When the U.S. government stopped paying banks to originate guaranteed student loans at the end of 2010, an expiration date was slapped on an enormous and highly attractive asset class.
That has refocused attention on new ways to play the business of securitizing these loans. One of them is the residual interest, which is anything left over once a securitization trust has made all of the required payments to the relevant parties in a transaction.
The Federal Family Education Loan Program (FFELP) was launched in 1965 and for the next 35 years, some 60 million Americans used it to pay for eduction expenses. There is now about $445 billion in FFELP loans outstanding (see pie chart, p. 15). That is roughly 40% of all student loans as of the first quarter.
Less than half the FFELP figure — $191 billion — were held in securitizations at that time.
Now that the U.S. Department of Education is the only entity making government guaranteed loans, banks have focused on making private loans. There are still portfolios of whole FFELP loans that have yet to be securitized, but, with no more supply on the way, many players have found that their time is better spent on other asset classes, particularly those with growth potential.
So when Sallie Mae priced a deal backed by the residual interest on existing student loan asset-backeds (SLABS) on June 10 of this year, it generated buzz, not least because it followed an aborted attempt two months earlier, in April. Then Credit Suisse followed up on June 27 with its own residual deal.
Sallie’s transaction, SLM Student Loan EDC Repackaging Trust 2013, was for $225 million. The coupon was 3.5% and weighted average life (WAL) was three years. Bank of America Merrill Lynch was the lead.
Credit Suisse ABS Repackaging Trust 2013-A, meanwhile, amounted to $178 million. With a WAL of 2.5%, the transaction had a 2.5% coupon.
The residual piece in a SLAB is fundamentally the equity tranche, the flows that are left over in a transaction after all payments have been made to investors and other relevant parties. SLABs that are seasoned enough to be releasing that excess cash, or close to be doing so, are particularly good candidates for residual securitization.
The low-yield environment also makes residuals’ juicier yields vis-à-vis higher-rated SLABs a major draw for investors.
Since Sallie’s deal, subsequent indications from the company — the largest issuer of SLABs and thus the big hope for more resid deals — was that their transaction was more strategic than part of any programmatic issuance.
Still, resids remain one of the few ways to play FFELP SLABs, —which observers say produce more attractive resids than private SLABs — before this segment of the asset class disappears.
So while this market may never produce massive volumes and even though it depends largely upon an asset class with a limited shelf life, the Sallie and Credit Suisse deals this year only whetted the appetite of investors that are now familiar with the asset class.
And while there haven’t been more public securitizations, players say for a host of reasons there have been private dealings in resids that are unrated and not necessarily packaged in a bond.
“I expect more residual activity,” said Mike Moro, a director at SecondMarket, a marketplace for alternative and esoteric assets. “While we’ve seen two deals sold publicly this year, there are many others that have been done privately post-crisis.”
The most active fixed-income securities traded over SecondMarket are the auction-rate variety such as munis and student loan deals. The company also hosts trading in other ABS and mortgage deals.
Moro said there weren’t reliable volume figures for trading in the residual SLAB market.
The holder of the residual piece — at least initially — is the sponsor of the SLAB. Many SLABS transactions allow for excess cash to be released to the residual interest holder while bonds are still outstanding, provided certain conditions are met, according to an October report on the asset class by Fitch Ratings. These conditions are typically set in the form of credit enhancement targets in terms of parity ratio (the ratio of trust assets over liabilities) or overcollateralization (the trust’s assets less its liabilities).
The holder of the residual interest can pledge it to a repackaging trust. Securitizations can be based on a single trust, or as was the case with Sallie’s transaction this year, multiple trusts.
Bonds issued off this repackaging trust would normally bear a fixed-rate coupon, with principal amortized on a schedule determined by the pool balance of the underlying trusts.
A reserve fund will most likely need to be established and fully funded at closing to provide liquidity support for timely payment of trust expenses and bond interest, and it would typically be much larger than the reserve fund for a standard SLABS transaction, according to Fitch. For example, the reserve funds of SLM 2013-M1 and CSART 2013-A were 6.3% and 5.1%, respectively.
Among the risks faced by these deals are prepayments on the student loans that ultimately serve as collateral. This can eat into residual interest by whittling down the balance of the deal’s collateral, which, in turn reduces excess spread, or the difference between the yield on the collateral and interest payments on the bonds issued by the trust.
In the case of residual securitizations from private SLABs, there is also the danger of losses from defaults. Features particular to this asset class, such as interest rate or principal rate reductions offered to borrowers by particular lenders, can also cut down the flows going into the residual piece.
Fitch said that the ratings of these deals cannot exceed those of the underlying trusts.
The agency gave “triple-Bs” to both the Sallie and Credit Suisse deals from June.
In the case of the Sallie deal, there were multiple underlying trusts — SLM Student Loan Trust 2006-8, 2006-9 and 2007-1. They had senior tranches rated AAAsf’ and a subordinated piece rated BBBsf.’
The underlying trust of Credit Suisse transaction is AAAsf.’ It was backed by loans that the lead had purchased from Access Group.
“You can never go above the lowest rated tranche of the underlying deal,” said Michael Dean, managing director of asset backed securities at Fitch. “But you can get equal depending on the structure and stress scenario we apply.”
Moody’s Investors Service has a similar take.
