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Contingent Liabilities & the Sale (5 of 5)

On 31 October 2017, when the student loan sale process was restarted following the General Election, Jo Johnson placed a Departmental Minute in the House of Commons Library outlining the contingent liabilities that the government would have to assume to proceed with a sale.

There are four areas where liability might arise and these would be recorded in subsequent DfE accounts:

  • Under certain conditions, the government would have to commit to repurchasing the securities issued:
    • RPI being abolished and not being replaced with a suitable substitute;
    • gross repayment collection failure (defined as missing three years of payments);
    • changed collection terms removing HMRC from the equation.
  • The government would offer an indemnity to purchasers against losses arising from any failure in the servicing of the securitisation;
  • The government would enter into the standard market indemnity against any misrepresentation of the loans in its sale prospectus;
    • this “Joint Lead Managers” indemnity is uncapped and in place as long as the securities are outstanding.
  • and finally, to guard against “democratic risk”, there will be compensation to purchasers were a future government to make changes to the loans:

A third area of contingent liability arises due to the offer of a compensation mechanism which provides assurance to investors that they will be made whole for changes made by the Government: (i) to the terms of the sold loans which affect repayments and therefore cashflows; and/or (ii) specified changes to their regulatory status which would have a material adverse effect on the securities. This would only apply to pre-2012 loan terms. The risk of these specific events occurring depends on the direction of future government policy.

With respect to the last, the government cannot prevent future governments from abolishing these sold loans or changing their terms, but it can set up a compensation mechanism which would prove off-putting to any such radical plans.

In sum, these contingent liabilities would have to be considered when deciding whether Income Contingent Student Loans 1 (2002-2006) Plc really is sufficiently independent of government to be considered a private sector entity.


When a loss is not a loss (4 of 5)

The government would like to have the recent securitisation of student loans and the transfer of their ownership to Income Contingent Student Loans 1 (2002-2006) Plc classified as a sale that achieved market price without any implicit subsidy or support for the sale process, have ICSL1 classified as a private sector body independent of government, and thereby have the relevant transactions recorded in the national accounts as a ‘revaluation’. This would avoid any of the transactions recorded as income and expenditure and thereby avoid recording losses against the deficit, the headline measure capturing the difference between the two and the focus of the government’s fiscal mandate.

By losses here we mean two aspects – whether the asset was sold for less than it’s worth and what the decision to issue loans (that were later sold) cost, i.e. the cost of the policy overall. While a ‘revaluation’ might give you some truth about the first of those (the market told you the loans were worth less than you thought), it ignores the historic aspect: you would not be able to use income and expenditure to capture what’s going on with loans as a policy. If the sale precipitates future anticipated write-offs, then losses associated with the original policy never show up in the deficit.

This is pretty attractive to government and could be seen as a driving factor behind the sale. As we will see a loss-making loan that is sold at further loss would not be recognised. But there is a broader problem with income contingent loans. They don’t fit the conventions governing “financial transactions” – as such, the Office for National Statistics should now be reviewing more broadly what is transpiring with pre- and post-2012 loans.

Although government officials insist that they have not chosen the accounting conventions in use, the current treatment of financial transactions was not designed for loans with such long lifetimes, such large balances or with such large subsidies or losses built in. ICR loans have been crowbarred into place and a fundamental review is now overdue.

As with company accounts, you can look at the cashflow, the balance sheet and the income/expenditure statement to get an overall sense of the UK’s fiscal position. When writing about student loans I have tended to focus on the cashflows and the impact on the balance sheet as it is relatively straightforward.

The problems arise when it comes to determining what counts as income or expenditure for loans, and thereby what impact policy has upon the deficit.

The government loans money to students (cash outlay) and collects repayments from borrowers (cash receipts). Currently, annual loan issuance is about £15billion and annual repayments from all previous borrowers about £2.5bn. The Treasury elects to fund the shortfall between the two by issuing gilts. This form of borrowing adds to the nation’s stock of debt. Although the balance sheet has had added assets (new loans issued) and a liabilities (new gilts issued), only the latter is captured in the headline measure of Public Sector Net Debt. One presentational reason for preferring to sell student loans, it that the cash generated can be used to offset liabilities (or reduce the need for new borrowing) and so lower PSND.

The manner in which a sale impacts on the balance sheet and cashflow is clear. Cash is received in return for transferring ownership of the assets (moving them off the public balance sheet). There’s no problem there, but that’s not where the focus is. The government asks the public to judge its economic competence on reducing the deficit. There is a huge presentational gain from keeping as much out of income and expenditure as possible. This leads us to the problem: we should want the accounts to capture the proper impact of decisions.

