Monday, October 15, 2012
Student Loan Bubble
I believe the next bubble to burst will be the looming student loan crisis. After our discussion about coalitions, I got to thinking that by teaming up with the federal government, these student loan agencies have devised an extremely powerful union of which will ultimately have a disastrous impact on the economy at large. If a loaning bureau can find a way to hedge its risk, the consequence of that hedge will ultimately always fall back onto the people receiving the said loan. I see many parallels between the sub-prime mortgage crisis and this student loan problem. Let me explain.
In simplistic terms, mortgage companies would – in the beginning – only lend money for mortgages to people with good credit ratings. They would then bundle these mortgages into something called a CDO and then sell them off to investors. These investors would then turn around and sell it to some other entity (hedge fund, etc) creating a continuing cycle of profitable exchange. This was great for the simple reason that it was both profitable and safe to do – largely because the only people with mortgages were those with sound ratings of credit. Yet, eventually the mortgage brokers ran out of people that met the necessary levels of credit to lend to. In order to combat this problem the brokers simply lower their credit threshold in order to find more applicants. By continuing to lower the threshold, it got to the point where people with no income, no job or assets (NINJA Loans) could take out huge sums of money to buy a house. Why was this? Because the broker knew that once he bundled the risky loans with the safer BBB loans and the safest AAA loans, thus creating a CDO, he would be able to quickly sell it to his usual investor – essentially pushing all of that risk onto that investor. It also made sense for the investor to buy that CDO for the same exact reason – he knew he could then flip it to his guys and so on and so forth. As long as you are not the last man in line, then who really cares how risky the loan may be.
Of course, with more and more sub-prime mortgages being thrown into the pot, the more risky each CDO became. At first it didn't really matter if someone defaulted on their loan because then the investor would simply seize the house. They could turn around and sell it to someone else. The problem was that when default rates started to rise significantly, investors became stuck with too many overpriced houses that no one on the market was willing to purchase. It soon became obvious that people were buying and selling an “asset” that was essentially worthless – thus forcing the whole process to come to a screeching halt.
What does this have to do with the student loan crisis? Well, it was only advantageous for mortgage brokers to loan to safe candidates until they could find a way to circumvent the risk of loaning to lesser qualified applicants. The same can be said about student loan agencies, or any loaning bureau for that matter. If the student loaning agencies could find a way to hedge their own risk, they too could go the route of the mortgage brokers and reap the greedy benefits in the process. Luckily for these agencies, the Obama Administration has made it a key initiative to send as many people to college as possible. By using the federal government as a backer – essentially hedging their risk with the most powerful organization in the world – these student loan agencies were now free to loan to whomever they damn well pleased. It doesn't matter whether or not someone looks like they will be able to pay back a hefty loan because the government tells them that no matter what happens that loan will not be forgiven. (Supposedly there is some discussion about possible loan forgiveness, but I don’t see that happening until a full-blown epidemic is at hand).
We learned that coalitions negatively affect the efficiency and growth of a society by increasing the complexity of regulation and the role of government. By doing this, Olson argues that these coalitions can change the direction of social evolution for the worse. It seems clear to me that these student loan agencies – by colluding under the guise of extreme greed – have negatively affected our society’s direction of social evolution. As long as the government is willing to take the risk away from the loaning agencies, there is nothing to stop the agencies from loaning to anyone who wishes to go to college. The fact is that a large percentage of students currently in college probably should not be there. We see people all the time who take out substantial loans so that they can get a completely worthless degree in Art History or English or any other related field that carries with it a very weak return on investment. No disrespect to those majors but it is quite unsound to take out, say, $80,000 to go to a private school majoring in a degree that will pay you next to nothing once you graduate.
What we need to see is a substantial decrease in not only the number of students attending college but also a decrease in the number of administrators; not to mention the ceasing of frivolous spending practices on sculptures, landscaping and the like – all of which adds to the ever-burgeoning increases in college tuition. A reduction across the board would be wise.
It makes perfect sense for the loaning agencies to form a coalition because their selective incentives to do so are abundant; the same cannot be said for students. I believe the selective incentives that were once very much alive for students are now corroding away. This is because students are no longer learning hard skills that can be easily transferred into the working sector. Why spend all of this money on higher education if it only marginally benefits your status from your non-educated peers? The gap is nowhere near what it was two or three generations ago. It has closed substantially. But I suppose this avenue of thinking is better left for a separate discussion.
In any case, we will not see dramatic changes to the system until default rates reach extremely disturbing proportions. Only then will people realize that college is perhaps not the once-sound investment that it previously claimed to be.