Structured Finance. Student Loan Criteria

Transcription

1 Structured Finance Student Loan Criteria

2 STANDARD & POOR S RATINGS SERVICES President Leo C. O Neill Executive Vice Presidents Hendrik J. Kranenburg, Robert E. Maitner Executive Managing Directors Edward Z. Emmer, Corporate Ratings Clifford M. Griep, Financial Institutions Ratings Vladimir Stadnyk, Public Finance Ratings Roy N. Taub, Insurance Ratings Vickie A. Tillman, Structured Finance Ratings Sanford B. Bragg, Managing Director, Managed Funds Ratings Joanne W. Rose, Senior Managing Director, General Counsel RATINGS INFORMATION SERVICES Managing Director Jay S. Kilberg Vice Presidents Andrew Cursio, Product Management Robert Frump, Production & Electronic Distribution Paul Stanwick, Editorial David A. Collins, Director, Asia-Pacific Guy Hewitt, Director, Europe Susanne Barkan, Product Manager Sara Burris, Director, Design, Production, & Manufacturing Jean-Claude Bouis, Editor, Franchise Products Donald Shoultz, Editor, Policy & Operations Editorial Jennifer O Brien, Managing Editor Ned Geeslin, Audrey Kennan, Suzanne Lorge, Donald Marleau (Tokyo) Cynthia Michelsen, Miriam Stickler, Lisa Tibbitts (Editorial Managers) Arlene Cullen (Melbourne) (Copy Editor) Design & Production Sandy Fong, Renee L. Mofrad, Beth Russo (Senior Managers) Elizabeth McCormack, Steve McLure (Senior Designers) Rosalia Bonanni, Theresa Moreno, Heidi Weinberg (Designers) Maura Gibbons (Junior Designer) John J. Hughes, Alicia E. Jones, Barry Ritz, Leonid Vilgorin (Managers) Dianne Henriques, Stephen Williams (Production Coordinators) Christopher Givler, Stan Kulp, Michelle McFarquhar (Senior Production Assistants) Subscription Information Hong Kong, (852) London, (44) Melbourne, (61) New York, (1) Tokyo, (81) Subscriber Services New York (1) Web Site Published by Standard & Poor s, a Division of The McGraw-Hill Companies, Inc. Executive offices: 1221 Avenue of the Americas, New York, N.Y Editorial offices: 55 Water Street, New York, N.Y Copyright 1999 by The McGraw-Hill Companies, Inc. All rights reserved. Officers of The McGraw-Hill Companies, Inc.: Joseph L. Dionne, Chairman; Harold W. McGraw, III, President and Chief Executive Officer; Kenneth M. Vittor, Senior Vice President and General Counsel; Frank Penglase, Senior Vice President, Treasury Operations. Information has been obtained by Standard & Poor s from sources believed to be reliable. However, because of the possibility of human or mechanical error by our sources, Standard & Poor s, or others, Standard & Poor s does not guarantee the accuracy, adequacy, or completeness of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information.

3 Student Loan Criteria Student Loan Programs Overview Programs Federal Family Education Loan Program (FFELP) Federal Direct Student Lending Program (FDSLP) Alternative Loans FFELP Student Loan Program Student Loan Servicing The Rating Process for Student Loan Transactions Operational Review Credit and Liquidity Analysis Committee Process Documentation Surveillance Confidentiality Evaluating Risk in Student Loan Transactions Credit Risk Liquidity Risks Interest Rate and Timing Mismatches Structural Elements in Student Loan Transactions Owner Trust Structure Subordination Payment Priorities Reserve Account Excess Spread to Build Parity/Overcollateralization Prefunding Revolving or Reinvestment Periods Net Student Loan Rate Cap Standard & Poor s Structured Finance Student Loan Criteria 1

4 Rating Methodology for Student Loan Transactions Sizing Cash Flow Variables Structural Elements Legal Considerations for Student Loan Transactions General Overview Securitizations by Code Transferors Securitizations by SPE Transferors and Non-Code Transferors Special-Purpose Entities Collateral-Specific Criteria Criteria Relating to Various Forms of Credit Enhancement Criteria Related to Retention of Subordinated Interests by Transferor in a True Sale Swap Opinion Criteria Interim Criteria for the Tenth Circuit Court of Appeals Eliminated Criteria: Trustee, Servicer, Custodian, Eligible Deposit Accounts, and Eligible Investments Select Specific Opinion Criteria/Language

5 Student Loan Programs Overview Student loan-backed securities have historically been issued in the U.S. securities markets. Consequently, the criteria presented are based on the federal student loan programs within the U.S. However, the criteria presented may have global applications. It is anticipated that a student loan pool originated outside the U.S. may have some credit and liquidity concerns that are similar to those of a U.S. pool. In addition to readers in the U.S., this publication is intended to provide an analytical framework for global market participants to evaluate student loan-backed securities. Programs Since its inception in 1965, the secondary education student loan market in the U.S. has expanded due to greater increases in the cost of higher education relative to the general inflation rate. Additionally, the number of students attending institutions of higher education has steadily increased. Students and their parents may borrow if they qualify under the following programs: Federal Family Education Loan Program (FFELP). Loans funded by private lending institutions and insured by the U.S. federal government. Federal Direct Student Loan Program (FDSLP). Loans funded by the U.S. federal government. Alternative Loans. Loans funded by private lending institutions with or without an insurance guarantee from a private institution. Federal Family Education Loan Program (FFELP) FFELP, established by Congress as part of the Higher Education Act of 1965, is the largest of the three programs. Under this lending program, private institutions fund loans to borrowers, regardless of the borrowers ability or willingness to repay the loans. The PLUS loan program, which comprises a relatively minor portion of FFELP, requires some credit evaluation. Standard & Poor s Structured Finance Student Loan Criteria 3

6 The loans are insured by private guarantee agencies up to the federal default reimbursement limit, currently 98%. The guarantee agency expedites the reimbursement of defaulted loans to lending institutions. Reimbursement of defaulted loans by the guarantor to the lender is contingent upon following servicing guidelines established by the U.S. Department of Education (DOE). The guarantor ultimately receives reimbursement from the DOE. FFELP is subject to reauthorization every five years. In general, reauthorization addresses program guidelines such as lending limits, interest rates charged to eligible borrowers, and federal reimbursement levels. Federal Direct Student Lending Program (FDSLP) One of the most significant changes in federal student loan lending occurred in As part of the 1993 Omnibus Reconciliation Act, FDSLP, which was previously established as a pilot program under the Higher Education Act of 1992, was expanded to compete directly with FFELP. FDSLP provides that the U.S. government fund loans directly to eligible borrowers with funds borrowed from the U.S. Treasury. Government contractors are responsible for servicing the loans. FDSLP was primarily created to make federal government student loan lending more cost efficient as a result of the direct involvement of the federal government. Under FFELP, the DOE reimburses guarantors for claim payments, and operational controls must be maintained to monitor the reimbursement process. Proponents of FDSLP maintain that direct lending removes some of the costs of monitoring the FFELP reimbursement process and creates revenues that will compensate the federal government for the costs. Chart 1 FDSLP Participants Private 4- year 6.2% Public 4- year 5.1% Public 2- year 8.5% Private 2- year 4.2% Proprietary (trade and vocational schools) 76.0% 4

7 Student Loan Programs To date, the FDSLP has originated less loan volume than had been originally anticipated. In addition, the majority of schools that participate in FDSLP are trade/proprietary schools, whose graduates historically have the highest default rates of all school types (see chart 1). Alternative Loans In addition to loans funded through FFELP or FDSLP, education loans may be funded by private institutions with no federal government involvement (see table 1). These loans may or may not be insured by private third parties. If insured, the insurer will reimburse the lender if the obligor defaults. The largest of the private guarantors is The Education Resources Institute Inc., a Massachusetts nonprofit corporation. The alternative student loan market is generally accessed by graduate students because the higher cost of postgraduate education relative to undergraduate education requires additional financing beyond that which is provided for under FFELP. Despite this trend, volume growth has been slower than anticipated due to three factors: Alternative loan programs are generally more expensive due to fees and higher interest rates payable by the borrower. Higher fees and interest rates are charged, because alternative student loans pose a greater credit risk to the lender or the insurer in the absence of default reimbursement by a guarantor. School financial aid officers present an obstacle for private lenders. When a student contacts a financial aid office, the financial aid officer is more likely to refer the student to a lender that funds loans under FFELP. This is because the private loans are credit-based and the student may be rejected by the lending institution based on the credit application. In general, no credit standards are applied within the FFELP structure, and the decision is based on need. Table 1 Examples of Alternative Student Loan Programs Sponsor Iowa Maine Massachusetts Michigan Nellie Mae Inc. New Jersey Ohio/SLFC Inc. Alternative loan program Partnership & Medical Loan Program MELA MassPlan MI-LOAN Share/Grad Share NJClass Ohio Supplemental Student Loan Standard & Poor s Structured Finance Student Loan Criteria 5

8 Many students and parents finance the cost of education from sources outside of the educational loan market. For instance, market participants have estimated that students may finance as much of their education costs through home equity products as through alternative student loans. FFELP Student Loan Program FFELP is the oldest and the largest of the three loan programs discussed above. Therefore, FFELP is the primary focus of Standard & Poor s student loan rating criteria. Under FFELP, private lenders make student loans to eligible borrowers following program guidelines established by the DOE. The private institution must be an eligible lender as established by the DOE. The loans are guaranteed by an independent guarantee agency and reinsured by the DOE. The eligible lender may service the loans it originates or may employ a third-party servicer. Servicing guidelines are determined according to the time period in which the loan was disbursed. Incorrect servicing may result in the guarantee agency not reimbursing the lender for defaulted loans. FFELP Participants Eligible Lenders. Eligible lenders, which are registered with the DOE, are eligible to originate and hold FFELP loans, and receive interest subsidy payments, special allowance payments (SAP), and default reimbursement. Eligible lenders include banks, savings and loan associations, credit unions, pension funds, insurance companies, and, under certain conditions, schools and guarantee agencies. Servicers. Servicing of student loan assets is more critical for FFELP lenders than for other consumer loans because losses on defaults are mainly dependent on the servicer s ability to service the student loans according to DOE guidelines. Proper servicing of a student loan is required in order to maintain eligibility for SAP and interest subsidy payments, and to guarantee reimbursement. The servicing effort may be segregated into two distinct time periods: the time period before a loan enters repayment and the time period after a loan enters repayment. Guarantors. Guarantee agencies expedite reimbursement for defaulted student loans to eligible lenders. Guarantee agencies collect revenue in the form of a one-time fee up to 1% of the principal amount of each new money, or nonconsolidation, loan that is insured. Reimbursement from the guarantor to the lender is contingent upon servicing in accordance with certain regulatory requirements. There will be 100% reimbursement of principal for loans disbursed before Oct. 1, 1993, and 98% reimbursement of principal for loans disbursed on or after Oct. 1, 1993, if the loans are serviced according to DOE guidelines. Guarantors reimburse 6

9 Student Loan Programs eligible lenders from reserve accounts established for this purpose. The guarantor, in turn, receives reimbursement from the DOE. The level of reimbursement to the guarantor depends on the claims level of the guarantor s insured portfolio. Reimbursement levels range from 75% to 95% for loans disbursed after Oct. 1, Additionally, the DOE reimburses the guarantor 100% for claims due to the borrower s death, bankruptcy, or disability. Typically, guarantee agencies guarantee loans to students attending eligible institutions in the state or region serviced by the guarantor. They may also guarantee loans to students who reside in their own state or region, but who attend eligible institutions in another state or region. After a claim has been paid, the guarantor assumes ownership of the loan and is obligated to pursue postdisposition recoveries. The guarantor retains a percentage of postdisposition recoveries and reimburses the DOE with the remaining percentage. Department of Education. The DOE s regulations provide a number of incentives to student loan market participants. The DOE provides eligible private lenders with an incentive to lend to students by guaranteeing default reimbursement. It also pays a specified yield above the capped borrower rate on the receivables to the lender through payment of the SAP. The DOE provides eligible borrowers with an incentive to borrow by providing interest subsidies and capped interest rates. In the event of a guarantee agency bankruptcy or a determination by the DOE that the guarantee agency is unable to reimburse claims, an eligible lender has the right to submit claims directly to the DOE for payment. The DOE is obligated to pay the holder of the loan the full insurance obligation of the guarantee agency, subject to its servicing guidelines. The DOE is obligated to continue paying claims related to the defaulted guarantor until the guarantee obligations have been met or transferred to another guarantor. Interest Subsidy Payments FFELP loans are divided into two separate categories: subsidized and unsubsidized. For subsidized loans, the federal government pays the interest on behalf of the borrower to the eligible lender at the applicable interest rate while the borrower is in school and during certain other periods. For unsubsidized loans, the borrower is responsible for making all interest payments or the lender may provide for them to be capitalized during these periods. Borrower and Loan Types There are five different FFELP loan types: Subsidized Stafford. This loan type is for students who meet certain needs and family income tests. Interest is subsidized while in school and during other periods Standard & Poor s Structured Finance Student Loan Criteria 7

10 Unsubsidized Stafford. This loan type is for students who meet certain needs but do not qualify for the subsidized program or who have additional borrowing needs beyond the subsidized program. Interest must be paid by the borrower or capitalized while in school and during other periods. Supplemental Loans to Students (SLS). This loan type was for independent student borrowers who met certain needs tests. This program was discontinued and combined into the Unsubsidized Stafford loan program in PLUS. This loan type is for the benefit of students who do not meet the needs test but require additional funds above Stafford loan limits. Interest on PLUS loans is not subsidized. Only parents may borrow under this loan type. Consolidation Loan. This loan type permits lowering of combined payments and extension of maturity up to 30 years, depending on the dollar amount of the loans consolidated. Interest subsidies are dependent on whether interest subsidies existed on the underlying loans. Both students and parents may borrow under this loan type. Eligibility Requirements and Lending Limits An eligible borrower for a FFELP loan may be a student or, in the case of PLUS and consolidation loans, a parent. Eligibility criteria for student borrowers are: The student has been accepted for enrollment or is currently enrolled and meeting academic performance standards at an eligible institution. Eligible institutions may include four-year and two-year colleges and universities, trade and proprietary schools, and postsecondary vocational institutions. The student is currently enrolled in at least one-half the normal course load for the student s course of study, as defined by the eligible institution. The student meets the needs requirements for the particular loan program as determined by a financial needs analysis. PLUS loan limits are determined on a case-by-case basis. A PLUS loan may be equal to the difference between a student s cost to attend after factoring in student and family contributions and all other forms of financial aid. Loan Status Regardless of the loan type, the borrower is obligated to pay interest, unless subsidized, and principal. However, the timing of interest and principal payments is a function of the loan type and the borrower s status (see chart 2 and table 2). A student loan can fall into one of the following five categories over the course of its life: In School. This is the time period before the eligible borrower s graduation or departure from school. No principal is required to be repaid under either Stafford loan type. For Stafford Subsidized loans, the federal government pays the interest. For Stafford Unsubsidized loans, the interest is either paid by the borrower or is 8

11 Student Loan Programs allowed to capitalize. PLUS loans enter the repayment period when the loan is fully disbursed because the obligor is the parent of an eligible student. In Grace. This is the time period between the eligible borrower s graduation or departure from school and the commencement of the repayment period. This is generally a six- to 12-month period. For Stafford Subsidized loans, the federal government pays the interest. For Stafford Unsubsidized loans, the interest is either paid by the borrower or is allowed to capitalize. No principal payments are required for either Stafford loan product. There is no in grace status for PLUS loans. In Repayment. This is the time period during which the borrower makes interest and principal payments on the loans. In Deferment. This is the time period after repayment has begun, in which the eligible borrower may suspend interest and principal payments. The reasons for deferment may include returning to school or entering the military. Most deferments may last up to three years. For Stafford Subsidized loans, the federal government pays interest. For Stafford Unsubsidized loans, the interest is either paid by the borrower or allowed to capitalize. Chart 2 Flow of Student Loans Stafford & SLS Consolidated & PLUS In School In Grace In Repayment In Deferment In Forbearance Standard & Poor s Structured Finance Student Loan Criteria 9

12 In Forbearance. This is the time period after repayment has begun, in which the eligible borrower may suspend interest and principal payments. The reasons for forbearance are related to poor health or other unanticipated personal problems. Forbearance may require a written agreement between the borrower and lender specifying the terms. For Stafford Subsidized loans, the federal government pays interest. For Stafford Unsubsidized loans, the interest is either paid by the borrower or allowed to capitalize. Borrower Interest Rates For Stafford loans disbursed after Oct. 1, 1998, the borrower pays the rate of the 91-day Treasury bill plus 1.7% during non-repayment periods, subject to a cap of 8.25%, and the 91-day Treasury bill plus 2.3% during repayment periods. For loans made on or after July 1, 1995, interest rates to the borrower are variable, based on a Treasury-bill index that is subject to a cap (see table 3). In School Table 2 FFELP Guidelines for Principal and Interest Payments Subsidized Stafford SLS/Unsubsidized Stafford PLUS/ Consolidated Interest* Government pays Accrue or capitalize N.A. Principal None due None due N.A. In Grace Interest Government pays Accrue or capitalize N.A. Principal None due None due N.A. In Repayment Interest Borrower pays Borrower pays Borrower pays Principal Borrower pays Borrower pays Borrower pays In Deferment Interest Government pays Accrue or capitalize Accrue or capitalize Principal None due None due None due In Forbearance Interest Government pays Accrue or capitalize Accrue or capitalize Principal None due None due None due *Regardless of who pays the interest, the federal government guarantees a minimum yield on the loans by paying a special allowance payment if required. N.A. Not applicable. 10

13 Student Loan Programs Special Allowance Payments To encourage lenders to make student loans, the DOE guarantees a yield on the loans through SAP to the lenders. Since the lenders already receive part of the yield in the form of interest payments from the borrower, the SAP is the amount of additional money to be paid by the federal government in order to bring the yield up to the level specified by federal regulations. Total yield to the lender is calculated as follows: Total Yield to Lender = Borrower Interest + SAP The SAP is paid quarterly at the end of March, July, September, and December. Lenders must apply to the DOE for the SAP. The yield is based on the average bond equivalent yield of weekly auctions on the 91-day Treasury-bill rate for each quarterly period (see table 4). Repayment Options Borrowers may repay part or all of the loan with no prepayment penalty. If a Stafford or SLS borrower elects to pay in regular installments, the lender must offer the following choices, subject to certain criteria: Standard Repayment Schedule. Level payments are made throughout the life of the loan. Table 3 Borrower Interest Rates for Loans Originated After Oct. 1, 1998 Loan Status Index Rate (%) Cap (%) Stafford In school, grace, and deferment 91-day T-bill* Index Repayment and forbearance 91-day T-bill Index PLUS N.A. 52-week T-bill Index Consolidated Dependent on which loans are consolidated. *T-bill Treasury bill. Note: Rates reset annually on July 1. N.A. Not applicable. Table 4 Yield Guaranteed for Loans Originated After Oct. 1, 1998 Loan type Loan status Index Market yield (%) Stafford In-school, grace, and deferment 91-day T-bill* Index Repayment and forbearance 91-day T-bill Index PLUS 91-day T-bill Index Consolidated 91-day T-bill Index *T-bill Treasury bill. For loans not originated with tax-exempt money. Standard & Poor s Structured Finance Student Loan Criteria 11

14 Graduated Repayment Schedule. Payment amounts increase over time. Income-Sensitive Repayment. Payments are adjusted annually as a function of the borrower s income. Loans other than consolidation loans must be repaid within 10 years. Repayment terms of consolidation loans can be up to 30 years, depending on the outstanding principal amount. Student Loan Servicing Servicer Actions Servicers are responsible for properly servicing loans from origination through final repayment. The servicer is required to track the loan eligibility status of the borrower before the repayment period begins. When the servicer is notified that the student is no longer attending school or is not carrying the required credits, the borrower enters the grace period. Generally, this means that the borrower has six months, depending on loan type, before beginning loan repayment. Once the loan has entered the repayment phase and the servicer and borrower have agreed on a repayment schedule, the servicer s main compliance objective is to pursue delinquent accounts (see box). Under no circumstance may a period of 46 days elapse without a contact effort by the servicer. In addition to pursuing delinquent obligors, the servicer must track borrowers who cannot be contacted. In this case, the DOE has established skip-tracing guidelines to be followed. The servicer also processes applications from borrowers who wish to enter deferment and forbearance. It is the servicer s responsibility to ensure that reports are filed with the DOE in order to collect interest subsidy payments and SAP from the DOE. The servicer is required to file a form with the department within 90 days after the end of a quarter DOE Schedule for Required Servicer Actions in Pursuit of Delinquent Obligors 1-10 days delinquent: Must send borrower at least one letter days delinquent: Make at least four diligent efforts, each consisting of one successful or two unsuccessful attempts. At least one effort must be made by the 90th day days delinquent: Servicer must send a final demand letter. Lender must allow at least 30 days for the borrower to respond before filing a claim. 270 days delinquent: Lender is eligible to file a claim. These guidelines are subject to change, based upon DOE guidelines. 12

