The risk of student loan debt

The ever-growing student loan debt is turning into a long term burden on the US economy. The American economy is tied to consumer spending, and the addition of this long term debt to consumers’ balance sheets diminishes total disposable income. This could delay (maybe for decades) and possibly keep young people out of the housing market. Unlike other consumer debt that has bankruptcy as a way to escape, student loans do not have that option.

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Student loans are a problem. But the Millennials have a number of harsher economic issues to deal with that their predecessors did not have. Rising student debt may prove to be one of the more painful aftershocks of the Great Recession, especially if left unaddressed.

The growing student loan burden carried by millions of Americans threatens to undermine the housing recovery’s momentum by discouraging, or even blocking, a generation of potential buyers from purchasing their first homes. Tightening loan standards have taken the amount of entry level buyers (homes in the $150K to $330K range), and reduced them dramatically. Think about that; older Americans started building our assets by qualifying for and purchasing an entry level home. The student loan issue of the last few years has the ability to put a huge roadblock in entry level buyer’s ability to build up their assets.

First-time buyers, the bedrock of the housing market, are unable to step up to fill the void. Historically, they have accounted for nearly a third of home purchases in the past. Now they make up less than 7% of the market, well below the historical norm. The trend has alarmed some housing experts, who suspect that student loan debt is partly to blame. That debt has tripled from a decade earlier, to more than $1 trillion, while wages for young college graduates have dropped.

The fear is that many young adults can no longer save for a down payment or qualify for a mortgage, impeding the housing market and the overall economy, which relies heavily on the housing sector for growth. Student debt trumps all other consumer debt. It’s going to have an extraordinary dampening effect on young peoples’ ability to borrow for a home, and that’s going to impact the housing market and the economy at large.

These days, federal student loans — the largest part of the market — are essentially made by the colleges, using government money. There is no underwriting criteria and few limits on how much any student can borrow. The limits that do exist apply to so-called dependent undergraduate students, who are at least partly supported by their parents. Graduate students can borrow what they want, and parents of dependent undergraduates can take out their own student loans after the student has maxed out.

Obviously, there is no way to apply conventional loan underwriting standards to students who, by definition, are not at the moment earning enough money to repay their loans. But the program is subject to abuse by colleges whose primary — if not only — goal is to get their hands on the money.

The Department of Education has been trying to come up with a rule to exclude programs that have a clear history of not producing people who can earn enough to repay their loans: a “gainful employment” rule. This is largely targeted at programs that do not lead to conventional degrees — largely the training programs pushed by for-profit private schools, the kind that do a lot of advertising

The Department’s first effort was rejected by a federal judge after the Association of Private Sector Colleges and Universities sued. The Department has now submitted a second rule to the Office of Management and Budget, but the details are not yet public. The Department did that after a panel it appointed, including representatives of various types of colleges and students, could not reach agreement.

It might make sense for the Department to instead, or in addition, design a “skin in the game” rule for the colleges. If a college’s former students turn out to default frequently, the college could be required to pay a substantial penalty. That could mean colleges would have good reasons not to promote programs that did nothing to help their students.

On the other hand, colleges whose alumni were particularly good at repaying loans might receive some kind of financial reward, perhaps in the form of a grant that could be used for scholarships. I personally feel that any place of higher learning that has a high number of defaults needs to be cut out of the program. Who are they serving?

Any such proposal would prompt protests that such a rule would keep needy students from receiving the aid they need to get ahead. But all too often now, student loans are not a pathway to the middle class but a burden that keep young people from having any real chance of success. Particularly if the ability to get a job based on their education and training is not available.

More needs to be done to regulate the companies that service the student loans. There are uncanny resemblances between issues faced by student loan borrowers and struggling homeowners.

At one time, student loans were a clear way to provide economic opportunity to people who might not have the ability or opportunity to attend college any other way. And the economic effect of lack of degree is apparent when looking at level of unemployment by education degree. In the US, those without a high school degree are over 25% unemployment, while those with a 2 year trade or 4 year college degree is below 4%. So the need for education is obvious.

