Wednesday, September 30, 2009

A Student Loan Tragedy of the Commons?

by Andrew Gillen

Tim Ranzetta has a great post up discussing student loans and bankruptcy.
The crux of the matter seems to be an access issue vs. an equity issue. On the access side, there are those who will argue that private loans will be more difficult to get if the rules are changed to make them fully dischargeable in bankruptcy. On the equity side, are the consumer advocates who ask why private student loans seem to receive the same special consideration in bankruptcy as outstanding income taxes, alimony, maintenance and child support in not being fully dischargeable.
Before we dig in, suppose we moved from a system where private student loans are dischargable (declare bankruptcy and they go away, though you won't be able to get a loan for anything else for a long time) to a system where they are non-dischargable (you have to pay them not matter what). We would expect for the interest rates charged to go down, and for underwriting standards to be loosened. As it happens, we can go straight to the record, since that's what happened in 2005.

Back to Tim:
provisions limiting the dischargeability of private student loans passed in October 2005... the margins on private student loans went up...

Did this change in the bankruptcy law increase lender appetite for taking on riskier borrowers?...Sallie Mae's loans to the non-traditional (i.e. high-risk) borrower climbed almost 40% between 2006 and 2008...
So we got looser underwriting, as we expected, but instead of interest rates going down, they went up. I don't think that banks are more greedy post 2005 than pre 2005, so what gives?

My first hypothesis is that this is an illusion from focusing on averages. While the averages moved as reported, the types of students who comprised those averages changed. Pre 2005, you had students with good credit who met relatively tough underwriting standards, and thus faced relatively low interest rates. Post 2005, lenders weren't as concerned, so they loosened standards, which resulted in a bunch of new higher risk loans. While they weren't dischargable, they were still more risky, thus they faced a higher interest rate. When these riskier loans were averaged in with the old low risk ones, it brought the average interest rate up. In other words, the type of students who could have borrowed pre 2005 did not see higher rates post 2005, but the average went up because it now includes lots of riskier students who couldn't have received loans before.

My second hypothesis is that there was a tragedy of the commons type occurrence where the students were the commons. Post 2005, lenders would have been less concerned about whether their loan sent students over the edge and into bankruptcy since they would have a claim anyway. Lenders therefore had an incentive to lend (explaining the lower standards), but such lending imposes an externality on the other lenders in the form of higher bankruptcy risk (to which they respond by raising rates). In other words, lenders had a strong incentive to lend, but were worried about overgrazing.

8 comments:

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doshimaitri said...

Nice hypothesis you made on student loan tragedy.The inforamtion you gave is really helpful for student who are planing to take student loan.

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Ali said...
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Baba said...
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Baba said...

nice hypothesis you have there. but, can you also answer this question. How much would a change back to full dischargeability impact lenders and whether they choose to make private loans? Also if you don't mind, visit me, and leave some words on it. | Shandra from Bankruptcy Records

bankruptcy records said...

I think that allowing students to file bankruptcy on student loans should only be allowed in such extreme cases as disability (or such). I also think that schools that go out of business before the student can graduate should also qualify. That tragedy has happened much more than once! The only issue is that collection agencies really hammer kids for these debts later in life. Texas bankruptcy records indicate that different states even treat bankrupt student loans differently. We'll have to wait and see if the new student loan policies will engender any new effects on these laws.