Once-regular issuers in the "orphaned" ABS market backed by government-guaranteed FFELP loans are now scrambling to reposition their businesses and offering new private loan products. But investors in student loan ABS are unlikely to see a regular deal flow anytime soon.

Top executives at student loan bellwether Sallie Mae were less than upbeat during their earnings conference call July 21. Albert Lord, Sallie's vice chairman and CEO, noted the firm's changing operations as it seeks greater market share in areas such as loan servicing and private loans. And he pointed to more than $100 million of "investment spending" in the first six months of the year to improve private credit, underwriting and loan service systems and other operations.

"Notwithstanding, our expenses are too high. You'll see expenses start to move down by year end," Lord added with an apologetic tone.

Worse still, however, were lending prospects. The firm originated $3.1 billion in FFELP loans in the second quarter, a decrease of 16% compared to the same quarter a year ago. And that was the last quarter ever to originate student loans carrying a government guarantee, since the U.S. Department of Education will now lend directly to students, leaving private lenders to rely on private loans to utilize their lending capacity.

"We originated a disappointing $219 million in private credit loans in the quarter, compared to $387 million in the second quarter 2009," Lord said, noting increased limits on federal student loans, more students applying for federal loans and students switching to lower-cost educational institutions as reasons.

Lord acknowledged that private student loan origination's fate depends largely on still-uncertain economic improvement. The conference call wasn't entirely gloomy, however. The firm recorded second-quarter generally accepted accounting principles (GAAP) earnings of $338 million, compared to a $123 million loss the same quarter a year ago. In addition, borrowers closing loans during the quarter had an impressive average FICO score of 735, reflecting the lender's tighter underwriting standards, and 77% of the loans had co-borrowers signing the papers.

Nevertheless, private student loan lending may be challenged for the foreseeable future, leading to a dearth of new-origination ABS deals. Lord said loan application flow has picked up in the last three or four months and is better than it was in 2009, but still tepid.

"Obviously, families are still deleveraging, there's a significant supply of cheap federal money in the marketplace and, frankly, families are much more discerning in assessing value for their dollars," Lord said.

Federal loan limits increased two years ago, squeezing the gap between government loans and student costs that private loans fill. However, educational institutions have started raising their tuitions again, and some market participants see an increase in private student volume as inevitable.

"Tuition costs are still going up faster than incomes and faster than inflation," said Guido van der Ven, founder of advisory firm Education Investment Group, noting that federal loan limit increases tend to happen once a decade, leaving plenty of time for the gap to widen significantly. In addition, he said, the home equity market helped finance students during the real estate boom, and since that market is now all but defunct, those borrowing needs are likely to shift to student loans.

"In light of the cost of education, the demographics of people going to school and the likelihood that the federal government is not going to throw any more money [at the market] in the foreseeable future, it seems like volume has to return to the $22 billion range," says Christopher Chapman, president and CEO of Access Group, a nonbank lender focusing on loans to graduate and professional schools. He added, "Simple math tells me it has to happen, but I don't have a good sense of when."

In the meantime, Access Group is changing its product mix to adapt to the new environment. The firm did complete a $470 million securitization of deferred graduate and professional loans in May that it had been holding since the credit crunch began.

Chapman said demand was "pretty good," but that such a high level of overcollateralization was necessary on the private loan transaction is "not the kind of deal we want to do routinely."

Until the ABS market becomes less burdensome for issuers, Access Group is pursuing more complex private deals that shift credit risk to investors, who receive some protection from schools involved in the program. Deutsche Bank and Moehn & Associates, run by Kevin Moehn, a former top executive at Sallie Mae, drummed up the investors to fund the Affiliated Loan Program for Students (ALPS). It's being offered to non-U.S. students attending a dozen graduate schools, including the University of Chicago; University of California, Los Angeles; and University of California, Berkley.

ALPS has been in place for about a year, and a similar program offered to students of the ITT Technical Institute has been up and running since February. "We're adapting the current environment because it's hard to do a straight-up securitization," Chapman said.

Some major lenders, such as Bank of America, have opted to exit the student loan business. Those remaining view working closely with schools and their financial aid departments as critical.

