The Gilded Quandary of Student Loan Asset-Backed Securities
By: Victor Leblanc
Tags: Asset Backed Security, Risk Management, Higher Education, Student Loans, Financial Markets

How guaranteeing student loan asset-backed securities could be amplifying moral hazards in derivatives markets.

Photo by Filip Zrnzević

College degrees — for better or worse — resemble the characteristics of a financial instrument. With a degree, people are essentially buying a security that promises annual income for most of their lifetime, depending on the career selected and how well it adapts to technological advances.

Notably, the upfront costs make a college degree act like a security but provides uneven returns and, at times, improperly exposes participants to counter-party risks. A future workforce and consumer hauling anywhere between $30,000 and $100,000 in non-dischargeable debt (for most cases) will dictate spending and investing patterns for future generations.

Student loan asset-backed securities (SLABS) are not a contained problem for students and investors directly involved, and such scenario may be unrecognized by most businesses’ risk frameworks today.

Comparable to the derivatives of the 2008 mortgage crisis, SLABS are created through the same process as mortgage-backed securities (MBS). The originator takes a pool of loans (i.e., student loans), securitizes it through a special purpose vehicle, and sells it to investors. In a nutshell, this cycle pertains to the asset-backed securities (ABS) market with varying degrees of risk.

SLABS seem to be the new asset that is too safe to fail, which should concern the business community and Congress, on some level. Although most SLABS are federally guaranteed (that is, federal student loans), losing the federally protected status can occur through several means, such as refinancing loans, consolidating loans, and failing to meet the standards set by the Department of Education.

Focusing solely on the guaranteed dynamics of the security promotes ignorance of other risk characteristics at play. Suppose SLABS lacked government guarantees; would they keep performing as well as they have? Assume enough SLABS lost a significant portion of their value, falling to lower credit tranches, such as BBB- or BB (junk). The momentum could be swift enough to trigger insurmountable levels of margin calls within the ABS market, potentially creating a cascading cycle of rapid devaluations and illiquidity. Determining the fair value of SLABS has its own set of hurdles. The fair value is partially dependent on higher education institutions and the prices and services attached to the degrees offered.

Examining law or aviation schools and the financing required to procure degrees in these fields illustrates the harmful financial imbalances running amok. Justifying the price tag of an $85,000 to $100,000 loan for a starting income between $35,000 and $65,000 (regional pilots and tower controllers, respectively) becomes increasingly ludicrous. Conversely, recently graduated lawyers must narrow their career options to lucrative positions, typically BigLaw or in-house counsel to a prominent corporation.

The remaining portion of the fair value derives from mark-to-model equations, similar to how MBS are valued. Any faults within these models could create an internal panic, leading to a fire sale of SLABS. Whether the impact is as large as the financial crisis of 2007–2008 is doubtful but not impossible.

Note that not all universities deserve the same grade. Many law schools aim to add value by offering classes with real-world experiences and reducing the amount of time spent in school. However, the majority of these attempts fall short. In his book The Lawyer Bubble, Steven J. Harper stated the following about Northwestern’s accelerated program:

“[F]or participating students, it seems destined to make the overall law school experience worse while increasing the size of the lawyer bubble.” He further explains that “accelerated students cram three years of academic work into two, starting with a Web-based course even before they arrive on campus . . . They continue into the fall and spring with the typically rigorous first-year academic schedule — plus an extra course throughout[.]”

Meanwhile, the cost of attendance stays the same. Ostensibly, these initiatives are generally lackluster when lowering the costs of law school, an out-of-state university, or a private university.

Remarkably, some universities lack interest in changing how students pay for school. According to a 2018 Government Accountability Office report, universities focus on delaying student loan defaults by three years, which helps them manipulate the cohort default rate (CDR). The CDR focuses on student borrowers’ default rates one to two years after entering repayment. If they maintain a CDR below a 40% and 30% threshold (depending on the program), it allows the university to retain its accredited status, renewing participation in federal student loan programs offered by the Department of Education. Additionally, a university that shuts down forces students to start over, leaving them with high hopes of being lucky enough to have their student debt forgiven.

Unsurprisingly, students have sued their law schools or universities for stretching employment numbers or providing misleading information regarding career income. Although courts rejected most of these cases, it shows students have noticed the underwhelming performance of the financial instrument they purchased.

According to an article in the New York Times, Michael Sullivan, a lawyer representing the Thomas Jefferson School of Law, explained to a jury, “I’m not here to tell you a law degree is a guarantee of career success, is a guarantee of riches. It’s not. No degree is.”

This candid disclosure is absent from most conversations when students start the application process for college.