Is the U.S. Student Loan Program Facing a $500 Billion Hole? One Banker Thinks So.

Government sees it as a moneymaker. Former JPMorgan executive sees a giant loss looming due to rosy repayment hopes. 

By Josh Mitchell of The WSJ. Excerpts:

"In 2018, Betsy DeVos, then U.S. education secretary, called JPMorgan Chase & Co. Chief Executive Jamie Dimon for help.

Repayments on federal student loans had come in persistently below projections. Did Mr. Dimon know someone who could sort through the finances to determine just how much trouble borrowers were in?

Months later, Jeff Courtney, a former JPMorgan executive, arrived in Washington. And that’s when the trouble started.

According to a report he later produced, over three decades, Congress, various administrations and federal watchdogs had systematically made the student loan program look profitable when in fact defaults were becoming more likely.

The result, he found, was a growing gap between what the books said and what the loans were actually worth, requiring cash infusions from the Treasury to the Education Department long after budgets had been approved and fiscal years had ended, and potentially hundreds of billions in losses.

The federal budget assumes the government will recover 96 cents of every dollar borrowers default on. That sounded high to Mr. Courtney because in the private sector 20 cents would be more appropriate for defaulted consumer loans that aren’t backed by an asset.

He asked Education Department budget officials how they calculated that number. They told him that when borrowers default, the government often puts them into new loans. These pay off the old loans, and this is considered a recovery, even though in many cases the borrowers haven’t repaid anything and default on the new loans as well.

In reality, the government is likely to recover just 51% to 63% of defaulted amounts, according to Mr. Courtney’s forecast in a 144-page report of his findings, which was reviewed by The Wall Street Journal."

"The program quirks Mr. Courtney analyzed resulted from a series of decisions by Congress and presidents of both parties dating back to 1990, many of them rooted in accounting.

Before then, the budget treated student loans as an expense. If the government lent $1 billion, the deficit rose by that amount, absent offsetting measures.

The law changed in 1990 to incorporate expected future repayments. Suddenly, loans became a potential source of profits, by assuming that most borrowers would repay with interest. This created an incentive for Congress to expand student lending. Doing so would increase access to higher education either at no cost to the government or with a gain in federal revenue, at least on paper.

Changes in 1992 made loans available for the first time to students from upper-income households, and provided that interest would start accumulating while borrowers were still in school, instead of after graduation. Congress also lifted a ceiling on how much parents could borrow for their children.

In 1993 the government introduced “Income-contingent” loans, under which monthly repayments were set as a share of borrowers’ income instead of fixed, and repayment could be spread over 25 years instead of 10.

This encouraged bigger loans. Congress and the Obama administration later expanded these kinds of loans. In all, the changes, by making nonpayment of student loans seem less likely, were justified as preventing losses from student lending.

One instance of how accounting drove policy came in 2005 with Grad Plus, a program that removed limits on how much graduate students could borrow. It was included in a sweeping law designed to reduce the federal budget deficit, which had become a concern in both parties as the nation spent on wars in Iraq and Afghanistan and as baby-boomer retirement was set to raise Social Security and healthcare outlays."

"The assumption that all this student lending would mean growing profits for the federal government and savings for taxpayers has been consistently off the mark.

The federal government extended $1.3 trillion in student loans from 2002 through 2017. On paper, these would earn it a $112 billion in profit.

But student repayment plummeted. In response, the government revised the projected profit down 36%, to $71.5 billion. The revision would have been bigger except for the fall in interest rates that let the U.S. borrow inexpensively to fund loans.

The phenomenon is worsening in recent years. For the fiscal year ended September 2013, the government projected it would earn 20 cents on each dollar of new student loans. For fiscal 2019, it projected it would lose 4 cents on each dollar of new loans, federal records show."

"If repayments come in lower than expectations—as has happened successively in recent years—the Treasury Department fills the gap with cash infusions to the Education Department.

This process takes place outside of the budget review and outside of congressional oversight. Ever-larger cash infusions from the Treasury have been needed."

"students who took out federal loans in the 1990s had repaid, on average, 105% of the original balance a decade later, including interest. Since 2006, they had repaid an average of just 73% of their original balance after a decade."

"Education Department budget officials didn’t look at basics such as borrowers’ credit scores to estimate the likelihood they would repay."

"The credit scores of four in 10 borrowers would qualify them as “distressed”—double the rate on all types of private consumer loans, his analysis found."

"Borrowers unable to make regular monthly payments sometimes lowered them by switching to income-based repayment."

"The accrual of unpaid interest caused loan principals to rise instead of decline, making the loans appear more profitable to the government, even though the accrual stemmed from borrowers’ difficulty in repaying."

"Education Department budget officials overestimated how much borrowers would earn and thus be able to pay back."

"Its estimates of how much borrowers’ incomes would rise were consistently wrong"