Moody's Investors Service in mid-January updated its rating methodology report for FFELP student loan ABS.
Of the agency's proposed changes, it particularly highlighted the reason for, and anticipated impact of, implementing four of the cash flow assumptions in a companion report. These four items are increased default rates: less voluntary prepayments; higher interest rates for deal surveillance purposes; and increased net reject rate.
Barclays Capital analysts in a report analyzing the changes noted that in Moody’s companion report, the first and the third items are likely to have the greatest effect on FFELP student loan ABS ratings.
Meanwhile the items on the decreased voluntary prepayments and the increased net reject rate will potentially have no effect on the sector.
In terms of default rates, the rating agency said that borrowers will still experience poor employment prospects that will prolong the period of high student loan defaults generally, which is something that Barclays analysts agree with.
Unemployment, Barclays analysts said, is a main driver of student loan defaults. Additionally, even wtih the strong employment report for January, analysts think that young college graduates will be negatively impacted by the weak jobs market disproportionately.
The analysts cited the fact that unemployment among 20-24-year-olds is typically higher versus any other age group. Unemployment also increased in this age bracket more than any other age cohorts in the latest recession.
Barclays analysts also noted that one of the rating agency’s proposal is to increase the cumulative default assumption on FFELP loans to students at four-year schools from 4% to 8% to as high as 11% to 13% for pre-2007 loans and 17% to 18% for loans disbursed in 2007 or later.
The biggest increases happen in Stafford and consolidation loan types, Moody's had stated in their revisions. Two-year school default rates have also gone up to 22% from 21% for Stafford loans on those disbursed prior to 2007 and to 30% on loans made in 2007 and after. The Stafford loan default rates for borrowers attending proprietary schools have also risen to 35% for pre-2007 loans and 45% for post-2007.
According to Barclays analysts, because of the rating agency's higher default rate assumptions, roughly $10 billion of FFELP term ABS classes from 15 transactions are at risk of downgrade, if the proposal is implemented as written.
Moody’s stated that FFELP ABS with 'Aaa' ratings could potentially have those ratings reduced to 'Aa'. Those with 'Aa' and 'A' ratings can end up as low as 'Baa'. Moody’s added that an added $10 billion from 20 deals that include tax-exempt auction rate classes are at risk of downgrade because of the higher interest rate assumption for monitoring purposes.
Barclays analysts noted that the new default assumptions will most probably impact post-recession and new-issue offerings given that the collateral pools backing these deals likely comprise loans that fit into the the rating agency’s categorization of those most at risk, including unseasoned Stafford, PLUS, and consolidation loans with borrowers entering repayment after 2007.
Analysts from the bank said that there will probably be some exceptions as new-issue FFELP deals might have seasoned collateral, but they believe that the amount of pre-2007 FFELP loans available for securitization is limited. Thus, analysts think there will be higher credit enhancement requirements on new transactions backed by FFELP loans, together with potential downgrades of recently issued (post-recession) deals.
By opening the criteria revisions for comment, Barclays analysts said that Moody’s is seeking input from the market. But, the agency introduces a conundrum for issuers – the comment period ends Feb. 20, although a final report implementing the proposals will not come out until sometime in March.
According to Barclays, the delay gives rise to questions such as if interim transactions are issued under the old criteria, will they be downgraded when the new criteria is adopted? Other questions are whether issuers need to structure new deals in the interim under the new criteria, even if they were not implemented to avoid a downgrade.
This is why, analysts said, the proposal might result in a slowdown in FFELP student loan ABS issuance until more clarity comes out about how the new criteria will be applied.
The secondary market will also be impacted by these changes. Many FFELP buyers likely will continue to hold and buy in the sector. However, analysts said this latest development is an added setback for ratings sensitive investors. Barclays analysts think that the government will make good on its promise to guarantee the underlying student loans, thereby limiting credit risk to buysiders, no matter what its rating. Because of this, they think that FFELP cumulative net losses will continue to be measured in basis points and the bonds backed by such collateral will continue to be paid in full.
Inspite of the continued ratings uncertainty, the latest Moody’s action impacts only a small part of the FFELP ABS universe or roughly 10% of its rated transactions, Barclays analysts said.
There is also the matter of S&P is still reviewing the sector given counterparty risk and the downgrade to the U.S. sovereign rating.
However, Barclays analysts said that considering the strong structural protections and attractive spreads versus other consumer ABS they are maintaining their overweight on the sector. Within FFELP-backed ABS, they like senior bonds from top-tier servicers including Sallie Mae and Nelnet.
JPMorgan Morgan Securities analysts also commented on this issue.They noted that the rating agency viewed the potential negative rating affect as limited to ABS deals backed by newer Stafford and Plus loans or pools with high concentrations of loans that enter repayment in 2007 and beyond.
The higher assumed default rates will cause higher expected net losses as well as lower excess spread, analysts sated
The projected $10 billion that are at risk of downgrade will be the unseasoned securitizations backed by such pools. Analysts noted that buyers should not look for ABS pools with high percentages of loans that entered repayment in or after 2007 as well as ABS structures with less cushion and comparatively less credit enhancement.
Higher credit support and excess spread can lessen more recently issued FFELP ABS. Additionally, while a FFELP ABS deal may have closed comparatively recently, the underlying pool might still be well-seasoned at time of the securitization.
There is also the chance that a seasoned FFELP ABS offering was issued prior to 2007, although a majority of its loans entered repayment in or after 2007.
Analysts noted that despite the higher assumed default rates, net losses on FFELP pools will still be quite low given the U.S. government reimbursement for losses at minimum 97%. The rating agency’s stress tests for 'AAA' FFELP ABS will be change so that the stressed net losses increase to 150-270 basis points from 140-180 basis points, while corresponding default rates go up to 26%-46% from 24%-30%, analysts stated.
Even though the rating agency offered a comprehensive update of its FFELP ABS rating methodology, the list of affected bonds is not disclosed, JPMorgan analysts noted.
Given that the changes are based on cash flow, finding the bonds that have negative rating risk involves running each bond under Moody’s proposed higher default rates as well as all the other variables and assumptions, analysts stated.
This has cause frustration, they said, as well as uncertainty with investors typically dependent on FFELP ABS being solid 'AAA' credits with minimum credit risk that need minimum credit analysis, JPMorgan analysts explained.
With only a very small share of the FFELP ABS sector possibly at risk for downgrade resulting from the rating agency's proposed changes, JPMorgan analysts think that the entire sector will continue to go through negative ratings volatility and more pronounced tiering between plain vanilla bonds and everything else.
They also noted that S&P is still looking at sovereign as well as counterparty risk on FFELP ABS bonds.
With these circumstances, analysts are staying with their neutral recommendation on FFELP and prefer short 'AAA' bonds out of clean, generic structures from the top-tier sellers/servicers.
They also expect FFELP ABS spreads to continue to lag credit card and auto ABS spreads, as the persistent negative rating cloud has "tarnished" this sector, which was once a solid and benchmark 'AAA' asset class.