Thursday, May 24, 2012

When Student Loans Default, Taxpayers Will Pay

There's a serious political debate today regarding how--not whether--to continue to fund below market interest rates for college students on their outstanding student loan balances.

However, their is no similar discussion concerning how to minimize student loan defaults in the first place and thereby reduce the burden on taxpayers with respect to defaulting student loans.

You see, the politicians in Washington know that taxpayers will be forced to pay up when students default. That's just the way it works, even though taxpayers deserve better from their elected "public servants."

{We'll save countless other examples of piling on taxpayers such as government home mortgage guarantees, underfunded public pension obligations, post office losses, unemployment compensation benefits, Solyndra type loans and such for another time, but they all amount to the same thing. Huge and absolutely quantifiable contingent financial liabilities exist, but the politicians simply choose to ignore them, knowing that they'll pass them along to the We the People taxpayers at a later time.}

Number of the Week: Student Loan Bubble helps to put this interest rate versus principal default payment comparison in perspective:

"368%: The jump since 2007 in the measure of consumer credit held by the government comprised primarily of student loans.

If a student loan bubble were to pop, the government, not private banks, would be the one standing around with gum in its hair.
Issuance of student loans has soared in recent years, hitting $867 billion at the end of 2011, according to an analysis from the Federal Reserve Bank of New York, more than credit cards or auto loans. The jump has led some to classify the student-lending market as a bubble, comparing it with the housing mess that nearly brought down the banking system in 2008.

But there are some big differences between student loans and housing. For starters, mortgage credit absolutely dwarfs lending for higher education — by nearly a 10-to-1 ratio. Troubles in an $8 trillion market pose a much higher systemic risk.

The other big difference is who holds the loans. Commercial banks and investment firms held the bulk of the mortgages that were going sour when the housing bubble burst. But that’s not the case with student loans. Despite some recent signals of banks getting back into the student-loan business, private lending has been pretty much stagnant since the recession hit. Since December 2007 nonrevolving consumer lending by commercial banks — a measure tracked by the Federal Reserve that includes student loans as well as auto and other personal credit — is up less than 11%. Over the same period, total consumer loans owned by the federal government — a measure that includes loans originated by the Department of Education under the Federal Direct Loan Program — has more than quadrupled.

The good news in all of this is that if a student loan bubble pops, there’s little chance of a systemic crisis similar to the one that hit in 2008. But there’s still a lot of bad news to go around.

For one, though banks likely wouldn’t take a big hit, the government — meaning the taxpayer — would. That’s not great news for the deficit, but the numbers aren’t large enough to be a huge concern. At the same time, it’s much harder for the borrower to discharge a student loan than a mortgage. You can’t get rid of student loans in bankruptcy, for example. So there’s a much higher chance that the government would get its money back eventually.

The bulk of any burden from a student-loan debt bubble bursting is likely to fall on the borrowers themselves. While that means the broader economy can avoid a systemic crisis, it will struggle with a younger generation whose spending power is constrained limiting growth for years."

Discussion and Analysis

We haven't heard much about the debt bomb building with respect to future taxpayer backstops of the rapidly expanding government funded student loans.

And to my knowledge, these recently dramatically increased government student loan programs aren't properly reserving for uncollectible debts at the time the loans are originated. My further bet is that the government's credit standards for student loans, if any, are a joke.

To the politicians, that's why we have taxpayers---to pay for the messes the "kind and caring"  politicians create. The OPM principle is very much at work with government granted student loans. {Pell Grants is another great example of OPM at work, but we'll save commentary on that $35 billion per year government expenditure for another day.}

Thus, no serious consideration is given by government with respect to what the bill to future taxpayers will be when students default on their loans. But we know one thing for certain---there will be defaults.

We just don't have a clue as to how many and how expensive the defaulted amounts will turn out to be. In any event, the taxpayers will be around to clean up the messes the politicians make with our money.

And here's something else we do know for sure. Since federal legislation made government the primary grantor of student loans in 2010, the government now is the biggest student loan originator by far. In recent years, taxpayer backed loans to students have quadrupled.

Summing Up

In making loans to students, the government has outpaced private lenders by an order of magnitude since enabling legislation was passed in 2010. So should We the People feel good about this recently introduced government knows best approach?

No, we shouldn't. The federal government won't even make a serious effort to use sound credit standards when making loans. Nor will it then properly set aside an allowance for bad debt reserves sufficient to offset the amounts of future student loan defaults.

Instead the government will make the loans and then lower the interest rates charged thereon, hoping that not too many defaults will take place. And if future defaults become too large and a developing political problem, the politicians will try to forgive some or all of the amounts owed. It will be taxpayers to the rescue, in other words.

And future student loan defaults definitely will stay high unless and until the economy gets moving again. Of course, that economic revival could be several more years down the road as new college graduates are entering a genuinely tough job market. Hence, their ability to service student loans will be at best questionable in lots of cases.

And here's what all this means to We the People, to our young borrowers and to taxpayers generally. And here's what it means for the near term prospects for our economy as well.

When the inevitable student loan defaults occur, the American taxpayer, as always, will be the one left holding the bad debt bag. Oh well, it's only money.

Finally, please consider one more thing. How can our politicians possibly use the word "austerity" in light of their ongoing and well established practice of more and more reckless and non-transparent new government spending and loan guarantees? I don't get it.

The politicians---of both parties---are out of control with respect to their fiduciary responsibilities regarding what once was MOM, or our money.

So when will We the People get "mad as hell and not take it any more?" Well, there's no time like the present.

Thanks. Bob.