Moody’s is taking its surveillance of federally guaranteed student-loan backed securities up a notch.
The credit rating agency is so concerned about the impact of the income-based repayment plans for student loans that it’s planning to revise its ratings criteria.
The credit rating agency this week released proposed criteria that would take into account the slowing rate of repayments on these loans, which is increasing the risk that some bonds backed by these loans will not pay off at maturity.
Moody’s has already put several tranches totaling tens of billions of dollars under review for a possible downgrade under its current criteria.
The proposed changes could result in even more downgrades. Most FFELP bonds currently carry Moody’s highest rating of AAA.’ However bonds that Moody’s projects will take too long to pay off could be downgraded to ratings of either low investment grade or below investment grade.
The extent of any downgrades will depend on the ability and willingness of the securitization sponsors to repurchase loans from the transactions, the amount of time until the final maturity dates and the tranche balance that Moody’s project will remain unpaid at the time of default.
The proposed changes would also increase cost of securitizing FFELP, since sponsors of future deals would either have to pay higher interest rates on bonds that obtain lower credit ratings or agree to repurchase loans that pay off too slowly.
The slower rate of repayments on FFELP loans is the result of the expanded programs that make it easier for borrowers to defer payments or pay a percentage of their discretionary income for up to 20 or 25 years, after which the balance is forgiven.
Most bonds will eventually pay off in full, because the government guarantees at least 97% of the defaulted loans and accrued interest as well as available credit enhancement, including excess spread. However, non-payment by final maturity would be an event of default for the rated securitizations.
The proposed criteria don’t just assume that more bonds will default over the life of a securitization; Moody’s also wants to apply a single, constant rate of default across the life of a deal. Currently, it applies a seven-to-10 year “default timing curve,” which assumes that older loans are less likely to default.
The “typical” expected-case default rate for a transaction will be in the range of 3% to 12% per year; in the “stress” cases, Moody’s proposes a default rate of 4% to 18% per year.
“The main reason for the proposed change is that, with the slowdown of repayment speed and the resulting lengthening of the lives of the securitized loan pools, a material amount of defaults continue to occur after the tenth year in many transactions,” the report states. “Therefore, a constant rate of default will generally increase the total amount of defaulted loans in our cash flow runs and better approximate the average default behavior of the pools of underlying student loans.”