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Americans now hold close to $1.2 trillion in outstanding student loan debt making it the second largest form of consumer debt after home mortgages. What are the implications for housing markets, household formation, and economic mobility for the next generation? Are there creative approaches to reduce the burden?

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By David A. Smith

Remember the subprime housing crisis? Now we have a subprime education crisis. This one is worse in two ways: asset-value recovery and a flawed governance model that is simply making the problem worse.

Forget the personal-growth or societal benefits: in crass economic terms student lending is similar to subprime home lending: the borrower acquires a major asset (a home, a sheepskin) at inflated cost that is supported only by taking out long-term debt shot through with principal-agent risk. As in the subprime fiasco, the assets purchased have proven not worth their cost and the borrowers can’t repay the debt, but worse than in subprime, a home is at least foreclosable while an education is not. Today millions of young households – historically, the prime generators of new home demand – are taking money they would otherwise use for home-buying and paying off old loans on assets that will never have the economic value to justify the expenditure.

Right now we are creating a lost generation of earners; for the sake of the nation’s housing and economy, we must reduce the payment burden on prime new labor-market entrants.

But we can’t do it on the backs of taxpayers, because this isn’t just a problem of recapitalization – universities are pushing matriculation the way Countrywide pushed teaser loans – except that the originators are the universities themselves, and they have no skin in the game. 

Everything about student lending violates basic risk-mitigation principles. 

In sound finance, the commodity price is set by the market, not by lending; in student lending, the same people offering the money set the (inflated) price. (Scholarships aren’t a discount for the needy; they’re a means of disguising the surcharge to those willing to pay or obligate themselves to pay.)

In sound finance, the originator takes first loss and a part of every loss. In student lending, the originator gets off scot-free at signing – and the Federal taxpayer is on the hook.

In sound finance, the borrower is not obligated until the property is delivered. In student lending, the debt is due even if the student drops out.

No wonder we have 17% delinquency and 30%+ ‘real’ delinquency (90-day past due where borrowers are being asked to repay) on loans with no durable collateral.

Just as in the subprime scandal, these over indebted underemployed borrowers got there because of principal-agent risk and an explicit federal guarantee, except that the originators are the universities themselves, aided and abetted by Sallie Mae.

Just as the Fannie/Freddie merry-go-round ended only when the duopoly was placed in conservatorship, the inflated-education money machine will be stopped only when the explicit link to unlimited Federal insurance is cut or controlled. And if student debts are to be cut or restructured, the economic losses should be borne by those who profited from over-lending: Sallie Mae and the universities. Today’s universities are equivalent to pre-1986 gonzo S&Ls, and they deserve to be FIRREA’d, so let’s treat them the way the European Central Bank treated those who cheerfully bought Greek bonds or Cypriot-bank deposits: make those who exploited and benefited from the loose financing (and grade/ cost inflation to boot), collectively own their financial exposure and moral hazard risk, and thus make them police themselves both academically and financially:

  1. Going forward, instead of full insurance on new student loans, make all new “Post-Guarantee” student loans risk-sharing akin to Fannie Mae DUS, with the originator/ university required to hold the top-loss position.
  2. Enact a mandatory CRA-style investment requirement that all universities whose students borrow for schooling both (a) own preferred, TARP-like shares in Sallie Mae and (b) invest a portion of their endowment in Post-Guarantee paper.

Because they don’t fix the principal-agent risks, bailouts don’t work. Bail-ins do because they force alignment of origination judgments and downstream financial risk.

Of course, this proposal will never happen – too many entrenched opponents – but it should. 

David A. Smith is chairman of Recap of Real Estate Advisors

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