Asymmetrical Information - Megan McArdle

05.09.13

Elizabeth Warren Wants the Fed to Get Into the Student Loan Business

Should students get the same loan rates as banks at the discount window?

Senator Elizabeth Warren (D-MA) has just introduced a new bill, the Bank on Students Loan Fairness Act, to offer student loans at the same rates that the Federal Reserve charges big banks through its discount window lending program.  At the moment, that rate is about 0.75%.  The rates on federally guaranteed student loans, meanwhile, is set to double to 6.8% this summer.

"Some may say we can't afford this proposal," said Senator Warren as she introduced the bill.  "I would remind them that the Federal Government currently makes 36 cents in profit for every dollar it lends to students . . . meanwhile, the banks pay interest that is one-ninth of the amount that students will be asked to pay.  That's just wrong.  It doesn't reflect our values."

"Now some explain that the banks get exceptionally low interest rates because the economy is still shaky and banks need access to cheap credit to continue the recovery." She sighed loudly.  "But our students are just as important to the economic recovery as our banks, and the debt they carry poses a serious risk to that recovery."

It's probably true that some say banks need low interest rates to keep the economy growing.  But no one except possibly a lunatic has told Elizabeth Warren that banks are getting 0.75% at the discount window as a thank you for all the hard work they're doing helping the economy.  Discount window loans are cheap for three reasons: the borrowers have assets and income that are easy to seize, the loans are quite short term, and the banks are required to put up collateral.  

As you'll have discovered with your own mortgage or car loan, the shorter the term of the loan, the lower the interest rate.  You will also have discovered that loans secured by collateral, like your car loan or mortgage, carry lower interest rates than loans such as credit card expenditures, which are secured by nothing more than your heartfelt promises to pay.  You may even have noticed that the more durable the collateral, the more attractive a rate your banker will extend on it.  

So it is with loans to other people, and businesses.  Banks get a very low rate because they're borrowing for very short periods of time--often overnight, always less than a year.  The Fed correctly figures that the bank is unlikely to go out of business by next month--and anyway, they're putting up collateral, which is unlikely to lose all its value in such a short period of time.  

Students, on the other hand, are borrowing for a decade, and the only thing they're putting up as a guarantee is their character.  How good a collateral is their character?  In 2011, 9.1% of borrowers had defaulted on their student loan within the first two years of the payment period.

The interest paid by the folks who don't default is the only thing keeping this program from hemorrhaging money.  Elizabeth Warren proposes to cut that interest rate to less than the rate of inflation.  

Of course, this isn't really a serious proposal, in the sense that it has any chance of getting passed.  Elizabeth Warren is a very smart woman who knows how the financial system works; she's very well aware of why student loans are expensive relative to the Fed's discount window.  And I presume that she is aware that the CBO will score her bill as costing rather a lot of money.  

But passing this bill probably isn't the point.  Rather, it's a populist values statement: we like students, we don't like banks.  As such, it's probably going to be quite effective.  But only among people who don't know much about the banking system.