The Secret History of Student Loans

This blog post highlights the dark side of President Biden's Student Loan forgiveness. Not whether it's a good or bad idea, but rather the economic underpinnings and implications.

Television pundits, radio personalities, politicians, and our more expressive friends on Social Media all have opinions on the Biden administration's recent announcement that they will forgive between $10,000 and $20,000 dollars of Federally Backed student loan debt. Some think it's an economic injustice that will raise taxes and cause inflation. Others think it's a financial necessity that will allow debt laden students and graduates to stimulate the economy. There's truth to both perspectives, but neither gets to the root cause as to why this is happening now.

Now I don't claim to be an economic expert, and none of this is financial advice, but in reading about the history of the Student Loan Industry, our current situation seems baked into the cake. Of course hindsight is 20/20, but the effect of giving money w/out collateral to students without any credit history to pay to institutions which aren't required to guarantee a return on investment seems like a recipe for disaster. And it has been. Although the Federal student loan program began with good intentions, like everything else in life, money inevitably corrupts it.

To better understand the timing of the president's announcement we should look at the history of Student Loans in the United States, as well their effect on student enrollment and the cost of tuition. The modern student loan is a distant cousin of the GI bill passed in 1944 which gave World War II Veterans and all subsequent veterans grants for college. This saw the first major boost in college attendance in the United States, allowing lower and middle class persons an opportunity to attend college where it had previously been relegated to the wealthy or the exceptionally academic. In the following years, veterans would account for over half of all college students in the United States.

Shortly thereafter the first Federally backed student loans were introduced in 1958 through the National Defense Education Act. It promoted college attendance to compete with the Soviet Union. Those who showed promise in Math, Science, Engineering, Foreign Languages or teaching were offered grants, scholarships and student loans.

Seven years later, in 1965, these federally backed loans were expanded through the Higher Education Act which established the Guaranteed Student Loan Program, also known as the Federal Family Education Loan Program or FFELP. It allowed banks and private institutions to provide government-subsidized and guaranteed loans to students. And so the modern Student Loan boon began.

For the most part, these early programs were well managed, supported by bipartisan coalitions, as well as the majority of the population, and effective in promoting higher education and increasing our economic competitiveness internationally. But this soon changed after the Vietnam War.

As the growing hippie movement challenged existing culture and financial paradigms, banks became concerned that an increasingly anti-establishment culture (which thrived on the majority liberal college campuses,) would attempt to sidestep the banks and escape their debt obligations by declaring bankruptcy on college loans. So In 1973 the Congressional Commission on the Bankruptcy Laws of the United States issued a report which included that student loan debt ought not be discharged for five years after graduation. Three years later the Education Amendments of 1976, Section 439A, was adopted which legislated that no student loans could be discharged in bankruptcy until five years after graduation, or unless the borrower could prove repayment imposed “undue hardship” (which was never defined by the law makers).

In 1979, Congress wanted to increase lender participation. So they passed an amendment giving banks a higher rate of return on student loan linking them with changes in Treasury bill rates. Prior to this the government set a cap on what lenders would make. With banks making more money, the student loan industry was born.

As time passed, banks saw these student loans as an increasingly attractive investment opportunity and pushed for fewer and fewer borrower protections. In 1990, the Crime Control Act extended the period before student loans could be discharged in bankruptcy from five years to seven years and then a year later the statute of limitations on defaulted loans, six years, was totally eliminated by the Higher Education Technical Amendments.

Congress raised the borrowing limits of students and created a new unsubsidized loan for the middle-class that was no longer based on financial need. This meant anyone could now take on a student loan regardless of their income or parents’ income. Smelling more money could be made off of the well-meaning, caring, loving parents, they also uncapped the Parent Loan (PLUS) program. Now parents could borrow, on behalf of their children, the full amount of their children’s’ educational costs. Because of these changes, enrollment took off and in a two-year period the amount borrowed increased over $10 billion.

