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Counting on banks to protect students from predatory colleges is insane

Bernard Weil/Toronto Star via Getty Images

If worst comes to worst and you can't pay back your debt, you can always declare bankruptcy. You'll have trouble getting a loan in the future, but you can move on with your life. Unless your debt is a student loan.

Megan McArdle, who once paid for a certificate from a for-profit college that turned out to be mostly useless, argues that should change — but that, in exchange, it should be harder to get a student loan.

The idea that student loan underwriting should be based, in part, on the track record of the program or college a student will attend isn't entirely new. And it makes some sense, because student loans don't have any collateral; they rely entirely on the promise that education will help you make enough to pay them back. It's why the federal government is supposed to kick colleges out of the student loan program if too many students don't pay back their loans.

But what McArdle proposes sounds like something much more radical: the end of the federal student loan program as we know it.

We also need to stop making loans for programs that have poor graduation records, high default rates and little evidence of economic benefit to degree holders. I'm not just talking about for-profit colleges here, but also about the wide array of programs at accredited four-year schools that allow students to amass substantial debt without giving them anything of value in return. The easiest way to do this is to stop making the loans directly, then invite private companies back into the student-loan market -- and force them to eat some of the losses. Let them do the job the government has failed to do: Assess which schools and programs actually add economic value and refuse to fund the ones that don't.

Direct lending by the federal government has cut costs

Until 2010, private banks made most federal student loans. The loans were guaranteed by the government to create lower interest rates than were available in the private lending market, and the banks got to take some profit for their trouble. It was a very good deal for companies like Sallie Mae: they got the governmental subsidies for making the loans but assumed little risk if the loans weren't paid back.

That ended in 2010, when Congress reformed the student loan program with the same legislation that created Obamacare. The Education Department became the only student lender.

Because making the loans directly is cheaper for the federal government, and because the switch to direct lending was fairly smooth, there haven't been many proposals to put the federal program back in the hands of banks.

But banks aren't banned from making student loans on their own, and they do — about $6 billion worth in the 2012 academic year. Private loans, though, don't have the generous income-based repayment and forgiveness options that federal loans do, and they typically have higher interest rates.

Letting banks decide who should get a student loan, and making them assume responsibility for losses if the loans aren't paid back, would essentially end the federal student loan program, even if the federal government partially guarantees the loans in order to keep the interest rate artificially low. But it's not clear that it would do much to fix the real problem of students taking on debt they can't pay back.

Why federal loans work the way they do

The federal government runs the student loan program in part because lending to students is an inherently risky proposition. A bank can't "repossess" a college degree they way it would a house or car if the borrower quit repaying the loan. And college students don't typically have a long credit history to help banks decide if they're credit-worthy.

So the Education Department lends at a rate far below the market to anyone who wants to borrow. It's not a perfect system by any means, but it's not entirely without safeguards. The department tracks whether graduates are defaulting on their loans and can throw colleges out of the student loan program if default rates get too high, or, for vocational and for-profit college degree programs, if borrowers' debt is too much to manage based on their income.

There's no evidence banks could do a better job weeding out (and, because the higher education system runs on debt, effectively shutting down) bad colleges than the federal government does.

Banks are perfectly willing to lend to students at for-profit colleges, who make up about 25 percent of all private student loan borrowers and are responsible for a disproportionate share of loan defaults. Even if the debt were dischargeable in bankruptcy, banks would probably still be willing to issue subprime student loans. And private student loan borrowers often haven't exhausted their cheaper federal lending options.

But say assuming risk made banks cautious enough to only lend to college students who are sure bets. What's a sure bet? Even at the same college, one English major could end up writing a best-selling novel by graduation while three others become baristas for the first few years out of college. Banks would probably fall back on the same underwriting criteria private student loans already use, such as the creditworthiness of co-signers, or the criteria the government look at, such as overall default rates for colleges and programs.

Allowing bankruptcy protection for student loans is a good idea. So is trying to ensure that students aren't borrowing to pay for worthless programs that won't help them get ahead in life. But banks aren't going to do that — they're just going to make sure they get their money.