WSJ and Bloomberg Notice the Student Loan Crisis

(Guest post by Larry Bernstein)

The Wall Street Journal and Bloomberg have stories on the student loan crisis.  I presume the articles were in response to my post a couple of days ago.

This is typical. I think the WSJ editorial page gets the issue wrong.  The editors blame the current crisis on new Fed limits on the allowable credit spreads.  In addition, there is a mention of an idea to allow the Federal Reserve to accept student loans as collateral at the discount window. 

I don’t think either of these issues is critical.  The key point is that students are defaulting on their loans at a rate much higher than expected.  With higher default rates and worse than expected recoveries, the loans are worth less than par.  State Street, who had bought billions of securitized private student loans in the secondary market, admitted last week that they may need to take reserves equal to as much as 10% of par.

The current crisis is not a funding crisis, or an ability to use the loans as collateral for secured financing by banks.  The problem is a basic financial problem.  The borrowers are unwilling to pay the lenders back.  There are two typical responses to this sort of problem.  The first is to stop lending until we figure out what the likely default rates are going to be and if the business makes economic sense.  This is the current lender response to the increasing rates of default in the subprime residential market.  The second response is to lend, but at much higher interest rates to cover for the additional expected losses from defaults and to cover additional risks of even greater defaults.  The market is seeing both responses from lenders.

What should public policy be for student lending?  This is clearly complicated and depends on your view of the role of government.  Do you think that the federal government should lend directly to students at a below-market rate?  The answer depends on the public’s willingness to accept substantial losses on the loans.  The market price embodies the market’s view of defaults.  Today, the market is saying that the government will lose more than 10% of the loan size.  There are $70 billion of new federally guaranteed loans each year, and both Democratic presidential candidates want to expand the program.

What is the market failure that requires government action?  Why shouldn’t the interest rates on student loans reflect the risk of the loans?  If we let the market work, banks will demand additional collateral (from the parents) at various interest rates to reflect the individual risk of the borrower.  It cannot be that whenever credit spreads go up to reflect greater risk of defaults that the government needs to step in and lend money at a below-market rate.

(As an aside, the current plan to use the FHA to solve the nation’s residential mortgage crisis will most likely result in government losses in excess of the 1980s thrift crisis.  Sadly, many years from now, Congress will investigate how this could have happened.)

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: