Why student loan business turned bad

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NEW YORK (CNNMoney.com) -- For years, financial firms made good money making government-guaranteed loans to college students.

Lenders were guaranteed a minimum interest rate at a healthy margin. Few borrowers defaulted and the federal government backed the loans if they did. Investors snapped up securities based on these loans, giving lenders a steady stream of funding.

Attracted by the easy profits, Wall Street jumped in. Goldman Sachs began investing in student lending businesses. JPMorgan Chase expanded its lending operations and upstarts appeared.

"It was a cash cow," said Mark Kantrowitz, who runs FinAid.org, an online college financing site. "A lot of these lenders popped up because it was a good business, an easy business."

Not any more. The $47.5 billion federal student loan world has been thrown into chaos in recent months. Lending has turned unprofitable for many firms, prompting scores of them to shut their doors or scale back.

Even Sallie Mae - by far the largest lender in the arena with 19% of the market - is questioning how many more loans it can finance. The company has already exited the market for consolidation loans, which are popular among graduates seeking to stretch out the repayment period. Sallie Mae (SLM, Fortune 500) had handled more than one in four of these loans. With the college financing season set to ramp up in May, the lender says it will not be able to meet the expected demand.

"We are literally in daily deliberations about how much further we can go," Sallie Mae Chief Executive Albert Lord said last week. "Our new loans are for the most part going to lose money."

Already, more than 55 lenders, which originate 13% of federal loans, have dropped out of the program, prompting fears that students will not be able to get funds needed for fall tuition. While some financing companies see the crisis as an opportunity to get more business, experts question whether this will be enough to make up for the exodus.

At this point, no one has been denied a loan, industry experts stress. But many are concerned this may change as a wave of students apply this summer, prompting lawmakers to propose temporary fixes.

JPMorgan, for instance, recently stopped making federal-backed loans at certain schools. The nation's fourth-largest lender evaluated the profitability of the loans it originates at each school. Factors included the school's default rate and average size of loans. While it costs the same for the bank to make a $1,000 loan or a $10,000 loan, it earns more on the latter.

The study led Chase (JPM, Fortune 500) to stop making federal loans at some schools, though a spokesman would only say: "It was not a small number."

Though Chase can fund loans through its own deposits instead of the costlier method of selling them to investors as securities, it must consider how much of its precious capital it wants to use for student loans. Ending lending at some schools will allow it to make more loans at more profitable ones. It is also expecting to get additional applications as other lenders leave the program.

Higher financing costs

The student loan squeeze began last fall when Congress reduced the subsidy given to lenders. The federal government provides a guaranteed rate to financial firms. The rate had been based on the commercial paper rate plus 2.34% - and that gave lenders a tidy profit when their cost of funding was low. The margin was cut to 1.79%, which combined with other changes, reduced lenders' yield on the loans by 0.7%.

Had this been the only change, most financial firms might have grumbled but that's about it, experts and lenders say.

Then, the credit crunch hit Wall Street. Mortgage defaults spooked investors of any kind of debt, forcing lenders to offer much higher rates to lure them in. Many lenders rely on securitizing these loans to obtain funding for new student loans. Nowadays, many financial firms find they have to pay investors rates that are 1.3 percentage points higher than last summer's to entice buyers of securities backed by student loans.

The result of lower rates from the government and higher borrowing costs? A profit margin of little to nothing on federal student loans.

"Lenders can't lend at these kinds of spreads and expect to meet the rise in demand that we're seeing from students for this upcoming season," Jack Remondi, Sallie Mae's chief financial officer, said last week. "The cost is just too high to continue those kinds of activity."

Response from Washington

With students starting to apply for funding in droves, financing companies are looking to Washington to jumpstart the market. Lawmakers have floated various proposals, including allowing the government to buy federal student loans or to allow the Federal Financing Bank to provide funds for loans.

The Department of Education on Wednesday said that it supports the effort to allow the government to buy loans at cost, thought it has yet to work out the specifics that would make this move beneficial for banks. But it concluded that the Federal Financing Bank does not have the authority to purchase the debt. Meanwhile, it is ramping up its direct loan program and working with guaranty agencies nationwide to make sure funding is available.

This may not prove enough, experts said.

"The letter fails to respond to questions posed by members of the Senate Banking Committee as to what actions the Treasury Department is willing to take to prevent [a student loan] crisis from occurring," said Christopher Dodd, D-Conn., chair of the Senate Banking Committee.

Some lenders see opportunity

Not all lenders, however, are fleeing the business. Bank of America Corp., for instance, is looking beyond the profitability of each loan, instead seeing college financing as a way to begin relationships with future banking customers.

Last week, the No. 3 lender said that it plans to focus more on the federal student loan market and exit the private loan industry. Bank of America said it hopes to grow loan volume by 20% over the next year.

Bank of America (BAC, Fortune 500) sees the market as an opportunity to connect with students and pitch them checking and savings accounts while they are in school and other products after they graduate.

"It doesn't end after the student gets out of school," said Diane Wagner, a spokeswoman. "We want to make sure we continue that customer relationship."