Sallie Mae

When the new Consumer Financial Protection Bureau starts its work on private student loans in earnest, it will have to confront a question that has vexed policymakers and student aid experts in recent years: Why do so many students take on this debt without exhausting their eligibility for federal loans first?

According to the most recent data available from the Department of Education, the majority of undergraduates who borrowed private loans in the academic year 2007-08 did so even though they hadn’t taken out all of the federal loan debt for which they were qualified. Nearly one quarter of these private loan borrowers did not take out any federal loans at all.

This is a major public policy problem because private loans are far more risky than federal loans and almost always much more expensive. Unlike federal loans, which carry a fixed rate, private loans generally have uncapped interest rates that vary month to month based on market conditions. While federal loans offer the same terms to all borrowers, private loan providers tend to charge higher rates to those with the greatest need.

Federal loans also offer much greater consumer protections than private loans. Borrowers in the federal programs who become unemployed or suffer economic hardship, for instance, have a legal right to have their loans deferred for several years. Private loan borrowers who run into trouble don't have that option. And unlike federal loans, private loans are not automatically discharged if a borrower dies, is permanently disabled, or attends a school that unexpectedly shuts down before that student completes his or her studies.

How much does it really cost a student loan company to collect on a defaulted private student loan? That question is at the center of a class action lawsuit that a federal judge in California has allowed to proceed against Sallie Mae, the country’s largest private student loan provider.

The case was filed by four borrowers who have defaulted on private loans they took out from the student loan giant between 2002 and 2004 to attend Career Education Corporation’s California Culinary Academy in San Francisco. Before sending these borrowers’ loans to a collection agency, Sallie Mae added a collection fee of 25 percent to their loan balances in a process known as capitalization. As a result, the total amount each of the plaintiffs owed ballooned -- growing, in one case, from approximately $48,000 to $60,000 and, in another, from about $73,000 to $103,000.

While Sallie Mae’s actions in this case were not necessarily unusual, the lawsuit argues that the company violated the terms and conditions of the loans. At issue is the following clause that Sallie Mae includes in its private student loan promissory notes regarding potential collection charges:

 “[Borrower] agree[s] to pay [holder] reasonable amounts permitted by law, including attorneys’ fees and court costs which [holder] incurs in enforcing the terms of this Note, if [borrower is] in default.” [Emphasis added]

The lawsuit contends that the 25 percent fee is "not reasonable" and has no relation to the true costs that Sallie Mae incurs when a borrower goes into default. Instead, the borrowers' lawyers argue that this is an arbitrary fee that is "designed to substantially exceed the collection costs actually incurred."

While “it would not be impracticable or extremely difficult to fix the actual costs of collection," the lawsuit says, Sallie Mae has not made “a good faith attempt” to do so. “The amount of the Collection penalties does not represent the result of a reasonable endeavor by Defendant to estimate a fair compensation for any loss that may be sustained."

By Deanne Loonin

Before the credit crash in 2008, many for-profit colleges partnered with third party lenders, such as Sallie Mae, to provide private student loans to their students. When these loans started to fail at devastating rates, nearly all of these lenders exited the subprime student loan business and terminated their partnerships with these schools. 

The sudden and unexpected exodus of lenders from this market left proprietary school executives facing a dilemma. The report that we at the National Consumer Law Center’s released earlier this week, “Piling It On: The Growth of Proprietary School Loans and the Consequences for Students” highlights how many for-profit schools responded to this “funding shortfall” by creating their own student loan products. Nearly all of the large companies -- with the notable exception of the industry’s largest player, the Apollo Group, which owns the University of Phoenix -- have increased institutional lending in some way. 

Industry and Wall Street insiders often describe the growth of institutional lending at these schools as inevitable. This misses the mark because the schools deliberately chose to make the loans. They made a purposeful decision that may have benefited the companies and their investors but was not in the best interests of their students.

Do colleges with high student loan default rates have any responsibility for their former students’ loan repayment problems?

While for-profit college lobbyists and leaders would like us to believe that the answer is “no,” Sallie Mae, the student loan company with the most experience lending to students at these schools in recent years, has a much different story to tell.

As we’ve previously reported, a little less than a decade ago, the student loan giant began forging sweetheart deals with some of the country’s largest chains of for-profit colleges, such as Career Education Corporation, Corinthian Colleges, and ITT Educational Services, among others. Under these arrangements, Sallie Mae agreed to provide high-interest private loans to low-income and working class students at these institutions. The company apparently viewed these loans as “loss leaders,” meaning that it was willing to make these risky loans in exchange for becoming the exclusive provider of federal loans to the hundreds of thousands of students these huge chains collectively serve.

