A Better Way to Solve the Student Loan Crisis

Skin in the game for student loans, the idea that colleges should face financial consequence when their students default, is gaining momentum in policy discussions. After all, when students take out loans, the colleges get all their money upfront, leaving taxpayers holding the bag when students default on the loan payments years later. It seems only fair that colleges should share in the cost of defaults.

I like the notion behind this effort—ensuring that colleges don’t get rich by saddling their students with disastrous financial burdens—but policymakers should also make sure to implement some complimentary policy changes to increase fairness and avoid unintended collateral damage.

Colleges Aren’t Yet in the Game

Skin-in-the-game requires accompanying changes to our financial aid system. Most proposals would have colleges pay a set percentage of any loan that defaults. But under the current system, colleges aren’t yet in the game because they are not a direct party to the loan. Once a college has admitted a student (and keep in mind that many colleges are open admissions, meaning virtually anyone can enroll), they have no say in whether or how much a student borrows.

[The Consequences of Forgiving $1.5 Trillion in Student Debt]

Instead, the lender, which is the government for most loans, determines how much the student can borrow. But if the loan is between the student and the government, why should colleges be held accountable when it goes sour?

As Matt Reed, a dean at a community college noted, if “we can’t screen borrowers, then holding us accountable is merely punitive. How are we accountable for what we’re forbidden to control?”

So a necessary change if we are going to implement skin-in-the-game is actually to have colleges in the game. If we are essentially asking colleges to be co-signers for their students’ loans, then they should be treated as such, including giving them veto power over any loan, as well as the power to reduce how much students can borrow.

For example, a college might set a higher borrowing limit for their nursing program than for their sociology program, something they are currently not allowed to do. Giving private entities veto power over the distribution of federal financial aid is a fairly revolutionary change in our financial aid system, but we need to make sure that there is a general awareness of the magnitude of this change.

Should College Enrollment Effects Be Counteracted?

This change would naturally hit the types of colleges with high default rates the hardest. Default rates are highest at for-profits and public community colleges (see table 7 on page 46 of this Brookings Institution report). But for-profits and public community colleges also disproportionately enroll the most disadvantaged students (see table 4 on page 9 of this College Board report).

Among dependent students at for-profit colleges, almost half come from families with incomes below $30,000. For public two-year colleges, the figure is slightly less than one-third of students. Even if these colleges provided the exact same education for the exact same price as other types of colleges, we would expect to see higher default rates just based on their student population, meaning that skin-in-the-game would punish colleges that are doing the most to provide educational opportunities to the Most Disadvantaged.

[Once Clear Way to Stop College Accreditation Fraud]

It Is Certainly A Defensible Argument That Too Many High-Risk Students Are Going To College (I Put Forward Such A Case At A National Association Of Scholars Conference Several Years Ago), But if we are going to restrict access, that determination should be made primarily based on educational risk, not default risk. Even if we restrict ourselves to purely financial concerns, default risk is still a poor proxy for return on investment because it accounts for only a portion of costs (how much is borrowed) and is affected by so many other factors, especially the student’s liquidity (35 percent of defaulters have a balance of less than $5,000).

In other words, even if we wanted to reduce access for high-risk students, student loan defaults are the wrong measure of risk on which to base such decisions, so serious thought will be needed on whether to counteract the enrollment effects of skin-in-the-game and if so how.

Skin-In-The-Game Could Lead to Government Interference in Admissions

In a nursery rhyme, an old lady swallows a fly, then swallows a spider to catch the fly, then a bird to catch the spider, and on and on until she dies from swallowing a horse. John Cochrane has recently been using this fable as an analogy of how government interventions beget more government interventions, and I see something very similar happening with student loans.

It all began when the government nationalized most of the student loan market as part of Obamacare. Unlike traditional lenders, the government doesn’t want to charge different students different interest rates based on the riskiness of the loan (e.g., what the student’s major is, the student’s academic track record, the quality of the college they are attending, etc.) so everyone has similar terms on their loans.

[Five Reasons Why Student Loans Are a Looming Disaster]

Not surprisingly, a lot of high-risk loans are being made, as reflected in the fact that 10.8 percent of borrowers default within three years of beginning repayment. But the government doesn’t want to cut off students that are at high risk of default; so, like the old lady, they are looking for the next best thing, which is to hold the colleges accountable when their students’ default.

