Private Markets for Student Financing

Kevin James

Summer 2016

Education is broadly considered to be the best and surest way to improve one's lot in life. And access to some kind of education after high school is widely believed — with good justification — to be essential to success in our modern economy. That is why most Americans say that everyone deserves the chance to get a college education.

But many students, particularly the most disadvantaged, simply can't afford to pay for post-secondary education, especially after the dramatic rise in tuition in recent years. Well-intentioned policymakers have swooped in to break down these financial barriers, partly with grants but primarily through subsidized loans that can offer families far more resources at a fraction of the budgetary cost. With little underwriting, however — partly due to a philosophical commitment to access and choice, and partly to institutional lobbying — government lending enables millions of students and parents to bury themselves in debt for programs of dubious quality. It also weakens the natural forces of market discipline that would encourage schools to keep tuition in check.

These programs have proved extremely difficult to reform. A recent attempt in fall 2011 is revealing. In an effort to reduce defaults and keep families from taking on ruinous student-debt burdens, the Obama administration made a small tweak to the underwriting standards for a federal college-lending program known as parent PLUS. The program allows parents of a dependent undergraduate to borrow to help their child cover any unmet college expenses; the loans are often used to supplement funding beyond the dependent-student borrowing limit, which is far below the average annual cost to attend a public college.

Aside from what an institution was willing to charge, there was no limit to how much a parent could borrow under the parent PLUS loan program to help fill this gap. Nor was there any check against a parent's income to determine whether it was likely he could pay the loan back. The sole hurdle a parent had to clear was a modest credit check. Absent recent credit trouble, parents could borrow potentially enormous sums without regard to their current economic circumstances.

The 2011 modifications were done quietly and were fairly modest, adding to the credit check only a requirement that a parent not have any charge-offs or accounts in collections within the past five years, leaving the credit hurdle quite low. The administration argued that these small changes brought the program a little closer to industry standards and better protected taxpayers, while helping to ensure families weren't assuming unmanageable debt loads.

Such small changes resulted almost instantly in a 10-point jump in PLUS loan denial rates across the board in 2012. Particularly hard hit were the nation's historically black colleges and universities, which enroll a disproportionate share of low-income students. In the 2012-13 academic year, students attending HBCUs with the help of a parent PLUS loan dropped 45% relative to the previous year. While some of this drop involved prospective students, it also included many existing students who ended up dropping out or deferring their education as a result of their families' inability to continue borrowing PLUS loans. The result was a firestorm of controversy. Under the banner of a "Parent PLUS Loan Crisis," HBCUs mounted an intense lobbying effort to have the changes reversed, including anecdotes about affected students like this one:

Kristina, a senior English major at Claflin University, needed a $10,770 Parent PLUS Loan to finish her senior year; her request was denied. Her single father is doing his best, but he has only a high school education and seven other children to support. Like so many HBCU students, Kristina is looking toward a career of service after graduation, as an officer in the U.S. Air Force.

No one wants to see talented young people drop out of school simply for lack of financing. This is particularly true given that finishing a degree will likely pay large dividends in the form of a much brighter future. Adding to the sense of injustice was the Obama administration's ham-handed management of the change; having offered little in the way of public notice and failing to grandfather in existing students, it needlessly blindsided many students and their families.

But this anecdote also crystallizes the unsettling trade-offs inherent in the parent PLUS program: Policymakers are right to worry about lending money to Kristina's father. After all, he is a single father attempting to raise seven kids, and he appears to be struggling already just to support his family under current circumstances. Should he hit any rough patches in trying to repay his loans, he will have few ways out, as federal loans are extremely difficult to discharge in bankruptcy. As a result, he could be stuck with an unmanageable — and potentially growing — debt obligation well into his retirement years, and perhaps for the rest of his life. Therefore, while parent PLUS helps students like Kristina pay for school, it does so at the expense of potentially burying low-income families in debt from which they may never be able to recover.

