Last Tuesday President Obama enacted a law requiring all student loans that are federally guaranteed to be originated by the federal government - effectively eliminating the Federal Family Education Loan Program (FFELP) starting on June 30. This is an event that, according to ABS analysts, will have a considerable and permanent impact on the SLABS market.
The education part of the Health Care and Education Affordability Reconcilation Act of 2010 (or the SAFRA) will make the role of the Department of Education (DOE) in the student loan market considerably bigger, observers said.
Because of this change, all new government student loans will be offered via the Federal Direct Loan Program (FDLP) while serviced by firms authorized by the DOE.
"FDLP loan servicing contracts should limit the operational risk of servicers caused by the elimination of new loan volume under FFELP (e.g., reduced revenues, over-capacity)," wrote Bank of America Merrill Lynch analysts in a recent report.
With the removal of FFELP, Deutsche Bank Securities analysts said they are expecting a transition period between when FFELP is phased out and when the FDLP starts. They based their assumptions on the fact that the DOE will be allowing the three student loan programs it has established - the Loan Purchase Commitment Program, the Loan Participation Purchase Program, and Straight-A Funding) - to expire in the next six months. With these programs ending, Deutsche analysts believe there will be a rise in new-issue FFELP ABS volume in this transition period, if the cost of doing an ABS stays economical for issuers.
However, if the ABS market is unable to absorb the rise in supply, FFELP ABS spreads might widen from current levels and issuance could once again be unattractive for lenders that have other options for funding, Deutsche analysts said.
But, they said that, "given the political sensitivity of educational funding and to avoid funding delays and uncertainties, we would not be surprised if the DOE extends the currently-in-place liquidity programs until the FFELP-to-direct lending transition is complete."
If this happens, FFELP lenders would still originate federal loans by funding them with low-cost government financings. Securitizations, according to analysts, would be limited to loans that are not eligible for the government funding programs, including private credit student loans and FFELP consolidation loans, which was the way it was in 2009.
Private student loans are not covered by both the government funding programs and the student loan reform legislation, although they have benefited from the Term ABS Loan Facility, analysts from Deutsche said.
They also mentioned that there is a separate bill that has ciruculated in Congress allowing students to swap their performing private student loans into less costly unsubsidized Stafford loans through the government's direct lending program. Analysts said that this proposal might not gain momentum and might be dropped off of Congress' agenda.
"For ABS backed by these loans, a wave of refinancing could shorten the average lives across tranches," analysts wrote. Aside from this, through adverse selection, a disproportionate number of perfoming assets might exit the pools, which would leave behind nonperforming assets, they said. This would cause higher-than-expected losses for private credit SLABS, according to analysts.
Servicing Student Debt
In terms of servicing, the removal of new loan volume under FFELP does not change FFELP ABS servicer obligations, according to BofA Merrill analysts.
They added that the firms that are in the best position to move ahead after FFELP is gone are those that have been given a FDLP loan servicing contract - the DOE has awarded five thus far - or have diversified product lines. These companies with contracts are also the sub-servicers for other lenders' portfolios and FFELP ABS, lessening the risk for those portfolios, the analysts said. They added that, "servicer quality is important since claims against guarantors and [the DOE] may be rejected, if servicers fail to adhere to specific standards."
Analysts said that because of the SAFRA, the number of FDLP loan servicers should rise since the DOE is required to consider all eligible not-for-profit lenders for servicing contracts.
Sallie Mae and Nelnet are included in the current list of five. According to data shown by BofA Merrill Lynch analysts in the report, as of December 31, 2008, Sallie Mae was servicing around 2 million accounts under its servicing contract with the DOE. This earned Sallie $9 million of servicing revenue related to the contract in 4Q09. The BofA Merrill report said that the student lender expects to increase this amount considerably as the third-party serviced portfolio rises over time.
Meanwhile, Nelnet was servicing around $3.4 billion as of December 31, 2009 and $6.3 billion as of March 1 loans under the DOE's servicing contract. The company, according to the BofA Merrill report, started servicing loans for the DOE in September 2009 and recognized about $1.7 million of revenue from this contract in 2009.
Private Student Loan Side
Because there will be a transition from the FFELP to the government direct lending program, and because there will be limitations on amounts available under direct lending for some students, many companies on the private student loan side are working to offer alternative loan products to fill the demand. (Please see sidebar for more on how lenders are reacting.)
"We are working as lawyers for lenders, specialty finance companies and hedge funds who are interested in making private and alternative student loans," said Lauris Rall, a partner at Sonnenschein, Nath & Rosenthal. "There is a perception that the transition to direct lending might be difficult and many schools may not be prepared for the school year 2010-11. However, there are very capable people in the Department of Education who are working hard on the transition."
Rall said that because of the termination of private lender participation in FFELP student loan programs, private student loan issuers have been developing different types of student loans to originate as alternatives to the traditional loan that the student repays after college.
"New alternative loans will be designed for students to get familiar with paying their debt and what it means to take out a student loan by requiring them to make interest payments throughout college," Rall said. There are also private student loans, according to Rall, for which parents are co-borrowers to achieve credit ratings that translate into lower interest rates for the loans.
