One of the main reasons the entire debt-fueled house of cards propping the western financial system, hasn’t collapsed in a smouldering heap so far – a development that has stumped all those who think of the Reinhart-Rogoff sovereign debt matrix as one dimensinal with only debt/GDP as the key variable and completely ignoring the interest rate (manipulated or not) – is that the cash interest payment on the global mountain of debt has been rather tame, courtesy of all developed world central banks going all in with serial, or increasingly more, parallel monetization of debt. However, while the US Treasury has the benefit of the Federal Reserve (and its Primary Dealer tentacles) as a backstopped buyer of all the debt that’s fit to print, individual Americans are not as lucky. And as America’s massively overindebted student body may be about to find out, there is no surer way to burst a debt bubble than to send its rates soaring. Because unless Congress pulls off a miracle in the next 24 hours and passes legislation that delays an inevitable doubling of rates on the most popular Federal (subsidized) Stafford loans, the interest is set to double from 3.4% to 6.8%.
The argument isn’t over whether to allow the rate on the most popular type of federal loan to rise above 3.4 percent, the level set by law until July 1. It’s about how much borrowing costs will increase.
“The likelihood of students keeping the interest rate they had for the last two years is diminishing by the hour,” said Terry Hartle, senior vice president at the American Council of Education, the largest lobbying group for colleges and universities. “The outcome will be students will pay more than 3.4 percent in the short term,” he said in a telephone interview.
Unless Congress acts, the interest rate for subsidized Stafford loans, available to undergraduates from low-income families, will increase to 6.8 percent from 3.4 percent. More than 7 million students use that direct-from-Washington loan program.
Instead of passing legislation to extend that rate or set a new flat rate, lawmakers have been negotiating ways to let the rate float by linking it to the yield on the 10-year Treasury note.
Getting an informal agreement on the concept of flexible rates was the easy part. The more challenging part of the negotiations, according to those involved, has been figuring out how much flexibility to build in, and how much profit the government should extract.
Not pro bono credit-funded handouts? The democrats are up in arms at the merest thought.
Senate Majority Leader Harry Reid contends that there should be no profit at all.
“The issue is this: Republicans want deficit reduction,” the Nevada Democrat said June 25. “We don’t think there should be deficit reduction based on the backs of these young men and women who are trying to go to college.”
Complicating the talks is the more than 50 percent increase in the yield of 10-year Treasury notes, to 2.5 percent, since May 1.
Under a House-passed plan, that would have meant a student loan rate of 4.3 percent, rising to as much as 8.5 percent.
“It’s very clear students would be worse off under that proposal than simply allowing interest rates to double” because rates “would be lower initially but rise as interest rates rise,” said Pauline Abernathy, vice president of the Institute for College Access & Success, a nonprofit research and advocacy group in Oakland, California.
We’ll spare our readers the details of the gargantuan size of the student loan bubble: after all last February we were the first to christen it so (for details on why the severity and cumulative losses on student debt will end up being on par with or worse than those from the subprime crisis, read here). However, what can not be emphasized enough is that the massive debt load is providing an effective firewall for the economy to grow in a normal fashion as it encumbers young men and women with an unprecedented amount of liabilities before they have even entered the work force.
The share of 25-year-old Americans with student debt increased to 43 percent last year from 25 percent in 2003, according to the Federal Reserve Bank of New York. During that nine-year period, the average education-loan balance of people in that age group increased 91 percent, to $20,326 from $10,649, according to the New York Fed.
With so much outstanding student debt, borrowers are having trouble contributing to the U.S. economy in other ways.
It has become harder for young people, especially those between 25 and 30, to secure other types of credit, including home mortgages, according to a February report on household debt and credit by the New York Fed.
Economists warn that what is owed in student loans may rival home-mortgage indebtedness as a drag on U.S. growth.
“The difficulties borrowers face when trying to manage cash flow may have a broader impact on the economy and society,” Rohit Chopra, student-loan ombudsman at the Consumer Financial Protection Bureau, told the Senate Banking Committee on June 25. “When young workers are putting large portions of their income toward student-loan-payment payments, they’re less able to stash away cash for that first down payment.”
