Monday, September 28, 2009

Student Loans

Recently an associate of mine received a government guaranteed and subsidized student loan.

On one hand I was very happy, because this extended an opportunity to a highly intelligent, motivated, ethical and economical individual, who will definitely pay the loan back. On a more general level, extending educational opportunities to individuals of limited economic means not only benefits them, but it socially and economically benefits the nation. So, if any activity were to merit state subsidies, it surely would be the pursuit of higher education.

On the other hand I found it troubling that they didn't check my associate's credit or seriously analyze their financial state. And needless to say, they did not analyze the potential economic costs and benefits of their educational decision.

An example of such an analysis would be: student X decides to study painting at the Art Institute, easily incurring $90,000 in debt, with a projected earnings of (let's say) $30,000 per year. At a 6% interest rate amortized over 10 years, their monthly payments would be $998.18, which would equal 39.92% of their monthly income. Without mom and dad's assistance their chances of defaulting would be quite high. Not all instances are this dramatic, but as a realtor who runs credit checks on prospective renters, I constantly encounter individuals who have amassed high levels of debt pursuing a liberal arts degree and are now employed in low wage service sector jobs. And even more worrisome are the many clients I have had who express very little concern about repaying their student loans because "it's only government money," which also leads me to believe that the federal government is relatively lax in enforcing the repayment of student loans.

Clearly a private bank would be unwilling to extend a loan to the aforementioned student without generous government guarantees and subsidies. And of course a private bank would not be so lax about collecting money owed to it.

So, the question remains why the federal government exercises such low standards in extending and collecting on loans? The answer lies in the fact that no one is as generous and careless as a politician or a bureaucrat spending the taxpayer's money on another third person without incurring any real consequences for their failure. This explains why Sallie Mae is deep in the red.

So, the problems of the government guaranteeing and subsidizing loans are:

1. Encouragement of economically unsound behavior that has lead to a higher rate of default, whose costs are bore by the public.

2. An increase in the number of student burdened with unmanageable debt-to-income ratios.

3. Encouragement of economically irrational behavior in students, such as a choice in majors of schools that will contribute to the increased default rate and debt-to-income ratio.

Without guarantees or subsidies, a bank would not extend the loan to student X forcing them to entertain one or more of the following scenarios:

1. Pursuing their art education at a more reasonably priced institution, thus lowering their projected debt-to-income ratio and probability of default.

2. Picking an entirely different major or perhaps pursuing a double major: art and a more practical major, such as education, which will also lower their projected debt-to-income and probability of default.

3. Student X would determine that he could earn $30,000 (or more) without going to university, by (let's say) becoming a plumber and pursuing art as a passion and not as a career.

Another key factor that is rarely mentioned is that subsidized government loans increases the demand for a particular good and service, which increases the cost of targeted goods and services, which further increases the need to obtain loans. The best example being the housing market. Predictably as banks curbed the availability of home financing, home prices became far more affordable and the ability of the public to amass debt dropped. So, by rolling back the policies that are contributing to an unnaturally high demand for college degrees, the government may actually help stem the tide of cost inflation that is plaguing higher education. And in addition it could limit the inflation of college degrees that has continuously lowered the value of a general college education (outside of lucrative degrees like medicine and law) in the workforce.

The answer is not necessarily to abandon all student subsidies, but for politicians and bureaucrats to be more cognizant of how they spend the public's money. But why should that matter to politicians? Facing a huge deficit? No problem! Borrow more money from the Bank of China or get your buddies at the Federal Reserve to print up some more! The next generation will have to pay for it with higher taxes, higher interest rates and endemic inflation, but by then the said politician or bureaucrat will be retired and enjoying their heavily subsidized pensions, regardless of the economic and social damage they unleashed with their policies and programs.

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