Stopping The Next Bubble: The Time To Reform Student Loans Is Now

November 04, 2011

Student loans have been on the forefront of the news recently.  Protestors involved in the nationwide “Occupy Wall Street” movement (many of whom are unemployed recent college graduates) have made student loan reforms or forgiveness a centerpiece of their movement.  Congressman Hansen Clarke (D – Michigan) is pushing a student loan forgiveness bill, which is getting support via an online petition by MoveOn.org. It has received over 640,000 signatures.  And in late October, President Obama announced two plans (via executive orders designed to by-pass an obstructionist Congress) to help around 7 million student loan debtors by (1) allowing certain federal and private loans to be consolidated at lower interest rates, and (2) accelerate and expand a program that puts an income-based limit on what lower-income debtors have to pay in student loans.

The flurry of activity concerning student loans is hardly surprising — student loan debt is approaching dangerous bubble levels and getting worse.  While exact figures are hard to determine, the Economist reports that experts believe total student loan indebtedness will soon pass $1 trillion total, with the average college graduate today carrying nearly $27,000 in student loan debt.  In fact, current student loan debt has surpassed total consumer credit card debt.  State governments faced with budget problems have cut funding to state universities, leading to sharp increases in tuition and thus greater loan burdens.  And with unemployment still high and wages stagnant throughout the economy (real wages for college graduates fell 8.6% from 2000 to 2010), greater and greater shares of income of recent college graduates are going to student loan debt repayment, and an increasing number of debtors are defaulting on their debt — the Department of Education reports that the default rate on student loans reached 8.8% in 2009.

The long-term trend for our economy is certainly dispiriting.  Student loan debts continue to increase, debtors are increasingly in default, and today’s college graduates (the would-be entrepreneurs and innovators of our economy) are saddled with debt loads that reduce their tolerance to take the risks necessary to create new businesses and/or support our economy through consumption spending and investment.

While recent efforts by the Obama administration to aid student loan debtors are a start, he needs the cooperation of Congress to achieve reform of the entire student loan industry; the President cannot do it alone.

Student loan debt remains an exception to other forms of debt in America in a myriad of ways: (a) student loan debt is extended almost without regard to the credit viability of the debtors; (b) student loans cannot be discharged via bankruptcy; (c) private student loans have are no limits on interest rates, penalty fees, or late fees; and (d) student loan debtors can have their wages directly taken out debtors’ paychecks by the government (a la child support payments).  Some of these exceptions are practical: unlike homes or consumer goods, the benefits of an education provided via student loans cannot be repossessed to benefit creditors, and asking lending institutions to write-off $1 trillion would create a crisis equivalent or exceeding the housing crisis.  Like it or not, as the Washington Post noted, “banks get bailouts, they don’t give them.”

But while outright student loan forgiveness is a non-starter both politically and practically, there are practical reforms that could benefit distressed debtors, reduce student loan payments generally, and thereby improve the economy for today’s as well as tomorrow’s student loan debtors.

First, public and private student loan lenders should be given a choice between keeping student loans non-dischargeable via bankruptcy, or else accepting strict reductions on interest rates, and penalty and late fees.  If lenders choose to keep their loans non-dischargeable via bankruptcy, then they must accept interest rates/penalty fees/late fees that are regulated and limited to protect consumers and reduce overall payments for debtors.  On the other hand, if lenders choose to retain their independence to set interest rates, penalty fees, and late fees, then they must take the risk that may lose the funds they loaned to consumers in bankruptcy.  The current system, which allows lenders complete control over interest rates as well as the security offered by the inability to discharge student loans via bankruptcy, is quite simply a handout to large lenders.  And to fully even the playing field, consumers should be allowed to re-finance their student loans or find other banking institutions to serve as their creditor (thereby allowing the consumer themselves to choose between lower interest rates or the ability to discharge student loan debts via bankruptcy).

Second, the process by which student loan credit is extended to students needs to be more heavily regulated.  Banks should extend credit on student loans in ways more similar to the way they extend consumer credit currently, looking at the likelihood that a student might repay the debt in their career.  Likewise, for-profit colleges need to be more fully regulated, as many of the most prominent abuses of the student loan industry have coincided with the rise of for-profit institutions.  For-profit institutions generally need to generate just 10% of their revenue from private sources — meaning many institutions have abused the federal student loan system to generate revenue, thereby hurting student lenders.  From 1998 to 2008, for-profit university enrollment grew by 225%; not coincidentally, from 2001 to 2011, annual student loan debt doubled from around $50 billion to more than $110 billion a year.

Third, alternatives to the traditional financial-institution model of student lending need to be developed.  One example, the $10 million Gen Y Fund launched with the support of President Obama, encourages young students to think about launching start-ups and entrepreneurial ventures at a relatively young age, and in exchange, the students get a number of nice perks: housing expenses covered, three years of debt forgiveness when they graduate, and mentoring as they go about launching new companies, and a nice chunk of equity (ranging between $15,000 and $50,000) to get things started.  Large companies themselves that are hungry for qualified employees should be encouraged (through tax breaks or other financial benefits) to help ensure the next generation of educated workers can join the workforce without being saddled with large student loan obligations.

Finally, going forward, the price of education needs to be reigned in by both the market and the government.  Over the past decade, tuition and fees at public colleges have increased by an average of 5.6% per year above the rate of inflation, and reports suggest that private college rates have increased beyond that rate.  The government needs to develop policies to stem the rampant and irrational inflation in university tuition, or at minimum demand that universities accepting federal research funds (nearly every university in the United States does so) provide public transparency as to why their costs are skyrocketing.  Consumers also need to be more cautious, accepting that the education of a lower-cost but still excellent university may be a better long-term investment over a more expensive but allegedly “prestigious” alternative.

Practicable solutions exist to prevent the student loan bubble from bursting.  Let’s hope Congress ends its intransigence and, together with the business community, musters the courage to seek them before student loan debt permanently hijacks our economy for the worse.  Regardless of his efforts to address the problem through the use of executive orders, President Obama simply cannot solve this by himself.

Photo Credit: David Shankbone



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