With FFELP student loan issuers having difficulty funding loans because of the current credit freeze, the Straight-A Funding student loan conduit was developed to provide a partial industry solution.
Citi and Morgan Stanley are the transaction's joint structuring leads, while BMO Capital Markets serves as the manager on the conduit. Bank of New York is the administrator, while Mayer Brown serves as the legal counsel. Five student loan issuers are on the Conduit Advisory Committee and are acting as advisers on the transaction.
The Department of Education (DOE) entered into a put agreement with the conduit, and the Federal Financing Bank (which is under the general supervision of the Treasury Department) is providing a liquidity facility. One of the conduit's unique features is its collaboration with these two government agencies.
In the event that the conduit cannot roll over its liabilities, then a draw occurs under the Federal Financing Bank facility, typical of a traditional commercial bank facility. If the Federal Financing Bank remains drawn for 90 days, then the conduit puts the loans to the DOE, generally at a price of 97%, in order to reimburse the Federal Financing Bank. Loans may also be put to the DOE under certain other events, including if students become 210 days delinquent on their loans. However, the DOE typically already guarantees these loans at 97%, so the DOE is not taking incremental credit risk and would receive the additional 3% return on repaid loans.
Currently, the cost of liquidity has priced issuers out of the market. The new conduit is supported by the Federal Financing Bank liquidity agreement as well as an obligation of the DOE to purchase the underlying student loans to pay off any draws on the Federal Financing Bank liquidity. Moreover, the DOE is obligated to purchase delinquent loans from the conduit before any loans default.
Reasons for Conduit
There are a number of for-profit, state and regional not-for-profit student loan issuers that relied on securitization that cannot originate loans for this past and the upcoming school years, as it became more expensive to issue compared to where the loans got paid out.
This became a public policy issue.This public policy problem was the reason why the Ensuring Continued Access to Student Loans Act (ECASLA) was enacted. It gave the DOE expanded powers to directly purchase loans from issuers. However, from originators' perspective, the direct purchase program had two drawbacks: It did not address existing loans that were utilizing issuers' bank warehouse lines, and issuers were unable to continue servicing loans upon their purchase by the DOE.
This is one of the reasons why Straight-A Funding becomes a viable solution because, through the efficiencies of the conduit, it will allow issuers to receive their traditional all-in funding costs and maintain, manage and apply the revenues from the loans that they originate. Unless the put occurs, the servicing aspect is retained by the originator and not taken over by the DOE.
In return for being able to access and benefit from the conduit, these originators are required to maintain a FFELP platform to the extent the program continues. They are also required to use the net funding benefit from the conduit to originate new or purchase loans. For instance, if an originator's current financing has an advance rate of 90% on an issuer's loans and the conduit funds at a 96% advance rate, then the lender is required to reinvest this six-point funding differential to originate or purchase new student loans.
From the government's standpoint, the conduit functions as a contingent funding obligation, since the Federal Financing Bank is serving as a liquidity backstop. With this strong support, the conduit managers can continually roll the conduit paper. The presence of the Federal Financing Bank also may mean there's less likelihood that the government has to actually fund these conduit notes, because this would happen only if there is a significant market disruption. This is different from the direct-purchase program the DOE implemented, which has the government purchase student loans on day one. The Department's 2010 budget estimates that the conduit will create $1.4 billion in net cost savings (when taking into account the fees being charged to the conduit) over five years, which the department may invest in other education programs.
As mentioned earlier, there are now eight participants in the program, with several more in the pipeline. According to sources, the conduit has basically all of the large student loan issuers participating, including a diverse array of both bigger for-profits and big and smaller not-for-profits. The DOE approves participating student lenders, which are required to submit a notice of intent to participate to the DOE. Only FFELP loans originated between October 1, 2003, and Sept. 30, under the Stafford and PLUS programs are eligible (consolidated loans are specifically not included) to be part of Straight-A Funding, pursuant to the DOE's authority under ECASLA.
The conduit's assets are currently roughly $25 billion, which is noteworthy because it just started operating between the second and third week of May. This amount makes it the largest conduit on the Street. Part of the rapid growth may have been driven by the need of money market funds for new investments following the culmination in a decline of other asset-backed commercial paper programs and the increase in their cash positions.
