Q3 2013 3
have incentives to default on studentloans first, before defaulting on creditcard debt. By keeping their credit cardaccount current, they can continue touse it as a transaction account or forborrowing purposes. Economists callthis phenomenon “preserving liquidity.”The benefits from defaulting onstudent loans are, by contrast, limited.Unlike credit card debt, car loans, andother consumer loans, student loanscannot be discharged or reduced by ajudge (known as “cramming down”)under personal bankruptcy. Instead,borrowers who are late with theirfederal student loan payments have toenter into a repayment plan that canlast 10 to 15 years, and during thattime, a fraction of their earnings will begarnished, similar to what occurs in aChapter 13 repayment plan under per-sonal bankruptcy. The government can
It is likely that those who default on studentloans will suffer a larger effect related to accessto credit than bankruptcy filers. Bankruptcywipes out some or all of a borrower’s exist-ing debts, a situation that is attractive to newlenders, who will not have to compete with oldlenders to be repaid. But default does not wipeout student loans.
The calculation is based on a 1 percentrandom sample of the FRBNY Consumer CreditPanel, while the panel accounts for about 5percent of all households that have files withthe credit bureau.
Although car loans are also collateralized, carsdepreciate much faster than houses. For mostcar loans, the resale value of the car is not theprimary determinant of the loan terms.
The Structure of the Student Loan Market
here are three types of student loans: federally guaranteed loansmade by banks and other lenders; federal loans made directlyby the government; and private loans, which are essentially thesame as other consumer loans from banks and companies. Inthe case of guaranteed loans, the government pays a subsidy tolenders that make the loans and also guarantees the amountloaned.*Effective July 2010, in response to the changing market and the debateabout the federal government’s role in supporting student financing, Congressexpanded federal aid to college students while ending federal subsidies to privatelenders through loan guarantees.The interest rate paid by students on both guaranteed loans and direct loansis fixed and set by Congress. The government pays the interest that accrueswhile the borrower is in school. Congress in 2007 temporarily reduced interestrates for low- and middle-income undergraduate borrowers to 3.4 percent from6.8 percent until July 1, 2012. Congress then extended the freeze in interest ratesuntil July 2013, at which time it pegged rates to the 10-year Treasury yield.Private loans usually have worse terms than either type of federal loan, andinterest rates on private loans can change over time. Because most students havelimited credit histories, private lenders often require cosigners. The borrower isresponsible for paying the interest that accrues.
* The top 10 holders of government guaranteed loans (FFELP loans) in the third quarter of 2010were SLM Corporation, Nelnet, Wells Fargo, Brazos Group, JPMorgan Chase Bank, the Penn-sylvania Higher Education Assistance Agency, College Loan Corporation, CIT, PNC, and GoalFinancial. SLM Corporation had the largest market share (close to 60 percent), and each of theother institutions had under 10 percent of the market share.
also garnish the borrower’s tax returnsand benefits. Other costs of defaultingon one’s student loans include limitedfuture access to the credit market, sincethe borrower’s decision to default willaffect his credit score from the creditbureau. Evidence from bankruptcy fil-ers may give some sense of the order of magnitude of these costs. For instance,using data from the Federal Reserve’striennial Survey of Consumer Finances,Song Han and Geng Li find that bank-ruptcy filers are more than 40 percentless likely to have credit cards thancomparable households that did not filefor bankruptcy. If they do have cards,their lines of credit have far lower limits(by $12,000) compared with those whodid not file for bankruptcy. Moreover,bankruptcy filers pay higher interestrates (1.2 percentage points higher)than people who did not file.
With this theory in mind, we cannow turn to the empirical evidenceand discuss how and why studentloans outstanding and defaults haveincreased sharply and the implicationsfor the broader economy.
MORE TREND THAN CYCLERising Student Loan Balances.
The analysis here draws on the FederalReserve Bank of New York (FRBNY)/ Equifax Consumer Credit Panel data-set, a nationally representative randomsample of anonymized credit reportsfrom Equifax, one of three majorconsumer credit reporting agencies inthe U.S., containing borrowers’ ages,amounts borrowed, and repaymenthistories for bank and departmentstore credit cards, car loans, mortgages,home equity loans, etc.
Figure 1 shows the outstandingbalances for various consumer loans,credit card debt, auto loans, homeequity loans, and student loans. Notethat I omit first mortgages because,unlike the other loans discussed here,first mortgages are of much larger valueand collateralized.
Two observationsare worth noting. Student loans havebeen trending up since the beginningof our sample period (the first quarterof 2003), and they did not come downuntil very recently. By comparison,credit card debt and auto loans did not