The next financial crisis: The student loan crisis

Alright, calling the student loan crisis a “crisis” is in fact an exaggeration. However, if we don’t get ahold of colleges and universities price increases, then we’ll certainly have a crisis on our hands and it will be ugly.

Introduction to the financial crisis

The financial crisis of 2008 was created by having available and cheap credit given to both banks and Americans. Causing a freeze in the credit market. Here’s a brief summary of what occurred to the years approaching 2008 and how it compares to the available and cheap credit to finance school for students.

Disclaimer

While some of these financial products (i.e. CDOs and sub-prime mortgages) were available prior to 2000, it only started ballooning to what is was after 2000

It was early 2000’s

There was an economic slowdown back in 2000, followed by the dot com bubble, and shortly after September 11th, the economic slowdown only became worse. In turn, to stimulate the economy, Alan Greenspan, Fed chairman at the time, lowered interest rates to 1% making borrowing cheaper for both consumers and banks. Rates that have not been seen since 1960’s.

Banks and financial institutions (such as Wells Fargo, JPMorgan, Bank of America) were delighted to pay 1% on borrowed money from the Fed. However, it’s no use for the bank to have cheap borrowed money and not be allocated to make a profit. So the banks started leveraging.

- Using borrowed money to create a positive profit is called leveraging. -

So, banks had a bright idea, they worked alongside mortgage lenders (such as Freddie mac and Fannie Mae), the companies who are in charge of giving homes/mortgages to future homeowners. Once the mortgage was finalized, the mortgage lender would then sell that same mortgage to a bank with the borrowed money that was given by the Fed.

Multiply that transaction

That same bank would end up borrowing millions, sometimes billions from the Fed in order to purchase as many mortgages as possible from the mortgage lender. It made sense for the bank to purchase the mortgage, at the end of every month, the homeowners would pay their mortgage plus any interest, and the interest would go to the bank, the bank pays off the borrowed money from the Fed, and any excess the bank would keep is profit. The only issue was, the average person can’t pay off their mortgage in one payment, it usually would take 15 or 30 years for the bank to be paid back, and YALL ALREADY KNOW THEY WERE NOT GOING TO WAIT 15 - 30 YEARS TO SEE THEIR MONEY BACK LMAOOO, SO THE BANKERS HAD ANOTHER BRIGHT IDEA.

The CDO was born

Right, so you know how the mortgage lender would sell all their mortgages to the bank? Well, the bankers decided to create an investment product out of those same mortgages, to sell to investors, here is how.

They bundled up ALLLL the mortgages, categorized them, and gave the bundle of mortgages a credit rating. What does that mean? Essentially, all the people who were deemed as safe individuals who would not default (miss their mortgage payments) on their mortgage would get a good rating and those who were at risk to default on their mortgage would receive a bad rating. Soon after the mortgages with safe, okay, and risky ratings were given, they were all bundled up into an investment bond called a CDO or Collateralized Debt Obligation. Investors would go nuts over these bonds and would invest millions into them. With the riskier investment yielding a higher return and the safer rating yielding a smaller return, however, always greater than 1%. And who you might ask were also investing heavily into these said bonds? You guessed it, the banks and hedge funds were.

Banks get greedier

So, banks see success in their returns on mortgages, their CDOs go up in price, they are all getting rich, home prices are skyrocketing since there is so much demand for a home, everyone is paying higher monthly bills for their mortgage, it’s all great. They push their mortgage lender to sell more homes. The only issue is, the ones who already qualified for a home, have a home and a mortgage. So they ponder, what could we do? They figured to give mortgages to those who didn’t qualify for one, why? If the homeowner defaults on their home, the lender (the bank since they purchased the mortgage) would keep the home, and since home prices were increasing significantly year over year, the bank would simply put it up for sale at a higher price to evade any losses and sell it again. In turn, banks did not require for you to place a down payment on the home, verify your income (or even have a job in the first place) or verify any assets.

Sub-prime mortgages were born

The mortgages given to those who typically were not eligible for a mortgage (no proof of assets, income, and no down payment) were called sub-prime mortgages. These mortgages had clauses in them that might have given the borrower an intro rate of 0% but would later skyrocket the interest on their mortgage. Very predatory lending on behalf of the banks.

