This study quantifies the role of lender moral hazard on rates of borrower default.  For more than 15 years, there were two parallel programs for originating federal student loans. In the Guarantee program, private banks funded loans at terms defined by the Government.  In the Direct Loan program, the Department of Education (ED) funds the loans. Critically, loan terms to borrowers were nearly identical across programs. Moral hazard exists in the former program due to a government guarantee in the event of default, while no guarantee exists in the Direct program. 

Annual default rates and program participation data from ED are used to estimate a model of default with school fixed effects. Identification comes from schools switching programs over time, in part from a 2010 policy change eliminating the Guarantee program. The study is supplemented by a student-level model of repayment using data from the Beginning Postsecondary Students surveys. The school-level model suggests that Direct Loan participation reduces cohort default rates by 0.93 percentage points (9.9%) and 1.42 percentage points (16.8%) for two-year and one-year schools respectively, with impacts concentrated in the for-profit sector. There is no discernible impact on four-year schools. The student-level model suggests that default rates are reduced by an increased use of forbearance. This research provides evidence that aligning the incentives of loan servicers with borrower repayment may continue to reduce default rates in the current system.