NEW YORK (MainStreet) — Recent graduates aren’t the only ones feeling the burdens of student debt. There’s an increased interest from banks and financial institutions to rid themselves of government-guaranteed student loan assets.
“There’s a lot of sell portfolios sitting on bank balance sheets,” said Brendan Sheehy, director of financial institutions at Fitch Ratings.
Case in point: On July 11, Wells Fargo & Company (WFC) - Get Report revealed it had transferred its $9.7 billion Federal Family Education Loan Program (FFELP) portfolio to held-for-sale during the second quarter. That announcement followed a move from CIT Group (DEL) CEO John Thain, who in April sold his company’s $3.6 billion FFELP portfolio to federal loan servicer Nelnet Inc. All told, large U.S. banks that could eventually sell FFELP assets, including Wells Fargo, JP Morgan Chase (JPM) - Get Report , Bank of America (BAC) - Get Report and U.S. Bancorp. (USB) - Get Report own approximately $24 billion of government guaranteed loans. Brazos Group (BRZL) , PNC (PNC) - Get Report , Access Group, SunTrust (STI) - Get Report and Northstar Guarantee also have sizable FFELP portfolios to sell off.
Why now? New regulatory requirements have made student loan assets less lucrative for banks and more burdensome. And though banks had been hesitant to sell their federal student loan portfolios because of the dearth of opportunities to reinvest money from potential sales, that’s changed. Improved prospects in core businesses – particularly auto loans – and greater interest from potential buyers have compelled more banks to explore potential sale opportunities with student loan servicers.
But that scenario could spell danger: in light of the student loan crisis and the looming potential for a subprime auto loan crisis, sales of assets from one crisis could be fueling another. Auto loans to people with subprime credit – those who have credit scores under 640 – have jumped 130% in the last five years. Banks, in turn, are looking to capitalize on that demand by putting money from FFELP sales toward subprime auto loans, with high rates and robust profits investors like to see.
Student Loan Run-Off
The route here was simple: federal education loans made through FFELP are in a wind-down situation, since there have been no new FFELP loans as of July 1, 2010 following the Health Care and Education Reconciliation Act of 2010. That means FFELP loans will continue to deliver increasingly meager returns for banks until they start netting a loss.
“Eventually, the servicing costs on these loans will exceed the interest revenue, since servicing costs are proportional to the number of borrowers while interest revenue is proportional to the loan balances,” said Mark Kantrowitz, a student loan expert who is senior vice president and publisher of Edvisors.com.
“Every quarter that goes by, you lose scale in this business, and at some point, it becomes unprofitable,” Sheehy said.
With loan balances in these portfolios down about 20 to 25% since the peak in 2010, the revenue wears thin. As banks see this point of inflection growing nigh, where they’ll move from slight profit to actual loss, they are making an exit.
School Rules Punish Returns
In the wake of the Great Recession’s credit crisis, banks are held to more stringent lending regulations that make it no longer economical to hold assets like FFELP loans.
Basel III in particular, part of the capital adequacy requirement to be phased in through 2019, requires banks to hold 8% of capital on all Tier 1 risk-weighted assets, including credit card loans, mortgage loans and federally guaranteed student loans.
Essentially, for every $100 of risk-weighted assets lent, a bank will need to hold $8 of Tier 1 capital in reserve. For FFELP assets, which have a 20% risk weight, banks would have to hold $1.20 (20% of $8) for every $100 lent. By contrast, student loan servicer Navient Corp. (NAVI) - Get Report has typically held 0.50% of capital against FFELP assets, or $0.50 cents for every $100.
That means banks have a lot of cash tied up, comparatively.
“Holding a greater amount of capital will put downward pressure on returns, all else equal,” Sheehy said.
FFELP portfolios have never been particularly profitable. “It’s one of the lowest yielding assets out there,” said Sheehy. “It’s more capital punitive than you’d expect.”
Still, banks got into the student loan business historically, because they wanted to be full-service lenders.
“Some also pursued it as a loss leader to gain other business from parents or future business from the borrowers,” Kantrowitz said.
But that was before they had to hold so much capital against these assets. Plus, as part of the regulatory burden for this asset class, there are added risks, like Sen. Elizabeth Warren’s (D-Mass.) student loan refinancing proposals, which could affect the profitability of existing loans. Even without Warren’s proposals, if a borrower consolidates a FFELP loan, the lender loses the loan; that means there’s a high prepayment risk for a holder of FFELP loans.
“Banks tend to be more conservative in their investments and so may be moving away from federal education loans to reduce their risk exposure,” Kantrowitz said.
As banks set their sights on acquiring auto loan assets, they are meeting an eager market of buyers looking to take their student loan assets off their hands.
