The Student Loan Sweatbox

Student loan debt is growing more rapidly than borrower income.  The similarity to the trend in home loan debt leading to the subprime mortgage bubble has been widely noted. Student loan debt in 1990 represented about 30% of a college graduate’s annual earnings; student debt will surpass 100% of a graduate’s annual earnings by 2023.  Total student loan debt also reflects more students going to college, which is a good thing, but the per-borrower debt is on an unsustainable path. Unlike the subprime mortgage bubble, the student loan bubble will not explode and drag down the bond market, banks and other financial institutions. This is because 1) a 100% taxpayer bailout is built into the student loan funding system and 2) defaults do not lead to massive losses. Instead, this generation of students will pay a steadily increasing tax on their incomes, putting a permanent drag on home and car buying and economic growth generally. Student loan defaults do not result in home foreclosures and distressed asset sales. They result in wage garnishments, tax refund intercepts and refinancing via consolidation loans, and mounting federal budget outlays. In many cases, borrowers in default repay the original debt, interest at above-market rates, and 25% collection fees. In other words, defaulting student loan borrowers will remain in a sweatbox for most of their working lives. Proposals to cut back on income-driven repayment options will only aggravate the burden, further shifting responsibility for funding education from taxpayers to a generation of students.

For the vast majority of student loans, the federal government is the lender, or the guarantor. The taxpayer bailout is already built in. The small private student loan sector consists mostly of very high credit score, high income borrowers with solid jobs. Goldman Sachs, for one, is bullish on the prospects for securitized private student loans.

Most defaults do not lead to losses because of the robust collection tools Congress has given the U.S. Education Department. Student loan borrowers in default end up paying, sooner or later, through wage garnishments, federal income tax refund seizures, and consolidation loans. Administrative wage garnishment (no court order required) take 15% of a borrower’s after-tax income. Tax refund intercepts take 100% of the most common form of annual savings, year after year. Borrowers who want to avoid these taxes can in some cases get a consolidation loan, capitalizing all unpaid interest and collection fees into a new loan, restarting the payment clock for another 20 to 25 years, perhaps in an income-driven payment plan at 10%, 15% or 20% of their discretionary income.

In recent years however, US Ed.'s recovery rate on defaulted loans has declined from nearly 90% to around 75%. Until 2015 the interest paid by successful borrowers, especially graduate student and parent loans, more than offset losses on defaults and discharges. For the past three budget years, losses from defaults and  income-driven repayment discharges are projected to outstrip interest earnings. This means that taxpayers will share somewhat more in funding student loan debt, although Administration budget proposals now seek to reverse that trend by reducing income-driven repayment subsidies.

The only way out of the sweatbox for borrowers are 1) bankruptcy discharges granted based on “undue hardship”, a very tough standard, 2) discharges based on death or permanent disability, and 3) write-offs of balances after 20 or 25 years of income-based repayment, or shorter periods for some public service loan forgiveness programs. These write-off amounts are modest now, but are growing as the bubble grows.

Instead of a 2008-style crisis, the student loan bubble will be a permanent and heavy drag on economic growth. An entire generation of borrowers cannot buy homes or cars, and will have their spending permanently impaired. When a tipping point will be reached, and when that generation of borrowers will take up their pitchforks, is impossible to guess.