The House Always Wins

I’m writing this post from beautiful, sunny Las Vegas, Nevada, where I just gave a talk and saved hundreds of dollars by not gambling. It strikes me that the casino business and the student loan business have something in common: the house can’t lose.

Casinos offer their customers beautiful surroundings, free food and drinks, as well as the occasional jackpot. Student lenders offer their customers inducements and discounts on fees and interest rates.

In both cases, the businesses can afford to sweeten the pot this way and still turn a very, very healthy profit because they operate at virtually no risk, with the odds heavily weighted in their favor.

But don’t take my word for it — listen to Sallie Mae’s former chief financial officer and newly installed chief executive officer, C.E. Andrews.

Last week Higher Ed Watch referred to a letter sent from Andrews to the Federal Reserve and other federal regulatory agencies in January 2006. You can read the letter here: http://www.federalreserve.gov/SECRS/2006/February/20060214/R-1238/R-1238_38_1.pdf.

I wanted to take a closer look. Sallie Mae maintains its cash flow and has an additional revenue stream from trading asset-backed securities (ABS) — investment products backed by portfolios of student loans. In the letter, Andrews is asking the Fed to bless the student loan ABS with a higher rating, one that reflects what a very, very, very safe asset a student loan is.

Why does ownership of student loans promote such peaceful sleep? Andrews explains, “The high quality of student loan ABS derives primarily from the largely sovereign risk nature of the underlying assets.” FYI, “sovereign” means the risk really belongs to the federal government, not to student lenders.

“The U.S. government’s guarantee of Guaranteed Student Loans is direct, explicit, irrevocable and effectively unconditional,” he continues. If a student defaults on a loan for any reason, the lender just has to file a claim with a state or nonprofit guarantee agency and they get 98 percent of their principal back, courtesy of the taxpayers.

But that’s not all. In theory, guarantees may be revoked if a lender fails to perform “due diligence” on a loan, by, for example, sending warning letters when an account becomes delinquent. But Sallie Mae usually finds a way around this basic servicing responsibility: “In fact, the historical data for Sallie Mae student loan ABS reveals that, in practice, virtually all guaranty claims rejected based on noncompliance with the due diligence requirements are eventually cured,” Andrews writes.

So let’s review. In the Federal Family Education Loan (FFEL) program, student lenders like Sallie Mae collect interest and fees on 100 percent of what they lend out, but their risk is just 2 percent of what they lend. And even as the lenders are arguing publicly that the slightest reduction in subsidies and guarantees will drive lenders out of business and make it harder for students to get the loans they need, they’re sending official letters to the government underlining, repeatedly, just what an outrageously sweet deal — a “de minimus credit risk” — they have right now.

There must be a way to lower subsidy levels and guarantees to the point where student lenders share an acceptable amount of risk in exchange for their profits. Truly open competition in the student loan program would allow the market to set that subsidy level.