The incredible danger of third-party payee systems

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Old money sign

USA Today and Get Rich Slowly both featured an absolutely amazing statistic recently that blew me away:

The amount of student loan debt outstanding in the US now exceeds the amount of credit card debt outstanding.

Rattle that around in your brain. The legions of people buying crap they don’t need with money they don’t have are now second to kids accruing massive amounts of debt for an education of questionable value. College tuition has gone up to astonishing highs, in which students are graduating with a bachelor’s degree at price tags of a quarter million dollars.

How did this happen? Why did this happen? The answer lies in third-party payee systems. Here’s what that means. You generally don’t pay cash for college. You take out loans, you get scholarships, etc. Uncle Sam pitches in with loans, too. What happens then is that the price becomes decoupled from the people who pay it. Colleges effectively are getting their money from banks, not consumers, and banks in turn get their money from consumers. The problem with decoupling cost from buyers is that it changes how market forces work.

In a normal market, prices change demand. If you raise your price to be too high, people will stop buying your stuff. They’ll find cheaper alternatives or simply do without. As a result, you have a soft cap on how high your prices can rise before your business becomes unprofitable and you have to bring prices down, or competitors step in to take profits at slightly lower margins, forcing you to reduce prices.

In a third party market, if someone is paying the bills and passing the costs on, neither party has an incentive to control prices. Neither party benefits from regular market forces – in fact, quite the opposite. Both parties acting on behalf of the consumer have strong incentives to make things as expensive as possible as quickly as possible. A good example is real estate – if you had to pay cash for a house instead of borrowing, there’s a good chance that:

  • many people wouldn’t own homes
  • those who owned homes would have bought them for materials cost plus labor

Once you introduce a third party into the system that pays on behalf of the customer, prices and reality begin to dine at separate tables. It takes much, much longer for a price increase to change the consumer’s behavior when a third party is paying on behalf of the consumer, and as a result, prices rise at amazing rates.

The only way to get prices back down to earth on any third party system – healthcare, college, housing, etc. – is to remove the intermediate party and recouple prices back to the consumer. The consequences of doing so are drastic, possibly economy-breaking. Colleges would lose 80% of their students overnight until they adjusted pricing. Houses would sit empty for years, or possibly never be bought at all. Healthcare would be denied to everyone but the wealthiest at first. It’s this nuclear scenario that prevents us from making substantive changes that in the long term would benefit us, but in the short term would be incredibly painful.

There is one other option, one which holds more promise, and that’s revolution. Online marketing has made life very hard for direct mail marketers and other channels. Online forums have been the death knell for newspaper classifieds. Once the way of doing business is shattered by a completely new model, the old model becomes affordable as the market leaves for greener pastures or is rendered irrelevant. Education is headed this way rapidly: why pay $250,000 for information and skill you can acquire with Google, iTunes, and online learning? Eventually, colleges and education groups may realize their role isn’t the dispensing of knowledge, but the certification that you have it and can wield it. Certification comes at a much lower price tag than today’s current model.

What do you think? Is college worth it? What about home ownership or other third-party payee systems?

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8 responses to “The incredible danger of third-party payee systems”

  1. Very interesting!

  2. Very interesting!

  3. Brilliant analysis. The influencing of market prices through 3rd party financing has been a subject of extensive academic research yet the vast majority of the American public are ignorant of the impact — even though it is the dominant pricing influence on items with relatively inelastic demand (healthcare, education, housing).

    Like many things that are “wrong” with the economy — 3rd party financing exists for a good reason and, even though we would be better off without it, the status quo benefits from it (e.g., Goldman, banks, etc.).

    Good luck eliminating it. Financing exists precisely because we can’t live without healthcare, education and housing — hence demand is not greatly influenced by price (inelastic).

  4. This is absolutely true. Unfortunately I do not see any interest by either the first or second parties in wanting to make a change or even take responsibility to lower the costs….yet.

  5. Thom Pastor Avatar
    Thom Pastor

    Great post. I’ve been thinking for a few years now that higher education is going to bust. With the massive tidal wave of unemployed enrolling to learn new skills, colleges are experiencing a boom just like the housing market did before the collapse. (Just today I looked at a house long listed at 100K with no sale; it last sold in 2008 for 205K. That scenario is not unique.)
    So how long until colleges bust? Students getting loans that their upcoming careers can’t afford is equivalent to all the A.R.M.s that destroyed so many families.
    Another thing working against the college industry is the fact that very smart and creative kids are putting all their work online. Many will find lucrative careers because they’ve been proving their abilities to the public for years before they enter the workforce. Who cares about a certificate when a job candidate has 5-10 years worth of work published online?
    Smart colleges are changing, slowly. The types of people who are attracted to careers in higher education (especially the administrators) don’t like or trust change. You have to drag these people by their ears in order to get them on the journey.

  6. While I agree that the disconnect between students and how they’re paying for school is definitely a big part of the problem, it’s certainly not the only one. Growing up most of us are told that going to college is very important and that the expense is worth it. Because of the way the financial aid system is designed sets the majority of students up for financial failure. Once loans have been taken out, it’s so easy to take out more than is needed (and in some cases the maximum allowed is forced upon you) that before you know it you can be in over your head. Add in having your loans go into deferment at any point for loss of job or returning for more education and the interest alone gets scary. So many things need to be changed with the entire system… and that doesn’t even include whether or not it’s a good value.

  7.  Avatar

    This is what happened here in Ireland with house prices. Once the market began to heat up, banks started to give out bigger loans to people who who couldn’t afford them. Because this credit was easy to get, builders raised their prices. Banks responded simply by raising the amount of credit they were prepared to give borrowers; and so on and so on.
    The old rule of thumb that used to have keep soft cap on how much someone could borrow for a mortgage (2.5 times your salary) went out the window as banks began to give out up to *10 times* a borrower’s salary.
    The whole country went on a building / borrowing spree, thus creating the so-called ‘Celtic Tiger’ economy. The amount of cash in the system was vast, the Irish government was also sucking in lots of cash via taxes on house purchases.
    * Building / property development became a large percentage of the country’s economy.
    * Huge numbers of houses and developments sprang up when there was no demand for them.
    * Houses were being sold for many times more than their worth.
    * Tens of thousands of ordinary people took the bait, got easy and ridiculous loans from the banks, and bought houses they couldn’t afford to become ‘investors’.
    * The Irish government’s tax coffers were bulging with money that came from builders and house-buyers who got it from banks.

    So, when the global recession kicked in and Irish banks were finally called upon to start repaying whoever was loaning *them* the money, the system broke down; crash.

    * A couple of banks went bust.
    * In an attempt to ‘save’ the banks and the nation’s economic profile (hah!) the Irish government nationalised the banks, and raised everyone’s taxes to start to pay for this mess.
    * The good ol’ IMF soon rode into town – we all know what that means.
    * Ireland is now littered with un-finished and empty housing developments that are just rotting away.

    Now unlike education, there is no ‘other model’ for housing; it has to be made of solid material upon solid ground. There was no revolution; we just said “OK, we better start paying back” and that will be our fate for many years to come.

    This is what happens when banks are allowed to give out finance to people who cannot afford it. The conspiracy-theorist in me says this was a very positive outcome for those from whom the bank borrow; they are in effect the owners of the Irish economy, as the country’s new direction is to pay back all this debt.

    Of course money is really debt and debt is really enslavement, and this cautionary tale is just a microcosm of what’s happening 24/7 around the planet.

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