Meet IBR, The Student Loan Bubble's Dirty Secret

A little over a week ago we asked: “Is The Student Debt Bubble About To Witness Its 2007 Moment?” We were prompted by Moody’s decision to place 14 student loan-backed ABS tranches on review for downgrade as the ratings agency cited the very real possibility that the tranches wouldn’t fully pay down by their maturity date. In other words, some $3 billion in student loan-backed paper is now at risk of default. As a reminder, here’s an excerpt from the rationale:

Voluntary prepayment rates in FFELP loan pools remain historically low as a result of sluggish economic growth and high unemployment rates among recent graduates… Deferment and forbearance levels remain high throughout the life of the collateral pools, although they recently declined slightly from peak levels in 2009-11... The growing popularity of IBR, which extends the life of the loans to up to 25 years from the standard 10-year term of non-consolidation loans, and the extended repayment option (for borrowers with balances of more than $30,000) is further lengthening the weighted-average life of the student loan collateral pools. In some pools, loans in IBR and extended repayment represented 10%-12% of the balance of loans in repayment.

As a reminder, “IBR” stands for Income Based Repayment and, as the name suggests, simply means that payments on federal student loans are calculated based on how much the borrower earns. Here’s how Fedloan Servicing (a Department of Education approved servicer), describes the program:

Under this plan, your monthly payments are based on your adjusted gross income and family size. If you're married and file a joint federal income tax return, your spouse's adjusted gross income, and eligible student loan debt, if applicable, is also taken into consideration.

And here is how the organization describes a typical IBR-eligible borrower:

I have little or no income and mounds of student loan debt, so I'm stressed about my monthly payments.

Now consider the following information about monthly payments:

They are based on your adjusted gross income (individually or with your spouse, as applicable), your family size, and your state of residence.

 

They may be less than the interest that accrues each month.

 

They may be as low as $0.00.

Note that last point — “may be as low as zero.” In other words, depending on your financial situation, you may not have to make monthly payments at all.

After 300 “qualifying monthly payments” — so after 25 years of payments — any remaining balance is forgiven and legally discharged. The interesting thing about this is that if the calculated payment is zero, it still counts as a “qualifying monthly payment.” That is, if, based on the borrower’s financial situation, he/she is not required to make an actual cash payment for a period, that period still counts towards the 300 “payments” needed to have the balance of the debt discharged, meaning that in the end, borrowers could end up paying substantially less than principal (taxpayers eat the balance) and are effectively allowed to remain in a perpetual state of default while avoiding actual payment default along the way. 

This of course led us to wonder just what percentage of the government’s student loan portfolio was comprised of borrowers who are now in IBR. Here’s BofAML:

With respect to Income Based Repayment (IBR) and extended repayment programs, the Department of Education’s most recent data shows that the percent of FDLP borrowers in repayment opting for IBR or PAYE increased from 10% on June 30, 2013 to 13% on December 31, 2014, and the related balances increased from 14% to 24%. 

So in terms of dollar value, nearly a quarter of FDLP loans are on an IBR or PAYE (which is a similar scheme and stands for “Pay As You Earn”) program while 13% of all borrowers have opted into some manner of income-based payment plan. 

We, along with the St. Louis Fed, have argued that stripping out loans in forbearance or deferment from the delinquency calculations paints a clearer picture of where things actually stand because while you can argue about how those loans should be classified, what you cannot do is count those loans in the denominator but not in the numerator when calculating delinquency rates because if you do, you're effecitvely ensuring that you will understate the true percentage of borrowers who are behind. As we’ve seen, the delinquency rate for borrowers in repayment is somewhere around 30%. 

That said, if those who are enrolled in an IBR or PAYE program but whose financial circumstances are such that their calculated payments are zero are counted as both "in repayment" and as "current" (which seems likely), then even the 30% figure is likely a woeful misrepresentation of the actual delinquency rate, because those borrowers are being counted towards the total number of loans in repayment (the denominator) but not towards the total number of delinquencies (the numerator). Put differently: it seems rather strange to count someone as “current” just because their income-adjusted payment happens to be zero.

In short, borrowers making no payments by virtue of their financial situation are really no dfferent than borrowers in forbearance or deferment so why count them as though they are? They should also be stripped out of the "in repayment" delinquency equation and if they aren't (i.e. if you want to count them as being "in repayment"), then you also have to count them as being delinquent, because they are.  

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We'll close with a few charts from BofAML which show that for the 2009 cohort, things are looking particularly grim:

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