Student Loans: Perhaps Our Nation’s Greatest Moral Hazard Problem

Andrew Kloster*

Andrew Kloster

Andrew Kloster

Last week, the U.S. Department of Education (ED) announced classwide “debt relief” to former students of Heald College, which was owned by parent company Corinthian Colleges, a for-profit entity that closed all its schools earlier this year.  It had already been the case that pursuant to 20 U.S.C. § 1087e(h), student borrowers brought before the department for failure to pay their direct student loans could point to “acts or omissions” of their school as a defense to nonpayment.  And it was already up to the ED to determine what “acts or omissions” qualified for this “borrower defense.”

What is new, however, is that the ED appears to be moving to a more prospective model where it works with state attorneys general and notifies borrowers of possible claims.  Ordinarily, this kind of fact-finding by the ED would proceed as follows: a borrower would default, the ED would initiate proceedings, and the borrower would claim misfeasance or malfeasance on the part of his or her university as a defense to nonpayment.  The federal government, which operates the Direct Loan program in question, would then have a variety of options for recouping its losses from the school.  Now, however, it appears that the ED itself is doing a searching inquiry of its own, and identifying and targeting prospective debtors rather than waiting for them to default for economic reasons.

According to the Consumer Financial Protection Bureau, in 2013, student loan debt was over $1.2 trillion: now, the number is likely much higher.  Student loan debt has ballooned since 2008, and is the only type of consumer debt that continues to go up, rather than down.  Not only that, but delinquency has doubled over the last six years.  Roughly a quarter of all student debt is at least three months in arrears. 

Student loan defaults have every hallmark of being a moral hazard, as shown by an analysis of the student loan market.  A moral hazard, in brief, is a situation in which one person is incentivized to take risks that a reasonable person wouldn’t take in an unregulated market, because the costs for bad behavior or risky choices that don’t pan out are shifted to someone else.  In the student loan market, the government assumes the risk of students, lenders, and educational institutions in different ways. Most Americans attending college for a first degree can borrow up to $57,500, no matter their creditworthiness.  At the graduate level, students can borrow much larger amounts.  And yet, student loan debt is non-dischargeable in bankruptcy, meaning that absent extraordinary circumstances, loan principal amounts are set in stone.

On top of this, the federal government sets interest rates for student loans.  It used to guarantee the principal on loans, but since 2010, the ED itself has become a direct lender, under the Ford Federal Direct Loan Program.   Any risk of default is borne directly and entirely by the federal government. 

That is not all.  The federal government has authorized “income based” repayment plans, setting monthly repayment terms based upon the borrower’s “ability” to repay rather than upon risk profiles (size of loan, credit history, etc.).   This has allowed some borrowers to have repayment schedules under which their monthly payment is less than the monthly interest on the loan.  Moreover, the federal government has a variety of forgiveness programs to ensure that after a set period of time, ballooning principals are eliminated.

This system has huge information imbalances.  Borrowers take out loans knowing only that the loan amounts involve numbers that are huge, even astronomical in comparison with the dollar amounts they recognize from their high school jobs.  While they know that the job market is not great, optimism prevails.  Data that they could use to make an informed decision is unavailable or unclear:  At the time of obtaining a loan, your average student is generally unaware of his or her field of study, likely educational performance, future job prospects, or likely salary.

For their part, universities have every incentive to engage in “puffery.”  In general, there is no obligation for universities to make data regarding predicted educational outcomes or job opportunities public.  Thus, it is highly unlikely that a university would or could be sued for consumer deception by disgruntled former students who are unsuccessful in the job market following graduation.

