Putting the problem in context, it is clear that the gravity of student loans is enormous. The average student leaves college with debt exceeding $35,000 and the total outstanding debt of all graduates is around $1.2 trillion. These factors are putting a significant damper on the United States economy, and the US is in dire need of an innovative solution.
To give Friedman’s idea the proper respect, we must first take a step back from the politics of the situation and break down the student loan market in the United States. Currently, students have the choice of going through either public or private sector channels in order to fund their ventures into higher education. The public loan market has a lot to offer students specifically since it promises low, fixed interest rates. The catch, however, is that most federal student loans do not even come close to covering the total costs of many universities in the US. The maximum amount any federal loan can provide is $12,500 per year while the average yearly cost for four-year institutions in the US exceeds $20,000. As a result, many students have to turn to the private market, which is much harder for students to navigate compared to the public market, to come up with the remainder of the bill. Typically – in the private market – students face interest rates that are both variable and comparatively high.
With a public market that doesn’t have the capacity to expand because the legislative process in the US is astonishingly slow, market restructuring needs to occur in the private sector, which is where Friedman’s proposal comes in. What he posits is to turn the central assumption surrounding student loans on its head. Why not allow students the same financing options that businesses have, specifically the choice between debt and equity financing? Friedman proposed that, just like businesses, students could fund their educations through debt in the form of loans, which is the status quo, or alternatively through equity in what is known more formally as a Human Capital Contract (HCC).
To make HCC’s easier to understand, let’s envision what equity financing for businesses looks like. For businesses that are looking to grow their operations or take on another venture, sometimes the better decision is to avoid taking a loan especially when it is a venture in which the timing and magnitude of the payout is uncertain or risky. In these instances, it often makes more sense for the business to finance through equity rather than debt by selling a fixed share of the company to investors. This allows a business to gain the necessary capital to take on a venture that would – in theory – increase the scale and profits of their operations. With equity financing, investors are in effect buying a share of the company and by extension a share of its profits rather than the right to a flow of debt repayment that commits a company to a structured repayment schedule, which could hamper its ability to effectively deploy its new capital.
Students entering into higher education have a similar risk calculus to business owners taking on a risky venture; so applying the same train of thought, with regard to financing, to higher education HCC’s is not difficult in the slightest. Connecting investors to students in a way that is ensures mutual benefit and diffusion of risk seems like a no brainer solution for the US’s student loan problem.
Some critics would ask, how could an investor possibly get to an accurate estimate of what a student’s future income which of course would determine the return on their investment? Indeed, the parameters by which these HCC’s would be written would likely have to be loose, since it is hard to expect all high school students to know with great certainty what they want to do with their lives or even what they want to study. However, every college’s median salary data is readily available to the general public. When HCC’s are being written up, it is clear that investors can make sure that they use the colleges their students are attending as a benchmark for future income, a process that can be improved on with time and is likely to vary from investor to investor. From this point, the student and investor can negotiate a mutually agreed upon equity share that the investor would be able to receive in the future. For those students that know what they want to do with their educations and – more importantly – careers, they have the option to add these variables into the calculation of expected future income and determine the parameters of their HCC’s.
With HCC’s, just like every other investment vehicle, there is the possibility that it can perform worse than, as good as, or better than expected; simply put, HCC’s would carry a degree of risk as well. Students, independent of graduation or entrance into the – if promised – predetermined career path, will still owe equity to their investors. Without a degree, students will not give nearly the same returns to their investors compared to expected returns. However, the opposite is true too. Students that enter into HCC’s and end up making substantial incomes will end up making their investors very happy by giving them returns that far exceed expectations. At the end of the day, like most assets, HCC’s will have a degree of uncertainty built in, but that is not to say it is necessarily a bad thing, because the equity sold can be adjusted on a case-by-case basis to account for these discrepancies.
