By Mitchell D. Weiss
If insanity is defined as repeatedly doing the same thing and expecting a different result, the student loan interest rate throwdown that's about to be reprised in Washington, D.C., warrants an intervention.
You may recall that at this time in 2012, Congress was in a lather over the subsidized student loan interest rates that the feds make available to financially needy students. The deficit hawks argued the program costs taxpayers some $6 billion annually. So as part of the deal that was cobbled together at the 11th hour to prevent the rates from doubling, those billions were extracted, in part, from the same consumer-learners who the program was intended to assist in the first place -- by eliminating the six-month interest-free grace period after students graduate until their first loan payment is due.
As it turned out, there were 33 billion reasons (the estimated dollar amount the Dept. of Education expects to earn from student loans in the 2013 fiscal year) why this was a false contention, as all hell broke loose once a Congressional Budget Office memorandum revealed how profitable the program actually is.
The New Calculation Method, Under a Microscope
So after the recriminating articles and caustic blog posts, the White House weighed in with a proposal to spend some of those profit dollars on grants, along with a scheme to reconstitute the manner in which student loan rates are calculated.
The administration proposes pegging the interest rates for 10-year student loans to the yield of the 10-year Treasury note, plus the following upcharges: 0.93% for subsidized Stafford loans, 2.93% for unsubsidized loans and 3.93% for parent and graduate student PLUS loans. Therefore, if the 10-year Treasury note yields 1.75% in today's market, subsidized Stafford loans would run 2.68%, unsubsidized Stafford's 4.68% and PLUS loans 5.68%---clearly better deals than what's currently in place for each.
However, the proposed methodology is misleading because it's not the way financial transactions are priced in the real world.
As I explained in an earlier post, a lender's cost is based on a given transaction's so-called half-life. So, in the case of a student loan that's structured to be fully repaid over a 10-year period, the half-life would be five years, in which case the government's cost would correspond with the five-year Treasury note.
Although it may sound as if I'm quibbling about a bunch of calculator keystrokes, bear with me because this really is a big deal. Here's why.
Today's yield curve is positive -- which means it costs more to borrow money for 10 years than it does for five. At .75% for a five-year yield, the government's true cost in today's market is more than 1% less than the proposed student loan index implies. Therefore, its spread (which is finance industry-speak for profit margin) isn't 0.93% for subsidized loans, it's actually more than 1.93%, and 3.93% for unsubsidized loans and 4.93% for PLUS loans.
What do all these interest rates and spreads mean? A boatload of profit.
The 2.68% subsidized loans would yield a 9.9% gross profit in today's dollars, the 4.68% unsubsidized loans would yield 20.8%, and the 5.68% PLUS loans would yield 26.5%. (For those who care to track my math, I calculated the loan payments for each interest rate scenario on the basis of a 120-month term loan and then discounted those values at the government's 0.75% cost of funds across the board.)
So, for the $33 billion of new loans the CBO projects will be made in 2013, if all were subsidized (which won't happen), the government would earn $327 million for its trouble, $686 million if all were unsubsidized and $874 million if all were PLUS loans.
Look, it's a lender's prerogative to charge whatever rate it wants. However, in this case, a more meaningful debate would center on whether the government is in the student loan business altruistically or exploitatively. And if altruistically, how much profit does it really need to make in order to cover its costs? (Per Senator Elizabeth Warren's recently introduced bill, the answer is "near-zero," as the rate she proposes is equal to what the Federal Reserve currently charges its member banks, which also happens to be equal to the yield of the aforementioned 5-year Treasury note.)
A Smarter Way to Lend
If we're going to talk pricing, shouldn't we also have a discussion about credit underwriting criteria so that we're not lending more to our children (and their parents) than they'll ever be able to repay?
Look at the repayment term. Is 10 years a reasonable duration for debts that can be as large as mortgages? Shouldn't the standard be moved to 20 years or more so the loan payments won't end up crowding out other borrowing for, say, cars and houses, as the Consumer Financial Protection Bureau points out in its recently published Student Loan Affordability analysis?
And what of the deferment period? Shouldn't we also talk about requiring interest payments while the students are still in school? The dark side of deferments (and forbearances, for that matter) is in the negative amortization that ensues, where the unpaid interest is added to the principal amount, on which more interest is then charged.
In fact, why are we even spending so much time jawboning pricing for $33 billion of 2013 loans when we've done little more than tinker with and whine about the $1.1 trillion debt debacle that's affecting many million more borrowers?
