By Ibrahim Ergen
The total volume of student loan debt has skyrocketed in the last decade, growing on average more than 10 percent annually. This article is intended to provide insights into the student loan segment of the credit market by providing information on the supply and demand dynamics, as well as the recent performance of the loans.
Data from the Federal Reserve Bank of New York’s “Quarterly Report on Household Debt and Credit” show that total student loan debt has grown 523 percent since 1999. During the same time frame, mortgage debt grew 166 percent and auto loans grew 102 percent. As of the third quarter of 2011, there was $865 billion of student loan debt outstanding. This amount is larger than total credit card debt ($693 billion).
There are three main drivers of this rapid growth. First, college enrollment rates are rising. Data from the U.S. Census Bureau show that the college enrollment rate for 18- to 24-year-olds increased from 25 percent in 1967 to 42 percent in 2010. Second, tuition and fees have increased rapidly. Data from Haver Analytics show that the consumer price index (CPI) for tuition and fees has increased 900 percent since 1980. During the same period, CPI growth has been 560 percent for healthcare and approximately 300 percent for housing and food. In California, tuition and fees increased by 21 percent just in the last academic year. Third, federal guarantees on student loans have contributed to the growth in student loan debt.
While the rapid increase in tuition was a driver for borrowing, it can also be considered an effect, as the increased borrowing has created a vicious cycle. Andrew Gillen, an economist at the Center for College Affordability and Productivity details this vicious cycle in his policy paper titled “A Tuition Bubble? Lessons from the Housing Bubble.” On one hand, as tuition keeps increasing, the government guarantees more and more student loan debt in order to enable students to pay for it. On the other hand, students who would otherwise be unqualified for loans are able to secure funds due to the availability of cheap credit introduced by these federal government guarantees. This increases the ability of more students to pay for school, makes education demand inelastic to price changes and leads schools to increase the cost of education without losing students.
Student loans cannot be shed in bankruptcy. Lenders have broad collection powers, including garnishing borrowers’ income and withholding their tax refunds. In performance monitoring, the U.S. Department of Education considers loans that are nine or more months delinquent as in a default state and releases official cohort default rates once a year. A cohort default rate is defined as the percentage of borrowers who entered repayment during a particular federal fiscal year and defaulted prior to the end of the next fiscal year.
In Figure 1 below, the cohort default rates for the latest three fiscal years1 are presented, broken into public, private and proprietary school categories. Proprietary schools are defined as the post-secondary education institutions operated by private profit-seeking businesses. The default rates have increased every year since 2007 for each category. The unemployment rate spiked from 4.4 percent before the financial crisis to 10.1 percent in October 2009, making it difficult for graduates to find jobs and service their debt. The performance observation window in the Department of Education’s default definition is two years. In fact, with a three-year observation window, the cohort default rates almost double for all types of schools.
In addition, proprietary schools are enrolling more students than ever, despite low performance in terms of graduation rates2. During the last decade, enrollment in proprietary schools increased from 2.9 to 7.6 percent of total college enrollment, according to data from the National Center for Educational Statistics. Default rates for proprietary school students are two to three times higher than for traditional schools.
It is not only default rates signaling deterioration in student loans. Delinquencies are also rising. For example, in Figure 2, the rate of the dollar balance that becomes delinquent during a quarter for the first time (new delinquent rate) is plotted, starting with the peak of the financial crisis in the fourth quarter of 2008.
While other consumer loan markets show some signs of improvement — evidenced by decreasing delinquency rates — student loans continue to deteriorate, and student loan performance is unlikely to improve in the short term. The labor market is taking much longer to recover than after previous recessions. As a result, new graduates are facing challenges finding work and paying off their debt.
To help struggling borrowers, the government previously capped monthly payments at 15 percent of monthly income and forgave the remaining balance after 25 years of repayment. Changes were recently implemented. Now monthly payments are capped at 10 percent of a graduate's income, beginning in 2012. The remaining balance is to be forgiven after 20 years of repayment. Those in public service careers could have their remaining debt forgiven after 10 years.
While helping struggling borrowers may be helpful as a social policy, it does not address the root of the student debt crisis. The existence of government guarantees fosters growth in student loan debt and tuition costs. A sudden elimination of federal student loan guarantees may create bigger problems in the education system; therefore, a policy that eliminates or limits guarantees gradually may be the best option.
The deterioration in student loan performance may become an additional burden on the federal budget. The federal government issued or guaranteed more than 80 percent of student loans originated before 2010. The Education Reconciliation Act of 2010 made the federal government the direct lender of all future federally insured loans. Since then, the government has backed more than 90 percent of new loan originations. In the event of a default, the federal government will cover 98 percent of the unpaid principal balance as long as certain servicing standards are met by the borrower’s lending institution.
What can be expected if the labor market stagnates and student loan performance declines? Borrowers that default on their loans and damage their credit histories won’t be able to use credit. The graduates who can pay will end up with less disposable income, since they will graduate with higher student loan debt, and they will be more likely to postpone life cycle investments such as buying a car or home. Colleges, particularly proprietary schools, can also be affected by worsening student loan performance because prospects of federal loans for new students depend on the performance of their graduates.
Finally, financial institutions might experience difficulties, even if their student loan holdings are federally guaranteed. The government will cover 98 percent of the unpaid principal balance, but if the servicing standards were not met appropriately, the government can reduce that coverage. Financial institutions are, therefore, prone to operational risk even in their federally guaranteed student loan portfolio. Financial institutions can also be affected by the secondary effects on the broader economy as mentioned above. These effects may be significant, especially if current conditions in the labor market continue for an extended period of time.
Ibrahim Ergen is a Supervision and Regulation financial economist with the Federal Reserve Bank of Richmond. He can be reached at firstname.lastname@example.org.
1As the definition implies there is a two-year observation window. Therefore, 2009 is the last fiscal year the cohort default rates are available.
2According to a 2007 New York Times article, The University of Phoenix estimates its own graduation rate at 16 percent.
The analyses and conclusions set forth in this publication are those of the authors and do not necessarily indicate concurrence by the Board of Governors, the Federal Reserve Banks, or the members of their staffs. Although we strive to make the information in this publication as accurate as possible, it is made available for educational and informational purposes only. Accordingly, for purposes of determining compliance with any legal requirement, the statements and views expressed in this publication do not constitute an interpretation of any laws, rule or regulation by the Board or by the officials or employees of the Federal Reserve System.
Supervision, Regulation & Credit