Understanding the student loan market

If you or anyone you know has college-age children, then you are likely familiar with the economic realities of an education nowadays. Some of the numbers can be very startling. According to the College Board, total costs at a private university, factoring in books and travel as well as tuition, room and board, and other expenses, are now closing in on $40,000 for a single year.¹ That's nearly $160,000 for a four-year degree.

Where are today's graduates finding their tuition funds? The growth in federally subsidized student loans, according to the College Board, has slowed from an average annual rate of 10.8% in adjusted dollars for the 10-year period from 1977-78 to 1987-88 to 5.5% across much of the first decade of this century.² Given these circumstances, it's no wonder that private student loan lenders have stepped forward to fill the gap. But now that they're in it, do they know how to prepare for the potential downsides of the student loan market?

The opportunity

The evidence for the crying need that drives this market is more than ample. Published college tuition and fees soared 439% (unadjusted for inflation) from 1982 through 2007, while median family income increased 147% over the same time period, according to the National Center for Public Policy and Higher Education, a nonpartisan organization.³ Yet federal student loan options offered by the William D. Ford Federal Direct Loan Program in many cases cover only a fraction of college costs. The current Stafford four-year limit of $27,000 covers only roughly 65% of a public four-year institution’s tuition and fees, or 30% of a private college's costs, if the schools' prices were frozen at today's levels (less if prices continue to increase). Subsidized Stafford loans, which are available to students who can show financial need, fell to 34% of total student loans in the 2008-2009 academic year, down from 49% 10 years earlier. The proportion of non-subsidized Stafford loans has also declined slightly.⁴

Private lenders have seized the opportunity. As reported by the College Board, the proportion of non-federal loans swelled to 25% in 2007-2008, up from 9% in 1998-1999.⁵ This increase in non-federal loans has occurred over a time when total education loans more than doubled.⁶  Private student loan originations did slow in 2009 amid widespread concerns about the economy and securitization funding, but this retrenchment may be only a temporary pullback from a market that has exploded.

Risk and realism

Where do private lenders in the student loan market find themselves now? One of the lessons of the recent economic downturn has been the simple reality that risk can bring a very tangible downside, and the student loan market is no exception. Earlier this year, the U.S. Department of Education (DOE) reported that the default rate for federally guaranteed student loans was 6.7% for fiscal year 2007, as shown in Figure 1. That represents a 2.1% jump in the default rate over the 2005 fiscal year and the highest rate since 1998. ⁷

Moreover, as troubling as this rise is, it probably still underestimates the magnitude of student loan defaults. That's because the DOE's cohort default rate is calculated using the cumulative number of borrowers who stop paying on their loans within the first two years after entering repayment, which is generally believed to be too short a timeframe to make an accurate assessment. Defaults can and do occur at later times, according to a 10-year follow-up study by the National Center for Education Statistics (NCES), a part of the DOE, which found that students typically default on their loans four years after graduating from college.⁸

The NCES study, which tracked the debt status of 1992-1993 college graduates, found the default rate to be nearly 10%. But this figure is an overall rate. Some sub-groups had decidedly higher default rates, as can be seen in Figure 2. For example, graduates with $15,000 or more in loans had a default rate that was slightly more than twice the average.⁹

With a poor economy, student loan defaults may be prolonged delayed by attempts to offer relief to imperiled loans. Each private student lender has the option, for example, to offer relief mechanisms such as in-school grace periods (i.e., the borrower may need to only make interest payments or no payments at all while in school), or forbearance/deferment programs (i.e., the borrower's payments are deferred due to an economic hardship experienced by the borrower or some other allowable condition, and the loan may or may not accrue interest). In any case, under the current economic conditions, the default is generally simply delayed, leaving one less tool in the risk management toolbox for lenders.

Staying safe in the student loan market

So how do student loan lenders manage risk in the current economic and business environment? It is generally believed that credit risk and the performance of the economy are strongly interrelated. Student loan lenders must move forward carefully with originations as we continue to endure tough economic times. Properly mitigating the risk associated with student loans is the key to avoiding unwanted defaults.

There are several ways lenders can alleviate the amount of credit risk they take on. One way is through stricter loan underwriting. Credit scores, interest rates, college dropout rates, and the presence of a cosigner on a student loan can each have an impact on default rates. Some 40% of students fail to complete college¹⁰ —which frequently puts them on an earnings path that doesn't support the debt levels taken on in college. Additional follow-up underwriting, such as a refreshed credit score, may also be prudent.

Geographic diversification can also help lenders weather tough times. As the recent economic downturn has demonstrated, some areas of the country may be more susceptible to credit risk. By diversifying a student loan portfolio across states, a lender avoids putting all its eggs in one basket.

Sizing up the level of defaults experienced by a company's peers is another important barometer for a lender. Benchmarking defaults can provide useful information and allow a lender to reassess its underwriting criteria to optimize profitability.

Finally, having proper internal controls can prevent a lender from exposing itself to too much risk. Monitoring the amount of loans generated through each origination channel and maintaining a high level of strong relationships with borrowers are examples of these kinds of controls.

Looking ahead

Student loan defaults may be prolonged by attempts to offer relief to imperiled loans. These macroeconomic factors are likely to persist for the foreseeable future, reinforcing the trend toward rising defaults for student loan lenders. This dynamic is reinforced because many of the relief mechanisms such as forbearance that allowed students to suspend payments for a period of time are now more scarce. Without the proper risk measures in place, a lender could find its student loan business in dire straits, something we all want to avoid.

1 Baum, S. et al. (2009). Trends in college pricing. College Board, Trends in Higher Education Series. Retrieved May 28, 2010, from http://www.trends-collegeboard.com/college_pricing/pdf/2009_Trends_College_Pricing.pdf.

2 Baum, S. & Ma, J. (2007). Trends in college pricing. College Board, Trends in Higher Education Series. Retrieved June 8, 2010, from http://www.collegeboard.com/prod_downloads/about/news_info/trends/trends_pricing_07.pdf.

3 Lewin, Tamar (Dec. 3, 2008). College may become unaffordable for most in U.S. The New York Times. Retrieved June 8, 2010, from http://www.nytimes.com/2008/12/03/education/03college.html?_r=1.

4 Baum, S. et al. (2009). Trends in student aid. College Board, Trends in Higher Education Series. Retrieved May 28, 2010, from http://www.trends-collegeboard.com/student_aid/pdf/2009_Trends_Student_Aid.pdf.

5 Trends in student aid, ibid.

6 Trends in student aid, ibid.

7 U.S. Department of Education (2009). National student loan default rates. Federal Student Aid, Default Prevention and Management. Retrieved June 8, 2010, from http://www2.ed.gov/offices/OSFAP/defaultmanagement/defaultrates.html.

8 Choy, Susan P. & Li, Xiaojie (June 2006). Dealing with debt: 1992-93 bachelor’s degree recipients 10 years later. National Center for Education Statistics. Retrieved May 28, 2010, from http://nces.ed.gov/das/epubs/2006156/index.asp.

9 Choy & Li, ibid.

10 Clark, Kim (April 8, 2007). Run the numbers. U.S. News & World Report. Retrieved June 8, 2010, from http://www.usnews.com/usnews/biztech/articles/070408/16intro.htm?s_cid=related-links:TOP.