Impact of the Subprime Mortgage Credit Crisis on Student Loan Cost and Availability
This page discusses the likely impact of the subprime mortgage credit crisis of 2007 and the College Cost Reduction and Access Act of 2007 on the cost and availability of federal and private student loans. Decreases in the profitability of federal and private education loans will likely lead to decreases in the availability of private student loans to subprime borrowers, increased minimum balance requirements for loan consolidation, cuts in loan discounts (especially on consolidation loans) and increases in interest rates and fees on private student loans as lenders adjust their products to compensate for the increased cost of capital.
The subprime mortgage credit crisis increased lender cost of capital in the asset-backed securitization (ABS) markets, forcing lenders to pay higher margins relative to the LIBOR index. It also decreased liquidity in the ABS markets, forcing lenders to rely on more expensive sources of funding for loans. Spreads between the LIBOR index and other common indexes, such as the Prime Lending Rate and the Commercial Paper Rate, also shrank. The College Cost Reduction and Access Act of 2007 cut lender interest income, increased risk sharing and increased lender-paid origination fees on federal education loans. The combination of the credit crisis and the lender subsidy cuts lead to significant compression of lender spread, making federal and private education loans less profitable for lenders.
Subprime Mortgages and Securitization
The subprime mortgage credit crisis started with an increase in defaults and foreclosures on subprime mortgages in late 2006 and early 2007. Subprime refers to higher risk borrowers with credit scores less than 650 or with other credit problems, such as bankruptcy or irregular income. Lenders had increasingly adopted looser credit underwriting procedures, such as no-documentation (stated income) and interest-only loans. Lenders also promoted adjustable rate mortgages (ARMs) as a way for borrowers to afford bigger houses, since the interest rate was set at a lower fixed rate for an initial period of 1, 3 or 5 years before switching to a variable rate. These practices were fueled, in part, by speculative investment in 'hot' real estate markets in coastal areas. When interest rates began increasing, borrowers found that their monthly mortgage payments had jumped to unaffordable levels. This precipitated an increase in defaults and foreclosures. Lenders began tightening underwriting criteria, making it more difficult for even good credit risk borrowers to get mortgages. This had a cascading impact on the housing market.
So what does this have to do with student loans?
Lenders do not carry the mortgages on their books. Instead, they transfer the loans to a trust and sell shares in the trust to investors. This process is called asset-backed securitization (ABS). Securitizing the debt provides the lender with the original principal balance of the loans (liquidity) plus some up-front profit (a premium). The lender may also get some fee revenue over time from servicing the loans and by acting as an advisor to the trust. In return, the investors get income from the loan payments, usually in the form of interest rates that are pegged to the LIBOR index plus a margin. (The LIBOR index is a 1 or 3-month average of the London InterBank Offered Rate, the interest rate on short-term loans from one bank to another.)
Student loans are also securitized. Most education lenders depend on being able to securitize their loan portfolios. They initially use a credit warehousing facility (a short-term loan for $500 million to several billion dollars from a large international bank) to fund the loans. However, credit warehousing facilities are expensive, so lenders securitize the loans to obtain a less expensive source of capital. Since a lender needs at least $100 million in loan volume to securitize, and preferably $1 billion or more, education lenders are focused on generating as much loan volume as possible as quickly as possible. The more frequently a lender can securitize, the more profitable the lender. As such, economies of scale favor larger lenders.
Theoretically, education loans should not have been affected by the subprime mortgage credit crisis. Private student loans use FICO score cutoffs of 620 to 650, and so have very little subprime exposure (roughly 10% to 11% of the loan portfolio). Federal education loans are guaranteed against default by the federal government, so the subprime exposure doesn't matter much. (Actually, default claims lead to earlier repayment of principal, reducing the interest income over the life of the loan. There is also a small amount of risk-sharing by the lender.) But there was a contagion effect, where unease about securitizations of subprime mortgages spread to the rest of the ABS market.
In August 2007 the subprime mortgage credit crisis began affecting the ABS markets. Investors were spooked by the increase in defaults and started avoiding mortgage securitizations. Investors don't like uncertainty and anything they don't understand. (Major banks also began writing down or writing off their investments in subprime mortgage securitizations.) This illness spread from subprime mortgage securitizations to the rest of the ABS market as investors got nervous about all forms of securitization.
