Under these proposed solutions, lenders would still originate loans, with the government paying fees to the lenders for origination, and with the Department of Education providing long-term liquidity. In our opinion, the prospects for the proposals put forth by lenders are dim, though the behavior of Congress is difficult to predict. It seems to us that the most likely scenario is passage of a law that will result in all federally supported student loans being made through the Direct Loan program, leaving the lenders we cover with one less source of income.
Private Loans Not a Cure for the Industry's Ills
In recent years, private student loans became a larger portion of the business for lenders, as growth in the cost of education outpaced dollars available to students from the federal government. However, as with many other types of credit, lenders went overboard, especially with regard to loans to students at "non-traditional" schools—trade schools and other for-profit educational institutions. In the third quarter of 2009, charge-offs in Sallie Mae's "non-traditional" portfolio reached an annualized rate of 28.5% of loans in repayment. Lenders have tightened standards as a result, but we think students will also be more reluctant to borrow in the aftermath of the current recession.
As a result, while the rise in education costs does not appear set to slow down any time soon, we expect that future growth in the private loan market will be far less aggressive. Furthermore, funding for this type of loan will be harder to come by without a healthy market for securitizations. While private loans can be financed by deposits, capital requirements are fairly high. None of the student lenders we cover is currently a bank holding company, though Sallie Mae is rapidly growing its deposit base with brokered deposits obtained via its Utah industrial bank subsidiary. Finally, there is the risk of government interference in the private loan market. The tide of public opinion has turned against lenders, and high-rate loans to college students would be an obvious area for further reforms.
Overall, we're not enthusiastic on prospects for student lenders. For the most part, the factors that allowed lenders to achieve returns in excess of their costs of capital are gone, and we don't see many sources of long-term competitive advantage. We therefore would demand a sizable discount to fair value before investing in any of these companies. The plight of the student lenders, like that of Fannie Mae (FNM) and Freddie Mac (FRE), aptly demonstrates the risk of investing in companies whose success depends on cooperative governments and healthy capital markets.
About the Author
Jim Sinegal is a stock analyst with Morningstar.