The Standard & Poor's downgrade of the U.S. long-term debt rating was followed a few days later by downgrades of debt issued by government-related entities such as the Federal Home Loan Banks and the Federal Deposit Insurance Corp. (FDIC), as well as a slew of funds with a majority of their exposures to U.S. Treasurys.

But what happened to securities guaranteed by the Federal Family Education Loan Program (FFELP)?

That's a big question for participants in the FFELP market, for which S&P has rated $259 billion in securities. Spreads on those transactions have widened and their liquidity has fallen since S&P became the sole rating agency to downgrade long-term U.S. Treasury bonds on Aug. 5, leaving FFELP ABS in ratings limbo.

"The market is in purgatory right now," said James Grady, head of structured finance at Deutsche Bank Securities. "Investors are expecting downgrades, but they don't want to buy assets today that get downgraded tomorrow."

S&P had placed the U.S. sovereign rating on CreditWatch negative on July 14. The next day it placed 604 structured finance transactions, including hundreds of FFELP transactions, on CreditWatch negative, a status it normally aims to resolve one way or the other within three months.

The rating agency then proceeded to downgrade U.S. Treasury bonds on Aug. 5, and three weeks later, on Aug. 30, S&P announced affirming the ratings of 239 classes from 178 transactions backed by FFELP loans. However, only 26 of those classes, from 22 transactions, carried the 'AAA' rating held by the bulk of FFELP securities.

"Pending completion of our review, we expect that we will lower some of our 984 'AAA' ratings [on FFELP securities] to 'AA+'," S&P said in its Aug. 30 announcement.

That means institutional investors are still awaiting the fate of most of the top-rated FFELP bonds they hold or may be looking to purchase. Many of those investors, including pension and mutual funds, have investment guidelines that require them to invest in 'AAA'-rated ABS, and future downgrades may force some to sell the securities.

So now the pressure is on S&P's structured-finance analysts. Gary Kochubka, a senior director at S&P, said his group was informed of the Treasury bond downgrade the day it occurred. "When an action is taken, that's when we effectively have a green light to go ahead" with the analysis of the impact on structured products, Kochubka said.

He added that since the Treasury downgrade, his group has been ascertaining "which actions we can take in the near term and which ones may require a further expansion of our criteria" to determine whether structured bonds can be rated above the sovereign debt.

The two other major ratings agencies, Moody's Investors Service and Fitch Ratings, have affirmed their top ratings for long-term Treasury bonds and have not taken any actions on government-backed or -guaranteed securities.

S&P typically aims to resolve CreditWatch actions within 90 days, giving the agency until mid-October to affirm or downgrade the transactions, or notify market participants of a further delay.

Only three days after the Treasury downgrade, S&P downgraded bonds issued by several federal government-backed entities - including Federal Home Loan Banks and the Federal Farm Credit Banks - by one notch, to 'AA+'. S&P also downgraded 130 transactions issued by financial institutions that were guaranteed by either the FDIC or the National Credit Union Association (NCUA).

"The downgrades on [those] issues reflect their direct credit support from the U.S. Treasury for timely and ultimate repayment," S&P explained.

Such quick action on FFELP securities has been more difficult because those structured transactions have moving parts that vary from deal to deal and must be analyzed individually and in the context of the overall transaction. Analyzing those parts is crucial however, because they may help a bond retain its 'AAA' rating despite the sovereign downgrade.

For example, some FFELP deals are structured to generate excess spread, or the difference between the interest rate received on the underlying bond and the coupon on the issued security, and that income can be applied to redeeming the most senior notes.

That bolsters the remaining 'AAA'-rated notes, which now have a relatively larger subordinated cushion beneath them. Excess spread is not structured into all FFELP transactions, however, and it may instead be diverted outside the transaction to compensate the issuer.

Bonds otherwise structured to provide significant credit enhancement, and/or grow that enhancement by paying off the 'AAA' portions first, are also a boon to investors because they further protect the highly rated portions from losses.

"There are a small number of deals where the combination of annual excess and subordination allow the deals to withstand defaults of 30% going forward, even if the government was not around to reimburse the losses," said Ronald Mass, the head of Western Asset Management Co.'s 25-strong team of structured finance professionals.

Those factors will help more "seasoned" FFELP bonds retain the highest rating, and a well-established performance history of the underlying bonds can also be a plus.

Gary Santo, head of capital markets at First Marblehead Corp., which specializes in providing private student loans, noted that during the rating process at the outset of a transaction, FFELP loan pools would typically be stress tested to withstand delays in guaranty payments from the federal government on a material percentage of the loans over the early years of the deal. Depending on how much that transaction has seasoned, and how well the loans have performed to date, it is possible for that transaction to retain its 'AAA' rating. "This analysis was designed to mitigate some of the counterparty risk associated with a third-party guarantor, irrespective of who that entity was," Santo said.

While S&P analysts are reviewing each of the remaining FFELP deals, however, investors are left to ponder the fate of their federally guaranteed bonds. Deutsche's Grady said leaving 984 'AAA' ratings on CreditWatch this long after a move as pivotal as downgrading Treasury debt is "unacceptable," given the impact on the FFELP market. He noted that the Aug. 30 rating affirmation determined that the 26 FFELP classes retaining the 'AAA' rating had parity support over 140% and so were well-protected. Grady also acknowledged that there is a borderline level of parity that requires closer review.

