Until recently private student loans were the laggards in the recovery of the U.S. securitization market, but demand is picking up.
So far this year, Sallie Mae has completed two private student loan asset backed securities (SLABS); the $2 billion SLM Private Education Loan Trust 2013-A in February and the $1.135 billion SLM Private Education Loan Trust 2013-B in April. Notably, the deals are the lender’s first to include subordinated tranches since 2007, an indication that investors are become more comfortable with the risk in these securities.
SecondMarket, the online trading firm that specializes in private securities, thinks there’s an even broader market for private SLABS. In March it launched a platform allowing lenders to distribute new issue SLABS to a new class of investors.
SecondMarket director Mike Moro said that the new product is an extension of the firm’s platform for trading auction rate securities, long-term securities that act like short-term securities because their rates are reset at periodic auctions. Or they did until auctions started failing in 2008, leaving many investors unable to cash out.
Student loan were a significant part of ARS market, representing a third of all municipal ARS issuance in the 10-year period from 1998 to 2007, as well as a third of the total outstanding amount at the end of 2007, according to the Securities Industry and Financial Markets Association.
Since 2008, efforts to restore liqudity to student loan ARS investors, or allow the underlying loan to be refinances, have been piecemeal.
SecondMarket is the largest independent secondary market for trading student loan ARS, according to Moro. He said that the issuers themselves have been active participants in repurchase their the securities in the secondary market. “They have come to us with the cash they are looking to allocate and we find the ARS bonds for them to repurchase at a discount,” he said.
By comparison, Moro said, the new private student loan platform will help raise capital for lenders by allowing investors to participate in the primary market, as opposed to matching buyers and sellers in the secondary market.
Pitching SLABs to ARS Investors
“Over the last five years, we have developed a brand new investor class – these are buyers that had never invested in private student loan securities before,” he said. “After educating them on student loans and the overall industry, we’re now able to show them investment opportunities through our platform that they simply were not getting from the Wall Street banks.”
SecondMarket sees an opportunity to tap this network of auction rate investors – many of which are small to medium sized hedge funds or asset managers or family offices. “These newer investors may not be able to commit the $100 million to $200 million orders we see from our more traditional investors, but we can easily collect $10 million orders to get issuers to that $300 million number,” he said.
Moro doesn’t expect that SecondMarket will impact how a securitization is structured or marketed. Instead the idea is that the firm will place its allocation of the bond on the new private student loan trading platform; where investors would have access to the deal prospectus and other information available for them to submit their bid. Initially, SecondMarket plans to play the role of co-manager in the first deals; the traditional investment banks will still be the bookrunners.
“We will have a bond allocation of 5% to 10% of the deal and we will go out to our investors and sell those bonds and get as many orders as we can at the best prices,” he said. “If the same 20 guys buy the deals, the amount of price tension may or may not be there, but if you bring an extra 30 more investors – you now have 50 guys competing for the same bond.
“Investors are naturally going to have to submit more aggressive pricing to get the bonds allocated otherwise they miss out on the deal entirely.”
Moro said there are a number of transactions coming up. SecondMarket has been engaged already by a few student loan issuers, both by first-time issuers and seasoned Libor issuers.
Karl D’Cunha, a senior managing director at Madison Street Capital, which tracks the ARS market for clients, said that for his ARS investors, there has been a shift in buying that is driven by a search for yield. Still, his clients aren’t necessarily lining up to buy private student loan issues.
“That market has definitely been hurt,” he said. Of his clients, those that hold private student loan ARS find it hardest to shift out of that paper, and these buyers aren’t as keen on other private student loan investments. “Each one comes with a special story and you either have to get lucky and hope you find a buyer that has a particular interest in that private issue,” he said.
This past experience, and the fact that private student loans don’t benefit from a government guarantee, makes private student loan backed securities a tough sell.
Moro points out that the private student loans securitized today are of much higher credit quality, with FICOs in some instance averaging 750, there are much stricter debt to income requirements. “As a loan product for securitization purposes, it is much more predictable and much safer from a credit perspective,” he said.
Another difference is that today most private student loans require at least one borrower to be “creditworthy,” meaning currently employed, having a minimum credit score and, in more recent years, meeting other criteria such as a debt-to-income ratio.
“Many undergraduates would not meet these requirements,” Credit Suisse analysts said in a recent report. So most private studen loans for undergraduates, and for a large number of graduates, must be co-signed by a creditworthy person.
This improved underwriting can be seen in the most recent deals from Salle Mae: SLM 2013-B and SLM 2013-A are backed by similar pools, according a to Fitch Ratings presale report on the latter deal. The average FICO score at origination for all borrowers is 740 for SLM 2013-B, virtually unchaged from 741 for 2013-A. Both are slightly higher than the issuer’s previous two deals, 733 for 2012-E and 740 for 2012-D. Co-signed loans accounted for approximately 80% of the pool backing the latest deal, consistent with the prior three transactions.