Take the recent letter of the Consumer Bankers Association (advocates for the retail banking industry) to the U.S. Comptroller of the Currency and chairmen of both the Federal Reserve and Federal Deposit Insurance Corporation (FDIC). In this letter, the CBA asks that its constituents be granted permission to offer graduated and interest-only repayment plans to their student loan borrowers. The CBA also asks for regulatory relief from the so-called Troubled Debt Restructure (TDR) designation that its member banks claim is impeding their ability to help their financially distressed customers (an issue that's also raised in the CFPB report and elsewhere).
First of all, while graduated plans will help to make larger payments more affordable in the short run, unless the durations of the underlying loans are also extended, borrowers will soon find their principal balances will have increased in size because of the negative amortization. Their future loan payments will also be higher than they were originally.
Second, the TDR issue is a smoke screen. I say that because when push comes to shove, lenders are responsible for the decisions they make. However, in this case, they are attempting to trade the financial consequences of their own mistakes for an offer to do what they should have been doing all along: restructuring the loans in a way that helps distressed borrowers with their payments.
A Better Solution
If we are truly serious about solving a problem that threatens the financial health and welfare of a generation of consumers in our consumer-driven economy, then consider the following suggestions.
Expand the government's relief programs so that all education loans --- public and private alike --- are eligible.
Yes, this expansion of government largesse won't come cheap, which is why the cost should be shared by all those who are responsible for this financial fiasco.
To start, the government's present-day relief programs (which are currently limited to federal loans) calculate repayment amounts on the basis of discretionary income: the difference between the poverty line and total household income. Once this program is opened up --- hopefully, with streamlined approval and documentation process --- a simpler and more effective way of going about that would be to reset the payment amount to 10% of pretax household income for up to 25 years.
A fundamental precept of good personal financial management is limiting debt payments to no more than 25% of pretax income. Therefore, allocating 10% of that 25% to education loans would leave 15% for other borrowing, spending and saving.
As for the financing for this expanded program, the debt the government would incur in due course would be self-liquidating (that is, money borrowed to finance the loans would be offset by the borrower's repayments) and the administrative costs would presumably continue to be handled as they are today: via upfront fees that may be added to the borrower's loan amount.
When it comes to the costs that are associated with payment delinquencies and defaults, however, these should be covered by a special-purpose government fund, one that is financially underwritten by the private lenders (the same ones that have benefitted from the high rates they've long charged for loans that are as bankruptcy-proof as the lower-rate alternatives the government offers on a direct basis), and also by the schools (those that blithely channeled their student borrowers toward the various loan programs without concern for their longer-term financial well being).
The private lenders' contributions can take the form of loan principal discounts to be determined by reconciling private loan rates with those the government offers within the context of its own relief programs. The level of the schools' financial support can be pegged to their individual cohort default rates, which would have the added benefit of encouraging a more judicious approach when it comes to counseling students on the long-range implications of the financial and academic decisions they're asked to make.
Reform the loan servicing process.
Lenders -- government and private alike -- are outsourcing their payment collection activities to private loan servicing companies. However, not only are these subcontractors failing to adequately address legitimate consumer issues, the incentive programs are warped. Reportedly, these folks earn bonuses for remediating defaulted accounts when they should instead be held accountable for failing to prevent the negative migration of delinquent payments in the first place. Drawing from my own lending experience, borrowers who miss one or two payments often can be brought back to current status. Those who miss three, four or more, however, are less likely to recover. Appropriately designed loan servicing incentive programs guard against this kind of slippage -- deliberate or otherwise.
Reform the bankruptcy laws, tax code and assist in the rehabilitation of personal credit.
As I mentioned before, private lenders enjoy the same protections against the easy discharge of student loan debt as does the government, thanks to their successful lobbying efforts. This needs to be undone, if only to encourage the peaceful transfer of private loan balances -- including those that have been securitized -- into the government's relief programs.
Regarding the tax code, just as it was modified to exempt the taxable gains on forgiven mortgage debts during the housing crisis, so too should it be revised to accommodate those whose unpaid student loan balances may be forgiven over time.
And finally, when it comes to the damage done to personal credit, it would help if the clock were reset after a student loan is restructured or modified, rather than having the event itself continue to negatively impact credit scores and the opinions of future lenders. Going forward, however, it would then be up to the student borrower to faithfully adhere to the reconfigured loan's terms and conditions.
This article originally appeared on Credit.com. Mitchell D. Weiss is a contributor to Credit.com, experienced financial services industry executive, entrepreneur and adjunct professor of finance at the University of Hartford. He is also the author of the recently published College Happens: A Practical Handbook for Parents and Students, Life Happens: A Practical Guide to Personal Finance from College to Career-2nd Edition, and Business Happens: A Practical Guide to Corporate Finance for Small Businesses and Professional Practices.