STUDENT LOANS, MORAL HAZARD, AND A LAW SCHOOL MESS

Throughout the summer, Massachusetts Senator Elizabeth Warren has been promoting legislation that would provide relief to students with educational debt. As the Senate concludes its work — and I use that word loosely — before the November elections, she is taking another run at the issue. Most recently, Senator Warren made her case in an article that appeared in the September 9, 2014 edition of the Huffington Post: “The Vote That Could Cut Your Student Loan Bills.”

Her point is simple: Students who took out educational loans prior to July 1, 2013 are locked into an interest rate of nearly 7 percent. “Older loans run 8-9% and even higher,” she writes. She’d like to bring that rate down by allowing graduates (and parents who co-signed their loans) to refinance them.

Politics, You Say?

Election year politics have rendered her proposal dead on arrival. That became clear in June when Senate Republicans filibustered the bill, even though three of them — Senators Bob Corker of Tennessee, Lisa Murkowski of Alaska, and Susan Collins of Maine — were among the 56-38 majority that was insufficient to bring it to the floor.

But the gridlock in Washington and resulting inaction may focus attention on a more important underlying problem: How does a system anchored in noble intentions evolve to produce such enormous and unsustainable levels of educational debt in the first place? Some law schools have become poster children for the unfortunate answer to that question.

Blame Professor Friedman

In the 1960’s, Milton Friedman argued that America would benefit if individuals had a way to borrow against future incomes and invest in becoming more valuable workers. In those days, a college education was the surest path to the middle class. To a large extent, it still is.

From Friedman’s idea came the federal student loan program. But over time, Congress and several presidents added features that became problematic. Imagined and unfounded fears of moral hazard — specifically, that students on the cusp of lucrative careers would declare bankruptcy to avoid paying their student loans — resulted in the rule that educational debt survives bankruptcy, except in extreme circumstances that courts rarely find.

Coupled with federal guarantees, the loans eliminated lender risk. That created a new moral hazard: Educational institutions themselves were at least two steps away from any financial accountability for their graduates’ outcomes.

Law School Misbehavior

For law schools, all of this has assumed special significance. Unlike undergraduate colleges that can claim to be creating well-rounded and better informed citizens entering a variety of careers, law schools exist to train people who want to become lawyers. Some law graduates may take rewarding non-legal paths, but undergraduates aspiring to careers in business, for example, typically attend business school. At least, they should.

If the ability of a school’s graduates to use their legal training initially in a JD-required job is an appropriate way to measure a law school’s success, then many are unambiguous failures. For the class of 2013, 33 of 201 ABA-accredited schools placed fewer than 40 percent of their graduates in long-term full-time JD-required employment (excluding law school-funded jobs).

But here’s the kicker. Thanks to the moral hazard that the federally-backed loan program creates, some schools with the worst employment records for recent graduates have students with the highest levels of law school loan debt.

For the class of 2013, three of the top ten schools with the highest average student loan debt at graduation placed less than one-third of their graduates in full-time long-term JD-required jobs (again, excluding law school-funded positions). They were: Thomas Jefferson ($180,000 average student debt; 29 percent employment rate), Whittier ($154,000 average student debt; 27 percent employment rate), and Florida Coastal ($150,000 average student debt; 31 percent employment rate).

Defying the Market

How do these schools and others like them accomplish this economically perverse feat? Large doses of prospective student confirmation bias combine with federally-backed student loans to create a dysfunctional market.

Marginal law schools seek to fill their classrooms to maximize revenues. Next week, I’ll examine a few schools pursuing this goal through recruiting materials that seem to obfuscate ABA-required employment disclosures. For now, the important point is that what happens to those students after they graduate becomes someone else’s problem. Once students pay their tuition bills, law schools have no financial stake in their graduates’ employment outcomes.

Searching for Solutions

This takes us back to Senator Warren’s bill aimed at giving past students a break. In the current low-interest rate environment, it’s reasonable to provide former students with the kind of refinancing opportunities available to homeowners, business proprietors, and other debtors. But that won’t begin to solve the real problem. The current system of financing legal education creates moral hazard that has produced — and will continue to produce — law school misbehavior at great expense, not only to affected students, but also to all of us.

