Student loans: The latest credit crisis
An integral credit market full of risky loans suddenly seizes up.
Borrowers can't find the capital they need, and banks are hesitant to lend in an uncertain and unprofitable market. The result? A sloppy, billion-dollar bailout courtesy of the federal government.
Thinking of the credit crunch that resulted in a $30 billion rescue of investment bank Bear Sterns by the Federal Reserve last month? Think again: A similar cycle of uncertainty is underway in the market for student loans, and it could have big consequences for those who need to pay for a college education in the coming academic year.
The government is by far the biggest player in the student-loan market, providing over $83 billion in student loans each year through a farrago of federally-subsidized programs designed to make college affordable for all. But over the last two months, more than 50 private lenders have withdrawn from government-backed student loan programs. Together, they make up almost 14 percent of the loan market by volume, according to the Wall Street Journal. That's a troubling indicator of uncertainty and potential turmoil.
Sallie Mae, the nation's largest student lender, didn't mince words with its latest quarterly earnings report. ""Today's environment,"" wrote CEO Albert Lord, ""is the most difficult we have seen in our 35-year history of student lending. It has become obvious that we can only meet the enormous student credit demands we are seeing at Sallie Mae if there is a near-term, system-wide liquidity solution.""
Translation: ""Help us, Obi-wan Bernanke ... you're our only hope!""
Policymakers are already tripping over each other to arrange yet another massive federal bailout. On Saturday, President Bush devoted his weekly radio address to student loans, affirming that ""a slowdown in the economy shouldn't mean a downturn in educational opportunities"" and urging Congress to rush an aid package to his desk ""as soon as possible."" The House is already on top of the request - earlier this month, they passed a bill that would give the U.S. Department of Education broad new authority to buy up bad loans.
How did the student loan market plunge into crisis so quickly? It's easy to blame the banks behind the mortgage mess, which has left lenders and investors wary of student loans, often sold off in bundles just like the subprime home loans that went bad in the last credit fiasco. But there's another important culprit: our lovable federal government.
Back in September, Congress passed the ""College Cost Reduction and Access Act,"" a measure that slashed subsidies to private lenders providing federal student loans. That's not a bad idea in principle, but the bill also made two dangerous interventions in the loan market: It mandated lower interest rates for borrowers and cut yields to lenders. Although it might have managed to succeed in a healthy credit climate, current uncertainty in the financial markets and bad policy have combined to leave the market for student loans trashed worse than a frat boy on Friday night.
That's not a new story. The student loan market has long been mired in information asymmetries and the distortions of government intervention.
Student loans follow the same model as loans for tangible assets like cars and homes - lenders give students cash upfront to invest in a college education, with the expectation that they will be steadily repaid after graduation. But there are profound differences between a house and a college education. It's easy to figure out how much a house is worth, and as a physical object, it's likely to retain most of its value. But when it comes to education - a good economists refer to as ""human capital"" ð- calculating value is much murkier. How much will a liberal-arts degree be worth immediately after college? It's tough to pinpoint, when it's as likely to lead to fame and fortune as it is to a job slinging caramel macchiatos. Plus, unlike a home, which can be sold or seized if a borrower can't keep up with the payments, a college education can't be used as collateral. That means lenders have always been a bit hesitant, and government eager to induce them with lucrative subsidies.
But in order to prevent similar loan crunches and expand access to college without loading students with mountains of debt, we'll need to scrap the current student loan regime altogether. Traditional loans simply don't make sense for students, who face big financial changes immediately after college ends. As any recent graduate can attest, the monthly payment schedule of a student loan can quickly become an unbearable burden - and it's unnecessary when loans are backed by the federal government. Instead, as Thomas Kane, a professor of education and economics at Harvard University, suggests in a recent issue of The Chronicle of Higher Education, it would make more sense for students to agree to pay a fixed percentage of their income after graduation, until the principal and interest on their loan is paid off.
More effective student loans could even be provided by markets completely free of government subsidies. Economist and revered free-marketeer Milton Friedman proposed ""human capital contracts"" as a replacement for student loans in which private investors would give students the capital to pay for college in exchange for a share of their future earnings - essentially investing in the profitability of individual students. Though the idea may have been infeasible when Friedman came up with it in 1955, with modern technology, implementing such a system would be easier than ever.
The student loan crisis is yet another product of government meddling in a market where it doesn't belong. Unfortunately, it looks like more of the same is in order to try and fix it.
Connor Mendenhall is a sophomore majoring in economics and international studies and the opinions editor of the Arizona Daily Wildcat. He can be reached at firstname.lastname@example.org.