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Keynote Remarks of Rohit Chopra
Assistant Director & Student Loan Ombudsman
Federal Reserve Bank of St. Louis
St. Louis, Missouri
November 18, 2013
Thank you to President Jim Bullard and everyone at the Federal Reserve Bank of St. Louis for inviting me to speak today on the impact of rising student debt on the balance sheets of young American households. As the name of St. Louis Fed’s Center indicates, household financial stability is a key ingredient to the health of our economy and financial system.
First, I will outline some of the distressing debt and wage trends among young Americans. I will then discuss some of the striking structural similarities between the mortgage and student loan markets, particularly in the years leading up to the crisis. Finally, I will argue that we must resist the temptation to address these concerns solely through an education policy lens, when, in fact, they may require very significant attention from financial regulators and the financial services industry.
As always, these views are my own and do not necessarily represent the views of the Consumer Financial Protection Bureau.
The Bureau estimates that there is approximately $1,200,000,000,000 in student loan debt owed by around 40,000,000 Americans. This equates to roughly $30,000 in outstanding debt per borrower and does not include what may be a substantial amount of education-related debt in the form of credit card, home equity, and retirement account borrowings.
While conventional wisdom has focused heavily on rising tuition as the primary driver of debt, this may be too simplistic. There is no question that the decline in state support for public higher education has been a long-running trend that has impacted tuition. But according to the College Board, average debt for new bachelor’s degree recipients at public institutions has risen more rapidly than tuition, room and board, and fees after grants and scholarships.
Outstanding student loan debt has doubled since 2007 – a stark contrast to the credit card and mortgage markets. Enrollment patterns and tuition increases alone do not solely explain this dramatic increase. The deterioration of household balance sheets seems to be a major culprit.
Over that same period, millions of American households experienced severe economic shocks, including unemployment, large declines in home values, and big drops in retirement account values. This reduced the wealth and credit capacity for families to fund the costs of higher education. In other words, rising student debt levels aren’t just the result of a cost shift from the public to the individual family, but within the household from the family to the individual student. As of 2010, 40 percent of households headed by an American under 35 are on the hook for a student loan, and I expect this to rise.
Rising student debt burdens may prove to be one of the more painful aftershocks of the Great Recession, especially if left unaddressed.
But are rising debt levels necessarily a bad thing? After all, the public frequently issues bonds to fund transportation and energy infrastructure which may yield substantial benefits that make the debt worthwhile.
Labor market indicators give us some clues. Much has been made of the college wage premium, that is, the difference between incomes of college graduates versus non-college graduates. According to analyses of Census Bureau surveys, a bachelor’s degree recipient can expect to earn an average of $1 million more in lifetime income than a wage-earner without a degree.
But behind that headline number is a more troubling trend. The growing gap between college graduates and others isn’t really due to rising starting wages for the average college graduate – it’s that the wages of those without a degree are falling rapidly. In fact, when accounting for inflation, young college graduates have found that starting wages are falling.
According to an analysis of the Current Population Survey, between 2000 and 2011, the real wages of young high school graduates declined by 11.1 percent, and the real wages of young college graduates declined by 5.4 percent. Even if we focus on the pre-crisis period from 2000 to 2007, the same trends hold, where young college graduates’ wages slipped, but not as fast as their high school graduate counterparts.
Among young workers, the unemployment rate for non-degree holders is twice the rate of college graduates. Ironically, it is more important than ever to go to college to ensure a secure middle class life; but, in terms of wages, the return on investment is declining. A college degree is turning out to be a valuable insurance policy, with premiums that keep going up and up.
The combination of more debt and lower incomes means more risk, and many young workers are walking on an economic tightrope.
So what are the implications of a large portion of the population entering the labor force with elevated debt-to-income levels? In March of 2012, my colleagues and I found that outstanding student debt was much higher than previously estimated, crossing the trillion dollar threshold in 2011. I expressed concern at the time that student debt levels may impede the recovery of the housing market, since borrowers may be less able to accumulate a down payment or qualify for a mortgage. Since that time, senior executives in the financial services industry and other financial monitors have also expressed worry about the impact of student debt on household formation, consumption of consumer durable goods, and credit creation.
In 2012, for the first time in at least 10 years, 30-year-olds with no history of student loans were more likely to have mortgage debt than those with student debt. According to a recent survey by the National Association of Realtors, 49 percent of respondents described student debt as a “huge” obstacle to affording a home.
Last year, Chairman Bernanke remarked that “lending to potential first-time homebuyers has dropped precipitously, even in parts of the country where unemployment rates and housing conditions are better than the national average. Indeed, the propensity of younger households – headed by adults aged 29 to 34 – to take out their first mortgage has been much lower recently than it was 10 years ago, a period well before the most recent run-up in home prices.” Two weeks ago, he noted that student debt may be impacting the ability of many young people to buy their first home.
