Methodology. Rating U.S. Federal Family Education Loan Program Securitizations

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1 Methodology Rating U.S. Federal Family Education Loan Program Securitizations december 2014

2 CONTACT INFORMATION Jon Riber Senior Vice President, U.S. ABS Global Structured Finance Tel Chuck Weilamann Managing Director, Head of U.S. ABS Global Structured Finance Tel Kathleen Tillwitz Managing Director, Head of U.S. and E.U. Operational Risk Global Structured Finance Tel Claire Mezzanotte Group Managing Director Global Structured Finance Tel RELATED RESEARCH Legal Criteria for U.S. Structured Finance Operational Risk Assessment for U.S. ABS Servicers Unified Interest Rate Model for Rating U.S. Structured Finance Transactions DBRS Master U.S. ABS Surveillance Methodology DBRS is a full-service credit rating agency established in Privately owned and operated without affiliation to any financial institution, DBRS is respected for its independent, third-party evaluations of corporate and government issues, spanning North America, Europe and Asia. DBRS s extensive coverage of securitizations and structured finance transactions solidifies our standing as a leading provider of comprehensive, in-depth credit analysis. All DBRS ratings and research are available in hard-copy format and electronically on Bloomberg and at DBRS.com, our lead delivery tool for organized, Web-based, up-to-the-minute information. We remain committed to continuously refining our expertise in the analysis of credit quality and are dedicated to maintaining objective and credible opinions within the global financial marketplace.

3 Rating U.S. Federal Family Education Loan Program Securitizations TABLE OF CONTENTS Scope And Limitations 4 Executive Summary 4 Introduction And Industry Overview 5 The Federal Family Education Loan Program 5 Origination Process And Eligibility 5 Loan Type 6 Loan Status 8 Loan Interest Margin 10 Loan Servicing 10 Loan Default And Reimbursement 11 Operational Risk Review 12 Servicer Review 12 Transaction Structure 12 Structure 12 Payment Waterfall 12 Note Triggers 13 Prefunding 13 Recycling Periods 13 Forms Of Credit Enhancement 14 Collateral Analysis 15 Pool Characteristics 15 Data Request And Developing A Base-Case Default Expectation 17 Static Pool Analysis 17 Seasoning Adjustment 18 Cash Flow Analysis 18 Stress-Case Defaults 18 Default Timing 19 Additional Cash Flow Assumptions 21 Legal Structure And Opinions 24 3

4 Scope and Limitations DBRS evaluates both qualitative and quantitative factors when assigning ratings to a U.S. structured finance transaction. This methodology represents the current DBRS approach for rating U.S. Federal Family Education Loan Program (FFELP) student loan securitizations issued in the United States with FFELP collateral originated in the United States. It describes the DBRS approach to analysis, which includes (1) a focus on the quality of the sponsor/servicer, (2) evaluation of the collateral pool and (3) utilization of historically employed credit evaluation techniques. This report also outlines the asset class and discusses the methods DBRS typically employs when assessing a transaction and assigning a rating. It is important to note that the methods described herein may not be applicable in all cases. Further, this methodology is meant to provide guidance regarding the DBRS methods used in the sector and should not be interpreted as prescribing a rigid template, but understood in the context of the dynamic environment in which it is intended to be applied. Executive Summary DBRS evaluates both quantitative and qualitative factors when assigning and monitoring ratings for FFELP student loan asset-backed securities (ABS), including the following: Operational risk review; Quality of the proposed collateral pool and historical performance of an issuer s student loan portfolio; Transaction capital structure, priority of payments and credit enhancement; and Legal structure and opinions. DBRS performs an operational risk review and assessment of the servicer. This review provides insight into the servicer s corporate performance and capabilities as well as processes that may affect pool performance. 1 For each target rating, DBRS analyzes the proposed transaction structure under various cash flow stress scenarios to determine the ability of the transaction to pay timely interest and repay ultimate principal in accordance with the terms of the transaction. DBRS reviews the transaction s legal structure and opinions to assess that all necessary steps have been taken and no subsequent actions are needed to protect the issuer s ownership interest in the assets. 1. Refer to DBRS Operational Risk Assessment for U.S. ABS Servicers. 4

