Historically, the notion that one can get a good education, work hard, and eventually create a better existence has been both an aspiration and an expectation. As the Financial Times described [here], education has been a "cultural imperative". Even more tellingly, "Education, like home ownership, is deemed a crucial part of the American dream."
Commensurate with the drive for further education has emerged a problem, however. As more and more people pursue higher education, and prices continue to rise, more students have had to take out loans to pay for the opportunity. Unwieldy student loan debts deserve greater attention from investors partly because they represent important changes in the economy and because they inhibit the economic capacity of a significant subset of the population. Interestingly, they may also help handicap the broader potential for economic growth.
It's not hard to understand why students take out loans. As the Economist notes, [here], "In rich countries the link between learning and earning has tended to follow a simple rule: get as much formal education is you can early in life, and reap corresponding rewards for the rest of your career." With an annual earnings premium of 65%, the discussion rarely goes beyond this. According to the Federal Reserve Bank of New York (FRBNY) [here], the median compensation of a recent college graduate is $43,000 (as of 2016) relative to the median compensation of someone with just a high school diploma of $26,000. On the surface it is an easy decision.
It's also a common decision. A summary of student loan statistics [here] reveals: "a total of $1.26 trillion in total U.S. student loan debt and 44.2 million Americans with student loan debt." The same report notes that "71 percent of students graduating from four-year colleges had student loan debt [as of 2012]". The exposure is wide, deep, and rapidly getting worse.
The decision to take out loans for education should not be treated lightly; college and other advanced learning is not a risk-free proposition. A lot of things can happen that prevent the realization of desired cash flows through higher earnings. For example, a student may not complete the program, it may take longer than expected, or the degree may not have much value in the market place for labor. Notably, the FRBNY qualified their return on investment conclusions [here]: "Significantly, our rate of return estimates pertain [only] to those who complete a college degree; the estimates do not account for the risks associated with not completing the degree and dropping out of college."
In addition, not all degrees and colleges are created equal. Slate also picked up an important thread in the FRBNY work [here], "Recently, researchers from the Federal Reserve Bank of New York noted that the bottom 25 percent of college degree holders basically earn no more than the median worker who ended his or her education after high school."
Further, the burden of student debt continues to weigh on students after they graduate. A high level of debt limits the options grads can viably pursue, restricts their mobility, and increases the risks associated with the opportunities they do pursue. As the Economist also notes, "Skilled and unskilled workers alike are in trouble. Those with a better education are still more likely to find work, but there is now a fair chance that it will be unenjoyable."
FRBNY highlighted another troubling trend: "Our analysis reveals that the average wages of college graduates have been falling for the better part of a decade." Specifically, "Between 2001 and 2013, the average wage of workers with a bachelor’s degree declined 10.3 percent, and the average wage of those with an associate’s degree declined 11.1 percent; for high school graduates, the average wage dropped a more modest 7.6 percent."
The evidence overwhelmingly suggests that an important change has occurred. The future earnings of students, and therefore the stream of cash flows that can be used to pay down debt, are now far riskier than they used to be. The Economist sums up the reality: "The returns to education, even for the high-skilled, have become less clear-cut. Between 1982 and 2001 the average wages earned by American workers with a bachelor's degree rose by 31%, whereas those of high-school graduates did not budge, according to the New York Federal Reserve. But in the following years the wages of college graduates fell by more than those of their less educated peers. Meanwhile, tuition costs at universities have been rising."
As the burdens of student debt have rocketed higher, so too have the consequences. These were characterized nicely by the Financial Times, "First, the explosion in student loans, like subprime mortgages, is a byproduct of decades of stagnant wage growth. Although the cost of education has spiralled in recent years, incomes have not, prompting households to use debt to paper over the gap." As a result, "Over the past decade, the level of outstanding student debt has almost tripled to $1.3tn." This has left students in a catch-22: Take out loans for college and take a big risk you don't get a payoff, or don't take out the loans and never have a shot at advancing.
We are beginning to see repercussions from these trends; for many, the weight is getting to be too much to bear. The Financial Times reported [here], "More than one in 10 student loans were more than 90 days overdue as of November, according to credit analysts Equifax Inc." Zerohedge noted [here] that, "many more students have defaulted on or failed to pay back their college loans than the U.S. government previously believed." Another FT piece [here] noted, "the 'shadow' default rate -- the debt 'delinquencies' that are not fully reported -- could be 23 per cent. Other economists have similar estimates."
The evidence suggests that while student debt problems are widespread, there are areas of special concern. According to the FT, "Adding to the concerns is research that suggests the biggest financial problems are faced by students who can least afford it: poorer Americans who took out smaller loans to pay for courses at less prestigious institutions."
Student debt problems are also especially pronounced among students at for-profit universities. The FT reported, "A central flashpoint in the student loan debate is the high prevalence of repayment problems at corporate owned, for-profit colleges — run as businesses to make money for owners and shareholders — which in recent years have aggressively courted lower income students."
