Government put loan sale hopes in securitisation

This morning, Jo Johnson set a written statement before parliament in which he confirmed that the government is ‘starting the process to sell part of the English student loan book’. (A sale will not affect borrowers from the rest of the UK).

Although the intention to sell has been announced several times in recent years, what today marks is the start of a formal process through which government tries to woo purchasers with a specific set of products. It may now take months before a final decision on a sale is made and any proceeds are announced. This decision is subject to a value for money test being passed, but this test can be passed if even the sale makes a significant loss for government (more on this below).

What is most significant about today’s announcement is that the government has shifted its position regarding the sale structure.

In 2014, when Vince Cable (then Secretary of State for Business), vetoed a sale, the government was proposing to sell whole cohorts of graduates  to pension funds and insurance companies.

Now, the government is still looking at the ‘pre-2012’ loans where repayment started between 2002 and 2006. These loans will form the backbone for the first sale in a planned four-year programme. But it is no longer looking for buyers to take on whole cohorts – it is instead looking to securitise those loans.

This means the government is looking to create and sell a set of tradeable notes (‘securities’) based on the rights to income steams which will be backed by the future repayments associated with those student loan accounts. As I understand it, the sale will offer purchasers five different types of note, which will vary by seniority, maturity and coupon (interest rate).

The maturity of the note indicates how many years it is in effect for: on a ‘vanilla’ bond, the purchaser gets their principal back at maturity and receives bi-annual coupon payments every year.

The seniority of the notes indicates who gets paid first and where different risks lie. The notes are backed by student loan repayments – these will vary each year.  A senior note gets paid first and is therefore less risky, but the payments will probably be fixed along the lines of the ‘vanilla’ bond outlined above. The holders of the most ‘junior’, or ‘equity’, tranches gets paid last and therefore take more risk – but they get what’s left and are potentially rewarded with higher repayments in good years.

When the government has looked at securitisation in the past, buyers have been keen on senior tranches, but less so on the junior tranches.

The problem for government is that if the junior tranches don’t get sold, then it may have to keep hold of those risks. In which case, it is unlikely that the securitisation would have achieved the main objectives of a sale and the Office for National Statistics might have to conclude that the loans were still on the government’s balance sheet. Securitisation is a very flexible – and therefore attractive – approach to selling financial assets, but it normally requires a special purpose vehicle to maintain ownership of the loans (only the rights to income from the loans have been sold to purchasers). If the SPV is still owned by government (and in many cases the SPV will buy the equity tranches), then it won’t have achieved two explicit loan sale aims:

• de-risking the government balance sheet;
• removing the loan accounts from Public Sector Net Debt.

It’s also worth noting here that the government has also abandoned the ‘synthetic hedge’ designed to deal with concerns over the interest rate terms on pre-2012 loans (interest accrues at the lower of RPI or bank base rates + 1%). This may also affect buyer appetite for the tranches with lower seniority.

Update (3pm): the ONS has confirmed to me that it will only make a final decision on classification after a sale is completed. An ONS spokesperson said: “ONS has considered a policy proposal from Her Majesty’s Treasury on the sale of the student loan book. However, we will not provide a final decision on the sale of the loan book for National Accounts purposes until the sale itself has happened.”

A sale will likely make significant losses for government

At this stage, £4bn of loan accounts are involved. This is the face value of those loans – take all the outstanding balances of borrowers who graduated between 2001 and 2005 and sum them together. As of the end of July 2016, the face value of pre-2012 loans came to £44.5bn.

More important to note is that the face value of loans is not what the government thinks they are worth – the fair or carrying value. The fair value is a present value estimate of what the loan accounts are likely to generate in future repayments.  The pre-2012 loans had a fair value of £33.7bn in the 2015/16 BIS accounts. (An illustrated explanation of the difference between face and fair value can be found towards the end of this video.  If I offer you an IOU for £100 in ten years’ time, what would you be prepared to pay? The face value is £100 but that’s not what it’s worth).

The key point that the government’s announcement obscures is that a value for money test can be passed even if the loans are sold for significantly less than the fair value – ie what the government thinks the loans are worth.

This is because the value for money test uses a higher discount rate to that used in the  fair value calculation. A higher discount rate values the same projected cash stream lower because a higher discount rate gives a higher value to today’s cash.

The fair value calculation uses RPI  plus 0.7, while the VfM test uses RPI plus 2.5 (at a minimum).  Let’s say RPI is 3 per cent, then the fair value discount rate is 3.72% (1.03 * 1.007), while the VfM discount rate is 5.58% (1.03 * 1.025). For the former, £1.037 next year is worth £1 today; the VfM test will sell £1.056 of next year’s repayments to get that £1: an additional 2p of next year’s repayments.

Compound over several years of repayments and that is a signficant loss that would be tolerated.

By selling the loans, the government may improve the headline public finance statistics (it says today that there is a ‘good prospect’ of achieving value for money), but its misplaced valuation of cash today over holding the loan assets will lead at best to a presentational gain, not a fiscal or economic one.