A crisis has hit the student-loan market, and it promises to be every bit as dire as the subprime bubble that caused such turmoil in 2008. The Washington Post estimates that outstanding student debt now totals $1 trillion. As many as 30 percent of borrowers have dropped out of their courses of study, leaving them no easy way to repay.
As it did in the housing crisis, the government has played a major role in bringing the student-loan market to such a calamitous impasse. Through programs such as the Federal Family Educational Loan Program (FFELP), taxpayers have guaranteed up to 97 percent of student loans extended by private lenders. Given that safeguard, lenders have had no incentive to restrain their activities or assess the creditworthiness of their borrowers. The government then raised the taxpayers’ exposure to 100 percent by replacing FFELP in 2010 with a system of below-market direct loans administered by the Department of Education (DOE). All students pay an identical low rate — currently 3.4 percent for subsidized loans — while the outlook for the student-loan crisis remains dim.
The growing debt burden is intrinsically linked to the high inflation in college tuition, as subsidized loan rates have drawn an increasing number of students to college, pushing up the total cost of education. The National Center for Education Statistics reports a 9 percent increase in post-secondary enrollment between 1990 and 1999, but a 38 percent increase between 1999 and 2009. Colleges, in turn, keep expanding their facilities and programs and are forced to pay more for the best faculty talent.
Private businesses answering to shareholders have incentive to operate efficiently; colleges, less so, especially when the demand from prospective students is insatiable. The result is that tuition rose 4.6 percent in 2011, a full percentage point higher than the CPI, although down from a 6 percent annual-growth average in the years leading up to the 2008 financial crisis.
Mountains of debt mixed with rapid tuition hikes are a perilous feedback loop that the nation must halt before it becomes an unsustainable burden on the economy. There are three root causes to this crisis in the making:
‐low, flat loan rates that disregard borrower risk;
‐a lack of loan-restructuring options; and
‐a lack of funding alternatives.
Fortunately, each of these three problems has a market-based solution that can be applied to address the student-loan crisis in a responsible manner.
Risk-Based Pricing
Replacing its low, one-size-fits-all loan rates with risk-based pricing is the most important step the DOE can take to bring balance and order to the loan market. Risk-based pricing is the cornerstone of all commercial lending and insurance markets. Commercial lenders price loans after conducting credit reviews of borrowers, charging higher rates for riskier borrowers so that additional funds can be held in reserve against a higher probability of default.
The DOE should not price loans according to a student or his family’s financial circumstances, as that would undermine the cherished ideal of educational meritocracy. However, there are other options.
One is to employ risk-based pricing according to a student’s high-school GPA. Surely there are correlations between high-school achievement and workplace success. Another option is to implement a sliding scale of loan rates that favors students committed to majoring in fields such as computer science or nursing, where the demand for new employees exceeds the supply. For fields where employment demand is weak, loans would be progressively more expensive. Granted, this policy would require students to declare a major at the beginning of their college career rather than during their sophomore or junior year. But solving a trillion-dollar crisis requires some changes to “business as usual,” and this may be one of them.
A risk-based pricing policy would result in some students’ electing against college. Students with lower GPAs would be encouraged to consider trade or technical schools. Those otherwise adamant about studying a field with little job-market demand might conclude that it is not worth the expense. The effects of this decline in enrollment would reduce the accompanying debt load. It would also reduce tuition inflation, as demand for the educational product declined, and decrease the expected default rate by directing loans to students with better job prospects. In short, it would shift the supply and demand of the nation’s college-educated work force toward greater equilibrium.
Evaluating the market demand for majors and related skills is straightforward. The Bureau of Labor Statistics (BLS) monitors job fields with the most openings. The Occupational Outlook Quarterly (Winter 2012) published a report projecting the growth in job fields from 2010 to 2020, subdividing them by the levels of education typically required for entry: graduate degree, bachelor’s degree, associate’s degree, and high-school diploma.
