Asymmetric Information in Student Loans

Student loans finance investments in human capital, and adverse selection and hidden actions can lead to credit limits and inefficient investment. This paper tests for and quantifies information asymmetries in the student loan market. I first identify selection parameters and the causal effect of increased borrowing on loan non-repayment by using (i) non-linearities in borrowing rules for federal student loans and (ii) changes in tuition for students already enrolled. The paper finds that larger loan volumes induce default - a 40% increase in borrowing increases non-repayment by 10%. Adverse selection effects are large in the 1980s when default costs were low, and selection is ad- vantageous in the 2000s following increases in non-repayment costs. Larger loan volumes inducing loan non-repayment is consistent with both strategic and non-strategic models of default. The pa- per uses policy induced variation in non-repayment costs to test for a strategic component in the repayment decision. The removal of bankruptcy protection and increases in wage garnishment re- duce default without affecting pre-default liquidity, providing evidence for strategic non-repayment. Reintroducing student loan bankruptcy discharge would cost approximately $90 billion. Estimates from a decomposition indicate that hidden actions resulting from increased borrowing can explain approximately one quarter of the increase in default in recent years, while most of the rest can be explained by changes in the selection of borrowers and the institution type attended.