Follow that FLOW

26 July 2013

United States

Student loans: two sides of the coin

In the previous edition of Follow that Flow, we
investigated the discretionary purchasing power of US households. We concluded that the benefit afforded to consumers by lower debt servicing outlays had been largely cannabalised by higher health care costs, which in part reflects the erosion of non-wage employee benefits in a world where new openings are increasingly temporary.
15 12 9 6 3 0 2003

Household debt decomposition

$trn
Student Loan Home equity Credit Card Mortgage

existing stock
Auto Loan

$trn
Source: NY Fed

15 12 9 6 3 0

In this edition, we turn our focus to a key concern of

a specific segment of the age spectrum: the impact of student loans on the potential spending power of prospective younger workers. The stock of student loans remains small relative to the stock of mortgage credit, but student debt has grown considerably in recent years. The growth has been such that the acumulation of student debt now has the capacity to materially impinge on financial health and discretionary spending power.

2005

2007

2009

2011

2013

The borrow-to-study culture in the US allows future

workers to leverage against their prospective income. If the future stream of income is delayed (post-graduation unemployment) or diminished (a less remunerative job, and/or a flatter increase in income in the early years of labour force participation) relative to expectations, then the cost-benefit analysis of debt financed higher education becomes less clear cut than in the post WWII era, when the decision was very simple and ultimately lucrative.

Employment to popn ratio, weak among young

100 %
1624 2534 3544 4554 55+

100

80

80

Long-term productivity growth in advanced economies

relies on the accumulation of knowledge. Ergo, we are not anti-education. Far from it. What we are saying is that the deep fundamental fissures in the US economic model have altered the arithmetic. The average prospective return from higher education has probably declined, but the cost has increased. Thus the servicability of newly acquired student debt is far less assured than in previous cycles and unfortunately there is more of it than ever before.
60 60

40
Sources: Ecowin, Westpac Economics

40

20 1970

20

1980

1990

2000

2010

When one considers the stern contractual conditions

associated with student loans, as well as the challenging labour market environment for new entrants, the rapid run-up in debt is a source of considerable concern. Key characteristics of standard student loan contracts are that they are not typically extinguished by personal bankruptcy; they are expensive relative to mortgage debt; and they generally accrue interest from the moment of disbursement. The implication is that many recent and forthcoming grads will see their finances challenged from the moment they wake up with their post-graduation ceremony hangover.

Student loan provider: Fed Govt provides flow

150 $bn
Federal Government Private

annual change in stock

$bn

150

100

100

The 20 to 40 years-of-age cohort is a major accumulator.

First of higher education (tick) then of housing and durable assets (a major driver of economic growth) all of which require access to credit. A besmirched credit record for a material part of Americas university educated youth ahead of their key accumulation years would be a significant drag on US (and global) economic growth.

50

50

0
Source: Federal Reserve, NY Federal Reserve

-50 2006 2007 2008 2009 2010 2011 2012

-50

Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.

