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Index Rate Mismatch

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Index rate mismatches are a significant cause of margin compression for education lenders. One of the solutions discussed in the white paper, Solving the Student Loan Credit Crunch (April 30, 2008), was focused on eliminating the index rate mismatch for federal education loans by substituting the 3-month LIBOR index for the 3-month Commercial Paper Rate (CP) in a cost-neutral fashion. Since then there have been several developments in the student loan industry that increase the need for such a solution.

Last Updated: November 18, 2008

Executive Summary

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The ongoing CP-LIBOR dislocation, which was unintentionally exacerbated by the Federal Reserve's intervention in the marketplace for Commercial Paper, will eliminate lender residual income in existing FFELP securitizations. It will also result in downgrades for at least the lower tranches of the securitizations, since the income will be insufficient to pay all the investors. This will prevent future securitizations of federal education loans, rendering a permanent need for the current set of temporary liquidity solutions.

The index rate mismatch should be addressed by switching the index rate used for special allowance payments from the Commercial Paper Rate to the LIBOR index in a cost-neutral fashion, such as by substituting the 3-month LIBOR index minus 10 basis points for the 3-month Commercial Paper Rate.

Index Rate Mismatches

An index rate mismatch occurs when a lender's interest income is pegged to a different variable index (base rate) than the lender's cost of funds. Both credit warehousing facilities and securitizations are usually pegged to the LIBOR index (either the 1-month or 3-month average). The special allowance payment on federal education loans, however, is pegged to the 3-month Commercial Paper Rate.

The index rate mismatch represents a potential source of credit risk, since changes in the spread between the two indexes can affect the amount of income the lender has available to pay investors. Excess spread provides reassurance to investors that the lender will be able to continue making the required quarterly payments.

Historically, the spead between the 3-month Commercial Paper Rate and the 3-month LIBOR index has averaged less than 10 basis points. Since the onset of the subprime mortgage credit crisis, however, the spread between the two indexes has grown significantly and become much more volatile.

The problems with Commercial Paper became so severe that the Federal Reserve intervened by creating a Commercial Paper Funding Facility (CPFF) on October 7, 2008 to purchase 3-month Commercial Paper from October 27, 2008 to April 30, 2009.

Unfortunately, this has had the unintended consequence of distorting the Commercial Paper index. From September 19, 2008 to October 24, 2008, the CP-LIBOR spread, on average, grew to 77 basis points as day-to-day volume decreased by a factor of 25 or more. On October 20, 2008, the CP-LIBOR spread reached a high of 239 basis points, in part due to very low volume. On November 14, 2008, the CP-LIBOR spread was 105 basis points.

The Federal Reserve has acknowledged this problem in the footnotes to the H.15 Statistical Release, writing that "the rates published after September 19, 2008, likely reflect the direct or indirect effects of the new temporary programs and, accordingly, likely are not comparable for some purposes to rates published prior to that period."

The Commercial Paper Rate index no longer reflects a market rate of return, since the index is now effectively determined by the actions of the Federal Reserve. The Federal Reserve is deliberately setting the Commercial Paper Rate at below-market rates in order to support the commercial paper market. The structure of the Commercial Paper Funding Facility has also artificially skewed the distribution of commercial paper volume within the quarter. The market for commercial paper is small enough that the index rate's volatility can become exaggerated by this inconsistent day-to-day volume. The Commercial Paper Rate is no longer a reliable market index and is unlikely to return to such a state for the forseeable future.

Eliminating the Index Rate Mismatch

The US Department of Education, in implementing the statutory authority provided by the Ensuring Continued Access to Student Loans Act of 2008 (ECASLA), eliminated the index rate mismatch on new Stafford and PLUS loans for the 2008-2009 and 2009-2010 academic years. Lenders may pledge loans originated since May 1, 2008 as collateral for one-year financing at a rate of the 3-month Commercial Paper Rate plus 50 basis points. This eliminates the index rate mismatch since both the cost of funds and the interest income are now pegged to the same index.

(Lenders receive income on the Stafford loan at the 3-month Commercial Paper Rate plus 119 basis points during the in-school and grace period and on the PLUS loan at the 3-month Commercial Paper Rate plus 179 basis points. Since the facility does not provide life-of-loan financing and the financing is available only for new loans, the lenders do not receive the repayment rate on the Stafford loan for the duration of the participation agreement financing.)

The ECASLA legislation, however, did not address older loans. Even the US Department of Education's proposal for an ABCP Conduit will not address the index rate mismatch for older loans. While 2007-08 loans originated since October 1, 2007 are unemcumbered with securitizations, the bulk of pre-10/1/07 loans are securitized and consolidated, and so are unavailable to be refinanced through an ABCP conduit.

Existing securitizations are negatively impacted by the CP-LIBOR dislocation. The index rate mismatch is eliminating a key form of credit enhancement, namely excess spread. The cash flows from interest income are applied to a "waterfall" within the securitization, first to pay for servicing of the loans, then to pay the tranches in order of priority, and finally to provide residual income to the lender. When cash flows are insufficient, it not only eliminates the lender's residual income but also the lower tranches. The volatility in the index rate is extreme enough that it may even affect the AAA-rated tranches. This will likely lead to downgrading of those tranches within the securitizations.

Unfortunately, this situation will probably prevent the execution of future securitizations. The possibility and actuality of the Federal Reserve's manipulation of the Commercial Paper Rate destabilizes the entire student loan ABS marketplace. The margins on federal education loans, if any, will be too thin to provide reassurance to investors that they will be paid. It eliminates the most important source of credit enhancement for the student loan securitizations. Thus the intervention by the Federal Reserve in creating the Commercial Paper Funding Facility has had the unintended consequence of creating a credit risk where one did not exist previously.

If the index rate mismatch is not addressed it will perpetuate the need for the federal government's various liquidity solutions, including the ECASLA loan purchase and participation agreements, the ABCP Conduits and TARP.

Solution: Replace the Index

The Solving the Student Loan Credit Crunch white paper included the following recommendation:

"Switch the special allowance payments from the Commercial Paper Rate to the LIBOR index in a cost-neutral fashion. This would eliminate the index mismatch between lender revenues and their cost of funds, providing them with more predictable spreads."

This would still be an effective solution. Specifically, the 3-month LIBOR minus 10 basis points should be substituted for the 3-month Commercial Paper Rate in section 438 of the Higher Education Act. This change reflects both the long-term historical spreads as well as where the markets were when Congress passed the College Cost Reduction and Access Act of 2007.

The substition should be permanent. While the distortion from the Commercial Paper Funding Facility is temporary, that facility is likely to be extended. A permanent substitution will reassure the capital markets by eliminating a source of uncertainty. It will also permit the costing of the change to be based on long-term historical spreads, as opposed to the current unprecedented CP-LIBOR spread. Basing cost to the government on the current spreads is unrealistic and unlikely to reflect future trends. The LIBOR index is also more robust than the Commercial Paper Rate index. Moreover, given that the cost of funds and the interest income would then both be pegged to the same index, lender spreads would be consistent and predictable, eliminating a key source of credit risk. This will make the loans more attractive to investors.

The US Department of Education would then need to change the interest rate on the loan participation agreements from the 3-month Commercial Paper Rate plus 50 basis points to the 3-month LIBOR index plus 40 basis points in order to maintain a consistent spread.

 

 
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