Faced with this trade-off, the Obama administration eventually sided with access: In October 2014, under a continued barrage of criticism, the Department of Education announced that it would largely roll back the changes it had made in 2011.

In this environment, policymakers on the right are correct to seek ways to shift toward a larger role for markets in student lending. Unfortunately, many have defended for years an alternative — federally guaranteed student loans — that has the appearance of being market-based but in reality preserves essentially these same troubling dynamics. For those who have recognized the flaws in the guaranteed-loan program, there has often been too little effort to cut through the market-based rhetoric to the reality on the ground. Specifically, many proponents of scaling back the government's involvement in student lending, including through guarantees, have not done enough to scrutinize and articulate what an alternative loan market without such involvement would look like.

The design of such a private option would have to, without federal loans or guarantees, adequately meet the needs of students like Kristina — seemingly talented students who have bright futures ahead of them but whose families lack the means to help them pay for their educations. Such a private market would not need to provide the same amount of financing — and for all the same individuals and schools — to meet a standard of adequacy. The government programs clearly over-supply credit. But one would hope that in such a market qualified students pursuing programs that offer a good value proposition would be able to obtain financing, regardless of the student's economic background. After all, the ability to borrow for education is central to ensuring equal opportunity. Wealthy kids can pay for school out of pocket; aside from grants and scholarships, low-income students are heavily reliant on their single largest asset: their future earnings.

A private student-loan market exists now, filling some of the gaps of need unmet by current government programs. But it falls short of this ideal in critical ways. Therefore, while conservatives are correct to criticize federal lending programs, they must devote an equal amount of energy to addressing some of the barriers — beyond crowd-out from federally subsidized loans — that prevent private markets from operating as smoothly as proponents would like. This is partly just good politics: By fostering a more robust and compelling array of private options, policymakers on the right can better make the case for alternatives to government involvement. But even more important, implementing such reforms would help ensure that students like Kristina have opportunities to advance themselves through education. With a much more limited (or nonexistent) role for government in student lending, a robust private financing market can meet the needs of all students based on their potential, not their background.


Any discussion of the role of private markets in financing students must begin with federally guaranteed student loans, which were for decades distributed through the Federal Family Education Loan program. Established with the Higher Education Act of 1965, FFEL was a public-private partnership through which private lenders made loans that were guaranteed by the federal government.

Prior to 1993, students seeking a federal student loan would obtain it through one of the program's participating banks. While banks had some control over the interest rate charged, Congress set most of the remaining terms and repayment options of the loans, and largely dictated who was eligible. In exchange for making loans through the federal program, banks received a 97% guarantee against default as well as subsidies to induce them to lend to students under the terms of the program. In short, banks had very little discretion in terms of underwriting, but were insulated from most of the lending risks a typical private lender would face.

In 1993, Congress created the Direct Loan (DL) program, initially as a pilot program, under which the Department of Education would provide loans directly to students, removing the banks from the process. From that point on, some schools participated in the DL program and others in the FFEL program, though the terms and eligibility from a student's vantage point remained largely the same either way.

In 2010, President Barack Obama and congressional Democrats eliminated the FFEL program after the Congressional Budget Office estimated that doing so would save the government roughly $61 billion over ten years. All federally guaranteed loans were directed through the DL program, but, again, because the terms of federal loans varied little between FFEL and DL institutions, students were still able to obtain loans on essentially the same terms as they were prior to the switch.

The Obama administration's decision, working with congressional Democrats, to do away with FFEL as part of the passage of the Health Care and Education Reconciliation Act of 2010 (part of what became known as Obamacare) was one of the most contentious student-loan policy changes in recent years. Many on the right did, and still do, accuse President Obama of "nationalizing" student loans, replacing private-sector actors with a federal behemoth controlling almost 90% of the student-loan market.

