Bond Market Collapse Worries Vermont Student-Loan Agency

Normally, this is a slow time of year for the Winooski-based Vermont Student Assistance Corp. [1], which loans hundreds of millions of dollars annually to parents and students looking to finance higher education.

But the latest crisis on Wall Street has the state’s largest student lender scrambling to secure $190 million to meet the demand for loans it expects to make this fall.

The apparent collapse last month of the auction-rate securities market, which VSAC relies on to finance its lending, poses no threat to students who have already borrowed, said Scott Giles, the agency’s vice president of policy, planning and research. However, it has threatened the short-term financial viability of VSAC, which currently lacks nearly half of the $390 million it needs for the 2008-2009 school year.

“Auction-rate securities were, for a long time, the most efficient way to sell bonds, take the money and give it to students,” Giles said. “It’s not very efficient now, nor will it ever be again.”

Nor, like most things related to the municipal bond market, is it easy to explain. Here’s one way to think about it: The sub-prime mortgage debacle may have finally found its mark in Vermont.

Auction-rate securities, or ARS, are variable-rate, long-term bonds that allow investors the opportunity to cash out at will and collect short-term interest rates, which are reset at auction every seven to 35 days. While a lack of bidders could result in a failed auction, in the past, underwriters — Wall Street banks such as Goldman Sachs, Lehman Brothers and Merrill Lynch — would submit a “clearing bid” to complete the auction and provide liquidity to bond holders.

The problems in the market peaked in mid-February when major underwriters refused to bid, instead allowing hundreds of bond auctions to fail. That kicked in a penalty, known as the “fail rate,” that increased — in some cases by more than double — the interest costs for bond issuers such as VSAC.

As a result, Giles said, VSAC is paying close to 1 percent more in interest on the nearly $2 billion in auction-rate securities in its portfolio. If the agency doesn’t refinance the bonds, the failure of the ARS market could cost VSAC $20 million. Giles said VSAC “has the ability to cover” the additional costs should it fail to secure re-financing before the end of the year. Likewise, because students continue to pay on existing loans, the agency has the resources to continue operations for the foreseeable future.

“We are prepared to draw upon our reserves to make sure Vermont students have access to student loans,” he said.

Giles’ optimism is in contrast to that of much larger student-loan agencies in Pennsylvania and Michigan, which have announced they will eliminate some student-loan programs or stop lending altogether for the time being. The problem in those states, Giles said, is the growing number of non-guaranteed private loans, which under current market conditions are a risky investment. (Private loans make up a small part of VSAC’s portfolio, about $54 million in 2007, down from $86 million in 2006.)

Just about everyone, including Giles, blames the collapse of the sub-prime mortgage market for declining confidence in the auction-rate securities market. The failure of bond-rating agencies and insurance companies to ascribe an appropriate level of risk to securities fashioned from billions of dollars in bad loans has spooked investors from the broader bond market.

Giles believes investors’ fears are “irrational,” especially when it comes to student loans, which are 97 percent guaranteed by the federal government. Moreover, he said, VSAC has the fourth lowest student-loan default rate in the country, making the agency’s loans a more attractive investment than those of less credit-worthy issuers.

“We actually believe the market will settle out,” Giles said. “At some point, people will start moving back into quality assets.”

Until then, VSAC is considering refinancing its bond portfolio with something called a variable-rate demand obligation. A VRDO, as it is known, is similar to an auction-rate security in that it would allow VSAC to borrow long-term while offering investors short-term interest rates.

Thomas Melloni, an attorney with the Burlington firm Burak Anderson & Melloni, said interest rates for a VRDO are set daily and weekly, and the “demand” function allows bondholders to cash out when they like. Unlike auction-rated securities, however, a VRDO requires a letter of credit from a bank or financial institution that agrees to meet the bondholders’ demand.

Vermont Treasurer Jeb Spaulding said officials are also exploring the possibility that the state pension fund “could play some role” in helping refinance some of VSAC’s existing debt. “There’s no way of knowing at this point whether that’s even possible,” Spaulding said. “First of all, that’s a board decision, and it will take a lot of due diligence.”

Indeed, timing could be VSAC’s largest hurdle at this point. Across the country, local governments and quasi-public agencies like hospitals and housing-finance and student-loan corporations that rely on auction-rate securities are desperately seeking ways to refinance more than $350 billion in total debt.

“Everyone is trying to do it at once,” Spaulding said, “and there is only so much capital out there.”

Under normal conditions, VSAC would wait another couple months to secure financing for the loans it will offer in the fall; that way, VSAC wouldn’t be paying interest to investors who are backing the loans before the loans themselves started earning revenue for the agency. Giles said VSAC has begun talking to various financial institutions about lines of credit to support re-financing through VRDOs.

Giles allowed that, should VSAC fail to refinance its bond debt, the federal government might have to step in. VSAC is the “lender of last resort” for the state of Vermont, meaning the feds would loan money directly to the agency should the crisis reach epic proportions.

Giles said that kind of action would lead to “complications that people will want to avoid.” However, he doesn’t believe it will come to that.

“This is a serious situation,” he said, “but one thing we don’t want to do is to create a sense of panic.”