Will Private Student Loans Follow Sub-Prime Mortgages in Default Crisis?

Writer Eric Dash of The New York Times says there are dangerous parallels between the subprime mortgage market problems and the private student loan industry, which reportedly signs up borrowers at variable rates which later skyrocket and make loan payments unmanageable. From The Times:

ON a sunny June morning, Daniel M. Meyers stands at the helm of the gleaming, 60-foot racing yacht he bought several years ago with part of the fortune he had earned as a pioneer in the private student loan industry.

Heading out to sea, he joshes with his 16 crew members as they prepare for the start of a regatta. Mr. Meyers’s love of finance is reflected in the name of his boat: Numbers. He also has a chase boat called Fractions and a dinghy called Decimals. “I know, it sounds a little corny,� he says.

Corny, absolutely. But his knack for numbers allowed Mr. Meyers to unearth riches by marketing loans to college students who needed financial assistance after they had exhausted less expensive options offered through federally subsidized loan programs.

Mr. Meyers’s student-lending niche has exploded into something of the norm as the cost of a college education has skyrocketed. And the company he helped to found 16 years ago, First Marblehead, is now one of the biggest in a $20 billion industry that occupies one of the most lucrative segments of consumer lending.

But such growth — as well as the fact that debt levels for newly minted graduates have more than doubled over the last decade — has drawn the scrutiny of Congress and regulators. Andrew M. Cuomo, the New York State attorney general, has helped expose financial ties between some lenders and colleges — including kickbacks to financial aid officers — that put their own interests ahead of those of students. (First Marblehead was not one of the companies implicated.)

The student loan industry could be in for more jolts. Policy makers and regulators say that there are dangerous parallels between the private student loan and subprime mortgage markets. In both, there have been phenomenal profits, aggressive marketing and, until the recent credit market turmoil, a healthy appetite from Wall Street investors.

And, as was seen in the subprime market, many student loans that were made in the last couple of years are resetting at much higher rates.

Benjamin M. Lawsky, who is leading the state attorney general’s investigation of student loans, says that certain practices in the business give rise to many questions. “Are lenders making responsible loans?� he asks. “Or are they just saddling people with debt they will not be able to repay?�

In the last few weeks, Mr. Cuomo’s office has started a broader inquiry into the industry’s marketing tactics, according to people close to the matter who did not want to be identified because they are not authorized to speak about a continuing investigation. These people say that First Marblehead, the company that Mr. Meyers helped found, is one of more than a dozen being examined, and that an inquiry into the incentives used by packagers of private student loans is coming next. [full text]

A rebuttal of Mr. Dash’s article is made by hedge fund manager Tom Brown in this article. Tom Brown discloses at the end that he holds positions in First Marblehead, the private student loan business that is featured in Mr. Dash’s article. Brown tries to discredit the idea that student loans will follow the disastrous course that subprime mortgages have taken. He also notes that the questionable tactics of direct-to-consumer student loans are something that First Marblehead subcontracts out to other businesses. Thus he suggests they are clean and not responsible for the practices.

The bottom line is that predatory lending is wrong and unfair. It sets people up for failure. To the extent that private entrepreneurs are getting massively rich by reeling in students and signing them up for loans that they are not going to be able to pay — this should be investigated, and those responsible should be charged and, if guilty, shut down. But the other side of the coin is that the government does not provide nearly enough student loans to cover the burgeoning cost of college education. These private lenders are providing a service that is in demand. If we really want to fix this problem, there needs to be a better alternative, which means more and better loans provided by the government.