Student-loan debt: The Next Bubble to Pop?

Day 3 of the protest Occupy Wall Street in Manhattan's Zuccotti Park. (Photo credit: Wikipedia)

 In the early 1990s, the savings-and-loan debacle shook financial markets and hammered employee
pension plans.  A decade later, the dot-com bubble burst, throwing the U.S. into recession and gutting another gaggle of pension funds.  Worst of all was the 2008-09 derivatives-driven debacle.  This disaster, which left many individual brokers richer than Croesus, but bankrupted (e.g., Lehman Brothers), nearly destroyed (e.g., AIG), or forced distressed sale of (e.g., Bear Stearns, Merrill Lynch) their firms, has generated a plethora of lawsuits. 

In November of last year, the Federal Reserve Bank of New York’s Research and Statistics Group released its Quarterly Report on Household Debt and Credit. http://www.newyorkfed.org/research/national_economy/householdcredit/DistrictReport_Q32011.pdf   The report contains a startling and very disturbing admission:

Revisions to Student Loan and Total Debt Balances

From the inception of the FRBNY Consumer Credit Panel, we have frequently compared the aggregate balances reported on our sample of consumer credit reports to other publicly available sources of data. For most categories of consumer debt, our aggregate figures are close to other public estimates and/or we are able to understand the differences we observe. However, we came to realize that our aggregate reported student loan balance was at the low end of the substantial range of publicly available sources. After several months of discussions with our vendor, we have now come to understand the source of this difference.

Our new data reflect changes to our vendor’s method of identifying outstanding student loans in 2011Q2 and 2011Q3. In particular, the new data for student loan balances – and total debt outstanding – incorporate additional student loan accounts that had previously been excluded.

The revisions to the data are fairly substantial: as of our August report, 2011Q2 student loan balances were reported at $550 billion. We now estimate that student loans outstanding in that quarter (2011Q2) amounted to $845 billion, $290 billion or 53.7% higher than we reported earlier. These previously excluded loans were also missing from the total debt outstanding; as a result, our estimate of total debt outstanding in 2011Q2 is also revised upward by $290 billion (2.5%).

For now, we only have data using the revised methodology for the two most recent quarters – 2011Q2 and 2011Q3. As noted above, the charts and data for the 2011Q3 Quarterly Report have been adjusted and annotated to reflect this fact. We are continuing to work with our vendor to make revisions to earlier data (1999Q1-2011Q1) and will report revised data when we have them.

       In the wake of this revelation, one knowledgeable commentator opined, “It is estimated that by the end of 2011 national college debt will surpass $1 trillion—that’s even more than the nation's credit card debt. Undergraduate students, on average, will owe $25,000 at the time they graduate, and they will be heading out into a job market that hired 20 percent of law school graduates as food servers in 2010.  While much focus has been placed on the problems associated with the funding sources (or lack thereof) responsible for the student debt crisis, few have taken aim at the actual increase in the cost of education, which has outpaced inflation by 3.1 percent.”

Who holds this debt?  Sallie Mae (formally SLM Corporation) currently owns or manages the student loans of some 10 million former students.  These loans total $130 billion.  (http://www.money-zine.com/Financial-Planning/College-Loan/Sallie-Mae-Student-Loan/)  In July 2009, the Public Broadcasting System reported on “two federal lawsuits that have been brought against student loan giant Sallie Mae over the last few years. Both allege that company employees were given incentives to push large numbers of borrowers into forbearance. Both say Sallie Mae wanted to put those borrowers into forbearance to keep loan default rates artificially low. Both lawsuits say, in some cases, the borrowers did not know they were being put into forbearance.” The complaint in the more significant of the two lawsuits states:

Lead Plaintiff SLM Venture and additional plaintiff Sheet Metal Workers Local No. 80 Pension Trust Fund… allege the following upon personal knowledge as to themselves and their own acts, and upon information and belief as to all other matters….

5. In fall 2006, the prospects of new legislation and overall declining prospects of SLM’s FFELP business prompted Defendants to undertake a sale of SLM to private equity investors.  In November 2006, then-Chairman of the Board Albert Lord initiated negotiations with a group led by private equity firm J.C. Flowers & Co, Bank of America and JP Morgan.  A sale of SLM on favorable terms to the Flowers group or another buyer depended on Defendants’ ability to persuade investors that SLM remained an attractive acquisition target despite SLM’s declining prospects.
6. In an attempt to secure a sale of SLM as an attractive price, Defendants devised and implemented a scheme to boost short-term profits by sharply expanding SLM’s PEL portfolio through aggressive and indiscriminate lending, thereby, allowing SLM to book favorable near-term financial results.  Simultaneously, SLM used a series of accounting manipulations to defer recognition of the loan losses implicated by its high risk lending strategy. Between June 2006 and December 2007, SLM’s PEL portfolio more than doubled, growing from $7billion to $15.8billion.  
7. Defendants achieved the increase in SLM’s PEL portfolio by relaxing SLM’s standards for PELs and writing “non-traditional” loans to students with low credit ratings or who were attending proprietary (private, for-profit) schools with low graduation rates and high default rates.