It didn’t take long for these loans to start going bad. For a while, the company, which had put itself up for sale, appears to have tried to hide the rapid deterioration of its “non-traditional” private loan portfolio from investors and potential buyers by pushing as many delinquent borrowers from these schools into forbearance as they could. But after an investor group led by the private equity firm J.C Flowers & Co. dropped its bid to buy the company, Sallie Mae came clean.

In a conference call with investors on January 23, 2008, executives at Sallie Mae announced that the company had sustained more than $1 billion in losses on these loans, and, as a result, would no longer make private loans to financially needy students attending these institutions. Al Lord, the company’s chief executive officer, laid the blame for the losses squarely on the shoulders of the schools with which they had been working:

Earlier this week, we wrote about a class action shareholder lawsuit that accuses Sallie Mae executives of having engaged in an elaborate scheme to hide the rapidly deteriorating state of the company's private student loan portfolio at a time when they were trying to complete a buy-out deal that would have brought them great riches.

At Higher Ed Watch, we find these allegations compelling. It was, after all, only a week after Sallie Mae's deal with J.C. Flowers & Co. collapsed that the company began to come clean about the huge amount of losses it was about to incur on the extremely risky private loans it had made to sub-prime borrowers at some of the largest chains of for-profit college companies in the country.

Unsurprisingly, Sallie Mae's lawyers tell a different story. Far from being conspirators, the student loan giant's leaders, they say, were "unsuspecting victims" of the financial turmoil that overtook the country during that period of time. "Although not recognized at the time, the second half of 2007 marked the start of what became the largest credit crisis since the Great Depression, described by former Federal Reserve Chairman, Alan Greenspan (who did not predict it), as a "once-in-a-century credit tsunami," the company's counsel wrote in their unsuccessful motion to get the case dismissed. "During this period SLM Corporation experienced unprecedented defaults by its student borrowers and its stock price declined substantially, on virtually the same downward trajectory as other consumer credit providers."

They concluded the motion by saying, "In sum, plaintiffs offer no contemporaneous, reliable evidence sufficient to support any inference other than that defendants were unsuspecting victims of a consumer credit tsunami that cause unprecedented numbers of its student borrowers to default."

This explanation could be convincing -- but only if you ignore the numerous statements that Sallie Mae officials have made since that time acknowledging the part they played in creating the mess in which they find themselves. At Higher Ed Watch, we thought we'd provide the following chronology to remind our readers of what Sallie Mae executives had to say as the true condition of  the company's private loan portfolio became known:

On December 12, 2007, Sallie Mae announced that the extremely lucrative buy-out deal that it had reached earlier in the year with an investor group led by the private equity firm J.C. Flowers & Co. had gone up in smoke. A week later, Sallie Mae executives began to acknowledge the rapidly deteriorating state of the company's private loan portfolio, particularly among those high-risk loans it had made to sub-prime borrowers at some of the largest chains of for-profit colleges in the country.

Was the timing a coincidence? Or had the student loan giant's leaders engaged in a deliberate scheme to mask the company’s true financial condition to make sure the deal -- which promised to bring great riches to its board members, including chairman Al Lord, who was set to rake in $225 million -- was consummated?

Those questions are at the center of a class action shareholder lawsuit (click here for part 1 of the complaint and here for part 2) that a federal judge in Manhattan has allowed to proceed against Sallie Mae [SLM]. Late last month, William Pauley of the Federal District Court in Southern New York rejected a motion by Sallie Mae to dismiss the lawsuit, saying that the investors suing the company had provided sufficient evidence of possible wrongdoing to allow the litigation to move forward.

The case dates back to the fall of 2006 when Sallie Mae put itself up for sale. In the immediate years preceding, the loan company had forged sweetheart deals with some of the largest chains of for-profit colleges in the country, including Career Education Corporation, Corinthian Colleges, and ITT Educational Services, as Higher Ed Watch has previously reported. Under these arrangements, Sallie Mae agreed to provide funds for private student loans, with interest rates and fees totaling more than 20 percent per year, to low-income and working class students at these schools who normally wouldn’t qualify for them because of their poor credit records. Sallie Mae apparently viewed these loans as “loss leaders,” meaning that the company was willing to make these loans, many of which were likely to go into default, in exchange for becoming the exclusive provider of federal loans to the hundreds of thousands of students these huge chains collectively serve.

