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Unintended Consequences: Student Debt
By Mel Miller

Within the sustainable, responsible, impact investing community, intention is important. Intention sets us apart from other investment styles, even if those other investment activities happen to generate unintended positive social and environmental impacts.

However, intention alone is rarely sufficient. When we use tools such as investing to solve sizeable problems, there is always a risk that unintended negative consequences may occur-despite our good intentions. This is also true within the public policy realm; it's a phenomenon that is particularly well illustrated by the alarming increase in student loan debt in recent decades.

How did we arrive at this point? The history of governmental support for higher education dates back to 1958 when President Dwight Eisenhower signed the National Defense Education Act of 1958. The program made loans directly from the government at low interest rates. Then in 1965, as part of Lyndon Johnson’s Great Society initiatives, The Higher Education Act expanded loans and grants to assist needy students and changed the way the loans were issued. Under the new program, the loans no longer were issued by the government but by banks. In case of default, the loans were guaranteed by the government (tax payers). No longer was the debt on the federal books, which pleased Congress.

President Nixon and Congress in 1972 went even further by creating the Student Loan Marketing Association known as Sallie Mae. As a "government-sponsored enterprise" (GSE), Sallie Mae issued its own debt to buy the student loans from the banks. The loan purchases allowed the banks to make more student loans. Sallie Mae was fully privatized in 2004. In essence, bankers got the rewards and taxpayers were on the hook for the risk.

President Clinton sought to change the program back to the program that existed under President Eisenhower, but Congress would not go that far. Congress reached a compromise in 1993 by phasing in some direct federal student loans while continuing to guarantee bank loans. The bank-issued loan program continued to expand much faster than the direct government loan program. All seemed well until the Great Recession hit. With credit markets in chaos, student loan funds dried up overnight, as banks refrained from issuing new loans and concentrated on collecting on faltering business and other consumer loans.

On March 30, 2010, President Obama signed the Student Aid and Fiscal Responsibility Act, which was packaged with the health care bill known as "Obama Care." The U.S. Department of Education is the lender of all student loans under the Act and the Federal Government is now responsible for the federal student loan program. Private loans to students issued after July 1, 2010 do not carry the governmental guarantee.

If use is a measure of success, the current program is a great success. Student loan debt amounted to "only" $788 billion when the Act was signed in 2010. Today it stands at $1.3 trillion and it's growing at $2,726 per second. As the supply of credit increased dramatically, it has resulted in the unintended consequence of soaring tuition costs.

The average cost of public and private university tuition has risen at a rate more than double the overall rate of inflation, and the average college student now graduates with over $35,000 in debt. Further documentation of the problem was provided by a recent study published by the Federal Reserve Bank of New York. Here are a few key facts:

  • According to the College Board, private university tuition has increased nearly 70% since 1994, rising from $18,161 per student to $31,231 in 2014.
  • Tuition at public four-year universities averaged $4,343 per student in 1994. This average has risen to $9,139 in 2014—a whopping 110% increase.
  • The average Federal loan amount per student has more than doubled during the last twenty years.

One unintended consequence according to the Federal Reserve study: Enrollment at all types of universities has been unaffected despite the massive increase in access to Federal aid. The study also points to the increase in Federal student aid as the main cause of the exponential increase in tuition costs.

Someone Must Do Something0430 MONEY Students 1...PA library file of students of Liverpool University waiting to receive their degree at the Philharmonic Hall, Liverpool. Consumer rights campaigners warned students Thursday September 18, 2003, to steer clear of credit card companies offering gimmicks such as free cameras and book tokens. Expensive credit card debt could push students over the edge , claimed the National Consumer Council in advice timed to coincide with Freshers Week. Surveys have suggested that graduates can expect to university with student loan, overdraft and other debts totalling between 10,000 and 15,000. See PA 0430 MONEY Students. PA Photo.

According to an August 2015 article in The Economist: "Better Ways to pay for college," the higher education system in the U.S. "is marred by soaring costs, stratospheric student debt, and patchy performance." It is obvious that increasing student loan availability exacerbated these three problems. But, making additional loans available or paying down the debt will only exaggerate the problem of escalating tuition costs. Supply and demand principals of Economics 101 are in play: Increasing the supply of credit will only increase the cost.

Initiating a method for existing borrowers to refinance their loans appears reasonable; yet Senator Elizabeth Warren's plan to allow graduates to refinance existing loans was rejected by the GOP. Many graduates are paying over 10% interest on their student loans!

Some suggest that schools are contributing to the problem by not being sufficiently zealous about cost control. As long as funding is available, there is little pressure to limit tuition increases. Critics also chide colleges and universities for not providing sufficient tuition assistance and instead being more concerned with expanding their endowments.

According to U.S. News data, the average college endowment was $355 million at the end of 2013. The average of the top 50 university and college endowments is a whopping $6.6 billion as of June 30, 2014, according to a study conducted by NACUBO. The top 10 most elite schools have endowments in excess of $1 million per student, with Princeton topping the list at $2.6 million per student.

Free Market Solutions…?

An internet search uncovered a few firms offering "student debt solutions." However, they appear to be nothing more than debt consolidation organizations. Examples of organizations providing a unique service are CommonBond and SoFi. As for-profit companies, they have a strong social mission, including but not limited to career support, connections with individual investors, flexible rates and terms, unemployment protection, and a simpler process. While these start-up firms are transformative in nature, they are still very small players in this space.

In the meantime, there's nothing particularly promising in the works in Washington. So far, the presidential candidates seem more content with name-calling than with policy discussions, though a couple of candidates have addressed the issue. One plan calls for capping the repayment of student loans at a maximum of 10% of income for twenty years. If the loan is not paid off after twenty years, the government (taxpayers) will absorb the loss. This plan is not unique in that it is a model used in Britain and Australia. This plan only addresses one of the three problems. To address the rising cost issue, the candidate would reduce subsidies to colleges that do not "control" costs.

Another plan attempts to address all three problems. Online education platforms would be emphasized to help control costs, and online resources would provide information on costs versus earning potential of various degrees.

The final, and most creative, idea is to link repayment of university funding to income by using equity financing. Private investors would fund a student's education, not taxpayers. Instead of taking on debt, students could sell a portion of their future income to private investors. At graduation, the liability would resemble equity, not debt. Lower-earning graduates would not be burdened with a high level of debt and a large drain on their income.

The cost control would come from the private investors who would be reluctant to fund "non-productive" courses and degrees. However, there are obviously potential risks-and no doubt unintended consequences-with investors being the primary determinant of the value of education. To reduce the risk for the equity investors, they would need to apply a basic principal of investing-diversify by investing in a basket of students.

It’s worthy of note that this equity financing proposal was first introduced in 1955 by Nobel Prize winner Milton Friedman.

Student loan debt and the sharply rising cost of a college education is a serious problem which deserves more political discussion. We need common sense solutions.

First Affirmative understands that the ways we save, spend, and invest can dramatically influence both the fabric and consciousness of society. We believe that in addition to the benefits of ownership, investors bear responsibility for the impact our money has in the world. Are you making conscious decisions about the impact of your consumer purchase and investment decisions?

Posted: December 16, 2015