Undecided, Unforgiven and the Future of Student Debt

In “Unforgiven,” Clint Eastwood’s almost reformed assassin, Bill Munny, explains the impact of murder on its victim. “It’s a hell of a thing killing a man,” Munny explains to the Schofield Kid. “You take away all he’s got and all he’s ever gonna have.”

The same might be said for another outpost of the unforgiven: the student loan industry.

A combination of an antiquated premise, good intentions spawning unintended consequences, and the influence of some bad actors, has saddled recent college graduates and their families with tens of thousands of dollars of burdensome and, in most cases, unforgivable debt.  Why unforgivable?  Because this is one of the terms through which the U.S. government sought to “protect” these loans in lieu of any underwriting. This means that for millions of borrowers, the American Dream has been replaced by a 21st century version of indentured servitude.

Fortunately, we see a path charted by a group of highly motivated FinTech entrepreneurs that can reshape the student loan industry into one that more effectively serves postsecondary schools, people seeking greater career opportunity, and ultimately the U.S. economy.  It’s a path carved by the digitalization of data, which provides much needed clarity on graduation rates, employability rates, post-completion salary averages, and projected industry needs. This data empowers prospective students and families to more precisely project likely outcomes of education decisions and­—armed with a basic return on investment (or “ROI”) calculation—determine if the benefits outweigh the costs.

This is a potential game-changer in the way the U.S. approaches the financing of postsecondary education, whether advanced or vocational, and it could present an impactful step to helping alleviate the economic and psychological pain induced by this slice of American debt.


Unforgiving Backdrop

While much has been written about Federal student debt in recent years, it is important to summarize some relevant facts to better appreciate FinTech’s new and creative solutions to this issue.

Almost 45 million Americans 1 – one third of the resident population in the 21-to-50 age bracket 2 – have student loans.  Student debt is the single largest non-housing consumer debt obligation at $1.6 trillion, surpassing auto loan debt at about $1.2 trillion and revolving consumer debt at about $1 trillion.3  More remarkable is the absolute and relative pace of student debt growth over the past 10 years: 9.3% CAGR (compounded annual growth rate), or almost 3x the rate of auto loan growth and 6x the rate of consumer debt growth.4  Note that the growth in student debt appears to be driven equally by increased tuition – growing 4-5% in nominal terms and 2-3% in real terms annually5 – and higher loan balances – because of large original balances and more deferment, despite a period of flat enrollment.Data from the class of 2016 reveals that statewide average debt balances range from $20,000 to $36,000, and the share of graduating students with debt range from 43% to 77%.7

Unfortunately, Federal policies – enacted to promote postsecondary education – have perpetuated a vicious cycle that links higher student loan availability to higher tuition rates, which in turn leads to more student borrowers with bigger loans.8 This mushrooming cloud of Federal student debt was born of a prevailing wisdom that attending any four-year, accredited institution post high school is the only path that assured a better economic future for young Americans.  As we see it, this premise is no longer valid for these reasons:

  • First, a college degree alone may no longer ensure a better future. After marked increases in the 1980s, the college wage premium, a measure of the wage gap between college graduates and those with a high school diploma, rose only marginally between 2000 and 2010 and has been unchanged from 2010 to 2015.9
  • Second, selectivity matters. Not all institutions are the same; the most selective schools offer students a path to above average earnings, whereas the least selective fail to deliver the goods. SoFi built a multi-billion-dollar business around this premise. According to Hoxby’s research, selectivity has declined at the average institution, and at least 50% of colleges are substantially less selective than they were in 1962.  Conversely, selectivity has moved up substantially at the top 10% of colleges.10
  • Third, a college experience financed with a high debt burden may not yield a positive return, economic or otherwise. Higher and more readily available student debt has created a cycle of perverse incentives, whereby institutions are encouraged to push tuition rates higher.  The unintended consequence is that students with the greatest financial need are forced to take on increasingly large amounts of difficult to service debt.

While most constituents would agree that academic advancement is generally a positive step, the challenges associated with carrying high student debt into young adulthood can be problematic.  If the cost of servicing that debt outweighs increased earnings, these borrowers may regret their decisions.  That’s why figuring out the affordability and debt value for prospective student borrowers — and for lenders — is essential.


No Forgiveness

The most poignant anomaly of traditional government sponsored student loans is that they cannot be forgiven through bankruptcy. This one covenant – the permanence of these loans – explains both the intractable future of the problem and the inadequate underwriting that conceived it.