15 Student Loan Programs in order to receive timely SAP and interest subsidy payments. The DOE ensures accuracy of the claim filing by comparing data in the National Student Loan Data System to the data presented on the guarantee filing. The federal government is obligated to remit SAP and interest subsidy payments within 30 days upon receipt of a properly filed form. Failure of the DOE to remit SAP and interest subsidy payments within 30 days results in an interest penalty for the DOE. Consequences of Improper Student Loan Servicing There are two types of violations that may void the reimbursement obligation of the DOE: due diligence violations and late filing violations. Due diligence violations may occur due to missing documentation or a violation of the servicing requirements. Reimbursement may be easily reinstated if the due diligence violation was caused by missing documentation due to clerical errors. Claims denied as a result of borrower contact deficiencies may be reinstated for reimbursement if the eligible borrower declares bankruptcy within 30 days of claim rejection, declares deferment or forbearance, or brings the loan current. The loan may also be brought current by implementing intensive collection and skip-tracing activities. Due diligence violations also may result in SAP and interest subsidy payment penalties even if the reimbursement obligation is reinstated. Servicers are required to file default claims with the guarantor by a maximum delinquency date in order to be reimbursed. Although some late filings may be resubmitted and ultimately reimbursed after the maximum delinquency date, the DOE will not reimburse the lender for SAP and interest subsidy payments on the loan. Standard & Poor s Structured Finance Student Loan Criteria 13

16 The Rating Process for Student Loan Transactions The rating process for student loan transactions is very similar to that of other structured transactions. Contacting Standard & Poor s to discuss the proposed transaction should be a prospective issuer or banker s first step. Once information or materials outlining the transaction have been furnished, Standard & Poor s attempts to provide as much feedback as is practical, either in a direct meeting or through a conference call. The primary focus of the feedback at this early stage is to help establish the preliminary feasibility of achieving the issuer s rating objectives and to discuss specific analytical matters with the prospective issuers. Operational Review When a decision has been made to proceed, a complete analysis of the transaction, including an operational review of the servicer and issuer, will be performed. The operational review meetings are tailored to the specific securitization transaction. In cases where a third party services the collateral, an operational review meeting with the servicer will be requested if Standard & Poor s is not familiar with the its operations and performance. Additionally, Standard & Poor s may conduct an on-site operational review with the issuer or originator of the loans. The goal in these meetings with senior management is to learn as much as possible about the company s operational performance and strategic direction, as well as policies, procedures, and systems that impact the performance of the collateral. Credit and Liquidity Analysis To assess whether the transaction has sufficient credit and liquidity support needed to achieve the requested rating, the results of various cash flow runs made with different stressed assumptions will be reviewed. First, the lead analyst on the transaction will review the preliminary drafts of the transaction documents to understand the Standard & Poor s Structured Finance Student Loan Criteria 15

17 transaction structure, payment priorities, and relevant features. Second, the analyst will request collateral performance data showing the issuer s portfolio characteristics, historical losses, and other performance data. Finally, the analyst will work with the available data and the issuer to gain an understanding of the expected performance of the collateral. Based on the information obtained, the analyst will size and stress the cash flow variables commensurate with each rating level. The analyst will request that the banker run representative cash flows for the transaction incorporating the stressed variables. Committee Process Analytical decisions about ratings are made by a committee that is drawn from among the ranks of analysts with appropriate backgrounds and experiences. Information from the due diligence examination, credit analysis, cash flow results, and legal research will be compiled into a confidential presentation. After the rating committee meets, its rating decision will be conveyed to the issuer or the banker. If the issuer accepts the decision and comments, the rating process will move forward, and the final review of documentation will begin. Documentation Draft documents will be examined and comments will be made to the banker and the issuer concerning aspects of the credit risks and legal structure, as well as the timely payment of interest and ultimate payment of principal to investors. Where final documentation is unavailable until signing, a review will be conducted of draft documents before launch and comments will be made on those aspects of the offering circular that could be considered material to the credit rating. It is expected that all changes be blacklined from prior drafts, including final documentation. Drafts of all necessary legal opinions should also be submitted for review to Standard & Poor s legal counsel as early as possible. Standard & Poor s relies on the issuer and its counsel, accountants, bankers, and other experts for the accuracy and completeness of the information submitted in connection with the rating process. Surveillance Once the transaction has been rated, the issuer will submit surveillance reports containing prespecified information. The Structured Finance Surveillance group maintains surveillance on all rated transactions to ensure that the rating continues to reflect the ongoing performance and structure of the transaction. Performance information is usually disclosed in a servicing report that is prepared by the servicer. Information 16

18 The Rating Process for Student Loan Transactions must also be made available concerning changes in the original structure of the transaction, or changes in the status of the initial parties involved in the transaction. Confidentiality All proposals and transaction and other documents, including financial statements and all other materials, as well as conversations concerning the transaction and materials, are treated as confidential in accordance with policies used in the ordinary course of business at Standard & Poor s. Unless a public rating is issued or unless it is required by law, the transaction will not be discussed with any third parties that are not identified by the issuer or its advisers. Standard & Poor s Structured Finance Student Loan Criteria 17

19 Evaluating Risk in Student Loan Transactions AStandard & Poor s rating carries with it an evaluation of the likelihood of receiving ultimate repayment of principal and timely payment of interest. Credit risks in student loan transactions exist because the U.S. Department of Education (DOE) currently reimburses only 98% of any defaulted student loan, and may reject and not reimburse funds in cases where there are servicer errors. Because Standard & Poor s rates to timely payment of interest, and due to the variable payment characteristics of the collateral, the analysis of liquidity also plays a significant role in rating student loan transactions. Interest rate and cash flow mismatches contribute to these risks. Credit Risk Default Frequency Credit risk analysis focuses on two elements: default frequency and loss severity. Unlike some consumer loans, Federal Family Education Loan Program (FFELP) student loans are generally not underwritten, thus default frequency can be relatively high. Cumulative default rates have been known to run as high as 60% for certain loan types. Given the lack of underwriting of student loans and the absence of a credit history for most borrowers, differences in default experience cannot be directly correlated with individual borrower demographics. Instead, the frequency of defaults experienced by a student loan pool have been shown to depend primarily on the following: loan type, school type, seasoning, and regional economic conditions. In general, differences in default frequency are caused by the relative ability of the student to achieve gainful employment following graduation. Students attending certain schools stand a better chance of obtaining better-paying jobs than their counterparts at other schools. As a result, students at four-year institutions have generally been Standard & Poor s Structured Finance Student Loan Criteria 19

20 shown to be better credits than students attending two-year institutions, while proprietary school students generate the highest default frequency. To determine default frequency, it is important not only to consider the type of school attended, but also the type of loan made to the student attending a given institution. For example, PLUS loans made to parents on behalf of students attending trade schools may, in fact, exhibit a lower default rate than those of Stafford loans made to students attending two-year schools. PLUS loans exhibit a lower default frequency because they are not made to students but to parents and, unlike other loans, involve some underwriting to determine the creditworthiness of the parents. Historically, PLUS loans made on behalf of students attending four-year institutions have the lowest default frequency. Loan seasoning in repayment also plays a significant part in default frequency. As obligors continue to make payments, the likelihood that they will default on their loans decreases. Even seasoning that represents a small percentage of the life of a loan in repayment can have a significant impact because a substantial portion of student loan defaults occur within the first year of entering repayment. Loss Severity Two elements are responsible for losses on student loans: risk sharing on student loans that qualify for reimbursement and servicer rejects. Notwithstanding their potentially high level of default frequency, student loans have a relatively low level of losses when compared to other asset types. This is because FFELP student loans are currently 98% reimbursed by the DOE, to the extent that they are properly serviced, with only 2% risk sharing by the holder of the loan. Losses on loans eligible for reimbursement by the DOE are currently 2%. In contrast, a loan rejected for reimbursement due to servicer error, known as servicer rejection, carries a 100% loss severity. As a result, the ability of the servicer to service a loan correctly in accordance with DOE guidelines becomes a crucial issue; it determines whether a loan will suffer a 2% loss severity or a 100% loss severity. The servicer rejection rate is stressed separately at a multiple appropriate to the rating requested, in order to account for potential deterioration in the performance of the servicer. Alternative loans do not enjoy the benefit of DOE reimbursement. Some alternative student loan programs are guaranteed by unrated entities or entities with ratings below the rating requested for the securities to be issued. As a result, credit cannot be given to the guarantee provided by these entities. Total Losses Total losses incurred by a student loan pool are a product of default frequency and loss severity (see box). Credit enhancement must be sufficient to cover total credit 20

21 Evaluating Risk in Student Loan Transactions losses. Assume, for example, a pool with a 20% default frequency and a 3% servicer rejection rate, expressed as a percentage of defaults. Loss severity on the servicer rejects would be 100%. In addition to the servicer rejection losses, loss severity would include the 2% losses on the portion of defaults that were properly serviced. Therefore, total losses would be 0.99%. Liquidity Risks In School and In Grace Periods During the first few years of a transaction, a large portion of the student loans in a securitized loan pool may be in their in school or in grace periods. As a result, unsubsidized loans may be capitalizing interest. Interest on subsidized loans will be paid by the DOE in the form of interest subsidy payments. These interest payments on the loans will lag behind interest payments on the bonds because application for payment must first be made to, and then received from, the DOE. Deferment and Forbearance After reaching repayment, a loan may go into deferment or forbearance status. During deferment and forbearance, either the government pays interest on a delayed basis for subsidized loans or the student capitalizes the interest for unsubsidized loans. Because the federal government is paying interest on a delayed basis on subsidized loans and the student is capitalizing the interest on unsubsidized loans, there is a liquidity risk in meeting interest payments on the rated securities. Sample Total Loss Calculation Total loss = Loss severity x default frequency = 2% loss severity on reimbursed defaulted loans + 100% loss severity on servicer rejects = 2% x [default rate - (servicer rejection rate x default rate*)] + 100% x (servicer rejection rate x default rate*) = (2%)[(20%-3%(20%)*] + (100%)(3% x 20%)* = 0.39% % = 0.99% *The servicer reject rate of 3% must be multiplied by 20% so that it is expressed as a percentage of total outstanding loan balance, as opposed to a percentage of defaults. Standard & Poor s Structured Finance Student Loan Criteria 21

22 Special Allowance Payment Lag The DOE makes special allowance payments (SAP) in amounts sufficient to ensure that the student loan returns a yield above the 91-day Treasury bill. SAP will be received after the interest payment date on the bonds because billing for SAP must be made to the DOE on each quarterly date. Reimbursement Lag A significant time lag may occur between the date on which a loan first becomes delinquent and the date of reimbursement by the DOE. This creates liquidity risk. Although a substantial percentage of student loan defaults occur within the first year, with the first date of delinquency occurring immediately upon entering repayment, DOE regulations specify that no claim for a delinquent loan may be submitted until it is 270 days past due. While properly serviced defaulted loans will qualify for 98% reimbursement by the guarantor, most guarantors are unrated. As a result, it is assumed that all defaulted loans must be referred to the DOE for reimbursement and that the DOE may take another 360 days to provide reimbursement of the claim. Therefore, a total lag time of 630 days is assumed from the date a student loan first becomes delinquent to the date claim reimbursement is received. Interest Rate and Timing Mismatches Interest rate and timing mismatches create both liquidity concerns and the need for additional credit enhancement in student loan transactions. For example, basis risk is created when the indices off of which the assets and liabilities are priced differ. In addition, there may be other cash flow mismatches. In total, there are four major categories of interest rate and timing mismatches in student loan transactions: basis risk, differences in periodicity, differences in payment dates, and reset risk. All of these risks are stressed in the cash flows to ensure that the structure performs to the required rating level. Basis Risk Basis risk arises in any transaction in which different indices are used to determine the interest rates on the assets and on the rated liabilities. In FFELP student loan transactions, as in other asset-backed transactions, this risk is present when the liabilities earn interest based on any index other than the asset index rate. Examples of indexes on the liabilities that have been used in student loan transactions include LIBOR, variable rates, and auction rates. Basis risk may erode credit support that is intended to cover credit risk caused by servicer rejections and loss sharing on reimbursed loans. As a result, the transaction 22

23 Evaluating Risk in Student Loan Transactions may require additional credit support in order to meet its payment obligations. To stress basis risk, a modified regression analysis is used, based on historical data for the 91-day Treasury bill the typical asset index rate and a correlation of the 91-day Treasury-bill analysis to other indices in the transaction. Differences in Periodicity Differences in periodicity arise when the frequency of interest payments on the assets differs from the frequency of interest payments on the liabilities. For example, periodicity risk will be created if interest on the liabilities is paid monthly, while interest on the assets is received quarterly. This would occur in transactions where the liabilities are priced off of one-month LIBOR ignoring, for these purposes, the basis risk that would also be present in such a case. The liquidity risk posed by differences in periodicity will be more severe in high interest rate environments since a larger portion of interest received on the assets comes in as quarterly SAP. Differences in Payment Dates This risk arises when interest payment dates on the liabilities precede the interest receipt dates on the assets. This risk may be present even if the assets and liabilities are based on the same index and pay with the same frequency. While payments on the liabilities are assumed to be made at the end of the quarter, SAP on the assets is assumed to be received 60 days after the end of the same quarter. This risk exists in rising interest rate scenarios because the SAP received from the previous quarter will be less than the interest owed on the bonds in the current quarter. Reset Risk This risk arises even when the indices for the assets and the liabilities are identical, but reset at different dates. Since floating interest rates may fluctuate significantly between periods, a reset risk may arise if the interest payable on the liabilities were calculated based on quarterly periods with different ending dates than the quarterly periods for the assets. Standard & Poor s Structured Finance Student Loan Criteria 23

24 Structural Elements in Student Loan Transactions Standard & Poor s began rating student loan-backed securities in the 1960s, initially as a form of tax-exempt financing for municipal entities. In both municipal student loan structures and asset-backed structures, the rating of the securities is based on the credit quality of a pool of student loans, rather than on the credit of the originator/borrower. Both municipal and asset-backed structures isolate the assets from the risk of bankruptcy of the originator, which allows the rating to be based on the credit quality of the assets. With the adoption of Rule 3a-7 under the Investment Company Act of 1940, banks were able to securitize their student loans in the asset-backed market. Before the adoption of this rule, only entities exempt from registration under the Investment Company Act, such as nonprofit organizations, municipalities, and other entities with state agency status, were able to issue student loan securities. Banks were left with substantial student loan portfolios on their balance sheets. In 1993, the student loan market also received a boost when the reauthorization of the Higher Education Act of 1965 took effect and direct access to the Department of Education (DOE) for claim payments became effective. Before the reauthorization, an issuer could not apply directly to the DOE for reimbursement of a defaulted loan; its only recourse was to apply to the guarantor, who would then apply to the DOE for reimbursement of its guarantee payments. This meant that the financial viability of the guarantor was a significant credit issue in the rating of student loan-backed bonds. As a result, most student loan transactions did not receive a rating above A on a stand-alone basis, due, in large part, to the issue s dependence on the receipt of default claims payments from the guarantor. In turn, this depended on the solvency of the guarantor itself. Once direct access to the DOE became possible, the credit risk posed by the need to access the guarantor for reimbursement of defaulted loans was eliminated. Credit risk was reduced to the risk of nonreimbursement caused by improper servicing of the loan. As Standard & Poor s looked directly to the guarantee by the DOE for reimbursement, the guarantor s financial health was eliminated as a rating issue. Standard & Poor s Structured Finance Student Loan Criteria 25

25 Owner Trust Structure A commonly used vehicle for issuing student loan ABS is the owner trust because it is particularly well suited to address the liquidity risks associated with this asset type. Owner trust structures permit principal collections to be used to pay interest on the bonds, providing needed liquidity in the early years of a student loan transaction. Furthermore, they permit the use of structural features, such as prefunding, and the manipulation of cash flows to create securities that match specific investor preferences. In 1993, Society National Bank (now Key Bank U.S.A. N.A.) was the first bank to issue an asset-backed student loan transaction using an owner trust structure. The transaction was a $220 million sequential pay structure, divided into three tranches: class A-1 notes, class A-2 notes, and class B certificates, all of which held AAA ratings and bore interest based on the one-month LIBOR index. The subordinated class achieved an AAA rating by virtue of a surety bond provided by Capital Markets Assurance Corp. Subordination In senior/subordinated structures, the underlying collateral supports both the senior and subordinated bonds. Additionally, reallocation of subordinate cash flows supports the senior bonds. As a result, issuers have been able to attain higher ratings on the senior tranches of a bond issue, thus realizing lower overall funding costs. Senior/ subordinated structures do not have the rating dependency issues associated with third-party credit enhancement. However, senior/subordinated structures pose greater liquidity risks because collateral is inherently less liquid than third-party credit enhancement. Payment Priorities Payments of principal can be either pro rata or sequential pay. In pro rata payment structures, principal on the subordinated tranche is payable, to the extent funds are available, before the senior tranche is fully retired. In sequential pay structures, no principal is payable on the subordinated tranche until the senior tranche has been paid in full. In sequential pay structures, although the dollar amount remains constant, subordination grows as a percentage of current outstandings because the senior bonds receive 100% of all principal collections. Given the nonamortizing nature of the credit support, sequential pay structures typically require lower subordination for the senior class than pro rata structures for the same rating level. Payment priorities can provide that interest on both the senior and the subordinated tranche are payable before principal on the senior tranche, or that, in addition to 26

26 Structural Elements in Student Loan Transactions interest, principal on the senior tranche is payable before interest on the subordinated tranche. Because Standard & Poor s rates to timely interest, the latter payment priority poses particular liquidity risks if the subordinate bonds are being rated by Standard & Poor s. Therefore, additional liquid credit support may be required to ensure the transaction s ability to meet timely interest payments on the rated subordinated debt. Reserve Account Student loan transactions are typically structured with reserve accounts because liquidity is needed to make interest payments on the bonds before receiving reimbursement of defaulted claims, SAP, and interest subsidy payments. The reserve account represents liquid collateral, unlike potentially illiquid student loan collateral, and earns interest at a rate generated by the investment of funds held in highly rated eligible investments. The reserve account may be funded out of proceeds of the bond issuance and may not represent any additional external contribution of capital. Some reserve accounts have been restricted to making interest payments only but may be available to pay principal only at the final maturity. Typically, the reserve account is allowed to amortize as a percentage of current outstandings until it reaches a floor amount. The higher percentage of coverage provided by the reserve account floor is intended to cover any increased risks associated with a less diverse loan pool and payment lags. The reserve account floor provides liquidity to meet all payments, including the legal final maturity. It primarily protects the subordinate bonds in sequential pay structures where all principal collections are used to pay the senior tranches, since these are the last to be paid out. Excess Spread to Build Parity/Overcollateralization Typically, the measure of credit support in a student loan transaction is the concept of parity, which measures the ratio of assets, including student loans and cash in the transaction, to liabilities represented by the bonds. Municipal transactions often begin with a total parity below 100%, with the liabilities exceeding the assets, and parity is built up by trapping excess spread. The premium proceeds structure used in student loan asset-backed transactions is similar to that of certain municipal transaction structures that open below 100% total parity. The premium proceeds structure was first implemented in the asset-backed market in Parity for the subordinated bonds is not available at the beginning of the transaction, but, rather, is created as excess spread is used to pay down the senior bonds. Total parity buildup above 100% can be used to create overcollateralization to provide credit support for all the securities. Standard & Poor s Structured Finance Student Loan Criteria 27

27 The key requirement regarding parity buildup is that the transaction reach 100% parity by the end of the transaction so that ultimate principal payments may be made. Additionally, when a transaction opens below parity, the subordinated tranche s voting rights as a separate class, if the collateral were to be liquidated for a nonmonetary default, must be evaluated for the protection the voting rights provide holders of the subordinated tranche. The only exception would be if there were sufficient proceeds to pay all principal and accrued interest in full for all tranches. Prefunding Prefunding refers to the practice of not using all proceeds of the bond issuance to acquire student loans at closing. Some originators find it more cost effective to do a larger bond issuance than to use the extra proceeds to acquire loans in the future over a prefunding period. For example, some municipal entities may issue bonds once a year and place virtually all the proceeds in a prefunding account to be used to meet student loan financing requirements throughout the next year. In addition, an originator may seek to lock in favorable spreads against which they transfer collateral originated at a future date. The proceeds of the bond issuance not used to purchase collateral on the closing date must be deposited into a separate prefunding account that earns a reinvestment rate until the money can be used to acquire additional collateral. Revolving or Reinvestment Periods Some transactions are structured to allow reinvestment of principal collected from the existing asset pool to acquire additional loans, instead of using the cash to pay down the bonds. As with prefunding, reinvestment of principal collections creates cost efficiencies by permitting an existing structure to finance additional collateral, rather than incurring the costs associated with issuing a new securitization. Net Student Loan Rate Cap 28 Most transaction structures incorporate a net student loan rate cap, which attempts to address the risks caused by interest rate and timing mismatches. A net student loan rate cap is a floating-rate cap that limits the coupon on the bonds to the amounts earned on the student loans plus SAP if applicable accrued for the relevant period net of fees and costs payable before interest is paid in the transaction s allocation of cash received. The cap attempts to ensure that the interest payable on the bonds will never exceed the yield earned on the assets. The net student loan rate cap may be ineffective in limiting some liquidity risks caused by interest rate mismatches other than basis risk, because the definition of the net student loan rate cap includes, for purposes of calculating the cap, SAP accrued for each monthly period, as opposed to SAP received.

