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"Everybody Benefits By Avoiding Defaults": Citi Explains How To Goalseek Student Loan ABS Ratings

We last checked in on America’s $1.2 trillion student debt bubble a little over two weeks ago.

At the time, we noted that Moody’s had just placed 106 tranches in 57 securitizations backed by student loans on review for downgrade. It was the second such warning Moody’s had issued in the space of just 3 months.

Meanwhile, Fitch was getting worried as well and had also moved to place dozens of tranches in FFELP-backed paper on watch. Our takeaway: The fact that Moody's and Fitch are beginning to reevaluate student loan ABS is indicative of an underlying shift in the market. Between the proliferation of IBR and the Department of Education's recent move to open the door for debt forgiveness in the wake of the Corinthian collapse, financial markets are beginning to see the writing on the wall. Perhaps Bill Ackman said it best: "there's no way students are going to pay it all back."

Moody’s concerns revolve around the likelihood of rising defaults attributable to "low payment rates … persistently high volumes of loans in deferment and forbearance, and the growing popularity of the Income-Based Repayment and extended repayment programs." We’ve discussed all of the above at length and have taken a particular interest in IBR, which we recently dubbed "the student loan bubble's dirty little secret ."

Facing shifting market dynamics, Moody’s last week called for comments on its methodology for rating FFELP-backed paper:

Moody's Investors Service has published a Request for Comment (RFC) proposing changes to the cash flow assumptions the agency uses in its approach to rating US Federal Family Education Loan Program (FFELP) securitizations.

Low prepayment rates, persistently high rates of deferment and forbearance, and the growing use of IBR and other similar programs have increased the risk that some tranches will not pay off by their final maturity dates, which would trigger an event of default for the securitizations.

Since the recession, many student loan borrowers have struggled to make their monthly payments. This has resulted in historically low rates of voluntary prepayments, high volumes of loans in deferment and forbearance, and the growing popularity of IBR and other similar programs.

"These trends have persisted despite the economic recovery and improving employment picture, and some levels of deferment, forbearance and IBR will be sustained through the life of the FFELP loan pools. Some repayment plans can extend loan repayment periods significantly, from the standard 10-year term for non-consolidation loans."

Top-rated securities backed by U.S. government-guaranteed student loans face cuts to as low as junk that may further roil the market for the debt, according to Citigroup Inc.

In terms of ratings on the bonds, Moody’s said that any cuts could lower bonds to either low investment grades or speculative rankings. Fitch said in a June 26 statement that it could also lower top-rated debt to junk as a result of its review over the next three to six months.

“Many triple-A investors would not be able to tolerate downgrades, and barring a cure of the possible maturity default, downgrades would present a significant market disruption,” Kane and Belostotsky wrote in

the report.

Rating analysts are likely to attach little-to-no value for future buybacks from a non-investment grade company” such as Navient, the Citigroup analysts wrote.

Got that? No? That's ok. Here's a summary. Some of these student loan-backed deals are going to experience technical defaults in the collateral pool because people aren't paying off the loans in time, which means Moody's needs to downgrade some of the tranches, but downgrades would be bad, and Moody's can't use projected future servicer buybacks as an excuse not to downgrade because the servicers aren't rated as highly as the securitizations themselves (which is of course absurd and suggests the paper never should have been investment grade in the first place). Therefore, someone needs to find another way to make this paper look less risky, and the best option may be to "cure" maturity default (i.e. extend the maturities). Here's Citi with more on how Moody's might go about goal seeking its FFELP-backed ABS ratings:

Controversy endures in the FFELP ABS market amidst another rating agency voicing concern about breaching legal final maturities and some secondary selling activity.

Yes, "cash flow delays" in the collateral pool are definitely "problematic" and really, it's not a problem that should be "solved" by tinkering with ratings methodology, because after all, if you just adjust the methodology instead of downgrading the securitizations. well, then what good is the rating? Citi continues:

Ironically, it was the rating agencies that required the sponsor to initially assign presently defined legal final maturities. Yet the numerous moving parts endemic to FFELP student loans make setting prepayment assumptions and setting legal maturity dates a virtually impossible task. At cutoff, almost every deal had about 50% of the loans in-school. The pricing prepayment estimates had to incorporate numerous moving parts, including the borrower’s graduation date, payment type (conventional, graduated payment or income-based payment) loan maturity and proportions of loans in grace, deferment or forbearance. In our view, the legal final maturity is meaningless.

See how that works? There are a lot of factors that make it "virtually impossible" to figure out when students might pay back their loans, so really, any estimate of when ABS investors might get their principal back is "meaningless," and because one can't really default on a loan with an indeterminate maturity date, "curing" the legal maturity problem, and thus eliminating the need for downgrades, is as simple as "amending" the bond indentures. "The sponsor could approach bondholders to formally extend the legal maturity date," Citi happily notes.

What's clear from the above is that billions in student loan-backed paper probably should be downgraded because as Citi correctly notes, there's really no telling when or even if any of these loans are going to be paid off given the proliferation of IBR and the prevalence of deferement and forbearance.

But rather than risk a "market disruption," Citi thinks it might be better for Moody's to consider doing away with definitive maturity dates because in the end (and this is the actual subheader for Citi's concluding paragraph ), "everyone benefits by avoiding default ."

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Category: Forex

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