Is the Senate’s Student Loan Plan Fundamentally Flawed?

Mark Twain had it right when he said, “No man’s life, liberty, or property are safe while the legislature is in session.”

The latest wretched manifestation of this truth is courtesy of Sens. Richard Burr (R-N.C.), Tom Coburn (R-Okla.), Angus King (I-Maine) and Joe Manchin (D-W.Va.). Their bipartisan proposal would index student loan rates to that of 10-year Treasury notes, plus an additional 2 percentage points for undergraduate Stafford loans, 3½ for graduate-student Stafford loans and 4½ for parent PLUS loans. Currently, the rate on subsidized student loans is 3.4%, and is set to double on July 1 if Congress doesn’t step in.

As you might expect, the proposal triggered a seismic blogospheric event, given what appears to be an already extraordinarily high rate of student loan profitability. All that rumbling aside, however, there remain three fundamental flaws with the underlying rationale for this and certain other proposed solutions: duration, amortization and cost.

One of the reasons the student loan program appears to be so profitable is that the government is engaged in a carry trade, where it routinely funds 10-year student loans with one-year money or less.

As long as the yield curve is positive (where short-term rates are lower than those for longer periods) and the rate environment is stable (as it’s been the past several years), all’s right in the world. However, once rates on the government’s short-term borrowings begin to move upward — as the most recent stock market gyrations indicate is a very real possibility — the feds would quickly see their profits shrink. So it’s fair to ask: Is this a sustainable plan?

Avoiding a Student Loan Meltdown

A more responsible solution would be for the government to lock in its own borrowing costs so that the spread (gross profit) between that and the rates its student-borrowers pay is assured.

The question is, which borrowing duration to choose?

If the feds were actually amortizing its debts the same way that student loans and mortgages are repaid, a logical argument could then be made for linking a 10-year Treasury note to a 10-year student loan. But that’s not what appears to be happening.

Treasury notes are, in effect, bullet loans, where the full amount comes due at maturity. In other words, the debts don’t amortize. Consequently, student loan payments that are remitted each month may be stored up for later or, more likely, used to pay off the government’s previous borrowings. There’s no way to tell. Moreover, given that federal indebtedness continues to increase at this time, it’s safe to surmise that the government’s older, short-term debts are being rolled into new, short-term debts when they come due.

Seems to me it would be fairer for the Department of Education to index student loan rates to the same short-term Treasury notes the government uses to fund these loans, or employ a half-life pricing strategy, as do private sector lenders in support of their own activities. Either way, students would end up paying less — and perhaps much less — than under any of these other legislative schemes.

However, as important as it is to settle on the right index, it’s equally imperative that we get our arms around the costs the government actually incurs to originate and service these loans, after taking into account all the fees it collects from student-loan borrowers on the front-end. Only then can any loan premium — whether it’s 2%, 3.5% or 4.5% — be rationalized.

Said differently, a little more transparency would help.

Image: Jupiterimages