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.

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. 

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.

The Not-Smart Option: Why Sallie Mae’s New Graduate Loan Program is a Scam

Sallie Mae announced this week that they will be offering a new and more attractively priced Smart Option loan product focused on competing directly with Federal Grad PLUS loans for graduate students.  Sallie Mae argues that, given historically low interest rates, they can offer competitive lending products that actually cost the borrower less than what the Department of Education offers.  This assertion is an outright lie aimed at tricking graduate students into taking much riskier loans that will be much more expensive for the average borrower.  In this post, we will outline why absolutely nobody should take out a Sallie Mae private loan instead of a Direct Grad PLUS loan.

The figure above outlines the major loan characteristics for the Grad PLUS loans and for the lowest and highest tiers of Sallie Mae’s new graduate loan product.  Clearly, the highest priced Sallie Mae product is out rightly more expensive than the Grad PLUS product, so there is absolutely no reason to believe borrowers would benefit from selecting the “Smart Option” in this case.  However, some borrowers might be tempted to accept the 5.75% fixed rate Sallie Mae loan instead of taking the 7.90% Grad PLUS loan.  There is a serious risk to this strategy: the borrower would be foregoing income based repayment and loan forgiveness programs only offered by the Department of Education and would likely need a parental cosigner on the loans who would assume equal financial responsibility for their repayment.  Given these risks, I conclude that the “Smart Option” is universally the wrong option for graduate borrowers; let me explain why.

Both Sallie Mae and Grad PLUS loans are readily prepayable at no expense to the borrower.  That means that every borrower has the right to refinance their existing student loans if they can find a lender who will offer them a more competitive rate.  So, when a graduate student is comparing loan products to fund their education they should not be comparing the nominal, contractual payment schedule, but instead they should be comparing the most advantageous repayment strategies.  Notably, a borrower can take out Grad PLUS loans to fund their education and if they graduate and attain high paying employment after graduation, then they can refinance their Grad PLUS loans into lower interest rate private loans in order to capture their improved credit quality.  However, if they don’t graduate or graduate but struggle to find high paying employment (or choose to start their own business or work for a non-profit), then they can keep their Grad PLUS loans and utilize the borrower benefits unique to that loan product.  It is all reward and no risk: Why take a private loan as a student when you can just wait and refinance into a private loan after graduation?  The only cost for the pursuing this strategy is the upfront origination fee charged by the Department of Education and the two years of interest expenses that accrue while the borrower is in school.  For a closer look, let’s examine the two competing strategies by comparing the financial outcomes for an MBA candidate who is taking out $30,000 for each of her two years of graduate study.

Sallie Mae “Smart Option” Strategy

In this scenario, we assume that the borrower opts to take the 5.75% Smart Option loan to fund the full cost of her education.  In this case, she has taken out $60,000 in principal ($30,000 each year with no origination fees) at a fixed interest rate of 5.75% and a repayment term of 15 years.  Let’s further assume that she successfully graduates and achieves her dream job on Wall Street and is making six figures from day one.  This is a great outcome and here risk of default is almost zero.

Grad PLUS with Private Refinancing Post Graduation

In this scenario, we assume that the borrower opts to take the 7.90% Grad PLUS loan to fund the full cost of her education.  In this case, she has taken out $62,400 in principal ($30,000 each year with a 4% origination fee) at a fixed interest rate of 7.90% and a repayment term of 30 years.  Let’s keep our Wall Street dream job assumption and assume that she uses Prime Student Loan to refinance her student loans immediately after graduation at a 5.75% interest rate on a 15 year term (identical to the Smart Option in the previous scenario).

The chart above summarizes the outcomes for each scenario.  What we see is that the “Smart Option” does, in fact, cost the borrower less in this ideal scenario.  However, it only amounts to $478 in annual savings or roughly one percent in annualized borrowing costs.  But what is the borrower sacrificing for this incremental gain?  The borrower loses ALL the generous borrower protections provided by the Department of Education and dramatically reduces their financial flexibility. 

What would happen if the borrower had a family crisis and had to suspend their studies?  If they took out Grad PLUS loans the impact would be minimal as they could opt into an income based repayment plan until they completed their studies or returned to a higher paying position.  If they took the “Smart Option” they may qualify for temporary forbearance, but ultimately they would be required to start making full payments on those loans with the threat of default and a 25% fee. 

What if the borrower wishes to start their own business or pursue a lower paying course of employment, such as a non-profit?  If they took out Grad PLUS loans the impact would again be minimal as they could take advantage of income based repayment while they pursued their passion.  If they took the “Smart Option” then they would be forced to pursue only higher paying employment opportunities in order to support their mandatory and inflexible student loan payments. 

What if the borrower graduates into a recession or loses their job early in their repayment schedule?  Again, not a problem if they took out Grad PLUS loans.  However, if they took the “Smart Option” then they would be at great risk of loan default, which carries enormous fees, ruins their (and their cosigner’s) credit, and is almost impossible to discharge in bankruptcy. 

The bottom line is the “Smart Option” is not smart at all.  The borrower is taking an enormous financial risk and gambling their own and potentially their cosigner’s financial wellbeing in exchange for a maximum savings of $478 a year.  That’s less than half of what the average MBA graduate spends at Starbucks each year.  Shame on Sallie Mae for trying to fleece students even more than they already are, but shame on any student or parental cosigner who accepts this financial risk without understanding the tradeoff.  So, take our advice on this one: don't buy what Sallie Mae is selling, take the Grad PLUS loan and just opt for a regular coffee at Starbucks instead of the mocha latte.