The Private Student Lending Industry’s Death Has Been Greatly Exaggerated

Mark Twain’s famous quip about the rumors of his demise applies to the private higher education lending industry. Many people think that because Congress did away with the nominally private Federal Family Education Loan Program in 2010 and the Education Department’s Federal Direct Loan Program has been mushrooming, the private lending business must be dead, or at least nearly so.

Happily, that’s not the case. While federal student loans constitute about 90 percent of all student loan originations now, there is still a vibrant and innovative private sector. Lenders there put their own money at risk, instead of ladling it out carelessly, as the feds do. In 2014-15, private loans for higher education were approximately $9 billion.

Private lenders, of course, can’t afford to be careless with their capital. If the Department of Education were a business, it would long ago have gone bankrupt from all the loans to students who defaulted.

How do the private firms avoid making mistakes?

In their recent AEI paper “Looking Backward or Looking Forward?” Andrew Kelly and Kevin James explore that question. Particularly interesting is their analysis of the criteria that private lenders use when deciding whether or not to extend a loan.

Private lenders, no matter what the market, need to have underwriting standards they can rely on. What the authors call “backward-looking” standards are based on facts known about the students or (more likely) their parents, mainly FICO scores.

This approach means that student lending is really “family lending.” The main attraction is that it’s safe—safe on two counts. Not only are FICO scores a reliable indicator of a borrower’s ability to repay, but they’re also approved by the pertinent federal law, the Equal Credit Opportunity Act (ECOA). College lenders don’t have to worry that they’ll be investigated by Federal Trade Commission officials for “unfair lending” if they use FICO scores, even though doing so favors wealthy and established borrowers.

In contrast, “forward-looking” underwriting standards evaluate the likelihood of student success, such as the probability of completing the program, placement rates, and average starting salaries for graduates in the field. Lenders including MPower Financing, Skills Fund, Pave, and Climb Credit search for reasons to believe that students will receive positive returns on their investment (or not) before deciding whether to lend them money for higher education.

Forward-looking standards help students who don’t have wealthy family members who can co-sign their loans. As Kelly and James note, “By including factors beyond traditional credit measures, these lenders can identify prospects who may lack a credit history but would likely be able to repay a loan after school.”

That is using scarce resources wisely, channeling scarce capital to students who are likely to benefit strongly from further education. In this case, higher education really is an investment.

But there is a problem, namely the possibility that the FTC or a state attorney general will investigate one or more of these firms for causing a “disparate impact” with their lending standards. Given that many regulators are obsessed with group equality, it is possible that a lender could end up in trouble because it rules out some programs that are highly popular among women and minorities but readily lends to others that mostly draw white or Asian men.

Kelly and James quote Rick O’Donnell, founder of Skills Fund, on the probability of running afoul of the government: “I think it is likely some ambitious state attorney general will make a case out of lenders, in essence redlining and creating a disparate impact with new-fangled underwriting standards, regardless of whether those standards technically are valid.”

So far, the ice hasn’t started to crack but these companies are nervous over the prospect of facing a “disparate impact” suit.

Therefore, if politicians wanted to spur the growth of private educational lenders, they should change the ECOA by taking out its disparate impact provision, which is a Sword of Damocles hanging over firms that use forward-looking underwriting.

It just might be possible to get liberal legislators to consider doing that because the demand for “fair lending” ironically limits access to credit for smart and ambitious students who don’t come from wealthy families. An unconstrained market would do the most to allocate scarce funds to needy students who’ll put them to good use.

The great thing about private educational lenders is that they have to pay attention to results. They operate under market discipline. They won’t lend to academically weak, disengaged kids who want to get a generic degree from a party school. They must discriminate between educational wheat and chaff.

It would be a mistake, however, to become too optimistic about them. That is because, no matter how successful they are, the gusher of federal money for college remains. If some good students who want to pursue worthy programs choose to go with private financing, that doesn’t do much to diminish the problem—federal loans available on easy terms for almost everyone.

Moreover, the deck is stacked against private lenders growing very much. One reason the authors point out is that federal law requires financial aid officers to encourage students to exhaust their government borrowing before they go into the private market. There is an obstacle to sensible higher ed financing that ought to be eliminated.

But even if we could get rid of that rule, the problem remains that federal loans are so easy and attractive (low interest rates and the prospect of partial forgiveness of the debt) that few students will even think about going into the private market.

As long as we continue the mistaken and constitutionally illegitimate policy of federal lending for postsecondary education, the private sector will remain a tiny segment and taxpayers will continue footing the bill for a great many unwise “investments” in college credentials.