Colleges Should Share the Risk for Student-Loan Defaults

Christophe Vorlet for The Chronicle

June 08, 2015

National student-loan debt is $1.3 trillion, and delinquency rates on student loans are roughly equal to those on subprime mortgages before the great recession. Given these grim statistics, policy makers are increasingly asking whether colleges should shoulder some of the financial burden, which now falls only on the taxpayer.

As I told the U.S. Senate Committee on Health, Education, Labor, and Pensions during testimony last month concerning the reauthorization of the Higher Education Act, it is in the best interest of students, taxpayers, and the economy that colleges have "skin in the game" when it comes to their students’ future economic success. The most straightforward way of doing this would be to impose a penalty on colleges equal to some proportion (e.g. 20 percent) of the value of the student loans that past students have defaulted on.

The current accountability system is too blunt: revocation of eligibility for student loans for colleges that fall above certain default-rate thresholds (40 percent in one year, 30 percent in three consecutive years). Even more troubling, there are enormous incentives and opportunities for colleges to game the system. For instance, thresholds are based on the percentage of students who default within three years of leaving college. This has led some colleges to make small enough payments to avoid a technical default for the first three years of loans. Moreover, there are no incentives for the overwhelming majority of colleges that are not near the default-rate thresholds.

While a risk-sharing policy would most harshly punish the institutional bad actors that have become synonymous with deceptive marketing and unfulfilled promises, it would also provide much-needed incentives to the entire higher-education landscape. It is important to recognize that there does not need to be fraudulent intent, or even poor teaching, for colleges to be held partially responsible for their students’ increasing levels of debt. Therefore, all colleges should be subject to a penalty that is proportional to their contribution to the current problem.

The benefit of risk-sharing lies not in the penalty itself, but in the changes in decision-making that it promises. As a general rule, any policy aimed at improving graduation rates, time to degree, debt, or earnings or employment after graduation would have an incentive under a risk-sharing policy. For example, a 2013 report by Complete College America found that the average associate-degree program offered at two-year institutions required 65 credits, with many programs requiring over 70 credits. This growth in required credits substantially departs from the historical norm of 60.

Depending on the state and program, this phenomenon may be due to either institutional decisions or an accrediting agency. Regardless of the cause, longer programs lead to more debt, a lower likelihood of graduation, and an increase in loan-default risk.

A risk-sharing policy could also improve advising. Students, and even academic counselors and professors, are generally aware of which majors earn more money but have no concept of the magnitude of the differ­ences. For example, degrees in economics and marketing are offered in most every school of business, with students in these programs often taking similar schedules during their early years of study. But grad­uates with an economics degree will earn an average of $1 million more over the course of their lifetimes than will the marketing-degree holders.

I am certainly not suggesting that students choose a major solely based on earnings. However, at a time when graduates of certain programs are unable to find work, we owe it to our students to make sure they are fully informed when they decide which college to attend and what to major in, as these are arguably the most significant financial decisions that most people ever make. And due to general-education and transfer-credit requirements, these decisions are often cemented before the age of 20.

A risk-sharing policy is not by itself a panacea. It must be coupled with other reforms to the financial-aid system that would give institutions the tools and flexibility to deal with the growing student-debt problem. Putting stricter limits on how much students are able to borrow above the cost of attendance is worth exploring, as is reducing the considerable amount of bureaucratic red tape surrounding the accreditation process.

Furthermore, policy makers must be mindful of the potential for unintended consequences arising from the sweeping reforms Congress is considering. One such consequence, increased tuition rates, is likely to be mild (a 1 percent increase for the average institution in the absence of any other reforms, many of which are likely to reduce upward pressure on tuition). The benefits of the incentive effects of a risk-sharing policy far outweigh this potential cost.

Another potential concern is that some colleges might stop admitting low-income students, who historically are more likely to default. This is a more serious concern that policymakers should be sure to tackle in any legislation. One proposed solution is to use the money generated from risk-sharing penalties to pay a bonus to institutions for each Pell Grant or low-income student who successfully graduates.

Senators on both sides of the aisle appear serious about and committed to broad-based reforms being discussed as part of the reauthorization of the Higher Education Act. Hopefully they will take this opportunity to add financial penalties to ensure that colleges are equally serious about and committed to their students’ economic success.

Douglas Webber is an assistant professor of economics at Temple University.