Follow that FLOW

26 July 2013
The promise of higher lifetime income has always seen young people looking to extend their education, thus delaying their initial entry into the labour force. As this desire is essentially a constant, the employment-to-population ratio for the younger cohorts tends to be lower than the mid-career cohorts. The ratio is steady during moderate economic expansions and it can increase during booms that generate get rich quick dont waste away on campus thinking. During recessions though, when new job opportunities decline and forced separations increase, demand for education rises, and the employment-to-population ratio among the young declines. This occurred in textbook fashion during the tech wreck downturn. However, the subsequent credit-fuelled boom saw no real increase; and when the GFC hit, there was a further step decline of 5ppts in the 25-34 cohorts employment-to-population ratio, to post 1970 record lows. More than three years on, the ratio is basically unchanged. Lower labour force participation has translated directly into higher participation in post-secondary education, and a consonant rise in the demand for student debt. In round figures, from 2005 to today, in the under-30 bracket, the stock of loans has increased 2 fold, with the number of borrowers increasing by around two fifths, and the average loan size increasing by roughly two thirds, implying a combination of cost escalation (fee inflation), slower amortization and longer study duration. How has this demand been met? Some of the details regarding the evolution of the supply side of the student loan business is in the box opposite. Following the move away from the indirect funding model for student loans (where the government guaranteed privately originated loans that conformed to its standards), the funding to facilitate this shift in work-study preferences was almost wholly and directly accommodated by the Federal Government from 2009. Higher loan limits also reduced the need for students to seek private loans over and above those offered by the Government. Credit fundamentals The Federal Reserve Board of Governors long-running consumer credit dataset is an excellent source of information on the financial position of households. The New York Federal Reserves Consumer Credit Report a relatively recent addition to the US macrofinancial dataset provides not only a quantitative estimate of US consumer debt, but also a qualitative assessment of its structure and overall balance sheet health. Together, they are a powerfully instructive resource. The first point immediately apparent from the data is that since the GFC, there has been a spectacular rise in outstanding student loan debt. As discussed above, this increase in student debt has been directly funded by the Federal Government. The decline in labour market participation and rise in student debt clearly highlights that, faced with an adverse economic environment and a dearth of attractive job opportunities, young professionals have sought further education as a way to improve their long-term job prospects. In a well functioning labour market, developing skills and knowledge would be well rewarded without undue delay. But in the current environment where quality, full-time jobs remain scarce, this cannot be the case for all, or perhaps not even the majority. From the payrolls survey, we see that around 30% of the jobs created over the past 18 months have been in the leisure, hospitality and retail space; in the past six months, this share has been higher still at 37%. The other key sector for job creation over the past 18 months has been professional and business services, a broad sector that includes skilled and unskilled positions. Over the past 18 months, 27% of the total new Box 1: US student loans, the essentials. The provision of student loans in the US ran as a public/ private partnership for going on five decades. Loans were provided directly by the government and via private lenders; if the latter conformed to the Governments standards, they were guaranteed, removing the need for applicants to have a credit history. In the lead-up to the GFC, private lenders became concerned over the risk/reward profile of these student loans, thus impinging on the supply of indirect government-guaranteed loans; the government subsequently retired the asset class in favour of direct supply. To smooth the transition to the direct model, the Congress provided the Department of Education with the capacity to purchase conforming private loans. Currently there are three primary types of direct government loans distributed under the Federal Student Aid program: Stafford subsidised (26.2% of new loans in 2013); Stafford unsubsidised (55.1%); and Plus loans (17.8%). Plus loans are taken out by parents. Stafford loans are taken out by students. All come at a comparably high interest cost (see table below), and generally accrue interest from the moment of disbursement. Subsidised Stafford loans are an exception as they only accrue interest following the completion of a degree. Origination costs are also payable, 1% for Stafford and 4% for Plus. Subsidised Stafford loans are only available to lower income families and have low loan limits, often necessitating a need to access funds under the other two schemes. Legislative changes made in recent years have seen annual and lifetime limits raised and, until 1 July 2013, the subsidised Stafford interest rate lowered. Private loans are still available, but are priced on individual circumstances at much higher rates.

Student loan particulars: loan limits and rates

Lifetime loan limit Subsidised Stafford Unsubsidised Stafford Plus loan $23k $31k remaining fees

Interest rate 6.8% 6.8% 7.9%

*Unsubsidised limit inclusive of subsidised loans. Rate on unsubsidised loans have recently risen from 3.4% to 6.8%. Limits given are for dependent undergraduate. Independent limit is $57.5k. Limit for graduate/ professional is $138.5k ($65 may be subsidised), or $224k for health professionals.

Govt provided student loans driving con credit

0.8 $trn
non-revolving consumer credit level
Commercial banks Finance companies

$trn

0.8

Sources: Federal Reserve, Westpac Economics

0.6

Credit unions Federal government

0.6

0.4

Securitised pools
Accounting change

0.4

0.2

0.2

0.0 1990

0.0 1993 1996 1999 2002 2005 2008 2011

Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.

