Citation
Student Loans and the Opportunity for Arbitrage

Material Information

Title:
Student Loans and the Opportunity for Arbitrage
Creator:
Faria, Taciana
Orovecz, Kathryn
Shelton, Ian
Publication Date:
Language:
English

Subjects

Subjects / Keywords:
Arbitrage
Student loans
Subsidies
Student loans ( jstor )
Mortgage loans ( jstor )
Arbitrage ( jstor )
Genre:
Undergraduate Honors Thesis

Notes

Abstract:
Student loans have been a part of American history and will continue to be a growing part as the country seeks to become more educated. Student loans available from the Federal government have gone through a series of changes, which has led to the Direct Loans seen today in a variety of forms. With the current loan system, there is a potential for students to easily execute arbitrage with the Subsidized Direct Loan. There is also an opportunity to execute arbitrage with an Unsubsidized Direct Loan, though not as easily. With student debt levels increasing, a significant question is how the money is being spent. Through a survey and research in the area, we concluded that some students are taking advantage of the arbitrage opportunity, while others are missing their chance at free money. Also discussed are student debt levels and default rates, which are at all-time highs and continue to grow. ( en )
General Note:
Taciana Faria awarded Bachelor of Science in Business Administration; Graduated December 17, 2013 . Major: Finance
General Note:
Kathryn Orovecz awarded Bachelor of Science in Business Administration; Graduated May 7, 2013 summa cum laude. Major: Finance
General Note:
College/School: Warrington College of Business Administration
General Note:
Advisor: John Banko

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University of Florida
Holding Location:
University of Florida
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Copyright Taciana Faria, Ian Shelton and Kathryn Orovecz. Permission granted to the University of Florida to digitize, archive and distribute this item for non-profit research and educational purposes. Any reuse of this item in excess of fair use or other copyright exemptions requires permission of the copyright holder.

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 1 Student Loans and the Opportunity for Arbitrage By: Ian Shelton, Kathryn Orovecz, Taciana Faria Finance Honors Thesis

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 2 Abstract Student loans have been a part of American history and will continue to be a growing part as the country seeks to become more educated. Student loans available from the Federal government have gone through a series of changes, which has led to the Direct Loans seen today in a variety of forms. With the current loan system, there is a potential for students to easily execute arbitrage with the Subsidized Direct Loan. There is also an opportunity to execute arbitrage with an Unsubsidized Direct Loan, though not as easily. With student debt levels increasing, a significant question is how the money is being sp ent. Through a survey and research in the area, we concluded that some students are taking advantage of the arbitrage opportunity, while others are missing their chance at free money. Also discussed are student debt levels and default rates, which are at all time highs and continue to grow.

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 3 Table of Contents ... p. 1 Abstract History of Student Finances Colonial America The Separation of Church and State p. 5 The Twentieth Century Higher Education Era Revolutionary Twentieth First Century in American Student Aid Present State of Student Finances Defining a Free Market for Student Financ Benefits and Drawbacks of Implementing a Free Market System Outstanding Student Debt Default Rates on Student Loans p.22 Survey on Student Loans Arbitrage 29 29 Student Loan Arbitrage Subsidized Stafford Student Loan Arbitrage Unsubsidized Stafford Student Loan Arbitrage Variable Student Loan Arbitrage Student Loan Arbitrage Summary Mortgage Student Loan Investing Strategy Defining the Mortgage Investing Strategy Potential Savings from the Mortgage Investing Strategy .. p.41 Restrictions in Executing Mortgage Investing Strategy Additional

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 4 Introduction As the world progresses, globalizes and open s frontiers, the demand for education in all levels rises with this development trend, especially in first world countries such as the United States. However, t his tendency is relatively new to our generation and has come a long way from the beginning of this rise in education demand in th e United States. Different government laws h ave shaped the history of post secondary education. A university degree has become what a high school diploma used to be. The rigorous standards the business world has adopted f or its working professionals have reached a level of no return and changed the future of young professionals forever. The weight of this high demand principle is not only felt by young kids pushing their way through college just to barely make it in the marketplace but also has a very he avy weight on their pockets. The cost of education is rising with the increased demand T he manner in which kids pay for what used to be a career advantage is now a requirement. This thesis paper has been strategically arranged to explore and discuss the history of student loans, the aid created to help students pay for their college degree s the present state of student loans in the United States and how there is an opportunity to execute arbitrage in this system. This analysis will discuss es many relev ant points, such as the evolution of the education system in America the change in interest and default rates associated with student loans, arbitrage, investing strategies for students, and the shift between guaranteed loans and the direct loan s

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 5 I. Hist ory of Student Finances A. Colonial America The S eparation of Church and State In the early years of settlement in North America and for th e following two centuries, there were very few higher education outlets and the outlets in place were centered on white protestant men studying religion Early forms of e du cation were funded by the Church. P ostsecondary education began to develop outside the chu rch as private institutions. There was no financial a id available for students who desired to attend these private institutions To provide students access to higher education, Lady Anne (Radcliffe) Mowlson created the first scholarship in 1643 This scholarship provided 100 British pounds to help deprived men attend Harvard. Harvard University was founded in 1636 and is the oldest institution of higher education in the United States B y the time of the Revolutionary War, there were already nine established chartered degree granting colleges in the colonies: Harvard, William and Mary, Collegiate School (Yale ), Academy of Philadelphia (University of Dartmouth However, all these college institutions were modeled ba sed on C ambridge and Oxford which meant that they required religious affiliation. A college education was therefore extremely exclusive and the cost of operating a university made the price of higher education exorbitant for common American men. Monetary encoura gement and college admittance remained insignificant although the church continued to provide financial support for students entering the ministry.

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 6 The Co nstitutional Convention of 1787 created a setback in the history of American post secondary educatio n development because it did not address higher education. Delegates of the convention such as James Madison and President George Washington battled for a national university free of religious membership, but their recommendations were ignored because Cong ress believed this matter should be left to each state. Thomas Jefferson was an influential figure in this scenario because he was one of the earliest proponents of state education in America and strongly believed in education being centere support ing democracy. (Addis 2003). Stat e education was considered to be primary school through college but did not take place until after the civil war. T he American branch of the Enlightenment played a significant role in the 18 th century movement towards the development of a state university system This system would expa nd human rights through making education available and affordable to all white males. The Morrill Land Act of 1862 caused 69 colleges to be established with the the forma tion of research un the foundations for the evolution of American post secondary education. Other institutions that were already developed expanded their programs, o ften in science and technology by constructing new colleges and disciplines into already dominant institutions. This rapid expansion in the 19 th century greatly benefited the future of American education development. H owever, start up universities had major financial distresses and therefore, student

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 7 loans was a topic still not addressed Societal perception of higher education was changing, increasing the need for funding and accessible education facilities. As time progressed, the supply of education would slowly reach demand and transform American post secondary education forever. B. The Twentieth Century Higher Education Era Post war prosperity following World War I and a new outlook on higher education affected college attendance causing it to almost double between 1920 and 1930. The next great jump in college enrollment and degrees awarded happened when members of the armed forces returned home from World War II. Post World War I n umbers are insignificant in comparison to the number of people entering college after World War II and the GI Bill created a grant to pay the college expenses of military members The Act provided monetary aid to pay for college tuition in return for two years of service in the Uni ted States armed forces. Consequently mass education for Americans began when 4.4 million World War II veterans returned home and attended college The GI Bill on the other hand, was not considered financial aid for college Instead it was regarded service s Therefore the concept of providing federal support for higher education became a politically motivated matter and numerous Americans who would not have formerly considered post secondary education went to college With these bills attending college started to become a social norm for middle class Americans seeking professional occupations.

