With the collapse of the housing bubble and corresponding financial crisis of 2008 occuring just six years ago as of this writing (2014), concerns over a bubble in higher education are beginning to emerge. It's amazing how many similarities there are between what happened in housing and what's happening in higher education. Considering the causes and outcomes of the housing bubble may help inform what might happen in higher education.
1. Same Players
The same "players" that were in the housing "game" are also in the higher education game: lenders, student loan borrowers, producers, and, perhaps the biggest, government.
In housing, the borrowers were home buyers. In higher education, the borrowers are students. In both cases, borrowers take on loans they can't afford to pay back. They become swamped with debt on assets that won't generate a return large enough to be able to pay off. "Owning" a house worth less than the mortgage is similar not earning enough to be able to pay off student loan debt.
Poor decisions were made by borrowers, in part because of being unable to value assets properly and/or forecast returns.
In housing, the producers were homebuilders. In higher education, the producers are schools.
Because of the abundant debt capital and corresponding demand, supplying a house or education seems attractive as prices continue to rise. However supplying the house or school means decreased supply of other goods or services. The reduced supply of other goods and services leads to an increase in price of other goods and services.
Schools, with poor cost management, are investing in fixed assets, not anticipating a declining price and revenue. If the prices decrease significantly they may be unable to continue to supply education, a service which our country needs. The reduced supply could prevent prices from dropping too low.
The government's role in the housing bubble of shouldering risk from lenders and encouraging or restricting lenders is similar in the housing bubble.
In the 1990s, the government encouraged banks to expand access to housing by reducing down payments and other risk reducing measures. Lenders' concerns were eased because two quasi-governmental agencies, Fannie Mae and Freddie Mac, were formed to guarantee the loans, reducing lenders' risk. Lenders could make loans, profit, and sell the loans to someone else where the government would pick up the proverbial "tab."
In 1996, the Department of Housing and Urban Development encouraged Fannie Mae and Freddie Mac to make more than 40 percent of their loans to low-income borrowers. Simultaneously, the Federal Reserve pushed interest rates to historically low levels, making mortgages cheaper, encouraging people to borrow money to buy houses.
In the case of education, the government is actually the biggest lender of student loans. In addition, the government is essentially subsidizing schools, by giving them tax breaks. The subsidization discourages competition which would help students. What seems like a noble objective, encouraging people to go to college, may actually be causing more harm than good as students take on debt to buy an asset that won't help them enough to be able to pay it back.
In both housing and higher education, lenders are "guilty" of lending irresponsibly, putting themselves at risk despite their services being necessary for the economy to function, and putting the government, the economy, and taxpayers on the hook. In the case of housing, because banks took on too much risk, when people began defaulting on their mortgages, there was a risk that they could lose their customer's reserves. In part to prevent a run on the banks and/or banks losing people's savings, the government announced the bailout, giving massive amounts of taxpayer dollars to banks.
Lenders, such as banks, are profit seeking entities. Having profit potential with loss potential encourages lending. In some cases they were actually forced by the government to make bad loans (such as laws requiring lending to low income families or with reduced down payments). In the case of higher education, the biggest lender is actually the government.
2. Excess Capital
In both housing and higher education, easy access to debt capital at low rates and with lax borrowing requirements, encourages borrowing to purchase assets, which increases prices. In both cases, banks are essentially ensured by the government and it's taxpayers, incentivized to make risk loans, and/or prevented from refusing to make risky loans. In additon, interest rates set by the Federal Reserve are at record lows.
3. Universal Belief
Per the definition of an economic bubble, bubbles are often created as a result of a universally held belief about an asset's value.
In housing the belief was something along the lines of "I have to buy even if I can't afford it because owning house is the american dream and it's a great investment because prices will always keep going up." The fact that amateur investors ("average people") were "flipping" houses was a sign that there was a near universal belief about housing prices.
In higher education, the belief is something along the lines of "I have to get a college degree, regardless of the cost, because a college degree is the only path to prosperity, and I won't be able to succeed without it." The fact that if you tell the average person not go to college they look at you like a crazy person is a sign that there is near universal belief about higher education.
4. Overvalued Assets
The combination of readily available debt at low interest rates with a universally held belief about the value of the underlying asset leads to significant increases in price. In the cases of education, the degree can become overvalued if the abundant capital and universal belief lead to more people graduating from college and entering the workforce. The additional supply of graduates, leads to a decrease in price (wage) if there is not a correlating increase in demand for labor.
In the case of a degree, it can't be re-sold the way a home can. In addition, a degree only has value (in the form of increased wages) because employers (the parties paying those wages) believe it does.
5. Weak Lending Standards
Just as mortgage lenders lead borrowers to think they could afford a house way outside their price range, student lenders and schools tout the promise of more job opportunities and higher wages. Lending standards for student loans may even be lower than mortgages.
In housing, borrowers often had to pay a certain percentage the price of the house as a downpayment. Borrowers also often had to show a history of employment at compensation sufficient to pay back the mortgage. Students do not have to pay any down payment, and do not have much history of employment. The lack of down payment leaves lenders with even more risk on the table.
Just as mortgages were being securitized into mortgage backed securities, student loans are being securitized into student loan asset backed securities (SLABS). Securitizing loans can be a good way for lenders to reduce their risk.
However, if too many of the securities are not owned by the lender, the lender can be less careful about their lending practices because their returns are less correlated to the borrower's ability to pay back the loan. In addition, if an investor, such as a bank, allocates too much of their capital to the securities and the underlying loans default at higher than expected rate, it could cause harm to the investor, and therefore impair the investor's ability to make other investments that spur economic growth.
7. Poor Ratings and Risk Assessment
During the housing bubble, many investors and ratings agencies did not properly assess the risk of default in mortgage backed securities. There may be similar problems with student loan asset backed securities.
Student loans are often based on credit score rather than a borrower's ability to repay. Evaluating the credit score of someone who hasn't entered the workforce, won't for at least four more years, and with unemployment as high as it, may not make for the best assessment.
Many student loans have co-signors. These co-signors, such as parents, often have higher credit scores than their children. Therefore the credit score may not properly reflect the ability of the actual borrower to repay the debt.
8. Large Market Value
According to Fiscal Times, the mortgage backed security market reached about $7 trillion, while the student loan asset security market has topped about $2.6 trillion.
While the student loan market may not be as large as the mortgage market, it's still very large, especially in an already fragile economy that's still recovering from the housing bubble.
Housing had and higher education has a long history of providing a strong return on investment. College graduates have historically earned more than high school graduates. Housing provided great investment returns for years, as housing prices actually did continue to rise for many years.
However, investors in both degrees and houses may fail to consider that the past is not always an accurate predictor of the future. At some point the rising price of education offsets the increased earnings potential, especially if earnings potential declines because of an increased supply in the number of graduates. Similarly, in housing, once a significant number of investors have their money in housing, there's not much more money left on the sidelines to continue to raise the price.
The housing bubble had significant and prolonged effects on many aspects of the economy. There are many similarities between the housing bubble and the higher education bubble. Analyzing the housing bubble may help us inform best actions for the higher education bubble. Higher education could actually be worse than housing.
Follow Michael B. Fishbein on Twitter: www.twitter.com/mfishbein