As they started to shop the company around, Sallie Mae executives, the lawsuit says, decided to double down on this risky strategy. "Defendents sought to increase short-term profits in an effort to negotiate a sale to the Flowers group (or another buyer) at an attractive premium and convince investors that an acquisition on favorable terms was likely,” the complaint states. “The scheme consisted of writing billions of dollars in private loans to high-risk borrowers, recording increased income from these loans (as a result of increased loan volume and higher rates of interest SLM was entitled to receive on the loans" as compared to federal loans), and "underreporting expected losses.” From June 2006 to December 2007, Sallie Mae’s private loan portfolio “more than doubled,” from $7 billion to $15.8 billion.

To make the strategy work, Sallie Mae officials needed to find a way to mask the amount of risk the company was taking on. Their aim was to keep delinquency and default rates on these high-cost loans artificially low while the buy-out deal was pending, the lawsuit says. Otherwise, they would have had to significantly raise the amount of money they held in reserve to cover possible losses on these loans -- which would have “reduced reported income and earnings” and ultimately the company’s value. 

According to the lawsuit, Sallie Mae officials found an easy solution: pretend that the problems with the portfolio didn't exist by pushing delinquent borrowers into forbearance. By manipulating the company's forbearance, they could ensure that delinquent borrowers would not default on their loans until after the buy-out deal was completed and ownership had changed hands.

One way or another, the whistle-blower lawsuit filed by Jon Oberg, the U.S. Department of Education researcher who uncovered the 9.5 student loan scandal, against six student loan companies that participated in the scheme should be resolved shortly.

The parties are currently in the third-day of court-ordered settlement talks to resolve the lawsuit, which seeks the return of approximately $1 billion to the government in overpayments these lenders improperly received. If the negotiations break down, the case is scheduled to go to a jury trial in the U.S. District Court for the Eastern District of Virginia on Tuesday.

The defendant with the most to lose in the case is Nelnet, the Nebraska-based loan company that was the most aggressive participant in the scheme, reaping about $300 million in excess federal subsidy payments from the government. The other defendants are: Brazos Higher Education Services Corporation (Texas), Education Loans Inc. (South Dakota), Panhandle Plains Higher Education Authority (Texas), Sallie Mae, and Southwest Student Services Corporation (Arizona). Brazos and Oberg have tentatively reached a settlement, the terms of which are now under review by the Justice Department.

As we have repeatedly said, this case should finally resolve many of the unanswered questions surrounding the scandal -- a goal we have been pursuing at Higher Ed Watch over the last couple of years. After doing a careful review of court documents publicly available on PACER (Public Access to Court Electronic Records), here are some of the truths that we believe have been revealed:

Senate Democratic leaders are coming dangerously close to allowing a golden opportunity to rein in predatory private student loan practices pass them by.

The Senate is expected to complete work over the next week on its version of a financial regulatory overhaul bill that would create a new federal watchdog agency in charge of regulating all forms of consumer credit, including private student loans. The aim of the Consumer Financial Protection Bureau would be to protect consumers from the types of unscrupulous lending practices that led to the near collapse of the financial markets not so long ago.

The legislation holds out the promise that private loans would for the first time be regulated by a single entity, rather than the patchwork of federal agencies that have done little to curb even the worst private lending abuses in the past.

Unfortunately, the Senate bill, as currently written, falls far short of that goal. As our colleagues at the Project on Student Debt have pointed out, the measure includes “worrisome gaps” that would hamper the bureau’s ability to provide meaningful oversight over the private loan market and to ensure that students are not being led to take on high-cost private loans unnecessarily.

The U.S. Senate is expected to begin considering financial regulatory reform legislation this week that would create a new federal watchdog agency in charge of regulating all forms of consumer credit, including private student loans. The aim of the Consumer Financial Protection Bureau (which is called the Consumer Financial Protection Agency in the version of the legislation that the House of Representatives approved in December) is to protect consumers from the types of predatory lending practices that led to the near collapse of the financial markets in the not-so-distant past.

But at least in terms of strengthening regulation over the private loan market, the Senate bill’s authors seem to have committed a major oversight of their own: as written, the legislation appears to prevent the consumer protection bureau from having any oversight authority over Sallie Mae, which is by far the single largest private student loan provider in the country. According to Student Lending Analytics, the company made nearly $5 billion in private loans in 2008-09, over three times more than its closest competitor.

Under the bill, the Consumer Financial Protection Bureau would not have any supervision or enforcement authority over banks with less than $10 billion in assets. Instead, these banks would remain under the jurisdiction of the existing bank regulatory agencies, such as the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC). The legislation’s authors included this provision to try and limit the regulatory burden that the measure would place on smaller banks and credit unions.

So what does this have to do with Sallie Mae? According to some consumer advocates and lawmakers, the student loan giant appears to fall under this exemption because it is currently financing private student loans through a bank it owns in Utah (appropriately called the “Sallie Mae Bank”) whose total assets fall well below the threshold.