(Complaint accessed at http://www.pbs.org/now/shows/525/9-3-09-FILED-Second-Amended-Complaint.pdf)

         These allegations are an eerie echo of the sub-prime-mortgages, bundled as so-called derivatives, which were the core causes of the 2008 financial-industry crisis.  In December 2011 a report, entitled State Inaction: Gaps in State Oversight of For-Profit Higher Education, was released by the National Consumer Law Center.  The NCLC opened the report with the warning, “The astronomical growth in for-profit higher education has exposed increasing numbers of students to the rampant fraud in the sector.”  The report argues, “State relief for students is critical because relief at the federal level is limited.  Many states have either a student tuition recovery fund… or a bond program to reimburse defrauded students.”  The report alleges conflicts of interest in some states, occasioned by for-profits’ dominance of state higher-education supervisory bodies, or statutes and/or practices which result in this sector of the higher-education industry enjoying similar undue influence.

       The NCLC report concludes with the warning, “The stakes are high.  If schools get away with fraud and deception, they leave individuals seeking to better their lives with nothing but worthless certificates and mountains of debt.”

        Combine the $1trillion dollars in student-loan debt with allegations of fraud in the student-loan industry and the tenacious nine-percent level of U.S. unemployment, and we arguably have the makings of another “Perfect Storm” in our financial markets with predictable impact upon, among other potential victims, employee pension funds.

        According to www.finaid.org, financial institutions with billion-dollar or better exposures to a massive student-loan default include:

1.  Sallie Mae ($20.99 billion)

2.  Citi Student Loans ($6.87 billion)

3.  Wachovia Education Finance Inc. ($6.54 billion)

4.  Well Fargo Education Financial Services ($5.14 billion)

5.  Bank of America ($$4.92 billion)

6.  JP Morgan Chase Bank ($3.54 billion)

7.  Pittsburgh National Corp. ($2.65 billion)

8.  U.S. Bank ($2.26 billion)

9.  Discover Bank ($1.72 billion)

10. EdAmerica ($1.55 billion)

11.  National Education Loan Network (($1.55 billion)

12.  Citizens Bank Education Finance ($1.25 billion)

13.  Regions Bank ($1.14 billion)

14.  Fifth Third Bank ($1.12 billion)

15.  Access Group ($1.01 billion)

 A comprehensive list of financial institutions and other organizations holding significant amounts of student-loan debt is accessible at http://www.finaid.org/loans/biglenders.phtml.

     Author’s comment.  The trillion dollars in student debt, viewed as individual debt obligations spread across millions of current and former students, is arguably manageable.  A November 3, 2011, CNN Money story pegged the average student loan among students graduating in May 2010 at $25,250.   http://money.cnn.com/2011/11/03/pf/student_loan_debt/index.htm An employed alumnus ought to be able to manage that “mortgage” on his/her diploma.  The total student debt is spread across many financial institutions.  However, the New York Times reported the following repayment rates for 2009, citing U.S. Department of Education data: “Although the department issued no analysis or comparison of repayment rates by sector, outside advocacy groups that analyzed the data found that in 2009, repayment rates were 54 percent at public colleges and universities, 56 percent at private nonprofit institutions, and 36 percent at for-profit colleges.”  http://www.nytimes.com/2010/08/14/education/14college.html

       How serious a problem this dismal repayment rate poses for the debt holders, some of which remain in shaky shape from the 2008-09 crisis, is something I can’t judge.  The SML litigation, which continues at this writing and in which at least one union pension fund is a lead plaintiff, suggests to me that the threat of another bursting bubble is not purely hypothetical.  Meanwhile, one keen observer, Blogger Robert Applebaum (http://forgivestudentloandebt.com/) opined late last year, “President Obama's recent announcement was little more than a baby step on a journey of a thousand miles, however, I don't blame him for the shortcomings of his plan -- his announcement merely highlighted, for me at least, the limits of unilateral executive power. The president can only do so much on his own, without a Congress willing to do the job it was elected to do.

“Congressional Republicans have made it abundantly clear that their sole priority is the defeat of Barack Obama for a second term. All other issues are secondary to that singular goal and, as such, they're ignoring not only the will of the people, but the needs of the people at a unique time in our history when we need everybody working towards the common good of all. Ideological purity is fine for lecture halls and think tanks -- not so much for a nation of 310 Million people who are truly suffering in the wake of 30 years of failed economic policies.” http://www.huffingtonpost.com/brett-greene/robert-applebaum-student-loan-forgiveness_b_1084979.html

       Mr. Applebaum’s politics are showing.  But his point may be well taken.