My Two Cents

The Student Loan Bubble Goes Bust?

Chris Farrell Jan 14, 2008

For more than three decades, students and their parents funded a college tuition bubble with borrowed money. Two-thirds of college students finish school with debt, up from less than half in 1993. Yet, reminiscent of the dynamics in the recent housing market downturn, investors are suddenly wary of the $78 billion student loan business. The borrowing boom could go bust.

Case in point: Returns on all the publicly traded student loan lenders are down sharply over the past year. Most striking is Sallie Mae, the market’s 800 pound guerrilla. Since last July, 60% of its market value vaporized, a price decline about double the drops suffered by troubled lenders Citigroup and Merrill Lynch. In its latest regulatory filing with the Securities and Exchange Commission Sallie Mae’s management says it will become more selective in its loan originations. I think investors perceive a fundamental change in that industry that goes beyond the normal correction process. We’re at a threshold point when loans for financing college topped what can be supported.

Recent research explodes the widespread myth that student loan default rates are low. To be sure, the federal Dept. of Education has announced for years that the default rate was a modest 4% to 5%. Problem is, the federal agency only looks at the first two years of debt repayments. Longer term studies find far more dire results. For instance, reaching back into the early 1990s and following students over the subsequent decade, students with loans totaling $15,000 or more had nearly triple the default rate of those with $5,000 or less in loans–20% versus 7%–according to a study by the National Center for Education Statistics came up with similar results. Compounding the financial stress on lenders is a new law limiting federal subsidies to them.

To be sure, the mantra has been that student loans pay for themselves with post-graduate earnings and opportunities. Yet the real earnings gap in constant dollars between a worker with a college sheepskin and her peer with a high school diploma increased by a mere $1,033 for women from 1995 to 2005 (after adjusting for inflation), and only $3,500 for men from 1995 to 2005–about $100 a year and $350 a year respectively. That’s hardly a reassuring return on education for a generation that has taken on unprecedented debt burdens. Over the past decade the average student loan debt burden has jumped by an inflation-adjusted 50%.

What does it mean for students and their parents? It’s a mixed bag for now. On the one hand, borrowers will have to pay more for their college education, either through savings or higher borrowing costs. Still, a growing number of colleges and universities realize that the loan business is out of hand. Harvard may have garnered the most notice when it announced cut rate tuition to families earning up to $180,000 a year. They’ll pay a maximum of $18,000 a year versus the full tab of more than $30,000. Caltech, Colby College, Duke, Indiana University, Pomona, and 33 other colleges have eliminated or mostly cut out loans for students, especially those from low-income families. The pressure is growing on other private and public colleges to follow suit.

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