The West Australian has a scoop today on one possible policy that could emerge from the new Government’s Commission of Audit:

The university education debt of millions of Australians could be sold off under a proposal to be examined by Prime Minister Tony Abbott’s inquiry into the state of the nation’s finances.

In a move that could boost the Budget bottom line, up to $23 billion of outstanding Higher Education Contribution Scheme debt would be effectively privatised under a plan that has already won support in some financial circles.

One proposal that has backing in the financial sector is to convert the $22.6 billion in HECS debt held by 1.6 million Australians into a financial product. In a process called securitisation, the responsibility for HECS debts would be bought by the private sector and then sold to investors.

This has been recommended before, as the article notes. The Commission of Audit established by the Howard Government in 1996 said “consideration should be given to securitising HECS.”

The proposal is kind of bananas.

Think about it from the perspective of a potential investor who might consider buying a security that entitled them to a stream of future HECS repayments from former students. As they’re currently structured, HECS debts have a 0% real interest rate (they’re just indexed by the CPI), there is no fixed timetable for repayments, and unpaid debts can’t be recouped from a debtor’s estate when he or she passes away.

It wouldn’t make sense to buy such an asset at its full value, when there are other safe assets with guaranteed repayment that pay real interest. To induce people to buy his HECS securities, then, Mr Hockey would have to either:

  1. Sell them at way below their face value; or
  2. Change the terms of the debt by charging real interest and/or allowing the debt to be recovered from the estates of deceased debtors.

In option 1, Mr Hockey would be exchanging an asset from the Government’s balance sheet (outstanding HECS debts are an asset from the Government’s perspective) for a sum of money upfront that would be worth way less than that asset. This is the opposite of responsible financial management.

Imagine you owned a house outright and were looking to sell it. You’re confident the house is worth $1 million, but finding a buyer willing to pay the appropriate price might take a couple of months. If someone approached you offering $500 000 in cash for the house if you’ll sell it today, you’d have to be nuts (or have a seriously high discount rate) to take the offer. Accepting way less than face value for the HECS assets would be much the same type of craziness – selling an asset for less than it’s worth just to get the money now rather than later. This is the fiscal equivalent of hocking your possessions at Cash Converters.

It’s not clear to me that selling the HECS assets would even help the fiscal balance. It’s my impression that the Budget treats the loans to students as an asset. The discount for early repayment is an expense, as is the estimated portion of the HECS debt that is unlikely to be repaid. The indexation of the debt is treated as revenue. Selling the HECS assets for cash shouldn’t affect the budget balance at all – it will just reduce the net financial assets held on the Government’s balance sheet. If I’m right, the sale would affect the cash balance but not the fiscal balance, which uses accrual accounting. The Budget moved to accrual accounting during Peter Costello’s time as Treasurer, for good reason.

In option 2, the Government could make HECS more attractive to potential investors by changing the terms of HECS debts. It could lower the repayment thresholds, collect HECS from Australians working overseas, and/or recoup HECS liabilities from the estates of deceased debtors. These options would all reduce the proportion of HECS debt that is never repaid. It could also start charging real interest on HECS debts. Each of these measures would increase the flow of income from HECS debtors to the owner of the asset.

There are a few problems with this. First, any change like this that would make the ownership of HECS debt more attractive to private investors would also make it more attractive to retain on the government’s books. Raising the real interest rate would increase HECS revenue. Increasing the proportion of HECS debt that is recouped (through whatever means) would lower the expenses associated with HECS. These changes would benefit the government, as the HECS lender, if it retains the asset on its books. That means that investors would need to pay more to buy the asset from government, or else the government is getting a bad deal. So changing the terms of HECS debts doesn’t raise the attractiveness of HECS assets for private investors relative to government – it lifts the value of the asset by an equal amount regardless of the owner.

The second big problem with changing the terms of the HECS debt is that it could discourage people from going to uni, particularly prospective students from relatively poor backgrounds. At the moment, HECS is a pretty good deal. Your debt doesn’t rise in real terms, you don’t start paying it back until you earn somewhere around the median full-time wage, and the repayment levels are not too onerous. If you change that deal, you risk putting people off from going to uni. This risk was clearly identified in the review of base funding for tertiary education, although the evidence about whether past cuts to repayment thresholds affected participation is inconclusive.

It is difficult to imagine conditions under which this policy makes sense.

UPDATE: I made this argument inelegantly. What I should have said is: the NPV of the outstanding stock of HECS debt would be worth less to a private sector agent than to Government (due to the higher discount rate of the private investor). Therefore the amount the Government could obtain for selling the asset would be less than the NPV of the future stream of income it would receive if it retained the asset. This doesn’t affect my conclusion that selling the asset is a bad idea.

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