Risk-Based Student Loans - PDF Free Download

Risk-Based Student Loans Michael Simkovic Seton Hall University School of Law 2013 Policy Summit on Housing, Human Capital, and Inequality Federal Reserve Bank of Cleveland Cleveland, OH Friday, September 20 th 10:40-12:10PM (c) Michael Simkovic 1

Risk-based student loans Policy goals of the federal student loan program Human capital theory and the economic value of education Some degrees have higher economic value than others Market failures in higher education and skills mismatch in the labor market Risk-based pricing as a solution

NDEA and HEA created student loans to serve economic policy goals Develop a skilled labor force to serve the needs of business and government Promote equality of opportunity and individual economic advancement Promote technological development and economic growth Note: Similar goals have been expressed in other Federal legislation supporting higher education: Morrill Act (1862, Land Grants) required mechanical and agricultural arts be taught National Defense Education Act of 1958 focused on STEM Higher Education Act of 1965 (NDEA, plus emphasis on social mobility)

Federal student loans are an increasingly important source of education financing Full-time, full-year undergraduates receiving federal student loans, 1993-2008 Percent of undergraduates, by type of institution 100% 90% Private, for profit 80% 70% 60% 50% 40% Private, not for profit All Public 30% 20% 10% 0% Source: National Center for Education Statistics, Digest of Education Statistics 2011, Table 358; Digest of Education Statistics 2008, Table 340

Educated workers earn more and are unemployed less Educational attainment and unemployment, 2012 Percent unemployed Educational attainment and median weekly earnings 2012 USD 2.1 Professional Degree Professional Degree 1,735 2.5 Doctoral Doctoral Degree Degree 1,624 3.5 Master's Master s Degree Degree 1,300 4.5 Bachelor's Bachelor s Degree Degree 1,066 6.2 Associate's Associate s Degree Degree 785 7.7 Some college, College, no no degree degree 727 8.3 High High school school diploma diploma 652 12.4 Less than than high high school diploma 471 Note: Workers age 25 and older only Source: Bureau of Labor Statistics, U.S. Department of Labor and U.S. Census Bureau, Current Population Survey 6

Decades of data show that educated workers are less likely to be unemployed Average annual unemployment rates, age 25 or older, 1992-2012 Percent of workers age 25 or older who were unemployed 16% 14% 12% Less than high school diploma 10% 8% 6% 4% 2% High School Some College Bachelor's degree Master's degree Doctoral degree Professional degree 0% Source: Bureau of Labor Statistics, U.S. Department of Labor and U.S. Census Bureau, Current Population Survey, Labor Force Statistics

Decades of data show that educated workers earn more, and the wage premium has increased over the last 30 years Median usual weekly earnings of full-time workers 25 years and over by educational attainment, 1979-2012 Real 2012 USD $2,000 $1,800 Professional degree $1,600 Doctoral degree $1,400 $1,200 $1,000 $800 $600 College graduate or above Some college or associate degree Master's degree High school graduate Bachelor's degree $400 Less than high school $200 $0 Source: Current Population Survey, Bureau of Labor Statistics

Education boosts wages after controlling for student ability Economists' estimates of increase in wages caused by one year of schooling Percent increase in lifetime wages from an additional year of school, midpoint estimate 16% 14% 12% U.S. Average, 11.8% 10% 8% Ex-U.S. Average, 9.2% 6% 4% 2% 0%

Some academic majors have a higher initial labor market value than others Recent graduates' median starting salary offer by major, 2011 2011 USD thousands Engineering Computer Science $56.2 $59.1 Mathematics Accounting Economics $49.2 $48.4 $47.9 Healthcare Business Administration $42.2 $40.9 Liberal Arts/Humanities Communications Biology History/Political Science English Education Psychology Sociology/Social Work $34.2 $32.9 $31.1 $30.7 $30.3 $29.7 $28.7 $28.5 Visual & Performing Arts $24.1 Source: National Association of Colleges and Employers, The Class of 2011 Student Survey Report 36 Figure 30 Note: Bachelor's degree recipients only

