The Immorality of Forgiving Student Loan Debt
Once Again, Government Meddling Creates Unintended Consequences in a Market
How did we get here? $1.7 trillion dollars of unmanageable debt, a debt that is unique in our system in that it cannot be extinguished in bankruptcy. Welcome to another in a series of episodes of Unintended Consequences: What happens when bureaucrats mess around in capital markets.
Trivia question: What is the only secured lending market in the history of the world where loan amounts are totally unrelated to the value of the collateral?
Answer: The US Student Loan market.
What do I mean by “secured”? The security in this case is the borrower’s earning power, which derives from the skills, capacity and connections students receive during their college years.
Is the information provided, the rigor, the ability to build a network of peers and predecessors worth the price of admission? Is the package of assets at Harvard worth the same value as the package at Boston College? Not remotely. Yet Boston College is actually MORE expensive than Harvard by a couple of thousand dollars. Why on earth would that be the case?
You can thank your US Government for that. The US Government has dominated the student loan market for decades. According to educationdata.org, 92.6% of outstanding debt is Federal. What is the basis for determining loan amounts? If there were no government loans and you were starting up a lending business in this space, how would you determine loan terms?
A profit-maximizing outfit would probably do a couple of things that do not happen now. First, we would go out and model the incomes of previous attendees of institutions who were studying similar curricula. We would probably be willing to lend 200% of the cost of college to an MIT engineer or Harvard data science major. How much would we want to lend to a “Perspectives on Spanish America” major from BC?
Unfortunately, the loan amounts in the student loan market are not based on what the product we are financing is worth, they are based on what it COSTS. It would be like underwriting a mortgage on a new house, without appraising that house, and instead basing the loan amount on the listing price. How efficient would the housing market be if banks always wrote loans at 85% of list price? Sounds like madness. That’s the monster we have created in the student loan world.
What’s the solution? First, all student loans should have a first-loss participation held by the educating institution. Second, the largesse the government bestows on four-year colleges should be extended to a variety of skills-oriented programs designed to give citizens at many stages of life the kinds of capabilities they need to adjust to a rapidly changing job market. Third, student loans need to be dischargeable in bankruptcy.
The benefit of the first-loss piece would be to make the boards of these institutions take stock of what kind of value they are really providing. The skills gap in our labor market is well documented and must be addressed by a wide array of training options. Four-year college is not the best answer for every person and many people who attended four-year colleges at some point are still in dire need of new, relevant skills. Finally, maybe lenders and guarantors in the market would take greater care if they didn’t have a “get out of jail free” card with respect to bankruptcy.
Now, to the headline of this piece - forgiveness of debt. One of the most basic tenets of corporate finance is the following: the total value of an enterprise is independent of that enterprise’s capital structure (how much debt vs. how much equity). Yet, we are now about to discriminate against individuals who decided to use their own funds (equity) instead of borrowed funds to finance their education. The moral hazard here is absolutely breathtaking. What are we going to say to the hard-working students and families who chose to forego vacations, work two jobs, and put off other consumption so that they could make it possible to emerge from college debt-free? If we are going to bestow this insane gesture on the borrowers of the world, we absolutely must rebate the equity costs that people who didn’t borrow took on. Whether you paid for college with debt or equity, your benefit from the government should be a function of your wealth, not your capital structure.
A final note, one would certainly hope that if we do forgive this mountain of debt that we will at least tax the recipients of that gesture in the same way that we have taxed debt forgiveness in the past. The American Rescue Plan Act (that didn’t rescue much of anything) exempted student loan forgiveness from taxation through 2025.
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