The Next Wave of Asset Backed Securities Litigation Student Loans

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A recent report authored by the Consumer Financial Protective Bureau and U.S. Department of Education highlighted concerns about the private student loan industry, which has generated more than $150 billion in outstanding student loan debt. As with the mortgage market, the secondary market was a driving force behind the widespread issuance of private student loans. Wall Street underwriters and issuers of student loan asset-backed securities (SLABS) were hungry for high volumes of student loans that could be securitized into SLABS with little additional collateral. SLABS generated significant revenue for the underwriters and passed the risk of loan default on to the investors—much like what occurred on Wall Street with the securitization of residential mortgage-backed securities (RMBS) that produced hundreds of millions in profit for the investment banks, billions in losses for investors, and spawned high-stakes litigation across the country.

It has become evident that as with the mortgage industry, this secondary-market demand for student loans led to a loosening of underwriting standards. More student loans were offered to borrowers with lower credit scores. During the SLABS boom, lenders intensified their efforts to market directly to students. Financial aid offices were often cut out of the equation, which led to a much smaller percentage of private student loans having a school certify the borrower’s need for funds for educational purposes.

Undergraduate students at for-profit colleges and universities turned to private student loans at rates much higher than their counterparts attending not-for-profit institutions. The Department of Education reports that student loan defaults are at their highest rates since 1997, with sharp increases for students attending for-profit institutions. Fifteen percent of borrowers attending for-profit institutions defaulted in their first two years of repayment.

Institutional investors who purchased SLABS believing they were purchasing investment-grade bonds are beginning to ask the same questions about SLABS as they have about RMBS. What information was available to underwriters of SLABS concerning factors like the borrower’s creditworthiness, educational program, school certification, and likelihood of being able to repay the loan? What due diligence was done to ensure the information about the borrowers was true? Did underwriters screen for fraud in loan origination? What information was passed along to the rating agencies and investors? Did the SLABS offering materials accurately reflect the risks as known or knowable to the underwriters?

If student loan default rates continue, SLABS losses could become significant as did RMBS-related losses. If these losses escalate as they are expected to do, institutional investors should analyze their portfolios with care and examine potential remedies under federal and state law.

© 2013 Robins, Kaplan, Miller & Ciresi L.L.P.

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