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CFAMAGAZINE
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NOV–DEC 2011
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HIGHER EDUCATION 
is perhaps the world’s leastcontroversial subject. Everyone agrees that it’s good forboth the individual and society, and virtually every govern-ment subsidizes it in one way or another.Lately, however, the U.S. model for delivering andfinancing higher education has come under intensescrutiny. Costs and related debt continue to soar whilegraduates default on student loans in record numbers.Could college education, like homeownership in theprevious decade, be a social good that becomes a liabilityif managed and financed unwisely? And does the resultingdebt pose risks to the stability of the financial system?Put more bluntly, is U.S. student debt a bubble that isdestined to burst like tech stocks and housing?
Washington Takes Control
The concept of student aid in the U.S. dates from the 1840s,when Harvard University began subsidizing its students’tuition. But things really got rolling after the Second World War with the enactment of the GI Bill, which financed theeducation of returning veterans of that war as well asother subsequent wars. In the 1970s, nearly three-quartersof Vietnam veterans paid for their education this way.Around the same time, the federal government begansubsidizing and regulating loans made by commercialbanks directly to students. Washington decided whoqualified and what interest rates students would pay andindemnified lenders against default. The result was a hugelyprofitable, nearly risk-free business for commercial banksand specialized lenders, such as Sallie Mae and Nelnet.This asymmetry of risk and reward rankled lawmakers,leading Washington in 2007 to halve the interest rate onsubsidized Stafford Loans (the main type of student loan)and scale back a host of other bank benefits. Banksresponded by partially withdrawing from the market, andin a legislative rider that was quietly attached to majorhealth care legislation in 2010, the U.S. Department of Education (ED) cut the banks out altogether and beganlending directly to students.This is where the story gets interesting. Because theED can borrow at low Treasury bill rates, student loans area hugely profitable business for the government, withhigher volumes producing higher earnings. As a result, themaximum loan amount available to students continues toincrease, with no end in sight. For the 2009–10 academicyear, the College Board, a higher education industry tradegroup, estimates that total federal student aid (includinggrants) was approximately US$147 billion, a 136 percentincrease over the past decade, with new loans (notincluding grants) accounting for the bulk of this growth(see
Figure 1
).Viewed charitably, the result is one of those rarewin–win bureaucratic scenarios in which a governmentagency can further a laudable goal—higher education—at no cost to taxpayers. Viewed cynically, the result is adaisy chain of moral hazard in which lending can soarwithout regard for the quality of the product it buys or theability of the borrowers to pay it back.
Rising Tuition
This steady increase in the availability of government moneycreates an attractive business environment (or, dependingon how you look at it, a license for unchecked growth)for colleges and universities. Because students are able toborrow more each year, schools can raise tuition at asimilar rate, safe in the knowledge that their customershave access to the necessary funds. As a result, growth of tuition and fees at private, not-for-profit U.S. colleges anduniversities has consistently exceeded the rate of inflation.“They’ve had amazing pricing power. How many businesses
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are able to raise prices for decades at significantly aboveinflation?” asks Vikram Mansharamani, Yale Universitylecturer and author of 
Boombustology
:
Spotting FinancialBubbles Before They Burst
.The result of this long-term compounding is striking. Within the University of California system, for example,average tuition in 1990 was US$2,000, which representedabout 6 percent of the state’s median household income.Today, the average tuition is US$10,000, which accountsfor 17 percent of median household income.
Soaring Debt
Combine a government that profits from lending to students,schools that profit from raising tuition, and students whobelieve a college degree is worth virtually any price, andthe result is a self-reinforcing cycle of increasing loanavailability begetting rising tuition begetting soaring studentdebt. U.S. students have incurred US$300 billion in newdebt since 2006, with the burden growing by 10 percentin the past year alone. Student loans have surpassed creditcard balances (US$830 billion versus US$825 billion) asthe second largest category of consumer debt, behind onlyhome mortgages.Today, says Mark Kantrowitz, publisher of financialaid-oriented websites www.finaid.org and www.fastweb.com,“the average debt at graduation is around US$27,000, notcounting parent-plus loans [which parents assume to coverexpenses beyond available student loans]. With them, it’sUS$34,000.”Meanwhile, private loans (offered by banks to studentswho need more than the US$20,000 annually the govern-ment is currently willing to lend) are growing at double-digitrates. These loans generally carry higher, variable rates,and though interest payments are deferred until six monthsafter graduation, they accrue from the inception of theloan. “So there’s a lot of negative amortization going on,”says Kantrowitz. The result: graduates with private loansend up owing considerably more than they spent on tuition.He estimates that US$160 billion of private student debtis currently outstanding.
