Using ISAs for College Funding

Many students struggle with paying for a college education and want easier terms for repayment of student loans. Bernie Sanders has even promised tuition-free and debt-free college. Sounds a little crazy to me, but an idea I think sounds fascinating is what Alex Tabarrok discusses in “Venture Capital to Buy Equity in Purdue Students”. An income-share agreement (ISA) is an alternative to private student loans in which an investor funds a student’s education and in return receives a percentage of that student’s earnings for a certain number of years after graduation. This concept is not unheard of, there are some companies that will help pay for an employee’s education as long as the student/employee agrees to work for the company for a certain number of years. But this idea is different because any investor could calculate the risks and take on this investment.

The article points out that this type of funding could be expensive for students who underestimate their earning potentials. Tabarrok offers this insight:

“Being unlucky or uninformed is less damaging [to the student] with an income share agreement than with a traditional loan. Loans have the greatest burden when a student overestimates their potential earnings and is poorer than expected. Thus, the loan offers no relief when relief is most needed. In contrast, payments under an income share agreement fall when income falls. An ISA does cost more than a loan when a student underestimates their potential earnings but in this case the student is richer than expected and can easily bear the extra burden. Thus, ISAs offer income insurance.”

Based on that I wonder if investors would only want to invest in students with higher earning potentials, while this option would actually attract students with lower earning potentials. In a Washington Post article that Tabarrok references, an executive from Vemo Education (a financial services firm working with Purdue students on the experiment) says that such adverse selection can be avoided. “It’s easier to scale [the agreements] and meet both investors’ and students’ needs if you fund people in groups.” The article continues, “By pooling agreements, investors could hedge against graduates who might wind up with low earnings or lose their job.” Students could be grouped by field of study or other characteristics to be better compared to their peers. This is a fascinating idea to help what some call the student loan crisis.

The Washington Post article includes a brief discussion on potential government regulation that would inevitably follow and notes that Senator Marco Rubio and Representative Tom Petri have already introduced legislation to help facilitate the use of ISAs. There are a lot more details to work out, but it is an interesting discussion and an exciting prospect. I think it could help slowly remove the government from the student loan business. I’m interested to see what happens with the Purdue experiment.

1 comment:

Dr. Tufte said...

JP: 100/100

Ideas like this have been practiced informally for centuries. More formal arrangements, like the syndication discussed here, have been discussed for about a generation, but have only picked up steam over the last several years.

While these may seem like a sensible idea to JP and me, they are quite hard to sell outside of our circle. We've self-selected into an environment where we're surrounded by "business types" who see this as sensible. Outside of our circle, this will not be so popular.

First off, this will be seen as elitist? Whose potential income would you want to invest in — someone who went to SUU or someone who went to Harvard?

Second, offering loan financing unconditional on degree choice or completion helps support majors with weak job prospects. And frankly, the number of academics working in fields with good job prospects for graduates is a minority.

Third, our media and political debates about student loans and the cost of college are ... a dodge that the public drinks up. Think about being a student as being a little firm that invests in education so that you can produce stuff later in life. What kind of market structure is that? Most likely, it's monopolistic competition: every student is producing a differentiated product (themselves) with the hope of getting some ability to mark-up over marginal cost, but if they do there is free entry by other people who drive economic profits down to zero. Making the cost of the investment in education cheaper (say, by student loans or ISA's) doesn't change that dynamic that leads to zero economic profits. All it does is increase the number of entrants by making it easier to enter.Here's the kicker: if the easier financing can't produce better outcomes for the student, then whose interest is served by the larger number of entrants? The answer is the higher educational institutions. Have you noticed what has happened to them over the last 50 years? Their tuition and fees have risen much faster than inflation (because the financing of potential students is a demand shifter). There are more of them (think UVU). They're all bigger (think SUU). And we have innovation in the sort of institution that can provide these services (think University of Phoenix).