28 Rating Methodology for Student Loan Transactions AStandard & Poor s rating addresses the likelihood of timely payment of interest and ultimate payment of principal on the rated securities. To assess whether the transaction has sufficient credit and liquidity support, the cash flow approach will be used. Reviews will be conducted of the results of various cash flow simulations, which will be stressed at levels commensurate with the rating. The cash flows should demonstrate that timely interest payments and ultimate principal payments can be made on the rated securities. Cash flow simulations are run to test whether there is enough liquidity in the transaction to meet timely interest payments. To test the transaction, the cash flows must be structured to mirror the payment priorities and other features detailed in the legal documents. Excluding municipal-type structures that have some kind of performance or moral obligation guarantee from a state government, both municipal-type and asset-backed transactions isolate the loans from the issuer/originator, and in both cases, the credit risk faced by the securityholders is based on the credit performance of the student loan pool. One of the differences between municipal and asset-backed structures is in their cash flow allocations. Despite these differences, Standard & Poor s uses the same cash flow approach. Asset-backed transactions typically employ a pass-through feature after the revolving period, if applicable, where all principal collected is passed through to the securityholders. Since losses decrease the asset pool, they must be paid, or passed through, to the securityholders with money available either from excess spread, the reserve account, or funds otherwise payable to the subordinated tranches, depending on the transaction structure. This forces the securities to be paid out as the loans balances decrease, minimizing the potential for negative carry. In such pass-through transactions, money is generally released back to the issuer each period, but only once total assets equal total liabilities, and only to the extent that the trust is current on all its obligations. In municipal-type transactions, there is generally no requirement that principal collections be passed on to amortize the securities. The money may be held by the Standard & Poor s Structured Finance Student Loan Criteria 29

29 trust in eligible investments until needed to retire the securities on the legal final maturity date. The issuer typically has the option of redeeming securities during the life of the transaction, but only if so desired and to the extent that money is available. For this reason, municipal-type transactions have the potential to incur higher levels of negative carry throughout their lives. Municipal-type structures typically employ parity set conditions that must be achieved before money is released back to the issuer, or subordinated tranches can be paid down. Parity is needed due to the potential to incur significant levels of negative carry. The parity set conditions specify the level of senior, subordinated, and total parity required before the trust can release money to the issuer. Parity ratios above 100% provide loss coverage for the rated tranches. As long as total losses are below the specified parity level and all loans pay out, there will be sufficient funds available at the end of the transaction to cover the obligations on the liabilities. The cash flow approach used to analyze municipal-type transactions based on parity set conditions is the same as the approach used to analyze asset-backed transactions. The cash flows must demonstrate that the transaction can pay timely interest and ultimate principal to the securityholders. While there are no pre-established parity requirements, parity levels have typically been set at 105% for AAA rated securities and 102% for BBB rated securities. Additionally, no money is released from the transaction until the parity level for each rated obligation is achieved and the overall transaction parity is 100%. There is not a pre-established time period in which all parity conditions must be achieved. Typically, AAA rated tranches start above 100% parity, while lower-rated tranches may start below 100% parity. The total transaction must reach 100% parity over a number of years, based on the characteristics of the student loan pool being securitized and the transaction structure employed. Sizing Cash Flow Variables A number of variables interact to determine the cash flow available for payment to the securityholders. Cash flow simulations are essential to the rating process in light of the complex interactions of these variables. These variables include: default frequency, default timing, claim rejects, deferment and forbearance, interest rates, payment lags, and prepayments. The variables stressed in the cash flow simulations are determined by the collateral pool being securitized, specific regulations of the Federal Family Education Loan Program (FFELP) or other loan program, and the transaction structure employed. The characteristics of the collateral pool tend to determine the default frequency and timing, prepayments, and the level of deferment and forbearance likely to be experienced. 30

30 Rating Methodology for Student Loan Transactions FFELP regulations determine interest rate indexes on the assets, SAP, and interest subsidy payments. Program regulations also drive assumptions regarding payment lags and the duration of deferment and forbearance periods. Claim rejects modeled in the transaction are a function of FFELP regulations regarding servicing and the quality of the servicer. Transaction features, such as interest rate indexes on the liabilities, prefunding, revolving periods, and payment priority, also will be modeled in the cash flows. The goal of the cash flow simulations is to model all the variables, including the transaction structure and the interaction of these variables, to provide assurances that the transaction will perform at the required rating level. Default Frequency Although student loans are guaranteed, defaults play a major role in the cash flows. Therefore, sizing the level of expected cumulative defaults for a student loan pool is essential in modeling cash flows. Typically, up to five years of static pool data are reviewed to ascertain the level of defaults that a securitized pool will experience. Ideally, the issuer would provide five years of cohort default data. Static pool default data are analyzed by loan type and school type because they have been proven to correlate with default rates according to statistics provided by the U.S. Department of Education (DOE). Static pool data are preferred over portfolio data because they provide the most precise measure of defaults and their timing. For example, PLUS loans, which are made to parents, tend to have lower defaults than Unsubsidized Stafford loans, which are made to students. This is primarily because parent borrowers have a source of income and greater economic stability. For these reasons, Standard & Poor s reviews issuer static pool data segmented by different loan attributes to determine the level of expected defaults that will be experienced on a loan pool. If static pool data are not available, Standard & Poor s may consider the following statistics to develop its expected default rates: Annual default rates for issuers adjusted for growth and loan status changes, DOE cohort default rates for the loan originator, and Guarantee agency default data. For pools of loans that have considerable seasoning, the expected cumulative default rate will be adjusted accordingly. Once an expected cumulative default rate has been established, the default rate will be stressed to the required rating level. A transaction rated AAA should withstand greater stresses; thus, a higher multiple is used than in transactions with a lower rating level. The multiple used to stress expected defaults depends on the quality and quantity of the performance data provided and the requested rating level. Therefore, in cases where the issuer has provided adequate static pool data, the multiples applied may Standard & Poor s Structured Finance Student Loan Criteria 31

31 be less than those in which alternatives to static pool data are used. The multiples also depend on the magnitude of expected defaults. For higher expected cumulative default levels, a lower multiple may be used. For low expected cumulative default levels, a higher multiple may be used, since low default rates may be subject to greater volatility, against which the multiple is designed to protect. Default frequency and claim rejects are analyzed and stressed separately because default frequency is driven largely by borrower and loan characteristics, while claim rejects are driven by the quality of the servicer and the complexity of DOE regulations. Because each parameter is stressed separately, somewhat lower multiplies are used in student loan transactions as compared with other structured transactions where a net loss rate is first calculated then stressed using a single higher multiple. While the magnitude of the multiples used in each approach is different, both approaches render similar stressed net loss rates. Typical default frequency multiples by rating category are generally: AAA : 2x to 3x; AA : 1.75x to 2.75x; A : 1.5x to 2.5x; and BBB : 1.25x to 2.25x. These multiples are indicative only. Standard & Poor s may use multiples outside this range at its own discretion, depending on its analysis of the overall transaction. Default Timing Determining the timing of defaults is as important as sizing the expected level of cumulative defaults. As with all consumer assets, defaults on student loans occur over time. Default timing is very important because credit is given to excess spread as credit support. The timing of defaults affects the amount of payments received by the trust and the amount of payments available to pay investors. Early defaults cause the greatest decrease in cumulative excess spread typically available to cover losses, build parity, or fund a buildup in the reserve account. This reduction in cumulative excess spread increases the level of structural credit support required to meet the needed payments on the securities. If defaults occur later in the transaction, there is a risk that excess spread has been released, and, as a result, will not be available for credit support. Defaults that occur slowly and constantly over time place a constant negative carry and liquidity stress on the transaction. Spikes in defaults place greater liquidity stress on the transaction. To derive the default curve for a pool of student loans, it is preferable to review five years of static pool data showing how many loans within the pool have defaulted as a function of time. However, as in sizing default levels, the issuer may not have this data. For running cash flows without issuer-specific data, assumptions may be 32

32 Rating Methodology for Student Loan Transactions made about industry standard default curves adjusted to reflect the composition of the loan portfolio. Most student loan default studies are in agreement that, excluding consolidation loans, most borrowers typically default relatively early once they enter repayment. A review of default timing data show that, although defaults happen fast once they enter repayment, the default rate is sensitive to loan and school type. Data reviewed show that PLUS loans default somewhat more slowly than Stafford loans and SLS loans. Additionally, loans made to borrowers attending four- and two-year institutions default somewhat more slowly than loans made to borrowers attending trade schools. Defaults on consolidation loans tend to be less front loaded than PLUS loan defaults. Consolidation loans are taken out by borrowers to combine their outstanding balances on different types of FFELP loans or the same loan type having large outstanding balances. This typically results in a lower monthly payment and a longer repayment period for the borrower. Consolidation loans are considered to have different default timing for several reasons. First, borrowers taking out consolidation loans are viewed as exhibiting a greater willingness to pay their obligations. A person who does not intend to make payments is less likely to go through the process of obtaining a consolidation loan. Second, borrowers seeking consolidation loans tend to have a higher average borrower indebtedness, most likely incurred due to more years of study, which might be indicative of greater earning potential. Finally, monthly payments on consolidation loans are lower than payments on the underlying loans because of the longer repayment periods. Therefore, a borrower may be able to better withstand short-term economic hardships. The presence of consolidation loans in the pool of assets and the possibility that such loans could be acquired during the revolving period can affect the timing of defaults and the ability of the transaction to meet its final legal maturity. Defaults on consolidation loans tend to occur at a constant rate over the beginning years of the repayment period; then they begin to level off. Therefore, asset pools with large portions of consolidation loans do not have the typical default timing curve but a more constant level of defaults over a much longer period. In modeling defaults in student loan cash flows, the default curve should be applied individually by loan type to each series of seasoned loans. Loans in repayment are given credit for seasoning by applying only the remaining portion of the default curve to the pool. For example, assuming an issuer s default curve shows that 60% of the losses occur in the first year of repayment, 20% in the second, 15% in the third, and 5% in the fourth and assuming that the loan pool has two years of in repayment seasoning, only 20% of the default rate will be taken for the remaining life of the pool. If credit for seasoning cannot be modeled by applying a default timing curve to each individual series of loans entering repayment, credit for seasoning will be given by lowering the cumulative expected default rate. Standard & Poor s Structured Finance Student Loan Criteria 33

33 To assess the transaction s sensitivity to the timing of defaults, multiple cash flows may be requested using different default timing curves. The transaction structure should be sufficiently robust to survive changes in default timing. Claims Rejects Claims rejects must be sized and modeled in the cash flow simulations because credit enhancement should be sufficient to cover them. Up to five years of annual static pool claims rejects data are reviewed, as well as cure data. Ideally, of the annual claims submitted, the data should show how many were rejected, and, of the claims rejected, how many were cured at six, 12, 18, and 24 months after the initial rejection. Standard & Poor s will take the initial reject rate and give credit to cures up to a certain period after the initial reject. Claims not cured in this period are assumed to be losses. For example, if five out of 100 claims are initially rejected and three of the five rejects are cured during the applicable period, a 2% claims reject rate (2 uncured rejects/100 claims) will be assumed for the transaction. Some issuers have difficulty providing claims reject data. Historically, the issuers have not tracked such data because they enter into indemnification agreements with their third-party servicers requiring the servicers to pay any claims rejects back to the issuer. However, indemnification cannot serve as credit support in a securitization unless the servicer is rated by Standard & Poor s at the necessary rating level. Therefore, a certain level of claims rejects must be assumed without giving credit to indemnification agreements. If claims reject data are not available on a static pool basis, the appropriate credit to be given to cures will be determined based on the data. If the servicer is rated by Standard & Poor s at the rating level of the transaction, credit will be given to indemnification agreements, provided the terms of the agreement are satisfactory. Transactions that rely on indemnification as credit support are subject to rating downgrades if the rating of the servicer is lowered. Once a reject rate that has been adjusted for cures is obtained, it will be stressed at the appropriate rating level in the cash flows. For example, AAA stress multiples for net reject rates range from 2x to 3x the historical numbers, depending on the quality of information available and the requested rating of the transaction. Multiples outside this range may be used, if applicable. In cash flow modeling, reject losses are typically expressed as a percentage of defaults in other words, claims submitted and they are recognized at the time that claim reimbursement would have been received from the DOE. Therefore, if a transaction has a 20% stressed default rate and a 6% stressed claims reject rate, the transaction would incur total claims reject losses of 1.2% (6% of 20%) over its life. 34

34 Rating Methodology for Student Loan Transactions Deferment and Forbearance Once borrowers have entered repayment, they may become eligible for deferment and forbearance if they meet certain criteria. The purpose of deferment and forbearance is to remove the payment burden during periods in which the borrowers are engaged in specific activities affecting their income levels, or the borrowers are suffering economic hardship. The objective is to reduce the likelihood of a borrower default. Deferment and forbearance status affect the liquidity of the transaction because borrowers stop making loan payments during these periods. If the loans are subsidized, the government will make interest subsidy payments for the borrower. If the loans are unsubsidized, interest generally will be capitalized. During these periods, the government will continue to pay the SAP. Conversely, deferment and forbearance may increase the cumulative spread in the transaction by maintaining a higher outstanding principal balance and extending the average life of the student loans. Deferment and forbearance also affect the timing of the defaults. If the borrower is not required to make payments, there is no payment obligation on which to default. However, there are no assurances that once the deferment and forbearance periods are over, the borrower will not default. Therefore, deferments and forbearances change the timing of the default curve by pushing a portion of the defaults to a later point in the life of the transaction. Deferment and forbearance are analyzed in a manner similar to the analysis of default timing. The main concerns are the levels of deferment and forbearance, the timing in the repayment period during which they most frequently occur, and their average duration. To stress the problems caused by deferments and forbearances, historical deferment and forbearance levels are examined. Deferment and forbearance levels should be expressed as a percentage of loans in repayment. As in sizing default levels, static pool data, as opposed to portfolio data, is highly desirable because it is not influenced by increases or decreases in the size of the in repayment portfolio. Additionally, static pool data show when deferments and forbearances occur during the repayment cycle. The timing of deferments and forbearances are similar to the timing of defaults. Most borrowers go in deferment or forbearance early in the in repayment cycle. This is natural because, as borrowers age, they return to school less often and their incomes tend to rise. Therefore, the longer a borrower is out of school and in repayment, the less likely the borrower is to enter deferment or forbearance. For pools with in repayment seasoning, expected levels of deferment and forbearance will be adjusted. Based on the deferment and forbearance history of the issuer, the quality of data provided, the characteristics of the student loan pool, and the transaction structure, deferment and forbearance levels and timing assumptions will be developed to be modeled into the cash flows. Deferment and forbearance must be modeled in the Standard & Poor s Structured Finance Student Loan Criteria 35

35 cash flow simulations. If defaults were not fully taken on the portion of the in repayment pool entering deferment and forbearance, they need to be taken once the deferment and forbearance periods are finished. Interest Rates Interest rate indices and timing mismatches pose unique risks that should be modeled in the cash flow simulations. To model the effects of interest rates, Standard & Poor s has developed a sophisticated method of simulating possible interest rate scenarios based on 25 years of historical data and using the 91-day Treasury bill as a benchmark. The simulation results are ordered, and two scenarios are selected. Typically, each transaction is subjected both to a high interest rate scenario and a low interest rate scenario. This is done to test that the transaction will perform at either extreme in the level of interest rates. The specific high and low interest rate vectors, or scenarios, that are selected depend on the rating level of the securities. For example, for an AAA rating, the maximum and minimum derived rate vectors are used as the high and low scenarios, respectively. For an A rating, rate vectors are used that are somewhat less stressful than the maximum and minimum rate vectors. Each interest rate scenario is made up of individual rates provided for each period of the transaction. All scenarios begin at current interest rate levels and fluctuate up and down month to month within a different range, depending on the current interest rate environment and the relevant rating scenario. If the transaction is structured to pay the liabilities based on an index other than the 91-day Treasury bill, appropriate interest rate scenarios will be provided for the liabilities generated from the Treasury bill benchmark. Each interest rate scenario for the liabilities will correspond with the high and low scenario of the assets. The corresponding interest rates are modeled on the liabilities, based on the historical relationship of different indexes to the 91-day Treasury bill index. The interest rate scenario, high or low, that will prove to be the most stressful to a particular transaction depends on the transaction s structure. When a floating-rate net student loan cap is used in a transaction, the most stressful cash flow simulation is a high interest rate scenario. In this scenario, a significant portion of the yield on the assets is received as SAP. Differences in periodicity, payment dates, and reset mismatch risk will have the greatest impact on the cash flows. However, when a transaction is capped at a fixed rate, such as 10%, a high interest rate scenario will not be stressful to it because the rate on the securities is capped, while the assets continue to earn the high rate based on the Treasury bill. As a result, the low interest rate may be more stressful to the transaction s cash flows. When transactions are structured with interest swaps, caps, or floors with a third party, additional cash flow runs may be requested to analyze the effects created by such instruments (see chart). 36

36 Rating Methodology for Student Loan Transactions Payment Lags Payments on student loans are derived from three sources: the student, the DOE, and the guarantor. The student pays all or a portion of the interest due and the principal installment on the loan. The DOE pays the interest subsidy payment, and if due, the SAP. If the borrower defaults, the guarantor pays the reimbursement amount of the claim. The relative amount of total payments coming from each of the three sources during any period is a function of interest rates, default rates, and default timing. To stress the liquidity of the transaction, it is assumed that there will be delays in the payments received. Based on current FFELP regulations and Standard & Poor s rating methodology, the following payment lags are assumed: Receipt of interest subsidies and SAP 60 days; Receipt of defaulted reimbursements 630 days; and Receipt of borrower payments 0 days. The 60-day payment lag in the receipt of interest subsidies and SAP from the DOE at the end of each quarter is assumed because the servicer must complete a payment request and submit it to the DOE, which must then process it and send in the payment. The 630-day default reimbursement lag exists from the first day of past-due delinquency on the borrower s payment to the day the issuer receives the claim payment. DOE regulations state that the servicer may file a claim with the guarantor starting at 270 days past due. The guarantor should make payment promptly, typically no later than 360 days past due. Additionally, DOE regulations state that if the guarantor cannot meet its obligations, the DOE should pay the full reimbursement amount to Chart 1 Sample AAA Interest Rate Scenarios (%) 14.0 High Low Months Forward Standard & Poor s Structured Finance Student Loan Criteria 37

37 the holder. Because many of the guarantors are unrated, it is assumed that all claims payments must be made directly by the DOE. Therefore, a delay of 630 days from the first day of the last payment outstanding is assumed to allow sufficient time for the DOE to make the payment. A delay is not modeled in the payments due from the borrowers because the stressed default rates modeled in the transaction already imply a stressed level of borrower payment delinquencies. These payment lag stresses may be changed, depending on the collateral pool being securitized and the perceived quality of the servicer, as established by an operational review. Prepayments Student loan transactions are increasingly relying on excess spread as credit support. As a result, prepayments become important because they would decrease the amount of excess spread available as credit support in a given transaction. However, limited data exists that would permit the extraction of voluntary prepayments from all in prepayment data that include default rates. Industry data indicate that voluntary prepayments on student loans are typically low. Students whose loans are capped at relatively low rates have little incentive or ability to prepay their student loans. However, student loan pools do experience involuntary prepayments due to default claim reimbursements. Since the transaction has already been stressed based on a prepayment rate caused by the stressed level of defaults, additional voluntary prepayments are not typically modeled. Standard & Poor s may request cash flows with different levels of prepayments in transaction structures where excess spread has been monetized and in transactions that are expected to have low defaults, in order to test the sensitivity of the transaction to prepayment speeds. Structural Elements Several structural features of the transaction interact with cash flow variables. Prefunding Regardless of the reasons for prefunding, the practice poses a number of risks. First, if the interest earned on the prefunded amount is not as high as the interest paid on the bonds issued, then additional funds are needed to cover this shortfall. To mitigate this risk, some transactions invest the money in guaranteed investment contracts paying at a minimum interest rate equal to the bond expense. If documentation is acceptable and such investments are made with entities rated commensurate with the rating of the transaction, Standard & Poor s will give credit to these contracts in the cash flows. 38