Diminishing Ability to Pay
Even in good times, soaring student debt would be anominous trend. But for recent and prospective collegegraduates, these are not good times. Since 2000, the realcost of college is up by 23 percent, yet the real earningsof college graduates is down by 11 percent. And unem-ployment among recent graduates is high and stubborn. Whereas graduates in 2006 and 2007 had a 90 percentlikelihood of holding a job by the following spring, only56 percent of 2010 college graduates were as fortunate.Delinquencies and defaults, as a result, are soaring.According to the ED, 8.9 percent of federal student loanborrowers who entered repayment between 2008 and 2009had defaulted by the end of 2010, up from 7 percent theyear before. And default rates understate the real extent of the problem, according to a March 2011 report by theInstitute for Higher Education Policy, a Washington, DC,think tank, which found that only about 37 percent of borrowers from the 2005 cohort managed to make timelypayments. “Default rates do not include the many borrow-ers who become delinquent on their federal educationloans, but manage to avoid default,” states the report. “Itis important to note that for every borrower who defaultsthere are at least two others who were also delinquent ontheir student loans, but successfully avoided default.”The more recent the graduation, the worse the situa-tion, says Richard Arum
,
professor of sociology andeducation at New York University. “We’re following thekids who graduated in 2009, and a year after graduating,31 percent were living with their parents. They couldn’tfind jobs and are highly indebted.”Meanwhile, even in default, this debt doesn’t go away.The Bankruptcy Abuse Prevention and ConsumerProtection Act of 2005 declared that student debt cannotbe discharged in bankruptcy and gave the U.S. IRS thepower to garnish wages and withhold tax refunds to getwhat the ED is owed. Missed payments are simply addedto principal, so failure to pay results in a higher balancewhen and if a borrower lands that elusive well-paying job.The current lack of job openings is no doubt thebiggest reason for the surge in student loan defaults. Butthe economy is apparently not the only problem. First,says NYU’s Richard Arum, Americans’ belief in the eco-nomic value of a college degree has been inflated by anunusually positive recent past. “There’s always been areturn to college, but this was especially true between1980 and 2008, when a credential was quickly and easilyrewarded with a good paying job.”So while a college education remains a valuable asset,the widespread assumption that any amount of tuition-related debt is acceptable because the returns will morethan compensate is misplaced. “The bottom fell out in2008, and I don’t think it’s coming back,” says Arum.Even more ominous, “Large numbers of students aregoing through university without really improving theirhuman capital. They’re not coming out any more produc-tive than they went in,” says Arum. A study conductedby Arum and University of Virginia sociologist Josipa
Figure
1
U.S. Federal Education Lending
US$ BILLIONS
SOURCE 
: BASED ON COLLEGE BOARD DATA 
42.545.651.358.162.263.964.97184.896.8
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
 
O
n the surface, the similarities between U.S.higher education and the recent housing bubble are compelling: A universally desiredgood is dangled in front of an ever-growing population of borrowers at ever-higherprices and paid for with government-subsidized easy money—resulting in rising debt and deteriorating outcomes.But is it actually a bubble, with all the future turmoil thata bubble implies? Vikram Mansharamani has conducted a moresystematic analysis, viewing the higher education/studentloan market through five lenses:Microeconomics.Normally, price is determined through theinteraction of supply and demand. A rising price depressesdemand and stimulates supply, leading to a stable or lowerprice, and vice versa. But in a bubble, “you have a reflexivedynamic in which price and demand rise at the same time. Withhigher education, tuitions are up dramatically but enrollmentkeeps rising. We seem to have one red flag,” saysMansharamani.Macroeconomics.