Student Loans: Hard Times for Private Lenders

There's little appetite for securities backed by private lendersbut Uncle Sam appears to be picking up the slack

While auto chiefs sat before Congress begging for a bailout in early December, private student lenders were quietly asking for money at the Ritz Carlton in Arlington, Va. In a posh ballroom under glittering chandeliers, Federal Reserve officials and industry executives discussed a $200 billion stimulus package designed to jump-start consumer lending. But it's not clear whether the plan will revive the market for private student loans—or whether the market needs help at all, since federal funds are filling the void.

College-bound students can tap two sources for loans, the government or private lenders. Often unaware of their federal options, families have flocked to private firms, which during the era of easy money made it relatively painless to get funds. Although Uncle Sam is still readily handing out cash, private players, including two of the largest in student lending—Sallie Mae (SLM) and First Marblehead (FMD)—have grown increasingly wary amid the crisis.

Like mortgages, student loans are bundled together and sold to big investors, freeing up capital for fresh loans. But there's no appetite for these securities now, a big reason why lenders don't have the money to make new loans. This year the volume of private student loans could fall an estimated 30%, to $13.3 billion.

To jolt the market, the Fed is contemplating offering one-year, low-rate loans to investors who buy new securities backed by student loans. But that may not be enough enticement. After all, a one-year loan is a short-term salve for an investment with a shelf life that can often stretch to 15 years. "The loan doesn't reduce investor risk," says Mark Kantrowitz, director of research firm FinAid. "It's wishful thinking."

What's more, investors are still licking their wounds from losses. Hedge funds, endowments, and others are currently sitting on $62 billion in education-related securities, deeply troubled debt trading as low as 20 cents on the dollar. "Investors would sooner stick a pencil in their eardrum than get near these securities," says Philip Aidikoff, a lawyer for investors in student loans.

Those existing securities aren't likely to perk up anytime soon unless the underlying loans' borrowers get relief. Consider Nick Keith. He enrolled in a two-year culinary school, taking out a $46,000 private loan with an 18% rate. But the 33-year-old Keith, unable to snag a high-paying job as a chef, has fallen behind on his payments, and his loan has ballooned to $116,000. There's talk of modifying bankruptcy laws to allow borrowers like Keith to expunge student debts—a change that is getting support from some private lenders. But unless that happens, says Keith, "I have a hopeless future."

A big question, though, is whether the private student loan market needs a boost in the first place. Congress has already upped the limits on federal loans, which typically have lower rates and more favorable terms. And the government has been able to pick up much of the slack. In the first nine months of the year, the volume of government loans jumped by $3.1 billion, according to FinAid, an increase that nearly offset the $3.4 billion drop in private loans. Says Sandy Baum of the nonprofit firm the College Board: "Reinvigorating private loans may not be in students' best interest."

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