Student Loan Debt Crisis and Broader Implications

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1 Student Loan Debt Crisis and Broader Implications Is student loan debt the next credit bubble? The growth of educational debt has increased rapidly in recent years even as other forms of consumer borrowing have declined materially. According to the Federal Reserve Bank of New York, total consumer indebtedness such as mortgages, credit cards and auto loans, fell $1.4 trillion since Q Mortgage debt represents the largest component of the change, decreasing from $10.0 trillion to $8.6 trillion. Over the same period, student loan debt increased from $611 billion to $966 billion. Even more eye-popping, student loan debt outstanding has almost tripled since The chart below illustrates the rapid growth. A primary cause of the sharp rise in student debt is the increase in college costs. Tuition growth rates have far outpaced the rate of inflation over the last 25 years and students have responded by tapping the loan market. The Department of Education conducted a survey showing 66% of bachelor s degree holders in 2008 borrowed money to pay for college compared to only 45% in This additional borrowing is

2 completely understandable given the fully loaded cost of attending college today. The table below provides a summary of tuition, room and board costs over the last decade and in the years beginning in 1980 and Constant dollars based on the Consumer Price Index, prepared by the Bureau of Labor Statistics, U.S. Department of Labor, adjusted to a school-year basis. According to the Department of Education, the total cost of attending a 4-year institution in 2011 was approximately $22,000 compared to just under $13,000 ten years earlier. You don t need to check the CPI numbers published by the Bureau of Labor Statistics to guess that the overall consumer inflation rate was much lower. However, a review of the actual data shows that CPI inflation averaged about 2.5% annually for the decade, well below the trend in college costs. This data clearly shows that students (and their families) face a different financial equation than in prior decades. The tuition inflation data may not be surprising for anyone with a child or grandchild who has attended or is planning to attend a four year university. What is surprising is how quickly the overall level of borrowing has increased in the last few years, to levels that may not be sustainable. The problem really began with the onset of the great recession in 2008 and the resulting financial hardship many have faced since. Families have fewer resources to pay and students utilize loans to fill the gap. Unfortunately, while recent graduates leave school with more debt they are also

3 experiencing diminished employment opportunities compared to prior generations. As of 2012, unemployment and underemployment among 18-to-29 year olds was about 33% according to Gallup, compared to about 18% for all Americans. Last year, the Associated Press reported on a study that showed about 1.5 million, or 54%, of bachelor s degree holders under the age of 25 were jobless or underemployed. Anecdotally, recent graduates unable to land suitable employment are turning to McDonald s or Starbucks for paychecks. A study performed at Rutgers University titled Chasing the American Dream: Recent College Graduates and the Great Recession showed only 46% of working recent graduates were paid a salary and more than half of graduates were compensated on an hourly basis. It still holds true that college graduates, on average, earn significantly more than those armed solely with high school degrees. It is also true that unemployment rates for college graduates are lower. However, for many graduates burdened with increased debt levels and inferior salary and wage opportunities, the averages don t matter. Over a lifetime they may earn more than their lesser educated peers, but the near term debt servicing costs in the current economic environment are daunting. The obvious result is financial stress and greater delinquencies. The chart below depicts the increasing delinquency rate among student borrowers since 2004 across various age groups.

