Lender Banks on College Alumni to Help Solve Debt Crisis

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Student debt is poised to top $1 trillion for the first time, default rates on some programs are hovering around 10 percent, college tuition continues to rise at twice the rate of inflation, and the job market for recent graduates is dismal.

What is wrong with this picture? Plenty, of course. But Silicon Valley entrepreneur Mike Cagney says the whole system is broken.

“You have the government, the student and the school. You have a set of disinterested parties,” Cagney said in an interview.

Cagney says the government—the primary originator of student loans—knows it will ultimately be repaid, since student loans cannot be discharged in bankruptcy. The student has little choice but to borrow in order to meet rising tuition costs, and the school has very little accountability for high tuition prices or default rates.

Cagney’s solution: get alumni involved.

The former hedge fund manager, an alumnus of the Stanford Graduate School of Business, is the co-founder of SoFi, a startup that ultimately aims to make college alumni the primary source of student credit, instead of the federal government.

The company is courting alumni of 40 colleges and universities to fund loans for their students. The alumni invest in funds made up of student loan-backed securities, which Cagney says will pay a competitive and reliable return. Students, meanwhile, get a ready source of credit. Interest rates, currently 6.24 percent for student loans and 5.99 percent for refinancing existing loans, are comparable with unsubsidized federal loans as well as some private loans. But Cagney says the big difference is that SoFi creates a new level of accountability in the system.

“The students are accountable to the alumni, not only because of the transparency but because that’s their community," he said. "The alumni have an interest to help the students, and an economic interest to see them succeed, and that’s a big differentiating factor between the alumni and the government in that context. And the schools now have an implicit level of accountability. Should students default, it impacts their alumni community, which indirectly impacts their giving, but it also impacts their reputation.”

Like other student loans, the SoFi loans cannot be discharged in bankruptcy, but Cagney says they offer deferment programs that mirror federal and private loans, as well as income-based repayment programs similar to federal loans.

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While Cagney hopes SoFi will ultimately transform the entire college financing system, so far it is barely a drop in the bucket. In a nearly $1 trillion market, SoFi has just completed its first $100 million offering.

The company is also seeking to revive the practically nonexistent market for student loan-backed securities, which nearly vanished as a result of the recession and the fact that in 2010, the federal government took over the origination of student loans rather than guaranteeing loans made by private lenders.

Michael Dean, head of consumer asset-backed securities for Fitch Ratings, says in general, student loan-backed securities offer some opportunities, and they are safer than they might appear.

“Despite all of the negative headlines and arguments that student loans are the next debt bubble or the source of the next financial crisis, we still feel pretty good about the student loan ABS market,” he said.

He said Fitch continues to assign Triple-A credit ratings to bonds backed by government student loans, while securities backed by private loans are performing better than they were before the financial crisis.

“All of the originators in this space have put much tighter underwriting standards in place,” he said.

Nonetheless, one of the greatest obstacles in SoFi’s program to get alumni to invest in student loans is that none of the credit rating agencies will look at the securities.

“What they want to see is issuance history,” Cagney said. But he said the risk profile, as well as the returns for investors—five to eight percent—are “very attractive.”

“It’s a way to bring much more interaction to students and alumni, to bring alumni into a position where they are vested in the success of the students, which is significantly helpful,” he said. “And it brings an upside to the school in terms of access to capital that they didn’t previously have, to address the funding gap. At the same time I think it introduces accountability to the school.”

Financial experts typically urge students and parents to exhaust all of their government loan options before turning to loans from private lenders such as SoFi. But Cagney believes his program could eventually supplant the government programs.

“I do think it’s a game changer,” he said.

Follow Scott Cohn on Twitter: @ScottCohnCNBC