Moody's Investors Service today examined the proposed legislation that changes the bankruptcy law to make some types of student loans dischargeable in bankruptcy.
Analysts said that, if adopted in its current form, the proposal can have a negative credit impact on existing and future private SLABS.
On May 3, 2010, Senator Al Franken (D-MN) submitted an amendment to the Senate’s Restoring American Financial Stability Act of 2010 that would change the bankruptcy law to make certain private student loans dischargeable in bankruptcy similar to other consumer assets such as auto, credit card, and residential mortgage loans.
The proposed legislation would apply retroactively to all outstanding private loans. However, it will not change the treatment of FFELP loans, which are now non-dischargeable in bankruptcy. This amendment is like the Fairness for Struggling Students Act of 2010 introduced in the Senate on April 15, 2010.
Moody's analysts expect that the legislation, if adopted in its current form, would have a negative credit impact on existing and future private SLABS that fall under the proposed legislation. This would likely show in higher default and lower recovery rates. How big the effect would probably differ across offerings, depending on each deal's specific mitigating factors.
If private student loans become dischargeable, analysts said that more borrowers would find it more of an advantage to file for bankruptcy and default on their loans than it currently is. Student borrowers usually have fewer assets that will be negatively affected by a bankruptcy filing and, with comparatively lower incomes, would likely emerge from bankruptcy with low, if any, payments, Moody's said.
Additionally, unseasoned borrowers that have just left school might not be as worried compared to mature borrowers about the probable hardship in getting credit after bankruptcy or by the related social stigma, according to the rating agency.
The appeal of filing for bankruptcy would probably be even greater for students who drop out of college because they tend to have lower employment and earnings prospects versus college graduates.
Moody's said that even borrowers with considerable assets and high incomes might benefit from bankruptcy, particularly if the balances of their student loans are considerable.
The rating firm said that allowing private student loans to become dischargeable in bankruptcy might also limit the future recoveries on defaulted loans.
Regardless of whether bankruptcy results in a discharge or a payment plan, the total payment will probably be less than what is collected currently. With recovery rates on private pools now already low, which are generally 20%-30%, and since collecting recoveries take awhile (usually up to 10-15 years), analysts think that the potential reduction in recoveries will have less of an impact on the overall credit quality of a loan pool compared to the potential increase in defaults.
Analysts think that the proposed legislation would have the least impact on deals that are backed by loans with strong credit characteristics, such as co-signed loans that offer lenders with an added chance to collect if one of the borrowers filed for bankruptcy; loans to borrowers with high credit scores who have a lower chance of default and might want to preserve their credit scores from bankruptcy-related deterioration; and loans to borrowers with a low incentive to file for bankruptcy including those in repayment that are financially established, who completed a college degree, and who have a low loan balance.
According to the rating agency, the proposed legislation might limit private student loan origination volumes. To make up for the increased risk of loss if bankruptcy judges can discharge private student loans, issuers might choose to tighten credit underwriting, change their criteria to increase originations of co-signed loans, and/or increase interest rates, Moody's analysts said.
In related news, Moody's also published its methodology for rating FFELP SLABS. The methodology incorporates comments the rating agency got from industry participants after requesting comments on a proposed methodology issued Jan. 18.
According to a release from the agency, the published methodology is mostly different from the one Moody's proposed in that it includes some added basis risk cash flow assumptions for one-month Libor indexed loans, to reflect recently enacted legislation that allows holders of FFELP student loans to change the interest rate index on their loans.
The published methodology also varies from the proposed one in terms of how it applies to cumulative defaults in the firm's cash flow analysis. Moody's has adjusted the default timing curve assumption to show that the curve will be applied to a different loan balance than what was initially proposed, the Moody's release said.