As things currently stand, outlay on student loans – the lending – does not count as expenditure; nor do repayments count as income. (National accounts are run on a cash in, cash out basis. The cash value of transactions is recorded when they occur. None of this discussion applies to departmental accounts, which are accruals).

Ignoring outlay and repayments, income and expenditure deals with only write-offs and interest. Write-offs, when they occur, count as capital expenditure using the face value of the balances expunged, while interest accruing annually counts as income.

The latter in particular seems odd. Income accruing is income receivable, not income received, which would be repayments and so is excluded. That is, interest is only what is accumulating against outstanding balances.

This works for most financial assets, because there is a basic accounting identity at work.

In cash terms,

Loan Outlay + Interest Accrued = Repayments + Outstanding Balance

Through a bit of jiggery-pokery that means that

Loan Outlay – Repayments = Outstanding Balance – Interest Accrued

Either side of the second equation can be used as a definition of profit/loss. If Interest Accruing scores as income and Balances written off as expenditure, then the loss or gain on issuing loans is effectively captured in the deficit by the time the accounts are closed. (Note that the right-hand side of the equation is what you get with “financial transactions”, the left-hand side of the equation is what you get with graduate or general taxation.)

For normal loans, interest is repaid as it arises and it is recorded as income; there are no planned write-offs; if all goes well that financial transaction treatment accurately captures the gains made from issuing a loan.

The same cannot be said of income contingent loans with loss exemplified through large, planned subsidies when accounts are closed and where interest accruing against the balance may never be paid.

You can see the effects. Interest accruing is recorded as income every year. This flatters the income/expenditure statement until the policy write-offs occur decades in the future.

That is, as things currently stand (and in the absence of a concerted sale policy), we will start to see large write-offs score as expenditure after the mid-2030’s. These hits will relate to policy decisions made decades before. This does seem ridiculous: the current deficit simply doesn’t capture the impact of issuing tens of billions of student loans today.

You might expect a sale to clarify things. We know that student loans are offered on soft terms and make a loss for government. This is accurately captured in departmental accounts. A sale precipitates that loss – crystallises it today – and possibly adds additional losses if the loans are sold for less than the accounts say they are worth. An accounting treatment consistent with what was outlined above would set the price received against the balances written off and determine an appropriate expenditure mark. That is, if you raise £1.7bn from balances of £3.7bn then you would expect capital expenditure to take a £2bn hit.

Something akin to that would result were the ONS to classify the sale as a “capital transfer”. The government doesn’t want this and instead wants the transaction to be classified as a “revaluation” – the sale shows that the loans were really worth £1.7bn. That might or might not be the case, but such an interpretation loses the connection to the fundamental accounting identity that allows the overall cost of HE policy to be recognised, albeit imperfectly in very attenuated fashion.

What worries people about the ‘revaluation’ classification is that any losses on loans as a policy would no longer show up anywhere in expenditure. A fundamental aspect of double-entry bookkeeping would have been lost.

You could issue £10bn of loans in the expectation that you would get £8bn in return, but avoid recognising that £2bn loss by selling on the loans. As long as the sale is classified as ‘revaluation’, outlay, repayments and price received would never appear in income and expenditure and nor would any equivalents. You would have no record in income and expenditure of the difference between loan value and price received and no record of the cost of HE policy. A generalised loan policy would evaporate the cost of HE leaving nothing in the deficit, but interest accruing as income.

Only the “capital transfer” treatment, would keep this relation to losses.

Whatever the Manual of Government Deficit and Debt allows you to conclude about the sale, trying to shoehorn ICR loans into these existing treatments needs its own revaluation. What we have is a mess.

Whatever you think about accounting, it should capture the full fiscal impact of policy decisions. The ONS needs to review the accounting treatment for ICR loans, not simply decide how to classify the sale.

Was it a sale? ONS decisions (3 of 5)

In order for the securitisation to be classified as a sale, the government needs to have shed all risk associated with student loan repayments.

Transferring those risks to the private sector required all of the junior tranches to be sold. Did the government shift the risk off its books by selling unrated bonds very cheaply? That’s a good question and one that’s hard to answer given that there was no market price in these assets – either the loans or the securities – beforehand.

