Private Student Loan Outlook

1. Private Student Loan Outlook

2. Project Approach • To gain insight into student lenders’ policies and practices, Consumer Financial Service Corporation (CFSC) completed the following: • Solicited interviews from almost 300 current or past employees of lenders, college financial aid offices, investment banks, and other organizations related to student loans. • Conducted interviews lasting 30–75 minutes with 59 industry experts, including: • 24 executives and employees at leading student lenders. • 6 credit union (CU) representatives. • 10 financial aid officers (FAOs) at educational institutions. • 8 student advocates. • 11 Wall Street analysts and other industry experts. • Synthesized findings, identified trends, and culled best practices. Prepared by Consumer Financial Service Corporation

3. Market Overview Prepared by Consumer Financial Service Corporation

4. Student Lending Outlook: Short Term • Interviewees see the industry contracting over the next 18–24 months, in terms of both number of lenders and loan volume. • Many smaller lenders have failed or will fail or be acquired, and only large lenders with strong underwriting and the ability to keep loans on their books will be able to persist in the market. • “Right now, four companies have 60% market share, and I expect them to consolidate even more market share once the fallout is complete.” —Advocate • “The few banks that were originating and holding are continuing to do that. I think banks will be the big players.” —Lender • Estimates of loan volume range from $10 to $15 billion, with a low of $8 billion and high of more than $30 billion. “At its peak, the industry was $18–$19 billion. I suspect it dropped last year to $12–$15 billion.” —Analyst • Reasons for the shrinkage include: • Absence of a secondary market. “Right now, securitizations are dysfunctional because people are not willing to take risks.” —Expert • Increased cost of funds and disappointing loan performance. “The trend is to increase prices because of the cost of funds and the uncertainty around the future cost of funds, and because of higher-than-expected losses.” —Lender • Tighter underwriting criteria. “We’ve already seen stricter credit requirements. It’s going to be tougher for students to get private loans.” —FAO • Despite these difficulties, large lenders who are currently in the business are believed to earn healthy returns. If FFELP is discontinued, these lenders may restrict their business to their existing customers and footprint. “Regionals are focused on not generating student loans outside their footprint.” —Expert Prepared by Consumer Financial Service Corporation

5. Student Lending Outlook: Long Term • The industry should stabilize because demand will always exist. • The gap between other funding sources and cost of attendance will remain. “I’m sure tuition will keep rising 5%–6% a year, so it will continue to outpace loan limits.” —FAO • The securitization market will return. “Financing and securitization will be possible, and there will be many players and a lot of competition. It may be a healthy market again, in only 5 years.” —Expert • Demand may change relative to today because: • Although students and their families are more likely to consider costs when choosing schools, many students will still reach college without a plan for how to pay for it, and private student loans will fill that gap. • “Some students are going to go to community college. They’re wondering if the value of education is worth the cost.” —Lender • “I think it’s always going to be around, because people are always going to be looking for money to fill the gap.” —Lender • Government funding will cover varying degrees of education costs. “With federal loans not increasing much and tuitions increasing, there is a larger and larger gap. Unless federal loans substantially increase, there is no other way to fill the gap except with private loans.” —Lender • Securitizations will return; however, the pricing will be higher. • Investors will require guarantees or participation by originators. • To attract investors, originators will showcase immediate income, stricter underwriting criteria, and shorter terms. • Competition from school credit unions may increase, as they have recently entered this business and they are visible to students because they are on campus. “Credit unions have started to come into the market in a big way within the last year. School-based credit unions are a natural fit—they have good volume, because they’re on-site.” —CU Prepared by Consumer Financial Service Corporation

