Thursday, August 18, 2011

When Is A Default Not A Default?

AboveTheLaw (ATL) had a post today entitled "The Student Loan Bubble: Only Stupid People Will Be Surprised When It Bursts".  The post derives from this Huffington Post article that details the massive and sudden increase in student loan debt from from 440 B to 550 B since 2008 - a 25% increase over three years.  I would also be really remiss if I did not point out that LawSchoolTuitionBubble (LSTB) has been calling attention to this for some time and his most recent post on it suggests that the total numbers may be even greater.

As opposed to the ATL article, I don't want to call people stupid - maybe "not paying attention" or "not understanding the consequences" would be better phrases.  However, when one looks at the data, it really does seem pretty apparent that there is an increase in the asset price (college degree) that has become decoupled from the underlying economic reality - at least for most college degrees.  The article cites the recent decline in starting salaries for college graduates vs. the increase in tuition in this regard.

Further, it also seems clear that there is acknowledgement of the risk by the agencies evaluating risk.  As the article points out, Moody's Analytics has pointed out that:
"many students will be unable to service their loans as income growth falls short of borrowers' expectations."
"Fears of a bubble in educational spending are not without merit"
This is different from the situation in the housing bubble where there really wasn't much appreciation of the system risk until it was pretty much too late.

What are the consequences of ignoring the problem?  The article cites a study from the Chronicle of Higher Education that finds that 1 in 5 government student loans that entered repayment in 1995 has since gone into default.  I remember 1995 - 1995 was not that bad a year, economically speaking.  We were coming out of the recession in the early 90s.  It wasn't go-go time, but not bad.  Additionally, student debt was much, much less - as recent studies point out, college costs have tripled from 1990 to 2009.

So if a 20% default rate is what you get in 1995 when you have a) better overall economic circumstances than now, b) less than one third the cost of going to college, and c) increasing starting salaries for college grads rather than decreasing salaries, what is the 2011 default rate going to be?  Absent some other factor, it would obviously be more than 20% - likely far, far more.  Maybe as high as 50%.  That would be terrible and it would be quite obvious that our student loan system was in serious need of reevaluation.

However, what about those "other factors"?  Well, as LSTB has pointed out to me, most federal student loans given today qualify for Income Based Repayment (IBR) which will allow those with student loans to not pay anything if they are not working (in certain situations).  Additionally, the loans may be forgiven after 25 years (although there may be a large tax consequence if current law is not changed).  The forgiven loans would be a taxpayer expense.

IBR does strange things to the "default rate."  Suddenly failing to make payments to your student loans because you are out of work is not "default" - instead it is just "participation in the IBR program."  Consequently, (as governments measure things) the "default rate" is likely to be calculated only based on those who are somehow not included in the IBR program.  For example, students have to take affirmative steps in the IBR program to establish how much they are paid - failing so, the remaining debt is amortized over 10 years and students have to pay the (typically higher) payment.  I suppose it would count as a default if someone failed to notify the IBR program and then ignored the new letters - and I am sure that of the millions of people taking the loans there will be a percentage that will do so.  However, based on the difficulty of actually defaulting under IBR, I would put that percentage at about 2%.  Frankly, under IBR, "default" no longer has anything to do with the student's underlying economic situation.

That is, IBR effectively hides the default rate.  It makes "default rate" into something that is no longer a useful barometer of the actual economic outcomes of people taking student loans.  This is by no means a scientific measurement, but the 80% non-default rate for the class of 1995 leaves one with the impression that college was a successful investment for 80% of those taking loans in 1995.  It's a gross, intuitive measurement, but it likely has at least some correlation with actual outcomes.

Alternatively, IBR pushes the accounting acknowledgement of the loss of money to the program due to lender non-repayment to the 25 year mark when it would presumably be possible to determine the amount of student loan debt forgiven.  And here's the big fat stinker - we have $110 B increase in student loans over the last 3 years ($36.6B/year).  Based on the current bag economic situation and the increased cost of college relative to earnings, it is highly likely that we will have a default rate greater than 20% - and I will estimate a reasonable value of 50%.  That would mean at least about $7B - 18B/year - and that's just for ONE YEAR.

Additionally, the actual amount forgiven would be considerably higher considering the 7.9% interest rate attached to the loans.  (People may or may not want to include the total loan amount because can we really consider losing money that we never had to be a loss?  That is, when recognizing loss is our "loss" just the loan capital given or does it also include the interest we never got.)  Regardless,  we are going to be looking at a big, big loss.  However, the loss may not be acknowledged for decades.

So, the answer to the question "When is a default not a default?"  Answer - when it's an IBR.

