CASE 2 STUDENT EDUCATIONAL LOAN FUND INC (ABRIDGED)

GROUP PAPER FINANCIAL RISK MANAGEMENT Case 2 : Student Educational Loan Fund, Inc (Abridged) Group Name : ADITYA SUJARMINTO - 18/436887/PEK/24411 CIKLA SAMIRA - 18/436921/PEK/24445 IDA AYU RACHMAYANTI - 18/436970/PEK/24494 PUTRI KHAIRUNNISA - 18/437037/PEK/24561 EKSEKUTIF B / FINANCE PROGRAM STUDI MAGISTER MANAGEMENT FAKULTAS EKONOMIKA DAN BISNIS UNIVERSITAS GADJAH MADA JAKARTA 2020 Company Overview Introduction Rick Melnick as an Associate Director of Financial Management at Harvard Business School (HBS). He provides a new policy of funding loans for Harvard Business School students that was called Student Educational Loan Fund (SELF). SELF had been established in 1961 to fund loans to HBS students. For the beginning, SELF offered the loans with semi-annually-paid with variable-rate loans. In response to student desires, the SELF board of directors proposed a new policy for the program. In the new policy, borrowers would receive monthly-paid with fixed-rate loans. Basically, tuition for an MBA program at HBS was $42,000 in 1996. With an additional $4,700 for educational materials. And there were other costs such as health insurance and living and personal expenses. The costs were predicted to be $45,372. There were also many sources of loans available to students. There are from the U.S Federal government Stafford loans and Perkins loans. Students can choose from available alternatives and also have a choice to get a loan from a bank. Stafford loans are given to U.S citizens and permanent residents. They were borrowed up to $18,500 annually and up to $8,500 of this was subsidized in the case of students demonstrating financial need and no interest accrued on subsidized loans during the student enrollment and until six months after graduation. Stafford loans have an interest rate set on July 1 each year based on the recent 13-week T-Bill rate plus 3.1% capped at 8.25% with a fee of 4%. Loan maturity is 10 years with level monthly repayment. Other alternative loans by Perkins loans. Same with Stafford loans was reserved for U.S citizens and permanent residents. The limit is $5,000 and annually $30,000. Rather than Stafford loans, Perkin loans were lower only with a fixed interest rate of 5%. Commercial bank also give loans for students. Bank allowed students to borrow an amount equal to the cost of education minus other financial aid. Basically, the Bank gives interest rate fees was about 5-10% and varies typically prime plus 1.5% - 2.0%. Loan approval was based on the credit history and repayment ability of the students and coapplicant. Traditionally, HBS loans are given to U.S citizens and permanent residents, citizens of Australia, Canada, Mexico, New Zealand and most West European. The HBS loan allowed students to borrow up to $25,000 with total MBA-related debt at graduation must be no more than $62,000. However, no interest payments were required while the student was enrolled in the MBA program, so all interests accrued during this period were capitalized at graduation. For repayment students have 6 months after graduation and HBS loan made up to 10 semi-annual installments. HBS loans involved a final balloon payment that was often a significant percentage of the original borrowed, while loans for smaller amounts were often repaid less than five years. (see exhibit 1). The New HBS Student Loans Since the 1960s, the annual aggregate value of HBS loans made had grown rapidly as the student body had become increasingly diverse. SELF was originally set up to accommodate this rapid expansion. In one year, SELF bought from HBS approximately 225 loans, with an average balance that had recently ranged from $15,000 to $22,0000. (see exhibit 2). SELF payment received by Holyoke Center. Holyoke Centre is a central student billing office for Harvard University. It would send bills to students and collect the payments. The interest rate was reset every 6 months based on SELF’s cost of capital in May and November. This was calculated as the weighted average of SELF’s cost of debt, based on credit lines established with its bank. Cost of equity had been arbitrarily set a 10% for the past several years. However, SELF voluntarily sought to moderate the interest rate it charged students, and thus the interest rate on HBS student loans showed less volatility than SELF’s cost of capital. For example, when the prime rat had been 18%, students had been charged only 12%. In fact, the problem that SELF faces is how to predict cash inflow based on students repayment, or default on their loan. According to the Holyoke Center students often made large prepayments in the first quarter of a year. For example, on past occasions when Wall Street had experienced a