Generational Dynamics: Forecasting America's Destiny Generational
 Forecasting America's Destiny ... and the World's


Generational Dynamics Web Log for 14-Feb-08
'Credit crunch' domino effect is now affecting student loans.

Web Log - February, 2008

'Credit crunch' domino effect is now affecting student loans.

College-bound students may have problems in the fall.

Quick review of the major actors:

It's now turning out that the ratings agencies took fat fees from the banks to give AAA ratings to many, many CDOs and other bonds that are turning out to be near worthless. And it turns out that bond insurers took fat fees to insure many, many of these same bonds, and can't afford to pay off the insurance on them.

Now let's take a look at the domino effect that's going to keep your son or daughter from going to college in the fall:

Step 1: Fitch downgrades some Ambac assets

On January 18, 2008, Fitch Ratings issued a press release saying that it was lowering the rating on many Ambac's assets (not the securities that Ambac insures, but the assets that Ambac owns for itself):

"The decision to downgrade the IFS rating by two notches, coupled with the continuation of the Negative Rating Watch, reflects the significant uncertainty with respect to the company's franchise, business model and strategic direction; uncertain capital markets and the impact of Ambac's recent decisions on future financial flexibility; the company's future capital strategy; ultimate loss levels in its insured portfolio; and the challenges in the financial guaranty market overall."

This could happen to any company these days, and it usually means that the company tried to make a lot of money by investing in mortgage-backed securities that were turned into near-worthless CDOs.

(For those interested in the math behind the creation of CDOs from mortgage-backed securities, see "A primer on financial engineering and structured finance.")

Step 2: Fitch downgrades some bonds insured by Ambac

Once Ambac's assets were downgraded, it meant that Ambac could no longer guarantee that it will be able to pay off on all its insurance policies.

CDOs insured by Ambac have been purchased by all kinds of organizations around the world. Many of those CDOs would have had BBB or CCC ratings without Ambac's insurance. But with Ambac's insurance, they received AAA ratings, since they're doubly protected: The bond investor would receive payment from the bond or payment from the insurance policy.

But if Ambac's ability to pay insurance was degraded, then the bonds insured by Ambac were degraded as well. And that's what happened.

On January 18, 2008, Fitch Ratings issued a second press release saying that it would downgrade the ratings on many "reinsurance transactions" insured by Ambac:

"Fitch Ratings downgrades 420 classes of asset-backed securities (ABS) Additionally, the ratings remain on Rating Watch Negative by Fitch. This action follows Fitch's downgrade of the ratings on Ambac Financial Group, Inc. and its affiliated entities (Ambac)."

The press release then included a very long list of downgraded contracts from many different types of organizations. It's quite a list, and I wish I could include all of it.

But here's a taste of the organizations affected: Ballantyne Re, Babcock & Brown Air Funding, Capital One Auto Finance Trust, Hertz Vehicle Financing, AmeriCredit Automobile.

The largest group of organizations on the list had names like: Access to Loans for Learning Student Loan Corp., Alaska Student Loan Corp., CollegeInvest, Connecticut Higher Education Supplemental Loan Authority, Michigan Higher Education Student Loan Authority.

In fact, there are similar names of student loan organizations from Maine, Iowa, Massachusetts, Missouri, New Jersey, North Dakota, Texas, Pennsylvania, Rhode Island, Utah, Ohio and Vermont.

And so, what's apparent is that a lot of student loans were in trouble.

Step 3: Student loan bond auctions fail

These student loan corporations do the same sorts of things student loans that mortgage lenders did with mortgage loans.

The student loan lenders bundled then together, divided them into tranches, and sold them to investors through auctions. Since they're sold through competitive bidding at auctions, and since the interest rate depends on the amount the bidder pays, they're called "auction-rate securities." With the money obtained from investors at these auctions, the lenders could then offer more student loans.

Well, disaster struck the week before last.

What happens if you give an auction and no one shows up? That's what happened when the lenders tried to auction off their student loan securities. In most cases, there were no bids. Nobody was willing to buy them.

