Cancel All Student Loans?

Well, this didn't take long...  Once Elizabeth Warren and Bernie Sanders and President Obama get together on an issue, the populist troika is guaranteed to result in something that hits the Taxpayers.

But, before you sign up, how about a little review of history (and economics)?

How Did We Get Here?

Here's a brief history of the student loan program, courtesy of the Treasury.

Key elements of the Federal student loan financing in the last 25 years:

• 1990: IHEs were given restrictions on eligibility for federal student loan financing, based on Cohort Default Rates (CDRs). Today, an institution loses its eligibility for the FFELP and Direct Loan programs if the most recent 3-year CDR is greater than 40% and / or if the three most recent 3-year CDRs are each 30% or greater.  
• 1998: Federal student loan debt cannot be discharged in personal bankruptcy. Private sector student loans cannot be discharged in bankruptcy after 2005.  
• 2008: Federal student loans could be discharged for permanently disabled people who have “no substantial gainful activity” (similar to the Social Security definition for disability) 
• 2010: The Student Aid and Fiscal Responsibility Act (SAFRA) of 2010 ceased the origination of federal student loans by private lenders, and as of July 1, 2010, all federal student loans are made directly by the Department of Education and funded by the U.S. Treasury Department. Newly originated federal student loans since July 1, 2006 are fixed rate loans.
• 2013: Introduction of Income-Based Repayment (IBR) alternative repayment schemes

As a result of the changes in 2010, 86% of all student loans are now backed by the taxpayer.  Further, more than 75% of these loans are made with no credit underwriting.   This is just as bad as the "no doc" or liar loans made during the housing crisis.  It is incredibly difficult to judge who will be a good credit risk, and the only way to manage the risk is by charging an appropriate interest rate.

Interest Rates and Risk

Do we charge an effective rate?  Let's see, according to this Internet meme, we're charging too much interest.

Using 6.8% as the rate, we'd have to have a very low default rate on the loans in order for the system to be solvent.   What kind of default rate do we have?  Let's ask the Treasury/Department of Education.  We're only charging 6.8% interest while we have a 9% default rate and another 23% at risk of default.  

Of course, you have to be careful about which headline you read to understand how much this will cost us.  Often, Congress passes laws that require novel or convoluted financial calculations to obscure the cost of programs.  That's what leads to a statement like:

CBO estimates that the program as currently designed yields budget savings of $135Bn from FY15 to FY24 (1) 

• Based on the current accounting methodology as prescribed by the Federal Credit Reporting Act of 1990 (FCRA). 

However, under fair-value accounting, the program results in an $88Bn cost to taxpayers 

• FCRA discounts expected future cash flows of the loan program using current UST rates, without accounting for market risk. 

• In contrast, under the alternative fair-value accounting approach analyzed by the CBO, “estimates are based on market values…which more fully account for the cost of the risk the government takes on.” 

 Given that you have seen the current 9% default rate and the 23% of at risk loans, what do you think?  Are we going to see that $135B savings, or are we going to drastically exceed the $88B cost once we "more fully account for the risk the government takes on?"

We actually have an estimate of that risk, courtesy of the Treasury as well:

Take the stock of FFELP loan balances ($402.5 bn as of FY Q3:2014) and multiply by the delinquency and default rate (37.5%). Then the contingent liability is $150.7 billion, if the Federal government is assumed to be the ultimate backstop for indirect loans.

Did Anyone Predict This?

Why yes, warnings have been sounded since right after the housing crisis as economists saw the preconditions for a bubble.  (This is the kind that neither Bernanke nor Krugman can spot until after it bursts).  For example:

While everyone is focused on housing right now, financial history tells us that another bubble lurks beneath the surface. Indeed, it was only eight years ago that we stood panicked at the prospect of dot.com companies going out of business and the chance to buy a house through innovative loan products seemed like a prudent decision. Predicting exactly where the next bubble lies is difficult, if not impossible. But given our research, we believe that a persuasive case can be made that higher education and the student loan industry are inflating a massive bubble. Trying to reform this bubble before it explodes should become a priority for lawmakers.  -  Richard Vedder, 2008

Of course, almost anyone could look at this chart and see that something strange was happening.
  

How Did College Get So Expensive?

Tuition increased dramatically, much faster than the rate of inflation.

The 61 percent increase in inflation-adjusted federal loans over the last decade leaves virtually all their students capable of paying more in tuition. The schools can either raise tuition, using the additional money to help build a better (more prestigious) college , or could leave tuition unchanged in an inflation-adjusted sense. The decision they made is obvious from U.S. Department of Education data. Over the last 10 years, after adjusting for inflation, tuition is up 48% at public schools and 24% at private schools.

Oh my god.  You mean if you pump money into a system that a bubble might form?  Just like the housing crisis, with the interest rates are too low, we find that people are enticed into making bad investments only later to find that there are no jobs for social science majors who would have been better off starting off working at Starbucks in the first place, rather than incurring $40K in debt and then starting their barista career. 

Defaults and Forgiveness

People might think that defaulting on the loan is an option.  Unfortunately, the laws were changed to make that a less palatable option.  For example:

• Tax Refund Offsets: IRS can offset the borrower’s income tax refund until the defaulted loan is paid in full. A number of states also have laws that authorize state guaranty agencies to take state income tax refunds.  

• Federal Benefits Offsets: The government can offset certain Social Security benefits to collect government student loans. Just as with other types of student loan collection, there is no time limit on Social Security offsets, according to a 2005 Supreme Court Case.  

• Wage Garnishments: The government can also garnish wages as a way to recover money owed on a defaulted student loan. The United States Department of Education or a Student Loan Guarantor can garnish 15% of disposable pay(1) per pay period without a court order.  

