DBRS Comments on Student Loan ABS Containing Auction-Rate Securities

Following a DBRS rating committee review of all outstanding student loan asset-backed securities (ABS) for transactions backed by Federal Family Education Loan Program (FFELP) loans, DBRS has concluded that no rating actions will be taken on any outstanding securities with the exception of NextStudent Master Trust I (see the related DBRS press release published today).

Investors traditionally viewed auction-rate securities (ARS) as cash equivalents from a liquidity standpoint, despite the product’s long legal final maturity, because of the historically liquid market. In late 2007, investors began to shun the product and auction agents encountered difficulty establishing clearing rates for auctions when fewer and fewer bidders emerged in the auction process. In February 2008, widespread auction failures ensued and have done so ever since.

In a failed auction, the interest rates on the ARS defaults to the maximum rate defined in the trust documents. The maximum rate is often equal to the lesser of the maximum auction-rate formula or the net loan rate on the trust, which serves to limit the amount of interest that can be paid to noteholders. Under certain circumstances, the ARS interest rate can be unusually low, even approaching zero. This phenomenon occurred in early 2008 in rare instances and for the most part has not returned. Typically, the interest rate paid on the outstanding ARS has been higher than it would be in a normally functioning market and frequently equals the net loan rate.

For many trusts, the elevated interest rate on ARS has at times eliminated the trusts’ positive excess spread (the difference between the weighted-average coupon on the loans and the weighted-average coupon on the notes, less fees and other trust expenses). In FFELP student loan ABS structures, excess spread is relied on to provide credit enhancement and to build collateralization up to or greater than a 100% an asset-to-liability (parity) ratio. Student loan ABS pools financed by ARS that are currently below a 100% parity are at risk of further parity deterioration, which makes subordinate classes particularly vulnerable to negative rating actions.

DBRS acknowledges that this is a very unique situation and believes that the threat to bond performance posed by prolonged failed auctions does not warrant rating actions at this time. From a collateral perspective, if the loans are originated and serviced according to industry guidelines, the assets will be reinsured by the U.S. Department of Education at 97% of principal and accrued interest in the event of a default. Accordingly, credit risk of the trusts should then be limited to the 3% risk share in the absence of a servicing error. From a liability standpoint, the outstanding ARS subject to the failed rates have very long legal final maturities (many in excess of 30 years). As a result, DBRS believes that as the business cycle turns and the capital markets recover, opportunities to refinance the ARS in FFELP student loan ABS trusts will return within a sufficient amount of time to eliminate the threat of principal shortfalls when payments come due.

DBRS believes that without further, significant deterioration of collateralization, most student loan ABS trusts containing ARS should be able to withstand between three and five years of continued failed auctions before the prospect of principal impairment on ARS with long-dated legal final maturities. Therefore, DBRS is not taking any further rating actions at this time and will continue to monitor the industry for future developments within the student loan ARS market and provide additional commentary as warranted.

Notes:
The applicable methodology is FFELP Student Loan ABS Criteria, which can be found on our website under Methodologies.

This is a Structured Finance rating.