STUDENT LENDING INDUSTRY BRIEFING. Presented by Thomas A. Breyer, ISAC Senior Policy Advisor to the

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1 STUDENT LENDING INDUSTRY BRIEFING Presented by Thomas A. Breyer, ISAC Senior Policy Advisor to the Illinois Student Assistance Commission Board Meeting University of Illinois at Springfield, April, 4, 2008 For nearly 40 years, the student loan industry went quietly about its business, staying off the radar screens of the public, the media and most of the government. More recently, those in the industry have found themselves under a bright spotlight to which they were previously unaccustomed. Last year, it was The Student Loan Scandal which largely dealt with business practices and conflicts of interest in the industry. This year, it has been The Student Loan Credit Crisis, related to possible threats to the continued availability of student loans. Whether or not there is a crisis already, or one is looming, is still a matter of debate. What seems certain, however, is that the student loan industry is in a period of rapid change and transition that will leave lasting impacts on virtually all participants in the industry -- students and families, institutions of higher education, lenders, guarantors and governmental entities. While the industry s where we are is not known with certainty, the how we got here is somewhat more clear. The roots of the current situation lie squarely at the intersection of two significant events: the enactment last fall of the College Cost Reduction and Access Act (CCRAA) followed by the global credit crisis that was touched off by a meltdown of the U.S. subprime mortgage market. Enacted on September 27, 2007, the CCRAA made cuts of nearly $21 billion over the next five years in federal subsidy and fee payments to lenders and guarantors in FFELP (the Federal Family Education Loan Program, the primary federally-guaranteed loan program, in which ISAC acts as both a lender and a guarantor). The Wall Street Journal recently quoted Kevin Bruns, Executive Director of America s Student Loan Providers, a trade group representing private lenders, as saying in reference to the previously mentioned scandal involving industry business practices, The scandal contributed to the political environment that made the deep cuts possible. The three primary components of the lender subsidy cuts contained in CCRAA are: 1) Reductions in Special Allowance Payments (SAP) [market-based interest rate subsidy payments]; 2) Increases in risk-sharing on defaulted loans [in the form of reduced reimbursement rates on defaults]; and 3) Increases in lender-paid origination fees. The sweeping changes instituted by CCRAA profoundly changed the economics of the student loan industry overnight and rendered some previously viable business entities unprofitable. On the heels of CCRAA, the subprime mortgage crisis that had begun in mid-2007 brought credit market disruptions that spread to the student loan industry. Early on, the industry merely experienced collateral damage as liquidity in the market for asset-backed securities (ABS), the primary form of financing for student loans as well as mortgages, tightened dramatically. Soon, the market for auction-rate securities, the specific type of debt instrument used in the majority of student-loan financings (including ISAC s) seized up completely, choking off the supply of new capital for student loans. Rather quickly, FFELP lenders experienced a double whammy: CCRAA had dramatically reduced the yield on their loan portfolios and the credit crisis had dramatically increased their cost of funds. Margins plummeted and in many instances turned negative. In some cases, lenders viewed the changes as permanently prohibitive and left the FFELP program for good. Some view the yield reductions as permanent but the capital markets disruptions as temporary and have just suspended participation. Or lenders have remained in the program but have run out of funding and been forced to suspend new loan originations and purchases. 1