Follow that FLOW

26 July 2013
payrolls jobs created have occurred in this sector. The concern is that roughly one third of these positions have been temporary jobs which come neither with the security nor the benefits of permanent employment. Long-term projections from the BLS point to a continuation of this seemingly endemic trend towards relatively faster growth in lower-skilled jobs openings. The BLS figures suggest that job openings due to growth and replacement needs over the decade to 2020 will primarily be for those with less than high school education levels. 29.5% of total job openings are expected to be appropriate for this level of education, compared to its share of total employment in 2010 of 25.9%. This has primarily come at the expense of the high school diploma or equivalent cohort. This expectations is a replacement phenomenon - those workers with less than high school education presumably entered the labour force many decades ago and are retiring. It is an indictment of the state of the economy that opportunity in the labour market is centred on the retirement of low-skill workers. The share of total job openings in 2020 deemed suitable only for degree qualified individuals is expected to be little changed from their 2010 employment share, suggesting that the BLS is not expecting a tilt in the composition of openings towards more higher education (and income) positions (and are implying few exits to create movement). Yet we have an enlarged cohort of indebted 20 and early-30 somethings looking for such openings. The consequence of mundane labour market outcomes has been a substantial rise in student loan delinquencies as recent graduates struggle to attain the income needed to service their loan(s). On the NY Feds data, the proportion of loans 90 days past due has risen from 6% mid decade to closer to 12% of late. (Note that these figures can vary substantially from the delinquency rates recorded for private student loan ABS, which represent a small sliver of the student loan universe. The price of these securities are yet to show any real sign of an asset-specific disturbance.) Even this doubling in the deliquency rate may be understating the problem. As highlighted by the NY Fed, with the flow of loans to current students having been so strong, many debtors remain in grace periods and, as such, are not presently counted as either delinquent or performing. We wont know until the grace periods expire and the borrower is left to sink or swim. The NY Fed estimates that, as at Q4 2012, some 44% of borrowers were not yet obligated to make repayments. The consequence of this is that if we do not see a marked improvement in the employment prospects for younger cohorts, we will see a substantial rise in student loan delinquency rates down the road. From an ABS point of view, the 2009-12 vintages do not look appealing, to say the least. Intentions and consequences Given that these loans are typically small in scale (an average of around $25k), many would argue that they dont matter for the overall health of the US economy. But this benign view needs to be discounted on a number of levels. First, the interest rate charged on student loans is typically well above the 30-year mortgage rate: at least 6.8% versus the current 30-year mortgage rate of 4.3%. (That is after a 100bp tapering increase in the mortgage rate, according to Freddie Mac). While we do expect benchmark yields to decline a little as tapering is recalibrated in time and scale, it is very likely that the yield trough has passed. A back of the envelope calculation shows that a 6.8%, 10-year, fully-amortizing $25k student loan would require monthly repayments of $288. That equates to roughly 9% of the average after tax monthly income of a 25-34 year old graduate.
70 60
60 63

US private payrolls
4 mn cumulative change from Dec 11 mn
Professional and business services Leisure, hospitality and retail Education and health Construction Manufacturing
Sources: Westpac Economics, Ecowin, BLS

4 3 2 1

Other

0 -1 Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 Apr 13 Jul 13

Delinquency rate by debt type

15 12 9 6 3 0 2003 % % of balance 90+ days delinquent
Mortgage Auto Loan Student Loan HE Revolving Credit Card

%
Source: NY Fed

15 12 9 6 3 0

2005

2007

2009

2011

2013

Average student loan balance by age cohort

30 25 20 15 10 5 0 <30 3039 4049 5059 60+
21

$000s
29 28 24

$000s
Source: NY Federal Reserve

30 25 20

20

15 10 5 0

Individual income of US graduate

000s
bachelors degree or higher; 2011 dollars

000s

Source: US Census Bureau

70 60

50 40 30 20 10 0 2534 3544 4554

44

60

50 40 30 20 10 0

5564

Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.