• Effect on Credit History: Adversely affects credit for many years. If borrower defaults, loan will be listed as a current debt that is in default. The default will also be listed in the historical section of borrower’s credit report, specifying the length of the default.  

• License Revocations: A number of states allow professional and vocational boards to refuse to certify, certify with restrictions, suspend or revoke a member’s professional or vocational license and, in some cases, impose a fine, when a member defaults on student loans

The Politics of Democracy

Of course, most of these issues simply add more motive for people to ask the government to step in and forgive them for their mistakes.  Politicians, who bear none of the consequences of the financial aspects of these decisions are glad to jump on the bandwagon and make promises that win votes and popularity contests.

What is missing from this graphic is the amount of money that the taxpayer will contribute to this loan forgiveness.  If, for example, you cap the monthly payment, that delays the recovery of the loan, and someone has to pay for that.  Further, if you then grant forgiveness after 10 or 20 years, then we have to write off the principle of the loan as well.  Who takes that loss?   Well, we'll know in 10 or 20 years, which is light years in election cycles.  And how many votes could be at stake?  How about we look at the number of possible voters by state, keeping in mind their families are also influenced by these policies.  Can you spot any Election 2016 "swing" states in this list?

At the same time, those poor students who took out these loans will have to learn about the consequences of compound interest, and it might as well be young in life.

The benefit for this poor soul is that she may also realize that saving and investing has the same compound effect, and if she saves just $59.47 a month and earn a decent return, she could have quite a bit of money set aside after 20 years.  (At 6% interest, that small savings amount would turn into over $28,000)

Is It About Improving Education?

I am a big fan of a good night's sleep and enjoy living in comfortable surroundings.  However, as the quote above shows, when the universities are showered in money, they don't direct it to research and education.  Instead, it results in the misallocation of capital due to the hand of the government in directing the economy.  

Today’s universities are congested with vast bureaucracies that stifle innovation and waste resources. Princeton University recently constructed a fancy dorm that cost $70,000 more per bed than the median home price. 

Some universities have taken and extra step and issued Century bonds to fund similar largesse.  100 years!   Imagine the compound interest calculations on that.

• President Barry Mills of Bowdoin College showed chutzpah last year in announcing that the school would borrow $128 million by issuing century bonds (at an average interest cost of more than $6 million a year, or about $3,400 for every student)
• Ohio State University borrowed $500 million for 100 years, mostly to build new dormitories. 
• The University of California issued $860 million in century bonds last year and, as an encore, an additional $2.39 billion in conventional debt recently. (If that sounds like a huge amount, consider that Harvard University, which has about 22,000 students compared with the UC system’s more than 225,000, is more than $6 billion in debt — about $300,000 for every student.)

So, cheap credit is fueling more wasteful investment that will eventually lead to the failure of the institution, or even higher tuition as they struggle under the debt burden because they made such short sighted decisions today.  Don't any of these universities have a decent Finance professor?

Consequences

Don't forget the human toll that this crushing debt is going to have on millions of people and their families.  

Nobody likes unpleasant surprises, but when Allison Brooke Eastman’s fiancé found out four months ago just how high her student loan debt was, he had a particularly strong reaction: he broke off the engagement within three days.
Ms. Eastman said she had told him early on in their relationship that she had over $100,000 of debt. But, she said, even she didn’t know what the true balance was; like a car buyer who focuses on only the monthly payment, she wrote 12 checks a year for about $1,100 each, the minimum possible. She didn’t focus on the bottom line, she said, because it was so profoundly depressing.

And

Student loan debt doesn’t only hurt the young. More seniors are carrying their college debt into retirement.
The total outstanding debt load held by seniors grew to $18.2 billion in 2013, up from $2.8 billion in 2005, according to a report released by the Government Accountability OfficeStudent loan debt doesn’t only hurt the young. More seniors are carrying their college debt into retirement.
The total outstanding debt load held by seniors grew to $18.2 billion in 2013, up from $2.8 billion in 2005, according to a report released by the Government Accountability Office....
As a result, more seniors are seeing a portion of their Social Security benefits garnished to pay back the debt. The number of people whose benefits were cut to pay for student loan debt grew to 155,000 in 2013 from 31,000 in 2002. Among those age 65 and older, the number grew by 500 percent over that time period, to 36,000 from about 6,000.

So as you sign that petition for loan forgiveness, just try to learn something from this fiasco and remember that even if you benefit from something in the short-term, it is hurting all of us in the long-term, often in ways you might not see.

References:

http://www.treasury.gov/resource-center/data-chart-center/quarterly-refunding/Documents/November%202014%20QRCombined%20Charges%20for%20Archives.pdf

http://www.zerohedge.com/news/2015-03-14/cancel-all-student-debt-petitions-begin

http://www.zerohedge.com/news/2015-03-10/next-mega-bailout-deck-white-house-studying-new-bankruptcy-options-student-loan-borr

http://www.aei.org/publication/student-loan-changes-worthwhile-but-little-more-than-rearranging-the-deck-chairs/

http://www.aei.org/publication/whos-struggling-to-pay-back-their-student-loans-hint-it-may-not-be-who-you-think/

http://www.aei.org/publication/thomas-sargent-incentives-and-student-loan-forgiveness/

http://www.aei.org/publication/why-student-loans-might-be-the-next-recipient-of-a-taxpayer-bailout/

http://www.aei.org/publication/170000-student-loan-debt-ends-engagement/

http://www.aei.org/publication/the-next-market-bubble-student-loans/

http://www.washingtonpost.com/news/get-there/wp/2014/09/11/more-seniors-are-carrying-student-loan-debt-into-retirement/