Skin in the Game

Students are defaulting on their college loans at worryingly high rates. Many observers of higher education believe that one reason for the defaults is that those most responsible for the high costs—the colleges themselves—have little or no incentive to prevent them.

Would requiring colleges and universities to have “skin in the game” deter defaults? The idea of having colleges share the risk of default has gained popularity recently, although few have taken the time to examine it extensively. 

Alex Pollock, who became a fellow at the American Enterprise Institute after thirty-five years in the banking industry, proposed giving colleges “skin in the game” in a January 2012 article for The American. Congress imposed a similar rule on mortgage lenders as part of the Dodd-Frank Act of 2010, requiring those who securitized loans to share at least 5 percent of the credit risk. It has apparently kept banks from making the same kind of risky loans that led up to the housing market crash, and Pollock argued that something similar could work for college loans.

“Who are the most important parties to have ‘skin in the game’ in student loans? The colleges themselves, of course!” wrote Pollock. “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 taxpayers.”

Experts at two AEI conferences on higher education have since discussed the idea. Law professor Glenn Reynolds, a.k.a. Instapundit, took to the Wall Street Journal in June to promote it. And former education secretary Bill Bennett and coauthor David Wilezol suggested the idea as a solution to many of higher education’s woes in their book Is College Worth It? (Reviewed here by George Leef).

Advocates see numerous benefits resulting from such a rule, starting with improvements in the likelihood of graduating. In 2010, nearly 375,000 students defaulted on their loans within two years of beginning repayment, a rate of 9.1 percent. Disturbingly, at more than 260 colleges in the country, a higher percentage of students default on their loans than graduate.

A “skin in the game” rule would dictate some selectivity in lending. If colleges were on the hook for 10 to 20 percent of the balance, wrote Reynolds, “You can bet … universities would be much more careful about encouraging students to take on significant debt unless they are fully committed first to graduating, and second to a realistic career path that would enable them to service that debt over time.”

Taxpayers would likely save money, too, since their money is used to make the loans. If more students can pay back their loans, taxpayers will lose less.

A third benefit, advocates say, is that it would change aspects of higher education itself, since (depending on the amount of “skin” in the game) colleges would have a much larger incentive to help students graduate and find well-paying jobs. For example, if colleges are afraid of losing money, they may steer students away from, say, gender studies and find new ways to cut costs to keep student debt low.

But there are strong objections to the idea of colleges sharing default risk. Some of them, understandably, come from universities and lobbyists, since some schools might have to pay sizable sums—or lose students. In an interview with the Pope Center, economist and higher education reformer Richard Vedder predicted a “firestorm” of protest from universities and lobbyists.

One criticism is that the rule would prevent many students with poor academic records from going to college, even though some of them will beat the odds and succeed. To use the popular phrase, it would limit “access.”

Vedder thinks that criticism is inappropriate. Keeping students from going to a school where they would likely default would be good for them, not bad. “Should the taxpayer be subsidizing sending kids to go to school to make some people feel warm and fuzzy about themselves,” he asked, “when they are in fact consigning these kids to a very, very bad future where they end up getting a job probably no better than had they not gone to college?”

Another criticism of colleges sharing the risk of default is the complicated nature of doing so. At a June AEI conference, Terry Hartle, senior vice president of the American Council on Education, pointed out that Congress had passed a similar law in the early 90s, except that state governments rather than colleges shared in the default risk. According to Hartle, President Bill Clinton’s Education Department decided that the idea was too complicated to administer and just gave up on it. State law corresponding to the “Student Loan Default Risk Sharing Program” of the 1993 Omnibus Budget Reconciliation Act is apparently still on the books in Missouri.

The idea that skin-in-the-game is too complicated strikes Vedder as “specious.” The Department of Education already dispenses and tracks millions of loans of varying amounts every year. Keeping tabs on universities’ risk sharing does not seem very complicated by comparison. 

A third criticism is that default risk sharing would be expensive. In addition to the fees universities would have to pay when their students default, they would also have to pay professionals to assess the potential default risk of each student (assuming they began to do so). Andrew Gillen, a researcher at Education Sector, told the Pope Center he is concerned that sharing default risk would “impose a new burden on universities.” Analyzing who is likely to default and who is not could be expensive, and colleges are not good at it.

If there were such a cost, the increased burden would fall primarily on schools with high default rates—which may be a moral victory, depending on your perspective.  And, as my Pope Center colleagues Jay Schalin and George Leef have pointed out in discussion, schools could outsource to a private firm the task of analyzing risk, thus minimizing cost. Many schools may not even bother with it, since their default rates are already so low. For example, the University of Michigan at Ann Arbor’s 3-year default rate is 1.6 percent.

A final objection is that shared default risk is an attempt at centralized government planning, something the government has no business doing and may well lead to more trouble than it solves. Gillen said it “strikes me as a Rube Goldberg method of trying to hold colleges accountable. ”

But others think the idea would actually allow the free market to work rather than stifle it. It would shift accountability for lending from the government (which has little incentive to take care in lending) to the universities (which would have an incentive). At the moment, no one except some savvy students and their parents have this incentive.

Vedder concedes it is a “second-best solution” to the problem of government subsidies luring many students to college who will be worse off for having gone. A better solution, he says, would be for the government to get out of the student loan business, allowing private lenders to decide whether or not the students pose a substantial risk of default.

But an improvement is an improvement. Giving colleges skin in the game could make our nation’s higher education industry a better steward of the funds it receives, and it’s something lawmakers should consider.