TCS Daily

Tales Out of School: The Financial Disaster Everyone Missed

By Kevin Hassett - March 10, 2004 12:00 AM

Most post-secondary students receive some kind of government-backed loan. Just about everybody thinks that is a good idea. Equalizing opportunity has always been a key social policy objective of conservatives and liberals alike. Since information concerning the drive and talent of students is difficult for lenders to discern from mere loan applications, lenders in a purely free market might be very reluctant to provide loans at affordable interest rates. Filling the possible gap, our student loan policies have historically done a magnificent job getting cash to kids who need it, at interest rates that make the choice to invest in education a rational one.

The track record of success explains why student loan programs have received impressive bipartisan support for decades. Which makes it surprising and disturbing that a flaw in the design of one specific policy has caused a massive and potentially catastrophic financial imbalance to arise.

Here is how the problem emerged. Borrowers often take out several loans throughout their academic careers. These loans tend to have relatively short duration (less than ten years) and variable interest rates. As students enter the workforce, they often have trouble making their monthly payments. In order to help them manage, Congress established a "loan consolidation" program that allows students to consolidate all of their various loans into a single loan that lasts for up to thirty years. The longer term significantly reduces the monthly payments. The problem with this program is that Congress decided to make the interest rate on these loans equal to the average of the interest rates on the original loans. Students are allowed to borrow at fixed rates for the long term at interest rates that are short-term variable rates!

Anyone who has purchased a house knows what a wonderful deal that is, especially lately. For example, the Washington Post's mortgage interest rate table cites one lender willing to make 1-year adjustable rate loans at a rate of 2-1/8, but the same lender demands 5-1/4 percent for a 30-year fixed loan. Imagine if you could get the loan for 30-years at 2-1/8. This pattern is quite common. Short term variable rate loans generally have much lower interest rates than long term fixed loans. The reason is simple -- if economic circumstances change and interest rates rise, a lender who has agreed to accept a low fixed rate gets hammered. To help balance the risks, lenders who lend for longer periods usually demand a higher interest rate.

If interest rates rise, lenders who have written fixed rate contracts lose money. For the student loan program, the taxpayers are the lenders who will suffer if interest rates rise. The calculations are quite simple. Right now, our government has guaranteed lenders a rate of return that is about equal to the commercial paper rate (a rate commonly used to establish a corporate cost of funds) plus 1-1/2 percentage points. If the lender has made a fixed rate loan, and the commercial paper rate increases to a rate higher than that on the student loan, the government pays the lender the difference.

So suppose you are a lender, and some student pays you a fixed interest rate of 4 percentage points. If the commercial paper rate rises to 5 percentage points, then the government will mail you a payment of 2-1/2 percentage points. Since commercial paper rates are about at an all time low, most economists (and the Congressional Budget Office as well) think that the rate will increase sharply in the next few years. Accordingly, the government will have to start making payments to lenders.

How big are those payments? Are you sitting down? Students, needless to say, have been quite smart, and have consolidated everything they could get their hands on. The total stock of outstanding consolidated debt is now in the neighborhood of $100 billion! And that stock is increasing quickly, since interest rates are now low, and students are acting fast.

My colleague Rob Shapiro and I recently added up the likely costs of this program, and they are very high indeed, totaling more than $12 billion if the CBO forecast for interest rates turns out to be true. But even more disturbing to us as we studied the problem was the risk associated with the government's loan portfolio. Even if there were no future consolidations, an increase in interest rates of a couple of standard deviations relative to baseline would lift the cost of the consolidation program to the neighborhood of $80 billion. If we allow consolidations to continue and we have the same bad (but not unprecedented) luck with interest rates, then the costs can easily top $100 billion. If interest rate movements like those seen in the past can bankrupt the program, the program is not well designed.

The potential costs dwarf those of the current student loan system, and possibly approach the realm of those associated with other modern financial catastrophes such as the S&L crisis. Congress should act quickly to reform the consolidation program. Doing anything less is the fiscal policy equivalent of Russian roulette.

Kevin Hassett is director of economic policy studies at the American Enterprise Institute. His study with Rob Shapiro was funded by members of the student loan industry. Read the study here.


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