38 Rating Methodology for Student Loan Transactions If the entities do not have a sufficient rating or if the money is not invested in an instrument guaranteeing a given rate, it is generally assumed, for cash flow purposes, that the funds are earning the 91-day Treasury-bill rate minus 10 basis points. In transactions in which the funds are invested in tax-exempt investments, it is generally assumed that the funds are earning 80% of the 91-day Treasury-bill rate. Different investment interest rate assumptions may be used, depending on the eligible investments incorporated in the legal documents. The second risk posed by prefunding is that the characteristics of the loans that will be acquired are not known. As a result, it is difficult to accurately estimate default rates and timing of defaults. To mitigate this risk, most transactions incorporate eligibility criteria for the assets. The eligibility criteria can be specific for the acquired loans or specific for the entire asset pool after the new loans are added to the initial pool. To determine default rates and default timing for cash flow modeling of these transactions, it is assumed that the characteristics of the pool will migrate to the most adverse levels allowed by the eligibility criteria. Such stressful default rates and timing curves would then be modeled in the cash flows. Eligibility criteria for student loan pools typically address the following characteristics: School type concentrations; Loan type concentrations; Minimum reimbursement rates on loans; Maximum term and maturity distribution of loans; and Average yield on loan pools. For the purpose of cash flow runs, all purchases of additional assets may be deemed to occur on the last day of the prefunding period. These runs indicate the maximum amount of negative carry risk that the prefunding period may pose to the transaction. In modeling such cash flows, the expected default rate and curves should be applied individually to each newly acquired asset pool. Revolving or Reinvestment Periods The revolving features of some transactions make it difficult to derive expected defaults and default timing because the composition of the final asset pool is not known. To mitigate this risk, eligibility criteria are used in the same manner as they are used for prefunding. If eligibility criteria are not provided in the legal documents, it is assumed the transaction will revolve into worst case loans that carry the highest default rates or longest terms. It will be requested that such characteristics be modeled in the cash flows. Additionally, revolving features also pose a risk when it comes to meeting the legal final maturity date of the transaction and the rated tranches in a sequential pay structure. The maturity profile of the collateral pool can change significantly if the Standard & Poor s Structured Finance Student Loan Criteria 39

39 principal payments received are used to acquire long-term assets, such as consolidation loans. For this reason, acquired loans must mature in sufficient amounts for the transaction to pay down before the legal final maturity date. Furthermore, there must be sufficient collateral maturing to pay out each maturing tranche if the transaction is structured with multiple sequential pay tranches, each maturing on different legal final maturity dates. In such transactions, the revolving period must be structured to ensure that sufficient assets mature before the legal final maturity of each tranche. Cash flow modeling of transactions with revolving periods should reflect the transaction s multiple asset pools the original asset pool and the asset pools acquired during the revolving period. In modeling such cash flows, the expected default rates and curves should be individually applied to each newly acquired asset pool. Legal Final Maturity In addition to requiring cash flow runs to determine the ability of the transaction to meet timely payment of interest, cash flows are also run to stress the ability of the transaction to meet its final legal maturity date. To establish the legal final maturity date, cash flows assume zero prepayments and zero defaults. These runs show the date on which all obligations of the trust will be paid, assuming no voluntary or involuntary prepayments have occurred. Typically, the legal final maturity date on each class of securities is set by adding 360 days to the maturity date obtained from the collateral cash flow runs, assuming zero prepayments and zero defaults. This additional time period is added to allow for the receipt of lagging government payments. It has been determined that 360 days is adequate for receiving such payments, due to the likelihood that only SAP and interest subsidy payments, not default reimbursements, will be due so late in the transaction life. 40

40 Legal Criteria for Student Loan Transactions This section discusses the critical legal issues raised by the structured student loan transactions (and Standard & Poor s criteria related thereto). The section sets forth the major legal concerns found in most structured financings, as well as the legal issues (and criteria) unique to student loan transactions. Structured financings are rated based primarily on the creditworthiness of isolated assets or asset pools, whether sold, contributed or pledged into a securitization structure, without regard to the creditworthiness of the seller, contributor, or borrower. The structure financing seeks to insulate the transactions from entities that are either unrated and for whom Standard & Poor s is unable to quantify the likelihood of a potential bankruptcy, or that are rated investment grade but wish a higher rating for the transaction. Standard & Poor s worst case scenario assumes the bankruptcy of each transaction participant not deemed to be bankruptcy-remote or that is rated lower than the transaction. Standard & Poor s resolves most legal concerns by analyzing the legal documents, and where appropriate, receiving opinions of counsel that address insolvency, as well as security interest and other issues. Understanding the implications of Standard & Poor s assumptions and its criteria enables an issuer to anticipate and resolve most legal concerns early in the rating process. General Overview Student loans are originated and/or transferred into a securitization structure by banks or other financial institutions, insurance companies, or nonbank corporations. Some of the legal issues raised by these transactions differ depending on whether the entity transferring the loans is a nonbank corporation that is eligible to become a debtor under the U.S. Bankruptcy Code (a Code transferor ), a bank, other financial institution, or insurance company that is not eligible to become a debtor under the Bankruptcy Code ( non-code transferor ), or an entity subject to the Bankruptcy Code (such as a municipality or public purpose entity ), but which is deemed by Standard & Poor s to be bankruptcy-remote in that the bankruptcy or Standard & Poor s Structured Finance Student Loan Criteria 41

41 dissolution of such entity for reasons unrelated to the transaction structure is deemed unlikely to occur (an SPE transferor ). Unless otherwise indicated, an entity either selling, contributing, depositing, or pledging assets for purposes of securitization, including the originator of the assets and any intermediary entity participating at any level in a structured transaction as a transferor of assets, is referred to as a transferor. Securitizations by Code Transferors General When a transferor of assets in a structured transaction is a Code transferor, as a general matter, a pledge of the assets by the transferor as collateral for the rated securities being issued in the transaction will not ensure that holders of the rated securities would have timely access to the collateral if the transferor became the subject of a proceeding under the Bankruptcy Code. Although, as a matter of law, a creditor ultimately should be able to realize the benefits of pledged collateral, several provisions of the Bankruptcy Code may cause the creditor to experience delays in payment and, in some cases, receive less than the full value of its collateral. Under Section 362(a) of the Bankruptcy Code, the filing of a bankruptcy petition automatically stays all creditors from exercising their rights to pledged collateral. The stay would affect all creditors of the transferor. A bankruptcy court could provide relief from the stay under certain circumstances, but it is difficult to estimate the likelihood of relief from the stay. Moreover, in most cases, it would be difficult to estimate the duration of the stay. Similarly, according to Section 363 of the Bankruptcy Code, under certain circumstances, a bankruptcy court may permit a debtor to use pledged collateral to aid in the debtor s reorganization or, according to Section 364, to incur debt that has a lien on assets that is prior to the lien of existing creditors. Under Section 542, a secured creditor in possession of its collateral may be required to return possession of this collateral to a bankrupt debtor. As a result, in the case of structured transactions involving the transfer of assets by Code transferors, the existence of strong assets alone to secure the rated securities cannot determine the issue credit rating of these securities. The structure of the transaction should provide the means by which the assets would be available to make interest payments on the rated securities in a timely manner and to ensure ultimate recovery of principal upon maturity, notwithstanding the insolvency, receivership, or bankruptcy of the transferor. In general, the desired structure is achieved by having all assets held by any Code transferor transferred to a bankruptcy-remote, special-purpose entity (SPE), which, in turn, either functions as an intermediate SPE and transfers the assets to an 42

42 Legal Criteria for Student Loan Transactions issuing SPE that issues the rated securities in a two-tier transaction or functions itself as an issuing SPE and directly issues the rated securities in a one-tier transaction. To ensure that a given transaction structure, whether two-tier or one-tier, provides for the timely availability of assets to pay the holders of the rated securities, Standard & Poor s analyzes each transfer of assets in a securitization transaction to determine whether each transfer constitutes a sale or a pledge, the nature of each transaction party s property rights in any assets, and whether third parties (that may be unrated or that are non-bankruptcy remote ) have retained rights that may impair timely payment on the rated securities. Depending upon the transaction structure (as discussed below), Standard & Poor s has certain requirements including, but not limited to, the delivery of opinions of counsel regarding these issues. Two-Tier Transactions In the typical two-tier transaction, the rated securities are issued by an issuing SPE. In the first tier, each Code transferor holding assets (which, in general, has either originated the assets or purchased the assets in a chain of transfers from the originator ) either sells the assets to an intermediate SPE or makes a capital contribution of the assets to the intermediate SPE. The intermediate SPE is usually a wholly-owned subsidiary of one of the transferors. In the second tier, the intermediate SPE deposits or sells the assets to the issuing SPE or borrows from the issuing SPE and pledges the assets to the issuing SPE to secure the loan. The issuing SPE then issues the rated securities and uses the proceeds of the rated securities either to purchase the assets from the intermediate SPE (if the second-tier transfer constitutes a sale) or to make a loan to the intermediate SPE (if the second-tier transfer constitutes a pledge). The intermediate SPE uses the proceeds of the sale or loan to purchase the assets from the transferors. In a two-tier transaction, in which the transferors are Code transferors, Standard & Poor s has the following interrelated criteria. First Tier: True Sale First, to avoid the risk that a court, in the event of the bankruptcy of any Code transferor, would deem any of the assets transferred in the chain of transfers to the intermediate SPE to be part of the transferor s bankruptcy estate (and thus subject to the automatic stay), Standard & Poor s generally requires that each transfer of assets from any Code transferor (through all intermediaries that are Code transferors) to the intermediate SPE be a true sale, as further described below. In this regard, each transfer of assets in the full chain of transfers from each Code transferor to the intermediate SPE is subject to review in terms of the factors courts generally consider in determining whether a transfer is a true sale or a secured loan. Standard & Poor s Structured Finance Student Loan Criteria 43

43 In particular, in this regard, whenever it is necessary that a transfer qualify as a true sale, the transfer must be examined for any arrangements by which the transferor retains a subordinated interest in the assets, whether the interest is in the form of a subordinated note or subordinated certificates that are being issued in the transaction. Depending upon the circumstances, Standard & Poor s may view a transfer that incorporates subordinated interests as more likely to be characterized as a secured loan transaction, rather than a true sale. True Sale Opinion. To obtain legal comfort that each transfer of assets through the chain of transfers from any Code transferor through the first-tier transfer to the intermediate SPE constitutes a true sale, Standard & Poor s will, as a general matter, request a true sale opinion for each transfer. The true sale opinion should state that the assets being transferred and the proceeds thereof will not be property of the transferor s estate under Section 541 of the Bankruptcy Code or be subject to the automatic stay under Section 362(a) in the event of the bankruptcy of the transferor. Sometimes, assets may pass through multiple owners before coming to rest in the intermediate SPE. In general, Standard & Poor s would want true sale opinions for each transfer in the chain. However, in some cases, this request would be burdensome and add little real value. Therefore, in certain circumstances, Standard & Poor s may waive true sale opinions on various transfers. For example, in cases of open market transfers, Standard & Poor s may waive the true sale opinion requirement for intermediate transfers. Standard & Poor s will consider transfers on a case-by-case basis to determine whether they are open market. As a general matter, if the transfer satisfies the following criteria, Standard & Poor s will deem the transfer to be open market: (i) the transfer is an arm s-length nonrecourse transfer between unaffiliated entities; (ii) the transferor received payment in full at the time of the transfer; (iii) the transferee is purchasing assets from multiple transferors; and (iv) the transferor does not receive, as payment, any securities issued in the rated transaction. Depending on the type of transaction, Standard & Poor s will consider additional factors in determining whether a transfer is open market. For example, in the context of most structured transactions, Standard & Poor s will generally require that the transferee purchased the assets in the ordinary course of its business. Standard & Poor s considers open market transfers to be true sales for bankruptcy purposes and, therefore, may not require true sale opinions in connection with such transfers. In addition, Standard & Poor s may view some direct purchases by the intermediate SPE from unrelated parties as open market transfers. In many instances, it may be difficult to determine whether a transfer was indeed an open market transfer. In these cases, Standard & Poor s may request a true sale opinion nevertheless. 44

44 Legal Criteria for Student Loan Transactions Nonconsolidation Second, under the equitable provisions of Section 105 of the Bankruptcy Code, a court has the power to substantively consolidate ostensibly separate but related entities and treat the assets and liabilities of the entities as if they belonged to one, thus enabling the creditors of each to reach the assets of the consolidated estate. Therefore, even if a first-tier transfer from a Code transferor constitutes a true sale, if the transferor becomes insolvent, property transferred to the intermediate SPE from the transferor may be deemed part of the transferor s bankruptcy estate, thereby jeopardizing timely payment to the holders of the rated securities. Because of this possibility of substantive consolidation and the resultant risk that holders of the rated securities would not receive timely payment on their investment, Standard & Poor s generally requires that, in circumstances in which consolidation of the intermediate SPE with a Code transferor is a possibility, it receive a legal opinion stating that, if the Code transferor were to become insolvent, neither the intermediate SPE, nor its assets and liabilities, would be substantively consolidated with the transferor. In this regard, the facts and circumstances of the relationship between the intermediate SPE and other entities in a transaction in terms of the factors courts generally consider in determining whether two entities should be substantively consolidated should be examined. In addition, each SPE should adopt separateness covenants in the transaction documents and/or its charter and by-laws. Nonconsolidation Opinion. As mentioned above, to obtain legal comfort in regard to consolidation in bankruptcy, in certain circumstances, Standard & Poor s will request a nonconsolidation opinion to the effect that, in an insolvency of the relevant Code transferor, neither the intermediate SPE, nor its assets and liabilities, would be substantively consolidated with the transferor. Since an intermediate SPE may take a variety of different forms, for example, corporate, partnership, or limited liability company (LLC), the particular nonconsolidation opinions that Standard & Poor s will request in a given transaction will depend upon the type of entities involved and their relationship to one another. In general, Standard & Poor s requires the following nonconsolidation opinions: If the intermediate SPE is a corporation, a nonconsolidation opinion stating that, under applicable insolvency laws, upon an insolvency of any entity owning 50% or more of the equity of the intermediate SPE corporation, the intermediate SPE corporation, or its assets and liabilities, would not be substantively consolidated with its 50% or more equity owner. (If all equity holders of the intermediate SPE are affiliates, Standard & Poor s will generally require the nonconsolidation opinion irrespective of the proportionate ownership.) If the intermediate SPE is a limited partnership, a nonconsolidation opinion stating that, under applicable insolvency laws, in an insolvency of any limited partner holding Standard & Poor s Structured Finance Student Loan Criteria 45

45 a 50% or more percentage interest in the profits and losses of the intermediate SPE limited partnership or an insolvency of any general partner (that is not itself an SPE) of the intermediate SPE limited partnership, the intermediate SPE limited partnership, or its assets and liabilities, would not be substantively consolidated with the general or limited partner. Furthermore, under Standard & Poor s criteria, at least one general partner of an SPE limited partnership must be an SPE. Accordingly, Standard & Poor s would, as a general matter, require a nonconsolidation opinion between the SPE general partner and its equity holders (if the SPE is a corporation) or partners (if the SPE is a partnership) as described above. If the intermediate SPE is an LLC, a nonconsolidation opinion stating that, under applicable insolvency laws, in an insolvency of any member or successor member (that is not itself an SPE), the intermediate SPE LLC, or its assets and liabilities, would not be substantively consolidated with the member or successor member. Furthermore, under Standard & Poor s criteria, at least one member of a two or more member SPE LLC must be an SPE. Accordingly, if the SPE member is a corporation, Standard & Poor s would, as a general matter, require the relevant nonconsolidation opinion. In connection with single-member LLCs, Standard & Poor s criteria, at the time of publication, are still in the developing stage. Therefore, transferors intending to use a single-member LLC in a structured transaction are encouraged to check with Standard & Poor s regarding its single-member LLC criteria, including its opinion requirements. For two-tier transactions, if the second-tier transfer is structured as a true sale rather than a secured loan, the assets transferred to the issuing SPE in the second-tier true sale would not be part of the intermediate SPE s estate. Thus, possible consolidation of the intermediate SPE with its parent would not affect the transaction. In such circumstances, Standard & Poor s typically will not request a nonconsolidation opinion between the Code transferor and the intermediate SPE. If the parties propose an intermediate SPE that is not subject to the Bankruptcy Code, such as an insurance company or bank, or, if the intermediate SPE is an orphan SPE whose parent is an operating company, Standard & Poor s will address the need for nonconsolidation opinions on a case-by-case basis. If the intermediate SPE is owned by a company established for the limited purpose of owning and providing management services to securitization vehicles, Standard & Poor s will not typically require a nonconsolidation opinion, provided it has already received at least one nonconsolidation opinion with respect to such company s participation in a prior transaction. Depending upon the circumstances, Standard & Poor s may require nonconsolidation opinions between an intermediate SPE and certain indirect affiliates. 46

46 Legal Criteria for Student Loan Transactions Second Tier: True Sale or First Priority Perfected Security Interest Because the second-tier transfer in a two-tier transaction is from an SPE, Standard & Poor s does not require the second-tier transfer to be a true sale. A pledge of assets from a bankruptcy-remote entity is sufficient to make Standard & Poor s comfortable that the assets would be available to make timely payments on the rated securities. Therefore, in connection with the second tier in a two-tier transaction, Standard & Poor s will be comfortable if the issuing SPE makes a loan secured by the assets to the intermediate SPE and obtains a first priority perfected security interest in the assets and the proceeds thereof. In addition, if the rated securities are debt of the issuing SPE, as a general matter, Standard & Poor s requires that the indenture trustee/custodian obtain a first priority perfected security interest in the assets and the proceeds thereof. Since the issuing SPE, like the intermediate SPE, is deemed by Standard & Poor s to be bankruptcy remote, a pledge of assets from the issuing SPE, rather than a true sale, is sufficient to make Standard & Poor s comfortable that the assets would be available to make timely payments on the rated securities. The grant of a security interest serves to reduce the incentive of the equity holders to voluntarily file a bankruptcy petition against the issuing SPE (an integral component of Standard & Poor s SPE criteria). If the second-tier transfer does not constitute a true sale, Standard & Poor s generally requires the parties to the transaction to take all necessary steps under the applicable laws to ensure that the issuing SPE or indenture trustee/custodian, as applicable, has a first priority perfected security interest in all of the assets and the proceeds thereof. True Sale Opinion, Security Interest Opinion, or Either/Or Opinion; Debt Security Interest Opinion. To obtain legal comfort that the issuing SPE in the secondtier transfer either purchases the assets and proceeds in a true sale from the intermediate SPE or obtains a first priority perfected security interest in the assets and the proceeds thereof, Standard & Poor s will generally request an opinion regarding the second-tier transfer. The opinion may be either (i) a true sale opinion, similar to the true sale opinion given in connection with the first-tier transfer, or (ii) a security interest opinion to the effect that the issuing SPE has obtained, or will have obtained following the taking of certain actions required by the transaction documents, a first priority perfected security interest in the assets and the proceeds thereof, or (iii) an either/or opinion to the effect that the issuing SPE either (a) has purchased the assets and the proceeds thereof from the intermediate SPE in a true sale or (b) has obtained, or will have obtained following the taking of certain actions required by the transaction documents, a first priority perfected security interest in the assets and the proceeds thereof. In addition, if the rated securities are debt of the issuing SPE, to obtain legal comfort that the indenture trustee/custodian has obtained, or will have obtained following Standard & Poor s Structured Finance Student Loan Criteria 47

