The Looming Collapse of Student Loan Asset Backed Securities

Austin C. Smith

By Austin Smith

Austin C. Smith is a litigator practicing in New York. His work on behalf of student debtors has been profiled in the Wall Street Journal, National Law Journal, the Huffington Post, ABC News, People Magazine, GOOD Magazine, Marketplace, and more. He can be reached at austin@acsmithlawgroup.com.

John Grisham’s latest novel, The Rooster Bar, explores an issue ripped from the headlines: student debt. In the novel, a villainous hedgie named Hinds Rackley lures idealistic college grads with big dreams and low LSAT scores into attending a string of for-profit law schools owned by his fund, trapping them in a cycle of debt that nets the hedge fund some $160 million a year. Mr. Grisham masterfully fictionalizes all the major issues in the student debt crisis, including the important distinctions between federal student loans and private student loans. Federal loans have capped interest rates, equitable repayment plans and are subsidized and guaranteed by the taxpayers. Private loans, on the other hand, are high-interest unsecured consumer debts owned by various pension plans and funds on Wall Street.

We all know about the student debt problem. It’s bad. There’s a lot of it. It’s a drag on the economy. The general consensus seems to be that the taxpayers will ultimately have to take a huge write-down, but otherwise there isn’t really anything to be done or anything to worry about in the immediate future.

Don’t be so sure. The federal student debt problem may be existential, but the private student debt problem is immediate and at least in part tied to the question of their status in bankruptcy.

There is a common misconception that anything called a student loan is non-dischargeable in bankruptcy. But as the Wall Street Journal and this publication have noted on repeated occasions, some student loans actually can be discharged in bankruptcy. In fact, the Bankruptcy Code only restricts discharge of three types of student loans: (1) federal student loans; (2) non-profit student loans; and (3) qualified private education loans. Qualified private education loans are those loans made to eligible students, attending eligible schools, for eligible expenses. Since each of these conditions is necessary and none are sufficient, there are three corresponding types of non-qualified private student loans that are dischargeable in bankruptcy: (1) loans made to ineligible schools; (2) loans made for ineligible expenses, and (3) loans made to ineligible students.

Maybe that’s interesting to you. More likely it is not, and you would not be alone in that assessment. There is a tendency by the academy to view the dischargeability of private student loans in bankruptcy as a whimsical exercise in statutory analysis. And there is a similar tendency by the bankruptcy bar to view this as a minor issue that may help a debtor here and there, but is not worth really taking any time to understand. Since neither of them really have a stake in the outcome, we may forgive them their disinterest.

Financial analysts, on the other hand, can no longer afford to ignore this. Of the roughly $150 billion in outstanding private student debt, approximately 20-30% is non-qualified private debt, meaning roughly $30-50 billion in private student debt is dischargeable in bankruptcy. And although many funds specialize in these asset-classes (both long and short), few if any seem to be aware of what is going to happen to these loans when everyone realizes they can be discharged in bankruptcy.

Most of these loans were made between 2004 and 2008, and are eerily similar to the subprime mortgages. Just like the mortgage crisis, the student debt crisis was caused, in part, by commercial banks lending (and students borrowing) far more money than the borrowers could ever realistically expect to pay. This time, rather than lending people money to buy a house they couldn’t afford, the banks lent kids hundreds of thousands of dollars in private student loans that they could never afford to repay. Most of these loans were originated under various “Direct-to-Consumer” lending programs, which means they were marketed and originated directly to students, without any involvement or oversight from the student’s financial aid office. Predictably, these loans have astronomical rates of failure. In fact, Navient reports that these “DTC” loan programs have suffered annual default rates of more than 60% in some years.

Furthermore, just like the mortgage crisis, most of these debts were securitized into student loan asset backed securities, called SLABS. And within this universe of SLABS, there are entire SLABS filled with dischargeable student loans. For example, the SLM Private Education Student Loan 2009-CT Trust is composed of more than 100,000 loans made to students attending unaccredited trade school programs, like cosmetology school, truck driving school, and dog-walking schools (yes, you read that correctly). Until recently, nobody thought these debts could be erased in bankruptcy. What happens when everyone realizes they can?

As more and more debtors realize these debts can be erased in bankruptcy, the bankruptcy rates on these loans will surely increase. And when that happens, how long until these SLABS collapse? The dischargeability of private student loans in bankruptcy is being litigated in the courts, and reported on in the media. It’s time Wall Street took notice.

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