While some of the problems of student debt reside with the decisions, or lack of decisions, many student borrowers and their well-intentioned parents made on their way into college, the entire government-sponsored student loan industry is also guilty of believing a dream rather than coldly considering the economic reality. Instead of conducting a true analysis of the merits of a prospective loan based on likely career and earnings outcomes, the government-sponsored loan originators relied on a combination of school eligibility for government loans, borrower citizenship requirements and an untraditional clause stating that the debt could never be forgiven to make loan issuance decisions. The result?  Billions in student loans that, regardless of the inability to default, will never be repaid, thus shifting the burden of debt to taxpayers and creating an even bigger issue.

Arguably, an even more costly ramification is the sociological and psychological damage this debt creates.  Studies have shown that student debt is weighing on the decision to get married and to have children, and it has already crippled this generation’s attainment of one historical element of the American Dream – homeownership.11  In addition, it has been suggested by the president of Purdue University, Mitch Daniels, that student debt discourages entrepreneurship, which could have significant effect on the nation’s economic growth.12


Credit 101: Informed Underwriting is Key 

While the idea of providing credit to prospective student borrowers is a good one, it should be based on outcome-driven accountability, and it should be adaptable to changing context and realities. This will have to begin with more comprehensive assessment of available data.

Until recently the U.S. Department of Education has been reporting delinquent and default rates of student loans for borrowers only three years post their graduation.  This is because the law requires that all higher institutions partaking in government-sponsored student loan programs keep their share of borrowers who default below 30% for three consecutive years or 40% in any single year.  These numbers should already raise red flags.  But six years into repayment, these numbers are even more alarming with 15.5% of loans in default (vs. a 10.4% default rate after three years).13  And the default rates, just like the value of a college degree, depend on the institution: borrowers at private, for-profit institutions are the worst offenders with a 25% default rate, contrasted with borrowers at public colleges with a 14% default rate and those at private non-profit with a 9% default rate.14  Clearly, institution type matters for both default and delinquency rates.15

Today, data is readily available to help refine and optimize the lender-borrower proposition.  Student loan originators can conduct rules-based underwriting – just like other private sector originators – so that it makes sense for all parties, with the goal of helping future generations realize their economic dreams.


Decisive and Creative Solutions

Not surprisingly, the challenges of the sector have attracted a great deal of attention in the world of FinTech and digital finance, where inquisitive minds are always ready to solve the most challenging and profitable problems.  At HCG, we are encouraged by recent developments among platforms that take a holistic look at the problem and leverage the full potential of digital finance investing in considering new approaches.

Our core belief is that while loans can still help millions of young people achieve financial well-being, not all students need to pursue an expensive four-year accredited education to get there. Available information on tuition trends, acceptance rates, graduation rates, and job placement statistics can provide powerful insight and transparency that was almost unheard of even a few years ago.  Students and their parents can now calculate a simple ROI, to determine if they should take on a loan and if so, what size of loan makes sense for a student’s educational choice.  They can easily evaluate that a school that graduates fewer than half its students, with those students seeing little, if any, increase in wages, is likely a bad investment.

For many, this increased visibility to data and outcomes has brightened and legitimized the path into vocational schools more tightly aligned with specific careers. While well-intentioned parents and guidance counselors have for decades pushed students toward four-year bachelor’s degrees, high paying jobs requiring far shorter and less expensive educations remain hard to fill.  A recent report by the Washington State Auditor found that good jobs in skilled trades remain hard to fill, partly because students are being almost universally steered towards four-year degrees.16  The report goes on to recommend that career guidance, including choices that require less than four years in college, start as early as seventh grade.

This trend seems destined to increase as the Bureau of Labor Statistics17 predicted that construction, along with health care and personal care, will account for one third of new jobs through 2022. There will also be growing need for new plumbers and electricians. And, as we move toward an overhaul of the nation’s roads, bridges and airports, the U.S. Department of Education expects there will be 68% more job openings in infrastructure related fields in the next five years than there are people now training to fill them.18

Some four-year accredited schools have also begun to recognize students’ value-based expectations. One example is Emerson College, a Boston based college with a focus on liberal arts, communications and the arts. As Lee Pelton, president of Emerson College explains “We have a responsibility to understand and deliver against the evolving career requirements of the industries our students hope to join.  In our case, that means providing students with the critical thinking, creativity, collaboration and communication capacities required to succeed and thrive in fields as varied as television production, speech therapy, writing and publishing and even comedy.”


