toronto new york chicago london paris frankfurt Commentary The Role of FFELP Guaranty Agencies in Student Loan ABS june 2007
CONTACT INFORMATION David Hartung Senior Vice President, U.S. Structured Finance +1 212 806 3269 dhartung@dbrs.com David Laterza, CPA Vice President, U.S. Structured Finance +1 212 806 3270 dlaterza@dbrs.com DBRS is a full-service credit rating agency established in 1976. 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.
The Role of FFELP Guaranty Agencies in Student Loan ABS TABLE OF CONTENTS Overview 4 The Creation and Role of the Guaranty Agencies 4 Pre-Claim Responsibilities 5 Additional Responsibilities 6 Financial Considerations 6 Federal Fund 7 Operating Fund 7 Risk to ABS Investors 7 Conclusion 8 Appendix: Guaranty Agencies Participating in FFELP 9 3
Overview The stable performance of Federal Family Education Loan Program (FFELP) student loans, as well as ongoing increases in loan origination volume, has resulted in FFELP student loan-backed asset-backed securities (SLABS) becoming one of the largest sectors in the asset-backed securities (ABS) marketplace. A unique feature that differentiates FFELP loans from other securitized consumer assets is the guaranteed reimbursement of defaulted principal and accrued interest paid to the loan holders. 1 These guarantees are provided by agencies which qualify as guarantors pursuant to federal guidelines and whose guarantee is also reinsured by the U.S. Department of Education (ED). In this report, DBRS outlines the role of the guaranty agencies in the FFELP, details the risks in SLABS transactions related to the guaranty agencies and outlines how SLABS investors can monitor the level of guaranty agency-related risk in their transactions. The Creation and Role of the Guaranty Agencies The FFELP was created by the Higher Education Act of 1965 (the Act) and stipulates that each state designate a single guaranty agency that must guarantee the FFELP loan of any student with a nexus to that state. A state nexus loan is a loan to a borrower who is a resident of that particular state or who is attending a school in the state. Currently there are 35 designated guaranty agencies participating in the FFELP, all which are not-for-profit entities, including many which are state agencies (see Appendix for a detailed list). A few states have declined to create their own guaranty agencies and have instead contracted with guaranty agencies from other states to serve as their designated guaranty agency (see Appendix for a list of current FFELP guarantors). Guaranty agencies guarantee FFELP loans originated by eligible lenders 2 against default for outstanding loan principal and accrued interest up to the date the defaulted loan claim is filed by the lender (or loan servicer operating on behalf of the lender). 3 The defaulted loan claim is reimbursed in an amount equal to a statutorily set percentage of outstanding loan principal plus accrued interest (see Table 1 for current percentages). Table 1 Disbursement Date % of Defaulted Principal and Accrued Interest Guaranteed Prior to October 1, 1993 100% After October 1, 1993 but prior to July 1, 2006 98% On or after July 1, 2006 97% In order for a FFELP loan to qualify for a guarantee, the loan must be properly originated and serviced in accordance with federal regulations and industry guidelines by an eligible lender or loan servicer operating on behalf of the lender. Errors in origination or servicing may result in the rejection of a defaulted loan claim by the guaranty agency and shift 100% of the liability for losses to the loan holder. 4 The industry guidelines for loan origination and servicing are contained in the Common Manual 5 and formulated by, principally, the guaranty agencies. 1 The guarantee also applies to loans discharged in bankruptcy proceedings involving borrowers of FFELP loans and in the event of the death of a borrower. 2 Lender eligibility is determined by conditions set forth in the Higher Education Act of 1965. 3 Default claims may not be filed by loan holders until the loan reaches 270 days of delinquency. 4 Loan holders are either (1) originators or purchasers of student loans who hold the loans on their balance sheets or (2) special purpose entities (e.g., trusts) into which loans have been sold for securitization. 5 The Common Manual is available online at http://www.commonmanual.org. 4
Under current federal regulations, the ED reinsures the guaranty agencies for payments on defaulted loan claims. The reinsurance rates are listed in Table 2 on the following page and are currently subject to two gross default triggers. 