Beware of the bubble

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Five years ago, the excessive lending of sub-prime mortgages rocked the financial sector and caused recessions in major economies around the globe. Today, the global economy is still recovering: banks are adjusting to new reforms and governments around the world are trying to decrease their deficits and increase household consumption in a desperate attempt to hold their economies together. One would think that, after the 2008 fiscal debacle, government officials would be able to recognize the formation of hazardous financial ‘bubbles.’ However, just as the mortgage bubble in 2007-2008 was inconspicuous in the years leading up to the crash, another bubble seems to be manifesting itself with the same camouflage.

Student loan debt has increased almost threefold in the past two decades. It now accounts for over $1 trillion worth of debt, a figure that has far surpassed credit card debt in America. Furthermore, student loan debt is packaged as an Asset Backed Security – the same way large investment banks packaged mortgages in the decade leading up to the crisis of 2007-2008. The parallel is eerie – as one delves into the nuances of the student loan franchise, the similarity between the mortgage and student loan ‘bubbles’ becomes frightening.

How does the loan process work? A loan is given to a student, repackaged and ‘securitized’ into an investment product, and then resold to an investor who perceives its credit rating to be worthy of its price. This ‘securitization’ of lending was one of the causes of the 2008 financial crisis, yet it remains unregulated as investment banks continue to use securitization to move of risky investments off their balance sheets. Wells Fargo and PNC are two of the largest private institutions pushing loans into students’ hands. However, the reality of the bubble may have begun to set in for these large institutions. Just last month JP Morgan, known for being one of the “less risky” investment banks, announced that it was ending its student loan operations because it was “no longer the place to be.”  Forbes reported that this statement is eerily similar to a statement made by Lehman brothers regarding mortgage lending in 2007, before the onset of the crisis.

How will the disproportionate provision of student loans affect the global economy? The downward spiral begins innocuously: a student wants to go to a university that is more expensive than what they can afford. They decide to apply for two loans, a private loan, of which they receive a relatively good interest rate due to the good credit of their cosigner, and a government loan, which is a fixed interest rate. Four years go by and through a part time job the student has been able to keep up with the monthly interest payments on his private loan. (The US government loans do not require monthly payments while attending school.)  After graduation, the student wants to begin to pay off the principal and interest of both his private and government loans. More often than not, however, due to the current financial instability and high unemployment rate – largely a side effect of the last financial crisis – the student can only find a minimum wage job and finds himself unable to make the payments and defaults on both his private and government loans.

On an individual scale, this situation spells trouble for the student and perhaps his family, but has little effect on the market. Unfortunately, this circumstance, due to the growing popularity of student loans, has become almost ubiquitous, affecting a large population of minimum wage earning college graduates who have accrued $1 trillion worth of debt. Egregious amounts of debt, coupled with instability in the market, reduces job opportunities and investment, leaving more university graduates without a job and consequently lacking a steady income to pay off their loans. Investors around the world who purchased these investment products will lose their money and the sensitive financial markets – barely risen out of the previous recession – will soon spiral out of control.

Financial regulators continue to squabble over the precise causes of the 2007-2008 financial crisis. So far, they have not been able to come up with a comprehensive answer as to why few if any people were aware of the imminent crash, and how it came to have such widespread effects. One thing is clear, however: excessive lending for mortgage costs was the crux of the problem, and yet no supervisory system exists to ensure that banks do not give away copious amounts of money to those who may not be able to return it. Our regulators have failed to come up with a preventative mechanism to stop the crisis of 2007-2008 from occurring once more, this time with student loan debt. Hopefully they will come to their senses in time to salvage the situation from disaster.

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