The Problem
Inflation. The war in Ukraine. A looming recession. These recent events have overshadowed what was becoming one of the major discussions in American politics — the student loan crisis. The ever-increasing cost of college has been widely established. And the explanation for why is simple. In the realm of economics, college is, by its definition, an inelastic good / service. Students and their families continue to pay higher and higher prices because students can cover the increasing costs by borrowing more from the federal government. While the cost of education has increased tremendously, student loan volumes (as well the number of loans originated) have been remarkably stable (see below). This has lead to students being burdened with a level of debt they cannot sustain.
The problem arises when borrowers graduate and then are required to pay off large loan amounts and cannot. Fundamentally, this is related to adverse selection, perhaps more aptly described in this scenario as willfully ignorant selection. Every borrower, regardless of current or future credit risk, receives the same interest rate. Seen below, just less than half of all student loan volume is borrowed by consumers with less than prime risk profiles (see below). The federal government (or the entity that owns over 90% of student loans) neither knows nor really cares that the loans it guarantees will not be paid back. Risk and reward have been uncoupled. In order to solve the student loan crisis, this fundamental relationship must be mended.
Student loans are treated in a similar fashion to mortgages, especially when originated by private firms. After origination, the loans are often pooled, securitized, and sold. These securities (also known as Student Loan Asset-Backed Securities or SLABS) are appealing because they offer predictable cashflows and (supposedly) diversified risk. Unlike mortgages, however, they are not backed by actual collateral (like a house). But, through the Federal Family Education Loan Program (FFELP), the federal government essentially guaranteed all the loans originated, which was essentially better than any collateral. Student loan debt is also nearly impossible to discharge via bankruptcy, making these loans very appealing to private investors. The FFELP program ended in 2010. Private lending volume has decreased since the program’s termination, but the federal government continues to blindly (even recklessly) lend billions of dollars a month to millions of young adults who will have no hope of repaying their debts.
The Solution
There is a clear information problem — just as there was in 2008. What’s to be done? A lesson can be learned from the Great Financial Crisis. Harkening back to the GFC, decision-making power must be shifted to those with the most information, which are the higher education institutions themselves. Higher education institutions should be the ones originating student loans, not the federal government. They have a better understanding of which majors and potential career paths are less likely to lead to default. They can screen accepted applicants for this information and originate the required loans (not unlike student aid already given out). There is a clear flaw when, under the current framework, an Arts major is able to saddle him- or herself with the same level of debt (at the same cost) as a hopeful oral surgeon (a pre-dental major) when earning potential is clearly skewed in favor of the latter. And the evidence is clear. The former is among the most likely to default on their loans as a result (especially when attending non-selective schools).
Schools, rather than the federal government, can more accurately price education. This does two things. One, it creates a feedback loop between schools and the job market. More in-demand occupations generate higher earnings, incentivizing schools to originate more loans to students wishing to go into these fields. And two, it creates a strong incentive for schools to further invest in the future success of students. When the school’s financial future depends on the literal success of its students, institutions may find themselves shoring up their career development services and doggedly pushing students to pursue internships, co-ops, or research. But, most important of all, risk is once again married to reward.
A key term in the legislation following the housing crisis was risk retention. To stop banks from originating, packaging, and offloading risky mortgages to other, unsuspecting firms, the securitizer (banks), under the Dodd-Frank Act, became required to retain some of the risk they create (not less than 5 percent). It should be the same for schools. They could securitize their student loan portfolios and sell them to private investors in return for immediate cash (which, in turn, would fund the next round of originations). They would, however, be required to retain a portion (perhaps up to 25%) of all loans originated. It can be imagined that these loan portfolios would be priced according to the strength of the school that originated the loans, not unlike corporate bonds. For instance, it seems likely that MIT’s loan portfolio (an AAA) would have a lower credit risk rating than say, the University of Massachusetts (maybe an AA or A — but still investment grade). If students start to default on their loans, schools will have trouble originating new loans and face significant financial pressure, creating a strong incentive for them to originate loans that will be paid back. Students, in turn, take on more manageable levels of debt and experience fewer defaults. While not a perfect solution, it is a market-based one and thus likely a more efficient means of both appropriating and pricing education loans.