Debt Déjà Vu
The student loan-housing connection is actually much deeper than the first-time homebuyer problem. It may be useful to note some of the similarities between the mortgage and student loan markets in the years leading up to the crisis.
Both the student loan market and the mortgage market made heavy use of explicit or implicit government guarantees. The credit risk on most mortgages had traditionally conformed to the underwriting standards set forth by government-sponsored entities (GSEs), like Fannie Mae and Freddie Mac. Similarly, the Federal Family Education Loan (FFEL) program allowed financial institutions to originate – and securitize – student loans meeting certain guidelines for students attending qualifying institutions to be insured by a set of guarantors.
As noted in the report by the Financial Crisis Inquiry Commission (FCIC), underwriting standards for conforming mortgages purchased by the GSEs had become less stringent; mortgages originated to the lower credit-tiers grew quickly. The parallel to the student loan market is striking here – over the same period, financial institutions originated an increasing share of loans under the federally-guaranteed program to students attending for-profit colleges. In the 2000s, for-profit college enrollment increased five-fold, to 1.2 million students in 2009. The sector continues to have higher rates of borrowing and lower graduation rates, along with significantly higher default rates. Mortgage brokers, for-profit college admissions personnel, and loan originators were able to arrange enormous loan volumes with little to no skin in the game.
The similarities are not limited to guaranteed mortgages and student loans. The 2000s also saw the expansion of private credit in both markets. In the mortgage market, Fannie Mae and Freddie Mac’s market share rapidly shrank, and taking their place were private-label securitizations. As the CFPB and the Department of Education noted in a 2012 report to Congress, origination and securitization of private student loans boomed, quadrupling from less than $5 billion in 2001 to over $20 billion in 2008, growing at a faster rate than the FFEL program.
Private-label mortgage backed securitization fueled origination of so-called “Alt-A” mortgages where credit scores may have been high but other factors precluded them to meet GSE guidelines, as well as subprime mortgages, which frequently had flimsy documentation requirements. Demand for private student loan asset-backed securities increased not only co-signed, school-certified loans, but also subprime-style lending, where loans were often originated in excess of tuition and fees. In many cases, private lenders didn’t even verify whether the student had already borrowed federal loans or even if the student was enrolled.
Given these similarities, it should not be surprising to find common problems when loans became due. A tough job market meant that many Americans needed to find options to honor their mortgage and student loan obligations. But both mortgage and student loan borrowers face two key problems with their servicers.
First, when borrowers do have options, they can still be stymied. In the mortgage market, borrowers whose loans were owned by GSEs had options available to them to modify and refinance their mortgages. Even though some sort of modification may have been in the best interest of the investors holding the mortgage, many mortgage servicers were unable to successfully work with troubled homeowners. Fed Governor Sarah Bloom Raskin lamented the “agonizingly slow pace of mortgage modifications and repeated breakdowns in the foreclosure process.”
In the student loan market, many borrowers with government-guaranteed student loans owned and serviced by financial institutions also report difficulty enrolling in Income-Based Repayment and other programs for borrowers facing hardship. While comprehensive data is not available, several major market participants in the FFEL program do not appear to be succeeding in enrolling struggling student loan borrowers in income-contingent plans.
In the servicing of government-guaranteed mortgages and student loans, incentive misalignment may be acute. A default may sometimes be more beneficial and less costly for the servicer, compared to enrolling a borrower in a loan modification program.
Second, many borrowers have simply run out of options. For homeowners whose mortgages were ultimately sold into a pool for investors in private-label mortgage-backed securities, servicers generally offered little (or no) help for the borrower to find an affordable payment. The same is true with private student loan borrowers who may be facing temporary hardship and looking for an alternative repayment option to get through tough times. Like a business, a consumer’s ability to manage cash flow is absolutely critical to financial health. Private student loan providers generally do not offer this cash flow management option, which is available to borrowers of federal student loans.
For struggling homeowners and student loan borrowers, the consequences of being unable to find an affordable repayment option are severe. The impacts of foreclosures may not just be felt by the former homeowner, but potentially by the entire neighborhood. For student loan borrowers who default early in their lives, the negative impact on their credit report can make it more difficult to pass employment verification checks or ever reach their dream of buying a home.
A similar roadmap?
Given that student loan obligations become due after a student leaves school, signs of distress emerged after similar signs in the mortgage market. Congress enacted a wide range of reforms to the mortgage market; they may shed light on options to address the significant structural deficiencies in the student loan market. I will mention a few of these reforms, along with how they might relate to student lending.
