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Image: Rogert Blackwell

How Students Are Forced to Prop Up the Education Bubble

If there was going to be major action to reduce the $1 trillion in student debt—or at least the rate at which it’s increasing—it probably should have happened by now.

The conventional wisdom going into the election was that President Obama and the Democrats would have to galvanize the youth vote if they wanted a repeat of 2008. With nearly 20 percent of families, and 40 percent of young families, owing a slice of the education debt, the issue affects a large and growing constituency. And because existing student loan policy is so anti-student and pro-bank, Democrats could have proposed a number of commonsense, deficit-neutral reforms, even reforms that would have saved the government money. The stars were aligned for a major push.

Remarkably, it didn’t happen. Instead we saw dithering, half-measures, and compromises meant to reassure voters that politicians were aware of their suffering and that something was going to be done. The moves that were implemented did not address the core problem: the amount of money debtors will have to pay. For example, President Obama claimed credit for delaying a doubling of interest rates on federal loans from 3.4 to 6.8 percent, while, at the same time, ending interest grace periods for graduate and undergraduate students. The first measure is temporary and is expected to cost the government $6 billion; the second is permanent and will cost debtors an estimated $20 billion in the next decade alone. Despite his campaign rhetoric, President Obama has overseen an unparalleled growth of student debt, with around a third of the outstanding total accruing under his watch.

Neither major party offered a credible plan to reduce the student-debt burden. While Obama assured voters (“Let me be perfectly clear . . .”) that he understood the importance of supporting students who wanted to go to college, the Romney campaign spouted free-market platitudes. The real difference between the two sides was ultimately more about who debtors would owe—the Treasury or private lenders—than about how much. Not a single policy proposal on the proper scale was offered, and so the true size of the problem fell out of the national debate. Obama won reelection with a smaller majority than in his first election—the first time that has happened to an incumbent president since 1944—and the Republicans retained control of the House of Representatives.

There’s nothing accidental about a student debt discussion that veers between insubstantial and nonexistent. An intricate web of government and financial interests and the laws that protect them have kept the fixes cosmetic while allowing the outstanding total to grow. Policy failures reveal the conflicts of interest that characterize the day-to-day business of governing and unmask the incentives that reduce “hope” and “change” to advertising copy. The challenge of student debt, like climate change and other urgent needs, threatens to exceed the capacity of our current political and economic systems.

• • •

Shortly after taking office in 2009, President Obama demanded an end to the Federal Family Education Loan Program (FFELP), which guaranteed student loans made by private industry. Funding loans through middle men meant that the government was paying a premium on credit it could be funding directly.

“Well, that’s a premium we cannot afford—not when we could be reinvesting that same money in our students, in our economy, and in our country,” Obama said.

He got his wish with the 2010 passage of health care reform, which included the cancellation of FFELP as a cost-offset. However, the step was not retroactive, and by that time, the damage had already been done: students had taken on crippling debt from private lenders that they had little prospect of repaying, thanks to the moribund job market in the wake of the financial crash.

Enter Senator Sherrod Brown of Ohio. The Democrat proposed the Student Loan Debt Swap Act, which would allow students caught in the old lending scheme to move their debt into a direct deal with the federal government, which would in turn pay off the private obligations ahead of schedule. When officials at the Congressional Budget Office scored the 2009 version of the bill, they found it would save the government more than $9 billion in lender subsidies and payments.

Yet Senator Brown’s bill failed in the Committee on Health, Education, Labor, and Pensions and has languished there ever since.

For banks, the FFELP was the best of both worlds while it lasted: private loans, government guarantees. And they made the most of it, relying on the government to backstop a huge amount of risk. In 2008 testimony before the Senate Banking Committee, Tom Deutsch, then deputy executive director of the American Securitization Forum (ASF), a trade and lobbying association for the securitization industry, claimed that a startling 85 percent of loans issued under the program were financed on the global market.

To the securities industry, college students seemed liked a perfect source of future value.

To securitize student loans, holders combine them into diversified tranches and sell them to investors as highly rated financial products. Combining a bunch of different loans into one investment commodity is supposed to allay the risk of individual defaults; the thinking is that even if some debtors can’t afford to pay, the securities will reflect successful overall repayment. And with the government guaranteeing at least 97 percent repayment in the event of catastrophe, the diversified tranches are rated AAA—as safe an investment as possible. It’s the exact same logic that governed the production and rating of mortgage-backed securities in the run up to the housing crisis.