As demand for securitizations started dropping, education lenders found it more difficult to find investors for the securitizations and had to offer higher margins to investors. One lender omitted the BBB tranche (the loans with the lowest credit scores) from their private student loan securitization and delayed their December securitization. An increase in defaults on private student loans and questions about the capitalization of private student loan guarantors also contributed to the pullback. The decline in demand for securitizations also sustained the LIBOR index at higher rates than other indexes, such as the Prime Lending Rate and Commercial Paper Rate, squeezing the spread between the rates lenders were charging consumers and the rates they were paying investors in the securitizations. The loss of liquidity from the ABS markets forced lenders to keep loans on credit warehousing facilities longer, also eating into their margins. (Reductions in the lender ratings by Fitch and Moody's also increased the lenders' cost of capital by making it more difficult for them to obtain credit warehousing facilities.) This decreased the lender spread by about 70 bp (0.70%) plus or minus 20 bp. (A basis point (bp) represents one 1/100th of a percent, so that 10 bp is the same as 0.10%.)
College Cost Reduction and Access Act of 2007
At about the same time, Congress passed legislation that cut the subsidies the federal government pays to encourage lenders to offer federal education loans. Congress used the savings to pay for increases in the maximum Pell Grant, cuts to the interest rates on subsidized Stafford loans for undergraduate students, increases in the amount of money students can earn before it affects aid eligibility, the addition of a new grant program for students interested in teaching in national need areas, and the introduction of the income-based repayment plan and public service loan forgiveness. The lender subsidy cuts were effective October 1, 2007 and reduced lender margins by 65 bp to 72 bp for for-profit lenders and 50 bp to 57 bp for not-for-profit lenders.
There are three key aspects to the lender subsidy cuts:
It is worth noting that consolidation loans have the tightest margins and so are the least profitable of the loans despite borrowers extending the repayment term of the loan. It is also worth noting that special allowance payments are pegged to the Commercial Paper Rate while the loans are securitized against the LIBOR index. So federal education loans are also affected by an increase in the spread between the Commercial Paper Rate and the LIBOR index.
The combined impact of the tightness in the ABS markets and the College Cost Reduction and Access Act of 2007 is a 110 bp to 160 bp reduction in lender spread. One lender joked that Congress took away half their profits and the subprime mortgage credit crisis the other half.
Sallie Mae's 8-K Filing
A Form 8-K SEC filing by Sallie Mae on January 3, 2008 raised concern that student loans might become less available. Sallie Mae wrote:
In response to the Act and market conditions, we plan to be more selective in pursuing origination activity, in both FFELP loans and private education loans. In addition, we plan to curtail less profitable student loan acquisition activities such as spot purchases and wholesale consolidation loan purchases, which will reduce our funding needs. We expect to see many participants exit the student loan industry in response to the Act as well as current market conditions and we therefore expect to partially offset declining loan volumes caused by our more selective lending policies with increased market share taken from participants exiting the industry. We expect to continue to focus on generally higher-margin Private Education Loans, both through our school channel and our direct to consumer channel, although in the case of the latter, with particular attention to continuing the more stringent underwriting standards that are necessary in this market. We also expect to adjust our private education loan pricing to reflect the current financing and market conditions. We also plan to eliminate certain borrower benefits offered in connection with both our FFELP loans and our private education loans. We will further de-emphasize pursuing incremental consolidation loans, in particular FFELP consolidation loans, as a result of significant margin erosion for FFELP consolidation loans created by the combined effect of the Act and the increased cost of borrowing in the current capital markets. Nevertheless we will continue our efforts to protect selected FFELP assets existing in our portfolio. We expect to continue to aggressively pursue other FFELP-related fee income opportunities such as FFELP loan servicing, guarantor servicing and collections.
It is unclear what Sallie Mae meant by their intention to become "more selective" in originating loans. Federal law bans discrimination in the origination of federal education loans. Section 421(a)(2) of the Higher Education Act bans discrimination on the basis of "race, national origin, religion, sex, marital status, age or handicapped status". Section 428C(b)(6) adds additional restrictions on consolidation loans, banning discrimination based on the number or type of student loans to be consolidated, the type or category of institution of higher education attended by the borrower, the interest rate to be charged to the borrower or the repayment plan selected by the borrower. Section 440A applies specifically to Sallie Mae and bans the company from engaging "directly or indirectly in any pattern or practice that results in a denial of a borrower's access to loans under this part because of the borrower's race, sex, color, religion, national origin, age, disability status, income, attendance at a particular eligible institution, length of the borrower's educational program, or the borrower's academic year at an eligible institution." The ban on discriminating on the basis of income would most likely preclude Sallie Mae (but not other lenders) from discriminating on the basis of credit scores, since credit scores correlate well with income.
