In 2006, the underpinnings of the American financial system began to crack from a speculative bubble in the country’s housing market. Fueled by irrational exuberance in which homeowners believed their home prices would rise forever, this was made worse by Main Street and Wall Street, both of whom repackaged mortgage loans for sale to everyday investors through a process called securitization. That’s right, this was a multipronged problem, not the hell-bent desires of a few financial fat cats, as Occupy Wall Street would have you believe.
When the bubble burst and home prices began to decline, this not only hurt the original lender, but also every investor that held a piece of a mortgage-backed asset. Imagine this process like a moldy pie that no one realizes is bad. Originally, the entire pie is held by one bank. Next, pieces of this pie are sold to other banks, pension funds, hedge funds, and anyone else that has an appetite. Soon enough, however, everyone holding this pie has gotten sick. Well, this happens with all kinds of assets, including car loans, credit cards and student loans. The benefit of securitization is that it allows organizations to grant more loans to people like you and me, but the downside is that it exposes the entire economy to the financial woes of an individual market. Without securitization, what happened in the housing market would have likely stayed in the housing market.
Six years later, many people are crying that the same thing will happen to the student loan market. While disbelievers can claim that these are just ‘cynics’ whose views are skewed by the world’s ongoing economic turmoil, a basic investigation into the matter yields some worrying results.
1. A college education has more in common with a house than you would think. Currently, the average cost of a single-family home in the United States is just above $150,000, while the average tuition of a private institution’s four-year degree program is around $130,000. Moreover, it is common practice for students to employ the use of debt to cover 20 to 50 percent of their costs, depending on the state. Just as homeowners once expected home prices to rise every year into infinity, students are undertaking loans with a shared expectation of a future income that exceeds the value of the loan. Unfortunately, historically high rates of unemployment have made this a pipe dream for an increasing number of students. In fact, the latest nationwide student default rates stand at 9 percent, up two percentage points from the previous year.
2. The student loan bubble has been growing faster than the housing bubble. According to a recent study by the New York Fed, the volume of student loans in the American economy has increased 500 percent over the past decade to a current value of $1 trillion. While this amount is less than the value of the mortgage volume peak before the recession, the growth rate is twice as high.
3. SLABS may be this crisis’s nuclear bomb. The acronym SLABS stands for student loan asset backed securities. In many ways, they are similar to the mortgage backed securities that played a hand in breaking the financial system in 2008. It is estimated that there are over $250 billion worth of SLABS in the markets today. This is a whopping 1,000 times the amount of SLABS in the American economy 20 years ago. More troubling, these investments have been viewed as the safest asset backed security in the post-recession era. While securitizes backed by mortgages, auto loans, and credit cards have been cut in half over the past few years, SLABS activity has continued to grow. In fact, they are marketed to individual investors, pension funds, and anyone else seeking an economic safety net.
4. Student loan debt is unforgivable. This ‘safety net’ belief is held partly because student loans are currently the only form of debt that is unforgivable even in bankruptcy. From investors’ eyes, this is good news because their return is generated from students making their loan payments. From a broader perspective, though, this spells bad news for the American economy. See, students can still default on their loans, which simply means that they are unable to make payments. Unlike mortgage debt, however, students who default are not given the option of leniency in the form of principal or interest rate reduction.
Instead, defaulting students are economically punished, as they are unable to receive any IRS tax refunds or federal benefits. Moreover, the government is entitled to take up to 15 percent of a student’s disposable income, and may even sue in some cases. In a world teetering on the edge of a double-dip recession, all of these actions would only make the situation shoddier. In fact, the worst thing that can happen to a mortgage defaulter is the loss of their home, but they can move on, economically speaking. Students who default on their loans, however, are not offered the same route. Moreover, this incentivizes lenders to offer loans to any and all students since there is no risk of payment loss in the long run. Tell me, do we trust our lending institutions enough to think that this would not be the case? Of course not; besides, it is arguably up to the government to provide an economic structure for banks to follow. If businesses are profit maximizing, which we’ve all learned in school that they are, then they are not to blame for taking advantage of this situation.
5. Unlike all other debt holders, students are not classified based on their ability to repay. Okay, most lending institutions look at the credit worthiness of a student’s parents, but this is insufficient. What lenders should be doing is rating students based on the probability that they can repay after graduation. Whether we like it or not, the only way to do this is to classify students based on their future earnings potential. Think about it – a student with an Engineering degree will be entering a field where the median salary is $90,681. Moreover, the unemployment rate in this field is around 2 percent. Compare this with a student majoring in English. This student is only expected to earn around $40,000 in a field with 7 percent unemployment.
Clearly, the student with the lower expected salary entering the riskier field should be granted a lower amount of student loans. While some may argue that this disincentives students to follow their dreams, it is common sense economics. Moreover, a student rating system would likely improve the U.S.’s fallback in the global Math and Science race, in which the country is currently ranked 23rd and 31st respectively. As college students would realize that they could only attend the best institutions if they chose the highest-earning majors, this problem could be corrected over the next decade. Now, doubters may cry that the most affluent students would not be subject to this plan, but this is an advantage that persists in any scenario. In fact, the implementation of this system could reduce a growing wealth gap, as a higher percentage of lower-income students shifted to the most fruitful career fields.