This week Sen. Elizabeth Warren, who has made student loan reform a personal cause since arriving in Washington, outlined her plan to help more Americans graduate from college “debt-free.” The gist: Make loans themselves cheaper (some kids are inevitably going to borrow), give more money to colleges to keep tuition down, and then heap on accountability measures to make sure schools don’t waste all that taxpayer cash.
All of this is potentially smart policy. But while many of Warren’s individual proposals sound promising, many of them are very light on details, which makes it hard to figure out exactly what her final vision is. For instance, much like presidential candidate Bernie Sanders, she wants the federal government to help states fund their university systems the way it helps them “build and maintain interstate highways.” Does this mean that, like Sanders, she wants Washington to spend enough that tuition drops to zero? Probably not, but she doesn’t specify.
Nevertheless, Warren is an key figure to watch on this issue. Making college affordable is shaping up to be a major piece of the Democratic agenda heading into 2016. And on top of the loyal following she commands among American progressives, Politico reports that Warren’s advisers on higher education seem to have Hillary Clinton’s ear as well. Whatever the Senator says now could end up as the party consensus.
With that in mind, there’s one piece of the Warren plan that I think deserves especially close attention. It’s called “risk sharing,” or, sometimes, “skin in the game.” The idea is that when students can’t pay their loans, their colleges (who encouraged them to borrow in the first place) should pay a fine—preferrably some not-insignificant percentage of the borrower’s balance. The theory is that colleges would work to keep costs down, or avoid loading up students with debt they can’t pay back, if their own financial health were at stake. Right now, the notion seems to be generating bipartisan enthusiasm. Along with fellow Senate Democrats Jack Reed, Dick Durbin, and Chris Murphy, Warren introduced legislation on the issue in 2013. But some of risk sharing’s biggest boosters have been conservatives policy wonks like Andrew Kelly at the American Enterprise Institute.
The skin-in-the-game approach is appealing because it would help fix the bizarrely and obviously misaligned incentives that have helped make the student loan market such an unholy mess. Today, colleges can admit students and encourage them to borrow. But if the students eventually default, however, the schools typically don’t suffer any consequences. Instead, taxpayers take the financial hit. That convenient setup has allowed predatory for-profit education companies to gorge themselves on federal student loans, building an entire business model around freighting students with debt in return for worthless degrees without having to worry much about what happens the day those students leave campus. Traditional private and public colleges haven’t been as ruthless about it, but many have still turned a blind eye to whether their students are actually capable of repaying their loans.
There are some regulations in place to keep colleges from throwing responsibility entirely to the wind. They’re just not very effective. If too many of its former students default, a school can lose access to federal aid. The problem is that the thresholds are extremely high. A college’s “cohort default rate“—the fraction of students who stop paying their loans within three years of starting repayment—has to hit 30 percent for three years in a row or 40 percent for one year before the feds cut the institution off. As long as the school stays under that high bar, it’s in the clear. Moreover, colleges have become very good at gaming their default measures by nudging students into temporary deferment or forbearance programs so that they’re technically current on their debts, even if they’re not repaying them.
Making colleges pay when their former students run into loan problems could fix this situation. Instead of being incentivized to keep defaults below an arbitrary bar, they would have a vested interest in every former student’s financial wellbeing.
Designing an effective version of risk sharing wouldn’t be be simple. For instance, student default rates naturally tend to rise in recessions. It’s not clear colleges should be held responsible for the effects of a poor economy. Some colleges have high default rates even though they charge modest tuition because they serve low-income students who often borrow for living expenses. We don’t necessarily want to punish those institutions. There’s also a possibility that, if they did have skin in the game, schools would try to keep their default numbers low by admitting fewer poor and minority students, who tend to be larger credit risks.
It’s also not clear that default rates are the best way to measure whether schools are pushing students to overborrow. Many undegrads with high debt loads enroll in income-based repayment programs that cap what they owe each month as a percentage of their earnings. This all but guarantees that they won’t fall into delinquency. But some end up making payments that are too small to even cover their interest, leaving their balance to grow. Since borrowers who choose an income-based plan now become eligible for debt forgiveness after 20 years, the government will likely end up on the hook in many of those cases where an individual fails to make a dent in what they owe, even if they never technically default.
There are also solutions to these dilemmas. As Kelly has suggested, the government could offer schools a bonus for each low-income Pell Grant recipient they graduate, to balance out the risk that some low-income students won’t be able to pay their debts. It could also adjust the penalty formula to account for downturns. Instead of defaults, the government could track the amount of progress students make repaying their loan, and hold schools responsible for a percentage of the balance after, say, a standard 10-year repayment period.
Whether risk sharing works in practice will come down to these sorts of details. But the higher education market is broken in fundamental ways. Most reasonable people acknowledge that by now. And making colleges put skin in the game when students borrow might realign some of the perverse incentives that have led to spiraling education debt loads. Given that both a liberal favorite like Warren and conservative thinkers can agree on the idea, it just might have legs.