The next crisis to avoid is in student loans

March 6, 2012, 9:12 PM UTC


FORTUNE – Ever since U.S. consumers began owing more on their student loans than their credit cards a couple of years ago, economists have kept a closer watch over whether soaring education debt could be America’s next bubble to pop.

For Federal Reserve Chairman Ben Bernanke, the issue apparently strikes close to home. At a Congressional hearing recently, the central banker told lawmakers that his son, who’s in medical school, will likely rack up $400,000 of student debt upon graduation. The rapid growth of education loans requires “careful oversight” from regulators, he added.

There’s reason to worry. After all, the latest outstanding student loan balance has risen to $870 billion – more than the total credit card debt (at $693 billion) and what people owe in car loans (at $730 billion), according to a report released Monday by the Federal Reserve Bank of New York.

More importantly, the rate of delinquencies may be higher than previously thought, the Fed’s economists noted. That’s because calculations that the central bank usually follows don’t take into account the proportion of federally guaranteed loans that typically don’t require repayment while borrowers are still in school. It also doesn’t consider those loans that can be deferred for up to six months upon graduation. If such groups were excluded from the tally, the percentage of borrowers with past-due balances as of last summer would jump to 27% – about double the 14.4% (or 5.4 million borrowers) under the Fed’s more conventional measure. And as many as 47% of student-loan borrowers appear to be in deferral or forbearance – a temporary option that many unemployed, underemployed or those facing financial hardships often chose.

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Some have compared the problem to U.S. subprime mortgages and the banking crisis that followed, but this isn’t to say student debt will necessarily threaten the U.S. financial system. If you believe most economists, the problems are entirely different. For one, the student loan market is only one-tenth the size of the residential mortgage market, says Moody’s Analytics economist Christian deRitis. Secondly, more than 90% of student loans are guaranteed by the federal government. And while private student lending surged from 2002 to 2007 amid alarmingly loose lending standards, those standards tightened abruptly amid the Great Recession. This leads deRitis to think the quality of private loans has since improved. Nevertheless, what’s really concerning is the default rate on loans for students attending for-profit schools, which has risen higher than loans for students attending public, not-for-profit institutions and private schools.

It’s not entirely clear what the implications of this ballooning debt will be, as outstanding student loans approach the $1 trillion mark this year. However, economists have suggested that high student debt combined with a weak job market, particularly for younger workers just starting out, has already added pressure onto the broader economy. And it will likely have an impact on future growth.

“Even if borrowers could service their debt, it means they might not start as many businesses, buy as many homes or buy as many automobiles,” deRitis says.

Take for instance the housing market. In a study sent to Congress in January, the Fed pointed out that tighter lending standards have disproportionately weighed on first-time homebuyers — typically an important segment of housing demand that broadly affects house prices and construction. In recent years, between 2009 and 2011, the proportion of 29- to 34- year olds with a first-time mortgage was 9%, compared with 17% a decade ago.

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The Fed doesn’t go as far as explicitly blaming student loans, but it would make sense that heavy education debt would contribute to the marked drop in first-time homebuyers. Going back to the Fed’s Monday report, borrowers between 30 to 35 years old (typically the age of first-time buyers) had the he highest average outstanding student loan balance at $28,500.

And because many younger people have put off buying homes, that potentially deprives the economy of faster growth. As The New York Times noted, under normal economic times, $145,000 is injected into the economy each time a new household is formed. But with the weak job market, hundreds of thousands of young people have delayed their moves, choosing instead to move back in with mom and dad. About 950,000 new households were formed in 2010, down from 1.3 million in 2007.

This would suggest a log of pent-up demand for new homes, but it’s hard not to wonder how long it will actually take for it to show up in the housing market.

The Obama administration has responded to the student debt problem in piecemeal. In the president’s State of the Union address in January, he proposed overhauling the federal financial aid system by linking colleges’ eligibility for campus-based aid programs, such as Perkins loans, to their successes in reducing costs for students. Administration officials say the current system gives colleges incentive to keep costs high.

Obama also wants to give families clearer information about the costs and quality of their education. The administration has proposed that colleges and universities be required to provide students with a “shopping sheet,” which would make it easier to compare financial aid packages, as well as provide post-graduate earning information and employment information.

It will certainly take time for such proposals to get anywhere. Luckily, with a doctor’s salary, Bernanke’s son might be in a position to pay off his student loans. Not everyone will be so fortunate.