Wednesday, September 02, 2009

Itchy Trigger Finger

by Andrew Gillen

A new report by Mark Kantrowitz shows that the rejection rate for PLUS loans is twice as high (42%) under FFEL than under DL (21%).

Tim Ranzetta and Ben Miller both see this as indicative of yet more unscrupulous behavior on the part of lenders. Their basic argument is that it is more profitable for lenders to reject applicants for PLUS loans and then give them private loans that carry higher interest rates.

Given lenders past behavior, this story is certainly plausible, but I’ve got three concerns about it.

First, that story only really works well if a specific lender has got a monopoly on both loan types at a school. Even if private loans are more profitable, lenders will still be willing to make the PLUS loans (assuming they are profitable – see below) if they think other lenders will be the ones making the high profit private loans. There is no sense in turning down some profit if all that does is give your competitors an even bigger profit. Moreover, if this is the cause, the problem is monopoly, not private lenders, which has very different remedies.

From the Dept of Ed description here, I can’t tell if lenders typically have monopolies on PLUS loans or not, but even supposing they do, it seems strange to me that folks would fail to shop around for the best deal on private loans once PLUS loans are taken off the table. While I don’t think it’s likely that a single lender has cornered both markets at enough schools to produce the reported statistics, I’ll defer on this point to Ranzetta, who knows much more about student loan market practices than I do.

My second concern is that it is possible that for some borrowers, PLUS loans are simply not profitable enough to compensate for the risk. The government guarantee on them limits losses, but the 2005 bankruptcy reform, which among other things made private loans very hard to discharge, essentially does the same thing for private loans --limit losses. But this doesn’t mean that any interest rate at all is sufficient to compensate for the risk of realizing losses --even if they are limited to 3%.

As a simplified example, suppose that as a lender, I expect to collect interest of 5% on a $10,000 loan. If I am certain that you will pay, I will only charge you 5%, and you’ll pay me 10,500 the next year. Now suppose that there is a 20% chance you won’t pay me anything but that if that happens, the government will pay me 97% of the principal. To get my expected 5%, I now need to charge 7% (.2*.97*10,000 + .8*1.07*10,000 = 10,500). The interest rate quickly grows as the chance of default grows. It doubles to 10% when the chance of default reaches just 38.5% (ie, the borrower is still paying in full 61.5% of the time). It’s conceivable that for borrowers with poor credit, the fixed interest rate of 8.5% on PLUS loans is too low to compensate the lenders for the risk of only getting 97% of their money back. This example also helps explain why 3 out of 5 PLUS loans under FFEL are still accepted, a significant fact that the Ranzetta/Miller story can't explain.

One thing we’ve learned in the past year or so is that Americans won’t hesitate to take out a mountain of debt if they view it as an investment, be it in houses or education. In both cases, it can end badly. When even the government, which definitely doesn't care about profits, is turning away 1 in 5 applicants, perhaps the 2 of 5 applicants being turned away by private lenders is a useful signal that repayment prospects are highly uncertain. I'll be much more convinced that there is foul play going on if several years from now, default rates on PLUS loans made under DL but rejected under FFEL are comparable to those made under FFEL.

This is the main reason why I think the calls for disallowing credit scores to be used are misguided. Credit scores contain useful information, and we shouldn’t be too quick to ignore that. Maybe people are taking on too much debt with unrealistic chances of being able to pay it back. Of course, we’ve all just been reminded that markets aren’t always sending the right signals, which brings me to my last point. You may have noticed that financial markets have been acting a bit strange lately, among other things --throwing much of the world into recession. I've heard rumors that Bill Gates would be turned down for a mortgage because he doesn't have a regular paycheck, and as Ranzetta points out, the government is basically ending up with many of the loans anyway. While the craziness in markets is not an argument for ignoring recent developments, it is a warning against reading too much into them until things normalize.

To wrap up, it’s quite possible the lenders are up to their normal unscrupulousness. But before we conclude that, I’d like to see some evidence that lenders have cornered both types of loan markets at lots of schools, and that it isn’t the relatively low fixed PLUS rate or the general craziness of financial markets driving this.

1 comment:

Ben Miller said...

Hey Andrew,
You raise some interesting ideas/objections. I responded to you here: