Sallie Mae (SLM:US), the largest U.S. education-finance company, is making a bet on the future of private student debt, a business under fire in Washington for marketing high-interest-rate loans before the financial crisis.
Officially known as SLM Corp., Sallie Mae said this week it will separate into two publicly traded companies. One will focus on servicing federal student loans; the other will concentrate on the fast-growing business of making private loans.
Students are turning to private loans because government programs, which typically have more favorable terms, don’t always provide enough money to pay for the skyrocketing cost of college. Just as subprime mortgages led to the real-estate collapse, pre-2008 private student loans were easy to get and featured high rates that borrowers often couldn’t afford, according to a 2012 report by the federal Consumer Financial Protection Bureau.
Sallie Mae’s announcement “really confirms what was already clear -- that the private education loan market is growing again,” said Pauline Abernathy, vice president of the Institute for College Access and Success, an Oakland, California-based nonprofit research and advocacy group. “We need to make sure that protections are in place so that we don’t make the same mistakes again.”
With college costs outpacing the inflation rate for the past four decades, borrowers have about $1 trillion in student loans, the largest category of consumer debt apart from mortgages. Private loans make up about 15 percent of the total.
Sallie Mae’s split comes as Congress is debating a host of proposals to reduce interest rates for federal loans and aid student borrowers -- proposals that might curb demand for private loans.
About 200 current college students and recent graduates rallied today outside Sallie Mae’s corporate offices in Newark, Delaware, during the company’s annual meeting. The students protested high student-loan interest rates, said Ori Korin, a spokeswoman for Jobs with Justice & American Rights at Work, a Washington-based nonprofit group, which calls Sallie Mae “the largest private profiteer off of student debt.”
For now, Sallie Mae should prosper because tuition continues to rise, said Scott Valentin, an analyst with FBR Capital Markets in Arlington, Virginia. The lender’s shares are up 40 percent this year (SLM:US). They rose 2.4 percent to close at $24.04 yesterday in New York trading.
“It’s a bet that the cost of college will outstrip the aid available,” Valentin said of Sallie Mae’s private-loan strategy. He rates (SLM:US) the shares “outperform.”
Sallie Mae is turning to private loans for growth because President Barack Obama’s administration in 2010 cut private lenders out of the lucrative business of originating new federal student loans. The government now does that directly. Sallie Mae still has a dominant position in servicing and collecting on those loans, a business with slower growth prospects. It also has a $118 billion portfolio of federal loans made before the government shifted to direct lending.
Private loans are riskier for students because they don’t offer the same kinds of protections for borrowers, such as the opportunity to defer payments or tie them to income, Abernathy and other consumer advocates said. They can also carry high interest rates -- more than 10 percent annually -- at times doubling what some borrowers pay in the U.S. program. Most have variable rates, which could expose borrowers to unexpectedly high payments in the future.
In responding to questions about the company’s private student-loan business, Sallie Mae spokesman Patricia Nash Christel referred to a conference call the company held with investors this week.
On the call, John Remondi, Sallie Mae’s chief executive officer, said the company had improved the credit quality of its private loans.
Unlike with federal loans, which are available to all students, private financial companies can make underwriting decisions, either refusing to lend to less credit-worthy borrowers or charging higher rates to compensate for the risk. Today, investors aren’t fully recognizing the growth prospects of the private student-loan business, Remondi said.
“Sallie Mae’s success over the last 40 years is in large part based on our ability to reinvent itself in the face of changing business climates,” Remondi said.
Before the financial crisis, the volume of private student loans -- with rates that could be as high as credit cards -- soared. Many were marketed to families with poor credit and to students at for-profit colleges, whose default rates surpass those of traditional institutions.
Private lending to students totaled about $25 billion in the 2007-2008 school year, according to a report last year by the College Board, a New York-based nonprofit group. Last year, the figure dropped to $8.1 billion, as lending standards tightened and federal loan limits increased.
Sallie Mae is gaining ground in this shrunken market, which has started to rebound. The company told investors this week it expects to make $4 billion in private loans this year, almost twice its 2010 lending level. As originations grow at a 20 percent annual clip, Sallie Mae said it expects a 51 percent market share this year.
Still, the Consumer Financial Protection Bureau continues to scrutinize private loans, and has received 4,600 complaints from borrowers as of March. In July 2012, the agency and the U.S. Education Department submitted a report to Congress that found more than $8 billion in defaulted private student-loan balances.
Often, students borrow for expensive graduate school programs and are confused about loan terms -- especially when they are offered with variable rates, according to the CFPB.
“It can often be challenging to determine what is the better deal when comparing a fixed-rate loan with a number of repayment protections against a variable rate loan with fewer options,” said Rohit Chopra, the CFPB’s student-loan ombudsman.
A number of proposals in Washington could crimp the private-loan business. Currently, student loans of all kinds can rarely be canceled through bankruptcy, making them among the most onerous of debts.
Senator Dick Durbin, an Illinois Democrat, and other senators have proposed making private student loans dischargeable in bankruptcy like almost all other forms of private debt -- making such debt less attractive to investors who might buy it in secondary markets.
Sallie Mae supports letting both private and federal student loans be dischargeable through bankruptcy for those who have made a good-faith effort to pay over a five- to seven-year period and are still in financial difficulty, Christel said.
Congress and the Obama administration are also debating proposals to keep down interest rates on federal loans. Unless Congress acts, rates for some Stafford loan borrowers will rise to 6.8 percent from 3.4 percent on July 1.
“Higher education cannot be a luxury for a privileged few,” Obama said today at the White House. “It’s an economic necessity that every family should be able to afford.”
Lower rates on federal loans could make private loans less attractive. For now, Sallie Mae and other private lenders can offer fixed rates for the most creditworthy borrowers below the 6.8 percent on many government loans, said Mark Kantrowitz, publisher of Edvisors Network Inc., a Las Vegas-based operator of financial-aid and college admissions websites. For those risking variable loans, the rates can be far lower, he said.
Obama has also proposed expanding the Perkins federal loan program, a move that could hinder demand for private loans, Kantrowitz said.
At the same time, some families are becoming more sensitive to the cost of college and moving to lower-priced institutions to reduce their debt levels, he said.
Regardless of any shifts in behavior, for the time being, “I don’t see the demand for borrowing leveling off,” Kantrowitz said.
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