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 8 The College Scholarship Service of 1954 was composed of a board of private institutions who came together in order to improve their systems of awarding financial aid. This im provement was seen in the criteria they used to select the students who received financial aid They removed the financial co nsiderations when evaluating their application s This would cause financial aid to be awarded ba sed on academic competence. This is the sp onsored merit based grants. An other rule created allowed less gifted but worthy students to still qualify for money and entrance to less selective schools. The College Scholarship Service designed prototyp es of high and low tuition aid based on financial need of students. These proto types were actually never executed at that time, but made their way into to the fi nancial aid system later, such as the Free Application for Federal Student Aid (FAFSA) The National Defense Education Act of 1958 was the first federal intervent ion in highe r education as a response to the 1947 report that the United States was falling behind in fields of science and engineering These fears developed when the Soviet Union launched Sputnik This Act was also created as a result of an increase demand for access to college higher education by providing low interest direct student loans capitalized by U.S. Treasury funds. T he federal governm ent then perfected its role by assisting students pursuing post secondary educa tion through the Higher Education Act of 1965. Title IV of this Act addressed the financial assistance to students through previously developed Educational Opportunity Grants based on institutions aggressively pursuing students with remarkable economic ne cessities. The Guaranteed Student Loan Program was

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 9 created to serve middle income students by providing loan subsidies. The government after graduation paid the difference between a set low inte rest rate and the market rate Prevailing budget rules in Congress made the guarantee approach seem more attractive than the direct loan approach in t he early years of student loan development. To distinguish the advantages and disadvantages that each one brings to the student and to the government issuing these lending terms it is important to understand the mechanisms of these two distinct types of student lending T he direct loans would have to appear in the United States budget as a total loss in th e year it was issued, even though the majority of its funds would be compensated with additional interest in the future years. The guaranteed student loan was backed up by the full faith and credit of the United States Treasury Guaranteed student loans were supported by private bank loans with no initial cost to the government. This occurred because ts and interest subsidies did not occur until future years The lack of recording liabilities in guarantee lending meth ods elevated alarms among many economists who were worried about the government making financial obligations without bookkeeping eventual future charges In 1972, the reauthorization of the H igher Education Act by Congress set in stone the basic foundatio ns of the present federal student aid system. This reauthorization contained some changes and improvements to the original document such as new types of assistance, expanded opportunity grants and more incentives for the individual states. This expansion continued to happen through the following decades.

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 10 In 1978 the Pell Grant arose from the Basic Economic Opportunity Grants. It was the largest to d ate and it was created to encourage students from low total income families to attend college. The Middl e Income Assistance Act of 1978 extended the eligibility of the Pell Grant in order to further tailor college education to middle class Americans. In addition, the State Student Incentive Grant Program was also a program established through the Higher Edu cation Act that presented equivalent funds to states to promote their separate need based financial aid programs and within three years of foundation, al l fifty states took part in it. In the 1980s, a sudden rise in tuition and a cut in government spending created a great gap between the availability of federal support and right of entry to educational organizations. Although the demand for student loans was rising steadily, the leveling of student aid spending by the federal government was accountable for the shift towards loan spending and away from grant spending that has been continuous through today. T o adapt standard rules for student aid eligibility and financial aid regu late stude nt loan policies. 1980s, the cost of co llege reached an all time high. During these decades, inflation held the fee of college education to unreasonable levels. In spite of these costs parents and students continue d to sacrifice to register for college, often incurring enormous debt result ing from complex student loans. Subsequently and 1990, the number of colleges and universities almost doubled, from 1,851 to (Lazerson 1998) and state and federal expenditure s on advanced education

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 11 climbed. y of postwar Prestige undergraduates and assurance powered the motivation to magnify wealth and build powerful institutions during the of American colleges and universities. In 1990 with the support of President George H. W. Bush, the Federal Credit Reform Act transformed all government loan programs, guaranteed or directed loans to a side when the loan is first made that will cover its costs to the government ove r the life of the loan. This regulatory shift in the accounting of student loans occurred because the transparen recognizing these costs sporadically on a cash basis over several years as payments This approach was more logic al than budget changes and policy negotiations In 1992, the government furthered its perfection of student lending program s for college students, by creating a pilot direct lending p rogram based on an analysis that proved direct loans to be less costly and easier to manage than guarante ed loans. Specifically, the study showed that direct lending would provide identical credits to students at considerably lower rates to taxpayers.

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 12 In 1993, President Clinton proposed replacing the guaranteed loans with direct loans as a part of his defi cit reduction plan. This phase of inclination towards direct lending started as a part of the Omnibus Reconciliation Act of 1993. It gave financial incentives to colleges willing to participate in this shift and gave the Secretary of Education the power t o oblige colleges and universities to switch to this technique until at least 60% of nation wide loans were direct. Along with this en try level shift of student loan types, 1993 also brought the next phase of widening gaps between loan and grant spending t hrough prog rams that amplified borrowing pa rameters and approved unsubsidized loans for middle class students. Fundam entally, more students qualified for aid. A s more students sought higher education, tuition also increased. Unfortunately, this occurred at a rate above inflation, outperforming the ordinary family income during the 1990s, causing more student loan burden. I n 1994, although President Clinton had aggressively pursued a revision to the federal financial aid system when the Republican Party took control in the 1994 election the many long term rolling phases of this refurbishment were lost. The new Republicans in office tried to eliminate direct lending. T his was not very prosperous considering many colleges and government agencies were not pleased with the guaranteed loan program according to the Government Accountability Office. The prospects for the new method of direct lending were positive In 1997, the fi rst lawful order of non need based federal financial aid became tax credits for college expenses. The last advancement in the history of student loans came in 1998 with the reauthorization of the Higher Education Act that reorganized

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 13 federal program s Education. C. The Revolutionary Twentieth First Century in American Student Aid This setback in the evolution of student loans was unfortunately made reality by R epublicans through their con tinuous push for guaranteed loans but it only stopped direct lending for a short term horizon. Also, this elimination was only m ade possible because of the Republicans Majority in Congress. Republicans were able to pass a law that prohibited the Department of Education from requiring colleges to switch to the direct loan program. This result ed in a decline in the direct loan program usage and many colleges switch ed back to the guarantee d program. This was triggered by old fashion political party bosses according to a team of undercover journalists from U.S. News and World Report in 2003, who investigated the along with their friends in Congress and the Department of Education to get what B y 2007, direct lending reached an all time low since it was first established in the 1990s, but not for long. The system of federal financial aid was not in good standing in re lation to its potential to achieve success because it was governed by the self interest of politicians and the programs offered were numerous and difficult to manage. The system was chronically underperformin g and its deterioration was highly visible. Higher education needed to be more affordable for the government. T his could be accomplished through decreasing grant spending and increasing l oan spending in a manner that would close this gap seen as a trend in previous years. Students

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 14 tremendously rel ied on student loans to pay for college and the increased demand for a higher education reached its peak as technology advanced and the U.S. economy continued to expand. However, tuition prices dramatically increased well beyond the Pell Grant maximum. C lear ly, the system needed to be reform ed. It was no t until the credit crisis of 2008 issues with student loans. This shift from guaranteed loans to direct loans occurred in 2008 when the credit crisis endangered the capability of numerous private banks to issue loans through the guaranteed stu dent loan program which caused banks to stop participating in the guaranteed program Consequently, colleges and universities were forced to switc h to the direct lending program which substantially increased the volume of direct loans in relation to the total market share of student loans Also, as a result of this credit bubble, legislators completely altered the configuration and maneuvers of the F ederal Family Education Program to save the future of American higher education. This was done by allowing the Department of Education to buy guaranteed loans made by private financiers and to use the proceeds from these loans to create new stude nt loans. This temporary program used to save the funding for post secondary education during the recession of 2008 and 2009 was call ed the Ensuring Continued A ccess to S tudent Loans Act (ECASLA) and was a major turning point in the history of the guarant eed loans program because it provided federal capital to private banks who wer e lending money for student loans This addendum to the guaranteed student loan program s actually made it very similar to the direct lending program structure.

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 15 Since the two stu dent loans programs were now very similar, in 2010 President Obama proposed i n his budget plan that Congress eliminate the gu aranteed loan program completely for the sake of the financial health and efficiency. His argument was that interest paid to priva te banks was wasted capital since the same product could be delivered at a lower cost through direct lending. On July 1 2010, C ongress passed this bill and it was signed into law eliminating the FFEL program and all federal student loans to this date have been made through the direct loan program. This change will save $68.7 billion over the following decade T hese savings will be used to increase funding for the Pell Grant progr am, benefiting US students even further. II. Present State of Student Finances From 1958 to the present, the government has been involved in student finances either through a guaranteed program or through a direct loan program. The following section will defi ne a free market for student finances and will explain the benefits and drawbacks of implementing a free market system. It will also explore the current state of student finances in relation to the outstanding student loan debt and de fault rates on student loans A) Defining a Free Market for Student F inances A true free market system for student finances would include a number of features. First banks would loan money to students directly and the students would then pay the university. Market forces including risk level and supply and demand would affect the interest rates for student loans. The risk levels would be based on two aspects: income and earnings potential after college. For example, if a student is a

