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Student debt-backed securities: Market for private loans

May 28, 2017

It’s time to meet the SLABS.

Student Loan Asset-Backed Securities, or SLABS, are a way for investors to start putting their money into the student debt marketplace. With billions of dollars in this marketplace, and with the increasing questions that surround America’s $1.2 trillion in outstanding student debt, it’s worth taking a look at how investors put their money into student loans and what they’re getting out of it.

What are SLABS?

For the layperson an asset-backed security may seem like a fairly confusing product that conjures up images of the 2008 recession and The Big Short. That’s not entirely wrong, but not entirely right either. These are actually incredibly common properties in the marketplace.

 

An asset-backed security is an investment that pays based on revenue received from some underlying asset. While that’s typically debt, such as credit card payments or auto loans, they can be built out of just about any revenue source. (Mortgage-backed securities are the same thing under a different name.) For example, movie studios have created bonds around film profits in the past. Debt is more common, though, because payments are regular and fixed, whereas profits off an asset are speculative and variable. Selling securities also helps lenders finance future loans, which encourages them to sell these products.

To create a security, a firm will typically bundle together a group of individual debts and sell pieces of that to investors, who make their money off the payments that individuals make.

So, for example, take a security backed by credit card debt. A credit card company could sell the debt of 10,000 cardholders to a financial firm. That firm will then bundle those individual debts into a security, which investors can buy shares in. As cardholders make their monthly payments, those are then distributed to the investors as their profit.

Securities backed by student debt are the same thing, except instead of credit card payments, the investors make their money off of student loans.

How popular are they?

Very.

“We have a billion dollars more in demand than we have supply right now,” said Mike VanErdewyk, the founder and CEO of ReliaMax, a private student loan solutions provider. “I’ve got investors who want to buy private student loans and I don’t have enough loans to sell them, which is kind of the opposite of a lot of business models out there.”

 

“We have actually facilitated the buying and selling of ten private student loan portfolios in the last two years,” he added. “So that’s moving it from one balance sheet to another. It could be moving it from a bank to a life insurance company, or from a private equity fund to a bank.”

The reason investors are interested in SLABS, according to VanErdewyk, is security. First they will invest either directly, by buying debt from firms like ReliaMax (which does not sell securities, but rather simply sells portfolios of debt directly), or through securities, which offer a chance to buy pieces of debt instead of the entire portfolio. As a debt class, student loans have much less risk than most other forms of lending.

The upshot is a financial vehicle viewed by many investors as highly reliable in a growing market, and as a result, SLAB investment has been increasingly popular.

Are SLAB investments a good idea?

Not everyone thinks so.

Student loan asset-backed securities have the advantage that they’re backed by a theoretically indestructible asset. With most (but not all) loans guaranteed by the government and bankruptcy forbidden, this debt class should be essentially bulletproof. Add in the fact that private student loans can have some pretty hefty interest rates and it’s almost a wonder this market isn’t white-hot.

On the other hand, quite a few sober voices have been warning that this is a market headed for a fall.

 

The trouble is not that student loan assets are, in and of themselves, a bad idea. This is an investment in individuals, and banking on a doctor or Google whizkid engineer to make some money and repay his loan is generally a pretty safe bet.

However, like mortgages before them, the risk with student loans is that the value of the debt has begun to outstrip the value of the asset itself.

Student debt has become a complicated, contentious and increasingly political issue; that’s appropriate, because most of the current landscape was established by policymakers. However, at its heart, the landscape fairly simple: students are taking on more and more debt to go to school, and their post-graduation gains have not kept up.

Incomes have stagnated while tuitions have soared, and the result is a debt class that increasingly looks unrelated to the value of the underlying asset. Or, to put it in more dire terms: a bubble.

The numbers are there to back up investing in student loans. Billions in securitized assets, $1.2 trillion in the overall market and a steadily growing debt class with no sign of stopping, that all points to a great investment.

 

However, the same size that makes student loans an attractive investment also makes this market potentially unstable. Defaults for federal student loans, the majority of the $1.2 trillion market, hover around 11%, but far more importantly, about a third of all student borrowers are in some form of deferral or repayment program. Those plans slow down or halt altogether the cash flow from a student loan backed asset, creating disruption and very real risks for investors who bank on a guaranteed rate of return. (Defaults for private student loans are around 3%.)

Indeed, in many cases, it would be better for the investors if borrowers were defaulting in greater numbers, as that would trigger government guarantees and stabilize returns.

SLABS aren’t a huge portion of the market and won’t bring down any major banks any time soon, but they’re also not negligible. For investors looking to get into this class of securities, there is real money to be made by investing in smart, well managed securities.

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