Are student loans profitable…for the government?

Like most complex financial issues, the answer to this question depends, a bit, on how ‘profit’ is defined and the accounting procedures used to calculate profit. If you go directly to the student loan projections by the Congressional Budget Office (CBO), it appears that the government is indeed profiting quite handsomely from direct loans. In 2013, the government will loan out 105 billion in student loans and expects a negative subsidy (profit) of ~36.5%, or over $37 billion dollars (closer to $35 billion once administrative costs are taken into account). These figures are presented as the net present value of future expected cash flow from the loans, accounting for expected future defaults and delinquencies.

Some groups dispute the CBO analysis; for example, the New America Foundation [page 7] explains that lenders (in the case of federal student loans, taxpayers) take on additional risks beyond default in any case where credit is extended:

“Like bond holders who earn interest for the risks that they bear, stock holders also seek a return on the capital that they have put at risk by investing in [a] loan company. When the federal government issues student loans, taxpayers are effectively stock holders in those transactions because they will have to bear default losses while Treasury bond holders who finance the government’s loans are theoretically never at risk of loss. [Additionally], in times of economic stress, loans may default at a higher rate than expected and these defaults are likely to be severe and costly. Lenders consider this type of risk an additional cost that is over and above expected losses from default and include an additional premium in the interest rate they charge borrowers to compensate for it.”

It is not uncommon for some people to argue that due to these additional risks beyond the cost of default, government accounting principles should include these additional risk factors in their discount rate (rather than using the risk-free discount rate of US Treasury Bills when calculating net present value of future cash flows). The term for this sort of calculation is ‘fair-value’ accounting, and the calculations substitute market interest rates for risk-free Treasury rates. The CBO also releases a ‘fair value’ accounting of student loans, and the difference in discount rates is enough to drop the subsidy on federal loans from $36 billion dollars to $5.5 billion dollars.

Regardless of how you discount for the risk in lending students money, however, the federal government is profiting from its current student loan practices (anywhere from $5.5 billion to $36 billion this fiscal year). Personally, I don’t think that the fair-value method for evaluating loan risk is an improvement because the federal government is not a corporation—the primary difference is that the US government can ‘lose’ money year after year (ie run a budget deficit) but actually improve its long-run fiscal position (if corresponding growth is higher than the budget deficit). Banks and other private lenders cannot do the same; it seems silly to me to evaluate risk factors equivalently when the market forces governing each type of lender are very different. Furthermore, and perhaps more importantly, private lenders’ sole revenue source from a loan is the interest paid by the debtor. However, in the case of the US government and student loans, the government makes money from interest payments, but the government also makes money from the increased earning potential of the college graduate.

For example, over the course of a lifetime, laborers with a Bachelors degree can expect to earn more than $500,000 more than an equivalently talented person with a high school diploma. For the person that wouldn’t otherwise be able to afford college, the government not only benefits from the interest payments on the student loan, but benefits from tax revenue on an additional half million dollars over the course of that student’s lifetime. When viewed in that light, it seems that there is really no way to argue that the US government doesn’t profit enormously from its student loan portfolio. In fact, given the positive spillover effects from higher education (increased tax revenue, more educated workforce, etc), the $36 billion projection may, in fact, understate the federal government’s profit from direct student loans. Given the abnormally high interest rates on today’s student loans, the positive externalities to a more educated workforce and populace, and the fact that the US government can (and should) be engaging in more fiscal stimulus to encourage growth in the aftermath of the financial crisis, I think there is a very strong case to be made that interest rates on student loans are much too high today.

Federal student loans are a part of the Department of Education budget, so running federal student loans at a significant loss would directly take spending away from other federal education programs (if there were no corresponding increase in the federal education budget). However, net subsidies from the program are deposited as receipts in the General Fund [page 14, footnote 1], which means that the Department of Education in no way benefits from making money off of the student loans. (In other words, it wouldn’t impact the federal education budget in any way if the net profit on student loans was 0 as opposed to $36 billion; that would just impact the overall deficit of that particular fiscal year.) To me, this is sufficient evidence to remove any doubt about whether the federal government should renew the 3.4% interest rate on subsidized Stafford loans to undergrads; in fact, I think there is a compelling case to be made that all student loans issued for the next fiscal year should be paying interest rates in the ~3% range.

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One thought on “Are student loans profitable…for the government?

  1. Pingback: Higher Education Policy according to the WSJ | lil stevie's econ blog

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