Working Paper: NBER ID: w29214
Authors: Daniel Herbst; Nathaniel Hendren
Abstract: Investing in college carries high returns but comes with considerable risk. Financial products like equity contracts can mitigate this risk, yet college is typically financed through non-dischargeable, government-backed student loans. This paper argues that adverse selection has unraveled private markets for college-financing contracts that mitigate risk. We use survey data on students’ expected post-college outcomes to estimate their knowledge about future outcomes and quantify the threat of adverse selection in markets for equity contracts and several state-contingent debt contracts. We find students hold significant private knowledge of their future earnings, academic persistence, employment, and loan repayment likelihood, beyond what is captured by observable characteristics. Our empirical results imply that a typical college-goer must expect to pay back $1.64 in present value for every $1 of equity financing to cover the financier’s costs of covering those who would adversely select their contract. We estimate that college-goers are not willing to accept these terms so that private markets unravel. Nonetheless, our framework quantifies significant welfare gains from government subsidies that would open up these missing markets and partially insure college-going risks.
Keywords: No keywords provided
JEL Codes: H0; I22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| private knowledge of students (Y40) | viability of equity financing contracts (G32) |
| private knowledge of students (Y40) | average expected return for financiers (G12) |
| average expected return for financiers (G12) | costs incurred due to adverse selection (D82) |
| private knowledge of students (Y40) | repayment terms needed for equity contracts (G32) |
| private knowledge of students (Y40) | repayment terms for completion-contingent loans (G51) |
| private knowledge of students (Y40) | repayment terms for employment-contingent loans (G51) |