Private student loans from the heady underwriting period leading up to the financial crisis are well past their most perilous early years. That, combined with an improving job market, would seem to bode well for securities backed by these loans. However, a structural flaw could prove fatal for investors in the subordinated tranches of older private student loan-backed securities (SLABS).
“Banks providing private student loans today are using much tighter underwriting criteria, but I would be cautious about getting into any securities originated between 2005 and 2008 unless you understand how their collections are being managed,” said Bill Weyandt, president and chief risk officer at Austin-headquartered Loan Science, which manages $1 billion in private student loan portfolios and provides a variety of consumer-loan support services.
Given the poorer credit quality of many of the pools during that period, Weyandt said, inadequate servicing and administrative fees were often structured into the deals.
Unlike private student loans underwritten today, which have often have credit enhancement north of 30%, older deals may be backed by direct-to-consumer loans, which were wired directly to student bank accounts instead of to the school to cover tuition and other expenses, according to Barbara Lambotte, an analyst at Moody’s Investors Service.
“I don’t see any issuer going back to that type of loan because their performance has been so bad,” she said.
In addition, older student loans are less likely to be co-signed: between 50% and 70% of those underwritten prior to 2008 had a co-signer, compared with over 90% of private student loans today, according to Weyandt.
Despite these additional risks, private student loans made between 2005 and 2008 are past their most perilous period—typically the first year or two, when students have entered repayment because they dropped out of school.
“So we’re basically seeing a leveling off due to the seasoning of the pools,” Weyandt said, adding, “A lot of the problem loans have been washed out, and a large portion … are loans that have been in repayment and made several payments. Those are probably people who have gotten a marketable education and are going to continue making payments.”
Those market dynamics are backed by research from Moody’s. In a March 18 report, it said the private student loan default rate in the fourth quarter of 2012 was 4.5%, considerably lower than the 5.2% a year earlier. Part of that stems from the unemployment rate for young college graduates dropping to 7.7% in 2012 from the roughly 9% between 2009 and 2011.
“Although the default rate is now approximately half of the 7.7% peak in third-quarter 2009, it is still nearly twice as high as it was before the recession,” the report says.
Current dynamics are likely to push default rates down further, though Moody’s expects the slide to be slow due to a still relatively high unemployment rate, as well as lower income levels and a median student debt level around $17,000.
Weyandt agreed that the challenging job market is detrimental to loan-pool performance, but said it may not be the primary factor impacting defaults.
“We feel that most PSL pools from that era [2005-2008] probably do not have adequate fees to drive the intensity and tenor of collections needed,” Weyandt said, adding that forbearance and deferment policies in the early years of a pool can mask problems, “but now the long-term performance trend of pools from that period are more evident.”
A handful of servicers maintain borrower records, issue invoices, and record borrower changes such contact information. But their collection paradigms, Weyandt said, typically evolved from the federal student loan approach, where the number of attempts to contact borrowers and the timeframe are specified, compared with the more robust contact and resolution-oriented collections programs employed in other consumer loan asset classes.
Weyandt said about 75 basis points was typically structured into deals during those years to cover administrative and servicing fees, but that’s insufficient to pay for the high-touch collection tactics often required.
“Investors would be unwise to make significant investments in private SLABS unless they understand who is directing the administration and servicing, and the collections strategy being employed,” Weyandt said. “Some of these pools no longer have someone who is managing the administration and master servicing processes that have a significant and ongoing vested interest in the performance.”
Loan Science clearly stands to benefit from additional scrutiny by investors, since it provides most of those services.
Nevertheless, said Weyandt, it is often complicated and time consuming to get in touch with borrowers who are often starting a new life. In addition to initial collections calls, Loan Science applies skip tracing techniques, door knockers, messaging, and letters. Once contact is made, said Weyandt, collection agents must engage in the often time-intensive process of educating borrowers about their obligations, and then collecting delinquent payments or considering other payment options or forbearance.
Weyandt said that investors in some low-rated tranches may never see their principal again, but some middling tranches have seen their prices drop and may represent attractive investments for educated investors, “assuming the ongoing collections servicing is good.”