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 transformed by securitization is the student loan market. But just how safe is this market for investors?
Key Takeaways
- Student loans make up more than $1.6 trillion in outstanding debt in the United States from over 43 million borrowers.
- Packages of student loans are being marketed as asset-backed securities known as SLABS.
- SLABS have enticed investors due to some structural guarantees—some worry that these instruments may adversely affect the economy.
- There would need to be significantly more factors in play for student loan debt to have the same impact on financial markets as the Great Financial Crisis.
Student Debt Relief
In June 2023, the U.S. Supreme Court blocked the student loan forgiveness plan from being implemented, ruling that President Joe Biden had exceeded his authority in issuing the plan.
As a result, the Biden administration implemented the Saving on a Valuable Education (SAVE), allowing eligible borrowers to reduce their monthly payments, shorten the maximum period for loan repayment, and avoid some interest charges.
SAVE Plan applications began in August 2023, and those enrolled in the Revised Pay as You Earn (REPAYE) plan were transferred to the SAVE Plan.
Important
On July 18, 2024, a federal court blocked the operation of the Saving on a Valuable Education (SAVE) Plan until court cases centered around the Income-Driven Repayment (IDR) plan can be resolved. In the meantime, the Department of Education has moved borrowers enrolled in the SAVE plan into forbearance, whereby they will not need to make payments, nor will interest accrue on their loans.
Options exist for borrowers nearing Public Service Loan Forgiveness (PSLF). Borrowers can “buy back” months of PSLF credit if they reach 120 months of payments while in forbearance or switch to a different IDR plan.
Student Loan Securitization
Student loan asset-backed securities (SLABS) are exactly what they sound like: securities based on outstanding student loans. These loans are packaged into securities that investors can buy, delivering scheduled coupon payments like an ordinary bond.
The United States alone has more than $1.6 trillion in outstanding student loan debt from over 43 million borrowers.
The purpose behind SLABS is to lower the risk for lenders. By pooling and packaging the loans into securities and selling them to investors, the agencies can spread around the default risk, allowing them to give out more and larger loans.
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.
$37,645
The average student loan balance outstanding in the U.S. as of the third quarter (Q3) of 2023
Student Loan Borrowing Metrics
As you can see in the following tables, the number of student loan borrowers and the average balance per borrower have risen yearly.
Note
The student loan default rate was 10.8% in 2018, but only 2.3% in 2022 (data from 2019, calculated in 2022).
Private Loans
Sallie Mae, or SLM Corp., a former state-owned enterprise, is the leading 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 bundles) to investors.
Since the Great Recession of 2007–2009 and the realization that asset-backed securities were the primary catalysts for the crash that preceded it, private lenders have imposed more strict credit requirements.
In recent years, Wall Street banks have stopped securitizing loans because federal backing of private loans was eliminated. The Federal Family Education Loan (FFEL) Program, 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 FFEL Program put a damper on student loan securitization. However, the popularity of these securities has recovered by using private student loans.
A New Type of Lender
A new generation of financial companies has entered the student loan space alongside traditional players. Companies such as SoFi and Ascent have offered students new options to fund their education.
These companies tend to have a modern image that caters to young people. Some focus on student lending, while others—such as SoFi—offer a range of financial products. Credit requirements still exist; if students can’t meet them, then a co-signer is normally needed. However, new companies and more lending options undoubtedly expand access to student loans. Programs that offer income-based or outcome-based lending allow students to borrow without meeting credit requirements or a co-signer based on their future earning potential.
Looking closer at SoFi, it requires borrowers to meet credit requirements but doesn’t publicly specify the required credit score. SoFi appears to be a responsible lender that minimizes default. Its base case default rate assumption on a 2021 batch of student loan-backed securities was 2.35%.
Public Loans
From the student’s perspective, one of the key advantages of government-backed loans over private lenders is that the cost of borrowing is much lower since it is a government program designed to aid students. Thus, students usually reach public loan limits before turning to private lenders.
