Student Loan Defaults in Texas: Yesterday, Today, and Tomorrow

Historical Trends

The student loan industry has seen many changes in the ten years since the SDI conference. In many ways, 1988 was the depth of the default crisis. Through acts of Congress and the hard work of the student loan participants, default rates have dropped significantly since the conference. This section attempts to highlight some of the key trends in student borrowing in Texas. First, while there have been substantial increases in need-based grant aid, this growth has not kept up with the cost of college, forcing students to rely increasingly on loans to finance their educations. Second, borrowing by students attending proprietary schools soared during the late 1980s, but started to decline by 1989 and has continued to fall since then. This trend had a ripple effect on the student loan program in Texas contributing to high default rates during peak loan volume years and reducing overall default rates as proprietary school volume declined. Third, while default rates have dropped since 1990, the pace of this decline differs by school type. Fourth, default claims have leveled off after a steep increase in the late 1980s and early 1990s. Another key trend is discussed in detail in a companion report, Education on the Installment Plan: The Rise in Student Loan Indebtedness in Texas.

Grant to Loan (Im) Balance

Many of the SDI conference participants identified the problem of funding equal access to higher education through loans rather than need-based grants. Students contemplating going to college must decide if the returns from higher education are worth the investment in time and money. On average and in aggregate, the investment in higher education pays off handsomely. A recent study by the economic analysis firm, Texas Perspectives, reported that students can expect to realize large profits by gaining a college degree, “[T]he net present value of the additional earnings from obtaining a college degree is just over $207,000.2 However, the choice between going and not going to college involves some calculation of the probability of success and the cost of failure. Not all students will be equally successful. Some students will not earn up to this average and some may not even complete their courses of study. For students in need of financial assistance, the difference between a loan (with the harsh penalties associated with default) and a grant is significant. As students begin their educational careers, their prospects for success are unclear. Providing grants helps reduce this risk; loans can increase it. This difference is accentuated for students from low-income families or from families with no prior exposure to higher education. As a tool for equal education opportunity, grants are much more effective than loans.

Unfortunately, budgetary pressures have dominated student aid policy during the last ten years. The 1988 need-based grant-to-loan mix has not been maintained, resulting in a growing reliance on student loans. During the last eight fiscal years for which we have data (1988-89 to 1995-96), state need-based grants increased by roughly 100 percent and federal grants rose 40 percent. (See Table 1)

However, loans have grown at even higher rates. From 1988-89 to 1995-96 the amount of state student loans to Texas students rose 72 percent, while federal student loans grew a whopping 252 percent. (See Table 2)

In 1988-89, the mix between need-based grants, student loans and work-study was 31 percent, 66 percent and 3 percent respectively. By 1995-96, this mix had changed to 21 percent of aid through need-based grants, 77 percent in student loans, and 2 percent by way of work-study. (See Table 3)

Public policymakers have sent the message to students that if they want to go to college they will have to take a significant gamble by paying higher tuition and fees for college and financing this through large loans. It is a testament to Congress and the student aid community that despite this growing imbalance default rates have declined.

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Portfolio Mix: The Rise and Fall of Proprietary School Borrowing

TG guaranteed its first loan in 1981. Since that time, there have been countless changes to the program rules and regulations. Borrower eligibility has expanded and contracted and expanded again. Need analysis has gone through numerous alterations. Loan limits have risen, especially for upperclassmen and graduate/professional students. Congress has abolished some loan programs and created others. All of these changes have had some impact on TG loan volume and portfolio mix.

During TG’s first year, the portfolio mix by school sector was actually quite similar to the mix today.

However, between these years there were considerable fluctuations. Perhaps the most significant trend was the rise and fall in borrowing at proprietary schools. From FY 1983 to FY 1986, TG proprietary school volume grew 938 percent. Volume then rose 80 percent more in the next year and an additional 172 percent between FY 1987 to FY 1989. A school sector with a volume of $15 million in FY 1983 grew to $423 million in 1989 — just 6 years later.

Slowly, news spread of unscrupulous business practices at some proprietary schools. Students from these schools began defaulting at rates much higher than students from other school sectors. It soon became clear that the phenomenal growth in proprietary school loan volume was also causing a default crisis.

