The Best of Times, The Worst of Times: How Student Loans Changed After the Financial Crisis

Charles Dickens famously began his 19th century novel A Tale of Two Cities: "It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity."  Dickens was, of course, referring to the contrasting developments in London and Paris at the turn of the 19th century - a time of both exuberant optimism and explosive turmoil.  One could very easily extend this description to the world of student loans at the onset of the Financial Crisis in late 2008.  The Financial Crisis affected broad swaths of our economy, but it had a particularly acute effect on financial services.  Industries from mortgages to credit cards to student loans changed overnight, and though many have recovered, it would be a mistake to extrapolate pre-crisis assumptions into the post-crisis world.  In this post, we examine one such assumption that is being inappropriately relied upon in the student loan market.

The student loan market, and the broader consumer credit markets in general, changed historically on September 15, 2008 - the day Lehman Brothers filed for bankruptcy.  Investors across the globe awoke to the realization that their investments held tremendously more risk than they had ever previously anticipated.  As a result, lenders began to restrict credit and increase interest rates in order to more accurately capture the default risk in their portfolios.  In the private student loan market, this had a particularly dramatic effect: the average interest rate on a student loan jumped from 5.5% in June 2008 to 12.5% by December 2008.  For a student, that meant that the spread on their second semester loan had widened by 700bps from the loan they used to fund their first semester.  As the chart below demonstrates, interest rates have receded mildly from their 2009 highs, but they have stabilized to a still elevated rate of 9.5%.  Increasing interest rates is an effective way to offset increasing default risk, however it does not address prepayment risk, and, in fact, greatly exacerbates prepayment risk.

The significant increase in interest rates has a profound effect on the prepayment risk in student loans: increasing interest rates increases the pressure in the adverse selection cycle.  Today, "Prime" borrowers are able to access private student loan refinancing opportunities for rates of ~5.0% through companies such as Prime Student Loan.  So, if a Prime borrower took out a loan before September 2008, then their interest rate was probably near 5.5% and there would be very little incentive to refinance.  However, if a Prime borrower took out a loan after September 2008, then their interest rate is probably near 9.5% and there is a significant incentive to refinance to the lower rate.  Thus, there is a much greater likelihood that borrowers will refinance these post-crisis loans; and, as a result, we are just entering into the heart of a new prepayment epoch in student loans.

Thus far, we have laid out several reasons why the voluntary prepayment rate in private student loans is set to increase dramatically.  We showed that the evolution of a student's credit quality mitigates the two greatest default risks within six months of graduation, producing a large amount of Prime borrowers.  In this post we outlined how post-crisis interest rates have created the demand for Prime borrowers to voluntarily refinance their loans - a demand that did not exist pre-crisis.  In the next posts, we will discuss some of the remaining hurdles to the onset of this prepayment avalanche and begin to quantify the effects of this prepayment trend for the existing student loan portfolio.

Byline:
Derek Kaknes