The cost of a college education continues to soar, and the interest rate on government-subsidized student loans is set to double. It would seem like a perfect recipe for more private lending and, by extension, for more securitization of private student loans, which has fallen sharply since the federal government took over this corner of the market two years ago.
In fact, the opposite appears to be happening: the ranks of private student lenders continue to thin amid increasing regulatory scrutiny, and those that remain are tightening their lending criteria. So while these products have new features allowing them to better compete with government-subsidized loans, they are also available to fewer students.
As if that were not enough, legislation that would forgive private student debt in bankruptcy is threatening to drive the remaining lenders in the sector away.
But right now the biggest impediment to securitizing private student loans is that they are no longer guaranteed by the government. That means lenders, or purchasers of student loan ABS, have no recourse to an asset should the borrower default. This makes private student loans one of the worst assets to fund, according to one securitization attorney who has worked closely with originators in the private student loan ABS space. "They are loaning money to someone with no credit history," the lawyer said. Nonbanks simply can't lend without the ability to securitize the loans, and banks that still make private student loans are largely keeping them on their books. That's what's pushing lenders to innovate, both by making the loans less risky and by attracting the best borrowers.
Funding Gap
There's certainly plenty of demand for loans. Outstanding student debt, including private and federal loans, has topped $1 trillion, surpassing previous estimates, the Consumer Financial Protection Bureau reported in April. A scheduled doubling of interest rates on government-subsidized undergraduate Stafford student loans can create a short-term opportunity for private lenders. The interest rate on subsidized Stafford loans is scheduled to double, to 6.8%, on June 30 as the College Cost Reduction and Access Act of 2007, which phased in interest rate reduction on subsidized Stafford loans over a four-year period, is set to expire. The phased-in interest rate cuts began in 2008 and eventually brought rates down to the levels seen today at 3.4%. But, even if the interest rate doubles on subsidized Stafford loans, borrowers still benefit from the 0% interest rate during the in-school period, which makes the loans less expensive than even the best rates offered on the private side.
Under the terms of the federal subsidized loan, the government pays the interest while borrowers are in school; once they enter repayment, an interest rate is charged. A better case can be made against unsubsidized Stafford loans. These student loans are also federally guaranteed, but like private student loans, the interest accrues from the time the loan is disbursed to the school. The interest rate on these loans is also at 6.8%, a rate that is comparable to some of the more competitive rates offered by the private student loan lenders.
"It's fair to say that students and parents are very interest-rate sensitive," said Vince Sampson, president of the Education Finance Council, which represents nonprofit and state agency lenders. "Whenever we see interest rates moving up or down, we are going to see consumers reacting in kind. So, given that interest rates on federal Parent PLUS loans are 7.9% and there are private student loans with better fixed rates, it's possible that students will try and use that lower interest rate loan primarily based on the effect that they will have less money to owe over time."
Sallie Mae, the biggest private education lender, in May launched a new fixed-rate product for the academic year 2012-2013 that undercuts the unsubsidized Stafford loan rates, but only for its best customers. Also in May, Discover Student Loans announced similar fixed-rate loans for undergraduate and graduate students with rates as low as 6.79% APR. SunTrust this year also introduced a new rate on its existing student loan product that plays out better for the borrower. The firm advertises fixed rates from 3.75% to 12.25%.
"Part of what enables these lenders to offer these products are the shorter repayment terms," said Mark Kantrowitz, publisher of Fastweb.com and FinAid.org. "Most other lenders have a 15-year repayment term, and these lenders have five to 15 years and they typically require in-school payment."
Still, while the products tap into the gap that a rise in interest rates might create, Kantrowitz noted that the best rates are only for the best customers. The fixed interest rates on the Sallie product, for instance, will range from 5.75% to 12.875%, although Kantrowitz said that less than 5% of their borrowers are eligible for those best rates.
On his FinAid.org site, Kantrowitz said that he requires lenders to list their worst rate along with the best rate on offer, although he does not require the lenders to release their tiering. "The lenders don't want people to realize that less than 5% of their borrowers are actually getting the best rates," he said.
The culture of secrecy seems set to continue, according to Kantrowitz. None of the commercial lenders left in the private lending space have made moves to offer clearer upfront pricing. "There are companies that establish student loan marketplaces where students can apply for multiple loans to see which lender will offer them the best rate," Kantrowitz said. "Those have had a lot of difficulty getting off the ground in part because the lenders don't want to make it easier for borrowers to figure out which lender has the lowest rate."
Kantrowitz believes that lenders still active in securitization have opted to privately place deals, post-financial crisis, not just because the lender is going to where the capital is available, but also because it may be a deliberate strategy of making the information on rates more difficult for their competitors to access.
The prospectus of a securitization can reveal a lot of information that lenders didn't realize could be derived. "If you examine very carefully the interest rate and the FICO score distribution, you can align them and usually you can use that to derive where their tiering is - at what FICO score does the lender give the next increment in interest rates," he said. It gives a very good idea on what the pricing breakdown is for that lender, which is something that all lenders consider to be proprietary information, Kantrowitz explained.