The question is what has changed? Why has student debt and its consequences mushroomed since 2009? The recession caused many to question their experience and ability to become employed again. Many for-profit schools aggressively pursued the ability to attract those unemployed by offering guaranteed federal loan programs tied to their educational offerings with little to no job placement after training. As in all educational pursuits, the ability to attain a job after graduation is the graduate’s responsibility. And if they did not complete the training they were still on the hook for the loan.

A positive way of looking at this problem is this consumer debt (student loans) is the largest asset on Uncle Sam’s balance sheet, bigger than U.S. Official Reserve Assets, total outstanding mortgages or taxes receivable. The negative is the dampening effect on consumer home buying.

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The rapid growth in student debt will continue to be an ongoing topic. The stunning chart on the first page illustrates the rapid growth in federal loans to students since the onset of the Great Recession. This chart is based on data from the Financial Accounts Table, which shows the Federal Government’s assets and liabilities. The loan balance has risen and astonishing 531 percent over the last 6 years, most of which dates from after the recession. The below referenced chart only includes federal loans to students. Private loans make up an even larger amount.

So back to the original question. Yes, the current student loan situation has and will continue to be a larger burden than ever before on home buyers.

The positive is that if you live, or are employed in Texas, where over 40+% of all jobs in the nation have been created in the last 5+ years, and own a home in Texas, you are better off than your friends in other states.

Are tighter lending standards holding back the recovery?

Is heavy financial regulation and tightening of loan and mortgage requirements slowing the housing recovery? Over the last six months, we have discussed the effects of Dodd Franks, Basel III, and QRM (qualified residential mortgages). There is tremendous concern over the tightening of lending standards.

How much do analysts think it is affecting markets? At what cost to prospective homeowners? Presently entry level buyers nationally are 7 to 8% of the buying market (historically, they have been somewhere between 18% to 25%). After real estate/financial ‘boom’ cycles we historically see a tightening of lending standards from banks, mortgage lending, and government regulators.

Underwriting standards as well as the regulatory standards have been put in place to prevent another financial meltdown. Most of us know the reason for the meltdown were lax underwriting standards that allowed no doc, low doc, and NINA loans that enabled people to borrow beyond their means.

Mark Zandi, chief economist for Moody Analytics, wrote in the Washington Post last week, “For the housing recovery to maintain its momentum, first time and trade up home buyers must pick up the slack.” I agree entirely. This analyst is concerned about the number of Millennials that have not been able to purchase a home, and reap the benefits of accruing equity. Many of the Baby Boomers’ largest source of wealth was from appreciation on their first home purchases. Yet these same buyers today face a significant barrier of qualifying for mortgages. The average score on loans to buy homes last year was above 750 FICO (on a scale of 300 to 850). This is some 50+ points higher than the average among those who received mortgages a decade ago, before the housing bubble. When most Baby Boomers bought their first house, late payments could be explained with a letter. No longer. The very ones that need more liberal underwriting seem to be paying the price of the previous decades loose standards.

It is harder to qualify. But there are loans buyers with low FICO can qualify for. You could have gotten a mortgage with a 620 Fico, 3.5% down payment, and debt to income ratios to 43%-50% for the last few years. Even today you can get an 80% loan with a FICO score of 620. Does it require more documentation? Probably. But for those that have been through the process, it would be a learning experience anyway.

The use of the average score of those who bought homes as proof that lending standards are too tight is somewhat of a flawed analysis. The FICO score reveals more about the buyers’ credit quality on average, but not that lending standards are tight. We must remember that there is no subprime lending in the mortgage business anymore, and that is a good thing.

Many critics point to the resurgence of the auto loan business and the strength of sales in the industry, which offers subprime lending and which is experiencing a boom, so that should be proof that housing should follow suit. However, the debt structure of car loans is much different from housing, and can’t fuel the fires of trouble that subprime loans in housing can (and once did). There is not the inherent ability to refinance a car loan like there is with real estate.

