April 5 (IFR) - San Francisco-based start-up lender SoFi has a novel idea to revive the moribund market in student-loan bonds -- get alumni to invest in their schools.
More precisely, get them to invest in securities backed by loans to their schools' students, who would in turn benefit from interest rates below the current rate on federal loans.
Students get a lower interest rate, and alumni get a way to support their university while earning a financial return, Mike Cagney, SoFi CEO and chairman, told IFR.
By offering alumni the opportunity to invest in students from their schools, we are restoring the historical norms of community-based lending, he said.
SoFi -- the name comes from social finance -- has already tested the waters with a $2 million pilot program at Stanford University Graduate School of Business, in which 40 of the school's alumni invested in the mezzanine tranche of a loan pool raised for student consolidation loans, used to refinance existing student debt.
The company is now looking to expand the program to 40 mostly top-tier universities, with a target of $150 million in originations for 2012; it hopes to scale up to $1 billion by 2014.
A separate program for new or matriculating students is also being rolled out. Interest rates are competitive with or even slightly lower than government-based loans.
EARNING FROM LEARNING
Student debt is now the second-largest segment of consumer debt in the United States after mortgages, with more than $1 trillion in loans outstanding.
And Cagney, a former head of proprietary trading at Wells Fargo, calls the current situation unsustainable -- more students are graduating with debt than without, while borrowers face high interest rates and a challenging job market.
Under his plan, alumni investors buy into a loan pool with a so-called certificate of participation -- basically, an asset-backed security -- and earn nominal returns of 5% to 8%, depending on the level of risk they take on.
Alumni can invest directly or through individual retirement accounts, which Cagney says makes the investments different from alumni donations to their schools.
He believes a school-specific alumni-based investment vehicle would make students less likely to default.
Alumni would offer mentoring and career support to students, although it's not clear how that would take place, or whether an alumnus would know the identity of an individual borrower.
The social aspect creates positive selection among borrowers and increases the credit quality of the pool, Cagney said. You are planting the seeds for lifetime engagement.
The proposed asset-backed securities (ABS) would have a senior/subordinate structure in which alumni would mainly have a stake in the mezzanine notes.
The senior tranche would be offered to institutional investors, while SoFi takes the equity piece, which is the riskiest. The lender retains 50% of residual cash flows for a reserve account.
Cagney said the senior notes would have roughly the same coupon and comparable subordination, or credit protection, as a traditional private student-loan ABS, except that the alumni-backed product would have better underlying credit quality.
But some student-loan ABS experts are skeptical -- and not only because ratings agencies will not rate the product, due to its lack of a track record.
While in theory this may be a viable product, there are serious legal implications that need to be thought about, investigated, and complied with, said Steve Levitan, a securitization partner at Bingham McCutchen.
Complying with new regulations laid out by the Consumer Financial Protection Bureau will be an uphill battle, he said.
And while the SoFi plan relies on cherry-picking the better students from good universities with a refinancing loan offering, Levitan said, traditional lenders such as Sallie Mae would be sure to respond aggressively with similar products.
Somebody has a loan to these people already, he said. No company likes to have their best loans taken away from them, Levitan said.
Moreover, it's not clear whether the connection to alumni is enough to guarantee borrowers will stay current on their loans, said Scott Weingold, the co-founder and head of College Planning Network, LLC, a college admissions and financial aid servicing and advisory center.
At the end of the day, the question is, does the alumni tie-in really make a student less likely to default than if the loan was written somewhere else? Weingold said.
That's unproven. Ultimately, it all comes down to whether a borrower has the money to pay the loan back.
And there are other questions as well.
If an alumnus were to call a student to put pressure on him to pay his debts, that would effectively make him or her a debt collector.
And there are legal ramifications to that, Levitan said. You need a license to do that.
But Cagney believes that students and alumni alike will benefit from the arrangement, not least because the federal government's role as lender is replaced by a more socially tight-knit connection.
If you replace the government with alumni, it becomes a virtuous cycle, he said.
Students want alumni to succeed because that's their future network. And the schools don't want the students to default into the alumni community, Cagney said.
Both sides are vested in one another's success.
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(Adam Tempkin is a senior IFR analyst; Editing by Marc Carnegie)