Does this sound familiar?
Ratings agencies colluding with issuers and bondholders to ensure that bonds that are almost certainly headed for default can maintain their investment-grade credit ratings and avoid rocking the boat of the US financial system.
If it sounds like the run up to the housing market collapse, well, you're not wrong. But in this scenario, we're talking about an entirely different kind of 'safe' debt: federally-backed student loans.
You see, back in 2009, Congress adopted a program of income-based repayment for some federally-backed student loans. This allowed borrowers like Julie Chinnock, a 50-year-old woman who owes roughly $250,000 in loans for two bachelors, masters and doctorate degrees, to limit their monthly payments.
This created a problem for certain lenders in a relatively small sliver of the student-debt market: loans that have been bundled into securities and sold off to investors. Investors once prized these loans since they offered higher yields than more-risky products backed by credit-card payments.
The new repayment laws created a problem for the issuers: Since borrowers would now take longer to pay back their loans, some of the debt securities backed by these loans were put on course for an all-but-certain default. Even though the loans are backed by the federal government, meaning that, in the event of a default, lenders should be made whole, the big ratings agencies would still consider it a technical default, and lower their credit ratings on the bonds to reflect this.
When bonds are downgraded, bondholders often end up with losses - at least on paper. Unless they're planning to hold the bonds until maturity, downgrades often mean losses, especially when the bonds are held by funds with strict rules around what credit ratings they can and cannot hold.
So what did the issuers do? As yields on the bonds climbed, Navient, the hated student-loan manager, managed to secure unanimous approval from borrowers to approve a haircut on the bonds, extending the maturity out several decades.
Yields on the bonds promptly dropped, rewarding bondholders, and punishing anybody who happened to be betting against the bonds. We fail to see how this arrangement between bondholders and ratings agencies is different from blatant market
Now, the maturities of the bonds that contain what the Wall Street Journal described as "a big chunk" of Julie Chinnock's loans have been extended out to 2083. By that point, Chinnock, who would be turning 114 that year, will almost certainly be dead. How can she keep up with her interest payments if she doesn't have a pulse?
To give readers a better idea of the scale of this problem, about $262 billion of those loans remain outstanding, and more than one-quarter of them are in default. That's a drop in the bucket compared to the trillions in mortgage-backed bonds that the federal government bought via TARP during the crisis.
18 months ago, we cited a study claiming that by 2023, approximately 40% of student loan borrowers will be in default.
If that's true, we imagine this won't be the first round of maturity extensions on these bonds.
But will ratings agencies hold them accountable by slapping the bonds with the ratings they deserve, and finally acknowledging the unavoidable truth: At some point, Congress is going to need to make a choice: Either bail out the lenders, or risk toppling the $1.5 trillion house of cards that is America's aggregate outstanding student loan balance.