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