Apples to interest rates

Last week, Sen. Elizabeth Warren (D-Mass.) added to her reputation as a populist heroine when she brought her first piece of stand-alone legislation to the Senate floor. The bill, which she calls the “Bank on Students Loan Fairness Act,” aims to drastically reduce the interest rate attached to federal student loans. It would force the government to lend to students at the same low rate it sometimes offers to major investment banking institutions, appealing to supporters of federal student loans and skeptics of the financial industry alike.

The BSLFA appears just weeks before the interest rate on federal student loans was set to double from its current rate of 3.4 percent to the former rate of 6.8 percent. Warren’s bill, however, would reduce that rate to a mere 0.75 percent, the rate the Federal Reserve currently charges banks through a program known as “discount window lending.”

“The federal government,” Warren claims, “is going to charge students interest rates that are nine times higher than the rates for the biggest banks.” Economist Joseph E. Stiglitz, a Nobel laureate known for his popular writings on income inequality, called Warren’s bill a “step in the right direction” and echoed her pointed rhetoric.

Warren and Stiglitz must be aware, though, that not all borrowers are necessarily alike. The discrepancy in interest rates between the federal student loan program and the Federal Reserve’s discount window lending policy actually has much less to do with morality and societal values than it does with maturity, collateral and the credit- worthiness of specific borrowers. Further investigation of these two types of loans should lay clear why students pay higher rates of interest than big investment banks do—and might begin to suggest that Sen. Warren’s BSLFA is less insightful than it initially appears.

When Warren explains that “banks pay interest that is one-ninth of the amount that students will be asked to pay,” she is not making a statement regarding the overall borrowing practices of investment banks. Banks, quite obviously, take on a variety of debts subject to a wide range of interest rates, and many of these rates may in fact be commensurate with or even higher than the rates paid on student loans. Warren is instead referring to one very specific type of loan program offered by the Federal Reserve—generally known as the Fed’s discount window. Banks with strong financial foundations can borrow cash overnight from the Fed at a rate of 0.75 percent. As a result of three main considerations—the short duration of these loans, their collateral requirements and the perceived credit-worthiness of the banks—the Fed can consider these agreements to be relatively risk-free.

To put it simply, the Federal Reserve’s discount window interest rates remain relatively low due in part to a high level of confidence that the loans will be repaid. But are there really any similar low-risk indications when it comes to the case of the federal student loan program? Is there anything at all to suggest that federal student loans are equally likely to be repaid in full and on time? Student loans, after all, differ from the discount window loans in essentially all of the most important ways. 

First of all, they are not mere 24-hour, overnight commitments, but instead typically take a full ten years to mature. This fact alone substantially increases the risk associated with student loans, since it leaves a longer period of opportunity for borrowers to unexpectedly default on their loans. On top of this, there are no collateral requirements associated with federal student loans—meaning that the lender does not have immediate access to anything else of value in the event of a default. Lastly, a student seeking a loan in order to pursue a college education will generally have little in the way of wealth and assets, which in turn undermines their credit-worthiness as borrowers. In fact, student loans have overtaken credit card debt as the leading source of 90-day delinquency, which attests to the level of risk that is associated with them.

In the end, this debate really comes down to a case of comparing apples to oranges. The significant differences in structure between federal student loans and the Fed’s discount window loans provide little reason to think that the interest rates associated with these programs should track together in any meaningful way. Of course, as many have already noted, Warren’s BSLFA has little hope to pass a vote in any case and is most likely intended to be a symbolic statement rather than a serious policy proposal. 

“It’s a populist values statement,” said one journalist. “We like students, we don’t like banks.” If Sen. Warren wishes to make a meaningful impact on the cost of higher education, however, she might consider bringing more to the table than a symbolic statement of progressive values.

Chris Bassil, Trinity ’12, is currently working in Boston, Mass. His second summer column will run on June 6. You can follow Chris on Twitter @HamsterdamEcon.