2 Respected industry expert Mark Kantrowitz, publisher of the FinAid.org web site, observed: The combined impact of the tightness in the ABS markets and the College Cost Reduction and Access Act of 2007 is a 110 bp to 160 bp reduction in lender spread. One lender joked that Congress took away half their profits and the subprime mortgage credit crisis the other half. Federal Family Education Loan Program (FFELP Loans) In recent months, numerous private lenders have announced their intention to either suspend their participation in the market for originating and/or purchasing federally-guaranteed loans under this program, or to leave it permanently. At first, most of the firms ceasing participation were smaller, newer non-bank lenders that had few reserves and were totally dependent on tapping the capital-markets for the funds to make student loans. Since the FFELP market is mature and had nearly 2,000 lenders, many of them banks with a stable base of low-cost deposits to fund their lending activities, there was little fear of a meaningful drop in the availability of FFELP loans to student borrowers. In fact, some of the nation s largest commercial banks rather quickly stepped up to expand their presence and maintain borrower benefits. However, as the weeks elapsed during the first quarter of 2008, more and more suspensions of participation were announced, first by state agencies and not-for-profit lenders, and then by bank lenders of increasing size and FFELP market share. Among the not-for-profit entities reducing their participation in FFELP are: the Pennsylvania Higher Education Assistance Agency (PHEAA), one of the industry s largest players, which suspended all new FFELP loan originations and secondary market acquisitions; the Missouri Higher Education Loan Authority (MOHELA), which recently announced an operating loss of $12.4 million, the first financial loss in its 27-year history, as well as the suspension of its loan consolidation program and private lending services, and Brazos Higher Education Service Corporation, the largest not-for-profit holder of federally guaranteed student loans in the U.S. (and purchaser of more than $1 billion of IDAPP s loans sold last summer), which recently announced its suspension of student lending and the layoff of 60 percent of its staff. National Education (also the purchaser of more than $1 billion in IDAPP loans last year) has halted the origination of new FFELP loans. Among bank lenders, TCF Bank, M & T Bank and HSBC Bank - all top 50 lenders in the program nationally - recently ceased participation in FFELP. TCF Bank was a leading lender with ISAC, with nearly $50 million in loan guarantees. So far, six of the top ten and 19 of the top 100 consolidation lenders have stopped making consolidation loans, and 15 of the top 100 originators have stopped making Stafford and PLUS loans. These lenders account for 10 percent of Stafford and PLUS loan origination volume and 30 percent of consolidation volume. The Chronicle of Higher Education reported that industry expert Mark Kantrowitz expects only about 15 private FFELP lenders to remain in the program by next year. Due to the significant level of concentration in the lending industry and the fact that the remaining lenders will be among the very largest, he does not anticipate widespread disruption of loan availability. Although there are approximately 2,000 lenders in FFELP, the top 25 provide almost 75 percent of the total loan volume and the top 50 provide almost 85 percent. Some Department of Education officials agree with Kantrowitz, stating that between the concentration of loan volume in large lenders and migration of schools to Direct Lending, a significantly diminished level of federal loan availability is unlikely. Among those lenders remaining in FFELP, it is likely that many borrowers will encounter a reduction in what had become typical borrower benefits, such as interest rate reductions and fee waivers. A survey released last week of the member institutions of the National Association of Independent Colleges and Universities (NAICU) showed that 68 percent of the institutions responding indicated that one or more of their 2

3 lenders are cutting borrower benefits on FFELP loans, and 57 percent reported that one or more of their lenders are no longer providing FFELP loans. DIRECT LOANS The Student Loan Reform Act of 1993 established the Federal Direct Loan Program (DL) as an alternative to the FFELP program. Under DL, loan funds are provided to student and parent borrowers by the Federal Government rather than by private lenders. The educational institution chooses which program it wishes to participate in and the student borrower is obligated to use that program. Direct Lending began with the academic year, and in recent years has seen a gradually declining share of the federally-guaranteed student loan market, with a recent share of approximately 20 percent nationally (and the other 80% coming from private lenders through FFELP). In Illinois, the market share for DL has always been significantly higher than the national average, having been close to 40 percent as recently as FFY2001, declining in recent years to a little over 30 percent. While the co-existence of FFELP and DL has been marked by a heated, ongoing debate over the relative merits and costs of each program, the competition between the two is widely credited with having generated the pressure for private lenders to dramatically improve customer service and cut the cost of borrowing through rate reductions, fee waivers and other borrower benefits. Those in Congress and the industry who have long sought to establish a competitive advantage for DL in the marketplace are trying to capitalize on the recent disruptions in FFELP to advance the pro-dl agenda. Indeed, within the past few weeks, many schools alarmed by the prospects of a disruption in the flow of loan capital to their students for the coming year have begun to explore the possibility of switching from FFELP to DL to protect their students from this prospect, joining others that had already decided to exit from FFELP in the wake of the Student Loan Scandal. Here in Illinois, Northern Illinois University, ISAC s number one public institution in terms of loan guarantee volume, has announced its intention to switch from FFELP to DL, and Augustana College and Olivet Nazarene University have made similar announcements. SCHOOL-AS-LENDER (SAL) PROGRAMS School-as-lender (SAL) programs enable educational institutions themselves to become lenders by partnering with FFELP lenders, such as Sallie Mae, Nelnet and IDAPP. The FFELP lender usually provides the loan capital and then purchases the loans originated, often at a substantial premium. The number of participating institutions has dwindled recently, having peaked two years ago at more than 150, some of whom earned millions of dollars to fund their own need-based aid programs. However, a number of factors quickly gathered momentum to curtail the growth of SAL programs. First, the Higher Education Reconciliation Act of 2005 (HERA) placed a moratorium on new schools entering into school as lender arrangements and tighter restrictions on schools already in such arrangements. Last year, several institutions and lenders grew wary of the programs as they began to draw increased scrutiny under the national focus on student loan business practices and conflicts of interest. Then, following passage of CCRAA, the dramatically reduced profitability of the FFELP program made the SAL programs no longer feasible under their existing cost structures. And finally, most recently, the U.S. Senate included a provision in its Reauthorization bill that would eliminate the SAL program (including the ability for a lender to act as trustee for a school) effective June 30, IDAPP, which once had more than a dozen SAL agreements, has already begun to phase them out. As SAL contracts mature, if the school is out-of-state, ISAC will seek to terminate the agreement; if the school is in Illinois, ISAC will seek to continue the agreement, but attempt to renegotiate under more favorable terms appropriate to current market conditions. PRIVATE LOANS 3

