Welcome to another issue of Net Interest, my newsletter on financial sector themes. This week, we’re looking at the American student debt crisis. There are $1.6 trillion of outstanding student loans in the US, but things may not be what they seem…

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Government Sponsorship and the Student Loan Crisis

Shortly after starting work as a hedge fund analyst in 2006, my boss called me into his office. He was allocating coverage responsibilities among the team and he handed me US financials. It was a big sector, with lots of sub-sectors to sift for investment opportunities – banks, asset managers, consumer lending companies, and so on. “One word of advice,” he cautioned as I left the room. “Don’t bother with the GSEs – no value to add there.”

The GSEs were Government-Sponsored Enterprises. They were listed on the stock exchange alongside other companies in my coverage universe, the only difference being that they fulfilled a public mandate and consequently had various government protections. The largest at the time were Fannie Mae and Freddie Mac, whose mandate was to promote liquidity and stability in the mortgage market, ensuring that mortgage credit was readily available throughout the nation. Other prominent GSEs included Farmer Mac, whose role was to reduce the cost of capital for farmers, and Sallie Mae, which performed the same function for students.

My boss had a point. These stocks were influenced much more by politics than by economics and, from my desk above a restaurant in London’s Mayfair, I had little edge when it came to American politics. A few months after our conversation, Sallie Mae’s stock plummeted on news that President Bush had sided with Democrats to support a reduction in federal subsidies available to the company. Not something I could have gleaned from a spreadsheet. 

But like anyone who’s told not to look at something, the flame can be all-too alluring. A political theorist once called politics “the most concentrated expression of economics”. On a long enough time horizon, GSEs operate to the same drumbeat of economics as other companies in the financial sector. The trick is to understand the incentives of the various stakeholders. As well as shareholders, debtholders, customers and employees, these companies also had the US government high up on their list of major stakeholders. Identify the motivations of the various players and the tensions between them, and I could get to the essence of the business. 

The effort was somewhat rewarded. We went short Fannie Mae and Freddie Mac ahead of their failure and entry into “conservatorship” a couple of years later. But the effort also provided an enduring lesson in how America works – useful for any outsider. That’s because government-sponsored enterprises are a major conduit through which the US conducts policy. One look at their balance sheet explodes the myth of the US as a free market of minimal government intervention. The US government may not get as directly involved in markets as governments in other countries, but it is no less interventionist. Rather than central planning, the US employs credit assistance to influence outcomes, often via GSEs. It’s a powerful tool. 

I was reminded of this last week as I watched President Biden announce the cancellation of a big chunk of student debt. For years, the US government inflated student debt – first through Sallie Mae in its incarnation as a GSE and then directly off its own balance sheet. Student debt outstanding in the US now amounts to $1.6 trillion. But this is no longer ordinary debt – it has morphed into something more akin to standard government spending. The reasons we continue to frame it as ordinary debt lie deep in the program’s history… 

The Rise of Student Debt

Before the government got involved in 1958, student loans were not especially popular. That year, only around 83,000 students borrowed a total of only $13.5 million. It wasn't that they didn’t need the funds – college was expensive. It was because the terms on private loans were onerous. As young people with little credit history and few pledgeable assets, students were not deemed good credit risks. Most private credit institutions stayed away and others charged high rates. 

The Soviet launch of the Sputnik satellite changed all that. Already gripped by the impact of the Cold War, US policymakers decided they needed to invest more in higher education, in particular science. They passed a bill introducing a federal student loan program. The focus on loans as opposed to grants stemmed from a political aversion to handouts. “The House denounced scholarships – ‘it was a waste of money and socialism and all of that,’” a Senate Democratic aide who worked on the bill, later recalled. “The minute the damn scholarship issue was done for, dead, the bill swooped through.” Yet rather than being structured as direct loans to consumers, the program offered loans to higher education institutions, which in turn loaned the money to students. 

By the time President Johnson took office a few years later, the goals of higher education policy had shifted. The Cold War remained a concern, but there was a renewed focus on domestic issues, particularly social welfare. Johnson himself had been loaned $75 as a student by a local bank and he wanted to make the opportunity more accessible to others. 

The problem was that a large scale loan program would weigh on the federal deficit. Loans were accounted for as spending and so all disbursements would add to the deficit before they were offset by future repayments. Policymakers settled on a guarantee scheme to skirt this obstacle, passing the Higher Education Act in 1965. Rather than issue loans directly, the government would guarantee loans made by private loan originators. 

The program significantly increased the volume of higher education financing available, authorising $700 million in its first year and $1.4 billion by 1968, compared with $17.5 million in the first year of the 1958 program. But it laid the seeds of problems to come. Under heavy lobbying from the banks, Johnson’s government did not retain full control of the program. “His intention was to create a Federal bureaucracy to run the program and surely kill it with red tape and mismanagement,” the head of the American Bankers Association later wrote. “Our group banded for lobbying and in the oval office [sic], told LBJ we strongly supported the concept but were unalterably opposed to federal ownership and operation.”

Nor did the program recruit colleges into the process, unlike the 1958 program. Consequently, the incentives of government, bank and college were not truly aligned. Banks made money off the loans, the government stepped in to cover losses, and colleges were off the hook entirely, incentivised instead to increase pricing. 

