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.

MAKING MONEY ON OUR KIDS

Where can an investor earn a 7.9 percent guaranteed annual rate of return? Not 30-year United States Treasury bonds; they pay around 3 percent. Not other countries’ sovereign debt; some of the most economically fragile nations in the Euro zone sell 10-year bonds bearing interest rates of less than 6 percent—and it’s certainly not guaranteed.

Try your kids. The interest rate on subsidized federal student loans is currently 3.4 percent, but it will jump to 6.8 percent on July 1 and covers just a slice of the market anyway. For undergraduates who don’t qualify for the subsidy, it’s already 6.8 percent. For graduate students (including law students), the rate is 7.9 percent.

Big returns with no risk

The program is a moneymaker for the government. According to a February 2013 Congressional Budget Office report, the federal government makes about 36 cents in revenue for every student loan dollar it puts out. Graduate (and law) student loans are especially lucrative — 55 cents on the dollar.

These eye-popping returns are especially juicy because the loans have virtually no risk of non-repayment. If a student defaults, the feds retain a collection agency to pursue the money (total cost of all federally retained debt collectors last year: more than $1 billion). Eventually, they’ll get it because such loans are in that small category of debts that survive a personal bankruptcy filing, along with alimony, child support, certain fines, and taxes. An exception for debtors who can demonstrate “undue hardship” rarely applies.

Bipartisan blame

How did this happen? Good intentions went awry. In the 1960s, Congress followed economist Milton Friedman’s earlier recommendation that the government provide direct loans for higher education. The underlying principle still resonates: a society’s investment in human capital pays long run dividends. The corollary is that those who benefit personally should repay loans for the education that gives them a better life.

Unfortunately, as that better life has become more elusive for so many, the student loan program has converted struggling young people into profit centers for the government. In the trillion-dollar world of educational debt, students entering the professions — including law — are among the most unfortunate victims, in part because both their tuition and their loan interest rates are the highest.

The special plight of young lawyers

Lawyers generate little sympathy from the rest of the population. But 85 percent of today’s law graduates have educational loans exceeding $100,000. The grim market for new attorneys means that only about half of them are finding full-time long-term employment requiring a legal degree. Even fewer earn enough to repay their staggering loans. (Before blaming these young people for their plights, take a close look at the behavior of many law school deans who misled them into the profession with deceptive information about post-graduate employment prospects. Meaningful transparency on that topic is a recent phenomenon.)

As the July 1 deadline nears, proposals that seem to be gaining traction in Washington would preserve all above-market rates and the student loan program’s profitability. They also suggest that we’ve learned little from the subprime mortgage debacle. The House recently passed Rep. John Kline’s (R-MN) bill, resetting the graduate student rate at 4.5 percent above the 10-year Treasury, subject to a 10.5 percent cap.

In the unlikely event that the House bill gets past the Senate, President Obama has threatened to veto it. However, he is willing to have students borrow at a lower variable rate that’s still significantly higher than the 10-year Treasury, but with no cap (although once set, the rate would remain for the life of the loan). Combining the floating rate elements of the House proposal with the president’s plan could produce a truly disastrous compromise. The president also wants income-based repayment and debt forgiveness. Because Republicans with blocking power oppose those partial remedies on the grounds that it will encourage students to take on bigger debt, those proposals seem doomed.

Recently, Sen. Elizabeth Warren (D-MA) offered her first bill. For a year, it would cut the student loan rate to 0.75 percent—the same rate that big banks get on their borrowing from the Fed. Unfortunately, a prospective one-year solution is no solution at all. Sen. Kirsten Gillibrand has the best current plan: set a 4 percent rate for all student loans and allow graduates with existing debt to refinance at that rate. But that won’t happen, either.

Guiding principles

As policymakers grapple with the growing educational debt bubble, they might consider two governing principles.

First, those running institutions of higher education should be held accountable financially for their graduates’ poor employment outcomes. Otherwise, federal dollars will continue to worsen the situation as administrators focus myopically on filling classroom seats to maximize tuition revenues. Allowing the discharge of educational debt in bankruptcy and permitting the federal government to seek recourse from schools that impoverish their graduates with tuition loans might alter some schools’ worst behavior.

A second principle should be even easier to implement. No mechanism for funding higher education should convert our kids into profit centers.