Options for Student Borrowers: A Derivatives-Based Proposal to Protect Students and Control Debt-Fueled Inflation in the Higher Education Market

Abstract:     
After the bursting of the housing bubble and the Great Recession that followed, there has been an increasing focus on improving market transparency and recognizing other potential bubbles. The higher education and student loan markets are under new levels of scrutiny because they display many of the hallmarks of a bubble. The American government’s model of freely extending federal loans to students, while improving lower- and middle-class access to higher education, has enabled the formation of detrimental distortions in the higher education market. At the same time, the soaring cost of higher education has saddled a generation of young Americans with unmanageable student loan debt. Evidence is beginning to mount that, for too many, their debt-financed higher education represents a stifling encumbrance instead of the great investment that society’s collective commonsense has long suggested.

This Article explores the factors that contribute to the distortions in the higher education market, including (1) the informational asymmetries that exist between the various parties to a typical debt-financed purchase of an education, (2) accreditation rules, (3) the peculiar incentives of school faculties, and (4) widely followed school rankings. Due to nuances between different segments of the higher education market, this Article focuses on one segment for the sake of brevity: law schools. However, the analysis and prescription have more general applicability to all segments of the higher education market.

After analyzing the causes, this Article draws on enterprise liability theory to propose a derivatives-based approach to stemming the runaway educational costs and improving the value proposition for American students. Specifically, this Article asserts that borrower put rights should be embedded into new student loan contracts. Such put rights could provide any student borrower the right, after a pre-set period of time following graduation, to obtain forgiveness of a portion of her student debt provided that certain objective criteria are satisfied. These criteria would center on whether, and to what extent, a particular student borrower’s aggregate post-graduation income fails to meet or exceed pre-determined benchmarks. The risk and cost of this student borrower put right would be borne primarily by those who, under the current higher education financing model, bear remarkably little of the risk and yet reap the bulk of the benefits of government-backed student loans: schools and lenders. By placing some of the risk of noneconomic student outcomes on the schools and lenders, diligence will be encouraged at a loan’s inception, and a school’s cost increases could only be rationalized if they were likely to return commensurate value to the school’s students.

Number of Pages in PDF File: 72

Keywords: Student Loans, Student Debt, Derivatives, Higher Education, Higher Education Finance, Legal Education

JEL Classification: H52, I22, I28, K00, K23

Accepted Paper Series