According to Rall, there are different funding mechanisms that lenders are exploring to manage their balance sheet and their cash available, such as various third party financing arrangements, securitization or special investments with one or a few investors who want to invest in this product. A hedge fund, for example, can arrange innovative financing to invest in these loans. However, the timing is uncertain as to whether these arrangements could be made by the fall semester of 2010.
Rall added that securitizations are not out of the question for private lenders. "Customization in the structure of asset backed securities can be negotiated - including the payment terms of the securities - what investors want and need for their investment portfolio will translate to the terms of the underlying student loans that lenders originate, such as repayment terms and length of the loan," he said.
It's Never That Easy
Although the private loan student alternative might be open to lenders and students alike who no longer have access to the FFELP market, sources said that it's not as easy as it might seem to simply resort to private student loan lending.
For issuers who had serviced government-guaranteed loans, the collection processes were very regimented to comply with federal requirements.
However, when lenders are originating non-government-guaranteed or private loans, they have to figure out a cost-effective way to service these loans. A knowledgeable source said: "Suddenly you have to develop and figure out how to optimize the servicing of these loans - should I call the obligors every day or should I send them a form letter only for those who are 90 days past due?"
Private student loans by nature are unsecured receivables to borrowers who have little credit history, with the only advantage being that they are not dischargeable in a bankruptcy.
According to the source, the most common forms of private student loans that lenders are currently looking at are those with shortened terms, probably around five- to seven-years.
The end of FFELP, however, does not mean an end to the securitization of this type of collateral - there are still long-dated student loans that are backing ABS auction-rate securities in which the auctions have failed, the source said. The question, he said, is how to get those student loans refinanced.
Investors initially bought these bonds when they were as liquid as money market investments, but are now left with a 20-year bond that has no liquidity and can be sold only at a significant discount.
For originators, the bonds originally priced at interest rates similar to money market instruments, but now their cash-flows are reduced because the rate in a failed auction is a "maximum rate," which has reduced the value of their residual interest in these transactions.
Student Loan Law Has Lenders Wondering
President Obama's enactment of a new law last Tuesday that would require all federally guaranteed student loans to be originated by the federal government has led the state and nonprofit entities that have historically loaned to students to contemplate their future in the market.
Some of these entities, which have been major issuers of student-loan backed municipal bonds, were considering recasting themselves as "private" lenders or as servicers of the federal loans.
In a speech prior to signing the legislation, which cleared Congress the previous week attached to the massive health care reform package, Obama hailed the lending reforms as a way to save $60 billion in reduced borrowing costs that can be plowed into additional grants for students.
Specifically, the legislation eliminates the Federal FamilyEducation Loan Program (FFELP) and requires all new federally-backed loans to be originated through the Ford Federal Direct Loan program beginning July 1.
Though FFELP lenders opposed the measure, student-loan lenders or their trade groups said on Tuesday that they will continue to have a role in student lending, possibly through new or expanded private lending programs in which they originate student loans that are not federally guaranteed.
Private loan demand is greatest in the Northeast, where there is a high concentration of expensive private colleges and universities, said Peter Warren, president of the Education Finance Council (EFC), which represents nonprofit state-level agencies. Kenneth Roberts, a partner at Hawkins Delafield & Wood in New York, said there is likely to be a significant role for private lenders to supplement the federal direct lending program, which caps the amount of loans an individual student can receive each year and over the course of his or her academic career. "Based on the law that just passed, there will be a good amount of unmet need in the sense that the aggregate cost of attendance will exceed availability" of direct loans, Roberts said. "Longer term, there's a very good likelihood that the federal government will not fully fund the cost of attendance."
States may continue to make private-activity bond volume capacity available for student loans if there is a lot of unmet need, allowing state-level borrowers to sell tax-exempt bonds backed by their private loans, Roberts said. However, the underlying loans would not be federally guaranteed as they have been in the past.
But an official at one large state-level agency, who did not want to be named, said while his agency is planning to originate a significant volume of private loans, there are several liquidity issues that must be resolved before the agency can ramp up its program.
The official said his agency is still grappling with a large portfolio of illiquid auction-rate securities (ARS). The EFC estimates that the bulk of the roughly $75 billion of outstanding student loan debt that has been sold by nonprofits consists mostly of ARS, though no precise estimate is publicly available. The official also said it is still difficult for large lenders to raise capital at affordable rates, as many large banks and financial institutions "are not in the mood right now to lend large sums of money."
In a conference call with reporters on Tuesday, Education Secretary Arne Duncan acknowledged that while the federal government would originate all future federal student loans, 100% of the loans would be serviced by private sector firms, giving them the opportunity to grow their businesses in "significant ways."
Duncan did not say when the department would contract with these additional nonprofits, but a spokesman for the agency said that it currently has sufficient servicing capacity to accommodate new direct loan borrowers.
Currently, only one existing nonprofit lender, the Pennsylvania Higher Education Assistance Agency, has contracted with the department as a servicer.
