The higher number of rehabilitated student loans in some recent FFELP ABS deals has increased near-term liquidity risk, Fitch Ratings said in a report released today.

This is inspite of the U.S. government's guarantee on these loans, the rating agency stated.

Rehabilitated student loans are those cases where borrowers default but later make nine on-time payments in 10 straight months.

In these instances, Fitch said that the collection costs, which reaches 18.5% of the outstanding principle and accrued interest, are built into the loan principal.

A loan might be rehabilitated only once after Aug. 14, 2008 under the common manual.

The rating agency has seen a rise in rehab loans, which usually trade at a discount, in several recent FFELP ABS given that supply has been "ample" after the crisis. From 2003 to 2010, rehab loan inventory has tripled. Fitch has also seen certain offerings that have 100% rehab collateral.

According to Fitch, these loans experience the same delinquency and default processes as non-rehab loans. After 270 days of delinquency, the loan is considered defaulted and the servicer submits a claim to the guarantor.

If the servicer meets the due diligence requirements, Fitch said that the guarantor will buy the defaulted loan from a lender within 90 days after the receipt of a claim. But, Fitch includes a 540-day payment lag from the first day of default in all cash flow scenarios. This is the rating agency's way of  accounting for potential delays in reimbursement to the trust such as those that can result from a guarantor's insolvency.

Considering the asset classes' history,  Fitch said that rehab loans are more likely to default and do so more quickly versus non-rehab loans. This causes higher near-term liquidity risk for deals that have a concentration of rehab FFELP collateral versus non-rehab FFELP offerings  because a considerable percentage of the loans will be nonperforming while the delinquency and claims processes are happening.

Given the historical data from servicers and guarantors, Fitch projected that the base case default rate for rehab loans should be in the 40%-60% range compared wiith 10%-15% for non-rehab loans.

This higher default risk is mostly mitigated by the government guarantee. Aside from higher default assumptions, Fitch also applies a more front-loaded default curve for rehab loans. Fitch believes that the assumptions that are applied for default level and timing, as well as the payment lag, help lessen the near-term liquidity risk from a high concentration of such loans in a deal.

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