“The note in front of [a residual transaction] should be rated higher because the residual by definition is getting paid after the note,” said Stephanie Fustar, assistant vice president - analyst in structured finance at Moody’s. “But in FFELP deals the lowest rated tranche is often Aa — that gives you a room to work with.”
Some types of student loan deals are ill-suited for a residual repackaging. Fitch pointed out that in a full turbo structure — in which all collections go to amortize the bonds — the holder of the residual piece would not get any cash flows until all the notes are fully paid.
Players said that FFELP deals are better suited to securitization than private deals, even though the net interest margin in the latter tends to be larger.
“As residuals, they can be highly impacted by net losses and prepays and other risks that may be in a transaction,” Fustar said. “In a private loan securitization, net losses will be greater than in a FFELP securitization, one reason you may worry about more risks in a private loan residual securitization than in a FFELP loan residual securitization.” This translates into FFELP throwing off a more predictable revenue stream.
As the largest holder of FFELP loans, the prospects for more residual securitization lie disproportionately on the shoulders of Sallie Mae. In a recent presentation, the company said that it had about $107 million of FFELP loans in its portfolio. It would like to buy more.
“We see [FFELP] as one of the biggest opportunities for this company,” said Sallie Mae chief executive John F. Remondi, on a call discussing the company’s third quarter financial results. “There’s about $150 billion of FFELP loans outstanding that we do not own or service today. We have a strong interest in participating in acquiring loans in that marketplace.”
The company announced earlier this year that it was splitting into two companies — Sallie Mae Bank and NewCo. The former will handle consumer banking and continue to originate private student loans. NewCo — apparently a provisional name — will hold Sallie’s portfolios, including securitizations, of FFELP and non-bank private loans; run the FFELP/Direct Loan servicing business, and manage collections.
On the residual side, the company has been coy about whether it would do more transactions following the one in June. The deal was backed by only a portion of the residual interest sold by Sallie so far this year, which, according to the company has a value of about $12 billion.
The other rights to residual interest were sold directly to the market.
Sallie declined to comment for this story. However, on the third quarter conference call, executives said that a major catalyst for the sale was to properly value the asset. “We wanted to demonstrate value that could be obtained in the marketplace,” said Remondi. “And once we sold those, I think we got a revaluation of the company’s FFELP cash flows as a result of that to the positive.”
The company saw core earnings for its FFELP segment soar to $237 million in the second quarter of this year thanks largely to a $257 million gain booked from selling residual interest in its loan trusts.
But holding on the equity piece — especially if you’re servicing the underlying portfolio to begin with — clearly has its advantages as well.
On the third quarter conference call, Remondi went on to suggest that Sallie could play the residual market from either end. “If it makes sense for us to sell we would be sellers and if it makes sense for us to buy we would be buyers,” Remondi said.
A few players said that right now residuals are too valuable for many sponsors to consider selling. But it’s clear that sellers are out there.
Student loan originator Nelnet, for instance, announced in a regulatory filing that it had purchased GCO Education Loan Funding Trust-II on Oct. 31 of this year, which gave the company rights to the residual interest in $1.6 billion of FFELP loans.
There was also talk that Nelnet purchased residuals from fellow lender KnowledgeWorks as the latter company has decided to exit the market.
“[Nelnet] have been one of the more active student lenders buying residuals,” said a market source. “They understand the FFELP product is almost dead and so they’re trying to get creative.”
Nelnet did not return requests for comment.
Banks might have particularly compelling reasons to offload them. Sources said that financial institutions facing capital constraints may want to re-sell the residuals they own. Indeed, apart from Credit Suisse, a couple of banks have been selling residual interest recently, said a market source. “JPMorgan has been buying rehab loans, securitizing them and selling the residual,” this person added.
Neither Credit Suisse nor JPMorgan returned a request for comment.
In another recent transaction, sources said that, following a $186-million deal off of Academic Loan Funding Trust on Nov. 15, the sponsor Barclays sold the residual interest in an auction and opted not to repackage the rights into a bond.
Barclays declined to comment.
“Student loans used to get favorable treatment under Basel II,” said a market source. “But now either banks know they won’t be [treated favorably] or they’re not sure, so from a risk management perspective it may not be as great an asset to hold.”
Sources said that, if an investor is looking to hold on to the deal and has an allocation for unrated trades, a simple certificate transferring the rights to the cash flow is enough.
Some insurance companies and even hedge funds fall into this rubric.
But there are still those who prefer the liquidity provided by a bond, sources said.
At any rate, the Sallie and Credit Suisse deals in addition to the private sales and auctions have made a segment of investors more familiar with the asset class.
Those who have done their homework on the asset class but were priced out of the recent transactions might be particular keen on further residual opportunities.
Spread compression is a major incentive, sources said. The climate remains one especially friendly to esoteric trades.
“There’s definitely an environment where the door is open to issuance of more one-off and esoteric situations, which this would certainly fall into,” said Stuart Lippman, the chief investment officer of TIG Securitized Asset Fund. “People are looking for yield-grab.”
A little over a year old, the fund has $350 million under management and focuses on a range of opportunities in the mortgage-backed and asset-backed sectors.
Moro added that hedge funds tend to prefer the residual piece because it offers more yield than the senior and subordinated piece of typical SLABs.
But tighter spreads are squeezing even the most rarefied of asset classes. “When they first heard of this, funds were looking for the low teens,” said Moro. “Now we’ve got guys coming into this space at high single digits.”