Student Loans and the Affordable Care Act: Threading the Needle

Answering questions about public policy is rarely easy. Usually it takes time, patience, and willingness to hear multiple sides of an issue in order to understand the depth, scope, and complexity of public issues. This article discusses one provision of the immensely complex Affordable Care Act (aka “Obamacare”). In fact, this article doesn’t even discuss the Affordable Care Act itself, but instead the Health Care and Education Reconciliation Act of 2010.

Some background to get our facts straight.

When the Senate passed the Affordable Care Act, the law went into a reconciliation process. During that process, Congress amended the original Affordable Care Act through the Health Care and Education Reconciliation Act of 2010. Those amendments included changes to the health care portions of the Affordable Care Act and an education reform portion that did not exist before. In other words, the reconciliation added education reform to the Affordable Care Act.

This raises a question: Why did Congress attach an education reform bill to a health care reform bill? The political reason is that this allowed Democrats to essentially kill two birds with one stone. The practical (and more interesting) reason is that Congress used, and continues to use, provisions of education reform to fund the Affordable Care Act, at least in the short term. But even this is not the issue of concern.

The issue of concern is a specific provision that ended government guarantees for student loans that private banks originate (Sec. 2202). Before 2010, private banks serviced most student loans. To create an incentive for banks to service these loans, the federal government guaranteed losses (to a limit) if students defaulted on those loans. Of course, in order to meet that guarantee, these loans had to meet certain underwriting standards (the ability to determine a borrower’s creditworthiness). Moreover, if a bank wished to sell student loans into the secondary market, those loans had to meet additional underwriting standards.

However, by removing loan guarantees, banks exited the market and the Department of Education became the de facto sole originator of student loans. The politics of this provision were that financial aid administrators and government officials did not believe that private lenders (especially banks) could provide the flexibility and service that students needed. In fact, they believed that the government could do a much better job at originating student loans.

While well intentioned, transferring the ability to originate student loans from private banks to the Department of Education has consequences. Unlike banks, the Department of Education does not have the underwriting standards or controls in place to originate student loans properly. In fact, one could argue that the provision moved student loan originations from a regulated entity (private banks) to an unregulated entity (who is the prudential regulator of the Department of Education?).

The consequence of having an unregulated entity originate student loans is that there are no standards in place to ensure the solvency of the agency or protection of the borrowers. Theoretically, an institution that does not have strong underwriting standards, has a monopoly on a market, and is unregulated is destined to be “too big to fail” and will preside over an inevitable market crash. As of 2013, total student debt increased to over $1.2 trillion and is expected to grow even larger. Since the Department of Education claimed the sole role of originating student loans, its share of servicing that debt ballooned to 55% from nothing (with 45% still in the hands of private institutions due to outstanding debt and will decline as loans reach maturity and the Department of Education originates more loans). This means that roughly $700 billion of newly originated student loans came from the Department of Education alone between 2010 and 2013, essentially doubling the total amount of student debt.

How could student debt have ballooned so quickly? There are several factors that I will lay out here. This is not an exhaustive list, but these are factors that are evident to me:

1. Education is very popular during recessions (demand side). During harsh economic times, jobs are few and unemployment is high — this was especially true during the Great Recession. It may be reasonable for people in the workforce who are laid off to use a recession to build human capital or pursue higher education, or for people who might have otherwise worked after high school to pursue college. Data from the National Center for Education Statistics show that more than 18 million students attended a four year college in 2007 and more than 21 million students attended a four year college in 2010. To put things into perspective, college enrollment increased from 17 million to 18 million students during the heyday period between 2003 and 2007. It goes without saying, as more people enroll into college, demand for student loans increase.

2. People are staying in school longer (demand side). This is partially due to the recession and partially to due labor market demands. First, during a recession we established that more people enroll in school. These same people are also more likely to stay in school or pursue graduate studies to “wait out” stiff economic times. Second, demand for a highly skilled labor force is increasing. More employers require candidates to have a Bachelors or Master’s degree to meet the minimum requirements. Whether such requirements are warranted is up to debate, but it is clear that this trend encourages students to stay in school longer. Data shows that between 2007 and 2012, enrollment to graduate schools increased from 630,666 to 754,229. Whereas, between 2003 and 2007, enrollment to graduate schools increased from 595,000 to 630,000. The effect on student loans is the same process: more students enrolled for a longer period of time generates demand for student loans.

3. Low interest rates (supply and demand sides). Currently, interest rates on student loans vary depending on the prevailing market interest rate (largely determined by the price of Treasuries). In a simple competitive market, low interest rates are particularly favorable to borrowers, but creditors are less likely to issue loans since it’s harder to turn a profit on the loan. As noted above, the reality of the situation is that this is a monopolized market where the sole seller of loans is the Department of Education, and the seller desperately wants to meet demand. As a result, student loans are oversupplied, thus diminishing the value of education itself and the solvency of the lender.

