In a global economy in which liquidity is increasingly important, securitization​, the repackaging of assets into marketable financial instruments, has slithered into every market. This affects the mortgage, credit, and auto loan markets but a less widely known space that has been transformed by securitization is the student loan market. 

Student Loan Securitization

The United States alone has approximately $1.2 trillion in outstanding student loan debt, 40 million borrowers and an average debt balance of $29,000. Student loan asset-backed securities, or SLABS for short, are exactly what they sound like; they are securities based on outstanding student loans that investors can purchase that deliver scheduled coupon payments much like an ordinary bond.

The main purpose behind SLABS is to diversify the risk for lenders across many investors. By pooling and then packaging the loans into securities and selling them to investors, loaning agencies can spread around the default risk, which in turn allows them to give out more loans and larger loans. This way, more students have access to loans, investors have a diversifying investment instrument, and lenders can generate consistent cash flow from their securitization and debt collection services.

Student Loan Borrowing Metrics (2004-2012)

*Tables courtesy of Business Insider 

As you can see in the above tables, the number of student loan borrowers and the average balance per borrower is rising year after year. Because of the inherent similarities between the student loan market and the sub-prime mortgage market, there is rampant fear that the student loan industry will be the next market implosion to trigger a financial crisis. Evidence has shown that even in the current recovering economy, the majority of new college graduates have not been able to find jobs that allow them to pay back their student loans. The result is a default rate that has been increasing since 2003. However unlike mortgages, student loans are not collateralized​, meaning investors get nothing in the case of default. So in the case of a student defaulting, lenders are out even more than they would be in the mortgage-backed securities market.  

Private Loans

Sallie Mae or SLM Corp (SLM), a former state-owned enterprise, is the main private lender for student loans. Sallie Mae makes loans that aren’t backed by the government and packages the loans into securities, which are sold in tranches (or segments) to investors. Since the recession and the subsequent realization that asset-backed securities were a primary catalysts for the crash, Sallie Mae has tightened its lending constraints. Nevertheless, it still services 3.6 million borrowers.

In recent years, Wall Street banks have stopped securitizing loans because federal subsidies were eliminated and because interest rates are so low now that student loans are not as profitable. The Federal Family Education Loan Program (FFELP), which ended in 2010, was a government-sponsored platform that subsidized and reinsured the loans, essentially guaranteeing that these loans would be paid back. As you can imagine, the expiration of the Federal Family Education Loan Program led to less enthusiasm from lenders and investors.

With these benefits no longer in place, banks have rapidly been replaced by peer-to-peer lenders like SoFi, LendingClub (LC), and CommonBond. As a result, private lending has been inching upwards to 7.5% of the total student loan market. Some lenders, like CommonBond, have been focusing on only lending to graduate students, who are much safer bets for repayment than undergraduates. Due to this, the company expects rating agency Moody to rate the debt Baa2 and the DBRS credit agency to rate it A--both signaling good credit quality. So far so good, as none of CommonBond’s 2000 borrowers have defaulted. This is in stark contrast to the 850,000 defaults for over $8.1 billion in private loans since 2007.


*Diagram courtesy of Business Insider

Public Loans

The U.S. Department of Education generated upwards of $100 billion in revenues from its student loan operations from 2008 to 2013. One of its key advantages over private lenders is that its cost of borrowing is much lower since it, after all, is part of the federal government. Thus, students usually take out as much as possible in public loans before turning to private lenders. On the other hand, because public loans usually have a lower interest rates and private loans higher interest rates, borrowers usually prioritize repaying private loans first. Another big difference between federal loans and private loans is that federal loans all have fixed rates, while private loans usually have rates that vary from borrower to borrower based on his or her credit. Moreover, public loans like Stafford loans don’t start accruing interest until 6 months after graduation.  

Unlike private lenders, the federal government doesn’t check credit records for student loan borrowers. This leads to many uncreditworthy borrowers qualifying for loans and then being saddled with debt indefinitely with little hope of paying it back. This harkens back to the sub-prime housing loans that drove up the housing bubble. Investors should be wary of how much longer these aggressive student loan lending strategies can be sustained.

Enticing to Investors

Investors are attracted to the seemingly endless growth potential of the education market. As students graduate from high school, they swarm to enroll in college in an effort to gain an advantage in the labor force. After graduating college, those who can’t find jobs go back to school to obtain even more degrees. Every step of the way, millions of students take on loans to pay exorbitant and skyrocketing university fees. It is no secret that with this pricing power, universities have continued to hike tuition and fees year over year, exponentially outpacing inflation.

The situation has become endemic throughout the United States. The government has tried to address it, but has not made much progress. The Obama administration is campaigning heavily for the government to cover the average cost of community college as well as to set a limit on the proportion of discretionary income that can be used to make loan payments. With interest rates hovering near 0 for several years and the stock market reaching all-time highs, yield-hungry investors are shying away from traditional securities and looking for alternative investment opportunities. Student loan asset-backed securities are a risky investment strategy for those betting on the continued growth of tuition fees and the demand stability of the secondary education market.

The Bottom Line

Considering the amount of money currently invested in them, student loan asset-backed securities have stayed out of the limelight for retail investors and haven’t gotten their fair share of attention. As wave after wave of college students take on debt, the entire U.S. economy and social fabric has felt the reverberations. Young people are postponing first marriages, leasing instead of buying cars, renting instead of buying houses, and diving into the sharing economy to lower costs or make extra money. The securitization of student loans results in liquidity for lenders, greater access for borrowers, and an additional financial instrument for investors. In this light, student loan asset-backed securities seem to be a valuable asset to the economy. However, whether this industry can sustain itself will come down to whether enough borrowers can eventually pay their debt obligations and that is looking like a slim prospect.




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