5 Introduction and Industry Overview In 2010, President Obama signed into law the Health Care and Education Reconciliation Act of 2010, which discontinued the use of FFELP, thus ending the ability of private companies to originate loans backed by the federal government. Since July 1, 2010, 100% of all new federally funded student loans have been made through the U.S. Department of Education s (ED) William D. Ford Federal Direct Loan Program (DLP). Under the DLP, the federal government, through the ED, borrows funds from the U.S. Treasury and disburses the loan amount directly to the student. The student repays the loan directly to the federal government. The federal government pays private sector servicers to handle most of the loan servicing and defaulted loan collection tasks. The federal government does not pay any subsidies to any guaranty agencies or private lenders. Going forward, it is anticipated that FFELP ABS issuance volume will be substantially lower than in previous years due to regular loan amortization and the termination of Straight-A Funding, the FFELP asset-backed commercial paper program implemented by the federal government as a result of the financial crisis. Additionally, there will be fewer refinancings of auction rate securities into new FFELP ABS as many of the failed auction rate securities have already been restructured. The Federal Family Education Loan Program FFELP was created to facilitate higher education in the United States. Authorized by Congress under Title IV of the Higher Education Act of 1965, the program provided tuition assistance in the form of loans to students and parents, thereby encouraging the pursuit of higher education and allowing post-secondary institutions to enroll more students. FFELP loans are reinsured by the U.S. government with respect to principal and interest in the event of a loan default. As stated, student loan lenders originated their last FFELP loans in The Health Care and Education Reconciliation Act of 2010 eliminated private sector funding of new government-guaranteed student loans under FFELP and directed all new loans to be funded through DLP. ORIGINATION PROCESS AND ELIGIBILITY FFELP was designed to encourage providers of private capital to make unsecured education loans based on need with minimum regard for a borrower s credit history, income or assets. To this end, the program stipulates that lenders are guaranteed a specified loan yield in addition to principal and interest reimbursement if a loan defaults. Strict compliance with FFELP rules and eligibility requirements during the loan lifecycle (see Figure 1 below) is necessary for such loan yield and default reimbursement benefits. Borrowers applied for financial support by listing family income and assets on a financial aid application. The information was submitted to the selected school, which compiled available sources and amounts of aid (grants, scholarships, work-study, etc.), including a FFELP loan amount. Aid reflected the differ- ence between a family s expected monetary contribution and the cost of school. If accepted, the borrower chose a FFELP lender and executed a master promissory note. Concurrently, a guarantor notified the lender that the loan was eligible for default reimbursement. 5

6 Determining borrower qualifications and loan amount was the responsibility of the school, which certified borrower eligibility to the lender. Graduate and undergraduate borrowers had to be enrolled in at least a half-time program of study, make satisfactory academic progress and be a U.S. citizen, permanent resident or eligible non-citizen. Parent borrowers who took out PLUS loans for dependent undergraduate students were required to pass a credit check and be a U.S. citizen or eligible non-citizen. Title IV of the Higher Education Act of 1965 set eligibility for institutions accepting FFELP loans. Schools had to be state licensed or authorized in addition to attaining national accreditation and being acceptable to the loan guarantor. Eligible institutions included two-year, four-year, graduate and professional schools, as well as proprietary institutions (also referred to as for-profit or vocational). The ED designated which lenders were qualified to offer FFELP loans. Institutions such as national or state-chartered banks, credit unions, selected non-profit agencies and for profit financial institutions were authorized to originate FFELP loans and receive interest subsidies and default reimbursement. Figure 1 illustrates the general lifecycle of a FFELP loan and will be discussed in detail throughout this report. Figure 1: FFELP Loan Lifecycle Origination In School Grace Repayment Borrower must be enrolled at least part time 6 months 10 to 30 years Deferment Forbearance Typically 3-year max Default Timeline 270 Days Default Days Lender submits claim to guarantee agency Days Guarantee agency must pay claim within 90 days LOAN TYPE FFELP loans are typically characterized by borrower status, level of education and repayment terms. Undergraduate borrowers were subject to annual borrowing limits based on dependency and year in school. Eligible parents and graduate students taking out PLUS loans could borrow the full cost of education net of financial aid received. Stafford Loans Stafford loans were the most frequently awarded FFELP loan. The standard level payment period is ten years, although some borrowers qualified for a longer term. 2 Principal and interest payments are not required while the borrower is enrolled in school at half-time credit or greater. Stafford loans were available to graduate and undergraduate students in varying amounts with interest payments subsidized or unsubsidized, depending on borrower eligibility For borrowers with Stafford debt exceeding $30,000, repayment may extend to 25 years under the extended repayment option. Under the Income Based Repayment option, borrowers with financial hardship may extend repayment up to 25 years.

7 For subsidized Stafford loans, the federal government pays interest to the lender during school enrollment, a six-month grace period after the borrower leaves school and deferment periods thereafter. Eligibility is needs based and reflects family income. A subsidized borrower can also borrow unsubsidized loans subject to annual and aggregate limits. Monthly repayment begins at the end of a six-month grace period after the student leaves school. For unsubsidized Stafford loans, interest is due throughout the life of the loan, although during in school and grace periods, interest may be capitalized, which increases the loan balance. All eligible borrowers qualify for unsubsidized Stafford loans regardless of financial need. Monthly principal and interest repayment begins at the end of a six-month grace period that starts after the student leaves school. Interest on Stafford loans disbursed prior to July 1, 2006, is variable, adjusts annually and is capped at 8.25%. For unsubsidized loans disbursed after June 30, 2006, the rate is fixed at 6.8%. For subsidized loans disbursed after June 30, 2006, the fixed rate is based on year of disbursement as follows: July 1, 2006, to June 30, 2008: 6.8% July 1, 2008, to June 30, 2009: 6.0% July 1, 2009, to June 30, 2010: 5.6% July 1, 2010, to June 30, 2011: 4.5% July 1, 2011, to June 30, 2013: 3.4% Figure 2: Annual Stafford Loan Limits (effective July 1, 2008) Program Level Dependent Undergraduate 1 Independent Undergraduate 2 Freshman $ 5,500 $ 9,500 Sophomore $ 6,500 $10,500 Junior and Senior $ 7,500 $12,500 Certification Programs $11,500 $11,500 Graduate students $20,500 $20, Parents who were not denied a PLUS loan. 2. Parents were denied a PLUS loan. Figure 3: Aggregate Stafford Loan Limits (effective July 1, 2008) Student Level and Program Dependent Undergraduate $ 31,000 Independent Undergraduate $ 57,500 Graduate/Professional $138,500 Medical $224,000 Note: Graduate and medical debt includes undergraduate debt. PLUS Loans PLUS loans are FFELP loans that parents of dependent undergraduate students and graduate students can use to help pay education expenses. PLUS loans offered to graduate students are referred to as GradPLUS loans. Unlike Stafford loans, PLUS loans are not subject to annual or cumulative dollar limits. The PLUS loan amount may cover the entire annual cost of education less financial aid provided by the school. PLUS loans are the only FFELP loan type for which some level of credit underwriting is performed. Applicants are subject to a credit check, and those who are 90 days or more past due on current debt or have derogatory credit events, such as defaults, bankruptcy or foreclosure, within the preceding five years are ineligible for PLUS loans. 7

