Understanding Student Loan Asset-Backed Securities (SLABS)

If you are a college student and had to take out student loans, you probably understand how large of an issue the student loan crisis is. In the United States, statistics show that there are over 43 million Americans who collectively owe more than $1.7 trillion in student loan debt. To put that amount into perspective, there are only 11 countries in the entire world whose GDP exceeds that. This figure does not seem to be slowing down as the growing cost of college tuition, overborrowing, and students choosing majors and universities with low ROI exacerbate the issue. For some on Wall Street, however, they are finding ways to profit from this problem. In this article, I want to explain what Student Loan Asset-Backed Securities (SLABS) are.

What are SLABS 

Just like you can securitize mortgages, credit cards or anything that has stable cash flow, you can also securitize student loans. Therefore, a SLABS is an asset that is a package of student loans that delivers timely interest payments like bonds and principal payments. These loans consist of two types: federal loans that a student would usually get from the federal government via FAFSA and private loans that are obtained through a bank, credit union or some other entity that does lending to individuals. To sell these securitizations, a Special Purpose Vehicle (SPV) must be set up where the investors will exchange cash with whoever underwrote the securitization for the bonds. 

 

For why these student loans would be securitized instead of just sitting on a company’s balance sheet, it is important to understand it from the lender, not the borrower, perspective. I will use  large banks for my example. For one, the Federal Reserve requires a certain amount of regulatory capital to be held relative to a bank's risk-weighted loan portfolio. What this means is that the more risky the loans held by the bank, the more capital that needs to be held, largely a development due to the 2008 Financial Crisis. For example, if a bank has $1 billion dollars of loans and 20% is rated as non-investment grade compared to a bank with the same quantity of loans but 10% is non-investment grade, the first bank will have to put up more regulatory capital than the second bank due to increased default risk.  Therefore, a bank like J.P Morgan may securitize some of its loans to meet these requirements. Another reason is to reduce any default risk from some of its large loans and this is mostly talking about Mortgage-Backed Securities (MBS). A paper by Andra Ghent and Rossen Valkanov wrote a paper detailing how loan size greatly affects the chances of whether a loan is securitized or not, with large sized loans being more susceptible to securitization and organization costs not being a substantial factor. This is due to the fact that large loans carry huge idiosyncratic risk and that there are huge risk-sharing incentives for the banks to offload some of these loans from their balance sheets. Therefore, these are two reasons for why securitization is done. 

For these student loan ABS, it is also important to understand the difference between a federal loan ABS like the FFELP student loan ABS and a securitization by a private lender like SoFi. First off, I do not believe you can combine federal and private loans into one securitization because federal loans are guaranteed. For the FFELP student loan, because all the loans are guaranteed, an investor should always be holding the equity tranche of debt because it will give the highest yield on investment and is basically default-free like a 10-year treasury, I would assume. The problem is that the return is so low that it may not be worth holding it. For an ABS issued by SoFi, the tranches will result in a much higher return given the default risk that is priced into holding that certain tranche of debt. 

Brief Outlook for 2024    

Now, whether they are a good investment or not has been disputed by many professionals who work in the space. In general, securitized products tend to have better credit quality and a higher yield than other fixed income products. That is quite attractive and, according to CNBC,  student loans are a lot harder than other types of debts to be discharged, meaning investors looking at SLABS know that there is a lesser risk of default. Looking at federal policy, the 3-year pause on federal student loans also recently ended in October 2023, which means that students will need to start making their student loan payments now. This all sounds good as there are some tailwinds that the SLABS market is facing.    

On the other hand, I would argue that it is quite bleak. Data from Finsight has shown SLABS issuances have decreased drastically from the peak of 2021 from $27.3 billion to under $5 billion as of August 2023. This is due to a couple of reasons. High interest rates are a concern for SLABS as securitized products are more sensitive to high interest rates than other fixed income products, though things may change as FED plans to decrease rates. For discharging student loans, Biden has recently made it easier for students to get a “fresh start” in their lives, causing a massive effect on why SLAB issuances may be down in the United States. Obviously, filing bankruptcy is never ideal given that it affects your ability to obtain other loans or buy certain assets like a house, but data shows that approval rates for getting the loans discharged is nearly guaranteed. Finally, for those who want to try and pay their student loans, they may just struggle as the U.S. The Department of Education indicated only 60% of borrowers made a payment by mid-November last year. This was the month after the 3-year pause ended, which may indicate why there was a huge shock from students being unable to repay their loans. Nevertheless, it will be interesting to see the default rate trends of SLABS. 