Securitization is about pulling future value into the present through aggregation and prediction, and college students seemed liked a perfect source of future value. As long as wages increase for graduates—surely as safe an assumption as ever-rising housing prices—then they will (in aggregate) pay back the loans. Which means, in the language of global finance, that we can assume they already have. Thus teenagers’ promissory vouchers for tens of thousands of dollars were pooled into Student Loan Asset Backed Securities (SLABS) and became legal tender.

When the program proved a loser for anyone but the lenders, Brown’s bill offered a way out for those left behind: it would have paid off private loans made under the FFELP from 1994 through 2010, effectively delivering on the government guarantee ahead of schedule—100 percent of principal plus interest and fees. You might think investors would be thrilled to collect their bets early and see students successfully access lines of educational credit (since this is, they stress, what securitization is for). But turning SLABS into money at its nominal value wasn’t enough for investors.

The ASF has consistently lobbied against the bill, warning the Senate Education Committee that the debt-swap program would inflict “extraordinary losses” on institutional investors, who “purchase SLABS . . . with the idea that the repayment of these securities will match their capital return objectives.” In other words, investors were counting on the vouchers being worth more than face value.

How can investors lose interest that hasn’t accrued yet? Are they bluffing to preserve a sweet deal? Chances are we’ll never know. The federal government has shown little appetite for fights with bondholders who make these kinds of threats. And the ASF knows the Feds particularly well.

• • •

The ASF represents 350 firms on both sides of securitization deals—including Sallie Mae, the premiere student lender and SLABS issuer. ASF’s purpose is to “achieve consensus among the various segments of the securitization markets to determine the best approaches to the important legal, regulatory, and market practice issues facing the markets,” which only sounds like a violation of the criminal conspiracy statute. But as Yves Smith has detailed at her blog Naked Capitalism, the ASF is most interested in representing the interests of its sell-side members, the firms that package and sell securities, not the Union of Little Old Lady buyers the organization uses for cover. When these interests conflict, such as when banks robo-sign loans then certify them as high-quality financial products, the ASF backs the salesmen. In February the world’s biggest bond manager, Pimco, withdrew from the association citing ASF’s unwillingness to reflect investor-side concerns. But this conflict hasn’t stopped the ASF from justifying its positions with frequent references to retirement accounts.

Although ASF may have lost Pimco, we can be confident it will still have the ear of the Senate Committee on Banking, Housing, and Urban Affairs. On March 27 of last year, James Johnson, senior counsel to ranking Republican Richard Shelby, stepped down from his post. The very next day, ASF announced that Johnson would be heading its new lobbying operation. You might think that Johnson would be subject to the one-year cooling off period before being eligible to lobby his former colleagues, but when Congress passed the Honest Leadership and Open Government Act of 2007, it defined senior employees as those making at least 75 percent of a congressperson’s salary. Right now that amounts to $130,500 per year. From April 1, 2010 to his final day as a federal employee, Johnson was paid $124,937.66. He thus narrowly dodged the designation, job title notwithstanding. Johnson effectively walked out of a senior position with the Senate on Friday, and walked back in on Monday with a new boss. It’s exactly the kind of situation the law was ostensibly designed to prevent.

Students loans are one of the few types of debt that can’t be discharged. The others are criminal penalties and child support.

Spring 2011 happened to be a crucial period in the development of post-crisis financial regulations. Referring to the signal pice of Wall Street–constraining regulation passed in the wake of the downturn, Shelby told the Senate, “For lobbyists, lawyers, and government bureaucrats, Dodd-Frank is proving to be a goldmine.” That was February 17, 2011, only five weeks before Johnson started at ASF. His office soon got busy making sure there would be as many holes as possible in the law’s 200-plus rules left to regulators, and he’s been overwhelmingly successful.

But Dodd-Frank wasn’t the only target on Johnson’s radar.

