Do Student Loan Servicers Expect to Be Sued?

“Maybe it’s because those who know won’t and those who don’t can’t.”

Such was my response to a colleague who, after reading a recent article in the Huffington Post on yet another legal action taken against a student loan servicing company for alleged unfair and abusive practices, asked why there’s little, if any, talk about the real reasons loan servicers continue to engage in these contentious activities.

In this instance, Navient Corporation — the nation’s largest student loan servicing company and a prior investigatory target of federal regulators and the Department of Justice — now finds itself under scrutiny from 29 state attorneys general.

Specifically, this coalition of law enforcement officers’ investigation alleges that instead of moving relief-seeking borrowers into one of the federal government’s many income-based repayment plans, Navient’s call-center employees often gave them the runaround, or worse, funneled them into financially detrimental deferment arrangements. Detrimental because the interest that goes unpaid when payments are deferred is then added to principal, after which interest is charged on the higher total amount (a phenomenon known as negative amortization).

Investigators believe that the company’s call-center employees operated this way for two reasons: because they stood to earn financial incentives for successfully concluding increasingly high volumes of calls (generally speaking, temporary deferments are easier, quicker and less costly to arrange) and because many didn’t understand how the government-sponsored relief programs worked in the first place.

If these allegations are true, it’s difficult to comprehend how such an obviously unsustainable scheme can be viewed as a longer-term value-added proposition for Navient. Certainly not after taking into account what it costs to defend its practices and pay the multimillion-dollar fines it’s sustained in the past and could continue to incur, let alone the impact of all that on the company’s standing in the financial markets. (Shares of NAV are currently selling for less than half their value at the time of the firm’s 2014 spinoff from Sallie Mae.)

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So it’s reasonable to speculate that something bigger is driving this seemingly self-destructive corporate behavior.

Those who purchase securitized debts are in it for the rate of return — a financial proposition that’s conditioned in part on the full repayment of the underlying loans, a matter that’s virtually assured in the case of government-guaranteed student loans.

That is, unless those loans are granted relief under one of the Education Department’s income-based plans, where unpaid loan balances are forgiven after 20 or 25 years, or after 10 years if the borrower qualifies for its Public Service Debt Forgiveness plan.

Investor rates of return are also negatively affected when the durations of the underlying debts are extended, as a quick look at the yield curve illustrates. Longer-term securities (U.S. Treasury Notes and Bills, in this instance) carry increasingly higher rates.

One of the reasons for that is inflation, which erodes economic value over time. Consequently, longer-term investments should yield more. But when 10-year loans are restructured to become 20-year loans or longer after the fact, investors end up earning less on a “real” basis (investment yield minus the rate of inflation) than they anticipated.

At the time of its spinoff from SLM, Navient was the single-largest holder and administrator of government-guaranteed Federal Family Education loans, of which approximately $300 billion is in private hands and currently in repayment. Its revenues are derived in part from the acquisition, sale and servicing of these and other loans.

The firm is also well-positioned to become an active acquirer, securitizer and servicer of a portion of the roughly $1 trillion of Federal Direct Loans that the government may decide (or be compelled) to divest sometime soon. That’s a tidy little package of profit opportunities — one that may well be worth a whole lot more than the aforementioned downside costs.

I can’t help but wonder if there’s a crapshoot taking place: Run the legal, financial and reputation risks today so tomorrow’s economic interests can be preserved, particularly if the government is as lax about setting the standards for a prospective divestiture of Federal Direct loans as it was with the FFEL program.

If that’s the case, it would make sense to hold investors equally responsible for the actions of those who create and administer the securities on their behalf. Otherwise, there’s no assurance that this particular action or the legal challenges that are sure to follow will have much of an effect on eligible borrowers who deserve to be promptly granted the relief to which they are entitled.

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its partners.