4. Unregulated lending (supply side). Back when private banks originated student loans, they were regulated by a number of institutions to ensure safe and sound lending practices. These banks were required by law to underwrite to a standard that would allow them to receive a loss guarantee by the federal government and sell the loans off into the secondary market. Moreover, these banks had to compete with each other to provide the best rates possible for borrowers. This type of market ensured that credit supply was constrained since young borrowers have thin credit histories, or else rely on parents as cosigners. In other words, in order to meet regulatory requirements, a private bank would never give a young college student $100,000 in loans.

However, since the Department of Education is the sole originator of student loans, those requirements are out the window. As an unregulated institution with a mandate to meet demand, it is now very easy for an undergraduate to accumulate $100,000 in loans.

After all this doom and gloom, is there anything that policymakers can do to help relieve student debt? The following is a non-exhaustive list of actions and scenarios that can help relieve student debt:

1. Grant banks the ability to originate guaranteed student loans. Students need more options for loan servicing, and banks need an incentive to originate loans. By allowing private banks to originate guaranteed loans again, it will allow creditors to compete with the Department of Education. One may think of the Department of Education as being the baseline student loan rate, but other much more affordable options could be available if banks can compete. This will help advance the market toward more efficient interest rates.

2. Place standards on the Department of Education. As a creditor, the Department of Education needs underwriting standards that are just as good, if not stronger, than private banks. As stated numerous times, the Department of Education does not face the same regulatory requirements of banks, but it dabbles with originating loans anyway. The economic effects have so far been disastrous and needs to be controlled now. Policymakers can do this through strict underwriting regulations or allowing the loans to be saleable on the secondary market.

3. Inflation. The “shotgun” approach may be to aggressively pursue higher inflation. Inflation essentially wipes away debt at the expense of creditors. The consequences of this action are wide and far reaching since high inflation will affect producer behavior, consumer behavior, and the value of other outstanding debts that are not as toxic, or even beneficial, to our economy. However, seeing that growth remains low, inflation remains low, and oil prices are falling, this scenario seems unlikely.

Before I conclude, I want to point out one more thing. The public space has discussed at length that the Affordable Care Act raises the costs of health care for employers. As far as regulatory standards go, the law requires employers who employ a certain threshold of full-time employees to provide health insurance. This requirement essentially increases the cost of labor. In order to meet these costs, employers have several options: they can eat the cost, they can raise prices, they can cut wages, they can lay off employees, or they can restrict full-time hiring to stay below the threshold. The last option is perhaps most damaging for young people. In addition to carrying the burden of high student loans, recent graduates must also contend with employers facing a strong incentive to hire young employees on a part-time or temporary basis to avoid health care costs. This type of labor market makes it incredibly hard for young people to plan financially and build careers.

So what can we conclude from this discussion?

· First, the Affordable Care Act is an extremely complex law. This article discussed almost nothing about health care, but it was all in the realm of the Affordable Care Act. Consequences are bountiful in complex regulations.

· Second, regulatory standards matter. This is not a libertarian critique of the Affordable Care Act. This is an analysis of a well-meaning policy that was poorly constructed. But as long as the Department of Education is not accountable to the extent that private banks are accountable for underwriting standards, borrowers are at a net loss.

· Third, the Great Recession has had deep effects on the financial well-being of young people, starting from when they took out their first loan to when they eventually pay the loan off (or enter bankruptcy!).

· Forth, competition matters. By removing private banking from the student loan originations, we created a monopolized system. While the monopoly is responsive to credit demand, the system is failing students by offering excessively high loan amounts without so much as a blink. The Department of Education is shooting itself in the foot if this practice continues.

As the borrower, the only advice I can provide are the following:

· Find a steady job that is likely to advance your career. While student loans are burdensome, do not let those loans consume you. It’s much easier to pay off your loans when you have a job that will pay you a predictable amount of money on a regular schedule. As you advance your career, you’ll find that paying off those student loans will become easier.

· If possible, refinance your loan. Some banks allow you to refinance your student loans. This means that the bank will pay off your existing loans and you will enter a loan contract with the bank at a lower interest rate. The bank does this in order to reap the revenue of your loan. Just be wary that many banks offer refinancing through a variable interest rate (the interest rate will change over time) and low interest rates will not stick around forever.

· Do not pay off your student loans early. Assuming that you are on a fixed payment schedule, the real cost of paying off a loan is highest at the early stages, but will diminish over time due to higher purchasing power (inflation). If you pay off a loan excessively early, you are essentially paying a higher real cost for the loan.

· If you are currently in the 90 day refund period, make regular payments on the principal. During the first 90 days of servicing your loan, you may apply payments to the principal of your loan. Making these payments will allow you to lower the overall cost of your debt.

· Consolidate your loans. If you took out student loans over the past four years, you may find that portions of your loans have different interest rates. Each portion is considered a different loan. If you consolidate your loans, you may be able to have a lower overall interest rate and, thus, lower monthly payments. You may also become eligible for other repayment options (ie. income-based repayment).

· Save. Youth is a magical time — you can do things that you will never be able to do when you grow older. However, that is not an excuse not to save. Remember, the person you are today is also responsible for the well-being of the person you will become tomorrow. Decrease spending where you can, make extra money where you can, and save your money in a brokerage account and Roth IRA. Remember the power of compound interest!