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Next time you sit down to sign your monthly student loan check, consider this: Somebody out there is trading bonds made up of thousands of loans like yours, profiting off your inability to pay for college. And it's not just the guy that lives in a way nicer apartment across the street and dons spiffy suits on his way downtown every day. It's also high rollers like him in Chicago, London, and Tokyo.
Sound ugly? Well, that's the way the student loan business works. Private lenders like Sallie Mae, and even state agencies, are increasingly funding college loans through capital markets. The bonds are an easy sell because most student loans are 98 percent guaranteed by the U.S. government. If Joe College decides to move to Sweden and never pay a dime on his debt, Uncle Sam picks up the tab. Plus interest.
What investor could refuse an offer like that? "You put it out there, and people eat it up," said one veteran banker.
Congress is presently considering whether the government should, if not end the party, at least turn down the music and raise the lights. It's been one big bacchanal so far. Last month, the Senate passed a bill that would limit the growth of loans qualifying for one generous federal subsidy, but left other substantial handouts in place.
This year alone, industry leader Sallie Mae has already issued $31 billion in bonds guaranteed by student loans. Since the banks that help sell these bonds, known as underwriters, get about 1 percent of the sale for their efforts, Sallie Mae's issuance should translate into at least $310 million in bank fees. And that's just Sallie Mae. Over a dozen other lenders, private and public, are also sharing the profits of your misery with bankers.
There are similar markets for credit card debt and home mortgages, but right now the growth is in student loans. Each year, 13 million people apply for federal student aid; the Department of Education expects to grant about half those petitions in loans this year, to the tune of $52 billion. The typical undergraduate leaves school owing $19,000, or double what the average 1997 graduate owed. In the bigger scheme of things, 70 percent of all federal student aid comes in the form of loans, while grants account for just 22 percent. Thirty years ago that ratio was reversed. Meanwhile, the U.S. is experiencing a population explosion among 18- to 24-year-olds that rivals that of the baby boom generation. All of these trends are playing right into the hands of the nation's big student lenders.
As recently as 2001, student loan providers sold just $11 billion in bonds. That figure rose above $27 billion in 2002 and hit $52 billion last year.
Each bond consists of thousands of student loans, known as a pool, that investors scrutinize to guess what percentage of borrowers will make regular payments, default, or pay ahead of schedule. In a best-case scenario for investors, everyone pays on time. The average trader rakes in $500,000 to $2 million a year, and never considers that he is wagering on individuals.
"I think about it in pools," said Greg, a 38-year-old Sallie Mae bond trader at a top-tier bank. Greg (not his real name) is a family man who wears Burberry suits and lives in Connecticut.
Freddy, a trader at another top bank, said it doesn't make a difference to him whether he's trading bonds backed by credit card debt or student loans. When asked whether he's ever thought the practice might be morally questionable, Freddy (also not his real name) got defensive. "Sallie Mae could not possibly keep all the loans they have on their books. They have to sell them; otherwise they wouldn't be able to make any more loans."
Graduating students facing huge debt find it a bit harder to be grateful for the role the bond market plays. "That's just wrong," said Margarita Testa, a 29-year-old confronting $35,000 in loans after receiving her bachelor's degree from Florida International University in May. Testa said she wouldn't mind that so many people are making a living off graduates like her if the practice were more transparent.
Longtime bond analyst Jimmy Lawson says students shouldn't be bitter. "When I was a student, I didn't know a stock from a bond. This is life. People invest," said Lawson (not his real name). Lawson, like many other Wall Street veterans who spoke with the Voice, declined to have his name used in this article for fear of losing his job. "Are people in this business highly paid? Certainly. But I'm a huge believer that this is nothing but a world of good," he said.
One of the benefits of turning loans into bonds is that cash in the lending pot is quickly replenished. In theory, the availability of cash should lower the cost of borrowing for the average joe. But since interest rates on student loans are fixed by the government, the savings aren't passed on to borrowers. Instead, the banks reap the benefits of playing with cheaper money.
As the student loan industry thrives, a debate is heating up in Washington about how big a cut of the student loan business middlemen should get and how much the program ends up costing taxpayers. Government-backed student loans were born under the Higher Education Act of 1965, which needs to be reauthorized every five years. The main proposal now floating to update the actthe Republicans' College Access & Opportunity Actwould lower government subsidies for lenders. A separate bipartisan bill, the Direct Loan Reward Act, suggests giving schools an incentive to use the government's Federal Direct Student Loan Program, which was created under the Clinton administration to compete with the Federal Family Education Loan Program, or FFELP, in which private lenders like Sallie Mae participate.
Both programs lend to students at the same rate, but some argue that FFELP costs taxpayers more because the government guarantees a certain rate of return to private banks. Also, if students consolidate their loans at a low, fixed rate, the government covers the lost revenue for private lenders. All of these extra payments have been a boon to private lenders in recent years.
"They're essentially funding their profits on the backs of excessive student debts," said Ajita Talwalker, president of the United States Student Association.
Sallie Mae has roughly doubled its profit in each of the past three calendar years, closing out 2003 with a net profit of $1.53 billion on $89 billion in student loans managed. Those gains put the Reston, Virginia, lender among the most profitable publicly listed offerings on the New York Stock Exchange. Its chief executive, Albert Lord, has collected about $10 million in bonuses since he rallied support in 1997 to make Sallie Mae fully private. Despite the change in Sallie Mae's corporate classification, this year 90 percent of the company's $98 billion in student loans are federally insured. And the company can now act as lender, servicer, and collector.
