Education Loans Jeopardized by Auction-Rate Securities Market Meltdown

Education Loans Jeopoardized by Auction Rate SecuritiesThe Massachusetts Educational Financing Authority (MEFA) announced late last month that it’s unable to raise funds needed to provide fixed-rate private education loans, as it has in the past. Families counting on MEFA loans will be scrambling to find other funds in the next few weeks unless a plan proposed by Governor Deval Patrick succeeds. At the end of the post I offer some last-minute ideas for families who will be facing a funding crunch if MEFA loans do not come through this fall.

MEFA provided loans to 40,000 Bay State residents last year, but its revenue-raising ability has been hampered by the lack of liquidity in the capital markets.  In the past, the non-profit state organization funded its loans using auction-rate securities (ARS), but as I noted earlier this week, the ARS market has been tainted by the failure of several auctions this year, resulting in losses for bondholders.

Governor Patrick has asked the state’s $52 billion pension fund to help kick-start MEFA’s broken funding mechanism by investing $50 million dollars in a $450 million issuance of MEFA bonds that will be held later this month.

He’s also asking major Massachusetts universities, including Harvard, Boston College, the University of Massachusetts, and the Massachusetts Institute of Technology to make similar investments in the new MEFA bonds, presumably from their endowment funds.

So far, the idea has gotten a chilly reception from the state’s treasurer, Tim Cahill.  According to yesterday’s Boston Globe, Cahill, who is also chairman of the Pension Reserves Investment Management Board, held a press conference in which he said that investing in the bonds would not be consistent with the board’s management responsibilities.  Instead, Cahill is proposing that the state legislature provide a guarantee for the bonds.

Cahill does have a point.  The pension board trustees are responsible to act as fiduciaries for the benefit of state employees.  Citigroup and Merrill Lynch just announced that they will buy back $17 billion in auction-rate securities in order to satisfy state and federal regulators who accused them of misrepresenting the securities as “safe” investments.  UBS, which had already entered into an agreement with Massachusetts, announced today that it will buy back an unprecedented $19 billion in auction-rate securities in a settlement with the SEC and several states.

The ink is barely dry on the agreement between the Commonwealth and UBS settling a dispute over auction-rate securities investments that soured in failed auctions earlier this year.  The MA AG’s argument was that such securities are risky investments that were inappropriately sold to state agencies.  How could another MA agency justify a decision to purchase the same kind of investment?

The state pension board is already having its own problems anyway, as it just fired five of its portfolio’s active managers for failing to beat their benchmarks for the last five years.  The Massachusetts pension fund’s assets have declined by $3 billion (about 5.8%) in the first half of this year.

It’s a little harder to say that the educational institutions that the Governor has approached should not buy into this plan.  Unlike the state pension board, the colleges have a direct interest in preserving half a billion dollars of funding for student loans in Massachusetts.

It does seem that Harvard, at least, with its $35 billion endowment, could chip in a few million to help.  Yesterday’s Wall Street Journal reported that Harvard’s endowment managers had a banner year in the fiscal year ended this June, earning 8% in a year when the average public pension plan lost 5%.  A $50 million investment is admittedly on the small side for the endowment, but it would be a nice gesture.

A big part of the problem that MEFA’s facing is that auction-rate securities are no longer perceived as low-risk investments.  In order to sell them as-is, MEFA would need to bulk up the interest rates being paid, resulting in higher loan rates for the students.  Having some big investors buying into a large chunk of the issuance would help, as would a state guarantee; otherwise this will be a problem for MEFA as long as the credit markets remain tight.

I guess that the state guarantee is not such a terrible idea.  Student loan default rates are pretty low, partly because it’s very difficult to discharge a student loan via bankruptcy.  However, given the Commonwealth’s projected 2009 structural deficit of $1.1 billion, I’m not sure why anyone would believe that a loan guarantee from the Massachusetts legislature is worth very much.

What should you do if you were counting on paying for college this fall with a loan from MEFA?  This funding problem affects a huge number of people.  If you wait for the Governor’s rescue plans to pan out and they don’t, your other options may dry up or be delayed by the surge in applicaiton volume.  Start investigating alternative college funding sources now.  Here are some suggestions:

Call up the aid office at your childs’ college or university
Yes, their phones will be ringing off the hook, but you might be able to make a case for additional institutional aid if you were counting on getting a loan.

Review your federal loan options
Information on various types of student loans is available at Staffordloan.com and Finaid.org.

Consider a family loan
Do you have relatives who might lend money for your child’s education?  Setting up an intrafamily loan with proper paperwork could be a great option; it would simultanously solve your college funding problems and provide your relatives with a better interest rate than a money market fund.  Virgin Money has acquired Circle Lending’s intrafamily loan facilitation business.  Setting an intrafamily loan up formally is a smart move to avoid misunderstandings and tax snafus.

Look for a private educational loan
These are a last-ditch option, as they are almost always variable rate loans at higher rates than the federal loans.  Here’s a list of private student loan sources at Finaid.org.

Photo by: Chaval Brasil

About the author

Thomas Fisher, CFP®
Thomas Fisher, CFP®

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