8 Monthly principal and interest payments begin 60 days following disbursement with a repayment period of ten years. 3 Graduate school borrowers may defer paying principal and interest while in school and during a six-month grace period after leaving school. Similarly, parent borrowers may defer payments if the student beneficiary is in school or during a six-month grace period after the student leaves school. Any deferred interest is capitalized and added to the loan balance. The PLUS interest rate is currently fixed at 7.9%. Interest on loans originated before July 1, 2006, is variable, adjusts annually and is capped at 9.00%. Consolidation Loans A fixed-rate Consolidation loan is available to borrowers that refinance Stafford and PLUS loans with a single lender under new terms and one monthly payment. Qualifying loans must be in repayment or grace and a new promissory note is executed. Consolidation can occur only once but an existing Consolidation loan can be reconsolidated with additional Stafford and PLUS loans. Interest rate on Consolidation loans is based on the weighted average of the underlying loans rounded up to the nearest one-eighth of a percent and is capped at 8.25%. Consolidated subsidized loans continue to qualify for government-paid interest during periods of deferment. Monthly principal and interest begins within 60 days of disbursement and the repayment term is based on the loan balance 4 (see Figure 4 below). Figure 4: Consolidated Loan Terms Loan Balance Loan Term Less than $7, years $7,500 $9, years $10,000 $19, years $20,000 $39, years $40,000 $59, years $60,000 or more 30 years LOAN STATUS Loan status refers to the payment classification of a FFELP loan during the course of its lifecycle. Loan statuses include: in school, grace and repayment. During repayment, a deferment or forbearance may be granted to qualified borrowers that have difficulty making scheduled loan payments. Deferment and forbearance reduce loan cash flows and extend the repayment period. In School/Grace The in school/grace designation is applicable only to Stafford loans. In school means the borrower is presently enrolled at least half-time at an eligible institution. Grace begins when the borrower leaves school or is enrolled less than half-time. Grace lasts for six-months. For unsubsidized Stafford loans, interest payments are due during the in school and grace periods, but principal is not required until after the grace period expires. The borrower can opt to capitalize interest until repayment begins. For subsidized Stafford loans, the federal government pays interest to the lender on behalf of the borrower during the in school and grace periods. 3. For borrowers with PLUS debt exceeding $30,000, repayment may extend to 25 years under the extended repayment option. Under the Income-Based Repayment option, borrowers with financial hardship may extend repayment to 25 years. 4. Balance includes other outstanding FFELP loans up to the amount of the loans being consolidated. 8

9 Repayment Stafford borrowers begin paying both principal and interest at the end of the grace period. PLUS and Consolidation loans enter repayment 60 days after loan disbursement. Repayment means the borrower is paying scheduled principal and interest under one of several repayment options, including: Standard: Level monthly payments over the loan term. Extended: Borrowers with more than $30,000 in FFELP debt can extend the loan term up to 25 years without consolidation. Graduated: Payments start out low and increase over time. The length of the repayment period is up to ten years. This plan appeals to borrowers who expect that their income will increase steadily over time. No single payment under this plan will be more than three times greater than any other payment. Income-Sensitive Repayment Plan: Designed to help new graduates with lower salaries, income-sensitive repayment lets borrowers select a loan payment in an amount between 4% and 25% of their monthly income as long as such payment is equal to or greater than the interest accruing on their loan. This plan requires the borrower to choose another repayment schedule after five years, with the new schedule extending up to ten additional years. Since this plan extends a borrower s repayment period, the total amount of interest paid may be greater than what would have been paid under standard repayment. Income-Based Repayment Plan: Loan payments are based on income and family size and the borrower must be experiencing a partial financial hardship. Repayment is extended to 25 years with any remaining balance forgiven after 25 years of qualifying repayment. The monthly payment amount is 15% of discretionary income. For subsidized loans, if the monthly income-based repayment amount does not cover the amount of interest that accrues on the loan, the government will pay such unpaid accrued interest for up to three consecutive years. Deferment and Forbearance Deferment and forbearance indicate scheduled payments are being temporarily reduced or postponed pursuant to FFELP guidelines. The statuses are utilized as default-aversion tools under circumstances indicating that a borrower should eventually be able to resume making scheduled payments. With deferment and forbearance, the lender receives the totality of loan principal and interest, although over a longer term. The borrower s underlying situation dictates whether a deferment or forbearance is used. The key difference is that the federal government pays current interest on subsidized Stafford loans (including those consolidated) during deferment but not during forbearance. PLUS and unsubsidized Stafford loans (including those consolidated) accrue interest during both deferment and forbearance. For a deferment, borrowers provide documentation demonstrating eligibility based on qualifying conditions. Borrowers are not required to pay principal during deferment. Interest for unsubsidized loans is capitalized and added to the principal balance of the loan. See Figure 5 below. Figure 5: Common Deferments Qualifications School Enrollment Economic Hardship Unemployment Military Service Peace Corps Rehabilitation/Mental Health Treatment Post Active Duty Time Limit None 3 Years 3 Years None 3 Years None 13 Months 9

