Government Steals to Fix a problem it CausedPoliticians have a taste for promising student loan forgiveness. The Obama administration made federal student loan borrowers in certain repayment plans eligible for forgiveness five years earlier, while the Trump administration has proposed moving the forgiveness date up yet another five years for undergraduate borrowers. At the other end of Pennsylvania Avenue, a loan forgiveness program for public-sector workers has received bipartisan support in Congress, and some members have even proposed expanding it to farmers.
But a new National Bureau of Economic Research (NBER) working paper suggests that loan forgiveness isn’t all it’s cracked up to be. The paper analyzes a mortgage-modification program created in the wake of the 2008 financial crisis, which offered partial loan forgiveness to certain underwater homeowners. The authors find no evidence that forgiveness had any effect on subsequent mortgage default rates.
To be sure, the NBER paper dealt with home mortgage debt, so its findings are not directly applicable to student loans. But it does present a warning to those who look to loan forgiveness as a way to relieve struggling student borrowers.
The authors, Peter Ganong and Pascal Noel of the University of Chicago, exploit how the federal government’s Home Affordable Modification Program (HAMP) treated borrowers in different ways. Borrowers participating in HAMP were all eligible to have their home mortgages modified, but on different terms.
The authors examine two groups of borrowers who both secured lower monthly payments under HAMP; however, borrowers in one of the groups also received an average of $67,000 in additional forgiveness of their principal balances. HAMP found ways besides loan forgiveness to finance the other group’s lower monthly payments, such as extending repayment terms.
Comparing the two groups and accounting for other factors, the authors find that principal reduction did not reduce subsequent default rates at all. Additional analyses also showed that loan forgiveness didn’t reduce the rate at which banks initiated foreclosure on homeowners. While taxpayers spent an average of $10,000 to provide a struggling homeowner in the analysis group with partial loan forgiveness, the paper finds no evidence that money succeeded in reducing defaults.
A True Solution
However, the authors find strong evidence that reducing a borrower’s monthly loan payments—even if the total amount owed on the loan remained unchanged—had a substantial effect on subsequent default rates. They show this by comparing borrowers who were eligible for large monthly payment reductions to those who received smaller reductions, again accounting for other factors.
Lower payments, rather than loan forgiveness, do the heavy lifting in reducing defaults.
Larger monthly payment reductions lowered subsequent default rates by six percentage points or roughly a third of a percentage point for every 1% payment reduction. Lower payments, rather than loan forgiveness, do the heavy lifting in reducing defaults.
The study’s findings are actually quite intuitive. What matters most for loan default is liquidity: whether a borrower can afford to meet his current financial obligations. Lower monthly payments make those payments easier to meet, thus lowering default rates. Loan forgiveness, whether a principal reduction today or a promise of forgiveness several years down the line, should have close to zero effect on default rates, apart from its effect on monthly payments.
Of course, home mortgages and student loans are different financial products. Mortgages are secured by the borrower’s home, and banks (in theory at least) vet borrowers’ finances and credit records before lending them money. Most federal student lending incorporates no such precautions. Borrowers also consider mortgage payments a higher priority than student loans, since a lender can foreclose on a home but not a college degree. More research is certainly needed to verify that the trends documented in the world of home mortgages hold true in the world of student loans.
But the NBER paper still raises some major red flags for those who champion loan forgiveness as a way to help student borrowers struggling to repay their loans. The onus is now on forgiveness advocates to prove that their policy wouldn’t just be a tremendous waste of taxpayer money.
Republished with permission by FEE