Some people are skeptical that rates on Stafford loans will actually double. Steve Levitan, a securitization partner at the law firm Bingham McCutchen, believes that the interest rate debate is a "political football," and much like the stakes in the federal debt ceiling debate, everyone loses if a compromise is not reached. Levitan has a wide range of experience in structuring highly complex securitization transactions backed by collateral encompassing a broad range of asset types, including residential mortgages, home equity, auto and student loans, among others.
"Given that it's an election year, a lot of negative publicity will be generated by a low interest rate environment not being extended - it would not look good for either side. There's so much talk about raising or not raising tax rates, yet here is this potential huge interest rate increase to some of the very people who can least afford it in troubled economic times. Congress and the administration will have to come to some kind of compromise," he said.
Durbin Bill
Another pressing and longer-term issue is how private student loans are treated in bankruptcy proceedings. This could negatively impact both the number of active private student loan lenders and the performance of student loan ABS.
In 1998, Congress enacted legislation that prohibits borrowers from discharging federal student loans in bankruptcy unless they could prove "undue hardship." In 2005, it extended the standard to private student loans.
Rep. Steve Cohen, D-Tenn., has sponsored a bill that would undo the 2005 change in the bankruptcy code that prohibits private student loan debt from being erased. Sen. Dick Durbin, D-Ill., has introduced a similar bill in the Senate.
Part of the reason for making private student loans hard to discharge in a bankruptcy is that they are unsecured credits. Lenders have no recourse to an actual asset, explained Jonathan Riber, a securitization analyst at DBRS. "Unlike lending in other sectors, like mortgages or auto loans, if a student defaults, there is nothing to repossess," said a securitization attorney who has worked closely with originators in the private student loan ABS space. "The only thing that is good about lending in this space is that the obligor is on the hook for the rest of the life of the student loan. Otherwise no one would make that loan." Adding to the risk, according to this attorney, who declined to be quoted by name, there is no way to know how long the student will be in school or whether he or she will eventually land a job enabling him or her to repay the loan.
The impact that a law making private student loans dischargeable in bankruptcy will have on securitization of these assets will depend on how it is written. Kantrowitz believes that if legislation is passed with restrictions that call for a repayment period before the loan can be discharged, the bankruptcy legislation will be at a nominal cost to spreads. "Although there is some pent-up demand for a discharge, it won't have that big of an impact," he said.
In fact, Sallie Mae has publicly supported a repeal of the legislation, providing certain conditions are met.
The private student lender has asked for two tweaks: one is a level playing field that would also subject not-for-profit lenders in the discharge. The other is a delay on when the borrower can discharge the loan. The borrower should have a five- to seven-year repayment profile before the loan can be discharged. Kantrowitz authored a report in 2010 where he discussed the issue with a Sallie Mae spokesperson. In an e-mail message, the spokesperson said that "Sallie Mae continues to support reform that would allow federal and private student loans to be dischargeable in bankruptcy for those who have made a good-faith effort to repay their student loans over a five- to seven-year period and still experience financial difficulty."
He urged Congress to consider the potential for unintended consequences, saying, "In reforming student loan bankruptcy, Congress should be careful not to inadvertently invite new abuses or increase consumer costs and decrease loan availability." He added that Congress should establish a level playing field, "extend[ing] the same consumer protections to all education loans, regardless of the source or tax status of the entity or governmental institution providing the funds."
Kantrowitz said in the report that Alan Collinge of Student Loan Justice, a group that advocates on behalf of defaulted borrowers, also said that his group would support the legislation but called on Congress to extend similar protections to "all student loans, public or private, held or guaranteed by nonprofits and for-profits." His group opposes the addition of any requirements that the loans be in repayment for five to seven years before they can be discharged. He added that student borrowers who are in financial distress need "the same fundamental consumer protections that all other borrowers enjoy."
Anything more lenient could, in effect, lead to a considerable increase in defaults within the sector. "I don't think they would pass legislation so black and white, and if they do it will be a law where you would have to prove you have an economic hardship and where you have to show that you have been trying in good faith to pay off the debt for a considerable period of time, or where borrowers are barred from discharging their student loans within a certain number of years, similar to bankruptcy laws from the past," Riber said.
He added that the general sentiment among industry vets is that the chance of any rule being passed is low. "Since this proposal has been languishing around for quite some time and hasn't gained any real traction, market participants don't expect any substantive legislation to pass," Riber said. Additionally, if the borrower filing for relief has other consumer debt, Bank of America Merrill Lynch analysts predicted more bankruptcy-related charge-offs in related portfolios, since borrowers cannot select which debt is included in a bankruptcy proceeding. This includes FFELP loans, as notification of filing starts the claim process.
