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 Postestimates 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.
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.