The Biden-Harris administration's student-debt relief plan may increase prepayment risk for investors in securitizations backed by government-guaranteed student loans, but that is likely to be outweighed by a reduction in their maturity risk that has increased in recent years.
Outstanding student loan volume, both federal and private, stood at $1.59 trillion as of Q1 2022, of which $225.7 billion are federally guaranteed Federal Family Education Program (FFELP) loans, according to Moody's Investors Service, which rates 696 FFELP-rated securities.
The administration announced plans on August 24 to cancel up to $10,000 in student-loan debt for borrowers earning less than $125,000 or $250,000 jointly, and up to $20,000 for those who had received Pell grants. That will impact securitizations backed by FFELP loans, the origination of which ended in 2010. Since 2015, various income-based programs have extended the maturities much further out on many of those loans.
The move provides at least some relief to investors in FFELP ABS, said John Anglim, senior director at S&P Global Ratings. He added that S&P's recent discussions with investors unveiled concerns about the extent to which borrowers will restart FFELP-loan payments, which the Biden-Harris administration paused early in the pandemic and has scheduled to resume at the start of 2023.
Consumers typically first cover phone, rent, car and other essential bills, Anglim said, while student-loan payments tend to fall lower down the payment priority stack.
Queueing up for relief
Nearly eight million borrowers will automatically receive relief because relevant income data is already available to the government, according to the Department of Education. Most FFELP borrowers, however, will have to provide that information in an application that the administration anticipates making available by early October. The program is moving on a relatively fast track, with the government recommending borrowers file applications before November 15 to receive relief before December 31, after which student loan payments resume.
The federal guarantee of at least 97% of defaulted FFELP principal and accrued interest minimizes their credit risk. However, payment plans have reduced borrowers' payment speed and so increased maturity risk of the securities backed by these loans.
"For FFELP transactions issued in 2015 and before, the predominant risk is really maturity risk," said Nicky Dang, associate managing director in the Moody's consumer ABS Group.
The new loan forgiveness program should lessen that risk by lopping off a chunk of the student loans, accelerating payments to lenders.
Fitch Ratings noted August 30 that the loan forgiveness will generate a one-time payment that could reduce maturity risk for the most vulnerable ABS trusts, since the high level of cash flow would, in most cases, pay down the most senior bonds with the closest maturity dates.
"Maturity risk has been the main driver behind ratings downgrades in the sector…," Fitch said.
The spectre of prepayment risk
Another potential risk emerging from the initiative is prepayment risk, since the most efficient way to receive FFELP loan forgiveness may be to convert FFELP loans to direct loans held by the federal government.
Anglim said prepayments generally reduce an ABS deal's excess spread, which is provided as a form of credit enhancement. However, excess spread is most relevant to investors in lower rated tranches in the 'BB' or perhaps 'BBB' range, and less so in the 'AA' and 'AAA' classes that comprise FFELP ABS deals. In fact, more prepayments may benefit investors.
"What could also result from higher prepays is more liquidity, which will help mitigate the increased maturity risk," Anglim said.
Moody's also sees less maturity risk as "credit positive," but to what extent will depend on how the Biden-Harris administration implements the program. Borrowers consolidating their existing FFELP loans to government-held direct loans would be the "more powerful way of relieving maturity risk," Dang said, because it would reduce borrowers' FFELP balances more significantly and provide payments to the ABS trusts that held the loans.
Direct relief with hurdles?
The other option would be for the Fed to provide the relief directly to FFELP lenders to reduce the outstanding balances to the amount allowed under the new forgiveness program for qualified borrowers.
If the student loan forgiveness program is restricted to direct loans, that could present a hurdle for borrowers, Anglim said, adding they would have to discuss with their servicers "a path to the direct-loan program." He noted that defaulted FFELP loans are likely already held by the federal government and could qualify, although the effective date for this new loan-forgiveness program is not yet clear.
Finsight records no FFELP-backed ABS issued so far in 2022, with 17 deals worth more than $9 billion issued in 2021, significantly higher than the 13 deals in 2020 worth just over $5 billion. New deals typically comprise FFELP loans purchased from other lenders and so-called rehab deals, in which the DoE has taken over defaulted loans, their borrowers have made six to nine consecutive payments, and the government has sold them back to the private lenders.
Navient Corp. was the top issuer in 2021, followed by Nelnet and Brazos Higher Education Service Corp.
