You saw Obama slow-jam the news, right? Ha, funny, he’s the President. But what was he talking about?
Obama has asked Congress to block a proposed doubling in the rate of interest on US “Stafford” student loans. These subsidised public loans make up a significant proportion of US student debt – over a third in 2011.
The President’s intervention is electioneering, and he stands no chance of blocking the vote. The Republicans control Congress, this will pass, and the rate of interest on these loans will increase from 3.4% to 6.8%. We have no way of knowing whether Obama would actually block the increase if he were able to, so let’s not dwell on it.
Obviously, this is a pain for US students. But it’s also likely to have unintended consequences: it could speed up the coming of another global financial crisis. This is because the US student debt situation is starting to worryingly resemble the US subprime mortgage housing crash that tipped the world into the 2008 crisis.
The US student loan situation is unsustainable, and it’s increasingly clear that the mounting pile of debt will never be paid back. The proportion of borrowers defaulting on their loans in 2009 hit 8.8%, the latest figures we have. This was up from 7% in 2008.
For comparison, default rates in the US subprime mortgage market topped out at 21.9% at the 2007 peak of the crisis, up from 7% in 2002. But even in 2007 the safer prime mortgage loans maxed out their default rate at 4.8% – student loans have gone way beyond that. While student loans aren’t quite at subprime level yet, they’re also not in a completely different ballpark, which is worrying.
These numbers are relevant because the subprime crisis was triggered by defaults reaching an unsustainable level. What the US Congress is about to do in doubling the interest rate on a third of all loans is make it a lot harder for people to pay back their loans, increasing the rate of default further. If the market is driving itself off a cliff, this is like putting your foot down on the accelerator pedal.
This is against a backdrop of falling US real wages – a 2% fall in 2011 – and so reduced means of paying back loans. And of course, US tuition fees are soaring, with inflation busting fee rises of 4.6% a year on average, meaning the gap between the cost and the ability to pay is rising. That can only drive the default rate up further.
The US student loan market is estimated to have $757 billion of outstanding loans. This is under half the size of the 2007 subprime mortgage market’s $2 trillion, but again, it’s not a completely different ballpark, it’s bigger than the total US credit card debt, and it’s growing at about $112 billion a year.
But if the market goes nuclear, there’s a big difference between the student loan book and the subprime book: the vast majority of US student loans are underwritten by the US government, with only 7% coming from non-federal sources. If borrowers default, the state pays – an automatic built-in bailout. The good news is this means it would be difficult to see how private financial institutions could collapse if out of control defaulting started, which means financial market shocks like the Lehman Bros. collapse aren’t as likely.
But someone has to pay. The entire US federal budget deficit for 2013 is $901 billion, with total expenditure of $3.8tn. A hypothetical mid-decade market worth $1.5 trillion with a subprimesque 20% default rate would be a very big deal indeed.