Student Loans as Asset Backed Securities
Many people are familiar with the phrase “commercial mortgage backed security” or CMBS. But what you may not be aware of is, that a CMBS is only one of several types of asset backed securities. The concepts behind CMBS can be just as easily applied to any number of other assets such as auto loans and credit card debt. In this article, we’ll take a brief look at how it’s possible to invest in student loans.
A Quick Recap
Since we’re using commercial mortgage backed securities as a reference point, it’s worth taking a moment to review what a CMBS is. In short, investors purchase shares from a trust that invests in multiple mortgage loans. As those loans are repaid, the investors receive payments of interest and principal. Investors also have the option of selecting a tranche, which is a way of deciding how much risk they’re willing to take on. Like most investments, lower risk investments have more modest returns, while riskier investments, when they go well can lead to more significant returns.
For a more thorough explanation of CMBS and tranching, please see my earlier articles on Commercial Mortgage Backed Securities.
Student Loan Asset Backed Securities (SLABS) operate just like their CMBS counterparts, wherein the loans are packaged into securities and investors have the opportunity to purchase shares. As loan payments are made, investors receive payments of both principal and interest.
Through the process of securitization, SLABS provide investors another asset to pursue or another place to invest their money. Every investor has different preferences including risk tolerance, time frame, and return potential. Many investors also prefer to invest in something they’re familiar with. With over 43 million borrowers in the United States alone, there are a lot of people who have personal experience with student loans.
Another benefit is that when more people invest in student loan securities, there is more money available to be given out in the form of new loans to new borrowers. When the system works properly, it feeds off itself and benefits people on both sides. More borrowers mean more loans to sell to investors and more investors looking to buy loans mean more opportunities to originate loans.
Repeating Past Mistakes?
Wary of how residential mortgage backed securities (RMBS) factored into the Great Recession, many people are wary of SLABS and other asset-backed securities. When homeowners were given loans that they couldn’t afford to pay, they began to default. This led to rampant foreclosures. Borrowers lost their homes and investors lost their investments.
If students are not able to find high enough paying jobs, they won’t be able to pay back their student loans. While the borrowers won’t lose their homes this time around, investors still stand to lose money.
Not all loans are created equal. Student loans and mortgage loans have two key differences. The first is that there is no collateral. If a person defaults on their student loan, the lender has nothing to recover. They can’t foreclose or repossess anything. The other major difference is that student loans are not discharged in bankruptcy.
So, what does that mean for investors of SLABS? If there’s no collateral and no opportunity for foreclosure or repossession, then it’s to the advantage of the lender (and the investors who purchase SLABS) to give students more time in hopes that conditions will change. An unemployed graduate today may find work tomorrow and start making payments.
Knowing that even in bankruptcy student loans cannot be discharged or dismissed, means that even if things get extremely bad, even if accrued interest gets out of hand, the loans will remain valid. Some borrowers may just ignore it, take the hit on the credit report and credit score, and move on with their lives. Others may eventually get to a better place and start to make payments again, even if its years in the future.
However, investors in SLABS may get impatient. They won’t be willing to wait endlessly for payments that may or may not materialize. This may lead to the selling to student loans at highly discounted rates. Just as we saw with mortgage loans, nonperforming student loans may be sold for pennies on the dollar.
The original investor may take a loss, but at least they can move on. The newer investors (those who bought the student loans for pennies on the dollar) will hope to profit by collecting a fraction of what’s owed. The market and the ability to collect on delinquent student loans will determine just how much the loans will need to be discounted in order to offload them in the secondary market.
It’s said that those who do not learn from the past are doomed to repeat it. As the memory of mortgage backed securities and the financial crash of 2008 becomes more of a distant event, there will likely be more people willing to invest in SLABS.
If graduates are able to repay their debt, which would assume that sufficiently well paying jobs are available, perhaps the SLABS industry could learn from the mistakes of RMBS and begin to operate as intended. On the other hand, increasing tuition rates, a slow economy with limited employment opportunities, and the complexity of securitization and tranching could lead many investors to lose money, repeating the woes of earlier investors in other asset backed securities.
With nearly $2 trillion in outstanding student loans there will certainly be ample opportunities for those who want to invest in SLABS. Hopefully though, the lessons of the past will make for more educated and disciplined investors.