Private borrowing for student loans grew after Congress overhauled bankruptcy laws and made such debts non-dischargable in personal bankruptcy.
That change meant that “there were very few reasons for banks not to make educational loans to anybody who wants them,” Hartle said. “Most students who get in trouble by borrowing huge amounts of money get there because they have borrowed from private lenders” without the knowledge of their college or institution, he said.
What is worse, is that as the Fed recently discovered, “student” loans are used for anything but and “the Education Department has flagged 126,000 applicants attempting to pocket federal loans and grants without any intent of going to school.” Of course the ultra low rates on most loans and the non-existent eligibility prerequisites only make student debt that much more attractive of a fundraising option for students and criminals alike. But the end result is the same: very few will end up repaying their loans in full.
What kind of loans?
The most popular government loan is the Stafford. Subsidized Stafford loans are limited to students with lower incomes, and the interest rate is 3.4 percent, set by Congress. The government pays the interest during school. The interest rate will increase to 6.8 percent on new originations if Congress doesn’t act by July 1.
Any undergraduate, regardless of income, can get an unsubsidized Stafford loan at a rate of 6.8 percent.
The federal loan limits for undergraduates are $5,500 the first year, $6,500 the second year and $7,500 in the last years. Graduate students no longer dependent on their parents also can take out Stafford loans.
Another type of direct federal loan, called PLUS, carries a rate of 7.9 percent for graduate students and parents of undergraduates.
One can see why the 3.4% number is starting to look shaky with the 10 Year recently surging from 1.8% to 2.5% and rising. It may not look too good for congress if subsidized students can borrow money at a lower rate than the US. Not unexpectedly, the GOP controlled House has come up with a base + spread type formula for rate pricing: “On May 23, the Republican-run House passed Kline’s legislation, which would tie student loan interest rates to the 10-year Treasury note plus 2.5 percent. In the Senate, Reid tried to round up votes for a two-year extension of the current 3.4 percent rate and fell short of a required 60-vote supermajority.”
What’s worse for those hoping to preserve the status quo is that an extension of the current system appears out of the question: “Some Senate Democrats say they will try again for an extension — this time going for just one year instead of two, as was sought in the unsuccessful bill, S. 953. Independent Senator Angus King of Maine questioned that approach. “What will we know in a year that we don’t know now?” he said today.”
For now there is one possible option:
As July 1 draws closer, with Congress planning a break next week for the July 4 holiday, a bipartisan group of senators say they have come up with a possible breakthrough — a floating rate for Staffords, the 10-year Treasury borrowing rate plus 1.85 percent.
That proposal still has the deficit-reduction element that Reid opposes; it would pare the government’s red ink by $1 billion over 10 years, according to a statement from King, Democratic Senator Joe Manchin of West Virginia and Republican Senators Tom Coburn of Oklahoma, Richard Burr of North Carolina and Lamar Alexander of Tennessee.
Both Senator Tom Harkin, the Iowa Democrat who is chairman of the Senate Health, Education, Labor and Pensions Committee, and the panel’s top Republican, Alexander, predicted that the Senate would go home for the week-long July 4 break without acting.
Alexander, a former U.S. education secretary, said that if lawmakers can reach a consensus this week, Congress can return July 8 and approve the change retroactively.
And yet, even if this were to pass, one should perhaps ask: are continued low rates what is needed? After all the reason there is a $1 trillion student loan bubble is because of low rates. And the longer they are kept artificially low through subsidized schemes, the more painful the ultimate credit bubble pop. Only since the end-holder of the liability is the Federal Government, unlike in Europe which recently adopted a bail-in regime, in this case there will be no investors to punish.
Which only leaves the taxpayers footing the coast, as usual. But for now the stock market is soaring, debt is cheap, funding is plentiful, and all those who dare to warn about what lies beyond the horizon are squashed as alarmists and doomsayers. So be it: but it doesn’t change the fact that there is only one ending to this credit-bubble story, whether in student loans, in mortgages or in US government bonds, and it is not a happy one.