10 If a borrower does not meet the criteria for a deferment, he or she may qualify for forbearance. During periods of forbearance, monthly principal and interest may be postponed or reduced and the repayment term can be extended. In most cases, forbearance is granted solely at the discretion of the servicer and is offered for up to 12 months up to a maximum of three years. Forbearances are usually reserved for cases of economic hardship or illness. Unlike a deferment, in forbearance both subsidized and unsubsidized portions of the loan continue to accrue interest. At the end of the forbearance period the loan interest is capitalized. LOAN INTEREST MARGIN FFELP lenders earn a statutory interest margin payable quarterly. The margin is based on loan type, loan status and year of disbursement. For all FFELP loans, the federal government guarantees the margin irrespective of the rate paid by the borrower. If the borrower rate is less than the statutory margin, the government pays the difference referred to as Special Allowance Payments (SAP). If the borrower rate is greater than the statutory margin, the lender returns the difference to the federal government (floor income). For FFELP loans disbursed before April 1, 2006, floor income is retained by the lender and may be used as additional credit enhancement. For loans originated prior to January 1, 2000, the FFELP margin is pegged to the 91-day T-bill rate. Loans disbursed after January 1, 2000, earn a spread based on the three-month financial commercial paper rate or one-month LIBOR. In April 2012, FFELP holders had the option to change the index from three-month commercial paper to one-month LIBOR (for loans disbursed after January 1, 2000). Today, most holders take advantage of SAP payments pegged to one-month LIBOR as funding costs are typically tied to this index. LOAN SERVICING Adherence to ED collection guidelines is the most important aspect of servicing FFELP loans. Full compliance throughout the servicing process is necessary for lenders to receive SAP and subsidized interest payments in addition to principal reimbursement in the event of default. Servicer responsibilities include making disbursements, handling collections, filing reports with the ED and loan guarantors, processing loan status changes, responding to borrower inquiries, and maintaining borrower contact and loan records, in addition to ensuring compliance with FFELP rules and regulations. FFELP loan servicers are subject to mandatory audits by guarantors and the ED. During the in school and grace periods, servicing is focused on monitoring borrower eligibility, including grade level, enrollment status and the anticipated graduation date. During repayment, servicing is more proactive with emphasis on maintaining borrower contact and performing due diligence on delinquent loans. The delinquency period begins the day after a missed loan payment date. A loan is considered in default after 270 days of non-payment (excluding periods of deferment and forbearance). Figure 6 summarizes the protocol required for delinquent monthly pay loans. Figure 6: Delinquent Loan Protocol Days Delinquent Required Collection Activity 1 15 One collection letter or written notice Four phone calls and collection letters. At least one diligent effort on or before the 90th day of delinquency and one diligent effort after the 90th day of delinquency. No gap of greater than 45 days Guarantor notification and request for Default Aversion Assistance Continuous collection efforts that urge the borrower to make required payments on the loan. On or after 241 Final demand letter sent Default claim submitted to guarantor In addition to servicer due diligence, the loan guarantor initiates collection assistance by encouraging borrower to make payments. 2. Interest is paid through claim date if loan default filed before 330th day of delinquency.

11 LOAN DEFAULT AND REIMBURSEMENT Failure to repay a FFELP loan can have serious legal repercussions for the borrower apart from civil litigation, including wage garnishment, withholding of federal and state tax refunds and loss of social security benefits. In addition, loan defaults are reported to national credit agencies, and the borrower may lose certain professional licenses and becomes ineligible for military service or further education aid. FFELP loans are not dischargeable in bankruptcy unless the borrower files an undue hardship petition. There is no statute of limitation barring enforcement action to collect FFELP student loans. Approximately 35 loan guarantors insure FFELP loans directly. Loan guarantors are state or private non-profit agencies that act on behalf of the ED to administer default claims and recover unpaid loans. The federal government reinsures these loans against default. If a student defaults on a loan, the loan holder (i.e., the securitization trust) submits a claim to the loan guarantor responsible for that loan. The loan guarantor will pay the loan holder a reimbursement rate plus accrued interest on the loan. Funds for paying claims are generated by a 1% default fee deducted from the borrower s loan balance upon disbursement. Reimbursement rates are based on year of origination as follows: For loans that were made before October 1, 1993: 100% of principal and unpaid accrued interest. For loans that were made from October 1, 1993, to June 30, 2006: 98% of principal and unpaid accrued interest. For loans made on or after July 1, 2006: 97% of principal and unpaid accrued interest. Guarantors may reject reimbursement claims if submitted loans are not originated or serviced in accordance with ED guidelines. Typical servicing errors include missing documentation, incorrect dates regarding payment status and failure to contact a delinquent borrower within prescribed time frames. However, lenders are permitted to correct or cure servicing errors and resubmit a claim for reimbursement. The vast majority of rejected claims are eventually cured with FFELP loan servicers. Net claim reject rates, on average, have historically been well below 0.50%. Figure 7: FFELP Guarantee Payment Process Borrower 1. Borrower defaults at 270 days. Loan guarantor attempts collection on the defaulted loan. 2. Loan holder submits claim to loan guarantor within 90 days of default. FFELP Loan Holder 3a. Loan guarantor purchases defaulted loan within 90 days of receipt of claim. Cured loan. Insurance is reinstated. Loan Guarantor 3b. Loan guarantor rejects claim due to a servicing related error. Loan becomes uninsured. 4. Reimbursement claim submitted within 30 days. 5. ED reimburses loan guarantor. Department of Education Loan cannot be cured. Becomes permanently uninsured. 11

