Going
forward in this blog, we will be using some conventional and some more complex
financial analytics to evaluate the current student lending market. We use this financial framework because we
believe it the best and only way to rigorously analyze the state of student
loans and to empower student borrowers in their personal finances. With that in mind, we put forth the following
framework for viewing the student loan market: the student loan market is an
offshoot of the much larger U.S. mortgage market – the same people are using
the same models to value similar securities.
We use this framework because it helps explain why the student loan
market works the way it does, why that model makes little logical sense, and
how the flaws in the model will likely unravel.
In this post, we will give a brief introduction to the mortgage market, describe
one way in which it has influenced student loans and uphold the comparison as a
framework for further analysis.
At
~$10 trillion, the U.S. mortgage market is the single largest capital market in
the history of the civilization. However,
roughly half of these mortgages are guaranteed by the U.S. government through
Fannie Mae, Freddie Mac and Ginnie Mae.
As a result, interest rates in the mortgage market largely track the
rate of U.S. Treasury securities with slight adjustments for prepayment
risk. This guarantee program is exactly
analogous to the federal student loan program in the student loan market (in
fact, Sallie Mae was created specifically to replicate the mortgage market). The $1.0 trillion student loan market is even
more heavily influenced by this government guarantee: ~95% of the student loan
market is government guaranteed. While
there are many consequences of this involvement, we focus here on how that
government intervention affects the burden of credit diligence for the private
lending market in both mortgages and student loans.
The
government guarantee in both the mortgage and student loan markets has the
effect of driving down the yield that investors receive on the loans they
invest in. If we assume that the risk of
a U.S. default is zero, then the yield in excess of the treasury rate (the “spread”)
represents the maximum value that an investor can extract through their own
research and credit diligence: if the spread is zero, then the investor would
be much better off just investing in risk-free treasuries. For guaranteed mortgages and student loans,
this spread has been extremely low – less than 0.50%. This small spread means that investors cannot
afford to perform extensive diligence on the credit quality of the loans or the
market before making an investment decision.
As a result, the amount of credit diligence performed in an industry is
inversely proportional to the amount of government guarantee in the
market. In the mortgage market, this
disparity implies that the market is “under-diligenced” by close to 50%. In the student loan market, this disparity
implies that the market is “under-diligenced” by over 90%. This is critical because it affects the market
as a whole and not just the specific investments: 50% of the capital going into
the housing market is not performing diligence; 95% of the capital going into higher education is not performing
diligence.
Investors
are highly rational, so the fact that the student loan industry is
under-diligenced would not in-and-of-itself dissuade investment. However, it does necessitate a larger burden
on the private segment of the market: the private student loan market is
responsible for completing 100% of the diligence but only reaps 5% of the
reward. Ultimately, this translates to
higher borrowing costs on private loans in order to offset the
disproportionately large diligence expense.
It also makes it tantalizingly attractive to take short-cuts.
The
sub-prime mortgage meltdown and the private student loan mass defaults in 2008
were examples of the private sector taking short-cuts. In 2012, the short-cut in student lending is
co-signers: 90% of new private student loans are cosigned by a parent. This effectively shifts the burden of
diligence away from evaluating higher education (which has a 90% diligence
deficit) to the broader consumer lending market – which is already thoroughly diligence
for mortgages, credit cards, auto loans and every other consumer credit
instrument. Lenders are able to leverage
existing credit models, existing data sets and existing credit metrics (like
FICO) in order to make decisions about student lending, and largely avoid
tackling questions about value in the higher education market as a whole. The consequence is that much of the analyses used
to evaluate student loans are techniques used to evaluate mortgages that have
been hastily and rudimentarily converted to evaluate student loans. Thus, it is often helpful to use mortgage
valuation techniques when reviewing student loans, which is why we will
continually return to this comparison throughout this dialogue.
Byline:
Derek
Kaknes
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