FT Alphaville " Student Loan In-securities As the topic of student loans has been gaining momentum this election year, it might be worth taking a moment to examine some not-so-rosy points about the whole business. First some background. In the world of US student loans, Uncle Sam reigns supreme. A recent research note by Credit Suisse noted that since the abolition of the Federal Family Education Loan Program (FFELP) in 2010, the government has become owner of an estimated 88% of total outstanding student debt. With the total amount of student loans outstanding estimated to be $904 bn in the US, a quick back-of-the-envelope calculation tells us that the federal government is exposed to approximately $795 bn of these loans. The fun begins when one takes a moment to scrutinise the performance of these loans, which have been hugely lucrative in recent years from the government's point of view. From Barclays: The subsidy rate, the major metric shown in the federal budget, is the expected gain or loss over the lifetime of loans issued in a given year as a percentage of loans issued in that year. A subsidy rate of 10%, for example, would imply that the deficit increased 10 cents for each dollar loaned... According to the CBO, total new student loan programs are expected to have subsidy rates of -30.5 per cent in FY 2012 and -32.4 per cent in FY 2013. So there you have it: returns of roughly 30% on the loans made. But before being too flabbergasted, let's take a closer look at the major drivers behind these estimates: These subsidy rates are re-estimated each year in which loans were issued. Subsidy rate re-estimates provide a good way to analyze changes in the value of the government's student loan portfolio because they incorporate changes in assumptions about interest rates and borrower behavior. As one can see, until the year 2000, interest rates were the biggest mover of subsidy rates for a time, whereas in the past decade, "technical assumptions" (default rates, delinquencies, borrower behavior, etc.) have played a larger role. But both remain important. So let's take a look each, starting with interest rates. In a Moody's note, the point has been made that as of April of this year, holders of federally-issued loans may tie the interest rate index for their loans to either LIBOR or one/three-month commercial paper. Moody's took the time to analyze the 251 student loan securitizations that it rates and discovered, staggeringly, that no fewer than 231 of these (comprising 95% of the dollar value of the 251) were voluntarily changed to being linked to 1-month LIBOR. (We hasten to add that the percentage of securitized loans that are LIBOR-linked is probably substantially higher than the general percentage of loans that are LIBOR-linked. This is because LIBOR-linked loans provide less basis risk for student loan securitizations, which are indexed to one or three-month LIBOR themselves. It's still unclear as to what extent the foul play involved with LIBOR submissions had an impact, but it is nonetheless something else to consider.) As for terms of "technical assumptions," Moody's points out: The default rate of securitized private (non-guaranteed) student loans... has been hovering at around 5 per cent since mid-2010... Defaults will remain stable but high because the unemployment rate, the key credit driver of student loan defaults, will remain high, at 8-9 per cent. But, in recent months, legislation has been brewing that would allow for the discharge of student loans in the event of bankruptcy. In theory, this could further increase the default rate, as borrowers would then find it to be more financially propitious to default, leading to securities being inherently riskier than they currently are. Moody's seems to agree: ... the renewed push to make private student loans dischargeable in bankruptcy is credit negative for private student loan securitizations because it would subject them to higher defaults and lower recoveries. Adding to the dubious nature of the government's forecasts, if past performance is anything to go by, default collection estimates have been consistently inaccurate. "Default collection" being defined as the net value of the assets the government collects from a borrower if he or she is in default. In other words, a combination of legislation and traditionally over-sanguine government estimates mean that "technical" issues might lead to bigger losses than expected. Of course, all this must be kept in perspective before one can start making comparisons to the shenanigans involving the underwriting standards in the MBS market in the years leading up to the crisis. Indeed, even today, total mortgage debt outstanding is roughly 14-15x greater than total student debt outstanding. But hey, given that taxpayers are (by definition) on the hook for losses to the government, it's an issue worth paying attention to. This entry was posted by Rahul Wagh on Friday, July 13th, 2012 at 18:10 and is filed under Capital markets. Tagged with college tuition, student loans.