But these charges overstate the degree to which the FFEL program constituted a market in any true sense and, thus, the significance of the changes enacted in 2010. The reality is that, while the elimination of the FFEL program was one of the farthest-reaching changes to federal loans in decades, it was more of a change in the back-end administration of a federal program than a federal takeover of a truly private industry. Such accusations of "nationalizing," moreover, are misleading and have helped perpetuate the profoundly flawed status quo.

At root, the FFEL program was not a market as commonly understood. It was private in that banks provided capital for a federal program in exchange for subsidies and a guarantee against default. But in providing such inducements, the FFEL program took away the central components that make a private financial market private: Banks did not share significantly in the risk of loss, nor did they have much discretion regarding which students or programs could receive loans and in what amounts; they also had limited discretion over the interest rates charged. To make matters worse, the program's structure created a relentless lobbying interest that was dependent on continued access to federal subsidies and that held significant sway over policymakers in both parties. The FFEL program was therefore a public-private partnership of the worst kind: Private entities profit when their investments do well, but taxpayers lose when those investments don't pan out.

Some might suggest reconstituting something like FFEL but reformed to address the basic contradiction inherent in that program's original design. For example, policymakers might give lenders more say over aspects of the borrowing process, including which borrowers and programs should receive loans, the size of those loans, and their terms. In exchange for that additional flexibility, Congress could reduce the fraction of a borrower's default covered by a guarantee and potentially eliminate the subsidies provided to lenders, giving them a stronger incentive to be cognizant of the quality of the loans they're making. While a partial guarantee would still mute lender incentives to a certain degree, such a reform could draw on the strengths of the private sector to help students make better investments — something completely absent in the current program.

While this would certainly be an improvement, there is substantial risk that Congress would unwind such reforms over time. Specifically, to the degree that taxpayer dollars are supporting private lenders, politicians would be tempted to exercise control over the choices those lenders make. Therefore, lenders' underwriting discretion would likely erode over time as politically powerful constituencies lobby Congress to require expanded access to credit. After all, the argument would likely go, access to education is critical, and taxpayers should have a say regarding who benefits from federally subsidized credit. In short, federal backing of any kind would make it difficult to sustain a process wherein lenders can allocate credit based on the economic realities of borrowers and education programs — how a financing system should work — rather than on which interest groups are in political favor.

Furthermore, private lenders might undermine this arrangement from the other side as well by lobbying for greater subsidies or guarantees. Part of this is simply the geographic nature of politics. As Andrew Ferguson wrote in the Weekly Standard in 2009, "In truth, the only people who like the system of guaranteed loans are the student loan industry...and the congressmen whose districts contain large numbers of people who work in the student loan industry." Lenders would certainly speak broadly about the benefits of markets and competition while pushing proposals that are merely rent-seeking in disguise. As a result, in the same way institutions and student-advocacy groups hold significant sway over sympathetic members of Congress, there would be little to prevent capture by the newly created set of private actors that stand to benefit from greater access to federal subsidies.

It would be a mistake to dismiss reforms such as partial guarantees out of hand. However, recreating any kind of guaranteed "private" lending program is fraught with political and policy challenges, and even if it could be established it's hard to know how significant the gains would be. As a matter of priorities then, instead of working to reinstitute a reformed FFEL program, policymakers should focus their energies on improving the availability and benefits of private financing options that are independent of government, and on advocating for true market-based reforms.

The next logical place to look, then, is the private student-lending market that existed separately from FFEL and continues to exist now, even after that program's elimination.


Private student loans made without any federal subsidies or guarantees represent a relatively small fraction of the student-lending market. In the 2014-15 academic year, private lenders issued roughly $9 billion in student loans. This figure represents approximately 9% of the $95 billion in overall student-loan originations during that period (this does not include loans made to parents through programs like parent PLUS). In contrast, the various federal loan programs constitute roughly $85 billion, or 89%, of the student-loan volume each year. Loan programs sponsored by states and institutions make up the balance of the market.