With HCC design out of the way, the first question that needs to be answered before we can delve into further detail is whether investors would be willing to buy into the system. The only way to evaluate this idea is by figuring out if the payoff from investing in a student’s education is worth the funds that are tied up in the venture. According to One Wisconsin Institute, a policy research group, the average time it takes for a student to pay off the entirety of his loans is about twenty one years. Assuming a similar payoff timeline in a HCC, the most similar market that HCC’s could be compared to is the bond market with one caveat: equity is sold at a fixed rate.This means that investors will have to steady percentage return on the incomes of students, compared to bonds that pay a variable return on their principal. The main issue with long-term bonds is that they are even more sensitive to swings in interest rates, which makes them riskier bets compared to their short-term counterparts; similarly, the central uncertainty with HCC’s is the initial income made by students. Once a student enters the workforce, a predetermined portion of his income is then given to the investor without a hassle, which means a stable source of long-term returns for investors that will not be nearly as market sensitive, but it is – sadly – not easily predictable either.
As long as the equity share and payoff timetable are properly decided before the investor decides to tie up assets in a student, it would appear that HCC’s could be viable in real life. However, taking on single students whose career paths and, therefore, future incomes are unknown is a risky venture. Investors’ returns from single students can be either above or below original estimates; there is little chance for middle ground. The solution – as Miguel Palacios, Professor of Finance at Vanderbilt University, points out – is for investors to mitigate risk by developing Human Capital Funds (HCF’s). Functioning similarly to mortgage backed securities, HCF’s have the potential to pool together many students with different future returns in order to make sure that one bad student, or a small group of students will not negatively impact the whole investment. With single students the risk and payout to investors is highly uncertain, but when students are pooled together, unique risk can be diversified. All of these parts working together would make sure the demand side of the market could potentially exist.
Before exploring the supply side of HCC’s, it would be more important to make sure that there is a market in which investors and students can meet and systematically produce these contracts. There must be a medium in which investors and students can gather to allow this transaction to occur. Similarly to how sell-side brokerage firms currently connect companies and governments that are in need of money to buy-side institutions that are willing to take on the investment, HCF’s could develop institutionally in the form of HCF firms. By aggregating students, calculating different payment structures given a plethora of education and occupation related variables, and projecting future earnings, HCF firms would be the medium where students and investors can have their respective needs met. The institutional framework for these firms already exists, creating them is merely a matter of taking on a strong supply of students.
The central idea that needs to be clarified to ensure that students would be willing to accept an equity funded education is that it needs to be as desirable or more desirable than the status quo for loans. We hear all too often the news reports on horror stories of students being inundated in post-graduation debt and how it is ruining the lives. Although not every single student has quite as terrifying an experience with the current system, a significant amount of students do report that their large student debts and the fear of defaulting on them – and the impact this would have on their future ability to borrow at a reasonable rate – do cause them a significant amount of stress. It seems like any alternative, like HCC’s, would beat the current system, especially because equity financing does not carry the same credit risk for the recent graduate as debt financing. The kicker: because the equity sold is a function of current income, not outside market functions or the bank’s complicated and treacherous payment structure, graduates are not beholden to the same long and short-term financial burdens that debt financing promises.
The conditions already laid out, however, cater more directly to the needs of low-earning individuals right out of college. An issue arises when high-earning individuals are considered. Notably when – to satisfy investors – the market would need to generate high returns, which would logically come from gaining a percentage of high-earning individuals’ income. So, high-earners are necessary for the market to function. Yet, why would a student that wants to go into a high-earning field such as medicine, law, finance, etc. want to sell shares in their future high earnings? Wouldn’t it be better for them to pay out traditional loans? Put simply, these individuals would be less likely to give up, let’s say, ten percent of their future incomes that can exceed six figures since committing a percentage of their incomes could incur more costs compared to paying off loans. To satisfy these students’ long term desires and the solvency of the higher education HCC market, HCC’s also need to contain provisions that make sure that the equity that is sold off to investors has some dollar cap, expiration timetable, or the bold option to buy the equity back. With these provisions, HCC’s will have the ability to attract students from all income ranges past, present, and – most importantly – future.
All of the evidence points to the fact that a market for higher education HCC’s seems entirely possible, remarkably because many of its working parts would resemble financial assets, institutions, and processes that are already in existence. While there are many legal frameworks that must also be established before a market for HCC’s could come to fruition, it is clear that the basic market structure is possible. The higher education HCC market has potential to be a national problem-solving venture, but whether or not people have the forethought to understand and accept it as a solution is an entirely separate matter.