Capco Institute Blog

Big changes may be brewing in the student loan market. For some lenders, notably those with weaker underwriting capabilities or affiliations with lesser institutions or programs, these changes could be disastrous. For others, it could present an attractive long-term opportunity. What is clear is that pricing in the education market has all the signs of being a bubble that is about to pop, both economically and legislatively, with a significant potential impact on lenders and investors.

The genesis of the bubble is the growing importance of education in determining economic success in America. A recent Georgetown study showed that the average lifetime earnings of a bachelor degree holder were 84 percent higher than that of a high school graduate. However, these benefits are not distributed evenly across all college graduates. Instead, major, degree type and occupation are among the key determinants of lifetime earnings. And job market is rife with young adults, often with liberal arts degrees, who have been unable to find a suitable job. On top of this, it appears that many colleges are doing little more than credentializing their graduates, with negligible gains in learning throughout their college years, and many end up working in jobs that don’t require a college degree.

At the same time, the cost of higher education has been skyrocketing. Tuition increases at colleges and universities have been exceeding inflation for decades, with large increases in the last decade partly fueled by state governments that have had to cut spending during the recession. There has also been a large increase in the number of students attending for-profit educational institutions, which often have high costs and high dropout rates, leaving students saddled with debt and little to show for it in terms of educational background.

As a result, the amount of student loan debt has been skyrocketing, even as credit quality has deteriorated significantly, with delinquencies rising to over 15 percent of student loans. This probably overstates the average credit quality of these loans, as 43.5 percent of student loans are in deferment, due to the borrowers either continuing their schooling or having difficulty in finding suitable employment.

There are significant innovations on the horizon that are likely to stem the rising cost of tuition. The most imminent are proposals in Florida and Texas to offer $10,000 degrees from state colleges. In addition, there is an increased availability of free online courses through resources such as MIT OpenCourseWare and the growing importance of nonacademic professional certifications in technology, finance and other fields offered by companies such as Microsoft and groups such as the CFA Institute.

We think there is significant political risk associated with student loan lending. One of the few (semi)coherent demands of the Occupy Wall Street crowd was for student loan debt relief. In the next few years, there is a good chance that Congress will make it easier to discharge student loans in bankruptcy (Sen. Durbin recently introduced a bill to do this). If this happens, there could be major disruption in the student loan market as the federal government is likely to shift its aid from loan guarantees to more direct forms of financial aid, and private lenders and investors in student loan asset-backed securities (ABS) will have to deal with an increased volume of student loan defaults. Lenders should prepare for these potentialities by shoring up their underwriting of student loans to better take into account what default rates would be if it were easier to discharge student loans in bankruptcy. And investors, who have recently bid up the prices of student loan ABS, may want to closely examine their exposures. At the same time, however, potential reductions in the availability of federal student loans could also present an opportunity to aggressive lenders to fill any void left by the federal government if it were to decrease the availability of federally guaranteed loans.