POLITICS: PennAve

The truth about the student loan 'bubble'

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Finance and Banking,PennAve,Joseph Lawler,Economy,Federal Reserve,Student Loans,Janet Yellen

The runup in student loan debt in the wake of the financial crisis might look like a classic financial bubble, but it’s not.

Student loan debt hit $1.1 trillion in the first quarter, according to the Federal Reserve Bank of New York — the only kind of consumer debt to increase after households began deleveraging after the 2008 financial crisis.

With average student loan balances and default rates rising, some prominent authorities have suggested that student debt is in a bubble similar to the mortgage debt that led to the 2008 panic, including the Federal Reserve's advisory council of bankers, the Consumer Financial Protection Bureau and Sen. Tom Harkin, D-Iowa, the chairman of the Senate Education Committee, among many others.

Yet fears about the dangers of mounting student debt to the U.S. economy are overblown.

Unlike other forms of household debt, student debt rises when the economy is struggling. Americans have plenty of reasons to take out more student loans when commerce slows, whether it's because they are trying to weather the poor job market in graduate school or are younger students taking on added debt to spare hard-hit parents the cost of subsidizing their educations.

And the risk of a financial crisis stemming from a collapse in student loan prices similar to the 2008 housing crash is negligible, according to economists.

A simple definition of a bubble is an increase in asset prices that is not warranted by the fundamentals.

Student loans are not in that category, according to John Campbell, a Harvard economist and top expert on asset prices and the possibility of bubbles. Campbell explained: “A bubble involves people buying assets that they believe or at least suspect to be overvalued, in the expectation that they will be able to sell them to other people (“greater fools”) at even higher valuations. This is a plausible story about tech stocks in the 1990s, and housing in the 2000s. However, I don’t think it applies to student loans today.”

Campbell added that “student loans may indeed be overvalued, and lenders may be mispricing the risks. But it is stretching the language too far to call this a 'bubble.' ”

More specifically, student debt would be in a bubble if, en masse, “lenders are charging rates that are too low given the risk of default,” explained Gadi Barlevy, an economist at the Chicago Fed who has researched asset bubbles.

The vast majority of student loans, however, are guaranteed by the federal government. The portfolio of government-backed student loans is roughly $1.08 trillion, according to the Department of Education.

That’s almost all of the total amount of student debt outstanding, which is either $1.1 trillion, based on the New York Fed’s estimates, or $1.25 trillion, based on the Federal Reserve Board of Governors’ broader metric.

If the federal government, or private lenders issuing federally guaranteed loans, systematically mispriced student loans, the fallout would accrue only to taxpayers, not to the broader financial system.

As for privately issued student loans, interest rates are far higher and delinquencies and defaults have dropped. “Things have gotten better since the crisis,” said Michael Dean, head of U.S. consumer asset-backed securities for Fitch Ratings.

Furthermore, student loans are not widely packaged into securities, spreading risk throughout the system the way mortgage-backed securities did before the crisis. “From a securitization standpoint,” said Dean, student loan-backed securities “are not a risk to the economy or the financial sector in any means near what the subprime mortgage situation was.”

Dean noted that less than $35 billion of securitized student loans is outstanding.

The bottom line is that the record amount of student debt does not pose a systemic risk to the financial system in the short term.

On the other hand, it is possible “that the bubble is not in student loans but in higher education (perhaps in certain types of colleges) in which students are borrowing to get degrees whose expected return may be risky and not necessarily very high on average,” Barlevy said. That would be “akin to what people think of in the housing boom — people borrowed to buy houses, betting that house prices would go up even though this involved a lot of risk.”

Another possible risk of rising student debt is that it is leaving young people without the ability to spend on other big-ticket items, especially cars and houses. Fed Chairwoman Janet Yellen voiced this concern in early May, warning that “that may be an effect we're seeing already in the housing market.” The New York Fed released data in May showing that holders of student debt were lagging in home and auto purchases.

Even that effect, however, may be overstated. Researchers at the Atlanta Fed have found that there has not been a “material decline” in the number of first-time homebuyers over the same period.

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