When pricing loans, the DOE can refer to this BLS data, periodically lowering interest rates for majors or courses with relevant job growth and raising rates for other majors. For example, the report lists elementary-school teachers, accountants, management analysts, and software developers as belonging to the fastest-growing fields requiring a bachelor’s degree. The DOE should therefore give preferential loans to students committed to studying for a bachelor’s degree in education, accounting, business, and computer science. Medicine and law dominate the list of growth jobs requiring graduate degrees, and because bachelor’s degrees are prerequisites, preferential treatment should be given to those fields as well. Nursing dominates the list for jobs requiring an associate’s degree.
Unsurprisingly, some majors that appear on the Princeton Review’s list of the top ten college majors in 2012, such as psychology and communications, do not exhibit related job growth (or opportunities, which are a function also of how many people are retiring from a given field) in the BLS data. It makes little sense to use taxpayer money to incentivize courses of study with limited job opportunities (or, for that matter, to extend cheap funding to students with lackluster GPAs). Doing so only exacerbates a trillion-dollar debt crisis.
Restructuring and Bankruptcy
The second main cause of the student-debt crisis is the absence of loan restructuring, which is the free market’s way of easing the impact of default. In restructuring, debtor and creditor negotiate a mutually agreeable deal whereby either payments are reduced or canceled, or collateral is foreclosed upon. Bankruptcy is the legal state in which this takes place.
Unfortunately, bankruptcy is not an option for student borrowers. In the event of default, a student’s debt follows him throughout life, often with debilitating and long-term consequences, including wage and tax-return garnishment, suspension of professional licenses, and termination from or ineligibility for public employment. A bankruptcy option would wipe out the riskiest debt and reduce the trillion-dollar bubble to a more manageable sum that existing borrowers could reasonably service.
One reason bankruptcy for student loans does not exist is the lack of risk-based pricing. A lending institution cannot afford to show lenience in a workout negotiation if that institution is not being compensated for taking on higher levels of credit risk. If risk-based pricing existed, the DOE could charge more for risky borrowers and hold the extra cash in reserve against expected defaults. Given the stories of devastation that some defaulted borrowers tell, there is a moral imperative, beyond a financial one, for the DOE to spearhead a bankruptcy option.
Alternative Funding Options
The third main cause of the debt crisis is the absence of alternative funding options, which would finance education without increasing debt. If countless start-up businesses with little collateral can owe their success to angel equity investors, students can as well. In a recent New York Times op-ed, University of Chicago economist Luigi Zingales made a compelling case for issuing student equity. Investors would pay lump sums to students in return for a negotiated percentage of the students’ future earnings over a specified duration.
While this is a controversial idea — extreme critics have likened the practice to indentured servitude — appropriate measures, such as limits on adverse “shareholder activism,” could make it viable. An online forum that allows students to post their transcripts, credentials, goals, and financial needs, while prospective investors can bid on payment terms and the time horizon, could create a liquid market in the model of Prosper Marketplace, a successful exchange for peer-to-peer lending. Bundles of student investments could be sold as a single instrument, to offer diversification. Investor interest might be limited primarily to higher-paying career paths such as business, law, medicine, and engineering, but those still account for a substantial share of students.
Advantages of equity issuance include a closer alignment of interest between student and financier. The two would mutually benefit from the student’s future successes. (In the current system, by contrast, public and private lenders make more money from fees levied when students default.) Further, should the student fall on hard times, the investor would be wiped out without recourse, and no legal or financial obligations would burden the student. This system could even inspire beneficial mentoring relationships, whereby, for example, scientists could sponsor and offer career advice to budding young minds interested in their field.
Time Is Short
Nothing about the market forces outlined in this paper is new or revolutionary, except that it has never been applied to student finance. The event of a trillion-dollar crisis necessitates creative thinking and fresh ideas. The parallels between student loans in 2012 and subprime mortgages in 2008 are ominously clear. Sooner than anyone knows, it will be too late to act.
— Jay Hallen is a New York City–based writer. He is still paying off his student loans.