The student debt mountain: another looming catastrophe

Student debt is a problem, and it’s only going to get worse as defaults shoot up and the millennial generation cut spending to repay their debts. Hedge fund manager James Rickards of Tangent Capital, discussing the US experience, even describes it as “the next subprime crisis” waiting to happen.

Here are some scary facts about the US situation: in 2013, total student debt hit $1trn – more than total US consumer debt (excluding mortgage debt). The average individual owes $24,000, but 11% had more than $50,000. This is at a time when US higher education costs have soared – from 2000 to 2012, the average price of college tuition rose by 44%.

The US government is on the hook for 90% of this debt. The good news is that it makes a small profit on this debt pile, because of the mark-up over ten-year Treasury rates. The bad news is that default rates are rising fast.

In 2013, the number of borrowers at least 90 days behind rose to 11.5%. That’s more than the 10% typical of consumer debt, but it could get worse.

The Zero Hedge website reckons things are deteriorating: while the “national two-year cohort default rate rose from 9.1% for the financial year (FY) 2010 to 10% for FY 2011… the three-year cohort default rate rose from 13.4% for FY 2009 to 14.7% for FY 2010”.

Dig deeper and even more worrying data emerges. ‘For-profit’ universities and colleges have the highest average two- and three-year cohort default rates at 13.6% and 21.8%, respectively. Even the Federal Reserve’s economists think the numbers are underestimated.

New York Fed economist Maricar Mabutas notes that “as of third-quarter 2011, 14.4% [about 5.4 million borrowers] have at least one past-due student loan account. Together, these past-due balances sum to $85bn, or roughly 10% of the total outstanding student loan balance”.

But up to 47% of borrowers “appear to be in deferral or forbearance, and so did not have to make payments”, and so weren’t counted. Others suggest that one in seven student loans defaulted in the three years to 2012.

This is bad as it is, but these numbers will only get worse as US borrowing costs start to rise. The Treasury pegs its loan rates to ten-year bond rates. These are already set to rise in the summer. New projections from the budget watchdog, the Congressional Budget Office, suggest that the interest rate is likely to rise every year through at least 2018, when the average rate will hit more than 7%.

The American student debt market is much more mature than our own, but there are already signs that UK debt levels might be even higher than in the US.

The Institute for Fiscal Studies and the Sutton Trust reckon UK students will leave university with £44,000 in debts, and repay an average £66,897 over a lifetime. Yet, despite these huge numbers, all this extra debt won’t actually rescue our new higher education funding system.

In 2010, the government said that uncollectable debt (defaults, plus those who never earn enough to repay their debts in the first place) shouldn’t exceed 32% of the amount lent. That number is now thought to be closer to 45%. Government economists are even modelling numbers of more than 50%.

The tipping point is thought to be 48.6% – that’s when the new system becomes more expensive than the one it replaced. Already the Treasury has allowed an extra £5.5bn for unexpected costs. And yet the Sutton Trust reckons this system will leave many graduates paying back loans through to their 40s and 50s.

Why does this matter? Because this huge debt overhang will affect short-term consumption, and effectively crowd out long-term savings. In the US, the clearest impact can be seen on credit scoring.

Another Fed study showed that by 2012, the average credit score for a 25-year old without student loans was 15 points higher than that of one with them. The gap gets wider as the borrowers get older. Thus former students could well find it harder to borrow money to buy a house or a car, despite better earning potential.

The good news is that these graduate borrowers are cutting down their wider credit exposure (student borrowers’ debt per head fell by $5,687 in 2012), but the bad news is that this is likely to harm GDP growth.

Not only could crushing student debt squeeze consumer spending, but it could also destroy the supply of funds available for risk capital formation. In other words, graduates will delay pension saving until the last minute.

I don’t agree that this is a subprime crisis waiting to happen. Our governments are on the hook, rather than dodgy loan structurers – which is either great news (no bubble and crash), or terrible news (yet more public debt), depending on your point of view.

But what is indisputably looming into view is yet another huge off-balance-sheet catastrophe – one to parallel our public pensions crisis – that will hurt our growth and crowd out savings. It’s a mess that will only get bigger and nastier.

The solution? Replace the system with a graduate income tax – whereby university education is free up front, but graduates pay additional income tax. It has its own problems (encouraging graduates to emigrate, for example), but at least it’s not leaving either students or taxpayers on the hook for debts that may never be repayable.

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