Well-founded criticism abounds that we shouldn’t be bailing out large banks that have profited by providing imprudent (and oftentimes scandalous and even criminal) sub-prime loans to homeowners.

One oft-mentioned alternative to bailing out the banks is to bail out the homeowners.  One might justify this move on the ground that many recipients of sub-prime loans were invited to take out loans with exploding ARMS (adjustable rate mortgages).  These are not the ARM’s from decades past, mind you. Rather, these are loans that, within a few years of the loan closing, are guaranteed to require monthly payments that the homeowners couldn’t afford, regardless of market fluctuations. Imagine, for example, a loan requiring payments of $1,000/month that would rise to $1,800/month within a few years, even when the cost of money stays relatively stable.  The mortgage companies offering these types of refinances would be long gone by the time that this kind of loan explodes, forcing many of these homeowners into foreclosure or bankruptcy.  In addition to the exploding ARMS, many distressed homeowners were victimized by hidden fees and penalties, including substantial pre-payment penalties, as well as “yield spread premiums,” which are essentially under-the-table bribes paid to brokers.

But why did so many homeowners sign up for loans they wouldn’t be able to afford? Many of them were lied to by the mortgage companies (disclosure: In my law practice, I’ve represented many of these folks). Other borrowers were clearly irresponsible.  Most of of the borrowers suffer from a condition mathematician John Paulos calls “innumeracy”: the “inability to deal comfortably with the fundamental notions of number and chance.”  I’m not accusing the borrows of stupidity; rather, they tend to lack a specific skill set, the origin of which often extends all the way back to the grade school struggles with mathematics.

The above observations serve as context to a discussion of a potential plan of action.  The simple question are these:  Should we bail out distressed homeowners?  To what extent would bailing them out solve their problems (which has become our national problem)?   One might think that handing a homeowner a wad of money would clearly help that homeowner, but research based on the bankruptcies of lottery winners should give us pause.

According to a study by a well reputed group of economists, the sudden receipt of a large and unexpected amount of money only postpones, but doesn’t actually prevent, bankruptcies.    According to a New York Times summary of this research, winning a large amount in the lottery tends to “postpone, rather than reduce, bankruptcy — even if the jackpot amount was more than enough to fully pay off the winner’s unsecured debts.”  Where do all of those lottery winnings go?  People spend that money in a variety of ways, but the bottom line is that unexpected winnings too often vaporize.   The authors of the research mention self-control issues and the tendency to engage in “mental accounting” to explain the way that winners so often let go of new-found money.

The NYT suggests that this research presents some “uncomfortable lessons for those favoring big homeowner bailouts right now,” even though the researchers admit that the lottery study isn’t the exact equivalent of providing financial relief to distressed homeowners.   Also consider the distressing track record regarding loan modifications:  “More than half of loans modified during the first three months of the year were delinquent by 30 days just six months after the terms of the loans were changed.”

The above information suggests that the exploding number of foreclosures and distressed home loans is a huge mess without any easy or obvious solution.  I’m sure that many financial services companies will use this data to suggest that we ought to do nothing at all to help victimized homeowners.  That is not what I am suggesting.    Perhaps, instead, we should seriously provide budgeting educations to those we are helping with bailouts–we should spend a bit of extra money to help them to understand the consequences of all of those numbers.  In additional to lending them a financial hand, we shoudl also work hard to rid them of their innumeracy.