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Are Student Loans the Next Subprime Debacle?

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Surveys show that what Americans want most is a good job, no surprise there. Over the last few decades, the best jobs have been in the public sector and those requiring a college degree. But the productivity of a growing public sector already suffers from rising costs and diminishing returns that impede economic growth, as in Greece where public sector employment doubled in the last decade or in Spain, where youth unemployment is 50%.

Even many college degrees have already passed the point of diminishing returns, as presidential candidate Rick Santorum recently inarticulately expressed. About 30% of high school grads attained a college degree during the past decade and enrollments continue to rise. But according to the Labor Department BLS forecast fewer than a quarter of all new jobs created this decade will require one. The flip side of the surplus of college educated job-seekers is the shortage of skilled workers requiring only a high school diploma, as one third of the students in public high schools don't graduate.

The Obama Administration's student loan policy to promote a college education shares many attributes with the 1995 Clinton-initiated Bush-promoted policy to promote homeownership that subsequently led to the subprime lending debacle. First, declare that the opportunity to own a home — go to college — is a basic right. Then set a public goal for homeownership — college attendance — well above private individual demand. When budgets become tight, have government lenders replace private lenders, mitigating the need to save in advance or demonstrate the ability to repay.

The government stayed out of the student loan business through the 1960s, so people saved for an education — mostly in banks — and those that needed to borrow often borrowed against homeowner equity. Student loans were uncollateralized personal loans, marketed by some banks — and beginning in 1964 federal savings and loans — specifically for education. Then in 1972, shortly after the "privatization" of Fannie Mae and the establishment of Freddie Mac, the federal government established another similar government sponsored enterprise — the Student Loan Marketing Association, or Sallie Mae – ostensibly to provide "liquidity" to the private student loan market. Just like Fannie and Freddie they didn't make a "market" in student loans but actually financed them with securities implicitly backed by federal taxpayers. As this was inevitably highly profitable, management "privatized" in 1997. Sallie Mae gave up all government backing by 2004, but the government continued to guarantee the loans and the off-budget implicit subsidies subsequently crowded out virtually all unsubsidized private lenders. And many people borrowed who couldn't repay.

As with subprime mortgage lending, the volume of student loans ballooned during the last decade to over a trillion dollars, and even with favorable deferral and forbearance provisions 27% of student loans are already past due according to a recent NY Fed study. The average student debt upon graduation won't quite reach the level of the average subprime mortgage, but the "investment" in education will likely be farther underwater than the average subprime house. The payment burden will lead many more to default. Recognizing the societal stress of living at home longer and delaying marriage, legislation was recently introduced to allow student borrowers to discharge student loans in bankruptcy, encouraging default while leaving taxpayers with the loss.

The effects of the student loan credit bubble are similar to the subprime home-ownership bubble. Just as the homeowner subsidy is mostly captured in the cost of houses, the education subsidy is mostly captured in the cost of education by educators, many of whom are members of public employee unions. Whereas private tuition costs have gone up about 25% in constant dollars over the last decade, public tuition has gone up at twice that rate.

The public role in higher education began in the mid 19th century when states started sponsoring schools of agriculture and/or engineering to meet a presumed need for employment not being met in the private education market. As the baby boomers came of college age in the mid-1960s, public colleges and universities grew in size and scope well beyond the underlying demographics, crowding out private educators, while further broadening their focus as full fledged universities.

The GI Bill was passed in 1944 to provide federal aid to returning vets for high school, college or vocational training to prevent the unemployment rate from returning to pre-war levels. Current education subsidies are similarly keeping a large pool of otherwise unemployed job-seekers out of the election year unemployment statistics.

No one questions the desirability of modest public grants targeted to the most deserving students. But the magnitude and scope of higher education subsidies for public institutions has widened the gap between the total cost and market value of public education, a primary motivator of "Occupy Wall Street." Ostensibly financing subsidies should be directed more toward private job-oriented educators to lower youth unemployment. But the Obama Administration has re-directed student loan financing toward public universities that require greater subsidies to keep their class rooms filled due to high fixed costs that are straining state budgets already deeply in deficit.

The CFPB isn't likely to provide students with a "truth in lending" statement regarding the market value of their education relative to the cost of their loan. Nor will politicians explain the cost to taxpayers of federal lending programs, directly — due to foregone taxes on private lender — and indirectly — bearing unlimited risk with no compensation. As we learned from the subprime lending debacle, the only reason politicians get involved with the lending business is because these unbudgeted opaque subsidies are largely captured by politically powerful constituents. Rest assured that if the proposal for a new federal infrastructure bank is implemented, for example, funded projects will be subject to the Davis Bacon Act requiring union wages.

Only market discipline can prick the student loan bubble, as it did the subprime mortgage bubble. Investors in euro-zone debt now understand the limits of taxpayer backing, and foreign buyers of U.S. Treasury securities are catching on, skipping recent Treasury auctions. So the U.S. Treasury will likely turn to domestic banks, as did their euro-zone counterparts.

When the student loan bubble bursts, you can bet that politicians will, as always, argue that "nobody saw this coming" and establish another inquiry commission to prove it! It is time for "change" back to traditional roles where bankers provide the loans and politicians provide the subsidies. But bankers and student borrowers should beware: the taxpayer-financed subsidies are directed more toward progressive political indoctrination than marketable job skills.

Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is an economic and financial consultant and a principal of University Financial Associates LLC.

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Comments (3)
Why is the outcome going to be any better if the government switches back to subsidizing private-sector lending? Isn't the bubble still a huge problem? And aren't taxpayers still ultimately on the hook if it's too-big-to-fail banks making the loans? -- Kevin Wack, Capitol Hill Reporter, American Banker
Posted by kevinwack | Tuesday, April 03 2012 at 11:36AM ET
Not only is this post extremely ideologically biased, it is also incredibly misleading. Yes, tuition at public universities has gone up at double the rate of their private sector counterparts over the last decade.

What this post does not tell you is that tuition went from an average of $3,141 at all pubic institutions in the 2000-2001 academic year to $4,705 in the 2009-2010 academic year (in constant 2008-09 dollars). This is compared to an increase in private sector tuitions from an average of $18,390 to $22,388 over that same time period.

While the percentage change may be smaller for private institutions, anyone can see that the absolute increase in tuition costs at private universities over this time period was almost larger than the entire average tuition at public universities at the end of the period. Overall, an education at public sector universities is still phenomenally more affordable than at private sector universities. This tells me that the problem here has absolutely nothing to do with public sector unionized employees.

Let's stop laying the blame for all of this country's problems at the feet of public sector employees people.
Posted by Andrew Dumont | Tuesday, April 03 2012 at 2:43PM ET
There is a positive for lenders, since 43% of student loan balances are less than $10,000. Nearly three-fourths of outstanding balances are for less than $25,000. Hopefully, that means that banks in most circumstances were disciplined enough to lend amounts equal to tuition rather than allowing students to take out more than what they needed.
Paul Davis, Editor, Community Banking, American Banker
Posted by pdavis1 | Tuesday, April 03 2012 at 2:50PM ET
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