12 Operational Risk Review SERVICER REVIEW The servicer review process evaluates the quality of the parties that service or may conduct backup servicing on the loans (leases or receivables) that are about to be securitized in a transaction rated by DBRS. While DBRS does not assign formal ratings to these processes, it typically conducts operational risk reviews to assess if a servicer is acceptable and incorporates the results of the review into the rating process. DBRS typically begins the initial servicer review process by sending a questionnaire to the company that outlines the topics to be covered during the discussion with management and includes a list of documents to be provided such as organizational charts, financial statements and performance statistics. In instances where DBRS determines that the servicer is below average, issuers may incorporate certain structural enhancements into a proposed transaction such as additional credit support, dynamic triggers or the presence of a warm or hot backup servicer so that DBRS can rate the transaction. The servicer review process typically involves an analysis of the following: (1) Company and management (2) Financial condition (3) Controls and compliance (4) Loan administration (5) Customer service (6) Account maintenance (7) Collections (8) Investor reporting (9) Technology For details on the servicing review process, please refer to the DBRS methodology Operational Risk Assessment for U.S. ABS Servicers. Transaction Structure STRUCTURE FFELP ABS structures are most often senior/subordinate sequential pay structures whereby there are one or more classes of senior notes, along with one or more classes of lower-rated notes. It has been common for post-recession senior/subordinate transactions to call for subordinate classes to be fully locked out of principal until the senior notes are paid in full (it has also been common for more recent structures to include just one rated class). Pre-recession transactions with subordinate notes were frequently structured to allow a shift from sequential to pro rata pay, assuming certain performance and credit enhancement levels were maintained. 12 PAYMENT WATERFALL In most FFELP ABS transactions, student loan principal and interest collections are commingled and distributed as available funds through one cash flow payment waterfall. Payments to transaction constituents are typically allocated first to servicing, trustee and then to other administrative parties. Noteholder interest and principal for all classes then follows pursuant to the waterfall specified in the transaction s legal documents. Amounts that remain may be required to replenish the reserve account or to build the reserve account to a required minimum balance. Release of remaining available funds to the residual holder in the form of excess spread may then be allowed, provided that a specified level of overcollateralization is maintained. Since the financial crisis, it has become more common for new FFELP ABS structures to not allow excess spread to be released until all noteholders have been paid in full.

13 Figure 8: Typical FFELP ABS Waterfall Allocation of Available Funds from Collection Account Servicing and Trustee Fees Administration Fees Class A Interest Class B Interest Reserve Account Deposit to Maintain Reserve Account Requirement Class A Principal Class B Principal Unpaid Trustee Fees and Expenses (if any) Carryover Servicing Fees (if any) Excess Spread (released to issuer or applied to principal) NOTE TRIGGERS In senior/subordinate transactions, note triggers may be included to protect senior noteholders. Note triggers are generally tied to a transaction s overcollateralization and performance levels. Triggers may shut off interest and principal to the subordinate noteholders, with such amounts being redirected to the senior noteholders. PREFUNDING Many FFELP securitizations utilize prefunding structures that allow issuers to deposit a portion of note issuance proceeds in an account (prefunding account) for future collateral acquisitions. Cash held in the prefunding account is an asset of the securitization trust and is used to purchase loans during the prefunding period. Prefunding periods can be as short as one month and as long as a year or more. Any unused prefunding amounts at the end of the prefunding period are applied as a bond principal payment. Prefunding can expose a transaction to negative carry risk as interest earned on the prefunding account balance may be less than the amount paid on the securities. To mitigate such shortfall, amounts are deposited in a capitalized interest account. Additionally, eligibility criteria are incorporated into the transaction legal documents specifying the type of collateral that may be acquired during the prefunding period. DBRS considers eligibility criteria in its determination of the base case default and cash flow analysis. RECYCLING PERIODS The use of student loan principal collections and/or excess interest to acquire new loans instead of repaying security holders is called recycling and permitted in some FFELP securitizations. The recycling period is predetermined and may be extended at the request of the issuer. The risk is that collateral characteristics may become less favorable depending on the types of subsequently acquired loans. DBRS considers the eligibility criteria and concentration limits in its determination of the base case default and cash flow analysis. 13

