What a Drag!

You don't need a Ph.D. in math to know that student-loan debt is compounding at an alarming rate. In the last six weeks alone, two new government reports have detailed the growing student debt burden, which has no doubt contributed to the weak economic recovery and could remain a drag on growth for decades to come. First came a report early last month from the Federal Reserve Bank of New York stating that the $870 billion in loans carried by some 37 million present and former students exceeded the money owed by all Americans for auto loans, as of the Sept. 30 end of the government's 2011 fiscal year. It's also greater than credit-card debt. The report went on to note that delinquencies, officially reported at about 10% of outstanding loans, were actually more than twice that number when things like loan-payment deferrals for current full-time students were properly accounted for.

But that was just prelude for a speech in late March, when an official of the new federal watchdog agency, the Consumer Financial Protection Bureau, asserted that total student debt outstanding actually topped $1 trillion. The Fed, it seems, failed to account for much of the interest that had been capitalized, or added to outstanding loan balances on delinquent and defaulted loans.

The cause of the binge is the unfortunate concatenation of steeply rising tuitions in the face of stagnating family incomes, a precipitous decline in states' funding of public universities and two-year colleges, and the burgeoning of avaricious for-profit colleges and universities—which rely on federally guaranteed student loans for practically all of their revenue, in exchange for dubious course offerings.

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Ever-rising tuitions are the biggest part of the problem. As the chart nearby shows, tuition and fees at four-year schools rocketed up by 300% from 1990 through 2011. Over the same period, broad inflation was just 75% and health-care costs rose 150%.

However you apportion blame, it boils down to this: Two-thirds of the college seniors who graduated in 2010 had student loans averaging $25,250, according to estimates in a survey by the Institute for College Access & Success, an independent watchdog group. For students at for-profit schools, average per-student debt is even greater for training in such fields as cosmetology, massage therapy, and criminal justice, as well as more traditional academic subjects.

WHETHER YOU HAVE KIDS in school or they've long since graduated, this is a big deal. Graduates lugging huge debt loads with few job opportunities to pay them off are reluctant to buy cars, purchase homes,or start families. Family formations, a key bulwark to home prices, have been in a seemingly inexplicable funk over the past five years or so.

Prospects are even more harrowing for defaulters on student debt. They are virtually excluded from the credit economy, unable to get mortgages, take out auto loans, or even obtain credit cards. "We are creating a zombie generation of young people, larded with debt, and, in many cases dropouts without any diploma," says Mark Zandi, the chief economist at Moody's Analytics.

Debt taken on by students pursuing professional degrees in graduate schools is even more daunting. Federal Reserve Chairman Ben Bernanke turned some heads in an aside during congressional testimony last month when he said that his son, who is in medical school, would probably accumulate total debt of $400,000 before completing his studies. Law students, even at non-elite law schools, often run up debt of as much as $150,000 over the course of earning their degrees. This even though top-paying law jobs at major corporate law firms are shrinking, consigning many graduates to lives of relative penury. Many are resorting to lawsuits against their schools, charging, with some justification, that the schools gilded the employment opportunities that awaited graduates.

IT'S NOT JUST STUDENTS who are being crushed by student-debt loads. Kenneth Lin, of the credit-rating Website Credit Karma, found something astounding when he examined credit reports on literally millions of households nationwide. Student debt borrowing by the 34-to-49 age cohort has soared by more than 40% over the past three years, faster than for any other age group. He attributes this in large part to bad economic times that prompted many to seek more training to enhance their career prospects. This is also the age group that the for-profit schools mercilessly mine with late-night television ads, online advertising, and aggressive cold-calling to entice with their wares.

Also, some folks in their 30s are obviously having trouble paying off student loans taken out earlier in their lives because of high unemployment rates and disappointing career outcomes. According to the aforementioned Fed report, the 30-to-39 age group owes more than any other age decile, with a per-borrower debt load of $28,500. They're followed by borrowers between the ages of 40 and 49, who had outstanding balances of $26,000. This is what happens to folks when loans go delinquent or fall into default (nine missed payments in a row), as back interest is added to principal and collection costs mount.

Parents, too, are getting caught up in the student-loan debt explosion. Loans to parents to help finance their kids' post-secondary education have jumped 75% since the 2005-06 school year, to an estimated $100 billion in federally backed loans; this according to data compiled by Mark Kantrowitz, the publisher of the authoritative student-aid Website FinAid.org. That's certainly a painful burden to bear for baby boomers, who are fast approaching retirement bereft of much of the home equity they'd been counting on to finance their golden years.