47 the taking of certain actions required by the transaction documents, a first priority perfected security interest in such property and the proceeds thereof, Standard & Poor s will generally request a debt security interest opinion. Criteria Relating to the Tax Status of the Issuing SPE To obtain comfort that the assets would not be needed to pay taxes of the issuing SPE, thereby depleting the funds available to make payments on the rated securities, Standard & Poor s typically requires an entity-level tax opinion to the effect that the issuing SPE would not be subject to federal tax or to state or local tax in the applicable jurisdictions. Without this opinion, additional credit enhancement might be required to cover any potential taxes of the issuing SPE. One-Tier Transactions Instead of the two-tier transaction discussed above, some transactions are structured with only one tier. In these transactions, the Code transferor does not use an intermediate SPE, but rather sells the assets and the proceeds thereof directly to an issuing SPE, which issues the rated securities. In a one-tier transaction from a Code transferor, Standard & Poor s has the following interrelated criteria: True Sale First, Standard & Poor s generally requires that a one-tier transfer of assets and the proceeds thereof from any Code transferor to an issuing SPE be a true sale. True Sale Opinion. To obtain legal comfort that a one-tier transfer of assets and the proceeds thereof from a Code transferor to an issuing SPE constitutes a true sale, as a general matter, Standard & Poor s will request a true sale opinion with respect to the transfer. The true sale opinion should state that the property being transferred and the proceeds thereof will not be property of the transferor s estate under Section 541 of the Bankruptcy Code or be subject to the automatic stay under Section 362(a) in the event of the bankruptcy of the transferor. Nonconsolidation Second, because of the possibility of substantive consolidation in certain circumstances and the resultant risk that holders of the rated securities would not receive timely payment on their investment, Standard & Poor s generally requires that, in circumstances in which consolidation of the issuing SPE with a Code transferor in a one-tier transaction is a possibility, it receive assurance that if the Code transferor were to become insolvent, neither the issuing SPE nor its assets and liabilities would be substantively consolidated with the transferor. Nonconsolidation Opinion. Standard & Poor s generally requests a nonconsolidation opinion to the effect that, in an insolvency of the Code transferor, neither the issuing 48

48 Legal Criteria for Student Loan Transactions SPE, nor its assets and liabilities, would be substantively consolidated with the transferor. Since the issuing SPE may take a variety of different forms, for example, trust, partnership, LLC, or corporation, the particular nonconsolidation opinions that Standard & Poor s will request in a given transaction will depend upon the type of entities involved and their relationship to one another. First Priority Perfected Security Interest Third, in a one-tier transaction, if the rated securities constitute debt of the issuing SPE, Standard & Poor s generally requires that the indenture trustee/custodian obtain a first priority perfected security interest in the assets and the proceeds thereof. Since the issuing SPE is deemed by Standard & Poor s to be bankruptcy remote, a pledge of assets from the issuing SPE, rather than a true sale, is sufficient to make Standard & Poor s comfortable that such property would be available to make timely payments on the rated securities. Standard & Poor s generally requires that the parties to the transaction take all necessary steps under the applicable laws to ensure that the indenture trustee/custodian has a first priority perfected security interest in all of the assets and the proceeds thereof. Debt Security Interest Opinion. In a one-tier transaction, if the rated securities are debt of the issuing SPE, to obtain legal comfort that the indenture trustee/custodian has obtained, or will have obtained following the taking of certain actions required by the transaction documents, a first priority perfected security interest in such property and the proceeds thereof, Standard & Poor s generally will request a debt security interest opinion to that effect. Criteria Relating to the Tax Status of the Issuing SPE To obtain comfort that the assets would not be needed to pay taxes of the issuing SPE, thereby depleting the funds available to make payments on the rated securities, Standard & Poor s generally requires an entity-level tax opinion to the effect that the issuing SPE would not be subject to federal tax or to state or local tax in the applicable jurisdictions. Without this opinion, additional credit enhancement might be required to cover any potential taxes of the issuing SPE. Criteria Relating to Preference and Avoidance of Transfers Fraudulent Conveyance In certain circumstances (for example, if the purchase price paid by an intermediate SPE for assets is less than the reasonably equivalent value of the assets, or where a transferor is insolvent or extremely financially distressed at the time of the transfer) there is a risk that the transfer would be voided as a fraudulent conveyance, either Standard & Poor s Structured Finance Student Loan Criteria 49

49 under Section 548 of the Bankruptcy Code or under applicable state law. If a transfer of assets were voided as a fraudulent transfer, the assets would not be available to make payments on the rated securities. Each transfer of assets in a structured transaction is subject to review to determine if there is a risk that the transfer could be voided under the theory of fraudulent conveyance. Fraudulent Conveyance Opinion. If Standard & Poor s determines that there is a fraudulent conveyance risk in connection with any given transfer of assets in a transaction, generally it will request a fraudulent conveyance opinion to the effect that the transfer and the related payments to the holders of the rated securities would not be recoverable as a fraudulent transfer under either Section 548 of the Bankruptcy Code or applicable state law. In addition, Standard & Poor s may request that the facts assumed in a fraudulent conveyance opinion be verified with either audits or independent valuations of the assets. Preferential Transfer In other circumstances, there is a risk that the transfer would be voided as a preferential transfer under Section 547 of the Bankruptcy Code. If a transfer of assets were voided as a preferential transfer, the assets would not be available to make payments on the rated securities. Examples of preferential transfers include debt payments made that were not in the ordinary course of business or pledges of additional collateral to a creditor within the applicable preference period. Each transfer of assets in a structured transaction is subject to review to determine if there is a risk that the transfer could be voided under the theory of preferential transfer. Preference Opinion. If Standard & Poor s determines that there is a preference risk in connection with any given transfer of assets in a transaction, Standard & Poor s will generally request a preference opinion to the effect that the transfer and the related payments to the holders of the rated securities would not be recoverable as a preferential transfer under Section 547 of the Bankruptcy Code. Note: It should be noted that if, as a credit matter, the value of the assets is not relevant to the rating of a structured transaction (for example, the transaction is based on a total return swap), Standard & Poor s generally will not require true sale opinions, security interest opinions, either/or opinions, or debt security interest opinions regarding such assets. 50

50 Legal Criteria for Student Loan Transactions Securitizations by SPE Transferors and Non-Code Transferors General The previous section addresses Standard & Poor s legal criteria for structured transactions in which the transferor of assets into the securitization structure is a Code transferor. Standard & Poor s criteria for structured transactions involving Code transferors attempt to minimize the risk that the assets would not be available for timely payment on the rated securities should any of the Code transferors become a debtor in bankruptcy under the Bankruptcy Code. This section addresses Standard & Poor s legal criteria for structured transactions in which the transferor of assets into the securitization structure is either an SPE transferor or a non-code transferor. Unlike Code transferors, SPE transferors, such as municipalities and public-purpose entities, while subject to the Bankruptcy Code, are deemed by Standard & Poor s to be bankruptcy remote in that the bankruptcy or dissolution of such entities for reasons unrelated to the transaction structure is deemed unlikely to occur. Non-Code transferors, such as banks and insurance companies, while not deemed by Standard & Poor s to be bankruptcy remote, are not eligible to become debtors under the Bankruptcy Code. Because structured transactions involving either SPE transferors or non-code transferors do not pose the same bankruptcy concerns as those involving Code transferors, Standard & Poor s criteria for structured transactions involving these entities differ in detail, but not in purpose, from the criteria for Code transferors. SPE Transferors Municipalities are entities that would qualify as municipalities under Section 101(40) of the Bankruptcy Code. As such, municipalities are not moneyed, business or commercial corporations[s] under Section 303 of the Bankruptcy Code. Public-purpose entities, such as 501(c)(3) entities under the Internal Revenue Code (IRC), state or municipal agencies, or state or municipally chartered corporations, are entities that are also deemed not moneyed, business or commercial corporation[s] under Section 303 of the Bankruptcy Code. According to Section 303(a) of the Bankruptcy Code, these entities may not be involuntarily filed into bankruptcy by their creditors, and, thus, their creditors would be unable to cause a timing delay on the rated securities or reach assets otherwise available to pay the rated securities by filing an involuntary bankruptcy petition. Both municipalities and public-purpose entities may, however, voluntarily file bankruptcy petitions under the Bankruptcy Code, municipalities under Chapter 9 and public-purpose entities under either Chapter 7 (liquidation) or Chapter 11 (reorganization). For Standard & Poor s to deem such entities to be bankruptcy Standard & Poor s Structured Finance Student Loan Criteria 51

51 remote, Standard & Poor s evaluates, as a general matter, the likelihood that a municipality or public-purpose entity involved in a structured transaction would voluntarily file for bankruptcy protection. This evaluation takes into account the entity s need to have access to the financial markets on reasonable terms, the nature of its business, its ability to control spending or to raise revenues, and, in case of municipal entities, the necessity of the services provided to its citizenry and the purpose of the securitization. Assuming that Standard & Poor s evaluation leads it to conclude that a municipality or public-purpose entity is unlikely to voluntarily file for bankruptcy protection, Standard & Poor s deems such an entity to be bankruptcy remote. As such, Standard & Poor s has the following interrelated criteria for structured transactions involving SPE transferors. One-Tier Transactions True Sale or First Priority Perfected Security Interest. An SPE transferor generally chooses a one-tier transaction structure and does not interpose an intermediate SPE between the SPE transferor and the issuing SPE. In such one-tier transactions involving SPE transferors, Standard & Poor s does not require the transfer from the SPE transferor to the issuing SPE to constitute a true sale. A pledge of assets from a bankruptcy-remote entity is sufficient to make Standard & Poor s comfortable that the assets would be available to make timely payments on the rated securities. Therefore, rather than requiring a true sale, Standard & Poor s will be comfortable if the issuing SPE makes a loan secured by the assets and obtains a first priority perfected security interest in the assets and the proceeds thereof. In addition, if the rated securities are debt of the issuing SPE, Standard & Poor s generally requires that the indenture trustee/custodian obtain a first priority perfected security interest in the assets and the proceeds thereof. Since the issuing SPE, like the SPE transferor, is deemed by Standard & Poor s to be bankruptcy remote, a pledge of assets and the proceeds thereof from the issuing SPE, rather than a true sale, is sufficient to make Standard & Poor s comfortable that the property and the proceeds thereof would be available to make timely payments on the rated securities. The grant of a security interest serves to reduce the incentive of the equity holders to voluntarily file a bankruptcy petition against the issuing SPE (an integral component of Standard & Poor s SPE criteria). True Sale Opinion, Security Interest Opinion, or Either/or Opinion; Debt Security Interest Opinion. To obtain legal comfort regarding the above, in a one-tier transaction involving an SPE transferor, Standard & Poor s generally requires either (i) a true sale opinion, or (ii) a security interest opinion, or (iii) an either/or opinion in connection with such transfer. 52

52 Legal Criteria for Student Loan Transactions In addition, if the rated securities are debt of the issuing SPE, to obtain legal comfort that the indenture trustee/custodian has obtained, or will have obtained following the taking of certain actions required by the transaction documents, a first priority perfected security interest in such property and the proceeds thereof, Standard & Poor s generally will request a debt security interest opinion to that effect. Entity Status Opinion/Involuntary Filing Opinion. If the status of an entity as a municipality is unclear, to obtain legal comfort, Standard & Poor s may request an entity status opinion to the effect that the entity would be deemed to be a municipality under the Bankruptcy Code. Similarly, if the status of an entity as one deemed not to be a moneyed, business or commercial corporation is unclear, to obtain legal comfort, Standard & Poor s may request an involuntary filing opinion to the effect that the entity may not be involuntarily filed by its creditors under the Bankruptcy Code. Criteria Relating to the Tax Status of the Issuing SPE. To obtain comfort that the assets would not be needed to pay taxes of the issuing SPE, thereby depleting the funds available to make payments on the rated securities, Standard & Poor s generally requires an entity-level tax opinion to the effect that the issuing SPE would not be subject to federal tax or to state or local tax in the applicable jurisdictions. Without this opinion, additional credit enhancement might be required to cover any potential taxes of the issuing SPE. Two-Tier Transactions A municipality or public-purpose entity, as transferor of assets in a structured transaction, may choose, for accounting, tax, or other reasons, a two-tier transaction structure in which it transfers the assets to an intermediate SPE, and the intermediate SPE transfers the assets directly to the issuing SPE, which issues the rated securities. In two-tier transactions involving SPE transferors, Standard & Poor s would permit either tier to constitute either a true sale or the grant of a first priority perfected security interest in the assets and the proceeds thereof to the intermediate SPE or the issuing SPE. If an SPE transferor chooses a two-tier transaction structure, Standard & Poor s criteria for the second tier are identical to its criteria for a one-tier transaction involving an SPE transferor. Non-Code Transferors Neither banks nor insurance companies are eligible to become debtors under the Bankruptcy Code. As such, the various sections of the Bankruptcy Code discussed in Standard & Poor s legal criteria do not apply to asset transfers in structured transactions in which either a bank or an insurance company functions as the transferor. Both banks and insurance companies may, however, become insolvent, and, therefore, unlike SPE transferors, are not deemed by Standard & Poor s to be bankruptcy Standard & Poor s Structured Finance Student Loan Criteria 53

53 remote. As such, Standard & Poor s criteria for structured transactions involving either banks or insurance companies as transferors are somewhat different from its criteria for SPE transferors, since in the case of banks and insurance companies, Standard & Poor s criteria seek to insulate the structured transaction from the consequences of the bank s or the insurance company s insolvency, albeit not under the Bankruptcy Code. FDIC-Insured Banks Bank insolvency regimes vary, depending on whether the bank is a national or statechartered financial institution and whether it is insured by the U.S. Federal Deposit Insurance Corp. (FDIC). Standard & Poor s has the following interrelated criteria for structured transactions involving FDIC-insured banks as transferors. One-Tier Transactions. An FDIC-insured bank generally chooses a one-tier transaction structure and does not interpose an intermediate SPE between the bank and the issuing SPE. As a general matter, rather than a true sale, as described further below, the grant of a first priority perfected security interest in assets from an FDICinsured bank as transferor in a one-tier transaction is sufficient to make Standard & Poor s comfortable with the timely availability of the assets to pay the holders of the rated securities. Federal Deposit Insurance Act. Under Section 11(c)(3)(A) of the Federal Deposit Insurance Act (FDIA), the FDIC is authorized to accept appointment as receiver or conservator for an insured state depository institution. Also, under Section 11(c)(1) and (2) of the FDIA, the FDIC is authorized to accept appointment as conservator and is required to be appointed as receiver for a national bank. Standard & Poor s criteria for transactions in which either an FDIC-insured state-chartered bank or a national bank serves as a transferor addresses the powers of the FDIC under the relevant provisions of the FDIA should such bank become insolvent. Unlike the Bankruptcy Code, the FDIA does not contain an automatic stay provision. However, the FDIC, in its capacity as receiver or conservator of the insolvent institution, has expansive powers, including the power to ask for a judicial stay of all payments and/or to repudiate any contract. To provide for greater flexibility in securitized transactions, however, the FDIC has stated that it would not seek to avoid an otherwise legally enforceable and perfected security interest so long as the following conditions are met: The security agreement evidencing the security interest is in writing, was approved by the board of directors of the bank or its loan committee (this approval is reflected in the minutes of a meeting of the bank s board of directors or committee), and has been, continuously, from the time of its execution, an official record of the bank (this condition, essentially codified in Section 13(e) of the FDIA, is based on 54

54 Legal Criteria for Student Loan Transactions the holding of the U.S. Supreme Court in D Oench, Duhme & Co. v. FDIC, 315 U.S. 447 (1942)); The security agreement evidencing the security interest was undertaken in the ordinary course of business, not in contemplation of insolvency, and with no intent to hinder, delay, or defraud the bank or its creditors; The secured obligation represents a bona fide and arm s-length transaction; The secured party or parties are not insiders of or affiliates of the bank; and The grant of the security interest was made for adequate consideration. Based on this advice, if a structured transaction involving the transfer of assets from an FDIC-insured bank complies with the above conditions, Standard & Poor s obtains comfort that a security interest granted by the bank in the assets should not be avoidable in the event of the bank s insolvency. In addition, Standard & Poor s derives comfort from a letter written by the General Counsel of the FDIC, commonly referred to as the Douglas letter, stating that the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA), which revised federal law relating to bank conservatorships and receiverships, does not contain an automatic stay provision similar to that found in the Bankruptcy Code and that a secured creditor of an FDIC-insured bank for which a receiver had been appointed may, on the conditions set forth below, undertake to liquidate the creditor s properly pledged collateral by commercially reasonable self-help methods. The conditions include the following: (i) that no involvement of the receiver was required; (ii) that there was a default, other than through an ipso facto provision; and (iii) that the transaction was an arms-length, bona fide transaction, not involving an affiliate or insider, which would pass muster under appropriate fraudulent conveyance law or other applicable law and which involved a legally perfected security interest enforceable under other applicable law. Standard & Poor s notes, however, that the General Counsel also stated in the Douglas letter that if some action is required by the receiver or liquidation would require judicial action, then the claims process in FIRREA would have to be followed. FDIC/D Oench Opinion. To obtain legal comfort regarding the above, in connection with the grant of a first priority perfected security interest in assets and the proceeds thereof from a bank governed by the FDIA directly to the issuing SPE in a one-tier transaction (in addition to a security interest opinion or either/or opinion discussed below), Standard & Poor s generally requires an FDIC/D Oench opinion to the effect that the above listed conditions have been satisfied and, thus, such security interest would not be subject to avoidance if the FDIC were appointed as a receiver or conservator of the bank. True sale or first priority perfected security interest. Because of the FDIC advice stated above, in a one-tier transaction in which an FDIC-insured bank serves as transferor, Standard & Poor s does not require the transfer to the issuing SPE to Standard & Poor s Structured Finance Student Loan Criteria 55

55 constitute a true sale. A pledge of assets from an FDIC-insured bank is sufficient to make Standard & Poor s comfortable that the assets would be available to make timely payments on the rated securities. Therefore, rather than requiring a true sale, Standard & Poor s will be comfortable if the issuing SPE makes a loan to the bank and obtains a first priority perfected security interest in the assets and the proceeds thereof, enforceable notwithstanding the insolvency of the bank. In addition, if the rated securities are debt of the issuing SPE, Standard & Poor s generally requires that the indenture trustee/custodian obtain a first priority perfected security interest in the assets and the proceeds thereof. Since the issuing SPE is deemed by Standard & Poor s to be bankruptcy remote, a pledge of assets and the proceeds thereof from the issuing SPE, rather than a true sale, is sufficient to make Standard & Poor s comfortable that such property and the proceeds thereof would be available to make timely payments on the rated securities. True sale opinion, security interest opinion or either/or opinion; debt security interest opinion. To obtain legal comfort regarding the above, in a one-tier transaction involving an FDIC-insured bank, Standard & Poor s generally requires, in addition to the FDIC/D Oench opinion discussed above, either (i) a true sale opinion, or (ii) a security interest opinion, or (iii) an either/or opinion. In addition, if the rated securities are debt of the issuing SPE, to obtain legal comfort that the indenture trustee/custodian has obtained, or will have obtained following the taking of certain actions required by the transaction documents, a first priority perfected security interest in such property and the proceeds thereof, Standard & Poor s generally will request a debt security interest opinion to that effect. Criteria Relating to the Tax Status of the Issuing SPE. To obtain comfort that the assets would not be needed to pay taxes of the issuing SPE, thereby depleting the funds available to make payments on the rated securities, Standard & Poor s generally requires an entity-level tax opinion to the effect that the issuing SPE would not be subject to federal tax or to state or local tax in the applicable jurisdictions. Without this opinion, additional credit enhancement might be required to cover any potential taxes of the issuing SPE. Two-Tier Transactions. An FDIC-insured bank, as transferor of assets in a structured transaction, may choose, for bank regulatory, accounting, tax, or other reasons, a two-tier transaction structure in which it transfers the assets to an intermediate SPE, and the intermediate SPE transfers the assets directly to an issuing SPE, which issues the rated securities. In two-tier transactions from FDIC-insured banks, Standard & Poor s would permit either tier to constitute either a true sale or the grant of a first priority perfected security interest in the assets and the proceeds thereof to the intermediate SPE or the issuing SPE. If an FDIC-insured bank chooses a two-tier transaction structure, Standard & Poor s criteria for the second tier are identical to its criteria for a one-tier transaction involving an FDIC-insured bank. 56