This structure crystallised a few years later in 1972 with the creation of Sallie Mae. Before then, there was no secondary market to sell student loans into, so they would pile up on banks’ balance sheets, constraining their ability to lend more. Sallie Mae bought loans from the banks and provided warehouse advances to enhance their funding. Sallie Mae sat at the heart of the money flow: The Treasury Department gave money to the Federal Financing Bank, which lent to Sallie Mae, which provided cash to banks, which lent to students, who paid the schools.

Over time, federal support, subsidies and guarantees were ratcheted up, skewing incentives further. Initially, guarantees were set at 80% of loan principal with interest excluded; in 1976 they were increased to 100% of financial losses. The same year, student loans were carved out from bankruptcy protection so that they couldn’t be discharged during the first five years of repayment unless the loan imposed “undue hardship” on the borrower. Later, the five year term was extended out and “undue hardship” came to be defined very stringently. 

All the while, student funding grew, finding its way to colleges. Enrollment picked up but so did tuition fees. In the 1970s, tuition rose in line with inflation but by the 1980s, tuition fees started rising at double and triple the rates of inflation. 

By blurring the flow of money, the process escaped scrutiny. Bill Ford, an early architect of the government student loan program compared it to a money-laundering operation. “The system is so complicated that everybody forgets that we started these programs for the purpose of buying education,” he said during a hearing. 

But here’s the thing: it’s what America does.

Government Intervention

Through its financing programs, the US government provides much, much more support for its economy than most people realise. Government intervention is most pronounced in housing – the topic of a previous Net Interest post (Financing the American Home). Today, the US government leaves its fingerprints on around two-thirds of household mortgages. 

But it’s not just housing. Through credit, the US government bolsters nearly every sector of the economy. Over the years, the US government has leaned on credit assistance programs as it has looked to steer the economy through developmental shifts. Programs were initially tailored to support agriculture before being deployed to support home ownership as the consumer economy took root. Then, parallel to the growth in the knowledge economy, home loans were joined by student loans.

In total, the federal government provides credit assistance through 118 distinct programs. Issuance next year is projected to amount to $2.2 trillion. 

The attraction of using credit as a tool of intervention is precisely that it is less overt. The biggest source of assistance is via credit guarantees, which are projected to contribute $2 trillion to the total next year. Guarantees do not require expenditures when issued, only resulting in a cash charge if a borrower defaults, and so they do not weigh heavily on government budgets. Even direct loans, which contribute the rest, can generate an income through fees and repayments. 

In addition, because they utilise the infrastructure of markets, credit programs are less ideologically contentious. By channelling credit via government-sponsored enterprises, government officials can tread the fine line between market and state. Programs have gained broad support by being structured just private enough to stay off federal accounts but public enough to follow government mandates. ¹

The problem is that by bringing in more participants, credit assistance injects complexity into the process. As well as the government and the college, we now have the bank, the investor (if the bank sells the loan), the guarantee agency, the servicer and the student – all looking to optimise different elements. 

In 1990, the government recognised that Sallie Mae was capturing too much value in the process and began to cut it out. By then, the company had almost $40 billion in assets on its balance sheet, including half of all student debt that Americans owed. Its return of 3.5% on student loans was at least twice as high as other banks could get on their assets. No surprise that its CFO called it “a gold mine”. 

The shift was heralded by a change to the law which removed the accounting smoke screen around student lending. Going forward, the federal budget would need to reflect the program’s long-run costs and profits. There was no longer any reason for the government not to get involved directly, which it promptly did, launching a direct loans scheme in 1993. 

However, the government didn’t shut off Sallie Mae’s guaranteed loan scheme for many more years. A few years later, it even allowed Sallie Mae to lend directly to consumers. In 2006, the year that I started looking at it, Sallie Mae was the biggest lender in the federal guaranteed program, originating 27% of federally guaranteed loans. Including private loans, Sallie Mae owned $142 billion in student debt – roughly a third of all student debt in the US.

Over the years, the government continued to make tweaks to its offerings. It raised loan limits. It enhanced an income-based repayment plan that enables borrowers to pay off loans via a fixed percentage of their discretionary income, with any outstanding balance cancelled after 20-25 years. Eventually, in 2010, it closed down the guaranteed loan scheme, prioritising its direct lending scheme as the source for government-backed loans. Sallie Mae continued to operate as a private-only student loan originator and spun off its government-backed servicing arm into a new business, Navient. 

But so much tweaking has gone on that the direct loans issued by the government today do little to resemble ordinary debt. This is an argument that two Georgetown University law professors make in a 2020 paper, Redesigning Education Finance: How Student Loans Outgrew the “Debt” Paradigm. They point out that unlike ordinary loans, there is no underwriting of student loans – borrowers get the same loan terms regardless of risk factors like major and school. In addition, interest accrual can be deferred and interest often does not compound. The income-based repayment scheme also differentiates student loans from all other types of loan – initially it was used sparingly, but its take-up has increased significantly. Biden’s plan to reduce the payment from 10% to 5% of discretionary income will do much more than cancellation to shift the nature of student debt away from ordinary debt. 

There are still features of student loans that reflect their legacy as ordinary loans. One is the presence of private sector servicers. When the guarantee scheme was eliminated in 2010, the government softened the blow on private firms by handing them servicing contracts. Navient and Nelnet are two big players for now – loan cancellations could cause their books to shrink materially. ²

Nevertheless, each reform brings the student funding model closer to a standard spend-and-tax model. It took a long time to get there, and money was made and lost by others along the way, but in the US, that’s how politics works.

On the history of credit assistance programs, American Bonds by Sarah Quinn is very good. On student loans, I would recommend Josh Mitchell’s book, The Debt Trap.