Buffeted by ever-changing federal regulations and operating in both the taxable and tax-exempt markets, student loan insurers in need of solutions have turned with success to the swaps market.

Student loan issuers have always had a difficult time matching their assets and liabilities. Swaps have helped these issuers resolve the problems inherent in their role as loan intermediaries.

The way the systems works now, federal regulations set condtiions on loans made by the student loan corporations. The regulations, which have changed many times since the program was established 30 years ago, dictate how rates on the loans are set and may also set minimum and maximum rates. The regulations often have little connection to the agencies' sources of funding.

Under current law, the federal government guarantees loans made to students by commercial banks, which sell the loans to state higher education authorities. The authorities often finance those purchases with tax-exempt bonds, and some operate bond-financed guarantee programms of their own to supplement the federal system.

There are 42 state authorities operating in 36 states.

In August, the federal government shifted course again, voting to set up a new program that will give seed money to colleges for direct revolving loans. Within five years, Congress may phase out the current system entirely.

Under the August legislation, direct lending over the next five years can grow to 60% of total federal student loan volume. In 1998, Congress will decide which program is most effective.

Swap Help

As federal programs have changed, swaps have helped the authorities manage their loan responsibilities.

One of the most fundamental uses of interest rate swaps is to allow an issuer to match its liabilities and assets. If an issuer borrows money at a fixed rate, for example, and has investments at a floating rate, the issuer is at risk.

If floating rates fall, for example, the yield on the issuer's investments will drop, but the fixed rate of interest owed on its borrowings will not change. Less money from the investments will be available to meet the same level of interest costs.

By using a swap, the issuer can match the liability and the asset. After borrowing at a fixed rate, the issuer might swap its interest obligation for a floating obligation. A swap counterparty would then agree to make the issuer's fixed-rate payment, and the issuer would agree to pay the counterparty a floating rate.

After swap is in place, if rates fall and the issuer's income falls, its debt payments would also decline.

Student loan agencies try to obtain low-cost financing to back their loans to college students. Even a slight mismatch between an agency's cost of funds and its loan rate to students or their parents can spell disaster.

"We have used swaps to hedge our interest rate risk and help provide the lowest-cost loans to students," said Larry O'Toole, president of the New England Education Loan Marketing Corp.

Nellie Mae, as the New England corporation is known, has swaps with a notional value of $500 million on its books, relative to assets of approximately $1.5 billion and liabilties of $1.4 billion.

The notional value of the swaps does not accurately represent the risk of the corporation's investments. In each swap, a flow of interest payments is exchanged on a set loan amount, the notional amount, but the loan amount itself is not exchanged But the notional value is an indication of swap activity.

Nellie Mae has a policy on swaps practices, including credit guidelines for counterparties, that was approved by its board of directors. All swaps must be approved through a formal process.

Nelie Mae looks to borrow money at the lowest cost, whether in the tax-exempt market, the public taxable market, or the private placement market. The corporation sells bonds and commercial paper-like securities. It also takes out commercial bank lines.

Some of Nellie Mae's swaps convert a fixed rate into a floating rate or vice versa. But most of the swaps are of a different type, known as basis swaps.

Because of federal regulations, some borrowers pay the corporation interest at a floating rate tied to the 90-day Treasury bill rate. But the corporation rarely borrows at that rate, because it can borrow at a lower cost if it sells debt pegged to other market rates. For example, it may raise funds at the London Interbank Offered Rate, or Libor.

Both rates are short-term rates, but there is frequently a spread between the two benchmarks. If the spread widens in one direction, the corporation could be in a bind.

If the Treasury bill rate drops, borrowers pay a lower rate to the corporation. If Libor does not also fall, the corporation's own borrowings will still be at the initial, higher rate.

Hedging With Basis Swaps

A basis swap allows Nellie Mae to hedge this exposure. The issuer agrees to apy a counterparty the 90-day Treasury bill rate, identical to the rate it receives from borrowers. And the counterparty agrees to pay the corporation the Libor rate, identical to the corporation's own borrowing costs.

The swap closes the spread between the two rates and reduces the corporation's exposure to basis risk.

To reduce credit risk on its swaps, Nellie Mae includes collateral provisions. If a counterparty is downgraded and the swap is paying in the corporation's favor, the counterparty would have to post collateral in the form of Treasury securities.

Not all student loan authorities are active swaps users. The Illinois Student Assistance Commission, for instance, considered entering a swap for its most recent financing, but did not. The commission has never used a swap.

"We had to tinker with our authorizing legislation to make sure we were fully authorized to do swaps," said Gary Rieman, director of the Illinois Designated Account Purchase Program and capital development for the commission.

With the authorization in hand, the commission asked underwriters to propose swap transactions for its last bond deal.

But in the end, the commission and its financial advisers were not convinced by the arugmentsfor using swaps in that specific deal, Rieman said. He added, however, that the commission will consider using swaps in the future.

Rieman also said that while swaps can be useful, the use of financially complex instruments is not the commission's primary goal.

"We want to give the best service to students. Planning swaps is not always the first thing that springs to mind to fulfill that mission," Rieman said. The commission is already busy grappling with the implications of Congress' direct lending program, he said.

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