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 16 dependent and comes from a wealthy family, there is a low risk that the student will default. In addition, if a student chooses a career path with high earning potential, there is also a low risk that the student will default. Family income and family assets are the components of income The bank or financial institution giving the loan would calculate an earnings potential metric by factoring into account major, number of credit hours, and grade point average. However, the risk level metrics would vary by financial institution, as different students would be perceived to have different levels of risk. The interest rates would also depend on fluctuations in supply and demand. Supply and demand refer to the supp ly and demand for loans. On a supply and demand diagram, the quantity is the available funds and the price is the interest rate. Under this defined free market system, banks would be subject to usury laws. Usury laws are unlawful rates of interest (Emers on 123). By definition, interest is a charge for the use of money and does not extend to finance charges or carrying charges that are related to the sale of goods (Emerson 123). These laws target the practice of charging excessively high rates on loans and vary significantly by state (Emerson 123). For example, in the state of Florida, the maximum interest rate depends on the amount of the loan. The maximum interest rate on a loan of less than $500,000 is 18%, while the maximum interest rate on a loan gre ater than $500,000 is 25% (Usury Laws). In Louisiana, the maximum legal interest rate on loans is 12%. The re is an exception to this maximum legal rate ; adjustable rate mortgages can be up to 17% (Usury Laws). In New Hampshire, there is no limit on charge able interest

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 17 rates. I n Michigan, the maximum legal limit on loans is 7% with a few exceptions (Usury Laws). These examples demonstrate that usury laws vary greatly depending on state. This is significant because th e binding price ceiling effect is deter mined by which usury laws are in place. In effect, the usury laws create a price ceiling on the traditional supply and demand curve. Although usury laws are government regulations, they are factored into this free market model because this model only foc uses on student finances, not other finances such as mortgages, car loans, and credit card loans. If this was truly a free market system, all federal direct loans and guaranteed loans would be eliminated. In addition government programs involved in stude nt finances, primarily Sallie Mae, would be eliminated. B) Benefits and Drawbacks of Implementing a Free Market S ystem One of the most significant benefits of a free market system for student finances is that there would be fewer burdens placed on taxpayers. As outstanding student debt burden continues to increase (Rampell). In addition, another benefit of the free market system is that it would encourage students to be more re sponsibl e with their student loan money. It would encourage these students to strictly use their student loan money for educational expenses. W e conducted a survey to determine how many students spend their student loans on non educational expenses. The findings showed

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 18 that a significant number of students use their loans for other expenses including clothes, vacations, and other leisure activities (Survey). Another benefit of the free market system is that it would potentially lower overall tuition co sts. P roponents strongly believe that government programs cause tuition prices to increase. W hen the government provides student loan subsidies, the educational institution can charge higher tuition because the students are not directly paying tuition, but instead pay tuition through an external source. However, if the government does not pay for tuition, supply and demand restrictions could push prices down. More specifically, an elimination of government subsidies could cause the demand curve to shif t leftward, decreasing the price. This would decrease the number of Americans applying to colleges thus decreasing the demand of higher education. One of the major drawbacks of this free market system is that it could cause higher interest rates. With go vernment intervention, the interest rates are capped at 8.4%, but with out government intervention, interest rates would be capped at the rates allowed by state usury laws. For example, in the state of Florida, since usury laws are capped at 18% for loans under $500,000, a bank could charge a student up to 18% for a student loan. In addition, another drawback is that if credit markets freeze, the supply curve would shift leftward, causing interest rates to rise. This is s supply disruptions. Since banks and other financial institutions are hesitant to loan money, these insti tutions require higher rates of return to compensate for higher risk.

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 19 However, since the usury laws limit the interest rate banks can charge, the banks ma y not issue any loans at all In economics, this concept is called a binding price ceiling. A price ceiling is a price above which it is illegal to charge. A binding price ceiling occurs when the price ceiling is set below the free market price. This binding price ceiling causes suppliers to exit the market, creating a shortage. In addition, the binding price ceiling creates excess demand because prices cannot rise above a given level. If the free market interest rate is 19%, but the usury law s (a price ceiling) restrict interest rates to 18%, the supply will decrease. I n the state of Michigan, the maximum interest rate is 7%. Thus, if market interest rates are 8%, the binding price ceiling would take effect. Exhibit 1 demonstrates the bindi ng price ceiling in student finances. Another drawback to the free market system is that low income families would have reduced access to student loans, further expanding the income inequality gap. Exhibit 1

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 20 C) Outstanding Student D ebt The amount of outst anding student debt varies slightly by source, but most sources state outstanding student debt is approximately $1 trillion. According to CBS Money Watch, the outstanding student debt as of November of 2012 was $956 billion (Schlesinger). The New York Time s states the outstanding student debt exceeds $1 trillion. There is $864 billion in federal government loan debt and $150 billion in private loan debt (Rampell). The New York Times presented a greater focus on private loans. A report from the Consumer Fi nancial Protection Bureau described that private lenders misled borrowers, or students, by offering loans at higher interest rates than federal loans. In addition, these loans were harder to discharge in bankruptcy (Rampell). Student loan debt should be compared to other forms of debt to determine whether student debt levels have created a bubble. Other forms of debt include auto loan debt, credit card debt, and mortgage debt. According to CBS Money Watch, when compared with auto loan debt, credit card debt, and mortgage debt, student debt has been increas ing significantly (Schlesinger) A report from the Federal Reserve Bank of New York cites statistics about different types of debt. According to the report, mortgage debt is at its lowest point since 2006, or $8.03 trillion (Federal Reserve Bank of New York). However, mortgage originations rose to $521 billion, the fourth consecutive quarterly increase. Delinquency rates for mortgages decreased from 6.3% to 5.9% (Federal Re serve Bank of New York). Using statistics about outstanding student loan debt and comparing it to other forms of debt helps to answer the following question: is the United States in a student

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 21 loan bubble? Derek Thompson, editor of The Atlantic does not b elieve the United States is in a student loan bubble (Thompson). Thompson emphasizes that students should focus on the c ollege premium, or the bonus students sho uld expect to receive from attending college. rice at the following sticker prices: $57,950 for Harvard University, $27,453 for a 4 year school, and $15,267 for a 2 year school (Thompson). He states that all three sti cker prices are far higher than what students actually pay for their education. Thompson believes that instead of foc using on student debt levels, Americans need to focus on fixing what Thompson calls the middle class crisis (Thompson). He states American s need to improve the human capital of the middle class, and allow them to be more clever and skilled in their jobs. Thompson also points out that many families do not take advantage of financial aid due to the perceived complexity of financial aid forms ( Thompson). However, consumerist.com believes the United States is in a student loan bubble (Quirk). According to the article, the riskiest borrowers, or the sub prime borrowers, hold 1/3 of the $900 billion of student loan debt outstanding. The article also discusses how higher student loan debt is creating a generation of high risk borrowers with low credit scores. These low credit scores prevent or delay college graduates from buying their first homes (Quirk).

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 22 D) Default Rates on Student Loans T he default rate on student loans is one of the most important indicators of student financing. According to consumerist.com, between 2005 and 2012, FICO found a 47% increase in borrowers who were at least 90 days behind on their payments. FICO is a public company that provides analytics services, including credit scoring (Morran). Seeking Alpha s tates the delinquency rate for student loans is now higher than the delinquency rates for credit cards, mortgages, auto loans, and home equity loans (Lokey). The information Seeking Alpha used was based on the 90+ day delinquency rates. A report by the De partment of Education found that the default rate on a 3 year cohort was 13.4% in 2012 In addition, 218 of those schools reported a 3 year default rate of over 30% and 37 of those schools reported a default rate of over 40% (Lokey). Simple Tuition points out that there is a strong correlation among the cohort default rate and the unemployment rate for people between the ages of 19 24 and 25 34 (Si mple Tuition). The default rate on student loans is essential to determine if a student loan bubble exists. If too many borrowers default simultaneously, the bubble will burst. Although the student debt bubble would not be nearly as significant as the mortgage bubble, the current student debt levels and default rates are very similar to circumstances present i n the 2008 United States mortgage crisis. Evidence from various sources suggests the student debt bubble is similar to the mortgage bubble in that many students have taken out student loans they cannot pay back. These loans may be paid back eventually, bu t the payments could be significantly delayed.

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 23 III. Survey on Student Loans As part of the research on this subject we created a survey to determine how students at the Un iversity of Florida spend their loan money. The Unsubsidized Direct Loan from the Federal government referred to in the survey has an interest rate of 6.8%. Interest accrues immediately on this type of loan. The Subsidized Direct t for the past two years it has been 3.4% with the interest paid by the government until six months after graduation A) Methodology This section explores the methodology used in conducting the student survey. The survey contains 7 questions, some of which a re yes and no questions, some of which ask for a specific amount, and some of which are open ended. The questions for the student survey are the following: 1) Have you taken out any student loans? 2) Are you eligible for subsidized student loans? 3) If yo u qualified for student loans, did you take any out? 4) How much in loans did you take out each year? 5) How much in subsidized loans did you take out each year? 6) For what did you use your student loans? 7) Did you invest money from subsidized loans? If so, in what did you invest?

