Trouble in Paradise

During the recent credit boom, homeowners used equity in their homes as an ATM . Most homeowners used home-equity borrowing to make home improvements. However, nearly one-third of home equity borrowers spent their home-equity cash on debt consolidation.

Bad move. The biggest home equity lenders are calling in home equity loans in response to the decline in home values and tightening of avaliable capital for home mortgage investment. Washington Mutual (WaMu), one of the biggest home equity loan investors, announced in May 2008 that it had reduced or suspended about $6 billion of available credit under existing home equity lines. Countrywide, Bank of America and JPMorgan Chase have made similar moves. As home values decline, loan to value ratios turn against homeowners. Under the terms of home equity loans, lenders have the right to cap the loan balance to reflect the current ratio. For example, suppose a homeowner qualified for a $25,000 home equity line three years ago based on a home value of $250,000. She draws down $10,000 to finance a vacation in Bali. When her home value drops to $200,000, the bank caps her home equity line at $10,000. The homeowner cannot find another lender to replace the $15,000 in credit she lost. Worse, the she's "maxed out" the newly configured equity line. The bank will report this as a negative event to credit reporting agencies.

But wait, there's more. A home equity line of credit is secured by a lien on the debtor's principal residence. In contrast, credit card debt is unsecured. Our homeowner feels the drop in her credit score and no prospects for paying off her consumer debt. She might contemplate filing for bankruptcy relief. If she had used her credit card to pay for the Bali vacation, she might be able to discharge the debt in bankruptcy. Not so with secured debt in the form of a home equity line.

The Student Loan Bubble

Andrew Gillen of the Center for College Affordability and Productivity thinks the next US financial crisis will be the popping of the student loan bubble. In a recent report, Gillen draws parallels between the conditions leading up to the current housing crisis and those in the market for higher ed.

Here's his argument: To expand access to higher education, government has expanded students' access to financial aid, particularly through subsidized loans. Consumer subsidies expand demand. Profit maximizing suppliers normally expand production to respond to increased demand. In the case of higher ed, subsidies do not work that way.

Universities are not profit maximizers. Rather they maximize prestige. Expanding production and supply (adding more students) actually decreases prestige. Rather than add more students, universities hold enrollment constant, raise tuition, and use additional tuition revenue (care of federal subsidy) to build prestige. Consumers can benefit even if output does not increase if product quality increases. But, more prestige for a university is not necessarily coincident with a better education for students. Gillen asserts that universities are not using expanded revenue to improve the education they deliver to students. They can charge higher tuition without rendering a higher quality because students cannot analyze tuition cost against benefit. They tend to equate high tuition with high educational value, a correlation that is, according to Gillen, dubious.

The analogy to the housing bubble is compelling: Low interest rates and innovation in capital markets may have fueled increase in demand for housing, rising home prices, and the spread of subprime mortgage products. The federal government's tuition subsidy programs, seem to have spawned the "sub-prime" student loan extended to students whose want a "prestigious" education, but sport prospects for graduation and loan repayment as shaky as their sub-prime home mortgage counterparts. The market seems to be correcting for the student loan bubble. But, just as private lenders are closing their 'sub-prime' tuition loan shops, the federal government is considering legislation to take up the slack.

Perhaps government intervention is better directed at stimulating greater accountability for colleges and universities on the facts that matter to students' cost benefit analysis. Consumers armed with comparative information about the quality of education a university offers, including the impact of a particular degree on students' financial prospects, may provide the discipline universities currently lack. Critical Mass and Inside Higher Ed ran stories on this idea yesterday.