4 These loans, lacking a federal guarantee and subject to fewer regulations and less oversight, operate in much more of a traditional, credit-based environment, both in terms of individual borrowers and loans and also in terms of the underlying financing in the credit markets. Changes in lending practices in these alternative loans have been dramatic and immediate. Quickly, lenders have begun to impose stricter credit underwriting standards, requiring higher FICO scores to qualify for a loan. This is expected to have a disproportionately greater impact on schools that serve lower-income students, primarily community colleges and proprietary schools. Further, more borrowers will probably need a co-signer for their loans. And for the smaller number of students who do qualify to borrow, it is likely that they will pay higher interest rates and higher fees. The recent NAICU survey showed that 46 percent of the institutions reported that one or more of their preferred lenders are tightening credit requirements; 43 percent reported that one or more lenders were no longer providing private loans; 30 percent reported that one or more lenders are reducing or eliminating borrower benefits, and 20 percent reported that one or more lenders were increasing interest rates. FEDERAL GOVERNMENT ACTIONS Federal agencies - most notably the Departments of Education and Treasury - are under increasing pressure to address the possibility of a loan access crisis, particularly in the FFELP program. Philip Day, President and CEO of the National Association of Student Financial Aid Administrators (NASFAA), has sent letters to the NASFAA membership, Secretary of Education Margaret Spellings and the applicable House and Senate Committees suggesting three safety nets to be put in place to ensure continued access to federal loans for all eligible students: 1) a Lender of Last Resort program structured to eliminate administrative obstacles to students; 2) a Direct Loan program prepared to handle a sharp increase in loan volume, and 3) federal intervention to provide liquidity in the financing markets relied upon by many FFELP lenders. Recently, both the House Committee on Education and Labor and the Senate Committee on Health, Education, Labor and Pensions held hearings to discuss the credit market issues and their affect on the future availability of student loans. Let me share a few quotes from the House hearing (courtesy of the Education Finance Council newsletter) which highlight some important perspectives: Ranking Member Rep. Howard Buck McKeon (R-CA) spoke to the level of cuts put forward as a result of the CCRAA and the effect of those cuts in combination with the current market conditions. McKeon noted that, The Federal Family Education Loan program has used innovation to absorb various program cuts and policy changes over the years. However, there is a point at which no further cuts can be absorbed and, in all likelihood, we will not know with certainty that we have reached that point until it s too late. The following statement is critical to maintaining the proper perspective on the work of ISAC and other state-based, not-for-profit loan industry participants. Because, even though this report has been all about loans, it really is not all about the loans. Chuck Sanders, President and CEO of the South Carolina Student Loan Corporation, expressed concern over outstanding debt now in auction rate securities and the difficulty he and other not-for-profit providers have had in securing necessary financings. He also spoke to a number of value-added services for students that would be lost should his organization and others like it no longer participate in FFELP. The current market situation directly affects what we can do to serve students and families in our states, he said. If my organization ceased to be a partner in the FFEL program, not only would a local missionbased organization vanish and 235 dedicated and service-minded employees be out of a job, but critical services would also be unavailable to our citizens. These include financial literacy programs, college planning, career planning, outreach, debt management programs, teacher and military loan forgiveness programs and training opportunities for higher education professionals, to name a few. 4

5 And although the current situation presents many challenges, let me close on a more optimistic note by quoting the minutes of our last meeting that you approved earlier today: Mr. Davis observed that it has been approximately one year since he became Executive Director and noted what a difference a year makes. A year ago, he recalled, he was greeted with some initial skepticism regarding the future of ISAC, and today he was delighted to report that the agency is alive, vital and strong, and in an excellent position to respond to events in the economy and elsewhere. In fact, he stated, based on observing recent events in the industry as it responds to the credit crisis, the agency appears to have positioned itself far better than many of its counterparts in the private sector. He thanked the Commissioners for the sound decisions they have made and the policies they have adopted, as well as the staff for their hard work and tireless efforts toward achieving the agency s mission. The changes that have been made in the agency s balance sheet, and the structural changes that have taken place, have put the agency in a position to do what many others in the industry are unable to do, and this bodes well for the students of Illinois. # # # Thomas A. Breyer, ISAC Senior Policy Advisor and a 30-year veteran of college financial aid, presented this analysis of the recent turbulence in the student lending industry to the ISAC Board at their April 4, 2008 meeting at University of Illinois at Springfield. 5