6 For example, for loans originated between October 1, 1993 and September 30, 1998, a guarantor will receive 98% reinsurance if the gross default rate on its guarantee book is less than 5%. If the gross default rate is greater than 5% and less than 9%, the agency will receive 88%. Note also that the reinsurance rates have declined over time as the ED has tried to provide an incentive to the guaranty agencies to be proactive in their default aversion responsibilities (see Pre- Claim Responsibilities section). All lenders and servicers who hold and service loans guaranteed by an agency are subject to annual audits of their origination and servicing operations by that guaranty agency per federal guidelines. As a result, lenders and loan servicers who hold and service loans guaranteed by multiple guaranty agencies are subject to frequent audits on nearly a constant basis. Table 2 Claims Paid Date Maximum Reinsurance Rate 5% Trigger 9% Trigger Before 10/01/1993 100% 90% 80% 10/01/1993 to 09/30/1998 98% 88% 78% On or after 10/01/1998 95% 85% 75% Source: U.S. Department of Education. Pre-Claim Responsibilities One of the guaranty agencies most important roles is to assist preventing loan defaults during the period of borrower delinquency. Under federal guidelines, when a borrower becomes 60 days delinquent, the lender or loan servicer operating on behalf of the lender for that delinquent loan must request default aversion assistance from the agency guaranteeing the delinquent loan. Default aversion activities to be performed by the guaranty agency include contacting the borrower, contacting the school attended by the borrower to verify the last known address of the borrower and the use of skip tracing techniques as needed in conjunction with those being performed by the lender or servicer. Guaranty agencies are compensated for their performance of these activities and are entitled to earning a Default Aversion Fee, equal to 1% of the outstanding amount of loans reported delinquent but not defaulted within 300 days thereafter. 7 Uniform agreements between the guaranty agencies and the ED outline standard default aversion techniques. However, to encourage the development of innovative programs to prevent defaults, enhance communication lines with borrowers and improve collection activities, guaranty agencies are permitted to enter into voluntary flexible agreements (VFAs) with the ED. At this time only four guaranty agencies have VFAs in place with the ED, but several others are developing VFA programs. Those agencies with VFAs in place include American Student Assistance (ASA), California Student Aid Commission (CSAC), Great Lakes Higher Education Guaranty Corporation (Great Lakes) and TG Student Loan Corporation (TG). At the heart of the VFA concept are methodologies that improve communication lines between lenders or servicers and borrowers, improve operating efficiencies for all parties touching the guaranty business and encourage proactive default prevention behavior on the part of lenders, servicers and borrowers 5 6 For the purpose of these triggers, the gross loan default levels are calculated as the dollar amount of loans that have defaulted as a percentage of the total amount of guaranteed loans in repayment at the beginning of the federal government s fiscal year (October 1 to September 30). 7 This fee is paid by transfers from the Federal Fund (see Financial Considerations section below for more detail).
alike. Uniform performance metrics are being utilized to enable the industry to compare programs and guaranty agencies. However, since VFAs have only been in use for a few years, the comparative usefulness of these metrics is still debatable, although most early observations indicate that VFAs are enabling guaranty agencies to improve efficiencies and the cost-effectiveness of their default prevention activities. Additional Responsibilities Besides paying claims on defaulted loans submitted by loan holders, guaranty agencies have other responsibilities and operations that are designed to reduce FFELP loan gross default levels and thereby reduce the cost of the FFELP. These duties include, among others, account maintenance collections, and loan rehabilitation. Guaranty agencies are responsible for maintaining records on all loans on which they have issued a guarantee. To compensate the agencies for this responsibility, the ED pays the agencies an account maintenance fee equal to 0.10% of the original principal amount of loans outstanding. Once the ED has made reinsurance payments to the guaranty agency for paid defaulted loan claims, the guaranty agency continues to seek repayment from the borrower through traditional collections activities. Simultaneously, the agency refers defaulted loans to the ED so that the federal government can seek to offset the reinsurance payment by withholding any federal income tax refunds that the borrower may be owed. Guaranty agencies may also rehabilitate defaulted loans. To rehabilitate a loan, the guarantor must receive reasonable and affordable payments for 12 months. No student loan may be rehabilitated more than once. Guaranty agencies can also sell rehabilitated loans to lenders upon receipt of approval from the ED. Financial Considerations Guaranty agencies earn fees for the services they provide which are listed in Table 3 below. Revenue from fees earned for items one through four below and other compensation earned by guaranty agencies are deposited into either the Student Loan Reserve Fund (also referred to as the Federal Fund) or the Operating Fund as required by federal regulations. Table 3: Guaranty Agency Fees (1) Insurance Premium/Guarantee Fee Up to 1% of the principal amount of the loan; withheld from the proceeds of each loan disbursement or paid by the lender on behalf of the borrower* (2) Loan Processing and Origination Fee 0.40% of the principal amount of the loan; paid by the ED (3) Account Maintenance Fee 