14 Forms of Credit Enhancement Credit enhancement is the method used in a securitization by which investors are protected from cash flow disruptions that can affect the timely and full payment of security interest and principal. Credit enhancement improves the credit quality of a security with structural features that mitigate collateral loss and liquidity risk. The amount and type of credit enhancement reflects the credit rating of a particular security. Common forms of credit enhancement in FFELP ABS transactions include note subordination, excess spread, overcollateralization, reserve account and capitalized interest account. Subordination Subordination protects senior securities from losses by prioritizing cash flow and loss allocation in favor of senior security holders. Once other forms of credit enhancement are exhausted, the risk of interest payment shortfalls and principal loss is allocated to subordinated security holders. Senior security holders will experience losses only after the subordinate bonds have been reduced to zero. Excess Spread Excess spread is a source of credit enhancement providing periodic first loss protection for the securities, as described in the previous section, and represents income net of debt, servicing and administrative costs. Once certain reserve levels and parity ratios are achieved, excess spread may be released from the transaction, or may be required to pay principal to senior notes. An important driver of excess spread is the yield relationship between interest income and interest expense. As discussed, FFELP loans are floating-rate assets that earn a statutory guaranteed interest rate indexed one-month LIBOR, the three-month financial commercial paper rate or the 91-day T-Bill rate. Trust liabilities usually pay a floating coupon most often indexed to one-month LIBOR. If the relationship between different indices diverges and the liability index increases over the loan index, excess spread would be negatively affected. Moreover, while note interest payments are determined on a set monthly date, SAP payments are calculated quarterly based on a three-month average of the underlying SAP index. This may negatively affect excess spread in a rising interest rate environment. Overcollateralization and Parity Overcollateralization is generally defined as the sum of the loan principal balance plus any reserve and capitalized interest accounts minus the aggregate principal balance of outstanding notes. Overcollateralization creates credit enhancement in a transaction by further increasing loan payments above the amount payable to the notes. Parity is also a measure of credit enhancement and is generally defined as the total assets in the trust divided by the total liabilities. In addition to the total parity ratio, in structures where there are any subordinate classes, a senior parity ratio is also tracked, which is the total assets in the trust divided by the senior liabilities. It is common for parity to begin at a certain level and then build up to a specified target amount. Starting parity ratios for recent deals have typically been between 100% and 110%. Before the financial crisis it was common for structures to have parity ratios below 100%. In these premium proceeds transactions, there were often auction-rate security tranches, which facilitated the quick buildup of overcollateralization through excess spread, as they had a much lower cost of funds. However, due to the auction-rate market failing in 2008, excess spread deteriorated to the point that it was impossible to build credit enhancement in many transactions. 14

15 Reductions in overcollateralization or parity levels may occur if transaction expenses, such as funding costs, dramatically increase in relation to trust income necessitating the need to use student loan principal collections to pay bond interest. Under these circumstances, the pool balance declines while liabilities remain unchanged. Loan losses net of reimbursed amounts may also diminish credit enhancement to the extent not covered by excess spread. It is common for transactions to call for overcollateralization or parity to grow to a specified target. This target amount is reached by using excess spread to accelerate the pay down of the notes. Once a target amount is reached, overcollateralization or parity may be required to be maintained at certain levels, or may be allowed to decline to a certain level as the deal structure pays down. Excess spread may be released from the trust as long as enhancement levels are maintained at their specified percentages. Other transactions have been structured so that excess spread may not be released from the trust until 100% of note principal has been paid Reserve and Capitalized Interest Accounts 5 Reserve and capitalized interest accounts are segregated cash funds that support transaction liquidity for the benefit of both senior and subordinate security holders. Funded at the inception of a transaction, cash in the accounts is invested in highly rated short-term debt obligations that mature prior to payment due dates. Reserve accounts are typically fully funded at the time the transaction is closed, are often static and are replenished on future distribution dates from available funds. Draws from the reserve account may be used to pay interest and administrative fees, reimburse the trust for defaults and fund cash flow timing differences caused by delays in receipt of interest from the ED and/or principal reimbursement from loan guarantors. 6 Capitalized interest accounts are created to enhance the certainty of security interest payments during the initial years of a transaction when many pool borrowers are in school or grace and are not obligated to pay current interest. The account also supplements liquidity affected by borrowers that capitalize interest during periods of forbearance and deferment. Drawn funds may be used to pay interest, servicing or administrative fees. Withdrawals from capitalized interest accounts are not replenished from available funds. On specified future dates, unused capitalized interest funds are released to pay security holders. Collateral Analysis As part of the analysis of the transaction, DBRS analyzes the characteristics of the underlying collateral pool to assess the probability of default. In addition, as warranted, DBRS assesses the collateral pool statistics against any eligibility criteria that may be set forth in the transaction legal documents. This step serves to ensure that prescribed limits of certain collateral types are reflected in the analysis. POOL CHARACTERISTICS The student loan collateral pool is primarily analyzed by loan type and school type characteristics. Loan types primarily include Stafford, PLUS (including GradPLUS), Consolidation, and Rehabilitation (Rehab). School types mainly include four-year, two-year, graduate and proprietary. DBRS typically receives pool stratifications that provide a break out of these loan types and school types, in addition to other pool characteristics as described herein. 5. DBRS assumes the one-month LIBOR rate minus 25 basis points for all cash investment accounts. Such assumption is applied for the duration of the cash account. 6. Reserve accounts can be drawn to pay security principal at the legal final maturity date. 15