"But there is also some level of parity that clearly is not protected enough, and [S&P] should be acting on those," Grady said.

The same holds true, Grady said, for FFELP issues over the last year. "It is almost a foregone conclusion that recently issued deals that were rated 'AAA' by virtue of the U.S. sovereign rating will not have had enough time to build up enhancement sufficiently to offset the effects of the sovereign downgrade," he said.

On Aug. 15, in fact, S&P gave a $523 million FFELP issuance from the New Hampshire Higher Education Loan Corp. a presale rating of 'AA+', attributing the lower rating to the bonds' relatively low initial parity support - defined as the deal's total assets divided by the note's principal amount - of 105%. The agency also pointed to the government's reinsurance of at least 97% that's typically the case for FFELP loans, and the likeliness of timely interest and principal payments made under stressed cash-flow modeling scenarios.

Frank Trick, S&P senior director, said the U.S.'s current 'AA+' sovereign rating was a significant factor in the New Hampshire bond's rating, and he pointed out that over time it could be raised to the 'AAA' level.

"It depends on a number of factors including but not limited to our refinement of our 'AAA' assumptions for FFELP transactions as well as loan performance and seasoning," he said.

The ratings fate of other recently issued FFELP deals - Wells Fargo Securities forecasts $20 billion in issuance in 2011 - remains unknown. The uncertainty surrounding those and other existing securities has left investors holding bonds with wider spreads and less liquidity. Mass at Western Asset, which manages $2 billion in FFELP loans, said spreads have widened about 15 basis points in recent weeks, due partly to the Treasury downgrade and partly to the ratings uncertainty.

"The student loan market has widened compared to credit cards and autos, given the potential for downgrades. And investors and dealers are concerned somewhat about the potential of forced selling," Mass said.

Forced selling could arise among investors whose investment guidelines require them to hold 'AAA'-rated ABS. Mass said a small number of Western Asset's clients, less than 10%, have that requirement.

John McElravey, head of consumer ABS research at Wells Fargo, said that usually between 85% and 95% of ABS has been rated 'AAA', creating a very liquid market for highly rated bonds. He added that liquidity in the ABS market had already diminished to some extent since the 2008 financial crisis, in part due to the disappearance of structured investment vehicles (SIVs), which were major buyers of FFELP ABS. Plus, he said, investors who were beginning to look at the FFELP market, attracted to its relatively wide spreads, are now waiting to see what S&P does.

"We think a downgrade has been pretty much built into the spreads," McElravey said. "One thing we have not seen so far is a lot of forced selling in anticipation of a downgrade."

Many pension funds, mutual funds and other institutions have guidelines requiring a certain level of 'AAA'-rated bonds in their core holdings, and often those ratings must be provided by specific ratings agencies.

"If the institution requires specific reliance on a ratings threshold and constituent or owner consent is required to change the relevant governing provisions, then the institution could have significant difficulty in adjusting to a scenario in which the universe of highest-rated securities is shrinking," said Grant Buerstetta, a partner at Blank Rome.

Although forced selling has yet to emerge, investors may be holding out until S&P finally resolves the FFELP securities' ratings status.

"It's surprising when expected events like a downgrade can be a catalyst for selling," Grady said.

Despite the current rating uncertainty, however, Western Asset views the FFELP market as "very attractive," Mass said. "Relative to the risk of agency mortgages and corporates, there's very good relative value long term."

Some big players on Wall Street agree. Analysts Joseph Astorina and Sarah Johns at Barclays Capital noted on Aug. 26 that their firm believes most investors have sufficient flexibility in terms of ratings constraints to avoid a sell off. He added that Barclays believes that "regardless of a rating action (or lack thereof) by S&P, the asset class remains fundamentally strong," and that investors have reached the same conclusion.

The Barclays analysts reaffirmed that view after S&P's action on Aug. 30, calling it "a partial resolution of the wholesale watch-listing of the FFELP universe ..."

McElravey wrote in a recent report that his firm does not expect FFELP spreads to tighten rapidly as long as market conditions remain unsettled, but given the safety of FFELP ABS his firm remains at least mildly bullish. "Our recommendation to add FFELP student loan ABS is based primarily on the ability to enhance yield in a low-interest-rate, flat-yield-curve environment."

Spreads for 'AAA'-rated FFELP bonds between three and five years, according to Wells Fargo, rest between 50 basis points and 80 basis points over three-month Libor - nothing to write home about, except in comparison to other securities with similar risk.

"They have similar risk to Treasury bonds but more yield," said Guido van der Ven, cofounder of Education Investment Group, which offers advisory and valuation services to investors in student loans. He added that for fund managers seeking "Treasury surrogates, I can't think of anything that would fit the bill as well as senior tranches of FFELP ABS."

Indeed, the biggest hurdle to drawing investors to student-loan ABS may be the lack of loan-level data for the transactions. Rubin Bahar, senior structured products analyst Eagle Assert Management, said that currently investors are privy only to aggregate numbers. "I do not know if one borrower, who is current now, has previously been in delinquency. Has he been flip-flopping between being current and delinquent?" he said.

"Student loans don't have any loan-level data," van der Ven said. "If anything is a deterrent to investors, it has more to do with the lack of data than the ratings."

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