Student loans are a big business.
The US has amassed over $1.7 trillion in outstanding
student debt. Until recently, it was the largest
non-housing debt for more than a decade.
The first time it broke $1 trillion was back in 2012
and that's when it caught all the media attention.
We've seen a big growth in the cost of education over
the past 10 or 20 years, and this has really showed
up in the student loans outstanding.
But while more than 43 million Americans are
currently holding student debt, many are unaware of
what exactly happens with their loans.
I think it would be pretty difficult for the average
American to try to track where their loan actually
resides.
There exists a market where billions of dollars worth of
student loans are packaged and sold as assets known as
SLABS to some of the biggest investors in
America.
I would say that most average Americans are not
aware of student loan securitizations.
These securities are very, I would say, not transparent,
and it's hard to understand by the average
investor.
So what exactly are SLABS and how does it help Wall
Street profit from student loans?
Securitization is the practice of converting
assets, usually loans into securities that can be
bought and sold by investors.
Wall Street uses securities to trade almost everything
you can think of: auto loans, business loans, and
even aircraft leases.
Let's say I'm a bank and I want to issue a bunch of
loans. After those loans are issued, I can then sell
them to a third party in order to securitize them.
Now, just because I sold them doesn't mean that I do
not get to account for the estimated value of those
securities. I've just sold their interest to a third
party. So it's a very lucrative arrangement for a
corporation. It's a very lucrative arrangement for
the investors.
The biggest and the most well-known type of
asset-backed securities are mortgage-backed securities
or MBS.
There were more than $12 trillion worth of
outstanding mortgage-backed securities
by the end of 2021.
Securitization, its history really started off with a
mortgage market.
And the mortgage market is a much larger market than
other forms of consumer credit, especially other
forms of financing of consumer credit.
So that lends itself to being a much larger market.
Student loan asset-backed securities or SLABS refer to
securities that are specifically built around
student loans.
The way that borrowers get student loans is of two
ways. If they're getting a federal student loan, they
usually apply using FAFSA, right?
If they're going to get a private student loan or a
private credit student loan, they would apply
through a bank or through a lender.
The loans that are then created are bundled together
into a pool.
And these pools are often highly diversified by
regions, by school, by borrower type, for example.
And that diversification really protects the investor
from losses that are idiosyncratic.
They're then transferred to a special purpose trust,
which is set up to hold the loans and issue the
securities. Once that's done, the securities are
then rated by a credit rating agency.
Once they're packaged in this way, the securities are
then sold to financially sophisticated institutional
investors. When the borrower pays down their
student loan, that cash flow is then used to pay
down the investor.
Sallie Mae and Navient are the two largest publicly
traded companies issuing slabs.
These assets are underwritten by some of the
biggest banks and corporations like Bank of
America, Barclays, JPMorgan , and Goldman Sachs.
$92 billion worth of student loans were issued as
SLABS within the past five years.
There are two types of securitized student loans.
So you have private student loans and you also have
federal student loans that have been securitized.
A majority of SLABS today, 56% to be exact, are based
on loans that were made before 2010 under the
Federal Family Education Loan Program, also known as
FFELP. These loans were enticing for many investors
because they came with a federal guarantee that
protected them against losses from defaults.
For about a decade FFELP securitizations, or FFELP
ABS were the only form of student loan
securitizations. It's a program where a private
lender originates the loan based on the guidelines that
have been put forth by FFELP.
As long as those guidelines are met, the loans are
guaranteed by the government, and that
guarantee runs between either 97% to 100% of the
loan balance.
But shares of private loans have grown with the recent
boom in the private student loan market.
The industry is estimated to have grown by more than
70% over the past decade.
Based on my research across the board with student
loans, the biggest sense of security outside of the
federal guarantee is the question of whether these
loans are dischargeable in bankruptcy.
While it is certainly possible, current bankruptcy
laws make it extremely difficult for student loans
to get discharged compared to other types of debt.
For investors, that translates to a lesser risk
of default.
The securitization of mortgages, all student loans
or auto loans actually has a very positive motivation
at the beginning, and that is to mobilize the capital
around the world and channel that to the most
needed. You are no longer being restricted to your
local bank or specific lender.