The predictable result of punishing colleges that enroll high-risk students will be to curtail colleges’ willingness to enroll such students dramatically. But such students will disproportionately come from lower income and/or minority backgrounds which then creates a new problem because the government won’t want to be seen as enacting regressive policies with a disparate impact on minorities.

So, like the old lady, they may look around for a “solution” to this new problem. That solution is likely to be government mandates or quotas for admissions, making sure colleges enroll enough low income and/or minority students. But then admissions quotas will lead to other problems, like gaps in the selection of major or success rates by different types of students, which will then be addressed by further government intervention into curriculum or students’ choices of major. Each government intervention creates a new problem which necessitates yet another government intervention a few years down the road.

Is There a Better Solution?

I believe there is. Let’s step back for a second and ask why isn’t there a proposal for car loan defaults? The answer is that car loan lenders cannot pass off losses from defaults to anyone else. Student loans are different because the government is the lender. Viewed in this light, skin-in-the-game is just the next band-aid needed to kludge our way around the simple fact that “government as lender” is an inherently flawed strategy.

Perhaps a better approach would be to establish a market-based student loan system that replaces government lending with lending done by financial institutions. Financial institutions have expertise and experience with lending in general as well as the requisite tolerance for risk over long time horizons. Colleges have none of these.

Some care is needed to ensure that we don’t simply reintroduce the terrible Federal Family Education Loan program we used to have (kudos to the Obama administration for ridding us of that monstrosity) and to account for some of the unique features of student lending. But these are not insurmountable barriers (see pages 7-10 of this report for some ideas on how to overcome them), so there is no reason that we could not harness markets to improve student lending.

Skin-in-the-game would introduce some much-needed market discipline into higher education. But it is essentially trying to partially paper over problems inherent with government lending. An even better approach would allow a market-based system to truly unleash market discipline.

3D graphics image by Quince Creative   


17 thoughts on “A Better Way to Solve the Student Loan Crisis

  1. What can we do about trade schools for profit that started off as identity theft rings for profit?
    There are students including me who DON’T owe but who are forced to pay via garnishment
    & taking income tax via federal government!

  2. I am all for the institution of higher education, especially lifelong learning, as a way for people to have upward social mobility and to participate as well trained professionals in a quickly evolving economy. High quality education provides enough benefit to society to be considered a philanthropic sector. So, the entire payment of tuition should be a tax deductible investment; investing into the career skills so that the human resources value goes up and positively impacts GDP. Don’t forgive student debt (it is good to learn to pay off debt without going into a lifetime of debt bondage nor into welfare dependency); keep annual interest rates on student debt very low (e.g. at the prime rate or linked to the same yield as treasury bonds) and make the repayment of tuition completely, principle and interest, a tax deductible expense (a business expense for the development of HR through higher education).

  3. It’s even worse than that.

    See, the .gov, in their infinite wisdom and mercy, created these lovely “programs” to “help” people who are unable to pay their loans or discharge them in bankruptcy. These programs are so great that an underemployed borrower can go a full 25 years paying nothing – while the interest continued to capitalize. Then, on the blessed day of redemption, the .gov “forgives” the now hyperinflated loan – which becomes a 1099 taxable event. So while the borrower is off the hook to the DoE, they suddenly “owe” the IRS upwards of 24% of the hyperinflated loan balance.

    So let’s look at some numbers:

    My Student Loan in 2000 was roughly $33,000. The Fed set it at 8.25%, which made my monthly payments $404.75.

    I grossed $4,795 in 2000. Like I could pay $404.75/mo. I grossed $18,642 in 2001. $15,818 in 2002. $15,931 in 2003. $20,328 in 2004. $20,280 in 2005 and $22,880 in 2006. I didn’t break 150% of “Federal Poverty Level” until 2007. So for the first seven years after graduation my only options were Deferment & Forbearance.

    Oh Look! IBR (Income Based Repayment) was started in 2007! I made $27,480 in 2007 (167.54% FPL) … my 25 year IBR payment was around $150 IIRC. Let’s call it $200. SO I get to cut my gross monthly earnings from $2290 to $2090. OK. And let’s see where that leads us…

    Ah… at the end of the 25 years, I get to have my now $204,635.16 “loan” forgiven… which means, using my 2018 AGI and 2019 tax tables, I get a $46,076 Tax bill from the IRS… AFTER paying $60,000 ($200*300 months)

    Wow. And given that my average annual income over the last 18 years has been LESS than $24K, what are the odds I could amortize “up” to a flat schedule?