Next Bubble?

With all this being said, some have suggested that the SLABS market is starting to feel like a bubble that can have a similar effect to the 2008 financial crisis, but I would disagree. First off, it is important to understand that federal student loans will never pose any systemic risk given that they are fully guaranteed (which also may be a reason why colleges are incentivized to hike tuition and accept as many students as possible). Therefore, there has to be considerable signs of distress from the private student loan market, which makes up 8% of all student loans outstanding. While I only have limited data on Private Student Loan (PSL) default rates, I will just note that it declined for Q3 2023 for the first time after 8 consecutive quarters of increasing default rates. There is also the fact that the SLABS market is extremely small, with only approximately $150 billion outstanding, according to Seton Hall professor Eleanor Xu. It just does not pose that much of a risk to the overall market if something were to happen. Finally, Fitch and Moody’s have extremely robust credit rating evaluation frameworks that most likely know how to accurately look at these SLABS. If something were to pose a problem in the SLABS market, I believe these ratings companies would be able to see it before something happened. 

For large institutional investors who are bullish and want exposure to the student loan market, I would suggest looking at the private student loan market rather than looking at government-agency issued student loan ABS. Private student market is estimated to be $140 billion dollars since Forbes last reported it and continues to be an attractive source of investment in my opinion. What makes it compelling to me is the fact that investors can vet through certain lenders’ underwriting capabilities to see who not only does it best, but also has the right pool of loans that the lenders are willing to sell from their balance sheet. With debt having a huge focus on downside protection and risk-adjusted returns, I would strongly assume finding loans that have low duration will be key as well as factors such as high likelihood of student debt repayments. Therefore, looking into a student’s major, where he or she goes to college and perhaps parent’s income are strong indicators of finding “safe” pools of loans to invest in for an investor. Studies show a strong correlation between university major and potential earnings, with those doing STEM-based careers outperforming those doing social sciences careers from an income perspective, as an example. In addition, those attending a top 20 private university in the country have a stronger likelihood of success when thinking about career trajectory and earnings compared to someone attending a community college. This is an extreme example, but helps illustrate my point why investors must pay close attention to the rate at which these private lenders charge certain types of students and understand the probability these payments are made on time. 

Thanks for reading my quick thoughts on student loans!  

Sources

Ghent, Andra, and Rossen Valkanov. “Comparing Securitized and Balance Sheet Loans: Size Matters.” Management Science, vol. 62, no. 10, 2016, pp. 2784–803. JSTOR, http://www.jstor.org/stable/44012216. Accessed 19 Jan. 2024.

Hahn, Alicia. “2024 Student Loan Debt Statistics: Average Student Loan Debt.” Forbes, Forbes Magazine, 16 July 2023, www.forbes.com/advisor/student-loans/average-student-loan-debt-statistics/

Hahn, Alicia. “Best Student Loan Refinance Lenders of January 2024.” Forbes, Forbes Magazine, 18 Jan. 2024, www.forbes.com/advisor/student-loans/best-student-loan-refinance-lenders/.

LindseyTweeted. “How Wall Street Trades Student Loans.” CNBC, CNBC, 13 Sept. 2023, www.cnbc.com/video/2023/08/31/how-wall-street-trades-student-loans.html.

Nova, Annie. “Only 60% of Student Loan Borrowers Made Payments When Bills Restarted.” CNBC, CNBC, 18 Dec. 2023, www.cnbc.com/2023/12/18/only-60percent-of-student-loan-borrowers-made-payments-when-bills-restarted.html.

Stange, Kevin, et al. “College Majors Affect More than Just Average Earnings.” CEPR, 27 Oct. 2022, cepr.org/voxeu/columns/college-majors-affect-more-just-average-earnings.

“U.S. Student Loan Debt Statistics [2023].” Credit.Com, 15 Nov. 2023, www.credit.com/blog/student-loan-debt-statistics/.