Tag Archives: default

Student Debt the Next Balloon to Pop In US?

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.

Students are obviously carrying more debt now with this plan and the next question is what will happen to default rates now that there exists an economic incentive to not pay these loans back because the tax payer obviously will. The parallel between this easing in debt rules and mortgages while different in the total amount of money being given away is different than that of houses, still sets a bad precedent for us in a post 2008 economy.

Turmoil in Chinese market

Last week in China, Shanghai Chaori Solar Energy Science & Technology Co. Ltd-one of the Chinese solar company confessed its inability to repay $14.6 million interest to the investors. This happened to be the first corporate bond default that occurred in the China mainland.

This time, the government and state-owned banks gave up their previous policy of bailouts and debt extension to ease defaults. According to the article on WSJ, the absence of actual defaults is leading to more risky lending practices and could cause more wasteful investments in industries that have already suffered overcapacity. To put restrictions on the shadow banking system in China, it is necessary for the government to stop supporting unregulated risky investment activities and lay the economy on the right track.

Yesterday, copper prices skidded to their lowest level since June 2010, also the prices of iron ore fell to its lowest level on Monday since 2012. This is because of several reasons.

First, the default last week brought down the faith of Chinese economy, some investors may expect more defaults after this first one.

Second, the slack of the growth speed of GDP leaded to the worries about the decline in demand of copper and iron. Mostly consumed by China each year, copper and iron prices are bellwethers of the Chinese economy.

Third, the pressure on the copper financing forced selloff of copper. Regulated by the strict lending standard, many companies used copper as collateral to get funding and use that either to import more copper or invest in high-earning assets. However, the fear of default and curb of demand transfer those copper from collateral into market, then the raise of supply pull the copper price down.

Those unwanted extra metal in the market has leaded to more worries about the large commodity such as oil. Brent crude for April delivery on London’s ICE Futures exchange was down 69 cents, or 0.6%, at $107.86 a barrel. On the New York Mercantile Exchange, light, sweet crude futures for delivery in April were down $1.40, or 1.4%, at $98.63 a barrel. This is because that China is the main force in emerging market countries that were hoped to increase demand for oil, according to the recent report from OPEC. On the contrary, gold price rose to a five-month high today due to the investor’s increasing demand for safe assets.

As approaching to the burst of the bubble in Chinese house market, those news showed that the government is starting its regulation over the unhealthy economy. In the short run, we may experience more turmoil in Chinese economy.

What’s the Easiest Way to Clean Up a Mess? Don’t Make a Mess

A WSJ article reports that Chinese banks are finding creative ways to deal with “non-performing loans.”  Specifically, these banks are raising capital to offset the losses they will inevitably incur when borrowers default on these non-performing loans.  Combined with gradual write-offs of bad debt, this increase in capital is intended to lessen the need for a government bailout. (Beijing Tests Tools to Tackle Bad Debt).

As was the case for many American banks after the housing crisis in 2008, government assistance was necessary to absorb the losses brought about by non-performing loans.  McKinsey estimates that over the next 5 years, Chinese banks will require $320 billion in capital to prevent non-performing loans from causing bankruptcy.  While this $320 billion is not as much as the near $500 billion pumped into the US economy by the TARP program, it is still a substantial amount of money that the government must spend.  And when the government spends money bailing out banks, it means the government is not spending money elsewhere (like improving education or infrastructure).  In my opinion, bailing out banks is certainly not the best use of the government’s money.

While reading the WSJ article cited above, one thing in particular stood out to me: the entire article discusses how Chinese banks are working to reduce the consequences of non-performing loans; not a single sentence discusses how Chinese banks are working to prevent non-performing loans in the first place.

After a little google searching on the topic, I found a few unsatisfying articles discussing how banks can reduce non-performing loans, but none of the proposed strategies really seemed effective.  For example, one article discussed how in late 2013, JPMorgan Chase announced that it would no longer issue student loans because on average, the risk of default on student loans is too high (Without “Meaningful Growth” in Student Loans, JPMorgan Chase Stopping Them Altogether) .  To the credit of JPMorgan Chase, not issuing loans at all is definitely one way to eliminate non-performing loans.  But the market demands student loans, and by choosing to not issue these loans at all, JPMorgan is reducing opportunity for students who will not default.  In this way, I don’t see JPMorgan’s solution as a viable way to reduce the number of non-performing loans in the long-term.

That said, reducing the amount of non-performing loans should be a top priority for economists and financial experts.  If we can reduce the amount of money the government spends on bailouts, we can redirect this spending to areas where it will have a greater impact of the country’s welfare.  Alternatively, we could not spend this money at all, helping to drive down America’s excessive pile of debt.  I’ll be interested to see how the focus of economists and financial experts evolves as the country recovers from the Great Recession, as I believe there should be less effort spent on solving the problem and more effort spent on preventing it.

As the economy continues to recover, I think increased regulation will likely be the primary way that the US addresses non-performing loans.  And while regulation has its place, I think that intrinsically motivating banks to issue smart loans is much more effective than extrinsically forcing them to do so.  To achieve such intrinsic motivation, we need to reduce moral hazard by allowing failing banks to fail.  By doing so, I believe we can demonstrate to banks that they are solely responsible for their own successes and failures, and hopefully banks will respond by making smarter lending decisions.