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Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

The student loan mess: how we got here

Controversy has swirled around President Biden’s student debt forgiveness plan since it was announced in August. On one hand, it recognizes that excessive student debt is hindering household formation and fulfills a central campaign promise. On the other hand, the plan in unfair to the millions of borrowers who timely repaid their obligations and creates a moral hazard to the degree that future borrowers will anticipate and plan for relief of their own debt.

In any event, legal challenges abound, and the President may not have the authority to unilaterally erase these obligations. But he has rightly focused much needed attention on the broken system of higher education finance in the US. Here is a brief look at how we arrived at this point.

As World War II was winding down, President Roosevelt signed the Servicemen’s Readjustment Act of 1944, known as the “GI Bill or Rights” or simply the GI Bill, to provide benefits for veterans returning from the war. Included among the provisions was the financing of up to 4 years of college or vocational training, marking the first large-scale direct federal support for higher education.

America’s post-war complacency was shattered in 1957 by the Soviet launch of Sputnik. Inspired by the work of conservative economist Milton Friedman, President Eisenhower signed the National Defense Education Act of 1958 creating the first federally funded student loan program, aimed at ramping up technical competence to counter the Russians. Friedman, a staunch free-market proponent, understood the importance of government funding of education as critical to promoting strong and functioning democracy. The Act provided low-cost direct loans and funds to colleges and universities.

A major shift occurred in 1965. Current budget rules tallied the government loans as expenditures even though they would eventually be repaid. The Higher Education Act of 1965 established a parallel program known as the Federal Family Education Loan (FFEL), whereby loans were issued by private banks with a federal government guarantee against losses.

While the FFEL guaranteed loan program proved popular, many banks were reluctant to participate. In response Congress created a quasi-governmental entity in 1972 called the Student Loan Marketing Association (SLMA) which quickly acquired the moniker “Sallie Mae”. Sallie Mae provided liquidity for the loan market by buying up existing loans to provide new cash for additional loans by the banks. This event marked one of the milestones in the evolution of the current morass. 

In 1996 Congress privatized Sallie Mae and effectively granted the entity the right to print money, as it could borrow at government rates but lend at market rates with the implicit backing of the US. The enterprise proved hugely profitable for shareholders (and executives) as well as colleges at the expense of student borrowers, while precipitating an upward spiral in intuition rates and indebtedness.

In addition to subsidizing for-profit enterprises in the lending business, Congress also enacted a series of laws between 1976 and 1990 that effectively made it impossible to discharge defaulted student loan debt in bankruptcy like any other contractual obligation. This has proven to be a serious policy error and had exacerbated the crisis.

The 1980 reauthorization of the Higher Education Act created the PLUS program of loans to parents as well as to graduate students. This too was a milestone in that nearly half of all outstanding student loan debt today was incurred to cover graduate education.

In 1992, Congress authorized “unsubsidized” loans to all students regardless of financial condition, and the next year created a new Federal Direct Loan Program, issuing loans directly from the US Treasury and bypassing Sallie Mae. The 1993 act reintroduced the idea of direct government support of higher education, but a 1997 law prohibited the Department of Education from promoting the program thanks to powerful lobbying efforts and it met with only modest acceptance. The 1993 legislation also introduced the first income-based repayment plan, of which several versions exist today.

In response to the financial crisis of 2008 and addressing the growing reports of deception and mismanagement among some private lenders, President Obama ended the guaranteed FFEL loan program in 2010, since which time all federal student loans have been initiated and funded directly by the Treasury. In response to intense political pressure from the private lenders, a compromise allowed these companies to continue servicing the existing and newly issued loans, collecting payments and negotiating repayment plans. Today private lenders play a smaller role in private lending but serve as the borrower contact for nearly all federal loan agreements. The outsourcing of loan servicing was another major milestone in the debt crisis that has yet to be fully addressed.

The servicing industry has been awash in consumer complaints and legal settlements. Navient Corporation, a 2014 spinoff from Sallie Mae, entered a $1.8 billion settlement with 39 states over deceptive practices, and other claims are being litigated against other firms. Loan servicing companies are paid a flat fee per loan and have an inherent conflict of interest when a borrower wishes to seek forbearance or an establish an income-based repayment plan. 

Federal student debt has doubled over the past decade to $1.6 trillion. Meanwhile, according to the New York Fed, every $1 increase in the federal borrowing limit yields a 60-cent hike in tuition. The system is broken and while the President’s plan is not a fix, it does at least elevate the conversation. Next week: thinking about solutions.

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