The Future: Digitalization and Impact 

We believe that the inevitable digitalization of all credit will play a transformative role here, especially because we now have enough information to track, understand, and predict the key determinants of the value of postsecondary education outcomes. Critically, as we have seen in real estate, consumer, and small business digital finance, understanding outcomes based on a deep, near-instant analysis of all available data, makes loan origination and underwriting faster, smarter, and mutually more beneficial for all parties.

 A more informed borrower, one who can easily manage available data to see down the road at the likely outcome of his or her plan, is already farther along in being able to manage a loan to full and timely repayment. Digitalization will make it easier for families to study the simple risk-reward metrics of a postsecondary education, just as they would consider any other loan. It will make it as easy for young adults and their parents to see the future – the likely outcome of a particular college or vocational education – as it is now for them to see the dining hall and dorms on a campus tour.

As for the schools, both for and not for profit, increased visibility of outcomes provided by digitalization should up the pressure to deliver on their promises to students.  Data democracy of outcomes should weed out underperforming postsecondary institutions, and lead to more resources for the institutions fulfilling their educational promises.

We have seen this digitalization movie before. Greater transparency into a growing pool of data (easy access to real time valuations and near-term market trends) converted the “Fix-and-Flip” real estate market from a mom and pop style local business into a sleek, institutionalized marketplace.  What had been an opaque and expensive arena was converted to one where borrowers could get fair pricing for projects deserving of funding, regardless of their location or economic background.

The credit underwriting story of student loans has already started benefiting as well. Underwriting considers outcomes and measures risk and borrower pricing the way it does for other loans. Ultimately, credit benefits by making less risky loans, yielding better returns for investors, and attracting more capital. The result, we believe, is lowering the structural cost of debt in the sector and improving outcomes for all participants without the need for extreme, non-economic measures like taxpayer-funded bailouts.

We, at HCG, have been following this segment for a long time and have started investing in what we believe are the opportunities that could have a real economic and social impact.  While this newly emerging approach is not without concerns – among them structure, duration, the prospect for new Federal policies on loan forgiveness, and mistakes by early players, we believe given the right partner/platform, the rewards outweigh the risks.

We believe the winners will be platforms that are focused on the majority of potential students who can be lifted into and above the middle class by investing two years or less into learning a skill that should lead to an above average salary. Loans to these students are, in our estimation, winners from an investment perspective and the broader perspective of a healthier economy and society.

Of course, we are not the only people in the digital finance arena with this point of view.  Digital loan origination platforms, like Climb Creditand Meritize, are solely focused on a new paradigm that ties lending terms to educational outcomes. Another example, Vemo, relies on income sharing agreements to provide a financing solution that engages the student, the institution attended, and the post-graduation employer.  The math has already been done and serious players and money are assembling behind students who want to attend schools with a track record of delivering entry to well-paying careers. We believe that the structure of these loans provides compelling benefits to investors.

Angela Ceresnie, the CEO of Climb Credit, explained how Climb’s platform and unique loan structure promotes economic mobility for those entering the workforce—and also helps current workers gain in-demand skills to pivot to more fulfilling and higher salary careers. “Our average borrower is 31 years old—not who you may expect to be taking out a student loan. Many of our borrowers have attained a bachelor’s degree, but then realized that they don’t have the skills they need to reach their career and salary goals. We’re attacking this problem head-on by offering access to accelerated programs that get students skills and jobs.”

The lesson we take away from this dive into unforgiven student loans is that digitalization is also unforgiving.  Transparency into educational outcomes and lifetime earning potential will hold schools to a greater level of accountability in justifying increased tuition and provide students and parents with easy to use tools to make informed decisions around one of life’s most important and costly investments. As we have seen in other pockets of digital finance, decisions informed by easy access to deep, relevant and timely data, should lead to greater transparency and efficiency in postsecondary education, better outcomes for more students and a far healthier slice of American debt.


About HCG 

HCG has been a pioneer in digital finance investing since 2012. We believe that foresight, enables us to look ahead at the critical issues around evolving fintech, credit underwriting, regulation, and financing markets that represent both the opportunities and potential pitfalls of investing in this industry.