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 24 These seven questions ultimately strive to determine what proportion of students qualified for student loans and how many of them did or did not take out these loans. The survey is purposely short to increase the response rate. Since students do not pay interest on subsidized loans until after they graduate, financial theory suggests students should take out subsidized loans, and should invest any unused money to generate a positive return, thereby executing arbitrage. The cent ral argument is that if students qualify for subsidized student loans, but do not take them out, they forego the opportunity to execute student loan arbitrage. The survey is not made to con sider students who are not eligible for student loans. These students most likely have parents who are wealthy and who can afford to pay for education without government aid. In addition, the survey does not consider students who qualify for unsubsidized or subsidized loans, but do require all of their loan money t o pay for educational expenses. The only group of students that can execute student loan arbitrage is students who qualify for subsidized loans, but who do not require these loans to pay for educational expenses. Another point is that question 6 of the su rvey attempts to determine how many students use loan money for items other than educational expenses. Students who do not require subsidized loans, but take them out to pay for leisure activities, do not execute arbitrage. Question 7 is significant becaus e it determines what types of investments students make with unused funds: low risk investments or high risk investments. This question helps to separate students who execute complete arbitrage return in the form of a treasury security investment determines if a student executes full arbitrage. Treasury

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 25 securities are almost entirely risk free and demonstrate the most precise definition of arbitrage, though they generate fairly insignificant ret urns. However, students who invest in low risk securities such as corporate bonds or high risk securities such as to be safe securities, full arbitrage is defined as only in vesting in tr easury securities, which are risk free. B) Survey Results Based on a sample of 83 respondents some information about what eligible students spend their loan money on was able to be determined. There are some limitations to this survey since it polled only U niversity of Florida students and used a small sample, but it shows that there is potential for students to spend loan money on items other than educational expenses. Throughout the survey results information about the overall University of Florida will be provided from the Bursars fact sheet. Total loans for the University of Florida amounted to $263,623,818 in the 2011 2012 fiscal year. Total federal aid including grants and loans amounted to $307,787,681. The loan breakdown from the university fact b ook is as follows: Type of loan Number of awards* Subsidized Stafford 18,309 $91,106,912 Unsubsidized Stafford 17,300 $125,632,939 *One student can receive both types so the number of awards can i nclude duplications of students

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 26 There were a total of 32,008 undergraduate students for this academic year so over half are eligible for subsidized loans. This is all information collected from the As for the survey conducted the answer to the first question showed responses were close but did not completely align with the university data. Exhibit 2 The next question asked if the students had ever been eligible for subsidized loans. The results showed that 24.4% of students were unsure, 59.8% said yes, and 15.9% said no. For the 24.4% who said unsure, that means they had not even thought about taking out the loans to do something with them other than the convention al paying for school. For the next questions the results showed that 38% of students who qualified for subsidized student loans did not take them out. This means that they are forgoing the opportunity for essentially free money with no interest until six months after graduation. Of the students that qualified for both types of loans the pie charts below show how much they borrowed each year in total and in only subsidized loans 48% 24% 25% 3% no loans sub loans unsub loans bank loans Student Loan Data

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 27 Exhibit 3 Exhibit 4 One of the key questions for this survey is what the students that borrowed spent their loan money on. Below are the results from the survey Students could check multiple answers so their responses are depicted in a bar chart Exhibit 5 The important part of these results is the fun items segment which includes students spending their money on nonessential items and instea d on items that they want Also the investing activities response is very important. Later will be discussed how the students spending the money on fun items could instead be used as an investment to earn a positive return. 15% 15% 33% 37% $0-1000 $1001-2500 $2501-5000 >$5000 32% 36% 14% 18% $0-1000 $1001-2500 $2501-5000 >$5000 Sub Amount of Loans Total Amount of Loans

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 28 The next question targeted students who invest their loan money. The goal was to determine in what they were investing The responses included: consumer du rables, defense, savings account s, SRGE, ONTC, and FROG 2000. O ne person responded that investing loan money was illegal. A savings account is not actually i nvesting because investors cannot earn a significant rate of retur n. Therefore, the student does not completely understand the importance of investment returns The student who thought it was illegal to invest loan money was not investing money based on false ethical behavior. The last question asked on the survey t argeted students with loans. The goal was to see if students knew the interest rate of their loans Eleven students said they were unsure what the rate of interest was on their loan. Although they did not know the exact rate s ome did mention that their interest rate was the federal loan rate This represents an incomplete understanding of the interest rate paid because the different types of federal loans have different interest rates. On e person said that they did not know what the rate was but that they do not have to pay any interest until six months after graduation. Three students stated that their loan rate is 6.8%. Two students responded that their loan rate is 6%, one student said 3.6% and one student said 2.73%. The students who responded 6.8% have taken out unsubsidized student loans or subsidized loan s when the rate of interest was still at 6.8%. The students that answered 6% may have just left off the 0.8% at the end or they could be like the 3.6% and the 2.73% who may have taken out bank loans.

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 29 Overall the survey provided information about the students taking out student loans, what they are doing with th e money they receive and if they have knowledge about the interest rate they are currently accumulating or will have to pay once they graduate. IV. Arbitrage A) History of Arbitrage Arbitrage in general is the practice of taking advantage of a price differential between two or more markets. Arbitrage is supposed to be risk free, but in reality there are always risks when practicing arbitrage. The concept of arbitrage has been around since ancient times, when it was risky, and has evolved to the mode rn meaning of a trading strategy that has low risk and possible outcomes of negative returns but in most scenarios positive returns occur In ancient times arbitrage was hindered by the lack of liquidity in markets, lack of information, and the labor re quired to move goods over long distances. Geoffrey Poit r s paper regarding historical arbitrage i n the Middle East states the first arbitrages can be traced back to as early as 1760 B C from the Code of Hammurabi. Since two payments for goods were separated by great distances and in different bullion currencies some merchants were too risk adverse to carry significant amounts of money a cross long distances. Arbitrage rs were able to make a positive return by making a local payment in exchange for t he good s of local suppliers at a lower cost, transporting the goods and selling them for a higher price.

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 30 The first exchange rate arbitrage occurred in 650 B C when there was a standardization of money. Based on the value of gold and silver the exchange rates would differ in different geographic areas. In those times arbitrage result ed from trading knowledge and n ot of being a career arbitrager because the link of information about exchange rates was created by trading goods. In the Middle A ges excha nge rates were set for the duration of fairs, where merchants engage d in bill trading, which meant that fairs in the same area had similar exchange rates but if a merchant left the local area and went to other fairs there was the potential for exchange a rbitrage. When the bill exchange developed there was more potential for exchange arbitrage because of the different rates for the bills in different areas. Arbitrage was monitored by the church in tha t if exchange rates set forth were too different in lo cal areas, the church would issue sanctions. The bills used in this arbitrage represented bullion currency. In the 16 th century exchanges started to replace the fairs for the bill exchanging and banking developed as a career. Since ancient times, arbitr age has developed in a very technical way. There are various forms of arbitrage including merger arbitrage, bonds arbitrage, dual listed companies, statistical arbitrage and regulatory arbitrage. Student loan arbitrage falls in the realm of bond arbitra ge and regulatory arbitrage since it is essentially a loan from the government. B) Student Loan Arbitrage Student loans from government partnerships have been around in different forms for over 25 years. During that period, the Internal Revenue Service put out rules

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 31 regarding arbitrage through swaps for the issuers of student debt, but never addressed rules for the students receiving the loans. i) Subsidized Stafford Student Loan Arbitrage The theory behind student loan arbit rage in subsidized student loans is that the government pays all of the interest until six months after graduation. Subsidized student loans are granted based on need, so in order for arbitrage to occur the student must be deemed by the government to nee d subsidized financial assistance and the student must have the capability to pay for school through other means than the loan. These other means could be through parental contributions, savings from prior years of work, etc. Students are determined to be eligible for subsidized Stafford student loans based on the following formula created by the federal government: Calculated Need (Loan Eligibility) = Cost of Attendance Expected Family Contribution Fi nancial Assistance* Cost of attendance is determined by the subsidized federal Stafford loan is offered only to meet the calculated need. The amount will be lesser the annual limit or the calculated need, whichever is less. When the calculat ed need is zero or less, the student is eligible only for an unsubsidized Financial assistance includes any other funds received or awarded by the of institutional scholarships, tuition waivers, work study, private scholarships, private