The Student Loan Reform Act of 1993 revised how loans are serviced and financed, allowing for more students to take out more loans. This also established an income-based repayment plan stretching out to a home mortgage length of 25 years.

By 1998 the Higher Education Amendments, Section 971 eliminated the seven year period required before a student loan could be discharged in bankruptcy. There had been no debates or hearings on this prior to President Clinton signing the bill into law. This meant there was no longer a statute of limitations nor could student loans even be considered for bankruptcy – ever, unless the ambiguous, indeterminate, undefined “undue hardship” provision could be proven.

In 2005 the final nail was hammered into the hands of student borrowers by Congress with the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act. This meant all federal and private educational loans were excepted from bankruptcy discharge unless the undefined “undue hardship” could be proven. In order to do this, a potential student has to take the loan provider to court. Having the students by the neck they guaranteed eventual payments via wage garnishments.

What's especially notable about the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act, is current President Joe Biden was one of it's biggest proponents in the Senate. This was while his son Hunter was a paid consultant and federal lobbyist for MBNA (the largest credit card company in Delaware) and recieving at least $100,000 dollars a year from the bank.

Which is an excellent segue to the financial corruption which the Federal Student Loan program has facilitated and the multiple negative effects it has had on our current debt crisis

As terms for these loans were extended, and bankruptcy options eliminated, more and more banks saw Student Loans as a strategic investment. Unlike a mortgage in which the house itself is collateral, student loans had no hard assets backing them. Paradoxically, this was preferrable for banks as they don't like real-estate assets which require maintenance, upkeep, and other costs to resell. Student Loans on the other hand were growing to sizes comparable to home loans, couldn't be wiped away through bankruptcy, and even in cases of default could be pursued through wage garnishment. Even if those pathways didn't result in repayment, the loan was insured by the Federal Government, meaning the banks could ultimately demand their money back from Uncle Sam.

And so lending increased, more students went to college, more colleges opened, and colleges increased their tuitions and yearly admissions. This created the modern college degree glut in which more Americans have a bachelor's degree, but the value of that degree has consistently decreased in value. For example, in the 1960's about 40% of all Americans had a highschool diploma. Today, about 40% of Americans have a 4-year degree. Thus for much of recent history, young Americans began to see a college degree as not merely a stepping stone to a higher salary, but a basic necessity to even enter the job market. Job recruiters and American industry, likewise began using college degrees as a prerequisite for entry-level positions, discouraging potentially qualified applicants from even applying.

Meanwhile colleges steadily increased tuitions and admissions as federal money was guaranteed to even the poorest performing students. While expanding degree programs in largely skill-less humanity departments, they promised students post-graduation incomes from hand-selected data that their own colleges produced as promotional materials. 

This has allowed colleges to make record profits, expand land-holdings, build and remodel buildings, provide non-educational lifestyle amenities rivalling resorts, develop professional-tier college sports programs, all while reducing academic standards to graduate as many middling federally-funded students as soon as possible to make space for another class of underachievers.

While the left is lauding Biden for helping students, and the right demonizing him for what they deem to be punishment of those who paid off their loans, neither side is placing the correct blame upon the banks which have consistently funded his political career or the universities which willingly laundered the money. And truly these are the two main beneficiaries of student loan forgiveness.

The banks found a lucrative secondary market in which they could turn outstanding student loans into a debt-backed security. And so, the financial institutions created a new financial instrument called Student Loan Asset Backed Securities or SLABS. Now even before they were repayed, they could pool the debt, and sell it to institutional investors thereby turning the debt into a secondary market opportunity

SLABS have been widely traded since their implementation, and are often proffered by the same institutions as Mortgage Backed Securites (like Sallie Mae). Seen as a very stable investment due to their AA to AAA rating, the industry has risen to over 1.7 trillion dollars, and has supplemented the Mortgage Backed Securities as THE "stable" investment in an investor's portfolio. However, much like the attitude towards Mortgage Backed Securities prior to their 2008 crash, the perceived stability is perhaps a paper tiger. In 2020 and 2019 multiple reports were issued by academics and loan advisors questioning if the SLABS market was going to cause the next market crisis.

