A Proposal to Fix Student Lending

Photo credit

Observers often compare the current student lending environment to the housing crisis, and they have many good reasons to do so:

(1) The current level of delinquencies on student loans has exceeded the number of households that lost their homes in the housing crash;

(2) Student lending targets subprime borrowers specifically — that is, the people least likely to have the ability to repay their student loans;

(3) Student debt burdens and histories of delinquency have become a drag on the rest of the economy;

(4) Although student loans cannot be discharged in bankruptcy, borrowers increasingly have an economic incentive not to honor their obligations as intended; and

(5) “Easy money” for colleges and universities has resulted in declining standards in education.

As I have written before, we should be wary of situations where behavior in the capital markets takes on an antisocial dimension. Student lending has transformed from a means of promoting social mobility to a predatory financial machine that destroys borrowers’ lives.

Student Lending, as it functions now, is an antisocial enterprise

According to the Wall Street Journal (emphasis mine):

As of September 2015, more than 330,000 people, or 11% of borrowers, had gone at least a year without making a payment on a Parent Plus loan, according to the Government Accountability Office. That exceeds the default rate on U.S. mortgages at the peak of the housing crisis. More recent Education Department data show another 180,000 of the loans were at least a month delinquent as of May 2016.
“This credit is being extended on terms that specifically, willfully ignore their ability to repay,” says Toby Merrill of Harvard Law School’s Legal Services Center. “You can’t avoid that we’re targeting high-cost, high-dollar-amount loans to people who we know can’t afford to repay them.”
Parent Plus is one thread in a web of higher education loan programs that have come to resemble the subprime mortgage industry a decade ago, given the shaky quality of many of the loans.
The number of Americans with federal student loans, including through programs for undergraduates, parents and graduate students, grew by 14 million to 42 million in the decade through last year. Overall student debt, most of it issued by the federal government, more than doubled to $1.3 trillion over that period.
The financing fueled a surge in college enrollment. Between 2005 and 2010, enrollment grew 20%, the biggest increase since the 1970s. The Obama administration supported such lending in an effort to widen access to college education.

Much of this spike in enrollment (and the corresponding lending) was due to the Great Recession. People who were out of work returned to school, and were no doubt financing their overall living expenses as well. This situation was only made possible by the federal government’s policy of extending a virtually limitless amount of credit to student borrowers irrespective of their ability to repay these loans.

Stop and think about that: A crisis created by subprime lending was answered by another crisis created by subprime lending, with government agencies at the center of both.

Back to the WSJ:

Nearly four in 10 student loans — the vast majority of them federal ones — went to borrowers with credit scores below the subprime threshold of 620, indicating they were at the highest risk of defaulting, according to a Wall Street Journal analysis of data from credit-rating firm Equifax Inc. That figure excludes borrowers, such as many 18-year-old freshmen, who lacked scores because of shallow credit histories. By comparison, subprime mortgages peaked at nearly 20% of all mortgage originations in 2006.
Roughly eight million Americans owing $137 billion are at least 360 days delinquent on federal student loans, nearly the number of homeowners who lost their homes because of the housing crisis. More than three million others owing $88 billion have fallen at least a month behind or have been granted temporary reprieves on payments because of financial distress. New research from Federal Reserve economists shows that most student-loan defaults are among borrowers who had weak credit.
Consumer advocates say defaults will continue to mount as loans taken out after the recession enter the repayment cycle.

With this spike in enrollment, the structure of colleges and universities and campus culture have changed dramatically. Colleges and universities have reduced their commitment to hiring talented faculty and instead become heavy on high-paying administrative positions (see The De-Professionalization of the Academy for a professor’s perspective). It increasingly seems that students are financing a second infancy instead of preparing for a career. One could offer countless examples of infantile campus behavior, but my personal favorite is this profile of students grieving the election of President Trump with Play-Doh, puzzles, and coloring books. And public wailing. Sounds like someone you want at your accounting firm, right?

There is no shortage of commentary that paints these shifts in campus culture as a perversion of left-wing philosophies. I would submit to you, however, that this is the logical outcome when “easy money” is introduced to a sector. Just as the originate-to-distribute model of lending reduced Wall Street’s standards (“we’d do a deal structured by cows”), colleges have subordinated their academic reputations to a whatever-the-consumer-wants mentality. And their consumers want to coddled.

