Credit impact of SCOTUS student loan decision

(6.30.23) June has not been kind to student loan borrowers, as both the legislative and judicial branches took a whack at substantive parts of student loan borrower relief.??These changes are credit negative for the economy, borrowers, and securities backed by consumer loans, as tens of millions of borrowers have little time to console themselves from the dashed hopes of debt cancelation and resume repayment this fall. The Biden administration is actively working on some new measures of borrower relief, including an alternative tack on debt cancelation and substantive changes to the income-driven repayment (IDR) plan, but the timing of these proposals remains uncertain.

June delivers a double whammy

Today, the Supreme Court decided against those hoping to have all or a portion of their student loan debts extinguished as a part of Biden's debt cancelation program. The White House estimated that, of the 43.5 million Americans with federal student loan debt, up to 20 million would have been eligible to have their entire remaining balance cancelled. That's a lot of disappointed borrowers.

Earlier this month, the end of the yearslong student loan payment pause was codified as a part of the politically contentious debt ceiling negotiation.??Come September, these federal student loans will again accrue interest and millions of borrowers will resume debt repayment.??For the average borrower, that amounts to a monthly payment of about $270, which isn't nearly as high as other consumer expenditures, like housing, transportation, or healthcare, but it's not nothing. Given that that forbearance has been in place for three-and-a-half years, we're about to see just how strong borrowers' repayment "muscle memory" is.?

Hope springs eternal

In this afternoon's response to the Supreme Court's ruling, Biden outlined some actions that will bring a measure of additional relief to struggling student loan borrowers.??For starters, he said he would continue to pursue debt cancelation using the Higher Education Act (instead of the HEROES Act).??He warned, however, that this rulemaking process would "take longer."

He also mentioned the changes coming to IDR, proposed back in January, which remain a meaningful part of his relief proposal.??These changes reduce the payment caps, from 10% to 5% of discretionary income, as well as raise the discretionary income threshold, making it easier to qualify.??Also, the path to loan forgiveness was shortened by half, from 20 to 10 years, for borrowers with an original balance of $12,000 or less.??These changes will likely change the IDR take-up rate, which has been about 33% [1] to date.

Reportedly [2], the revisions to IDR will also eliminate the "negative amortization" issue whereby IDR borrowers who dropped out of the program for any reason, financial or administrative, could find themselves owing more than the original balance, a meaningful amendment.??

These changes, taken together, may substantively boost both the take-up rate and completion rate for IDR; however, they have yet to complete the rule making process, which includes vetting more than 13,000 comments [3].

Another change, discussed below, would offer borrowers a longer-than-usual and extendible grace period (up to 12 months) for missed payments, protecting borrowers from getting immediately dinged on their credit reports.

Macroeconomic impact is small, but ill-timed?

Payment resumption is not expected to slow economic growth by much, but these headwinds will begin to manifest in the fourth quarter, when there's already a higher risk of negative real GDP growth according to the Philly Fed's consensus survey [4].??To be clear, impact of the resumption of payments on consumer spending will be small. One way to estimate the impact is by comparing the amount of student loan revenues collected in 2019, the last full fiscal year unaffected by COVID, with the annual consumer spend figure for the same year. According to?Slate [5], the government collected $70.3 billion (Direct only, no FFELP or private) in student loan revenues in 2019. Consumer spending was about $19 trillion, so $70.3 billion is quite small (0.4%) [6].

Loan performance will quickly revert, unless…

As a base case assumption, we can reasonably expect student loan delinquency rates to quickly revert to pre-COVID levels (Figure 1). Back then, the proportion of seriously delinquent student loans was between 9% and 10%.??It could go higher.??Compared to pre-pandemic period, households today are contending with sharply higher inflationary pressures while excess savings accrued during the teeth of the pandemic are expected to be depleted by year end.??Still, an important consumer credit performance indicator, the unemployment rate, remains now, as it was then, quite low (~3.7%).??If the economy dodges a recession and the labor market remains solid, then delinquencies may remain range bound to pre-pandemic levels.??More optimistically, delinquencies could improve if the proposed changes to IDR are enacted.

Figure 1

FICOs will eventually drop for the most vulnerable

Nonetheless, as a consequence of this degradation in performance, FICO scores will drop adding to the already growing credit insecurity felt by certain cohorts of borrowers.??Vulnerable groups skew towards the usual suspects:??younger, lower income, or less educated. For example, the proportion of non-degree holders with student loan debt is surprisingly high - at least 40% - leaving them saddled with the debt without the benefits of a degree [7].

As mentioned above, a proposal announced today would offer borrowers a longer-than-usual and extendible grace periods for missed payments, protecting borrowers from getting immediately dinged on their credit reports as they get back into the habit of repaying their loans [8]. This would, of course, delay the aforementioned impact on FICOs.

Knock-on impact to other consumer credit sectors

The knock-on impact to other forms of consumer credit (cards, autos and mortgages) will be marginally credit negative in aggregate as borrowers who are strapped for cash re-prioritize their debt payments. That said, consumer lenders with a concentration of riskier profile borrowers will likely see a measurable drop-off in performance beginning in the fourth quarter of this year.??It will be interesting to see how borrowers order rank their payment priorities now that a sizeable student loan payment is back in the mix.?

Footnotes:

[1] Markus, Nat, "The Looming Student Loan Entitlement," AEIdeas. June 21, 2023. URL

[2] U.S. Department of Education. "New Proposed Regulations Would Transform Income-Driven Repayment by Cutting Undergraduate Loan Payments in Half and Preventing Unpaid Interest Accumulation." Press Release, January 10, 2023. Accessed June 30, 2023.

[3] Turner, Sarah, "Student loan pause has benefitted affluent borrowers the most, others may struggle when payments resume," Brookings Institution. April 13, 2023. URL

[4] Federal Reserve Bank of Philadelphia. "Second Quarter 2023 Survey of Professional Forecasters." May 12, 2023. Accessed June 30, 2023.

[5] Weissmann, Jordan, "An Extremely Important Statistic About Student Debt That Has Never Been Published," Slate. March 24, 2021. URL

[6] Moore, Simon, "Resuming Student Loan Payments May Slow Economic Growth," Forbes. June 29, 2023. URL

[7] Bernard, Tara Siegel, "They Got the Debt, but Not the Degree," The New York Times. June 1, 2022. URL

[8] Stratford, Michael, "Biden admin finalizes student debt ‘safety net’ as repayment looms," Politico. June 29, 2023. URL