Monday, January 07, 2008

Is the Student Loan Market Imploding?

By Richard Vedder

I was talking with one of America's finest business reporters the other day, Chris Farrell of Business Week and NPR. Chris was asking for my take on the student loan market, picking up on Andy Gillen's series of blogs on the possibility of a student loan "bubble."

A look at the evidence shows that top companies in this field may be sicker than the top companies burned by the subprime/private equity problems. Consider the following:

The price of common stock fell from July 3 to January 4 for the following companies:

J.P Morgan & Co. 16%
Bank of America 17%
Merrill Lynch 37%
Citicorp 44%
Bear Stearns 47%

Big declines --especially for companies like Citicorp and Bear Stearns. But what about Sallie Mae, by far the largest student loan participant? The price of SLM stock fell OVER 71 PERCENT in the same period, from $57.92 to $16.67 a share. A far more dramatic decline --well over two-thirds the company's capitalization.

What is the problem with student loans? There are both supply and demand factors at work.

First, the risk premium associated with student loans is apparently significantly greater than assumed by the lenders and investors in those companies. Evidence that defaults are far higher than the Department of Education lets on furthers the concern.

Second, the Democrats controlling Congress had a bad idea --lower interest rates on loans and finance the subsidization in part by cutting fees payable to private lenders. The "squeeze the lender" philosophy (similar to "squeeze the physician" with Medicare and Medicaid) can only have negative supply consequences.

Third, public awareness of the consequences of excessive borrowing are rising, as newspapers, TV, and the internet are filled with horror stories of students with huge debts.

Fourth, the student loans scandals unearthed by Andrew Cuomo and others have made some colleges leery of getting involved with student loan companies. Some heads have rolled, and we have perhaps not heard the end of this matter.

Fifth, maybe in part because of the previous point, some prestigious schools are ending loans as part of student financial aid packages --when Princeton and Harvard do that, others follow --and they are. Joe Six Pack U. cannot afford to do it, but more and more private schools are taking the plunge, using endowment monies more aggressively to support tuition discounting.

Sixth, the demand for higher education has risen sharply over time because of the rising college-high school earnings differential. Yet the evidence is, at least for women (who make up 57 percent of all students), that that differential has ceased widening over the past decade. As the cost of education rises, but the financial benefits remain roughly constant, the advantages of borrowing for college decline.

Hence, there already is a slowdown in loan growth --will it turn into an absolute decline? Stayed tuned.

4 comments:

Brett said...

Yes, the market is imploding, for many reasons. It is incredibly short-sighted of government to hurry up legislation in the hopes of winning re-election. Eliminating student loans will have costly consequences that will ultimately keep many students out of college. College remains a good investment and every study that has been done shows that the salary associated with a college degree far outweighs the cost of that degree.
The ultimate fate of student loans is in the hands of the next President. For each candidates proposal, read the following article:

Predidential Candidate Positions

Patrick Bott said...
This comment has been removed by the author.
Patrick Bott said...

Sallie is but one player in a multi-billion dollar industry. Yes, Sallie is hurting (as are others in the space). It has been a perfect storm for student lenders and Sallie Mae in particular. You might recall she was left at the altar by JC Flowers and company. Read Sallie's SEC disclosures carefully and you'll notice that Sallie bet the farm on the deal being consummated (let's call this problem #3).

Another issue (problem #1), is the crusade launched by a certain political party to end private involvement in student lending. Congress in its infinite wisdom, decided at the most opportune moment (a credit crunch), to punitively reduce the fixed spread that FFELP lenders enjoy on their loans. You might recognize some parallels here between the California Energy Crisis. The lender return is fixed on FFELP loans (CA utilities retail prices were fixed). The wholesale cost of money for student lenders is subject to market gyrations, dislocations, and so on, read: it's not fixed (CA utilities had to buy power in wholesale markets higher than they could sell it in the retail market). Only in the mind of a politician is it OK to buy high and sell low. Let's call the credit crunch problem #2.

Let me digress here breifly, higher defaults / delinquencies are normal when an economy is teetering on the edge of a recession (no loan types are immune: mortgage, auto, credit cards, and so on). Let's not forget that the government stands behind the vast majority of student loans. So, even if a ton of students don't pay back their loans (an unlikely outcome), the American taxpayer will enter the void to pick-up the tab.

The disaster scenario is somewhat mitigated for students also b/c starting in 2009, public-sector workers will have their loans forgiven after 10 years, and everybody else after 25 years (the loan payments will also be linked to income, very similar to how our progressive tax code works). As news of this spreads, I'm betting that more people borrow (much to the chagrin of the student loan activists, and consistent with Murphy's law). Why should parents save to put junior through school, or students work to put themselves through school when they can borrow and put their loans (and therefore college costs) back to the taxpayer after 10 or 25 years?

Back on point now...chaulk up the current problems for Sallie Mae to populist politics, a credit crunch, Sallie putting all her eggs in one basket (i.e., the failed merger), and a higher education system that's screaming for reform.

No worries, I'm sure President Obama will have plenty of entitlements up his sleave that will push the problem out two or three generations hence, while sapping any remaining incentives for good behavior right out of the system!

Happy New Year!

ks said...

I have been reading your blog. I thought it's nice blog.

repayment student loan