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Do Some Investors Actually Want You to Default on Your Student Loans?

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Ever been involved in a conversation where the party who’s doing all the talking about one thing inadvertently spills the beans about something way more important?

I felt that way after reading a recent Bloomberg post on securitized student loan debts. The authors of the article, which is provocatively entitled $40 Billion Worth of AAA Student Loans Are at Risk of Becoming Junk, appear to have intended it to be read one of two ways: as a warning to those who have already invested in securities that are collateralized with student loans, or a hot tip about an upcoming opportunity to buy government-guaranteed debt on the cheap.

To me, though, the article is yet another example of how our system of higher-education financing is indeed a toxic concoction of misaligned interests. Here’s why.

Bloomberg warns that two rating agencies (Moody’s Investors Service and Fitch Ratings) are contemplating downgrading $40 billion worth of securities that represent tens of thousands of student loans. But not because the borrowers have defaulted on their obligations. Rather, it’s that an increasing number may actually succeed in restructuring their contracts under the government’s various relief programs, much to the chagrin of investors.

That’s because investors purchased these higher-ed loans at prices that reflected, in part, a specific duration (10 years, in this instance) and the promise of a government buyback in the event of a borrower’s default. Therefore, when the feds provide relief to borrowers by extending the maturity dates for these contracts, or worse, forgiving a portion of the balance, it may very well cause what was a really good investment to morph into one that’s akin to the walking dead.

In fact, the Bloomberg authors essentially spell that out when they write, “Bondholders would be faring better if more Americans were actually defaulting, instead of pushing off paying down their debt through a variety of means.”

Is it any wonder, then, why the feds are having so much trouble moving troubled loans into one of its many relief programs? The loan-servicing companies that are responsible for the day-to-day administration of these contracts are paid by the lenders and investors that hold the notes. How likely do you think they would be to take actions that run contrary to their benefactors’ interests?

The Bloomberg article goes on to note that the problem pertains only to those loans that were transacted prior to 2010 (of which less than $300 billion remains). That’s when the Obama administration terminated the Federal Family Education Loan program (where private lenders issued loans that were guaranteed by the federal government) in favor of the less costly Federal Direct program.

Yet the authors neglect to also take into consideration the various state-level higher education lending programs, which often pick up where the government’s plans leave off (i.e., when borrowers max out under Federal Direct). Nor do they mention how some of these are actually mini-FFELs, in that they are public-private partnerships where the state guarantees the loans that are held by private-sector lenders and their investors.

Unlike FFEL borrowers, however, those who finance their education in this manner are not eligible for relief under the federal government’s programs. Consequently, those who experience financial hardship are fully at the mercy of the noteholders and their loan-servicer agents, just as they are with all other private student lenders.

What’s Next for Troubled Student Loans?

Last, the largest heretofore unacknowledged elephant in the room is the $1 trillion (and counting) worth of Federal Direct loans that are currently on the Department of Education’s balance sheet.

At some point the ED, which has become the de facto higher-education lender of last resort, will either decide or be compelled to divest all or part of its holdings to make room for more. When that happens—and I’m betting it will, around the time of the next election cycle—the FFEL program may well be reborn, potentially with all these misaligned interests intact, unless:

1. All noteholders — public, private and public-private partnerships — are held equally accountable for any wrongful actions of their subcontractors, including the loan-servicing companies and the collections firms to which severely delinquent and defaulted accounts are transferred. Fining the subcontractors is not enough.

2. Policymakers mandate that all education lenders – that means private lenders and state funding authorities, too — offer relief programs that are comparable with those by the federal government, until lawmakers change the law to allow these loans to become dischargeable in bankruptcy. Not having that as an option encourages private lenders and investors to stonewall struggling debtors when it comes to granting student loan relief.

3. Policymakers craft a plan for the orderly transition of Federal Direct loans into the private sector whereby the Department of Education acts as principal. The government is guaranteeing these debts against default. It should therefore fully control the terms by which the loans are administered.

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its partners.

