Mounting Student Debt Is Reshaping The U.S. Student Loan Market

STRUCTURED FINANCE RESEARCH Mounting Student Debt Is Reshaping The U.S. Student Loan Market Primary Credit Analyst: Erkan Erturk, PhD, New York (1) 212-438-2450; erkan_erturk@standardandpoors.com Business Leader, North American ABS: Michael J Binz, New York (1) 212-438-2401; michael_binz@standardandpoors.com Table Of Contents More Students Are Carrying More Debt College Education Is Less Affordable Higher Default Rates Among For-Profit School Graduates Rising Debt's Limited Impact On Student Loan ABS Growing Debt Could Hurt Household Finances WWW.STANDARDANDPOORS.COM/RATINGSDIRECT AUGUST 13, 2012 1

Mounting Student Debt Is Reshaping The U.S. Student Loan Market U.S. student debt outstanding has quietly grown an average of more than 10% annually to nearly $1 trillion since 2003, eclipsing auto loan and credit card debt for the first time in 2010. In the run-up to such record numbers, the federal government's takeover of most student lending looms large, even as some are calling into question the value of a college education. Students are confronting rising college costs even as employment opportunities continue to diminish. Tuition is increasing more steeply than the consumer price index, college affordability is falling, and students are borrowing more to finance college educations. The result is that many students graduate with more limited means to pay off larger debt, and student borrowers are defaulting more often, signaling a fundamental shift in the student loan market and growing pressure on household finances. Underpinning this fundamental shift are questions about what has caused the significant growth of student debt, the implications for household finances and consumer spending, and college affordability. Overview Student debt has been growing at a much higher rate than other consumer assets, such as auto and credit cards, since 2003. While the growth mainly comes from government funds or guarantees, the rise of excessive student borrowing could negatively affect consumer finances in the future. Although education typically results in lower unemployment and higher pay prospects for those graduates, the rising cost and elevated unemployment rate for new college graduates call into question the value of a college education, especially in recent years. Default rates are higher, while graduation rates are lower for for-profit schools. College enrollment has increased the most for for-profit schools in recent years, and those students borrow the most, signaling a potential imbalance in that segment of the market. Weakness in the U.S. economy has hit graduates of for-profit colleges and universities harder than graduates of traditional schools. For-profit schools tend to focus on career and vocational education more than traditional academic subjects. The percentage of for-profit enrollment has increased at a higher rate than for both public and private institutions of higher learning, to 10% of total enrollment in 2009 from 4% in 2000, according to the latest figures available from The College Board. Easy access to student loans and financial aid has been a significant recruitment tool to increase enrollment at for-profit schools. However, the latest data from for-profit school financial statements seem to suggest that new student enrollments at for-profit schools have been declining since 2010. These schools have lower graduation rates, and their students tend to default at higher rates with greater debt than graduates of not-for-profit colleges, according to data from The College Board. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT AUGUST 13, 2012 2

Another factor that could affect private student loans and securitizations of them is the Consumer Financial Protection Bureau (CFPB) and the U.S. Department of Education's suggestion to make it easier for private student loan borrowers to discharge certain student debt in a bankruptcy. This would reverse Congress' 2005 amendment to the bankruptcy code, which made it nondischargeable. More Students Are Carrying More Debt With the U.S. economy shedding millions of jobs during the financial crisis and its aftermath, many students are choosing to prolong their studies--and many have returned to school to deepen their skills until the job market revives. Either way, far more students are shouldering much more debt these days. In fact, as consumers have borrowed less and reduced debt in other areas--autos and especially credit cards, for example--student borrowers have bucked that trend. Growing student debt has implications for household finances, consumer spending, and even for economic growth. In particular, it could dampen consumer spending and household obligation ratios. Consumers saddled with student loan debt have less to spend and are likely to delay home purchases. Lower spending means lower economic activity and weaker job creation. This, in turn, would reduce GDP and increase unemployment rates, causing more consumers to default on their obligations. Unlike other consumer finances, student debt is nondischargeable in a consumer bankruptcy filing, so higher defaults haven't necessarily slowed down the growth in student debt. In addition, the housing downturn has had little impact on growth--even home equity lines of credit outstanding have declined as consumers have continued borrowing from the government for their college needs. Roughly $904 billion in student loan debt was outstanding by the end of the first quarter of 2012 (see chart 1), and it's a trend Standard & Poor's Ratings Services believes will generally continue going forward. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT AUGUST 13, 2012 3

