Private education companies are set to receive a boost from federal efforts to curb the student loan crisis that has gripped the sector. The Bush administration recently endorsed measures to help inject liquidity into the $85 billion market for student loans by giving the Department of Education the right to guarantee and purchase federal student loans from private lenders.

A solution to this problem would be great news for private education companies like ITT Educational Services (NYSE:ESI), Career Education Corporation (Nasdaq:CECO), Corinthian Colleges (Nasdaq:COCO) and DeVry University (NYSE:DV) among others. While students are not currently experiencing difficulty obtaining loans, there is concern that a continued decline in the market could spark difficulties in the near future. And private educational companies are the most vulnerable due to their higher cost and reliance on loans.

The Student Loan Crisis
The market for student loans froze up during the credit crunch after concerns about rising defaults spooked investors. The lack of liquidity that came as a result forced many banks and institutional investors to substantially write-down the value of the student loan securities, much like what happened in the market for sub-prime mortgage securities.(For background on the issue, check out Student Loan Lenders The Next To Fall?)

Some institutions are halting their student loan operations altogether. The Wall Street Journal recently reported that more than 50 companies - or nearly 14% of the private student loan lending market - have said they are withdrawing from the business. JPMorgan Chase (NYSE:JPM) is one such lender that will stop accepting applications for federal student consolidation loans on May 1, according to a memo obtained by Reuters.

The problem is so bad that some student loans are being considered worthless by investors, since there is no market to sell them. Bloomberg issued a recent report stating that more than $9 billion of auction-rate bonds sold by student loan agencies are paying 0% interest. In essence, investors are stuck holding this student loan debt with absolutely no benefit.

How can this be possible? Student loans are often securitized into so-called auction-rate securities. Interest rates on these securities are set weekly or monthly and give holders the option of selling during these auctions. The problem is that there is no market for student loans right now, and the interest rates are now approaching zero as they are tied to benchmark rates.

These problems have caused most lenders to stop making new loans altogether. Given the cost of education in the United States, many students are unable to attend higher education without access to such loans. This is especially true as tuition costs increase higher than inflation in the U.S. which means higher loan requirements. (To learn more, check out Preparing Parents' Pockets For College Tuition.)

Proposed Solutions
The proposed solution endorsed by the White House would inject liquidity into the market by allowing the government to step in and purchase loans from these private lenders. The result would be an active market for student borrowing that many are hoping will give lenders the courage to step up and start making more loans. Meanwhile, the same people are hoping that banks will begin to remake a market.

The solution also differs from the one recommended by Sallie Mae, a subsidiary of SLN Corp. (NYSE:SLM) that is one of the largest originator of student loans in the United States. Sallie Mae called for the intervention of the Federal Financing Bank (FFB), a division of the Treasury, to step in and provide the liquidity to originate new loans. However, Bush administration officials determined that the FFB would be stepping outside of its authority.

Many are also hoping for reforms to the College Cost Reduction and Access Act, which caused the crisis in the first place. The law reduced interest rates paid on federally insured student loans. This was done through the Federal Family Education Loan Program which provides 70% of lending for educational purposes. Congress also took action to cut the yield on the loans in order to make education more affordable. Unfortunately, the side-effect was reduced profits for lenders, and thus made the loans less appealing for securitization.

Bottom Line
The new legislation to boost liquidity was passed by the House of Representatives on April 17 and the endorsement from the President means that a solution could arrive in time for the next round of student loan financing, which must be a relief to private education companies.

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