Income-based repayment programs only transfer costs to taxpayers

The Obama administration’s response to the student lending crisis was to introduce new income-based repayment programs. Traditionally, when you borrow money, you repay your loan according to an amortization schedule where the only inputs are the term of the loan, interest rate, and amount you borrowed. With the amounts students have been borrowing, their loan payments quickly crowded out their other living expenses. The income-based repayment programs allow student borrowers to pay what they can based on what they are earning after they graduate. The cost of the loans does not go away, but is transferred to American taxpayers. Student lending programs are funded by American taxpayers through US Treasury borrowing, such that US Treasuries are increasingly becoming asset-backed securities.

The cost of these programs to American taxpayers is not insignificant and difficult to forecast.

According to the Washington Post:

To help people manage their student loans, the Obama administration has expanded programs that cap monthly payments to a percentage of earnings and eventually forgives the balance. Enrollment in these income-driven repayment plans is soaring and so is the cost, but the government’s budget estimates are not keeping pace, an oversight that fuels criticism of a federal policy that conservatives say has become far too expensive.
Current budget estimates for income-driven plans are more than double what was originally expected for loans made in fiscal 2009 through 2016, climbing from $25 billion to $53 billion, according to the GAO report. The growth is primarily a result of the rising volume of loans in the plans, but researchers at the GAO say faulty projections from education officials may cause costs to be over- or understated by billions of dollars …
As it stands, there are 5.3 million people enrolled in an income-driven repayment plan with about $353 billion in outstanding student loans. Although the government has let people repay education debt based on their income for the past 20 years, few took advantage until the Obama administration expanded the number of options and eligibility. Plans are designed to prevent borrowers from defaulting on their loans and ruining their credit.
“This is a way that we can ensure that graduates are fulfilling their basic responsibility to repay the government for the money that they borrowed,” White House press secretary Josh Earnest told reporters Wednesday. “But we want to make sure that when students graduate, that they’re not saddled with so much debt that they’re essentially penalized financially for pursuing college education opportunities.”
The GAO estimates that $215 billion, or 61 percent of the debt in income-driven plans, will be paid in full. Another $108 billion will be forgiven, with the remaining $29 billion discharged because of death or disability. But those estimates are only for loans made from 1995 to 2017. As more people sign up, the cost of the program will soar.

The higher education industry — and yes, it is an industry — thus benefits from the same stealth bailout approach that subprime lenders benefited from during the housing crisis. Instead of asking why college costs so much, the consequences of bad lending decisions are automatically transferred to taxpayers sans introspection and meaningful change.

Skin in the game

This brings me to the biggest similarity between the housing crisis and student lending that almost no one mentions: the institutions that capture the economic benefits of this arrangement have no skin in the game (as Nassim Nicholas Taleb would say). Colleges and universities capture all of the upside of this predatory student lending machine and bear zero risk. Whether they perform or not doesn’t actually matter to the availability of credit going forward. The federal government has the ability to punish institutions with high student borrower default rates, but that isn’t really enforced with non-profit institutions.

I think we can fix the cost of higher education and campus culture with a simple change in government policy: force colleges and universities to backstop student loans. The federal government will still continue to provide cash flow support for higher education by borrowing in the Treasury market to fund student loans. But if a student defaults on that loan, the university gets to take over their payments to the federal government.

How will this change things?

(1) There would be a ceiling on the amount colleges and universities can charge.

(2) Students would no longer be able to use student loan proceeds to pay for whatever they want.

(3) Universities would have an economic incentive to replace the second infancy they are currently promoting with pragmatic career services and mentoring programs.

(4) Universities would no longer have an economic incentive to admit every bonehead to a PhD program. If a student is not expected to do well in an area of study, they won’t be humored so the university can collect their student loan proceeds. You wouldn’t have a ton of humanities majors with no prayer of ever receiving a tenure-track job.

But we can’t afford to backstop student loans, universities will cry in response. Right, tell us how much you can’t afford it from the jumbotron in your brand new football stadium.