It's just the whole liquidity enhancement around
the world. So that itself is a pretty good idea.
But Wall Street sometimes can go a little bit too far.
As student loans continue to balloon, experts have
expressed growing concern surrounding the SLABS
market. The worry is that SLABS could pose a
systematic risk to the American economy, similar to
how subprime mortgage-backed securities
contributed to the crash back in 2008.
This is something that came up for me back in 2018 when
I began to study student loans, and prior to that, I
had been covering mortgages and specifically
mortgage-backed securities.
I saw the parallels and it really freaked me out
because I realized that this cycle was only going to
repeat. One of the key ways to uncover these
similarities between student loans and mortgages
is to look at the affordability issue.
You have a bunch of well-intentioned people
hoping that their income is going to increase.
Now, when the income does not increase, you have a lot
of loan debt and nothing to pay it with.
The national cohort default rate for student loans has
plummeted, boosted by the payment pause during the
pandemic. But the Consumer Financial Protection Bureau
estimates that 1 in 5 student loan borrowers have
risk factors that could cause them to struggle when
federal student loan payments resume in October.
I personally do not feel like the inability to pay
something back really needs to be scary.
I think what's scary about it and what was scary about
2008, was the tremendous uncertainty that everyone
had about what valuation even was.
Housing prices were falling dramatically.
Nobody knew when housing prices were going to stop
falling. And the reason that they were falling was
because their valuation had been propped up by the
mortgages that supported them.
So when the ability to pay was revealed, that's when we
saw this tremendous crash in the housing market.
When discussing student loan auction rate securities, a
type of SLABS with variable interest rates, Navient, a
major player in the SLABS market, acknowledged that an
economic downturn may cause the market for auction rate
notes to cease to exist, which could lead to holders
of auction rate securities to experience a potentially
significant loss of market value, according to an SEC
filing from 2015.
But not every expert sees eye to eye.
I think to say this market is going to be the trigger
of the next financial crisis is really overstated.
Nobody is really concerned about the
government-guaranteed portion of this market.
It's really that private credit market.
The SLABS market is much smaller and therefore poses
less of a systemic risk to the economy.
There's no way.
With the depth and the size of the US financial market,
there is no way.
Increased credit enhancement following the devastation of
the 2008 recession was put forth to protect against
this exact scenario.
If you're looking at Moody's and Fitch, they're rating
these pools with extra vigilance.
They are asking for internal credit enhancement,
external guarantee, extra credit support in terms of
over-collateralization, even if there are
substantial charge-offs and stuff like that, they're
mostly going to be absorbed within the internal and
external credit enhancement measures that have been put
forth very aggressively after the financial crisis.
Recent developments, like the three-year pause on
federal student loans and the Biden administration's
initiatives to relieve student debt, have sent
shockwaves through the SLABS market.
The volume of newly issued SLABS dropped from the
height of $27.3 billion in 2021 to just $7.1 billion in
2022.
I do not think that SLABS is a really attractive
investment at this point, given that we are in a very
high interest rate environment and you look
around with risk-free Treasury security paying 5%,
are you really attracted to SLABS at 5%?
A lot of investors really don't know much going on
with the pool, and the transparency is pretty bad.
But SLABS are not going away anytime soon, especially as
tuition continues to rise and more borrowers rely on
private loans to pay for their education.
Private credit has always been used to supplement the
federal loan program, and that's going to continue.
I think that there will always be a need to do so to
the extent that that continues, those lenders,
the lenders of the private credit student loans, will
be looking for ways to fund these borrowers.
As the student loan market faces a period of tumultuous
change, the securitization market must also change and
adapt to it in order to thrive.
I think in general, SLABS is not evil.
SLABS is just an opportunity for lenders to
package illiquid student loans and to create credit
enhancement to a point where the average investor
might participate in financing in these pools.
But in the meantime, though, as we move into the
future, more education, more transparency about
SLABS is necessary if this market wants to continue and
have a healthy contribution to the financing of our
nation's student debt.