The possibility of the Canadian ABS market witnessing its first student-loan securitization is not far from happening, experts said.
"To date, there have been no securitizations in Canada involving student loans," said Mark Adams, assistant vice president at Dominion Bond Rating Service. "However, it is possible that one or more could take place."
Martin Fingerhut, a partner at Blake, Cassels & Graydon LLP's Toronto office agreed. "The bottom line is I don't think there's any reason why this asset class couldn't be successfully introduced into Canada.
"There's quite a large volume available to be securitized," he added, "and a growing need for new student loans as increasing numbers of Canadians are going to universities and colleges, and as tuition fees increase as a result of lower government subsidies."
However, recent developments may hinder such a securitization from taking place.
According to published reports, Royal Bank of Canada, Bank of Nova Scotia and Canadian Imperial Bank of Commerce (CIBC) expressed their intention to withdraw from Canada's student-loan program, which the institutions have participated in since 1995.
Up until 1995, all student loans were government-guaranteed. They were at the risk of the Federal and participating Provincial governments who managed the recovery of these loans.
"Nobody knows how successful they were in collecting the loans, because we essentially had limited information on the loss experience prior to 1995,"said Ed Rogers, managing director of securitization at CIBC.
In 1995, the government decided to change its policy; instead of guaranteeing the loans, it opted to pay the financial institutions a 5% risk premium of the loan value, a one-time payment for each loan that was written.
This program will end by July of this year. "The Federal government has decided not to extend the program in its current form and has decided to take over the funding of the loans themselves," Rogers said. "The participating Provincial governments are still discussing what they want to do, but, in any event, they will guarantee any new loans written after July 2000."
The program was also not very beneficial for the banks involved.
"What happened was the financial institutions discovered very quickly that the 5% risk premium was not large enough to cover the losses that actually occurred," Rogers noted. "All of them suffered losses in excess of the 5% risk premium and now the governments are effectively taking the whole program back."
Finding An Incentive To Securitize
Though the banks will continue to manage and bear the credit risk of the loans that they wrote under the existing program, the financial institutions will no longer be underwriting new loans after July. Furthermore, since the participating governments have decided to bear the risk of the loans originated after July, the banks will have no reason to securitize them because there will be no capital required for these loans.
But what will happen to the student loans that the banks have already taken into their fold? The securitization of these loans does not seem to be an option for these institutions.
"The big driver for financial institutions to securitize their existing portfolios is to gain capital relief," said Andrew Stuart, executive director of securitization at CIBC.
"Though we - the Securitization Group - don't know the loss statistics, we have been led to believe that they are high enough to impair the economics of a securitization transaction."
Since the loss statistics are relatively high, Rogers explained that the amount of recourse that would have to be provided would have to be so large that the financial institutions are not going to get the amount of capital relief that they would want.
"Let's assume that losses were in fact 5%, rating agencies require at least three times that, that's 15% recourse," he said. "Also, the banks are governed by the Canadian accounting rules and, while it may be possible to attain accounting sale treatment, we're generally still limited to a maximum of 10% recourse."
"You might get around the sales treatment issues, but the banks are not going to accept the 15% reserve or whatever it would take," Stuart added. In other words, the lack of capital relief is the major reason why there is no incentive for the banks to securitize student loans.
Another factor in the decision not to securitize these loans is the fact that these institutions have other alternatives. "I think they have other assets that would give them a better benefit and the banks have not finished securitizing all those assets yet," Stuart noted.
The Rating Agency Perspective
One of the aspects that need to be addressed in introducing student loans into Canada is the lack of portfolio data.
For instance, though information from the Ontario government provides some default information, it does not specify how long those defaults are outstanding, what the write-off policy is and what the recovery levels are. The behavior of these assets through business cycles is also unknown.
"In order to model a portfolio for credit enhancement, we would need to see that information over preferably, a minimum five year period (although I would prefer to see data from the early 1990s)," said DBRS's Adams.
Though more specific student-loan information cannot be obtained, the chartered banks, having participated in the student-loan program, should have good aggregate portfolio information.
"I suspect this may be the best source for general performance information," Adams noted. "It is possible that the Federal government also has information but we have not seen any information from the Federal government."
Aside from the issue of obtaining more specific portfolio information, the rating agency is also concerned with servicing and underwriting issues.
Since the banks have withdrawn from the student-loan program, "the issue from our perspective would be, who would be the servicer in a securitization? Would it be the government or would it be a private institution?" Adams noted. "If it is the government, we would have to conduct due diligence with respect to their servicing policies and abilities," Adams said.
On the underwriting side, since the federal government's underwriting standards have been relatively loose, the question would now be the quality of underwriting in the future.
"If the government continues to underwrite these loans, one does not know whether they will tighten their standards or not," said Adams. He also noted that because of increasing tuition, it would likely be difficult for the government to become more restrictive in granting student loans. However, if the government wishes to dispose of such loans to the private sector with only limited recourse, it would be helpful to have tighter underwriting standards and better performance.
Adams said judging from the default information in Ontario, the student-loan program would look like a subprime-loan program.
"Of course, enhancement levels will reflect the portfolio, and comparatively, higher enhancement levels may be needed with a program like this," he said. "A lot would depend on the portfolio statistics and the eligibility criteria of any program (for example, in Ontario, defaults in dentistry programs are far less than defaults in arts and sciences)."
Securitization, Still a Possibility
Though there are many obstacles to student securitization in Canada, it remains a distinct possibility.
Fingerhut, the attorney, believes that the government has the ability to access the capital markets but the question would be "whether the cost of a guarantee, sub debt, insurance or other enhancement would be less than what has been rejected by the banks as being insufficient."
There's also cross-border deals to consider. "There may also be an ability to securitize cross-border to the U.S. market," Fingerhut explained, "because of a withholding tax exemption for interest-bearing obligations which are guaranteed by the Federal government."
Or the government may even consider regulatory changes. Adams said that another issue in structuring a potential securitization will be any future regulatory changes that will affect the risk level and attractiveness of these loans for financial institutions.