Tuesday, October 16, 2012

A Framework for Analyzing Student Lending: How the U.S. Mortgage Market Influences EVERYTHING


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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