Question

Sallie Mae is a quasi-governmental agency that packages individual student loans into pools of loans and sells shares of these pools to investors as Sallie Mae bonds. a. What is this process called? What effect will it have on investors compared to situations in which they could only buy and sell individual student loans? b. What effect do you think Sallie Mae's actions will have on the ability of students to get loans? c. Suppose that a very severe recession hits and, as a consequence, many graduating students cannot get jobs and default on their student loans. What effect will this have on Sallie Mae bonds? Why is it likely that investors now believe Sallie Mae bonds to be riskier than expected? What will be the effect on the availability of student loans?

Short answer

Answer: The process is called securitization, wherein individual student loans are packaged into pools and shares of these pools are sold to investors. It allows investors to diversify their risks compared to buying and selling individual loans, which might lead to concentrated risk exposure to the specific borrowers.

Step-by-step solution

Part a: Identifying the process and its effect on investors

The process of packaging individual student loans into pools and selling shares of these pools to investors is called securitization. It allows investors to diversify their risks compared to buying and selling individual loans, which might lead to concentrated risk exposure to the specific borrowers.

Part b: Effect of Sallie Mae's actions on students' ability to get loans

Sallie Mae's actions will likely increase the availability of funds for student loans as securitization reduces the lenders' risk so that they are more willing to provide loans to students. Additionally, when investors buy shares in the pool of loans, it creates more capital for lenders to distribute as loans to students, possibly enabling more students to have access to loans.

Part c1: Effects of a severe recession on Sallie Mae bonds

If a significant number of graduating students cannot find jobs due to a severe recession and end up defaulting on their loans, the Sallie Mae bonds will be adversely impacted. Investors holding shares in the pools of student loans will experience losses as the defaults increase in the underlying loans.

Part c2: Perception of Sallie Mae bonds by investors

In the situation of increasing loan defaults, investors would perceive Sallie Mae bonds to be riskier than initially expected. The higher defaults lead investors to reevaluate their risk assessment regarding these bonds to account for the heightened risk associated with a severe recession and its impact on student loan repayment.

Part c3: Effect on the availability of student loans

The increased risk perception and losses associated with Sallie Mae bonds may lead to a reduced appetite among investors to invest in these bonds. This, in turn, might decrease the capital available for lenders to provide student loans, negatively impacting the availability of such loans for students.

Key concepts

Risk Diversification

Securitization is a key strategy for risk diversification in financial markets. When student loans are bundled together into a pool and shares of these pools are sold to investors, it allows for risk to be spread across many loans rather than concentrated in a single loan. This is beneficial for investors because:

• Diversification: The risk is spread over many borrowers, reducing the potential impact of any one borrower's default.
• Stability: Investors can expect more consistent returns as the risk is mitigated across the entire pool of loans.

This approach contrasts with the scenario where investors hold individual loans, where the risk is much less predictable and potentially more volatile due to reliance on specific borrowers repaying their loans. By investing in a diversified pool, investors are less exposed to the financial distress of individuals.

Student Loan Availability

The securitization of student loans by organizations like Sallie Mae significantly impacts loan availability. Here's how:

• Increased Funding: By pooling loans and selling them as bonds, there is a steady influx of capital from investors. This capital allows lenders to offer more loans to students.
• Reduced Risk for Lenders: With securitization, the risk is transferred from lenders to the investors in the loan pools. This reduced risk incentivizes lenders to approve more student loans.

The result is that more students are likely to get access to necessary funds for their education, as lenders are more willing to issue loans knowing they can offload a portion of the risk.

Economic Recession Impact

During a severe economic recession, the landscape for student loans and related securities can change dramatically. If a recession hits, it's common for graduates to struggle in finding employment, potentially leading to higher default rates on their loans:

• Impact on Bonds: Increased defaults translate into losses for investors who have bought into student loan pools. The value of these bonds can decrease as the financial health of the underlying loans weakens.
• Investor Confidence: As defaults rise, investors may view these bonds as riskier, which can lead to decreased interest in purchasing new issues of such securities.

This heightened sense of risk during economic downturns can ripple through the student loan market and affect loan availability.

Loan Default Risks

Loan defaults pose significant risks in the realm of student loan securitization. When a significant number of borrowers fail to repay their loans, several outcomes may occur:

• Bond Value Decline: The market valuation of student loan-backed securities may drop in response to rising default rates, affecting investor returns.
• Increased Risk Perception: Investors may start perceiving these bonds as having a higher risk profile, prompting a reevaluation of their investment strategy.
• Limited Capital for New Loans: With reduced investor interest, there might be less capital flowing to lenders, which can result in stricter loan issuance criteria and reduced loan availability for students.

Effectively managing default risks is crucial in maintaining the stability and confidence in the student loan securitization market.