The potential contents of a firesale if there is a downgrade of the US’s AAA rating are receiving a fair bit of attention, as investment funds weigh up what they can and should do in the event.
Defeased or prefunded securities are uniquely vulnerable and, according to a note out Thursday by Citigroup’s securitised products team, so are the $250bn of asset backed securities linked to the Federal Family Education Loan Program (FFELP).
FFELP was a federally-guaranteed student loan scheme used by three-quarters of US colleges. Technically, it’s not a guarantee but the federal government does provide 97 per cent (according to S&P) reinsurance on the outstanding loans. Thus there’s a direct link between the AAA sovereign and the AAA FFELP ABS. (21 Srabble points, if you’re wondering.) Moody’s listed these securities as a related risk when it placed the US on review for possible downgrade and now Citi reckons they’re the main form of ABS to worry about:
FFELP Loan ABS Could Force Ratings-Based Selling
A ratings downgrade would be a significant blow to the FFELP ABS sector and the likelihood of forced selling is elevated, in our view. The sector registers roughly $250 billion in outstandings as of 30 Jun 11. Many of the investors which own this sector specifically do so because it is highly rated and it is a US government credit risk. Banks and money managers are the largest holders of these assets, in our opinion, although investment holding data is unavailable. Money managers with rating-based guidelines would have no choice but to sell into a sinking market, forcing spreads to gap out. The FFELP sector is already wider than other ABS sectors, partially because it is no longer an active new issue market.
These rating-based guidelines are being given a close read at the moment, with funds asking lawyers to look at them closely, according to the Economist. (And why hedge funds are said to be piling up cash.) Citigroup also notes that fallback plans are afoot:
Contingency Plans Evolve
As the previously unthinkable possibility of a US downgrade looms closer to the anticipated early August deadline, some money managers which operate pursuant to rating guidelines are attempting to implement contingency plans. A contingency option could permit them to remain invested in ABS securities rated commensurately with the US government debt credit rating instead of benchmarking to a triple-A standard. Such a plan could avoid forced asset selling. Moody’s placed all triple-A rated FFELP student loan ABS on watch negative. This includes 233 transactions, composed of 1,087 tranches ($196.5 billion).
Plans that are looking increasingly necessary — S&P
repeated itself for effect warned on Thursday that there’s more than a 50-50 chance of a US downgrade.
Not that everyone is acting so seriously. On Friday House speaker John Boehner tried this jape out on his Republican colleagues:
A day after breathless news reports that a deal was imminent, the Ohio Republican jokingly told his conference that he had reached a sweeping agreement with President Barack Obama to slash trillions of dollars in government spending.
“I’m just kidding,” Boehner then added, drawing a laugh from rank-and-file Republicans, according to those in the room.
Investors eye US Treasuries amid downgrade threat – FT