The federal government took over the student loan business during President Obama’s first term as president. At the time, the move seemed worthwhile. It ensured that private banks would deal with federally backed student loans no longer. Instead, with the government becoming the sole lender to students, the deal resulted in cutting the intermediaries out of the picture.
The result was quite profitable for the government. Becoming the sole provider of student loans eliminated the fees that banks typically received for acting as intermediaries. Therefore, this move ended up saving the government billions of dollars. Yet, the world of student loans has undergone quite a few changes since those days of 2009-10.
Currently, student loans are usually in the news for their higher volumes and higher delinquency rates. Given this backdrop, the critics of the Obama administration’s decision to take over the student loan business have found their voices. After spending years of listening to how profitable the move was, they are now questioning the government about the risks involved with a burgeoning student loan portfolio.
The Federal Government Holds Record Volumes of Student Loan Debt
Two months ago, the Federal Reserve released data showing that the federal government held approximately $876.1 billion in student loan debt. This figure represents the highest ever volume of student loan debt held by the US government.
Megan McArdle writes that estimates from the Congressional Budget Office reveal that the government will reap profits from the student loan program for the next decade at least. But, these estimates do not provide any answers to the following two questions:
- What will the scenario look like if the conditions prevailing at present change the environment under which the student loan program operates?
- How comfortable or positive does the Congressional Budget Office feel about the student loan program’s profitability beyond the next 10 years?
The Difficulties Involved in Answering Questions Concerning the Risks Involved in the Student Loan Business
McArdle mentions that the answer to the first question throws up some counter-questions instead. For instance, how will the government estimate the cost of its guaranteed loan programs?
One way of dealing with this would typically involve adding up the expected costs of the student loan program. These expected costs could include figures for:
- The overhead expenses for loan origination and collections
- The interest that the government will need to pay for borrowing the money it will lend and,
- The money that it is likely to lose via defaults
Thereafter, the government will need to compute its expected revenues by adding the interest and the principal that it will collect on the loans. On subtracting the expected costs from the expected revenues, the government could arrive at the figure it needs. It is worth noting though, that this method does not account for any changes that take place in the market conditions.
Should the Government Account for Changes in Market Conditions?
When lending money to borrowers, private lenders often account for changes in market conditions. Should the government do likewise? Critics might argue that the federal government is not a private lender. In their view, accounting for changes in market conditions will only serve to inflate the accounting costs of the student loan program. By doing so, the government will only succeed in reducing the attractiveness of the program.
On the other hand, not considering the changes in market conditions is not wise either. McArdle suggests that the interest rates on treasury bills could see a sharp rise. If this were to take place, the government would re-visit the precarious position experienced by savings and loan associations in the 1980s. At the time, these associations found themselves paying an exorbitant 12 percent interest on savings accounts, while holding only three percent on mortgages.
Student loan delinquency rates have risen in recent times. Given the rising costs of college, borrowers will take out larger amounts of student loans. Therefore, the probability that delinquency rates will continue to increase in the coming years remains an imminent one. If any of these two situations unfolded in the coming years, they would invariably make the student loan program a loss-making proposition. This is why advocates of fair value accounting clamor for including changes in market conditions in the overall cost of the program.
Other Risks Associated with the Student Loan Program
Oftentimes, people do not realize that student loans involve other risks as well. For example, when it gives a student loan to a first-time borrower, the government is taking on a significant risk. After all, it is issuing a long-term, unsecured loan at capped rates to a borrower who will usually not have any credit history. Without a proper credit history, no lender would have any viable means for assessing whether the borrower will repay the loan or not.
If that is not bad enough, consider this aspect as well. The federal government also provides a wide range of forbearance and deferment options to borrowers struggling with their loans. In addition, it provides income-based repayment programs too. Integrated together, each of these options merely increase the costs of a student loan.
Why Delinquency Rates Deserve a Closer Examination
Recently, the Federal Reserve released data that showed that delinquency rates for student loans were 11.3 percent in the fourth quarter of 2014. Although this figure is significantly better than the delinquency rates witnessed at the time of the Great Recession, delinquency rates on student loans are significantly worse than delinquency rates on other types of loans. It is worth mentioning here that the Federal Reserve calculates delinquency rates as a percentage of the total number of outstanding loans. This makes the delinquency rates appear much better than they actually are.
McArdle writes that nearly half the loans are currently in forbearance, deferment or in one of the various income-based repayment programs. Therefore, when you calculate delinquency rates on all loans for which borrowers are supposed to be making payments, the figure that you will arrive at will be twice the official figure. This makes clear the risk that delinquencies pose to the student loan program. If delinquency rates continue to increase as people leave school or if deferments ended, McArdle believes that the government could end up losing a considerable amount of money.
Why the Congressional Budget Office Needs to Review the Viability of the Student Loan Program Beyond 2025
As mentioned earlier, the Congressional Budget Office has forecast that the government’s student loan program will be profitable for the next 10 years. That takes us to 2025. However, it is worth mentioning that the income-based repayment programs typically have longer terms of about 25 years. Thereafter, the government provides loan forgiveness for any remaining balances on the loans. Interestingly, McArdle reveals that the Congressional Budget Office has not considered this in its 10-year budget forecast window.
The situation would become even worse if the government decides to makes this loan forgiveness tax-free. At present, the government regards all forms of debt forgiveness as income to the borrower. As a result, on receiving loan forgiveness, borrowers usually pay about 25 to 40 percent of their loan balances as taxes to the government. But the reason why the government is providing loan forgiveness is primarily because these borrowers did not have the funds to repay their loans entirely. As a result, claiming money from these individuals is hardly a realistic proposition.
Given that the government already holds $876.1 billion worth of student loans, it will need to assess the risks to its student loans portfolio quickly. For any lenders who lend money without evaluating the risks involved usually end up falling flat.