The Foreshadowing Of The Student Debt Crisis
By Romina Florencia Arrieta
The number of college student has grown considerably in the last two decades. In 2016, approximately 20.5 million American students chose to attend college or university, up by 5.2 million since 2000. Tuition fees have also been experiencing exponential increases, which is why many students take out loans to sustain themselves during college. However, their loan repayments have been difficult, as defaults in the US have been steadily increasing in the past few years, with federal student loan defaults reaching 8 million in 2016. Many liken the student debt market’s current condition to the wake of the subprime mortgage crisis. Though the potential fallout of a student loan market collapse is hardly comparable to that of the subprime mortgage crisis, investors are seeking to profit from a potential downturn.
Students in the US can fund their college degrees through public loans, issued by the US Department of Education, or through private loans, issued by financial institutions. Federal loans represent the majority of student debt and are offered at low-interest rates. Such loans have received criticism for being uniformly priced, meaning that their interest rates are not adjusted according to the loan’s risk. For instance, a key source of default risk that is not reflected in the loan’s interest rate is the student’s course of study and the employment opportunities associated with it or lack thereof. Additionally, because many borrowers are students without a credit history, credit score checks are not used.
Private loans involve more thorough vetting and are offered at higher interest rates. Still, credit default risk is not necessarily properly priced. For example, Department of Education statistics shows that default rates vary a lot from university to university, even within tight tuition fee ranges. Yet, as prescribed by Federal Deposit Insurance Corporation rules, private lenders cannot offer different terms and interest rates based on the student’s choice of institution.
Concurrently, the return on a college degree has been falling. According to a recent report published by the New York Federal Reserve Bank, 30-40 percent of college graduates are unemployed by a definition which includes college graduates working in jobs that do not require a college degree. In widening their definition of unemployment, the New York Fed has shed light on a key factor underlying high default rates. The number of college graduates has grown a lot faster than the jobs requiring a higher level of education, diminishing the number of available positions and the value of a college degree.
Indeed, today’s student loan market bears a resemblance to the housing bubble that led to the 2008 market collapse. The bubble was marked by an excess number of subprime mortgages, whose borrowers were unable to make payments, ultimately leading to millions of defaults. It seems as though some student loans may also be considered “subprime”, in that they are given to individuals who are likely to end up un- or underemployed and unable to make the necessary payments on their loans. Much like the subprime mortgage holders in 2008, the payments they make go towards the accumulating interest on the loans, without actually diminishing the debt principal.
The housing bubble was marked by a belief similar to the one surrounding the student loan market today: that the real estate market was infallible. The industry was deemed rock-solid and unlikely to fail. Diplomas are perceived in the same way as these mortgages were ten years ago: as a foolproof investment, guaranteeing a stable job and stream of income. Yet, the return on investment of a diploma is dwindling and the aggregate student loans constitute over a trillion dollars in debt, with forecasts suggesting this number could reach an amount of 3 trillion dollars by the mid 2020s.
The education bubble has already started to show signs of bursting. The Wall Street Journal has recently stated that half of the students attending 1000 trade schools and colleges “have defaulted or failed to pay down debt within seven years”. This number of defaults is higher than anticipated for 98 percent of these institutions. Further, over 10 percent of all student loan accounts have failed to make a payment for over 90 days. Hedge fund manager William Ackman firmly believes the US government will lose hundreds of millions of dollars on these loans and he is not the only one. FlowPoint Capital, for instance, is a fund whose investment strategy has involved shorting the shares of student loan- and education-related companies, like loan collection agencies, lenders and even textbook makers.
However, Charles Trafton, the fund’s manager, has commented on the difficulty of betting against student loans due to the lack of suitable financial instruments. Though student loan asset-backed securities (SLABS) are issued by private lenders, no equivalents to credit default swaps exist for SLABS. When the 2008 housing bubble burst, investors who held credit default swaps on the mortgages reaped immense profits. Their swaps acted like an insurance policy on the underlying mortgage-backed security and paid out when the borrowers defaulted on their mortgages. Banks are reluctant to create credit default swaps for student loan securities, fearing damages to their image as a result of profiting from the massive debts of students nationwide. In spite of these constraints, FlowPoint’s strategy has been immensely profitable, yielding up to five times the amount of the original investment, and further suggesting that the student loan debt is a bubble that will eventually pop.
Though the student loan market is experiencing turmoil that is reminiscent of the subprime mortgage crisis, it is unlikely to have the same impact on the US economy. In 2010, the US government ended FFELP, or the Family Federal Education Loan Program, through which the government-guaranteed private loans. This cooled down many lenders’ enthusiasm about issuing and securitizing student’s debt. Indeed, student loan asset-backed securities are only issued by private lenders, whose loans represent less than 10 percent of that debt category. The remaining loans are issued by the US Department of Education. As default numbers climb, it seems like the US government and its taxpayers will be the ones footing this bill.