Monday, October 22, 2012

The Evolution of Credit Quality: Student Loans ARE NOT Mortgages


In the last post we discussed the two types of prepayment risk: interest rate risk and equity prepayment risk.  In this post, we focus exclusively on how equity prepayment risk affects each mortgages and student loans.  We note that there are fundamental differences between the loan types that make using similar credit analyses impossible. 

Equity prepayment risk is derived entirely from the change in the credit quality (e.g. default risk) of the borrower.  A borrower will only be incentivized to refinance into a lower rate if their credit quality has improved significantly since the loan was originated.  Thus, in order to analyze equity prepayment risk, we need to review the evolution of credit quality in both mortgages and student loans:

The traditional mortgage is a secured loan that is collateralized by the real estate asset (the house) with a loan-to-value of no greater than 80% (20% down payment).  As a result, the vast majority of the credit quality of a mortgage is dependent upon the value of the underlying home as collateral: if the borrower defaults the bank can foreclose on the home and sell it for 80% of its original value without taking any losses.  Thus, the evolution of credit quality for a mortgage is almost entirely derived from the change in value of the underlying home.  The last decade notwithstanding, U.S. home prices have historically been very stable.  Consequently, the evolution of credit quality of mortgage borrowers is very gradual as well and thus we would expect the effect of equity prepayment risk to be minimal.  The exception to this rule is in instances where housing prices increase dramatically in a short period of time.  In this case, we would expect homeowners to rapidly and consistently refinance their mortgages as the value of the underlying collateral increased.  This is precisely what occurred from 2002 to 2007 during the housing bubble.

Student loans are not like mortgages.  Student loans are unsecured debt whose underlying credit quality is solely determined by the expected future income of the borrower (and cosigner).  The credit quality of a student loan will evolve with direct proportion to the certainty regarding the borrower’s ability to earn an income commensurate with their debt level.  This figure, however, is extremely volatile in the early years of a student loan.  Key binary metrics that determine credit quality evolve dramatically over the student’s educational period, most notably: the likelihood that the student will graduate and the likelihood that they will attain a high paying job post-graduation.  In fact, the failures to adequately meet these qualifications are the top two causes of student loan default.  As a result, the evolution of credit quality in student loans is extremely steep: 70% of defaults occur within the first two years of a loan entering repayment.  

This phenomenon reflects the huge level of uncertainty and variability in the value of higher education degrees.  More importantly, this phenomenon would lead us to believe that there is enormous equity prepayment risk in the student loan market, and particularly for private student loans held by Prime borrowers.  That is an assertion that we will look into further in the following posts.
   
Byline:
Derek Kaknes


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