This may be the first time you see the European debt crisis and the U.S. student loan crisis mentioned in the same sentence- but likely, not the last. Hard to believe that our kids, or their parents, have wracked up a debt the size of the total national debt of Italy. One trillion dollars. A debt large enough to sink the global financial ark, in Italy’s case. Most of this student debt is owed directly to the U.S. government, and is one of the few kinds of debt that cannot be forgiven in a bankruptcy proceeding. In other words, unlike sovereign debt, default is not an option- yet.
Greece gets the headlines, but the real fear has always been the possible default contagion spreading to Italy. The EFSF at $750 billion, was deemed sufficient to manage Greece, Ireland and Portugal, but not Spain and certainly not Italy. Undercapitalized European banks would collapse under the weight of their exposure to the sovereign debt of these countries, and dominos around the world would begin to topple one upon another.
The European Union has crafted a response that is being met with cork-popping celebration today, and may ultimately serve as a template to our problem here at home. Call it a ‘force multiplier’ strategy. First, the EU concedes the inevitability of default and losses. But rather than indemnify bondholders against those losses altogether- primarily the European banks- the EFSF will be used as a buffer, an insurance policy against losses greater than the banks can withstand. The banks themselves, will be required to raise $140 billion in new capital to offset the potential ‘haircut’ on the value of these bonds. And so, it is hoped, the sovereign debt defaults rolling across Europe will be painful, but not catastrophic.
President Obama is hoping to avoid a similar solution here, which explains why the issue is suddenly getting air time along his campaign trail this week. The problem is one of unintended consequences. Student loans, like mortgages, have been essentially ‘nationalized’ during the Obama adminstration. The banks were deemed to be predatory, and cut out of the equation. As a result, the Federal Government became the lender of first, last and only resort. And a trillion dollars is a lot of money. Too much even for Uncle Sam to contemplate a default on.
Hence, the President’s conciliatory tone this week, with regard to repayment of student loans. Start paying back later, pay a little less, and do so over a longer period of time, seems to be the plan at the moment. Whether this finger in the dyke will suffice- particularly as graduates find that the pot of gold waiting for them at the end of this rainbow was not as advertised- remains to be seen.