May 23, 2011

Editors Note: From time to time we write about topics that may not connect to the markets we serve, but still have financial markets relevance and interest to our readership. Today we write about higher education and provide our perspective.

Is there a coming calamity in higher education? Asset bubbles are nothing new, but we’re not talking tulip bulbs, nor dot-coms, nor housing here. Unlike most other assets, a diploma is worthless outside of the hands of the holder. Two articles this week, one in Bloomberg and the other in forewarned of a crisis that has scarily similar characteristics with the housing crisis and the Tech bubble (the Tech 1.0 bubble that is, not the 2.0 one that debuted this week with the LinkedIn IPO). Unfortunately it has the potential to combine the worst characteristics of both.

The Situation

A pair of Pew Research surveys conducted this past spring found that a majority of Americans (57%) say that the U.S. system of higher education does not provide good value for the money spent to send Junior to college, and fully 75% of respondents say that college is just too expensive. According to the Project on Student Debt, the average college graduate from the class of 2009 finished his or her four-year degree with $24,000 in student loans, a large and often budget-straining financial obligation for the new graduate. In June 2010 the total student loan debt outstanding surpassed total credit card debt for the first time, and is now estimated to be a jaw-dropping $912 billion.

What is Raising the Concern?

As unemployment continues to plague both those with and without college degrees, the number of defaults on student loans is deepening. According to the U.S. Department of Education, the average default rate for the FY2008 cohort (2008 graduates who defaulted within their first 2yrs of repayment) was 7.0%, up from 6.7% for the previous class. This trend extended across public (6.0%, up from 5.9% prior), private, (4.0%, up from 3.7% prior), and for-profit schools (11.6%, up from 11.0% prior). When students default on their loans, this becomes a direct obligation of the government. True, it is very difficult for a student to discharge his or her debt these days, but workouts and restructuring plans only add cost to the equation. Not only does this increase our government’s precarious financial situation but there will be pressure to severely limit new government guaranteed student loans.

How Did We Get Here?

Political Hot Potato – Like the promotion of increased housing rates, higher education is a popular political cause that both parties support. Government guaranteed loans encourage more students to pursue education which most would agree is a good thing. However, just like the lax standards on housing loans drove housing demand to bubble price levels, politically backed availability of student loans is driving the price bubble on higher education.

Wrong Financing Mechanism – When the Tech 1.0 bubble burst the impact to the overall economy was limited and taxpayers were not required to pay for the “irrational exuberance.” This was because tech was being financed with equity, not debt, and the funding was from investors, not backed by taxpayers. Higher education is one of the purest forms of a venture project that theoretically should be financed with venture equity yet it is heavily financed with taxpayer-backed debt.

Terribly Inefficient – It really didn’t take the Pew survey to tell us what parents already knew. College is increasingly providing our kids with ultra modern campus facilities, gourmet meal plans and unlimited extracurricular activities. If we stripped away the Disney World out of the college experience, could we educate our kids to compete in global markets for half the cost? I haven’t done the research but with two kids in college, I would not be shocked if at least 30% could be cut with no impact on academics whatsoever.

Psychological Inversion – State of the art fitness facilities, executive chefs with menu options galore, dorms rivaling professional apartments, student centers with multiple entertainment options—why would anyone want to leave? The amenities on many campuses are so grand that graduates have almost no way of maintaining the standard of living “to which they’ve become accustomed.” Add a large student loan payment to a newly minted (and possibly unemployed) graduate and most kids are doomed to dramatically drop their living standard after college which plays psychological havoc on anyone’s mind.

What Will Happen?

America‘s universities continue to lead the world in higher education. However, the current system is likely not sustainable. As students and parents wake up to the fact that college lifestyle costs are excessive and inefficient, and begin to demand greater value for their education dollar; as graduates continue to see a difficult employment outlook and as student loan default rates of recent cohorts possibly climb higher; and as the U.S. government makes tough decisions on spending cuts which may include cuts to higher learning; the education bubble could burst. Will this lead to widespread university layoffs, a wave of college consolidations, and abrupt structural changes to the U.S. educational system? Or will these trends lead to gradual, manageable reforms as we regain our financial footing in the larger economy? One thing is for sure, you don’t need to have a college-bound senior in the family to be impacted by the challenges that lie ahead.