TO BE SURE, student loans aren't the debt bomb that many doomsayers claim, poised to destroy the U.S. financial system as the residential-mortgage-market collapse nearly did. Moody's Mark Zandi ticks off a number of reasons why:

Student loans are just one-tenth the size of the home-mortgage market. Subprime mortgages, including alt-A, option ARMs (adjustable-rate mortgages), and other funky constructs, were bundled into $2.5 trillion worth of securitizations at their peak, ensuring that the damage wrought by their collapse spread far and wide, destroying the value of U.S. families' biggest asset. The impact of these mortgage securitizations was only amplified by huge bets made by financial institutions like insurer American International Group (ticker: AIG) on the home-mortgage market in the form of credit-default swaps and the like.

Finally, and most important, the bulk of the student debt outstanding, some $870 billion of the total, is guaranteed by the federal government—and ultimately taxpayers. "Thus, the damage can be contained, at least until the next recession," Zandi asserts. "We should worry more about more subtle things like how indebtedness is causing the U.S. to fall behind some…emerging nations in the proportion of our population with college degrees than about any direct financial system fallout."

THE EVENTUAL BILL to taxpayers on defaulted student loans won't be overwhelming. That's because Uncle Sam has enough collection powers to make a juice-loan collector envious and most debtors cry, well, "Uncle!" Among other things, the government can garnish the wages and glom onto income-tax refunds or Social Security payments of defaulters. And student debts are treated like criminal judgments, alimony and the like when it comes to bankruptcy. They can be discharged only under the rarest of circumstances, no matter how fraught the deadbeats' financial circumstances have become.

A recent story by Bloomberg's John Hechinger describes the hard-nosed tactics used by collection agencies hired by the Department of Education to go after the defaulters on $67 billion in loans. The collectors, operating out of boiler rooms, badger their marks with all manner of threats in return for bonuses, gift cards, and trips to foreign resorts if they pry at least nine months of payments above a certain minimum out of the defaulters. No mention is made of more lenient payment plans.

Such strategies apparently work, tawdry though they may be. The government claims it collects around 85 cents on the dollar of loan defaults. By contrast, credit-card companies are lucky to collect 10 cents on the dollar from borrowers in default.

CHANGES IN REPAYMENT PLANS instituted in 2009 allow some student-loan borrowers in extreme hardship to pay monthly on the basis of what they can afford rather than what they owe. Under this "income-based repayment plan," after 25 years of payments based on the borrower's discretionary income, the remainder of the loan will be forgiven. Thanks to the Obama administration, that number will soon be just 20 years.

Students going into public-service jobs like teaching can receive a get-out-of-debtors'-prison card after 10 years of income-based payments.

But these programs aren't likely to add much to the taxpayer tab on student-loan defaults, since the participation in the programs has been light (550,000 out of 37 million student borrowers), and the money collected is better than nothing.

Nor are the major players in the private, nongovernment-backed student-loan market, such as SLM, formerly known as Sallie Mae (SLM), Discover Financial Services (DFS), Wells Fargo (WFC) and PNC Financial Services (PNC), likely to suffer much from delinquencies or defaults. Their student-loan balances, at around $130 billion, are relatively manageable. They also were able to slip into 2005 legislation a provision prohibiting student-loan borrowers from discharging that debt in bankruptcy, mimicking the government's leverage over defaulters.

The private student-loan industry has also tightened up its underwriting standards since the financial crisis, demanding higher FICO, or credit, scores from borrowers and parents to co-sign most education loans. However, Fitch recently warned that private student-loan asset-backed securities, especially bundled before the recent recession with less stringent standards, are expected to continue to suffer from "high defaults and ratings pressure." Little surprise then that JPMorgan Chase (JPM) announced last week that it would stop underwriting student loans as of July 1, except to customers of the bank.

DESPITE ALL THIS, some observers blame the government for the debt spiral—by making subsidized loans overly available to students. Without easy federal Pell grants (up to $5,550 a year for full-time students at four-year colleges) and federal undergraduate loans, now capped at an aggregate of $57,500, there would have been no spiral in college costs.

But this smacks of blaming the victims—students encumbered by debt and taxpayers ultimately subsidizing and guaranteeing the loans.

