Opportunity Unraveled

Investing in college carries high returns, but comes with considerable risk. Since at least Friedman (1955), economists have recognized the potential value of financial products that mitigate this risk. Despite this, college in the US typically financed through government-backed loans. The paper presented in this Mannheim Applied Seminar argues that adverse selection can explain this absence of private-market alternatives to student loans. It formalizes this hypothesis through a model of private information that characterizes when contracts to finance higher education can be profitably sold. The authors then use survey data on students' expected post-college outcomes to estimate the frictions imposed by private information for a variety of hypothetical contracts that could help insure college-going risks. It is found that students hold private knowledge of their future earnings outcomes, academic persistence, future employment, and likelihood of defaulting on future loan repayment obligations. This knowledge remains even after conditioning on screen able public information. The paper estimates that borrowers would need to pay a roughly fifty-percent markup over the actuarially fair price to prevent unraveling of risk-mitigating financial products, such as equity contracts. These generally fall below calibrated measures of the markups individuals would be willing to pay. Although private markets are not profitable, the framework of the authors quantifies significant welfare gains from government subsidies that would open up these markets and partially insure college-going risks.