First Marblehead Corp. has specialized in private student lending since 1991, and the majority of loans backing its securitized volume was sold directly to consumers, a channel that has all but disappeared. The company has spent the past two years developing its Monogram product line and recently announcing the launch of a program with SunTrust Bank, a major student-loan provider, to facilitate the Atlanta-based bank's Custom Choice student loan program. The program is built upon Marblehead's Monogram chassis, which provides flexibility for banks to shape the program to meet their risk objectives while offering borrowers a wide variety of loan options based on their credit profile.

Now lenders and investors favor schools' financial-aid departments involved in the underwriting process. "Involving the school makes for a better asset," said Gary Santo, a managing director at First Marblehead. "They are best able to assess the needs of their students and can verify their enrollment. When combined with disbursements directly to the school, you have a solid first line of defense against potential over-borrowing and fraud.

Santo noted that Monogram was designed with prepping loans for securitization in mind.

As of the end of the second quarter, 19 private and FFELP-backed loan securitizations were completed for a total of $12.5 billion, according to data collected by the ASR Scorecards database. Sallie Mae issued four of those transactions, totaling more than $5 billion, followed by the Student Loan Corp., Bank of America and Nelnet. That total volume compares to $21 billion in deals in 2009 and $30 billion in 2008, when the credit crisis began.

Sallie Mae led the pack in terms of volume in those years as well, and its lead is continuing. In recent weeks, Sallie Mae has issued $2.65 billion in ABS, split between a $1.65 billion refinancing at lower rates of an existing deal among existing investors, and the rest backed by newly originated loans and sold to a new investor group. "[The bonds] had anywhere from a one- to a three-and-a-half-year average life and were sold at spreads of about 165 basis points to 265 basis points over Libor," according to John Remondi, Sallie Mae's chief financial officer, who also spoke in the earnings conference call.

Remondi added that all of the loans backing the two recent ABS deals allow students to defer payments. That's typically an unattractive feature to investors, who seek steady cash flows. In an effort to curry investor favor, Sallie Mae has recently expanded its loan offerings to include one with a fixed-rate payment option. The fixed-rate Smart Option loan, like the existing floating-rate version, requires students to begin paying off the loans while going to school, eliminating the risk that they'll forget about deferred loans and be confronted with a much larger loan to pay off later on.

"Requiring borrowers to pay interest while in school does make the loans easier to securitize, but it is also the right product for students and families," Remondi said, adding, "It significantly lowers the finance charges they'll pay over the life of the loan, thereby making the loan more affordable."

Besides private student loans, lenders have sold the bulk of FFELP-backed loans to the government in recent years, through the Ensuring Continued Access to Student Loans Act (ECASLA). However, some niche areas could result in significant ABS issuance.

Barbara Lambotte, an analyst at Moody's Investors Service, said her group has seen issuing trusts with cash pursue tender offers of impaired auction-rate securities comprising student loans - typically at a discount - to redeem them. Those transactions are likely to lessen, she said, adding that she anticipates more larger transactions that take the loans out of the trust estate and re-securitize them. A few such deals, such as one from the Brazos Student Finance Corp., which successfully completed an $87 million ABS transaction last spring, have already occurred. And a number of such transactions are in the works, Lambotte said.

However, those auction-rated securities are mostly backed by FFELP loans, for which spreads have recently experienced hiccups. "It seemed for a while that there were some FFELP deals where spreads came in to about 80 basis points or 85 basis points over Libor - if those spreads were to keep tightening, we would have seen more auction-rate restructurings," Chapman said.

Instead, however, spreads have widened. "The FFELP spread in the second quarter was 104 basis points compared to 90 basis points in the first quarter," Remondi said in the conference call.

Although no new FFELP loans can be generated, existing FFELP-based ABS and any new deals cobbled together from loans now housed in auction-rate securities or those resting on banks' balance sheets could be attractive to investors. John McElravey, an analyst at Wells Fargo Securities, said that the market for manufactured housing loans also became "orphaned" in the early 2000s when many of those lenders went out of business.

"Some of those deals actually gained some scarcity value over time as the sector shrank," McElravey said.

However, when new student loan ABS arrives, it's likely going to be too little and too late for most lenders to continue providing student loans profitably post-FFELP without significant changes. Sallie Mae may lead the way on this front as well, as it considers breaking up the company. Michael O'Dell, an analyst at AIG Asset Management, inquired during the earnings call about rumors of Sallie Mae spinning off its banking and servicing operations.

Lord responded that such a spinoff is under consideration. "We believe the entity that was spun off would finance itself with deposits and would have access to the capital markets, just as we do."

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