The perps clearly seem to be the so-called nonprofit universities and colleges that have been gunning tuition and fees ever higher since 1980, vastly in excess of consumer inflation, health care, and nearly any other cost index one can imagine.

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Just take a look at the chart nearby, helpfully provided by the College Board in its latest 2011 "Trends in College Pricing." Inflation-adjusted, private four-year college tuition and fees have jumped 181% on a smooth but relentlessly higher glide path. Public four-year college tuitions have risen by an even larger 268%, although it's clearly a case of catch-up. In-state tuition this year averages only $8,244, compared with the privates' $28,500 average tab. Student-debt outstanding, meanwhile, is growing far faster, climbing ninefold since 1997.

THE COLLEGE BOARD and private colleges and universities obdurately defend themselves, saying the "sticker price" in no way represents the actual price paid by families after taking into account federal and state grant aid, federal-tax breaks to families paying for college, and, of course, scholarship money provided by the schools themselves. In fact on a "net-price" basis, private four-year tuition costs, at $12,970, were slightly lower than in the academic year five years ago, the report brags.

That assertion is true as far as it goes. But the lower net price is not the result of the munificence of schools' scholarship programs, but is almost solely due to large increases made under President Obama in the size of Pell grants and educational tax credits. Throw in room and board—"not really part of the cost of attending college," the report says dismissively—and college costs are indeed higher this year. Room and board—$8,887 on average for in-state students at public schools in the current school year and $10,089 at private colleges—have long been a means for colleges to make stealth price increases.

Ivy League schools with total sticker prices including room and board of $50,000 to $57,000 in the current academic year use their large endowments to give out large dollops of student aid. In fact, Yale and Harvard are said to offer scholarship money or assistance to families with incomes up to $180,000. As a result, students graduating from elite schools like Princeton, Yale, and Williams College are able to graduate with total debt under $10,000, making them among the lowest-debt college and universities in the country.

But the Ivies can't be absolved of all blame in the current debt mess. They began the sticker-price arms race in the early 1980s, reasoning correctly, it turns out, that they could boost prices with impunity because of the scarcity value, social cachet and quality of the education they offer. They've led the charge ever since, even getting caught by the U.S. Justice Department for colluding on tuition increases and grant offers to applicants in the early '90s. They signed a consent decree neither admitting to nor denying the charges.

Don't think that state governments—which have been methodically cutting appropriations to higher public education for the last decade—aren't aware of the still-yawning gap between the sticker prices of state and private schools, which means that tuitions are likely to continue to rise at break-neck speed.

Too, elevated sticker prices by the privates have given cover to for-profit schools, including University of Phoenix, owned by Apollo Group (APOL), Bridgepoint Education (BPI), ITT Educational Services (ESI), Washington Post's (WPO) Kaplan University, and Career Education (CECO), a capacious umbrella under which to nestle. The schools live off of Pell grants, federally backed student loans, and, increasingly, the GI bill for veterans. Thus, they derive as much as 90% or more of their revenue from such government money, so they concentrate their recruiting efforts on the less affluent in order to qualify for such government largess. (For a look at ITT Educational's practices, see "Clever is as Clever Does.")

The industry's course content is often risible, and graduation rates horrible. Students naively hoping for a big jump in earnings power end up saddled with debt averaging about $33,000, with little to show for their efforts. Students at for-profits make up about 10% of the post-secondary-school population. Yet according to congressional researchers on the Senate Health, Education, Labor, and Pensions Committee, which has been investigating the for-profit industry, they account for between 40% and 50% of all student-loan defaults.

THE STUDENT-DEBT CRISIS is emblematic of issues bedeviling the U.S. as a whole, such as income inequality and declining social mobility. For as scholarship money is increasingly diverted from the needy to achievers with high grade-point averages and test scores, boosting institutional rankings, the perhaps less-privileged applicant is thrust into the position of having to take on gobs of debt, indirectly subsidizing the education of more affluent classmates. The race to the career top is likely over long before graduation.

Student debt also helps sustain many school hierarchies that are virtually bereft of cost controls—the high-salaried tenured professorates, million-dollar-a-year presidents and provosts, huge administrative bureaucracies, and lavish physical plants.

The debt game will continue until students and their families revolt or run out of additional borrowing capacity. Don't expect the educational establishment to rein in its spending. Things have been too cushy for too long. 

E-mail: editors@barrons.com