Nestled near the end of his 2012 first quarter lobbying report is a mention of S. 1102, or the Fairness for Struggling Students Act of 2011—the only item not obviously tied to the securities industry. S. 1102, sponsored by Illinois Democrat Richard Durbin, makes an exception to current statues and allows debtors to discharge private student loans in bankruptcy. At present, students loans are one of a few types of debt that can’t be discharged. The others are criminal penalties and child support. This nonsensical and dangerous treatment of student debt began with a false panic in 1976 about doctors and lawyers shrugging off their loans and continued through three decades of tweaks to the bankruptcy code. This turn against student debtors culminated in 2005, when congress classified all education debt as nondischargeable. Durbin’s bill in effect repeals the 2005 law as it applies to exclusively private loans, which comprise only 15 percent of the existing total. But the new bill promised a meaningful step toward a fair system. Or at least it would have, had it been passed. It didn’t even get a vote, dying in committee in 2010 and again in 2011.

We don’t know whether ASF’s lobbying against the bill was decisive. But we can be confident that Johnson got a fairer hearing than the struggling students the act was meant to help.

• • •

Not only has Congress failed to create new legislation to aid student debtors, but existing law and the courts have offered inconsistent protection. Nondischargeability is only one of many outlandish ways student debt is an especially crippling type to have. Student debt never expires, and most loans are subject to tax-refund and government-benefits withholding. Creditors can garnish student debtors’ wages. And courts haven’t been clear on whether the vast majority of student debts are meaningfully subject to restrictions on abusive collection practices.

The Fair Debt Collection Practices Act is the chief legal protection against the abusive conduct of debt collectors. But the law’s definition of debt collectors has many exceptions, including one for government agents, and the Department of Education has fought to extend these exceptions to its private contractors. In Brannan v. United Student Aid Funds, Inc. (1996), the Ninth Circuit Court of Appeals ruled against the DOE’s intermediaries: private guaranty agencies that refund lenders and continue to collect from defaulted student loans on behalf of the DOE did not fall under FDCPA’s exception for government collectors. Twenty days after the ruling, however, the Department of Education issued notice that it considered student loan guaranty agencies to be acting in a trustee capacity for the government. Two years later, The U.S. District Court for Kansas followed the DOE’s guidance and officially exempted guaranty agencies again under a different provision in the FDCPA, this one excluding firms pursuing debts as part of activity “incidental to a fiduciary responsibility.” Since then, lower courts have continued to apply the fiduciary-responsibility exception to dismiss harassment claims (see Rutz v. Education Credit Management Corporation [2012]).

If the rules governing the implementation of the FDCPA are murky, its spirit and intention still read clear. Collectors are not allowed to call after 9 p.m. or before 8 a.m.; collectors are not permitted to show up at a debtor’s place of work or talk about the debt to a third party; collectors are not allowed to make harassing phone calls or threaten arrest. The FDCPA specifically protects against “misrepresentation or deceit.” The law’s various provisions send the unambiguous message that, in this country, owing someone money doesn’t give them or their agents the right to make your life a living hell. But according to the Department of Education, that rule doesn’t apply to you if you happen to be a student.

Even whistleblowers who have attempted to alert the public to shoddy student-loan practices have failed to get a fair hearing. In 2005 an employee in the Las Vegas collections division of Sallie Mae alleged a wide-ranging pattern fraud by a corporation supposedly acting on behalf of the federal government. Michael Zahara filed a suit under the whistleblower provision in the False Claims Act (FCA) on behalf of the U.S. government, accusing Sallie Mae of abusing forbearances, a repayment option in which debtors are allowed to cease monthly installments for up to five years without defaulting. During this period interest accumulates and compounds, building on itself and pushing the total owed ever higher. In his suit, Zahara said Sallie Mae encouraged collectors to falsify oral agreements from debtors putting their loans into forbearance, thereby keeping default rates artificially low while inflating eventual interest totals.

There’s no escape from student debt, and the government and markets both know it.

Despite earning his own PBS special, Zahara saw his counsel withdraw after it was revealed that Zahara had a previous arrest, and his suit was dismissed. Fired for his cooperation, Zahara sued for false termination, but a judge also dismissed that suit after Sallie Mae buried him in discovery motions. The judge cited the case’s slow progress and his “inherent authority to do so in order to manage and control my docket.”