Update:  Here's another article on the debt crisis from The Atlantic.  They also draw parallels with the housing bubble.


  1. While IBR clearly affects default rates, the biggest issue to me is that defaults are not counted after two years. When one considers how easy it is to defer in addition to the IBR and ICR options, it seems pretty obvious that the first two years are going to only catch a sliver of the majority of defaults.

    Ahh the brilliance of this scam: the untraceable fuel of young educated debt slaves seeking deferred gratification. No entry into the workplace so not counted as unemployed. No defaults in the first two years, no liability for schools. Tick, tick, tick....

  2. I disagree with you that IBR=default, and I plan to discuss it on my blog. IBR is more like an extended deferment/forbearance, for those who pay nothing. Please keep in mind that most people under IBR DO pay something, and most people who are eligible for IBR do not use it.

    So your assertion that "IBR hides the default rate" is not accurate. Defaults are the failure to make the required payment. If someone's payment under IBR is nothing, then they aren't defaulting by benefiting from what amounts to a longer deferment/forbearance.

    Unless you want to call everyone who puts their loans in deferment and forbearance a "default," then I suggest you rethink your position. Also, once again, most people under IBR are paying something, just not as much as they'd be paying under the standard repayment plan.

  3. I meant to say, they aren't defaulting by paying nothing if nothing is what they're required to pay. It almost sounds as though you don't understand what defaulting IS.

    1. Hi! Thanks for the comment! "Default" is an interesting concept - in one sense, it can mean the failure of the lendee to pay as agreed. In another sense, it can mean that there is some net economic loss for the lender. Certainly I agree that under the first definition, a student that is in a deferment of forbearance in accordance with the terms of the lending agreement is not "in default". However, in most deferment or forbearance situations, there is not a net economic loss to the lender - just a delay of payments. In this situation, there is usually only a real economic loss to the lender if there is a default.

      Conversely, under IBR, the "default rate" can no longer be used to measure the economic success of the program for the lender. For example, if the lender recovering only 10% of the amount loaned (as could happen under IBR) is not going to be considered "a default", then the "default rate" no longer has economic significance. Consequently, the performance of the lending program - already muddled by forbearance and deferment (but not too bad because they just delay payment) - is no longer gaugeable by looking at the default rate.

      One concern is that I don't think that there should be effectively infinite federal loan dollars - especially for programs that will not allow their graduates to pay the loans back. You used to be able to identify these programs by looking at the "default rate" - for example, if the graduates of a specific program are defaulting because they can't pay their loans, then maybe the federal government should stop making loan dollars available for that program - or at least control the loan dollar. Adding forbearances and deferments makes that calculus less reliable, but you still have the fig leaf of no economic loss. Conversely, IBR makes it pretty much impossible to use default rate as an economic gauge of return on the federal loan dollars because the dollars recovered could be zero (earnings below limit and forgiven at 25 years) and the loan would not be considered "in default."

    2. I am speaking for myself and probably many others under IBR.

      1. Many people under IBR are paying something.

      2. Those of us who are paying nothing, it is most certainly a temporary situation. When I am economically in a position to pay back every penny I borrowed, I will. All of those dollars will be recovered.

      I think you might want to rethink your stance a bit.

      It's also hard to ignore the fact that you tie up the article by calling IBR "a default." I am letting you know that this line of thinking is wrong. We are not defaulting on our loans like someone who agreed to pay something every month and then didn't. You're kind of saying we are.

    3. First, you and the other people on IBR have done nothing wrong - even if you are paying nothing- as long as you are in compliance with the program. There is no need to be defensive. It's not the people on IBR that I have a problem with. Instead, I have a problem with how the IBR program itself clouds the issue as to whether taxpayers are getting a return on their student loan dollars - which in turn lessens the pressure on schools to reform their tuition practices, possibly by reducing tuition.

      For example, consider a straightforward loan program with no IBR, deferments, or forbearance. 98% of the people who take out loans are going to be doing their best to repay them. Now, if you discover that only 80% of people who took out the loans are actually able to pay them, then you can clearly see that there is a problem. The inability to pay back the loan calls attention to there being something off about the financial calculus of taking a loan/getting a career. As to what you do next, that can vary, but at least you can clearly see that you have to do something. In this case, you are using default rate as a metric for whether or not the program is doing its job.

      Conversely, you can no longer use default rate as a metric of the performance of the loan program under IBR. This is actually pretty dangerous and really takes pressure off of schools to reform tuition practices.

