Basis risk is exposing some U.S. FFELP SLABS to considerable short-term volatility, Fitch Ratings said.
After the recent periods of unprecedented interest rate volatility, Fitch conducted a study to investigate the nature and magnitude of basis risk, which is a significant factor influencing the FFELP student loan ABS performance.
Some U.S. FFELP SLABS are exposed to considerable short-term volatility in the basis spread, according to Fitch. Most of the volatility, the rating agency said, was caused by the difference in the spot and average rates and not the difference in the indices.
The rating firm is currently refining its FFELP student loan ABS rating criteria to better account for basis risk based on the study.
"Senior FFELP student loan ABS bonds with 3% or more of credit enhancement appear to be well protected against basis risk," said Fitch Senior Director Aoto Kenmochi. "However, subordinate bonds with minimal or no enhancement that are not benefiting from excess spread accumulation are
much more susceptible to this risk and are more at risk for downgrades."
Fitch placed ‘AAA’ subordinate bonds on Rating Watch Negative based on this risk, even though other subordinate bonds rated lower might also be at risk for downgrades depending on the structure.
Fitch's research involved observing the historical distribution of basis spread between the relevant interest rates, considering that the liability rate is based on a three-month Libor spot rate, while asset earning is mostly based on the average of the three-month financial commercial paper rates over a calendar quarter.
The historical median basis spread is approximately negative seven basis points per year over any given horizon (a quarter to 10 years).
But, while longer horizons — five to ten years — have very tight spread distribution around the median, the distribution becomes more volatile as the horizon is shortened, Fitch said.
The minimum spread seen for one-quarter horizon is negative 2.4% (annualized), which is tied to the rise in Libor that occured after the Lehman Brothers bankruptcy.