Two years after the first filing, another collector reported the same pattern of forbearance fraud, this time in Sallie Mae’s New Jersey office. Loan collector Sheldon Batiste’s allegations were so similar to Zahara’s that they should have lent credibility to Zahara’s original claims. But instead the similarities put Batiste right in the middle of another loophole. The FCA only allows one blow per whistle, which means Zahara’s complaint—though it was dismissed on procedural grounds without any judgment on the case’s merit—will be the last word on Sallie Mae’s allegedly fraudulent use of forbearances, at least as far as the government and debtors are concerned. In June 2012 a federal district court judge in New York gave the preliminary okay to a $35 million settlement of a suit brought by Sallie Mae’s shareholders against the company’s leadership alleging, among other malfeasance, “Forbearance became a means for Defendants to remove loans from delinquent status, without regard to the borrowers’ ability to repay the loans, for the sole purpose of reducing reported loan delinquencies and defaults and recording additional interest income.” The settlement did not require Sallie Mae to admit any wrongdoing. Defrauded borrowers will get nothing from the deal, despite a March 2012 report from the New York Fed that found an unsettling 47 percent of student debtors in deferment or forbearance. None of them are counted among defaults.

• • •

To see why legal safeguards have apparently failed student debtors, it helps to understand the fears around the student loan bubble. The bubble has been a valuable metaphor for illustrating the way finance creates the illusion of value that may not actually exist; the housing bubble popped when markets could no longer sustain the fiction of ever-increasing real estate prices, and suddenly there was nothing to fill the void vacated by all that hot air. Rate of growth over the same period (the last 30–35 years) dwarfs even the rate of housing price increases. All the hallmarks of a bubble are there, including massive securitization and seemingly risk-free financial products. But, as the financial analysts are quick to remind us, the vast majority of this debt is government-backed. What’s the worst that could happen?

As far as investors are concerned, this line of thinking works just fine, but it should look less rosy for the Treasury. If it turns out the subsequent work of student debtors isn’t worth as much as the markets figured, another trillion-dollar bailout may be required, and the taxpayers can hardly afford it.

Yet neither investors nor the Treasury seem particularly concerned. In March the ratings agency (and “ASF 2013” conference lead sponsor) Fitch reaffirmed its AAA ratings for student loan–backed securities, despite the news that 27 percent of borrowers categorized as in repayment are actually more than 30 days late. Congress’s turn to student loan reform has singled out private loans and for-profit colleges for regulation, but mostly ignored Treasury’s lending practices. The assumption is that the government guarantee renders any bailout unnecessary, since the value of the securities is ultimately a referendum on the functional solvency of the United States. You can’t pop a red-white-and-blue bubble.

This understanding is partially true. But the part that’s gone largely unnoticed is what the government and markets expect to happen to defaulted loans. Defaulted loans don’t just disappear into a government loss column—in fact, they never disappear anywhere. The idea of defaulting implies that the debtor is unable to, and therefore does not, pay off the loan. But that’s not exactly how it works. The Department of Education releases default projections a year in advance, so the latest numbers are for loans issued in Fiscal Year 2013: The government expects to originate, across three major categories, a staggering $121 billion in student loans, of which more than $20 billion, or 17 percent, is projected to default.

The real plan for the education bubble: students will be forced to fill it in.

Twenty billion dollars in defaulted loans sounds like a lot of money for the government to back, but that doesn’t take into account the money defaulted debtors will pay on these loans despite defaulting. Of the $20 billion in dud loans the government guarantees, it expects to recover $22 billion from debtors. If you subtract the $3 billion the feds will pay in collection costs, they still recover around 95 percent of principal from loans that default. When you default on your mortgage, you can walk away from the house, but when you default on a student loan, you can’t give your degree back. All you can do is work and pay. There’s no escape from student debt, and the government and markets both know it.

This is, then, the real plan for the education bubble: student debtors will be forced, in one way or another, to fill it in. Not only are student loans not a burden on the federal government, they’re a good investment. In 2012 the DOW estimated its subsidy for student lending at -17 percent. In other words, the DOE “subsidies” actually represent money coming in. Including all expenses, from loses on defaults to debt collection to program administration, the DOE will pull in more than $25 billion in profit from student lending this year alone—billions more dollars than the IRS will assess in gift and estate taxes combined, and more than enough to pay NASA’s whole budget. The DOE explains the negative subsidy through a divergence between “the Government’s borrowing rate and the interest rate at which borrowers repay their loans.” After all, no one can borrow at lower rate than the U.S. Treasury, certainly not college students and their families. Bondholders aren’t the only ones who think student debtors—including defaulters—will pay back every cent they owe, with interest. The government is literally counting on it.

