Is the Federal Student Loan Program Really Profitable?! No, no it is not.

Again this weekend we saw articles published declaring that the Federal government was making “obscene profits” through the Federal student loan program.  This assertion is based upon the forecast published by the Congressional Budget Office that estimated the Federal government would record profits in excess of $50B on its loan portfolio – making it more profitable than Exxon Mobil.  As an individual who works and reviews the Federal student loan portfolio every day, I find these assertions a little bizarre because the Federal student loan program is not making money, it is losing money.  A lot of money.  In this post, I will outline how faulty accounting creates the illusion of profits in the student loan portfolio by reviewing the actual cash flow data within the Federal loan portfolio.

The disparity between CBO forecasts and the reality of the Federal student loan pool is a difference between non-cash accounting and real cash flow.  In the case of student loans, this is the difference between a loan that is in deferment and accruing interest versus a loan that is in repayment and is actually making cash payments.  Currently, the Federal government does not make a distinction between the two: a loan that has never made a payment and accrued interest for five years is considered equally profitable as a loan that has made full payments over the same five year period.  To demonstrate how big of an issue this is, let’s turn once again to the Sallie Mae asset backed securities data (I prefer Sallie Mae data because it is audited independently and any faulty accounting comes with legal liability to Sallie Mae and her shareholders).  

The figure above is a summary of several Sallie Mae student loan trusts.  Let me quickly review the data that I am summarizing.  First, we start with the “Pool Balance”, which is the total outstanding balance of all the loans in the trust.  In the case of the SLM 2010_2 trust, there are ~130,000 loans with a total notional value of ~$525 million.  The “WAC” is the “Weighted Average Coupon” and represents the average interest rate on the loans in the portfolio.  Multiplying these two figures together produces the “Implied Interest”, which represents the contractual interest that accrues on the loan pool each year.  Notably, these are all purely accounting figures and do not represent the actual cash flows within the portfolio.  

We start seeing the actual cash flows from the portfolio as we move down to Payment Data.  “Borrower Interest” represents actual cash interest payments made by borrowers against their loans.  “Guarantor Interest” represents cash interest payments made by the Department of Education in place of students who defaulted on their loans, and “Other Interest” represents several other relatively small payments made to reconcile interest payments.  The sum of these three categories represents the “Cash Interest” paid by the portfolio of loans.  Next, “Negative Amortization” represents the non-cash interest that has accrued on outstanding loans that are in some form of deferment or forbearance – that is, loans that are accruing interest but not making any actual cash payments.  The sum of these figures is the “Total Interest”, which reconciles (approximately) with the Implied Interest we previously calculated.  

There are a couple things that immediately stick out in this data.  First, of all the interest that is accruing in the loan pool only half of it is being paid in cash, while the remainder is non-cash negative amortization.  This is not necessarily disastrous for a student loan portfolio as every loan goes through a negative amortization period while the borrower is in school.  What is alarming about the Federal loan portfolio is that this negative amortization trend continues even after students are graduating: in the 2010_2 portfolio less than 6% of the portfolio is still in school but 50% of the interest payments are non-cash.  The problem is even more revealing in older portfolios like the 2006_3 trust, which is comprised of loans that were made to borrowers who were students at least seven years ago.  In the 2006_3 pool less than 2% of the loans are still in school, and yet nearly 60% of the interest payments are non-cash negative amortization!  

And what about those individuals who are making payments; those filed under “Current” loan status?  First, they make up just 50% of the total loan pool – meaning that half of all borrowers in the Federal loan portfolio are not current on their obligations.  Second, there are some alarming trends even in these “successful” borrowers.  Notably, the introduction of Income Based Repayment and other partial payment programs means that borrowers can stay “Current” on their obligations but still be making payments that are less than the interest accruing on their loans.  We can see evidence of this trend in the “Return” column of the Loan Status block.  This figure represents the Cash Interest amount divided by the outstanding amount of Current loans.  If each current borrower were making full payments on their obligations, then this figure would roughly equal the WAC on the total loan portfolio; if this figure is meaningfully less than the WAC, then that means that more Current borrowers are making only partial payments and still accruing interest on their loans.  What we see is that the Current borrowers in the older loan pools (from 2008 and 2006) are making full or near full payments on their obligations; however, Current borrowers on newer loans (2010) are not making anything close to full payments.  In fact, only 70% of the interest accruing on Current loans is being paid in cash, the other 30% is accruing as negative amortization.  So, for the 2010_2 pool of loans, just 37% of borrowers are Current and just 70% of those borrowers are making full interest payments on their loans – to say nothing about actually repaying the principal balance.

So, to return to our initial question, is the Federal loan pool really generating a profit?  One way to answer that question would be to look at the Cash Interest Return; that is, the total Cash Interest divided by the Pool Balance.  We see that the Cash Interest Return is hovering somewhere around 2.0% for these loan pools.  We can compare that to the Treasury’s ten year borrowing rate, which currently sits at a historic low of 2.2%.  At this point you might ask yourself: If the Treasury is borrowing at 2.2% and only getting 2.0% in return, then how are they making a profit?  The reality is that the Federal student loan portfolio is producing accounting profits but real losses.