“Default rates identify only a fraction of delinquent borrowers — those who have actually defaulted on their debt. They overlook the much larger shares of borrowers who are neither repaying their loans nor in default….that includes borrowers who are delinquent or whose loans are in deferment or forbearance or in repayment plans in which the balance is growing rather than shrinking.” (SOURCE)
I began working in the home mortgage business in 2002 and I stayed in that line of work originating new loans right through the economic meltdown of 2008 – a meltdown caused in no small part (primarily even?) by bad home mortgages that defaulted.
I originated “A” mortgages – none of the bad credit or high interest rate loans that dominated the defaults. But prior to 2008, more and more marginal loans were being squeezed into the category of “A” loans. Those loans could then be packaged and sold on Wall Street as “A” paper – even though those of us originating on the street knew better.
Some of the key terms of these ‘marginal’ loans that I originated look stunningly like what I’m seeing in student loans right now. We originated loans that had key characteristics that made them different from traditional 30 year fixed rate mortgage loans:
- Negative Amortization Loans
- Interest Only
- Adjustable Rate Loans (ARMs)
- Zero Down Payment Loans
I’m seeing eerily similar terms duplicated in student loans right now.
NEGATIVE AMORTIZATION LOANS
Washington Mutual was the biggest supplier of these and anyone could broker loans to them. If you’re not familiar, a Negative Amortization Loan has a minimum payment that is LESS than the interest that is accumulating – meaning that each month the balance of the loan actually goes UP. This ‘snowball’ effect causes you to pay interest on interest causing the balance to rise even faster. It wasn’t a surprise to those of us in the industry when in September of 2008 WaMu was one of the first large banks to be placed into receivership by the FDIC and ultimately their assets were sold to Chase Bank.
A student loan can be set up this way today. If you set up Income Based Repayment (based on a percentage of your income – NOT based on the interest accumulating or the balance of what you actually owe) with a payment LESS than the interest accruing each month the extra interest is rolled into the balance of your loan and the principle of your loan goes UP.
These loans provide an extremely low payment – just enough to cover the interest on the loan. You can still do a Home Equity Line of Credit (HELOC) on your home with a minimum payment – an “Interest Only Payment” – that just covers the interest.
In student loans, I see a version of this with forbearance and deferment. It is a financial ‘kicking the can down the road’ that doesn’t require the balance to be repaid. For a variety of reasons, you can stop payment on your student loans for a period of time without them becoming delinquent. In some instances, the interest doesn’t stop, it is just rolled into the principle of the loan.
ADJUSTABLE RATE LOANS (ARMs)
Prior to 2008, we had a portfolio of home loan options that offered very loan rates that could adjust in the future. Some of those loans were quite good – the mechanics of the loan caused the interest rates to drop and stay low for years. But an adjustable rate loan is in its nature a loan that passes the risk of future higher rates from the bank to the borrower.
The government has structured student loans in a way that also passes this risk on to the borrower – albeit in a different way. Unlike a home mortgage in the example above, the interest rate on a student loan is fixed for the life of the loan. But the government can change the rate each year – and most students borrow one year at a time through school.
The government is essentially borrowing money through 10 year Treasury Bills at around 2.16% today and lending back to us between 4.29% and 6.84% (WITH additional fees from 1%-4.2%). If the cost to borrow goes up next year, they will pass that risk on to the borrower with higher interest rates. If the cost to borrow goes down, they can lower the current interest rate and still have all the profit from the previously originated loans locked up.
Needless to say, the math on a Trillion Dollars lent at those margins is staggering – Student Loans are EXTREMELY profitable to the government. My back of the napkin math estimates that student loans profit (not revenue, profit) of $51 Billion in 2013 is more than 35 states collected in GROSS federal tax revenue. The entire Federal Department of Education only has a budget of $67 Billion.
Sadly, this amounts to a massive tax on the poor, lower middle class, and those bad at math.
ZERO DOWN LOANS
We originated a lot of 80/20 loans – home purchases that were funded with one mortgage covering 80% of the purchase price, and a second mortgage covering the remaining 20% so the home owner could buy the home without any down payment at all. One of the biggest buyers of these loans was Bear Stearns, and we were even able to do these loans through them on 2nd homes and investment properties. Needless to say when property values dropped, someone owning an investment property in which they didn’t have any of their own actual cash into was quickly moving toward default and foreclosure. Bear Stearns was profitable with $18 Billion in cash reserves on the very day it went bankrupt. Stop for a moment and just think about that.
Current student loan policy allows students to take out 100% of the cost of their education and borrow well above the actual costs for living expenses. This “Buy now, pay later” takes away any financial pain from higher education. Some amount of pain might be a good idea. It may cause the borrower to pause and realize: “This is a big deal. It’s expensive. It’s important. I don’t want to waste this opportunity.”
Layered together, these risks are very difficult to calculate. We are terrible at understanding layers of risk.
The quote I began this article with was taken from this article. It makes the point that Default Rate isn’t a complete picture of student’s ability to repay because of deferment, forbearance, and super low income based repayment options. And it offers this stunning statistic:
At 475 colleges, more than 40 percent of borrowers had not paid a single dollar toward their principal as of three years into repayment, according to a Chronicle analysis. …. At 171 of the 475 colleges, more than half of borrowers were not repaying their loans.
As someone who worked and lived through the pain of a massive reorganization of the entire mortgage industry because of poor lending guidelines, this all sounds very familiar.