Adverse Selection: Equity Prepayment Risk In Student Loans

Most good insurance companies and every failed insurance company are familiar with a phenomenon called “adverse selection.”  Adverse selection says that any situation in which the buyer and seller of insurance have asymmetric information will ultimately create a cycle whereby the low-risk individuals forego insurance that they perceive as too expensive while the high-risk individuals aggressively purchase insurance that they perceive as cheap.

Take the example of health insurance.  In the U.S., there are strict regulations about discriminating against individuals with hereditary pre-existing conditions: let’s take hereditary hypertension as an example.  Hereditary hypertension creates a higher risk for cardiovascular disease and, thus, a higher risk for a health insurer.  However, because the insurer cannot discriminate for this condition in its pricing model, the insurer is forced to ignore this predictive factor and price the insurance as if this information were unattainable.  However, most individuals who are purchasing insurance will know whether or not they have hereditary hypertension, and those individuals who do will have a great demand for insurance at a price that is ignoring that risk.  For those who do not have hypertension, however, this insurance will seem unduly expensive.  As a result, each year the “healthy” individuals will tend to opt against purchasing insurance that is unjustly expensive while the “sick” individuals will aggressively purchase insurance that is irrationally cheap.  The cost of insurance will increase each time a “healthy” individual leaves the insurance pool or an additional “sick” person joins at the price that ignores this risk.  As this cycle progresses, the risk in the underlying insurance pool becomes ever more highly concentrated, until eventually you are left with an insurance pool consisting entirely of sick individuals – which isn’t insurance at all, it’s just the original risk.

Lending is a lot like insurance: a lender creates a diversified portfolio of loans under the assumption that while some may fail, on average the portfolio will perform to some level of consistency.  Like insurance, a lender is trying to minimize an unpredictable risk (or difficult to predict risk) through diversification and the law of large numbers.  Unsurprisingly then, we find that adverse selection is also highly relevant for student loans.  In the previous post we noted that the top two causes of student loan default are the failure of the borrower to graduate and the failure of the borrower to attain gainful employment within six months of graduating.  We also previously noted that student loans, like mortgages, are freely prepayable – a unique attribute in the broader capital markets.  Further, we reviewed how the combination of these two qualities introduces meaningful equity prepayment risk into the system.  At its core, we can show that this equity prepayment risk becomes a textbook example of adverse selection.

The primary goal of a student lender is to predict default risk.  A lender who is more skilled at predicting the probability that a borrower will default on their obligation will experience smaller loan losses, which will allow it to offer lower rates than its less adept competitors.  Consequently, we would expect student lenders to expend great efforts attempting to predict graduation rates and post-graduate employment rates.  Although there are some lenders partially doing this, the vast majority of student lenders ignore these risks almost entirely or else price them very broadly: law students have higher average interest rates than medical students, but the interest rates between individual law students are largely ignorant of the individual’s academic prowess.  Most importantly, student loans by their very definition are priced at the time when the uncertainty of the borrower’s eventual graduation and employment is at its highest – that is, when the borrower is actually a student.  The result is that student lenders do a very poor job of predicting which borrowers are going to default; they only consistently predict how many borrowers are going to default.

This presents an obvious problem: lenders are pricing loans under the assumption that the risks of failure to graduate and unemployment are effectively unknowable to both the lender and the borrower.  More importantly, lenders are assuming that this fact will remain unknowable throughout the life of the loan.  This is obviously untrue: within six months of entering repayment a borrower will know with complete certainty whether they have graduated or attained a job.  In a rational market, we would expect these “healthy” borrowers to view their existing interest rate as unduly expensive while the “sick” borrowers would view their interest rate as far too cheap.  Further, given that student loans, like mortgages, are fully prepayable, then we would expect increasing numbers of healthy borrowers to exercise their prepayment option and opt out of their high-interest loans.  This is just adverse selection and will ultimately have the same consequences: student lenders will find that the risk in their loan pools are becoming increasingly concentrated. 

There is one key difference, however, between adverse selection in insurance and lending.  In insurance, the insurer has the opportunity each year to withdraw or modify its offer to sell insurance at the same price, that is: adverse selection in insurance drives up annual premiums, but it does not create long-term liabilities for the insurer.  In lending, the lender has no opportunity to withdraw or modify their initial loan terms, that is: adverse selection in lending reduces the value of the existing loan portfolio through the concentration of default risk, which creates an enormous long-term liability for the lender.  This creates major instabilities in today’s student loan market and, ultimately, makes the entire practice unsustainable.

Byline:

Derek Kaknes