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economic brief
december 2008, eb08-03

turmoil in the Student
loan market
by John r. Walter and Samuel henly

Recent credit market problems
have diminished the availability of
some types of student loans.
Nevertheless, new sources of
funding have become available,
changing the structure of the
market while helping to meet
the demand for student loans.

Earlier this year, a number of large financial firms curtailed the number
of loans they issued to students because they were unable to cover the
costs of those loans. The largest student lender, Sallie Mae, announced
in April that it could make student loans only at an economic loss.
Other lenders failed.
The broad financial system turmoil that began in the subprime mortgage
market spread to the student loan market, raising funding costs for
lenders. Recent changes to federal student loan programs appeared to
exacerbate the problem. The government has since taken steps to
ensure adequate funding for those seeking a college education, but
the financial infrastructure behind the student loan market remains
unsteady. This Economic Brief will outline the forces that have shaped
the market this year.
Size of the market and the Government’S role
College students collectively borrow huge sums of money to pay for
school. Over the 2007-2008 academic year, for example, about $100
billion in student loans were issued. About two-thirds of students in
four-year colleges graduated with debt, and the average debt-carrying
graduate owed about $19,000.
The size of the student loan market accounts for some of the press coverage and congressional interest in recent developments. But an additional
factor is the significant role played by the government in the allocation
and pricing of student loans (see figure).
The student loan market is heavily subsidized by the federal government through the Department of Education. The government issues
some loans itself through the Federal Direct Loan Program (FDLP).
In addition, it supports the private organizations – hereafter called
“loan originators”or“lenders”– that issue most student loans through
a public-private partnership called the Federal Family Education Loan
Program (FFELP).

eb08-03 - the federal reServe bank of richmond

These organizations, a mixture of banks and specialized student loan
originators, receive two forms of support through the FFELP. First, the
government can guarantee a loan, promising a minimum rate of return
to lenders and to cover most of the bill if a student defaults. This guarantee results in a lower interest rate for borrowers. Second, the government

a SnaPShot of the Student loan market
originations in 2006 ($billions)




Unsubsidized Stafford




Total from Government Programs
Total from Private Sector


SourceS: Student Marketmeasure Inc.; FY 2007 Federal Student Aid Annual Report; Internal
Federal Reserve System

can subsidize a loan by making interest payments on the student’s behalf
until six months after graduation.

uncle Sam StePS in
In response to burgeoning problems in the student loan market, government agencies took a number of actions to increase originators’access
to affordable capital. In the spring of 2008, the Federal Reserve allowed
financial institutions to begin using student loan-backed securities as
collateral to borrow from some of its lending facilities, increasing the
desirability of the securities. In May, Congress passed legislation enabling
the Department of Education to buy FFELP loans from lenders, effectively
acting as an investor. The Department of Education also permitted its
direct loan program to expand, and a flood of educational institutions
applied to participate in the FDLP.
Students seem to have been able to obtain adequate funding this
academic year despite the recent turmoil, but structural shifts in the
student loan market have become apparent. By early September, FDLP
loan origination volume, in dollar value, had expanded by 50 percent
over the previous year while FFELP loan issuance contracted by 4 percent.
Despite renewed government support, more than 100 lenders ceased
offering FFELP loans. Many of the remaining companies have curtailed
their lending to students attending schools with high default rates.

the coSt of lendinG
Before issuing a loan to a student, a lender must have funds of its own.
One common mechanism for raising funds – capital – is through the sale
of student loan-backed securities, a type of asset-backed debt. Student
loan originators borrow money at a low interest rate from investors
by using future income from loan payments as collateral.

Credit markets remain tight and lenders continue to rely on the Department of Education loan buying program for capital. Private loans have
become scarce, although dominant lender Sallie Mae announced a program to issue $10 billion in new private loans to creditworthy borrowers.

Before 2008, this arrangement between lenders, investors, and the
government did a good job of providing students with funding for
college. Lenders made loans to students, the government backed the
loans to keep them inexpensive for students, and lenders used guaranteed student debt as collateral to borrow at low rates from investors.

Most students borrow to cover college expenses. Recent credit market
turmoil and federal legislation lowering lender revenues have diminished the availability of some types of student loans. Nevertheless, new
sources of funding have become available, changing the structure of the
market while helping to meet the demand for student loans.

Unfortunately, this system has encountered problems over the last year.
One straightforward reason is that the demand for student loan-backed
securities, like that for all asset-backed debt, has contracted significantly
since mid-2007.
Federal legislation also has contributed to the breakdown. As credit
markets tightened in 2007, investors demanded higher interest rates for
their capital. In other loan markets, a lender might be able to respond to
pricier capital by raising the interest rate charged to customers. However,
for a major portion of the student loan market, specifically for subsidized
Stafford loans, lenders’proceeds are capped, and the cap was lowered
by legislation passed in September 2007. As a result, rising funding costs
bumped up against and even surpassed the cap. Many lenders indicated
that they were losing money on every loan they made. By April 2008,
lenders accounting for 15 percent of FFELP loans had left the market.

PAGE 2 EB08-03

John r. Walter is a senior economist and research advisor in
the research department at the federal reserve bank of
richmond. Samuel henly is a research associate in the
research department.


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