Paul L. Caron

Friday, May 4, 2012

Risk-Based Student Loans

Student LoansMichael Simkovic (Seton Hall), Risk-Based Student Loans:

Credit markets serve a vital function in capitalist economies: evaluating the riskiness of a range of possible investments and channeling resources toward those investments that investors believe are most likely to prove successful. This process is known as the “risk-based pricing” of credit. Ideally, risk-based pricing should lead to lower cost of capital for lower risk investment choices, and therefore more investment in such promising activities. Conversely, risk-based pricing should lead to higher costs of capital, and therefore less investment, in high-risk activities. If creditors are well informed and analytic, and borrowers respond to financial incentives, then risk-based pricing — compared to uniform credit pricing — leads to a more efficient allocation of society’s limited resources.

Although risk-based pricing is standard in business loan markets, and is increasingly common in consumer credit markets such as mortgages and credit cards, risk-based pricing is rare in the market for student loans. The reasons for the rarity of risk-based pricing in the student loan market include limitations of the available data, bankruptcy and collections laws that shift default risk from student loan lenders to borrowers, and moral and philosophical beliefs about the primacy of individual choice and the role of education as an engine of equal opportunity.

This article argues that the lack of risk-based pricing in student loans may ultimately undermine many of the interests and values that uniform student loan pricing ostensibly seeks to promote. Without risk-based pricing of student loans, there may be no reliable price signal about the long-term financial risks inherent in different courses of study. This lack of price signals undermines students’ ability to make informed decisions about the course of study that will best balance their innate abilities and individual preferences with postgraduate economic opportunities. Similarly, the lack of price signals may undermine post-secondary educational institutions’ ability to adjust their programs to improve their students’ postgraduate prospects. Misallocation of educational resources is not only harmful to individual students and their families — it could threaten to undermine the productivity and competitiveness of the U.S. labor force and the U.S.’s ability to continue to invest in education and research.

Transparent, risk-based student loan pricing could greatly benefit students and educational institutions, particularly if it were data-driven and sensitive to the values of equal opportunity and independent research that are central to the academic enterprise. This article discusses legal and policy reforms that could facilitate risk-based student loan pricing, potential hazards from a shift toward risk-based pricing, and safeguards that could help protect students and educators from abuse.

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"The reasons for the rarity of risk-based pricing in the student loan market include limitations of the available data, ..."

A verbose way of saying that if you tell students and their parents the truth about the worthlessness of these degrees, they won't continue to pay for them.

But that would hurt everybody's feelings.

Nothing to see here, move along...

Posted by: JS | May 7, 2012 3:27:40 PM

Rather than having Uncle Sam figure out what the "good" and "bad" majors are, let the colleges do it. I think an even better idea would be to require the college to insure any gov loans for their students against default risk, and let the colleges charge whatever premium they regard as appropriate for each student, with the student required to add to the loan amount to cover this default risk premium. The colleges should well know which majors and which students are most likely to not get good jobs and default, and like any good insurance outfit would have an incentive to tailor premiums to default risk. And if they get it wrong, the college pays the penalty, not the taxpayers. And any colleges that have really lousy grad rates, or lousy job prospects, or excessive tuitions that require larger loans, will have to charge more to cover their added default risk.

Posted by: richard40 | May 7, 2012 12:16:23 PM

On the "limitations of available data" for risk-based loan pricing, there is a way out: Schools can underwrite their students' loans, and the departments and even the staff can share in the risk by some sort of commission scheme. The flip side of this is that the staff is given autonomy over who is admitted (and even better, the tuition negotiated individually in a competitive market). That way, each individual professor has an incentive to maintain academic rigor and block out unprepared students (lest defaults eat into his pay) but to admit qualified students and provide good instruction (to maximize commissions). What better gauge of risk than the professor looking at *individual* students?

Posted by: M. Rad. | May 6, 2012 6:14:33 PM

Student loans started out, following Sputnik, as the National Defense Student Loan, restricted to folks majoring in the sciences or linguistics. LBJ expanded them to cover all majors. Not everything LBJ did was wise.

Posted by: Kevin M | May 6, 2012 8:20:02 AM

I've thought about this for awhile, and how to implement it, but as long as the government, and universities themselves, are in the business then no commercial entity can compete in a market. Student loans should be entirely market priced, based not only on major, but university attending, grades achieved, and student background including high school grades, activities (discipline in sports might be assessed to translate to some degree to discipline in academics), and probably several dozen other factors that a market would eventually shake out via demand for information.

But free markets are the antithesis of political agendas.

Posted by: billy harvey | May 6, 2012 8:08:31 AM

Sort answer YES!  In fact some degrees are so worthless and the risks so high that they should not be supported by student loans.  This one concept alone would begin to reorganize our colleges to graduate students we need in the future.  This along with the ability for students eliminate their students loans in bankruptcy. If that could happen the free market would quickly sort through students that are not serious and degrees that are worthless making loans impossible or too expensive.  The results would be lower cost education and elimination of non-functional degrees. 

Posted by: wiredman | May 6, 2012 8:03:58 AM

Having student loans that are transparent and risk based means getting rid of government backing and guarantees. Yes. If the system had been set up this way there wouldn't have been so many false signals, and we wouldn't have had an education bubble. So let's get the government out of it, and let the chips fall where they may. Otherwise, you get educational versions of ARRA, QEwhatever, and Operation Twister, which will only make things worse. Pull the damn plug. Euthanize the system.

Posted by: teapartydoc | May 6, 2012 5:45:49 AM

When I was in college in the 80's, engineering students paid a surcharge of about 15%, which was claimed to be because the engineering faculty cost more than the other majors. Seems fitting to give those majors the market advantage that is truly real.

Posted by: Pablo panadero | May 6, 2012 5:30:24 AM