Unfortunately, the problem is rapidly getting worse. According to zerohedge, "According to an analysis of the [recently] revised data, at more than 1,000 colleges and trade schools, or about a quarter of the total, at least half the students had defaulted or failed to pay down at least $1 on their debt within seven years." Exacerbating the already troubling trend was the recent revelation that problems had been under-reported. The story continued, "In September, the [Education] Department released data tracking students who should have begun repayment in 2007 and 2008, and that number rose to 477 [from 347]. But with the updated number released last week, that number grew to 1,029."
The FT notes, “This tier of people tends to be lower income than the traditional middle class student, whose parents drop them off in the family minivan at a two or four year institution,” Mr Mitchell says. “So not only is more of the weight falling on students and families, but it’s falling on an increasingly less well-off population . . . and they don’t have the wealth buffer to fall back on.” Finally, the report concluded, "'Defaults are outrageously high among poorer Americans,' he says. He argues the rise of for-profit institutions has created a 'problematic dynamic' among people of modest means and believe college will enhance their ability to move up the income ladder, yet leave their courses financially vulnerable."
Just how vulnerable was made clear by The Financial Times: "Seth Frotman, acting student loan ombudsman at the CFPB, says: 'We see a breakdown in student loan repayment eerily reminiscent of what we saw in the mortgage crisis'." In addition, “There is a generation of people straddled with unprecedented student debt. We see this impacting household balance sheets, and this has broader implications for the economy.”
A key source of trouble is that debt still plays a central role in financing higher education. Despite the increasing fragility and volatility of college graduate earnings, debt is still a primary source of funding. This is so despite finance theory suggesting just the opposite. Indeed, it is a straightforward tenet of corporate finance that equity should be used to finance riskier ventures and debt should be used to finance safer and more stable ventures. This is why risky business propositions like startups are normally funded with equity. By extension, the riskier cash flows from education become, the more they ought to be funded with equity rather than debt. Debt finance of risky cash flows can easily become exploitative and antithetical to a better future.
These conditions have important implications at the household level. First and foremost, the value proposition of higher education should not be considered a self-evident one. Especially when large amounts of debt are required to finance that education, factors such as the likelihood of completion, the estimated income from the degree, the capacity of the student (and/or student's family) to weather difficult times are among many additional factors that need to be considered.
For those skeptical of just how much things have changed in the return on investment calculation for higher education, a couple of statistics provide stark reminders. Zerohedge also highlighted an analysis of Fed data [here] that showed, "millennials now earn 20% less than boomers did at the same stage of life in 1989." Despite being better educated, millennials have a "median household income of $40,581" as compared with boomers "who earned $50,910 some 25 years ago." The same story noted, "But the median college-educated millennial with student debt is only earning slightly more than a baby boomer without a degree did in 1989." The unfortunate reality is that many students simply do not have the same prospects for future income as their parents did.
This creates implications for society as a whole. Students are both current and future consumers. The prospect for their earnings power and financial condition are directly relevant to economic growth and resilience. Further, as the path to the American dream by way of higher education becomes increasingly constrained by debt capacity, that dream becomes far less inclusive. This is especially troubling since student debt disproportionately affects a subset of the population that is relatively young, talented, ambitious and willing to make a sacrifice for a better future.
This issue would seem an obvious target for public policy since education represents an important form of investment. If you want your country to grow, provide more education to your people. John Hussman illustrated quite clearly [here], "What raises both real wages and employment simultaneously is economic policy that focuses on productive investment – both public and private; on education; [and] on incentivizing local investment and employment ..." Conversely, any obstacles to furthering education naturally constrain an economy's capacity to grow.
Given the potential of education to foster economic growth, it can certainly be argued that it ought to be a primary focus of public policy. It is not that this issue has been ignored altogether; the public service loan forgiveness program, for example, was created in 2007 in an attempt to mitigate the deleterious effects of excessive student loan debt. The reach of the program is limited, however, as it only applies to certain government and non-profit organizations and affects less than one percent of students with loans. As a result, it barely scratches the surface of the bigger problem.
This seems like a missed opportunity. The US has world class colleges and universities and a wide variety of alternative educational and training resources that are the envy of the rest of the world - and a distinct competitive advantage. Existence of such resources is not the problem; social and political will to leverage them is. Importantly, there is a useful precedent in this regard. The GI Bill educated millions of veterans after World War II which led to a period of exceptional economic growth.
So this is the key point for investors. Change in productive investment is a useful indicator by which to determine the economy's growth potential, and higher education is one form (of many) of productive investment. As a result, the degree to which political actions target sustainable, productive investment, such as education, the greater likelihood that we will have a solid foundation for stronger growth. In the context of a chaotic political environment, this gives investors a useful filter to differentiate between noise and signal. Thus far, the signs are not good.