The Simple Economics of Student Loan Crises

Yesterday, my students heard my second lecture on supply and demand. You know, the one in which we examined how government policies like rent control and the minimum wage can affect market outcomes. Those are important examples, and I dutifully discussed both of them. But I must admit they also feel a smidgen stale – how many millions of students have seen a lecture on rent control and the minimum wage?
To spice things up, I threw in a third example of government intervention: the market for guaranteed student loans. As I mentioned a few weeks ago, the government has a major program in which it provides guarantees for private student loans. Under the program, lenders are protected against the risk of future defaults by the student borrowers. In return for providing these loans, the lenders receive interest payments that are limited by a formula that is specified in law. (These payments are determined completely separately from the amounts that are charged to students which, for simplicity, I will ignore in what follows.)
This program is currently the focus of a major political battle: the Obama administration has proposed eliminating the program and replacing it with direct loans from the government (which currently account for a much smaller portion of the market). But I didn’t get into that larger debate in class. Instead, the reason I focused on this program is that it has experienced two crises in recent years:
In 2006 and 2007, the crisis was kickbacks. In their enthusiasm to win more business, private lenders were offering “inducements” to schools and student loan officers in order to get preferred access to students who wanted loans.
In 2008, the crisis was a lack of lending. In large part because of the financial crisis, private lenders had no enthusiasm whatsoever for making loans. As a result, there was a real risk that students might not be able to get loans.
As I told my students, I think both of these crises had the same root cause: the fact that the government, rather than market forces, determined how much lenders were paid for making guaranteed student loans. In both cases, the government got the payment levels wrong, and the crises followed soon thereafter.
Back in 2006 and early 2007, the government had set payment rates too high. Lenders thus competed aggressively among themselves to win as much of the market as they could. Some of that competition had arguably beneficial effects (e.g., some lenders passed benefits on to students), albeit at a notable cost to the taxpayer. But the competition also took on unsavory characteristics, as in the kickbacks to the university officials in charge of deciding which lenders would get preferred access to students.
To their credit, the folks in Washington correctly diagnosed this problem. Late in 2007, the Congress passed and the President signed a bill that reduced the amount that lenders were paid.
Unfortunately, those reductions happened at the start of a financial crisis that dramatically increased the cost of private lending. In micro-speak, the private lending market experienced a negative supply shock. And all of a sudden, lender payments were too low. Lenders thus threatened to flee the student loan market, which could have left millions of students without funding for their education.
Again to their credit, the folks in Washington stepped up and eventually found a solution to this problem (which involved more financial engineering than I want to discuss right now). But it was a painful process.
To me, one attraction of this (admittedly simplified) description of recent student loan crises is that it focuses on a different type of government price-setting than the usual examples. Rent control and the minimum wage are situations in which policymakers believe that market prices are “wrong” (either too low or too high), and the point of the policies is to try to correct that (which turns out to be easier said than done).
The point of the student loan example, however, is that similar problems arise even when the government is trying to get prices “right”(i.e., to choose prices that are just high enough to get private lenders to provide all the guaranteed loans that students want). In practice, the government is hard-pressed to know what the “right” price is, and thus even sincere efforts will often result in prices that are too high (spawning kickbacks) or too low (spawning shortages).
I did not have time to get into this in class, but this line of reasoning ends up quite agnostic about the future role of government in the student loan market. Someone with a free market perspective could easily conclude: aha, government price-setting doesn’t work, so we should allow the marketplace to determine the interest rate that is paid to lenders. At the same time, however, someone more amenable to government intervention could easily conclude: aha, this system of setting payments for private lenders is fundamentally flawed, we might as well have the government make the loans itself (as the Obama administration has proposed).
The direct loan approach would certainly eliminate the Goldilocks question of whether private lenders are being paid too much, too little, or just enough. But a full comparison of the two programs should consider many other factors, e.g., budget costs and the relative capability of private lenders and the government in making loans and managing loan portfolios. I will leave such a comparison for another day. For now, my point is simply to suggest this might be an interesting example for other micro classes.


Source

U.S. House passage seen for student loans overhaul

The U.S. House of Representatives is expected to approve a bill on Thursday that would cut banks and private lenders out of a large slice of the $92 billion student loan market.

If subsequently approved by the Senate, the bill would likely be signed by President Barack Obama, marking the biggest shift in higher education finance in 35 years and a setback for Sallie Mae (SLM.N) and other lenders.

U.S. Secretary of Education Arne Duncan told Reuters in an interview that he was optimistic about passage. The bill has been endorsed by the administration. A House leadership aide said debate on it will start on Wednesday.

Duncan said private firms would still have a role as servicers of government student loans under the bill.

He criticized an alternative proposal being promoted by lenders, including Sallie Mae, which would preserve a role for them in originating government-guaranteed loans, while also providing them with a steady stream of fee income.

"To invest in banks right now, rather than students, that just doesn't make sense to me," Duncan said at a Capitol Hill news conference where he urged approval of the legislation.

Some Republican lawmakers have attacked the bill as an unjustified government takeover of an industry that has served students well, but at least one Republican favors it.

Appearing at the news conference with Duncan, Republican Representative Thomas Petri pressed for passage of the measure, which he called "long overdue and certainly welcome."

Jaret Seiberg, policy analyst at investment research firm Concept Capital in Washington, D.C., said: "We believe the odds favor enactment of this legislation in 2009."

KILLING FFELP

The House education committee approved the bill in July. It would shut down the Federal Family Education Loan Program (FFELP) and shift most student lending into the Direct Loan program run by the Education Department.

Besides Sallie Mae, other lenders with a stake in the outcome include Student Loan Corp (STU.N) (C.N), SunTrust Banks (STI.N) and Nelnet Inc (NNI.N).

Since the 1970s, FFELP has formed the core of a lucrative business model used by private lenders of government-guaranteed student loans. The profitability of the FFELP model fell sharply when the Bush administration cut subsidies to lenders.

FFELP lenders were embarrassed by a 2007 scandal in which some were found to have given money and gifts to college financial aid officers to drum up business.

They also took a devastating hit in the financial crisis of the past year, when the secondary market for student loans froze up, forcing Congress to step in with an emergency bailout so that college students would be able to go to school.


Source