Fitch Ratings-New York-24 May 2023: Significant change to basis risk is not anticipated for Federal Family Education Loan Program (FFELP) ABS following rate transition away from LIBOR under the Adjustable Interest Rate Act (LIBOR Act), according to Fitch Ratings. All FFELP ABS and Special Allowance Payments (SAP) will transition to SOFR-based rates on the first business day after June 30, 2023. Basis risk arises when the SAP rate index differs from the rate index for the FFELP ABS bonds, including differences in reset dates and reset frequency. We will apply similar basis risk stresses as those currently applied to LIBOR rates under our U.S. Federal Family Education Loan Program Student Loan ABS Rating Criteria, with no changes to ratings as a result of basis differentials under SOFR.
Fitch will continue to model various interest rate levels and applies basis spread stresses that align with historical movements of the relevant indices. The stresses test a transaction’s vulnerability to both short-term and long-term rate movements at all rating categories.
SAP paid by the U.S. Department of Education on the underlying assets effectively turns fixed-rate student loans into variable rate assets. FFELP ABS transactions are more sensitive to interest rate basis risk than other consumer ABS sectors, given the low absolute level of credit enhancement for these transactions that limits the ability of FFELP ABS to absorb any form of loss.
The LIBOR Act and the related final rule for implementation from the Federal Reserve Board requires the following replacement rates be applied for contracts transitioning away from LIBOR:
–SAP indexed FFELP loans: 30day Average SOFR (30dy SOFR) + spread adjustment of 0.11448%;
–For FFELP ABS when more than 50% of the portfolio consists of FFELP loans (all Fitch-rated FFELP ABS meet this threshold): (i) one-month LIBOR will be replaced with 30-day SOFR plus the tenor spread adjustment (0.11448%, the same as SAP replacement rate); and (ii) three-month LIBOR will be replaced with 90-day Average SOFR (90dy SOFR) plus the tenor spread adjustment (0.26161%). This is different from other consumer loan transactions that will utilize the CME Term SOFR and was a new addition to the final rule;
–Derivatives SOFR will be compounded in arrears for the applicable tenor, plus a stated spread adjustment based on the applicable tenor.
The 30-day SOFR and 90-day SOFR rates are relatively new rates published by The New York Federal Reserve Bank starting in 2020. SOFR observations are not available in periods of prolonged economic stress, such as the Great Recession, complicating the derivation of forward-looking stresses at all rating levels. SOFR basis spread did decrease last year as interest rates increased, which could be indicative of a decrease in basis spreads going forward; however, due to the short historical performance of the SOFR indices, historical basis spreads during periods of economic stress will continue to be factored into Fitch’s basis spread assumptions post-LIBOR transition.
Therefore, Fitch’s basis risk stresses will remain unchanged, and rating actions will not result from the transition to SOFR. Ratings downgrades in the sector remain predominately due to maturity risk, the risk that senior classes will not pay in full prior to legal final maturity dates.
The limited number of FFELP ABS with derivatives will face a meaningful operational challenge with the transition under the LIBOR Act as the date for determining the derivative payment amounts is likely to change to two days before payment in line with the Fed final rule. Such a change may interfere with the calculations for the transaction waterfall and lead to a disruption of payments on the bonds if the change in date for the swap is not successfully incorporated into the structure.
Related research:
U.S. Student Loan ABS Defaults Reach Highs in 1Q23
Contacts:
Nicole Edwards
Director, US Structured Finance
+1 212 908-9114
Fitch Ratings, Inc.
Hearst Tower
300 W. 57th Street
New York, NY 10019
Sarah Repucci
Senior Director, Fitch Wire
Credit Policy – Research
+1 212 908-0726
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