0.10% of the principal amount of loans outstanding; paid by the ED (4) Collection Retention Fee 23% of the amount collected on a loan on which reinsurance has been paid (18.5% of the amount collected on a defaulted loan that is purchased by a lender for rehabilitation or consolidation); withheld from gross receipts. (5) Default Aversion Fee 1% of the outstanding principal amount of loans reported delinquent but not defaulted within 300 days thereafter. This fee is paid by transfers from the Federal Fund (see Federal Fund section). * Traditionally, some guaranty agencies either waived or charged reduced guarantee fees. However, in 2006, Congress passed the Higher Education Reconciliation Act, which included a requirement that all FFELP guarantors collect and deposit into the Student Loan Reserve Fund 1% of the principal amount disbursed of all Stafford and PLUS loans originated after July 1, 2006. 6
FEDERAL FUND The Federal Fund is considered the property of the federal government. Amounts deposited into the agency s Federal Fund may only be used by the agency to pay defaulted FFELP loan claims and Default Aversion Fees. The Default Aversion Fees are transferred to the agency s Operating Fund as earned (see Operating Fund section). Default reinsurance payments received from the ED, insurance premiums collected from borrowers and the percentage of collections on defaulted loans are deposited in to the Federal Fund. Under current law, the Federal Fund is required to be maintained at a level equal to at least 0.25% of the original principal balance of outstanding guarantees. 8 If the ED determines that a guaranty agency has been below this required level for two consecutive years, management of the agency must submit a plan to the ED which details how the agency will reach the required level within 18 months. OPERATING FUND The Operating Fund is the property of the guaranty agency and there are no restrictions on the use of funds deposited into this account. As guidance, the federal regulations state that the Operating Fund shall be used by the agency to fulfill its responsibilities under the Act. The activities that traditionally fall under this broad mandate include loan application processing and disbursement, enrollment and loan status monitoring, default aversion tactics, collections efforts, school and lender training exercises, awareness and outreach programs, compliance controls and other activities related to student financial aid. Agencies deposit loan processing and origination fees, account maintenance fees, default aversion fees and collections revenue net of amounts owed in relation to the ED s share into the Operating Fund. In the event a guarantee agency becomes insolvent, under the 1992 amendment to the Act, the ED is required by statute to honor the guarantee obligations, on terms equivalent to the original guarantee. Risk to ABS Investors Given the nature of the guaranty agencies primary role in FFELP to make timely payments on defaulted loan claims and the relative financial stability of these entities, for investors in FFELPbacked SLABS, the risk inherent in guaranty agencies is liquidity risk, as opposed to credit risk. Given the highly regulated nature of the process through which guaranty agencies perform their duties, the degree of liquidity risk is nominal. Further, DBRS addresses this risk in its cash flow stress scenarios. When reviewing SLABS transactions the prospectus will provide a breakout of the collateral pool by which guaranty agencies are guaranteeing the loans. For guaranty agencies that comprise large percentages of the pool, there will be additional disclosure on the financial results of the agencies and the performance of their books of loans. As a guaranty agency pays lenders on claims submitted and the agency s gross default rate increases, the agency may receive reduced reinsurance from the ED as a result of a default trigger threshold being crossed. This decrease in reinsurance from the ED could force the guaranty agency to tap its Federal Fund to compensate for the growing difference between the dollar amount paid out to lenders and the amount of reinsurance it receives from the ED. This scenario could lead to the inability of the agency to make payments on claims and could result in reduced available funds in a SLABS trust thus causing a delay in the trust s payment of principal and interest to SLABS note holders. The 1992 amendment to the Act created the explicit federal guarantee by the ED of loan reimbursement in the event a guaranty agency was to become insolvent. An additional comfort to investors should be 7 8 Traditionally, the ED has calculated this ratio as of September 30, which is the closest date to the close of the federal fiscal year.
