We’ve recently been thinking about wealth transfers resulting from student loans insured or directly issued by the U.S. government. On initial examination, the situation appears to be one where an implicit transfer of wealth from taxpayers to higher education students takes place.

The transfer results from loans being issued to students at rates below a proper risk-adjusted market interest rate. However, on examining the market more closely, we see that the reality is that taxpayers and students are both being used in a much larger transfer of wealth. The ultimate beneficiary in this government-led cartel is the higher education sector.

A Brief Overview Of Student Lending

In the United States most of the cost of higher education is covered by students and their families, at least ostensibly. Much of the cost is financed through borrowing, and the share of this portion has been rising, particularly since the start of the 2007 recession. As we can see in charts 1 and 2 below, the share of students who borrow and the average balance have both been climbing steadily over the course of the past decade at rates much higher than inflation.

War on Women - Chart 1   Title IX - Chart 2

Chart 3 below gives us a simple view of the composition of student debt currently outstanding. The vast majority of these loans have been either insured by or issued directly by the federal government. “Federal” student loans outstanding had topped $1 trillion, 83% of all student debt, and another $200 billion in “private” student loans is also outstanding—these loans are not subsidized by the government.  Readers interested in a more detailed overview are referred to here and here.

Federally-insured or issued loans use pre-packaged terms that cover everything from the interest rate charged (historically about 5-7%) to the manner which lenders are required to go about collecting payments. From 1965 to 2010, private lenders made student loans using federal terms in exchange for government insurance covering student defaults and a guaranteed interest rate on the loans.

This program was called Federal Family Education Loan Program (FFELP) and operated in conjunction with SLMA, the GSE better known as Sallie Mae. Sallie Mae began to privatize in 1997 and the process was completed in 2004. The federal government also ran a “public option” loan program called Federal Direct that covered small and high-loss schools not serviced by private-sector lenders.

As a horse-trade to get votes from hard-core leftists in Congress not satisfied by ObamaCare, the “Affordable” Care Act legislation was amended to end FFELP and establish Federal Direct as a monopoly for federally-insured loans. Currently, about 45% of the outstanding federal loans are left over from FFELP with the remainder issued and held by the Federal government.

The FFELP loans will have largely been securitized, with the possible exception of loans which Sallie Mae or Citigroup have in term warehouses. Since no new FFELP loans are being issued, the share of Federal Direct loans is steadily rising.

The private-label student loan market only makes up about 15-20% of currently outstanding student debt, but the “Wild West” qualities of this market make it very interesting. The loans are priced based on credit, so in this case we can actually see a market estimate of the proper risk pricing for these types of loans.

What we see is that these loans are largely priced like personal loans, with rates ranging from 5 – 25%.  Many large and reputable banks do have private loan programs, but the high interest rates draws in all sorts of players. One example was the “non-profit” EduCap, which focused on making loans to students from upper-income families that didn’t qualify for financial aid.

The company bumped into unwanted attention when Tom Daschle was criticized for hitching a ride to Bahrain on the non-profit’s corporate jet. The incident was viewed by commentators as ending his chance of being named Secretary of Health by the Obama Administration.

Title IX - Chart 3

A brief overview of the terms and attributes of the loans will also be helpful. As mentioned, Federal student loans have historically carried 5-6% rates with repayment terms of 20-30 years. The student isn’t required to repay while in school and can “defer” the loan for up to two years due to lack of income.

The actual expected life of the loans is about 10 years. Federal loans for undergraduate students do not include a credit check, but loans for parents and graduate-level students do have a minimal credit screen. Private student loans will have repayment terms from 10-20 years, but have a shorter expected life 5-7 years due to prepayments.

The most important feature of student loans is shared by both types – non-dischargeability in bankruptcy. Thus, even for privately offered loans, bankruptcy laws give strong lender protections. This gives the loan a premium value above a standard yield calculation. The exceptions are that, in the case of Federal loans, loans can be forgiven after working in education, public safety or the military for a specified period.

