‘Forward Guidance’ and student loans

The Bank of England has just announced that it is only going to review the current base rate of 0.5% once unemployment has dipped below 7%.

This is termed ‘forward guidance’ and is meant to provide more certainty for investors and producers than inflation targeting.

Regular readers will know that this is unwelcome news for the financing of English Higher Education, since, for income contingent repayment loans issued to those who started undergraduate study between 1998 and 2011,  interest accrues on outstanding student loan balances at the lower of RPI (for the preceding March) or the bank base rate plus one. For 2013/14, the relevent RPI is 3.3%, well above 1.5%.

The annual accounts for the department of Business, Industry and Skills – responsible for higher education – show that the value of the ‘loan book’ was written down by £1.6billion (c. 4.5%) in 2012/13 as a result of the low base rate.

The Bank of England predicts that the headline unemployment figures given by the Labour Force Survey will remain above 7% until 2016. This would leave us with another 3 years of 1.5%. (And that’s before we consider any implications for this headline statistic generated by the current furore around ‘zero-hours’ contracts).

With the government announcing plans to sell £10billion of these loan accounts to insurance and pension funds between 2015-2020, this new announcement is significant. The government has ruled out changing the interest rate terms for these borrowers, but would have to compensate potential purchasers for continuing low base rates as they will not contemplate purchasing any ‘asset’ with below inflation interest otherwise. The government proposes to offer a ‘synthetic hedge’ here. I quote from ‘Project Hero‘:

If RPI is above Base Rate +1% at any time following the sale, the underlying loans will accrue less interest, leading borrowers to repay earlier than would otherwise have been the case. Government will therefore compensate investors by paying them cash flows (towards the back end of the maturity profile) representing the final payments borrowers would have made had the cap been removed.

Beyond emphasising the fact that a sale therefore entails a long-run loss for the short-term gain of lowering the headline statistic of public sector net debt, three points can be underscored:

• Additional years of an unanticipated interest rate subsidy means that money will have to come from somewhere to cover the continuing impairment in the departmental accounts to the valuation of existing loan balances.
• Impairment to the value of the loans means that a greater proportion would need to be sold to achieve £10bn of sales. It’s not clear that such investor appetite exists.
• Since rates will only be reviewed when unemployment reaches 7% and will not then leap to match RPI, any sale entails further years of interest subsidy and costs to a future government, who pick up the ‘back-ended‘ tab left by those who put the deal together.

Perhaps, though, the new governor’s first act will force a pause to current thinking around loans.