Fitch Ratings placed 132 subordinate FFELP student loan ABS tranches on Rating Watch Negative.


The actions result from an ongoing review of Fitch-rated FFELP student loan ABS  ratings  focusing on exposures to basis risk.


The rating agency conducted  a  preliminary  analysis and has determined that subordinate  tranches rated triple-A might not have  enough protection against basis risk in today's volatile rate environment to support the current rating.


Even though Fitch had included basis risk stresses in its analysis of the deals at the time the initial rating was assigned, the recent  rate  movements  have  far  surpassed  the historical
volatility upon which the prior assumptions were based.


The agency will be conducting a detailed review of bonds placed on Rating Watch Negative over the next several months to find out these bonds' ability to withstand a higher level of basis risk stress.


Rating actions as  a result of the review are expected to include both affirmations and downgrades. Downgrades  are  expected  to  be  limited  to one to three categories.  


Considering  the  unprecedented market volatility seen, the rating agency  might  revise  the base case assumptions and stress related to rate movements  to  conduct this analysis. Important deal-specific factors  include  current  parity level, minimum parity level for a cash release,  reserve  account  amount  if excluded from parity calculation, current  pool  factor,  spread on the bonds, and loan breakdown based on type and origination year.


Depending  on  the loan type and origination year, detailed analysis might reveal  that  certain  trusts benefit  from favorable Special Allowance Payment  (SAP)  spreads  or  floor income, allowing a significant buffer against  basis  risk  that  can  support a higher rating than otherwise.

According to Fitch, an effective and significant enhancement level in the form of parity buildup or a reserve account could have the same effect.


Since  the start of the market turmoil in 2007, the Libor/CP spread, which is the key component of basis risk in the majority of student loan ABS,  has  shown increased volatility. Before the economic crisis, SAP rates  were  based  on  the  average of 90-day double-A financial commercial paper rate in effect for each day in the quarter.


With the lack of data available  and other factors, the Department  of Education (ED) took a hybrid approach  for  4Q08, Fitch said,  using  the existing method and the Commercial  Paper  Funding  Facility (CPFF) rates to determine SAP. This approach, Fitch said,  proved  favorable for generating trust income because it narrowed the  spread  of  Libor over SAP rates significantly as the CPFF rate was considerably higher compared with the CP rate.


But, the ED reverted to the original method of using the market determined CP rates to calculate SAP for  the  latest  quarter. As such, the CP index for SAP for the quarter ending  March  31 declined  to  0.74% from 2.58% in the previous quarter, thereby compressing the trusts’ ability to generate income.


Considering the compressed SAP rate and continued volatility of rates, student loan  transactions  are  exposed  to elevated levels of basis risk. This risk  is  particularly significant for subordinate bonds since many do not  require  nor benefit from hard enhancement, and cannot build parity via de-levering, Fitch said.  Parity buildup in excess of 100% cannot be viewed as  an  enhancement if a cash release can bring down the parity.

Cash releases are usually contemplated by the documents and can be implemented if the specified minimum parity level is maintained. Reserve accounts  may  have been included in the structure to mitigate liquidity risk, but, in many cases, they are not a form of enhancement that can be used  to cover shortfalls created by basis risk because reserve accounts are often included in the parity calculation, according to Fitch.

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