Two years after the federal government largely took over the student loan market, the remaining banks in the industry are bracing for another shakeup.

Today fewer private lenders are competing for pieces of a smaller market, as some of the biggest banks have sold, shuttered or slimmed down their student loan businesses. Those who remain are now facing increased regulatory scrutiny over student loan default rates and borrowers’ overall debt levels.

That scrutiny already appears to have helped hasten the exit of some remaining private student lenders. Last month U.S. Bancorp (USB) said that it was pulling out of the student loan market, while JPMorgan Chase (JPM) is dramatically scaling back its operations. But other big financial companies, including Discover Financial Services (DFS), see the upheaval as an opportunity.

“It’s a competitive space and I think it’s a good thing,” said Steve Olszewski, a senior vice president of student loans for Discover. “It has weeded out the players not committed to the space.”

Discover is not alone finding a silver lining in the regulatory cloud. Other dominant private student lenders include Wells Fargo and Sallie Mae.  Those big lenders may also have some new competition from community banks, which are considering making more student loans  as a way to diversify their businesses.

The size of the federal loan market is about $100 billion annually, but banks originated just between $7 billion and $8 billion in private loans last year, down from about $22 billion during the peak of 2006, according to estimates from Kirk Bare, the head of Wells Fargo’s education financial services unit. That dropoff came after the federal government eliminated its FFELP in 2010, ending subsidies for loans originated by private lenders.

Now private lenders of all sizes are still waiting to see how banking regulators and other policymakers reshape the market again. 

Lenders must now report their practices, including the underwriting standards they use and the pricing and terms of their loans, to the Consumer Finance Protection Bureau (CFPB), starting on July 21.

For details on the impact of CFPB's supervision on SLABS, please see this ASR story.

Illinois Sen. Richard Durbin is making a strong push to allow private student loans to be discharged in bankruptcy, an idea that is fiercely opposed by the banking industry. And President Barack Obama in January announced his plan to expand the Federal Perkins Loans Program, from $1 billion to $8 billion, which could further chip away at banks’ business by expanding the availability of lower-cost federal loans to students.

For the Durbin proposal's effect on SLABS, please click here.

The CFPB so far has focused mostly on collecting data about student lenders’ practices, but bankers and other industry members are bracing for greater scrutiny.

“I would think the CFPB will be looking very closely at those programs,” says Kevin Petrasic, a partner with the law firm Paul Hastings and a former official at the Office of Thrift Supervision.

Other analysts say the Durbin proposal presents the biggest threat to banks’ student lending operations. 

“It’s very hard to get student loans discharged in bankruptcy … and that’s one of the reasons why students loan are cheaper than credit card debt, and why it makes collectability much higher," says Scott Valentin, managing director for FBR Capital Markets & Co.

Mark Kantrowitz, publisher of FinAid.org, a financial planning Web site for student borrowers, says banks also need to pay attention to Obama’s push to expand the Perkins loan allotment. He points out that the proposed $7.5 billion increase represents roughly the entire private loan business. If that expansion takes place, more student borrowers could migrate to the less expensive Perkins loans, rather than continuing to use private bank products.

“It quite clearly … is attacking the private loan industry,” he says.

Much of the current discussion of the student loan industry has been fed by concerns over rising default rates, and the eye-popping statistic that Americans now owe more than $1 trillion in student debt. Bankers have tried to disassociate themselves from those statistics, arguing that private student loans have stricter underwriting practices and lower default rates than the federal loans that make up the vast majority of the market.

“We do not see a private student loan bubble,” says Sallie Mae spokeswoman Martha Holler, adding that the lender’s charge-off rate has dropped from 5.4% in September 2010 to 3.5% in December 2011.

That marks a sharp contrast from losses on government loans. The Department of Education in September said that 8.8% of its borrowers were in default – the highest level since 1997.

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