The Manual of Government Deficit and Debt, is the EU guide to the relevant national accounting. Its section on securitisation contains the following paragraphs, which the government endorses:

V. “The sale of a financial asset to the securitisation entity will not affect the government net lending/borrowing.”

V. “In national accounts, the disposal of assets should be recorded at the market price that prevails at the time the transaction takes place. It is generally the observed sale price, the price agreed in the contract. However, if there is evidence that the observed sale price is lower than the market value it may indicate that the operation is not carried out on a pure commercial basis and that there is an implicit support of the securitisation entity. In such a case, it is necessary to record a capital transfer from government to make up the difference between the observed price and the market value as the sale is recorded at market price in national accounts”

The “securitisation entity” here is the special purpose vehicle that will take ownership of the loans. In this case, Income Contingent Student Loans 1 (2002-2006) Plc. Was there “implicit support” for the securitisation entity and indeed the process of securitisation? Whether there was or not determines whether the sale is categorised as a ‘revaluation’ or a ‘capital transfer’. The government would far prefer the former as it would mean that any losses associated with student loans and the sale would have no impact on the deficit.

A full sale and transfer of the asset to the private sector also requires that the special purpose entity holding the loan accounts be independent of government. (Although the securities can be traded, the underlying loans are not being sold, but transferred to the SPE.)

This means there are two related issues that are in the purview of the Office for National Statistics.

  • Were the loans sold at market price?
  • Is Income Contingent Student Loans 1 (2002-2006) Plc sufficiently independent of government?

The next paragraph in the MGDD explains:

V. “If there is no obvious market price for specific assets, then, in order for an arrangement to be recorded as a sale, there should be a process by independent bodies to determine an equivalent market price, on the basis of the usual valuation methods used in business areas. The absence of such a process could be interpreted as a lack of autonomy of the securitisation entity, such that it should be classified to government.
(my emphasis in bold)

No independent body, as far as I am aware, has been involved in the sale process. The government would argue that the prices achieved through the securitisation were equivalent to market prices: there is only a market as a result of the securitisation. But the final sentence points to the general issue for the ONS to address.

Even if it is agreed that a market price was achieved, there is a general question about the status of the Special Purpose Entity that now owns the loans. It has to be independent to be taken off the public books. If its operations are circumscribed by government, then it should probably be classified to government.

Here is how the Manual characterises the requisite autonomy:

V. “… the SPE should have autonomy of decision in respect of the management of the debt securities that it issues: indicators of this are issuance rhythm, debt management, repayment strategy, etc. It should be clear that the SPE does not act on behalf of government. It should also have complete autonomy concerning the management and disposal of its assets. Otherwise the SPE should not be recorded as separate institutional unit.”
(my emphasis in italics)

Most of the evidence available suggests that Income Contingent Student Loans 1 (2002-2006) Plc could be seen to lack the requisite autonomy.

  • The SPE has not conducted the securitisation, it was set up subsequent to it – indeed its title indicates that a separate company will be set up for each sale process;
  • Under the terms of the 2008 Sale of Student Loans Act, the SPE cannot sell on the loans without government permission: it cannot dispose of its assets;
  • HMRC and the SLC will continue to administer loan collections on behalf of the SPE and purchasers;
  • DfE remains the ‘Master Servicer’ – with responsibility for transferring repayments to the SPE – and the government has undertaken various warranties and contingent liabilities as part of the sale process (see Part 5).

ONS hasn’t reached a decision yet on these classification issues. I will update this post when it does.

The next post will look at the resulting accounting issues. If the sale is classified as a capital transfer or the SPE is deemed not to be independent, then the government will probably have to book a £2bn hit to expenditure and the deficit: the difference between the £1.7bn raised and the £3.7bn face value of the loans transferred.

Securitisation structure & loan sale value for money (2 of 5)

Kit Malthouse: Just on the sale of the book, why would anyone want to buy it? If you think about it from a commercial point of view, you have this large asset, which is subject to the vagaries of the economy; people’s ability to repay is down to their employment prospects, and so you are going to see economic variability on it. They already know that there is going to be a fairly big chunk that will not be repaid.

Joseph Johnson: The facts speak for themselves. There was a very large pool of investors who achieved a competitive price that delivered value for money for the Government for this asset.

Kit Malthouse: Okay. Basically the reason they wanted to buy it is because the price was competitive, in your words, or cheap.

Joseph Johnson: We achieved fair value.

Kit Malthouse: It was cheap.

Joseph Johnson: We believe we achieved at least fair value, otherwise we would not have sold the asset. It passed all the relevant tests that the Treasury requires departments to take when selling assets.

