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A Magazine of Ideas

Fixing Student Loans: Let’s Give Colleges Some ‘Skin in the Game’

Thursday, January 26, 2012

What lessons on student loans can be learned from the searing national misadventure with mortgages?

There are provocative parallels between student loans and the mortgages that created the disastrous housing bubble. In both cases, the government promoted plausible goals— higher education and home ownership—to excess, through the overexpansion of debt to levels beyond the repayment ability of a large percentage of borrowers. In both cases, the government guaranteed much of the credit, putting the ultimate risk of bad debts on taxpayers. In both cases, debt expansion drove the price of the object being financed (colleges and houses) to heights sustainable only if debt could always be increasing. In mortgages, it could not, and the subsequent collapse raises the question: will there be a similar outcome with student loans?

Professor Richard Vedder, considering the question of a student loan bubble, recently concluded that the worst idea ever “was the creation of federally subsidized student loans in the first place.” Can any lessons from the searing national misadventure with mortgages be usefully applied to student loans? I believe so.

A principal lesson from mortgages, nearly universally agreed upon, is that those who create the mortgages should retain a material part of the credit risk. Such “skin in the game” obviously aligns the incentives of the originator of the loan with taxpayer guarantors to control excesses in debt expansion. For mortgages, this “skin in the game” concept was adopted by the Dodd-Frank Act of 2010. More importantly, its advantages are displayed by one of the highest quality mortgage portfolios that exist today: the Mortgage Partnership Finance (MPF) mortgages of the Federal Home Loan Banks. All of these MPF mortgages have credit risk retained by the originator, with excellent results for their credit performance. This program has been operating for more than 14 years.

Let’s apply this mortgage lesson to student loans.

Colleges are the effective originators, the promoters, and the chief financial beneficiaries of student loans.

Who are the most important parties to have “skin in the game” in student loans? The colleges themselves, of course! They are the effective originators, the promoters, and the chief financial beneficiaries of student loans. It is their rising costs which result in ever more debt and more risk of default for student borrowers and for taxpayers.

The federal student loan programs should simply compel colleges which get proceeds from the programs to maintain a 10 percent first-loss share in the credit performance of the loan. This puts a material risk of excessive and un-repayable debt and of high college costs on those who are promoting the loans. The colleges would stand to take losses on bad loans before the taxpayers, as they should—they would, in financial parlance, be subordinated or “junior” to the taxpayers. A highly desirable improvement in financial structure and incentives!

So, just as for the mortgage lenders, let’s give the colleges some “skin in the game.”

Alex J. Pollock is a resident fellow at the American Enterprise Institute. He led the creation of the MPF program during the 1990s when President and CEO of the Federal Home Loan Bank of Chicago.

FURTHER READING: Pollock also writes “Elastic Currency, With a Vengeance,” “There’s Usually a Banking Crisis Somewhere!” “Goodbye, Gold Redemption of the Dollar,” “Uncertainty Is More Dangerous Than Risk; Error Is More Dangerous Than Fraud,” and “A Fairer System for Taxing U.S. Corporate Dividends.” Edward Pinto contributes “Government Housing Policy: The Sine Qua Non of the Financial Crisis” and “Cleaning House: The Financial Crisis and the GSEs.”

Image by Rob Green / Bergman Group