Credit where credit is due – kudos to the House for passing. Here’s Derek Thompson on the bill:
The House of Representatives voted today to pass a bill that effectively kills private lenders in the student loan market. That might sound terribly disruptive, but most of these student loans have always been backed by the government in the case of default and so the House essentially voted to cut out the middleman — banks who were profiting from zero-risk student loans. This law is without question good for the the federal government, which stands to save $87 billion in the next ten years, and for low-income students who will likely reap the dividends.
I want to focus in on the government backing. Let us remember our Fischer Black on risk – a loan consists of 3 people: one provides the money, one takes a loss or a gain (in other words, risk) on the interest rate, and one takes a loss or a gain on whether it gets paid back (default, or credit risk). Usually those are the same person; with derivatives we can split it off.
Now right now, the government back 97% of the credit risk of a student loan. Which is to say, they have written a CDS contract for every English major with a private student loan – they have absorbed all the credit risk. The problem with students loans is that there is no recovery – you can’t send Emilio Estevez to repo man someone’s undergraduate education and sell it at auction, like you can do with a house or a car. Because of this, the credit risk and this non-recovery should be the biggest driver of the rate and the taxpayer absorbs that risk. If the interest rate is variable on a private student loan, which it often is, then that interest rate risk is negligible – it is held by the borrower (or it can be hedge in private markets). So the only thing left is the cost of funds. A private student loan should be very cheap, yet they tend to be expensive. Something has gone wrong in the process.
In so much as the wave of financial deregulation has been an experiment, this is one part of the experiment that has failed. Rather that diffusing risks and making things cheaper, it has been hijacked into a situation where private lenders get all the upside and the taxpayer gets all the downside.