Is Student Loan Debt the Next Financial Crisis?

The Great Financial Crisis feels like a lifetime ago, yet the world hasn't let down its guard. Some believe the nation's $1.63 trillion in outstanding student loans could pose a threat to the economy in much the same way as the mortgage crisis did in 2008 and 2009, but is that true?

While student loan repayments are a burden on many households and could impact the economy, a repeat of the widespread devastation of the Great Financial Crisis seems very unlikely.

Student Loan Debt vs. the Great Financial Crisis

When comparing student loan debt to the Great Financial Crisis, it's important to remember that mortgage-backed securities (MBS) based on subprime mortgages and the swaps derived from them are considered one of the main culprits of the collapse. A housing boom in the years that led up to the crash created an abundance of mortgage approvals by lenders who issued sub-prime loans to people who couldn't afford them, leading to a subprime meltdown.

Mortgage-Backed Securities

A standard procedure in the mortgage industry is to bundle loans together into a security and sell them to investors. Mortgage-backed securities work similarly to bonds by providing a steady flow of interest payments, while also freeing up capital at banks which can then issue new mortgages.

However, during the Great Financial Crisis, a large number of these securities were rated as investment grade when their underlying assets were shaky sub-prime loans. Credit default swaps (CDS) exacerbated this already tenuous situation. If you held an MBS but were worried about getting repaid, you could buy a credit default swap as insurance, which transferred the risk to an investor who was happy to receive a premium in exchange for accepting the risk. But when sub-prime borrowers defaulted en masse, these investors couldn’t pay up, and MBS holders lost their money.

Student Loan-Backed Securities

There are several reasons why this scenario isn’t likely to repeat itself in the student loan market.

First, although there is significant student loan debt outstanding at $1.63 trillion, it pales in comparison to outstanding mortgage debt at $12 trillion. Furthermore, student loan debt accounts for just 9% of household debt versus 70% for mortgages. The following image shows household debt percentages as of the second quarter 2023.

Secondly, although student loans can be packaged and sold to investors as student loan asset-backed securities (SLABS), this market is very small at $146 billion at the end of 2021. This doesn't pose the sort of systemic risk that securitized mortgages did in 2008.

Thirdly, to cause a financial collapse, student loan defaults would need to be much higher than they are today. During the Great Financial Crisis, the delinquency rate on mortgages rose rapidly and ultimately peaked just north of 11%. The Federal Reserve reports that less than 1% of student loans were delinquent or in default and this expected to remain low until the end of 2024.

It is possible that a crisis will evolve from student loan debt, but other forms of debt could cause or contribute to one also—nearly all forms of consumer debt are securitized, including auto loans, credit card debt, and mortgages.

It would take a significant event to cause a financial crisis equal to that of the GFC.

Student Loan Debt Is a High Priority

Student loan debt is a much higher profile issue than subprime mortgages were before the housing market collapsed. According to the Department of Education, 43.4 million borrowers owe $1.63 trillion in federal student loan debt.

Progress is being made through initiatives that help student loan borrowers pay back their loans. The College Board reports that as of March 2022, one-third of borrowers paying back a federal student loan were enrolled in an income-driven repayment (IDR) plan.

The federal government has also done other work to try and alleviate the mountain of student debt with other proactive measures. This is a giant leap from the reactionary measures taken after the financial crisis.

2022 Student Debt Relief Measures

In 2022, the Biden-Harris administration announced its Student Loan Debt Relief plan, intended to forgive up to $20,000 in student loan debt per borrower. The White House estimated more than 90% of the relief would go to households making less than $75,000.

However, the action was met with legal challenges. On June 30, 2023, the Supreme Court declared the program unconstitutional, forcing the Biden-Harris administration to pivot to new measures for student debt relief.

2023 Student Debt Relief Measures

In response to the Supreme Court decision, the Biden-Harris administration announced the Saving on a Valuable Education (SAVE) plan. The new plan, which replaced the older REPAYE plan, includes several student debt relief measures, such as:

• Lowering monthly payments to 5% of discretionary income for undergraduate borrowers
• Raising the discretionary income threshold, which means an estimated one million borrowers will owe $0 per month because they do not make enough to have discretionary income
• Forgiving loan balances after 10 years of payments if the original loan balance was $12,000 or less
• Ending the capitalization of unpaid interest, which means student loan balances will never grow as long as borrowers keep current with their payments

The COVID-19 moratorium on student loan payments and interest has come to an end. Interest began accumulating again on September 1, 2023, and the first student loan payments since the pandemic were due on October 1.

To help financially vulnerable borrowers, the White House also announced a payment "on-ramp" period from October 1, 2023, to September 30, 2024. Payments will be due during this time, and interest will accrue on student loan debt, but that interest will not capitalize at the end of the 12 months. Additionally, borrowers with late, missed, or partial payments will not be considered in default, reported to credit bureaus, or referred to collections agencies.

Borrowers are still expected to make payments during this time. However, the on-ramp is intended to help them adjust their finances once payments and interest resume.

Other Debt Forgiveness Measures

Before the sweeping relief, targeted debt forgiveness had already taken effect for students who attended predatory or fraudulent schools. Students that attended several technical or vocational schools, such as ITT Technical Institute, may be eligible for federal loan forgiveness.

On a broader scale, the Public Service Loan Forgiveness (PSLF) program allows those that work in public service positions to receive debt forgiveness after 120 qualifying payments while working in a nonprofit or government job. Income-based repayment programs also aim to lessen the monthly financial burden for low-income borrowers.

The Bottom Line

Undoubtedly, the student loan system is in desperate need of reform, but comparing it to the mortgage crisis is similar to comparing apples and oranges.

Although the total amount of outstanding student loans now stands at about $1.63 trillion, that number is small compared to the roughly $12 trillion in outstanding mortgage debt.