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Biden's plan to cancel student debt can apply to billions of dollars in investor-owned loans, but there is a hitch

10:32 am ET September 7, 2022 (MarketWatch)

By Joy Wiltermuth

"The consumer finance companies are going to be all over this," a former Wall Street trader said of Biden's plan to cancel some student debt

The Biden administration's plan to cancel up to $20,000 in student debt isn't limited to borrowers seeking relief on loans the government already owns.

Roughly $110 billion in older "privately" held student loans created under the now defunct Federal Family Education Loan Program (FFEL) also could qualify, even through they aren't directly eligible for debt relief under President Biden's plan, a person with direct knowledge of the matter told MarketWatch.

As long as they meet the income criteria for the debt relief plan, borrowers with FFEL loans held outside of the government's reach, including those packaged years ago into bond deals, can be consolidated into a new federal "direct loan" to qualify for cancellation, according to the Department.

If borrowers with these loans take the government up on its offer to consolidate to receive the debt relief, it also could mean an unexpected deluge of payments to bonds that benefit investors.

Who owns student loans

Like in the mortgage market, the U.S. government for decades has been the dominant player in financing student loans.

With the Education Department's roughly $1.1 trillion stake, the federal government owns everything but a tiny slice (see chart) of the overall $1.6 trillion student loan pie.

With the government's outsized footprint, Biden's debt relief plan can reach most borrowers earning $125,000 or less , but not all of them.

Before 2010, banks and other private lenders were busy packaging billions worth of government-backed FFEL student loans each year into asset-backed securities (ABS), or bond deals that promise to pay holders principal and interest payments over a certain period of time.

Deutsche Bank analysts estimated that issuance of FFEL asset-backed bonds averaged $6 billion annually from 2018-2021, with an outstanding tally as of the second quarter of about $110 billion.

"We would expect a wave of prepayments," said Kayvan Darouian's research team at Deutsche Bank in a weekly client note published in August, particularly if more borrowers achieve debt forgiveness under the Biden plan through consolidation.

Biden's aim is to forgive up to $10,000 for each eligible borrower making less than $125,000 a year, or $250,000 for a married couple. Eligible borrowers who received Pell grants, or need-based financial aid, would see $20,000 canceled.

While past student-loan relief programs have been difficult for borrowers to navigate and slow to catch on, the prospect of sweeping debt cancellation could galvanize households.

FFEL ended during the Obama administration and was replaced with direct government loans, even though many of the old loans in bond deals are still due to be repaid by borrowers.

Read: Biden's $10,000 student-loan-debt relief plan could mean 15 million borrowers owe nothing

Should you consolidate?

The Consumer Financial Protection Bureau, a consumer watchdog, in February updated its guide for borrowers looking to consolidate student loans.

Since many students take out new loans for each year of study, consolidation into a federal direct loan can combine several older loans into one loan. Consolidation doesn't lower a borrower's interest rate -- the rate on the new loan is a weighted average of the loans that were consolidated. But consolidating FFEL loans into a direct loan offers other benefits, such as making the loan eligible for certain programs, including a debt forgiveness initiative for public servants. For borrowers with commercially held FFEL loans, consolidating will also make them eligible for the Biden administration's broader debt relief plan.

"For the most part, it's a great opportunity for borrowers," said Persis Yu, policy director and managing counsel at the Student Borrower Protection Center, in a call with MarketWatch.

However, there could be a few potential drawbacks, Yu said, including that outstanding interest would be wrapped into the balance of the new direct loan, offsetting the size of any debt cancellation. Also, any unresolved issues with a prior lender, such as disputes over past payments, would be waived under the new loan.

Finally, borrowers due for debt cancellation under the Corinthian College settlement, or from other for-profit colleges that the Biden administration said misled students might want to wait for that relief to be finalized before consolidating, Yu said.

Of note, the Biden plan doesn't include lower student loan rates. Private lenders and many refinancing startups like SoFi Technologies Inc., (SOFI) and Earnest began refinancing student loans roughly a decade ago at lower rates.

Those loans can't be consolidated into a new government direct loan. However, over the next couple of months, the Education Department will consult with private lenders to consider providing relief that includes these loans, the person said.

Beyond debt cancellation, eligible borrowers also might want to consider the government's consolidation option as a potential cost-saving measure if one of their student loans has a variable rate (all federal student loans taken out by borrowers on or after July 1, 2006 have a fixed interest rate). The Federal Reserve plans to continue raising its benchmark rate to about 4% this year from its current 2.25%-2.5% range to fight high inflation.

Rate hikes make variable-rate debt more expensive for borrowers and can lead to a higher borrower defaults, which was a key catalyst some 15 years ago of the subprime mortgage crisis.

Lenders 'are going to monetize this'

In addition to debt cancellation, Biden's plan also bolsters existing income-driven repayment plans for many student loans, including by capping monthly payments on undergraduate loans at 5% of a borrower's discretionary income, instead of the existing 10% cap.

While more details are expected in the coming weeks, the White House said the effort would give "families breathing room" before the pause on federal student loan payments put in place at the onset of the pandemic in 2020 is set to expire at the end of December.

"We still don't know what the specifics look like," said David Sacco, a former fixed-income trader on Wall Street who now teaches finance at the University of New Haven. But he does suspect lenders already have begun gearing up for clients to receive some student debt relief.

"The consumer finance companies are going to be all over this," Sacco said, adding that while the Biden debt relief targets only lower-to-middle income households, many will have existing mortgages, credit cards and other consumer debt, in addition to student loans.

"In some cases, access to a $10,000 grant can be a meaningful down payment on a house," he said.

Concerns about higher rates BX: TMUBMUSD10Y and a potential U.S. recession have been weighing on equities after a brief summer rally, but the Dow Jones Industrial Average , S&P 500 index and Nasdaq Composite Index were all higher Wednesday.

Read: Biden's student-loan forgiveness is a 'game-changer,' but will it enable millions of renters to finally purchase a home?

-Joy Wiltermuth


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September 07, 2022 10:32 ET (14:32 GMT)

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