America’s Student Loan Crisis Risks Turning AAA Debt Into Junk

While the default rate fell to 1.36 percent in May from an average of 1.9 percent through March 2013, it appears consumers aren’t paying off their loans as they increasingly use so-called income-driven repayment plans, the analysts wrote in a July 14 report. An Obama administration push has expanded use of those programs, which let borrowers send in smaller amounts over a longer period before their debt eventually gets forgiven.

Wells Fargo analysts John McElravey and Ryan Brinkoetter found that the securities would need to fall either 4.5 cents or 7 cents on the dollar to offer investors yields similar to the spreads of 1.75 percentage point to 2.25 percentage points on low-rated subprime mortgage securities unlikely to suffer losses, depending on how low its rating fell.

Forced Selling

JPMorgan says selling may provide a buying opportunity, while it may be difficult for typical investors in this market to capitalize on it. Those buyers often treat top-rated asset- backed securities as a surrogate for cash.

“Should there be forced selling,” JPMorgan analysts led by Amy Sze wrote in a July 10 report, “we recommend investors take advantage of the potentially very attractive discounts.”

For securities whose ratings have been under review since April, yields have widened about 0.1 percentage point more than other similar debt relative to benchmark rates, according to JPMorgan data. Typical spreads on AAA rated student-loan bonds have increased about 0.2 percentage point, with seven-year notes now at 0.75 percentage point.

Loan Buybacks

The problem is unique to loans issued before the crisis because Congress passed legislation in 2010 that ended government guarantees in favor of direct federal lending for education. Issuance of bonds backed by the debt has since collapsed, with outstanding securities declining to about $170 billion from almost $200 billion in 2008, according to Securities Industry & Financial Markets Association data.

Even though sponsors of bond deals are considering their options to repurchase loans to help transactions pay off by maturity, investors may not get much relief from downgrades. While Moody’s plans to consider the potential for such action, “Aaa securities can’t be contingent on buybacks from sponsors without similar ratings,” said Debashish Chatterjee, a managing director at Moody’s.

While the final outcome of the rating reviews is hard to predict, “the probability of a downgrade action has increased to more than 50 percent and opened the possibility for a wider set of” bonds than just those under review now being affected, Nomura Holdings Inc. analysts Lea Overby and Radhakrishna Gowrishankara wrote in a July 10 report.