In 2013, the newly created Consumer Financial Protection Bureau (CFPB) began issuing a series of warnings about a mounting student debt problem. The bureau reported that in just two years, from 2011 to 2013, the cumulative student debt increased from $1 trillion to $1.2 trillion. To put that in perspective, according to Federal Reserve data, the total housing mortgage debt in the second quarter of 2013 stood at $10.8 trillion.
The rapid increase in student debt mirrored rapid growth in housing mortgages between 2003 and 2005 in which the number of loans increased by 20%. The aftermath of that run up was not pretty, as GDP shrank by 6.2%. When the housing bubble burst in 2008, it created the worst financial crisis since the Great Depression.payday loans With the exception of a few perennial doomsday sayers, no one saw the crisis coming not even the much vaunted chairman of the Federal Reserve Board, Alan Greenspan. On June 9, 2005, Greenspan appeared before a congressional testimony and insisted that there was no bubble, simply “froth.” He was so sure that it was merely “froth” that he repeated this no less than three times.
In the aftermath of the crisis, in hindsight, it is clear that Greenspan had sorely misjudged the bubble.payday loans He is not the only one the greedy financiers, the nave borrowers, the complicit bankers, the inept rating agencies and the overhyping financial news media all played a certain role in their mistaken belief that in this digital age, in the era of “big data”, number crunching and quantitative analysis had taken all financial risks off the table.
Economists have studied the financial crisis in great depth and have found multiple building blocks that led to the crash in 2008. Stable growth during the Clinton era banished the budget deficit, creating a glut of cash that depressed interest rates and forced investors to seek higher return alternatives. Financiers bundled low quality mortgages with high quality ones, issuing bonds of dubious quality to unsuspecting investors. Rating agencies were unable to adequately rate such complex securities. Regulators underestimated the risk associated with such products. With easy money rolling in, banks suspended rigorous checks on borrowers, doling out mortgages to those who had little ability to pay. The banks were also encouraged by politicians, who wanted an increase in homeownership, fueling the growth in housing mortgages. Analyzing the build up of the last financial crisis brings into question, what is fueling this latest bubble. What exactly are the factors driving the increase in student loans?
CPFB reports indicate that most of the student loans are held by the Federal Government $1 trillion out of the total $1.2 trillion in outstanding student loans. CPFB also reports that there are 39 million borrowers with federal student loans as of mid 2013. According to Department of Education, in 2014, subsidized student loans to undergraduates carry a 4.66% interest rate, while the interest rate on unsubsidized loans is 6.21%. All graduate students are currently borrowing at a rate of 6.21% to 7.21%. This is a pretty substantial interest rate, considering the current 30 year home mortgage rate is only 3.8%.
How can one explain the 20% increase in student debt between 2011 and 2013? There are three myths surrounding the increase in student debt: increases in enrollment, tuition, and the number of for profit institutions.
Student enrollment? One plausible explanation for increase in student debt is the increase in student enrollment. This certainly does not explain the total increase in student debt.
Increasing Tuition? On the surface it is true that college tuition has been rapidly rising. However, like student enrollment, this growth does not justify the growth in student debt. For example, in 2010 2011, Cornell’s tuition was listed at $39,666 while in the 2012 2013 it was $43,413, an increase of about $3,747 or about 9.45%. Cornell, however, tends to be on the higher end of tuition hikes. Department of Education, the average tuition that students paid at Cornell, after all financial aid is taken into consideration was $24,249 in 2010 2011 and $25,652 in 2012 2013, an increase of only $1,403 or 5.8%. Thus, increase in tuition alone cannot justify a 20% increase in cumulative student debt. News, for profit institutions have poor graduation rates and account for more than 50% of student debt default. Student debt default at for profit institutions affects students elsewhere by raising the cost of borrowing, because as Congress envisioned, the student loan program must be self sustaining. While it is true for profit institutions contribute most to the current nominal portion of student debt, their enrollment actually declined sharply during that period by almost 16%.
