Wednesday, November 28, 2007

A Tuition Bubble? Part 2 of 4

By Andrew Gillen

This is the second 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. Part 1 is available here.

Similarities in Higher Education

Part 1 of this series explored how lax lending standards and artificially low interest rates contributed to the housing bubble. This part is concerned with how they may be doing the same thing to tuition rates.

For many students, the only way to pay for rapidly increasing tuition is to take out student loans, primarily through government programs run by their schools' financial aid office, but increasingly through private lenders as well. The Federal government encourages this by providing guarantees for a large number of these student loans. This essentially means that lenders don't need to worry about default, since the government will pick up any slack. And it is clear that lenders have almost nonexistent lending standards when it comes to student loans Choy and Li (2006) analyzed the default rates of the 1992-1993 cohort of graduates, and found that 20% of those who borrowed more than $15,000 had defaulted on their loans.

The interest rate on student loans secured through government programs is also much lower than would otherwise be the case. Student loans are essentially loans with no collateral to people with uncertain repayment prospects. As such, we would expect for the interest rates to be high, a reflection of the riskiness of the loan for the lender. But interest rates on loans secured through government programs are reasonable, even downright low. This is entirely due to the government guarantees. To be sure, lower rates are typically a condition that the government requires for the loans it guarantees, but even without that requirement, interest rates would be lower because there is less risk involved for the lender. The impact of the guarantees on interest rates is huge. Currently, the rate for government backed loans is 6.8%, while for private loans, which don't have a guarantee, the rate can be as high as 18%.

While lax lending standards and low interest rates for the housing market were caused by securitizaiton and the Fed respectively, they are both caused by government guarantees for student loans when it comes to higher education. Unfortunately, while these would appear at first to improve access to college by increasing the ability of students to afford college, their main effect is to make it easier for colleges to increase their tuition rates. Part 3 in the series will explore the reasons for this.

Coming Friday: Part 3: How these parallels play out in higher education


Patrick Bott said...

Student lending is not subprime mortgage lending. On the Federal side, the government sets the underwriting standards, which are basically that you have a pulse, and haven't defaulted on previous student loans. Federal loans are a socialized product as you point out. The defaults are amortized over the 300+ million taxpayers in this country. Private industry federal lenders don’t have any say in who receives a loan. You highlight a study that said federal borrowers with balances over $15K defaulted at a rate of 20%. Well, that’s only a quarter of the information. That population in total had a 10% default rate. Moreover, 45% of the 10% re-entered repayment. So, conceivably the net default rate was closer to 5.5%. That’s hardly a worrisome figure, and doesn’t come close to defaults associated with subprime lending.

Private loans are more expensive than there socialized counterparts but that is to be expected since 300+ million Americans aren’t standing behind the paper. There are no subprime lenders in the private loan space today. Let me repeat: no subprime lenders. In fact the average FICOs you see associated with private students loans are in the 715ish range-well into prime borrower territory. The industry also encourages borrowers to obtain a co-signer for their loans. Co-signer rates are approx. 70% across the industry. Co-signers are usually the parent of the borrower. This helps explain why average rates on private loans are around 10% today. That’s pretty extraordinary for credit with no collateral like a house standing behind it. The 18% you site is not representative of the rate the average borrower obtains. In fact, the company that offered such rates is no longer making loans. You might have heard of them-Loan 2 Learn? Believe me when I say nobody in the industry misses Loan 2 Learn.

On the securitization front, I have many issues with the implications of your post. Securitization was developed primarily to allow companies to obtain cheaper credit than they could with their traditional balance sheet. It was not designed as a mechanism to dump poorly underwritten assets on unsuspecting investors. Securitization takes an asset and removes it from the credit risk of the original company. If that original company was not investment grade, its stands to benefit from a lower cost of funds if it can take assets that are of high quality, add any necessary credit enhancement, and sell them to a diverse investor base. One of the good things you’ll notice about this current pain in the credit markets is that the risk has been spread across many investors foreign and domestic and not just banks. You’d see a lot more insolvent entities today if the dumb loans that were made were more concentrated on American bank balance sheets. When student lenders securitize, they retain an economic interest in the securitizations through what is called the residual. This is simply the positive spread that the loans generate via what the student lender charges the borrower and what the investors charge the securitization. To say it is sell and forget is totally disingenuous. Student lenders make their profit through these residuals so they have little incentive to pump and dump. Securitization has also made student lending a more competitive market. Many FFELP lenders that gave Sallie Mae a run for her money wouldn’t have been able to do it without securitization. It has the potential to do the same for private lending.

I also disagree that lenders are to blame for the mortgage mess. This is another instance of behavioral economics at work. “Irrational Exuberance” to quote Alan Greenspan was on display in the housing market. History is replete with examples, the tulip binge of antiquity, the dot-bomb bubble of recent history are good examples. Assets prices don’t go up unabated forever. Yes lenders contributed to the insanity, but in the end it was the buyer who thought that their house would never stop appreciating at unsustainable levels that made the error.

As you’ve argued here before, I think higher education could use a little less federal money thrown at it. Maybe if student borrowers had to pay more realistic market-based rates the inevitable unwinding of the tuition bubble would occur that much more quickly. Your work outside of this particular series of postings has been outstanding, I hope you keep up the good work and go a little easier on student lenders. They sure could use a break.

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