Margin Call: Can Alumni Lending Survive the Current Rate Environment?

In the last three years, there has been significant growth in the peer-to-peer lending space, particularly within the student loan segment.  While we applaud the entrance of new funding sources into the student loan market, there are increasing signs that some of these lenders might face challenges in the current interest rate environment.  These challenges stem from their use of market-based funding sources, rather than deposit funding sources like traditional banks.  Market funding, particularly through the use of “warehouse” credit facilities, can be particularly unstable because market lenders can demand more collateral against their loans as asset prices fall – what is known as a “margin call”.  If a borrower cannot provide additional collateral, typically within 24 hours, then the market lender can seize and liquidate the existing collateral in order to cover their lending position – a positive feedback loop that amplifies losses.  Traditional deposit holding institutions are insulated from this loop because they can hold their loans to maturity and fund them through both customer deposits and the Federal Reserve’s discount window.  While these traditional banks are still subject to bank runs and mark-to-market losses, they typically happen much more slowly than market based borrowers.

To demonstrate how this type of market based lending can go wrong; let’s take an example where the Student Lender uses alumni investment to fund a portion of their portfolio and borrows from a Market Lender for the remaining portion.  In this example, let’s assume that the Student Lender funds their initial portfolio with 20% alumni investment and 80% debt from a Market Lender.  Let’s further assume that the portfolio of loans has a fixed coupon rate of 6.25% and a maturity of 10 years.  So, for a $100 million portfolio, the Student Lender would use $20 million of alumni investment and $80 million of debt from the Market Lender.  If we assume that the Student Lender has accurately priced the risk of the loan portfolio, then we can determine the market value of the portfolio by calculating the spread over the equivalent Treasury security; in this case, the 10 year Treasury yield.  

Because the Student Lender’s portfolio has a fixed interest rate, the market value of the portfolio is subject to change based upon changes in the equivalent Treasury security; in this case, changes in the 10 year Treasury yield.  If 10 year yields go up, then the market value of portfolio will go down, because investors could readily achieve the same fixed rate return while buying less risky securities.  The figure below shows how the market value of the loan portfolio would change if the Student Lender had originated the loans in May of this year. 

There are a few very notable points in this figure.  First, we note that 10 year Treasury rates have increased from 1.75% on May 3, 2013 to 2.88% today – that is a very large and rapid increase by any historical standard.  Correspondingly, we note that the market value of the Loan Portfolio has fallen ~8% over that same timeframe; however, due to leverage the value of the alumni investment has fallen by almost 40%.  Even more notably, the ratio of Debt to Portfolio Value has increased significantly.  In the third set of rows, we outline a potential 85% Collateral Requirement; in other words, the Market Lender may stipulate that at no point can the ratio of Debt to Portfolio Value increase beyond 85%.  In order to rectify any imbalance in this ratio, the Market Lender could force the Student Lender to post greater collateral through a margin call.  We note that, under these assumptions, the Student Lender would be faced with a $1.6 million margin call at today’s rates.  If the Student Lender is unable to post that amount –within 24 hours of the request – then the Market Lender would seize the portfolio and liquidate it in order to recoup its investment, effectively wiping out the entire Alumni Investment.

Finally, in the last two columns we have forecasted out the same calculations based upon the prevailing assumptions for the 10 year Treasury yield.  As you will notice, the implications are not pretty for Alumni Investors: by March 2014 the Alumni Investors have lost nearly 60% of their investment and are facing a margin call of nearly $5 million.  Now, to be fair, if the Student Lender were a traditional bank then the equity investors in the bank would face the same market losses on their investment; however, they would be largely exempt from a potential margin call, which is the ultimate destabilizing factor in a market based lending system.  Further, from a borrower perspective none of this may matter: regardless of whether the Student Lender makes or loses money, the borrower has already locked in the terms of their loan and will be largely unaffected.  However, borrowers who sign up for alumni lending programs because of the social aspect of the loan product might find themselves in a sticky situation if those alumni start seeing their investments evaporate.

Private IBR: Solving the Distressed Private Student Debt Problem

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:

1. 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;
2. 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;
3. 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%);
4. 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;
5. 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:

1. For any individual that adopts the Private IBR program, the Department of Education will partially match their payments above a Performance Hurdle Rate;
2. 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;
3. 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.