Changing Demographics: According to the National Science Foundation, enrollment for whites is projected to decrease from 63% in 2008 to 58% in 2019, whereas the same percentages for Blacks and Hispanics are projected to increase from 14% and 12% in 2008 respectively, to 15% in 2019 for both groups. A 10% change in composition of student body indeed explains the increase in student debt. Statistically, minority students are poorer, so according to my hypothesis, they need to borrow more, which drives up student debt.
Increased student borrowing should not be seen as a bad thing, if students can find gainful employment at the end of their graduation. However, several warning signs indicate that there may not be enough jobs at the end of graduation due to the impact student debt has on the future national economy. I will dare to make some gross forecasts here, based on some back of the envelope calculations:
Reduction in spending per household will shave at least 1.5% from GDP: A recent report estimates that the number of households under age 40 that owe $250 or more each month in student loans has nearly tripled since 2005, to 5.9 million. If you pay $250 a month for student loan, it takes away $250 a month that you could pay towards your home mortgage. This reduces home purchasing power by $44,000 at today’s interest rates. When multiplied by the number of debt holders, it gives the magnitude of money that will not be spent on real estate. GDP. A 10% reduction in aggregate home value will shave 1.5% from GDP.
Reduction in number of households, an even bigger worry: Record numbers of young adults are living with their parents. According to the Pew Research Center, 3 out of 10 young adults under the age of 35 live with their parents today. Sociologists have found that as loans accumulate, students stay at home to cut their costs. This invariably delays formation of new households. Since much of the economy such as home purchases and spending related to rearing children is dependent on marriage, a postponement in marriage will further shave the GDP. According to 2010 census, children now make up 24% of nation’s population, down by nearly 2% in last 10 years. This trend is accelerating sharply. Fewer children today means fewer households tomorrow. This could easily shave another 2% of GDP in next 10 years.
Student debt trend: 41% of women who gave birth in 2013 are single compared to 5% in 1960. Statistically, children born into families with two parents are economically better off than children raised in single parent households. Students from lower income families have greater need to borrow. As we have seen in previous calculations, a 10% change demographics, resulted in a 20% increase in student debt. Thus, the forecast of another 20% increase based on changing demographics will further increase the cumulative student debt with all the implied perils.
Debt spillage into skill base: A recent report shows that as debt for medical students increase, they flock to specialty professions with higher pay leading directly to shortage of family practitioners which in turn increase costs. Similar shortages have been observed among high school teachers. Students with debt are less likely to go into low paying teaching jobs creating a shortage. Shortage of teachers diminish the skill base of the next generation of students. Lower skills means lower income, which erodes the economy further in a knock on effect.
So far, we have seen that an increase in student debt will result in loss of GDP. Loss of GDP will invariably lead to fewer jobs, which will lead to more student debt defaults. If such a trend continues, this could lead to an increase in the interest rate fueling a vicious cycle with pernicious effects on the economy.
Unlike the real estate bubble, which was fueled by a glut of cash looking for higher return, the student debt is fueled entirely by federally guaranteed loans. Since the problem originates in the government, a viable solution must come from the government. The Department of Education has begun this task, by setting up a website to allow college cost comparison for students. However, Professor Susan Dynarski of University of Michigan has pointed out a major flaw in such comparisons informed consumers lack realistic choices. Even if in state tuition in South Dakota is cheaper than in New Hampshire, a student in New Hampshire cannot realistically access this tuition.
Many argue that loans should be outcome based. If for profit colleges are driving up the loan default rate, then the government should raise the barrier of securing loans in such institutions. This solution can work well. Another proposal is to increase the length of high school by one additional year for the college bound students. This would help students but hurt many colleges, leading to large scale consolidation. Such loans would surely be opposed by college administrators.
In the current political climate, any solution that diminishes the presence of for profit colleges is unlikely to pass Congress. Thus, a decline in the potential GDP of at least 5% over the next decade with 1.5% directly from loans, 2% from fewer households and 1.5% from loss of skill base is highly likely. While this may not have the feel of a precipice like 2008, it will still be significant, albeit without the drama of the last crisis.