College and Housing Bubbles
Remember the mid-2000s housing crash that wiped out homeowners? Well, there’s another bubble getting ready to pop, and this one’s in student debt. Prof. Antony Davies explains.
- Why Do We Have Student Loans? (video): Student loans skyrocketed from the 1980s to the 2007 recession. Professor Brian Domitrovic says this is a bubble that needs to pop.
- 2016 Presidential Election: Student Debt (video): Forgiving student loan debt and increasing subsidies for higher education were popular ideas on the campaign trail in the 2016 presidential election, and they remain popular ideas today. Professor Don Boudreaux explains why these policy changes would lead to negative outcomes while failing to address the underlying issues at play.
- How to Solve the Student Debt Crisis (video): Manhattan Institute fellow Jared Meyer talks about how innovation in the student loan industry could help solve the student debt crisis.
ANTONY DAVIES: To understand what’s going to be happening with the student loan bubble, it’s useful to understand first what happened with the housing bubble. To understand what happened with the housing bubble, it’s necessary to understand first how mortgage markets work. Let’s take commercial banks. Commercial banks loan money to borrowers, some of them safe, some of them risky. The borrowers, in turn, sign mortgages, which they hand over to the bank, and the mortgages are pieces of paper that say that the borrowers promise to pay back this money they have borrowed, over time, the interest plus the principle.
Now, the commercial banks, who now have these mortgages, behind them sits large savers, such as pension funds, reinsurance companies, other large entities with large amounts of savings. These entities save their money with investment banks. Investment banks, in turn, turn around and purchase mortgages from commercial banks. So the savings goes from the savers to the investment banks, the investment banks purchase the mortgages, the investment banks then combine these mortgages into what are called mortgage backed securities.
Mortgage backed securities, roughly speaking, are to mortgages what a sheet of plywood is to wood chips; wood chips come in various shapes and sizes, and because they’re non-uniform you can’t do anything with them, but if you glue them together and press them into a uniform shape, you now have something that you can actually use to build and to create construction plans from. So this is what the mortgage backed securities are; they’re more uniform financial securities, that generate returns to savers, and they’re based on, or constructed from, individual mortgages.
These mortgage backed securities are rated by rating agencies, which will bless them and say, “This mortgage backed security represents a small amount of risk, or a moderate amount of risk, or some large amount of risk.” And once rated by the rating agencies, they’re then turned over to these large savers, who now are, over time, going to be earning the interest that the people who took out the mortgages originally are now paying.
What’s happened on the backend, is that the commercial banks have now had their coffers refilled with cash from these savers. They then turn back to mortgage markets and offer this money to borrowers who want to borrow the money to buy houses. They turn around, again they sell the mortgages to investment banks, which in turn hand them over to pension funds, reinsurance companies, and the whole system starts all over again.
What happens here ultimately, is that people with savings loan to people who buy houses. The banks, the commercial banks, the investment banks, are simply middle men in the transaction. So if we take away the middle men, what the transaction really looks like is these savers have cash, these people want mortgages, and so they exchange the cash for the mortgages, these people then turn around, use the cash that they have to buy houses.
What happens next is that the people who borrowed the money to buy the houses now make monthly interest payments, principal interest, to these savers, and over time some of these people may go bankrupt and they stop making their payments, but the people who were safe borrowers may continue to make the payments. So in total, these savers are receiving interest on some of the mortgages that people didn’t go bankrupt on, they’re not making interest on other ones that people did go bankrupt on, but on average they’re making some reasonable rate of return on their savings.
Where the interest rate settles, we call the equilibrium. The equilibrium interest rate is the interest rate at which the savers are willing to lend as much as money as the borrowers are willing to borrow. Now, what happened in the housing bubble is that this process of attaining the equilibrium interest rate was short circuited, and it was short circuited by two sets of players. One, the Federal Reserve, which intervened in markets, pushing interest rates to the lowest levels that they have been in this country historically.
The other group was Fannie Mae and Freddie Mac, these are government sponsored entities, and they buy mortgages. It turns out that they bought mortgages with little regard for the risk that those mortgages represented. So the first thing that happens is, the Federal Reserve lowers interest rates. As it lowers interest rates it attracts more people, both risky and safe, into the market; as interest rates are lower it’s cheaper to borrow money, and so we get more people looking to borrow.
Then Fannie Mae and Freddie Mac come along, and they start lending money to mortgage markets. These two entities were less concerned with the riskiness of the borrowers; they were less concerned for two reasons. One, is that because they were government entities, they tended not to be as profit driven as non-government entities tended to be. If Fannie Mae and Freddie Mac lost money, implicitly people understood that the federal government would come behind and bail them out. Consequently, Fannie Mae and Freddie Mac were not as afraid of lending to risky borrowers as private investors were.
