This story appears in the December 29, 2014 issue of Forbes.
It's a chilly autumn evening in trendy Williamsburg, Brooklyn, and 28 Millennials are gathered in the Greenhouse private dining room of farm-to-table restaurant Wild, washing down gluten- and hormone-free gourmet pizza with free-flowing wine. Like 55% of their college-educated peers, the partygoers carry student loan debt; unlike their less fortunate peers, they're not being dunned but wined and dined by their lender, the venture-capital-backed CommonBond.
"This is not what you picture student debt to look like," remarks Zoe Fuller-Young, who is earning an M.B.A. at New York University with the help of a CommonBond loan.
That's because Fuller-Young and her fellow partygoers are what might be called the indebted 1%--folks with five- or six-figure student debt racked up earning pricey and prestigious graduate degrees. Their earnings potential and expected low default rates make them such attractive borrowers that smart private investors can lend to them at less than Uncle Sam's one-size-fits-all student loan rates and still make a nice return, even after the cost of free organic pizza and such extras as career counseling.
"It's a trillion-dollar opportunity. You don't get a lot of those," gushes Brian Hirsch, cofounder of Tribeca Venture Partners, an early investor in CommonBond. (He sits on its board.)
Well, maybe not a trillion, but hundreds of billions. About 75% of the $1.2 trillion in outstanding student loan debt is eligible to be refinanced, and the creditworthy tranche of this debt--the part private investors are eyeing--totals at least $200 billion. So far CommonBond has made some $100 million in loans to current students and graduates of 109 M.B.A., J.D., M.D. and engineering programs at 50 brand-name schools. Another VC-backed company, three-year-old SoFi (for Social Finance), has refinanced more than $1 billion in student debt held by 13,500 graduates of 2,200 schools, making it the largest refinancer in the market.
By cherry-picking the best borrowers, these fast-growing upstarts could leave the federal government with an even higher default rate on its portfolio. That "has the potential to undermine the confidence in the student loan system," worries David Bergeron, vice president for secondary education at the Center for American Progress and a former official at the U.S. Department of Education.
Maybe. But meanwhile, Millennials with good prospects look to save some nice bucks on their student debts, while older, established folks, maybe even their parents or grandparents, have a new fixed-income investment to consider--with a feel-good kick.
This year a graduate student can borrow up to $20,500 in a Stafford loan from Uncle Sam at a fixed rate of 6.21% and the balance of his school's costs in a Direct Plus Loan at 7.21%. (Direct Plus Loans made from 2006 until 2013 carried an even steeper rate: 7.9%.) The government offers no refinancing deals for high earners but charges no penalty for early repayment.
That makes it easy for SoFi and CommonBond to refinance and undercut federal loans. Both now offer five-year fixed-rate refinancing that ranges from 3.625% to 5.99% (depending on their judgment of a student's creditworthiness); ten-year fixed rates of 4.74% to 6.625%; and a buffet of longer-term and adjustable-rate loans. SoFi estimates that its average borrower this summer refinanced $71,000 in debt and will save nearly $12,000 in interest over the life of a ten-year loan.
The upstarts are out to disrupt traditional banks, too, figuring they can use student loans as an entrée to long-term relationships with young bank-wary high earners (71% of Millennials say they'd rather go to the dentist than talk to a bank). SoFi, which says its average borrower has an income north of $130,000, recently started offering mortgages of up to $3 million in six states, including California and Texas, with down payments as low as 10%.
The tenant directory of 1 Letterman Drive, a brick office building tucked away in San Francisco's lush Presidio Park, reads as a partial who's who of venture capital funds: On the third floor is Trulia investor Polaris Partners; one floor up is Tesla backer Tao Capital Partners and billionaire Peter Thiel's eponymous Thiel Capital. And on the ground floor is SoFi, which counts Thiel among its more recent investors. (It has raised a total of $161 million from VC and angel investors.)
SoFi's CEO and cofounder is Mike Cagney, a 43-year-old with curly auburn hair and a ruddy complexion who began his career as a proprietary trader for Wells Fargo, rose to head trader and then built Finaplex, a wealth-management software company, selling it off to Broadridge in 2007. In 2010 he was running his own hedge fund, Cabezon Investment Group, when he decided to recharge his entrepreneurial batteries at Stanford Business School's Sloan Fellowship program for midcareer execs. In the school's famed "Startup Garage" class Cagney and his three SoFi cofounders (two are still at SoFi) conceived it as a peer-to-peer lending operation organized around university affinity groups: Prosperous alumni would lend to borrowers from their alma maters.
With startup investments from Joseph Chen, founder of Chinese social-networking site Renren, and Baseline Ventures founder Steve Anderson (both sit on its board), SoFi launched in the fall of 2011. Its first project was a $2 million fund for Stanford students raised from 40 alums who qualified as accredited investors (meaning they had investable assets of $1 million-plus or annual incomes of $200,000-plus).
