It’s back to school time, and there’s so much noise about a student loan crisis that there’s a need to corral all the noisemakers and to gain an understanding of what’s actually going on. Sister Mary Elephant had the right idea when she scolded her classroom to be quiet some 40 years ago.
It does sound pretty bad. Student debt surpassed $1.5 trillion earlier this year, and it’s estimated that nearly 40 percent of borrowers will default on their student loans by 2023. But talks of a collapse are not marrying up with performance and other data. Prospects for graduates are rosier than they have been in some time, with unemployment at around 3.9 percent – the lowest level since 2000. And, by some reports, student loan delinquencies are the lowest they’ve been in more than 10 years.
Understanding the market
The three main sectors in the secondary market – refinancings (refis), traditional private student loans, and Federal Family Education Loan Program (FFELP) student loans – are being impacted by different factors and deserve a separate look.
The refi market has experienced very low delinquency and charge-off rates due to strong borrower credit profiles, but competition is growing in the space. Wells Fargo is considering expanding its student lending and refi business to include federal student loan refinancing, and SoFi is reportedly targeting a wider range of borrowers. The fight for market share may erode the protections to which investors have grown accustomed.
Traditional private loans
While private student loan asset-backed securities (SLABS) issuance decreased last year, delinquencies and defaults have been on a downward trajectory since 2009 and are now at historic lows, helped by more stringent underwriting standards following the financial crisis. Private lenders now have their sights set on the graduate market, and calls by the Consumer Bankers Association to cap federal lending to graduates could potentially increase demand for private student funding.
Loans under the FFELP were discontinued in 2010, but this asset class still comprises a significant portion of the overall SLABS market. Delinquencies are deteriorating, but investor risk is mitigated due to the government’s guarantee to reimburse defaults in addition to more borrowers opting for income-driven repayment (IDR) plans.
What lurks beneath the surface?
Deferment and forbearance
Stated delinquency rates may be trending down, but the data excludes loans that are in deferment or forbearance, as these loans are not considered to be in the repayment cycle. Deferment and forbearance often means borrowers have exchanged short term gain for long term pain, as these options ultimately increase borrower costs.
Such programs are also at the heart of lawsuits and investigations. For example, in an action commenced last year by the Attorney General of Illinois, the core of the state’s allegations is that Navient schemed to steer borrowers into forbearances. And earlier this year, the Government Accountability Office (GAO) uncovered a similar trend of colleges hiring consultants to encourage borrowers to put their loans in forbearance. Colleges are incentivized to try to impact default rates, as federal law provides that schools with default rates of 30 percent or above for three consecutive years, or more than 40 percent in a single year, may lose eligibility to participate in federal student aid programs. After the three year period, official loan tracking ends and new evidence suggests that default rates skyrocket after this point.
Regardless of the cause, the effect of the current market dynamics is that the percentage of borrowers in forbearance for 18 to 36 months doubled between 2009 and 2013, and actual delinquency levels could be around twice as high as reported.
It’s the little things that kill
Although much is made of the large amount of student loan debt outstanding, it’s actually the small loans that are performing the worst. This goes hand in hand with the dual problems of borrowers who do not complete a degree but must shoulder the burden of the debt without the higher income prospect of a degree, and borrowers who attended for-profit schools and unaccredited programs who are unable to find employment with sufficient income to service the debt. It is not uncommon for such loans to end up in securitizations.
But the question remains: who will ultimately bear the burden of a student debt crisis?
Private student loans represent a small portion of the overall student debt balance – the market is dominated by federal loans, which are responsible for about 92 percent of outstanding student debt. Federal loans generally have more protections than private loans, such as IDR options, but even so, defaults are still prevalent. As Goldman Sachs analysts have noted, a significant amount of student loan default risk is borne by the U.S. Treasury, and any costs will ultimately be passed on to the taxpayer.
In his recent resignation letter, the Consumer Financial Protection Bureau’s (CFPB) student loan ombudsman described a “broken student loan system” and accused the bureau’s current leadership of turning its back on young people and their financial futures. In light of a weakened CFPB and given that the Department of Education is not supporting the bureau’s lawsuit against Navient, borrowers that believe they have been harmed by the system may be left on their own to pursue costly private litigation, including class actions, with uncertain results.
For securitized student loans, performance has been stable – a sea of calm in stark contrast to the frothy activity in the press regarding the student loan debt crisis. But stated delinquency and default rates are just the tip of the iceberg and mask the undercurrent of consumer struggle. It would be unwise to view the effect of the current education and student loan systems – runaway education costs, borrowers’ financial obligations to fund those costs regardless of graduation or quality of program, and certain questionable practices at servicers and institutions to manage the growing debt levels – as merely a consumer or taxpayer problem. Ultimately, if left unchecked, these issues will not be confined to one particular contingent.
Investors, particularly with respect to private loans, should be at least wary of the undertow or risk being deceived by seemingly benign statistics that don’t reflect what lies beneath.
H. Seiji Newman and Massimo Giugliano are both counsel in the Insolvency, Creditors’ Rights & Financial Products Practice Group of Davis & Gilbert and contributed to this post.