Is The Student Debt Bubble About To Witness Its 2007 Moment?

Two days ago we highlighted a new study from the St. Louis Fed where someone had the very prudent idea to strip out loans in deferment and forbearance from the denominator of the student debt delinquency rate equation so everyone could get a better idea of what the real numbers look like. 

The thing is, you can’t be delinquent when you aren’t required to make payments, so if you divide the number of delinquent student loans by the total amount of outstanding debt including loans in deferment and forbearance, you are comparing apples to oranges. Only around 55% of outstanding student loans are in repayment, and obviously, what we really want to know is what percentage of those loans are delinquent. We don’t care what percentage of total outstanding student debt is delinquent because 45% of borrowers aren’t yet required to make payments so it makes absolutely no sense to include them in the equation — we know what percentage of that group is delinquent, it’s 0%, because no one is asking them for any money yet. 

What we can do though, is divide the amount of debt that’s delinquent by the total amount of debt in repayment and then extrapolate from that and say something like this: “If 55% of total student debt is currently in repayment and 27% of that is delinquent, then it seems reasonable to assume that a similar rate will prevail for the other 45% of borrowers once they go into repayment unless something changes in the economy which it won’t, so in all likelihood, about 1 in 3 student borrowers will end up 30 or more days delinquent and that adds up to about $400 billion in student debt that likely won’t be in good standing.”

This is particularly bad news when you consider that “the TBAC forecasts, in its worst economic case scenario for the millennial generation (which sadly, based on recent employment and income trends for America's young adults is more like the base case scenario), total student loans, which currently stand a little over $1 trillion (or more than all the credit card debt in America), is set to triple in just the next decade, hitting a whopping $3.3 trillion by 2024.”

Needless to say, a near 30% delinquency rate on a projected $3.3 trillion mountain of debt is a very, very bad thing especially when that debt ends up packaged and sold to investors in the form of ABS. Here’s a brief look at what the market looks like for student loan-backed ABS currently via Deutsche Bank:

With $3.5 billion pricing year-to-date, student loan ABS issuance lags Q1 2014 by 20%, but remains on track to reach our projection of $15 billion in 2015. Navient leads the way with $1.7 billion in issuance year-to-date, followed by Nelnet with $1.3 billion. Although they have yet to come to market during 2015, we expect to see Sallie Mae issue multiple transactions during the remainder of 2015. Additional supply resulting from FFELP loan portfolio sales should continue to bolster SL ABS issuance as well.

Given (real) delinquency rates on the assets backing this paper, we wonder when this market will have its own version of what happened to the MBS market in July 2007 when suddenly, all three major ratings agencies woke up to what they had helped facilitate in the housing market and quickly moved to downgrade billions in deals backed by souring mortgages. Here, as a reminder, is a recap of what happened then:

On July 10, 2007 Moody’s downgraded 399 bonds backed by subprime mortgages which together totaled some $5.2 billion. Meanwhile, S&P suggested it was close to cutting ratings on more than $12 billion in mortgage-backed securities due to declining home prices and rising default rates. On July 12, Fitch Ratings placed 19 structured collateralized debt obligations on Ratings Watch Negative due to a significant deterioration in the underlying portfolios of residential mortgage-backed securities. Fitch said that as part of a revised rating methodology, it was raising the default probability it assumed on residential mortgage-backed securities issued since 2005 by a full 25%. That same day, S&P cut its ratings on 498 subprime mortgage related bonds worth some $6.39 billion.

With all of the above in mind, we bring you the following, from Moody’s:

Moody's reviews for downgrade several tranches in FFELP student loan securitizations as a result of the risk of default at maturity

 

Approximately $3.0 billion of asset-backed securities affected

 

New York, April 08, 2015 -- Moody's Investors Service has placed on review for downgrade the ratings of 14 tranches in 14 securitizations backed by student loans originated under the Federal Family Education Loan Program (FFELP). The loans are guaranteed by the US government for a minimum of 97% of defaulted principal and accrued interest.

That’s right, just 9 days ago, Moody’s put $3 billion (so nearly the equivalent of 2015 Q1 supply) of student loan-backed ABS on watch for downgrade based on the likelihood of default. Here’s a list of which tranches from which deals are at risk:

Here’s a little color from DB:

On April 8, Moody’s placed 14 FFELP SL ABS tranches on review for downgrade due to their view that these bonds may not be fully paid down prior to legal final maturity, resulting in an event of default for these transactions. In an event of a default, repayment of the class A notes may be accelerated at the request of the majority of class A note holders…

 

Prepayments in the affected deals have come in slower than anticipated at issuance due to factors including higher-than-expected utilization rates of deferral and forbearance, weakness in the job market for new grads following the financial crisis, and expanded availability and uptake of income-based repayment (IBR) plans. The use of IBR has been heavily marketed by the Obama administration as it helps borrowers avoid default by lowering monthly payments and ultimately forgiving any remaining principal after 25 years. 

So just as we have been warning about for sometime now: an underestimation of the impact of deferral and forbearance and weakness in the job market is likely to trigger defaults on billions in student loans and because these loans comprise the collateral pool backing ABS sold to investors, the ripple effect is magnified and we wonder if the July 2007 moment for the student loan-backed ABS market may come sooner rather than later.

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Full text of Moody’s PR:

RATINGS RATIONALE

The reviews for downgrade are a result of the increased risk that the tranches will not fully pay down by their respective final maturity dates. Failure to repay a note on the final maturity date represents an event of default under the trust documents. Recoveries upon default would be very high, although the timing of such recoveries would depend on the transaction structures and voting rights upon default for each transaction.

The risk is a result of low payment rates on the underlying securitized pools of student loans, driven by low rates of voluntary prepayments, high volumes of loans in deferment and forbearance, and the growing popularity of Income-Based Repayment (IBR) and extended repayment programs.

Voluntary prepayment rates in FFELP loan pools remain historically low as a result of sluggish economic growth and high unemployment rates among recent graduates. Although prepayments rose to 2%-3% of the loans in repayment in 2014, partly as a result of borrowers refinancing their FFELP loans through private student loans and Federal Direct consolidation loans, prepayments remain low relative to historical levels. Deferment and forbearance levels remain high throughout the life of the collateral pools, although they recently declined slightly from peak levels in 2009-11. As of December 2014, roughly 33% of loans in repayment in Navient's non-consolidation loan collateral pools were in deferment and forbearance, compared with 16% for Navient's consolidation loan collateral pools. The growing popularity of IBR, which extends the life of the loans to up to 25 years from the standard 10-year term of non-consolidation loans, and the extended repayment option (for borrowers with balances of more than $30,000) is further lengthening the weighted-average life of the student loan collateral pools. In some pools, loans in IBR and extended repayment represented 10%-12% of the balance of loans in repayment. Similar trends are common among most collateral pools underlying FFELP student loan securitizations.

The rating actions are focusing on tranches that mature in the next five years because they are at most risk of breaching final maturity dates. Tranches that mature after that could benefit from higher voluntary prepayments and lower deferment and forbearance rates as economic conditions continue to improve.

During its review, Moody's will evaluate recent and expected future pool amortization trends and structural features of the transactions. In addition, Moody's will consider Navient's December 2014 amendments to a number of its transactions that allow for the limited and discretionary repurchase of loans. Any such repurchases would accelerate the repayment of the related notes. In its review, Moody's will consider, among other things, the amount and timing of any such loan repurchases.