In the coming weeks prior to my October 24 presentation to the American Bankruptcy Institute Law Review Symposium at St. John’s University School of Law, I’ll offer some ideas for dealing with that larger problem. Some people won’t like them.

9 thoughts on “STUDENT LOANS, MORAL HAZARD, AND A LAW SCHOOL MESS

  1. I’ve been a follower of your blog for quite some time. Great stuff. A small quibble here with “Blame Professor Friedman”. Seriously? Prof Friedman’s idea was a terrific one. It allowed those without means to obtain the means. It was the failure of the legislature, schools, etc to fine tune and regulate the principle with the changing times. How about renaming that section “Great Idea; Poor Follow Through”.

  2. Speaking of moral hazard and law schools, it should probably be noted that the ~200 accredited law schools actually jointly own a non-profit student loan company called AccessGroup as a membership corporation. Back in the pre-GradPLUS and Direct Loans years, it claimed to be the biggest graduate student-only provider of FFEL and private student loans. And while a non-profit, it was one of those non-profits that lavished its execs with salaries ranging from a few hundred thousand to several hundred thousand per annum, according to its Form 990s over the years. Oh yeah, and they appear to have taken all of those FFEL and private loans, bundled them into SLABS (Student Loan Asset-Backed Securities) to sell to institutional investors and pension funds on Wall Street. Almost $11 billion in SLABS originations between 2000 and 2008. Today, several years after GradPLUS killed virtually all of their business and they outsourced their existing loan administration out to third parties (ex. Great Lakes, Navient, ACS, etc), Access appears to be sitting on at least $300 million in assets. Obviously, as a non-profit it cannot legally slip any financially flailing law school co-owner some funds, but I’m getting cynical enough to believe just about anything is possible these days.

    In any event, it does make one wonder why law schools, whose students took out more private loans than anyone else in higher education and whose professoriate tends to skew very liberal/pro-consumer, were so very, very quiet when Congress made those private student loans retroactively nondischargeable in bankruptcy in 2005. Perhaps it was because they knew their student loan lending pseudo-subsidiary would make a killing on Wall Street selling SLABS once bankruptcy protections were removed? (for the record, SLABS originations and valuations virtually exploded once that bedrock consumer protection was removed, and as far as I have been able to work out, have held their value better over the course of the recession that the three other major ABS classes – home mortgages, car loans, and credit cards).

    And then there is the side issue of the longstanding complaints in those pre-Direct & GradPLUS years of colleges and universities that directed students towards “preferred lenders” who had subpar lending terms in exchange for kickbacks and bonuses to that school’s FA and admissions offices. NYU/Jack Lew & Citibank is the most prominent example, but who knows if any law schools directed their wards to their membership corporation without disclosing the seeming conflict of interest?

  3. P.S. I forgot to mention that in that golden decade-ish of SLABS issuances, law schools raised tuition faster and higher than virtually every other sector of higher education, including the for-profits.

  4. Mr. Harper misuses the term “moral hazard.” This one of those wonderful terms in economics that purports not to make any normative claim but, by appropriating ordinary English terms with inherent normative meaning, inevitably does. Like “optimal.”

    Technically, moral hazard arises when government intervention creates externalities that would otherwise not exist. Standard welfarist theory predicts that, as a result, decisionmakers will take more of the affected actions than they would have in some idealized pre-government-intervention state of nature. This is not “optimal.” So, for example, by bailing out big banks every time we have a meltdown, we externalize the costs of the most risky behaviors those banks undertake. This, in turn, leads them to undertake more such risky behaviors than they would in the absence of bailouts. And this, in turn, deviates from that pre-government-intervention state of nature that is the best of all possible worlds.

    By guaranteeing student loans, current US policy shifts the risk of default from lenders to the government. If this were all that government does, the effect would be to induce lenders to make more loans that they would in that hypothetical best of all possible worlds. But current US policy takes a further step that more than reverses this effect: student loans are effectively excluded from bankruptcy relief.

