for them
and training teachers in the new curriculum.
We also take part, as do representatives from
commercial banks, in Teach Children to Save Day,
an annual event for first- through third-graders.
In the St. Louis metro area alone, our volunteer
employees taught lessons in over 400 classrooms
last year on the importance of saving regularly
and what it means to save over the long term for
something you really want.
There are many places teachers can go to for
useful information and classroom-ready lessons
on money, credit and economic concepts. Two of
the best are web sites: first, our Bank’s web site
at www.stlouisfed.org. Clicking on the “education”
link brings teachers to conferences, materials,
lessons, teaching tips and much more. The other
site is actually a portal at
www.federalreserveeducation.org. It’s an entry
to web sites providing help of all kinds for teach-
ers of personal finance and economics. Just
about any topic under the general “economics
and personal finance” heading is included in
one or both web sites, along with support mate-
rials and tips on using them.
In St. Louis and our Branch cities of Little
Rock, Louisville and Memphis, our economic
education staff in 2007 conducted well over 100
separate meetings, workshops, competitions or
other events aimed at equipping teachers to pro-
vide their kindergarten through high school stu-
dents with the skills they need to deal with money,
debt, credit, saving and economic decisionmaking.
For example, in early 2007, high school
teachers in Southhaven, Mississippi, attended a
“Growing Smart with Money” workshop led by
our Memphis Branch economic education staff.
ECONOMIC EDUCATION
4In the St. Louis metro area, we worked with local
libraries to put on a program for middle-schoolers
called “Money Smarts for Kids.” We worked with
the Kansas City Fed and centers for economic
education staff at Missouri universities to conduct
the first-ever Missouri Personal Finance Competi-
tion in St. Louis, Kansas City, Springfield and
Columbia, with the championship held in
Jefferson City. A program begun by our Little Rock
Branch staff, the Piggy Bank Primer, has helped
early grade school students throughout our District
to learn more about saving. A program we helped
roll out in Quincy, Illinois, “Your Paycheck” is
expanding in our District. It’s aimed at teenagers,
particular those holding their first jobs, and
teaches them about paychecks—what the various
deductions mean and how you can learn more
about benefits, saving, withholding and more.
That’s just a partial listing of the community
development and economic and financial educa-
tion efforts we’ve got going. And there’s more of
that coming for 2008 and beyond.
What can we all do to move this trend along,
to put learning the basics of saving, borrowing
and credit higher in the public’s mind? There are
a number of things, and it is going to take the
Federal Reserve, the Financial Planning Associa-
tion of Missouri and Southern Illinois, and thou-
sands of other organizations to pull it off.
• Contact your local schools and ask them
where learning about saving, spending,
investing and borrowing fit into their cur-
ricula, what lessons are being taught and
how. Bring up this subject at school board
meetings and parent meetings.
• Support legislative efforts to require course-
work in economics and personal finance
for high school graduation. Let your state
representatives and senators know through
calls, letters or e-mails and personal contact.
• Write op-ed pieces highlighting the need
for expanded financial education and offer
them to local news media. Don’t overlook
influential internet bloggers…they can help
spread the word quickly.
• Get behind or start financial and economic
education programs in professional organi-
zations and lend your skills. We ask a lot
of our educators; they can do a lot, but they
can’t do it all. We can all add our voices…
and ourselves.
CONCLUDING COMMENT
The current financial turmoil will take awhile
to play itself out. The fundamentals of our econ-
omy remain strong, however, and 2008 looks to
be a year of rising growth. Economic forecasters
expect slow expansion in the first half of the year
and a quickening pace in the second half. Mean-
while, if borrowers, lenders and investors can
refocus on financial basics and re-emphasize
critical lessons about credit and risk, the financial
future can be brighter than the second half of
2007. For that brighter future, we need to infuse
our education at all levels with the lessons of
2007—old lessons to be sure but easy to under-
stand at a very practical level from 2007 experi-
ence. With continuing effort we can expect that
financial upsets such as the current one will be
infrequent and milder when they do occur.
Thank you and I’d be glad to take your
questions.
Dollars and Sense
5

Dollars and sense

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