Banking and loan problems don’t stay contained in the sub-prime mortgage industry. Borrowing is borrowing, and the availability of cash affects the profitability of the lending industry, whether its in home loans, car loans, or student loans.
The Federal Reserve can try to keep interest rates from spiking too fast by lowering their reserve lending rates, but the market still has to price in risks created by inflation, regardless of what the Fed says is a good interest rate.
As more banks cut off the supply of loans due to insufficient reserves and defaulted sub-prime mortgage accounts, the price of student loans has been rising even though the official interest rates are down. Students are a risky investment to begin with, and right now the financial markets have little tolerance for big risks.
Since many of the student lenders also participate in the federally subsidized loan programs, the recent legislative reform drastically reduces the amount of income they are able to generate from this part of their business. To make up the difference, lenders are: raising rates on private loans; denying loans to students with low credit scores; or getting out of the subsidized loan business all together.
In the long run, this could be helpful for tuition costs as more schools figure out business models that allow them to admit students without necessarily needing loans to pay for it. In the short term, it limits a lot of the options that students have in paying for their college education. Students who qualify for federally subsidized Stafford and PLUS loans may be unable to find a provider who is willing to loan the money at the prices the government requires. Parts of the federal education budget may go unspent – and colleges might have a hard time meeting recruiting goals.
Hopefully, this doesn’t put any schools into bankruptcy. That would be the worst possible outcome, but it would force Congress to consider new legislation to fix the new set of problems they have unintentionally created.