A Fearsome Financial Freight Train
I’m not a physicist. But I do know that an object that’s headed downhill picks up speed as its gravitational potential energy (at rest) converts into kinetic energy (movement).
Imagine taking the first big stomach-flipping drop — straight down through a 270° right-hand spiral — on the Kingda Ka roller coaster, at Six Flags in Jackson, New Jersey. Or bungee-jumping off the 140-foot-high Kawarau Bridge, in Queenstown, New Zealand, as our daughter did during her college semester abroad.
Scarier still, imagine a $1.4 trillion portfolio of education-related loans headed downhill in a hurry.
According to the New York Federal Reserve Bank, student loans that are 90 or more days past due (including those that are in default) total 11% of all outstanding student loans. Taken at face value, that’s a terrible number, and not just because it dwarfs every other form of consumer debt. What makes this statistic even scarier is that it’s understated.
The more accurate number is closer to 22% because only half the entire portfolio of student loans is actually in repayment mode. The rest are deferred. And that number doesn’t take into account the contracts that are between 30 and 60 days past due. Nor does it include the loans that are currently in forbearance or have already been restructured via one of the many income-based repayment plans that the Department of Education offers to financially distressed borrowers.
All told, I believe we’re looking at a failure rate of between 40% and 50%. And even that’s not the worst part of this story.
This downhill-headed financial freight train is picking up speed.
Thanks to the Bipartisan Student Loan Certainty Act of 2013, which pegs the various Federal Direct undergraduate, graduate and parent-PLUS loan interest rates to the fluctuating yields of 10-year Treasury notes, the interest rates on all these loans are rising.
Certainly, that won’t help the failure rate. Not when we continue to be stuck with a standard repayment term (10 years) that doesn’t take loan-size into account. What’s more, Congress compounded that blunder by benchmarking interest rates to the wrong index.
Loans that fully amortize — where the principal value is fully repaid over time, such as in the case of mortgages, auto and education loans — are routinely financed by lenders at the so-called half-life rate because, mathematically speaking, 50% of the principal is presumed to be outstanding at any given point. Consequently, the base-rate index for a 10-year loan should be the 5-year Treasury note.
So, by basing the interest rate for a 10-year student loan on the 10-year Treasury note, Congress has, in effect, quietly tucked in a substantial amount of added profitability, because 10-year rates are higher than 5-year rates.
How much extra profit? Well, the difference between the 5- and 10-year Treasury notes at the time of this writing is roughly 50 basis points, or one-half of 1% (each basis point represents 1/100th of a percentage point). That means that if $50 billion in new student loans are taken out during the coming year, 50 basis points would add roughly $125 million in excess profitability per year over the course of the standard 10-year repayment term: $1.25 billion in total (50% of $50 billion X 0.5% interest X 10 years).
And that’s only if the lender is actually borrowing on that half-life basis.
I say that because if the feds are continuing to borrow at the low-rate, short-end of the current yield curve (as they have these past several years), doing so has the potential to add yet another 100 basis points of profitability for as long as those rates (and the difference between the two points) remains constant.
An additional $250 million per year for 10 years: $2.5 billion atop the $1.25 billion. Keep in mind, we’re only talking about a single year’s worth of loans here.
Now, before you assume that it should be an easy matter to undo this perverse inequity, think again. To the extent that the payments collected from student loan borrowers exceed the governmental debt obligations that underlie these same loans, those excess payments become available for other things, such as balancing the budget, paying down the federal debt or … funding tax cuts.
As Congress contemplates a new series of personal and corporate tax cuts that by most accounts will add to the federal deficit, at least in the short run, it’s unlikely that this unfairly devised student loan-pricing mechanism will be addressed anytime soon — if at all.
Frankly, though, I would willingly trade that consideration for an agreement to restructure the existing loan portfolio in its entirety to properly coincide with that 10-year Treasury note on which its pricing is based.
I’m talking about doubling the standard repayment duration to 20 years, which, when you think about it, is precisely what the government is doing as we speak — that is, for those who request student loan-payment relief.
Short of that, this freight train full of debt will continue to gain speed as it plummets downhill.