The Next Crisis in Asset-Backed Securities: Student Loans?

February 19, 2017, Chicago, IL

By Kevin J. O’Brien

When the housing bubble burst during the 2007-08 economic meltdown, the ripple effect on residential mortgage backed securities (RMBS) was profound. Hundreds of billions of dollars of residential mortgages had been bundled into securities and sold to investors at a premium on the assumption that “housing prices will always go up.”  When the opposite occurred, and millions of Americans defaulted on their mortgages, the security holders were left with significantly impaired collateral.  Myriad litigation ensued involving the banks who had extended the credit (in many cases, to borrowers who were not reasonable credit risks), financiers who had sold the loans, and insurers who had guaranteed repayment.

A similar scenario may be on the horizon with regard to securities backed by student loans (known as “SLABS”).   Unlike RMBS, there is no “asset” securing the obligation, only the student’s promise to repay.  As a result, the SLABS investor’s interest is even more precarious than that of the mortgage-backed securities holder.  Now, with a variety of factors hampering the collection of student debt, some commentators are warning of a “looming collapse” in the SLABS market.

One factor echoes the RMBS crisis—overextension of credit to risky borrowers. The problem is especially acute with respect to “private” student loans made outside the federal student loan program, which typically carry higher interest rates.  Second, the amount of loans to students attending “for profit” colleges has increased, where statistics show that borrowers’ default rates are higher in light of the lower graduation rates and more limited career prospects associated with those institutions.  Finally, billions in defaulted student loans may be uncollectable due to shoddy paperwork—courts across the country have rejected creditors’ lawsuits where the underlying loan documents have disappeared or do not demonstrate that the borrower actually received the financial aid at issue.  The U.S. Consumer Financial Protection Bureau sued the National Collegiate Student Loan Trusts (one of the nation’s largest owners of private student debt), charging violations of federal consumer financial laws in connection with the Trusts’ servicing and collection of private student loan debt.  A proposed consent settlement requiring a third party audit of the loans, restitution and fines has been challenged by SLABS investors and companies who extended credit insurance on the bundled loans, arguing that their contractual interests would be impaired by the settlement.  The court’s decision will be closely monitored by investors, insurers, and borrowers alike.

Kevin J. O’Brien is a partner with Butler Rubin Saltarelli & Boyd LLP in Chicago. He is a litigator with experience in both trial and administrative hearings including cases in insurance coverage, reinsurance, environmental law and other types of commercial litigation. The opinions expressed are those of the author and do not necessarily reflect the views of the firm or its clients, or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.