There are many factors keeping mortgage credit tight:
• Lenders are less willing to take on risk because they were burned in the housing collapse. The costs associated with riskier lending (legal, debt carry, maintenance, etc.) and the problems and additional infrastructure / manpower needed to service distressed borrowers and property (15+% annual cost) is also a factor.
• Bank and mortgage regulators have a mountain of regulations put in place by Dodd Franks, Basel III, and the CFPB. 95+% of new loans are subject to these tighter standards.
• Besides the debt-to-income ratio standard being moved down from 45% to 43%, a lot of the new QM (qualified mortgage) guidelines have already been accepted by the marketplace. Also, lenders will do non-QM loans and even interest only loans but only for the upper income home buyers in America. What I am trying to stress here is that the guidelines that we have seen in the last few years, and in place today, are not overly stringent. Lenders are all adjusting to the new guidelines that went into place January 10th. There was no practice run, so conservatism will reign initially. The QRM rule provides safe harbor from borrower suits under the Truth in Lending Act. Most lenders will in all probability not make loans that fall outside the safe harbor rule. And those that do stay within guidelines will have harsher lending parameters than they have had in the past.
• Lenders are qualifying consumers for loans to people with 620 FICO scores and 3.5% down. How much more risk do you want them to take? How much more risk would you take? Because ultimately it is all the taxpayers that bear the brunt of another financial meltdown.

Do we need to slacken lending standards? This analyst believes if a borrower does not have ‘skin the game’ without a stake or ramifications, that it is not lending, it is giving money away with longer term negative consequences. Most of the lending guidelines currently are reminiscent of the lending standards back in the early 90’s when rates were higher and the affordability was not as attractive as today. It did not slow down the market. People still want shelter, and if they want to buy they will find a way.

So what is slowing the economic recovery and how does current lending affect it?

Unemployment

As a country we have not caught up to pre-recession numbers. The number of underemployed from the Bureau of Labor Statistics is closer to 13% than the headline rate of 6.7%. The country needs to find employment for the unusually high number of long term unemployed. Only 7 states are at pre-recession employment numbers. For those states that are not there, what industries need to be incentivized? Nationally and locally we have a roadway and utility maintenance issue. We can fix our infrastructure and get the unemployed working again at the same time.

Income

Incomes are weak. Years of soft income growth has caught up to an economy that is based on debt consumption. One of the key reasons for the mediocre economic growth in the US has been the ongoing weakness in household wages. As the chart below shows, US median inflation-adjusted household income (red line) remains well below pre-recession levels (the chart also appropriately shows U6 unemployment).

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Debt to income

Debt to income ratios probably need to re-evaluated. Is the current household debt to income ratio when purchasing a home too high, even after all the deleveraging that has gone on? There are many monthly expenses Americans pay for with credit that don’t properly show up on debt to income ratios. Many Americans add these monthly expenses, such as cable bill, insurance bill and others, to credit cards because monthly cash flow doesn’t cover it.

Currently the American jobs being created do not, on average, pay enough to support and sustain an increase in mortgage applications and approvals. Since the majority of the jobs nationally recovered have been in the low wage service sector and going to people 50 and over, the improving employment picture has not done much to help housing. Many Americans are making less than what they made during the housing bubble, so the debt to income and liability to income ratios aren’t as strong as most think. The after tax expense incomes for Americans is not rosy. Texas is in a better place. When comparing straight income, Texas might look worse off; however, considering the low cost of housing and general living expenses, Texans have more money to spend. Housing and job creation in Texas remains strong. The first chart show jobs created on a national level:

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Compare that to the Austin breakdown of job creation/loss:

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Student loan debt

Student loans today are one of the only deteriorating pockets of consumer credit, with balances and delinquency rates rising to record highs even as a strengthening economy allows Americans to reduce total borrowing. Outstanding student debt topped $1 trillion in the third quarter of 2013, and the share of loans delinquent 90 days or more rose to 11.8 percent, according to the Federal Reserve Bank of New York. By contrast, delinquencies for mortgage, credit card, and auto debt all have declined from their peaks.

