The market for student loan auction rate securities (ARS) contracted to $39 billion in outstandings as of May 2012 from where it stood at $85 billion in February 2008, according to data provided by SecondMarket.

Volumes for mortgage ARS also contracted and outstanding as of May 2012 put the market at $19 billion from where it stood at $150 billion in February 2008.

"Recent weaknesses in the U.S. and continued struggles in the sovereign debt loans in the eurozone have continued to keep prices lower for structured products," SecondMarket said in a report published on Thursday. "Demand for U.S. credit has caused FFELP-backed securities to slightly increase in price because of the U.S. government guarantee."

ARS are long-term securities with interest rates or dividend yields that are periodically reset through an auction process. Historically, broker-dealers often supported auctions to prevent them from failing. But during the financial crisis in mid-2007, firms stopped providing that support and auctions of ARS began to fail on a widespread basis. By February 2008, the markets were virtually frozen.

The investment strategy for ARS is different than for the traditional ABS investor, explained one portfolio manager.

"Typically it's a matter of how much discount they can purchase to get the best deal," the manager said. "On the one hand if its super deep discount paper then theoretically it could yield pretty high, if the coupon is high but has very bad collateral. Its. It could also be good collateral but you don't have access to it because there is a monoline insurer that could exercise a put right and get back collateral."

The investment strategy for student loan ARS brings its unique set of concerns. Some of the bonds are considered really solid if the loans are government subsidized because there is less doubt that the issuer is going to go out of business and more importantly the bonds are also structured better.

"The problem with student loan paper is that the issuer has a lot of rights and in some cases they can withhold payment of the monthly coupon for months at a time and if you are the issuer trying to manage the cashflow it can be a challenge," the portfolio manager said. "I have clients that hold millions of dollar of private issued student loan paper worth that have not received a coupon payment since last year."

Student loan ARS are sometimes structured with a make whole provision, where the investor may not get paid for 11 months but is made whole on the 12th month, but "even then there is a lot of uncertainty," he said.

 

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