6. Acquisitions • Acquisition efforts have been dialed down in all channels. “Acquisition is really not so important to us these days. Acquisition is expensive, and the cost just isn’t justified by the small profit margins of the business.” • The one remaining strong channel is schools, but budgets have been cut there as well. • Schools dominate because they have a trusted relationship with the student and parents, and they have the infrastructure to guide the student through the loan process. “The school is the be-all and end-all. From a brand point of view, the school is the trusted agent in higher education financing, not the bank. Students rely on the recommendations of schools, and until we have better consumer information, this is their best information resource.” —Advocate • In addition, the default rate is lower and loan performance is better for the school channel. “Even the biggest proponents of [direct-to-consumer] origination would tell you that it absolutely does not compare to the school channel, where you get a better, more counseled borrower. They aren’t borrowing in excessive amounts, and the incidence of default diminishes.” —Lender • Direct-to-consumer (DTC) marketing is perceived as a potentially positive channel in the long term because it gives lenders the opportunity to build relationships with students and their parents. At present, however: • Direct mail has dropped off sharply and when used is primarily focused on existing bank customers. “Lenders are marketing through direct mail to existing borrowers and banking customers. They aren’t buying fresh lists or using aggressive direct mail to get new customers.” —Expert • Internet acquisition is down because the quality of the applicants has declined. “A lot of servicing is done over the Internet, but not much marketing.” —Expert Prepared by Consumer Financial Service Corporation

7. Funding • Today, lenders need a balance sheet to continue their student lending business. • “If securitization doesn’t come back the assets will be carried on balance sheets.” —Lender • “Right now, the only way lenders can get the capital required to make student loans is having a balance sheet.” —Expert • Those that don’t have access to capital must partner with institutions that do, e.g., warehouse lines of credit, for-profit schools, community banks. • “We’ve been approached by a few companies to book loans—which we would maintain on our balance sheets—through their platform. We might eventually do that, but as of now there are a limited number of loans and our network isn’t that big.” —Lender • “Larger for-profit schools are trying to come up with an institutional loan program, or are hiring newer lenders or lenders that recently closed to do their origination and servicing.” —Lender • Long term, securitization is anticipated to provide a significant source of funding. • “I think that credit will loosen up in the long run. We will get into a more traditional model where large commercial banks provide warehouse lines, and I think that ultimately we’ll go back to securitization lines.” —Lender • “The securitization market will free up. Compared to other assets in asset-backed securities—even with the higher default rates on re-securitized portfolios—student loan quality is still higher than other types of consumer credit. And considering their non-dischargeability in bankruptcy, it’s likely you’ll get money back from these loans after 15–20 years.” —Lender Prepared by Consumer Financial Service Corporation

8. Loan Terms • Pricing has gone up. • “If you think about giving a large, unsecured loan to someone who you have minimal information about, where there is a very long repayment period, you have to price for that risk.” —Lender • “Loan terms will be more expensive than they were in the past few years because the cost of lending money for lenders has increased. On average they’ll be higher.” —Lender • Fees have been added. “We’re seeing origination, application, and repayment fees because lenders can’t cover losses with the interest rates anymore. Some charge for a deferment on the private loans.” —Lender • Terms are becoming shorter. “Terms will be shorter: 10- to 15-year loans rather than 25-year loans.” —Lender • Interviewees mentioned interest-only payments as a growing trend. “Traditionally, private loans mirrored federal loans—you didn’t have to pay until after school. I think this will change. Many lenders will require interest payments during school.” —Advocate Prepared by Consumer Financial Service Corporation

9. Underwriting and Risk Mitigation • Underwriting criteria are much stricter. • Minimum FICO scores are higher, and additional scores are being used. • “FICO requirements have gone up. Your score has to be in the 700s these days, and everyone’s FICOs have gone down recently, so it’s a double whammy for the consumer.” —Expert • “To get a real sense of creditworthiness, we looked at payment histories; number of open accounts; high and low balances of open accounts; number of hard inquiries within a 12-month period; and, of course, income.” —Lender • Debt-to-income (DTI) ratio is now considered. “Banks are looking at debt-to-income ratio—740 FICO doesn’t mean your income is particularly high.” —Lender • Income verification is common. “There is more verification of income. You don’t have the loose standards of 3–4 years ago. There is more scrutiny of your finances, what you own, your income, etc.” —Analyst • Subprime borrowers and students at for-profit schools do not qualify. • “The underwriting has changed…it’s very difficult for someone subprime or near-prime to get a loan.” —Expert • “Lenders have become much more strict…we cut out junior colleges and for-profit schools completely.” —Lender • It is almost impossible to get a loan without a cosigner, and the cosigner has to have good credit. • “Cosigners will be the rule rather than the exception.” —Lender • “Cosigners need to be prime for the loan to come through.” —Expert • Lenders are interested in using servicing data as part of the approval process. “Servicing customers may give you learnings about predictors of people who won’t graduate, which is the highest predictor of whether or not they’ll pay back your loan.” —Lender Prepared by Consumer Financial Service Corporation

