The student loan industry is resigned to disappointment. President Bush signed a bill today that cuts subsidies and increases grants. The bill will reduce profitability at all student loan lenders. It is a prime reason why the buy-out of Sallie Mae (SLM) by a group led by JC Flowers is facing rocky times. The terms of the deal were set at a time when funding for buy-outs was easily obtained and investors were more willing to accept riskier deals. The increased risk due to this bill and today’s credit market situation where investors are demanding higher risk premiums has put this deal in jeopardy. I agree with JC Flowers -- they deserve a better deal.
How the bill affects student lending
One of the ways lenders make money is through the subsidies paid by the U.S. Education Department on subsidized loans in the Federal Family Educational Loan (FFEL) program. The FFEL program consists of Stafford and PLUS loans. Stafford loans are the first ones financial aid administrators advise students to obtain; therefore, they are probably the most popular type of student loan at schools not in the direct lending program. Stafford and PLUS loans are a huge portion of every lenders portfolio so reducing the amount the government will pay essentially reduces the lender’s margin on each subsidized loan. The subsidies are based on aggregate amount of borrower interest accrued during certain periods in the life of the loans in the loan portfolio. It is expected that subsidies will be reduced by about $20 billion per year. By way of comparison, in 2006 there were about $23.3 billion in subsidized Stafford loans issued, $23.8 billion in unsubsidized Stafford loans and $8.3 billion in PLUS loans. There is close to $600 billion dollars in FFELP loans that have been issued since 1966.
Equally if not more troublesome is the fact that this bill also puts in motion a process whereby the interest rates on student loans would be halved over a four year period. If cost of capital rises while federally mandated interest rates decline, lender profits will be significantly squeezed. It is unlikely that lenders can make up for this kind of margin compression via origination fees, late fees, handling fees, etc. though they will certainly try.
In terms of grants, Congress is increasing Pell grants for low-income students. Students with grants will obviously need less in the way of loan money so this will impact loan volume. The Democrats claim they are replacing the funding, around $12 billion, that was reduced by Republicans in previous years so this may end up being a wash.
Another change that will reduce lender profitability is related to PLUS loans. These loans are part of the FFEL program and are made to parents to pay for the education of their children. Instead of rates being set in Washington, the government will now auction off the right to make federally-backed educational loans to parents in each state, instead of setting the rate from Washington. The two lowest bidders will win the right to make subsidized college loans to parents. This increases uncertainty about expected loan volumes and will tend to result in lower rates for borrowers (ie, lower margins for lenders).
Lenders will try to offset losses but...
Besides increasing fees, lenders have the option of tailoring their private loan products in ways to increase profitability. Private loans are increasingly important to both borrowers and lenders as the FFEL program has annual loan limits that are far below the cost of education for most schools. Look for lenders to set these loans to higher interest rates.
Impacts on Sallie Mae underestimated
Sallie Mae claims that the impacts of this bill will be limited to merely 2% or so of "core earnings" net income over five years. Given all the implications of the legislation as described above, 2% seems like a huge underestimation of the true negative impact. To reduce the impact to only 2%, I can only think that Sallie Mae intends to securitize large portions of their portfolio. That is like selling the furniture to get through a short-term rough patch. I agree with JC Flowers -- this deal should be renegotiated.
Disclosure: author owns no shares of Sallie Mae
How the bill affects student lending
One of the ways lenders make money is through the subsidies paid by the U.S. Education Department on subsidized loans in the Federal Family Educational Loan (FFEL) program. The FFEL program consists of Stafford and PLUS loans. Stafford loans are the first ones financial aid administrators advise students to obtain; therefore, they are probably the most popular type of student loan at schools not in the direct lending program. Stafford and PLUS loans are a huge portion of every lenders portfolio so reducing the amount the government will pay essentially reduces the lender’s margin on each subsidized loan. The subsidies are based on aggregate amount of borrower interest accrued during certain periods in the life of the loans in the loan portfolio. It is expected that subsidies will be reduced by about $20 billion per year. By way of comparison, in 2006 there were about $23.3 billion in subsidized Stafford loans issued, $23.8 billion in unsubsidized Stafford loans and $8.3 billion in PLUS loans. There is close to $600 billion dollars in FFELP loans that have been issued since 1966.
Equally if not more troublesome is the fact that this bill also puts in motion a process whereby the interest rates on student loans would be halved over a four year period. If cost of capital rises while federally mandated interest rates decline, lender profits will be significantly squeezed. It is unlikely that lenders can make up for this kind of margin compression via origination fees, late fees, handling fees, etc. though they will certainly try.
In terms of grants, Congress is increasing Pell grants for low-income students. Students with grants will obviously need less in the way of loan money so this will impact loan volume. The Democrats claim they are replacing the funding, around $12 billion, that was reduced by Republicans in previous years so this may end up being a wash.
Another change that will reduce lender profitability is related to PLUS loans. These loans are part of the FFEL program and are made to parents to pay for the education of their children. Instead of rates being set in Washington, the government will now auction off the right to make federally-backed educational loans to parents in each state, instead of setting the rate from Washington. The two lowest bidders will win the right to make subsidized college loans to parents. This increases uncertainty about expected loan volumes and will tend to result in lower rates for borrowers (ie, lower margins for lenders).
Lenders will try to offset losses but...
Besides increasing fees, lenders have the option of tailoring their private loan products in ways to increase profitability. Private loans are increasingly important to both borrowers and lenders as the FFEL program has annual loan limits that are far below the cost of education for most schools. Look for lenders to set these loans to higher interest rates.
Impacts on Sallie Mae underestimated
Sallie Mae claims that the impacts of this bill will be limited to merely 2% or so of "core earnings" net income over five years. Given all the implications of the legislation as described above, 2% seems like a huge underestimation of the true negative impact. To reduce the impact to only 2%, I can only think that Sallie Mae intends to securitize large portions of their portfolio. That is like selling the furniture to get through a short-term rough patch. I agree with JC Flowers -- this deal should be renegotiated.
Disclosure: author owns no shares of Sallie Mae
Comments
Now we are bullish on Indian Stock/Share market to see on new highs. Now Sensex is due to kiss 18000 mark Till Diwali or beforeDiwali. So now starts count on us to see Sensex on 18000 Mark.
Now BEST Buy is INFOSYS for Trgt 2000-2100. RELCAPITAL for Trgt 1800, RNRL For Trgt 100-110 & APIL for trgt 1000
Regards.
Sai Stocks n Shares
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