Overwhelmingly, these reports concluded that while the entire system was at risk of failure, the size of the overall SLABS market was only about half of the size of the Mortgage backed securities when they crashed. Though the 1.7 trillion+ number was threatening and could cause ripple effects, it was not quite as large as the 2.2 million Mortgage Backed Securities market in 2008. Moreover, most of these reports were written from the perspective of investors in the securities, not the average American. They reassured investors that the rate of defaults and slower/smaller payments were actually a good thing as it meant that the overall student loan repayment period would be extended, increasing the average interest paid, and the value of the securities in the long-term. Secondly, the insurance by the Federal government would guarantee repayment, even if the avg loan holder couldn't. Even in the case of looming loan forgiveness the banks would still get their money, as would the security holder.

Yet this rosy picture left out the extenuating damage these outcomes would have on the economy at large. Ultimately, the federal government would be on the hook. If the market crashed, the insurance would force the government to pay off the banks. If they forgave loans wholly or partially, the same thing would happen. Thus outside of the students paying their loans off themeselves. The government would have to either increase taxes to pay off the loans, or print money to pay them off and create inflation.

Even prior to Covid-19 lockdowns, job losses, and associated financial instability, many investors were beginning to question the legitimacy of Moody & Fitch's ratings of the securites. Beginning in 2015, defaults increased and the rate of repayments slowed. These drastically increased during Covid and were the real reason the Federal Government paused repayments. Because the Loans are insured up to 97% by the federal government, had the majority of students defaulted, the government would have had to come up with nearly 1.7 trillion. So they came up with a solution that staved off runaway inflation while satisfying the banks. Stop the payments, but not the interest generated. Thus, though students didnt have to pay, their outstanding debts continued to grow. This pause has been extended again multiple times. It was given a "final" extension in Biden's loan forgiveness plan, but all it's doing is keeping the ball in the air. Ultimately it will come down, and students will be on the hook.

In summary that's the real purpose of this "loan forgiveness". The banks are not forgiving the loans, the government is paying 10,000 dollars on behalf of the students. It's a temporary fix to keep the system solvent. As zoomers and millenials become more and more disenchanted with college, the ponzi scheme that is student loans will gradually fail. Despite the prior history of defaults, banks had an always growing pool of new students they could mine for new loans and new slabs. But as college enrollment decreases, these securities will have less and less new blood reinvested into them.

Thus, this loan forgiveness is a last ditch effort to keep the college-debt machine greased. Many loan holders have not completed their degrees, so the unspoken aspect of this relief program is the hope that former students with some college will re-enroll as their debt obligations have been reduced. Whether this happens, remains to be seen, but in my estimation it's unlikely. The covid shuttering of schools and online-only programs have completely decimated the prestige that in-person colleges and universities once held.

So I return to the question, will the student loan debt crisis be the driver of the next financial crisis? In my opinion, it already has. Rather than a single bailout, we are seeing a progressive series of bailouts that will limp the system along until it can't stand anymore. Now that debt relief has been introduced, it's only a matter of time before subsequent infusions occur. Both the Republicans and Democrats will inevitably use it as a policy issue to gain votes, and from a practical perspective, it's an effective tool.

Will it completely crash the economy? I don’t know, but considering our national expenditure, military spending, and other pork, it's not a matter of if, but when. At the same time, new housing loan programs, fuel costs, farming insecurity, or a number of other economic threats loom on the horizon. So its more of an inevitability that our economy will suffer, but placing the blame on student loans alone isn't necessarily true.


So what does that mean for students? Colleges will always exist, but many institutions will eventually fail. The concept of online college is now as legitimate as an on-campus university. So we'll continue to see more students taking advantage of those programs. Trade schools will similarly see greater enrollment as their after-graduation job security is getting better understood by younger generations. The fact that these events are changing student behaviors after they’ve historically taken on mountains of debt, in my mind is a good thing. Institutional in-person college is only one path to potential success and the last few years have exposed this truth.