Follow that FLOW

26 July 2013
Although that appears serviceable for those who find the employment for which they are trained, it is a major drag on the disposable income of the individual, and is a material barrier to accruing the savings required to enter the housing market. By way of scale, for the individual with the representative $25k student loan, the servicing estimate above would be 1 times as large as either food or transport as a share of total household disposable income. Secondly, a related concern is that there is no real minimum level of income below which student loan payments are deferred.* Direct government loans can be deferred, but this is usually only possible if the former student undertakes further study, is unemployed, or experiencing economic hardship; for the latter two categories, deferment is only available for up to three years. As such, sooner or later, low income earners generally find that their purchasing power is reduced by loan repayments. Each of the above concerns pale in comparison to the inability of borrowers to extinguish student loan liabilities if their income proves insufficient to pay down the debt, and all avenues of forebearance have been exhausted. That is, the indivual declares bankruptcy. In such an instance, the individual remains liable for the debt as long as it is deemed that they have a chance to pay it back in the future. In the interim, the credit standing of the individual/household deteriorates, while their total debt continues to grow in line with accrued interest. At best, these obligations limit the amount a young household can borrow; at worst, they destroy their credit standing. The importance of an individuals credit standing and the consequences for the housing market was discussed in May by FOMC Governor Elizabeth Duke, titled A View from the Federal Reserve Board: The Mortgage Market and Housing Conditions. In the speech, Duke explained how banks were restricting credit to individuals with lower credit scores. The speech is worth considering in full, but in this instance we merely highlight that between 2007 and 2012 originations of prime purchase mortgages fell about 30 percent for borrowers with credit scores greater than 780, compared with a drop of about 90 percent for borrowers with credit scores between 620 and 680. Further, the median credit score for FHA purchase loans (i.e. governmentinsured mortgages) has risen from 625 in 2007 to 690 in 2013, while the 10th percentile has increased from 550 to 650. Qualitative evidence in the speech points to this trend being, at least in part, due to tighter credit standards, as opposed to a lack of demand. Regardless, it is clear that the confluence of soft labour market conditions and legacy debts is impinging on US economic momentum. Conclusion The accrual of student debt by US households over the past five years has been a spectacular, if often overlooked, macrofinancial trend. The stock of student loans remains small relative to the stock of mortgage credit, but the growth has been such that the acumulation of student debt now has the capacity to materially impinge on financial health and discretionary spending power. The consequences are wide-ranging and long-term in nature. Long-term productivity growth in advanced economies relies on the accumulation of knowledge. Ergo, we are not antieducation. Far from it. What we are saying is that the deep fundamental fissures in the US economic model have altered the arithmetic. The average prospective return from higher education has probably declined, but the cost has increased. Thus the servicability of newly acquired student debt is far less assured than in previous cycles and there is more of it than ever before. For the US to have a chance at attaining persistent, above-trend growth, young households need job opportunities that allow them to put their skills to work and receive adequate compensation in return. In doing so, the underpinnings of a period of stronger economic growth will be put in place. Should this not occur, younger cohorts will find themselves in the unenviable position of having low incomes, high debt and uncertain prospects. This is a particularly pressing concern for the US economy. Specifically, the 20 to 40 years-of-age cohort is a major accumulator. First of higher education, then of housing and durable assets, all of which require access to credit. A besmirched credit record for a material part of Americas university educated youth ahead of their key accumulation years would be a significant drag on US (and global) economic growth. Combined with the existing debt liabilities of older cohorts and all levels of US Government, such an outcome would make a sustained, domestic-oriented resurgence in growth extraodinarily difficult to engineer. Should soft labour market conditions persist, as we expect them to, student debt will increasingly become a core concern, both on macroeconomic and social grounds. Elliot Clarke, Economist +61 (2) 8253 8476 With contributions from the Westpac Economics team.
* It is stipulated that 15% of discretionary income (the difference between gross income and 150% of the relevant poverty guideline; not the new definition of household income we introduced in the previous edition of this series) is the minimum repayment rate for the accrued debt balance.

Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.

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