What's Wrong with SLABS? (Student Loan Asset-Backed Securities)

EDUCATION

3/20/2023

“Education is the way out of the poverty trap. It shouldn't be the poverty trap itself and make those trying to better themselves incur massive student debt.”

- Stewart Stafford -

Student loan asset-backed securities (SLABS) are exactly what they sound like: securities backed by outstanding student loans. These loans are packaged into securities that investors can purchase, with scheduled coupon payments similar to bonds. The main goal of SLABS is to spread lenders' risk. By pooling loans, packaging them into securities, and selling them to investors, agencies can spread the default risk, allowing them to make more and larger loans. Since student loans are not dischargable in a bankrupcy, this makes them attractive to investors who are concerned about default rates.

The total outstanding student loan debt in the United States is approximately $1.75 trillion, with 45 million borrowers, according to the Education Data Initiative. The average outstanding federal student loan balance in the United States in 2022 is $37,787, if including private loans it is $39,590, and tuition costs keep rising at a frenetic rate.

Because of the similarities between the student loan market and the subprime mortgage market, there is widespread concern that the student loan industry will be the next market to implode, triggering a financial crisis. The majority of new college graduates have been unable to find jobs that adequately allow them to repay their student loans. As a result, the default rate has been rising since 2003. However, unlike mortgages, student loans are not collateralized, which means that investors receive nothing if the loan defaults. In other words, if a student defaults, lenders are worse off than they would be in the mortgage-backed securities market.

Sallie Mae, a former state-owned enterprise, is the most important private lender for student loans. Sallie Mae makes non-government-backed loans and packages them into securities, which are sold to investors in tranches (sound familiar?). Sallie Mae has tightened its lending restrictions since the recession and the subsequent realization that asset-backed securities were the primary cause of the crash. Nonetheless, it continues to serve over 3 million borrowers. Wall Street banks have stopped securitizing loans in recent years due to the elimination of federal subsidies. Another reason is that interest rates were so low that student loans were no longer profitable. The Federal Family Education Loan Program (FFELP), which ended in 2010, was a government-sponsored platform that subsidized and reinsured loans, essentially guaranteeing repayment. As you might expect, the expiration of FFELP caused lenders and investors to lose enthusiasm.

SLABS have remained out of the spotlight for retail investors, despite the amount of money currently invested in them, and have not received their fair share of attention. The entire US economy has felt the repercussions of waves of college students taking on debt. To save money or make extra money, young people are deferring their first marriages, leasing instead of buying cars, renting instead of buying houses (or simply living longer with parents), and participating in the sharing economy. What little money they make is spent on basic bills such as rent, utilities, and transportation costs.

Besides the practice of bundling student debt into investment vehicles, the industry is rife with misleading practices and incompetence. According to the ED, the cohort default rate (CDR) is “the percentage of a school’s borrowers who enter repayment on certain FFEL or Direct Loan Program loans during a particular federal fiscal year… and default or meet other specified conditions prior to the end of the second following fiscal year.” Schools with high cohort default rates may face sanctions, loss of eligibility for federal loan programs, and other consequences. Unfortunately, many colleges with high default rates try to reduce them by abusing the loan forbearance option, as opposed to enrolling borrowers in income driven repayment plans. In 2017, Navient, one of the largest student loan servicing companies in the United States, was found to have collected $4 billion in interest charges incurred by borrowers' use of multiple forbearance periods.

Many students are unaware that, as required by law, they are eligible for income-driven repayment plans on federal loans, and servicers frequently fail to assist them. Instead of income-driven repayment plans, borrowers are frequently placed in suspended payment plans that accrue interest. Furthermore, borrowers frequently enroll in plans that their servicers claim qualify them for Public Service Loan Forgiveness. They have been making payments for many years only to be denied when they apply because they have not been enrolled in a “qualifying” repayment plan. Service providers also fail to explain that loan consolidation halts a borrower's progress toward loan forgiveness. Some sobering statistics include:

  • In 2015, less than 6% of eligible FFELP borrowers were enrolled in income-driven repayment plans, compared to nearly 30% of borrowers with direct Department of Education loans.

  • More than 20% of FFELP borrowers were late or in arrears.

  • Navient, the federal student loan servicer, received 43% of all federal servicer complaints.

