Student loan myths and implications for taxpayers
There is considerable debate about whether the federal government should ease the terms of outstanding student debt or forgive student loans altogether. There is also a lot of misinformation. I am writing this article to provide some context and clarification on the government’s lending activities. I am not writing this article to debate whether federal student lending serves a public good or represents an essential government service. I will leave that to you.
Unless otherwise specified, the figures I cite come from the US Treasury’s Fiscal Year 2014 Q4 report to the Treasury Borrowing Advisory Committee. The report has many fantastic charts, so I highly recommend perusing it.
The federal government has been providing financing for higher education since 1965 with Title IV of the Higher Education Act. Origination of federal student loans by private lenders ceased with the Health Care and Education Reconciliation Act of 2010. (Yes, these provisions were tucked into the Affordable Care Act legislation.)
All federal student loans are now made directly by the Department of Education and funded through the issuance of US Treasury bonds. So the federal government borrows money from investors in the bond market and then uses the proceeds to make student loans. US Treasury bonds are increasingly becoming a form of asset-backed security — and, as I will get to later, poorly structured ones at that. According to Treasury, direct lending for higher education accounts for around 8% of federal debt held by the public. It is estimated to be approaching 12% within 10 years. Treasury is borrowing these funds at a market rate, but the interest rates on the loans are established by law.
The amount of student debt outstanding has doubled since 2007 to around $1.3 trillion. The federal government’s direct lending represents more than 85% of origination volume. (Pause for a moment and reflect on the fact that the federal government backs more than 85% of student lending, but is responsible for only around 15% of total infrastructure investment in the US.)
Myth #1: Student lending is a profitable enterprise for the US Government
It actually costs taxpayers billions of dollars.
This myth is debunked on a regular basis, but often resurfaces when policymakers are looking for a justification for easing the terms on student loans. Most recently, this argument was made by Senator Elizabeth Warren in trying to build support for her student loan refinancing legislation, which would have also been offset by raising taxes on wealthy households.
The “budget savings” some policymakers cite is an artifact of an accounting methodology that even the Congressional Budget Office acknowledges is nonsensical.
Here is a good explanation of CBO’s methodology from the Washington Post:
The Congressional Budget Office is required by law to use a bizarre and faulty method for determining the cost of government loans. Just like any institution, the CBO determines the cost of loans by “discounting all of the expected future cash flows associated with the loan or loan guarantee — including the amounts disbursed, principal repaid, interest received, fees charged and net losses that accrue from defaults — to a present value at the date the loan is disbursed.” To do that, it needs to settle on a “discount rate,” which is usually the expected rate of return on the loan in question. Banks and other private institutions generally estimate that by finding loans with similar risks and maturities to the one being evaluated, and then using those similar loans’ rate of returns.
The CBO does not do that. It discounts all government loans using the returns on Treasuries of a similar maturity. So a 30-year student loan would be compared to a 30-year Treasury bond. But Treasuries are the safest bets in the world. The US government does not have a very high risk of defaulting, not least since it prints its own money. Student loans are much riskier.
Of course, saying that student loans are riskier than Treasuries is kind of like saying Alpha Centauri is farther away than London. First, approximately 76% of federal student loans are originated with zero credit underwriting — here’s a loan for tens of thousands of dollars, no questions asked.
Second, according to Treasury, the default rate (270 days without repayment) on outstanding student loans is about 9%. However, “behind the default rate is a shadow book of potential future defaults, reflected in the volume of loans in deferment and forbearance. Those loans add 23% to the 9% that are already listed in default.”
It should be an obvious point that student loans are costing taxpayers money as long as the loans are made at anything below a market rate. (One could consider this a form of negative arbitrage.) And it should be an obvious point that — assuming a private lender could be found for such loans — a market rate would be multiples of the interest rate on Treasuries.
Based on the methodology required by the Federal Credit Reporting Act of 1990, CBO estimates that student lending programs will result in a profit of $135 billion over the next ten years. However, using fair-value accounting, the programs will result in an $88 billion cost to taxpayers. Any modifications to existing programs (reducing interest rates, more generous repayment options, extending maturities to increase the chances of repayment) could increase this cost dramatically. For example, Treasury estimates that “the gross cost of maturity extension in order to increase the probability of repayment would be approximately $220 billion.”
Another point to be made here: much of this borrowing — which is driving up the country’s debt and generating this cost to taxpayers — benefits for-profit schools. Per Treasury, students at for-profit universities are twice as likely to utilize federal student loans. Furthermore, many of these schools have predatory business models: approximately 68% of the students at these schools either drop out or do not finish their degree programs within 6 years. As of 2011, loans for private, for-profit institutions had a 13.6% default rate.
There could potentially be broader social costs as student debt burdens crowd out other forms of borrowing (mortgages, auto, small business, etc.), although this is still somewhat controversial.
Myth #2: Student loan growth is driven by English majors (Kidding, but really, isn't this the stereotype in most articles on this topic?)
Treasury identifies a number of drivers behind the dramatic rise in student debt:
· There are more college-aged people (the cohort aged 20–24 has grown by 9.4% over the last 10 years);
· More students are choosing to attend college and stay in school longer to pursue advanced degrees;
· A larger percentage of students are taking out federal student loans (48% in 2012 versus 33% in 2002);
· Tuition has increased as state governments reduced subsidies for public universities;
· Outstanding balances are declining at a slower pace because (1) more loans are in deferral and forbearance, (2) the tenors of the loans are longer than they have been historically; and
· The number of for-profit institutions has been growing rapidly, along with enrollment and borrowing
Myth #3: Student lending necessarily contributes to economic and social mobility
This depends entirely on how much a student borrows, how long they stay in school, and if they graduate.
According to Treasury, “today an average of 40% of students at four-year institutions (and 68% of students in for-profit institutions) do not graduate within six years, which means they most likely do not benefit from the income upside from a higher degree yet have the burden of student debt.” Furthermore, student loan debt cannot be extinguished in bankruptcy in almost all cases and the federal government can withhold other benefits to offset amounts owed.
The dynamics of student lending programs are a lot more complicated than they seem on the surface.