So what happens, as Fannie Mae and Freddie Mac enter the industry, we have here regular private savers who loan money ultimately to borrowers, but now enter Fannie Mae and Freddie Mac, and they start loaning money. And as they start loaning money, because they’re less concerned with risk than the private entities are, what happens is they start attracting more and more risky borrowers into the market.
What does this do to the housing market? And notice there are two distinct markets here we wanna talk about. The first is the market for mortgages, the second is the market for housing. The market for mortgages we’ve seen, as the Federal Reserve pushes interest rates low, it attracts more borrowers into the market, and as Fannie Mae and Freddie Mac come along and provide more loanable funds, they attract more risky borrowers.
As we get this increase in borrowers in the mortgage market, this translates, in the housing market, into an increase in demand. So we have more borrowers showing up, particularly not just more borrowers in general but more risky borrowers, the demand for housing starts to increase, and as the demand for housing rises we get an increase in the price of housing, and we get an increase in the quantity of housing being produced.
Now, what happens when the bubble bursts? Everything is fine until the market takes a downturn. When the market takes a downturn people’s incomes start to fall, and the first people who are hit the hardest are those riskier borrowers, who perhaps are living very close to the edge, you know, earning just about as much money as they’re spending. As the economy turns down, they start to get behind on their mortgage payments, eventually a lot of them declare bankruptcy, and so what happens is that a bunch of these borrowers now disappear. But although they disappear, they have ceased making payments on their mortgages, their houses still exist.
So two things happen in the housing market. One is, there’s a decline in the demand for housing, as these borrowers who used to be coming into the market now stop. Second, as these existing borrowers, who had already built houses, they go bankrupt, the banks confiscate their houses, turn around to sell them on the market, we now have an increase in the number of houses being offered for sale. So we have this combination of a decline in demand for housing and an increase in the supply of housing, as existing houses come back onto the market. And the result is, the price of housing declines. This is the crash of the housing market.
So ultimately, what happened here? What happened here is that the government broke the link between risk and return. If you think about a mortgage, a mortgage represents to a bank two things. One is return; over time the people who borrowed this money will pay it back, and with interest. But the other is risk; if the people go bankrupt, they walk away, they stop making the payments, the bank is left with this house that they don’t want, and they’re not receiving income on the mortgage that they were promised.
These two things, the desire for return, and the desire to avoid risk, ’cause banks to loan prudently; not too much, not too little. But when the government comes along and breaks this link between return and risk, what happens is, there’s now no penalty for loaning too much, there’s only a return. So the detailed answer goes something like this: Fannie Mae and Freddie Mac enter. Because they’re backed by the government, they effectively force taxpayers to bear the risk of loans that they make. Second, Congress passes, in 1977, and it persists through 1995, the Community Reinvestment Act. In this Community Reinvestment Act, Congress required that banks provide loans to low income, to high risk borrowers.
Despite the Community Reinvestment Act, banks were not loaning enough money to higher risk borrowers to satisfy Congress, so Congress then turns around in 1994 and passes the Riegle-Neal Act. And the Riegle-Neal Act tied something the banks wanted, which is interstate mergers, to something they didn’t want, which is loaning to high risk borrowers. HUD, starting as far as 1996, started required that Fannie Mae and Freddie Mac loan up to 40% of their portfolio to low income borrowers. The Taxpayer Relief Act, in 1997, exempted profit taxes on home sales up to half a million dollars. And then finally, from 2000 onward, the Federal Reserve was holding interest rates at historically low levels.
These are major interventions in the mortgage market, that caused the link between risk and return to be broken. In effect, what the government was doing, principally through Fannie Mae and Freddie Mac, was saying to banks, “You go ahead, loan out money, and keep the profits that you earn from lending. Any risk that goes along with that lending, you can just give to us. Fannie Mae and Freddie Mac will handle it.” And by we, what they really meant was, the taxpayers.
So if we look at the data, what we see is, going back to 1990, this is the fraction of all mortgages in the United States that were held by Fannie Mae and Freddie Mac. And if you see, round about 2003, Fannie Mae and Freddie Mac came to comprise almost 50% of the mortgage market. As they loaned more and more money, implicitly backed up by taxpayers, more and more risky borrowers came into the market looking to borrow.
So if we look at the mix of risky versus un-risky loans back in 2001, the black bar represents conventional mortgages in the United States. The lighter bars at the top represent what we would call risky mortgages; these are mortgages in which the borrower has not put any money down on the house, or the bank has not confirmed what the borrower claims his income and job history is. These are risky loans, as of 2001.