I have not seen a good chart comparing debt from four-year universities vs. for profit school (University of Phoenix, etc). The understanding we have is that student debt from four-year schools may not be as burdensome as thought. However the structure of that debt needs to be rethought. This debt stands at 1 trillion dollars and is growing. Unlike other household debt that can be written off in a bankruptcy filing or through foreclosure or a short sale, student loan debt just grows and grows and grows. This is the one household debt that has been rising throughout this cycle.

Aversion to borrowing

According to Federal Reserve and other financial analysts, credit debt has been paid down dramatically since the boom. For most Americans, what matters is how much they must spend, line by line, to pay their regular monthly bills. It is clear that even when a person has little debt, if their monthly expenses plus a new house payment will exceed their ability to pay, the mortgage will fall into trouble. As stated the good news is at the start of this cycle most Americans aren’t as willing or likely to borrow as much money as they have in the past. They have budgets and know how much their total mortgage payment which includes principal, interest, taxes and insurances is. This is a plus for America because this means consumers have more money in their pockets at the end of the month.
Consumers and their families should look at housing as the cost of shelter, and take on only the debt they can afford to pay. This is and should be a different perspective than looking at investments or hard assets in the way Wall Street firms or foreign cash buyers who are looking for yield investments or wanting a place to park cash. The theory that buying a home will allow the homeowner to both live in it, and watch the investment grow is still accepted by many Americans. Now, they are more likely to believe it is the payment they are buying. They want to buy within their means.
Economic cycles seek equilibrium. They also seem to come full circle historically. Since the late 50’s we have been in a very long economic cycle driven by corporate globalization, technology, debt, and demographics. In this phase capital gets better treatment than labor, meaning that corporate profit is paramount to higher wages. If incomes don’t grow in an economy based on debt, and that economy has no financial bubble to create fake demand to create fake well-paying jobs, then you get this type of cycle we are seeing right now.

Conclusions

It’s not lending standards that are too tight, it’s the economy. We need more people employed full time, and long term unemployment needs to be addressed.
In conclusion, the good news is the housing market is getting better. Not just in Texas, but across the nation. The problem we have with this housing cycle is that home price increase appreciation, caused by a shortage of inventory following the bubble, is pricing Main Street America out of the market. Employment and incomes need to rise before we can say the recovery is complete.

Where is the economy headed in 2013?

Discussion over the impending “fiscal cliff” and continued fiscal instability from the Eurozone, combined with a still sluggish recovery are leaving many Americans feeling pessimistic about our economic future. However, that fact remains that we are recovering, and there are some less-reported economic barometers that show we are moving in a positive direction. A great place to start is FRED, the economic research of the Federal Reserve Bank of St. Louis.

Household debt is way down over the last five years

For the quarter-century leading up to the Great Recession, American consumers accumulated ever-larger piles of debt, both in absolute terms and relative to the size of the economy. Home mortgages were the largest portion of that, but it also included credit cards, auto loans, and student loan debt. The good news is that in the past three years, Americans have made remarkable progress cleaning up their balance sheets and paying down those debts. After peaking at nearly 98 percent of economic output at the start of 2009, household debt was down to 83 percent of GDP in the spring of 2012. That represents debt reduction of $636 billion, or more than $2,000 for every man, woman and child. It should be noted that some of the decline came from debt being written down (such as in mortgage foreclosures), not from being paid off. But the simple fact is that excessive household debt played a major role getting us into this mess; we are well on our way toward fixing it.

A huge obstacle in recovering from this recession is decreased consumer spending. That trend may have reversed in the latter part of this year, particularly after a 12+% increase this last weekend over previous years in spending during Black Friday. For the first time since the Great Recession hit, American households are taking on more debt than they are shedding, a shift that might represent a more resilient recovery.

For two of the last three quarters, American households’ total outstanding borrowing on things like credit cards, mortgages and auto loans has increased after falling for 14 consecutive quarters. Many analysts even see an end to the long, hard process of deleveraging. That process has been a central reason for the sluggishness of the recovery.

