Last month, the Bureau for Consumer Financial Protection released a request for information regarding initiatives to help alleviate distressed private student loan borrowers. We at PSL are coordinating a response that centers around a Private IBR path to loan forgiveness. You can find the Bureau's request here and our response below.
The student loan Ombudsman has
requested information on ways to encourage the development of more affordable
loan repayment mechanisms for private student loan borrowers. In this document, we focus on one mechanism
to achieve affordability for existing private student loan borrowers and how
that mechanism could be effectively implemented:
Private
IBR Program: In exchange for
continued bankruptcy protection and the ability to institute prepayment
penalties, lenders would allow private student borrowers access to irrevocable income
based loan forgiveness programs with maximum repayment terms no greater than 10
years;
Private IBR Program
The Department of Education’s IBR
plan can never be implemented in the private sector because it offers borrowers
the opportunity to opt into the program when advantageous and out of the
program when disadvantageous; thereby guaranteeing a loss for the lender. Most notably, for private lenders this risk
is compounded because their highest quality loans will quickly refinance into
lower rates once they have established their creditworthiness, while their most
risky borrowers will remain in the portfolio and utilize the IBR path to loan
forgiveness. Lenders can solve this
problem by offering an irrevocable IBR option: borrowers may opt into a 10 year
IBR program, but once adopted the borrower cannot opt out of the IBR program
until the end of the 10 year period, at which point the obligation would be
terminated.
The details of this “Private IBR”
plan would reflect the Federal program but differ in a few key ways:
- Once the Borrower opts for Private IBR, she would be committed to the contractual payments as calculated under the Private IBR plan for the full 10 years without the ability to opt back into a standard repayment;
- Discretionary Income under the Private IBR plan should be defined as Total Income (Line 22 of IRS Form 1040) less a Hurdle Rate, which would start at $25,000 and increase indexed to the Consumer Price Index (CPI). This means that lenders will be rewarded for both wage growth and capital gains achieved by the borrowers, which gives lenders an incentive to promote entrepreneurial endeavors that have low wages but high potential capital gains;
- Annual payments under Private IBR would equal 25% of Discretionary Income with total payments capped at 5x the loan balance at the time the borrower opts into Private IBR (a maximum implied interest rate of 17%);
- Any year in which the Borrower’s Discretionary Income is less than the Hurdle Rate will be a Deferred Year and will not count towards 10 years of repayment, with a maximum of up to five Deferred Years;
- Cosigners on private loans that enter Private IBR would be held jointly responsible for payments under Private IBR; however the formula for calculating payments would be exclusively indexed to the primary borrower.
Private lenders will be more
willing to accept this Private IBR plan because it gives them opportunity to
participate in the upside of educational investing: if Sallie Mae can make
targeted investments to increase their borrowers’ annual income, then they are
able to recoup 25% of that increase to justify the investment. Borrowers are protected under the Private IBR
plan because the Hurdle Rate is meaningfully higher than the Federal IBR
program to reflect the fact that they are only expected to pay a portion of the
income above that which they could have earned without a college degree. Finally, indexing payments to Total Income provides
lenders a profit incentive to promote entrepreneurial endeavors that have very
large return profiles, but which would be very difficult to finance with
traditional amortizing loan schedules.
How the Math Works
The figure above outlines the
Private IBR payments that would be made by a borrower with initial earnings of
$40,000 annually that grow at 5.0% annually.
We note that the borrower would make total loan payments of approximately
$55,000 over the 10 year period. The net
present value of those payments, assuming a 3.0% discount rate, is $46,654. That means that this borrower should be able
to “refinance” $46,000 in private student loans without the lender having to modify
the value of the asset.
Navigating Existing Trust Agreements
Existing ABS Trust Agreements
will not allow loan servicers to modify the terms of the underlying loans. It is highly unlikely that existing servicers
and bondholders will voluntarily modify their Trust Agreements unless they are
presented with either a significant profit or loss avoidance motive. Unlike the mortgage crisis, it would be unfair
to target the banks and investors explicitly for punitive financial
retribution: in the mortgage crisis, most loans were made to facilitate flipping
or refinancing the same assets over and over again, which uniquely benefited
the banks; in the student loan crisis, the flow of capital is one-way from the
investors to educational institutions, so punishing lenders would grossly
ignore the fact that the educational institutions themselves were the chief beneficiaries
of these transactions. Therefore, we
propose the Department of Education introduce an Outperformance Reward Program
to help incentivize lenders to adopt Private IBR modification
Outperformance Reward Program
The Outperformance Reward Program
is a financial contract from the Department of Education that offers to partially
match payments under the Private IBR program for outperformance. We propose the following terms for the
Program:
- For any individual that adopts the Private IBR program, the Department of Education will partially match their payments above a Performance Hurdle Rate;
- Annual Performance Payments will be equal to 10% of the borrower’s Discretionary Income in excess of a Performance Hurdle Rate of $60,000, indexed to the CPI, over the entire Private IBR term;
- Total Performance Payments will be capped at 5x the loan balance at the time the borrower opts into Private IBR;
The Outperformance Reward Program
is attractive for several reasons.
First, it provides an enormous profit incentive for lenders to adopt the
Private IBR program. Second, the program
greatly incentivizes lenders to make strategic investments in their student borrowers
in order to significantly increase the borrower’s earnings power over the Private
IBR period. These investments could
include ongoing career advice and training, mentorship, continuing education or
additional financing to help fund new business ventures. Finally, the program will be immediately and
perpetually self-funding. The marginal Federal
Income Tax rate on income over $36,250 will be 25% in 2013, versus a rate of
just 15% for income under $36,250. Thus,
the Performance Payments would constitute only a portion of the incremental tax
revenues that are created as a result of the program; the program should
actually be accretive to tax revenues.
Notably, the Performance Payments will last only the 10 years of Private
IBR, while the increased tax revenues will continue for the entire working life
of the borrower, which should further aid the fiscal sustainability of the
program.
Conclusion
In conclusion, we believe a
Private IBR loan modification program is the ideal solution to the large amount
of distressed private student loans.
There are several hurdles to implementing this program, notably the
reluctance of loan servicers and ABS bondholders to modify loan terms; however,
we note that there are several opportunities for the Bureau to help drive
towards a settlement. We believe the
best way for the Bureau to help implement the Private IBR would be institute an
Outperformance Reward Program that would reward lenders and investors for the
economic value that they help create through further investment in their
borrowers. The Program would be
self-funding and accretive to Federal tax revenues, and would properly align
the incentives of borrowers, lenders and investors.