Chris Chapman, president of Access Group, said that his firm has a little more than $800 million worth of loans in Straight-A Funding. "We've been very pleased with the conduit as a medium-term funding source, given the trouble we faced with the freezing up of the securitization markets," Chapman said. However, he said that there are some elements of the conduit that could be improved, including the equity contribution required of participating issuers, which is currently at 3% plus required reserves. "It's not high, but it is higher than it used to be," he said. "And although pricing in the conduit is in line with our expectations, we're hoping that pricing will still tighten some."
Chapman acknowledged that it is easier for those issuers that have equity to participate in the conduit. Aside from the relatively steep equity contribution that is required by the Department of Education for conduit participants, there are also some operational items that could be improved, although Chapman said that participants have effectively worked around or otherwise resolved these glitches. He added that the conduit has been running as advertised for the most part and it's proven flexible in special situations where certain entities needed to finance loans out of another financing.
Market participants, including dealers, structuring agents and investors, have suffered from the significant pullback or the dearth of ABCP. However, Straight-A Funding has seen tremendous demand, particularly from money market funds, showing that investors have licked their wounds.
Investor comfort is further demonstrated by buyers overcoming the fact that reimbursement occurs after three days, as opposed to same-day liquidity. On the expected maturity date, investors receive a notice that reimbursement will occur in three days. Although investors took time in gaining comfort, they ultimately got comfortable with this reimbursement timing.
Dennis Cariello, who was formerly from the DOE, said that after the credit dislocation in early spring and late winter 2008, the DOE was looking at how it could ensure that students would be able to obtain student loans for the 2008-2009 academic year. Unfortunately, the DOE didn't have the legislative power to address the problems facing lenders that prevented the loans from being made.
After the DOE gained the authority to buy loans from student lenders, an ABCP conduit like Straight-A Funding was one of the options that were considered. However, because of timing issues, the DOE decided not to use the conduit as a funding strategy, although Straight-A remained on the back burner.
The problematic aspects of the student lending industry remained, where lending became unprofitable because of the changes of subsidy calculations and the mismatch between commercial paper and Libor funding.
Starting the conduit program was not a seamless exercise. "It took a while to get this up and running - a lot longer than we thought when we originally announced the program in mid-January," Cariello said. "After we signed the first contract for Straight-A, rating agencies took a second look at the implementation documents. It produced a good, safe product, but it took quite some time."
Stafford and PLUS loans that were first dispersed in October 2003 and will be last dispersed in September 2009 are eligible under Straight-A Funding. According to Cariello, the net proceeds from these loans will be used to fund loans for the school years 2009-2010 and 2010-2011. "Once we solved the problem of funding for the 2008-2009 school year through our Put and Participation programs, we were ready to think longer term and we returned to the concept of this conduit once again," Cariello said.
The lenders have two years to make good on Straight-A's lending commitment as a result of the popularity of the Put and Participation programs that the DOE reenacted for the 2009-2010 academic year. "Lenders can take advantage of the 2009-2010 Put and Participation programs but must use 100% of the net proceeds from Straight-A to fund new student loans. Because we didn't want lenders to double-count loans from the 2009-2010 program toward that commitment, we gave them until 2011 to make good on the commitment and excluded loans that were already in a DOE program," he explained.
Some student loan players consider the equity required for lenders to participate in this conduit to be rather steep. "The authority we received from Congress requires budget neutrality at worst. Because of this, and because of difficulties in accurately predicting savings to the government, we had to err on the side of caution when offering a put price to lenders," Cariello said. "When we enacted this program in January, we projected savings of $500 million or so. In the recently released president's budget, the savings are predicted to be about three times that. Honestly, though, I think this program will save even more because of the potential for fees that get paid to the government from the participating lenders."
He added that one of the problems with setting the loans at rates higher than the 97% offering price for the put is that many lenders have higher leverage on their loan portfolios - some as much as 103 leverage - and would have had difficulty participating in the conduit without an above-par put price.
Many lenders, however, had equity reserve - at one point student loans were valued at 80% or 84% of loan value, a rate Cariello described as "irrational" in light of the 97% guarantee on the asset. This equity reserve has increased the number of different lenders that can participate in the program.
Cariello said that one of the advantages of the conduit program is that the loans pledged stay in the hands of the private sector, including the servicing rights. He added that, while the projected outlays for the program are accounted for, the debt is contingent debt. "It's on the books, but it's not actually debt incurred, thus gaining the benefits of the program without actually spending the money," he said. "It will not, for example, increase the government's cost of funds because no new Treasuries have to be sold. Additionally, considering the budget estimate that the department would buy no more than 10% of the volume - about $5 billion - it is a great bang for the government's dollar."