ESG Frontiers: US Student Debt: The $1.5trn problem which isn’t going away

A systemic risk that is now larger than the subprime mortgage market at its height

With bank CEOs highlighting a “systemic risk” in the student loan industry, there are calls for investors to push the sector to “do the right thing”. In the latest ESG Frontiers article, we look at the issue in more detail.

In the wake of the 2008 financial crisis, Wall Street pleaded ignorance. Robert Rubin, the former Treasury Secretary who was briefly chair at Citigroup, told US Congress: “Almost all of us, including me, who were involved in the financial system…missed the powerful combination of factors that led to this crisis.”

No one wants to be caught sleeping at the wheel again. In the US, alarm bells are being rung for outstanding student debt which – estimated at $1.5trn by the Federal Reserve Bank of New York – is now larger than the subprime mortgage market at its height. It is now the second highest source of household debt, eclipsing car loans and credit cards.

“In the absence of adequate regulatory action, it’s up to investors to push the student loan industry to do the right thing” – Seth Magaziner, Rhode Island Treasurer

In April, the CEOs of seven major banks told Congress that student debt had become a systemic risk. One of them, JPMorgan’s influential Jamie Dimon, is now a figurehead for the cause. He’s called student lending “a disgrace” and described it as “hurting America”. In JPMorgan’s annual letter to shareholders, Dimon put the contractionary effect of student lending to the economy in the following terms: a $1,000 increase in student debt reduces subsequent homeownership rates by 1.8%.

The candour is understandable. Banks have not been involved in student lending since it was nationalised in 2010.

Student debt has exploded once before and under very similar circumstances. In the 1980s, the post-secondary education sector was flush with federal aid and new commercial opportunities. As the sector grew, for-profit education providers found a market in minorities and those previously excluded from a conventional college education. In turn, default rates shot up as graduates of low-quality courses found themselves unable to attain the high-paying jobs required to pay off their debt.

Lawmakers devised a pragmatic workaround. Eligibility rules for federal funds were amended to exclude education providers with a record of high graduate defaults. This pushed more than 1,500 for-profit schools out of business and loan default rates declined.

In 1998, the arrival of the internet once again relaxed eligibility rules for federal aid. This was ostensibly to encourage private sector innovation in anticipation of “advances in education technology”. Congress then removed annual borrowing limits for postgraduate courses so the entire cost of attendance was covered.

Access to federal funding has revitalised the for-profit education sector, but research continues to suggest these qualifications don’t pay off. Analysis shows that graduates with for-profit qualifications were paid the same as those without a college education.

Spiralling college fees across the board have amplified the crisis. Former US Treasury staffer, Adam Looney, believes that cheap loans played a role in this too. He said to RI: “Unconstrained lending allows schools like the University of Southern California to charge 220% more than the equivalent course down the road at UCLA. I think the fact that the largest graduate programme for social work in the country is now the most expensive one is a result of the expansion of the federal student aid programme.

“There is broad support for subsidising and providing access to post-secondary education for those previously excluded. The question that needs to be asked isn’t to do with that. Rather, it is whether significant federal resources should be expended to fund graduate studies in areas which don’t have an obvious social or labour value, or are too expensive.”

A policy re-think is unlikely to happen soon. President Trump and Education Secretary Betsy DeVos – both with well-known business interests in the for-profit education sector – have already struck down an Obama-era law protecting for-profit college graduates from high debts.

Now’s the time for investors to get involved says Seth Magaziner, Treasurer of Rhode Island and custodian of its $8.3bn public pension fund. Speaking to RI he said: “In the absence of adequate regulatory action at the federal level, frankly I think it is up to investors to push the student loan industry to do the right thing.”

Investors have direct exposure to the student debt crisis through investments in the for-profit education sector and student loan service providers. While most of the seven federally-appointed student debt servicers are nonprofits, two – Navient and Nelnet – are publicly traded, and between them administer 67% of all US student loans.

Critics have said that servicers are guilty of trapping borrowers in a vicious cycle of escalating repayments. The Nasdaq-listed Navient has a reputation as one of the worst offenders and is currently facing lawsuits from the state governments of Illinois, Washington and Pennsylvania, and from the Consumer Financial Protection Watchdog (CFPB) over deceptive and harmful practice.

Magaziner said: “At Navient, we have seen a range of abusive behaviour which includes actively discouraging borrowers from loan repayment options which they are legally entitled to, such as income-based repayment plans and loan forgiveness programmes. Instead, borrowers are steered toward forbearance under which no payments are required for a certain period of time although the interest continues to accumulate. This almost always ends up being the more expensive option.

“The company admitted to us that staff in their call centres are compensated by how short the calls are. So, when borrowers call in because they are having a hard time keeping up with their loan payments, the call centres staff are actually incentivised to get people off the phone quickly,” he says, adding that this risks not giving borrowers the best possible outcome.

Last year, a resolution co-filed by Rhode Island, calling for enhanced governance at Navient, received the backing of more than 40% of shareholders in what was described as “a stunning result”. CEO Jack Remondi hit back in a statement after the AGM, in which he attributed the criticism to a “need to blame someone [for] the failures of the higher education system and the federal student loan programme” more broadly. Instead of addressing structural problems within the sector, Navient said its critics found it “much easier to file a lawsuit, creating the perception that something is being done”. 

However, a year later, Navient has now disclosed its internal governance measures – including board-level responsibilities – to manage financial and reputational risks, in response to the resolution, it told RI.

Magaziner remains optimistic about reforming debt servicers. As he sees it, servicers have the opportunity to “be part of the solution” while still making sustainable returns.

“Our position for now is to continue to engage with Navient and other loan providers to do the right thing and to serve borrowers well,” he says, but claims that investors must make a decision between divesting or engaging – not simply remaining holders of their stocks. “It should be one or the other. Staying invested only makes sense if you want to engage and encourage better behaviour.”

The other avenue for influence is the for-profit education sector itself, which, for the most part, has been off the radar for investors. Back in 2013, New York City Comptroller John Liu tried and failed to get graduate student debt onto the AGM agenda of for-profit college operator DeVry. The SEC backed the omission of his shareholder proposal that called for improved disclosure to avert further erosion of shareholder value because of aggressive marketing tactics and the limited success of graduates finding good jobs.

Liu’s office successfully filed a similar proposal at Career Education Corporation (CEC), another for-profit operator, although it fell flat when it came to the vote. The office of the current New York City Comptroller, Scott Stringer, confirmed to RI it is no longer pursuing engagement in this sector; and there is a little activity from elsewhere. Indeed, under the Trump administration, major for-profit education stocks have comfortably outperformed the S&P500. But only the adoption of sustainable, quality-driven business models can ensure continued eligibility for federal funding and therefore, long-term returns. Shareholders are uniquely positioned – and incentivised – to facilitate such a transition.