The $2 billion SLM 2013-A offered both fixed and floating rate tranches. The final pricing of on the ‘A2’/ ‘A’, 5.66-year class B, subordinate notes was 237.5 basis points over the interpolated swaps curve, according to a March 1, J.P. Morgan report. By comparison, the SLM 2013-B though upsized, but its subordinate tranche priced wider, at 260 basis points over swaps.
Still the deal was met by strong investor appetite; the single-A tranche was increased to $110 million from $83 million originally.
“A functioning securitization market would be a key factor in allowing private credit lenders to provide competitive products as well as borrower incentives, J.P. Morgan analysts said in the report. “With private credit student loan ABS spreads continuing to tighten, we do think that the ABS market can support future growth, ultimately extending credit and providing liquidity to borrowers.”
Sallie Mae has a $163 billion student loan portfolio, 23% or $36.9 billion of which are private student loans, as of December 31, 2012. Approximately 65% of these loans have a co-signer, typically a parent. Loans originated since 2009 are approximately 90% co-signed with average FICO scores above 740.
But Sallie Mae remains the only issuer of private student loan backed securities post-financial crisis, the two other major lenders, Wells Fargo and Discover, have yet to bring any deals to market.
Discover said in a statement accompanying the release of first quarter results in late April that total loan portfolio ended the quarter at $60.4 billion, up 7% compared with the prior year. Private student loans, at $431 million, were a tiny subset, but were up 6%, from the prior year.
Sallie Mae Sole Issuer
Mark Kantrowitz, publisher of Fastweb.com and FinAid.org and author, Secrets to Winning a Scholarship, said that other private lenders believe that “the capital markets are still too tentative for them to float an issue of the loans on their balance sheet,” despite the fact that these portfolios are largely better structured than pre-2008 loans and are therefore less risky.
Issuance of private student loan backed securities is still well below the upwards of $20 billion that was issued annually between 2005 and 2008, according to Bill Weyandt, president and chief risk officer of Loan Science, a firm that manages $1 billion in private student loan portfolios. Weyandt said that just $8 billion was issued in 2012.
The $30 billion of private student loan backed securities outstanding accounts for just a small portion of the $1 trillion in student loans outstanding. Another $300 billion carry a government guarantee from the now defunct Federal Family Education Loan Program, and the rest are guaranteed directly by the federal government.
Threats to Private Loans
Despite the more positive credit trends in the private student loan market, lawmakers and regulators continue to look for ways to help borrowers who are having trouble making payments, and these effort are largely focused on the private student loan market. It’s created some uncertainty for how private SLABS may be impacted .
On February 21, the Consumer Financial Protection Bureau released a Notice and Request for Information in the Federal Register seeking information regarding affordable payment options for pre- and post-default borrowers who want to repay their loans but may be lacking the ability to do so in the near term. The Request for Information notes that while federal student loans often have income-based repayment options and rehabilitation options for borrowers in default, private credit student loans generally do not include similar modified repayment options.
There is also some concern about President Obama’s proposal for reengineering the Federal Perkins Loan Program, which would drain potential borrowers from the private market. The proposal to expand the Perkins loan program, a program based on “exceptional” financial need, would provide up to $8.5 billion of new loan volume annually.
“The packaging rules and the volume increase seem designed to wipe out the private student loan marketplace,” said Kantrowitz. “A lender will not invest in setting up mechanisms for originations if there’s no future in it.”
Stafford Loans to Reset
Private student lending could get a boost from the reset of the Stafford loan rate, however. Fitch Ratings said in an April 16 report that the anticipated doubling of the interest rate on federally subsidized student loans, to 6.8%, would open up new opportunities for private lenders to fill financing gaps.
It would make the products offered by for profit private lenders – Sallie Mae, Discover and Wells Fargo -- look relatively more attractive. According to Fitch, Sallie Mae starts fixed-rate loans for undergraduates start at a 5.74% annual percentage rate (APR) and Discover starts them at 6.79% APR. The private lenders’ variable rates start at 2.25% APR and 3.25%, respectively.
Additionally, neither lender charges origination fees, while the federal Stafford loan comes with an origination fee equal to 1% of the loan amount.
But Kantrowitz noted that Stafford loans, even at the higher interest rate, are still cheaper than the rates on most private student loans long-term. Some borrowers, he said, may be lured in by the variable rates set as low as 3.4% for the best credit customers and fixed rates of 7.89% and 6.79%; but they shouldn’t overlook the lack of repayment options like deferments, forbearances, income-based repayment, public service loan forgiveness, death and disability discharges.