Deflating the Student Loan Bubble with Better Risk Management

The student loan market is broken again: too much student debt, too many defaults, and large write-offs pending as a result of income contingent repayment. Not that it was ever fixed, but it’s gonna blow again to hemorrhage real costs across the federal balance sheet.

Back in 2008, as the first step in the financial crisis, the Bush Administration led the federal government to take over the private elements of the student loan industry. Today, talks of evil banks continue, but student loan lending is done by the federal government and the “evil bank” is actually the Department of Education. Thanks to an overindulgent Pelosi Congress in 2007, education credit has been easy and plentiful without serious consideration of risks; this error has been costing both the students and the taxpayers.

Previously, there were three legs helping to manage risk in the federal student loan system:

  1. state and regional guarantors who would absorb defaults and collect debts before the Department would take losses,
  2. a risk share penalty against external lenders on defaulted loan, and
  3. loss of access to all Title IV program dollars for schools having a quarter or more of their students default in three consecutive years.

Now, there are no intermediary guarantors and no external lenders to limit federal exposure to losses; as a risk to taxpayers, it is worse than the bad old days of FISL in the 1970s as if nothing had been learned from that mistake. Further, currently, schools will not lose access to federal loans and Pell grants until they have had three consecutive years of 30% or more defaults per year.

The Department of Education has reported that the cohort default rate for FY13 is 11.3%, which is down from 14.7% in FY10.  There are several problems with this calculation that underreports the true impact of bad debt, including:

  • a changing definition of default,
  • the possibility of gaming the numbers by delaying defaults so that they are not counted in the numerator,
  • not accounting for future loses due to income contingent repayment, and
  • measuring rates by people and not dollars.

Thus, the Department of Education is not measuring the taxpayers’ actual loss risks with those cohort default rate numbers.

While my solution to the risk of losses to taxpayers and the harm identified by former students is to sell the loan portfolio and fully privatize student loans, I lost that argument in 2008. Given this terribly flawed government financing of post-secondary education, what could be done to address the already evident problems before the taxpayers make the politicians pay the price for this bad government policy? Better risk management as a lender by the Department of Education, which will require statutory changes by the current Congress.

So what are the risks to be managed better:

  • Post-secondary costs have grown through gold-plating on campuses due to the abundant financing provided by the federal government.
  • Students are borrowing more than a reasonable person would expect for them to be able to repay.
  • The lives of former students are being crippled by student loan debt when it comes to marriage, family, independent households, and employment.
  • Students are getting degrees unrelated to available future employment, which contradicts the idea of borrowing and lending as an investment.

Related to these problems, the stupid long-standing Republican idea on the legislative committees has been to implement federally mandated cost controls to slow tuition increases. Sorry Comrade, but that is an ineffective five year plan.

However, it is easy enough to manage immediately by reusing existing concepts and data. The idea is simply: no new government student loans to students enrolled in majors with historically high rates of underperforming loan assets based upon modernizing the long standing Department of Education cohort default rate sanctions.

Previously, the government attributed the risk of default to underperforming schools and the government cut off bad actors from future federal financing to reduce defaults. Now, we can use a similar default rate strategy, but instead target rates by the Major Course of Study (MCS); thus, if history majors or hair stylists have had unacceptably high rates of underperforming loans, then stop loaning them money.

How could this work? Using existing Department of Education data, and without delay, calculate a cohort rate for each of the past 10 years to identify the rate of underperforming assets [including all defaults (non-payment, death, disability, and bankruptcy) and assets with income contingent repayment terms); the equation would simply be the current outstanding principle balance on underperforming assets as of the end of the fiscal year divided by total disbursed loan amount (less school refunded amounts) entering repayment during the cohort year.

If an MCS’s bad asset cohort rate for any one of the prior 10 years is more than 10%, then no new federal student loans in the new school year for students with that MSC, but their students would still retain access to all other Title IV programs. If psychology majors or education majors have not been repaying their loans timely, then the federal government will stop making new loans for that major. Note that the threshold rate can be set by the Congress differently than 10% according to how much loss risk the Congress has the stones to embrace or more reasonably based upon the loans’ interest rates.

How does this help the Department of Education manage its loss risk?

  • It can immediately stop investing good money after bad.
  • Schools that are dependent upon federal loan financing will shift their educational focus into areas that will benefit future earnings for current and future students.
  • Schools will be impacted immediately by the negative consequences of their high costs, which should inspire greater frugality on expenses such as on-campus recreation facilities and activities.
  • Schools could develop effective education programs to encourage students and parents to pay unsubsidized accrued loan interest during the interim period before loan repayment.
  • Some schools could attempt to reduce their costs so that students can cover their bills with other Title IV programs, but not loans.
  • Accreditation bodies and professional organizations have a role to work across schools to improve performance and to weed out ineffective programs.
  • Students and parents can use the published rates to better understand risks associated with a MCS and debt choices, including the potential to lose access to future student loans before their program has completed.
  • Schools and other interested organization can help reduce the historical rate of bad assets by refunding to students that were not benefited by their education, educational intervention to rehabilitate bad assets, and interventions to increase job placements for former students with bad loans.

Some people may object to this new risk management policy, because of their feels; sorry, it is simply math. However, there are two salves that can be offered for their feels:

  1. federal loan repayment profits are supposed to finance Pell Grant entitlements so bad loans hurt the poor, and
  2. consider the suffering of the former students under the current destructive federal student loan program.

The below brief documentary offers testimonials about how federal student loan debt has crushed these individuals’ lives. Not loaning students more money than they could hope to repay will be a good start to preventing government created hardship.

What are the lessons to be learned for selfish citizens from this incremental transitional proposal?

  • Moving from the current bad government programs to private solutions will likely require a transition period.
  • Current laws substantially diminish the actual value of government assets, so that simply selling them can require the government to take losses, which are often hidden in pension costs and debt.
  • As part of the transition, current laws can be changed to increase the value of government assets for potential sale.
  • Early transition of failed government programs leveraging market discipline can help initiate corrections to irrational behaviors, caused by irrational government price signals, so as to mitigate disruptive transition impacts.
  • The negative impacts of failed government programs affect the lives of real people and those costs should be publicized with correct attribution to the guilty government program.
  • Sometimes the confluence of governmental problems (student loan losses and unfunded guaranteed pension liabilities) create unusual opportunities for reform and privatization, because they exist as concurrent problems requiring immediate solutions, without additional government money, from the same legislative committee.
  • There is a substantial recidivism risk to offering incremental reform to some temporal government program problems, like the above. Legislators may assume that, instead of full privatization, old errors can be renewed later after the crisis has passed, because of feels (aka irrationalism). This has been historically true of the “public-private” partnership that had been the student loan industry…private means subordinated to public ends until the private was consumed.
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