• • •

There are consequences to imposing a trillion-dollar deductible on generational prosperity, and they’re just beginning to emerge. In 2011 Gallup released a disturbing report entitled without exaggeration “In U.S., Optimism About Future for Youth Reaches All-Time Low.” The pollsters found that for the first time since they started measuring, less than half of surveyed respondents think today’s young people will live better than their parents. There’s considerable evidence Americans aren’t just being pessimistic; a Pew study found that between 1984 and 2009, real net wealth for households headed by someone under 35 declined 68 percent. Over a third of young households owe more in debt than they own in assets. Considering that tuition costs are still increasing and neither lenders nor the Federal Government have an incentive to make any changes, there’s no reason to think these trends won’t continue.

At the end of the day, all the numbers, all the loopholes, all the stories of jobbery don’t tell us anything we didn’t already know. That the financial system manufactures value that doesn’t exist isn’t exactly news any more, and government-industry collusion is a campaign talking point (not to mention funding mechanism) for both parties. Everyone knows that banks have stables of lawyers on call to suffocate small-fry complainants with paperwork and that debt collectors find ways around the rules. To treat these as revelations would be to do everyone a disservice. All the legal intricacies can’t camouflage the fact that, in the search for more things to sell, investment banks priced and auctioned a sizable portion of college students’ anticipated future wages, all with, to put it charitably, the government’s cooperation. And when the bills inevitably come due, the laws ensure that there’s no choice but to pay.

Meanwhile, reformers are outgunned by a powerful financial lobby and a pro-business Congress and White House. The most heartening recent piece of student loan–policy news was a report from the Consumer Financial Protection Bureau (CFPFB) and the DOE on private loans that concluded, “It would be prudent to consider modifying the [bankruptcy] code” to allow debtors to discharge private loans in bankruptcy “in light of the impact on young borrowers in challenging labor market conditions.” But not only would the change affect just the small minority of debtors who have private loans and no cosigner, but Congress also has already considered this same modification the last two years in the form of Durbin’s bill (with corresponding legislation in the House) and has been content to watch it twist in the wind. After the CFPFB-DOE report was released, Fitch felt compelled to reaffirm its SLABS evaluation, describing a the CFPB’s proposed policy change as “unlikely” to come about. Given that Congress is predominantly composed of the same members who expanded nondischargeability to private loans in 2005, it’s unsurprising they haven’t changed their minds.

Congress nibbling the edge of the problem may give the public the impression that someone is looking out for them, but when it comes to student loans, there’s not a single piece of legislation that would have a meaningful impact on the most important number: the large and rapidly increasing amount debtors will have pay. And even the relatively meaningless pieces of legislation don’t stand a chance of passing. There’s not a single proposal on the table that might decrease the cost of tuition, and there’s a solid chance Democratic plans to shift the lending burden to the Treasury will only exacerbate the problem by spurring universities to raise prices disconnected from even the pretense of a conventional demand structure. The government trumpets flexible repayment plans that end up extending both the lifespan of a loan and its interest period. Besides, no interested party cares if student debtors pay up soon; they will have to someday, and the longer it takes them, the more interest accrues, the bigger the haul. In the meantime, markets and investors are empowered to just pretend the money is there anyway.

The problem with the bubble metaphor is that everyone is waiting for a bang when they should be listening for the splash of value accumulating at the bottom. As long as the public is focused on the education bubble and whether or not it will pop, they won’t notice it filling in slowly. Record-high youth unemployment and stagnant or declining pay even for college graduates (at least in part due to the downward impact on wages caused by a desperately indebted workforce) make it harder for borrowers to pay back their loans with any expediency. Assuming current rates of repayment and issuance (which is, admittedly, low-balling it), the $1 trillion outstanding total will double within a decade. And short of suicide, expatriation, or revolt, there’s not much 37 million American student debtors and counting can do about it.