Along the way to becoming a private banking superpower, Sallie Mae bought several small lenders and seriously shook up student lending. "Nobody is putting any significant money into this business to improve delivery and technology," Lord barked at a Consumer Bankers Association conference in 1997. "You've got to get your tails out from between your legs and stop apologizing for making a profit."
Since then, Sallie Mae has become the country's second biggest student loan lender after Bank One, which for years has handed its loans straight over to Sallie Mae for management. So, has Sallie Mae made our lives better? Should all of us borrowers be writing the company thank-you notes? Well, that depends on whom you ask.
"It's evidenced that the fat is there," said Robert Shireman, a former Clinton education aide. He's crusading to have the government's direct-loan program replace the guaranteed program. "The government takes all the risk, and we give away the profit."
Shireman, founder of Student Loan Watch and a member of the federal advisory committee for student financial assistance, argues that taxpayers are forking over to the guaranteed program billions each year that could be used for grants or other assistance. Shireman calculates that if all of the loans given between 1995 and 2003 had been direct, then the government would have saved more than $20 billion, or enough to give an extra $4,000 grant to every low-income student in college today.
The Direct Loan Reward Act, sponsored by representatives Thomas Petri, Republican of Wisconsin, and George Miller, Democrat of California, proposes doing just that. The bill would give schools an incentive to use the direct-loan program by splitting the cost savings. Half of the savings would be channeled into grants for the participating school's students, the other half into the U.S. Treasury.
Policy and industry experts alike consider the start of the direct-loan program a wake-up call for the student loan business, which was lazy and complacent with its guaranteed returns on investment. Schools stampeded into the streamlined new system. "We just love the program," said Eileen O'Leary, director of student aid at Stonehill College, a small liberal-arts school in Easton, Massachusetts. O'Leary and other financial-aid administrators volunteer for the National Direct Student Loan Coalition.
About one-third of all student loans are direct, with around 1,100 schools participating. But private lenders, and Sallie Mae in particular, have been chipping away at those numbers. Sallie Mae has a sales force of several hundred reps that make, on average, 1,500 visits to schools each week. Many of these reps are former financial-aid officers, so they know the ropes. This marketing onslaught, combined with rising tuition costs and the schools' desire to provide discretionary loans to students, has contributed to a recent exodus from the government's direct program.
Not everyone, obviously, is a fan of direct loans. Critics cite a May report by the General Accounting Office that shows cash outflow for the direct-loan program exceeding inflow by about $10.7 billion between 1995 and 2003. Congressman Pete Hoekstra, Republican of Michigan, calls the proposal to reward the direct-loan program "an apparent admission that Direct Lending can't compete."
But is the playing field truly level between the two programs if loans from FFELP lenders like Sallie Mae are guaranteed by the government? And if their profits are subsidized? Some would call this arrangement corporate welfare.
"If you really, truly wanted a free-market program, then you'd take away all of these incentives," said the student association's Talwalker.
Eliminating lender subsidies would take a massive political fight. During his presidential campaign, Democrat John Kerry proposed that banks wanting to lend to students participate in a public auction, rather than having guaranteed interest rates set by Congress at as much as 9.5 percent. Kerry reckoned that the auction would drive down rates and save money for both students and taxpayers.
That idea worries Wall Street.
"While it is possible that the U.S. government could reduce the margins allowed on student loans (as it did in 1993), we believe this risk is relatively low during a Republican administration," Citigroup analyst Matthew Vetto, who covers Sallie Mae, told investors in an August research note.
Even so, there is dissent among the Republican ranks. After all, Thomas Petri, a veteran GOP congressman from Wisconsin, is a lead supporter of the Direct Loan Reward Act.
And George W. Bush's budget office included this note in its last assessment of the loan programs: "Significantly lower Direct Loan subsidy rates call into question the cost effectiveness of the FFEL program structure, including the appropriate level of lender subsidies."
The lending lobby has tried to cover its tail with both parties. According to political contributions compiled by The Chronicle of Higher Education, sources affiliated with five big student lenders have given more than $400,000 to members of the House Committee on Education and the Workforce in the 18-month period ending in July 2004, with 75 percent going to Republicans.
Since Republicans have a majority on the committee, their bill has taken center stage. Parts of it actually threaten to make repayment more difficult for graduates. For example, the College Access & Opportunity Act suggests that loan consolidations be made at variable rather than fixed rates. Critics of this measure say that it would force the average student with $17,000 in debt to pay $5,500 more in interest over the life of his loan.
Bankers argue that further cutting lender subsidies and perks could push more small players out of the market. Lots of lenders exited the business when the Clinton administration launched the direct-loan program in 1993. Bankers warn that lower subsidies and more support for the direct-loan program could push interest rates up for students.
Around 5 percent of students default on their school loans, compared with just over 1 percent of home owners who miss mortgage payments to the point of foreclosure. Students with little or no credit history are able to get large loans for school because of the guarantees and provisions in the Higher Education Act, which itself was a by-product of the civil rights movement. They're also entitled to flexible payment options, hardship deferments, and in some cases loan cancellations. The flip side is that it's virtually impossible to write off student debt through bankruptcy, the way you can other debt. Uncle Sam can collect until you're old and gray, seizing your tax refunds and attaching your wages without a court ruling. He can even go after your Social Security benefits.
With collecting muscle like that, the big lenders have stuck it out in the market even as their subsidies have been cut and their profit margins squeezed. Of course, if the government decides to overhaul the system, say by introducing auctions such as Kerry has proposed, then the middlemen will end up with little say in the matter. And perhaps students and taxpayers will get a bigger share of the profits. Otherwise, maybe we should all buy stock in Sallie Mae.