Moody's Sounds the Alarm on Student Borrowing

A growing chorus of economists and educators think that the higher education industry will be America's next bubble. Easy credit, high tuition, and poor job prospects have resulted in growing delinquency and default rates on nearly $1 trillion worth of private and federally subsidized loans. Now the ratings agency Moody's has weighed in with a chilling diagnosis: "Unless students limit their debt burdens, choose fields of study that are in demand, and successfully complete their degrees on time, they will find themselves in worse financial positions and unable to earn the projected income that justified taking out their loans in the first place." 

In August 2010 financial aid guru Mark Kantrowitz announced that student loan debt had, for the first time, surpassed credit card debt. A month later, the Department of Education announced that default rates for student loans had jumped from 4.6 percent in 2005 to 7 percent in 2008, the most recent year for which data is available. While the two announcements went largely unnoticed, some took the data points as evidence that America's next big bubble—higher education—was becoming dangerously inflated.

I ran that thesis—shaped by data that show the default rate for student loans (two-thirds of which are guaranteed by the government) have steadily increased over the last decade—by Kantrowitz last year. "You can't flip an education," he told me. In other words, higher education can't be a bubble because there's no speculation. Howard Horton of the New England College of Business and Finance was on the fence in 2009 about the higher ed bubble, but when demand for college degrees increased during the recession, Horton suggested that the college industry had more in common with Detroit than the housing crisis.

"These subsidies are kind of like propping up the auto industry with cash for clunkers, or the housing industry with cash for first-time buyers," he told me last year. "We have this financial aid system that is keeping the system alive."

Moody's new report has a much grimmer take: While "delinquency and loss rates on outstanding student loan balances remained steady throughout the recessions," the report reads, "the performance of other consumer loan segments has significantly improved as the economy has recovered." But that's likely to change soon, and not for the better. Moody's projects that delinquency and default rates will actually get worse, even if the economy recovers in the next few years (itself an increasingly unlikely prospect).

To start, it helps to understand why student loans are doing poorly. Unlike home and auto loans, the conditions for which have been tightened drastically since 2008, student loans are for everybody. Borrowing isn't based on income or even a salary expectation, but the promise that a college degree will pay for itself. But with unemployment hovering around 9 percent, college graduates from the best programs and schools are finding that's not not the case. Eventually, the snake eats its own tail: Easy credit and the college myth have caused tuition to double since 2000, while tightened credit requirements have caused home prices to plummet. 

"The dollar volume of student lending is expected to grow at a faster rate given rising costs, although the growth rate of total tuition paid over the past decade may slow as students seek out cheaper options from proprietary and traditional educators," the report reads. Yet due to gainful employment regulations handed down by the Department of Education, the proprietary sector—composed of for-profit colleges—is likely to shrink. The rules are designed to staunch the flow of federal aid to schools that have high drop-out and loan default rates, and it appears that the effect is being felt across the sector. The Washington Post Company announced today that that revenues at its biggest moneymaker, the for-profit college company Kaplan, were down 64 percent in the second quarter.

Moody's also points to digital education tools driving down educational costs, but adds that "the expectation is that tuition will continue to rise at a rate greater than overall inflation over the next 10 years, thereby contributing to persistent growth in new loan originations."

The threat of a prolonged recession means that an increase in borrowing will most likely lead to an increase in delinquencies and defaults. Students and workers alike see higher education as a shelter from the poor economic climate. But while a two- or four-year program may seem like a sensible way to wait out a recession, more and more students are emerging on the other side with improved skills—that's if they studied an applied science, as opposed to humanities—and no job prospects. While entering a weak job market with an advanced degree makes many debt-saddled MBA recipients (for example) overqualified for the entry level jobs available to them.

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The report authors anticipate bleak times ahead if the federal government and private banks maintain their relaxed lending standards, especially if they continue to lend with the expectation that students will be able to pay them back: "Unless students limit their debt burdens, choose
fields of study that are in demand, and successfully complete their degrees on time, they will find themselves in worse financial positions and unable to earn the projected income that justified taking out their loans in the first place."

To his credit, Kantrowitz anticipated a future in which would-be students shy away from expensive higher educations, due to the double-whammy of high debt and and gloomy job prospects. But he puts that future at least 20 to 30 years away, when today's college graduates are likely to still be paying back student loans and thus reluctant to extravagantly finance their own children's educations as well. Moody's sees that problem coming to a head possibly within the next decade, and anticipates that the aftershock of declining demand for higher education will hurt both college towns and big cities, which rely on students (and their borrowed money) to keep businesses afloat during down times.

Even in the absence of speculation, says Moody's, "Fears of a bubble in educational spending are not without merit." The higher education optimists might want to batten down their hatches.

Mike Riggs is an associate editor at Reason magazine.