56 Legal Criteria for Student Loan Transactions Nonconsolidation. Regarding nonconsolidation, if a transaction from an FDICinsured bank is structured as a one-tier (with a true sale) or a two-tier (with a true sale at the first tier and a first priority perfected security interest at the second tier), Standard & Poor s may not require a nonconsolidation opinion between the FDICinsured bank and the intermediate SPE or the issuing SPE, provided that the rated securities constitute debt of the issuing SPE and, in connection with the true sale opinion, there are delivered (i) an alternative security interest opinion to the effect that, if a court did not consider the purported true sale transfer to be a true sale, it would be a grant of a first priority perfected security interest by the bank to the intermediate SPE or issuing SPE and (ii) an FDIC/D Oench opinion. Non-FDIC-Insured Banks Insolvency of a non-fdic-insured bank is generally governed by state law, and it is beyond the scope of this publication to examine and differentiate state insolvency regimes for state-chartered non-fdic-insured banks. The principles of securitization discussed throughout this publication and Standard & Poor s criteria regarding other types of transferors, however, can be used to derive, in general, Standard & Poor s criteria for structured transactions from non-fdic-insured banks; that is, the assets should be sufficiently separated that, as a legal matter, in an insolvency of the non-fdic-insured bank they are available in a timely manner to pay principal and interest on the rated securities. Standard & Poor s will generally require comfort, including legal opinions, regarding the treatment of the asset transfer in an insolvency of the non-fdic-insured bank, including any possible stay on enforcement, avoidance, rejection, disaffirmance, or set-off issues. Transactions With Comfort From State Banking Regulator. Because state laws governing state-chartered non-fdic-insured banks differ, transactions structured from these banks tend to vary. If the state banking regulator in the state of incorporation of the non-fdic-insured bank is able to issue comfort along the lines of the FDIC regarding FDIC-insured banks, for example, that a first priority perfected security interest granted by the non-fdic-insured bank would be respected by the state s banking regulator, notwithstanding the bank s insolvency, and Standard & Poor s receives a non-fdic-insured bank opinion to that effect, a non-fdicinsured bank may be able to structure a transaction either as a one-tier transaction (with either a true sale from the bank to the issuing SPE or the grant of a first priority perfected security interest from the bank to the issuing SPE), or, alternatively, as a two-tier transaction (with either tier structured as a true sale or a first priority perfected security interest). If the state banking insolvency law provides for an automatic stay, the transaction may need to be structured as a true sale. Alternatively, Standard & Poor s may become comfortable with a secured loan transaction if the duration Standard & Poor s Structured Finance Student Loan Criteria 57

57 of the stay is specified by statute and the transaction includes a liquidity facility to cover the timing delay. Opinion requirements. In these cases, Standard & Poor s criteria and opinion requirements for transactions involving state-chartered non-fdic-insured banks as transferors are the same as its criteria for transactions involving FDIC-insured banks as transferors (with the non-fdic-insured bank opinion being required whenever an FDIC/D Oench opinion would have been required for FDIC-insured banks). Transactions Without Comfort From State Banking Regulator. If, on the other hand, no comfort from the appropriate state banking regulator is available, transactions from non-fdic-insured banks would be required to be structured with a true sale, either as a two-tier transaction (with the first tier consisting of a true sale to an intermediate SPE that would not be consolidated with the non-fdic-insured bank, and the second tier either as a true sale or the grant of a first priority perfected security interest), or as a one-tier transaction constituting a true sale. Opinion requirements. In these cases, Standard & Poor s criteria and opinion requirements for transactions involving state-chartered non-fdic-insured banks as transferors are the same as its criteria for transactions involving Code transferors, including its requirement for comfort regarding nonconsolidation (see Nonconsolidation below) between the non-fdic-insured bank and the intermediate SPE or the issuing SPE. Nonconsolidation. Although the doctrine of substantive consolidation is an equitable doctrine under the Bankruptcy Code and a bank is not eligible to become a debtor under the Bankruptcy Code, it would be legally possible for a state banking regulator, as the receiver or conservator for an insolvent bank, to administer jointly a substantively consolidated insolvency proceeding for the bank and another entity in which the bank holds a 50% or more equity or other interest. Based on this, if a first-tier transfer to an intermediate SPE from a non-fdic-insured bank is structured as a true sale (and the second tier is a grant of a first priority perfected security interest), the facts and circumstances of the relationship between the intermediate SPE and the bank in terms of the separateness covenants will be reviewed to determine if there is a risk of substantive consolidation of the intermediate SPE, or its assets and liabilities, with the bank. Because of the lack of legal certainty in analyzing consolidation in a bank insolvency, the structure may need to use an orphan SPE. Nonconsolidation opinion. To obtain legal comfort regarding the above, if the first-tier transfer from a non-fdic-insured bank is structured as a true sale (because the relevant bank regulator is unable to provide Standard & Poor s with comfort, as discussed above, that a grant of a first priority perfected security interest from the bank would be enforceable, notwithstanding the bank s insolvency), and Standard & Poor s determines there is a risk of consolidation of the intermediate SPE, or its assets and liabilities, with its parent (whether the bank or another entity) Standard 58

58 Legal Criteria for Student Loan Transactions & Poor s may require a nonconsolidation opinion stating that, under applicable insolvency laws, upon an insolvency of the SPE s parent, the intermediate SPE, or its assets and liabilities, would not be substantively consolidated with the SPE s parent. If, however, a transaction from a non-fdic-insured bank is structured as a true sale, and Standard & Poor s receives both (i) an alternative security interest opinion to the effect that, if a court did not consider the purported true sale transfer to be a true sale, it would be a grant of a first priority perfected security interest by the bank to the intermediate SPE or the issuing SPE and (ii) a non-fdic-insured bank opinion, Standard & Poor s generally will not require a nonconsolidation opinion. Insurance Companies Insolvency of an insurance company is generally governed by state law, administered by the insurance commissioner or superintendent of the state. Although the National Association of Insurance Commissioners has promulgated a uniform insolvency act, the act has not been enacted uniformly in all states, and it is beyond the scope of this publication to examine and differentiate state insolvency regimes for insurance companies. In addition, the act leaves broad discretion to state commissioners in the conduct of insolvency proceedings. The principles of securitization discussed throughout this publication and Standard & Poor s criteria regarding other types of transferors, however, can be used to derive, in general, Standard & Poor s criteria for structured transactions from insurance companies; that is, the assets should be sufficiently separated that, as a legal matter, in an insolvency of the insurance company they are available in a timely manner to pay principal and interest on the rated securities. Standard & Poor s will generally require comfort, including legal opinions, regarding the treatment of the asset transfer in an insolvency of the insurance company, including any possible stay on enforcement, avoidance, rejection, disaffirmance or set-off issues. Transactions With Comfort From State Insurance Commissioner or Superintendent. Because state laws governing insurance companies differ, transactions structured from insurance companies tend to vary. If the state insurance commissioner or superintendent in the state of incorporation of the insurance company is able to issue comfort along the lines of the FDIC regarding FDIC-insured banks, for example, that a first priority perfected security interest granted by the insurance company would be respected by the state s insurance commissioner or superintendent, notwithstanding the insurance company s insolvency, and Standard & Poor s receives an insurance law opinion to that effect, an insurance company may be able to structure a transaction either as a one-tier transaction (with either a true sale from the insurance company to the issuing SPE or the grant of a first priority perfected security interest from the insurance company to the issuing SPE), or, alternatively, as Standard & Poor s Structured Finance Student Loan Criteria 59

59 a two-tier transaction (with either tier structured as a true sale or a first priority perfected security interest). Opinion requirements. In these cases, Standard & Poor s criteria and opinion requirements for transactions involving insurance companies as transferors are the same as its criteria for transactions involving FDIC-insured banks as transferors (with the insurance law opinion being required whenever an FDIC/D Oench opinion would have been required for FDIC-insured banks). Transactions Without Comfort From State Insurance Commissioner or Superintendent. If, on the other hand, no comfort from the appropriate state insurance commissioner or superintendent is available, transactions from insurance companies would be required to be structured with a true sale, either as a two-tier transaction (with the first tier consisting of a true sale to an intermediate SPE that would not be consolidated with the insurance company, and the second tier either as a true sale or the grant of a first priority perfected security interest), or as a one-tier transaction constituting a true sale. Opinion requirements. In these cases, Standard & Poor s criteria and opinion requirements for transactions involving insurance companies as transferors are the same as its criteria for transactions involving Code transferors, including its requirement for comfort regarding nonconsolidation (see Nonconsolidation below) between the insurance company and the intermediate SPE or the issuing SPE. Nonconsolidation. Although the doctrine of substantive consolidation is an equitable doctrine under the Bankruptcy Code and an insurance company is not eligible to become a debtor under the Bankruptcy Code, it would be legally possible for a state insurance commissioner or superintendent, as the receiver or conservator for an insolvent insurance company, to administer jointly a substantively consolidated insolvency proceeding for the insurance company and another entity in which the insurance company holds an equity or other interest. Based on this, if a first-tier transfer to an intermediate SPE from an insurance company is structured as a true sale (and the second tier is a grant of a first priority perfected security interest), the facts and circumstances of the relationship between the intermediate SPE and the insurance company in terms of the separateness covenants will be used to determine if there is a risk of substantive consolidation of the intermediate SPE, or its assets and liabilities, with the insurance company. Because of the lack of legal certainty in analyzing consolidation in an insurance company insolvency, the structure may need to use an orphan SPE. Nonconsolidation opinion. To obtain legal comfort regarding the above, if the first-tier transfer from an insurance company is structured as a true sale (because the relevant insurance commissioner or superintendent is unable to provide Standard & Poor s with comfort, as discussed above, that a grant of a first priority perfected security interest from the insurance company would be enforceable, notwithstanding 60

60 Legal Criteria for Student Loan Transactions the insurance company s insolvency), and Standard & Poor s determines there is a risk of consolidation of the intermediate SPE, or its assets and liabilities, with its parent (whether the insurance company or another entity), Standard & Poor s may require a nonconsolidation opinion stating that, under applicable insolvency laws, upon an insolvency of the SPE s parent, the intermediate SPE, or its assets and liabilities, would not be substantively consolidated with the SPE s parent. If, however, a transaction from an insurance company is structured as a true sale, and Standard & Poor s receives both (i) an alternative security interest opinion to the effect that, if a court did not consider the purported true sale transfer to be a true sale, it would be a grant of a first priority perfected security interest by the insurance company to the intermediate SPE or the issuing SPE and (ii) an insurance law opinion, Standard & Poor s generally will not require a nonconsolidation opinion. Special-Purpose Entities General Standard & Poor s legal criteria for securitization transactions are designed to ensure that the entity owning the assets required to make payments on the rated securities is bankruptcy remote; that is, the entity is unlikely to be subject to voluntary or involuntary insolvency proceedings. In this regard, both the incentives of this entity, known as a special-purpose entity or an SPE, or its equity holders to resort to voluntary insolvency proceedings and the incentives for other creditors of the SPE to resort to involuntary proceedings are considered. The analysis also examines whether third-party creditors of the SPE s parent would have an incentive to reach the assets of the SPE (for example, if the SPE is a trust, whether creditors of the beneficial holder would have an incentive to cause the dissolution of the trust to reach the assets of the trust.) The Characteristics of Bankruptcy Remoteness In this regard, Standard & Poor s has developed the following SPE criteria, which an entity should satisfy to be deemed bankruptcy remote. An entity that satisfies these criteria is regarded by Standard & Poor s as being sufficiently protected against both voluntary and involuntary insolvency risks: Restrictions on objects and powers, Debt limitations, Independent director, No merger or reorganization, Separateness, and Security interests over assets. Standard & Poor s Structured Finance Student Loan Criteria 61

61 Each of these characteristics is important to the overall concept of bankruptcy remoteness and, regardless of the specific organizational structure of the SPE, these elements should, generally, be treated in the relevant organizational documents. Their rationale is briefly explained below, while the precise terms of these criteria are found in the following section. Restriction on Objects and Powers The fundamental SPE characteristic is that the entity s objects and powers be restricted as closely as possible to the bare activities necessary to effect the structured transaction. The purpose of this restriction is to reduce the SPE s internal risk of insolvency due to claims created by activities unrelated to the securitized assets and the issuance of the rated securities. In structured transactions, Standard & Poor s generally requests that the SPE embed in its organic document of establishment (articles/certificate of incorporation for corporations, deed of partnership/partnership agreement for limited partnerships, articles of organization for limited liability companies (LLCs) or deed of trust/trust agreement for trusts, etc.) an objects clause that constrains the SPE to those activities needed to ensure the sufficiency of cash flow to pay the rated securities and powers incidental to this purpose. The organic documents are the preferred locus for this constraint (as well as the other SPE restrictions discussed below) for two reasons. First, these documents are publicly available and provide some measure of public notice of the restriction, rather than merely notice to the parties to a particular transaction. Second, an organic restriction is less likely to become lost in the corporate files and more likely to remind the management of the SPE to act in accordance with its charter. Standard & Poor s generally requests that, where possible, this limited objects clause, as well as the other SPE criteria, be reiterated in appropriate transaction documents. In brief, the SPE should not engage in unrelated business activities unless the parties to a transaction are willing to allow the rating to reflect the effect of these activities on the entity s resources, cash flows, and the ability to pay the entity s obligations in a full and timely manner. Debt Limitations An SPE should be restricted from issuing other debt except in circumstances that are consistent with the rated issuance. For example, an SPE may issue multiple classes of debt as long as the classes all have the same issue credit rating and, if any class rating is downgraded, the rating of the other classes will be downgraded (or the SPE complies with Standard & Poor s segregation of assets criteria). In some cases, the SPE may be able to issue subordinated nonrecourse debt that is related to the rated issuance. Because creditors can file involuntary petitions against an entity, determining whether 62

62 Legal Criteria for Student Loan Transactions an entity is bankruptcy remote (thus an SPE) involves analyzing the likely creditors of the SPE and their incentives to reach the assets supporting the rated securities. The thrust of additional debt criteria is to ensure that a holder of additional indebtedness would be unable to affect the creditworthiness of the SPE and would be unable or unwilling to file the SPE (because there is no recourse to the SPE and the holder is subordinated to the rated securities), or, alternatively, the risk to the SPE would be no greater than that posed by the original issue (because the additional debt is rated at least as high). In this regard, Standard & Poor s looks for nonpetition language in any agreement between the SPE and its creditors whereby the creditors agree not to file the SPE into bankruptcy and not to join in any bankruptcy filing. The Independent Director An SPE acts through its board of directors, general partner, management committee or managing member. For example, corporate activity is conducted at the direction and under the supervision of the board, although day-to-day management of the corporation is generally delegated by the board to the corporation s officers. The directors are elected by the shareholders, the corporation s owners. Among the major decisions taken by the board of directors is the decision to file the corporation into bankruptcy, and it is this concern that prompts Standard & Poor s to request the independent director. In many structured transactions, the SPE is established by a non-spe operating entity parent. This parent is, at times, either unrated or has an issuer credit rating below its SPE subsidiary. Moreover, the directors of the parent may well serve as the directors for the SPE. These interlocking directorates present a potential conflict of interest. If the parent becomes insolvent in a situation where the SPE is performing adequately, there may be an incentive for the parent entity to voluntarily file the SPE into bankruptcy and consolidate its assets with those of the parent. If the SPE has at least one director who is independent from the parent and this director s vote is required in any board action seeking bankruptcy protection for the SPE or the amendment of the organic documents of the SPE, the SPE is unlikely to voluntarily file an insolvency petition. Standard & Poor s requests that, where possible, the organic documents of the SPE recite that, in voting on bankruptcy matters, the independent director take into account the interests of the holders of the rated securities, as well as those of the stockholders. This approach is designed to provide additional protection against the SPE being filed into bankruptcy. In cases where an SPE is a limited partnership or an LLC, Standard & Poor s requests that a general partner or a member be constituted as an SPE, usually a corporation, with an independent director. Standard & Poor s Structured Finance Student Loan Criteria 63

63 No Merger or Reorganization This requirement ensures that, while the rated securities are outstanding, the bankruptcy-remote status of the SPE will not be undermined by any merger or consolidation with a non-spe or any reorganization, dissolution, liquidation, or asset sale. Standard & Poor s generally also requests that the SPE not amend its organizational documents without prior written notice to Standard & Poor s. Separateness Covenants Separateness covenants are designed to ensure that the SPE holds itself out to the world as an independent entity, on the theory that if the entity does not act as if it had an independent existence, a court may use principles of piercing the corporate veil, alter ego, or substantive consolidation to bring the SPE and its assets into the parent s bankruptcy proceeding. The involvement of an overreaching parent is a threat to the independent existence of the SPE. Piercing the corporate veil is the remedy exercised by a court when a controlling entity, such as the parent of an SPE, so disregards the separate identity of the SPE that their enterprises are seen as effectively commingled. The remedy is sought by creditors with claims against an insolvent parent who believe funds can be properly traced into the subsidiary. The alter ego theory is used when the subsidiary is a mere shell and all its activities are in fact conducted by the parent. Substantive consolidation is an equitable doctrine under the Bankruptcy Code that combines elements of both piercing the corporate veil and alter ego analyses. Successful motions for consolidation are based on this overly familiar relationship between parent and the subsidiary or partner and partnership. An important element of the SPE analysis is the comfort that the SPE entity would not be consolidated with its parent. In this regard, the entity should observe certain separateness covenants, set forth in the following section. In addition, Standard & Poor s generally requests legal opinions to the effect that the SPE would not be consolidated with its parent. Security Interests Over Assets There is a requirement that in the case of the issuance of debt securities the issuing SPE grant a security interest over its assets to the holders of the rated securities. In connection with this grant, Standard & Poor s generally also requires a debt security interest opinion. This element helps Standard & Poor s in reaching the analytic conclusion that an issuer is in fact an SPE by reducing the incentives of the parent to involuntarily file the entity. By reducing the practical benefit of an insolvency filing, the likelihood of voluntary insolvency is decreased. 64

64 Legal Criteria for Student Loan Transactions SPE Criteria General SPE Criteria Based on the principles discussed above, Standard & Poor s has developed criteria to help it conclude that an entity is an SPE: 1. The entity should not engage in any business or activity other than those necessary for its role in the transaction. 2. The entity (and, as applicable, its partners, members and affiliates) should not engage in any dissolution, liquidation, consolidation, merger or asset sale, or amendment of its organizational documents as long as the rated securities are outstanding, unless Standard & Poor s provides written confirmation of any outstanding ratings. 3. The entity should not incur any debt (other than indebtedness that secures the rated securities) unless (a) the additional debt is rated by Standard & Poor s at least as high as the issue credit rating requested for the rated securities in a given structured transaction, (b) all of the entity s debt meets Standard & Poor s segregation of assets criteria, or (c) the additional debt: Is fully subordinated to the rated securities, Is nonrecourse to the entity or any of its assets other than cash flow in excess of amounts necessary to pay holders of the rated securities, and Does not constitute a claim against the entity to the extent that funds are insufficient to pay such additional debt. 4. The entity should be qualified to do business under the applicable law in the state in which any assets are located. 5. The entity (and, as applicable, the entity s partners, members, and affiliates) should agree to abide by the following separateness covenants: To maintain books and records separate from any other person or entity; To maintain its accounts separate from those of any other person or entity; Not to commingle assets with those of any other entity; To conduct its own business in its own name; To maintain separate financial statements; To pay its own liabilities out of its own funds; To observe all corporate, partnership, or LLC formalities and other formalities required by the organic documents; To maintain an arm s-length relationship with its affiliates; To pay the salaries of its own employees and maintain a sufficient number of employees in light of its contemplated business operations; Not to guarantee or become obligated for the debts of any other entity or hold out its credit as being available to satisfy the obligations of others; Not to acquire obligations or securities of its partners, members, or shareholders; Standard & Poor s Structured Finance Student Loan Criteria 65

65 To allocate fairly and reasonably any overhead for shared office space; To use separate stationery, invoices, and checks; Not to pledge its assets for the benefit of any other entity or make any loans or advances to any entity; To hold itself out as a separate entity; To correct any known misunderstanding regarding its separate identity; and To maintain adequate capital in light of its contemplated business operations. SPE Corporations In addition to the general SPE criteria set forth above, an SPE corporation should conform to the following additional criteria: The corporation should have at least one independent director. The unanimous consent of the directors, including that of the independent director(s), should be required to: (i) file, consent to the filing of, or join in any filing of, a bankruptcy or insolvency petition or otherwise institute insolvency proceedings; (ii) dissolve, liquidate, consolidate, merge, or sell all or substantially all of the assets of the corporation; (iii) engage in any other business activity; and (iv) amend the articles of incorporation of the corporation. The directors should be required to consider the interests of the corporation s creditors when making decisions. Standard & Poor s generally requests nonconsolidation opinion(s). SPE Limited Partnerships In addition to the general SPE criteria set forth above, an SPE limited partnership should conform to the following additional criteria: At least one general partner of a limited partnership should be a bankruptcyremote entity, usually an SPE corporation. The consent of the bankruptcy-remote general partner should be required to: (i) file, consent to the filing of, or join in any filing of, a bankruptcy or insolvency petition, or otherwise institute insolvency proceedings; (ii) dissolve, liquidate, consolidate, merge, or sell all or substantially all of the assets of the partnership; (iii) engage in any other business activity; and (iv) amend the limited partnership agreement. If there is more than one general partner, the limited partnership agreement should provide that the partnership will continue (and not dissolve) as long as another solvent general partner exists. The general partner(s) should be required to consider the interests of the partnership s creditors when making decisions. Standard & Poor s generally requests nonconsolidation opinion(s). 66

