Here's how to fix the whole mess.

The Department of Education and the federal student loan program needs to be fixed. We've got THE solution right here.

We operate from several premises here. First we'll assume that the government is not in the business of running a business, but to regulate, police, and guide us as a society. Kind of a stretch there, but it's our beginning premise. Our second premise, and we may loose some of you here, is that the free market forces will allocate technology, resources, innovation, and entrepreneurship to the most productive uses demanded by our economy. Not everyone agrees with Premise #2, but we do. We’ll debate this premise to the grave though.

With those premises in hand, let’s explore the student lending industry. In fact, let’s compare a student lending operation to a bank. Student loan companies lend money – banks lend money. Student loan companies borrow money that they lend – banks borrow the money they lend. Student loans are regulated by the Department of Education – banks are regulated by bank regulators. Whoops, things fell apart with that last one.

But we think you get the picture. An education policy administration is regulating the financial intermediation process? Yes that’s right. The Department of Education.

Here how it should work: The Department of Education provides a loan level guarantee to student loans that meet certain criteria. We’ll let the Department of Education devise the criteria, but it must be regulated and policed consistently. Now, all marketing, financing, underwriting (the usual banking stuff) should be regulated by the bank regulators. So as long as lenders fund loans that meet the Department of Education’s criteria, the lender can apply for the government sponsored insurance policy for each loan that funds (an individual loan-level guarantee). The insurance policy or guarantee will protect the lender in the event of a loan default event. The Department is therefore limited to tinkering with the guarantee criteria – which we hope would be focused on accessibility and affordability and not the process of funding loans, processing loans, or marketing loans.

See, the financial intermediation process is beautiful. There is no discrimination in financial intermediation; capital will flow to the best uses of that capital naturally (see Premise #2). The more restrictions, covenants, and friction introduced in the intermediation process, the less efficient it becomes. Sure there’s some involvement of the government here, they need to provide the guarantee to create the market. But there’s no reason for the government to absolutely smother the process – unless you insist on ending up with our present student loan mess.