
Risk Based Student Loans by Michael Simkovic - protomyth
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1941070
======
ecmendenhall
The discussion of formulas for pricing risk and forecasting methods is a great
(if unintended) example of the problem with student loans: any government
subsidy will distort price signals in unintended ways. Even if government
tries to price in risk (which is a good idea), the signals will only be as
good as the regression analysis, will still be subject to political pressure,
and will still concentrate rather than distribute risk. A poor forecast of the
future demand for philosophers, or the decision to train more teachers for the
public good will still result in human capital misallocation, even if it's not
as bad as the current system.

Compare this to private loans, which use the price system and mechanisms like
futures markets to evaluate and distribute risk. Instead of one formula to
price risk, many formulas compete and the information they contain is
aggregated and summarized by relative prices. Risk is distributed among many
lenders instead of concentrated in the hands of government.

The worst possible equilibrium seems to be the system in place now: price
signals are distorted by subsidies that cover most of the loan market, while
private lenders serve those whose educations are so expensive that they aren't
covered by already-generous government subsidies. Private lenders encourage
these students to take out risky loans, while strict rules on default shift
the risk to borrowers.

There are all kinds of alternatives to student loans, but they will not be
competitive while federal subsidies continue to distort the student borrowing
market. One of my favorite ideas is human capital contracts (here's a good
paper: <http://www.cato.org/pubs/pas/pa462.pdf>), which would work like equity
instead of debt. Students could sell "shares" of their future earnings to
investors in exchange for the start-up capital for an education. There are
lots of potential pitfalls with this model, but I think it aligns the
incentives of lender and borrower (or investor and future earner) in a much
more positive way: investors would have strong incentives to help students
succeed that do not exist under the current debt-based model. Unfortunately,
big subsidies are a big barrier to entry: there's no reason to offer equity
when one can easily obtain a subsidized loan.

I chose to attend a large state university on a generous scholarship and
graduate without debt rather than attend one of the more prestigious schools
where I was accepted and take on student loans. So far, I think it was the
right choice. But if I had the necessary capital, I'd start a Y combinator for
students: find students like me who would otherwise stay in-state and finance
"prestige degrees" at an Ivy or other top university in exchange for a share
of future income. The model would operate very much like a start-up incubator:
providing mentorship and advice and placing students in well-paying jobs after
graduation would have a direct effect on the profitability of the investment.
It's just a matter of figuring out how to pick (or make) students who will
succeed.

~~~
karamazov
The potential of buying shares in someone's future worries me, because it
begins to look like indentured servitude. High school seniors are not
financially or legally savvy, and a large oversight system would need to exist
to insure that they aren't signing away their futures to predatory lenders.

If the system is like the current loan system, where student debt can't be
discharged even in bankruptcy, students run the risk of being settled with a
tithe that will prevent them from making ends meet if they can't find a good
job.

~~~
learc83
How would it be worse than the existing situation? As you said, students
already can't bankrupt out of student loans.

~~~
icegreentea
There appears (I think that is the key word, I'm not actually sure if its
true) that paying off debt is more flexible than fulfilling your 'future
shares' option.

------
ibejoeb
> ...there may be no reliable price signal about the long-term financial risks
> inherent in different courses of study.

So credit availability and interest rate is going to be directly related to
what _other_ people ahead of you studied in school and how well they settled
the debt. Also:

> Educational institutions may have incentives to funnel students into areas
> that do not maximize students’ future incomes or employment prospects.

I guess they do. Unfortunately, the instituions are not even a factor. As far
I can tell, the proposed solution is to deprive the student of the opportunity
to get involved in that "low-value" field. Then, indirectly, we punish the
institution by reducing revenues. Interesting.

It's an interesting read.

~~~
robrenaud
I've heard an even crazier idea.

Have colleges charge a percentage of a student's future income. This aligns
economic incentives for the student and the college.

~~~
dangrossman
What if I just want to take a few foreign language classes? Does a percentage
of my income as payment make sense?

Or I'm self employed and want to get another degree at night just because I
can. Does a percentage of my income as payment make sense?

What if I studied art history, but the side project I was working on after
classes was acquired by Google for $30 million and now they're paying me
$200k/year as part of the deal. Does a percentage of my income as payment make
sense?

