White House Is Wrong, Student Loan Debt Constraining Economy, Represents Systemic Risk

by: APAC Investment News

Summary

White House claimed in a recent report that student loan debt is good for America.

Student loan debt, however, could cause major changes in consumption as cash-strapped borrowers spend less.

High default rates and dependency on income-based repayment could also create systemic risks.

Student loan debt is now greater than credit card debt at $1.35 trillion dollars, and is estimated to be growing by more than $2,700 dollars each second. Meanwhile, the Associated Press found that the average young family saddled with student loan debt was spending more on student loans than on groceries. For investors, student loans are important for at least two reasons. First, debt repayment is squeezing consumer spending. Second, student loan debt could swell into an unsustainable bubble, and pop. With debt levels now racing past $1.3 trillion dollars, student loans are quickly becoming a large, sick elephant in the room.

The White House released a report tackling the growing student loan debt problem, audaciously claiming that student loan debt levels are good for the U.S. economy. Of course, the full argument is more nuanced, but trying to paper over student loan debt as "good" seems foolhardy, at best.

The Obama administration correctly noted, however, that college is, or at least can be, a great investment. The on-going changes in the global economy have made a college degree all but a prerequisite for landing a decent paying job. In many, if not most cases, the money spent on a college degree from a reputable university will eventually be paid back in the form or higher earnings.

Still, high student loan debt levels are already beginning to have effect on consumer consumption, which is essential given that about 70% of America's economy is dependent on said consumption. Further, activist investor Bill Ackman has identified student loans as the biggest risk to credit markets.

Student Loans Are Already Impacted consumption

For the economy, student loans are already having an impact on consumer spending. An extensive survey by American Student Assistance uncovered some concerning points regarding student loan repayments and their impact on consumption.

  • 35% of respondents reported difficulties paying for daily necessities

  • Of those wanting to start small businesses, 61% reported that student loans impacted their ability to do so.

  • 52% reported that student loans affected their ability to make big purchases, such as buying cars.

  • 62% report that they are putting off saving for retirement and investing.

  • 55% reported that they were putting off buying a home.

  • 21% put off marriage, and 28% are delaying starting a family.

It might be tempting to disregard survey results, as often they don't correspond with reality. People sometimes exaggerate their conditions and feelings when asking survey questions. Still, the above points are backed up by real world data.

Millennials are bearing the brunt of the student loan burden, though older generations are also indebted. Car purchases were historically low among millennials in the years immediately following the Great Recession. In 2010, only 18% of cars were purchased by millennials. This number did rise to 27% in 2014. Regardless, spending on new cars is far lower for millennials compared to the past. This is true of all groups, but is most pronounced for millennials.

Instead, millennials are buying used cars. For automakers, this is bad news.

In 2005, 43.3 percent of those under the age of 35 owned a home. By the first quarter of 2015, this had dropped to 34.6%. Student loans are also making it difficult for people to save up money to put down payments on houses. In fact, 23% of people report having trouble saving up for a down payment, with 57% reporting student loans as impeding their savings. As a result, younger people may resort to putting increasingly lower down payments, as low as 5% or less, or else renting. Both carry risks for the economy. Low down payments can result in higher defaults, and renting can reduce discretionary income.

The impact of changes in consumption being driven by student loans is hard to underestimate. If millennials put off or completely eschew having children, for example, it will affect retailers. Fewer people buying baby clothing, food and diapers. Fewer trips to Disney World too, and smaller families will generally equate to smaller spending on groceries, entertainment, and everything else.

For investors, these changes in consumption need to be taken into account.

Students Loans Represent a Systemic Risk

I hate being a doom-sayer on Seeking Alpha, but at the same time, it's important to consider potential risks, especially systemic, to the financial system. With debt already at $1.3 trillion dollars, the potential impact of a student loan bubble popping can't be underestimated.

The Federal Government has essentially guaranteed the loans to financial institutions, but with almost $19.5 trillion worth of debt on government books, hundreds of billions (trillions?) of dollars worth of bad student loan debt is a hefty burden for a government already stretched thin.

Student Loan Defaults Are Up, Income-Based Repayment Increasingly Popular

Below, are statistics from the Department of Education showing the lifetime default rates for student loans. To default on a loan, students must fail to make payments for nine consecutive months.

The rates, obviously, are quite high. For the 2008 cohort year, rates have reached 11.8%. In the next chart, using an older report, we can see projected default rates over the lifetime of the loans. These are projections, what the government expects to happen. Again, the numbers are concerning, to say the least.

Click to enlarge

High default rates have made it necessary for the government to launch income-based plans. Students under these plans pay a percentage of their income, generally 10 to 15% of their discretionary income. This means that someone with $100,000 dollars worth of debt, and with a $1,500 dollar non-income based repayment plan might end up paying only a few hundred dollars month, or less (sometimes down to zero). After twenty five years, the loans will be forgiven.

Some 4.8 million borrowers are already on income-based plans, representing 20 percent of all borrowers. The Obama administration is hoping to enroll another 2 million on the plans this year. By doing so, they might be able to lower default rates, though from the perspective of actually repaying loans and lowering debt, this program is of questionable value. Instead, income-based plans may end up simply kicking the can further down the road. Debt levels will continue to increase as interest accrues, balances will barely shrink, if at all, and eventually the music will come to a stop when the debt forgiveness date is reached.

Conclusion: Student Loan Debt Presents Consumption and Systemic Risks

Whatever rosy picture the White House might want to paint, student loan debt presents a major risk to the economy. It is already having a major impact on consumption, and likely will have an even greater impact going forward.

Further, with so many borrowers already on income-based repayment, or in default, the Federal government may end up having to forgive hundreds billions of dollars worth of loans. This could both rattle markets, and create systemic risks.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.