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 32 financial assistances reduce the total loan amount for which students are eligible. Te chnically the money from these other assistances could be invested at a zero cost to commit arbitrage, but the money never has to be paid back to the issuing institution Therefore, using the money from these programs is more of an investing strategy than an arbitrage opportunity. T he amount awarded in financial aid from government loans increases as the number of years in school increases, which means in the later years of school more money will be available to invest, but it will have less time t o earn a return. If this way of disbursing loan money was reversed there would be even greater potential for higher return on arbitrage. Once a student is deemed eligible for subsidized student loans, each semester the loans are disbursed with a 1% service fe e taken out. To commit arbitrage a higher return than 1% must be made over the investm ent period of the loan For example a student entering the first semester of college and planning on attending school for the full four years would have four and a ha lf years to generate a return on this investment of greater than 1% As each semester progresses the amount of time to invest the loan money decreases in approximately six month increments. Assuming the last loan is taken out in January of the fourth yea r of schooling there is still almost an entire year to invest due to the time of graduation and the six month time frame of repayment. All of the investments made must become liquid six months after graduation, so all of the loans can be paid back in on e l ump sum to avoid any interest payments on

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 33 the loans. This would make the only cost of the loans the 1% service fee because up until six months aft er graduation the government subsidizes all of the interest payments that would have been required if the loan was unsubsidized. There is an additional tax benefit to schooling that could also be taken into account in determining personal benefit and returns from student loan arbitrage. Acco rding to TurboTax, there is an American Opportunity tax credit that will cover tuition payments and the cost of books and supplies in the first four years of schooling as long as the student maintains at least half time status. This credit allows for up t o $2,500 of the costs stated above becomes a tax credit, of which up to 40% or $1000 is refundable. According to the IR S, even if a student does not owe any taxes, the student can receive this $ 1,000 back assuming the student reaches the maximum credit. To be eligible for the credit enerally, a taxpayer whose modified adjusted gross income is $80,000 or less ($160,000 or less for joint filers) can claim the credit for the qualified expenses of an eligible student. The credit is re duced A taxpayer whose modified adjusted gross income is greater than $90,000 ($180,000 for joint filers) cannot claim the Overall the tax credit can add an extra benefit to investing the loan money through refunded tax money when tuition is paid from a different s ource. For the American Opportunity Tax Credit, an eligi (1) is enrolled in a program leading toward a degree, certificate or other recognized post secondary educational credential; (2) has not completed the first four years of post secondary education as of the beginning of the taxable year; (3) for at least one

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 34 academic period is carrying at least of the normal full time work load for the course of study the student is pursuing; and (4) has not been convicted of a felony Overall subsidized student loan arbitrage is very easy to commit as long as the student is deemed to need enough financial assistance to qualify for subsidized loans from the government and has other means of paying for school. Below are exhibits that show investment in four year certificate s of deposit, 30 year treasury bonds to mimic the risk free rate, and the S&P 500. The rate of interest on the subsidized student loans has been removed because it is not relevant si nce the government pays the interest In later exhibits for other loans the interest rate of the loan will be shown. Subsidized student loans have only been available since 2008 so the return data depicts this restriction. Exhibit 6 2008 2009 2010 2011 2012 30 Year Treasury 4.28% 4.08% 4.25% 3.90% 2.92% 4 year CD 4.31% 3.14% 2.37% 1.72% 1.30% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% Interest Rate Subsidized Student Loans

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 35 ii) Unsubsidized Stafford Student Loan Arbitrage Although subsidized student loan arbitrage is the easiest way to commit arbitrage because there is only a 1% service fee hurdle to make the investment pay off, arbitrage is still possible with unsubsidized student loans. The government de termines eligibility for unsubsidized loans through a different formula. Students eligible for subsidized loans are always also eligible for unsubsidized loans. These loa ns increase in the amount granted as the years of school ing completed increase s. The following is the formula for the calculation of need for unsubsidized Stafford loans: Calculated Need* = Cost of Atte ndance Financial Assistance ford Loan is non need based. It may consist of the annual loan limits (for first through fifth year grade levels) as well as additional unsubsidized loan funds for independent students. As of July 1, 2008, all undergraduate borrowers, regardless of depende ncy, can receive an additional $2,000 in unsubsidized Stafford 2008 2009 2010 2011 2012 30 Year Treasury 4.28% 4.08% 4.25% 3.90% 2.92% SPY S&P 500 -36.42% 19.88% 11.73% -0.17% 13.47% 4 year CD 4.31% 3.14% 2.37% 1.72% 1.30% -40.00% -30.00% -20.00% -10.00% 0.00% 10.00% 20.00% 30.00% Interest Rate Subsidized Student Loans

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 36 contribution. This is because it is not a need based loan. The additional unsubsidized loan for independent student s is calculated by the following: Additional Unsubsidized Eligibility = Cost of Att endance Financial Assistance The method to commit arbitrage for unsubsidized loans is to invest at a higher rate than the 1% service fee and the yearly interest rate Below are exhibits of rates for unsubsidized loans and returns on 30 year treasury securities, 4 year certificates of deposits and the S&P market the interest rate for the loans of 6.8% is much higher than the riskless opt ions. Looking into the riskier S&P 500 in some years the returns are greater than the cost of the loans, but in other years there would be a significant loss, making investing in the S&P 500 more of an investing str ategy than pure arbitrage. I f the econ omy improves this form of arbitrage may become possible. Exhibit 7 2008 2009 2010 2011 2012 Student Loan rate 6.80% 6.80% 6.80% 6.80% 6.80% 30 Year Treasury 4.28% 4.08% 4.25% 3.90% 2.92% 4 year CD 4.31% 3.14% 2.37% 1.72% 1.30% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% Interest Rate Unsubsidized Student Loans

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 37 iii) Variable Student Loan Arbitrage Variable rate student loans existed from 1992 until 2007 when they were replaced by the fixed rate St afford loans. The variable interest rate is calculated until 2010 beca use students, who started school in 2007, were still eligible for the in school rate until 2010. All of the rates used will be the in school rates because to commit arbitrage while remaining a student the stude nt would pay back the loans upon graduation. Exhibit 8 2008 2009 2010 2011 2012 Student Loan rate 6.80% 6.80% 6.80% 6.80% 6.80% SPY S&P 500 -36.42% 19.88% 11.73% -0.17% 13.47% -40.00% -30.00% -20.00% -10.00% 0.00% 10.00% 20.00% 30.00% Interest Rate Unsubsidized Student Loans 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 Student Loan rate 6.94 6.22 7.43 8.25 8.25 8.25 7.46 6.92 8.19 5.99 4.06 3.42 3.37 5.30 7.14 7.22 4.21 2.48 2.47 SPY S&P 500 4.46 7.06 -1.5 34.1 20.2 31.0 26.6 19.5 -10. -13. -23. 26.3 8.99 3.00 13.6 3.53 -36. 19.8 11.7 -40.00% -20.00% 0.00% 20.00% 40.00% Interest Rate Variable Student Loans

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 38 A six month CD rate is used because that historical data was available since 1992, and because the rate is reset every year for the student loan variable cost, so the investment horizon is less than a year before the studen t would have to reevaluate the investments t o determine if arbitrage was still feasible. The six month rate is very similar to the longer term rates for certain period of times as can be seen in Exhibit 9 on the next page. E xhibit 8 above shows that through investing in the S&P 500 the student would have e arned a positive return on investment s during the following years: 1995 1999, 2003 2004, and 2009 2010. This, although not riskless, does show that a profit through investing is possible. Exhibit 8 also shows that the 30 year treasury rate, or the risk free rate, is greater than the student loan rate in the beginning of 2002 to the beginning of 2005 and then again in the beginning of 2009 until 2010 This demonstrates that arbitrage would have been possible during these times since the risk free rate of investing was higher than the cost of the interest rate of the loans. The six month CD never makes enough to generate a positive return because the cost of the loan is too great. 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 Student Loan rate 6.94 6.22 7.43 8.25 8.25 8.25 7.46 6.92 8.19 5.99 4.06 3.42 3.37 5.30 7.14 7.22 4.21 2.48 2.47 30 Year Treasury 7.67 6.59 7.34 6.88 6.70 6.60 5.57 5.87 5.94 5.49 5.28 4.93 5.03 4.57 4.88 4.84 4.28 4.08 4.25 6 month CD 3.80 3.78 5.05 6.10 5.39 5.69 5.33 5.49 6.55 3.68 1.76 1.16 3.75 3.74 5.28 5.36 3.68 1.27 0.64 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% Interest Rate Variable Student Loans

