March 26, 2006
An Upside-down View of the Student Loan Industry
At first leading economists said that student loans were not possible because students did not have collateral to guarantee the loans as, for example, a building is collateral for a mortgage loan. Then government stepped in with student loan guarantees to remedy the above situation in effect making all tax payers the guarantors. Seeing that students did pay back their loans, and seeing a good profit, the private sector got into the business.
How does the private student loan industry look to the traditional observer? My best guess is as follows: Banks are at the center of the business, after all, they are the ones doing the lending. In the periphery there are the schools that need to make sure the students have the money to pay for the tuition and there are facilitators that take care of the messy details like origination, collection and securitizing. According to this view, the banks are in the drivers seat.
But what if that view is all wrong?
According to Our Brave New World by GaveKal Research, "things are different this time." Assuming they are right then let's have a look at how private student loans really work.
One thing is fairly obvious, if the loans are being securitized and sold, then banks don't want to have the loans on their books. In other words, banks are only temporary lenders, facilitators for the trusts that eventually buy the loans. If First Marblehead is doing three securitizations per year then the loans live on the bank's books for about 4 to 6 months. If the trusts are the final destination of the loans, then it's not the banks that set the rates and other conditions but the trusts, albeit indirectly.
Since banks have "outsourced" the management of the student loans, they no longer decide who gets approved or who gets denied except, again, indirectly. This "intelligence" passes to the facilitator who deals with it with the help of the student loan database.
The trusts that buy the securitized loans want as little risk as possible so there is another intermediary who takes care of that, either an insurance company or TERI in the case where the facilitator happens to be First Marblehead.
The question now becomes: Is there a market for these securitized loans? Here is where Our Brave New World comes in. The Malthusian doom sayers hold that exporting jobs and importing goods is not sustainable on account of the trade deficit it creates. GaveKal Research counters by saying that foreigners get rid of their excess dollars by buying American assets such as Florida real estate and they show some statistics that indicate that at most foreigners cannot buy more that around 2.2% of existing American assets and they contend that these assets are growing as fast or faster than the foreigners can buy them.
My contention is that foreigners are not limited to buying American real estate which has a fixed supply. They are not limited to buying shares in American companies which are not so limited. Now they can also buy American student loans. Securitizing converts a risky student loan into a security with a much lower rate of risk, that is its whole purpose. Curiously, if foreigners do buy securitized American student loans, they are helping America stay ahead by financing American education! But this is not the gist of my argument, only a necessary detour.
Before coming to the conclusion let me add that banks are not the only "sources" for private student loans. There are many other albeit smaller players that are currently being "recruited" by First Marblehead.
From all the above I would conclude that it is not the banks that are at the center of the private student loan industry but those who currently are looked upon as the facilitators, in a word, First Marblehead. Let's look at it from this new perspective.
Students want an education. Schools want students. Students are strapped for cash to pay for it. Banks and others are willing to be short term lenders. Specialized trusts are willing to be long term lenders. What is the missing ingredient that makes it all happen? The facilitator. Looked at it this way, it is First Marblehead that is outsourcing the short term lending to banks and others just as platform companies outsource the manufacturing to industries in the less developed world. The intelligence is not in the money, it is in the process from setting up loan programs, originating loans to students, securitizing the loans and selling them to the trusts. This intelligence belongs to First Marblehead, not to the banks or to other "lenders."
Twenty years ago students needed money for education just as they do today. Twenty years ago banks had to the money to lend but didn't because they could not figure out how to collateralize the student. This is the expertise that First Marblehead brings to the table and, IMO, what puts them in the driver's seat.
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