Picture yourself in charge of a college or university where you are competing with other universities for the best students and teachers. There is a national ranking system that everybody (students, faculty, alumni and the board of directors that hired you) pays a lot of attention to — and it will rank your university higher if you spend more money.
Spending more also helps you build nicer buildings and better programs to compete for the best students and faculty. The government will give as much money to your students as they need to pay for college. And the best part is, if those students don't pay the loans back, your university doesn't lose one cent — the taxpayers have you covered! What does this system incentivize? Spending more, building more, raising tuition more. That is, until the system breaks.
On September 1, many Americans began to face a dim financial reality. After an extended moratorium on federal student loan payments, including attempts at debt forgiveness by the Biden administration, consumers are once again obligated to repay their student loans. For many, this debt totals tens of thousands of dollars, with repayment resuming at a time of higher interest rates as well as higher costs on goods and services. The administration's latest moves to help borrowers through the income based
The root of the problem is that the lending decisions on most student loans do not include any assessment of the risks of nonpayment. Underwriting is run by the government, and credit decisions are often divorced from reality, with some loan types requiring no credit check at all and others requiring a parent co-signer, rather than an assessment of the student's ability to repay.
Combine that with the fact that the student being saddled with this debt — and significant financial responsibility — is entering college as a teenager, with limited to no education in financial literacy. Universities receive the money, and it is U.S. taxpayers who bear the risk when these loans are not repaid. We learned from the Great Recession 15 years ago the catastrophic effects of a system in which lending decision-makers don't bear the risk of nonpayment.
The endless flow of cash, subsidized by taxpayers, means that universities have no incentive to control costs or assess the ability of their students to repay the debt. As a result, tuition and fees continue to far outpace inflation. Skyrocketing prices have another perverse benefit — increasing a university's ranking — as some, including U.S. News and World Report, factor in spending per student in their ranking systems.
Banks continued to downsize their retail networks and invest more in digital services last year. But they shut down fewer branches in 2023 than in recent years partly because of an M&A slowdown.
Meanwhile, options for consumers to resolve student loan debt during times of financial stress are limited. Since 1976, student debt has generally been ineligible for bankruptcy discharge, due to its special exception treatment under the U.S. bankruptcy code.
Like the housing market leading up to 2008, the status quo in student lending is unsustainable. The impacts of the student loan problem are wide-reaching and similarly systemic. These impacts are just beginning to be felt, as many borrowers who graduated within the past three years have yet to make a single payment.
The first step in addressing this crisis is to make universities have skin in the game by holding a portion of the default risk on any loan originated for their students. This will incentivize universities to consider risk and a borrower's ability to repay when making lending decisions. It will further incentivize the institutions to set appropriate tuition and fees, and adjust operational and capital expenditures to make the business model work. A similar paradigm shift occurred after 2008, when risk retention mandates in the securitized loan market dramatically changed lender behavior, resulting in a spillover effect that benefited consumers and the economy.
Once incentives are aligned, the next step is to allow federal and private student loans to be discharged through bankruptcy. The special exception for student loans under the bankruptcy code has done more harm than good, by trapping the most burdened and hardest-hit people in debt that they can never get out of. The purpose of the bankruptcy code is to give insolvent debtors, who have had the misfortune of finding themselves in an untenable financial situation, an opportunity for a fresh start. If you believe the bankruptcy code serves a useful purpose (which most Americans do), then you should agree that it makes absolutely no sense to have student loans sit outside this system.
It is not rocket science, but it will take political will. Taken together, these two policy changes would go a long way toward addressing the bad incentives in student lending that are leading too many people far beyond their breaking point.