Closely watched economic figures underscore households’ sense of strength. Despite tepid growth and still-high unemployment, consumer confidence has been up dramatically, and last month was at a five year high. It since has slacked off a little this week with concerns over the fiscal cliff, but it is still higher than it’s been in the last three years. Economic growth numbers for the third quarter showed household spending picking up pace as well.

The drop in overall debt is in no small part because of foreclosures. Delinquencies and write-offs by lenders are slowing but have not stopped. But the struggle to pay down old debts might not prove such a drag on economic growth in the future.

Now, with the economy more stable and interest rates at generational lows, Americans finally feel more comfortable taking out a loan on a new car or putting money down on a mortgaged home. With their finances more in balance, workers have started spending less of their paychecks paying off old loans and more on leisure or household goods.

Given the importance of consumer spending to the American economy, those changes translate into a more resilient recovery. Consumer spending still drives 65 to 70 percent of the US GDP growth. The end of deleveraging and the recovery of the housing sector will be strong engines for the United States economy.

Experts estimate that the overall level of debt, compared with income or economic output, would continue to fall for the next one to three years — with the earliest prediction for the end of deleveraging coming in mid-2013 and the latest at the end of 2015.

In addition to household debt being down, the cost of servicing that debt is way down. Not only do American families owe less money than they did a few years ago, the price of maintaining that debt is much lower than it once was. In late 2007, debt service payments added up to a whopping 14 percent of disposable personal income. Now it is down to 10.7 percent, about the same as in the early 1990s. That reflects both Americans reducing their debt burdens (see above), and ultra-low interest rate policies from the Federal Reserve that have reduced rates paid on debts. Translation: It costs Americans $403 billion less, or about $1,300 per person, to make their debt payments than it would if debt service costs were still at their 2007 ratio. Ultimately, the consumer is in a better place to purchase, ultimately driving our economy.

Electricity and natural gas prices have fallen

Americans who cook or heat their homes with natural gas are seeing big savings, thanks to falling prices for fuel. The retail price for consumers’ gas service piped into their homes is down 8.4 percent in the year ended in October. The lower wholesale price of natural gas is also pulling down electricity prices; they are off 1.2 percent over the past year.

A shale-driven glut of natural gas has cut electricity prices for the US power industry dramatically and reduced investment in costlier sources of energy.

These are both utility costs that people can’t control much in the short-run, so low prices here translates directly into more disposable income for Americans to use for everything else they want or need to buy. And in percentage terms, it is most helpful for the middle income and poor, who spend a greater proportion of their income on basic energy needs.

This may appear to be blasphemous in a state whose economic growth is so tied to energy and the natural gas boom. However, due to the quality of the natural gas produced in Texas, we have not been as hard hit as other areas of the country. There are different levels of natural gas generated off of natural gas produced from shale. The Eagle Ford shale south of San Antonio benefits from a higher amount of liquid yields across much of the play, which bring higher prices even while natural gas prices are low. Higher oil prices have helped spur development as oil, condensate, and NGLs (ethane, propane, and butane) all command better prices than natural gas pumped from other shale plays in North America that don’t have as much oil mix or liquid natural gas.

Additionally, although energy is a big portion of the Texas region GDP currently (around 10%), the amount of economic impact it has compared to the ‘Texas oil recession’ of the late 80’s has lessened when 20+% of the states GDP was directly tied to energy. Also unlike the late 80’s, there is a lack of real estate development ‘boom’ presently, potentially softening the economic risks we saw in the ‘oil region’ in the late 80’s.

Businesses quit laying off people

If you are in a Texas metro, you know that businesses are hiring. The national job market has been underwhelming in an economic recovery that officially began more than three years ago, and unemployment remains high at 7.9 percent. But there is some hidden good news in the jobs numbers. While businesses aren’t adding new workers at a pace that would put a dent in the millions of unemployed back on the job very rapidly, they also aren’t slashing jobs at a very rapid clip. Private employers laid off or discharged 1.62 million people in September, according to the Labor Department’s Job Openings and Labor Turnover data. That may sound like a lot, but it’s near the lowest level in the decade the data goes back. During the depths of the recession, employers were slashing more than 2 million jobs a month. And even during 2006, which was in theory a good year on paper for the economy, employers slashed an average of 1.66 million workers a month, more than they are now. It is a sign that even though employers aren’t adding jobs in large numbers, they also are reasonably happy with the workers they have and are not dismissing workers in unusually large numbers. It’s a good time if you already have a job.