Finally, as law school professor Paul Campos has noted, the increase in higher education costs has closely tracked public spending on higher education, and this is largely attributable to increased administrative costs

A Broad View

Putting this all together, the system appears as follows.  In exchange for a shot at a degree and a job, a student guarantees the federal government a portion of his or her labor for a period of years.  This period of time is capped by statute (the duration of repayment before loan forgiveness kicks in).  Not all students fare the same under this system.  The amount a student will be required to pay is progressive: wildly successful students are able to buy their way out of this contractually-obligated servitude quickly.  Wildly unsuccessful (or shrewd) students will end up paying only a small portion of the bill (and this portion is often tax deductible), and the taxpayers will pay the bulk.  Students in the middle---who make just enough to meet payments--- are saddled with crippling long-term debt.  Furthermore, if anything, this problem may be expected to worsen, as college tuition fees, a major driver of loan burdens, continue to increase.    Growth in non-instructional costs is the major driver of tuition increases, and while it is hard to quantify, anecdotal evidence suggests that compliance with governmental mandates such as antidiscrimination and reporting laws are quite costly.  Vanderbilt University has, for example, found that 11% of its entire yearly budget--- $150 million--- is spent on regulatory compliance.

Unfortunately, proposed solutions to the college debt problem appear to have significant problems.

First, making student loans dischargeable in bankruptcy might appear to facilitate efficient risk shifting, but this benefit is uncertain and must be weighed against serious countervailing problems.  On the plus side, bankruptcy for student loans would ordinarily have the advantage of shifting risk to lenders, who are presumably in a better situation to make informed choices about cost-control.  However, as the lender right now is the ED, this will carry no cost control benefits unless the ED steps up its regulation of educational institutions.  Even if there are some cost control benefits, however, these must be considered in light of significant offsetting costs.  First, there would be an inequity in dealing with previous generations of debtors, who obtained loans and incurred debt under the old system and who may have struggled to pay off their loans because the option of discharging that debt by declaring bankruptcy was not available.  . Second, bankruptcy protection can be an economically efficient risk-management tool if it incentivizes an efficient degree of business risk-taking and the assumption of prudent levels of personal debt.  But if applied to student loans, it would simply reward existing debtors for past “bad” conduct and perversely help prop up an economically inefficient market rife with moral hazard.

A second option is to put universities on the hook for student loan interest (but not the principal).  One could imagine that this would make universities think twice about raising tuition rates (lower costs means less interest and risk), and it could make universities care more about student outcomes (since better-paid students means faster payoffs by them and not by the university).  However, legislation doing this could simply lead colleges to raise up-front tuition to cover the risk associated with future interest rate payments.  If future interest payments for an average student are valued in present-day dollars at $30,000, for example, the college could just increase the rack-rate tuition by that amount (plus interest on that amount)..  In other words, a simple mandate putting universities on the hook for interest on student loans could be easily evaded by universities changing the payment structure up front. 

A third option is to facilitate the filing of consumer protection lawsuits against universities.  This does not appear to be a viable option, however, because it would be unclear as to what promised benefits universities had failed to deliver (jobs are not directly linked to degrees in our society) and virtually impossible to demonstrate that non-educational factors had not contributed to former students’ inability to make repayments.  However, this consumer protection model is what the prospective borrower defense system appears keyed to do.  Students can get their debts discharged by, in essence, establishing that they were misled by their university and incurred debt as a result.  The ED can then try to recoup the money from the university.  Such a system is inherently political, because it relies upon top-down enforcement rather than allowing private ordering and the market to self-police.  One could imagine a consumer-protection model offering relief to graduates with “gender studies” degrees who are unable to get a job because the university never told them that the job prospects for students with that degree are limited.  One could imagine similar claims against universities by legacies, affirmative action admittees, or other  possible “victims” of so-called “mismatch.” 

In the end, however, the problems with American higher education involve large policy questions, significant vested interests, and potentially controversial solutions.  We are a long way off from a situation in which schools compete for students and prospective students make decisions about where to attend school based upon actual educational and employment data and a realistic assessment of the risks and likely rewards involved in saddling oneself with student debt.

*Andrew Kloster, a former NYU Journal of Law and Liberty Senior Articles Editor and NYU Law graduate, is a legal fellow at the Heritage Foundation.