Also, with income-based repayments, the percentage of income used for student loan payments is capped at 10%.  In addition, if you stay poor for 25 years, the loans are forgiven. It can almost be taken for granted, but for the record these programs have been expanded and their terms made more generous under the Obama Administration.

Wealth Transfer Implications Of Interest Subsidies

As mentioned above, on its face, the subsidy appears to be a wealth transfer from taxpayers to students. The amount of the transfer would be the shortfall in interest received from government loans compared to what would be received at market interest rates. Based on what we’ve seen, the spread appears to be in the neighborhood of 8-12%.

At the current level of $1 trillion in outstanding Federal loans, the transfer is approximately $80-120 billion annually.  As we can see in Chart 4 below, the outstanding level of Federal student debt has climbed aggressively over the past 10 years so the annual transfer has as well.

Title IX - Chart 4

Clearly, the subsidization of interest rates means there is a transfer to someone taking place. However, to determine the ultimate beneficiary we must ask ourselves whether these loans would be made at all if borrowers were forced to pay the market rate. This writer believes they would not.

Without sufficient financing available, demand would fall. As a result, tuitions would need to fall or the total number of students able to attend would fall; most likely a combination of the two would occur. Whatever the case, the annual income of the higher education sector would fall.

Chart 5 below gives some indicative ranges on how the $1.2 trillion of currently outstanding student debt would be financed without government support available. Specifically, we are interested in how the 83% currently funded by the government would be handled. It seems reasonable that when faced with higher interest rates students and families would divert cash from other sources to minimize debt incurred.

We make the guess that 10-20% of the debt outstanding would have been covered using cash. Presumably some shift to higher-interest private loans would take place, but as discussed above we believe it is unlikely the entire balance would move. So, depending on one’s assumptions, 30-60% of the $1.2 trillion of student debt outstanding would not be funded.

Title IX - Chart 5

Thus, without subsidization, $360-720 billion of the currently outstanding debt would never have been accrued. Given this, how should the $80-120 billion transfer related to the interest subsidy be attributed? We believe a transfer to students from taxpayers only applies to the reduction of interest on the loans that would have taken place in the absence of market distortions.

So, the transfer to students only applies to the $130-330 billion of additional borrowing from private lenders that would have taken place without subsidies. That amounts to an annual benefit of $10-40 billion, depending on assumptions about the spread and the level of private loans taken.

As we mentioned though, there are still currently outstanding $360-720 billion of student loans under the Federal loan program that we believe would not exist in a private-lending-only world. We believe the education sector is the end beneficiary of the transfer resulting from the subsidy on that portion of the loans; representing $40-110 billion annually. Thus, taxpayers are providing a lucrative transfer to higher education.

Readers will naturally ask, how can the transfer be going to the educational sector if students are paying interest to the government (even if it is an artificially low rate)? The answer to this lies in the mal-investment taking place as a result of artificially low interest rates on student loans.

Investment Boom In A Box

What we find most interesting about the student debt discussion is what it shows about the relationship between interest rates and investment booms. Like Darwin observing his finches, studying a specialized animal operating in its native environment can tell us a lot about the larger process going on.

What we find most remarkable in this case is that the investment boom is taking place in a totally abstract context. The object of all this investment is “human capital,” the increased expected income streams of millions of young Americans.

As with any other form of capital, an artificial repression of the interest rate causes an increase in the ex ante desired level of human capital. Assuming all else equal, a lower financing rate gives a larger number of people a positive NPV for the cost of higher education.  But, as we should all know, all else is most definitely not equal. Two factors that are not fixed will render prior assumptions about the return on higher education to be overstated.

First and foremost, the supply of college-educated people has gone way up. Like any overbuilding of capital in a particular sector, production oversupply leads to cuts in selling prices that reduce return on investment. Secondly, it is far from clear that the education provided at many American universities provides any improvement in employability in the first place – the contrary may in fact sometimes be the case. Indeed, by definition, the marginal borrowers will be those with lower expected return on their education.


Thus, we believe the “Not Funded” portion in the chart above represents malinvestment. To the extent that the return on higher education falls short of the expectations, someone’s expected future path of consumption will have to be lower. That will happen because, for many borrowers, their income streams will not be sufficient to pay back their loans and provide the level of consumption they expected.

