Protocol | Fintech

Wall Street is driving income share agreements behind the scenes

Fintech lenders and regulators don't agree on whether income share agreements are loans. But Wall Street sees a big opportunity nonetheless.

 A diploma illustrating criticisms of income share agreements

Income share agreements have graduated to Wall Street.

Image: Christopher T. Fong/Protocol

A debate over the benefits of income share agreements is erupting in state capitals and Washington, chiefly over whether the programs that pay tuition in exchange for a share of students' future salaries are just repackaged student loans. But Wall Street, always eager for more revenue streams it can package and resell, isn't quibbling over the distinctions. The securitization of these fintech creations is raising some of the same questions mortgage-backed securities once did: Who's profiting, and how do their interests affect or even distort the products being offered?

In the case of income share agreements, the product is an education, ranging from a traditional four-year degree to a coding bootcamp certificate. Schools and fintechs powering the agreements pitch them as an innovative way for students to access education. But some advocates say that ISAs deceive students and can end up costing them much more than they would have paid with traditional loans.

The widespread securitization of income share agreements raises a different issue: Do educational institutions retain any interest in the kind of jobs their students end up getting? Part of the pitch of income share agreements is that they align schools' and students' interests. But to the extent that Wall Street parcels off the risk and reward to investors, that promise doesn't hold up.

States such as California, Illinois, Colorado and Washington have recently issued new guidelines for ISAs, including some rulings that ISAs are loans and must be regulated more tightly. The Consumer Financial Protection Bureau recently issued a consent order against Better Future Forward, an ISA company, for misleading borrowers by saying ISAs are not loans.

"Because of the novelty of ISAs, there has always been significant uncertainty about where they fit within existing regulatory regimes. Nonetheless, since the beginning [Better Future Forward] has developed and used disclosures built around the principles of federal disclosure laws," a company spokesperson said in a statement.

The wholesale finance back end of ISAs, a multilayered system that turns promises of future payments into marketable securities, is getting far less scrutiny.

One of the big facilitators of this system is startup Edly, a 2-year-old New York company bringing sophisticated Wall Street-style loan securitization to a seemingly innocent corner of education. On its website, it advertises "great schools, great returns" from students at universities such as MIT, Stanford and Columbia with starting salaries as high as $132,000, as well as students at coding bootcamps such as Lambda School.

Income share agreements have a number of similarities to mortgage-backed securities and their synthetic cousins, collateralized debt obligations. Those financial instruments were at the heart of the 2008 financial crisis. Like borrowers during the real estate boom who quickly signed balloon mortgages, ISA borrowers may not always understand what they're responsible for paying back and under what conditions. And like mortgage-backed securities, the contracts are packaged and sold off to investors who may not scrutinize what's inside the securities.

The connections are not just theoretical. Edly was founded by former finance gurus including Christopher Ricciardi, dubbed the "grandfather of CDOs" by the Wall Street Journal. Ricciardi had previously helped Wall Street capitalize on subprime mortgages. He then became a master of bundling asset-backed securities into collateralized debt obligations, which were then sliced and diced into tranches for investors. In 2017, Ricciardi joined FlowPoint Capital Partners, which helped create a new asset class by buying income share agreements. Ricciardi's firm attempted to determine what a degree was really worth.

ISA loans are typically offered by schools or ISA providers, which partner with Edly, which sells them to investors. Edly operates an online marketplace for investors to buy the ISA contracts.

As of January, Edly managed more than $20 million in ISAs, according to an investor brochure circulated in February. Edly charges investors management fees including a percentage of cash flows, according to its website. Edly also works with ISA servicers that also get paid a fee that can be as high as 5% of cash flow, according to the brochure.

For ISA investors, Edly's managed account, which invests in different schools in different areas and student industries, offers a target yield of 14%, according to Edly's crowdfunding prospectus.

One partner Edly has worked with is Lambda School. Here's the arrangement: Lambda gets paid a certain amount upfront, then when former Lambda students get a job above a certain income threshold, they start to pay back the ISA and that cash flow goes to investors until the investors get a 13% return, according to a Lambda School and Edly investor presentation obtained by Protocol.

Anything that students pay after investors reach the 13% threshold is split, 60% to Lambda and 40% to investors. The split aligns incentives and ensures the school also wants students to succeed, Ricciardi said in the presentation. "So, it's really important that we have that upside for Lambda in that shared risk. That's really what makes the whole thing work in ISAs, in our opinion," Ricciardi said, according to a transcript.

"When we purchase contracts from schools, we ask them to have a significant alignment of interest in the student outcomes," said Ricciardi in a statement to Protocol.

But the incentives of upfront payments and the creation of demand from ISA investors could have unintended consequences. One potential effect is to boost efforts by schools to bring in more students to meet that demand, regardless of how well the students perform. At Holberton School, an institution that works with Edly, "almost everyone who bothered to finish the online application was admitted," Harper's reported last year.

That's where the mortgage boom that preceded the bust echoes most loudly: In the runup to the 2008 crisis, mortgage-backed securities fueled demand for more home borrowers, regardless of credit score.

"When you have the opportunity to sell investors something with so much demand you will do whatever you have to to get the materials to make the stuff to sell it," said Ben Kaufman, head of investigations and senior policy adviser at the Student Borrower Protection Center, a nonprofit advocacy group. "And that's how a race to the bottom starts with regard to underwriting."

Income share agreements are often marketed as a way for people to get jobs in the high-paying tech sector. But some former students have sued, claiming that they didn't get adequate training and still had to pay back big bills. In May, former students sued Lambda School alleging false job placement numbers and deceptive marketing. In July, former students sued Make School, a former coding school that has since liquidated, and Vemo, which serviced Make School's ISAs.

Students at Holberton said that the school had a misleading job placement rate of 92% and didn't prepare them well to get jobs — and that since their contracts became effective one month into their schooling, they had to pay back the fees regardless of whether they even finished the program.

"Coding bootcamps have cloaked themselves in the language of aligned incentives," said Kaufman.

For its part, Edly is telling investors the same thing. In a brochure reviewed by Protocol, it said it looks for students who will land jobs that have the best potential to pay back the loans. It uses data on graduation and placement rates, salaries and time for graduates to find a job in order to find the highest "return on student investment."

But it's not clear if that data takes into account the distorting effects of the incentives players like Edly are introducing. No less an authority than Alan Greenspan, the former chairman of the Federal Reserve, told Congress that bad data from "a period of euphoria" distorted the models that Wall Street relied on. It could be a costly education to learn that lesson twice.

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