In addition, government layoffs have slowed down, helping the economies of Austin and San Antonio who felt the effects of Federal and state budget cuts over the last few years.

Nationally housing is dramatically more affordable

People often speak as if higher home prices are an unambiguously good thing, but that can be misleading. Sure, a retiree looking to sell off a large house and live in a small condo benefits from high home prices. But as we all know, the majority of the ‘boom’ states saw homeowners taking equity out of their homes to fund a lifestyle, so when the market corrected, their was minimal equity left due to the homeowners spending. But most everyone else is better off when buying a home is more affordable rather than less. Six years ago, an average of 40% of each month’s wages were used to pay for housing. Today that amount is closer to 26% of the average private sector employee’s pay. For young people just starting out, young families, or those looking to buy a bigger place, that is hard to beat.

As the media has stated, a housing comeback is now underway; that much is clear. Adding to a steady drumbeat of positive data for the sector, the latest monthly data has showed steady gains in housing starts in the last three months.

The question now is how strong it will be and where it will take place. And to answer those questions it helps to look into the fundamentals of the major US housing markets. These numbers suggest the future for housing is looking bright in the Texas metro areas. But that’s getting ahead of things. A good way to look at which housing markets are potentially overvalued and which are undervalued—and where the market seems to be begging for new home construction and where there is still a surplus of unneeded houses—is to look at the relationship between rents and home prices. Over long periods of time, the price to rent a given house should rise at about the same rate as the price to buy one.

But over shorter periods of time, the two can diverge. And when they do, it is usually a sign that something is up in that market. For example, from 2000 to 2005, prices in the Miami metro area rose by 136 percentage points more than did rents, a sure sign that it was one of the nation’s most bubbly housing markets. Those numbers come from comparing changes in the S&P Case-Shiller home price index for different major metro areas compared with the Labor Department’s consumer price index measure of “Owner’s Equivalent Rent,” for those same areas. Owner’s equivalent rent is a measure of what it would cost to rent the housing stock that people in that city own.

Sure enough, in Miami, in the four years starting in 2005, rents kept rising, up 23 percent, while home prices fell 38 percent. Essentially, the imbalance reversed itself.

Few places have experienced booms and busts quite that dramatic, and we definitely did not see this type of appreciation in rents or home prices in Texas. Nevertheless, the same analytical tools can help explain what cities are poised for a rise in prices and construction in the future. When rents are rising faster than home prices, it is a sign that purchasing a home is becoming relatively more affordable, and so it will behoove people to seriously think about buying. That in turn should create upward pressure on prices in the future and coax builders into the market. These things can move in slow waves, so it’s not necessarily proof that the markets flashing green lights for improvement will get better next year. But over time, this is a solid indicator of where new construction ought to occur.

Here in Texas we never saw the rapid appreciation the rest of the country was experiencing. In the boom years of 2001 through 2006, Texas was 50th in appreciation according to OFHEO, which tracks each state’s residential appreciation. The best news out of this analysis, though, may be this: All of the Texas metros have housing markets that have been in pretty good balance over the last year, with prices rising at about the same rate as rents. And that may be the best sign for the housing market of all. After all these years of bubbles and busts, ups and downs, there finally is a measure of stability. And that is a shift that bodes well for the economy.

So where is the economy headed in 2013? We are optimistic. After the past five years it is easy to continue to be negative, everyone expects it. Third quarter GDP growth was announced this week at 2.7%. We’re not back to the ‘boom’ years, but we are improving. Housing is improving, employment is improving, GDP has some legs underneath it, and all in all the economy shows to be improved in 2013-14 with sustainable demand fueling its growth.