Monday, January 04, 2010

Equity Not Debt: New Approaches to College Financing

By Richard Vedder

Reading the transcript of an appearance by Warren Buffet and Bill Gates before students at Columbia University's Business School, I was delighted to hear Buffet say he would buy a 10 percent interest in any of the students in the room for $100,000. Buffet was showing an investor's interest in an idea I have long advocated, one whose time has definitely come: financing college more through the use of equity than of debt.

Currently, students often graduate college with vast amounts of debt. They have to almost immediately start paying off loans that exceed their expected annual income, meaning it takes 10 percent or more of that income to service the debt. For persons with $50,000 in debt taking a $30,000 teaching or social work job, the burden is especially onerous. Take home pay is probably about %25,000 a year, and debt service almost certainly is $4,000 to $5,000 annually --16 to 20 percent of a very low income.

If students sold, either as individuals or as part of a group, a right to 10 percent of their income for X number of years for an amount covering college costs, the students would not have a larger post-graduate burden than now --but would have no debt and certainty about their future finances. This would reduce the number of lower income students scared to go to colleges for financial reasons and would provide new ways of financing higher education.

As indicated earlier, this idea is really stolen from earlier historical examples. In the 17th and 18th centuries, migrants to the American colonies often financed their trip by accepting indentured servitude. They agreed to work for subsistence wages for a period of, say, seven years, in return for the money to pay for their American passage. Indentured servitude has been given a bad rap, often associated with slavery, but in reality it is a voluntary financial arrangement that enables low income persons to make what is essentially a human capital investment.

Groups of, say, 500 students of XYZ University can collectively sign an agreement selling 10 percent interest in their post-graduate earnings for, say, 10 years. Pooling individuals reduces investor risks and may allow for some reduction in administrative and enforcement costs.

Now, none of this would be needed if college and universities had been run with a modicum of efficiency over the past half century. If productivity among university employees, for example, had risen at the average rate for the population as a whole, college costs today would be far less --at least 50 percent --than they actually are, and many persons could finance much of their education from savings, parental contributions, and work during college. Finding new ways of financing college in what respect simply aggravates the fundamental problem, namely that colleges are not cost conscious, and, indeed, spend whatever resources they can get their hands on. Indeed, new financing methods might merely prolong the inevitable day when colleges are forced to become more efficient or face extinction.

Nonetheless, I am willing to work with venture capitalists and entrepreneurs like Michael Clifford or Randy Best on devising a company specializing in buying pieces of human capital --college students needing financial help. I think I would even invest in such a venture.


Steve said...

I have some wonkish concerns about that.

1. If this became common-place then we would have a large portion of the populace, the most educated portion, with a 10% higher marginal tax rate. That could be very bad for work incentives.

2. If you are willing to invest and other people are, then there must be a belief that the returns would be above the market average, i.e. above the rate of return you could get offering students loans. So this would be a bad deal for students compare to the loans (aside from those who plan to exploit it by moral hazard and the benefit from taking on their risk).

I think there is some value in a risk-neutral body taking on the student's risk. But the trade-off to assuming their risk is creating moral hazard both in terms of finishing college and finding productive employment.

Overlook said...

I would think that a good amount of the funding of higher education is already funded by equity investment(s) and other financial instruments. The investment in the future of our children is, by many, started around the time a child is born and the parents begin putting money into investments. The problem however is that a good many people don't plan, don't invest, or can't invest because their wages are consumed by bills - possibly because they are not living within their means. Possibly because they are stuck in poverty. This is nothing new.

I have not read the transcript, but it sounds to me like Buffet was talking without having thought through such an idea. But then, that's what a lot of wealthy people do; they shoot their mouths off about how they are going to save the world using money - as if money fixes all problems. And to rely on a man to invest in a student, or students, is perilous. What's to keep him from selling his stake and who would buy it? I can see many problems with such a proposal, not the least of which is many, many substitute products.

We do indirectly invest in people when we purchase stock in a company. But that is about the only (questionable) parallel with Buffet's boast.