Infrastructure issues hinder student loan ARS recovery

Liquidity in the secondary student loan auction rate securities (ARS) sector has been boosted in recent weeks by demand from distressed investors. However, a number of infrastructure issues still need to be addressed before wider concerns about the market dissipate.

Brian Weber, senior associate at Houlihan Smith & Co, confirms that there has been an up-tick in bids for student loan ARS lately, accompanied by an increasing number of institutional distressed investors entering the market. Depending on the credit rating of the paper, bids are in the range of 70c to 95c, with one Sallie Mae deal recently being purchased at 98c. This compares with a range of 55c to 80c previously.

"The increased interest is being driven by tightening spreads in comparable student loan term ABS," he says. "Investors are getting the same safety of the underlying, including in some cases FFELP guarantees, but with a much better yield (around 50bp-100bp more)."

By way of comparison, ABS analysts at JPMorgan point out that triple-A rated long-dated Sallie Mae ABS have recently traded at around 100DM, while rate-reset notes (RRNs) and ARS in the student loan sector have traded at roughly 85DM and 200DM respectively.

Traditional investors in ARS have exited the market completely, however, having been too badly burnt by the auction failures in 2008. "ARS are complex products that were largely marketed to corporate treasurers, who had little understanding of the structure or the auction process. Investors found themselves needing to educate themselves about their holdings after the time when they most needed to understand them (at purchase). While corporate treasuries still don't typically have the capacity to do sufficient credit analysis on ARS or structured credit in general, distressed investors have a better ability to price the security and understand the auction mechanism," Weber explains.

The majority of ARS auctions are still failing, however - albeit a couple were successful recently due to the deals' higher maximum rate penalty features. Investors continue to be concerned about the market, according to Weber.

He continues: "Investors need spreads to tighten in order to get out of their positions and I believe there is a good chance that they'll be able to do so soon. But there are also infrastructure issues, which if addressed would help to create greater confidence in the sector. Trusts will have to be amended to facilitate refinancing and secondary market liquidity needs to be further developed."

Weber says that SecondMarket provides a great platform for trading secondary ARS, but banks also need to become involved in terms of providing liquidity. "They're unwilling to step into the auction process, let alone facilitate trading," he notes.

ARS activity remains concentrated in the secondary market, but while liquidity is greater than it has been in the past, the market is still illiquid. "I believe that liquidity will return eventually - though not through the auction process, but through secondary demand and refinancing activity once spreads begin tightening," Weber adds. "For example, spreads on student loan deals are currently at around 170bp over Libor, but they need to reach 100bp to facilitate more refinancing in the sector. Sallie Mae transactions are already trading at around 100bp over and this is reflected in the ARS price: there is a direct relation between tighter underlying spreads and higher prices in the secondary ARS market."

The JPMorgan analysts suggest that another concern about ARS is that the current higher coupon costs could erode excess spread in those transactions. Coupons on failed ARS step up, typically to 150bp over Libor. However, they note that for seasoned deals that have reached parity, the triple-A tranches remain well protected by the available credit enhancement.

The analysts agree that the ARS market is unlikely to recover sufficiently any time soon. At the very least, spreads would have to recover to below the ARS step-up coupon margin to consider the possibility of a successful auction. Nevertheless, they believe that the spread pick-up available on ARS relative to comparable RRNs, plus the discount price relative to premiums on term ABS, remains worth investigating for distressed investors.

Meanwhile, University of Delaware economics professors James Butkiewicz and William Latham have conducted a study of the economic impact of restoring liquidity to frozen student loan ARS. A coalition of over twenty US corporations holding such securities is seeking a solution to the problem, as the loss of liquidity has adversely affected the capital expenditures and continuing operations of these firms. Their study finds that restoration of liquidity to US$25bn of student loan ARS held by non-financial corporations would provide economic stimulus of US$64bn to the economy.

CS