record year, the overall amount of prepayments had jumped significantly. It was extremely difficult to obtain accurate or comprehensive data on prepayment patterns. Traditional policies of HBS loans over the years have some dissatisfaction for the students. So that Rick Melnick proposed a new set of terms for that. His proposal envisioned a mortgage-like structure, with equal monthly payments over five years and fixed interest rate set in advance. We can see exhibit 2, assume that the fixed interest rate was 9% with the example calculated loans $5,000 and $20,000. How Funding SELF Works SELF was required to maintain compensating cash balances equal to 5% of the unused part of the commitment which is these compensating balances earn no interest for SELF. SELF was also required to maintain a debt to net worth ratio of not more than four to one and also permitted to drawdown and repay without penalty. With these conditions, SELF was faced with critical situations. SELF used the two credit lines identically, borrowing in equal amounts as required and repaying in equal amounts as loan repayments and prepayments were received from students. These credit lines were secured by the assets of SELF (the loans receivable from students) but were non-recourse to Harvard University. However, the University issued a “comfort letter” to the two banks, stating that it would maintain a specified minimum amount of equity in SELF. The credit lines had a term of one year, and thus had to be renewed annually. This had never been a problem in the past. Key Issues Mismatch beetwen semi-annual and balloon payment with the regular pattern of salaries, make students unable to meet the requirement (default 1,4%), this creates a huge risk of default and the student didn’t like the current loan policy that SELF offers. SELF is a non profit organization, this organization is trying to help the students to fund their study. Securely refunding Harvard Business School’s capital, in order to create enough funds for new loans to new incoming students is the main issue. Since SELF does not have the objective to create profits, the strategy should be risk adverse organization. With the new structure, this risk will be reduced because students will have a fixed rate and monthly payments, which is in better line with their future income, so it's the right decision to change loan policy. Theory Derivative instruments are very helpful in market risk management. It transfers risk in opposite market conditions. While derivatives are very useful for hedging and risk transfer, and hence improve market effectiveness, it is necessary to keep in view the risks of too much leverage, lack of transparency particularly in complex products, difficulties in valuation, tail risk exposures, counterparty exposure and hidden systemic risk. a. Option A contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset at a specified price within a specified price within a specified period of time. b. Caps A call option on interest rates, often with multiple exercise dates. In this type of ‘interest lid agreement’, the seller of the cap (also known as the writer, as in option parlance), undertakes the following: On each fixing of the interest rate, he pays the difference between the previously determined strike price and the variable reference rate, if this is higher than the strike price. The buyer pays a premium for the writer’s risk when concluding the transaction. This can be regarded as an insurance premium against rising interest rates. On each interest date, the current reference interest rate is compared with the strike price. If the interest rate is lower than the strike price, no payment takes place. If the interest rate rises above the strike price, the ‘insured event’ occurs: The bank as the writer pays the difference, so that the holder of the cap can restrict the interest rate costs for his liabilities to the agreed level. c. Floors A put option on interest rates, often with multiple exercise dates. A floor offers protection against falling interest rates. An investor who operates in the money market can profit fully from rising interest rates by paying a premium for a floor. At the same time he will receive a minimum yield during the term. The seller of the floor undertakes to pay the difference between the strike level set and LIBOR, if LIBOR is below the strike. d. Collars A position taken simultaneously in a cap and floor. The collar is a combination of a cap and floor, and is therefore a bandwidth option. A cap is bought and a floor is sold at different strike prices. The reverse is also conceivable: A cap is sold and a floor is bought. The cost of the cap is offset against the earnings from the floor that reduce the premium costs. In the