16 Loan Type Stafford (including subsidized and unsubsidized Stafford loans), PLUS (including GradPLUS) and Consolidation loans are the three major loan types and are key indicators of credit risk. Stafford loans are made to student borrowers seeking post-secondary education (for subsidized Stafford loans, the ED pays current interest while the borrower is in school and during periods of grace and deferment). PLUS loans are made to parents of students and graduate students. GradPLUS loans are made only to graduate students. Consolidation loans are available to borrowers that combine individual Stafford and PLUS loans into one loan balance. Based on historical data, PLUS loans have the lowest cumulative default rates and are considered the least risky because parents are likely to have more stable sources of income and, unlike Stafford loans, qualification requires a satisfactory credit check. Further, compared to Stafford borrowers with less education, graduate borrowers historically gain employment more quickly and have the potential to earn higher incomes. Unsubsidized Stafford loans default more frequently than subsidized Stafford loans, reflecting the interest supplement provided to subsidized Stafford borrowers. School Type School type is a second characteristic considered by DBRS in determining default frequency. School types include four-year, two-year, graduate and proprietary schools. Historically, defaults on student loans made to graduate and four-year college students tend to occur less frequently than loans made to students attending two-year community colleges and proprietary schools. The DBRS school type default expectations are the highest for proprietary schools followed in descending order by two-year and four-year undergraduate institutions. When analyzing a pool of Consolidation loans, DBRS provides one default assumption that encompasses all school types, as issuers do not typically provide performance data for each school type separately. Rehabilitation Loans DBRS also analyzes pools with concentrations of Rehab loans. Rehab loans are FFELP loans that have previously defaulted, but the borrower has made a specified number of on-time payments (nine on-time payments within ten consecutive months) in order to clear the default and resume payments per the original terms of the loan. Upon rehabilitation, a loan is eligible for all the benefits under the Higher Education Act for which it would have been eligible had no default occurred, such as new federal aid. The only exception is that a Rehab loan is no longer eligible for borrower benefits. A Rehab loan carries the same government guaranty level (97% to 100%) and the same margins for calculating SAP payments as it did before going into default. Rehab loans have a higher rate of default and default quicker than non-rehab loans. This increases the liquidity risk of a transaction because a more significant concentration of loans is expected to be non-performing and the default timing curve is more front-loaded. Additionally, Rehab loans have historically demonstrated more variability regarding credit performance and are more negatively affected by any adverse economic events. Rehab loans experience lower claim rejection rates than non-rehab loans, as the loans have already defaulted and have been through the required default review process. When analyzing a Rehab pool, DBRS uses specific default assumptions for such pool, regardless of the loan type or school type. 16

17 Data Request and Developing a Base-Case Default Expectation As part of the rating process, DBRS develops a cumulative default expectation for each FFELP pool. DBRS analyzes issuer-specific performance history and pool-specific characteristics provided by an issuer. DBRS expects issuers to provide historical default information, as described herein, that covers asset performance during various economic cycles. This assists DBRS in evaluating the impact that macroeconomic factors, such as unemployment levels, may have on collateral performance. STATIC POOL ANALYSIS DBRS uses a static pool approach to develop its expected cumulative default assumption for a transaction. In this analysis, a ratio of defaults to original loan balance is tracked on a monthly basis or quarterly basis for the static pool of assets as they amortize. The average of the periodic change in defaults for each vintage determines the issuer s overall average cumulative default rate at each period from origination. The year-over-year changes are also used to determine the issuer s historical default timing curve, which serves as a useful tool in anticipating the timing for defaults on the proposed pool. The historical default timing curve is also used to project cumulative defaults for more recent vintages that are still active. The weighted average of the realized and projected cumulative defaults for all vintages is used as the base case default proxy for the proposed pool. DBRS seeks to receive static pool data segregated by sub-pools consisting of each loan type and school type. DBRS uses this to determine a default estimate for each distinct sub-pool, and then uses this information to develop a weighted-average default expectation for the entire securitized pool based upon the relative contribution of each sub-pool. If the collateral composition of the proposed pool is similar to the collateral composition of previous vintages reflected in the static pool data, static pool analysis is an effective tool for establishing default expectations because, all else being equal, two pools of assets that have similar collateral composition during similar economic environments can be expected to have similar defaults over their lives. Based on the DBRS database of FFELP performance history, generic base case cumulative default rates determined via historic static pool analysis are shown in Figure 9. If issuer data is unavailable, limited or deemed unreliable, DBRS may use these generic default assumptions as a proxy for a proposed FFELP pool. Since FFELP loans are uniformly originated based on minimal underwriting criteria, and must be serviced within prescribed guidelines, historical default frequencies amongst different issuers are generally very similar. Figure 9: Base-Case Cumulative Default Rate Assumptions School Types Loan Type Four-Year Two-Year Proprietary Stafford 12% 30% 40% PLUS 3.25% 13% 13% Loan Type All School Types Consolidation 16% Rehab 45% 17

