In response to the growing balance of student loan debt in the United States, lawmakers have proposed legislation that would eliminate the most lender-protective feature of student loans – the inability to discharge the debt in bankruptcy. Similarly, to foster the restructuring of student loan debt, the Department of Education has recommended making privately issued student loans dischargeable in bankruptcy if the lender fails to offer debt relief payment options. If implemented, these and similar initiatives could significantly impact investor returns on student loan asset-backed securities (or SLABS) backed by privately issued student loans and give rise to lawsuits by or on behalf of investors.
SLABS and Recent Growth From Online Lending
The outstanding balance of U.S. student loan debt has swelled to nearly $1.3 trillion. Responding to borrower demands for refinancing options, online lending startups like Social Finance (or SoFi), Lending Club and CommonBond have entered the student loan market. Since 2015, these so-called "online marketplace lenders" or "peer-to-peer lenders" have refinanced billions in student loans. The refinanced loans are then bundled to create SLABS, which are securities that allow investors to buy into a pool of student loans. As of 2015, SoFi alone had completed $2.6 billion in SLABS.
Many SLABS have received investment-grade ratings from the nation's most prominent rating agencies, including Moody's and Standard & Poor's. These high ratings are attributable in part to the fact that the refinanced student loans underlying the securitizations are said to be originated pursuant to strict underwriting guidelines. For example, many of these lenders require a minimum credit score of 700, at least $2,000 in monthly disposable income and advanced graduate degrees.
The most attractive feature of SLABS, however, is arguably the treatment of the underlying student loans in bankruptcy. Unlike most consumer loans, student loan obligations are not automatically discharged – i.e., deemed unenforceable – in bankruptcy. In fact, under Section 523(a)(8) of the Bankruptcy Code, unless a student loan imposes an "undue hardship" on the borrower – a nearly impossible threshold for a borrower to meet – a student loan is not dischargeable and will survive a bankruptcy filing. The inability to discharge student loan debt affords investors substantial protection, as it ensures that the loans underlying the securitization will remain enforceable until they are paid down in full.
Proposed Legislation and Reforms
Proposed legislation threatens to negatively impact the quality and performance of SLABS backed by privately issued student loans. To remedy what some are calling a student debt crisis, in October 2015, the U.S. Department of Education issued a report, "Strengthening the Student Loan System to Better Protect All Borrowers," proposing a number of initiatives and legislative reforms to ease the burden on student borrowers. One of these initiatives proposes to make private student loans dischargeable in bankruptcy if the lender fails to offer debt relief payment options like the federal government's "Pay as You Earn" program or "PAYE" (under PAYE, an eligible borrower's monthly loan payments are capped at a percentage of the borrower's monthly income and any student loan debt that remains after 20 years is forgiven).
Even more drastic, in 2015, members of the House of Representatives from both parties introduced bills that would repeal Section 523(a)(8) of the Bankruptcy Code and make student loan debt dischargeable like any other consumer debt, regardless of whether PAYE-like programs are offered.
Implications for SLABS
If implemented, these and similar initiatives could negatively impact the rating and performance of SLABS backed by private student loans. Moody's recent action on SLABS backed by federal student loans illustrates this threat: In 2015, Moody's placed certain SLABS backed by federal student loans on review for downgrade in part because of the growing popularity of income-driven repayment plans similar to PAYE. In the event private student loan lenders are forced to offer similar programs (or face the possibility of discharge), SLABS backed by private student loans could also face a possible downgrade. The negative impact on ratings could be even more dramatic if the current bills to amend the Bankruptcy Code are made into law.
In addition to negative ratings, under the proposed legislation, borrowers that previously had no choice but to pay their private student loans may choose instead to default, file bankruptcy and seek a discharge. In the event borrower defaults persist and cause the related SLABS to incur losses, investors and trustees may become emboldened to commence lawsuits against the issuer of the SLABS, similar to the recent wave of fraud and repurchase lawsuits commenced against issuers of residential mortgage-backed securities. Any such claims could be based on representations in the governing documents or statements in the offering materials that become breached or are deemed materially false, respectively, as result of the new legislation. Moreover, if these lawsuits are successful, it could motivate opportunistic investors to purchase SLABS at a discount solely for purposes of commencing litigation and extracting settlements. Ultimately, if legislation is passed, the potential for lawsuits will depend on the terms of the agreements that created the SLABS and the statements in offering materials that were provided to investors.
The historically lender-friendly aspects of student loans that have attracted so many new players to the market and investors in SLABS may be negatively impacted by proposed legislation aimed at student debt relief. At this time, both investors in and issuers of SLABS should consider actions to protect their respective interests going forward, including review of the representations and warranties made by originators and issuers in existing deals and evaluation of their approach and criteria for future investments and transactions.
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