      For example, under IBR, if you are a school, why not raise the tuition to $1M/year (as long as you can get the federal government to increase the loan amount to that level). The students will never pay it back, but the school doesn't care - they have their money. The students don't care (but should) because their payments are limited to a maximum. However, the taxpayers are going to be footing the bill when the program crashes in a few years. I can draw some similarities to what CDOs did for the mortgage market - and we all saw where that led.

      Bottom line - students that are paying as agreed under IBR are great people. However, is IBR as currently implemented the right program for the US? Is it transparent as to whether there is a return on taxpayer dollars? How do you even tell if the program is working? Maybe report the percentage of people that are paying their full payment rather than any reduced payment?

      Putting it another way, if I was an educational institution, I would be very much behind IBR because it probably means that I can raise the tuition very significantly without a lot of pushback (either declining enrollment or resistance to raising price).

      For example, one aspect of pushback that I would have had to deal with as I raised tuition would be students wondering whether their increased salary justified the expense of the tuition. Now I can tell them that "it doesn't matter" (although it really does) because their payments will be limited by IBR. Thus, I can jack the tuition to as high as the federal government loan limit will allow.

      At the same time, I have paid people on my staff to lobby congress to increase the student loan limit to "support education". Note that the people on my staff are paid for with loan dollars from students (taxpayer money) and have the job of getting more taxpayer money for me.

      Another areas of pushback might be from lawmakers questioning whether the program is working. Under IBR, I would be able to report a "default rate" of probably about 1% and use that to assert that the program is "working' and should be expanded. In reality, that "default rate" now had nothing to do with the underlying financial reality as to whether the program is working or not.

      Bottom line, I don't like things that make it more difficult to tell whether things are working. If schools have raised tuition to out of proportion to inflation that the economic reality is crumbling, then we should deal with the problem directly rather than "sweeping it under the rug" with IBR.

    4. I think keeping many people out of default is a GOOD thing. If you honestly would prefer that people's personal and financial lives get wrecked by a student loan default, I don't know what to say. Sure, it "calls attention to a bigger problem" but how would I, as an individual, cope if I defaulted? I don't want to know, and so I'm glad for IBR.

      You make some valid points, but none of it changes the fact that you refer to participation in IBR as "defaulting," and that's not correct.

  4. Also I think you think we're a bunch of deadbeats who are just going to keep working minimum wage jobs and wait out the 25 years. I have no intention of doing such a thing. This is just a safety net so I don't get into huge trouble now. I'm not counting on the government forgiving my loans and I think if you asked most people on IBR, they don't either. My goal is to get my finances where they need to be and then pay off the loan as quickly as humanly possible.

    Also, can you IMAGINE the interest that would build up if I just let it sit and counted on the government to forgive it one day? Holy crap.

    Yeah. No.

    1. It's not about you - you are great! You are going to get out there any try your hardest. You are by no means a deadbeat.

      Let me turn this around - if the student loan program was reporting a 50% default rate, there would be tremendous pressure on congress - who would in turn place tremendous pressure on schools to lower tuition. Schools SHOULD have only been increasing tuition at the rate of inflation, but instead have been drastically increasing it. You have been WAY WAY overcharged for your education - but there is no one to place pressure on them to reduce the price. In the absence of such pressure, they increase the price as much as they can. With a high default rate, there would be pressure to reduce tuition or at least lower increases.

      Why are you willing to let the schools get away with overcharging you? It's like you have bought a Kia from a shady car dealer who charged you $250,000 for it and you are defending legitimacy of the transaction because you are successfully making the payments.

      Also, regardless of whether you desire to avoid "counting on the government to forgive it one day", the reality is that the economic transaction of the loan is becoming decoupled from the economic reality of your ability to repay it with IBR. This has been happening gradually over the last couple of decades. Certainly you would agree that there is a tuition level at which you would most likely never be able to pay back your loans - and this will vary by your major. I think that this level has likely already been reached for some majors, and if schools keep increasing tuition faster than inflation (and are allowed to do so by IBR) then more and more majors will not provide the increased earning power necessary to pay of the loans - regardless of the good intentions of our students.

      This is not about you - you have done nothing wrong. In fact, you need to be protected from the predations of being overcharged for your education. Also, taxpayers need to be sure that they are getting a return on their money or the program will not be sustainable - which means that it will crash, which we want to avoid.

    2. Sure, but it wouldn't help the people who were in default and had their financial lives ruined. It would help future students, but what about someone like me who's done with school and grappling with huge debt?

      A car payment isn't really comparable to financing an education. There are no breaks on car payments (nor should there be), and a car is a depreciating asset.

      Again, I see IBR as no different from forbearance and deferment. I'm not sure why you put deferment and forbearance in different categories just because they don't last as long.