How the Federal Reserve can fix student lending/student loans
The Federal Reserve does have the capacity to help fix student loans, and might, if there was sufficient pressure to do so. Here’s how. Right now, the Federal Reserve has a new liquidity facility created last year to deal with the subprime mortgage mess, called the Term Auction Facility. How it works is simple.
- The Federal Reserve puts up a fixed amount of money that it wants to get into circulation.
- Banks bid on how much they want to borrow from the Federal Reserve at the discount rate for a given term.
- Banks pledge collateral equivalent to the amount they borrow, minus fees and the “haircut” procedure.
- Banks receive the money, with which they can then lend.
The TAF allows the Federal Reserve to do two things - first, get more cash into the economy, and second, allows it to work with collateral that may be substantially lower in quality than it would normally otherwise work with, like toxic subprime mortgages.
The reason the Federal Reserve doesn’t get left holding the bag on those mortgages is that there are fixed short terms under which banks can borrow - 28 days, 35 days, all depending on how long the Federal Reserve wants to lend or accept risk. At the end of the term, the cash comes back to the Federal Reserve, and it returns the collateral.
Currently, the Federal Reserve does not allow consumer loans or securities composed of consumer loans to be pledged as collateral under discount window rules. This, of course, includes student loans.
How the Federal Reserve could help student loan availability would be to temporarily alter the discount window’s collateral requirements to include, at a minimum, federal student loans (or securities composed solely of federal student loans) in the Term Auction Facility for a term of 180 days, with a requirement that liquidity obtained using student loans as collateral be used exclusively for student loan issuance (and require recordkeeping to document it). Banks could approach either the TAF or the discount window directly to obtain funds for student loans.
This would ensure enough funding was available for the fall semester, and at reasonable, if not optimal, interest rates for banks. Private student loans could be a different issue, or just be left out, but at least allowing federal student loans as collateral in the TAF could do a lot to help provide liquidity to student lenders. Presumably, as credit markets eventually thaw, normal securitization of student loan securities would eliminate the necessity of term auction facility funding for student loans down the road.
While Congress and the Department of Education try to figure out a longer term solution to student loan availability and college affordability, I’d encourage you to contact both your Congressional representatives and the Federal Reserve and petition them to permit student loans as collateral in the TAF as outlined above.
Economists - did I get something flagrantly wrong? Is there some reason that this would NOT work?
Update: Since this article, the Fed created the Term Securities Lending Facility, which accepts a broader range of investment grade collateral - this facility would be an even better fit for federal student loan collateral than the TAF.
