Massachusetts Senator Elizabeth
Warren released her first authored legislation today: The Bank on Student Loans
Fairness Act. Essentially, Senator
Warren argues that the Department of Education should lower interest rates on
student loans to 0.75% because that is the rate at which the Federal Reserve System
lends to deposit holding institutions (referred to as “Big Banks”). Without treading too deeply into the
political malaise, I’d like to take a little time to address concerns I have
with the logical framework that Warren is relying on.
The Discount Window is a
mechanism through which the Federal Reserve makes secured overnight loans to
banks in exchange for high quality collateral (in most every instance, loan
assets). The Fed charges a pre-set interest
rate, called the “discount rate”, on these overnight loans, which is what
Warren refers to when she references a 0.75% interest rate. However, the Fed also institutes a discount
margin on these overnight loans; that is, the amount the Fed will lend is
capped by a loan-to-value ratio based upon the quality of the underlying
collateral. This pre-set loan-to-value
ratio is called the collateral margin (or the “haircut”) and is readily
available on the Fed’s website: Fed Collateral Margins.
The only Big Bank able to borrow
at 0.75% from the Fed is the US Treasury.
This is because Treasuries have a very low collateral margin, whereas
most every other asset has a meaningful margin that caps borrowing. For example, US Treasuries have a collateral
margin of 97%, which means that the Fed will lend me $97M in cash at 0.75%
interest for every $100M in Treasuries that I bring to the discount window. Alternatively, AAA rated corporate bonds have
a discount margin of 95%, so the Fed would only lend me $95M for $100M in AAA
corporate bonds. The collateral margin
for private student loans is 83% because the Fed perceives them as
significantly more risky than either Treasuries or AAA corporate bonds (which,
clearly, they are). Given that Federal
student loans default at a rate that is roughly 5x higher than private student
loans, we would expect the collateral margin for Federal student loans to be significantly
less than 83%: let’s generously say 70%.
The rate a bank charges borrowers
is dependent upon the collateral margin because loans that have a lower
collateral margin are more expensive to fund.
For example, an investor can take in $5M in equity and use that equity to
buy $100M in AAA corporate bonds: $5M comes from the equity and $95M comes from
the Fed discount window. If the AAA
bonds pay 2.5% interest, then the investor will collect $2.5M in interest each
year and pay just $0.7M in interest on the loans from the Fed ($95M x 0.75%),
which makes them an annual profit of $1.8M or a 35% return on equity. That’s a great deal! Unfortunately, great deals don’t last very
long, so soon competitors will jump in and start buying up AAA bonds, which
will drive down yields until they reach a stable return on equity. Today, AAA corporate bonds are paying 2.0%
interest, which (under the same conditions) would provide a return on equity of
25%.
How much would the Department of
Education be able to charge in interest if it were lending under the same terms
as the Big Banks? To figure that out, we
simply reverse the calculation we did above.
The investor (the DOE) needs to make a 25% return on equity in order to
match the returns of the AAA corporate bonds.
However, in this case the investor can only borrow up to 70% of the loan
value from the Fed, which means it needs to bring $30M in equity in order to
purchase $100M in student loans. Thus, the
investor would need to charge an interest rate of over 8.0% in order to match
the returns of the AAA corporate debt. The
figure below demonstrates how this math works for several different types of
loans (note that we are not factoring in certain other risks that would drive
interest rates even higher). So, if
Warren were to get her wish, then student loan interest should actually increase
rather than decrease under her proposed financing scheme.
Now, all this is not to say that
Warren is wrong in her belief that student loan interest rates are too high or
that the federal government is unable to rectify the situation. The Department of Education does not need to
borrow from the Fed in order to make loans: it can borrow directly from the Treasury. Therefore, the Department of Education can
charge any interest rate it wants: it could charge 5.0% or 0.0% or even
negative 5.0%. However, these
lower interest rates would produce investor (taxpayer) losses that probably
should be accounted for. A simpler solution to lowering student loan burdens might be to stop making them in the first place.
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