Korea Capital Market Institute

We report that in order to expand the higher education support system in Korea it is necessary to further promote the securitization of student loans. We believe that the securitization of student loans will help to improve the quality of education and to expand the opportunities for education for the low income class. In Korea, KHFC (Korean Housing Finance Corporation) has been issuing student loan backed securities (SLBS) since May, 2005. In this study, we examine the securitization of student loans as a way to expand funds for higher education. We also attempt to find ways to improve the functioning of the student loan market, which is the basis of successful operation of the student loans securitization market. We postulate directions for developing the higher education support system as well as the student loan securitization program in Korea by examining the policy innovations in the higher education support system in the United States where the student loan markets and their securitization markets are well developed. In the US, the system where students fund their own educational costs through scholarships and student loans has taken a firm root. The US government has introduced a series of student loan programs to help students cope with increasing. For the Korean government guaranteed student loan program the cost to the government for a 100 won of a educational costs and has introduced a funding system where student loan backed securities are sold to institutional investors in the capital market. Student loan securitization has increased the funds available for educational expenses and has brought to the investors securities with very high credit rating. A number of financial institutions in the US originate government guaranteed student loans, then routinely access capital markets by pulling student loans and issuing student backed securities. For example, in 2004 alone, Sallie Mae sold US$26 billions of student loan backed securities in 12 separate issues. For the Korean government guaranteed student loan program the cost to the government for a 100 won of a student loan at the 95% level of government guarantee is estimated to be 7.125 won. This means that with a 100 won of government budget, the government is able to extend 1,400 won of student loan. The figure for the US student loan program is comparable; at 100% government guarantee the cost to the government is 8.9 cents. Clearly, the securitization of student loans backed by the government guarantee is a powerful program in which the government is able to access the private capital to fund the student loans with a minimum of the taxpayers‘ funds. In recent years, the US student loan default rate has been around 5%. We have evidence that the default rate in Korea can be greater than that observed in the US once the students who received the student loans graduate and need to repay their loans. We conclude that the controlling the default rate below 5% is crucial for the success of the program. We make a series of policy recommendations that improve the student loan securitzation market in Korea. The Korean government must increase the number of student beneficiaries sharply from the current 10% of all registered students. The comparable figure for the US is well over 50%. As in the US, the government guaranteed higher educational lending program must apply differential lending criteria based on the economic ability of the students` families. The government guarantee on the student loan must increase from 90% to 95%~100% given that the additional cost of a complete or a near complete guarantee is only incremental and modest. While increasing the government guarantee the loans must be more carefully dispensed and the loan performance must be more strictly monitored to control the cost of the government loan guarantee program. We also recommend that the educational authority issuing the SLBS assume the subordinated tranches so that the educational authority in charge will be able to absorb the profits and losses and set the interest rate more accordingly. In order to price the SLBS fairly, manage prepayment efficiently, hedge cashflows for an offshore placement of SLBS, useful prepayment as well as loan loss models need to be developed. The SLBS issuer must hedge the interest rate risk from the time of acquiring the student loans and to the time these loans are pooled and structured as SLBS and sold to the institutional investors. This risk known as pipeline risk is managed typically by taking a short position in treasury futures, or taking the IRS pay position, or taking the pay swaption position. A further development in the treasury futures markets, IRS markets and swaption markets would facilitate the pipeline risk hedging as well as other hedging needs of the SLBS market. We recommend that default data of individual schools be tracked and used to allocate the limited loan funds rewarding schools where students pay back their student loans as expected and punishing schools where students are defaulting on their student loans. Credit rating system must be developed based on default models that include borrower characteristics and other economic factors having influence on student default behavior.