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Student loan ‘earnings’ show government should get out of student loan business

This week Shahein Nasiripour at The Huffington Post reported on the huge projected profit from the government-run student loan program. The article mainly focuses on whether the government is wrong to profit from student loan money and whether these projected profits could be used to reduce the interest rates charged to students. A better view of the situation, however, is offered by Jordan Weissmann on at Slate, Who pointed out that most of the projected profits over the next decade will come from graduate student loans. Realizing that it is doctors, lawyers and MBAs who will produce these benefits puts things in a rather different light. However, the relevant point is that all of these issues are only being raised because the government has become involved in what should be a private sector undertaking.

According to the latest CBO projections, the federal government will earn about $127 billion over the next ten years from its newly acquired role as the direct provider of most student loans. The distribution of these profits (CBO makes you do the calculation from tables which are here) accounts for about three-quarters of graduate student loans, one-quarter of parent loans, and a slight loss of undergraduate student loans. The reason for the difference is that undergraduate students who meet federal limits on family income and assets are eligible for subsidized student loans. This means that even after giving out unsubsidized loans to undergraduate students, the federal government is close to breaking even on all undergraduate loans given out.

These latest figures show exactly how difficult it is for the government to get involved in the student loan business. The basic argument for government involvement is that the private sector will not lend money to students because their future earnings and therefore their ability to pay are too speculative. This led first to the government providing guarantees to private lenders, then to President Obama’s administration cutting out the middleman and making the loans itself.

However, the CBO figures seem to offer evidence that the private sector may be more interested in this market than big governments think. After all, the need to take out high-risk loans and pool them together to reduce overall risk in a credit pool is exactly what modern financial institutions are designed to do. Potential profits of $12-13 billion a year is enough to get a lot of people interested in a business opportunity. Yes, individual student loans can be risky, but thousands of them should be much safer.

I can already hear the howls about how the idea of ​​bundling subprime lending has worked in the mortgage market, so before everyone shouts too much about it, note that this is rather different. House prices have plummeted, leading many people to voluntarily stop paying. If student loans retain their bankruptcy-protected status so that borrowers have to pay them back (or try to) no matter what, there is less risk than with mortgages. Moreover, it seems highly unlikely that the entire pool of student borrowers will lose their jobs at the same time.

In addition, many of the mortgage-backed securities bundled sub-prime mortgages with other sub-prime mortgages. Financial institutions may have learned enough to bundle riskier student loans with safer student loans (like medical student and parent loans). They will certainly do so if the market, that is, the people who are going to buy these packages, demands it. For example, there are many credit card companies that can raise funds to lend to risky cardholders.

Also, who cares if these loans or groups of these loans would be risky or if the lenders could lose money? Investors and lenders lose money on risky investments all the time. They do this assuming that on average they will make money. This is how both the stock market and the credit markets work. The question is not whether some people will lose money from time to time. The question is whether people will be willing to enter this market and lend money to students.

Graduate students and parents are certainly potential borrowers for whom lenders can easily assess creditworthiness. Undergraduate borrowers would be more difficult as their credit history is short to non-existent, but I suspect lenders could create reasonable credit models based on school, major, and a few other characteristics.

Would some people be denied student loans under a private system? Yes, some surely would. Is this a bad thing? Probably not. After all, the current system allows the government to lend people money without considering the likelihood that they will be able to repay the money. Curiously, the federal government now requires mortgage lenders to ensure that borrowers repayment capacity their mortgages, but it does not impose a similar requirement on the student loan market.

Are student loans different in that we should allow borrowers to take on debt that they cannot afford? I do not think so. If some students cannot borrow money for college because they will likely be unable to repay their debts, the student is probably better off without the loan. If such a system means that some students are encouraged to study a subject that is supposed to generate income after graduation rather than one that is not, society will not only survive, but it will probably benefit.

An argument can be made that the government provides a good or service when society demands it, but the economy is such that the free market cannot provide it. Usually, these cases are where no profit can be made from the activity. If government can take advantage of student loans, so can the private sector.

Rather than asking the government to lower interest rates to eliminate the profits, we should be asking the government to get out of the student loan business and let the investors earn the profits. For the federal government to operate a business for profit in order to subsidize other activities simply does not make sense.

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