Student Loans: The Next Financial Crisis? (Revised)

As I have been browsing the news the last couple of days, an article on the WSJ got me really thinking about student loan debt and the uncanny parallels shared with housing debt in the mid 2000’s. To preface, mortgage standards in the US were lowered in the early 2000’s in a push by the Clinton Administration to get people into houses. Loans that were issued by banks were sold to entities like Fanny & Freddy and then bundled into securities that were bought up and sold by different banks and hedgefunds around the US. Obviously we all know how this ended, but the issue as I see it, was two fold on the banking side of things. The first issue was the relaxed standards set by Washington for loans to be given out and the second issue was the moral hazard represented by the banks writing the loans because they could turn around and sell them just as fast as they could write them.

Almost 6 years now after all of the events of the financial crisis happened, I see a striking parallel between another type of debt and mortgages: Student loans. One of the bigger facets of Mr. Obama’s presidency has been the lowering of the barriers of entry for people to goto college. In 2011 the president enacted a program in which students can attend college and then pay after the fact as they earn at whatever jobs they may find– this program is aptly titled, “Pay As You Earn”. Under this plan, you would attend college at the cost of the government, and then 10% of your total discretionary income per year after school would be taken as repayment for the loans. If you find a job in the private sector after school then you pay for 20 years and then the remaining balance is forgiven, 10 years if you work in the public sector. (Student Aid Website)

Unsurprising to any market failure monitoring economist though, this plan is backfiring, even despite noble intentions. In an article from the WSJ we see that the plans have expanded to over 1.3 million people (originally less than a million before changes to debt forgiveness were enacted) and total debt balances rising to $72 billion from $52 billion before the easing in forgiveness measures were enacted. A moral hazard exists here between the tax payer and the schools who are now incentivized to raise their tuition prices and pay for more of the students bills because the government will pay them back regardless after 20 years and as everyone attending this great University of Michigan knows; tuition has been rising.

So the first ingredient in a recipe for financial crisis obviously being bad debt, the time must have seemed perfect for a dash of bundling; the bundling of asset backed securities. In another WSJ article, we see SLM Corp who happens to be the largest student lender in the US selling over a billion dollars worth of student loan backed securities (SLBS). The interesting part about this and other SLBS sales is that the majority of the demand for the offerings is for the riskiest parts (the most likely to default) of the securities. Why this appetite for risk? Low interest rates may be the answer. Thinking back to the early-mid 2000’s there was a refusal by Alan Greenspan to raise interest rates and people were hungry for yield; the mortgage backed securities promised a rate of return higher than what anyone could find in the bond market and was still rated AAA to top things off. Many believe that the mix of moral hazard and systemic risk present in the banking structure combined with the low rate environments was the catalyst for the financial bubble to blow up and eventually burst. These student loan offerings show that investors are indeed searching for yield wherever they can today.

With default rates on these loans continuing to rise, the government needs to act now to reform this pay as you go expansion for the student loan program. The best solution I think would be to work with colleges to lower tuition rates and quit forgiving the debt that these students take on. Because as long as people can have something for nothing, or rather, a college education at the expense of the US Taxpayer, they will continue to do just that until we are in the midst of another massive asset bubble.