It is also unclear whether Sallie Mae could refuse to originate loans at colleges with high loan default rates, since that would amount to discrimination based on attendance at a particular eligible institution. On the other hand, the Higher Education Act itself discriminates based on a college's default rate, making ineligible any college with a cohort default rate of 25% or more for three years in a row or more than 40% in a single year. Lenders are also permitted by regulation to establish more stringent credit underwriting criteria for PLUS loans than the adverse credit history requirements set by law and regulation. In particular, 34 CFR 682.201(c)(2)(iii) states "Nothing in this paragraph precludes the lender from establishing more restrictive credit standards to determine whether the applicant has an adverse credit history."
Likely Lender Changes
The Higher Education Act does not, however, preclude a lender from establishing a minimum balance for loan consolidation. In 2007 most education lenders had minimum balances of $7,500 or $10,000 to consolidate (Sallie Mae's minimum balance was $5,000) and higher minimums for various loan discounts. It is highly likely that most education lenders will increase the minimum balance to $10,000 or more, since low balance consolidation loans are not profitable given the 75 bp tighter margins. It is also likely that lenders will significantly reduce the premiums they pay to acquire consolidation loans or just stop acquiring all but the highest balance consolidation loans. This will drive many consolidation-only lenders and marketers out of the market, reducing the need for the remaining lenders to engage in defensive consolidation of their loan portfolios by encouraging borrowers to consolidate their loans. (A consolidation loan is like a refinance and represents a risk that the lender will lose the loan to another lender. Since most borrowers are able to consolidate their loan only once, a defensive consolidation encourages the borrower to consolidate the loans with the originating lender, thereby preventing another lender from poaching the loan.)
An increase in the minimum balance to consolidate will not harm borrowers. If a borrower is unable to obtain a consolidation loan from a FFELP lender, they have the option of consolidating the loan with Federal Direct Consolidation. Extended repayment does not increase the repayment term for consolidation loans of less than $7,500, and increases it from 10 to 12 years for loan balances of $7,500 to $10,000. (Borrowers with more than $30,000 in debt do not need to consolidate to obtain extended repayment.) Borrowers who still have variable rate loans will want to consolidate their loans on or after July 1, 2008, in order to lock in a low rate. But since new loans originated on or after July 1, 2006 are at fixed rates, very few borrowers will be graduating with enough variable rate loans to matter past this year. When income-based repayment becomes available on July 1, 2009, borrowers will not need to consolidate their loans in order to obtain a reduction in the monthly loan payment. (The economic hardship deferment also provides some relief for borrowers for up to 3 years.)
Lenders are unlikely to reduce origination activity in Stafford and PLUS loans, since those loans have lower default rates and are more profitable.
For-profit lenders may start selling their federal education loan portfolios to non-profit lenders, since those lenders have 15 bp greater profit margins.
Lenders do not have the option to increase the interest rates charged borrowers on federal education loans. The interest rates on Stafford and PLUS loans are fixed rates set by federal law at 6.8% and 8.5%, and the interest rate on a consolidation loan is set by a formula (the weighted average of the interest rates rounded up to the nearest 1/8th of a point and capped at 8.25%). These interest rates, however, are maximum rates, so nothing prevents a lender from charging lower interest rates and fees. Previously many lenders offered a variety of loan discounts. It is highly likely that these lenders will reduce or eliminate these discounts. In particular, lenders will likely cut the value of back-end loan discounts on Stafford and PLUS loans in half and eliminate all but a 25 bp interest rate reduction for auto-debit on consolidation loans. Some lenders may eliminate all discounts on consolidation loans. Some lenders may eliminate front-end fee waivers. Although the financial benefit to a lender of eliminating fee waivers is temporary, since the federal government is phasing out the origination fees on Stafford Loans, the subprime credit crisis is also likely to be temporary, so this is a way of matching the discount cuts to the duration of the lender's acute financial stress. Minimum balances required to qualify for loan discounts will also be increased to as much as $20,000 to $30,000.
Lenders will likely increase the FICO score minimum on private student loans to 650 in order to eliminate any exposure to subprime borrowers. In addition, changes implemented by Fair Isaacs in late 2007 and early 2008 to eliminate a form of mortgage fraud known as piggybacking will also affect student eligibility for proviate student loans. The change means that authorized users of a credit card account will no longer inherit the credit history of the primary card holder. Students who obtained a good credit score solely by virtue of a credit card provided by their parents will have to apply for private student loans with a cosigner. (Applying with a cosigner often results in a better rate, since lenders offer better rates on cosigned loans due to the lower risk and also base the interest rate on private student loans on the higher of the two credit scores.)