Ability to repay: Many policymakers have viewed the lack of an explicit federal requirement for lenders to consider a borrower’s ability to repay as a critical flaw in the housing finance system prior to the crisis, which enabled lenders to make unaffordable loans to borrowers. For centuries, creditors would generally earn a profit only if a borrower could pay back a loan with interest. But modern structured finance allows a number of market participants to profit from a loan, even if a borrower isn’t able to repay it.
While housing GSEs were providing a credit guarantee for a substantial share of the mortgage market, lenders did not have a strong incentive to ensure that borrowers could repay their loans. As a Countrywide Financial Corporation executive noted to the Financial Crisis Inquiry Commission (FCIC), the company’s essential business strategy was “originating what was salable in the secondary market.”
The Dodd-Frank Act seeks to address the moral hazard implicit in this arrangement. More specifically, the qualified mortgage provision generally requires that lenders make a reasonable and good faith determination that a borrower has the ability to repay a mortgage loan.
Admittedly, this ability-to-repay framework is not totally applicable to student lending, given that the purpose of the credit obligation is for human capital investment. Most federal student loans currently have a safeguard to ensure a borrower can repay, namely in the form of various income-contingent plans. But as noted earlier, private student lenders do not offer these features and their loans were disproportionately utilized by students enrolled in programs with low graduation rates and high default rates.
The Department of Education is currently seeking to address similar moral hazard issues by addressing program eligibility for schools that may not be preparing graduates for employment that helps them repay their debt.
Incentive alignment: Other provisions of the financial reform law seek to align the incentives across various market participants in a credit transaction. The risk retention requirement for securitizers is worth noting.
Dodd-Frank generally requires that a securitizer of asset-backed securities (ABS) retain an economic interest in not less than 5 percent of the credit risk of the assets collateralizing such ABS. Theoretically, if a securitizer has skin in the game, more attention will be paid to the credit characteristics of the underlying collateral. A report to Congress from the Fed noted that “by retaining a portion of the credit risk, the securitizer and/or originator will have an incentive to exercise due care.”
In 2010, Congress enacted a law suspending origination under the government-guaranteed FFEL program, shifting almost exclusively to direct lending. The incentive misalignment in the market today seems to primarily exist between schools and the federal government.
Program eligibility for federal student loan and grant programs is generally binary, and a small number of schools have been removed. For example, a school can be removed if roughly a third of borrowers entering repayment in a particular year default within the next three years. But as long as that line is not crossed, schools generally qualify for similar levels of loan and grant programs.
But regardless of whether a student graduates or drops out, the school’s revenue from federal aid programs does not vary. The same is true of revenue derived from veterans qualifying for benefits under the Post-9/11 GI Bill. This may provide an incentive for schools, particularly for those who owe a fiduciary duty to shareholders, to focus primarily on enrollment rather than outcomes. The similarity to a mortgage originator whose compensation is not dependent on loan performance is quite striking. Providing upside potential and downside risk may better align incentives.
Servicing: As I described earlier, the breakdowns in the mortgage servicing industry were severe and widespread. Many large mortgage servicers reached settlements with regulators to address a range of troubling practices, including a practice known as robo-signing, where banks submitted foreclosure documents that were not properly reviewed or notarized. In addition, there were a number of cases of improper treatment of military families, many of whom faced foreclosures, which are restricted under the Servicemembers Civil Relief Act.
The CFPB has received a number of complaints from private student loan borrowers, indicating that market participants may not always have adequate proof that they own a loan that is allegedly in default, as well as complaints of improper – and potentially illegal – conduct when active-duty servicemembers seek their legal right to an interest rate cap on their student loans. In general, many of the complaints from private student loan borrowers are arrestingly similar in nature to the troubles faced by struggling homeowners when dealing with their mortgage servicers.
Earlier this year, the CFPB proposed a rule defining larger participants in the nonbank student loan servicing market. If finalized, the rule would create a level playing field between banks and nonbanks Supervision can help correct deficiencies early, before harm becomes widespread.
The Dodd-Frank Act included a number of provisions that seek to correct weaknesses in the mortgage servicing industry. The provisions include changes to servicing transfers, payoff statements, error resolution, records retention, and interventions for troubled borrowers, among others. Many market participants and policymakers are looking closely at these reforms to determine whether they might also strengthen the student loan servicing industry.
Earlier this year, the CFPB published a report that discussed potential options for creating a consistent framework for a potential industry-wide program to rapidly accelerate the pace of loan modification activity in the private student loan market. Existing industry players have indicated that they plan to make progress, but results to date have been lackluster.
Many student loan subsidiaries are very small parts of their large, complex financial institution parents. As a result, senior executives and directors may lack adequate incentive to allocate sufficient management attention to the sector. Like the mortgage market, this may prove to be a significant structural impediment to proper functioning of the market.
