Will the Student Loan Industry Be Bailed Out Next?

Will companies that issued derivatives based on bundled student loans be the next financial dominoes that will require a government “bailout”? The country’s long dedication to education makes it a virtual certainty.

The emphasis of the role of government in education predates the establishment of the United States as a country. As early as 1642, a year before the founding of Harvard, laws of the Massachusetts Bay Colony broke with English tradition of purely private education and introduced a role for the state. The law essentially suggested that the colony’s government would assume the duty of teaching children if parents failed to do so.

A century later, the new Congress of the United States enacted the Northwest Ordinance of 1787. It set forth the role and obligation of the state in education. Article 3 of the Ordinance stated that

Religion, morality, and knowledge, being necessary to good government and the happiness of mankind, schools and the means of education shall forever be encouraged.

Early in the 19th century, Horace Mann took a leading role in the advancement of public education. Both as a Senator from Massachusetts and later as Secretary of the State Board of Education in 1837, Mann was instrumental in establishing textbooks and libraries, doubling the wages of teachers, and securing state aid for education. He argued that the country’s wealth would increase by educating the public and should be borne by the taxpayer. He was immensely successful in the task. Mann ultimately became president of Antioch College in 1853, six years prior to his death.

The fundamentals for universal public education were established and accepted on both a private and state level. However, it took nearly three quarters of a century, in 1935, for direct federal government loans to be debated. First, government student lending began on the state level when Indiana initiated the waiver of fees to students who successfully competed in statewide tests.

By 1944, the Serviceman’s Readjustment Act (commonly known as the G.I. Bill) was passed. It was the first legislation to provide direct aid for students on the federal level. The bill was amended and expanded following the Korean and Vietnam conflicts. Now called the Montgomery G.I. bill, it forms a crucial benefit to men and women voluntarily joining the military services.

The next half century saw a rapid rise in various federal, or federally-guaranteed, student loans and grants. Loans are to be repaid at subsidized low interest rates, while grants are outright gifts, requiring certain criteria and qualifications.

Some examples include:

  • National Defense Education Act was launched after Russia orbited Sputnik I in 1958. It was centered on science, mathematics and language. The federal program is now called the Federal Perkins Loan program for low-income students with ten years to repay at five percent interest.
  • The Health Professions Educational Assistance Act 1963 for medical and health program students was later broadened to add scholarships in addition to loans.
  • The most significant and sizeable is the Federal Stafford Loan Program. It was initially passed by Congress in 1965 as the Guaranteed Student Loan Program. The program used private banks and other lenders, guaranteed by the federal government.
  • Outright grants, such as the 1965 Educational Opportunity Grant Program and the 1972 Basic Educational Opportunity Grant, now known as the Pell Grant, consist of outright gifts to students in low income brackets. Eligibility is based strictly on need.

Later yet, government educational funding started to be offered to middle and upper income families such as the 1978 Middle Assistance Act and the 1981 PLUS loans.

Finally, loan consolidations and the William D. Ford Direct Student Loan Program of 1993 expanded loans available directly from participating schools.

As the population increased, and students availed themselves of the increasing variety of grants and loans, so did defaults on student loans.

A report published in October 2007 by Education Sector, an independent non-profit, non-partisan think tank, shows that student loan default rates were approximately five percent. Twenty percent, the largest percentage of those defaulting, owed $15,000 or more after attaining a four-year undergraduate degree.

According to the report,

Black students who graduated in 1992–93 school year had an overall default rate that was over five times higher than white students and over nine times higher than Asian students. … Hispanic students’ overall default rate was over twice that of white students and four times higher than Asian students. (www.educationsector.com)

The current financial crisis offers some serious food for thought.

Most significant is that, unlike mortgages, student loans have no underlying asset value. While defaults on mortgages have the backing of real estate – no matter if it has depreciated in market value – student loans are unsecured. Recourse to recover default payments may exist through attachment of wages and other measures, including tracking of an individual through IRS records, but has no tangible value except the student’s future earning power.

Despite the high-risk exposure, private firms in the student loan industry, such as SML Corporation, generally known as “Sallie Mae,” realized some $18.5 billion in derivatives sales in 2007. According to Bloomberg.com on October 22, Sallie Mae lost $185.5 million for the third quarter, compared to $344 million year-to-date. The company increased contingencies for bad student loans by some 31%. It also had extraordinary legal expenses in connection to a failed sale of the company to a third party. The stock declined from a high of $48.24 to close at $4.50 October 22, year-to-year.

According to Bloomberg, SLM “is partly insulated from the crisis because the company’s loan portfolio is 82 percent government guaranteed. The U.S. Department of Education is offering funding for those loans through July 2010.”

SLM Corporation owns or manages some 10 million student loans in addition to its ancillary businesses of college savings accounts and collection agencies. It was originally formed in 1972 as a “government-sponsored entity” similar to Fannie Mae and Freddie Mac. It became a totally independent company in 2004.

The question remains: if SLM Corporation’s management underestimates its potential student loan defaults and overestimates its cash and asset positions, will the federal government be in yet another “bailout” mode?

The history of government’s historic and stated position regarding education is clear. It remains for legislators to determine how best to reduce or eliminate student loan defaults. Don’t let the fear of college debt keep you from getting your degree. See the affordable degree options available at Belhaven College.