Chart 1 The federal government dismantled the Federal Family Education Loan Program (FFELP) in 2010 and replaced it with its Direct Lending Program, combined with more financial aid and easier access to federal loans with no underwriting, which could encourage colleges and universities to raise tuition. The U.S. government has dominated new student loan originations through loans or guarantees over the years (data available since 2000; see chart 2), accounting for roughly 84%, compared with the private sector's 16%. However, since 2009, private student debt represented less than 10% of total originations, given fewer issuers, tighter underwriting standards, and growth in federal loans to parents under the Direct Lending program. With the government's new Direct Lending Program, we expect federal loan originations to continue to dominate the student loan market going forward. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT AUGUST 13, 2012 4

Chart 2 College Education Is Less Affordable College education has been less affordable as the cost of education has grown higher than the overall consumer price index over the years. While the education cost index increased 96% since 2000, overall consumer prices rose 35% during the same period, according to the Bureau of Labor Statistics (see chart 3). Average tuition and fees, after adjusting for inflation, at public and private four-year colleges and universities, rose 55% and 33% since 2000, respectively, according to the College Board. However, the median household income rose 18% during the same time, highlighting a growing pressure on household spending and financing decisions. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT AUGUST 13, 2012 5

Chart 3 Higher Default Rates Among For-Profit School Graduates The collision of additional available credit in the system and rapidly growing debt can often cause an imbalance between demand and supply in any sector. For student loans, this imbalance has perhaps been most acute in the for-profit college world. These schools tend to have lower graduation rates, and their students generally have more debt and a higher propensity to default on their loans (see chart 4). Yet enrollment at for-profit schools has increased at a higher rate than at other types of schools through 2009, which is the latest data available from The College Board. However, the latest for-profit company statements indicate that new student enrollments at for-profit schools have been declining since 2010. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT AUGUST 13, 2012 6

Chart 4 Borrowers who graduate with a four-year bachelor's degree from for-profit schools tend to borrow more than others, according to The College Board. An estimated 53% of students attending for-profit schools leave carrying at least $30,000 in debt compared with 24% for private non-profits and 12% for public universities (see chart 5). WWW.STANDARDANDPOORS.COM/RATINGSDIRECT AUGUST 13, 2012 7

Chart 5 The U.S. Department of Education took measures to prevent for-profit college students from graduating with too much debt, requiring at least 35% of graduates to be in a position to repay their loans for the college to qualify for federal student loans or grants. However, in June 2012, a U.S. district judge struck down that ruling, finding it arbitrary. We believe the U.S. Department of Education will continue proposing new rules for qualification of federal student loan eligibility in the future. Rising Debt's Limited Impact On Student Loan ABS Rising student debt and elevated default rates are likely to have a limited adverse impact on student loan ABS transactions. Student loan defaults and delinquencies have stabilized in recent months but are still elevated because of high unemployment. We believe default rates are likely to remain high as long as unemployment does, especially for new college graduates (see chart 6). Since most of the existing student loan ABS transactions still carry the FFELP guarantee of a minimum 97% of a loan's value in the event of a default, the rise in student debt has little impact on credit performance. The private student loan ABS market, which constitutes roughly 18% or $42 billion of $234 billion in outstanding student loan ABS, however, is more susceptible to credit volatility because it lacks such guarantees, although those loans benefit from cosigners and credit evaluations through underwriting processes. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT AUGUST 13, 2012 8

Private student loan ABS collateral could weaken if Congress amends the bankruptcy code to make it easier to discharge private student debt in bankruptcy, in our view. A new report from the CFPB on July 20, 2012, recommended reforms in the private student lending market, with the White House's support, making it easier for borrowers to discharge certain student debt in bankruptcy. This potential change in the bankruptcy code could lower loan originations and increase interest rates on these loans because lenders would be undertaking greater risks. However, about 90% of private student loans in 2011 had cosigners, and we believe having a cosigner is likely to help mitigate the frequency of defaults resulting from bankruptcies because a borrower and coborrower are unlikely to both file for bankruptcy. Chart 6 Growing Debt Could Hurt Household Finances Although the growth in student debt mainly comes from government funds or guarantees, it could hurt household finances and consumer spending in the future, while making college education less affordable and creating imbalances in the student loan market. Rising student debt, along with the higher cost of college education and the high unemployment rate for new college graduates, has reduced the value of a college education in recent years. Another potential imbalance is in the for-profit schools, where students borrow the most with high default and low graduation rates. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT AUGUST 13, 2012 9

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