Some academic majors are more likely to lead to employment at graduation than others Job offer rate by major, 2011 Percent of recent graduates with job offers at graduation Computer Science Accounting Economics Engineering Business Administration Mathematics Sociology Psychology Communications Liberal Arts/Humanities Biology Visual & Performing Arts History/Political Science 56.2% 53.8% 50.9% 50.0% 46.3% 41.7% 38.9% 37.9% 37.6% 36.2% 35.3% 34.3% 33.8% Healthcare 28.7% English Education 19.5% 23.5% Source: National Association of Colleges and Employers, The Class of 2011 Student Survey Report 34 Figure 28

Some academic majors have a higher labor market value than others Job offer rate by major, 2011 Percent of recent graduates with job offers at graduation Recent graduates' median starting salary offer by major, 2011 2011 USD 56.2% 53.8% 50.9% 50.0% 46.3% 41.7% 38.9% 37.9% 37.6% 36.2% 35.3% 34.3% 33.8% 28.7% 23.5% 19.5% Computer Science Accounting Economics Engineering Business Administration Mathematics Sociology Psychology Communications Liberal Arts/Humanities Biology Visual & Performing Arts History/Political Science Healthcare English Education $56,168 $48,361 $47,918 $59,084 $40,906 $49,169 $28,463 $28,687 $32,941 $34,170 $31,095 $24,091 $30,682 $42,167 $30,279 $29,724 Source: National Association of Colleges and Employers, The Class of 2011 Student Survey Report 36 Figure 30, Report 34 Figure 28

First year salary for wokrers who received their bachelor's degree in 2008 Past starting salary for graduates with a certain major is a reasonably good predictor of future starting salaries by major Median salary one year after graduation by major for 2000 and 2008 graduates 2011 USD Thousands $65 $60 2000 vs. 2008 regression line [salary 2008 ] = 0.93*[salary 2000 ] - 898 R² = 0.85 $55 Engineering $50 Healthcare Mathematics and Computer Science $45 $40 $35 $30 Public Affairs and Social Services Education Social Sciences Biological and Physical Sciences History Psychology Humanities Business and Management $25 $25 $30 $35 $40 $45 $50 $55 $60 $65 First year salary for workers who received their bachelor's degree in 2000 Source: National Center for Education Statistics, Digest of Education Statistics 2011, Table 404 Note: Bachelor's degree recipients only

Over the long term, college graduates in some fields earn more and are more likely to work full time Annualized median earnings by bachelor degree field, 2009 Population age 18 and over where highest degree is bachelor's 2011 USD thousands Engineering Computer Business Mathematics Communications Health sciences Other Natural science Agriculture Architecture Liberal arts Social science Philosophy Literature Education Foreign language Psychology $0 $10 $20 $30 $40 $50 $60 $70 $80 Source: US Census Bureau, Survey of Income and Program Participation, 2008 Panel, Table 4G. Note: Bachelor's degree recipients only; annualized earnings calculated by multiplying monthly earnings by 12 $37 $37 $39 $39 $38 $43 $42 $42 $49 $49 $48 $48 $47 $46 $43 $45 $53 $48 $47 $52 $52 $50 $50 $50 $54 $52 $58 $57 $56 $59 $70 $75 $72 $80 Full time workers All wokers with earnings

Some majors may provide better opportunities to boost earnings with additional work experience or graduate education Median earnings by college major, age, and education attainment 2009-2010 Real 2011 USD thousands Graduate Degree Holder (age 30-54) $120 Experienced College Graduate (age 30-54) $100 Recent College Graduate (age 22-26) $80 $60 $40 $20 $0 Source: U.S. Census Bureau, American Community Survey 2009 & 2010; Anthony P. Carnevale, Ban Cheah, & Jeff Strohl, Georgetown University Center on Education and the Workforce, Hard Times, College Majors, Unemployment, and Earnings: Not All College Degrees Are Created Equal (Jan. 2012).