Student loan servicers like Navient and Nelnet, which already hold sizable FFELP portfolios and service federal student loans for the Department of Education (ED), are hungry for these FFELP portfolios.
Sure, they are, like banks, holding these government-guaranteed student loans in run-off. Yet precisely because they are not banks, they are not subject to the same regulatory capital requirements. And they have another major advantage.
“They have the economy of scale to make servicing the loans profitable even when the loan balances remaining drop below 10% of the original loan balances,” Kantrowitz said.
Whereas Wells Fargo had near $10 billion in its sell portfolio, Navient, for example, has ten times that – a $100 billion FFELP portfolio.
“That means an incremental cost to put [FFELP loans] on their servicing platform to very easily generate incremental earnings that flow down to the bottom line,” Sheehy said. In other words, because there aren’t a lot of expenses for Navient and Nelnet to handle these loans, the revenue is largely net income.
The spread on Navient’s FFELP loans was 0.98% at quarter end June 30, 2014, an annualized number and represents what Navient will earn on an annual basis via net interest income.
FFELP portfolio acquisitions would be positive for the credit profile of Navient and Nelnet, as they would create additional earnings capacity and potentially extend the duration of the companies’ existing FFELP portfolios.
That could mean aggressive auctions. Navient, which acquired CIT’s portfolio, said the bidding process was competitive. Non-bank financial institutions may have had difficulty buying loan portfolios due to a lack of capital to acquire the portfolio. Yet according to Credit Suisse equity research, both Navient and Nelnet recently increased their credit lines, which could be a telltale sign they may want to bid on the Wells Fargo portfolio.
Nelnet has said it would acquire a large portfolio piecemeal over a period of time. Navient, by contrast, has the war chest to purchase the Wells Fargo portfolio in one fell swoop.
In Navient’s second quarter earnings call on July 17, 2014, Navient president and CEO Jack Remondi discussed why his company is well-suited to acquire the WFC portfolio.
“We think we’re a strong buyer because of our scale, our cost efficiency, what we bring to the loan performance itself through default prevention,” he said. “When we can pick up portfolios, particularly if we can put them on our system for servicing, those are benefits – distinct advantages for us.”
The acquisitions have an added wrinkle: this year, Sallie Mae spun off its student loan servicing arm, now dubbed Navient, from its consumer banking business.
“Because Navient doesn’t originate student loans anymore, they might be slightly more aggressive in bidding for these assets,” Sheehy said.
Also, with borrowers having paid down as much as a quarter of their loan balances, the lenders may now have cash available to buy some loan portfolios. The loan portfolios have also matured – most defaults occur within the first four to five years after entering repayment – so the cash flow characteristics are more predictable.
Opportunities Rev Up
That clears the track for banks to get deeper into auto loans.
Beyond the heightened costs and lower returns of FFELP loans, demand in the consumer credit market has created opportunities for banks and financial institutions to redeploy money made on government-guaranteed student loan sales.
There’s interest in credit card loans, commercial and industrial lending and middle market commercial lending, but the demand for auto loans is particularly hot.
Banks in the U.S. have $370 billion in auto loans owed to them, up 20% from 2012.
That’s good news for them: banks can earn a higher spread on auto loans compared to FFELP loans. They get 5% to 6% on prime loans, and those margins grow down the credit spectrum as borrowers veer increasingly subprime.
Of course, this is a process with the potential to spin out of control. As with the mortgage boom, banks and private equity firms are investing in lenders to make money available for loans and thus fuel subprime auto loans.
But like chopped up and processed subprime mortgages before the Great Recession, these subprime auto loans are often bundled into complex bonds, a hodge-podge of asset-backed securities. Banks, in turn, hawk these to insurance companies, mutual funds and public pension funds. That creates still more demand for the auto loans.
But as the history of the housing bust reveals, this could be a case of reckless driving.
The student loan crisis – with student loans held or guaranteed by the federal government surpassing the $1 trillion mark and more than $1.2 trillion in outstanding student loan debt – has attracted much attention for its burdens on the economy: debt-saddled Gen X-ers and Millennials have experienced a delayed onset adulthood with major purchases pushed back.
But this particular flow of student loan assets, sold off by banks to get into troubled auto loans, could potentially spell more trouble for the economy at large.
A Standard&Poors report from July suggested that delinquencies on auto loans resemble the state of non-performing mortgages prior to the Great Recession. That implies the ramifications could be grave.
“In our opinion, we’re at a turning point with respect to subprime auto loan performance, similar to where we were in 2006,” S&P analyst Amy Martin wrote in her analysis.
--Written by Ross Kenneth Urken for MainStreet