About half of private student loans are pegged to the LIBOR index and 2/5 to the Prime Lending Rate. All such loans, however, are securitized based on the LIBOR index. The decrease in the spread between the LIBOR index and the Prime Lending Rate is problematic for lenders who peg their interest rates to the Prime Lending Rate. Lenders that peg their private student loans to the Prime Lending Rate will either increase the interest rates by 50 bp to 100 bp or switch to the LIBOR index. Lenders that peg their private student loans to the LIBOR index will increase the interest rates by 25 bp to 50 bp, corresponding to the increase in lender cost of capital.
Increases in the default rates on private student loans may cause lenders to increase the guarantee fees they charge on the loans. In addition, pending federal legislation to eliminate the exception to bankruptcy discharge for private student loans will likely cause lenders to increase the guarantee fees by 50 bp to 100 bp.
Borrowers of private student loans typically have the option of making payments of principal and interest during the in-school period, paying only the interest during the in-school period, or deferring all payments until they graduate by capitalizing the interest. Many do the latter. The average life of the in-school period is 2 to 2.5 years. This means that the lender who is unable to securitize is paying interest to the credit warehousing facility for 2 or more years without any payments from the borrower to compensate. Lenders may try to discourage borrowers from deferring all payments during the in-school period, either by raising the interest rates and fees for such borrowers, or providing an incentive for borrowers to make payments of interest during the in-school period. This not only helps the lender's cash flow, but also helps the borrower avoid substantial increases in the loan balance through interest capitalization.
Since private student loans are more profitable than federal education loans, and Stafford and PLUS loans are more profitable than consolidation loans, lenders are likely to eliminate all paid marketing of consolidation loans. They are also likely to shift most of their marketing dollars from federal loans to private loans. Even though private student loans represent a smaller segment of the market, their margins are much greater than the margins on federal education loans. This may result in borrowers obtaining private student loans even though the federal loans are cheaper. Borrowers should not consider private student loans until they have exhausted their federal education loan eligibility.
Lenders will layoff staff to realign their operating expenses with the new financial environment. Call center staff are the employees most likely to lose their jobs, but the layoffs are deep enough to affect all areas of the business including sales and management. Lenders that intend to remain in operation have laid off 3% to 50% of staff. Those that are exiting the market have laid off nearly all their staff. Major lenders that have laid off staff include College Loan Corporation, Nelnet and Sallie Mae. See Lender Layoffs and Loan Program Suspensions for additional information.
Note that the non-bank education lenders are hardest hit by the cost of capital and liquidity issues, since they must rely on credit warehousing facilities and securitizations. Banks, on the other hand, can draw on deposits as a source of funding for education loans. The banks, therefore, are likely to try to gain federal and private education loan market share. Borrowers may find better discounts and interest rates at bank than non-bank education lenders, such as Citi Student Loans, Bank of America, Wells Fargo and JP Morgan Chase. The non-profit state loan agencies may also be increasing their loan volume, since their spread is 15 bp greater than the for-profit lenders and they can obtain funding from state bond issues. (State loan agencies that depend on taxable bonds may experience a similar decrease in investor interest in their bonds and have to stop originating and acquiring loans as a result.)
Based on FY2006 data for the top 100 lenders, who originate 91.5% of all FFELP loans, banks originate 44.1% of all federal education loans (excluding consolidation loans), the Direct Loan program originates 21.8%, non-bank lenders originate 17.9%, state loan agencies originate 11.3%, school as lender schools originate 2.6% and nonprofit non-state lenders originate 2.3%. So the lenders that are most likely to be affected by the turmoil in the ABS and bond markets represent 31.5% of the federal student loan marketplace. Since private student loans represent approximately 25% of overall education loan volume, and private student loans tend to be dominated by non-bank lenders, it appears that slightly less than half of all loan volume is potentially at risk of disruption. There is also the possibility of a cascading effect, as nonprofit state loan agencies provide some liquidity to other lenders, including banks. Not all will be affected, and the banks and direct loan program can pick up the slack in origination volume.
Some lenders may continue to offer private student loans to subprime borrowers if they believe that they are better able to predict which borrowers are less likely to default. The lenders will wait until after the borrower graduates, gets a good job and starts repaying the debt (thereby improving their credit scores) to sell the loans to another lender. This is a strategy that some of the for-profit colleges might pursue if they increase the number of loans they make to their students. It has less of an impact on their cash flow than holding the loans to maturity.