This material is confidential and intended to the recipient only. It cannot be republished, reproduced or retransmitted without our permission. No information herein constitutes an offer or a solicitation to buy or sell any securities or any interests in any fund or investment strategy managed by HCG Fund Management LP (“HCG”). Please see here for important additional information.

1 Federal Reserve Bank of New York Consumer Credit Panel / Equifax, 4Q2017
2 U.S. Census Bureau – National Population Estimates by Age
3 U.S. Federal Reserve, G19, December 2018
4 HCG calculations based on U.S. Federal Reserve, G19, April 2008 – April 2018
5 College Board, “Trends in College Pricing 2017”. Accessed on March 5, 2019 and retrieved from https://trends.collegeboard.org/sites/default/files/2017-trends-in-college-pricing_0.pdf
6 NCES (National Center for Education Statistics). Accessed on March 5, 2019 and retrieved from https://nces.ed.gov/programs/digest/d17/tables/dt17_303.70.asp
7 The Institute for College Access & Success, “Student Debt and the Class of 2016”, September 2017.  (The survey is based on information collected from 1,055 public and nonprofit four-year colleges.)
8 Mary Clare Amselem at The Heritage Foundation, “High Student Loan Debt Threatens Upward Mobility” (July 2, 2017) referenced Mark J. Warshawsky and Ross Marchand, “Dysfunctions in the Federal Financing of Higher Education,” Mercatus Center at George Mason University, January 2017, p. 42, (Accessed April 19, 2017); David O. Lucca, Taylor Nadauld, and Karen Shen, “Credit Supply and the Rise in College Tuition: Evidence from the Expansion in Federal Student Aid Programs,” Federal Reserve Bank of New York Staff Report No. 733, July 2015, revised February 2017, p. 19, (Accessed April 19, 2017).
9 Robert G. Valletta, “Recent Flattening in the Higher Education Wage Premium: Polarization, Skill Downgrading, or Both?”  Economic Research Department Federal Reserve Bank of San Francisco. August 2016.
10 Caroline M. Hoxby, “The Changing Selectivity of American Colleges.”. NBER Working Paper No. 15446. October 2009
11 Danielle DiMartino Booth, “Student Loans are Starting to Bite the Economy”, Bloomberg
12 Mary Clare Amselem at The Heritage Foundation, “High Student Loan Debt Threatens Upward Mobility” (July 2, 2017) referenced Kelley Holland, “The High Economic and Social Costs of Student Loan Debt,” CNBC, June 15, 2015, http://www.cnbc.com/2015/06/15/the-high-economic-and-social-costs-of-student-loan-debt.html (Accessed April 19, 2017)
13 Ben Miller, the senior director for postsecondary education at the Center for American Progress, “The Student Debt Problem is Worse Than We Imagined” New York Times
14 Ibid (refer to footnote 12)
15 Adam Looney, U.S. Department of the Treasury, and Constantine Yannelis, Stanford University, “A Crisis in Student Loans? How Changes in the Characteristics of Borrowers and in the Institutions They Attended Contributed to Raising Loan Default.” Brookings Institute Study
16 NPREd “High-Paying Trade Jobs Sit Empty, While High School Grads Line Up For University” (April 25, 2018, All Things Considered)
17 Bureau of Labor Statistics, “Occupational Employment Projections to 2022”
18 Perkins Collaborative Resource Network, “Advancing Career and Technical Education (CTE) in State and Local Career Pathways”. NPREd “High-Paying Trade Jobs Sit Empty, While High School Grads Line Up For University” (April 25, 2018, All Things Considered)

The information contained herein represents the views and opinions of HCG.  It is intended solely for informational purposes and is not intended to constitute investment, legal, tax or accounting advice.  The views about market trends and digital loan investing expressed herein reflect those of HCG management as of  2019  and are a reflection of our best judgment at the time.  They are subject to change based on market and other conditions, and we have no obligation to update them. Some of our comments are “forward looking statements.”  Actual results, however, may prove to be different from our expectations.

An investment in the notes is appropriate only for financially sophisticated investors capable of analyzing and assessing the associated risks fully disclosed in the Private Placement Memorandum.  Investors should consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The Private Placement Memorandum contains this and other information about the Fund. A prospective investor should have no need for liquidity with respect to its investment and should view it as long-term and not a trading vehicle.  Additional risks are disclosed in the Private Placement Memorandum including, lack of registration,  dependence on HCG’s principals, and short operating history.