Eakinomics: Loan Delinquency and Student Loan Policy

Sarah Chaney at The Wall Street Journal notes in an interesting blog post that the “share of new delinquencies on student loans has fallen to the lowest level in more than decade — and it’s not just due to the healthy labor market.” Now is an interesting moment to reflect on student loan policies.

First, the data: Based on work by the New York Federal Reserve, the fraction of loans that are newly delinquent fell to roughly 9 percent in the first quarter of 2018. This somewhat understates the actual rate of new delinquencies because it includes loans to those student still in school. Since they are not required to make payments until they leave school, there is no way for them to enter delinquency. Tossing them out of the calculation would yield a higher rate. Nevertheless, delinquency rates have been falling in recent years; as AAF pointed out earlier this year, there are still slightly more than 12 million borrowers, representing $321 billion in outstanding federal direct loans, that are in some form of non-payment and at risk of defaulting. And today more than 8 million borrowers are nine months or more behind making even $1 in payment toward their student loan debt.

Second, why? Obviously, the economy is a big part of the story. With unemployment falling below 4 percent, those leaving school have a much better chance of finding the employment and income that permit one to stay on schedule with loan repayments. But a second part of the story is that increasing fractions of student borrowers are taking advantage of federal program options that either limit their repayment (so-called Income-Based Repayment, IBR) or put off paying entirely for a while (forbearance). Under the IBR programs, the basic idea is to cap repayments as a fraction of income, say 15 percent. Moreover, if the student takes employment in the non-profit world, any outstanding balance is written off after 25 years.

These policies cost the taxpayers. So they better have virtues that offset these costs, and that’s the issue. IBR is essentially a tax on labor-market success — make more and you have to pay more. Why does it make sense to have an extra tax on the youngest workers in the economy? And the forgiveness policy violates basic rules of fairness. Two workers, one at AAF (yes, AAF, as it is a non-profit) and one in manufacturing get different treatment, with the differential in favor of the think tanker. Why?

Forbearance makes even less sense. There is a low bar for entry into forbearance. But the interest costs continue to accrue, with the result that most ultimately default entirely.

The basic problem is that the Obama Administration fundamentally changed the nature of the program in two important ways. First, by eliminating the private sector entirely from the process of offering student loans, it eliminated any scrutiny of the quality of borrower-loan match. Poor underwriting inevitably leads to poor loan performance. Second, pressure from progressives (e.g., Bernie Sanders) in favor of “free college” led the administration to treat student loans more like grants with optional repayment. Both shifts are fundamental distortions of the basic goal of providing genuine loans to give individuals access to a college education. And the legacy of these shifts lives on.