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Harsh lesson in student lending


By: Michael McDonald | July 13, 2008

Five months after the collapse of the $330 billion auction-rate securities market, bonds backed by student loans show no signs of recovering. And that means no new house for Martin Doolan.

The former corporate turnaround executive delayed buying a home in Dallas because he can't access the $4.85 million he has in student loan auction-rate bonds without selling them at a loss of at least 20 percent. Doolan said he bought the securities over the past two years through Zurich-based UBS AG because they were billed as easy to turn into cash, like money market funds.

"I was advised these were the safest" of all the auction-rate securities, said Doolan, 68, who declined to identify his financial adviser at UBS.

Kris Kagel, a spokesman for UBS, said the firm doesn't comment on individual cases, though it is "working with clients on a case-by-case basis to address their immediate liquidity needs," including offering loans.

The $85 billion of auction-rate securities sold by state agencies and private lenders to finance student loans are emerging as the most toxic type since Wall Street dealers abandoned the auction-rate market in February amid worries about the financial health of the bond insurers who guaranteed the debt.

The auctions-held every seven, 28 or 35 days to set interest rates on the student loan debt-fail about 99 percent of the time, leaving investors with no choice but to take discounts to get out of the bonds.

Companies that hold student-loan auction-rate securities wrote down the value of the debt this year, some by as much as 35 percent, according to a survey by Pluris Valuation Advisors LLC. More than two-thirds of the publicly traded companies tracked by Pluris marked down the debt, compared with half that took a loss on their municipal auction-rate debt or securities sold by closed-end funds.

"The entire issue is one of lack of liquidity, and the very poor returns," said Espen Robak, president of Pluris, a New York-based firm that helps companies place values on their holdings.

Auction-rate bonds, invented about two decades ago, allowed local governments, hospitals and universities to borrow money for the long term at cheaper, short-term rates.

Until mid-February, banks supported prices by bidding for bonds that went unsold. Once the banks stopped buying, interest costs soared as high as 20 percent because the failed auctions triggered a penalty rate for issuers.

While rates on student loan securities initially rose, they have ultimately fallen because the bonds contain provisions that prevent rates from rising for an extended period of time. The solvency of the lenders is dependent on their ability to borrow at lower rates than those at which they lend.

According to Moody's Investors Service, more than half the student loan securities contain these provisions. That has resulted in interest on at least $8.6 billion of the debt falling to zero percent as the auction failures persisted, Bloomberg data show.

"That made them, needless to say, totally unattractive to other investors," said David Hartung, a structured finance analyst in New York at Dominion Bond Rating Service Ltd.

The collapse of the auction-rate market compounded the financial problems for lenders after Congress last year cut the subsidies it makes to those who sell bonds backed by federally guaranteed loans. More than 100 lenders curtailed or ceased making federally guaranteed loans this year, forcing lawmakers to intervene by expanding its direct lending program, according to data from, a Pennsylvania-based Web site about student loans.

"There is no easy solution," said Andrew Davis, executive director of the Illinois Student Assistance Commission, which has $880 million in auction-rate securities outstanding in the market. "The alternatives for us in raising new money are significantly more expensive."