How Privatization of Student Lending Creates Opportunity — and Risk
By Steve Cocheo, Senior Executive Editor at The Financial Brand
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A multi-billion-dollar new lending opportunity, with the potential for establishing deep and long-term new consumer relationships, arrived in early July, courtesy of the “Big Beautiful Bill.”
How many lenders will actually take advantage of this development? That remains to be seen: Experts agree that student lending is not something neophytes can (or should) get into quickly nor at scale.
Need to Know:
- Washington’s student loan portfolio stands at around $1.7 trillion, according to the Education Department. Under the latest changes, a big chunk of that will migrate over time to the private sector.
- Student lending is a political football, and future changes at the White House may demand nimble planning on lenders’ part.
- For a private lender, an education loan, especially for a graduate or professional degree, is in part an investment in the future earnings potential — and repayment ability — of a degree in a particular field and from a particular school.
What it’s all about: The new opportunity results from major changes made to federal student lending programs by last year’s law and implemented by the Department of Education.
The bill, which picked up the official moniker, “Working Families Tax Cuts Act” along the way, kills a major federal graduate student loan program as of this year, with a phase-out for current borrowers. In addition, more-stringent limits on an individual’s federal student debt borrowing overall are taking effect.
The Trump administration has argued that these steps will force colleges and universities to contain their costs and make education more affordable, while getting the government further out of the student lending business.
Key insight: In practice, the federal policy shift is pushing a huge amount of credit demand into the private sector.
“There are going to be a lot more students who have needs and those needs will be unmet by federal programs,” says Joshua Turnbull, SVP and consumer lending business leader at TransUnion. “That creates an opportunity for private lenders to enter the fray.”
Chris Hahn, head of consumer healthcare and student lending at KeyBank, puts the sea-change in perspective:
“The federal government doesn’t underwrite credit quality. There is no use of credit scores nor debt-to-income ratios. There is no, ‘What is your credit profile? What is your past performance?’ But for private lenders, and traditional bank lenders, credit quality matters.”
About half of the demand that’s coming will be readily bankable, Hahn estimates. The other half? Under current conditions, not so much.
Student lending requires more than simply pushing a product out to the market, according to Fred Good, SVP of education finance product and portfolio development at Citizens Bank.
“This is a specialized business that requires strong risk management, established school relationships, servicing capabilities and the ability to support borrowers over multiple years — all of which can make it difficult for new entrants to scale quickly,” Good explains.
“With roughly 30% of federal student loan borrowers in repayment being delinquent, lenders cannot assume that rising demand will translate into profitable growth,” says TransUnion’s Turnbull. “Success will depend on identifying consumers with both the willingness and capacity to repay.”
Read more: How Today’s Student Loan Mess Could Choke Tomorrow’s Loan Pipeline
How Is Student Lending Changing?
The federal Grad PLUS loan program allowed graduate students to borrow as much as the full cost of attendance with no aggregate or lifetime ceiling. As of July 1, no brand-new loans will be made under that program. Graduate and professional students’ federal borrowing will be subject to annual and aggregate limits. Likewise, parents borrowing under the federal Parent PLUS loan program will have limits.
What’s really at stake: The changes are intended to prevent students and parents from taking on education debt that they may struggle to repay. At least in the near term, it instead may leave many with funding gaps that they will look for private credit to fill.
The core student lending business consists of a small number of lenders, including the behemoth Sallie Mae Bank and the fintech/bank SoFi. Student loan refinancing was SoFi’s first business and a funnel for building broader relationships.
Gauging the gap. According to Joseph Grohotolski, vice president of the structured finance group at Moody’s Ratings, the cutback in federal graduate education lending will create opportunities worth an estimated at $14 billion in annual loan volume.
“We expect existing lenders to expand their offerings and compete for this business, particularly among borrowers with strong credit characteristics and earning potential,” says Grohotolski.
Grohotolski says the demand may stimulate interest from new players, but he expects current players’ activity to be expanded and modified rather than attracting many newcomers, at least initially.
“New entrants would need to develop underwriting expertise and establish relationships with schools, which could limit the pace of direct entry,” says Grohotolski. “Even so, new capital can still participate indirectly, by investing in or lending to established originators to help fund higher volumes, rather than by building lending platforms from scratch.”
A recent Moody’s report anticipates that rising volume of private student lending will foster growth in private student loan asset-backed securities. However, it also suggests that heavier private debt burdens for students and new types of lending could increase the risk in those securities.
