Degrees of Debt

No, Student Borrowers Don’t Need to Worry About Loan Market Turmoil

Turmoil in a financial market has caused some speculation that college students will face higher rates on federal loans — or see them dry up completely. Are student borrowers at risk?

In short, no. But a fuller answer requires a brief history of how Wall Street has an impact on student loans.

Until 2010, banks provided capital for federal student loans, through the Federal Family Education Loan (F.F.E.L.) program. The government set the terms and guaranteed the loans, while banks put up the dollars.

After students received their money, banks frequently packaged similar loans and sold them in a secondary market, a process known as securitization. There is a similar secondary market for mortgages; these became big news during the economic meltdown in 2007 that preceded the Great Recession.

Investors happily snapped up student loans in the secondary market, in part because they were guaranteed by the federal government. If a student borrower defaulted, Uncle Sam was on the hook to pay off the loan.

Securitization is generally considered good for the economy because it gives banks ready cash, what economists call liquidity, to make more loans. There are potential downsides, however: In both the mortgage and student-loan markets, some struggling borrowers have had difficulty determining who owns their loan and has authority to modify its terms.

In 2010, the Health Care and Education Reconciliation Act ousted banks from the federal student loan program. This legislation was, in part, a response to a liquidity crisis in the student-loan market. As a consequence of the global financial crisis, capital dried up and lenders lacked cash to make new student loans. Students in several states faced delays and uncertainty as lenders struggled to find capital. The federal government finally stepped in with an injection of liquidity to get the market moving again.

Since then, the Department of Education has provided all federal student loans through the Direct Loan program. No loans are being made through the old system, though billions in outstanding loans are still being paid off — and traded on the secondary market.

It is this secondary market on old F.F.E.L. loans that is suffering. Credit-rating agencies are threatening to downgrade the bonds sold by firms like Sallie Mae, which was one of the biggest lenders in the defunct program. U.S. Bancorp recently failed to find any buyers for an offering of F.F.E.L. loans.

This is what has led to speculation about another liquidity crisis: If lenders can’t sell the old loans, they will lack capital to make new loans. So won’t students suffer?

The catch is that the private banks trying to sell their loans no longer make federal loans to students. The Direct Loan program makes all new loans, and they are funded (like all federal programs) by tax revenues and Treasury bonds. Tumult in the secondary market has zero impact on the availability of federal student loans.

There is a relatively small market squeezed by low demand for securitized student loans. Private banks still market a product called student loans, but they differ in important ways from federal student loans. Federal student loans are given out based on need, rather than ability to pay. Private student loans require that a borrower have a strong credit record or a co-signer.

Private student loans are more akin to unsecured debt such as vacation loans or credit cards than they are to federal student loans. But unlike other unsecured debt, private student loans can’t be discharged in bankruptcy. Neither can federal student loans, but they also provide protections that private loans don’t, such as access to an income-based repayment program, which cuts payments and forgives loans of struggling borrowers.

Private loans are a shrinking segment of the market, down from 12 percent of undergraduate loans in 2007 to 7 percent today. Given lackluster demand for private student loans in the secondary market, it’s likely this market will continue to contract.

