Selling loans

So maybe it’s also worth setting out the basics of loan sales clearly. Or at least trying to.

The government is hoping to raise between £10 billion and £15 billion in ‘sale revenues’ between 2015 and 2020.  It’s ‘central estimate’ which is repeated throughout the Autumn Statement documents is £12 billion, with £2.3bn each year on the basic modelling published.

§2.16 Borrowers’  loan terms will be fixed prior to a sale. The interest rate charged will remain at the Retail Prices Index (RPI) or base rate plus 1%, whichever is lower.

So it looks like a ‘synthetic hedge’ will be used to persuade enough buyers to take a piece of the action. I won’t go into that here, but it amounts to offering purchasers a deal whereby they are compensated if interest rates remain below RPI.

There are three ‘values’ needed to understand loan sales:

• ‘face value’ – the aggregate total of outstanding loan balances. At the end of March 2013, loan balances made to English graduates stood at £43billion;
• ‘fair value’ – this is what is recorded in the departmental accounts. It is the value of the asset in terms of anticipated future cash flows (in net present value terms).  The fair value of those same outstanding loan accounts was assessed as £31billion at the end of March;
• ‘price’ – the upfront cash purchasers would pay the government. This will be lower than ‘fair value’ perhaps  as much as 5-6p lower per pound of face value. That is, if the government thinks £1 of face value is worth 65p in fair value terms, then it might get 60p in price.

So, the first point is that much of the discussion of the sale of the ‘old style mortgage loans’ announced last Monday missed the difference between face value and fair value. Those loans had a face value of £900m but were worth considerably less given their particulars.

The second point is that any sale will lose ‘value’, if you compare the price to the fair value.  But a seller who wants cash upfront today may be prepared to forego an income stream of greater present value if it is spread over 30 years. (You might wonder why the government should be in that position given that it doesn’t appear to face any lending constraints at present).

The question then is: if you want to raise £10-15bn, what proportion of the loan book do you have to sell? The government probably has a fair idea about price, but is not so sure about how much market appetite exists.

This sale will be structured by auctioning whole cohorts (determined by year of graduation commencing with the oldest, the 2001-03 vintages which are expected to fetch a better price) and is envisaged to focus on pension funds and insurance companies. Purchasers have to be large enough to purchase tranches of £1billion at a time and want this kind of asset. (ICR loans are unusual with odd repayment patterns meaning that many potential buyers may be reluctant to take them on – this is one reason the price will be lower than the government’s fair value). In 2011, Rothschild told the government that total ‘appetite’ would be in the region of £10billion. That is, it’s not clear that such a sale is repeatable. Hence the concerns about quite what was announced yesterday for sector expansion.

The government may try to sell as much as possible so we may be looking at half of all existing loan accounts. The sales will be spread across the five years, 2015 to 2020. The decision to sell rests with the Secretary of State, Vince Cable; loans can be sold without consultation or the consent of borrowers.

The IFS called yesterday’s proposal to fund more loans with the loan sale, ‘economically nonsense’. One thing to consider: why would you sell this asset class at the bottom of the market? that is, when the economy is only just beginning to recover from recession. If you believe in ‘the growth to come’, wouldn’t you be better holding on to an income stream tied to graduate earnings?