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.
First and foremost, FFELP is not collapsing. While some non-profit and for-profit lenders are having difficulty obtaining capital, this is not the rule. We currently have 2700 active FFELP lenders. Even if a couple hundred cannot lend in 08-09, there are sufficient additional lenders who could absorb the market share. In addition, Congress created the Lender of Last Resort option for guaranty agencies to provide funds for FFELP in dire emergencies.
Your suggestion for the Federal Reserve to fund FFELP is inappropriate and unnecessary. If the federal government wants to be the funder of student loans, it should require schools to be in direct lending.
As you state, private loans are another matter. The market will eventually correct itself; however, in the meantime, students/parents with bad credit may not be able to get very expensive loans. This is not necessarily a bad thing.
March 10th, 2008 | #
Eileen -
I’m curious where the count of 2,700 FFEL lenders comes from. Does that include all the consolidate-by-night lenders that appeared from 2003-2006?
My point about opening TAF as a source of funds is not that the Federal Reserve should be funding student loans, FFEL or otherwise. You are correct to say that the Federal Reserve’s role does not include the Department of Education or FFEL. However, the proposal above is not a funding of FFEL; it is an interbank loan using TAF, as are all repo agreements the Federal Reserve processes. The only change proposed is that instead of using ABS or CDO paper as collateral, federally-backed student loans be permitted as collateral.
Is FFEL in danger of collapsing? No, nor did I ever make such a bold statement. However, of the thousands of FFEL lenders, I’d advance the proposition that most of them ultimately derive their funding sources from either large banks - Chase, Citigroup, Bank of America, Wachovia, and PNC - or “superlenders” such as Sallie Mae. These organizations -are- running into liquidity problems at all levels, in all markets, and if market conditions continue to deteriorate, as expected, I would indeed anticipate many more FFEL lenders and state agencies to run into trouble long before the fall semester.
Take a look at the Credit Suisse charts on subprime and alt-A mortgage debt for 2007 - 2012.
We are at the start of the giant green wave in March 2008 of subprime resets that dwarfs anything and everything that has come so far. The credit crisis of the past seven months was caused by much less mortgage debt decaying than is about to start this month and continue for the rest of the year.
Take a look at the yellow and beige waves beginning in 2009 through the end of 2011. These waves are alt-a and option ARM mortgages, many of which have the same delinquency and decaying value problems that subprime mortgages do - and at its peak in 2011, the option ARM loan volume actually eclipses subprime.
Creating options such as TAF for student lending now, in advance of a crisis rather than waiting for one, is prudence. If we never need it, so be it. If we do need it, we’ll be glad we have it.
Your last point is the most important one, and a lesson I hope we all learn as a country from this: do not lend to people who cannot afford to repay, and do not borrow if you cannot repay, no matter the loan type.
March 10th, 2008 | #