Kit Malthouse: Were you not slightly alarmed that people were so keen to buy it, given the pricing of it?

Joseph Johnson: You seem to be making two different arguments. Your first argument was: why would anybody be interested in it? Now you are arguing there was such interest because we were under-pricing it.

Kit Malthouse: No, I said why would anybody be interested, and you mentioned competitive pricing, which I translated as cheap—the price would be such that it stimulated a lot of people wanting to buy it.

Joseph Johnson: We believe that we achieved at least fair value for the asset and that it cleared the tests that the Treasury requires departments to have for the sale of assets.

The above exchange is taken from the transcript of Jo Johnson’s appearance before the Treasury Select Committee on 19 December.

Did the government sell it cheap or did it achieve value for money? It’s not an either/or. As noted in the first post in this series, the government raised £1.7bn from a securitisation of income contingent repayment loans with a face value of £3.7bn.

Read more…

Sale of Student Loans – Part 1 (of 5)

There has been a two-month hiatus on this blog as my other projects, including Fine Art Maths Centre, led to an increase in teaching commitments last term. My workload is much lighter in coming months so I will be able to catch up on various financial developments in English HE.

The obvious place to start is with the government’s efforts to sell income contingent student loans to the private sector. This post will introduce a short series on various aspects of the sale, including value for money, the complex structure of the deal and a pair of classification decisions that now sit with the Office for National Statistics. The series will aim to address the key question: what has the government achieved with the sale? I begin with an introduction and some basics.

Back at the beginning of December, Jo Johnson announced that the first ever such had been completed raising £1.7bn for the governmentWith the exception of the Financial Times, the mainstream media largely failed to cover this significant deal. As Johnson told the Treasury Select Committee when he appeared before it as a witness on 19 December,

We are establishing a new asset class in the market. It is a ground-breaking transaction in that respect, and it is part of a much bigger programme of student loan sales that should raise £12 billion for the Treasury over the relevant financial period. That is an important contribution towards how we are going to sort out our public finances.

There wasn’t previously a market in income contingent loans: earlier sales had only dealt with the older fixed period repayment loans, so-called “mortgage-style” loans, issued to those who started undergraduate study before 1998. Attempts to sell ICR loans stretch back a decade and have been repeatedly promised.

This government finally achieved its aims with a complex securitisation deal. As a result, there are now in existence “securities” of different kinds that can be traded: notes with a minimum denomination of £100,000 that entitle the owner to a share of the future repayment stream generated by the loans sold.

What has been sold are not the loans outright, but a right to a share in future loan repayments. Ownership of the loans will pass to a special purpose vehicle, Income Contingent Student Loans 1 (2002-2006) Plc. This company is designed to be independent of government (but see Part 3) and its only purpose will be to receive the cash inflows and dispense the appropriate payments to those holding the securities. The government has been keen to emphasise that conditions for borrowers will not change as a result of the sale and that collection will continue to be made through HMRC and the Student Loans Company.

The government will in future provide a fuller report to parliament, which will focus on the two main aims of the sale:

  • how risk has been moved to the new company and security purchasers so that the loans will be reclassified as a private asset: that is the loans will be moved off the government’s balance sheet;
  • and how the government has assured itself that the sale has achieved value for money.

As explained before on this blog, the government can pass its own Value for Money test and still make a loss on loans.

An analysis by the FT suggests that the sale will have cost the public coffers £800m; that the government sold assets worth £2.5bn to raise that £1.7bn. That is, by holding on to the loans more value would have been realised than by receiving cash today.

Read more…

Video: Economic Affairs Committee (with Dr Gavan Conlon)

On Tuesday, Gavan Conlon from London Economics and I appeared before the Economic Affairs Committee.

It was a long and complex session – there will be a transcript and I anticipate having to make a written submission to clarify some of the more complicated points that I tried to squeeze out before the end of the session.

But there is a video.

A corrected transcript is now available.


The session was interrupted twice by the ‘division bell’. These intervals have not been edited out of the video available. The session was suspended around 16:31, we returned very briefly around 16:47, but there was only time for Livermore to ask his question before we were interrupted again.

We returned from the second interruption at “16:59:20”.

Video: Treasury Committee appearance

A video from my appearance alongside Dr Carasso at the Treasury Committee yesterday.

Topics covered: student loans, interest rates, accounting and other related matters!

Approximately 1h45.

Update 26 October

A transcript is now available, though I haven’t had a chance to review (or correct) it.