    Bankruptcy itself creates “moral hazard.” It allows debtors to offload the negative consequences of their decisions to creditors. We think that the positive consequences of doing so outweigh the negative. Hence bankruptcy law.

    By excluding student debt from bankruptcy relief, however, we eliminate this source of moral hazard from educational lending. All of the consequences of incurring debt are internalized to the borrower. Rational, self-interested borrowers will only borrow to the extent doing so will maximize their risk-adjusted welfare which, because all externalities have been internalized through the elimination of bankruptcy relief, should also maximize aggregate social welfare. To this point in the analysis (and this is as far as Mr. Harper’s complaint goes), there is no moral hazard. If this is what he’s complaining about, then his technical analysis is simply wrong.

    The real moral hazard arises at the next step – when government subsidizes education with income-based-repayment regimes. Now students will not bear all of the costs of education. Therefore, welfarist theory predicts, they will overconsume education – buy more of it than they would have in that idealized pre-government-intervention state of nature. This reduces aggregate social welfare.

    The real question, therefore, is: should we subsidize education? Use of the term “moral hazard” leads almost inevitably to the conclusion that we should not without framing the question for fair debate.

    The question is more complex than simple-minded welfarist theory would suggest. The resulting subsidies have strong distributional effects. Children of rich parents (e.g, George W. Bush, Al Gore) can always afford to get good educations even if, in the process, they get terrible grades. In the absence of government intervention, children of middle- and lower-income parents generally cannot.

    The law schools Mr. Harper picks out for special criticism tend to service students from less privileged backgrounds. That’s part of why their LSATs and UGPAs are lower, part of why their educational debts are higher, and part of why they can’t get jobs as easily as their more socially-connected peers. Blaming the schools misses a significant part of what’s going on.

    Most other wealthy countries solve this problem by making education free. FREE. Since education is one of the best predictor of socio-economic mobility, we would expect the United States to trail in this morally essential indicator. And, indeed, the latest OECD report on economic mobility confirms that the United States is one of the worst of all developed countries in this regard. In the United States, a father’s income predicts almost 50% of his son’s income. In Denmark, by contrast, it predicts about 16%. Kids in Denmark rise or fall far more on their own merits than here. At least in this regard, the Danes have managed to create far more of an opportunity society than we have.

    Yes, standard welfarist theory asserts that Denmark is therefore inefficient – that folks in Denmark overconsume education. But is this a bad thing? In my view, it would be more productive to argue this question on the merits, not by invoking terms like “moral hazard” that purport to be objective but are not.

    • As I read Prof. Seto’s analysis, the steps are:

      1. Government student loan guarantees alone would create moral hazard, but
      2. Rules preventing students from discharging educational debt in bankruptcy eliminate that hazard, because
      3. All consequences of educational debt are internalized to the student borrower who will not over-consume education.

      That ignores the law school side of the dynamic. As a group over the past 20 years, law schools have raised tuition at a rate exceeding all of higher education. Likewise, a fundamental disconnect exists between the dismal JD-required employment rates of some law schools and the tuition they charge — which is typically comparable to tuition at top schools where most graduates actually get jobs requiring a JD.

      In Prof. Seto’s model, where and when are marginal law schools accountable — especially those that have the worst employment prospects for their graduates as they burden those graduates (including the underprivileged) with the highest levels of law school debt?

      Moral hazard is “a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost.” (The Economic Times of India, but similar definitions abound.) That describes how some law schools are exploiting a dysfunctional market. For schools unable to place a significant percentage of their graduates in full-time long-term JD-required jobs, attending law school is a “risky event.” It’s just not risky for the school.

    • “Rational, self-interested borrowers will only borrow to the extent doing so will maximize their risk-adjusted welfare which, because all externalities have been internalized through the elimination of bankruptcy relief, should also maximize aggregate social welfare. ”

      Add ‘well-informed’ to the list of bad assumptions.

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