    Well, that would be $451.62/mo. So, I’d get to live on $1,548.38 gross/mo. AND I would have the pleasure of paying $112,453 total over 20 years. But at least I avoided “loan forgiveness” and the tax man, right? No! Going all 25 years at a mere $200/mo only costs $106,076‬ – a full $6,377 less! WHOOPEE!

    This system was DESIGNED to crush people who couldn’t find professional work immediately, especially at higher interest rates, and keep them from ever getting ahead – all to increase the “asset value” of the “student loan debt”.

    And it works smashingly well.

    Oh, & FWIW… If I get a Wage Garnishment, (25% of discretionary income) it will only cost me around $100/mo until I die in 30 years give or take. That’s only $36,000 – or roughly equal what my original principal was. Gotta love math.

  4. How about we stop lending money for over priced colleges with bloated million dollar administration salaries and luxury accommodations for students. When students are unable to borrow the money for $50K tuition they will be forced to choose more affordable options. Enrollment to these expensive colleges will drop and they will be forced to to exercise some fiscal responsibility. They have absolutely no reason to be the least bit affordable because we have been brainwashed into an “education at any cost” mentality. Tuition is out of control because we have enabled it to be out of control and people are getting rich off the backs of students in an industry that is supposed to be serving the community as a not for profit. We have created the most lucrative educational system imaginable and it is destroying the lives of an entire generation.

  5. All the solutions I’ve seen toward this keep ignoring the fact that a student loan is an unsecured debt. Having the interest rates down in the 5% range is a distortion of reality. The true risk rate for unsecured debt is reflected in our credit cards: 18%-22%. That’s where student loan risk should be priced.

  6. A market-based student loan program would be very, very different than the one we have now. For such a market would consider not only the student’s major but also the student’s academic performance as well as the school’s flunk-out rate (by major) and its record in placing graduates in the field they have trained for.

    If one views investment in a student’s education as an investment in that student’s future productivity it would seem to make sense to invest the most in the most promising students Yet the terms for government loans must inevitably be determined by political considerations, for what is a democratic government if not political?

    And democratic-political considerations seem far more likely to depend on each voter’s calculation of “what’s in it for me?” than in some sort of altruistic “how can my country best use its limited resources?”

    In any case, there is some low-hanging fruit, in that “promising student” need not mean an unusually bright student performing well at a highly selective college. It could, for example, refer to a student at an HVAC trade school that successfully launches most of its graduates into a career in HVAC.

    And (as has been said) if a thing can’t go on forever then it won’t. College expenses have outpaced inflation by a wide margin for decades now, and if this were to continue eventually higher ed. would consume 100% of GDP. Since that’s impossible, a renewed emphasis on reducing the actual (not out-of-pocket) cost of college seems inevitable.

    And finally, a relaxation of relentless credentiallism should help businesses in selecting employees and students who might no longer have to obtain costly credentials. Doing so, however, might require a substantial relaxation in “disparate impact” liability so that hiring businesses could replace credentalism with appropriate testing.

  7. I would suggest that college debt be partially dischageable in bankruptcy. If a BK Debtor can’t pass a uniform test on civics, the Bankruptcy court would determine the graduate got less than fair value for his money, and on that finding, require the college to kick enough money to the Bankruptcy Trustee to pay the Debtor’s unsecured debt. (There’s a parallel procedure that’s used to recover lake houses when Debtors convey them to brothers-in-law to hide assets from creditors.)

  8. How about the government lending money to the University/College with the stipulation that it be used for student loans? The money loaned to the school would be at a relatively low interest rate, The schools would then loan the money to qualified students at a higher interest rate to cover the costs occurring to the school in making the loan. The school would have to recover the loan money from the student after he/she graduates or drops out. Schools could join together to set up loan recovery systems or something similar-they should be intelligent enough to figure out a way of loan recovery, since they seem to think they are smart enough to instruct the public on numerous issues.
    If the school refuses to pay back the money loaned by the government, at a certain point the government should refuse to lend the school any more money. The school would have to go to the lending market to get money for their student loans-probably at a much higher rate-or else go out of business altogether.