If they did need private loans in addition to federal ones, borrowers typically prioritize repaying private loans first due to higher interest rates, a greater risk to their credit, and less borrower assistance. Another big difference between federal and private loans is that federal loans all have the same fixed rates, while private loans can have variable or fixed rates that will differ with each borrower. Moreover, some public loans, such as 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; they do, at least, limit the amount that can be borrowed. However, some of these borrowers will struggle to repay these loans, depending on their career choices and future earnings. Luckily, federal loans made after the Federal Family Education Loan (FFEL) Program ended in 2010 cannot be securitized.
Securities and Risk
Returning to the issue of student loan asset-backed securities, the fact that federal loans made without a credit check cannot be securitized should lessen some of the fears around these securities. However, loans made during the FFEL era carry some risk, as the federal government guaranteed loans made by private lenders. This is what made them popular in the first place for securitization, encouraging some risky behavior.
Of course, new and outstanding private students can be securitized as well. These have credit checks and co-signers if requirements are not met. Such measures are a guard against excessive risk and reckless lending. Still, there are fears that the student loan industry will be the next market implosion to trigger a financial crisis.
However, the scale of the Great Financial Crisis (GCF) was much larger than that of student loan debt, and regulations have been changed to address the issues that caused it. While asset-backed securities were the root cause of the GCF, the housing market’s collapse, a decrease in home values, and a foreclosure rate explosion from subprime loans initiated it. Many factors have to converge for there to be a crisis caused by student loans.
Important
Federal student loans made under the Federal Family Education Loan (FFEL) Program were federally guaranteed loans made by private lenders that could be securitized. The program ended with the 2009–2010 school year. Federal loans made since then are publicly owned and cannot be securitized.
The Politics of Student Debt Relief
Investors and lenders are attracted to the seemingly endless growth potential of the education market. As students graduate from high school, they move on to college, hoping to gain an advantage in the labor force.
Most students take out loans to pay for school. However, not all of them can find a job or one that allows them to pay off their loans after graduation. Some students even decide to take on more debt to remedy this by borrowing for a graduate degree, which may pay off over the longer term but could also make things worse. These situations lead many students to feel frustrated and trapped by their debt.
With the high demand for education and easy access to loans, universities have taken advantage and continue to hike tuition and fees, 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 and limit the proportion of discretionary income that could be used to make loan payments.
President Biden’s Student Debt Forgiveness
President Biden took the idea of student loan debt relief further when he attempted to deliver on a campaign promise to forgive up to $10,000 in federal student loans and up to $20,000 for those who qualified for Pell Grants. That plan was scuttled by the U.S. Supreme Court, which ruled in June 2023 that the president had no authority to implement the plan.
Saving on a Valuable Education (SAVE)
The Biden administration responded by rolling out a new plan called Saving on a Valuable Education (SAVE). The plan allows eligible borrowers to reduce their monthly payments, shorten the maximum period for loan repayment, and avoid some interest charges.
Federal Court Blocks the SAVE Plan
As mentioned earlier, on July 18, 2024, a federal court blocked the Saving on a Valuable Education (SAVE) Plan from operating until legal cases regarding the Income-Driven Repayment (IDR) plan can be resolved. Borrowers enrolled in the SAVE plan have been moved into forbearance, whereby they will not need to make payments, nor will interest accrue on their loans.
Borrowers nearing Public Service Loan Forgiveness (PSLF) can “buy back” months of PSLF credit if they reach 120 months of payments while in forbearance or switch to a different IDR plan.
What Is a Subprime Student Loan?
A subprime loan for any purpose has an interest rate higher than the prime rate, the interest rate that commercial banks charge their most creditworthy customers. Subprime borrowers may have poor credit scores or no credit histories and are deemed to be at higher risk of default.
Are Student Loans Asset-Backed Securities?
Student loans are not asset-backed securities individually. A student loan asset-backed security, or SLAB, is a type of investment that consists of a package of outstanding student loans.
How Do I Know If My Student Loan Is Subprime?
Subprime loans have interest rates that are higher than the prime rate at the time of loan approval. Subprime loans are usually given to borrowers with FICO Scores of 620 or lower.
The Bottom Line
Considering the amount of money currently invested in them, student loan asset-backed securities (SLABS) have stayed out of the limelight for retail investors. As waves of college students take on debt and struggle to find a good income after graduating, the entire U.S. economy has felt the reverberations.
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. Since new student loan asset-backed securities consist of private loans where borrowers meet credit requirements, default rates should be somewhat under control.
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