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4 Phases of the Crushing Student Debt Bubble

The price for an education has been rising rapidly while the value of that same education seems to be diminishing. Underemployment is an epidemic in the U.S. and traditional career paths are becoming more and more competitive. This has resulted in a student debt bubble in the U.S. that the model that Hyman Minsky developed to analyze financial bubbles. The 4 phases are the systematic development of financial fragility, the movement to the brink of financial crisis, the disruption of stability by a surprise event and Debt-Deflation.

The Systematic Development of Financial Fragility

This is the phase of the cycle when the bubble is expanding. For the student debt bubble this is last 20 years when the amount of student debt rose significantly faster than inflation. Optimism about the value of an education generally increased while the returns associated with higher level of education seemed to decline. Minsky also noted that attitudes towards risk change during this stage of a financial bubble. This is completely true with the student debt bubble. The average amount of student loan debt that individuals graduate with each year has been increasing and the media regularly reports about students graduating with hundreds of thousands of dollars of debt. The bubble has been inflating at a rapid rate for many years.

This phase of the bubble is also characterized by an increase in fragility. U.S. interest rates have been declining since the 1990’s. While the low levels of interest rates encourage lending, they also expose borrowers to rising rates in the future. Rising rates for student loans will mean a higher level of defaults similar to the rising rates that sparked the mortgage crisis,

The Movement to the Brink of Financial Crisis

This is where the United States finds itself currently. We have already seen speculative lending and financial engineering increasing. Take the recently founded business Social Finance, Inc. (SoFi). SoFi was founded in 2011 to provide more affordable student loan options. The Company is an online personal finance company that focuses on student loan refinancing, among other things. Since it was founded in 2011 the Company has grown at an exponential rate and currently has $12 billion in total loan volume. Sofi is characteristic of a typical financial bubble because it shows the rapid growth in financial innovation. Financial innovation and an increase in innovative financing solutions is a typical characteristic of a financial bubble.

A common theme when the mainstream media discusses student loans is that they are exempt from bankruptcy proceedings. This means that unlike credit card debt and mortgages, student loans stay with you even if you declare bankruptcy. When the Clinton administration signed the Higher Education Amendments of 1998 they made defaulting on student debt impossible. This piece of legislation leads most economists to conclude that student loans can’t be in a bubble because borrowers are unable to default. To Boom Bust Market, this sounds very similar to claims that housing prices can never go down, a common idea espoused by economists during the housing boom of the mid 2000’s.

The Disruption of Stability by a “Not Unusual” (Surprise) Event

Given the events of 2016, surprise events suddenly don’t seem so uncommon. Brexit and Trump’s election are prime examples of surprise events that the financial media failed to predict. A surprise event for the student debt bubble could be the passing of new legislation. It doesn’t seem too outrageous to imagine Donald Trump supporting a law which makes student loans subject to bankruptcy proceedings. Donald Trump is a populist leader and huge fan of debt restructuring. If his supporters decide to support a change to the treatment of student debt, then it would be an easy law for him to push through congress. Rising rates on high student loan levels will cause an undue burden on borrowers. This could be the factor that pushes his supporters to ask for a change in the law.

Debt-Deflation

The final stage of the student loan bubble will be debt deflation. The increase in defaults from student loan borrowers will drive banks to lend more conservatively. Banks and financial institutions will be unwilling to invest in student loans because of their negative prior experiences with irresponsible student borrowers. Headlines in the press will be highlighting the high level of defaults and financial company failures. This last phase of the bubble is always the most painful. People who should attend college are unable to afford the education and are penalized for the excesses of prior generations. In an ironic twist, politicians will call for the financial industry to be reined in without realizing that they caused the bubble. The legislation passed in 1998 caused the excesses we are seeing today because lenders no longer feared non payment.

A Way Out?

The United States needs to solve the student debt bubble as soon as possible. This is not another issue that can be kicked down the road. The Federal Reserve estimates that Americans have around $1.4 Trillion of student loan debt outstanding. This massive amount acts like an anchor on the U.S. economy as payments are funneled to financial institutions and entrepreneurship is hindered. The student debt bubble needs to be resolved before the United States can unlock its full economic potential.

Originally Posted on Boom Bust Market.