It is unlikely that the higher education sector will be asked to give back any of the money it has received. Thus, the nation will need to come to a political agreement allocating the loss of consumption between the borrowers and the taxpayers.

Here is where we see the big benefit received by the higher education sector. Universities have been selling human capital investment services for significantly more than they turn out to be worth ex post. The extent to which excess tuition was paid (anything above the true present value of the investment) represents an unrequited wealth transfer from the students to the education sector.

How Big Is The Higher Education Bubble?

We can begin our tally with the $1.2 trillion of student loans currently outstanding.  Of course, the loans currently outstanding don’t represent the total amount of tuition that has been financed over the years. Each year billions of previously-borrowed funds are repaid.

Good numbers regarding repayment rates are hard to come by, but we assumed a straight line amortization over the course of ten years. As we can see in Chart 6 below, just looking back over the past 10 years we estimate an additional $180 – 360 billion has been transferred to higher education.

Title IX - Chart 6

In total, a back-of-the-envelope calculation that includes current Federal loan balances plus repayments in the past ten years indicates excess investment in human capital by students of between $500 billion and $1 trillion. To the extent that the expected rate of return disappoints, a transfer from students to the higher education sector has occurred.

Thus, we believe the reduction in interest rates for loans funding overpayments (the “Not Funded” category in Charts 5 & 6) should be accrued from the taxpayer to the higher education sector. By subsidizing interest rates, the taxpayer shares some of the cost of overpayment for higher education investment. In effect, the students get a rebate from the taxpayers for part of their exorbitant tuition.

Social And Political Implications

Given the size of the wealth transfer and the fact that there is a very high concentration of borrowers among people in their 20s and early-30s, this issue is bound to have political consequences. First, there will be the allocation of losses from the loans already made. In Chart 7 below, we can see that in federal student loan delinquencies are at a disturbingly high level – over 40% of the borrowers that are actually in repayment.

Many citations of student loan delinquencies erroneously include 46% of borrowers that are either in school or the grace period – these borrowers are not required to make any payments and thus cannot be delinquent. When we exclude these borrowers we get a much higher delinquency rate. Whether to amend bankruptcy law and if so, how much of the balance should be forgiven will become a major issue.

Secondly, there will be a second group of borrowers who do not default but rather pay off their loans over the maximum amortization period. These borrowers will have the opportunity to experience diminished consumption possibilities over a long period of time.  Resentment of the inability to discharge loans made for a human capital investment that didn’t pan out will create pressure to further socialize the losses.

Readers assessing the U.S. Federal fiscal situation should be sure to include the taxpayer’s exposure to losses on student loans, including insurance liabilities and directly-held loans. From a monetary policy perspective, further expansion of Federal liabilities and the difficulty of explicitly allocating losses between borrowers and taxpayers both increase the government’s incentive to allocate losses via inflation.

Title IX - Chart 7

Who’s getting rich from this?

At the end of the day though, who ends up bearing the cost of the human capital investment bubble is not as important as who is benefiting. The real danger of the situation lies in the funding and empowerment of the intellectual elites, the intelligentsia. In any society the intelligentsia reflexively stands against the status quo in order to be relevant.

The leftward bias of the American higher education system has been widely reported and anecdotally this writer has experienced the bias first-hand. True to form, the intelligentsia aligned itself against the established social order. Schumpeter’s Capitalism, Socialism and Democracy discussed this very issue at length.

First, we must remember that nobody ever made a name in academia advocating for the status quo. According to Schumpeter, to be an academic means to be a perpetual stone thrower at whatever represents “the establishment.” He sums the sentiment up by saying:

The critical attitude, arising no less from the intellectual’s situation as an onlooker – in most cases also as an outsider – than from the fact that his main chance of asserting himself lies in his actual or potential nuisance value…

Who’s afraid of the big bad professors though? It is true that the intelligentsia is not a powerful enough group on its own to effect social change against its capitalist adversary. However, the intellectual elite can operate on a larger scale by co-opting other movements and infusing them with an anti-capitalist orientation.