18 SEASONING ADJUSTMENT DBRS may make certain adjustments to its default projections for a securitization pool based on loan seasoning. Loans in repayment may be given credit for seasoning by applying the remaining portion of the default curve to the pool. For example, if approximately 40% of defaults for a given loan type historically occur in the first year of repayment, and assuming that a proposed loan pool has one year of in repayment seasoning, approximately 60% of the default curve would be expected for the remaining life of the pool. Although default expectations for seasoning would typically reduce the default estimate on a FFELP securitization pool (considering the front-loaded nature of the relative default curve), the potential impact of loan seasoning on default estimates also depends on the pool amortization speed. Cash Flow Analysis In the following section, DBRS describes the manner in which it evaluates proposed credit enhancement levels to support each target rating. Cash flows are then examined and stressed in order to assess whether investors are protected against losses and to determine if there is sufficient credit enhancement available to pay obligations at each target rating when due. STRESS-CASE DEFAULTS To assess whether there is an appropriate level of proposed credit enhancement to support a target rating, the base case default rate is stressed by applying certain multiples to such base case default rate. To achieve a given credit rating, a transaction would have to maintain credit enhancement in an amount sufficient to withstand the stressed multiple of default over the life of the transaction, as well as other cash flow stresses as described in this section. The multiples serve to protect the rated securities from much harsher and more stressful conditions than assumed within the base case cash flow scenario. The multiples in Figure 10 are representative of those that DBRS uses to assign ratings to FFELP ABS transactions and are designed to capture uncertainties and variables that may affect future transaction performance. Ranges are expected to encompass most outcomes of an asset correlation analysis performed by DBRS. Figure 10: Range of Multiples Utilized in the Rating of FFELP ABS Transactions1 AAA AA A BBB BB Multiple 3.00x 2.25x 2.50x 2.00x 2.00x 1.75x 1.75x 1.50x 1.50x 1.25x 1. For Consolidation loan transactions, DBRS uses multiples that are approximately 0.25 higher due to higher historical default correlations for this loan type. For Rehab loans, DBRS uses a multiple of 1.65x for its AAA (sf) stress scenario and 1.55x for its AA (sf) scenario with multiples varying based on the projected default percentage. In the determination of the multiples used in each transaction, DBRS generally starts at the midpoint of the prescribed multiple ranges for each rating class. DBRS considers various quantitative and qualitative factors and may adjust, up or down, from the midpoint based on its assessment of the transaction s perceived risks. The combination of the relevant factors ultimately results in the multiple used to determine the amount of loss coverage necessary to achieve each target rating. These factors include, but are not limited to: The absolute level of a proposed pool s base case default rate, The results of an operational risk assessment of the servicer, Macroeconomic conditions, Concentrations and The results of an asset correlation analysis. 18

19 For example, for a transaction with a relatively high default expectation (such as is the case with a high concentration of proprietary or two-year school loans), DBRS, absent other factors, would gen- erally adjust to a multiple that is at the lower end of the prescribed multiple range for a target rating. Conversely, for a transaction with relatively low default expectations, DBRS, absent other factors, would generally adjust to a multiple that is at the higher end of the prescribed multiple range for a target rating. A description of some of the above factors and the directional impact on the determination of the multi- ples within the prescribed ranges, when considering each factor in isolation, are discussed in the following sections. Operational Risk Assessment As mentioned, DBRS conducts an operational risk review of the servicer as part of the rating analysis. With regard to this factor, the multiple considers the potential for future operational risk. For companies with servicing operations that DBRS deems as less robust compared to other industry participants, the multiple may be on the higher end of the prescribed ranges. Conversely, a lower multiple may be used for servicers that demonstrate standards that exceed those deemed by DBRS to be typical for entities in the same sector. Adherence to ED servicing rules is required to receive guaranty payments, therefore a FFELP servicer s effectiveness is generally reflected in their historical default claim rejection rate. For example, a servicer with a low default claim rejection rate is deemed as being more effective at adhering to policies, procedures and standards, and generally has better operational risk than servicers with a higher rejection rate. Macroeconomic Conditions In determining the multiples, DBRS considers potential variability in future macroeconomic conditions. Macroeconomic conditions are considered with respect to the timeframe that the issuer s historical performance statistics cover and the degree of relevance of the historical performance data in the derivation of the expected loss rate. DBRS also considers macroeconomic conditions in terms of the presence of benign or recessionary environment over the period of the issuer s historical performance data and derivation of the expected default rate. Concentrations The degree to which a pool has concentrations, geographic or otherwise, can also affect a transaction s risk profile and may magnify the risk of default. DBRS assesses any pool concentration and determines whether such concentration would contribute to an adjustment of the default multiple. DEFAULT TIMING Default timing is an important component of the DBRS cash flow analysis as it affects the availability of excess spread to cover losses and other potential liquidity stresses. The default curve for FFELP loans reflects the underlying loan type. DBRS uses distinct default curves for Stafford, Consolidation, PLUS and Rehab loans. DBRS reviews an issuer s historical default experience to determine the expected shape of the default curve. DBRS may also develop and apply front-ended and back-ended timing curves. The curves are developed to evaluate scenarios whereby defaults materialize sooner or later than expected, as might be the case if the economy entered a recession shortly after a transaction closed or toward the tail end of the transaction s life. The impact of default timing stresses typically affect transactions differently under different scenarios. Front-loaded default scenarios typically add stress to the credit enhancement of the most senior securities in the structure. A front-loaded stress scenario also compounds liquidity risk, which is typically the highest in the beginning of a securitization, as many borrowers have not entered repayment or may be in grace, deferment or forbearance. Back-ended defaults add stress to subordinate bonds and may increase maturity risk, especially if there are delays with claim reimbursements by a loan guarantor. DBRS may assume the following default timing curves, as outlined in Figure 11, for each type of loan if an issuer does not provide adequate historical performance data. 19