The sheer size of the federal loan programs, and the fact that taxpayers subsidize them, is surely one factor limiting the extent of the private student-loan market. To this point, one significant catalyst for the private loan market — which largely didn't exist until the late 1990s — was the steady rise of tuition relative to fixed federal borrowing limits. Similarly, graduate students were the most likely to borrow private student loans in 2004; however, after Congress removed federal borrowing limits for graduate students in 2006, they became the least likely to do so. Put simply, if there weren't such a sizeable subsidized federal loan program, there would probably be a much larger private student-loan market.

That said, it's worth considering what that market would look like. While it's difficult to know with any certainty, we can look for clues in the market that does exist now, largely in the gaps around current federal programs. The most notable feature of the current private market is that almost 94% of undergraduate private loans include a co-signer, something that could indicate a market lending largely based on a student's family circumstances rather than his individual potential. In fact, as American Enterprise Institute scholar Andrew Kelly and I highlight in a recent paper, many lenders and industry experts agreed with this assessment, with one expert noting that "we basically feel that what's going on in the private student market right now is family lending rather than student lending." This is fine as far as it's helping some people who need the funds; however, if students like Kristina don't have a credit-worthy family member — as is likely to be the case among students who need the most financial help — it doesn't look like a market doing enough to foster opportunity for students of all backgrounds.

To be sure, there are some newer, smaller lenders employing models more closely resembling the market that right-leaning observers typically describe — ones where students are funded based on the quality of the educational investment they are making rather than their circumstances before school. Skills Fund, for example, is a start-up lender that offers financing to students at partner institutions — traditional or otherwise — that meet its standards of educational quality. MPower Financing and Climb Credit are two other examples with a similar focus. As in the private market generally, these lenders largely operate as top-offs to federal loans or in the small spaces of higher education — like coding "boot camps" —  that are not eligible for federal financing. While promising and growing, these lenders nonetheless represent a drop in the bucket in the already-small market for private student loans.

It could be the case that a private market absent federal loans would evolve more in this student-investment direction and away from the family-lending model that is prevalent today. It's hard to know. There are, however, steps policymakers can take to make it more likely, even absent addressing crowd-out from federal loans.

For example, fair-lending laws — intended to prevent lenders from discriminating against historically disadvantaged groups — appear to be a complicated legal morass that may be inhibiting, to some degree, the types of forward-looking lending models of interest in this context. These laws are a critical part of our nation's commitment to equal opportunity; however, the degree to which they may be preventing otherwise-beneficial underwriting practices deserves, at a minimum, more research and attention. Ultimately, there may be reforms policymakers can undertake, such as safe harbors or other regulatory guidance, that both prevent discrimination and give lenders clearer rules and guidelines.

Furthermore, markets tend to function better with good information. After all, a market focused on student potential and the quality of educational programs relies on data about how students actually fare in those programs, particularly the typical earnings of a program's alumni after graduation. While some sources like the Census already provide some high-level information — such as earnings by occupation and levels of education — policymakers could go much further in breaking down information, particularly by institution and program. To this point, a number of lenders have indicated they already make use of some of the institution-specific information the Obama administration has released as part of its College Scorecard. Given that the government has ready access to data — such as earnings — that is difficult for any private actor to come by, it is well-positioned to provide a public service that will help markets operate more effectively. Bipartisan legislation, the Student Right to Know Before You Go Act, has been introduced in both the House and Senate to do just this.

Finally, policymakers should consider expanded bankruptcy protections for private student loans if the goal is to have them play a more central role in student financing. In 2005, Congress did just the opposite, creating an exemption from bankruptcy discharge for private student loans except in cases of "undue hardship." This standard is quite strict in that it requires demonstrating that one cannot maintain a minimal standard of living now or through the extent of the loan's repayment period, potentially decades into the future. Such reforms need not mean treating student loans exactly like other consumer-lending products — for example, it is possible to restrict access to bankruptcy for a certain time period after a student has left school.