Proprietary schools are different from traditional colleges and universities. They offer short-term career training on a for-profit basis. Proprietary schools aggressively advertise and recruit. Especially in the mid- and late-1980s, these schools served students primarily from low-income families, many of whom had dropped out of high school and lived in economically disadvantaged areas. These were precisely the types of people that were not in the education pipeline that led to a four-year university degree. Advocates for proprietary schools boasted of the successes schools had with this disadvantaged population, turning the down and out into productive employees and taxpaying citizens. High default rates were defended as the price to be paid for training this high-risk, under-served group. Critics, however, argued that many — but not all — proprietary schools actually had a negative impact on the lives of their students and that the federal and state governments should protect the student consumer from fraudulent schools.

TG was among the most vocal critics of proprietary schools. In School or Scandal? former TG Executive Director, Joe McCormick, identified unscrupulous business practices by proprietary schools.3 By making false promises, providing inadequate instruction, and training students for jobs for which the expected salaries were insufficient to repay their loans, critics claimed that these schools hoodwinked students out of their money and left them with bad credit. Largely to combat growing default rates and to better protect students, the federal government increased oversight of all schools. Since the federal government’s primary tool of oversight was sanctions against schools with high default rates, the effect on proprietary schools was most pronounced. Cohort default rate restrictions and tighter oversight by guarantee agencies effectively drove out the schools with the highest default rates and most problems. Proprietary schools that retained their eligibility were either already operating effectively or had corrected their administrative practices. Many schools also quit operating in inner-city neighborhoods raising concerns of decreased educational opportunity in these areas.

The largest guarantee agency in the country, the Higher Education Assistance Foundation (HEAF), sent notice in 1988 that it was in the middle of a financial crisis due to its large proportion of loans to students attending proprietary schools. These students had defaulted on their loan obligations at alarming rates. HEAF pulled out of Texas in 1988 and would later become unable to back its guarantee to lenders. ED liquidated the assets of HEAF and assumed financial responsibility for its liabilities. HEAF’s substantial proprietary school volume in Texas largely switched to the designated state guarantor. This influx of proprietary school loans sent TG into a financial downward spiral similar to the one that ruined HEAF. In FY 1990 and FY 1991, TG hit the second default reinsurance trigger rate forcing the corporation to be reimbursed at a rate of 80 cents on the dollar for a portion of its default claims. Fortunately, TG managed its way through this difficult time with the help of Congress, ED, and the student aid community in Texas and now maintains a more balanced portfolio of loans.

Proprietary school volume with TG peaked in FY 1989. During that year, proprietary school students accounted for 46 percent of all loans guaranteed by TG — 15 percentage points higher than for all students attending four-year public schools. Increased oversight and loss of market share within this sector had lowered TG proprietary school volume by 37 percent in FY 1990. By FY 1993, proprietary school volume had dropped to $85 million and accounted for only 10 percent of TG’s volume. As of FY 1997, proprietary school volume was at $79 million — just 6 percent of TG’s total loan volume.

With the decline in proprietary school borrowing, TG’s portfolio mix became more weighted towards the four-year school sector. This shift has been relatively steady since FY 1989.

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Cohort Default Rates

The official ED Cohort Default Rate came into being in 1987 when the Department of Education Secretary William J. Bennett publicized the formula in his attempt to crack down on schools associated with high defaults, which the Secretary announced by proclaiming, “It’s accountability time.4 The calculation was to provide a relatively quick look at default behavior. Research at that point suggested that most defaults occurred shortly after students left school and exhausted their grace period.5 Schools were not pleased with the punitive use of these rates; they were unaccustomed to being held responsible for an obligation a student made with a private lender. The Cohort Default Rate — and the sanctions based on these rates — forced schools to be more accountable for the outcomes of their students.

The Cohort Default Rate became the standard calculation for assessing default experience. TG has applied this formula to prior years to allow for a wider historical perspective. As Table 7 shows, TG’s Cohort Default Rate peaked in FY 1990 at 33.6 percent and has declined each year since.

