The Next Debt Crisis

We saw the light at the end of the tunnel, but it turns out that light is an oncoming freight train of trouble. Outstanding U.S. student loan debt passed $1 trillion and is being hyped as “the next financial crisis.” College costs continue to rise at a rate double inflation, and students keep borrowing as the job market recovers at a glacial pace. These frightening numbers indicate that the education financing appears to be as dysfunctional as the American health care system.

The middle class is poised to take the biggest hit and the problem promises to impair US productivity well into the future. The recession played a major role in creating the crisis, but there is something inherently wrong with the system. College financing is ripe with perverse economic incentives for lenders and borrowers alike that distort the employment market and will continue to cause problems if left unchanged.

Lenders

In no other industry do lenders know so little about the investment their dollars are purchasing. A student could be studying underwater basket-weaving, aerospace engineering, or simply searching for that elusive Mrs. degree, but the lender doesn’t know. Imagine a mortgage lender loaning money without any regard to the house purchased. Or consider an even better example: envision a business loan being approved without a business plan. It would simply never happen.

Thanks to a law passed by Congress in the 1970’s, students can’t bankrupt (or die) themselves out of trouble and in many cases parents are also on the hook for outstanding debt. No escape or reprieve means a riskless investment to lenders, ranking student loans up there with United States T-Bills.  A “riskless” ten-year treasury earns a rate of 2%, while current student loan rates are 7%+. An investor would be stupid not to lend to any warm body headed for college. Why don’t these loans more closely follow the risk/reward model? Students are getting a raw deal while lenders make money hand over fist.

Borrowers

Students, what are you thinking? College is meant to be a stepping stone to a career; an investment in order to have a well-paying job after graduation. Take a look at these majors:

Children & family studies

Elementary education / Special education

Social work

Culinary arts

Leisure studies

Religious studies / Theology

Art /Art history / Studio arts / Drama arts / Theatre arts (pretty much any major with “art” in the name)

These are ranked as some of the worst college majors, yet students are taking out massive loans to enter these fields with no earning potential. If you do land a job in your field, you’re likely to be earning as much as a fry-flipping dropout. There is a reason the term “starving artist” was coined.

 

The desire to “do what you love” and follow your dream is noble but understand that these fields aren’t careers, they’re hobbies. You can play with children, go to church, cook, help people, and paint without a high-priced education.

Lenders are throwing money at you because it’s impossible to escape the debt and you offer a great return. To lenders, you’re a living, breathing annuity and you will be repaying those loans the rest of your life.

Solution

Although it won’t help borrowers currently drowning in a sea of debt, there is a way to ensure this crisis doesn’t repeat itself. Education financing isn’t an efficient market and the risk/reward ratio heavily favors the lenders. Students need competition to fight the evil, predatory, and price-fixing lenders. A lender is needed who uses information to make informed investments at efficient market rates.

Reform is necessary and economic incentives must be in place to promote the right behaviors on the part of lenders and borrowers. Here is my suggestion:

Student loan interest rates should vary based on the likelihood of a student’s ability to repay the loan. It’s simple – the higher the risk of default, the more the student pays in interest. In today’s society information is everywhere. This deluge of data can be crunched to determine an appropriate interest rate of a loan based on a number of factors:

College major: Not all college majors are created equal. Engineers and computer science majors will be paid well. Art majors and social workers will not.

School rankings: Not all schools are created equal. Harvard, for example, ranks near the top of the charts, while University of Bridgeport has been ranked America’s worst college. Ouch.

GPA: Students ranked near the top of their class are much more likely to be gainfully employed than students who’ve spent more time staring at the bottom of a beer mug than at a textbook.

 

Test Scores: An actuary can use standardized tests like the SAT, ACT, IQ and other exams to statistically predict earning potential.

Credit Rating: Your (or your parents) previous record of credit repayment is a good indicator of future performance.

Medical history: Do you binge drink every weekend? Add 1%. What is the likelihood that you’ll croak during the life of the loan? These risk factors can be mathematically included in the price of your student loan.

Loan forgiveness upon death should be standard. Like other business models, losses from borrower casualties should be priced into the operating costs of the business. A loan company can estimate the likelihood of death, similar to a life insurance company. The premium can be included in the loan rate or the borrower can forego the increase and take out an inexpensive declining-balance term life insurance policy, listing the lending institution as the beneficiary.

Like mortgages or any other type of debt/investment, the rate of interest should reflect the risk of the borrower repaying. The algorithm will determine which students are the most likely to secure well-paying jobs and which will be living on mom and dad’s couch. Different weights can be assigned to each category and can be reassessed each year based on the progress of each student.

Students who are pursuing money-making degrees, receiving good grades, and attending quality institutions will pay low interest rates. These low rates should increase competition amongst students and will entice more students to strive for success in areas where job growth and future potential is highest.

Students in the less than stellar majors (cough, art) will be faced with higher interest rates due to the risk they pose to investors. If you can’t make money, it isn’t a career and you shouldn’t be borrowing other people’s money to screw around for four years. University isn’t meant to churn out Starbucks baristas and Verizon sales reps.

Impact

The United States is concerned, and rightfully so, with its students’ performance in math and the sciences. Countries like China and India repeatedly outscore us and many of our best jobs are being outsourced. Our economically inefficient system – the system that loans money to art majors and engineers at the same rate – produces a distorted labor market.

Presently, there is a gap between labor demand and the supply of students who pursue a specific career path. The majority of students choose a career based solely on what they want to do (since their education costs the same regardless of degree) with no thought to the ultimate goal: employment. An intelligent lender with access to more information than a single student can close the gap using interest rates to incentivize students into fields promising employment. This will create an equilibrium between students graduating with specific degrees (supply) and finding meaningful employment (demand).

 

What if too many students shy away from the now “high-priced” art degree? Or education? At first, that should be the goal. There are too many art graduates for the number of jobs, which potentially lowers salaries. But in the future, a simple adjustment of the interest rate can change incentives. Simply put, offer a sale.

Sale! Sale! 0% financing on art loans!

Students will again fill the seats of art classes and equilibrium will be reached. At this point, art becomes expensive and student numbers drop. And the cycle repeats. This method of financing college expenses will create a more efficient market for financing university costs and will positively affect the job market by funneling people to where they are needed (i.e., financially rewarded). An economic “nudge” can be an effective way at changing behaviors and producing desired results.

The days of the one-size-fits-all, high-priced student loans are over. Maybe one day we will see the light at the end of tunnel.