Furthermore, there is some potential that expanded bankruptcy protection would lessen the amount of private financing available. In one sense, this is valuable: Lenders would have stronger incentives because their future claim against a borrower has some reasonable limits. More important, however, is that some minimal level of risk protection is essential if young people are being asked to borrow large, unsecured sums for an investment with uncertain payoff — a topic addressed more fully below.

With or without changes to the federal programs, these reforms would help to bring about a private student-lending market that is consistent with what many on the right envision — a market that expands opportunity by emphasizing potential rather than one's economic background. Even a well-functioning private loan market, however, would come up short for some students since it would not offer them adequate protection against financial risk — even with expanded bankruptcy protections. In addition to improving private loans, then, policymakers must also expand the set of financing tools students have at their disposal.


As I detail in my essay, "Fixing Student-Loan Repayment," in the Fall 2015 issue of this magazine, borrowing for education is fundamentally different than other forms of consumer loans. Students have no collateral to offer and limited income or credit history; instead, they're borrowing large sums against the promise of a future increase in earnings. In some cases, that earnings bump may never materialize, and because student loans are unsecured and very difficult to discharge in bankruptcy, a struggling borrower may have virtually no way to escape an unmanageable, and potentially growing, debt balance. This is less problematic for high-income students who often have an informal safety net through their families; for students like Kristina — whose families have limited resources — a stumble or mistake could spell years or decades of financial ruin. Finally, while bankruptcy reform could help mitigate these risks, it should be viewed as a sort of nuclear option, and many students would likely prefer to have options that aren't quite so drastic.

Milton Friedman pointed out decades ago that these characteristics make borrowing for higher education very risky. Looking at other areas of finance that deal with similar challenges, he suggested an alternative to traditional loans: Students should be able to obtain money for school in exchange for agreeing to pay a percentage of their income for a set period after graduation. This arrangement, called an income-share agreement, or ISA (or "student-investment plan" or "human-capital contract"), differs from a loan in that it has no principal balance or interest. That is, the amount a student ultimately pays depends entirely on his income after school. Some students may pay more than the amount given them, some less, but the structure of an ISA guarantees that a student's payments will always adjust with his income — thus substantially reducing the financial risk borne by the student.

Some commentators have unfairly analogized ISAs to indentured servitude. This comparison, however, misunderstands how this type of agreement works. ISAs don't require students to work for the organization that financed them; that is, students are not selling their future labor. Instead, they are simply agreeing to make payments linked to their income for a defined period. Students are ultimately free to make their own career decisions, including choosing not to work at all. In this sense, students have far more freedom with an ISA than with a traditional loan, which constrains all their financial decisions due to the need to ensure they can always meet their payment obligations. In short, ISAs offer students an alternative to the anxiety and risks — and inflexibility — of traditional debt.

Other observers have questioned whether ISAs would truly be an option for a large majority of students. In an essay in the Spring 2014 issue of National Affairs, for example, Judah Bellin raises this concern, arguing that, with ISAs,

investors will only lend to students who they believe will provide a good financial return — in other words, students with a record of success and a high likelihood of future achievements. Shifting from a federal loan system to one dominated by equity contracts would mean that students with mediocre high-school accomplishments would struggle to obtain funding for their college educations.

It's worth asking, however, whether "students with mediocre high-school accomplishments," who don't stand a reasonable chance of success given the institution and program they've chosen (as implied in this example), should get financing for that institution and program. However, if that's not the case, or if there are other programs — remedial, vocational, or simply more cost-effective options — where the math does work, it is theoretically possible to finance them with ISAs. Importantly, this condition also holds for loans: A lender, public or private, cannot sustain itself by financing students for programs where they are likely to fail. The fact that federal loans enable such investments is not a virtue but a shortcoming — one that is ultimately a disservice to students and taxpayers.

