Moody's, Fitch Fret Over Billions In Student Loan ABS As Defaults Loom

Back in April we asked if the student loan bubble was about to witness its 2007 moment. 

The reference, of course, was to a wave of MBS downgrades in July of 2007 which sent a series of tremors through global financial markets and triggered an asset backed commercial paper crisis in Canada which, although no one knew it at the time, presaged the crisis that would wreak havoc in the US a year later. As a reminder, 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. That same day, S&P cut its ratings on 498 subprime mortgage related bonds worth some $6.39 billion. 

We’re starting to see a similar situation unfolding in the market for student loan backed paper.  In April, Moody’s put some $3 billion in student loan backed ABS on review for downgrade citing an increased likelihood of default. Now, Moody’s has placed more than 100 tranches across 57 student loan-backed deals totaling some $34 billion on review. The rationale? “Low” payment rates, deferment, forebearance, and IBR. From Moody’s:

Moody's Investors Service has placed on review for downgrade the ratings of 106 tranches in 57 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.

 

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.

 

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

And BofAML has more color:

Moody's announced that it has placed on review for downgrade the ratings of 106 tranches in 57 securitizations backed by FFELP loans. This announcement follows a similar announcement made on April 8, 2015, which stated 14 tranches in 14 securitizations backed by FFELP loans were placed on review for downgrade. 

 

The data shows deferment and forbearance levels for FFELP Stafford/PLUS and Consolidation Loan ABS have recently trended down, although 30+ days have increased. The increase could lead to higher involuntary prepayments (i.e., defaults). A portion of the increased use in IBR plans noted by Moody’s could be a substitution effect, as certain borrowers may have reached the time limits on economic deferment and forbearance.

 


 

As we indicated in an earlier report, the use of income based repayment (IBR) plans has increased for FDLP loans. A similar upward trend is likely occurring for FFELP loans but the magnitude is likely less, especially for Consolidation loans. 

 

To be fair, numerous payment options under the Federal student loan programs make the cash flow analysis for FFELP loan ABS relatively complex for rating agencies, issuers, investors, and other market participants. Market participants must consider payment options that are influenced by economic and legislative/regulatory factors (e.g., PAYE and REPAYE) and generally, not available in other retail loan products (e.g., auto loans), along with delinquencies, defaults, claim rejections, interest rates and payment delays, among others. 

 


In other words, there are all kinds of reasons to expect this paper not to perform well that do not apply to ABS backed by other types of credits.

Meanwhile, as discussed at length in these pages, the Education Department is aggressively promoting the IBR program, which is bad news for taxpayers. These plans allow borrowers whose incomes are not deemed sufficient to service their debt to make monthly ‘payments’ of zero. After 300 months, the loans are forgiven. In other words, it’s theoretically possible to remain ‘current’ on a student loan and have that loan legally discharged after 25 years without ever making a single payment. It’s easy to see how this type of arrangement might negatively affect the cash flows in a student loan backed securitization and hence it comes as no surprise that the proliferation of IBR is cited by Moody’s as a contributing factor to its review.

Lending some credence to our 2007 MBS comparison, Fitch has also moved to place 57 tranches of FFELP-backed paper on Ratings Watch Negative.

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."

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Full Moody's statement:

Approximately $34 billion of asset-backed securities affected.

New York, June 22, 2015 -- Moody's Investors Service has placed on review for downgrade the ratings of 106 tranches in 57 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.

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. Because of the government guarantee and the available credit enhancement, 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 elevated risk is a result of low payment rates on the underlying securitized pools of student loans, driven by a combination of low rates of voluntary prepayments, persistently high volumes of loans in deferment and forbearance, and the growing popularity of the Income-Based Repayment (IBR) and extended repayment programs.

During the financial crisis, prepayment rates dropped to historically low levels. Although prepayments have risen in the last few years, partly as a result of borrowers refinancing their FFELP student loans through federal Direct consolidation loans, prepayment rates of near zero in 2008-09 slowed pool amortization rates and resulted in pool balances exceeding the original projections.

The percentage of FFELP loans in various payment plans, including deferment, forbearance, IBR or extended repayment, has remained between 20% and 30% for consolidation loan pools and between 40% and 50% for non-consolidation loan pools. Borrowers in these plans either suspend repayment of their student loans or make reduced payments of principal and interest. Although the level of loans in deferment has declined over the last two years by approximately 7%, the level of loans to borrowers in IBR has increased by approximately the same amounts and offset this recent decline in deferments. IBR and extended repayment option plans that can extend loan repayment periods up to 25 years, from the standard 10-year term for non-consolidation loans, are significantly lengthening the weighted-average life of FFELP loan collateral pools. In some FFELP securitizations, loans to borrowers in either IBR or extended repayment represent approximately 10%-15% of the balance of loans in repayment