    1. For many years there WAS a similar program. It was the Perkins loan. About 5 years ago the federal government started phasing out this fantastic program. It had a 5% fixed interest rate and a 9 month grace period. It helped many students, including myself over 30 years ago. You didn’t have to be Pell or State Grant eligible to qualify so many many students received it. There were some qualifications but unmet need – the difference between the estimated cost of attendance and expected family contribution (EFC) -was key. The Perkins loan helped bridge the gap so fewer private education or Parent Plus loans were needed, and it can be consolidated with other federal loans. I was very disappointed to learn it was cancelled.

  9. Instead of loaning Fed money direct to students…give block grants to colleges that they are responsible to pay back from student payments.
    This would weed out screwy degrees that will never generate wages to pay it back. They will eventually stop offering bogus degrees.
    Likely half of students need be in lower tier colleges or vocational school anyway.

  10. “For example, a college might set a higher borrowing limit for their nursing program than for their sociology program, something they are currently not allowed to do.”

    They are, however, allowed to eliminate their sociology program…

    What’s not being said is that student loans are guaranteed by the purported enhanced earning ability (and related employability) of the graduate. The same thing is true of home loans which are guaranteed by value of the home itself and not really the creditworthiness of the borrower — that factors in because it is property value less foreclosure and other costs, but almost anyone can get a mortgage with a sufficiently large down payment.

    But what if the house is shoddily built and falls down or is otherwise destroyed in a manner not covered by insurance? Or if property values plummet and the outstanding amount of the loan vastly exceeds the value of the house (as happened a decade ago). Then the creditworthiness of the borrower and willingness to be “upside/down” in a mortgage becomes relevant.

    And the colleges are issuing shoddy degrees — ones which neither enhance earning ability nor employability of their graduates. If 35% of the defaulted loans are under $5,000, it’s probably because they don’t HAVE $5,000…. It’s not because they were poor prior to attending college but because they are still poor after having graduated from college…

    Because the college neither enhanced their earning ability nor their employability.

    Open admissions or not, the college definitely has control over this — it has control over it’s own curriculum and doesn’t have to have all the foolish majors. It can ensure that its graduates actually are employable so that they have the ability to repay their student loans.

    To argue otherwise is like the shoddy builder nonchalantly dismissing the fact that the house he built fell down and instead complaining about the creditworthiness of the person he sold it to.

    1. And as to car loan defaults, arguably that’s what Obama’s “Cash for Clunkers” was all about — increasing the prices of used cars by creating a scarcity and thus eliminating defaults because the vehicles could be sold to retire the loans.

      Like all things the government does, this created a new problem, that of sub-prime auto loans — a lot of which are now edging their way toward default. The amount due on the loans is greater than the value of the vehicle, and this will become a problem in the near future.

    2. Normal financial institution responsibility for all college loans might have a similar effect. They won’t be willing to loan money to students studying foolish majors, thus starving the colleges who tend to funnel students into those majors.

    3. There is a conflation (in the argument presented) between educational risk and risk of failing to increase employability and income post graduation. Colleges are culpable to some extent, not for enrolling people who might fail to gain a degree, but for encouraging the enrollment of people who are unlikely to use what they learn to improve their earnings… whether that unlikelihood is from learning ability or choice of major subject.

      It can be argued that traditional liberal arts – humanities, arts, critical thinking – are worthwhile whether they result in higher future earnings or not. Probably true – but that simply puts them outside the scope of courses that should be paid for with federally-guaranteed loans.

      1. ” but that simply puts them outside the scope of courses that should be paid for with federally-guaranteed loans.”–this is the point. If someone else is going to loan you money to pay for college, they have every right to ask how your degree will help you pay them back. If the answer is “it won’t”, then they have every right to *not* loan you money. But no one wants to be accused of racism/sexism for refusing to loan money on degrees in women’s/Latino/African American studies. Also, art and music degrees become very poor investments. If you want to invest in your own personal enrichment, go for it! But don’t expect investors to do it for you with such a poor promise of any return.

        The real problem comes from things like education degrees. Few aspiring teachers can afford a degree, but they can’t get a teaching job without one. Will only rich people be allowed to become teachers?

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