Student loan moans

In the US the credit crunch is having an adverse effect on student loans. John Zhu discusses the long-term damage this may cause

When the world starts falling apart, further education is one escape. Too many people hunting too few jobs creates a sellers' market and you have little choice but to take what you can get. Going to university is a bit like buying a European call option (giving the right, but not the obligation to buy at a set price on the option expiry date). You pay a premium - tuition fees - betting that you will be "in the money" when the economy recovers (hopefully by the time you graduate!) and firms begin selling themselves to potential recruits again. However, 2007's global credit crunch touched even this hitherto solid insurance plan.

A student loans agency in the US recently suspended one of its programmes because of troubles involving auction-rate securities. These debt products offer floating interest rates, determined at regular intervals through auctions. Student loan companies liked auction-rate securities because they are normally a cheaper way of raising financing than issuing standard long-term debt, for which sellers need to offer higher rates. Buyers saw them as relatively safe and almost as liquid as cash because of constant auctions, but with better returns than holding money. The market is worth an estimated $330bn (£165bn).

When demand in auctions is low, investment banks used to mop up excess supply by putting in supporting bids. However, the current financial turmoil has hit banks' balance sheets, and auctions are collapsing because of a drop in liquidity. When an auction fails, the interest rate on the security jumps to a high, predetermined level, to compensate buyers. Issuers are also hurt by a feedback effect and are liable to pay punishing interest rates of as much as 20%.

Hundreds of auctions have already failed this year. Aside from low investor confidence and banks conserving cash, the ongoing "monoline" bond insurers saga has compounded problems. These companies sell insurance on bonds, but have been hit by the subprime losses, leading to their treasured top-notch credit ratings to be threatened. You can imagine what markets will think of bonds insured by a guarantor whose own credit rating is being questioned.

Attending university may be expensive, especially in the US, but it can also shelter students during recessions. If student loans dry up, it could cause long term damage to both individual careers and the economy. Current students in the UK have more reason than ever to thank their lucky stars.

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