Mark Schniepp: Student Loan Debt: How Serious is it and Where Will it Lead? (Part 2)

By Mark Schniepp
July 2018

Is the Student Loan Debacle a Bubble, and will it Burst?

In a word, and despite what Mark Cuban says: No.

However, student loan debt is still a problem due entirely to its enormity. It’s already having an impact on the economy, and this will continue for many years to come.

Why it’s a Problem

This particular debt issue is not a repeat of the financial crisis of 2007 that occurred when the housing bubble exploded. Student loan debt is not really a bubble that will pop. It’s more akin to a balloon that will slowly leak.

Most of the debt is carried by Millennials, who were born between 1980 and 2000 and are now roughly 18 to 39 years old. They are now the largest generation in the nation and represent the largest age cohort in the workforce today. Student loan debt is the largest debt load they carry and it will persist for many years hence.1

Debt is hampering overall spending by Millennials in the economy. This is especially evident for the existing housing market and the consumption that goes with it. There is decidedly less home buying during this economic expansion, and that means less homeownership. With lower homeownership, there is less spending on furniture, fixtures, and furnishings. There is less home building, and fewer architectural, engineering and construction services needed.

And other expenditures are being replaced by debt repayment, which produces less economic stimulus than expenditure on private sector goods and services.

Since you can’t get rid of these loans via bankruptcy (like you could with any other debt) borrowers are on the hook for them until they are ultimately paid. The only way borrowers can avert the debt is to flee the country or die.

Default is more likely to have a slow motion impact, in line with the notion of a leaky balloon.

Why there’s no Bubble

Most of the debt will be repaid over time, and both banks and the federal government could well make a profit from these loans. But if delinquency and default rates continue to rise, then the public sector loses.

Federal student loans constitute 85 percent of all outstanding student loans, and most of these loans are backed by guarantee, which means that banks making these loans through 2010 are not on the hook for payment default.2 The federal government is. Back in 2008 when the housing bubble popped, it was the financial institutions that took the loss. This time, it will be the federal government. We don’t expect to see a financial crisis spreading through the private financial sector.

But who really loses? You do. It’s your loss, the taxpayer, since you provide the government with most of its revenues for running government programs like federally insured student loans.

Bubbles burst when asset pricing in markets does not make sense. So a correction occurs. But the price mechanism that corrects does not exist for loans held or guaranteed by the federal government. So what happens?

Consequences Ahead

Taxpayers will be on the hook for providing the federal government with increased revenues to offset the losses. We already have large federal deficits and they are rising. This will only increase the size of the deficit until the public pays for it through taxation.

Education costs will be driven higher as students obtain loans and inundate colleges and universities. This notion was advanced by former Education Secretary William Bennett and is known as the Bennett Hypothesis. Students have relatively easy access to uncollateralized loans and this has led higher educational institutions to raise prices (increase tuition). Consequently, federal student aid has not necessarily made higher education more accessible or more affordable. The resulting education may ultimately not return an income stream that justifies the cost of that education. When this happens, the demand for education will decline.

Colleges and universities that did not contain their costs might become insolvent.

The federal government will continue to change its policies regarding student loans. Right now, it does offer loans to students that need assistance. Everyone else must obtain loans from private institutions. And interest rates on these loans are not always designed to hedge the overall risk factors that could lead to delinquency and default. There will be changes in how we finance higher education.

Look for student loan caps, higher interest rates, and the removal of loan forgiveness options for any borrower.

Finally, we might already be seeing a shift in Generation Z, currently the youngest generation who are just now entering 4 year colleges and universities. They appear to be much more calculating when it comes to higher education and are more apt to factor in college affordability and community college than Millennials were.

By Mark Schniepp

June 2018

With over $1.5 trillion in loans outstanding, student debt is now the second-largest source of household debt (after mortgage debt) and is the only form of consumer debt that continued to grow during the aftermath of the Great Recession.

The principal concern over the last few years has been the sheer volume of student loan debt and the speed at which it is rising over time.

Per graduating student, debt loads are non-trivial, and are now at their highest levels ever measured. The average student loan burden for Class of 2017 graduates was $39,400, up 6 percent from the previous year. More than 44 million Americans today carry some student loan debt.