Labor never craved intellectual leadership but intellectuals invaded labor politics.  They had an important contribution to make: they verbalized the movement, supplied theories and slogans for it – class war is an excellent example – made it conscious of itself and in doing so changed its meaning.  In solving this task from their own standpoint, they naturally radicalized it, eventually imparting a revolutionary bias to the most bourgeois trade-union practices.

An excellent case-in-point is Senator Elizabeth Warren. Until being elected to the Senate, the Senator was a professor at Harvard. She provides us with two anecdotal examples of the aforementioned issues. Professor Warren taught one class and received an annual salary of $350,000. How is that for investment-driven inflation? Secondly, we point to her campaign for Senate, which was drenched in anti-capitalist rhetoric.

Parts of her campaign-launch speech were taken almost directly from Marx. We encourage readers to read Chapter VII, Section 2 of Marx’s Capital, Volume One. In this section Marx has a hypothetical conversation with a capitalist factory owner. Basically, the derisively delivered message is “you didn’t build that.”  Interestingly, President Obama then drew inspiration from Warren in his “You Didn’t Build That” speech.

Just as Schumpeter predicts, capitalist society has tried to buy-off the intelligentsia in an effort to bring a truce. The fatal flaw of this strategy is that the intelligentsia defines itself by its expansion of the higher education sector, which generates an ever growing class of anti-capitalist faculty who spread their message to an ever growing audience. As Schumpeter bluntly states,

One of the most important features of the later stages of capitalist civilization is the vigorous expansion of the educational apparatus and particularly of the facilities for higher education.

A Farewell to ARNs

The topic of student lending is of particular interest to this writer, who cut his teeth on Wall Street securitizing student loans. We must admit that we have mixed feelings about our association with the student loan industry. While in securitization this writer learned a lot and had the opportunity to work with a lot of great people. No doubt, our role was a small one, but we were still involved in a cynical and exploitative process.

Government-led cartels benefiting rent-seeking vested interests are certainly not a new thing under the sun. What makes this whole process so distasteful is the relationship between the exploiters and those being exploited. We aren’t talking about one group of industrialists getting one over on another group of industrialists by using political connections.

In this case, the group being exploited for rent are young people looking to improve their lot in life and the exploiters are the educational professionals entrusted to help their students. Indeed, those most vulnerable to the student debt scam tend to be low-income students who simultaneously have the greatest informational disadvantage and are least likely to rely on parents for funds.

We acknowledge the counter-argument that these students are legally adults and should be able to understand the implications of taking out so much debt. However, we remain unconvinced for a few reasons.

First and foremost is the tremendous social pressure placed on seniors graduating high school to attend college in order to fulfill what has become a middle-class right of passage. The reasoning behind going to college has devolved into, “well that’s just what you do after high school.” Second, there is a massive asymmetry of information and implicit relationship of trust between the student and the school.

Is it ethical for a school to say nothing when a student borrows an amount that can never realistically be paid back based on their preferred career path? We think not. Because the student has placed their trust in a school to help them achieve their life pursuits, the school cannot help but take on a trust-based advisory relationship. Much like a financial adviser, these institutions should be expected to put their clients’ well-being before their own. The practice of loading up students with debt while putting no thought into their post-graduation path is exploitation.

Finally, because of inflated return expectations for college degrees, every authority figure in a young person’s life is in agreement that they should borrow the money because “the interest rates are so low.” Thus, we believe students should be held less accountable for the student loan bubble than the system that is driving it.

The government and the higher education system have built a fine rent-generating machine, complete with a moral authority that makes the system difficult to attack. Like any government scheme to provide rent to a favored group, the people are the ones that pay the price.

The situation is made all the worse by the fact that the group benefiting the most from this arrangement is made up of enemies to global capitalism. In closing, in the event a downfall of global capitalism takes place, please accept in advance our apologies for our time spent as a pawn at the service of the educational-industrial complex.

Nobody’s perfect.

Read More: Title IX, The Education-Industrial Complex, And The Manufactured “War On Women”