Boom in Private Student Loans Mirrored Mortgage-Lending Frenzy, Report Says

July 19, 2012

The same kind of lending frenzy that created the subprime-mortgage crisis also fueled a dangerous boom in private student loans, says a report released on Friday by the Consumer Financial Protection Bureau and the U.S. Department of Education.

The rise in private student loans, which now account for about $150-billion of the more than $1-trillion in outstanding student debt, has left hundreds of thousands of borrowers stuck with bigger loans than they needed under repayment terms that are less flexible than those for federal loans, the report says.

Most of the growth occurred between 2001, when less than $7-billion in private loans were issued, and the onset of the financial crisis, in 2008, a year in which more $20-billion were.

Richard Cordray, the bureau's director, said the "aggressive lending" practices of the banks were "strikingly similar" to those of the mortgage industry during the same period. "Borrowers who took out loans at the height of the boom are still suffering from those excesses," he said on Thursday during a briefing for reporters.

The report says some of the demand was driven by investors who, as they did with mortgages, would buy the loans from the banks and then repackage and sell them as asset-backed securities. "With little skin in the game, many lenders employed risky practices like avoiding the school's financial-aid office and loosening underwriting standards," the report says. "Many borrowers accepted more money than they needed. The result: more borrowers and more debt."

Many of the 850,000 private loans that are now in default were issued in that period, bureau officials said.

The report highlights the role of lenders who made their money by originating loans and then selling them. Many of them "had more incentive to increase the number of private student-loan borrowers and the amount of debt, and less incentive to assure that the borrowers could afford the loans," it says.

Since 2008 fewer investors are in the market for such asset-backed securities, and lenders are now using more conservative standards when making loans. As the report notes, however, some for-profit colleges are still directly or indirectly increasing the levels of private lending to students, even as they expect default rates as high as 55 percent. In 2008, 42 percent of undergraduates at for-profit colleges had private loans, three times the proportion of all undergraduates.

While the report notes that for-profit colleges may be encouraging the use of such loans to satisfy federal rules that require at least 10 percent of their revenues come from sources other than federal student aid, the Association of Private Sector Colleges and Universities said more of its students use private loans because federal grants and loans often do not provide students with enough support.

'The Best Deal Around'

 In the report, Mr. Cordray and the education secretary, Arne Duncan, recommend several changes in lending and student-aid laws, including a proposal that would require colleges to sign off on students' private loans. That change would help ensure that students don't borrow more than necessary and don't resort to a private loan before exhausting their options for federal loans.

In its analysis for the report, the bureau found that about 40 percent of borrowers with private student loans had not exhausted their federal loan options. "Simply put, that's a mistake," Mr. Duncan said during the briefing. "Federal student loans are the best deal around."

Although some private lenders now offer loans to their most creditworthy borrowers at interest rates lower than the federal rate of 6.8 percent, the lenders typically don't guarantee that the rate won't go up. Federal loans are offered at a fixed rate. Federal loans also offer borrowers greater flexibility when it comes to paying off their loans, including income-based repayment options.

In conjunction with the release of the report, the Education Department has established a new Web site that Mr. Duncan said was designed to help students and their families better understand their options for planning and paying for college. The two agencies have also created a new interactive tool, the Student Loan Debt Collection Assistant, to advise students who have fallen behind in their loan payments but are not yet in default.

They also called for Congress to roll back a 2005 change in the law that made it extremely difficult to discharge a private student loan through bankruptcy. Because private loans carry fewer consumer protections than federal loans do, the report suggests that Congress consider more lenient treatment for borrowers of private student loans in bankruptcy, since those borrowers have none of the last-resort options available to those with federal student loans.