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  • AlanCollinge

    The perverted incentives enveloping the federal student loan system are far more dire than what is shown here. The fact of the matter is that for FFELP loans, the federal government has been “recovering” $1.23 for every dollar paid out on FFELP default claims. Even allowing for extremely generous (large) collection costs, this still leaves the Federal government strongly in the black on defaults. See http://www.studentloanjustice.org/defaults-making-money.html to understand why this is true. For FFELP loans, the government clearly makes more money on defaults than they do on healthy loans! This is a DEFINING CHARACTERISTIC of a PREDATORY lending system!

    Under the new, Direct Loan program, where the government has subsumed the guarantor function on the loans (guarantors make the majority of their revenue from penalties and fees associated with defaults), the government is making even more money ON DEFAULTS than under FFELP!! THIS IS WHAT HAPPENS WHEN BANKRUPTCY PROTECTIONS AND OTHER BEDROCK CONSUMER PROTECTIONS ARE REMOVED FROM THE LENDING INSTRUMENT.

    Every economist going back to Adam Smith himself must agree with this. The Founding Fathers of this country got it, too, when they put bankruptcy ahead of forming a standing army and coining currency when enumerating the powers of Congress.

    THIS is what kills the incentives for the Department of Education to meaningfully crack the whip on the schools to get their prices down, put meaningful limits/underwriting criteria onto the loans, and what ultimately fuels the inflationary spiral that has led us to this point.

    The author is absolutely correct that standard bankruptcy protections, AT A MINIMUM, MUST be returned to ALL student loans. Rational prices, good faith administration of the system, and indeed the legitimacy of the ENTIRE LENDING SYSTEM DEPEND UPON IT.

    • educator57

      Yadda, Yadda, Yadda–we’ve heard all this before from this individual who feels he has been cheated for having to repay his student loan with interest. Now he is hell-bent on destroying a system that has provided students a means to achieve a college education for decades. When you borrow a loan, you have to repay it. With interest. I paid mine at the highest interest rate ever on a standard (GSL/FISL/Stafford) federal student loan and with no tax deduction, like there is now, and before education tax credits. And you want me and all the other taxpayers, many of whom did not have the benefit of a college education, to pay your loans as well as those of all of your friends? You have incredible nerve! If you and your colleagues who feel that you should be “entitled” to having your loans wiped out spent half as much time working and repaying your loans as you do railing at the government and the taxpayers for giving you the opportunity to get a college education, you could repay the obligations which you committed to repay and then come up with some constructive suggestions as to how to fund higher education so that the taxpayers can afford it and the beneficiaries contribute to it.

      • AlanCollinge

        What we’ve heard before is tired, knee-jerk banker’s rhetoric like this, using the principle of personal responsibility as a cover for massively irresponsible, bad faithed, unconscionable, indefensible lending. You ain’t impressing anyone anymore jack.

        For years, Anonymous hacks like this guy have been throwing up this kind of shameless nonsense instead of acknowledging the facts about this broken, corrupted lending system that is cutting a swath of financial destruction across this country so wide, and so deep that we may never recover.

        Proud of yourself, anonymouse?

  • educator57

    The investment ratings agencies need to look at the history of student loans. Even under the now-defunct FFEL program, borrowers could stretch out their payments past 10 years using an extended repayment program, loan consolidation or income-sensitive repayments. And if the borrowers in the FFEL program consolidate their loans into the federal direct loan program, the direct loan program pays off the old FFEL program so the investors get their money back in the same way they would if the student paid the loan off early. Loan forgiveness/cancellation is limited on these loans–death, permanent and total disability, a portion for teaching in certain subjects or low-income areas, the closing of a school while the student was still attending (where there is no teach-out program), fraud (like when an identity thief takes out a loan in a student’s name) and bankruptcy in a situation where repayment would cause a severe hardship for the borrower. This is a small portion of the FFEL portfolio. Thus I would expect that while gains will not be extremely large, since loans issued before July 1, 2006 had a variable interest rate tied to the 91-day T-bill rate, which has been low for quite a number of years now, I expect that the portfolio will be consistent and produce a small but steady income stream.

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