4 Unfortunately, the chart above understates the full extent of the problem because it shows the delinquency rate among all borrowers, including those NOT yet in repayment. According to the Federal Reserve Bank of New York, approximately 44% of borrowers were not repaying due to deferment or forbearance. The delinquency rate among those in repayment was much higher than the overall rate. For example, in the under 30 age cohort, the share of borrowers in repayment that were 90+ days delinquent was 35% vs. 17% in the overall borrower pool. The 35% rate for borrowers in repayment was up from approximately 20% in 2004 and 25% in There are other signs of stress within the student debt complex. Last year J.P. Morgan and U.S. Bancorp exited or curtailed student lending in the private market. Given the backdrop of higher delinquencies and defaults (the percentage of defaults by borrowers in the second year of repayment has doubled to 8.8% from 2007 to 2011) their exit should not be surprising. Another example of stress is the sharp rise in defaults on federal Perkins loans that are provided to low income borrowers. According to Bloomberg, in the year ended June 2011, students defaulted on $964 million in Perkins loans, 20% higher than five years earlier. The picture has so deteriorated that major Ivy League institutions with endowments in the billions have begun resorting to litigation against former students over nonpayment. Clearly there is a large and growing problem in student loans. However, it begs the question: what are the implications for investors? There is no readily apparent mechanism to wager on bad outcomes. There is no derivative index similar to the ABX (subprime mortgages) that would allow investors to trade in student loans. While not tradable, the student loan problem has important long-term economic implications. Broadly speaking, the trajectory of future economic growth could be impacted if the problem worsens. Excessive consumer debt of any type impacts the ability of households to obtain and service mortgage debt, the lifeblood of the housing industry. Without a strong housing recovery, the foundation for economic growth would be impaired. The multiplier effect from housing is huge. Construction jobs are one thing, but housing related spending drives growth in many industries over the long run. The million dollar question becomes: is the incipient recovery in the all-important housing sector self-sustaining over time if younger families are unable to obtain mortgage financing due, in large part, to excessive student loan debt? The answer may not come for a number of years. The Federal Reserve s loose monetary policies could be simply offsetting this current structural problem. However, we do know that in

5 the long-term, new household formation and first time homebuyers drive the vibrancy of any housing market. First time buyers purchase homes from move-up buyers who in turn purchase larger and more expensive homes generating growth throughout the chain. Without first time buyers, any short term recovery in housing would be tenuous at best. We have seen significant improvement in housing fundamentals over the last 12 months. Indeed it has been a key bright spot in the U.S. economy. Home sales have picked up and inventories have declined. Most analysts agree that new homes starts are poised to materially bounce to meet new demand. A key element of the resurgence is the astonishingly low level of mortgage rates. Not many would have predicted a 3.5%, 30 year mortgage rate a few years ago. These low rates have made housing more affordable countering other negative variables. Another important factor is that much of the recent home buying has come from institutional buyers who have raised billions of dollars from investors to purchase pools of homes for profit. This class of buyer has never existed before and no one really knows if they are artificially pushing up prices, creating the appearance of healing. Nonetheless, recent data from the Standard & Poor s Case-Shiller home price index show average home prices increased about 9% nationally in the 12 months ending February See the chart below.

6 However, the current strength in housing could simply be a temporary bounce off the bottom. For the recovery to be sustained, young adults armed with college degrees need to become first time homebuyers. There is already evidence that high levels of student debt are crowding out other forms of debt, including mortgages. Recent data compiled by the Federal Reserve show the impact that high student loan balances has had on young graduates in the age group. This group experienced material deleveraging from 2005 to The decline was most severe for those with larger levels of student loan debt outstanding and most of the contraction was related to mortgages. See the chart below. As students awaken to the economic reality of funding 4-year college tuition with debt only to see recent graduates fail to secure scarce viable jobs, they may re-evaluate the proposition. If this recognition becomes pervasive, demand for higher education may wane and colleges and universities will become less insulated from market forces. If so, it is likely that colleges would have to cut spending. Real competition for a declining supply of students (with financing) could even cause tuition rates to decline. Market forces like these might solve the problem, but government subsidies

7 have altered the market for a long time and excesses are now obvious. Taxpayers might be asked to fill the hole. Conclusion Investors should closely monitor the level of stress in the student loan market as it could become the canary in the coal mine that the impending housing and economic recovery in the U.S. may not be sustainable. It was only five years ago that investors thought that stress in the subprime mortgage market was well contained and unlikely to have knock on effects to the broader markets. Yes, subprime mortgages, unlike student loans, involved derivatives and securitization that made the inherent problem more systemic and exponentially worse for markets. However, as discussed above, excessive student debt could cause first time homebuyers to not show up, resulting in illusory housing strength that could stall the economic recovery. The result could have cautionary long-term implications for economic growth and the performance of risk assets. Kevin O Shea