Amid the political frenzy that seized the nation and culminated on election day last week, some investors expressed concern over what impact a Republican-led initiative to halt the creation of student loans with 9.5% floor payments would have on outstanding student loan ABS. However, investors' fears are unwarranted, according to a recent report from Morgan Stanley.
The 9.5% floor represents a minimum lender yield on student loans financed by eligible tax-exempt bonds issued before October 1993. Part of the yield comes from the rate charged borrowers, while the difference between the charged rate and the 9.5% floor is covered by the government with taxpayer dollars. Recent legislation passed by both houses of Congress would halt the origination of these loans for one year. However, the act is not retroactive, and should have no impact on outstanding student loan ABS. "Seeing as legislation does not call for retroactive actions, we do not believe ABS investors will be affected," Morgan Stanley analysts wrote in the report.
Moreover, ratings analysts at both Fitch Ratings and Moody's Investors Service have provided assurance that even if the floors on these transactions were to be revoked, they would continue to perform unhindered. "Both rating agencies have modeled the transactions without the 9.5% floor, assuming instead the regular FFELLP [special allowance payment (SAP)] and report that all of these bonds would perform well," analyst noted.
In particular, analysts ran stress tests on three outstanding transactions from Nelnet backed solely by 9.5% loans: NSLC 2004-1, NSLC 2004-2 and NSLC 2003-1. All three held up under scrutiny.
Morgan Stanley maintains that despite inquiries received by the Securities and Exchange Commission questioning some of Nelnet's practices in this area, any future investigation is unlikely.
"Seeing as Nelnet disclosed all material relating to its holdings in the past and corresponded with the [Department of Education] regarding this matter, we do not believe SEC investigations will be productive," analysts wrote in the report.
Citing a publication from the Institute for College Access and Success, Morgan Stanley analysts found the top three holders of 9.5% loans to be Nelnet, Pennsylvania Higher Education Assistance Authority and Sallie Mae. Sallie Mae has not included any of their 9.5% loans in a securitization. Other lenders have, but to a relatively limited extent, analysts found.
Traditionally, investors like 9.5% loans because the minimum rate provides additional excess spread, as well as additional assurance that the bond will reach parity by maturity. These transactions are issued at 98% to 100% of parity. Analysts compared this to the overissuance of other FFELP loan backed bonds. Investors can view this as further assurance that the bonds will perform similarly despite removal of the 9.5% minimum payment, according to the report.
Regardless of the 9.5% floor payment, the underlying loans are still government guaranteed at 98% of the principal and interest in the case of borrower default. In the case of a lender or servicer being named an exceptional performer (EP) by the DOE, the guarantee on unpaid interest and principal is 100%. Lenders with EP status include Nelnet, Sallie Mae, Wells Fargo Education Financial Services, Great Lakes and the Student Loan Corp., among others.
Congress first attempted to end the origination of 9.5% loans in 1993, yet loopholes remained. The pending legislation would address some of those loopholes, including the "transferring" and "recycling" of funds, along with the "refunding" of pre-1993 bonds. Transferring refers to the lenders' ability to switch the funds financing a loan, while recycling allows the lender to reuse the money from a borrower paying off their loan along with the government SAP to make another 9.5% loan. The refunding loophole enables lenders to extend the life of these bonds by making a new bond issued to refund/refinance a pre-1993 tax-exempt bond - which would be eligible for the guarantee - for the 9.5% guarantee also eligible for that guarantee.
Critics claim that these loopholes have increased the volume of outstanding 9.5% loans substantially, thereby creating excessive SAP. Morgan Stanley analysts estimate that the cost to the U.S. Treasury in 2004 could approach $1 billion. The proposed legislation would prohibit both transferring and refunding, although recycling would still be allowed.
The act in question - the Taxpayer-Teacher Protection Act of 2004 - was passed early last month, and calls for the issue to be revisited in 2006. President George W. Bush is expected to sign the bill into law in the near future. Both sides of the aisle in Congress would prefer to avoid the issue in the future, and market sources believe a permanent fix is likely on the horizon.
Copyright 2004 Thomson Media Inc. All Rights Reserved.