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 39 Exhibit 9 The time horizon on variable loans is very complicated because the investments to commit arbitrage need to be more liquid than the other forms of loans due to the variable rate changing every year based on the economy. The variable rate also had different caps during this time frame. It was 9% until 1994 and then was 8.25% afterwards. Arbitrage would be com pletely possible if there was a longer term investment of a guaranteed return above the cap because then the variable nature of the loan would be eliminated. iv) Student Loan Arbitrage Summary The historical data of loan co sts and returns within the market demonstrate that arbitrage of student loans i s completely possible. T he easiest way is throu gh a subsidized loan but the data demonstrates that it is still possible to commit arbitrage on the other loan structures as well given the right market conditions. The following

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 40 are key factors for making a student a candidate to commit any of the kinds o f arbitrage listed : Being eligible for financ Direct Stafford loan program Having the actual costs of schooling paid for through some other means Investing in a security with a rate of return above the service fee costs and in the case of the unsubsidized loans the interest rate cost each year. C) Mortgage Student Loan Investing Strategy In some cases, student loan interest rates and the amount required to complete an education are so high and large that it makes financial sense to look focus will be on precisely defining how it to execute this investing strategy what restricts its execution, and how much money could be saved through its execution. i) Defining the Mortgag e I nvesting S trategy In this mortgage investing strategy the student takes advantage of differing interest rates on student loans and mortgages. Students may require the assistance of their parents to execute this strategy. The ste p by step process to e xecute this concept is the following: 1) The homeowner takes out a mortgage on a house, regardless of whether the homeowner has an existing mortgage 2) The homeowner uses the mortgage loan to pay for educational expenses 3) The homeowner pays the mortgage back at the mortgage interest rate, which is lower than the student interest rate

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 41 Arbitrage in finance is defined as the simultaneous purchase and sale of an asset in order to prof it from the difference in price. Arbitrage, also known as the law of one p rice, is one of the most significant concepts in finance (Livingston 133). The idea is that in a frictionless market, the same asset must have one price at a certain instance in time, regardless of where the asset is traded (Livingston 133). Arbitrage is clearest in a frictionless market that holds the following assumptions: no default risk, no taxes, no storage or transaction costs, and unrestricted short selling (Livingston 133). Since this concept does not involve the simultaneous purchase and sale of an asset, it is more appropriate to define this concept as a n investing strategy to reduce borrowing costs. ii) Potent ial Savings from the M ortgage Investing S trategy To determine the potential savings from executing a mortgage investing strategy it is necessary to first define the assumptions used to calculate these savings. First mortgage interest rates are calculated on a nominal basis, which is how traditional fixed mortgages are calculated. The nominal rate differs from the effective annu al rate (EAR). The nominal rate can be converted to the EAR by the following formula: 1 + EAR = [1 + (i (nom) /m)] m Nominal rates are calculated by dividing the nominal rate by the number of convers ion periods. For consistency, the nominal rate was us ed for both student loans and for mortga ges. A student loan rate of 6.8% and a mortgage rate of 3.74% were used. This mortgage rate was the 30 year fixed average as of March 24, 2013 (Mortgage Calculator). Savings is defined as the difference between the

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 42 monthly payment using the mortgage rate and the monthly payment using the student loan rate. This difference is then multiplied by 360, the number of payments throu ghout the course of the loan. This calculation of savings w as then discounted back using a required rate of return. The risk free rate used was the 30 year treasury yield for this required rate of return. The required rate of return was .02% per month. Exhibit 10 (p. 46 ) shows the potential savings for differen t loan amounts. In Exhibit 10 the first column is the loan amount, the second column is the monthly payment using the rate on student loans, and the third column is the monthly payment using the rate on mortgages. These payments were calculated using the payment function in Excel, and both use an annuity immediate not an annuity due. The fourth column simply calculates the difference between these two payments and the fifth column multiplies this difference by the number of payments, or in this case 360 p ayments. The sixth column then gives the present value of this total payment. Although the student loan rate changes infrequently, the mortgage rate changes frequently, as different lenders offer different rates. These rates are n ormally very similar, but an average was taken of 30 year fixed rates to create a valid comparison. To account for the variations in mortgage rates, a sensitivity analyses was conducted to examine the effect of changing the mortgage rate and changing the student rate. The sensitivity analysis uses four different loan amounts: $10,000, $50,000, $100,000, and $150,000. Each sensitivity analysis has its base case scenario or the assumption s in Exhibit 10

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 43 In addition, a savings analysis was conducted for a 15 year fixed mortgage. The APR used was 2.89%, which was the i nterest rate as of March 24, 2013. T he same student loan interest rate of 6.8% was used However, for this analysis, th e assumption was made that the loan for both the fixed rate mortgage and for the student loan was 15 years. Exhibit 11 (p.48 ) conveys the potential savings for different loan amounts. Exhibit 11 calculates savings and present value using the same assumptions as Exhibit 10 As i n Exhibit 10 in Exhibit 11 the first column is the loan amount, the second column is the monthly payment using the rate on student loans, and the third column is the mon thly payment using the rate on mortgages. These payments were again calculated using the payment function in Excel, and used an annuity immediate, not an annuity due. The fourth column again calculates the difference between these two payments and this f ifth column multiplies the diffe rence by the number of payments which in this case is 180. The sixth column then calculates the present value of thi s total payment. The requir ed rate of return is .02% per month. To account for the variations of fixed 15 ye ar mortgage rates, a sensitivity analysis was conducted for four different loan amounts: $10,000, $50,000, $100,000, and $150,000. iii) Restrictions in Executing the Mortgage Investing Strategy Executing this mortgage cost saving measure has restrictions, most importantly attaining access to a mortgage. The common rule of thumb fo r loan eligibility is that monthly mortgage payment s should not exceed 28% of gross income. The mortgage payment s in clude all components of the mortgage

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 44 including principal, interest, taxes, and insurance. These components are commonly referred to as PITI. However, if someone has a higher credit rating, he may be able to acquire a mortgage that is 30% to 40% of his gr oss income. Conclusion There are a number of points that can be concluded regarding the history of student finances, the present state of student finances, and the opportunity for arbitrage and investment in the student finance system. Regarding the his tory of student finances, there has not been a true free market for student finances since 1958. T here has been a constant shift between the direct loan program and guaranteed loan program. After the Obama administration eliminated the FFEL Program in 20 10, all government student loans have been direct. History has also shown that Americans value education now far more than they did in the 1600s and 1700s. S tudent debt levels and default rates have reached record highs. These default rates and debt le vels have created a generation of new students with low credit ratings and massive debt levels. While some believe the United States is not in a student loan bubble, it is clear that student debt levels are becoming increasingly important. There are two distinct methods that exploit loopholes in the American student aid system. First, students can commit full arbitrage using subsidized and unsubsidized student loans. While stricter conditions must be present to commit arbitrage with unsubsidized loans, this arbitrage can be executed in the right market conditions The second method is an investing strategy which helps

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 45 students reduce borrowing costs on student loans. Students can save thousands of dollars depending on how much money they need. Based on the student survey, it is evident that the majority of students do not take advantage of either loophole. Financial theory suggests these students forego an opportunity at free money and reduced borrowing costs from the investing strategy

