Thursday, January 31, 2013

Costly Federal Loan Subsidies

What you may not know or think about is the many ways that the Federal Government is dominating certain parts of the economy and markets.  For instance the Federal Gov't (thru Fannie Mae and Freddie Mac) is now 90% of the mortgage market and some 80% of the upwardly spiraling student loan market.  Medicare/Medicaid is about 45% of the healthcare market and set to increase (if the Feds can find more taxpayer money, or worse, print more money).

Some of these roles have led to loses and will lead to more to come.

Taxpayers have had to bailout Fannie and Freddie to the tune of $200 billion and are still 'on the hook' for further and even unlimited loses, thanks to Barney Frank and our wonderful lawmakers. Thanks to Federal Reserve pump-priming, printing and MBS purchases, housing prices appear to be stabilizing which should help stabilize mortgage portfolios at those agencies.  But keep an eye on upcoming bailouts for Sallie Mae, the agency that dominates the student loan market.

I recently commented about the student loan 'bubble' in my blog entitled The Student Loan Bubble and Bailout.   The government (Sallie Mae) is still loaning to students at record rates and student loan burdens have quadrupled in 10 years.  While student loans have soared 400% in 10 years, college tuition and fees have risen about 300%.  Do you see a connection here?    See the following chart showing college tuition inflation  from

College Tuition and Fees Vs Overall Inflation (CPI)
The problem is that the debt burden for students is now so great and employment opportunities so poor that delinquent student loans are now 11% of loans.  This assures that defaults will rise as well.  The bad news for student loan holders is that these loans are not dischargeable in bankruptcy. The other bad news is for taxpayers who will inevitability absorb more losses.

The Federal Government Subsidizes Student and Mortgage Loans and the Taxpayer Incurs Loses

You ever wonder why credit card rates from your bank are 13 to 15%?   It's because, in private enterprise, banks have to set rates to take into account default losses. Credit card debt defaults have recently run about 4 % or so, meaning that banks are making a very profitable 9 to 11% on credit card balances.  Default rates can run much higher however.

Since student loan delinquencies are suddenly 11% with 9% in default.  Since the cost of money for the government is about 3%, this means that, if the government priced student loans taking into account the cost of defaults, then student loan rates would be about 12% or near typical credit card rates.

The beauty of free markets is that if student loan rates, if set in the private market, would have already risen gradually along with default rates and this rise would have already curtailed the quantity of loans being made.  This means that we wouldn't have a student loan bubble today if the government hadn't encouraged it (had been more like a private enterprise).  It's why the government became 80% of the student loan market: private lenders bowed out long ago.

But instead, we have ANOTHER financial bubble on our hands and losses will accrue to the taxpayer.  Worse, student loans are still being made at inappropriately low rates which means loans are continuing and losses will continue to mount!  But there are No Adults In Charge in Washington!

Similarly, mortgage money supplied in part by Fannie Mae and Freddie Mac, fed the housing boom in the 2000s and fueled housing inflation (along with favorable tax benefits for capital gains and interest deductability).  If the lender, the Federal Government, were correctly pricing mortgage interest rates today, they'd be at 5% and not 3.5%.  That's because the cost of money is 3% and the current mortgage default rate is about 2%.  The default rate was over 6% in recent years. If housing loans had been priced to reflect losses, the interest rate would have been 8 or 9%.  Yes, that would have really crushed the housing prices and banks.  No one has been accustomed to any kind of tough love coming from the government in half a century or more.  It's another form of moral hazard of government intervention.  So, the taxpayers are absorbing the default loses.

Indeed, the treasury has had to fund about $200 billion in losses at Fannie Mae and Freddie Mac (gov't mortgage entities) over the past 5 years. See Figure 1 below.  There may be more to come.  But keep an eye on subsidies to Sallie Mae to cover delinquent student loans.

Figure 1
Net Income for Freddie Mac and Fannie Mae
Interestingly enough, mortgage default rates remained low during the bubble years so market mortgage interest rates did not curtail the housing bubble like they would have in the student loan market.  Yes, many mortgage loans were made by the private sector.  But the bubble remained mostly hidden as rising asset prices supported the entire housing and mortgage markets---until it didn't.

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