If any legislation were to pass, there is the possibility that certain segments within the industry, such as borrowers that attend for-profit schools, could be carved out, Riber explained. "Reform may be introduced that would liberate such debt for those who have tried in good faith to repay over a certain duration," he said. "This view reflects similar bankruptcy laws from the past (before the most recent law) where Congress barred borrowers from discharging their student loans within five years and then later barred discharge until after seven years."
The bottom line is that until securitization funding becomes a viable funding option for lenders, the private student lending business will continue to be dominated by just a handful of lenders. Securitization rationalized the underwriting criteria, the tenor and the spread charged on many of the products underwritten by lenders, stated an investment banker.
SLABS Volume
Last year, five to six private student loan securitizations were done, tallying up approximately $3 billion dollars, according to figures reported by DBRS. Barclays Capital said that issuance of private credit student loan ABS has totaled $1.4 billion so far in 2012, accounting for about 70% of last year's total issuance. Year-to-date, private credit student loan ABS issuance represents 48% of total student loan ABS volume, according to Barclays.
In 2011, three private credit student loan ABS transactions totaling $2.1 billion priced, and year-to-date, two deals for a total of $1.4 billion have come to market. In the 20 months since July 2010, only seven such deals - for a total of $6.1 billion - have priced. Sallie Mae has been responsible for this portion of SLABS issuance. By comparison, the student loan lender represented 68% and 84% of the total private credit student loan ABS new issue volume in 2010 and 2009, respectively.
Lenders that are left in the space are almost entirely banks that can rely on customer deposits, but even then, Kantrowitz said, they aren't giving unlimited lending to their student loan programs. "When I talk with the lenders I still hear that the demand for their loans exceeds their supply of capital," he said.
Recently, two major lenders dropped out of the student loan marketplace. U.S. Bank ended its student loan program at the end of March, and JPMorgan said that it would stop making private student loans as of July 1. But the real phenomenon is that nonbank financial institutions that depended solely on the capital markets for funding cannot exist until capital markets funding returns, Kantrowitz said.
That is partly due to the economics of the products. Before July 1, 2010, the lenders were involved in making both federal loans via the government-guaranteed FFELP program and private student loans. As of July 1, 2010, all new federal loans have been made through the government's Direct Loan Program. This means that a significant number of private lenders that once used the government's machinery has evaporated, said Kantrowitz. The government's Direct Loan Program offers a few types of loans: subsidized and unsubsidized (Stafford) loans for students; PLUS loans for parents and graduate/professional students; and consolidation loans for both students and parents. These loans are made directly from the government to the borrower.
"Investors in student loan asset-backed securities backed by pools of FFELP loans are not just looking at the student; they are looking at the underlying government guarantee," Levitan said. "The thing that no one is really talking about is the fact that the government has been uploading more and more of these loans onto their balance sheet, which means that when students default it just increases the overall budget deficit because the government has them on the balance sheet and they are not being paid."
In addition, Levitan said that because student loans are not dischargeable in bankruptcy, people are struggling with the debt for decades, and increasing interest rates will only worsen this problem.
Kantrowitz explained that before the financial crisis, there were about 60 private student loan lenders. Post-financial crisis, there are now only around two dozen. Of the players remaining are big banks like Wells Fargo; Citi, which last September sold $2.5 billion of its private student loans to Discover Financial Services; and Sallie Mae. "These players, because they are bigger, still have the economics to execute deals in the capital markets," he said.
The vast majority of lenders that dropped out during the financial crisis relied on the capital markets, where they would use a credit warehouse to hold the loans. As soon as they accumulated at least $100 million in credit, they would securitize the loans. "The name of the game was to push through as much volume as you could and as quickly as you could," Kantrowitz said.
The big banks still lending in the space originate the private student loans and just keep them on balance sheet and collect on the coupon. And because the banks rely on customer deposits for funding, there is no real need to come to market.
"Banks don't have as much of a need for securitization. Because of the increased credit enhancement and the high pricing, there is no incentive for banks to do deals," the securitization lawyer said. "Because they don't get off-balance-sheet treatment, the banks don't get capital relief and, in fact, because the loans have good returns, it's actually an asset that banks like having on the books - these are high-earning assets after all."
Extending the tenor on the loans and getting originators to take on more risk will be dictated to some degree by the discipline in the capital markets, although it will ultimately be the banks that start lending in the space again.
"This is really what will drive the product to change; it won't be the securitization market per se," the investment banker said. "If rates continue to be low and yields unattractive for other investment alternatives, regional banks, for instance, will increasingly turn to this product as a place to grow a revenue base."
As credit gets looser and there is more money to lend, originators will naturally move to the bottom part of their underwriting guidelines to originate riskier loans.However, investors in the space are fickle, even with FFELP-like transactions, and trying to get buyers in on the longer term seems to be a real challenge. According to Riber, shorter maturities are what all ABS investors have been looking for lately, not only student loans.
