How The Private Student Loan Industry Resembles The Subprime Mortgage Market

The financial industry’s quest for profits led to increased securitization of student loans and more aggressive lending practices that “resembled the subprime mortgage market” that collapsed ahead of the 2008 financial crisis, a government report released Friday says.

Total outstanding student loan debt surpassed $1 trillion in 2011, the report from the Consumer Financial Protection Bureau and Department of Education found. $150 billion of that total is on private student loans, and defaults on private loans total more than $8 billion, according to the report.

The default total has risen over the last decade because of industry practices that are similar to those that led to the subprime housing collapse. A large portion of the student loan boom that took place from 2005 to 2008 was financed by Asset-Backed Securities (ABS), and because more money could be made off such loans, lenders became more aggressive in their lending practices. Increased profits gave lenders “an incentive to increase loan volumes” with “less incentive to assure the creditworthiness of those loans.” Lenders relaxed their lending requirements, lowering the minimum credit score required to secure a loan.

The lenders also created new ways to reach students by bypassing school financial aid offices and going straight to customers through direct marketing, which “could
simultaneously increase the number of borrowers and the amount each one borrowed,” the report found.

As the report notes, the practices resemble lending practices that overheated the housing market before the financial crisis, when banks and lenders relaxed standards to push more and more Americans into homes through subprime mortgages. Those mortgages were then securitized — divided, packaged, and traded — leading to a complex market that collapsed when borrowers began defaulting en masse.

And much as minorities were more likely to be affected by the housing crisis, minority borrowers are more likely to attend schools with higher default rates than are white borrowers.

“Subprime-style lending went to college and now students are paying the price,” Education Secretary Arne Duncan said Thursday. “We still have some work to do to ensure that students who take out private student loans have the same kinds of protections offered by federal loans. In the meantime, if you have to take out a loan to pay for college, federal student aid should be your first option.”

In yet another tie to systematic failures of the financial industry, the report notes that banks used the London Interbank Offered Rate (Libor) to determine interest rates on private student loans. Libor is currently the subject of a rate-rigging scandal that has engulfed multiple American and European banks and is currently being investigated by the Justice Department and authorities in the United Kingdom.