The passing of 2007 marked a historic period in the U.S. student loan industry. An unprecedented amount of attention was directed towards student loan market participants in both federal and private programs. Business practices, underwriting, servicing and marketing practices were put under a microscope over the course of the year. As we enter the second month of 2008, education continues to be a hot topic in Congress with the presidential election fast approaching. Legislation passed in 2007 will begin to have its affects felt in 2008, with additional higher education reform proposals likely to follow.
The College Cost Reduction and Access Act, passed in September of last year, contains several changes to the federal financial assistance programs related to postsecondary education. The law could result in more than $20 billion being cut from the Federal Family Education Loan Program (FFELP), with the majority of the savings allocated across new and existing grant programs, interest rate reductions, and loan forgiveness programs. Reductions in special allowance payments (SAP) to loan holders and lower reimbursement rates on defaulted loans comprise a major portion of these cuts. While Fitch does not anticipate these changes will result in negative rating actions on existing FFELP ABS transactions, higher credit enhancement levels may be required for transactions including increasing levels of loans originated under these guidelines.
Excess spread continues to be the primary source of credit enhancement in student loan ABS. The SAP cuts will reduce the amount of available excess spread by one-third to two-thirds of current levels in an expected case, depending on the portfolio composition and the issuer's tax status. This will leave future FFELP student loan transactions with less excess spread to cover losses. To offset this reduction, bankers and issuers may elect to structure new transactions with lower student loan premiums financed by a trust, higher starting asset to liability or parity ratios, a decrease in servicing and trust fees that provide incremental spread amounts, or an increase in subordination within the capital structure.
Fitch expects FFELP ABS performance to remain generally stable in 2008 even as deteriorating consumer health may potentially push delinquency and loss rates moderately higher. However, private student loan ABS will experience a more challenging environment not only due to adverse economic conditions but also competition within the industry. Importantly, Fitch is concerned that as traditional FFELP lenders test the more lucrative waters of private student loan lending, underwriting guidelines may be stretched leading to more volatile performance.
As volatility continues to permeate the broader credit markets, student loan issuers who have traditionally relied on the auction-rate market for funding have experienced an extended disruption. Clearing auction rates are at levels which introduce the possibility of failed auctions for a number of issuers. While student loan ABS trusts with auction-rate debt are generally structured to withstand failed auctions, Fitch has concerns regarding the duration for which these trusts can sustain the potential drag on excess spread caused by the market disruption. Should market conditions persist, trusts dependent on the auction market may need to restructure some or all of their debt in order to better insulate the trust from any future rate volatility.
From a broader perspective, the U.S. economy continues to show signs of weakening as the unemployment rate rose 0.3% to a two-year high of 5.0% in December. Although consumer ABS performance tends to be sensitive to such increases, an increase of this magnitude is not likely to cause performance issues severe enough to result in a significant increase in negative rating actions. As usage of revolving credit continues to grow and bankruptcies continue to increase, delinquencies will increase across consumer sectors such as credit cards, auto loans and student loans. Historically, a weakening economy triggers an increase in enrollment in higher education as existing students faced with a shrinking job market elect to remain in school to obtain an advanced degree while members of the work force return to school to increase their skill sets.
As a result of this confluence of events, the coming months will prove critical to the industry. The cost of education continues to rise and consumer demand for student loan products remains strong. Lenders both large and small must continue to test and refine their business models, adapting not only to recent legislative changes but also the current volatility in the capital markets. Traditional sources of funding for their programs may no longer be viable. The ability of issuers to survive and compete in this new landscape will be the measure by which these tests are graded.
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