10. Approvals • In the past, approval was almost guaranteed. “If a student could fog a mirror, they got the loan—an unsecured debt with 20%–30% successful repayment. It was still profitable due to higher interest rates and longer repayment terms, and it was shored up by the margins made on FFELP. The College Cost Reduction Act severely cut margins and eliminated floor income, and that was the beginning of the end.” —Lender • Over the past year, however, approval rates have fallen significantly. Among interviewees, there appears to be consensus that they are currently in the <20%–25% range. “Approval rates are much lower. They were 20%–25%, just because not everyone goes to those 1,100 first-tier schools. Now less than 20% of private loans are going through. Students don’t have credit quality, and with the economy as it is now, their cosigner may not either.” —Lender • In particular, approval rates have decreased for student borrowers who lack a cosigner. “We see more people getting denied without a cosigner. Students can’t get loans on their own.” —FAO Prepared by Consumer Financial Service Corporation

11. Account Opening and Welcome Process • Applying for a loan has become a more involved process. “Private loan applications are much longer now: They ask for more demographic information, and lenders look at the number of inquiries on an applicant’s credit report.” —Lender • As a result of recent legislation, loans must now be certified by the school. “Before the requirement that schools certify student loans there was a lot of abuse in private lending. Lenders were giving loans for up to the amount of tuition. They hadn’t evaluated whether the student really needed that much and what exactly it was for.” —CU • Coborrowers are being scrutinized more carefully than in the past. “Not only are we strongly encouraging coborrowers, but we also have tighter criteria and we verify their income.”—Lender • As in the past, there isn’t a new account welcome process of the sort employed by card issuers and other consumer lenders. “Student loans are not transactional accounts, like cards, which have a welcome kit. A lot of things happen when you first get your card, but student loans don’t have the same need for interaction. Lenders focus on providing financial literacy materials. It makes no sense to mail someone a 10-page brochure for every student loan they get. What might be better is to include a quiz or a questionnaire to make sure the borrower understands key aspects of the loan or the application.” —Lender Prepared by Consumer Financial Service Corporation

12. Cross Sell • Most interviewees acknowledge that students and their parents are attractive existing and potential customers. “It has intuitive appeal: a 19­year-old student, a customer for life. I’m sure this happens, but nowhere near as much as you might think. It’s not that cross sell isn’t successful, but it’s hard to determine if a student who opens a checking account or credit card at 19 will continue that relationship at 40.” —Lender • As a result, lenders attempt to cross sell student borrowers, but there are few conspicuous success stories. • “It’s a lot harder to cross sell from student loans than you would think. If you use student loans as the lead product, it’s important to remember that people think about the product more than the lender. Students go to a lender because it provides them with the best rate or it’s convenient. They don’t care if they get a bank account from the same bank or somewhere else.” —Lender • “I’ve seen a couple of good cross sell programs from student lenders, but I don’t have any evidence that they have occurred in large volumes.” —Advocate • Obstacles to cross sell include: • Lack of branding and customer engagement at application. “Lenders say they cross sell to student loan customers, but I don’t believe they are successful at it. That’s where the intervention of the school as a brand comes in—a lot of student borrowers may not even know who they are borrowing from.” —Advocate • Lack of support by the financial aid office. “Schools didn’t like cross sell, especially with federal loans, so many lenders didn’t try. They didn’t want students getting anything from the lenders.” —FAO Prepared by Consumer Financial Service Corporation