The Latest Derivative: Your Earnings Tomorrow for College Today

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The New York Times ran a piece on July 3rd by Richard Pérez-Peña about a proposal working its way through the Oregon legislature that would allow students to attend college today at no cost in return for forfeiting a part of their future earnings.

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As the article notes:

This week, the Oregon Legislature approved a plan that could allow students to attend state colleges without paying tuition or taking out traditional loans. Instead, they would commit a small percentage of their future incomes to repaying the state; those who earn very little would pay very little.

This contract is a derivate, a call option to be exact, where the buyer is the state of Oregon, the seller is the student, and the strike price is some agreed upon income level (I am going to guess some derivate of the average US income for college graduates). The plan would kick off with Oregon state money, but in the future repayment flows from former students would, theoretically, keep it afloat. “The plan’s supporters,” notes the author, “have estimated that for it to work, the state would have to take about 3 percent of a former student’s earnings for 20 years, in the case of someone who earned a bachelor’s degree.”

The author claims that this is a novel idea but it’s not. In fact, a similar scheme was tried by Yale Law in the 1970’s. A quick search of nytimes.com finds this summary of the scheme’s outcome from April 13, 1999:

Yale University officials said today that they would erase the remaining debts of alumni who borrowed money in the 1970’s under two programs that were meant to further altruistic careers like missionary work but instead saddled some students with years of payments.

About 3,900 alumni from the classes of 1971 to 1978 received loans under the Tuition Postponement Option or the Contingent Repayment Option. For each $1,000 borrowed from the university, the students pledged 0.04 percent of their future earnings for 35 years, or until the whole class paid off its aggregate debt, whichever came first.

The programs doled out $8 million in loans, but despite paying about $25 million in principal and interest, no class has paid off its debt because about 20 percent of the students fell into default.

A Yale spokesman, Lawrence J. Haas, said the university, presuming its graduates would prosper, had never anticipated that alumni would actually be writing checks 35 years later.

”We received, over the course of the last year or so, complaints from borrowers who were paying for a longer period of time,” he said. ”We took these complaints seriously.”

The programs were designed by the Nobel Prize-winning economists James Tobin and Milton Friedman. Mr. Haas said they were created for anyone who wanted to borrow, with the understanding that those who went into lower-paying professions, like the Peace Corps, would end up paying less.

I guess even Tobin and Friedman, two giants of 20th Century economics, had a hard time predicting the value of Yalie’s future incomes, so let’s hope the Oregon State Legislature does a better job. I say that in all seriousness, because I applaud the attempt to think differently about how students should pay for college. Today’s archaic higher education systems needs to be completely reinvented. While this Oregon scheme may or may not pan out, the effort to go back to square one with the whole notion of how college should be funded is a laudable one.

[By the way, the idea of selling an option on future income immediately begs the question of whether there would also be some way for the student to hedge that risk, and this is where another Yale man, Prof.  Robert J. Schiller (a Yale economist) enters the scene. Schiller (of the now-famous Case-Schiller housing price index) has long been an advocate of new ways of managing risk, and his book, The New Financial Order (Princeton 2003), talks at length about this very topic.]

Read more:

http://www.econ.yale.edu/~shiller/pubs/aggregate-income.pdf

http://www.econ.yale.edu/~shiller/books.htm

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