SoFi 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, which are used to refinance existing debt where loan amounts range from $5,000 to $200,000.
The company is now looking to expand the consolidation-loan program to 40 mostly top-tier universities, with a target of $150 million in originations for 2012, and 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 to, or even slightly lower than, government-based loans.
"We are using the capital markets as an effective medium to perpetuate a market-based solution to a social problem," said Mike Cagney, SoFi CEO and chairman. "By offering alumni the opportunity to invest in students from their schools, we are restoring the historical norms of community-based lending."
"Students get a lower interest rate and alumni get a way to support their university while earning a financial return. Both sides are vested in one another’s success."
Feasible, but unproven
The current US student loan market is broken, said Cagney, a former head of proprietary trading at Wells Fargo. With education costs on the rise and $1 trillion in outstanding loans -- student debt is now the second largest consumer segment behind mortgages -- more students are graduating with debt than without, and borrowers face high interest rates and a challenging job market.The "social" piece of the puzzle is what’s missing, SoFi believes. Cagney claims that a school-specific alumni-based investment vehicle provides mutually beneficial interactions that would make students less likely to default. Moreover, alumni will be empowered to offer advice, mentorship, and career support to students, although it’s not yet clear exactly how that connection will take place, or whether an alumnus will know the exact identity of a borrower.
"You are planting the seeds for lifetime engagement," says Cagney.
Alumni investors buy into the 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 in their investment. Alumni can invest directly or through their individual retirement accounts, meaning that investing does not affect alumni donations to the school.
The proposed ABS will have a senior/subordinate structure where the alumni investors mainly have a stake in the mezzanine notes. The senior tranche goes to institutional investors – many regional banks are interested, Cagney said – and SoFi takes the equity piece, which is the riskiest. The lender retains 50% of residual cashflows for a reserve account.
The social aspect "creates positive selection among borrowers and increases the credit quality of the pool", Cagney added. In fact, he claims the senior notes would have roughly the same coupon and comparable subordination, or credit protection, as a traditional private student-loan ABS, except the SoFi alumni-backed product would have better underlying credit quality.
There is one problem, though. Rating agencies will not rate the product, due to its lack of a track record. "We hope to get it shadow-rated by a bank. We think it has Triple A capitalization," Cagney noted.
More thought required
But some student loan ABS experts are skeptical. "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.Firstly, complying with the new set of regulations laid out by the Consumer Financial Protection Bureau will be an uphill battle, Levitan said, and cherry-picking the better students from mostly top universities with a postgraduate refinancing loan offering will cause certain classic lenders such as Sallie Mae to respond aggressively with similar products.
"Somebody has a loan to these people already; no company likes to have their best loans taken away from them," Levitan said.
Moreover, while community-based loans are a unique concept, it's not yet clear whether the connection to alumni is enough to guarantee borrowers will stay current on their loans, says 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 lastly, the market needs more details on how the "social connection" works. For instance, if an alumnus ends up calling a student to put moral pressure on him to pay his debts, that makes the alumnus a debt collector. "And there are legal ramifications to that,” Levitan said. "You need a license to do that."
Adam Tempkin
