The shit is hitting the fan: all those sub-prime mortgages given out so recklessly over the past two years are getting their interest rates re-adjusted. And that, of course, is when the foreclosures begin.
By most measures, sub-prime loans are a bad idea. Look, for example, at the popular 2/28 loan, which consists of a low, fixed-interest rate for the first two years and a much higher, adjustable rate for the next twenty-eight. Most people taking out a 2/28 loan can’t afford the higher interest rates that will hit later on. It’s not unusual for interest payments on a 2/28 loan to double within four years. (That’s why you’re seeing such high foreclosure rates in the sub-prime market.)
So why do people take out sub-prime loans? Don’t they realize that they won’t be able to afford the ensuing 28 years of mortgage payments? I think a big part of the reason sub-prime loans remain so seductive, even when the financial terms are so atrocious, is that they take advantage of a dangerous flaw built into our brain. This flaw is rooted in our emotional brain, which tends to overvalue immediate gains (like a new house) at the expense of future costs (high interest rates). Our feelings are thrilled by the prospect of a new home, but can’t really grapple with the long-term fiscal consequences of the decision. Our impulsivity encounters little resistance, and so we sign on the bottom line. We want the house. We’ll figure out how to pay for it later.
The best evidence for this idea comes from the lab of Jonathan Cohen. Cohen’s clever experiment went like this: he stuck people in an fMRI machine and made them decide between a small Amazon gift certificate that they could have right away, or a larger gift certificate that they’d receive in 2 to 4 weeks. Contrary to rational models of decision-making, the two options activated very different neural systems. When subjects contemplated gift certificates in the distant future, brain areas associated with rational planning (the Promethean circuits of the prefrontal cortex) were more active. These cortical regions urge us to be patient, to wait a few extra weeks for the bigger gift certificate.
On the other hand, when subjects started thinking about getting a gift certificate right away, brain areas associated with emotion – like the midbrain dopamine system and NAcc – were turned on. These are the cells that tell us to take out a mortgage we can’t afford, or run up credit card debt when we should be saving for retirement. They are our impulsive pleasure seekers, the hedonists inside our head.
By manipulating the amount of money on offer in each situation, Cohen and his collaborators could watch this neural tug of war unfold. They saw the fierce argument between reason and feeling, as our mind was pulled in contradictory directions. Our ultimate decision–to save for the future or to indulge in the present–was determined by whichever region showed greater activation. More emotions meant more impulsivity.
This discovery has important implications. (A more recent paper by the Cohen lab extends the theory.) For starters, it locates the neural source for many of our financial errors. When we opt for a 2/28 mortgage, we are acting like experimental subjects choosing the wrong gift certificate. Because the emotional parts of our brain reliably undervalue the future – life is short and they want pleasure now – we end up delaying saving until tomorrow (and tomorrow and tomorrow.) George Loewenstein, a neuroeconomist at Carnegie Mellon University and a collaborator on the Cohen paper, thinks that understanding how we make decisions will help economists develop better public policies: “Our emotions are like programs that evolved to solve important and recurring problems in our distant past,” he says. “They are not always well suited to the decisions we make in modern life. It’s important to know how our emotions lead us astray so that we can design incentives and programs to help compensate for our irrational biases.”