Taxpayers aren’t the only ones on the hook when Uncle Sam gives borrowers more time to pay off their student loans; investors in student-loan backed securities are also paying a price.   

While the Department of Education guarantees up to 98% of principal and interest on Federal Family Education Loan Program loans, it doesn’t guarantee that these payments will be made on time. This puts investors in FFELP securitizations at risk of default if the loans don’t pay off by maturity.

Moody’s Investors Service and Fitch Ratings last month put several tranches of FFELP-backed bonds under review for a possible downgrade, citing low rates of voluntary prepayments, persistently high volumes of loans in deferment and forbearance, and the growing popularity of the income-based repayment (IBR) and extended repayment programs.

In some cases, these bonds, which are typically rated triple-A, could be cut to below investment grade.

Concern about the increased risk of default can also be seen in the secondary market, where spreads on FFELP bonds have been widening.  They have moved out by 10 to 15 basis points since the end of March, according to Bank of America, although analysts say the move is partly attributable to the fact that several banks have “re-positioned their portfolios to better meet their targeted capital and liquidity ratios.”

Lower voluntary prepayments can result in some FFELP bonds not fully paying down before they mature, which represents an event of default under securitization trust documents. While investors may eventually recover their interest and principal, the timing of eventual recoveries would depend on the transaction structures and voting rights upon default for each transaction.

The level of loan deferments, which allows the obligor to temporarily postpone repayments, has actually declined in the last two years, by 7%, according to Moody’s. However, this has been offset by a commensurate increase of borrowers in IBR.

How much exposure do investors have?

In some FFELP securitizations, loans to borrowers in either IBR or extended repayment represent approximately 10% to 15% of the balance of loans in repayment. “IBR and extended repayment option plans that can extend loan repayment periods up to 25 years, from the standard 10-year term for non-consolidation loans, are significantly lengthening the weighted-average life of FFELP loan collateral pools,” Moody's stated in a June 22 report.

In June Moody’s placed more than 100 tranches across 57 FFELP student loan ABS deals totaling some $34 billion on review. It focuses on tranches that mature beyond the next five years. Most of the securities involved were issued by SLM Student Loan Trusts in 2007 and 2008.

This follows some $3 billion in student loan backed ABS the rating agency placed on review for downgrade in April, citing an increased likelihood of default because of the lower repayments. The April review involves 14 tranches in 14 securitizations backed by FFELP loans that mature in the next five years.

On June 26, Fitch placed 57 tranches from 23 trusts of FFELP student loan ABS totaling approximately $8 billion under review for a possible downgrade. “Absent any issuer actions, structural or other mitigants, it is possible that 'AAA' ratings could be lowered to non-investment grade rating categories,” the report states.

At least one sponsor, Nelnet, is taking steps to offset the risk of slower than expected borrower payments in new deals, according to BofA Merrill Lynch.  Nelnet’s most recent FFELP ABS, NSLT 2015- 3, included a “full turbo” feature which allows for excess revenue in the deal to help pay off the bonds as soon as possible.  

Another sponsor, Navient, has taken action to mitigate the impact of slower repayments on existing deals. Servicing agreement amendments allow Navient to make optional purchases of up to 10% of the initial pool balance, up from 2% in previous deals. This would lower the extension risk and help those tranches meet their maturity dates. According to a June 26 BofAML report, the company has been purchasing loans from several trusts (six trusts in the last collection period).

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