Mike’s Financial Pocket – The Student Loan “Fix” is in

During the 2012 presidential campaign, the Speech-Giver-In-Chief successfully continued to secure the youth vote with the following simple phrase-turned-twitter #hashtag, which was directed at “Congress” (read: the GOP/Mitt Romney). The irony of it all is that prior to 2012, the last student loan rate vote took place in 2007 – when both houses of Congress were controlled by the Democrats — and then-Senator Barack Obama did not even participate in the vote.

Of course, facts should not get in the way of a great story.

Congress was painted as anti-education for not passing legislation to fix the 2007 legislation that contained a sunset provision, making it expire in 2012. Eventually, in an uncharacteristically wise move from a political standpoint, the GOP agreed to pass a one-year extension and took the issue off of the table during the campaign.

Obama still won the youth vote by a ridiculously large margin, garnering 67% to Mitt Romney’s 30%.

Some may say that the Federal government should be helping out students by providing them access to student loans with low interest rates. This, they say, will help everyone get to college and pursue their dreams that previously may have not been affordable. A worthy endeavor, right?


First of all, the outstanding student loan debt has risen to over $1.1 trillion — that is more than was authorized by TARP for bad housing loans. Second, as student loans increase, education costs increase, which then require more loans… and the circle continues.

Gosh, that’s interesting — when the federal government steps in and manipulates the market by providing cheap access to money, costs increase. Have we seen this before? Spoiler alert: we saw this with the housing bubble in 2007 – 2008.

In an attempt to “fix” the student loan rate “problem,” Congress approved legislation lowering the rate for federal student loans permanently:

The House overwhelmingly approved tying student loan interest rates to market rates and reversing an interest rate hike that took effect for some new loans July 1. The 392-31 vote comes a month after the interest rate for new, federally subsidized Stafford loans doubled.

President Barack Obama has said he will sign the bill, which links student loan interest rates to the 10-year Treasury note.

Because interest rates are low right now, the measure means all borrowers will get an interest rate break on student loans for the upcoming academic year. It sets rates at 3.86 percent for undergraduate Stafford loans, 5.4 percent for graduate Stafford loans and 6.4 percent for PLUS loans. Rates vary from year to year for new loans, but are fixed over the life of the loan.

If interest rates rise, the rates are capped at 8.25 percent for undergraduate loans, 9.5 percent for graduate loans and 10.5 percent for PLUS loans.

Welp, there it is. The student loan rate problem is now permanently fixed.

On the one hand, linking student loan rates to the 10-year Treasury note is a decent idea, assuming that the 10-year note was not being manipulated by the Federal Reserve’s asset purchases.

On the other hand, now the federal government (through the Federal Reserve) has an incentive to continue manipulating the 10-year note forever. If it does not, then student loan rates could jump year-over-year and become a campaign issue again.

But the end result of government manipulation of interest rates is cheap credit and a bubble. By providing cheap money, more and more people will be able to borrow in a whimsical manner, taking on six figures worth of student loans for any sort of major his or her heart desires and being left with a worthless piece of parchment and no full-time job prospects post-graduation, let alone a job in one’s major.

So, how do we remedy this? Get the government out of the student loan business.

This article from Slate suggests that the government should remove the inability to discharge student loans in bankruptcy, thus providing a means for people with crushing student loans to get a fresh start, similar to Detroit.

I agree, to an extent.

The government should be out of the student loan business and the market should set the rates for student loans on the basis that is used to fund other loans: (1) creditworthiness and (2) ability to pay the loan back.

In other words, if the student is pursuing a major that has solid job prospects, the risk of the loan going into default should be lower (all things equal) than someone pursuing a major with little or no job prospects.

Don’t misunderstand me — I’m not suggesting that everyone needs to major in a certain field. Full disclosure: I majored in classics and minored in philosophy in college, prior to law school. What I am suggesting is that frivolous educational prospects should not be guaranteed by the federal government and students should have to consider job prospects prior to taking out large loans (as anyone who purchases a house, for example, must do).

I joke around that the “South Pacific Interpretive Dance” majors should have to borrow at 30%, while people who major in engineering or science should be able to borrow at a much lower rate. This actually makes sense from a lender’s standpoint.

When the government guarantees the loans and the loans cannot be discharged in bankruptcy, the private lender has no credit risk. Of course, the taxpayer is on the hook if the loan goes south. Indeed, when loans cannot be discharged in bankruptcy, the lender is more likely willing to fund loans for more frivolous educational endeavors. A system where students have to seriously consider the impact of taking out large loans to fund majors which will not assist in career prospects will very likely cause students to think twice before majoring in “Aboriginal Human Sexuality.” The lender will also need to consider the prospects of the candidate and fund accordingly.

A free market student loan system will force both actors — the lender and the borrower — to act responsibly with respect to the borrowing and lending of serious sums of money.

As always, free markets are better markets.

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This week, we can expect consumer spending reports on Monday.

Earnings season will continue this week. Look for companies such as CVS, copper giant Freeport-McMoRan, and various financial institutions to report this week.

Retail sales, as well as first-time unemployment claims, will come out Thursday.