Don't Panic: Wall St.'s Going Crazy for Student Loans, but This Is No Bubble

On Sunday, The Wall Street Journal reported that hungry investors are gobbling up risky college loans as millions of borrowers fall behind on their payments.

Got a sinking feeling, like you've heard this story before? Well, cheer up. We're not looking at the mortgage bubble redux. Even if it were to go bust, the slice of the student loan market open to investors is still too small to do serious damage to the country's financial health. Most of the loans are backed by the government, and most of the ones that aren't are fairly safe anyway. And while Wall Street's sudden interest in college debt could fuel some unscrupulous lending, the most at risk population of student borrowers is actually shrinking.

So for the sake of sobriety, here's a brief guide to what is and isn't worth worrying about when it comes to Wall Street and student loans.

THE NEXT BIG BUBBLE?

From afar, it's be easy to mistake the student debt market as a single, massively inflating bubble on the verge of bursting. On Friday, the Federal Reserve Bank of New York reported that Americans are now shouldering about $970 billion worth of student loans, roughly triple what they owed eight years ago. It's by far the fastest growing category of household debt. And of those student borrowers whose loans are currently due, a staggering 30 percent are at least 90 days behind on payments.

Yet, none of this seems to be of much worry to investors, who are desperate to park their money in something more profitable than the rock bottom interest rates being offered on Treasury bonds. As the WSJ noted, the country's largest private education lender, Sallie Mae, announced Wednesday that it had sold $1.1 billion worth of new securities backed by student debt. There was 15 times more demand for the highest-risk, highest-return batch than there was supply. 

Dicey loans. Stampeding investors. What's not to worry about?

Well first, we need to put the size of the student loan market in a little context. Relatively speaking, it's tiny. If the mortgage market was a Costco-sized superstore of exotic investment vehicles, the trade in education debt is more like your local bodega. At the height of the housing bubble, the banks, Fannie Mae, and Freddie Mac combined to issue trillions of dollars worth of mortgage backed securities a year, then placed huge sides bets on them using credit default swaps. By comparison, Sallie Mae (again, the biggest name in private student lending) sold just $13.8 billion worth of student-loan-backed securities in 2012, according to its annual report. 

What's more, most of those bonds were extremely safe. That's because they were made up of debt issued under old Family Federal Education Loan Program, in which the government guaranteed student loans made by banks. Tax payers could sadly end up on the hook for those assets if students start defaulting en masse (frustrating, I know), but they won't ever blow up Wall Street, especially because unlike mortgages, banks don't use student-debt-backed assets as collateral to secure their day to day.

When you subtract the dusty old government-guaranteed loans from the picture, the student debt market that's left is positively miniscule. Ever since 2010, the Department of Education has been making loans directly to students instead of using banks as middlemen. The government doesn't sell those loans to investors, and so the only source of new student debt available to Wall Streets are private loans originated by Sallie Mae and its competitors, such as Wells Fargo. As this graph below from the Consumer Financial Protection Bureau shows, there were only about $140 billion of these private loans outstanding by the end of 2011. That's a tiny, tiny drop in America's bucket of debt. Last year alone corporations issued more than a trillion dollars of debt, and local governments sold $379 billion worth of municipal bonds, according to the Securities Industry and Financial Markets Association.

In short -- unless Wall Street has created a massive and mostly invisible trade in derivatives around them -- student debt is still just a niche investment.

It's also still a mostly boring niche -- which I mean in a good way. Whereas the government doesn't care how credit worthy federal student borrowers are, private lenders can pick and choose who they lend to.  Before the financial crisis, their standards were, shall we say, lacking. But after the meltdown, they cut back on lending and tightened their underwriting practices. That's reduced the amount of troubled debt on their books. Among all borrowers, including those whose loans aren't yet due, Sallie Mae reported a delinquency of 4.6 percent in 2012, down from 4.9 percent in 2011. The comparable figure for the government: 17 percent.

In other words, the private lenders are far more careful about who they give money to than Washington. The question is whether they will stay careful.

PREYING ON STUDENTS

If investors are beating down the door for subprime student debt, chances are someone will want to sell it to them. But the risk there is less that bankers will foolishly pile into a frothy securities market than it is that, like the subprime mortgage lenders that preyed on minority communities, private lenders will try to funnel more loans to low-income, low-information students who don't realize that they have better options. Already, the CFPB has found that 12 percent of students who take out private student debt don't ever apply for federal loans, which are usually lower interest and have more flexible repayment terms. It's safe to assume many of those students just don't know better. 

The good news is that the most vulnerable population seems to be shrinking. College enrollment dipped overall in 2012, but it fell hardest at for-profit colleges, where students were disproportionately likely to take out private loans, as they often maxed out the amount they could borrow from the government. Meanwhile, with default rates getting more attention from the media, both for-profits and more expensive traditional colleges have an added incentive to steer students towards federal loans that can be paid back based on income. 

If we've learned anything from the last few years, it's that we should be wary any time investors start creating demand for risky consumer debt. But it's worth keeping things in perspective. There are real problems with student debt -- the way it forces young people to delay their futures, and the way it sometimes ruins their finances, chief among them. But it's not a bomb waiting to blow.