And why would anyone want to buy them? They may turn out to be worthless. Fitch Ratings had just downgraded many of these securities (see Step 2 above), and there's no way to know how much to bid for them, since there's no way to know whether or not they'll turn out to be near-worthless.

And so, many student loan lenders have no way to sell off their old student loan securities, and so they have no way to get money for new student loans. That's how the 'credit crunch' works.

Step 4: Michigan freezes student loan program

Notice in the list in "Step 2" above, the name "Michigan Higher Education Student Loan Authority" appeared as one of the organizations whose securities had been downgraded. Actually, it appeared many times on the Fitch press release, listing many of Michigan's securities.

On Monday, the following announcement appeared on the Michigan student loan web site:

"The Michigan Alternative Student Loan (MI-LOANŽ) Program is offered by the State of Michigan, through the Michigan Higher Education Student Loan Authority (MHESLA), for the exclusive use of students who are attending Michigan degree-granting colleges and universities. This alternative loan program is intended to help students bridge the gap between college costs and traditional federal financial aid resources.

Due to the current and unprecedented capital markets disruption, there is not sufficient available capital to continue making MI-LOANs. After considerable analysis and significant efforts to secure sufficient MI-LOAN capital to make new MI-LOANS, the difficult decision to temporarily suspend MI-LOANs had to be made. Therefore, the MI-LOAN Program will be temporarily suspended at the close of business on Friday, February 15, 2008. When conditions warrant and funds become available, the MI-LOAN Program will be reinstated.

This temporary suspension will not affect any MI-LOANs for which school certifications have been received as of February 15, 2008, and those loans will continue to be disbursed in accordance with current MI-LOAN procedures. As the school certification process takes time, new MI-LOAN applications will not be accepted online after the close of business on Wednesday, February 13, 2008."

So far, only Michigan has made this kind of announcement. It remains to be seen whether other states will follow suit.

According to a WSJ article,

"The credit crunch that has so far caused more than $100 billion of losses for big Wall Street investment firms now extends to students in Michigan, and it could soon hit many other borrowers, ranging from California museums to the prestigious Deerfield Academy prep school in Massachusetts. ...

In the past few days, problems have mounted for many borrowers as an obscure -- but important -- corner of the credit market called auction-rate securities has gone into a deep freeze.

Borrowers ranging from student-loan authorities to municipalities to big bond funds depend on this market to raise money for making loans and funding projects. They do so by selling securities whose interest rates are reset every week as they change hands in auctions....

Moody's Investors Service estimates the size of this market at $325 billion to $360 billion.

In recent days, the money managers and other investors who typically buy auction-rate securities have been balking, out of fear the credit turmoil is spreading. The remaining bidders have commanded higher interest rates from borrowers including Deerfield, San Francisco's de Young Museum, New York's Carnegie Hall and many others. ...

Meantime, many investors who hold the securities would like to sell them but can't. Of roughly $20 billion in such securities auctioned yesterday, half -- or about $10 billion -- failed to generate enough demand from money managers to sell, according to one trading executive at a top dealer. That pushed up borrowing costs for the issuers to levels ranging from 4.6% to 18%, as their interest rates reset to "penalty" rates that kick in when an auction fails."

Take particular note of the last sentence above: "pushed up borrowing rates ... to levels ranging from 4.6% to 18%." These are HUGE interest rates for investors, at a time when Treasury bills pay around 3% or so.

This increase in securities interest rates (or "spreads") is not particularly visible to the public view, but it's something that's getting worse, and is another example of something that could reach a "tipping point" very soon.

In this article, we've used the mechanisms of Steps 1 through 4 to illustrate the domino effect, or chain reaction, that's beginning to occur more and more. A failure in one area triggers a failure in another area.

From the point of view of Generational Dynamics, we're going to see a lot more of these situations, as the massive credit bubble keeps leaking, and the "credit crunch" worsens. Generational Dynamics predicts that we'll see a generational stock market panic and crash, and a new 1930s style Great Depression.

If you're a parent hoping to send your kids to college in the fall with a student loan, then you may wish to take this situation into account, and apply for more loans than you had planned to. Better yet, line up a rich uncle who'd like to pay for the education of his nieces and nephews. (14-Feb-08) Permanent Link
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