The most valuable graduate degree fields are medicine, computers, engineering, law, and business Annualized median earnings by advanced degree field, 2009 Population age 18 and over where highest degree is an advanced degree 2011 USD thousands Medicine, dentistry Engineering Computer Law Business Mathematics Natural science Nursing, public Other Architecture Education Liberal arts Social science Psychology Philosophy Literature Communications $57 $57 $57 $57 $56 $55 $52 $48 $70 $69 $66 $63 $63 $61 $63 $55 $58 $57 $70 $70 $73 $83 $75 $80 $83 $95 $93 $93 $86 $96 $100 $99 $113 $115 Full time workers All wokers with earnings Source: US Census Bureau, Survey of Income and Program Participation, 2008 Panel, Table 4H. Note: Annualized earnings calculated by multiplying monthly earnings by 12.

In spite of high wages and strong employment prospects, the U.S. produces relatively few STEM degrees STEM college degrees as percent of total by country, 2008 Percent of total college graduates Korea Luxembourg Germany France Austria Finland Japan Sweden Switzerland United Kingdom Italy Canada Ireland Belgium New Zealand Denmark Australia Norway United States Netherlands Iceland 15% 15% 14% 14% 24% 24% 23% 23% 22% 22% 22% 20% 20% 19% 19% 29% 27% 27% 27% 33% 33% Source: Organization for Economic Cooperation and Development, Graduates by Field of Education

Starting Salary USD Thousands SAT Score Differences in earnings by major do not appear to be due solely to differences in student ability 2011 median starting salary offer and 2007 mean SAT score by college major Real 2011 USD thousands SAT Score $60 $50 $40 $30 $20 $10 $0 2011 Starting Salary 2007 Math SAT Score 2007 Reading SAT Score 630 610 590 570 550 530 510 490 470 450 Source: Digest of Education Statistics, 2006-2011; College Entrance Examination Board, College-Bound Seniors: Total Group Profile [National] Report; National Association of Colleges and Employers, The Class of 2011 Student Survey Report 36 Figure 30 Note: Differences in SAT scores may be underestimated because SAT scores are for intended majors and salaries are for completed majors. There is some evidence that lower ability students switch from challenging majors such as Engineering and Computer Science into less challenging majors such as Business, English, and other social science and humanities fields.

Differences in earnings by major do not appear to be due solely to differences in student ability Average SAT scores of high school seniors by intended college major, 2005-2008 Mathematics Physical sciences English Foreign languages, literatures,and linguistics Social sciences Philosophy/religious studies Engineering Biology General/interdisciplinary History Area, ethnic, cultural and gender studies Theology and religious vocations Liberal Arts/ Humanities Social sciences and history Computer science Communications Architecture Visual & Performing Arts Business and commerce Psychology Healthcare Education Agriculture Public affairs and services 0 200 400 600 800 1,000 1,200 618 589 541 549 545 541 579 554 534 517 518 525 521 521 533 504 531 503 511 488 499 484 483 464 Math Score Reading Score 536 560 598 576 568 563 524 541 544 552 551 543 543 540 505 524 491 518 486 505 487 481 481 473 Source: Digest of Education Statistics, 2006-2011; College Entrance Examination Board, College-Bound Seniors: Total Group Profile [National] Report

Many students who currently choose lower value fields have the ability to succeed in business Percent of GRE test takers who have quantitative GRE scores that are above the average scores of students who intend to study business in graduate school, by intended graduate major, Aug. 2011 - Apr. 2012 Percent of students with high quantitative GRE scores Physics and Astronomy Mathematical Sciences Economics Chemistry Philosophy Biological Sciences Architecture and Environmental Design Agriculture Political Science Religion and Theory Foreign Languages and Literatures Natural Sciences Other Arts Performance and Studio Arts History. Theory, and Criticism Anthropology and Archaeology English Language and Literature Health and Medical Sciences History Education Psychology Sociology Public Administration Library and Archival Sciences Communications 53.8% 52.3% 50.9% 42.4% 41.2% 37.7% 36.8% 36.5% 35.0% 31.4% 30.7% 28.7% 28.1% 28.1% 27.5% 27.3% 26.9% 26.7% 26.2% 24.6% 90.9% 90.5% 81.7% 73.1% Note: Most graduate business students take the GMAT rather than the GRE. Those taking the GRE may intend to pursue a Ph.D. in business rather than an MBA. Source: Educational Testing Service, GRE Guide to the Use of Scores (2012), Table 4

