The concept of hedging is originated in the commodity market (CBOT). Just a simple illustration, a farmer named Joe grows corn in the spring, but the harvest may not come till first week in October. During the planting, growing and harvesting time, he may get exposed to different source of risks or many uncertainties, such as weather (flood, or dry) which will definitely affect the selling (spot) price at the harvest time. However, he can minimize selling the corn at a loss (low price), by locking at current, and possibly hedge his crop through futures markets mechanism. Example, he can hedge his corn at the beginning of the planting season to a certain price (possibly higher than the price 3 months later), with the hope that if something bad happens, he still gets his locked guaranteed price. Usually, but not always, when supply of corn is higher around the harvest season, then the cash/spot price will also be lower, citeris paribus.
The same situation can be applied to a student who takes loans to get his or her college degree. Four years, to earn an undergrad degree or 2 years for an Associate degree, surely longer than what famer Joe has to wait before harvesting. Technically speaking, students are facing greater risk than farmers do. yet, there is no market mechanism to shift some of the risks.
When students and their co-signer agree and sign the student loans application or agreement, they basically assume that her/his future income will be higher to pay back the loans and cover her/his living expenses after graduation. In such a case, she or he bears all the possible adverse events which may affect her or his ability to finish school. In other words, students and their family are going to absorb all risks, without having a chance to shift part of it to others for there is no market mechanism for that.
Let us put some simple numbers here. Supposed James, the son of farmer Joe after graduation net monthly earning (after tax) is $2K. If he needs to pay back his loan equal to $1K per month then 50% of his net income will be gone. So, a monthly payment is directly affected by the amount of loans that he needs to take. Generally speaking, the higher the tuition that James is charged by the school, the higher the pay-back amount.
The old Joe can hedge his risk of getting lower price or crop failure through the futures markets. He, the famer, even can buy crop insurance to cover the possible loss of his crop. But his son James does not have such a luxury, because there is no insurance or market for James to hedge his possible risk associated with (1). School drop-out without a degree or (2). Get a job with salary that can pay back the loan. James is lucky that he is able to finish his undergrad degree and get a job, but some of the other students may have to face different outcomes. Two possible worse scenarios that could happen to anyone after signing the student loans agreement.
- Drop-out of school with non-zero student loan debts or
- Receiving income which is less than or equal to loan payback amount.
Option one are commonly found in the US higher ed. Graduation rate at the national level is less or on average around 40%. Meaning 60% of students who attended colleges will not graduate, but have to repay their loans, plus interest. This is the main reason why the Association thinks it is important for the American public, students, school administrators and both state and federal lawmakers to realize how serious this country is facing with the rising education cost due to moral hazard.
Unlike his father, James and million other young Americans have to bear the whole risk on their shoulder. It will be a total nightmare, If they cannot find employers who will pay them at a price where they can pay back the loan plus its interest and living expenses. Some of them may end up working at places which do not need a college degree, such as fast-food chain. There have to be a market mechanism which can be used by the young generation to hedge the risk to go under or if things do not work out as planned. Or there should be some types of insurance to cover such risks. The Association shares this idea to the Wall Street or the federal or state government to create a product or financial instruments which the students and their family can buy this “College Drop-out Insurance (simply CI)” to cover student loans balance in the event of school drop-out occurs. CI innovative idea is purely originated by AAEA. For courtesy, please cite appropriately.
Until this happens, the regulator needs to step-up its control professionally, literally to police that higher ed institutions do not take advantages of the innocent little guys and let them to bear the total risk on their own shoulder. If any of the lawmakers happen to read this blog, can you guys do a real contribution to the American public or your constituents who have put you in office? So, do something meaningful! Something similar as the Crop Insurance.