Default rates vary greatly by school type. Four-year private schools typically have the lowest default rates and proprietary schools often have the highest rate of any school sector. These school sectors draw on very different student populations. On average, the most affluent and academically successful students typically attend four-year private schools, while the most economically and academically disadvantaged students usually attend proprietary schools. In addition to the difference in duration, the four-year private school sector has lower dropout rates than the proprietary school sector. Four-year public schools behave similarly to four-year private schools, while two-year schools more closely resemble proprietary schools in the population served and in the shorter duration of the educational program.

The Cohort Default Rates for four-year public and private schools have remained remarkably consistent over the years. The slight increases in FY 1990 were followed by gradual declines. This suggested that many of the default prevention measures recommended by Strategic Default Initiative participants and adopted by Congress had moderate positive effects on students attending the long-term programs. The highest default rate for two-year schools also occurred in FY 1990; however, this sector did not decline in subsequent years as notably as four-year schools.

Proprietary schools showed the greatest change in default rates. Within this school sector, default prevention measures — especially Limitation, Suspension, and Termination provisions based on Cohort Default Rates — had an enormous effect. In FY 1990, the Cohort Default Rate at proprietary schools was 48.3 percent. Within two years this rate had dropped to 30 percent and in FY 1995 had fallen to 23.8 percent. The schools with the highest default rates were forced out of the program and those that remained usually altered their way of business (and sometimes instruction) to lower their rate in order to retain eligibility for federal Title IV student aid money.

Table 8

There is concern about the adverse effects of increased borrowing following the 1992 liberalization of aid eligibility through changes in need analysis, expansion of loan limits (excluding first year students) and the creation of the Stafford Unsubsidized Loan Program. However, increased borrowing appears to have had little impact on Cohort Default Rates thus far. As Section IV will show, holding all other variables constant, incremental increases in debt load increases the chance for default.

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Default Claims

TG is a relatively young guarantee agency. TG guaranteed its first loan in FY 1981. Just like the current newcomer to student loans, direct lending, TG’s early years were focused on the front end of the process — making sure that students got their education loans. The back end of the process — paying claims and collecting on defaulted loans — grew in significance for the corporation. The negative effects of the growth in proprietary school borrowing lagged about one to two years from the time of guarantee. In the year prior to the SDI conference (1987), TG default claims were at $45 million. In two years this amount would more than double. By 1991 — two years after the peak in proprietary school borrowing — default claims ballooned to $230 million, the highest total in the corporation’s history. Since then, annual default claims have leveled off despite tremendous growth in guarantee volume. This leveling off is a result of a portfolio that is weighted increasingly towards less risky loans.

Graph 2 shows TG’s default claims paid by the type of school attended by the borrower. This table illustrates the impact of proprietary school borrowing. In FY 1990, seven out of ten default claims paid were for students who attended proprietary schools. As proprietary school borrowing receded, so too did their percent share of default claims paid. Although proprietary school students still account for a disproportionate amount of default claims (relative to their percent of loan volume), now it is more common for a typical TG defaulter to have attended a four-year public school than a proprietary school. This change represents a major shift in perspective from when the SDI participants gathered in 1988.

TG has also looked at default claims paid by the highest grade level attained. The peak of proprietary school borrowing is reflected in the higher percentage of borrowers whose highest grade was only the first year of college. In FY 1990, 83 percent of all default claims were paid for first-year students. The proportion of all default claims paid for first year students has been decreasing since FY 1990 as a larger share of borrowing has occurred at four-year schools. Nonetheless, graph 3 shows that most default claims paid are for students who attended school for only one year either as proprietary school students or dropouts in longer-term programs.

While many of the issues raised at the 1988 SDI conference remain with us, the climate has changed somewhat. Default rates have declined. Schools with the highest rates have left the program, and the press is no longer saturated with stories of abuses by unscrupulous schools. Default prevention measures have been largely successful. However, the growing debt burdens of students causes concern both as a strategy to promote equal access to higher education and as a warning of potential default problems in the years to come. The profile of a typical defaulter is evolving. Section IV explores the characteristics of defaulters and explains an econometric model to identify those students most at risk of defaulting.

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