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Dan Nestlerode: Is Student Loan Takeover Just Another Bailout?

by on April 22, 2012 7:47 AM

Management guru Peter Drucker declared that organizations are good at some things and bad at others based solely on their structure.

So it follows that the various organizations that comprise our country are excellent at some endeavors and not so good at others.  Corporations are good at focused activities that are customer centric and profit producing.  They are not so good at social activities like dealing with homelessness.

Our government is great at foreign policy, but not so good at providing effective, cost efficient healthcare.  Charities are great at dealing with homelessness and poverty, but find it difficult to contain costs and deliver products.  Hierarchical systems common in corporations and other business structures are good at focused and vertically directed behavior, and not so good at flat and broad behavior.

Conversely, our government is much better at flat and broad behavior dealing with the democratic process of hopefully resolving conflicting interests.

Different organizational structures lead to different outcomes and disregarding principles of management often leads to bad outcomes.    

In 2010, the Federal Government assumed all aspects of the student loan business, essentially removing the banking system from lending money to students to complete their higher education.  The federal student loan program, originally established in 1965, guaranteed loan repayment to the banks, essentially underwriting borrowing students who had no income or assets to collateralize.

Because the Federal Government was willing to provide subsidies and guarantee the interest and principal money flows should the student default, the banks made no judgment on the repayment ability of the borrower.

This was a slam dunk business for the banks, essentially providing loans to students at zero risk to themselves.  Over time, Congress gradually reduced their subsidies and expanded Pell Grants, but the banks still had their steady loan business – until the government moved to take over the entire process, pushing the commercial banking system to the side.

The student loan business is now the fastest growing credit business in the country, outpacing credit card debt for the first time in 2010.  It is also a business with a huge default rate (8.8 percent of those starting repayments in 2009 and 15 percent of those who borrowed to attend for profit institutions).

Is this then, the next bailout business, just like the auto companies, banks and brokerage firms?

At first blush, student loans appear to have benefits because it is assumed that persons with college degrees and advanced degrees earn substantially higher life-long incomes than those with just a high school or lower level of education.

But the truth is, the student loan program falls far short of what might otherwise be considered prudent or sustainable in terms of loan commitments and eventual repayments.  All borrowing students must understand that sweeping generalizations about life-long income does not guarantee that every student who gets a higher degree will get a higher income.

Every borrowing student will still have a loan to repay regardless of the amount of their future paycheck.  There is a substantial risk to life-long financial success that is incurred when one borrows money for college or some other advanced education.

It is important that every student gets the appropriate financial counseling before signing any loan papers.  Borrowing without a repayment plan is foolhardy.  I was chatting with a neighbor recently who is representing an unemployed young woman who has an advanced degree and more than $200,000 in student loans.  Since bankruptcy does not eliminate student loans, this young lady faces at least 25 years of paying a substantial part of her income (should she get a good job) just to pay the interest on her loans, nevermind any principle reduction.

I understand that after 25 years of making payments the Federal Government forgives the remaining principle balances (bailout alert!).  Did anyone counsel this woman about the unfeasibility of her borrowing at the point of signing the loan papers?                   

In this economy with high unemployment, many are seeking to further their education in order to qualify for better jobs in the future.

Many students are taking advantage of the student loan programs to further their education, putting themselves in a huge financial hole from which they might never be able to recover.  The government makes borrowing easy and the higher educational institutions encourage such borrowing.

It seems no one has any foresight as to where this program is headed on either the individual or macroeconomic level.  As Drucker said, some organizations are good at some things and bad at others.  No one wants to take responsibility for the consequences of a bad outcome.  I wonder if we learned anything from the collapse of Freddie Mac and Fannie Mae.

I guess not, as they are still underwriting unsustainable real estate loans with a full draw from the U.S. Treasury.  It would seem that we are institutionalizing the right to a higher education, just like healthcare and retirement.

Until our political system finds a way to rein in its financial largesse for every voting group, we are destined (read: doomed) to use monetary policies to make up for our lack of fiscal restraint. 

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Dan Nestlerode is the Director of Research and Portfolio Management at Nestlerode & Loy Investment Advisors in State College. A graduate of Penn State University, Nestlerode has been an investment advisor since 1965. He can be reached at danielj@nestlerode.com.
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