66 Legal Criteria for Student Loan Transactions SPE General Partners An SPE general partner should meet all criteria set forth for SPE corporations, SPE limited partnerships or SPE LLCs depending on whether the general partner is a corporation, a limited partnership or an LLC. SPE LLCs In addition to the general SPE criteria set forth above, an SPE LLC should conform to the following additional criteria: At least one member of an LLC should be a bankruptcy-remote entity, usually an SPE. Generally, only the bankruptcy-remote member should be designated as the manager by the law under which the LLC is organized, and the LLC s articles of organization should provide that it will dissolve only on the bankruptcy of a managing member. The unanimous consent of the members, including the vote of the independent director of the bankruptcy-remote member, should be required to: (i) file, consent to the filing of, or join in any filing of, a bankruptcy or insolvency petition or otherwise institute insolvency proceedings; (ii) dissolve, liquidate, consolidate, merge, or sell all or substantially all of the assets of the LLC; (iii) engage in any other business activity; and (iv) amend the LLC s organizational documents. The member(s) should be required to consider the interests of the entity s creditors when making decisions. To the extent permitted by tax law, the articles of organization should provide that, upon the insolvency of a member, the vote of a majority-in-interest of the remaining members is sufficient to continue the life of the LLC. If the required consent of the remaining members to continue the LLC is not obtained, its articles of organization must provide that the LLC not liquidate collateral (except as provided under the transaction documents) without the consent of the holders of rated securities. Such holders may continue to exercise all of their rights under the existing security agreements or mortgages and must be able to retain the assets until the rated securities have been paid in full or otherwise completely discharged. Standard & Poor s generally requests nonconsolidation opinions. In addition, Standard & Poor s generally requests a tax opinion to the effect that the LLC will be taxed as a partnership and not as a corporation. In connection with single-member LLCs, Standard & Poor s criteria, at the time of publication, are still in the developing stage. Therefore, transferors intending to use a single-member LLC in a structured transaction are encouraged to check with Standard & Poor s regarding its single-member LLC criteria, including its opinion requirements. Standard & Poor s Structured Finance Student Loan Criteria 67

67 SPE Trusts Based on an analysis of Sections 101 and 109 of the Bankruptcy Code, only a trust that is determined to be a business trust under the Bankruptcy Code is eligible to become a debtor under the Bankruptcy Code. Thus, if the entity holding assets in a structured transaction is not a business trust for Bankruptcy Code purposes, Standard & Poor s generally will not be concerned with the entity s ability to make payments on the rated securities as a consequence of the entity s insolvency. In such a case, Standard & Poor s SPE criteria for bankruptcy remoteness would be inapplicable. The term business trust, however, is not defined in the Bankruptcy Code. Rather, whether a particular trust will be determined to be a business trust for bankruptcy law purposes depends upon a very fact-specific analysis of the trust, focusing on factors such as the purposes, organization, and activities of the trust and whether the trust is a business trust under applicable state law or under the IRC. In the absence of settled legal standards, Standard & Poor s legal review assumes, as a general matter, that any trust, whether the trust is a state common law trust, a statutory business trust, or an owner trust, is eligible to become a debtor under the Bankruptcy Code. Therefore, to conclude that a trust is bankruptcy remote, the trust should meet Standard & Poor s SPE criteria, including in the appropriate cases, nonconsolidation opinions. In addition, in the case of state common law trusts, Standard & Poor s generally requires that the trust agreement provide that the bankruptcy of one or more of the beneficiaries of the trust will not result in the dissolution of the trust. In some cases, Standard & Poor s may also ask for comfort that a trust will not be subject to early termination. In this regard, Standard & Poor s may request a trust opinion to the effect that, under the law of the relevant state, the trust is irrevocable and that, under such state s law, no creditor of a beneficiary would have the right to terminate the trust and reach the assets and that no receiver, liquidator, or bankruptcy trustee would have any rights to the trust s assets greater than the rights of the beneficiaries of the trust. Collateral-Specific Criteria Student loans are originated in accordance with various programs, both public and private. The majority of student loans securitized consist of FFELP Loans, that is, those made under the Federal Family Education Loan Program (FFELP) in accordance with the Higher Education Act of 1965 (HEA). Under FFELP, if a student obligor defaults on a student loan, the holder of the loan (which must be an eligible lender under FFELP) may file a claim with the applicable guarantee agency. 68

68 Legal Criteria for Student Loan Transactions Provided that the loan has been properly originated and serviced, the guarantee agency pays the holder all or a portion of the unpaid principal balance on the loan as well as accrued interest. Origination and servicing requirements are established by the U.S. Department of Education (DOE). A guarantee agency is entitled, subject to certain conditions, to be reimbursed by the DOE for all or a portion of the payments made to the holder of the defaulted student loan. In addition, the holder of FFELP loans is entitled to receive certain special allowance payments and interest subsidy payments with respect to some FFELP loans. Alternative loans are originated under various programs established by banks, insurance companies, and other nongovernmental entities. Alternative loans do not have the benefit of any guarantee or reinsurance from the DOE. As stated above, as a general matter, Standard & Poor s requires that all necessary steps be taken to perfect any sale of, or grant of a security interest in, assets being securitized. In structured student loan transactions, the assets backing the rated securities include the promissory notes evidencing the debt, and any related assets, including any guarantee payments, special allowance payments, and interest subsidy payments (in connection with FFELP loans). In the case of FFELP loans, Section (d)(3) of the HEA provides that, notwithstanding the provisions of any state law to the contrary (including the UCC as in effect in any state), perfection of a security interest in FFELP loans may be accomplished either by possession or in the manner provided by state law for perfection of security interests in accounts. In general, as accounts, the grant of a security interest in, and the sale of, the student loan receivables can be perfected against the transferor by the filing of UCC financing statements. Based on this, in connection with FFELP loans, filings should be made in the appropriate states to perfect each sale of, or security interest in, the student loan receivables and any guarantee payments, special allowance payments, and interest subsidy payments being securitized. The servicer (which may be the transferor) generally retains possession of the promissory notes as custodian in order to perform the necessary servicing functions. The filing of the UCC financing statements gives notice to third parties of the issuing SPE s or indenture trustee/custodian s rights in the student loans and that the assets are being held by the servicer solely as servicer for the issuing SPE or indenture trustee/custodian, as applicable. In addition, a segregrated collection account also ensures that payments made by the borrowers are not commingled with other servicer funds. In the case of alternative loans, Standard & Poor s typically requests a characterization opinion (which may be from in-house counsel) stating how the receivables would be characterized under applicable state law and setting forth the state s requirements for perfecting a sale of, or grant of a security interest in, the alternative loans. Standard & Poor s generally requires that appropriate steps be taken under Standard & Poor s Structured Finance Student Loan Criteria 69

69 state law to perfect any sale of, or grant of a security interest in, alternative loans being securitized. In the case of FFELP loans, because the holder of a FFELP loan must be an eligible lender for the holder to benefit from the guarantee, special allowance, interest subsidy, and any other payments under FFELP, Standard & Poor s generally requires an eligible lender opinion. This opinion should state that the entity holding the FFELP loans satisfies FFELP criteria for eligibility. Criteria Relating to Various Forms of Credit Enhancement Credit enhancements can take many forms in structured finance, most of which trigger the application of specific criteria. Cash collateral accounts (CCA), collateral investment amounts (CIA), and reserve accounts are frequent choices for enhancement in structured transactions. A CCA or a CIA is typically provided for in a loan agreement among the provider, the issuing SPE, the intermediate SPE, and the original transferor into the securitization structure. Standard & Poor s looks for non-petition language in the loan agreement, whereby the provider agrees not to file any intermediate SPE and the issuing SPE into bankruptcy and not to join in any bankruptcy filing, and for clear language as to the subordinated position of the provider. Standard & Poor s may require an enforceability opinion that the loan agreement is the legal, valid and binding obligation of the provider, enforceable in accordance with its terms. To the extent the provider is a U.S. branch or division of a non-u.s. institution, Standard & Poor s will generally require a home country enforceability opinion under the law of the country where the non-u.s. institution s head office is located, addressing the enforceability of the obligation against the non-u.s. institution, among other matters. To the extent that a transaction relies on funds invested under an investment agreement with a rated entity, Standard & Poor s may require the opinions described above in connection with the use of a CCA or CIA. The investment agreement should not contain any provisions that would relieve the institution from its obligation to pay. In both cases, the issuer credit rating of the provider must be consistent with the issue credit rating of the transaction. If credit enhancement takes the form of a reserve fund or account, the transfers of funds deposited in the account will be subject to review. To the extent that monies other than the proceeds of the rated securities are used to fund the account, Standard & Poor s may require a preference opinion to the effect that the funds transferred and the related payments to the holders of the securities would not be recoverable as a preference under Section 547(b) of the Bankruptcy Code. Standard & Poor s may also require a fraudulent conveyance opinion to the effect that the funds transferred and related payments would not be deemed a fraudulent conveyance under state and 70

70 Legal Criteria for Student Loan Transactions federal laws. In addition, if the reserve account is kept in the name of a party other than the issuing SPE or indenture trustee/custodian, as applicable, Standard & Poor s generally requires that the owner of the reserve account grant a first priority perfected securitiy interest in the account to the issuing SPE and deliver a security, either/or, and debt security interest opinion, as applicable. Moreover, all credit enhancement funds must be held in accordance with Standard & Poor s criteria for eligible deposit accounts. Criteria Related to Retention of Subordinated Interests by Transferor in a True Sale In certain circumstances, Standard & Poor s is unwilling to rely on the characterization of a transaction as a true sale even though the parties to the transaction are comfortable that they have achieved a true sale and counsel is willing to deliver a true sale opinion as required by Standard & Poor s criteria. For example, Standard & Poor s will generally not rely on true sale opinions if the transferor takes back a subordinated interest in assets that, in Standard & Poor s opinion, do not have an adequate capacity to pay principal and interest on the subordinated interest. This subordinated interest may be in the form of a deferred purchase price, subordinated note, or subordinated certificates. Similarly, Standard & Poor s generally will not rely on true sale opinions if the transferor guarantees payments significantly higher than reflected by the level of historical losses on the assets being sold. Standard & Poor s believes that, although these transactions may actually be true sales, they have a higher likelihood of being recharacterized as secured loan transactions. In structured transactions in which the securities issued are rated AAA, the assets should be able to withstand severe economic stress scenarios. Thus, the value of the assets purchased will be in excess of the amount of rated securities issued. On the other hand, to avoid fraudulent conveyance concerns, the purchase price should reflect the fair market value of the assets. The balance required to pay the purchase price may be contributed as capital to the SPE. Alternatively, the SPE, regardless of whether it is a subsidiary of the transferor, may use a subordinated promissory note to cover the balance of the purchase price of the assets. The subordinated note permits the deferral of the payment of a portion of the purchase price until the SPE has funds available for the payment. Payment is usually made in accordance with a schedule based upon anticipated cash flow on the assets. In other instances, a transferor may retain a subordinated interest in a senior/subordinated transaction characterized by the subordination of certain certificates to serve as credit support for the senior certificates. (More complex transactions involve multiple levels of subordination and also may be structured to contain reserve funds and/or insurance policies to provide credit support for certain enhanced classes of Standard & Poor s Structured Finance Student Loan Criteria 71

71 subordinated certificates.) In these instances, the SPE usually sells the senior certificates and the enhanced subordinated certificates either to the public through an underwriter or through a private placement offering and transfers the unenhanced subordinated certificates to the transferor as partial consideration for the sale of the assets. When a transferor takes back either a subordinated note or subordinated certificates (either in partial payment for the assets that are sold or otherwise) or guarantees payment on the sold assets, the sale from the transferor to the intermediate SPE (or directly to the issuing SPE) can be undermined. The transferor could arguably be said not to have fully divested itself of all rights to the assets (one of the legal tests of ownership) by holding the subordinated note or subordinated certificates or by guaranteeing payment on the assets. A court could view and recharacterize the transfer of assets and the holding of the subordinated note or subordinated certificates or the making of the guarantee as a financing by the transferor (secured by a pledge of or lien on the assets), rather than a true sale of such assets. Standard & Poor s is concerned that the use of a subordinated note or retention by the transferor of subordinated certificates (or the provision of a guarantee) may be viewed as recourse retained by the transferor, that is, that the transferor has not transferred all of the risks and benefits of owning the assets because, to be repaid, the transferor is dependent on the performance of the assets. Accordingly, Standard & Poor s will evaluate the likelihood of repayment of the subordinated note or payment of the retained subordinated certificates (or the likelihood of the need for the guarantee) in adequately stressed economic conditions to get comfort that no recourse was retained by the transferor. Generally, Standard & Poor s requires that the subordinated note or retained subordinated certificates be shadow rated on a pool default analysis, that is, without regard to possible dilutions in the pool, at an investment-grade level. In the case of a retained subordinated note, Standard & Poor s analysis typically focuses on, among other things, the amount of equity that is contributed to the SPE and is available for payment of the subordinated note. This requirement offers Standard & Poor s additional comfort that the risks and benefits analysis (because of the likely repayment of the subordinated note or payment of the retained subordinated certificates) would result in the transaction being deemed a sale. In many cases, the transaction can be structured in a manner acceptable to Standard & Poor s or the transaction can be analyzed under a blended rating approach (relying in part on the issuer credit rating of the parent). In some situations, the transferor may hold the subordinated note or subordinated certificates if they represent only a small portion of the assets or if the retained subordinated certificates constitute a strip or noneconomic residual. Alternatively, the transferor may retain subordinated certificates if it represents that it intends to resell the retained subordi- 72

72 Legal Criteria for Student Loan Transactions nated certificates. If the transferor retains all of the securities issued in a structured transaction, Standard & Poor s generally requires the true sale opinion to state that when the securities are sold to a third party, the transfer of assets by the transferor will be deemed a true sale, except for any portion remaining with the transferor. In other cases, an affiliate (either a wholly owned subsidiary or a sister company of the transferor) may hold the subordinated certificates or subordinated note. The affiliate may or may not be an SPE. If the affiliate is newly created solely for the purpose of holding the subordinated certificates or subordinated note, there is an increased concern that the affiliate is really the transferor. In such circumstances, in addition to the opinions otherwise required by the transaction structure, Standard & Poor s will generally request a nonconsolidation opinion to the effect that the affiliated entity holding the subordinated certificates or subordinated note would not be consolidated with the transferor in the event of the latter s bankruptcy. Swap Opinion Criteria Structured finance transactions frequently include swap agreements that transform the cash flow characteristics of an issuing SPE s assets into payment terms desired by investors in the rated securities. For example, interest payments on a specified principal amount of the issuing SPE s assets may be calculated based on a fixed rate and denominated in a non-u.s. currency. Investors in the rated securities may be willing to accept the credit risk of the asset but desire payments calculated based on a margin above a specified index and denominated in U.S. currency. In this event, the issuing SPE would enter into an agreement with a swap counterparty providing that the fixed rate, non-u.s. currency payments that the issuing SPE receives on the assets will be paid to the swap counterparty in return for the swap counterparty s floatingrate payments to the issuing SPE in U.S. currency. The issuing SPE will make its payments on the rated securities from the payments received from the swap counterparty. In this example, Standard & Poor s issue credit rating would depend on the issuer credit rating of the swap counterparty and on the issue credit rating of the issuing SPE s assets. If the swap counterparty does not have an issuer credit rating or has an issuer credit rating that is lower than the issue credit rating sought for the transaction, its obligations must be guaranteed by an affiliate or another entity of sufficient credit quality to attain the desired rating. In transactions where the issue credit rating is dependent on a swap agreement and guarantee, if any, Standard & Poor s generally requests the following legal opinions for the swap counterparty and guarantor, as applicable, under the law of the jurisdiction of organization of the relevant entity and under the governing law of the swap agreement and guarantee, as applicable: Standard & Poor s Structured Finance Student Loan Criteria 73

73 An enforceability opinion in connection with the swap agreement and guarantee against the swap counterparty and the guarantor, as applicable, according to their respective terms; A pari passu opinion stating that payments due under the swap agreement and the guarantee, as applicable, rank at least pari passu with the unsecured and unsubordinated obligations of the swap counterparty and the guarantor, as the case may be; A choice of law opinion stating that local courts in the jurisdictions of the swap counterparty and the guarantor, as applicable, would recognize the choice of law in the swap agreement and the guarantee, as the case may be, and the choice of law is prima facie valid and binding under such local law; A recognition of claim opinion stating that local courts in the jurisdictions of the swap counterparty and the guarantor, as applicable, would recognize and enforce as a valid judgment any final and conclusive civil judgment of a court of competent jurisdiction for monetary claims made under the swap agreement and the guarantee, as the case may be; If payments to the holders of the rated securities may be affected by the subsequent imposition of taxes on payments made by the swap counterparty or the guarantor under the swap agreement or guarantee, as the case may be, a swap counterparty/ guarantor tax opinion stating that, under current law, no such tax applies and that there is no pending legislation to create such a tax; and If payments to the holders of the rated securities may be affected by the subsequent imposition of taxes on payments made by the issuing SPE under the swap agreement, an issuing SPE swap tax opinion confirming that under current law no such tax applies and that there is no pending legislation to create such a tax. Standard & Poor s may waive the enforceability opinion described above for swap counterparties and guarantors if Standard & Poor s previously has received similar opinions under the same governing law in similar transactions. Interim Criteria for the Tenth Circuit Court of Appeals Eliminated Based upon the decision of the Tenth Circuit Court of Appeals in Octagon Gas System Inc. v. Rimmer, 1993 U.S. App. Lexis (Tenth Cir. May 27, 1993) in June 1993, Standard & Poor s adopted certain criteria for transactions involving the sales of receivables by originators that have a principal place of business in the Tenth Circuit. The Octagon decision, contrary to existing authority, suggests that in a bankruptcy of a seller of accounts or chattel paper, the sold accounts or chattel paper would be considered part of the seller s property. The interim criteria imposed an AA ceiling on transactions originated by Tenth Circuit Code transferors and 74

74 Legal Criteria for Student Loan Transactions required an amortization trigger if the entity s issuer credit rating fell below investment grade. Standard & Poor s believes that two developments have reduced significantly the likelihood that a Tenth Circuit Court would follow the Octagon decision. These developments are the rejection of the Octagon court s interpretation of Article 9 of the UCC by the Permanent Editorial Board for the UCC in PEB Commentary No. 14 (June 1994) and the amendment of the Oklahoma UCC (April 1996) to provide that Article 9 does not prevent the transfer of ownership of accounts or chattel paper and that the determination of whether a particular transfer of accounts or chattel paper constitutes a sale or a transfer for security purposes is not governed by Article 9. As a result, Standard & Poor s has eliminated the interim criteria adopted in June 1993 for transactions originated in the Tenth Circuit. Standard & Poor s rates these transactions under its usual criteria. Standard & Poor s recognizes that, as a matter of law, the Octagon decision has not been overruled in the rest of the Tenth Circuit and will, therefore, accept opinions of counsel that include a discussion of Octagon as long as counsel also opines that Octagon was wrongly decided. Criteria: Trustee, Servicer, Custodian, Eligible Deposit Accounts, and Eligible Investments Criteria Related to the Trustee and Affiliated Trustee The indenture trustee/custodian in a structured transaction is primarily responsible for receiving payments from servicers, guarantors, and other third parties and remitting these receipts to investors in the rated securities in accordance with the terms of the indenture, in addition to its monitoring, custodial, and administrative functions. To ensure that the indenture trustee/custodian performs these functions and preserves investor rights, Standard & Poor s generally requires that the following criteria be met: The indenture trustee/custodian should hold dedicated assets in funds and accounts designated for a particular transaction. The funds and accounts should be held, in trust, for the benefit of investors in the rated securities. Such funds should be held in the indenture trustee/custodian bank s trust department unless such bank has the required rating. The funds should not be commingled with other funds of the indenture trustee/custodian. The indenture trustee/custodian cannot resign without the appointment of a qualified successor. Standard & Poor s Structured Finance Student Loan Criteria 75

