With a global economy in which liquidity is increasingly important, securitization – the repackaging of assets into marketable financial instruments –has slithered into every market. While this affects the mortgage, credit and auto loan markets, a less widely known space that has been transformed by securitization is the student loan market. But just how safe is this market for investors? Here are some key facts about student loans.
- Student loans make up more than $1.5 trillion in outstanding debt in the United States from more than 44 million borrowers.
- Student loans are being securitized as asset backed securities known as SLABs.
- SLABs have been enticing to investors due to some structural guarantees, but as student debt loads increase, they may become more risky than originally thought.
Student Loan Securitization
The United States alone has approximately $1.52 trillion in outstanding student loan debt, 44 million borrowers.Student loan asset-backed securities, or SLABS for short, are exactly what they sound like: securities based on outstanding student loans that investors can purchase, which 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, agencies can spread around the default risk, which 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.
The average student loan balance outstanding in the United States.
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 each 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.
Sallie Mae or SLM Corp., 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 primary catalysts for the crash, Sallie Mae has tightened its lending constraints. Nevertheless, it still services more than three million borrowers.
In recent years, Wall Street banks have stopped securitizing loans because federal subsidies were eliminated. Another reason is that 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.
Peer-to-Peer (P2P) Lending
With many of the benefits listed above no longer in place, banks have rapidly been replaced by peer-to-peer lenders like SoFi, LendingClub and CommonBond. As a result, private lending has been inching upwards to 7.5% of the total student loan market. These companies allow borrowers to take out credit without the need of an official banking institution to do the financing. This method also takes on more time, effort and risk, but is a big boon to people who can't get credit elsewhere. Typically, these lenders will advance credit to those with lower credit scores, but that usually comes at a price. Loans can come with extremely high interest rates, which can put pressure on the borrower when it comes time to repay.
In SoFi's case, though, it does take credit and income into account when approving a loan. People with a stronger credit score and history are usually those who get approved, which means that the default rate is lower. SoFi's default rate as of 2017 was listed at only 3%. That's pretty good when you compare that figure to the latest national statistics overall — a default rate of 10.7% on payments that are 90 days delinquent or more, as per the Federal Reserve's data in the first quarter of 2018.
*Diagram courtesy of Business Insider
One of its key advantages of government-backed loans 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 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 six months after graduation.
Unlike private lenders, the federal government doesn’t check credit records for student loan borrowers. This leads to many borrowers who aren't worthy of credit 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.
Because federally-guaranteed student loans are back-stopped and qualify riskier borrowers, they may promote moral hazard - or excessive risk taking by both financial institutions in SLABs as well as individual student borrowers.
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, 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 campaigned 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. It was also part of the dialogue during the 2016 presidential campaign as well. Both Democratic candidates Hillary Clinton and Bernie Sanders made affordable and no-cost college part of their campaigns. Their platforms also focused on student loan forgiveness as well.
With interest rates hovering for several years at and just above 0, 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 waves of college students take on debt, the entire U.S. economy 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.