As for current private education lenders, during a late July earnings briefing Jonathan Witter, CEO and director at Sallie Mae, estimated that the federal changes could mean $4.5 billion or more in annual originations over the next few years just for his organization. Put another way, the company estimates that its originations could rise by as much as 70%.
Sallie Mae launched multiple new graduate and parental loan products from March to June. A roundup of major private student lenders in the Moody’s report showed a range of responses, from new products to promotion of existing graduate school loans as a Grad PLUS replacement.
Read more: Rising Student Loan Defaults Reveal a Shocking New Borrower Persona
How Student Lending Could Evolve in the Private Sphere
TransUnion’s Turnbull says the nature of applicant evaluation is going to change significantly.
What’s going to be different: “You’re not just going to be underwriting me and my current state of credit, but also an evaluation of the program I’m in, the earnings potential over time, how likely it is that I’m going to be in a position eight years from now that will enable me to service the debt,” Turnbull says.
This will lead to even tighter partnerships between private student lenders and schools or specific programs, he says, “where the financing is baked into the experience.”
Moody’s report points out that lenders will focus on individual programs’ overall performance, such as the percentage of graduate students that complete their programs.
Closer attention will be paid to career choices, too. Sallie Mae officials told analysts during a June conference that product design would be critical. Pete Graham, co-president and CFO, noted that payment deferral needs would differ among professions, for example.
“What a medical school student needs, given residency periods and the like is very different from what a law school student needs,” he said. He added that the colleges Sallie Mae works with “appreciate the level of effort we’ve put into tailoring our programs to meet defined needs of different student cohorts.”
Read more: Why Banks Could Lose Their Edge in Personal Loans — and How to Keep It
What About Those Who Get Left Behind?
Moody’s report also makes the point that access to credit will change in transitioning from public to private lending.
Key change: “While borrowers’ reliance on scholarships, institutional aid and other funding sources may rise, some demand will likely remain unmet,” the report says, “potentially causing some students to delay or forgo graduate education.”
What could ameliorate the hard reality that private lenders with shareholders need to be paid back?
KeyBank’s Chris Hahn says a longer-term idea that’s been buzzing around student financing circles for a while envisions a variation on the Small Business Administration guaranteed loan program. The idea would be that the government wouldn’t be lending but would be providing a backstop for conforming lenders. (SBA guaranteed loans include some risk sharing.)
“If the government’s willing to take on default risk, I think you could have private lenders coming out of the woodwork to build businesses to support that,” says Hahn.
That may not get legs during the current administration, however.
Getting more data could help private lenders make additional loans further down the credit hierarchy, according to Hahn. Various forms of alternative data, concerning programs, income trajectories, and more, could make a difference, he says. So, he says, would making more use of data that’s already available. Now there’s more urgency.
Reality check: However, bank lenders would need new, creative approaches to have some government approval.
“We’re regulated and we have underwriting standards we have to follow,” says Hahn. “There’s a wild card with using alternative data points. What is the federal government going to allow us to use?” Even something as basic as lending with projected borrower income in mind may not have a 100% blessing.
“But as we need to buy further down the buy boxes, as we call them, and need to find a way to approve someone with a 680 credit score with no income, we’ve got to supplement with something,” says Hahn.
Read more: How SoFi Powers Its Relentless Loan Origination Machine
Thinking Beyond the Banks’ Lending Role
KeyBank’s operation pivoted to a different approach a few years ago in the wake of acquiring a student loan consulting firm called GradFin. While the bank does a limited amount of student loan refinancing — limited by the level of market rates and pricing realities — the bank now offers free consulting with deeply qualified specialists. They come from backgrounds in student aid offices, the federal student loan operation and more.
KeyBank’s approach focuses on building relationships for the long term. It is reminiscent of an auto dealer finance department, in that it works with approximately 15 lenders, including Sallie Mae and SoFi, with their own preferences regarding borrower profiles, etc. The bank counsels the student and their parents, if applicable, on the best deal for their circumstances and then matches them to the best lender. KeyBank receives remuneration for the referral.
Citizens Bank has also adopted consulting roles in addition to lending roles in the student banking area, including introduction of the Citizens Student Hub.
The bank’s Fred Good notes that the bank has a new lending product in the wings, with its introduction slated for the fall.
Read next: Why the ‘K-Curve’ Demands Proactive Strategies from Banks Right Now