Stephan is a former department chair for economics and taught at various colleges and universities at both graduate and undergraduate levels. If you would like Stephan to answer your economics-related questions, read his post “Got an Economics Question?” and submit your questions in the comments area there.

8 comments to Will the Student Loan Industry Be Bailed Out Next?

  • Stephen, I have been asking that same question to members of the Student Loan Justice google group for the last 4 months. And I think the answer is yes.

    The student loan industry will be the next big bail out – and like the mortgage bail out, it is AVOIDABLE, and is being created by the same forces that created the home loan crisis.

    That is, Congress’s failure and neglect to provide the REQUIRED oversight, to the industry.

    Congress knew as far back as 1975 that things in the student loan industry were messed up. They even knew of a group of students who were VICTIMS of trade schools, who would never be able to pay off their debts. YET this same congress never offered any relief from that crushing debt. – instead they removed all consumer protections from student loans. The only loan exempt from bankruptcy protection.

    WE the people at Student loan justice, spent the last 4 months in email creating the 27 item call for student loan reform found on the VOPTSSLF blog. WE also have another blog showing a historical timeline of Higher Education and student loan companies activities, as well as some media published articles.

    There is a solution to this fiasco.. but it will mean the banksters (some fat cats) won’t get as big a piece of pie as they want.

    Its either that, or the taxpayers will suffer.

    Guess with this congress, it means taxpayers suffering.

  • Stephan Zimmermann

    Mac – Thanks for your comment!

    As department head, I learned quickly that a good thirty percent of my enrolled students at the beginning of a semester dropped classes as soon as they had received their government guaranteed student loan or grant funds. Few ever returned, using the funds as a form of “redistribution” to support themselves or their families instead of using them for the education for which they were intended.

    As with the mortgage crisis, blame rests on all the participants, from Main Street to Wall Street!

  • brad

    I’m sure if Sallie sticks out her scaly hand, the taxpayers will be required to give her money. This company has been inflexible with me and countless other Americans. My principal has more than doubled, my interest rate was more than 18% (now at 15%) on a loan that has not defaulted.

    If Sallie accepts more of my money, via taxes, what’s in it for me? will they lower my interest rate, implement amnesty by rolling back my principal to the original amout? I doubt it.

    The root cause of this issue is the cost of education, how can it be so high???

    Employers shouldn’t value a degree so much, that may drop the cost of college — seriously, i’ve worked in several major US Cities (NYC, Columbus, Austin) and the kids that come out of school today (except for the truly smart ones) are not well educated.

  • Stephan Zimmermann

    Brad – I fully sympathize with any honest student who graduates and deals with the loan problem conscientiously. This is especially true in a down economy when jobs are scarce and initial salaries are lower than in boom times.

    If society as a whole believes that a well-educated public will increase the economic status of the country, students should not have to incur debt for education. They should rather receive non-recourse outright grants, depending only on maintaining passing grades and adhering to the rules of the institution they choose to attend.

    Since there would be no loans involved, but only personal incentive to develop their brains and ancillary skills, students should be highly motivated to meet the guidelines for personal success, whether as a would-be mechanic or scientist!

    There would have to some adjustments in American society’s thinking, however.

    Consider, for example. instead of giving a student a Pell Grant in full at the beginning of a school year, students should receive their funds in stages (monthly?) based on performance accomplished.

    If a student stops his or her education voluntarily, the grant wpuld simply stop if not in attendance at the college.

    That would tend to pevent individuals from using their education funds to subsidize their personal living habits. It should stop the overcrowding of classrooms at the beginning of a semester, simply to find a thirty percent decrease in enrolment a few weeks later!

    Similarly, higher standards of admission should be demanded of entering students, whether at two-year or four year public colleges.

    Of course, the various levels of government bureaucracies insist on “equality” without setting any minimum standards, especially at “open ernollment” junior colleges.

    Private colleges, of course, should be able to decide entirely on their own standards, not subject to a federal bureaucracy.

    Unfortunately, for too many students, attendance at college, whether two or four year, public or private, has come to mean solely learning for a potential paycheck. instead of seeking knowledge.

    The “knowledge” offered by the present higher education system makes it fairly clear that “free enterprise capitalism” does not effectively mix well with a paternalistic state!

  • [...] 4.     If you can’t do any of these three things, then don’t go to school and go into debt, as you will have little hope of bailing yourself out.  For more information on this, read “Will the Student Loan Industry be Bailed Out Next?” [...]

  • [...] and (coming soon) the automobile industry. Who’s next? Another financial-sector player, like student-loan packagers and resellers? More insurance companies? The steel industry? Food processing? Healthcare? Perhaps professional [...]

  • Emory Collymore

    I’m a little confused when it comes to loans. I’m reading up all I can but I still feel lost!

  • A declining student loan default rate (5.4% against 7.6% in 2009 according to Moody’s) does not necessaily call for a requirement for anyone to “bailout” the government. Nor does it mean that that the lending institution are likely to go bankrupt.

    The Health Care and Education Reconciliation Act of 2010 with its rider,the “Student Aid and Fiscal Responsibility Act” claim that government savings of nearly $20 billion would be recognized by the passage.

    Whether government should be primarily involved in overseeing more than 80%-100% of educational loans depemds on your personal outlook and study of American history of education since its early days.

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