For those of you who remember the multiple Greek bond restructurings, the gimmicks now being used to pretty up the prospects for student loans look awfully familiar.
One of the devices Greece’s creditors used to make it more plausible that broke and prostrated Greece might someday make good was extending maturities to lower the amount due in any year. This was particularly true of the loans that came from European governments, where payments in the 2015 restructuring were deferred to 2020 and 2022. We pointed out that the maturities of various borrowings had already been pushed out so far (40 to 60 years) that additional deferrals would buy little in the way of payment relief.
The Wall Street Journal tonight describes how a similar trick is being used with student loans. Unlike Greece, investors in bonds that have Federally-guaranteed student loans as the source of their cash flows will eventually get their money. However, as the article explains, the timing is in question. And unlike Greece’s creditors, who were more concerned about optics than discounted cash flows, bond investors know that payments that come in late are less valuable than ones that come in as scheduled.
Bond rating agencies are playing along with this “kick the can” strategy, typically issuing a downgrade at the time the maturity is extended, then marking it back up to triple A. From the Journal:
Because borrowers were taking longer to pay off their loans, there was a risk the bonds backed by the loans wouldn’t be paid off in time. Bond-rating firms were watching and getting ready to downgrade the highly rated bonds, potentially causing losses for investors.
The issuer of the bonds and the investors who owned them hatched a plan to avoid the downgrades. Their solution: make sure bonds were paid off in time by extending their maturity dates by decades…
Bond-ratings firms like Moody’s Corp. and Fitch Ratings follow strict rules. They will downgrade a security if they don’t think it will pay off by the due date, even when the underlying loans are guaranteed by the federal government…
Investors who hold on will eventually get paid back, but a downgrade might cause them to suffer a temporary loss….
Some bonds went on a ratings roller-coaster ride, including a $406 million chunk of triple-A debt that Moody’s downgraded to junk on Nov. 1, 2016. Later that month, the maturity date was moved from 2026 to 2055. Within weeks, Moody’s upgraded the bond back up to triple-A.
Other bonds ended up with widely divergent ratings. A $30 million chunk of a 2008 student bond deal is either triple-A, if you believe Moody’s, or deep inside junk territory, if you believe Fitch. That bond is also now due in 2083.
Mind you, this payment delay issue applies only to a subset of student loans, ones that Congress allowed to participate in an income-based repayment scheme, which limits monthly payments to 15% of discretionary income. The program was short-lived, ending with loans from 2010, but still has $262 billion in principal outstanding, of which roughly 26% is in default. The later loans total $1.2 trillion, with about 10% in default.
The Journal points out that investors have incentives to maneuver borrowers into programs that aren’t in their best interest:
The threat of downgrades got the attention of federal regulators at the Consumer Financial Protection Bureau. In a 2015 report, the agency’s student loan ombudsman cited issuers’ “economic incentive to ensure that bonds backed by these loans perform on schedule” as a concern because it might mean issuers steer borrowers toward temporary payment pauses and away from income-based repayment plans that provide longer-term relief.
In January 2017, the CFPB sued [student loan servicer] Navient for allegedly “failing borrowers at every stage of repayment. ” Navient says the CFPB’s allegations are false and is fighting the lawsuit.
Needless to say, we see in a very small way how securitization increases rigidity in handling borrower distress. We saw it in a far more dramatic manner during the foreclosure crisis, when loan servicers refused to make modifications that would have both salvaged many borrowers and reduced losses to the securitization trust. The immediate reason was that they were paid to foreclose and not paid to modify loans, which is a high-touch, customized activity, as much work as underwriting a new loan. But an additional reason was so-called “tranche warfare”: the riskiest bond tranche that was still getting payouts benefitted from foreclosures, because they would still get advances from the servicer until the foreclosed home was sold, while if a loan was modified, their income would be hit immediately. Those investors were often hedge funds who’d picked up those bonds at distresses prices and were just the sort who would really could and would sue the servicers for arguably hurting their interest.
However the events above illustrate an interesting conundrum. What would happen if Elizabeth Warren’s awfully-slow-in-coming proposal to have student loans be dischargeable in bankruptcy were to become law again? You’d see a lot of broke borrowers doing just that, filing for bankruptcy to get their loans written off or reduced. There is other proposed Federal legislation to provide relief for student loans, including two with new income-based repayment plans with lower required payments (10% of discretionary income versus the old 15% level). So far, investors seem to recognize that government guaranteed student loans are such a gimmie that they aren’t about to squawk much publicly about having some features less favorable to them become more common. But rest assured, they have plenty of proxies they can use to argue their self-serving case.