Navient is no longer contracted to service federal loans from the United States Department of Education as of 2022. The Consumer Financial Protection Bureau (CFPB) filed a lawsuit against Navient (formerly known as Sallie Mae), the largest student loan servicing company in the United States, in 2017. This company services over $300 billion in federal and private student loans under a contract with the US Department of Education. The CFPB accused the company of gross mismanagement, defrauding students and borrowers, and depriving them of their legal rights. Read more about the settlement and legal action here.

The Consumer Financial Protection Bureau (CFPB) received over 20,000 complaints about federal and private loans in 2019, resulting in ongoing enforcement actions. The Federal Trade Commission (FTC), Consumer Financial Protection Bureau (CFPB), US Department of Education, and state Attorney General offices announced "Operation Game of Loans" in October 2017 to pursue 36 enforcement actions against student debt relief companies in 11 states and the District of Columbia: $95 million in illegal upfront fees scammed from student debtors. In 2018, the FTC obtained judgments in eight actions totaling more than $88 million, and in 2019, it obtained judgments totaling more than $43 million. CFPB enforcement actions alone have resulted in judgments totaling more than $17 million.

Why are SLABS a subprime market? Unlike private lenders, the federal government does not conduct credit checks on student loan applicants. As a result, many borrowers who aren't creditworthy qualify for loans and are then saddled with debt indefinitely with little hope of repaying it. This is similar to the subprime mortgages that inflated the housing bubble. Because federally guaranteed student loans are backed by the government and qualify riskier borrowers, they may encourage moral hazard or excessive risk-taking by both financial institutions in SLABS and individual student borrowers.

Investors are drawn to the education market's seemingly limitless growth potential. When students graduate from high school, they flock to college in order to gain an advantage in the labor force. Those who are unable to find work after graduating may return to school to obtain additional degrees. Millions of students take out loans to pay exorbitant and ever-increasing university tuition. With this pricing power, universities have continued to raise tuition and fees year after year, far outpacing inflation.

The problem has spread throughout the United States like a mlaignant tumor. There have been some feeble attempts to address it, but little progress has been made outside of campaign promises. The Obama administration campaigned hard for the government to cover the average cost of community college and to limit the percentage of discretionary income that can be used to make loan payments. It was also a topic of discussion during the 2016 presidential campaign. Democratic candidates Hillary Clinton and Bernie Sanders both made low-cost and no-cost college a priority in their campaigns. Their platforms also emphasized student loan forgiveness. President Biden expanded on the idea, promising to forgive up to $10,000 in federal student loans and up to $20,000 for those who qualified for Pell grants during his 2020 campaign. The action has been met with court opposition and may not proceed. With historically high market volatility, high inflation, and an impending recession, some investors are seeking large returns on what appears to be a constant commodity.

A subprime student loan is one that has an interest rate that is higher than the prime rate, or the rate that commercial banks charge most creditworthy customers. As a result, subprime student loan borrowers frequently have low credit scores. Student Loan Asset-Backed Securities (SLABS) are private and federally insured student loans that are bundled, rated, and sold as bonds to institutional investors in tranches. In other words, student debtors' and their families' private debt is converted into investments that are considered low risk, but high yield in some cases. The most profitable investments are the most risky loans.

This grouping of loans, which consists of old FFELP government-backed loans and private sector loans, is valued at around $200 billion, but it is referenced in untold billions more of complex financing instruments such as structured investment vehicles, stocks, and unsecured corporate debt and repurchase facilities. SLABS are rated from AAA to B (junk), but all are marketed as safe, and demand exceeds supply. Outside of the industry, no one knows who owns the financial instruments, but it is assumed that they are almost always large institutional investors like banks, state and municipal funds, and retirement funds. SLAB sellers have recently extended the maturity dates of some SLABs by decades in order to avoid lowering their ratings. It is common for issuers to game the system by shopping around for better credit ratings.

Who is in charge of regulating the SLAB industry? Moody's, Standard & Poor's, and Fitch Ratings are the three rating agencies. These organizations are paid to rate the SLABS and are also responsible for government oversight as Nationally Recognized Statistical Ratings Organizations (NRSROs). Credit rating agencies not only rate SLABs, but they are also paid to do so by loan issuers such as Navient and Nelnet, creating a fairly obvious conflict of interest.

How problematic are SLABS as an investment? Chances are they are a much bigger risk than they appear, as stated in Samantha Bailey and Chris Ryan's SMU Law Journal article titled "The Next "Big Short": COVID-19, Student Loan Discharge in Bankruptcy, and the SLABS Market." SLABS are human lives packaged in the form of crippling debt for consumption by a variety of large investors, including large banks and pension funds.