At the height of the housing bubble, 2006, what we see is these risky loans comprise almost 50% of all mortgages in the United States. This is the effect of Fannie Mae and Freddie Mac entering the market and making taxpayer money available to risky borrowers. And finally, when the housing bubble burst, we end up with the mortgage market going back to where it was; most of the mortgages are now considered safe mortgages, and a small fraction are still risky.
So this raises the question, what does any of this have to do with college loans? Well, it turns out that the government is taking almost the same steps, in almost the same order, in the college loan market that it took in the housing market. And again, the effect is going to be breaking this link between risk and return.
So the government institutes Stafford and Perkins loans, these are taxpayer subsidized loans, to college students. The Taxpayer Relief Act provided tax credit for college debt, much the same way as the government provided tax credit for housing loans. In the Affordable Care Act, the Department of Education is set up to loan directly to students. So the Department of Education now is doing in the student loan market the same thing that Fannie Mae and Freddie Mac did in the housing market.
The Loan Forgiveness Program allows for student loans to be forgiven, and this is an interesting thing, because it sounds quite magnanimous to say that we’re going to forgive student loans, until we remember that the government doesn’t have any money with which to forgive those loans unless it first takes it from taxpayers. So what the government really means when it talk about loan forgiveness is, let’s force people who didn’t go to college to pay for people who did.
The Community College Act calls for taxpayers to pay for students to attend community college, this was proposed in 2015. Debt Forgiveness Act, also proposed in 2015, calls for student loan debt to be dischargeable in bankruptcy, which it currently isn’t. And then finally, we have again the Federal Reserve doing what it has done since 2000, which is holding interest rates at historically low levels.
So what are the consequences of all of this? The consequence is that high school students who actually would do better in technical schools, are being encouraged to get college educations, because the cost of the college education is artificially low. College students are being encouraged to major in fields that have little earning power. What this results in, is a bubble demand for college education. People are being encouraged to take on debt to go to college, who actually would be better off not, or people are taking on debt to go to college to study things that actually they’d be better off not studying, and so we have the demand for college rising, and college tuition commensurately rising as well.
What happens when the bubble burst? First, taxpayers will be tuck with up to $1 trillion in student loan debt. This is the amount of money that students have currently borrowed to go to college. Second is that millions of low skilled students will find that they wasted years of their life obtaining a college degree that does now have the value that they anticipated it would have.
Notice there’s an additional problem here, with the college loan market, that did not exist in the housing market, and that additional problem is this: In the housing market, when I, as a high risk borrower, borrowed $300,000 to build a house, and then I find I can’t make my monthly mortgage payments, I at least have an asset, this $300,000 house, that I can sell to recoup some of the money that I owe the bank. But that dynamic doesn’t occur in the student loan market. If I borrow $80,000 to go to college, and when I’m done with college I find that I can’t pay off my student loan, I have no commensurate asset that I can sell to turn around and raise money to pay off some of this debt.
College presidents will be decried as greedy profit seekers in the same way that bank presidents were decried as greedy profit seekers. And I don’t mean to defend bank presidents; some of them certainly were greedy profit seekers. But the banks did exactly what the government encouraged them to do, by breaking the link between risk and return. When the government said, “You banks go ahead and loan out whatever you want, and keep the profit, and I, the government, will bear the risk,” banks did what anybody could have anticipated. They turned around and they started loaning to everybody in sight.
Similarly here, college presidents, when the government says to colleges, “Go ahead, admit whoever you want. I, the government, will subsidize it, I’ll provide low interest loans, I’ll provide grants to these students.” What do college presidents do? The same thing any reasonable person would do; turn around, open the doors, and let anybody who wants in to come in. The end result its, many small colleges, like many small banks, are going to go bankrupt.
There will come a point, in the not too distant future, when a large swath of students who have gone through college turn around and discover they can’t afford to pay for this debt that they have incurred. And the world will go forth to high school students, “Don’t go to college, because all that will happen is you’ll be saddled with this large debt that you can’t repay.” And so, there’ll be a tremendous decline; like the burst of the housing bubble, there’ll be a tremendous decline in the demand for college education, and many small colleges will go bankrupt.
What’s the moral of the story here? The moral of the story here is not that banks, or colleges, are somehow blameless in all of this. The moral is that banks and colleges are made of human beings, and human beings will make mistakes, some of them will act selfishly, some of them will act duplicitously. But when the government steps in, and removes the penalty for acting like that, as it did when it broke the link between risk and return, it takes off the table the punishment that the market can dole out for bad behavior.
And without that punishment, banks, colleges, are going to do what any reasonable person would guess they would do. They will turn around and give as much of their product to as many people as show up, because in the end they believe the government is gonna pay for it.