At the Wall Street Journal today, Cezary Podkul has a beautiful story about bonds backed by student loans. The basic issue is that there were a bunch of securitizations of federally guaranteed student loans, and it became apparent that those loans might not be repaid in full by the maturity date of the bonds. That is bad for investors: They had bought the bonds expecting to be paid off by a certain time, and now there will be a delay. But there’s not much they can do about it: The delay is due to a federal program allowing for income-based repayment, in which borrowers can cap their repayments at 15% of their discretionary income and stretch out their repayment period. This is not a negotiated modification of the loan terms that the bondholders could object to; it’s just part of the structure of federal student loans, and they have to accept it. Also it’s not that bad for them, because the loans are federally guaranteed, meaning that they’ll be paid off eventually; the federal government will generally pay any remaining balance after 25 years, or when the borrower dies. It’s just that now that might happen after the maturity date of the bonds.
For the investors, this is a matter of degree: Getting a government-guaranteed payment a year late is worse than getting it on time, but, in a low-interest-rate environment, it’s not that much worse. But for bond ratings agencies, it is a big stark difference: If a bond is paid off by its maturity date, that’s good, but if it’s not, that’s a default. If a bond has a high likelihood of defaulting, then it should not have a high credit rating. Many of these bonds—senior tranches of government-guaranteed student loans—had triple-A ratings. If they were likely to default, they should not have had triple-A ratings: