Student loans: Welcome to subprime university

February 14, 2013: 1:05 PM ET

Unlike the U.S. mortgage market, an imploding student loan market will have few immediate consequences, and that could be its biggest risk.

By Lauren Silva Laughlin

121129043105-college-tuition-gallery-horizontalFORTUNE -- Make no mistake: the student loan market is a disaster. The Wall Street Journal recently reported that a third of borrowers in the $900 billion market are subprime, and about a third of those subprime borrowers aren't paying bills on time. Lending standards are not rigid. College education prices are inflating. And, at the very least, young college students facing a poor job market are offered seemingly endless amounts of cash with little initial recourse.

It's tempting to draw parallels to the U.S. mortgage market. But the two markets, at close glance, are nothing alike. A blow-up in the student loan market would have few immediate consequences -- and that is its biggest risk.

The most important distinction between the student loan and mortgage markets, apart from size (the mortgage market was nearly $11 trillion at the peak), is that the world's most creative lenders, big U.S. banks, are hardly involved. In mid-2010, the Department of Education began lending to students directly. Credit Suisse reckons the United States government now backs 88% of student loans.

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The lack of private competitors eliminates large scale risk to the banking system. So it wasn't just that the mortgage market was enormous, and the borrowers low quality. But also that bank lending and insurance against bank lending was so intertwined that the write-downs at one institution threatened the others.

Conversely, "[the student loan market] has no systemic financial risk," says Michael Feroli, chief U.S. economist at JPMorgan.

That could mean that any blow-up in the student loan market won't be dire.

"It does have fiscal consequences, but more like FHA than subprime -- just a steady drain on budgetary resources," Feroli says.

Yet the closed-market dynamic could also make student lending more dangerous in some respects. Banks had several different types of watchdogs when the mortgage market started to get out of control. Short sellers drew attention to bank balance sheets. The SEC checked up on accounting marks. Investors demanded explanations for loan criteria and valuations.

But the government has no one keeping watch.

"The subtle message here is when government is a large lender and crowds out others, the kinds of rules that the government makes are not disciplined by market forces," says Deborah Lucas, distinguished professor of finance at MIT's Sloan School of Management. "This is true of any credit market when the government under-prices the private market."

Lucas has spent several years, first at the Congressional Budget Office and now at MIT, highlighting one questionable practice the government uses in its credit programs. The government exercises an accounting quirk that encourages risky lending to support the budget.

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Here's how it works. When the government issues a loan to a student, it considers future payments it expects to receive. As part of its budget calculation, it takes the value of all those payments, including interest and fees, discounts them, and books the net present cash value in the budget. The money lent to a student is offset by the value of the assumed cash it will receive in the future -- the promised principal and interest after accounting for amount lost to default.

But the government's little quirk comes in the way it discounts the cash payments. Typically a private sector company would have to look at the risk associated with receiving those future payments. The riskier the payments, the higher the discount rate becomes, and the lower the present value of the cash.

Despite student loans having higher delinquency rates than mortgages and auto loans, the government uses the Treasury rate -- akin to having no risk -- to discount the loans. This makes present values higher than they would be if you accounted for the risk associated with those loans by using a fair market discount rate.

"The government doesn't fully account for credit risk in the way the private sector would have to," Lucas says.

The Congressional Budget Office (CBO) projects that credit programs will reduce the reported budget deficit by about $45 billion in 2013. But, if accounted for correctly, the same programs will cost taxpayers $11 billion, a swing of $56 billion.

"The government views itself as making money when it is actually costing money," Lucas says.

There are other concerns too. Unlike Wall Street banks, the government has public opinion to worry about. This can ultimately drive the market into a deeper hole.

"Student loans are very popular," says Lucas. "It is hard for the government to cut back on a program that is popular."

Even Lucas's private sector counterpart agrees.

"The ultimate cost is greater," JPMorgan's Feroli says. "Unlike with banks, student loan debtors can vote in people to forgive their loans."

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