The initially benign tumor of student debt has grown into a malignant mass. We now have a $1.6 trillion of student debt burden affecting 45 million people. Student loans account for more debt than credit cards, car loans, or any other type of consumer debt except for mortgages. This debt is a crushing burden. According to data from the National Student Loan Data System, at the end of 2019, 14.1 million of the 34.1 million federally held student loans that should have been paid were either in default, deferment, or forbearance. And that doesn't include any loans with an income-driven repayment plan that require no payments (due to the borrower's inability to make enough money). Estimates put the figure at millions more.

According to the National Center for Education Statistics, only 41% of first-time full-time college students graduate in four years, and 59% graduate in six years. After eight years, the college completion rate is only 60.4%. Borrowers who did not complete their degree have a default rate three times that of borrowers who did earn a diploma. According to National Center for Education Statistics (NCES) data analyzed by the Hope Center's Mark Huelsman, an estimated 38.6% of the 43 million student debtors in the United States — roughly 16.6 million people — have debt but no degree six years after first enrolling in college. While some people may graduate after 6 years, the statistic is still disturbing. Looking further into the numbers, 39% of borrowers did not complete a degree, they only account for 23% of the debt borrowed. Bachelor's degree holders make up 41% of all borrowers but carry 64% of the debt. In other words, about 20% of those who took out student loans do not have a degree, only debt.

College costs have risen two to three times faster than inflation over the last five decades. Higher education has devolved into a luxury good, subsidized by loans that prey on young people and parents. Despite exorbitant price increases, the product hasn't changed significantly. You're still paying for a four-year experience of auditoriums, cramped dorms, mediocre cafeteria food, and increasingly large class sizes. Or you may be paying full price for mere virtual access to learning, with most universities not adjusting any of their tuition fees during the Covid-19 pandemic, despite the fact that dorms, classrooms and cafeterias were empty for over a year.

And demand is squeezing supply. In other words, there are more students applying for college, but colleges have not significantly expanded their capacity to enroll students. Lets look at history to further illuminate this point. According to a TIME article entitled “The Squeeze on Elite Colleges,” in 1980, if you were to apply to UCLA, the acceptance rate was 74%. It is now 9%. Stanford's acceptance rate in the 1980s was in the 15% to 20% range, but it is now at 5%. Roughly 20% of applicants were admitted to Yale in the 80’s; a quarter-century later, just over 6% are admitted. Acceptance rates at Northwestern University fell from more than 40% a quarter-century ago to less than 13% in 2014. This trajectory is mirrored at dozens of America's most coveted colleges. College acceptance rates in the United States fell to a record low of 3.4% in 2021.

In 1980, your Pell Grants would have paid for all of the tuition and a large portion of your living expenses. Fast forward to the academic year 2022/23, students in public four-year institutions in the United States used the federal Pell Grant program to cover a mere 30% of their expenses. Only 13% of expenses at private, nonprofit four-year institutions were covered by Pell Grants. According to an article for CNBC, aptly entitled “Here’s how much more expensive it is for you to go to college than it was for your parents” For the 1987-1988 school year, students at public four-year institutions paid an average of $3,190 in tuition, with prices adjusted to reflect 2017 dollars. That average has risen to $9,970 for the 2017-2018 school year, thirty years later. This represents a 213% increase. The disparity is even more pronounced in private schools. In 2017, the average tuition for a private nonprofit four-year institution was $15,160. It was $34,740 for the 2017-2018 school year, a 129% increase.

More than 1,800 colleges in the United States have student loan default rates of 15% or higher. One in every ten Americans has a student loan default, and 5% of all student loan debt is in default. At any given time, 7.1% of student loans are in default. Our government has done nothing to discourage colleges from raising tuition. The only safeguard in place is that if a university's student-loan default rate exceeds 25%, it will no longer be able to access federally backed loans. In other words, one in every four students must default before a college will pay any penalty. A student loan debt forgiveness program can therefore only address the symptoms of the illness, not the root cause. As long as student-loan-money flows and young people feel they have no option except higher education to advance their economic futures, the college industry and the securitization of such debt will remain in constant, cancerous growth.

Student loan securitization provides liquidity for lenders, increased access for borrowers, and an additional financial instrument for investors. In this light, student loan asset-backed securities appear to be a valuable economic asset. However, whether this industry can survive depends on whether enough borrowers can eventually pay their debt obligations, which appears to be an increasingly remote possibility, as the crisis of college affordability only continues to worsen.

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