Student Loans - Opportunity or Bubble?
If one had to point the most discernible features of American system of higher education, the two that probably would come to his mind would be excellent quality of teaching and research as well as gigantic cost of thereof to be incurred by students. While inevitability of the link between the two arouses a great deal of public and academic debate, we would like to focus on a matter, which is a derivative of traits mentioned – an enormous level of student debt accumulated over decades by scholars lured by bright perspective of a university diploma. In the era of political and demographic transformations driving economies around the world, does anyone even have time to take a look at colossal debt burden of U.S. households and its possible implications? Let’s try to briefly describe the story behind the potentially second largest credit bubble after subprime crisis of 2008.
The U.S. education bubble is now upon us
Student loans play a pivotal role in U.S. higher education. Out of nearly 20 million Americans attending college each year, almost 60% of them borrow annually to cover costs of studying. While there are multiple varieties of them, the loans are in general split into federal and private student loans. Further breakdown of the first category encompasses subsidized (interest is covered by the government) and unsubsidized ones. On the other hand, we have private loans which usually offer way worse terms of borrowing – interests start to accrue immediately after graduation and the deferred interest is added to the principal, effectively making students pay interest on interest which is not the case with federal loans. Taking into account that also interest rates are in general higher, private loans are considered a last resort when more favorable ways of funding are exhausted. Once a student graduates, there is 6-month grace period followed by request to payment – either by fixed monthly payments or via an income-driven scheme, adjusting repayment schedule to their disposable income.
Over the past 10 years, higher tuition fees combined with more student enrollment and greater reliance on loans have caused the level of student debt to nearly triple to more than $1.2 trillion. Today, 70% of post-secondary students graduate with debt with the total volume eclipsing that coming from auto loans and credit cards combined. What is more, student loans account for 45% of federally owned financial assets. And on the credit side of things, the situation does not look too good either. According to the Wall Street Journal, more than 40% of student borrowers are not making payments. About 1 in 6 borrowers were in default on $56 billion in student debt, meaning they had not made a payment in at least a year. What makes the matters appear even worse, is the fact that we are facing an exponential trend in regards to both debt volume and detrimental credit events. Nonetheless, the numbers must have some structural origin, deeply embedded in the state of American society and economy.
Financial dysfunction: who, exactly, is higher education for?
While this may be true, that too many students sign up for useless degrees in things like sports marketing, it is on the other hand also worth noting that they are aggressively pushed into it by both non-profit and for-profit institutions that spend an increasing amount of their revenue on marketing to students. Parent company of the for-profit University of Phoenix, Apollo, which went public in 1995, at one time had a marketing budget larger than Microsoft’s.
Colleges, on the other hand, often invest in luxury facilities in order to attract full-fee paying students, or, in the case of the for-profit sector, take big profits with margins typically running above 30 per cent. Students are regularly over-promised financial aid in complex arrangements that then alter year on year, just like the subprime mortgages that blew up in 2008.
The “fictionalization” of education has grown night and day with the rise of the financial sector over the past 40 years. In countless cases, universities themselves are being deluded by Wall Street and duped into bad debt deals, just as public municipalities such as Detroit were in the run-up to 2008.
The Roosevelt Institute indicates that seven of the eight biggest universities in the state of Michigan, for example, have got involved in risky interest rate swap deals in recent years, resulting in millions of dollars in redundant fees, further raising costs for students. The idea itself, that a large number of American universities are now involved in interest rate swap transactions, that put them far out of their financial depth, raises questions about how their balance sheets are being managed.
The bubble is starting to burst
In 2014, one of the largest banks in the United States – JPMorgan Chase – announced that it will stop making students loans, explaining that it just don’t see this as a market that JP can significantly grow. With the official reason being quite dull, the move is bizarrely reminiscent of the subprime shutdown that happened in 2007. Every single time a bank shuttered its subprime entity, the news was presented in much the same ways, stating that JPMorgan is spinning the end of its student lending. JPMorgan is actually the second largest private lender to step away from the business in recent years; in 2013 US Bancorp exited the market as well. This situation leaves Wells Fargo & Co., Discover Financial Services, PNC Financial Services Group, SunTrust Banks, and distinct credit unions as the largest private student lenders.
At the same time, the CFPB agency reported that over $8 billion of private student loans were in default. That number is expected to go higher if interest rates rise (and they probably will) because most private student loans, unlike the federal one, are variable rate loans linked to Libor or the prime rate. The market reacted right away: a $15 million hedge fund founded in 2014, FlowPoint Capital Partners, started betting against companies such as student-loan servicer Navient Corp. to profit from what it calls “a college bubble bursting in slow motion”. This is mainly anticipated as the students who got loans for college before 2008 are taking longer than expected to pay off their debts, thanks in part to U.S. relief programs. Additionally, Fitch Ratings and Moody’s Investors Service have been considering downgrading nearly $50 billion of federally insured student-loan bonds.
What should we do about it?
First and foremost, U.S. politicians need to take full responsibility for economic governance, pursuing not only to improve growth, but also to forestall a reduction in long-term growth potential. Having trusted in unconventional monetary policy for far too long, the U.S. Congress needs to implement a more far-reaching approach, with methods aimed at improving worker training and overhaul, modernizing education curricula, and incorporating transformational technologies more adequately into the economy. Increased infrastructure financing, better corporate-tax policies, and an updated budgetary approach are also needed.
On the other hand, universities, which have benefited greatly from the wide availability of student loans, should keep a curb on their costs, while offering more forthright financial aid funded through philanthropy. Few universities have already ratified “no loan” policies; students being exposed to financial need are met entirely with grants financed by the university and other donors. Obviously, not all universities need to go to such an extent, and most can’t because they lack large enough donations to cover the costs. But for sure a broader move in the direction of non-debt financing of higher education is essential.
Efforts could also be made in the area of encouraging households to save more, while starting earlier, for education. Student loan agreements should be made more transparent, thereby allowing applicants to make responsible decisions, with inexpensive two-year community colleges serving as a useful mechanism to a traditional college education. And more could be done to broaden income-based repayment schemes.
None of these measures will be easy to fulfill. But if implementation process continues to stay behind matter on the ground, the challenges will be far larger down the road. As students’ expanding debt burdens restrains their financial flexibility and productive contribution to the economy, the policy priority will shift from mitigating future perils to reducing indebtedness directly through bailouts and loan forgiveness. That would raise delicate issues of rationality and misaligned incentives, and could ultimately have the wicked effect of reducing educational access.
WRITTEN BY SERGIUSZ NOWAK & KACPER ŻYTKOWICZ FOR BESA
PLEASE DIRECT ANY INQUIRY TO AS.BESA@UNIBOCCONI.IT