Sunday, December 09, 2007

Surprise! Surprise!!! Student Loan Defaults Are Rising

By Richard Vedder

My CCAP colleague Andy Gillen has adroitly likened the student loan situation to the subprime lending mess facing the nation. Loans made at below market rates of interest led to a ballooning in debt. Not only are homeowners (and some private equity borrowers) going broke, but the same is happening in higher education, if the Saturday Wall Street Journal is right (as I am sure it is).

Officially stated student loan default rates are too low, since they are based on only two years of post-schooling history. Now the big lenders are starting to take balance sheet hits from bigger losses (except for the federal government, which does not even have a balance sheet, and if it did, it would be meaningless as it would fail to record tens of trillions of dollars of unfunded health care and pension liabilities).

Some are predicting the following not so rosy scenario. The economy will enter a downturn, new college kids will graduate and have trouble getting good jobs --but will be faced with healthy five digit sums of debt requiring thousands of dollars in annual payment to service --even with subsidized interest rates. While I am not nearly as sure of a recession as some of my friends, the problem outlined is there --and will continue to grow unless we fundamentally change the system. Moderate increases in Pell Grants and tinkering with interest rates is not 'fundamental change". As long as the ratio of debt repayments to disposable income of new college graduates continues to rise, this problem will worsen. The effects of the inefficiencies of the higher education system could rear up and bite some pretty big financial services firms, or, if bailouts occur (as is Congresses' tendency), taxpayers could take it on the chin. If the financial services companies take a hit, some may exit the business, as the feds are already trying to cut the fees they receive for their loan involvement.

The root cause of the problem, of course, is the soaring cost of colleges --to students and to society. We must find a way to stop the academic arms race (I am surprised someone has not proposed disarmament talks!) College presidents are worried more about how their colleagues will receive them at meetings of the American Council of Education or similar organizations than on what the general public is saying. The "public be damned", "let them eat cake", attitudes dominate, costs rise faster than inflation, debt soars, the debt-income ratio increases, and defaults rise. What's next? The bad solution would be for Congress to simply drop more money out of airplanes to borrowers of student loans in distress. The good solution would be to face up to the root causes, clamp down on publicly funded or guaranteed student loan growth, and, sadly to be sure, let some people fail as a lesson to the nation of the pitfalls of a debt-financed decline in higher education productivity. Above all, this shows federal involvement in the market for student credit causes more problems than it solves - the feds are doing to student loans what they have done to pensions for the elderly, treating them irresponsibly.


TC said...

Subprime lending conceptually parallels student loans in some ways, and in most other ways it is much more complex and does not parallel student loans. (No disrespect to Andrew)

The Student Loan industry is an $85 billion industry? And the Hedge Funds (CDO’s) that are built on credit and leveraged, has an estimated $1 trillion in assets.

"While there's no apparent shortage of loans available to college-bound Americans, analysts say rising defaults, coupled with a new law that cuts federal subsidies to student lenders, are beginning to strain the industry."

I think the main parallel is in the loan application and approval process and that's about all I can think of right now.

What I think people need to look at when analyzing student loans is the cause – tuition is too high and unaffordable unless one subsidizes an education with student loans (for most people). The result is student loan defaults. Maybe there are lax lending standards and artificially low interest rates. But that is a symptom of a larger problem – tuition costs. The root cause is that college tuition is too high – if it were not, student loans would probably not be a problem.

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