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 46 Exhibit 10: 30 year fixed Loan Amount PMT (Student Rate) PMT (Mortgage Rate) Difference Total Savings PV (savings) 5,000.00 32.60 23.13 ($9.47) ($3,408.78) $3,288.64 10,000.00 65.19 46.25 ($18.94) ($6,817.57) $6,577.29 15,000.00 97.79 69.38 ($28.41) ($10,226.35) $9,865.93 20,000.00 130.39 92.51 ($37.88) ($13,635.13) $13,154.57 25,000.00 162.98 115.64 ($47.34) ($17,043.92) $16,443.21 30,000.00 195.58 138.76 ($56.81) ($20,452.70) $19,731.86 35,000.00 228.17 161.89 ($66.28) ($23,861.48) $23,020.50 40,000.00 260.77 185.02 ($75.75) ($27,270.27) $26,309.14 45,000.00 293.37 208.15 ($85.22) ($30,679.05) $29,597.79 50,000.00 325.96 231.27 ($94.69) ($34,087.83) $32,886.43 55,000.00 358.56 254.40 ($104.16) ($37,496.62) $36,175.07 60,000.00 391.16 277.53 ($113.63) ($40,905.40) $39,463.71 65,000.00 423.75 300.66 ($123.09) ($44,314.18) $42,752.36 70,000.00 456.35 323.78 ($132.56) ($47,722.97) $46,041.00 75,000.00 488.94 346.91 ($142.03) ($51,131.75) $49,329.64 80,000.00 521.54 370.04 ($151.50) ($54,540.53) $52,618.29 85,000.00 554.14 393.17 ($160.97) ($57,949.32) $55,906.93 90,000.00 586.73 416.29 ($170.44) ($61,358.10) $59,195.57 95,000.00 619.33 439.42 ($179.91) ($64,766.88) $62,484.21 100,000.00 651.93 462.55 ($189.38) ($68,175.67) $65,772.86 105,000.00 684.52 485.68 ($198.85) ($71,584.45) $69,061.50 110,000.00 717.12 508.80 ($208.31) ($74,993.23) $72,350.14 115,000.00 749.71 531.93 ($217.78) ($78,402.02) $75,638.79 120,000.00 782.31 555.06 ($227.25) ($81,810.80) $78,927.43 125,000.00 814.91 578.19 ($236.72) ($85,219.58) $82,216.07 130,000.00 847.50 601.31 ($246.19) ($88,628.37) $85,504.72 135,000.00 880.10 624.44 ($255.66) ($92,037.15) $88,793.36 140,000.00 912.70 647.57 ($265.13) ($95,445.93) $92,082.00 145,000.00 945.29 670.70 ($274.60) ($98,854.72) $95,370.64 150,000.00 977.89 693.82 ($284.07) ($102,263.50) $98,659.29 Assumptions Term (Years) Term (Months) 30 360 Student Loan Rate Mortgage Rate 6.80% 3.74% Nominal Student Loan Rate Nominal Mortgage Rate 0.57% 0.31% Monthly Required Rate of Return 0.02%

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 47 Exhibit 10A: Sensitivity Analysis: 30 year fixed $10,000 Loan Savings Student Loan Rate 6.25% 6.50% 6.75% 7.00% 7.25% 7.50% 3.00% 6,741.78 7,309.67 7,883.78 8,463.94 9,049.99 9,641.75 Mortgage 3.25% 6,269.36 6,837.24 7,411.35 7,991.52 8,577.56 9,169.32 Rate 3.50% 5,788.74 6,356.62 6,930.73 7,510.89 8,096.94 8,688.70 3.75% 5,300.04 5,867.92 6,442.03 7,022.19 7,608.24 8,200.00 4.00% 4,803.39 5,371.28 5,945.38 6,525.55 7,111.60 7,703.35 4.25% 4,298.93 4,866.82 5,440.93 6,021.09 6,607.14 7,198.90 $50,000 Loan Savings Student Loan Rate 6.25% 6.50% 6.75% 7.00% 7.25% 7.50% 3.00% 33,708.92 36,548.34 39,418.88 42,319.70 45,249.94 48,208.73 Mortgage 3.25% 31,346.80 34,186.22 37,056.77 39,957.58 42,887.82 45,846.61 Rate 3.50% 28,943.68 31,783.10 34,653.65 37,554.47 40,484.70 43,443.49 3.75% 26,500.19 29,339.61 32,210.15 35,110.97 38,041.21 41,000.00 4.00% 24,016.96 26,856.38 29,726.92 32,627.74 35,557.98 38,516.77 4.25% 21,494.67 24,334.09 27,204.64 30,105.46 33,035.69 35,994.48 $100,000 Loan Savings Student Loan Rate 6.25% 6.50% 6.75% 7.00% 7.25% 7.50% 3.00% 67,417.84 73,096.67 78,837.77 84,639.41 90,499.87 96,417.46 Mortgage 3.25% 62,693.60 68,372.44 74,113.53 79,915.17 85,775.64 91,693.22 Rate 3.50% 57,887.37 63,566.21 69,307.30 75,108.94 80,969.41 86,886.99 3.75% 53,000.37 58,679.21 64,420.30 70,221.94 76,082.41 81,999.99 4.00% 48,033.91 53,712.75 59,453.85 65,255.48 71,115.95 77,033.53 4.25% 42,989.35 48,668.19 54,409.28 60,210.92 66,071.39 71,988.97 $150,000 Loan Savings Student Loan Rate 6.25% 6.50% 6.75% 7.00% 7.25% 7.50% 3.00% 101,126.76 109,645.01 118,256.65 126,959.11 135,749.81 144,626.18 Mortgage 3.25% 94,040.40 102,558.66 111,170.30 119,872.75 128,663.46 137,539.83 Rate 3.50% 86,831.05 95,349.31 103,960.95 112,663.41 121,454.11 130,330.48 3.75% 79,500.56 88,018.82 96,630.46 105,332.91 114,123.62 122,999.99 4.00% 72,050.87 80,569.13 89,180.77 97,883.23 106,673.93 115,550.30 4.25% 64,484.02 73,002.28 81,613.92 90,316.38 99,107.08 107,983.45 *Note: The highlighted regions represent the current rates

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 48 Exhibit 11: 15 year fixed Loan Amount PMT (Student Rate) PMT (Mortgage Rate) Difference Total Savings PV (savings) 5,000.00 44.38 34.27 ($10.12) ($1,821.42) $1,788.85 10,000.00 88.77 68.53 ($20.24) ($3,642.85) $3,577.70 15,000.00 133.15 102.80 ($30.36) ($5,464.27) $5,366.56 20,000.00 177.54 137.06 ($40.48) ($7,285.69) $7,155.41 25,000.00 221.92 171.33 ($50.60) ($9,107.12) $8,944.26 30,000.00 266.31 205.59 ($60.71) ($10,928.54) $10,733.11 35,000.00 310.69 239.86 ($70.83) ($12,749.96) $12,521.96 40,000.00 355.07 274.12 ($80.95) ($14,571.39) $14,310.82 45,000.00 399.46 308.39 ($91.07) ($16,392.81) $16,099.67 50,000.00 443.84 342.65 ($101.19) ($18,214.23) $17,888.52 55,000.00 488.23 376.92 ($111.31) ($20,035.66) $19,677.37 60,000.00 532.61 411.18 ($121.43) ($21,857.08) $21,466.22 65,000.00 576.99 445.45 ($131.55) ($23,678.50) $23,255.07 70,000.00 621.38 479.71 ($141.67) ($25,499.93) $25,043.93 75,000.00 665.76 513.98 ($151.79) ($27,321.35) $26,832.78 80,000.00 710.15 548.24 ($161.90) ($29,142.77) $28,621.63 85,000.00 754.53 582.51 ($172.02) ($30,964.20) $30,410.48 90,000.00 798.92 616.77 ($182.14) ($32,785.62) $32,199.33 95,000.00 843.30 651.04 ($192.26) ($34,607.04) $33,988.19 100,000.00 887.68 685.30 ($202.38) ($36,428.47) $35,777.04 105,000.00 932.07 719.57 ($212.50) ($38,249.89) $37,565.89 110,000.00 976.45 753.83 ($222.62) ($40,071.31) $39,354.74 115,000.00 1,020.84 788.10 ($232.74) ($41,892.74) $41,143.59 120,000.00 1,065.22 822.36 ($242.86) ($43,714.16) $42,932.45 125,000.00 1,109.60 856.63 ($252.98) ($45,535.58) $44,721.30 130,000.00 1,153.99 890.89 ($263.09) ($47,357.01) $46,510.15 135,000.00 1,198.37 925.16 ($273.21) ($49,178.43) $48,299.00 140,000.00 1,242.76 959.42 ($283.33) ($50,999.85) $50,087.85 145,000.00 1,287.14 993.69 ($293.45) ($52,821.28) $51,876.71 150,000.00 1,331.53 1,027.96 ($303.57) ($54,642.70) $53,665.56 Assumptions Term (Years) Term (Months) 15 180 Student Loan Rate Mortgage Rate 6.80% 2.89% Nominal Student Loan Rate Nominal Mortgage Rate 0.57% 0.24% Monthly Required Rate of Return 0.02%