Other elite school funds followed. Still, Cagney wanted to grow faster, and to do that, he figured, he needed to focus on refinancing the big debts of those who had already graduated--rather than making smaller semester loans--and to tap institutional as well as individual investors. He approached Wall Street in 2012 but got a chilly reception. "Student loans? Good luck," one Bank of America official scoffed, recalls Cagney. Still, he kept pitching away and hired experienced execs: His CFO is the former CEO of KKR Financial, a subsidiary of private equity megalith KKR, and his general counsel spent a chunk of his career at Sallie Mae.
Finally, in March 2013, SoFi secured a $60 million line of credit from Morgan Stanley. In December 2013 it completed a $151 million securitization of refinanced graduate student loans--the first such securitization by a peer-to-peer lender. It sold another $251 million in notes in July and $303 million in November, with an A rating from S&P and A2 from Moody's.
About 20% of SoFi's loan money so far has come from accredited individual investors, who can elect to invest in a general pool or one where returns are linked to the performance of loans from their alma maters. (About half pick a single school.) They can also buy SoFi perpetual preferred stock, which carries a 6.5% qualified dividend if 99% of their chosen school's loans are paying on time but 0% if less than 97% are in good standing.
MIT graduate Chris Neil, a 48-year-old senior vice president at San Jose-based semiconductor maker Maxim Integrated, has put $125,000 into the loan pool for his alma mater. He's been earning 4% to 5% (double what bank CDs are paying), and knowing that MIT loans back up the notes "helps me sleep at night," he says. (Another selling point for investors: Unlike normal consumer debt, student loans are almost impossible to discharge in bankruptcy.)
As for those once standoffish banks, they've shown an "insatiable" appetite for SoFi's paper, Cagney boasts. Why don't they just refinance loans themselves? Discover Financial has a pilot program going, and Citizens Bank expanded its offerings in September, with fixed rates as low as 4.74% for those who set up automatic payment from a Citizens checking account. Wells Fargo also offers loan consolidations, giving borrowers a chance to apply for a lower rate. But the big banks would likely be skewered by consumer advocates if, like SoFi or CommonBond, they offered lower rates to graduates of more prestigious schools.
SoFi doesn't lend solely based on a borrower's degree, however. It requires each to have a job or job offer in hand (law school grads must have passed the bar) and looks at salary and credit scores. If a borrower loses his or her job through no fault of their own, SoFi will suspend monthly payments and help with the job search, reaching out to its well-connected investors. It boasts that it hasn't had one default in its entire re-fi book. By contrast, 14% of federal student loan borrowers default within three years of beginning repayment.
Cagney's next goal is an IPO in 2015. Beyond that, he says, he wants to create "self-sufficient" school-centered lending machines. Harvard graduates would borrow from other Harvard graduates and, once they repay their loans, reinvest in the next generation of Harvard grads. "That way there's something rewarding and meaningful about that social aspect," he says, "but it's still done at market rate."
School ties are nice, but return is key. "Under almost no circumstance has any of my investors ever looked at this as a gift," says Cagney. "They're constantly focused on return, liquidity and getting paid back. It's almost draconian."
Like SoFi, New York-based CommonBond was born from a prestigious M.B.A. program; unlike SoFi, CommonBond emerged from the debts of its founders. David Klein, 34, Mike Taormina, 31, and Jessup Shean, 32, met at Wharton and bonded over dissatisfaction with the rates and service on their own federal and private student loans. All had experience in finance: Klein at American Express and the other two at JPMorgan. They launched in November 2012, shortly after graduation, with $1 million in angel equity investment and a $2.5 million loan kitty raised from accredited-investor Wharton alums, using the money to refinance debt of their classmates. Klein is now CEO and Taormina CFO. (Shean joined M&A advisory firm Greenhill & Co.)
CommonBond is taking growth slower than SoFi and has yet to lend beyond the academic elite. Last year it raised $100 million in a combined debt and equity offering led by Tribeca. Among the new investors: former Citigroup CEO Vikram Pandit and the Social + Capital Partnership.
"Not to be glib about it," says Tom Glocer, former Thomson Reuters CEO and a CommonBond equity investor, "but if you're coming to me for a loan and you're a dentistry student at the University of Pennsylvania, I'll be more willing to make a loan than if you tell me you're an art history major at Texas Christian."
CEO Klein defends staying focused, for now, on only 50 schools. "You could argue," he says, "that part of the reason we got into the financial crisis was that lending was happening because people were knocking at the door without appropriate underwriting happening." Still, he expects to have $500 million in loans out to graduates of the 200 top schools by the end of 2015, financing that growth with institutional capital.
Meanwhile, both startups face a risk that Uncle Sam could somehow ruin their party. If there's one thing that scares him, Cagney says, it's the prospect that the government will start refinancing loans at rock-bottom rates. That seems unlikely for now, with Republicans in control of Congress.
There's also the possibility that larger peer-to-peer lenders like Prosper and Lending Club might elbow their way in. CommonBond investor Glocer suggests the student refinancers might end up as acquisition targets for peer lenders or for the likes of Amex, which could see it as a way into the wallets of the educated elite. "You get someone early enough, they'll stay," he says.