Can Income Share Agreements be securitized? Should they be?

To briefly introduce ISAs for those not familiar, they are a financial instrument that students can use to pay for their education without taking out debt. In an ISA, an institution says to a student “You can study here, and you don’t have to pay us right away, but you have to pay us a portion of your future salary”. The key components of ISAs are

1. The term (the defined period of time after graduation during which a student must make payments to a university)
2. The cap (the total possible multiple of tuition a student might pay back, usually 1.5–2.5x tuition)
3. The floor (the minimum repayment amount required even if the student does not successfully gain employment)
4. The rate (the percentage of a student’s future salary to be paid back each month)

If you believe ISAs should become widespread, securitization is a necessary and inevitable function. Securitization is the last step of the value chain and exists in order to enable risk transfer and liquidity transfer. For ISAs, this would mean providing more liquidity to the market (consolidating large groups of ISA obligations that can be sold to another party) and transferring risk further to outside investors (those who would seek to buy different tranches of ISA products). The thinking behind this is that risk is transferred to those who are better able to manage the risk based on the specific products that they but. While this is rosy thinking (recall the subprime mortgage crisis), it nonetheless is one of the main two theoretical functions of securitization

How would this work? Let’s say you have a coding bootcamp that appeals to risk-averse students with an ISA arrangement with the offer that they can attend the coding bootcamp for only 20% of the future salary (in reality there are more features to the contract: term, cap, and floor, in addition to rate). The student gets to keep the other 20%. The coding bootcamp does this for dozens of students, but now the coding bootcamp needs money to run the school. So, they go to an ISA financier and offer the financier 50% of the aggregate 20% of future salaries that they are entitled to. The ISA financier buys this equity from not only the aforementioned bootcamp, but a dozen others as well. The process continues however, as the ISA financier decides to sell 50% of their 50% (of the coding bootcamps’ original 20%) to another party, such as an absolute return fund. When the ISA financier sells a portion of their equity in these ISAs though, they do so by pooling the ISAs together and then tranching them into pieces. This tranching could occur along any lines, such as student demographics, course of study, geography, etc.

Like with the underlying ISA product, regulation will ultimately be one of the gating items prior to successful securitization. Rating agencies will need to get involved to be able to provide ratings for different tranches of ISAs so that investors can properly assess investments. Standardization is highly necessary for any type of investment (for banks to make off-balance sheet trades, for example) and will be essential to securitize ISA offerings as well. Without some sort of safe harbors provisions (read more here) you will be unlikely to attract myriad types of sophisticated investors. Legislation will also help create a stable environment around the asset class; legislation will likely occur at the state level prior to the federal level (Indiana and Illinois have recently begun legislating around the subject of ISAs)

Data will be essential to securitization as well. As more data becomes available regarding the parameters of different tranches of ISAs, investors will become increasingly willing to consider ISA securities. For example, impact investors and high-yield investors have different investment mandates and will need to understand the profiles of investing in different tranches of ISAs. Other underlying data streams that are relevant to evaluating ISAs will need to be factored in as well, specifically macro trends such as wage growth and unemployment. This type of data is typically outside the domain of the asset backed security market and so will take time to be processed and priced in.

Securitization will also require answering the question, “What happens if students don’t pay?” The issue of ISA default isn’t currently a pressing issue because the ISA market is tiny (it is $100M — $200m compared to the student loan market which is $1.6T), and ISAs are primarily limited to programs with strong labor market outcomes. The question of default will become increasingly pressing as ISAs expand to populations with lower graduation rates. In the loan model today, students bear the entire risk of loan repayment. One of the beautiful features of ISAs is risk spreading that enables incentive alignment; this risk spreading should philosophically extend to ISA default scenarios as well. Consider the schools that offer job guarantees with a full refund to students if no job can be secured: should schools refund the ISA financier, or should the ISA financier bear the risk? Should schools be required to add an ISA into the ISA pool that they underwrite themselves? I expect that as the industry shakes out, schools will likely have to bear some of the cost should they be unable to ensure all students achieve successful labor market outcomes; otherwise, this defeats the purpose of them taking student equity so as to have aligned incentives with students.

The implications of securitizing ISAs are much more profound than the idea that we just have another security floating around. A public trading market for ISAs as an ABS provides quick and powerful feedback for the asset class. Investors will buy different tranches of ISA obligations, which will quickly elucidate the level of demand for different ISA products. Remember though that these products can be tranched by characteristics such as demographics, course of study, geography, etc. The concept here is incredibly powerful: to be able to purchase securities that represent the fundamentals of the economy (purchasing the upside to successful labor outcomes) tranched by any type of demographic. You are securitizing people’s futures.