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 49 Exhibit 11A: Sensitivity Analysis: 15 year fixed $10,000 Loan Savings Student Loan Rate 6.25% 6.50% 6.75% 7.00% 7.25% 7.50% 3.00% 6,741.78 7,309.67 7,883.78 8,463.94 9,049.99 9,641.75 Mortgage 3.25% 6,269.36 6,837.24 7,411.35 7,991.52 8,577.56 9,169.32 Rate 3.50% 5,788.74 6,356.62 6,930.73 7,510.89 8,096.94 8,688.70 3.75% 5,300.04 5,867.92 6,442.03 7,022.19 7,608.24 8,200.00 4.00% 4,803.39 5,371.28 5,945.38 6,525.55 7,111.60 7,703.35 4.25% 4,298.93 4,866.82 5,440.93 6,021.09 6,607.14 7,198.90 $50,000 Loan Savings Student Loan Rate 6.25% 6.50% 6.75% 7.00% 7.25% 7.50% 3.00% 33,708.92 36,548.34 39,418.88 42,319.70 45,249.94 48,208.73 Mortgage 3.25% 31,346.80 34,186.22 37,056.77 39,957.58 42,887.82 45,846.61 Rate 3.50% 28,943.68 31,783.10 34,653.65 37,554.47 40,484.70 43,443.49 3.75% 26,500.19 29,339.61 32,210.15 35,110.97 38,041.21 41,000.00 4.00% 24,016.96 26,856.38 29,726.92 32,627.74 35,557.98 38,516.77 4.25% 21,494.67 24,334.09 27,204.64 30,105.46 33,035.69 35,994.48 $100,000 Loan Savings Student Loan Rate 6.25% 6.50% 6.75% 7.00% 7.25% 7.50% 3.00% 67,417.84 73,096.67 78,837.77 84,639.41 90,499.87 96,417.46 Mortgage 3.25% 62,693.60 68,372.44 74,113.53 79,915.17 85,775.64 91,693.22 Rate 3.50% 57,887.37 63,566.21 69,307.30 75,108.94 80,969.41 86,886.99 3.75% 53,000.37 58,679.21 64,420.30 70,221.94 76,082.41 81,999.99 4.00% 48,033.91 53,712.75 59,453.85 65,255.48 71,115.95 77,033.53 4.25% 42,989.35 48,668.19 54,409.28 60,210.92 66,071.39 71,988.97 $150,000 Loan Savings Student Loan Rate 6.25% 6.50% 6.75% 7.00% 7.25% 7.50% 3.00% 101,126.76 109,645.01 118,256.65 126,959.11 135,749.81 144,626.18 Mortgage 3.25% 94,040.40 102,558.66 111,170.30 119,872.75 128,663.46 137,539.83 Rate 3.50% 86,831.05 95,349.31 103,960.95 112,663.41 121,454.11 130,330.48 3.75% 79,500.56 88,018.82 96,630.46 105,332.91 114,123.62 122,999.99 4.00% 72,050.87 80,569.13 89,180.77 97,883.23 106,673.93 115,550.30 4.25% 64,484.02 73,002.28 81,613.92 90,316.38 99,107.08 107,983.45 *Note: The highlighted regions represent the current rates

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 50 Bibliography Addis, Cameron. 2003. 1760 1845. New York, NY: Peter Lang Publishing, Inc. Archibald. Robert B. 2002. Redesigning the Financial Aid System: Why Colleges and Universities Should Switch Roles with the Federal Go vernment. Baltimore, MD: The Johns Hopkins University Press. Emerson, Robert W. Business Law 5th ed. Hauppauge, NY: Barron's, 2004. Print. "Federal Student Loans Program." Federal Education Budget Project The New America Foundation, 28 Mar 2012. Web. 12 Apr 2013. . Fin Aid! "FinAid | Loans | Historical Interest Rates." FinAid | Loans | Historical Interest Rates Fin Aid!, 2013. Web. 1 Apr. 2013. < http://www.finaid.or g/loans/historicalrates.phtml > Gladieux, Lawrence E. and Arthur M. Hauptman. 1995. The College Aid Quandary: Access, Quality, and the Federal Role. Washington, D.C.: The Brookings Institutions. "History of America n Higher Education." Random History N.p., 29 Apr 2008. Web. 12 Apr 2013. . IRS. "American Opportunity Tax Credit: Questions and Answers." American Opportunity Tax Credit: Questions and Answers. IRS, n.d. Web. 09 Apr. 2013. < http://www.irs.gov/uac/A merican Opportunity Tax Credit: Questions and Answers >

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 51 Lazerson, Marvin. "The Disappointments of Success: Higher Education after World War II." Annals of the American Academy of Political and Social Science, Vol. 559, The Changing Educational Quality of the Workforce. (September 1998): 64 76. Livingston, Miles. Bonds and Bond Derivatives Malden, MA: Blackwell Business, 1999. Print. Lokey, Colin. "Student Debt: A Trillion Dollar Bubble." Seeking Alpha N.p., 10 Jan. 2013 Web. 23 Mar. 2013. Morran, Chris. "Student Loan Debt Is Creating Generation Of High Risk Borrowers With Low Credit Scores." Consumerist N.p., 30 Jan. 2013. Web. 24 Mar. 2013. Nemec, Mark R. 2006. Ivory Towers and Nationalist Minds: Universities, Lead ership, and the Development of the American State. Ann Arbor, MI: The University of Michigan Press. "Not Just for the Elite." Random History N.p., 15 Mar 2008. Web. 12 Apr 2013. . Poitras/ Faculty of Busines s Administration, Geoffrey. "Arbitrage: Historical Perspectives." Thesis. Simon Fraser University Vancouver, B.C. Canada, 2009. Arbitrage: Historical Perspectives Simon Fraser University, 23 July 2009. Web. . 1 Apr. 2013 Press Release. "Decrease in Overall Debt Balance Continues Despite Rise in Non Real Estate Debt Federal Reserve Bank of New York." Decrease in Overall Debt Balance Continues Despite Rise in Non Real Estate Debt Federal Reserve Bank of New York

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 52 N.p ., 27 Nov. 2012. Web. 23 Mar. 2013. Prosser, Marc. "5 Reasons the Student Loan Crisis Is Nothing Like the Mortgage Crisis." Forbes Forbes Magazine, 22 Aug. 2012. Web. 24 Mar. 2013. Quirk, Mary B. "A Third Of $900 Billion In Outstanding Student Loan Debt Held By Subprime Borrowers." Consumerist N.p., 31 Jan. 2013. Web. 24 Mar. 2013. Rampell, Catherine. "Report Details Woes of Student Loan Debt." The New York Times The New York Times, 20 July 2012. Web. 25 Mar. 2013. Schlesinger, Jill. "Student Loan Deb t Nears $1 Trillion: Is It the New Subprime?" CBSNews CBS Interactive, 28 Nov. 2012. Web. 25 Mar. 2013. Thompson, Derek, and Nicole Allan. "The Myth of the Student Loan Crisis." The Atlantic N.p., 20 Feb. 2013. Web. 23 Mar. 2013. Turbo Tax. "About Stud ent Loan Tax Credits." TurboTax Tax Tips & Videos Turbo Tax, n.d. Web. 1 Apr. 2013. < http://turbotax.intuit.com/tax tools/tax tips/Tax Deductions and Credits/About Student Loan Tax Credits/INF14771.html > University of Florida. "Publications." University of Floridas Office for Student Financial Affairs RSS University of Florida Financial Affairs, n.d. Web. 1 Apr. 2013. .

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FIN4403 Thesis Ian Shelton, Kathryn Orovecz, Taciana Faria 53 US Dept. of Education. "FFELP Loan Amount Eligibility Scenarios." Federal Student Aid US Dept. of Education, n.d. Web. 1 Apr. 2013 < www.nela.net/.../FFELPLoanAmountEligibilityScenarios.pdf > US Dept. of Education. "Understand How Interest Is Calculated and What Fees Are Associated with Your Federal Student Loan." Interest Rates and Fees US Dept. of Education, n.d. Web. 09 Apr. 2013. < http://studentaid.ed.gov/types/loans/interest rates > "Usury Laws by State." LoanBack N.p., n.d. Web. 24 Mar. 2013. Weiser Varon, Len, Jeremy Spector, and Maxwell Solet. "IRS Announces Closing Agreement Program for Tax Exempt Student LoanBonds Subject to Taxability Determination Due to Loan Swapping." IRS Announces Closing Agreement Program for Tax Exempt Student LoanBonds Subject to Taxability Determination Due to Loan S wapping Mintz Levin, 21 Mar. 2012. Web. 1 Apr. 2013. < http://www.mintz.com/newsletter/2012/Advisories/1742 0312 NAT PF/ > "Welcome to the Trillion Dollar Club." Simple Tuition, n.d. Web. 23 Mar. 2013. "What Will Your Monthly Mortgage Payment Be? Use This M ortgage Calculator." Mortgage Calculator N.p., n.d. Web. 23 Mar. 2013.