Monday, February 13, 2012

Financing Education, another mortgage crisis in the making?

Originally published on Technorati as Financing Education, Another Mortgage Crisis in the Making

Every once in awhile you see an article come up about Federal Student Loan programs and this week I saw two.

Reuters published an article a few days ago suggesting some fuzzy math by's Mark Kantrowitz concerning the nation's total student loan debt. It suggested that Kantrowitz may have overstated the number and was actually more like 610 to 800 Billion dollars. Not quite the 1 trillion dollar number being bandied about but historically large nonetheless.

On the political side Ron Paul (Republican candidate for president) in an interview on Sunday's (10/23/2011) Meet the Press on NBC said, "he'd kill the loan program eventually if he were president". His comments were framed in the context of higher education costs being inflated by government intervention.

While it's refreshing that the magnitude of the problem is coming to light, I've yet to see any real action to change it. Last year as part of President Obama's health care reform act, new student loans were going to be directly administered by the federal government. The goal was to eliminate the loan servicers who are in effect the middlemen of the student loan industry. Their function was to handle the administrative aspects of the Federal student loan programs adding fees and costs to the borrowers total indebtedness as well as to the Federal government.

While a welcome change, the legislation did virtually nothing for current loans. Student loan servicers haven't gone anywhere and as student debt grows it's a sure bet that a portion of that increase can be attributed directly to fees and gaming of the system by both schools and loan servicers.

The issue is that this isn't a fair game; in fact it's got worse odds than a Vegas slot machine. As I look at the overall condition of the economy it's not a stretch to believe that default on student loans is going to be the next financial bubble to collapse taking the government backed student loan program with it as well as the banks participating in it.

The Federal student loan programs were meant to give an opportunity to those who'd otherwise not have it. At its core it was meant to back education loans made by private banks with federal money virtually eliminating any risk of non-payment to the bank.

Let's make this point crystal clear. The bank that loaned you the money is at absolutely no risk of default from giving you a student loan. That's why you almost never had to produce a credit report or collateralize the loan. The Federal government in essence vouched for you.

Of course as it is with most government programs without adequate oversight things eventually went wrong. Private Schools and profiteering middlemen (loan servicers) have been able to game the system with increasing tuition rates and complex loan terms. Banks frequently bundle and sell student loans using the loan servicer as a kind of broker. In my own experience, my student loans have been serviced by two servicers and owned by at least 4 different banks since their origination.
Sound familiar? It should. It's not unlike the packaging and reselling of mortgages or the operation of the derivatives market.

The school's role in this has been to; increase tuition, raise the number of required "filler" classes unrelated to the degree program and in the most egregious cases direct their financial aid departments to promote programs more favorable to their relationship with preferred lenders.

It's easy to say "Caveat Emptor" but then how many of us really understand the terms of our loan agreements or their connection to the financial markets that have corrupted the process.

Once you're in the system you do have certain benefits from having a government backed student loan such as the ability to defer payments due to unemployment or disability. The down side is that you suffer the penalty of "capitalized interest" each time you need to defer a loan payment. Your entire balance is recalculated to encompass the unpaid interest into the principal. Over the life of a loan that can mean as much as an extra 10% to the original principal. Add in the standard 3% to 8% standard interest on the loan and you can quickly find yourself digging an ever deeper financial hole.

With more of us barely getting by, exercising options such as loan consolidation, payment deferment or both becomes more likely. Consolidation can lower payments but your term extends indefinitely. This makes it harder to pay down the principal since the amortization schedule becomes a moving target.

 Most consolidation and income sensitive repayment programs try to front load the loan so that only interest is being paid for most of the loan's life with principal payments only applied much further down the line.

This sounds familiar as well, it's not unlike like the interest only mortgages being written before 2008.

There's no end to the traps a borrower can fall into and I won't even get into the dire consequences of default on a student loan. While recent changes help new borrowers, something needs to be done for those already encumbered by a corrupt system.

I'd suggest that after 10 years of repayment history that no more interest can be charged and all payments go directly to the principle balance of the loan. I'd also outlaw capitalized interest as it's a hidden extra cost which is unjustifiable due to the simple fact that the lender still receives interest payments and has no risk. I understand fees to offset risk and that's fair. A government backed loan offers no risk which raises such fees and practices to the level of extortion.

Regardless of who's talking point it is, nothing real has been done for those truly affected. Until it is nothing being said has worth outside of today's 30 second sound bite