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Home > Cases > Auction-Rate Securities > Student Lenders Caught in Auction-Rate Securities Trap

Student Lenders Caught in Auction-Rate Securities Trap

The allure of auction-rate securities - which attracted student-loan lenders on the promise of low short-term interest rates on long-term debt - has turned into a financial nightmare, costing student loan companies millions of dollars and placing many students in need of college loans out in the cold.

The recent meltdown of the auction-rate securities market has hit the student loan industry hard. Nearly every student-loan related auction has failed in recent months due to lack of bidders, leaving issuers with debt they cannot refinance or buy back.

Case in point: Brazos Group Inc., the largest municipal borrower in the $330 billion auction-rate securities market. As reported in a June 2 article on Bloomberg.com, Brazos currently holds $7 billion of student-loan-backed debt. The company pays about 5 percent on auction-rate bonds - up from 2 percent in 2007 - and receives about 4 percent on the loans backing the securities. Unable to generate additional financing to buy back the bonds or come up with a feasible restructuring plan, Brazos is forced to join a long list of student lenders trapped in the fallout of the auction-rate market.

Student loan authorities, as well as not-for-profit groups, have sold about $85 billion of auction-rate bonds. Since the market's collapse in February, more than 100 student lenders have stopped making government-backed education loans. To date, only $1 billion of the $85 billion outstanding has been refinanced.

The Dilemma

Auction-rate securities - which are long-term bonds sold by issuers such as municipalities, student loan companies, hospitals and closed-end funds - have interest rates that reset every seven, 14, 28 or 35 days.

From 1998 until recently, Brazos paid an average of 2 percent on its auction-rate debt. When the credit ratings of the insurers backing the securities began to plummet as a result of growing losses on subprime mortgage-linked debt, yields on the auction bonds rose significantly.

As a result, debt costs for issuers rose rapidly. For Brazos, they have climbed by $11 million a month. In March, the company stopped making education loans altogether.

“It's an ugly situation. Every dollar coming in is going out to higher interest rates,” said David Hartung, a senior vice president at DBRS Ltd., a credit-rating company, who is quoted in the Bloomberg article.

There is one bright spot for student lenders, however. In May, the federal government announced a rescue plan for student loan companies in which it would buy federally subsidized loans that lenders have been unable to sell as securitized debt. Once that happens, many lenders, including Brazos, are expected to resume lending again, and students will have uninterrupted access to loans.

Under the government's plan, student lenders will be given the option of selling the government securities backed by student loans on more favorable terms than the rates currently available in the financial markets.

For Brazos, though, the government's help may be too little, too late for its auction-rate dilemma. According to the Bloomberg article, while the plan may indeed keep the company in business, it's expected to have little - if any - effect on helping it refinance or restructure its auction-rate securities. That's because any money Brazos receives will go toward new loans, and it's more than likely it won't be able to sell any of the loans that back its bonds.

Brazos and other student loan lenders are now looking to Wall Street, which controlled the auction process, to come up with some sort of solution for the auction-rate fiasco. So far, the response has been one of deafening silence.

Our affiliation of lawyers is actively involved in advising individual and institutional investors in evaluating their legal options when confronted with subprime and other mortgage-related investment losses.


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