The student loan sector is still in relatively good health, all things considered. In fact, Fitch Ratings released a report last week saying that for the most part, student loan ABS has continued its stable performance despite the negative funding issues plaguing the market.
The rating agency also said that the weakening economy has not had an immediate impact on collateral performance as student loan delinquencies and losses typically lag economic cycles. "Students have the option to defer payments by staying in school or applying for forbearance, in effect, providing a bridge across economic cycles," said Gary Santo, a managing director at Fitch. He added that performance also has a seasonal component driven by the academic calendar and when students enter repayment after graduation.
There is also a differentiation between the risk that underlies FFELP and private student loan deals, according to Fitch.
Andrea Murad, a senior director at Fitch, said that 60+ day delinquencies, forbearances and claims levels on private student loans have increased by an average of 22% over the past year, which is explained in part by the seasonal patterns. The data was derived from the rating agency's Student Loan Indices, which will be published in August and track performance on 111 FFELP and 48 private student loan transactions.
"As an investor in a FFELP deal, loss is not your main concern due to the government guarantee of at least 97% of the defaulted amount. Instead it is more a liquidity concern," Santo said. "In private loans, however, net loss becomes your main concern along with liquidity - if a certain percentage of the collateral disappears because of poor performance, can the deal still perform? We are definitely less optimistic there, especially in the subordinate tranches of these transactions. Although, while we are currently seeing performance at the lower end of the spectrum, it's not off the charts."
Santo also noted that an additional challenge with private student loans is that products are different across issuers. "With FFELP, loan terms do not vary beyond when it was originated and the seasoning of the loan," he said. "On the private side, seasoning is a factor as well as differing terms making it more difficult to compare products, apples to apples."
In addition, Santo added, the structure of a private deal is almost as important as the collateral. For instance, when comparing a Sallie Mae and a First Marblehead deal, the collateral may perform within range of each other, but deal leverage creates a more pronounced effect on transaction performance.
Murad said Fitch is also looking at issuer-specific concerns in rating deals, especially given the difficult capital market conditions. "We are looking at how issuers are changing their business models to determine if they are going to stay in business." For example, she said that as a result of auction-rate market failures, issuers are looking for alternative ways to refinance their debt and sustain their investor base. "If your business plan involves closing up shop, you may be less inclined to refinance that debt, increasing the credit risk in those transactions."
Issuer Focus
With troubles in the student loan sector, issuers are focusing on maintaining the health of their student loan portfolios. GCO Education Loan Funding Corp. (GCO ELF) is a good example.
Recently, the student loan issuer made a tender offer to purchase certain outstanding senior auction-rate bonds at a discount, a move that is aimed at improving the health of its GCO Education Loan Funding Master Trust-II.
Officials from GCO - which has been coming to market regularly with deals backed by government-guaranteed loans - are monitoring market conditions closely. "Our position is that we will come out with a deal when the market feels right for us, and whether it be a FFELP or a private loan deal, we have the ability to wait," said Robert Culnane, president of GCO ELF. "It's a question of timing, which is a very individual thing depending on the pressure that each issuer is under, although I can't imagine anyone with a firm issuance calendar right now."
Despite the challenges, Culnane said that the FFELP market is crawling back, as every deal that gets done has priced "a little bit more attractively than the deal before. Investors are returning, albeit slowly."
On the private market side, Culnane said that the recent MRU Holdings private student loan deal created a benchmark, given the lack of issuance in the sector. The deal provided some indication of what investor appetite is like for this sector. Culnane said that despite the depressed volume levels, private student loans, if properly underwritten, remain good risks. "What the market has seen during this lending season is that lenders granting private loans have established stricter credit criteria and a combination of interest rates and fees that are consistent with what the capital markets and rating agencies think of the risk," Culnane said.
Despite his relatively optimistic views on the student loan sector, Culnane believes that the U.S. government's participation on the debt side will be very limited. "We have to operate under the assumption that there will be limited Federal intervention to help out the auction-rate market," he said. "It's unusual for the government to support a market that largely has private sector involvement. Bailing out the auction-rate market is not high enough on the government's list of priorities."
Government Intervention
After an auction failure, the interest or dividend rate on the auction-rate securities (ARS) defaults to a maximum rate that is generally above market at issuance, according to law firm Morrison and Foerster (MoFo). The higher rate is meant to pay ARS holders for the illiquidity of the securities. However, the credit crisis has made these rates below market, causing ARS to become even more illiquid.
To respond to this problem, the Internal Revenue Service (IRS) has issued Notices 2008-27 and 2008-41 offering guidance to issuers of tax-exempt bonds that want to either convert their outstanding bonds from ARS to bonds with fixed or floating interest rates to maturity or to buy their own ARS from the market.
Other regulatory developments include the Securities and Exchange Commission (SEC) grant of a no-action relief to certain closed-end funds that want to issue a new class of preferred securities. Liquidity protected preferred (LPP) shares will now be offered by closed-end funds to finance the repurchase or redemption of their outstanding auction-rate securities, according to a MoFo client alert.
Anna Pinedo, a partner at MoFo, said that the SEC has not provided the same relief to student loan auction-rate holders, but she is confident that the commission will be doing so soon.
One of the problems, she said, is that it's challenging for a lot of student loan issuers to determine the value of their securities in terms of using the fair value method of accounting, which a lot of these issuers had to do for the first time in the first quarter. Also, since there has not been a liquid market for student loans, it has become harder to determine their value.
"It's very difficult to get broker bids or fair value on discounted securities considering current liquidity and impairment issues," Pinedo said. "This has been especially hard for issuers to do, as even experts such as investment managers are having difficulty valuing the securities, or are working really very hard at it."
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