Don’t Ignore the Lenders — and Investors — Behind Student Debt

by Alyssa Oursler | March 7, 2013 10:30 am

Most of the talk regarding student debt revolves around the students themselves — the huge holes many are digging themselves for a college degree, the struggle to find a job afterwards[1] and the effect it could have on the broader economy[2].

But there are two sides to the student debt coin: For every person taking out a loan for school, there is someone else lending the money.

Actually, make that three sides: In some cases, people are investing in those loans.

Of course, more than 90% of the nearly $1 trillion total student debt is directed by the government, meaning there is no underwriting and the loans are not investable. Still, the remaining chunk — a pretty hefty pile — is in high demand. Earlier this week, The Wall Street Journal[3] ran an article about student-loan securities, referring to them as a “hot asset.” As the article explained:

“Investors had been slow to embrace student loans since the financial crisis, even as other asset-backed securities rallied. But investors have stepped up their search for yield since the Fed in September announced its latest bond-buying program, aimed at lowering long-term rates.”

And the numbers prove it. In the first two months of the year, more than three times as many student-loan-backed securities were sold — for a total of $5.6 billion — than at the same point last year. Heck, last week alone, Sallie Mae — formally known as SLM Corp. (NASDAQ:SLM[4]) — issued $1.1 billion of such securities, according to the WSJ.

Such booming demand has even sparked the creation of a platform that will allow lenders to issue student-loan securities directly to investors. SecondMarket Holdings debuted the platform Monday.

Mike Cagney, CEO of SoFi[5] — an alumni-funded lending community seeking to improve the student loan landscape — finds this shift surprising.

“As an asset class, student loans are not classically considered ‘hot,’” he said. “They are relatively long-dated, there’s an upfront deferral of cash flows while the borrower is in school, and they come with less-than-stellar default rates.”

Apparently, though, investors aren’t fazed by the high default rates[6] — in fact, they’re flocking to them. For Sallie Mae, demand last week for the riskiest loans was 15 times greater than the supply available.

Such a reality is noticeably analogous to the mortgage situation[7] that pummeled the economy a few years back. Granted, private lenders do have stricter lending standards since the crisis[8] and tighter standards compared to federal lenders. But that comes at a cost for borrowers — higher interest rates and fewer protections — and hardly helps when those loans are quickly turned over. As Cagney put it:

“One of the main problems with the current loan system, besides a lack of financial literacy, is a lack of accountability. Once a loan leaves the books, the lender doesn’t care about performance. If the student drops out or graduates and doesn’t pay, there are no repercussions. This doesn’t encourage anyone to underwrite responsibly.”

That pawning-off of loans to investors makes it “even harder to know who has the authority to make decisions about repayment options, discharges, or other issues that arise,” Slate says.

And government-backed student loans[9] — even though they aren’t bundled and sold — are hardly part of a more responsible landscape, as most have no lending standards at all. Stafford loans, for example, account for more than 75% of federal student loans and not only impose no credit standards, but have a high $57,500 cap for undergraduates.­

This reality is something SoFi hopes to fix, but it’ll be an uphill battle.

SoFi is trying to create both a social and financial benefit (hence the name SoFi) from its lending program, and an interest in the success of the borrower is one part of that equation. SoFi connects students and alumni through a dedicated lending pool, where alumni lend to students, creating a “natural affinity” not just to the school itself, but to the individual borrower, Cagney said. An “explicit social contract” is thus created, encouraging the lender to help the student be successful — whether through job placement, funding business ideas or overall mentoring.

This year, SoFi expects to lend around $1 billion to students at its 78 participating schools.

Still, that’s a drop in the bucket compared to the piles being pushed through Uncle Sam and other private lenders like Sallie Mae. And with investors rushing to snatch Sallie Mae & Co.’s loans off the books … chances are there will be even less incentive to lend wisely.

As of this writing, Alyssa Oursler did not hold a position in any of the aforementioned securities.

Endnotes:
  1. find a job afterwards: http://investorplace.com/2012/08/study-raises-question-is-college-worth-it/
  2. on the broader economy: http://investorplace.com/2012/12/the-specter-of-student-debt-is-bigger-than-you-think/
  3. The Wall Street Journal: http://online.wsj.com/article/SB10001424127887323293704578334542910674174.html
  4. SLM: http://studio-5.financialcontent.com/investplace/quote?Symbol=SLM
  5. SoFi: https://www.sofi.com/
  6. high default rates: http://investorplace.com/2013/02/subprime-student-debt-is-a-huge-red-flag/
  7. analogous to the mortgage situation: http://www.salon.com/2012/10/27/why_student_loans_are_just_like_mortgages/
  8. since the crisis: http://blogs.reuters.com/great-debate/2013/03/07/student-loan-bubble-babble/
  9. government-backed student loans: http://online.wsj.com/article/SB10001424127887324469304578145092893766844.html

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