Many students who currently choose lower value fields have the ability to succeed in engineering Percent of GRE test takers who have quantitative GRE scores that are above the average scores of students who intend to study engineering in graduate school, by intended graduate major, Aug. 2011 - Apr. 2012 Percent of students with high quantitative GRE scores Mathematical Sciences Physics and Astronomy Economics Chemistry Biological Sciences Architecture and Environmental Design Philosophy Agriculture Natural Sciences Other Political Science Arts Performance and Studio Religion and Theory Foreign Languages and Literatures Arts History. Theory, and Criticism Education Communications Public Administration Sociology English Language and Literature History Anthropology and Archaeology Health and Medical Sciences Psychology Library and Archival Sciences 17.3% 17.1% 16.8% 12.5% 11.8% 11.4% 11.4% 10.8% 7.8% 7.2% 7.1% 7.1% 6.7% 6.4% 5.9% 5.5% 5.3% 5.2% 5.1% 4.9% 36.1% 49.2% 66.1% 61.0% Source: Educational Testing Service, GRE Guide to the Use of Scores (2012), Table 4

Students who take courses in high value fields receive lower grades, especially in the early years of college when they select a major Grades by course type and school year for a sample of Duke undergraduates Non-cumulative within-year grade point average, 4.0 Humanities / Social Sciences (excluding economics) Natural Science / Engineering / Economics 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Freshman Sophomore Junior Senior Source: Peter Arcidiacono, Esteban M. Aucejo, & Ken Spenner, What Happens After Enrollment? An Analysis of the Time Path of Racial Differences in GPA and Major Choice (2011) Table 10.

Lower STEM grades cannot be explained by ability levels: Students in high value fields have higher test scores SAT scores by pre-college intended major and completed major for a sample of Duke undergraduates Mean SAT points 1600 Humanities / Social Sciences (excluding economics) degree completers Natural Science / Engineering / Economics degree completers 1400 1379 1434 1362 1406 1389 1434 1200 1000 800 600 400 Students who persist in their intended major Studens who switch majors Students who did not have an intended major Source: Peter Arcidiacono, Esteban M. Aucejo, & Ken Spenner, What Happens After Enrollment? An Analysis of the Time Path of Racial Differences in GPA and Major Choice (2011) Table 11.

Lower STEM grades cannot be explained by effort: Students in high value fields study more Percent of full time seniors who spend more than 20 hours per week preparing for class, by major Hours per week spent preparing for class by full time college seniors, by major 42% Engineering 19 36% Physical sciences 18 34% Biological sciences 17 31% Arts & humanities 17 26% Education 15 23% Social sciences 14 19% Business 14 Source: Indiana University Center for Postsecondary Research, National Survey of Student Engagement 15 (2011) Figure 7, 8

Students who initially intend to major in high value STEM fields switch to less demanding fields prior to graduation Percent of bachelors degrees conferred each year versus percent of college-bound students who intended to major in field four years earlier -14% -12% -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% BUSINESS ENGLISH 2010 2008 2006 2005 BIOLOGY COMPUTER SCIENCE ENGINEERING HEALTHCARE Source: College Board; National Center For Education Statistics

Workers with undergraduate degrees in some fields with low staring salaries (but high grades) are likely to attend law school or medical school Propensity for Pursuing Professional Degrees by Undergraduate Major Percent of workers aged 35 to 55 from the 1993 National Survey of College Graduates Political science Biology Chemistry History Philosophy & theology Economics Psychology- English Foreign languages Sociology Chemical engineering Secondary Education Maths Accounting Fine arts Physics Business administration Mechanical engineering Social work Nursing Electrical engineering Physical Education Marketing Civil engineering Elementary education Computer science 4.1% 3.2% 2.6% 2.6% 2.5% 2.5% 2.3% 2.2% 1.9% 1.8% 1.6% 1.6% 1.4% 1.2% 0.7% 0.7% 0.1% 13.0% 11.5% 9.8% 9.0% 7.2% 7.0% 6.1% 20.7% 24.7% Source: 1993 National Survey of College Graduates; Dan A. Black, Seth Sanders & Lowell Taylor, The Economic Reward for Studying Economics, 41 ECON. INQUIRY 365, 371 Table 4 (2003)

