TCW writer Nathan Punwani illuminates how the volatile credit crisis is besetting your student loans.

The mayhem in the housing sector is spilling into a variety of different financial markets from mortgage-backed securities to credit card debt, auto loans, and corporate bonds. Now, student loans are the latest victims of the credit crisis.

In February, the state of Michigan cancelled a critical student loan program after the abrupt collapse of the $300 billion market for auction rate securities. Government agencies in Missouri, New Hampshire, Texas, Pennsylvania, and Iowa have terminated or limited their education lending. The Connecticut Higher Education Supplemental Loan Authority is begging the state legislature to boost its borrowing facility from about $170 million to $300 million. Undergraduate students are no longer unscathed by the economic turmoil.

Why is this onslaught happening? Financial innovation enabled local authorities and quasi-public institutions like the Michigan Higher Education Authority to borrow long-term without paying the high interest rates that long-term transactions usually require. In return, investors who made the loans received an IOU that is theoretically as good as cash but confers higher returns than a simple bank deposit. Auction determines the rate of return that investors garner. 

Nevertheless, this novel financial arrangement, bridging a sea of borrowers and lenders, contains a penalty provision. If an auction is unsuccessful, then the interest rate that the borrower pays ratchets up.

The auctions were not supposed to fail, but the largely frozen credit markets have inverted conventional wisdom on its head. For the first time in 40 years, no municipal bonds backed by student loans were sold during the first quarter of the year. With investors losing their appetite for the loans, the owners of the student debt are unable to redeem their IOUs for cash; meanwhile, lending agencies are paying penalty rates. The Rhode Island Student Loan Authority has seen the interest rates on some of its bonds double! As a result, the elevated cost of borrowing will eventually be passed on to students, making it harder to receive financing for higher education purposes.

In some ways, the credit freefall is eerily reminiscent of a modern day bank run, in which bank customers withdraw their deposits at the same time. This can cause the bank to go bust.

Likewise, frantic investors have lost confidence in the U.S. financial system after they've experienced evaporating returns on their mortgage-backed securities. Savers no longer trust that the exotic financial instruments that they purchase, like credit default swaps and collateralized debt obligations (don't ask), will function properly. If there are no buyers for the products, a market does not exist, and countless sellers are unable to convert their assets into cash. Consequently, lenders curtail loans to would-be borrowers, strangling the economy.

Except for prayer, not much can be done to resolve the credit crunch. The Federal Reserve could slash interest rates to reduce the cost of borrowing for millions of families. However, this policy tool is widely considered to be fruitless. According to economist Paul Krugman, "Reducing the cost of money doesn't do much for borrowers if nobody is willing to make loans. Ensuring that banks have plenty of cash doesn't do much if the cash stays in the banks' vaults."

The U.S. Congress could mitigate the burden of college tuition by doling out more subsidies to students. On April 3, U.S. Senator Edward Kennedy (D-MA) introduced the "Strengthening Student Aid Act for 2008" to provide support like federal grant and loan aid to young adults. A separate bill in the House calls for similar measures by expanding education loan limits as well. Despite the ambitious proposals, it will still require a lot of resources from the federal level to bail out the $86 billion worth of student loan auction-rate bonds.

College students have no other choice but to weather the credit crisis as best as possible. Across the country, institutions of higher learning are engaging lenders in order to assist students in procuring less expensive private loan alternatives. Schools and lenders are also attempting to restructure and even allow refinancing options for tuition payments. Pupils should consult with university financial-aid offices for further information.

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