Undoubtedly, there are a number of lessons to be learned from the mortgage market that may provide valuable clues to improving the student loan market.
Not just an education issue
Education policymakers are rightfully focused on ways to increase college completion rates, to reduce college costs for future students, and to prepare students for the labor force. But this cannot be the sole focus, since these policy interventions will not address the numerous problems posed by the debt already owed by tens of millions of Americans. It would be irresponsible for financial regulators and economic policymakers to ignore the existing trillion.
I was asked to briefly discuss some specific areas where the Federal Reserve System might devote attention. There are two areas in particular that are worth noting.
First, the existing structure of the student loan market may prove to be an obstacle in the transmission of monetary policymakers. A significant trouble spot in the market is the lack of refinancing options. Borrowers, even after graduating and attaining employment, find themselves unable to take advantage of their improved credit profile and today’s historically low interest rates.
A 2012 Fed white paper submitted to Congress noted that “barriers to refinancing blunt the transmission of monetary policy to the household sector. Further attention to easing some of these obstacles could contribute to the gradual recovery in housing markets and thus help speed the overall economic recovery.” Given that a large portion of younger households have student debt that is difficult to refinance, the benefits accrued to these households from today’s interest rate policies may be limited, compared to a household with a mortgage to refinance. Since younger households tend to be poorer, reduced rates and lower payments might translate into higher consumption levels, given their marginal propensity to consume relative to other households. Ironically, the lack of refinance options, combined with rising residential real estate prices, may actually put homeownership even further out of reach for younger households with student debt.
Second, Fed Vice-Chair Yellen noted last week that, prior to the crisis, financial regulators “missed some of the important linkages whereby problems in mortgages would rebound through the financial system.” I believe that the student loan market, relative to other consumer asset classes, is quite opaque, adding further uncertainty about the potential spillovers into the rest of the economy. I am quite concerned that financial regulators and the public lack basic, fundamental data on student loan origination and performance.
For example, my colleagues and I published an analysis of the status of government-guaranteed and direct student loans. The data revealed something surprising to many researchers: the average balance on loans in default was much smaller than the average balance in forbearance or repayment. To me, this suggests that borrowers who default are overwhelmingly non-completers. These borrowers take on some debt, but do not benefit from the wage increase associated with a degree.
But without robust performance data, we cannot know for sure whether this is the case, or whether borrowers are successfully paying down substantial principal and defaulting when experiencing an income shock years later.
Most loan-level mortgage origination data is currently subject to public disclosure, stripped of borrower-identifiable information, under the Home Mortgage Disclosure Act. Data from housing GSEs and mortgage-backed securities filings shed significant light on loan-level performance.
The Federal Financial Institutions Examination Council collects reports from insured depository institutions on balance sheet holdings, but student loans are aggregated with many other types of non-mortgage credit products. SEC filings from large financial institutions rarely report key data on student loans. Student loan ABS filings and servicer performance reports are much less granular than similar mortgage reports. The drivers of prepayment, delinquency, and default in the student loan market are not well-understood by financial analysts. Questionable accuracy of credit reporting data furnished by lenders and servicers in the student loan industry adds further noise and uncertainty.
The CFPB and other regulators have made significant strides to assemble existing mortgage data to better monitor the market. Similar efforts are needed to better understand the drivers of student loan origination and performance, as well as the impact on household balance sheet composition and the mortgage market.
The path forward
The CFPB, as the primary financial regulator of the student loan industry, and the Department of Education, as administrator of federal aid programs, have worked closely to provide consumers with better decision tools. The new Financial Aid Shopping Sheet that gives clear information to prospective students on loans and grants has been voluntarily adopted by nearly 2,000 colleges and universities. The Department of Education’s new College Scorecard and the CFPB’s Repay Student Debt tool are already helping consumers make smarter choices.
In conclusion, I do not believe that the student loan market poses an immediate threat to the solvency of systemically important financial institutions like the mortgage market posed in the period leading up to the crisis, but in some ways, this reduces the urgency for action. And inaction bears the risk of economic drag.
The upcoming expiration of the Higher Education Act may present an opportunity for creating a better functioning student loan market. But this will require the close cooperation of education and financial policymakers to address the incentive misalignment, servicing infrastructure, and data gaps in the student loan market. There may be important lessons to be learned from recent efforts to address similar structural deficiencies in the mortgage market.
Thank you again for this opportunity, and I look forward to working with many of you to ensure that young American households with student debt can fully participate in the economic recovery in the years to come.
This presentation is being made by a representative of the Consumer Financial Protection Bureau. It does not constitute legal interpretation, guidance, or advice of the Bureau. Any opinions of views stated by the presenter are the presenter’s own and may not represent the Bureau’s views.