Bonds backed by federally guaranteed student loans are subject to greater short-term basis risk because of a mismatch in the way the interest rate on the bonds is calculated compared to the way the Department of Education sets interest on the underlying loans that flow into bond trusts, according to a report released by Fitch Ratings yesterday.

A highlight of the 10-page report, “Quantifying Basis Risk in U.S. FFELP Student Loan ABS,” is that the basis risk arises not only from the different indexes used to set the two interest rates, but also from the method of determining the rates.

Specifically, the rates on the bonds are typically based on the “spot” three-month London Interbank Offered Rate, which changes every day.

However, interest on the underlying loans is based on the special allowance payment, or SAP, determined by the Education Department, and based on the commercial paper rate or the Treasury bill rate, plus a fixed spread.

Unlike the three-month Libor, SAP is set once every calendar quarter and is the 90-day average of spot rates observed over that period.

As a result, evaluating basis risk by directly comparing the spread between three-month Libor and SAP rates does not adequately capture all the basis risk of these types of securities, according to the report, which was written by Aoto Kenmochi, a senior director in Fitch’s asset-backed securities group.

While Congress voted to eliminate the Federal Family Education Loan Program effective July 1, the report is still relevant as issuers repackage the billions of existing bonds backed by FFELP loans, Kenmochi said.

The Fitch report notes that volatility created by the mismatch between the interest rate on the bonds and the rate on the loans is much lower over the long-term horizon than in the short term.

Fitch also found that senior FFELP-backed bonds with 3% levels of credit enhancement generally had sufficient collateral to weather short-term basis volatility. The implication, however, is that there may be some downgrades for subordinate bonds that are not enhanced.

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