UK's student loan book sale

Earlier this month (6 Feb 2017) the UK Government announced it will commence the process to sell a part of the pre-2012 English student loan book through securitisation. The plan is to sell the loan book which entered repayment between 2002 and 2006, with the reminder of pre-2012 loan book to be sold over the next 4 years. A bunch of investment banks are working towards bringing the initial tranche to market and the sale is expected to close in the second quarter of 2017.

There has been a lot of press over the last few days – mostly negative for the Government and its plans. But what caught my eye were the numbers.

The total pre-2012 English loan book stands at ~£45.4bln as at April 2016; and the Government expects to raise £12bln through the sale of this loan book over the next 4 year. This equates to a ~74% discount to the outstanding loan book. Given these numbers, this opportunity is worth a look. 

Valuing the student loan book is not easy. This is not your typical fixed income instrument where you have a defined cash flow and you apply a discount rate based on your cost of capital after taking account of credit and interest rate risk. These student loans are income contingent where repayment is triggered based on the income of the borrower. Broadly, each student pays 9% of the difference between his/her income over a set threshold. Currently, for the pre-2012 loans, this threshold is £17,495; therefore, a borrower earning £25,000 would pay £675.45 per annum. On top of the income contingent nature of these loans, default rates tend to be very high – current average default rate on the loans granted between 2002 and 2006 is ~50%. The high default rate reflects the fact that there is no credit or other checks needed to be eligible for these loans which means that almost any student enrolled in any university course is eligible. Before getting to my estimate of value for the 2002 – 2006 loans, here is a brief table showing the key terms for these loans:

Key terms of the English student loans granted between 2002 and 2006

Type of loan	Income Contingent -current annual repayment threshold - £17,495
Payment terms	9% of income above annual threshold
Annual Interest rate set on 1 Sep each year	Retail Price Index (RPI) in the previous March, or 1% above the base rate, whichever is lower. It is worth noting that as the graduates only pay 9% of the income above threshold, interest rates only change the duration of the loan and not the amounts repaid.
Cancellation	Any outstanding balance on the loans taken between 2002 and 2006 is cancelled when the borrower reaches the age of 65; the loans are also cancelled upon death or disability of the borrower
Collection process	For most borrowers, payments are collected by the HMRC through the UK tax system by employers taking amounts from their salary through the Pay as You Earn (PAYE) system. Borrowers who are self employed pay through the tax self-assessment process by filing returns with the HMRC. Borrowers living abroad pay direct to Student Loan Company

Valuation

There is some data available from the Student Loan Company (SLC) which I have used to estimate future cash flows and to value the loans which entered repayment between 2002 and 2006. It is by no means easy to do and requires some big assumptions. I see this exercise as a bit of homework before I can get my hands on the pitch book from the banks when they bring these loans to market. By doing some homework and knowing the difficulties / assumptions required in valuation, I should be better prepared to review the sales pitch from the Government and its advising banks when it becomes available.

Data available from the SLC

The SLC has some good data from which can get the following information for each repayment cohort:

a)       number of students paying their loans each year;

b)       number of students who were liable to repay each year (borrowers become liable to repay the April after graduating or otherwise leaving their course and are required to make payments if their income is above the threshold);

c)        implied default rate (number of students repaying divided by number of students liable to repay);

d)       total amount outstanding (liable to repay) at the end of each year;

e)       total amount paid each year;

f)        average amount paid by each paying student (total amount paid divided by number of students paying);

g)       income threshold for each year;

h)       interest rate for each year; and,

i)         implied average income per paying student (on the basis that each paying student pays 9% of his/her income above the income threshold, this can be calculated as – [(f) average amount paid per paying student divided by 9% plus (g) income threshold per year]

The below tables show the trend in above variables, from the first year when they entered repayment, for each of the repayment cohort currently earmarked for sale. 

Projecting future cash flows                 

Projecting cash flows for these student loans is more art than science. I have used the following variables to arrive at my projected future cash flows for each repayment cohort:

1.       I have assumed that the number of students repaying will fall by ~10% each year for the reminder of the payment period. The trend over the last 5 years for each repayment cohort indicates that the number of students repaying has fallen by ~10% each year.

2.       I have assumed that the implied annual income per paying student increases by 1% each year. Again, the trend over the last 5 years is consistent with this assumption.  

On the basis that the repayment cohorts above are fairly mature – these repayment cohorts include students who would have finished their education between 2001 and 2004 – I believe that the last 5 year trend in number of students repaying and implied annual income should be a reasonable estimate to use in projecting future cash flows. For example, if the average implied income over the past 10 years has been ~£28k and growing at ~1% over the past 5 years, it is unlikely to change materially in future given the amount of time it has been since the student graduated and any uncertainty should be to the upside.

3.       I have assumed that each repayment cohort will pay for 30 years from the year it entered repayment. I believe this is a conservative estimate – e.g. these loans pay till the borrower turns 65 and assuming an average age of 25 when the borrower becomes liable to pay, these loans should pay for 40 years from the year they entered repayment.

4.       The other key assumption required to forecast cash flow is the income threshold for each year. This variable has a significant impact on the cash flows as the payments are set at 9% of borrowers’ income above the income threshold. This is a difficult one to predict and I am sure will be a key focus for investors when they see more detail on the sale. This will be a political hot potato for the Government – for example, freezing the annual income threshold could maximise the proceeds from sale as there is less uncertainty for the investors but will likely invite severe rebuke for the Government; similarly, any uncertainty on this variable (e.g. if a future socialist Government is able to increase this threshold materially to the detriment of the private investors but playing well to its constituents) will mean reduced proceeds. Based on last six year trend, average increase has been ~2.5% and I have used this as the basis for my cash flow forecast.

5.       Interest rate is another key variable which is difficult to forecast. As discussed earlier, this is the lower of RPI or base rate plus 1% each year. Given the low base rate in the UK over the last several years, this rate has hovered around the 1.5% mark over the last several years and is at 1.25% at present. I have assumed a rate of 1.25% for my forecast cash flow. As discussed above, the interest rate does not impact the amount of cash a student has to repay but only impacts the duration of the repayment – e.g. the amount repaid each year is fixed at 9% of the income earned above the income threshold with the interest being added each year to the outstanding balance. On the basis that I am assuming cash flows coming in for the next 30 years only, interest rate should not impact my valuations and any uncertainty should be for the upside.

Using the above variables to project cash flow for each repayment cohort and discounting cash flow at a rate of 10% gives a present value of ~£1bln for 2002 – 2006 repayment cohort, implying a discount of 75% to estimated £4bln outstanding amount on these cohorts. 

The assumptions I have made in arriving at the above valuation are fairly conservative and provide a decent chance for an upside. If the Government does decide to sell these loans at a ~74% discount, it definitely merits a detailed look. The other point of interest will be how the securitisation is structured – e.g. will it be by repayment cohort where earlier years merit a higher discount than later years, or will it be by quality of borrowers.

From the UK Government’s perspective one could ask why sell at such a heavy discount?; clearly these loans should be worth more than 25p in a pound to the Government given its low cost of capital. Apparently, for the Government, immediate cash is worth more than cash coming in over a number of years in future; this is because it can then use this cash to fund near term needs (like making more student loans) instead of borrowing which impacts on its commitment to reduce public sector net debt in the near term. 

It appears that we have a situation where the seller is selling for reasons other than pure economic value which should present an opportunity for the buyer.