Wednesday, April 30, 2008

Thinking Outside the Box on Student Loans

By Richard Vedder

Lenders are shy about lending to students all of a sudden. One reason, of course, is that the government, in its wisdom, decided to reduce maximum fees paid to private lenders for loan processing. A second reason is that artificially low interest rates engineered by the Fed led to a housing boom, and, subsequently, to a housing bust, foreclosures, and weakened financial institutions. It also led to a flight from insanity to extreme caution among lenders --who now are aware that lending to 20 year olds with dubious job prospects is a risky business. So, of course, the Feds want to do some more stupid things, like subsidize lenders to induce them to lend, promote greater Federal entry into the student loan business, etc. It is a monumental case of government failure all around.

It is time to think creatively and do something bold (but not like in Germany, where Chancellor Angela Merkel is rumored to be hitting the nightclubs late at night wearing very revealing outfits --Germany's new Weapon of Mass Distraction.) As my sidekick Bryan points out, students are using web sites to find innovative ways to finance their education --borrowing from non-traditional lenders, getting help from persons sympathetic to needy kids, and, finding entrepreneurs willing to buy "a piece of the action " --investing in persons with enormous potential.

That gets to my next point. I wish some of my affluent friends with an interest in higher education --Charles Miller, Jeff Sandefer, Randy Best, maybe even Catherine Reynolds --would start a "human venture capital fund" that would invest in EQUITY interests in students, modeled in part after an overly maligned 17th century idea: indentured servitude. (In return for passage to America, workers received very low subsistence wages for a period of up to seven years).

Jim goes to the Human Capital Venture Fund (HCVF) and says "look at me --I have good grades, I am a campus leader, I have great evaluations on my internships, etc. But I need $30,000 to finish school." The HCVF says, "we will give you $30,000, if, in return, you give us 10 percent of your income after federal income taxes and a $25,000 subsistence allowance, for a period of 10 years after graduation." It is close to selling common stock in oneself.

Alternatives abound. Those preferring lending to equity investments might say, "I will lend you $30,000, with you agreeing to paying $2,400 a year (8 percent) in interest payments, plus 10 percent of your after-tax, after-interest payment income over $25,000 a year until such time as the loan is paid off, with a 30 year maximum.

There are hybrid approaches --sort of like convertible debentures or preferred stock.
There can be an upper limit to the gains to lender imposed --the lender gets repaid for financing of the education over 10 years, subject to a maximum payment equal to 3 times the amount lent (or some such provision).

I have offered these options before. My guess is that we are evolving towards such a market system --just as financial markets evolved with all sorts of new methods of lending and providing equity in the last generation --securitization, derivatives, hedge funds, etc. --so will the market for student loans. The government should relax, get out of the loan business, and let markets work.