This leads to a final common criticism of ISAs. Fundamentally, ISA providers are likely to provide financing to large numbers of students such that it's not essential that any particular student be successful. However, some surmise that only students with low expected earnings will sign up, or that the arrangement will deter students from working — leaving ISA funders hemorrhaging losses over time. In the former case, ISA providers can mitigate this challenge by offering less funding (for each percentage of income committed) for less lucrative fields — ensuring that students are not over- or undercharged based on their program of study. In the latter case, it's important to note that most people want to earn income, so changing one's life around to avoid small payments on a temporary contract isn't likely to make financial sense. More fundamentally, there are other products, like insurance, that face many similar challenges, yet these markets exist. The question then is not the presence of these issues, but how significant they are and whether firms can manage them effectively.

One may be inclined to ask why a market for ISAs has not developed already if the concept is indeed worthwhile. One of the most significant reasons seems to be that there is a good deal of legal and regulatory ambiguity that surrounds these contracts, on a number of fronts. That is, there appear to be few established answers as to how regulators, the courts, and other relevant agencies such as the IRS would treat ISAs given their distinct differences from traditional loans. This is not a prohibition: In fact, there are a number of small start-ups, both for-profit and non-profit, attempting to offer ISAs in the United States. But the cumulative effect of policy uncertainty in a number of areas — including tax, financial regulation, consumer protections, and other areas of law — creates a significant headwind for an industry that already faces large hurdles, most notably stiff competition from subsidized federal loans. To address this issue, Senator Marco Rubio and others in Congress introduced legislation, the Investing in Student Success Act, to provide a legal framework, including consumer protections, for ISAs. State legislators in some instances have also introduced legislation to reform their state's laws and regulations to accommodate ISAs.

At root, this legislation gets at the core public-policy issue with ISAs. The legislation does not spend any money or change any existing federal programs. Instead, it simply attempts to provide ISA providers with a clear legal framework — something generally taken for granted in other sectors of the economy. As to the concerns some raise about the viability of the idea generally, as well as whether it would be available to a broad range of students, there are no firm answers; while ISAs have much theoretical promise and some compelling real-world examples, it's ultimately hard to know how effective they can be. That said, this is fortunately not something policymakers have to figure out: Either market actors can make it work or they can't. Unlike typical proposals, then, a better analogy for these reforms would be laying fertile soil with the hope that, in time, better market options will emerge.


Critics are right to disparage the government's vast and troubled college-loan programs. At the same time, many Republicans have paid insufficient attention to some of the big deficiencies in the current private market for financing students — too often seeing the issue largely through the prism of crowd-out from federally subsidized loans. Crowd-out is obviously a primary issue: Private financing options will always be constrained in a world of substantial taxpayer-subsidized competition. And, given the downsides of unlimited borrowing through parent PLUS loans, policymakers would be justified in imposing borrowing restrictions regardless of the state of private alternatives. After all, as Bellin highlights, while federal loans can help facilitate access, they should not guarantee access to any institution at any price.

But policymakers must also take steps to facilitate private markets worthy of all students — most notably Kristina and others like her. This starts with avoiding questionable public-private entanglements that enable politicians to talk big about markets while maintaining a troubled status quo. It also means looking at reforms — clarifying fair-lending laws, increasing market transparency, and bolstering bankruptcy protections — that would help private student-lending markets operate in a way that more closely approximates a real market. Finally, it means taking steps to ensure that students have all the right tools in their financing toolboxes, including adequate protections from the risks of borrowing for their education.

Such reforms are not just good politics, though policymakers interested in moving toward a world with a significantly diminished role for government in student lending should take note. Beyond politics and far more important, these reforms are essential to the task of ensuring that all students, from any background, have an equal shot to invest in their own educations — without risking decades of financial ruin.

The results of such changes will not appear overnight; whereas government programs can be created with the stroke of a pen, markets take time to develop. Thus, reform-minded policymakers would be advised to plant these seeds now — with the hope that an improved set of market options tailored to the needs of a broad array of students will emerge in time.

Kevin James directs the higher education program at the Jain Family Institute. 


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