Colleges need to have skin in the game to tackle student loan debt

Republican Senator Lamar Alexander of Tennessee rightly wants to make colleges more accountable for the results of student loans. With these federal loans, the government lends with no credit underwriting, the students get in debt, but who gets all the money? The colleges. If the students fail to repay the loans, who takes the hit? The taxpayers. This is a perverse incentive structure. It leads to, as his committee report found, “nearly half of all borrowers not making payments on their student loans.”

Alexander proposes a “new accountability system for colleges based upon whether borrowers are actually repaying their student loans.” Great idea! In a similar vein, the annual White House budget correctly observes a “better system would require postsecondary institutions that accept taxpayer funds to share in the financial responsibility associated with student loans.” Indeed, each college should share the risk of whether its students repay the money they borrowed and the college spent. Nothing improves your behavior like having to share in the risk you are creating. In his book “Skin in the Game,” Nassim Nicholas Taleb wrote, “If you inflict risk on others, and they are harmed, you need to pay some price for it.”

{mosads}In student loans, with their abysmal repayment rate, colleges play the same role as subprime mortgage brokers did in the infamous housing finance bubble. They promote the loans without regard to how they might be repaid, they make money from the loans, and they pass all the risk on to somebody else. In the housing finance case, the risk went ultimately to the taxpayers. In the student loan case, it goes directly to the taxpayers. Just as the flow of easy mortgage credit induces higher house prices then takes even more debt to pay the higher price, the flow of easy student credit induces higher college prices then takes even more debt to pay the higher tuition. It is a sweet deal for colleges that create the risk, keep all the money, and stick the taxpayers with all the losses.

A Brookings Institution research paper points out that with low repayment rates, the federal student loan program represents a “sizeable taxpayer funded transfer” to the colleges. It rightly asks how much of the taxpayer losses the college should have to pay back. It proposes that each cohort of college borrowers be measured at the end of five years of required payments, and each college has to pay at least 25 percent of the amount by which the actual principal reduction has fallen short of 20 percent of the total of the original loans after five years. The 20 percent principal reduction results from what would happen with a 15 year amortization of the loan pool as the standard used. That seems perfectly reasonable.

This proposal is a good stab at it, but I would say do not wait for five years to address the problem. Do it every year. Take the total loan pool of each borrower cohort of the college. Establish a 15 year amortization schedule for the principal of the pool. Measure every year how much principal has actually been paid in the pool as a whole. Each year the college should pay to the Treasury, I suggest 20 percent of any repayment shortfall against the standard. That would be a steady financial feedback loop.

After 15 years, the college will have reimbursed taxpayers for 20 percent of whatever loan principal was not paid. Of course, taxpayers would still be paying for 80 percent of the losses. The 20 percent loss participation would be enough to give the college the right incentives to improve its repayment performance and control instead of constantly bloating the debt of its students. Student loan borrowers, like mortgage borrowers, are hurt being saddled with thousands of dollars in debt they cannot pay.

Colleges should have maximum flexibility for how to work on this. They could increase efficiency, reduce their costs and their prices, or shorten the time to graduation to scale back the need for borrowing. They should make sure the students understand what loans mean and how they are expected to repay, consider their ability to pay, guide the students to programs with the most promising job prospects for them, and adjust their mix of programs. They can do all of the above plus other ideas and managing the tradeoffs involved. Colleges should no longer play the role of subprime mortgage brokers. They need some skin in the game now.

Alex Pollock is a distinguished senior fellow at the R Street Institute and former chief executive officer of the Federal Home Loan Bank of Chicago.