The Federal Reserve and US Treasury are monitoring the situation, as documented in testimony before the Senate Banking Committee on February 14, 2008 by Federal Reserve Chairman Ben S. Bernanke and US Treasury Secretary Henry M. Paulson Jr.
Possible Federal Government Interventions
Currently the problems are mostly limited to non-bank lenders and state loan agencies. The non-bank lenders depend on securitizations and the state loan agencies depend on bond issues as a source of funds. Both are impacted by a decrease in investor interest. Banks, on the other hand, depend on customer deposits as a source of funds, and so are not affected as much by the credit crisis. However, there is the potential for cascading failures as the state loan agencies stop acting as secondary markets to provide smaller banks with additional liquidity. There is certainly the possibility of a disruption and some turbulence if many of the larger education lenders exit the FFEL program or suspend participation.
Even without widespread disruptions, there are still several areas in which students may find it more difficult to obtain financing for their education:
Clearly, subprime borrowers (borrowers with a FICO score under 650 or an adverse credit history) are most likely to be negatively affected by the credit crisis.
Given that the federal government's mission is to ensure access to higher education by low income students, it is possible that the federal government will intervene to ensure that subprime borrowers continue to have access to federal loans. (It is unlikely that the federal government will inject liquidity into private loans, which are not guaranteed by the federal government.) There are several possible scenarios:
The Consumer Bankers Association (CBA), which represents banks, sent a letter to financial aid administrators on March 10, 2008 affirming the intention of the nation's banks to continue making FFELP and private student loans in 2008-09. The letter also announced that CBA is asking Congress to reconsider some of the cuts to lender subsidies made as part of the College Cost Reduction and Access Act of 2007. Politically, Congress is unlikely to roll back the subsidy cuts. It is more important to increase liquidity than to cut lender costs, although the two are, to some extent, intertwined.
The student loan credit crunch will mainly affect subprime borrowers,
who disproportionately attend community colleges and for-profit
colleges. Overall, a few percent of students will not be able to
obtain PLUS and private student loans, and most borrowers will see the
cost of their private student loans increase somewhat and federal loan
discounts at least cut in half (possibly eliminated). Some students
will have to spend a little more time searching for a lender,
especially if they want to consolidate their federal student
loans. Non-bank lenders are affected to a much greater extent than the
banks, who can rely on customer deposits as a source of funds.
The subprime mortgage credit crisis and
the College Cost Reduction and Access Act of 2007 will affect the cost
and availability of federal and private student loans as follows:
Federal Education Loans
PLUS loan denial is based on an "adverse credit
history", which includes defaults, discharges, writeoffs and
foreclosures within the last 5 years or 90 days late on any
obligation. To the extent that the subprime mortgage credit crisis was
precipitated by an increase in foreclosure rates one would expect to
see an increase in PLUS loan denials.
Private Student Loans
As always, borrowers should try to minimize their debt. Live like a
student while you are in school so you don't have to live like a
student after you graduate.
Additional Resources for Families
Students and parents can use loan comparison sites
to shop around for private student loans. However, many of these sites
compare loans based on the best advertised rates and not the actual
interest rates, and so are of limited utility.
Additional Resources for Analysts and Educators
The student loan credit crunch will mainly affect subprime borrowers, who disproportionately attend community colleges and for-profit colleges. Overall, a few percent of students will not be able to obtain PLUS and private student loans, and most borrowers will see the cost of their private student loans increase somewhat and federal loan discounts at least cut in half (possibly eliminated). Some students will have to spend a little more time searching for a lender, especially if they want to consolidate their federal student loans. Non-bank lenders are affected to a much greater extent than the banks, who can rely on customer deposits as a source of funds.
The subprime mortgage credit crisis and the College Cost Reduction and Access Act of 2007 will affect the cost and availability of federal and private student loans as follows:
Federal Education Loans
PLUS loan denial is based on an "adverse credit history", which includes defaults, discharges, writeoffs and foreclosures within the last 5 years or 90 days late on any obligation. To the extent that the subprime mortgage credit crisis was precipitated by an increase in foreclosure rates one would expect to see an increase in PLUS loan denials.
Private Student Loans
As always, borrowers should try to minimize their debt. Live like a student while you are in school so you don't have to live like a student after you graduate.
Additional Resources for Families
Students and parents can use loan comparison sites to shop around for private student loans. However, many of these sites compare loans based on the best advertised rates and not the actual interest rates, and so are of limited utility.
Additional Resources for Analysts and Educators
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