Tuition costs have soared at colleges and universities. Between 1997 and 2017, in-state tuition at public universities jumped nearly 240 percent. During this same period, consumer price inflation increased 53 percent. Consequently, the cost of college and university tuition outpaced the general price level by five times.

And relative to expected income, tuition has increased to between 25 and 40 percent of an adult’s median household income. Back in 1970, annual tuition represented between 7 and 20 percent of the annual median household income. The result is that student graduates owe a far greater amount today relative to their current and future incomes than the baby-boomer generation who graduated from colleges in the 1970s and 1980s.

Student loan payments average $351 per month for those who carry debt. If your starting salary after graduating from a four-year university is $60,000 per year, those debt payments represent 9 percent of your monthly take-home income. Clearly, graduates earning less have a higher loan payback percentage of income, and this diverts household spending from private sector goods and services to federal loan repayment, an area of expenditure with a much lower, if any, economic multiplier.

Interest rates on new student loans currently range from 5.05 to 7.6 percent. This makes student loans more expensive than paying a mortgage. And this is especially true for graduate students (and parents) who face the highest rates from Sallie Mae. Freshly minted lawyers and doctors can have student loan debt of $200,000 to $500,000, which is often larger than a mortgage.

The size of student loan debt and its growth over time has previously been the focus of attention, but now a growing concern is the default rate among borrowers.

Delinquency

New data show that delinquency rates on student loans may be going as high as 40 percent of borrowers by the year 2023. The default rate is already higher than anticipated for the particular student cohorts studied, so the federal government should be bracing for substantial non-payment of debt.

Currently 58.5 percent of all direct student loans are in repayment, and 41.5 percent are not. Regarding those that are not, 23 percent are in deferment or forbearance, meaning the repayment is temporarily suspended with or without interest, on the request of the borrower. Five percent are still in the grace period and 15 percent are in default.

When a borrower defaults, he or she simply fails to pay interest or principal on a loan when due. So ,if the loan is federally insured, as most loans were up to mid-2010, then the federal government is on the hook. It’s the same thing as when the U.S. loans a few billion dollars to the Cayman Islands and they don’t pay it back. In fact, as of 2017, the Caymans owed the U.S. $302 billion. Canada owes the U.S. $380 billion. Neither of these countries is likely to default however, but countries have in the past like Mexico in 1994 and Argentina in 2001. And we can’t trace these defaults to an impact on our economy.

Can students merely declare bankruptcy to avert paying back the loan? No. Student loan debt is virtually inescapable and is precluded from debts that are dischargeable in the U.S. bankruptcy code.

Consequently, there are increasing stories online reporting how debt strapped former students are fleeing the country and hiding out from Sallie Mae and collection agencies.

Sallie Mae is the nation’s largest originator of federally insured student loans. It was formerly a GSE (government-sponsored enterprise), but it is now entirely independent from the federal government.

Is the Potential Flood of Defaulting Student Loans Another Looming Financial Crisis?

1. First, the Basics

Our lending systems generally work efficiently and borrowers don’t default on debt because lenders won’t make too many high-risk loans. System risk rises when lenders extend unwarranted credit. This occurred during the housing bubble days of 2004 to 2007 when easy credit gave rise to massive home buying pushing selling values to record levels.

A bubble “pops” when prices correct to more accurately represent the intrinsic value of the asset. Clearly, home prices towards and at the peak exceeded the true value of those homes. Prices corrected, borrowers owed more than the home was worth, and there were unprecedented numbers of defaults and lender bankruptcies. Loans ultimately became restricted and this slowed down the economy because businesses had difficulty obtaining capital needed to grow, invest and hire.

2. Student Loans

Is the current student loan debacle a bubble? And if so, when will it burst?

I’ll address this in the upcoming July newsletter.

Reprinted by permission.

Mark Schniepp is head of the California Economic Forecast, an economic consulting firm that produces commentary and analysis on the U.S. and California economies. The firm specializes in economic forecasts and economic impact studies, and is available to make timely, compelling, informative and entertaining economic presentations to large or small groups.

Posted May 4, 2018

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