Is the US profiting from student loans?

Donald Trump and Hillary Clinton don't agree on much, but they do agree on one thing: the government should not be profiting from student loan debt. Both candidates offer predictable responses to the issue. Clinton promises to use interest rate cuts to prevent student loan profits (thus indirectly having government foot the bill), while Trump says he will "fix it" without saying how.

Given that collective outstanding student loan debt is approaching $1.4 trillion, you might expect a large profit from debt repayment. Would you believe that there is no profit at all, but that the government actually loses money by holding this debt? An argument can be made both ways.

In true governmental fashion, estimates from the same government agency, namely the Congressional Budget Office (CBO), have the U.S. government either making a profit of $1.6 billion or losing $20.6 billion on student loan debt in 2016. The reason has to do with risk and how to assess that risk properly, combined with the future value of money.

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Consider that student loans are not like most forms of credit. Federal student loans are available to most students without any consideration of their ability to pay back the loan in the future, and default rates on student loans are significant. For example, according to the Federal Student Aid website run by the Department of Education, the three-year cohort default rate (the default rate on Stafford loan borrowers who enter their repayment period in a given year and default before the end of the second following year) was 13.4% for 2009 and 14.7% for 2010. Two-year cohort rates for 2007-2011 range from 6.7% to 10%.

The government, as private institutions do, must assess the value of those loans over time based on some sort of discount rate — essentially an average return on investment — to determine the present value of all the money that is to be received over the life of the loan. Defaults cut into that return on investment by reducing the future cash flows. Financial institutions evaluate value all the time by attempting to assess the repayment risk based on market conditions — how have similar loans turned out in the past, and are they likely to change in the future?

The official government accounting method to estimate student loan debt, mandated by Congress and applied by CBO, does not use discounting at market rates. Instead, the discount rate is the return on Treasuries of similar maturity (a thirty-year loan would be discounted at the relatively low rate of a thirty-year Treasury bond). However, Treasuries are far less likely to default than student loans. Jason Delisle, Resident Fellow at the American Enterprise Institute, notes that the government accounting method shows higher relative returns compared to Treasuries without capturing the corresponding greater risk.

As a result, the discrepancy snowballs into future years. According to Forbes, the CBO estimates for student loan profit/loss show a $37 billion profit with standard government accounting and a $170 billion loss using market value discounting.

Not all categories of student loan carry the same risk. There are five basic federal student loan programs (unsubsidized loans for both graduates and undergraduates, subsidized loans for undergrads, and PLUS loans for both graduates and parents). Subsidized loans for undergraduates are not profitable under either accounting scenario — reasonable, since the government is subsidizing the interest rate — and the PLUS loans for parents make a profit under either scenario. For the other categories, standard CBO accounting shows a profit while market-risk assessment shows a loss.

So is the government really profiting from student loans? In a technical sense, yes — but in a more practical sense, the answer is no. It is hard to see how default rates will ever sink low enough to make student loans collectively profitable with market-risk discounting. It's telling that the one accounting method that produces governmental profits is the one mandated by Congress.

Unfortunately, neither choice of accounting practice helps students that are drowning in debt, nor does it address the skyrocketing cost of college as the root cause of excessive student debt. Perhaps both Congress and the Presidential candidates should consider working on those issues first before debating accounting practices.

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Originally Posted at: http://www.moneytips.com/is-the-us-profiting-from-student-loans

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