Like a much-hyped summer blockbuster, on July 20 the Consumer Financial Protection Bureau (CFPB) and Department of Education released a highly anticipated report on Private Student Lending (PSL). The 131-page report researches the boom — and ultimate bust — in private student lending, analyzes the current marketplace, and provides recommendations for the future. PSLs are just a fraction of the overall student lending market, at less than 15% of total outstanding student debt and less than 7% of the $112 billion in student loans originated from 2010-11, according to The College Board. However, they are a valuable financial resource for students and families who need to fill educational funding gaps, not to mention an increasingly popular product offering for credit unions.
Unfortunately, as accurately detailed in the CFPB report, greed circumvented responsible underwriting during the boom period of 2005-2008, leading to high defaults and overburdened borrowers. A recently published white paper from nationally recognized student lending experts John Hupalo and Paul Sheldon corroborates the government report and provides in-depth analysis on key risk management factors. While both reports detail some scary scenes from the past, they provide valuable insight for all lenders hoping to avoid a sequel.
As college costs skyrocketed and student enrollment grew in the 1990s and 2000s, demand for private student loans to fill funding gaps was increasing quickly. With cheap capital from the asset-backed securitization market flowing freely, aggressive lenders focused squarely on volume and placed little emphasis on risk management. Credit score standards were relaxed. Co-signers were rarely required. The school being attended didn’t matter. And to top it off, savvy marketers sold directly to eager students, circumventing school financial aid offices. As Hupalo and Sheldon so eloquently state in their white paper, “the witch’s brew was complete.”
As lenders look to the future, what does history identify as the key factors to properly manage risk? According to Hupalo and Sheldon, while many factors come into play, research points to three key drivers that must be considered in order to build a sustainable private student loan portfolio.
1. Use Of A Co-Signer
In researching publically available data from Sallie Mae, Hupalo and Sheldon indicate that co-signed loans perform significantly better than those without. While this finding is likely not surprising, what is noteworthy is the level of differentiation. Default levels for non-cosigned loans can be more than double the rates for those with a co-signer. For example, the default percentage for Sallie Mae non-cosigned loans from a 2006 repayment period is nearly 18%. For co-signed loans from that same vintage, the default rate is less than 8%.
2. Marketing Channel: Direct-To-Consumer VS. School-Certified
One of the recommendations within the CFPB and the Department of Education report is that all private student loans should be school-certified. This is a process whereby the loan request is certified by the school financial aid office to verify the loan amount (not to exceed cost of attendance) and validate enrollment. Funds are then disbursed directly to the school. Direct-to-consumer loans, on the other hand, are disbursed directly to students without any type of involvement from the school financial aid office. While the direct-to-consumer model boomed in the 2000s, research from Hupalo and Sheldon’s white paper clearly indicates that those loans have performed very poorly when compared with school-certified loans. Data from one national lender shows default rates nearing 20% for direct-to-consumer loans and approximately 8% for those that were school-certified.
3. School Type
The type of school being attended plays a huge factor in loan performance. Evidence for this comes from a plethora of sources. According to a recent article from Inside Higher Ed, entitled “Trouble Ahead on Student Loan Defaults,” the spike in federal student loan defaults happened most dramatically at for-profit schools. Students from for-profit colleges, who make up about 12% of all undergraduate students, made up about 27.7% of federal student loan borrowers who entered repayment beginning in October 2008. Yet they made up nearly half (47.4%) of all borrowers who had defaulted on their loans within two years of entering repayment. Data from the Department of Education in regards to the federal student loan program highlights this important factor and mirrors what occurred with private student loans that went to students attending non-traditional schools.
2009 Federal Direct Loan Program and Federal Family Education Loan Program Cohort Default Rate by School Type
Source: U.S. Department of Education
A Happy Ending?
While it’s clear that misguided lending practices in the mid 2000’s resulted in major problems for students and lenders, the data also underscores the tremendous opportunity that exists for balance-sheet lenders. By implementing prudent and reasonable underwriting criteria, certifying all loans through the school, and emphasizing borrower education, credit unions have the chance to deliver real value to members and positive returns to the cooperative.
To learn more about private student lending and request a free copy of the white paper mentioned in the article above, please visit www.studentchoice.org.