“Credit market dynamics [in the form of student loan availability] are clearly supporting higher prices.Federal financial aid has risen almost exponentially in the lastcouple of years.” This, says Mansharamani, recalls “theembedded financial instability hypothesis as described by[former University of California professor] Hyman Minsky. Hetalks about a migration of credit supporting prices that movesfrom hedge financing to speculative financing to Ponzi financing.Over time it takes more and more debt to support that sameasset price. [In education], credit volumes are rising even morerapidly than prices, so an increasing amount of educationspending is supported by debt. That’s red flag number two.”Psychology.In a bubble, participants display “overconfidence,hubris, an almost religious belief in something.” Today, asMansharamani sees it, the idea that a BA is a good thing hasmorphed into the belief that “going to www.diplomamill.eduand getting an online degree in massage therapy forUS$50,000” is a smart career move.Political Support.Mansharamani asks, “Has the governmentgotten involved and created a sense of moral hazard or pricemanipulation? Is there a philosophical or value-based belief that’s driving the politics of funding?” The similarity to thehousing bubble seems eerie. “We once believed that housing was a right that every American was entitled to; we nowbelieve the same thing about a college degree,” he adds.From this perspective, the ED’s uncritical granting of loans for virtually any type of higher education echoes the CommunityReinvestment Act, the rise of Fannie and Freddie, and thesubprime mortgage market.Biological.“Think of a speculative mania as a fever spreading through a population. How many people are left to infect? If taxi drivers are talking to you about internet stocks, it’s not agood time to buy. When the topic becomes such a broad andpervasive element of popular discourse and starts attracting the marginal participants to the party, it’s usually a late-stagephenomenon,” explains Mansharamani. “The for-profiteducation sector indicates that we’re now going after peoplewho may not be appropriate, though the pervasiveness of thisproblem is not yet clear.”His verdict: “I see 4.5 out 5. It’s bubbly, and it’s probablyoverpriced generically. People should be willing to pay a lotmore for a brand name than for an unknown school, but youdon’t see as much price disparity between the top- and lower-level schools as you might expect.”
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Roksa found that 45 percent of U.S. college students showno significant improvement in critical thinking, complexreasoning or writing by the end of their sophomore years.
Systemic Risk for Taxpayers
 With the government now the main provider of studentloans, the securitization flow has diminished. Nonetheless,private student loans from such lenders as Sallie Maeand Discover are still packaged into bonds (known asstudent loan asset-backed securities or SLABS) and sold toinstitutional investors. SLABS worth US$10.6 billion werecreated in 2010, with a similar amount expected for 2011.Perhaps due to the recent credit market turmoil,“Credit quality in the private loan portfolio has improvedmarkedly. The overwhelming majority of private loansnow require co-signers,” wrote Alex Sellinger, an analystwith New York City investment bank NewOak CapitalAdvisors, in a recent note to clients. “As a result, privateloans—which require a private lender’s credit approval asopposed to the automatic disbursement under [federalstudent loan programs] for qualifying borrowers—mayperform better than federally guaranteed loans.” Thus, aSLABS meltdown does not appear to be imminent.Longer term, however, the full-recourse featuremight actually become a liability. “Unlike their housing-bubble counterparts, [U.S. student borrowers] havecommitted to a loan that they have to pay off no matterwhat. No dropping off the diploma at the universityadministration office and walking away from their debt,”says Massachusetts venture capitalist and author Eric Janszen. “College students are facing the worst employ-ment market in decades. I expect they’ll band together todevise a way to not repay.”Does this scenario present systemic risks? Privateloans and their asset-backed securities are certainly prob-lematic if borrowers demand a bailout en masse. But thebulk of outstanding student loans carry a governmentguarantee, so a mass default would mostly bypass thesecurities markets and land directly on the federal balancesheet, producing yet another increase in general taxpayerliabilities. Whether this development would be decisive inthe overall scheme of U.S. finances is anyone’s guess.
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