Workers with undergraduate degrees in some fields with low staring salaries are likely to attend law school or medical school Propensity for Pursuing Professional Degrees by Undergraduate Major, 2009 Percent of college graduates aged 18 and over with professional degree Natural sciences 0% 2% 4% 6% 8% 10% 12% 14% Liberal arts, humanities Health care, health sciences Social sciences, history English, literature Foreign languages Philosophy Psychology Mathematics, statistics Engineering, drafting Art, architecture Business Communications Agriculture, forestry, horticulture Education Law Medicine Computer and information science Source: Stephanie Ewart, U.S. Census Bureau, What It's Worth: Field of Training and Economic Status in 2009, 3 Table 3 (Feb. 2012); Survey of Income and Program Participation 2008. Note: Preprofessional majors, not shown, have the highest rates of professional school attendance, at 23.4% law degrees and 26.8% medical degrees.

Among those with a law degree, workers with high value undergraduate degrees earn the most Earnings of workers with a law degree, by undergraduate major Earnings as a percent of earnings for economics majors, workers aged 35 to 55 Economics 100.0% Finance* Accounting* Political science History English Psychology Criminology Business administration Philosophy & theology Sociology 91.2% 90.6% 85.2% 83.8% 83.1% 83.0% 79.7% 76.1% 69.9% 64.5% Source: 1993 National Survey of College Graduates; Dan A. Black, Seth Sanders & Lowell Taylor, The Economic Reward for Studying Economics, 41 ECON. INQUIRY 365, 374 Table 7 (2003) Note: * No statistically significant difference compared to economics majors. Foreign language not statistically significant and not shown.

MBAs with high value undergraduate majors generally earn more than MBAs with low value undergraduate majors Earnings of workers with a master's degree in business, by undergraduate major Earnings as a percent of earnings for economics majors, workers aged 35 to 55 Chemical engineering* Economics Electrical engineering* Aerospace engineering* Maths* Political science* English* Industrial engineering Civil engineering* Computer science* Finance Chemistry Mechanical engineering Marketing Accounting Business administration Other business Physics Biology Psychology Sociology History Foreign languages 108.2% 100.0% 99.0% 96.6% 94.6% 92.1% 91.2% 89.9% 89.5% 88.2% 85.5% 83.2% 82.7% 82.0% 81.1% 80.2% 80.2% 79.3% 77.7% 77.4% 72.4% 70.3% 68.8% Source: 1993 National Survey of College Graduates; Dan A. Black, Seth Sanders & Lowell Taylor, The Economic Reward for Studying Economics, 41 ECON. INQUIRY 365, 373 Table 6 (2003) Note: * No statistically significant difference compared to economics majors.

Basic features of risk based pricing Data-driven pricing of interest rates on loans Focus on historic data Limited use of forecasting based on anticipated demand and supply Focus on factors that are under students control Choice of major (measured by course completions not declarations) Choice of geographic location of school Ability (?) Increase labor market transparency Before students even arrive on campus through institutional rates Each semester, pricing for new loans based on latest labor market data Clear, comprehensible, salient disclosures to students Certain predictors can be excluded for ethical or moral reasons race parental wealth or income Ability (?)

Theoretical advantages of risk based pricing Universities shift resources toward fields that are most in demand, esp. STEM Increased employment Increased wages Better skills matching Wage compression and increased socioeconomic mobility Increased tax revenue and reduced burdens on social services Higher levels of technical and mathematical skill, economy wide

Risk-based pricing would incorporate prevailing interest rates, the probability of default and the loss given default into loan pricing Simplified risk based pricing equation Risk-based loan interest rate Note that credit spreads can be driven either by likelihood or severity of default Credit spread Risk-free rate (duration-matched US treasuries) Probability of default Loss given default

Risk-based pricing would incorporate prevailing interest rates, the probability of default and the loss given default into loan pricing Slightly less simplified risk based pricing equation Risk based loan interest rate to break even Risk-free interest rate Simplifying assumptions: Annual probability of default Loss given default Lender is risk neutral Lender not subject to liquidity risk Lender can borrow at risk free rate No administrative costs