While Wall Street often values its debt holdings based on the prices they would fetch in the market, the government’s markdowns mainly reflect “amounts not expected to be recovered.” From a valuation perspective, that means there wouldn’t be much immediate difference between forgiving doomed loans and waiting for borrowers to turn out their empty pockets.
Still, there’s the issue of moral hazard: If authorities offer relief to struggling borrowers, it could create an incentive for others to stop repaying too, causing more of the portfolio to sour.
Rush for Relief
Much of the gap between what is owed and what the government reckons will be repaid stems from loan programs that cap monthly payments relative to borrowers’ incomes. Income-based repayment plans promise the possibility of loan forgiveness after two decades of steady payment, or one decade for public-service workers. As annual borrower defaults climbed past 1 million, Barack Obama’s administration made the repayment plans increasingly generous. Enrollment has tripled since 2014.
The anticipated cost of income-based plans has risen, too. The Education Department recently realized borrowers in the plans were earning “substantially” less than it had forecast. So the government cut its projections of borrowers’ future income by 35%, boosting the estimated tab to be forgiven in later years.
“There already is significant loan forgiveness,” said Constantine Yannelis, who researches student debt and teaches finance at the University of Chicago’s Booth School of Business. “We’re just talking about moving it up or giving it to borrowers who wouldn’t qualify for it under current rules.”
Yannelis said he recently found that debt owed by lower-income borrowers had a lower present value to the federal government than debt owed by high-income borrowers.
Rising Odds
Across-the-board loan cancellations make little sense, but the government has all the information it needs to target forgiveness, said Adam Looney, a finance professor at the University of Utah whose research on student loans dates to his time as a tax official at the U.S. Treasury Department. In fact, he said, the Education Department’s own valuation reflects a belief the government will eventually cancel large amounts owed by people earning little or at least too little relative to their debts.
Forgiving loans could encourage future students to over-borrow on the hope that their debts will be wiped away, advisers to the federal consumer bureau warned in a report this month. And that could, in turn, remove some of the pressure on colleges to lower their costs.
But there is a growing expectation in the public anyway that relief is coming. In a December survey by the Federal Reserve Bank of New York, respondents estimated there is a 39% chance -- more than ever in five years of polling -- that the federal government will cancel some amount of student loans over the next year.
This article was provided by Bloomberg News.