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There’s a Better Way to Securitize Student Loans

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Loan securitizations were once a mainstay in the world of structured finance. But that was before the recent economic collapse and the financial market freeze that ensued.

For a time the government intervened to support the secondary-market because of the important role it plays in the economy: by recycling existing loans to others, the originating lenders are freed up to make new loans, thereby bringing fresh money into the system.

Essentially, investors purchase bundles of loans that are repackaged as securities, and take on the risks that are associated with these transactions in exchange for an acceptable rate of return. These risks include changes in interest rate while the loans are outstanding, payment delinquencies and borrower defaults. Consequently, certain classes of loans have higher risk profiles than others because of creditworthiness, the value of the underlying collateral (if any) and the amount of time it will take for the loans to be repaid.

For example, credit card securitizations are often riskier because the loans are uncollateralized and the creditworthiness of the borrowers is all over the map. By contrast, mortgage securitizations are often less risky because the loans are typically supported by strong collateral positions – which gives lenders a solid way out of the room in the event of default. The credit applications are also more thoroughly underwritten, that is, except for during the run-up to the housing market collapse.

Student Loans Are Different

Student loans are an interesting anomaly. The financings are uncollateralized (how can you repossess an education?), and the credit profiles of most of the borrowers are weak (how many 18-year-olds with stellar credit histories do you know?). Yet, these transactions are exceedingly attractive to the investment community, for two very good reasons. Foremost, most of the loans are guaranteed by the federal government, which pretty much ensures that the investors won’t take a hit if the borrowers default. Second, even if the loans weren’t backstopped by the feds, the debts are virtually impossible to elude in bankruptcy court, which means they’ll probably liquidate over time.

Clearly, lots of good things come to those who invest in student-loan securitizations, but what’s in it for the borrowers? Sure, interest rates on government-guaranteed education loans are lower than for other forms of uncollateralized debt, but what if a borrower requires assistance on a loan that’s been securitized?

One of the most common complaints I hear from students goes something like this: “I took out a government-backed loan [FFEL or Direct], ran into trouble, contacted my loan servicer and got a six-month forbearance. What they didn’t tell me was that the interest rate clock would keep on ticking or that I was eligible for one of the government-relief programs that would have been better for me in the long run.”

The students are referring to the U.S. Department of Education’s Pay As You Earn and Income-Based Repayment plans, and Public Service Loan Forgiveness program.

It’s hard to believe that this “oversight” was unintentional.

That’s because the investors’ rate of return on a financial transaction of this type hinges on three variables: principal (loan balance), payment amount (monthly remittance) and term (duration). Forbearances only modestly impact the investors’ profits because these short-lived accommodations rarely extend the term, let alone abate interest or reduce principal.

That’s not the case when it comes to government relief programs.

Why Relief Programs Aren’t Popular With Lenders

Simply, while relief programs can be helpful to borrowers, they aren’t a good deal for those who’ve invested in their debts, for several reasons.

To start, borrowers who qualify for PAYE or IBR may take up to 20 or 25 years to pay off their debts, instead of the standard 10. Given that the yield curve is usually positively sloped — interest rates for short-term investments and obligations are lower than for those that come due further into the future — and the reality of inflation, an investment that pays off sooner is a better deal for investors than one that pays off later when the interest rates are the same in both instances.

There’s also the matter of the principal variable. Loans that qualify for any of the government’s relief programs have the potential to be only partially repaid — particularly those that max out at 20 and 25 years under PAYE and IBR, and 10 years under the PSLF — which negatively impacts the investors’ profits as well.

So it should come as no surprise that financially distressed, government-backed borrowers are prodded by the loan servicers to accept potentially ruinous non-government solutions (“ruinous” because new interest is piled atop old interest, aka negative amortization). The same is true for private student-loan borrowers.

The Bigger Picture

To give you a sense for the potential scope of this problem, of the more than $1 trillion of student debt that’s outstanding, roughly half is currently in repayment mode (students who’ve graduated or left school) and more than that amount (approximately $300 billion) represent FFEL loans controlled by the lenders that originated the notes or purchased them after the fact. (Sallie Mae has been especially busy buying up and securitizing FFEL loans.)

Now that the government has discontinued FFEL’s in favor of the Direct Student Loan Program (loans that the DOE carries on its own balance sheet), you may think the problem has been contained.

Not likely.

At some point, the government will be pressed to liquidate its holdings in order to make room for more — no different from when a bank sells a portion of its loan portfolio so it has the resources to lend again. When that happens, the odds are these loans will find their way into the investment community via securitization.

So the key is to incorporate into this new wave of student-loan securitizations the flexibilities we now know are needed to temporarily restructure or permanently modify loans that require that kind of support.

Prospective investors can then decide if the rewards they stand to earn for these virtually loss-proof securities are high enough to compensate for the moderate amount of economic risk they’ll now be asked to accept.

My guess is they will, and student borrowers will be better off because of that.

This story is an op/ed contribution to Credit.com and does not necessarily represent the views of the company or its affiliates.

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