~~~
learc83
You're arguing with a straw man. Nothing about that plan precludes a fixed fee
option in situations where a future percentage doesn't make sense.

~~~
randomdata
> Nothing about that plan precludes a fixed fee option in situations where a
> future percentage doesn't make sense.

That doesn't really answer his questions though.

Professionally, I work as a software developer and a farmer. If I had taken
the percentage of future income option while receiving my CS degree thinking
that's all I'd ever do, would the school be entitled to the profits from my
farm too?

I didn't even consider farming until I was 26, so it's definitely in the realm
of possibility.

~~~
philwelch
I'm massively curious about how you got into farming and how you do that
alongside software development.

~~~
randomdata
I grew up on a farm, so I was not without connections, but it was actually on
the suggestion of my father that I got started down that path.

I knew pretty early on that programming was my thing. That was where I put all
my focus, getting my first part-time dev job in high school. Farming wasn't
even a consideration in my mind. It was only after working full-time in the
software game for a few of years, dad approached me and suggested that I take
some of the money I had earned, find some land to rent, and buy some crop
inputs with it. I agreed that it sounded like a good plan, and he helped me
put it in motion.

My farm is strictly cash crop, so the work is highly seasonal. Right around
this time in the spring and later in the fall there is a lot of work to do,
but the rest of the year is fairly light on the time required of me. The
second thing that made it work is that I was already telecommuting and my
hours were flexible. There have been days where I've been in the field all day
and working on code all night. Additionally, it's not completely unheard of to
find me writing code from the seat of the tractor. Mobile internet access has
been a lifesaver.

I hadn't really considered this to be an interesting topic to the HN crowd,
but maybe I should write up a more detailed blog post about it?

~~~
learc83
>but maybe I should write up a more detailed blog post about it?

Yes you should write more about this. It's fascinating.

And to answer your previous question about whether the college would get a
percentage of your farm income, I would have to say yes.

The option of limiting their stake to a particular profession would introduce
too many loopholes.

For instance I could get a math degree, and sign something giving them a share
of all future earnings as a mathematician--then work as a programmer instead.
That being said I'm sure there could be some sort of maximum.

Student loans already work somewhat similarly. There is an option to pay off
loans based on a percentage of your total income, so you are in effect paying
x percent of your income for y number of years.

------
theorique
This is a great idea.

Place all the information in the hands of students, including the estimated
present value of anticipated future earnings, as well as statistical
distributions.

Estimating default risk, completion of degree, and so forth should be child's
play for analysts who are familiar with mortgages and credit risk. It would be
great to apply similar risk comparisons to the higher education bubble.

The irony is that the rising freshmen who are actually numerate are probably
already entering high average return fields (CS, engineering, sciences,
business) and those who are innumerate (and thus can't interpret those data)
are probably entering low average return fields (humanities, sociology, gender
studies).

------
ebiester
How does such a system factor that STEM fields are more difficult and have a
higher drop out rate? What is half a Chemistry degree worth compared to an
anthropology major and chemistry minor, for example?

~~~
lmm
Statistics, dear boy. Sure, it's complex, but this is loan companies' bread
and butter.

~~~
ebiester
Ah, but changing the rules will change people's behavior, changing the
statistics. We will have far more people failing out of STEM fields, with
nothing to show for two years of study. Remember that a third of people who
start in the sciences end up with a degree in the social sciences and
humanities.

Do you really want our CS courses to be filled with people who have no chance
of succeeding in the major? People who cannot pass college algebra wasting the
time of the class? Who does that benefit?

The problem isn't statistics. The problem is not having an outlet for those
drummed out of the sciences.

~~~
lmm
Closing off (or at least making one think twice about) the option of "do a
degree that's not actually any use to them" for such people is a good thing.
That they have other bad choices available to them does not diminish this.

------
eli_gottlieb
So I don't suppose I could persuade anyone that education is a public good?

/sigh

------
Daniel_Newby
The professional victims will cry racism and destroy any such scheme. (IQ is a
strong predictor of future income, is mostly genetically determined, and some
human groups drew the genetic short straw.)

~~~
dkrich
Not sure whether you are being serious or not, but beyond a certain IQ (I
think around 120) there is no correlation between IQ and income (or success in
general). This has been studied over and over.

~~~
gwern
You are misinformed; the correlation shrinks a great deal (diminishing
returns) and becomes dominated by other factors like personality (Extraversion
and Conscientiousness especially), but it's still positive. Look at the Terman
study's lifetime incomes.

