Monday, November 26, 2007

A Tuition Bubble? Part 1 of 4

By Andrew Gillen

This is the first in a four part series that will explore the similarities between the housing bubble and rapidly increasing tuition. A study that explores these issues in greater detail will be available at the conclusion of the series.

What Happened in the Housing Market

Before we can start comparing the housing bubble to the increases in tuition, we first need to establish how the housing bubble occurred.

In the wake of the 9/11 attacks, the Fed lowered interest rates to stave off a recession. One of the impacts was to lower the rate that banks charge for home mortgage loans. At a lower interest rate, people can take out larger loans (assuming a fixed income). With more people qualifying for larger loans, the demand for housing increased, which naturally led to an increase in housing prices.

At the same time, a trend called securitization was taking off. In the old days, when a bank made a loan, the loan would be kept on the bank’s books. If the borrower defaulted, the bank would lose money. This helped ensure that banks tried to make only loans that they were confident could be paid back. With securitization however, this was no longer the case. Now when a bank made a loan, it would sell it to investors who typically bought packages of these loans called collateralized debt obligations (CDOs). This allows for investors to have a lower overall exposure to risk since holding multiple loans lessens the impact from any one of them defaulting. While doing a wonderful job of spreading risk, securitization leads to a principal agent problem between the banks and the investors. Because the banks will no longer shoulder the costs of a bad loan, they don't have an incentive to make sure that the loans they make are likely to be paid back. As a result, the banks lowered their lending standards.

Between the low interest rates and the lack of lending standards, people making very little money were qualifying for enormous loans. This increased the demand for houses which in turn lead to increases in prices. The increasing prices then attracted speculators who sought to make a fortune flipping houses, which drove up demand and prices even more.

Everybody was happy until the Fed increased interest rates. This led to an increase in the payments on variable rate loans. Some borrowers, especially in the sub-prime category, were unable to meet these higher payments, and started to default on their loans. The investors, who were expecting payments from all these loans, started to realize that many of the loans that they held were not worth much, and stopped buying mortgages from the banks. The banks, unable to offload bad loans on investors anymore, quickly re-established rational lending standards. With fewer people qualifying for loans, the demand for housing dropped, leading to lower prices, which in turn scared off the speculators, which led to even lower prices as demand from them subsided as well.

While the relative contribution to the housing bubble of each of these three factors (low interest rates, a lack of lending standards, and speculation) will no doubt be debated for years to come, CCAP has noticed some troubling parallels when it comes to tuition.

Coming Wednesday: Similarities in Higher Education


TC said...

This should be an interesting read and I will withhold final judgement until I have read all of you blogs.At the risk of quibbling over cause and affect, you left out "introductory rates" or "teaser rates" which expire after a period of time. But this aspect of lending practices might not fit into the framework you are setting up for the comparison, and it's not a big deal.

There are still many, many introductory rates out there which have not yet expired - so we have possibly two more years of being rode hard and hung up wet.

I look forward to the rest of your installments - and any disagreement I may have is provided with all due respect. I have been screamming about this for quite sometime and I am happy this suject is becoming more and more talked about as it is kiling the market.

Thanks Andrew.

TC said...

I'm guessing you found that the sh_t is deeper than you may have thought. Wait until you get to the part about how deeply endowments are invested in hedge funds. Here's an article that is over a year old that gets into endowments and hedge funds. More to be found elsewhere (eg. - NACUBO). This is going to be quite interesting if you can work through it full circle. Figuring this out will be like unscrambling an egg - but oh, the way the story ends... it will blow people away. Nobody has any idea just how deep colleges and universities are in. But I can tell you, there are a lot of endowment financial managers out there right now that have their back sides puckered up so tight they could, well... use your imagination.