75 If the servicer resigns or is removed, the indenture trustee/custodian should be willing and able to assume the responsibility for interim servicing. The presence of trust funds and accounts protects the transaction against the indenture trustee/custodian s insolvency. Funds held in trust for the benefit of investors in the rated securities cannot be enjoined with an insolvent indenture trustee/custodian s estate. Affiliated Trustees As a general matter, in a structured transaction, Standard & Poor s derives comfort from the independence of the trustee from any transferor of assets into the securitization structure. In this regard, Standard & Poor s has several concerns. First, if an affiliate of any transferor serves as trustee, the true sale of assets from the transferor might be negated. Second, according to the commentary to Section of the UCC, for certain types of collateral, possession of the collateral by an agent of the secured party is sufficient to perfect a security interest in the collateral. The section states, however, that the debtor or a person controlled by [the debtor] cannot qualify as such an agent for the secured party. Thus, Standard & Poor s is concerned that if an affiliate of a transferor serves as trustee, the trustee might be deemed to be controlled by the transferor and the trustee s security interest in the assets might not be perfected. Consequently, Standard & Poor s typically will permit an affiliate of a transferor to serve as trustee, only if the following conditions are met: (i) the affiliated trustee is an entity that is in the business of functioning in the trustee capacity for other parties; (ii) if the transfer of assets to the issuing SPE is a true sale, the true sale opinion delivered in connection with the transfer (a) should cite the affiliated relationship between the transferor and the trustee and (b) give an opinion to the effect that the trustee is holding the assets on behalf of the holders of the rated securities and that, by delivering the assets to the trustee, there has been a valid true sale of the assets by the transferor to the issuing SPE; and (iii) the security interest opinion delivered in connection with the trustee s first priority perfected security interest in the assets on behalf of the holders of the rated securities includes the opinion that the trustee would not be deemed to be controlled by the affiliated transferor in accordance with Section of the UCC. In some circumstances, Standard & Poor s may require that the trustee be replaced by an unaffiliated trustee based on a downgrading of the trustee or its affiliated parent/ transferor. Criteria Related to the Servicer In a structured transaction, the servicer agrees to service and administer assets in accordance with its customary practices and guidelines and has full power and authority to make payments to and withdrawals from deposit accounts that are governed by the documents. 76

76 Legal Criteria for Student Loan Transactions The servicer s fee should cover its servicing and collection expenses and be in line with industry norms for securities of similar quality. If the fee is considered below industry averages, an increase may be built into the transaction. The increase might be needed to entice a substitute servicer to step in and service the portfolio. If the servicing fee is calculated based on a certain dollar amount per contract, the fee will increase as a percentage of assets due to amortization of the pool. This is an important consideration when assessing available excess spread to cover losses and fund any reserve account. Independent accounting reports should be provided at least annually. The reports should state whether the servicer is in compliance with the transaction documents and whether its policies and procedures were sufficient to prevent errors. Exceptions, if any, should be listed. To ensure continuity, the transaction documents should provide that a servicer is not allowed to resign unless it is no longer able to service under law or finds a successor. No resignation should become effective until a successor or the trustee, as successor, has assumed the servicer s responsibilities. The trustee generally has the power to replace the servicer if the servicer is not performing its servicing functions adequately. Commingling The filing of a bankruptcy petition would place a stay on all funds held in a servicer s own accounts. As a result, receipt of these funds to make payments on the rated securities would be delayed. In addition, funds commingled with those of the servicer would be unavailable to the structured transaction. As a general matter, Standard & Poor s addresses this commingling risk by looking both to the rating of the servicer and the amount of funds likely to be held in a servicer account at any given time. Criteria Related to the Custodian and Affiliated Custodians As a general matter, in a structured transaction, Standard & Poor s derives comfort from the independence of a custodian from any transferor of assets into the securitization structure. In this regard, Standard & Poor s has several concerns. First, if an affiliate of any transferor serves as custodian, the true sale of assets from the transferor might be negated. Second, according to the commentary to Section of the UCC, for certain types of collateral, possession of the collateral by an agent of the secured party is sufficient to perfect a security interest in such collateral. The section states, however, that the debtor or a person controlled by [the debtor] cannot qualify as such an agent for the secured party. Thus, Standard & Poor s is concerned that if an affiliate of a transferor serves as custodian, the custodian might be deemed to be controlled by the transferor and the custodian s security interest in the assets might not be perfected. Consequently, Standard & Poor s generally will permit Standard & Poor s Structured Finance Student Loan Criteria 77

77 an affiliate of a transferor to serve as custodian, only if the following conditions are met: (i) the affiliated custodian is an entity that is in the business of functioning in the custodial capacity for other parties; (ii) if the transfer of assets to the issuing SPE is a true sale, the true sale opinion delivered in connection with the transfer (a) should cite the affiliated relationship between the transferor and the custodian and (b) give an opinion to the effect that the custodian is functioning as an agent of the trustee (that is, the agency relationship may not be assumed) and that, by delivering the assets to the custodian, there has been a valid true sale of the assets by the transferor to the issuing SPE; and (iii) the security interest opinion delivered in connection with the custodian s first priority perfected security interest in the assets on behalf of the trustee includes the opinion that the custodian would not be deemed to be controlled by the affiliated transferor pursuant to Section of the UCC. In some circumstances, Standard & Poor s may require that the custody arrangements terminate and the assets be returned to the trustee for safekeeping, based on a downgrading of the custodian or its affiliated parent/transferor. Criteria Related to Eligible Deposit Accounts A structured financing provides for different accounts to be established at closing to serve as collection accounts in which revenues generated by the securitized assets are deposited and to establish reserves funds. Often the accounts in which the reserves are held contain significant sums held over a substantial period of time. Standard & Poor s has developed criteria regarding these accounts. The criteria are intended to immunize and isolate a transaction s payments, cash proceeds, and distributions from the insolvency of each entity that is a party to the transaction. An insolvency of the servicer (sub or master), trustee, or other party to the transaction should not cause a delay or loss to the investor s scheduled payments on the rated securities. As a general matter, Standard & Poor s relies on credit, structural, and legal criteria to ensure that a structured transaction s cash flows are protected at every link in the cash flow chain. When analyzing a structured financing, Standard & Poor s criteria adjust to the specific circumstances presented by a transaction. The criteria for the collection of funds will depend on who will hold the funds and how the funds will be held. The subservicer and the institution where the collection account is established can be different entities. When two entities are involved with the collection of funds (the servicer and the institution holding the account), investors should be protected from the insolvency of either party. The following criteria address many of the potential combinations typically found in a structured finance transaction. 78

78 Legal Criteria for Student Loan Transactions Collection Accounts Unless collections on assets are concentrated at certain times of the month, for a period of up to two business days after receipt, any servicer, whether or not rated, may keep collections on the assets in any account of the servicer s choice, commingled with other money of the servicer or of any other entity. Before the end of the two business day period, the collections on the assets should be deposited into an eligible deposit account, as described below. As a general matter, all servicers, including unrated servicers, may keep/commingle collections for up to two business days, based on Standard & Poor s credit assumption, made in connection with all structured transactions, that two days worth of collections on assets will be lost. If, however, collections on the assets are concentrated at certain times within a month (for example, the first, 15th, or 30th of a month), a servicer rated below A-1 should not be able to keep/commingle collections on the assets even for the two business day period, as described above. Rather, to prevent a potentially significant loss on assets, Standard & Poor s generally requires that, in transactions involving concentrated collections in which the servicer is rated below A-1, either additional credit support be provided to cover commingling risk or obligors be instructed to make payments to lockbox accounts, which, in turn, are swept daily to an eligible deposit account. The servicer, unless rated the same as the rating sought on the structured transaction, should be prevented from accessing either the lockbox or sweep accounts. In addition, if a transferor does not wish that Standard & Poor s factor two days worth of losses on collections into its credit analysis, it may structure the transaction (whether or not collections are concentrated at certain times of a month) to have a lockbox account, whose deposits are swept daily to an eligible deposit account. Beyond the two business day period discussed above, a servicer rated at least A-1 may keep/commingle collections on assets or deposit collections in an account of its choice, at any institution, provided the servicer obligates itself unconditionally to remit all collections to an eligible deposit account once a month. In addition, the transaction documents should provide that, if the servicer s rating falls below A-1, the servicer will establish an eligible deposit account within not more than 10 calendar days and transfer collections to this account within two business days of receipt. If a servicer is rated below A-1 or is unrated, or if an A-1 rated servicer s obligation to remit collections is not unconditional, the servicer should deposit all collections into an eligible deposit account within two business days of receipt. Other Accounts. All other accounts maintained by the master servicer, special servicer, or trustee in a structured transaction (for example, reserve accounts) should qualify as eligible deposit accounts. Standard & Poor s Structured Finance Student Loan Criteria 79

79 Eligible Deposit Accounts An eligible deposit account is one that is either: An account or accounts maintained with a federal or state-chartered depository institution or trust company that complies with the definition of eligible institution, as described below; or A segregated trust account or accounts maintained with the corporate trust department of a federal depository institution or state-chartered depository institution subject to regulations regarding fiduciary funds on deposit similar to Title 12 of the Code of Federal Regulation Section 9.10(b), which, in either case, has corporate trust powers, acting in its fiduciary capacity. In transactions rated AAA by Standard & Poor s, eligible institutions means institutions whose: Commercial paper, short-term debt obligations, or other short-term deposits are rated at least A-1+ by Standard & Poor s if the deposits are to be held in the account for less than 30 days; or Long-term unsecured debt obligations are rated at least AA- if the deposits are to be held in the account more than 30 days. Following a downgrade, withdrawal, or suspension of such institution s rating, each account should promptly (and in any case within not more than 10 calendar days) be moved to a qualifying institution or to one or more segregated trust accounts in the trust department of such institution, if permitted. Each eligible account should be a separate and identifiable account, segregated from all other funds held by the holding institution. The account should be established and maintained in the name of the trustee on behalf of the issuing SPE, bearing a designation clearly indicating that the funds deposited therein are held for the benefit of the holders of the rated securities. An eligible account should not be evidenced by a CD, passbook, or other instrument. The trustee should possess all right, title, and interest in all funds on deposit from time to time in the account and in all proceeds thereof. The account should be under the sole dominion and control of the trustee for the benefit of the holders of the rated securities and should contain only funds held for their benefit. Criteria Related to Eligible Investments The recent proliferation of market risk in securities being issued in the debt markets has caused Standard & Poor s, as a general matter, to restrict eligible investments for structured financings. Standard & Poor s generally will not accept as an eligible investment, without prior review, the following: Any security with the r symbol attached to the rating; 80

80 Legal Criteria for Student Loan Transactions Any security that contains a noncredit risk that the r was intended to highlight, whether or not the issue is rated; and All mortgage-backed securities. These requirements are part of an ongoing effort by Standard & Poor s to address the increase of noncredit risk in the fixed-income markets. In July 1994, Standard & Poor s introduced the r symbol to alert investors that certain debt instruments may experience high volatility or dramatic fluctuations in their expected returns because of market risk. Standard & Poor s first started to address market risk with the introduction of market risk ratings on bond funds in January Government Securities Not Immune Standard & Poor s believes the obligations of the U.S. and certain other issuers whose securities would be classified as government securities are of very strong credit quality. However, a credit opinion does not take into consideration noncredit factors, such as market risk or timing of payments, which are a part of the overall investment decision. Standard & Poor s does not believe that the government securities market is immune from market risk. The Standard & Poor s eligible investment list contains both government and nongovernment securities. While the list is widely used, it is sometimes used inappropriately. When used by Standard & Poor s in rating a structured financing, the list provides the low-risk, short-term investments eligible to house, temporarily, the cash flows of the transaction (usually 30 days or less). Eligible investments generally mature before the next scheduled distribution date. Longer-term reserve funds also are invested in eligible investments. Because the funds may be needed to make the next scheduled distribution, at least a portion of the funds should be invested in short-term investments. The following eligible investments should not have maturities in excess of one year. Any use other than those listed above may not be appropriate. Eligible Investments The following investments are eligible for AAA rated transactions: 1. Certain obligations of, or obligations guaranteed as to principal and interest by, the U.S. government or any agency or instrumentality of the U.S. government, when such obligations are backed by the full faith and credit of the U.S. As Standard & Poor s does not explicitly rate all such obligations, the obligation must be limited to those instruments that have a predetermined fixed-dollar amount of principal due at maturity that cannot vary or change. If the obligation is rated, it should not have an r highlighter affixed to its rating. Interest may be either fixed or variable. If the investments may be liquidated before their maturity or are being relied on to meet a certain yield, additional restrictions are necessary. Interest should be tied to a single interest rate index plus a single fixed spread, if Standard & Poor s Structured Finance Student Loan Criteria 81

81 any, and move proportionately with that index. These investments include, but are not limited to: U.S. Treasury obligations all direct or fully guaranteed obligations; Farmers Home Administration certificates of beneficial ownership; General Services Administration participation certificates; Maritime Administration guaranteed Title XI financing; Small Business Administration guaranteed participation certificates and guaranteed pool certificates; U.S. Department of Housing and Urban Development local authority bonds; and Washington Metropolitan Area Transit Authority guaranteed transit bonds. 2. FHA debentures. 3. Certain obligations of government-sponsored agencies that are not backed by the full faith and credit of the U.S. As Standard & Poor s does not explicitly rate all such obligations, the obligation must be limited to those instruments that have a predetermined fixed-dollar amount of principal due at maturity that cannot vary or change. If the obligation is rated, it should not have an r highlighter affixed to its rating. Interest may be either fixed or variable. If the investments may be liquidated before their maturity or are being relied on to meet a certain yield, additional restrictions are necessary. Interest should be tied to a single interest rate index plus a single fixed spread, if any, and move proportionately with that index. These investments are limited to: Federal Home Loan Mortgage Corp. debt obligations; Farm Credit System (formerly Federal Land Banks, Federal Intermediate Credit Banks, and Banks for Cooperatives) consolidated systemwide bonds and notes; Federal home loan banks consolidated debt obligations; Federal National Mortgage Association debt obligations; Student Loan Marketing Association debt obligations; Financing Corp. debt obligations; and Resolution Funding Corp. (Refcorp) debt obligations. 4. Certain federal funds, unsecured CDs, time deposits, banker s acceptances, and repurchase agreements having maturities of up to 365 days, of any bank whose short-term debt obligations are rated A-1+ by Standard & Poor s. In addition, the instrument should not have an r highlighter affixed to its rating, and its terms should have a predetermined fixed-dollar amount of principal due at maturity that cannot vary or change. Interest may be either fixed or variable. If the investments may be liquidated before their maturity or are being relied on to meet a certain yield, additional restrictions are necessary. Interest should be tied to a single interest rate index plus a single fixed spread, if any, and move proportionately with that index. 82

82 Legal Criteria for Student Loan Transactions 5. Certain deposits that are fully insured by the FDIC. The deposit s repayment terms should have a predetermined fixed-dollar amount of principal due at maturity that cannot vary or change. If the deposit is rated, it should not have an r highlighter affixed to its rating. Interest may be either fixed or variable. If the investments may be liquidated before their maturity or are being relied on to meet a certain yield, additional restrictions are necessary. Interest should be tied to a single interest rate index plus a single fixed spread, if any, and move proportionately with that index. 6. Certain debt obligations maturing in 365 days or less that are rated AA- or higher by Standard & Poor s. The debt should not have an r highlighter affixed to its rating, and its terms should have a predetermined fixed-dollar amount of principal due at maturity that cannot vary or change. Interest can be either fixed or variable. If the investments may be liquidated before their maturity or are being relied on to meet a certain yield, additional restrictions are necessary. Interest should be tied to a single interest rate index plus a single fixed spread, if any, and move proportionately with that index. 7. Certain commercial paper rated A-1+ by Standard & Poor s and maturing in 365 days or less. The commercial paper should not have an r highlighter affixed to its rating, and its terms should have a predetermined fixed-dollar amount of principal due at maturity that cannot vary or change. Interest may be either fixed or variable. If the investments may be liquidated before their maturity or are being relied on to meet a certain yield, additional restrictions are necessary. Interest should be tied to a single interest rate index plus a single fixed spread, if any, and move proportionately with that index. 8. Investments in certain short-term debt of issuers rated A-1 by Standard & Poor s with certain restrictions. In this case, short-term debt is defined as: commercial paper, federal funds, repurchase agreements, unsecured CDs, time deposits, and banker s acceptances. The total amount of debt from A-1 issuers must be limited to the investment of monthly principal and interest payments (assuming fully amortizing collateral). The total amount of A-1 investments should not represent more than 20% of the rated issue s outstanding principal amount, and each investment should not mature beyond 30 days. Investments in A-1 rated securities are not eligible for reserve accounts, cash collateral accounts, or other forms of credit enhancement in AAA rated issues. In addition, none of the investments may have an r highlighter affixed to its rating. The terms of the debt should have a predetermined fixed-dollar amount of principal due at maturity that cannot vary or change. Interest may be either fixed or variable. If the investments may be liquidated before their maturity or are being relied on to meet a certain yield, additional restrictions are necessary. Interest should be tied to a single interest rate index plus a single fixed spread, if any, and move proportionately with that index. Standard & Poor s Structured Finance Student Loan Criteria 83

83 19. Investment in money-market funds rated AAAm or AAAm-G by Standard & Poor s. 10. Certain stripped securities where the principal-only and interest-only strips of noncallable obligations are issued by the U.S. Treasury and of Refcorp securities stripped by the Federal Reserve Bank of New York. Any security not included in this list may be approved by Standard & Poor s after a review of the specific terms of the security and its appropriateness for the issue. Select Specific Opinion Criteria/Language General As a general matter, Standard & Poor s requires that true sale, nonconsolidation, security interest, either/or, and debt security interest opinions be delivered by outside counsel to any participant in a structured transaction. As a general matter, in connection with security interest opinions, either/or opinions, debt security interest opinions, characterization opinions, and certificate of title opinions (all opinions based on state law), Standard & Poor s accepts an opinion of counsel not admitted to the bar of the relevant state, provided such counsel states that it bases its opinions on a review of the laws of such state, including both the state s relevant statutes and case law. As a general matter, Standard & Poor s will not accept an opinion based on the Legal Opinion Accord of the American Bar Association Section of Business Law (1991) unless such opinion specifically identifies (by number) those sections of the Accord on which the opinion is relying. Standard & Poor s will accept an opinion stating that it should be interpreted in accordance with the Special Report by the TriBar Opinion Committee, Opinions in the Bankruptcy Context; Rating Agency, Structured Financing and Chapter 10 Transactions, 46 BUS. LAW 717 (1991). As a general matter, Standard & Poor s requires would opinions except for nonconsolidation opinions and common law security over deposit accounts. In these two cases, should opinions are accepted based on the fact dependent nature of nonconsolidation opinions and the scarcity of deposit account jurisprudence, respectively. Language to the effect that the issue is not free from doubt or that the conclusion is more probable than not is not acceptable. The proviso although a court may find otherwise is not preferred but is acceptable. A statement that the opinion is not a guarantee of outcome or result is acceptable. Bring-Down Opinion. Counsel delivering a bring-down opinion in the context of a subsequent transfer should state that it has reviewed (i) the facts of the subsequent transfer and that such facts do not differ from those recited in the previously delivered 84

84 Legal Criteria for Student Loan Transactions opinion and (ii) the assumptions set forth in the previously delivered opinion, which assumptions are the only assumptions being made in the bring-down opinion. Standard & Poor s accepts bring-down opinions only from the same counsel that delivered the opinions being brought down. Corporate Opinion. As a general matter, in U.S. transactions, Standard & Poor s receives comfort as to the due organization, valid existence, and good standing of transaction participants from the representations and warranties of the transaction participants. Depending upon the circumstances, however, Standard & Poor s may request a corporate opinion to the following effect: (i) that each party to the transaction is duly organized, validly existing under the laws of the jurisdiction of its formation, and is in good standing under the laws of such jurisdiction and any other jurisdictions in which it is required to qualify to do business; (ii) that each party to the transaction has the full power and authority to carry on its business and to enter into the transactions documents to which it is a party and the transactions thereby contemplated; (iii) that the execution, delivery, and performance of the transaction documents by the relevant party will not violate any law, regulation, order, or decree of any governmental authority or constitute a default under or conflict with the organizational documents or other agreements governing or to which the relevant party is a party; (iv) that no approval, consent, order, or authorization is required in connection with the execution, delivery, and performance of the transaction documents other than those approvals, consents, orders, and authorizations that have been obtained in connection with the closing of the transaction; and (v) that the payments set forth in there transaction documents do not violate applicable usury laws. Standard & Poor s generally requests corporate opinions in international transactions and in connection with a transaction participant that is a non-u.s. entity. Enforceability Opinion. As a general matter, in U.S. transactions, Standard & Poor s receives comfort as to the legality, validity, and enforceability of the transaction documents from the representations and warranties of the transaction participants. Depending upon the circumstances, however, Standard & Poor s may request an enforceability opinion to the effect that the transaction documents, or any particular transaction document, constitutes the legal, valid, binding, and enforceable obligations of the signatories. Standard & Poor s generally requests enforceability opinions in international transactions and in connection with a transaction document to which a non-u.s. entity is a signatory. Standard & Poor s Structured Finance Student Loan Criteria 85