Student Lenders Pull a Failing Grade

This column was written by Stockpickr member Ira Krakow.

Open up any major newspaper and you can't miss the bad news about the student loan industry. Major banks that fund student loans such as JPMorgan Chase(JPM Quote) and Citibank(C Quote) are withdrawing student lending at certain schools. Prominent loan guarantor The Education Resources Institute (TERI) declared Chapter 11 bankruptcy on April 10, 2008, knocking its for-profit origination partner First Marblehead(FMD Quote) down to a 52-week low of $4.49 from a 52 week high of $42.50.

What caused all of this? The answer lies in two parts. Part 1 is legislative. In the fall of last year, Congress passed the College Cost Reduction and Access Act (CCRAA), which slashed subsidies for banks and lenders in the Family Federal Education Loan (FFEL) program. This program is responsible for connecting banks to federal student loans such as the Federal Stafford Loan. These loans, previously profitable loans for banks and lenders participating in FFEL, shaved off up to 72% of the value of the loans, making them less appealing for securitization due to lower yields, and reducing the default insurance protection from 97 cents on the dollar to 95 cents on the dollar.

In their most recent earnings report, SLM Corporation(SLM Quote), commonly known as Sallie Mae, the largest student loan lender in the country, recently stated that due to the CCRAA, virtually all of its federal student loans are being originated at a loss. This, in turn, makes the sale of these student loans much more difficult. Sallie Mae reported a $104 million dollar loss in the First Quarter of 2008.

The second part is the credit crisis' continuing impact on virtually all forms of lending. Beginning in August 2007, the mortgage market implosion began to drain capital from banks and investors. This in turn caused sales of student loan asset backed securities (ABS) and auction rate securities (ARS) to become more and more difficult. This has especially impacted state student loan agencies that float bonds to raise capital, such as MEFA, the Massachusetts Educational Financing Authority, which recently announced a suspension of federal student lending effective July 1.

Large student loan companies such as Sallie Mae, CIT(CIT Quote), and The Student Loan Corporation(STU Quote) raise capital through the same method and have been impacted as well, issuing no securitizations in 2008. Equally impacted have been private student lenders such as First Marblehead and My Rich Uncle, who rely solely on securitization to obtain lending capital.

The net effect has been a sector decline of 62% over the past 52 weeks with no sign of recovery in sight. While Congress, the Department of Education, and various agencies are working to provide some short-term solutions, no broader recovery is possible until the credit crisis abates or additional sources of liquidity are tapped. One proposal currently being debated is opening up the Federal Reserve's Term Securities Lending Facility (TSLF) to student loan agencies to exchange federal student loan debt as collateral for liquidity, but no firm solution has been created yet.

Students seeking financing for their education face increasingly strict credit criteria for private student loans and more lenders withdrawing from federal student lending. Students, parents, and families should seek out scholarships and obtain financing as soon as possible; investors in the student loan industry would do well to carefully monitor the mortgage-backed securities markets for signs of recovery there. As stability returns to the securities markets, expect the student loan industry to recover in tandem.

Editor's Note: Ira would like to thank Christopher Penn, who did the research for the article. Christopher is the Chief Technology Officer of the Student Loan Network, an FFEL lender based in Quincy, MA. He is host and producer of the Financial Aid Podcast, a daily internet radio show about paying for college. Disclosure: Mr. Penn owns one share of FMD and one share of UNCL for a combined total worth of $5.32.