First Mortgages, Now Student Loans?

Last week, First Marblehead Corporation, a Boston-based company, saw its stock plummet after cutting its dividend. The problem? First Marblehead is in the business of “securitizing” student loans. A year ago, this would have required some explanation, but the sub-prime mortgage mess has taught Americans – and people all over the world – the meaning of “securitizing.” It is one of those words that means the opposite of what it sounds like. A company bundles together some high-grade debt, some middle-grade debt, and some really doubtful debt and sells it to investors, who only think they are making a secure investment. As we learned with the securitized mortgages, no one really knows what these chimeras are worth. And a little bit of bad debt, like a little bit of ptomaine, goes a long way to making the whole meal undigestible.

First Marblehead isn’t saying exactly what happened, but Matt Snowling, analyst with Friedman Billings Ramsey, told AP report Dan Seymour, that he believes First Marblehead “was trying to sell about $1 billion in bonds.” As Seymour explains, First Marblehead bundles student loans from numerous banks to put together its bond offerings. The deal usually specifies that First Marblehead has 180 days to sell the bonds, and failing that, has to buy the student loans itself.

Apparently, First Marblehead has been trying since October to sell $1.1 billion in these student loan-backed bonds – and found few takers. Meanwhile, banks keep issuing more student loans.

As with the housing market, the potential danger is that if investors grow wary of student loan debt, the banks will refrain from issuing new loans. We could then face a situation in which students who relied on private loans to meet the steep tuition and other costs of attending college will have to cut back too.

At least one analyst forecast this situation. Andrew Gillen, writing for the Center for College Affordability and Productivity, issued a working paper, “A Tuition Bubble? Lessons from the Housing Bubble” just as First Marblehead alerted its stockholders to its dividend cut. Gillen points out that just as artificially low interest rates drove the housing bubble, the federal government’s subsidization of student loan interest rates and its guarantee to reimburse lenders if students default on their loans has driven the remarkable rise in college tuition. Gillen provides a helpful chart showing that when the federal government increases student loans, college tuition quickly climbs.
First Marblehead is involved in the student loan business in a variety of ways. In addition to securitizing loans issued by other lenders, it makes its own loans, and developed a specialization in lending to “students who would not ordinarily qualify,” as it says in a brochure. Sub-prime students? In 2006, a First Marblehead sales director, David McLaughlin, told the Chronicle of Higher Education that the company will “approve students without FICO scores or credit histories, and incoming freshmen can get a loan without a cosigner…That’s pretty unique in the industry.”

I don’t know for sure, but I presume the $1.1 billion in student loans that First Marblehead has been unable to sell through its bond offering belong to the class of non-federally guaranteed loans. These bear much higher interest rates and a much higher risk of default – especially if they represent (in some cases) the kind of debt Mr. McLaughlin was boasting about a year ago.

The student loan industry has spent the last twelve months battered by revelations of predatory lending, collusion between lenders and college financial aid officials, and improper deals between lenders and universities that resulted in students paying higher fees and higher interest rates. The investigation begun by New York Attorney General Andrew Cuomo marches on with new instances of shady deals coming to light every few weeks.

It is hard to say how deep a hole First Marblehead has got itself into, but it is safe to say this isn’t a time when it can expect much public sympathy. But as with the home mortgage mess, we need to be attentive to the bigger picture. Nearly 15.3 million undergraduate students are enrolled in America’s colleges and universities, and 35.1 percent of them have student loans. Tuitions and the college budgets that depend on tuition dollars are linked to the ready supply of loans. Perhaps First Marblehead will shrug off its failed bond offering, but don’t be surprised if we are at the beginning of a “liquidity” crisis in higher education.