Consumers are dumb anyway, the bank does not care about educating the client, they just want whatever they can take from them and sell that mortgage. So now, everyone in America was purchasing a home, the demand for a house skyrocketed and in turn, so did housing prices which inflated significantly.

Sub-prime mortgages become CDOs

Now, apply the same concept of the CDO but this time with sub-prime mortgages, just a bunch of shit mortgages bundled up, rated, and sold to investors. Keep in mind, they were given good ratings since their standards were against other sub-prime mortgages. However, they had the riskiest borrowers out of all the CDO bonds.

Disaster strikes

The bank does not care if one person defaults on their home, they simply place it up for sale and wait for the next sucker to purchase it. Plus, the bank receives a lot more monthly income from all the other mortgages, it offsets the loss, it isn’t a big deal at all. Prices for mortgages increase and so does the value of the home. However, as time goes by, the Fed rose rates and in turn, mortgage rates went up as well. Suddenly, more of that monthly income become clients who default on their payments and the bank is stuck with another home, and another home and another home. Soon, millions of Americans default on their homes as they struggle to make their payments, and millions of said homes are place for sale, in turn, creating a surplus of homes and little to no Americans who would like to purchase a home. Home prices fall drastically, the few homeowners who are fortunate enough to continue affording their homes realize that other homes are place for sale around their neighborhood and question why they pay a high monthly mortgage on a property that is not worth or equivalent to that of the mortgage and is instead worth less. In turn, they foreclose their own property and move elsewhere.

Panic strikes

The bank is left with homes and mortgages that are worth less. Investors attempt to sell their CDOs to anyone at this point, but find no buyers. The Fed or other lenders are demanding their money back since the banks used borrowed money to purchase up these mortgages and can’t pay them back. The lenders attempt to sell any mortgages outstanding to the bank, but the bank refuses to purchase. In turn, the credit market froze, the mortgage lenders would file for bankruptcy, the banks are in the brink of bankruptcy. The whole financial system falls apart.

College tuition versus home prices

Now, how does college tuition and home prices compare? Well, for starters, they’re something that has been increasing year over year, in the chart below, you can see that tuition, school fees, etc. increased even during recessions. Far outpacing inflation.

inflation on tuition.PNG

Now, in comparison to home prices, where they actually temporarily dip during recessions and especially dipped in 2008. Meaning that tuition prices do not have any regards to the economic environment.

cpi for college and house prices.PNG

Usually during a recession, individuals face economic hardships, either job loss, a tightening budget, or a decrease in their income. Which begs the question, if tuition prices are increasing year over year, even during economic hardships, how are consumers still able to afford it?

Student loan debt

student loan debt over time.PNG

Students find loans and borrow excessive amounts of cash, Americans now owe about $1.5 trillion in student loans. While mortgage debt is at $10.5 trillion. However, the big difference between a mortgage and a loan for school is this; if you default on your mortgage, you lose your home, if you default on your student loan you don’t lose your degree… in fact, you can’t default on your student loan. You see, you default after 270 days of not making your payment and within that time frame, your credit score tanks. You then enter delinquency, which is followed with an awful amount of consequences such as; wages garnished, your loan holder can take you to court, you can’t receive any federal student aid, you cannot get any deferments or forbearance, and your federal payments can be withheld.

If your student loans are Federal student loans, well, it’s even harder to default on them, when the government can pursue their payments without needing to take you to court.

You can’t file for bankruptcy

Well, yes and no, yes because it’s possible, but chances of your filing for bankruptcy and getting your loans either forgiven or reduced are small. How small? Well, only 0.1% of student loan borrowers attempt to discharge their student loans in a bankruptcy filing. Of that 0.1% only 40% actually receive a discharge or a payment reduction. Meaning that percentage is now 0.04%

The connections

Student loans are given to high school seniors that are seeking higher education who do not have any credit background, little to no assets, or a job and on average end up with a balance of $25,000 - $30,000 to pay after their 4 years. Sub-prime mortgages were given to those without a job, no assets, and no credit background check, but was certainly given a nice home.

Number of students are now struggling to make their payments, find a job, or have majority of their income go towards loan payments rather than necessities and wants (which also harm the overall macroeconomic environment) the home owners were struggling to make their mortgage payments as home prices and interest rates went up.

Homeowners then foreclosed, others questioned if the value of their home was remotely worth what they were paying for, in turn home prices fell. Should these students question the value of their education and ultimately have the price of education fall?