hard · Asset-Backed Securities asset-nuances
An FFELP student loan ABS trust holds a pool of loans that reset quarterly off the 91-day Treasury bill auction rate, with a government guarantee covering principal and a substantial share of interest via Special Allowance Payments (SAP). The trust's senior notes pay a floating coupon indexed to 3-month SOFR, reset monthly.
What is the primary risk this basis mismatch creates for the trust, independent of borrower default?
- Credit risk increases because the government guarantee does not cover any interest shortfall arising from index mismatches between the collateral and the bonds.
- Basis risk arises because collateral yield tracks T-bill/SAP while the notes float off SOFR, so index spread compression can erode excess spread with zero defaults.
- Prepayment risk increases because quarterly collateral resets are structurally incompatible with monthly note resets, which under the PSA forces an automatic mandatory cleanup call.
- Extension risk increases because SAP payments recalculate only annually, which under Treasury methodology causes the notes' average life to lengthen whenever T-bill rates rise.
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