the historical precedent established in 1991 when the ED agreed to pay 100% of eligible default claims filed by Higher Education Assistance Foundation (HEAF), which had experienced losses and cash flow shortages and faced insolvency. The managed liquidation of HEAF by the ED averted potential losses and delays of note principal and interest payments to SLABS investors that could have been attributed to HEAF s financial deterioration and established precedent that the ED would, in fact, intervene when a FFELP guaranty agency faces financial difficulty. Conclusion The credit risk to SLABS investors stemming from the guarantor agencies is negligible given the following: (1) the highly regulated nature of the policies and procedures governing how guaranty agencies conduct business, (2) the direct obligation of the ED to reinsure FFELP loans, (3) the not-for-profit nature of the guaranty agencies, (4) the requirement of the ED to accept defaulted loan claims directly should a guaranty agency be deemed insolvent, and (5) the precedent demonstrating the willingness of the ED to fulfill such a role. Although remote (only one agency has been wound down by the ED since the inception of the FFEL program in 1965), an insolvency of a guarantee agency may create potential liquidity risk for SLABS transactions. Investors can monitor the guaranty agencies backing their collateral pools for any rise in gross default rates or lower reserve ratios, which could be advanced indicators of potential liquidity concerns that could cause delays in guarantee payments to SLABS trusts. 8
Appendix Guaranty Agencies Participating in FFELP Guaranty Agency State(s) Designated Guarantor Loan Guarantee Volume in Repayment Reserve Ratio 2 Claims Rate 3 Recovery Rate 4 as of 9/30/05 1 as of 9/30/05 1 as of 9/30/06 as of 9/30/06 American Student Assistance DC, MA $22,357,154,761 0.228% 5 0.98% 25.28% American Education Services/PHEAA DE, PA, WV, CA, FL, GA, MD, OH 27,510,562,706 0.155% 1.42% 33.93% California Student Aid Commission (EdFund) CA 14,718,977,913 0.250% 3.00% 25.01% College Access Network CO 6,353,159,290 0.271% 5 1.52% 22.35% Connecticut Student Loan Foundation CT 1,134,979,900 0.414% 2.33% 29.47% Education Assistance Corporation SD 1,770,817,360 0.290% 1.94% 38.17% Educational Credit Management Corp. OR,VA 3,098,915,971 0.294% 3.97% 28.88% Finance Authority of Maine ME 698,892,764 0.343% 0.65% 52.27% Florida Department of Education Office of Student Financial Assistance FL 3,884,439,607 0.902% 2.20% 23.80% Georgia Higher Education Assistance Corporation GA 691,414,768 0.591% 3.65% 45.38% Great Lakes Higher Education Corporation MN, OH, PR, VI, WI 20,741,363,530 0.578% 5 0.62% 21.64% Illinois Student Assistance Commission IL 5,012,026,760 0.809% 1.82% 19.87% Iowa College Student Aid Commission IA 1,601,857,966 0.775% 1.97% 25.28% Kentucky Higher Education Assistance Authority AL, KY 2,164,218,220 0.302% 2.33% 42.94% Louisiana Student Financial Assistance Commission LA 1,275,476,233 0.158% 0.62% 22.10% Michigan Higher Education Assistance Authority MI 2,015,646,442 0.796% 2.59% 34.99% Missouri Department of Higher Education Student Loan Program MO 2,096,606,193 0.432% 2.18% 35.55% Montana Guaranteed Student Loan Program MT 1,114,893,186 0.417% 0.98% 25.92% National Student Loan Program NE 5,092,929,861 0.307% 1.88% 37.28% New Hampshire Higher Education Assistance Foundation New Jersey Higher Education Student Assistance Authority NH 1,044,616,831 0.385% 0.88% 33.78% NJ 3,091,643,571 0.449% 2.23% 16.76% New Mexico Student Loan Guarantee Corporation NM 530,799,315 0.467% 1.63% 30.54% New York State Higher Education Services Corporation North Carolina State Education Assistance Authority NY 20,723,325,390 0.252% 1.47% 19.59% NC 1,452,501,106 0.287% 1.13% 36.64% 9
Guaranty Agencies Participating in FFELP Guaranty Agency State(s) Designated Guarantor Loan Guarantee Volume in Repayment Reserve Ratio 2 Claims Rate 3 Recovery Rate 4 as of 9/30/05 1 as of 9/30/05 1 as of 9/30/06 as of 9/30/06 Northwest Education Loan Association ID, WA 3,655,359,474 0.377% 0.76% 58.91% Oklahoma Student Loan Program OK 2,129,097,920 0.547% 2.64% 34.85% Rhode Island Higher Education Assistance Authority RI 1,072,260,769 0.849% 1.84% 35.05% South Carolina Student Loan Corporation SC 1,662,860,054 0.334% 0.80% 31.52% Student Loan Guarantee Foundation of Arkansas, Inc. AR 1,311,965,680 0.252% 2.17% 48.68% Student Loans of North Dakota MN, MT, ND, SD, WY 567,641,193 0.594% 0.72% 33.17% Tennessee Student Assistance Corporation TN 2,911,858,447 0.427% 2.46% 24.22% Texas Guaranteed TX 11,639,915,413 0.849% 5 3.06% 26.94% United Student Aid Funds, Inc. AZ, HI, IN, KN, MD, MS, NV and WY 50,952,228,326 0.452% 1.21% 38.03% Utah Higher Education Assistance Authority UT 1,584,418,708 1.405% 1.83% 26.94% Vermont Student Assistance Corporation VT 1,281,028,882 0.607% 0.96% 22.42% 1 9/30/05 is the last date published reserve ratios from the ED are available as of the publishing date of this report. 2 The reserve ratio represents the net assets of the guaranty agency as of the end of the ED s fiscal year (9/30) divided by the original principal amount of the outstanding loans guaranteed. 3 The claims rate represents the percentage of federal reinsurance claims received from the ED during the fiscal year relative to the guaranty agency s balance of loans in repayment at the end of the prior fiscal year. 4 The recovery rate represents post-claim amounts recovered from borrowers by the guaranty agency during the fiscal year relative to the aggregate amount of default claims paid by the agency outstanding at the end of the prior fiscal year. 5 Guaranty agencies with a current VFA are waived from the requirement to maintain a 0.25% reserve level. 10
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