ideal scenario, the premium expenditure and earnings offset each other. The interest rate may only fluctuate within a specific bandwidth. The hedge against rising interest rates is financed through the waiving of some profit potential. e. Swaps Swaps divided to interest rate swaps and currency swaps. Interest swaps is an agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified interval. Currency swaps is an exchange of debt service obligations, denominated in one currency which purpose for the service on an agreed upon principal amount of debt denominated in another currency. Interest rate swaps do not typically generate new funding like a loan or bond sale; rather, they effectively convert one interest rate basis to a different basis (from floating to fixed), divided into : - Basis Swap (floating-for-floating swap) In a basis swap, the Agency enters into a receive-floating, pay-floating interest rate swap where, for example, the Underlying for the first Floating Leg is the Prime rate and for the second Floating Leg is based on the one-month LIBOR rate. A basis swap may be used to reduce risk associated with potential changes in tax law, decrease basis risk, or to move from one index to another. - Coupon swap (fixed-for-floating swap) The floating-to-fixed rate swap allows an issuer to convert a portion or all of an outstanding variable rate issue to a fixed rate payment structure. Issuer receives variable payments from the swap provider and pays a fixed rate of interest to the provider. The funds received from the provider are then used to pay interest on the outstanding variable rate bonds. Synthetic Fixed Swaps act as hedge against interest rate risk. Analysis For the new policy of SELF, Rick Melnick had asked his banks to outline several interest rate derivative products. It could be combined with some of these products, including fixed-for-floating swaps, caps, floors, and basis swaps (see exhibit 3). But first, we will elaborate a little bit more on the WACC of SELF. We can calculate the WACC of SELF based on some information from the case. Currently, the cost of equity is arbitrarily set at 10% and the cost of debt changes over time. WACC to about 9,13%, in our calculations we will assume this to be the level of which we cannot allow the cost of debt to increase above. In the future, SELF will be able to set limits on their cost of debt, by using some of the available alternatives 1. Do nothing Since we know the strategy of SELF is risk averse, with this scenario SELF will then be exposed to a high interest rate on their debts when the prime-rates are high. This is not acceptable, since the interest rate income is fixed. Therefore the possibility of a gap between income and expenses is too great. 2. Fixed-for-floating swaps Fixed-for-floating swap was a contract where SELF and the bank would exchange a fixed interest rate for floating rate. Based on the article, this method shows SELF would pay a fixed rate of interest of 5.76%. In return SELF would receive floating rate of interest (LIBOR) on the same “notional principal”. This swap would transform that debt into fixed rate debt, with SELF paying the bank if LIBOR less than 5.76% and the bank paying SELF if LIBOR exceeded 5.76%. 3. Caps Based on the article, by buying a cap SELF will get the right, and receive the excess of floating interest rate over the fixed cap rate. A borrower could set an upper limit or cap on its borrowing cost with interest payments tied to LIBOR. See exhibit 3, if example SELF bought 6% cap in 1 month, it would cost 1.52%. If LIBOR below 6% SELF would receive no payment. This option is required for which party bought. Buy a cap (the right to borrow funds at a set interest rate) in the money if interest rates go up, so it protects the LIBOR payments SELF must make. 4. Floors Same with Caps, by using exhibit 3, with example bought floor rate of 6% SELF would receive 2.12% of the notional principal amount. Floors would give the SELF option which paid its holder the difference if LIBOR fell down below a present amount. Borrowers will sell floors to receive the excess of fixed floor rate over a floating interest rate. 5. Basis swaps Based on the article, basic swap would obligate SELF to exchange one floating rate for another. For example, SELF would exchange prime for LIBOR. Each month it would pay the current LIBOR rate and receive the prime rate less 2.80%. By combining this swap between basis swap with the prime based, SELF could transform into LIBOR based floating rate. Combination SWAPS Scenario 1 : Basis swaps Only using this swap will not change anything in the assumed risk, since we are now exposed to fluctuations in the LIBOR rate, whereas we were first exposed to fluctuations in the Prime-rate. Therefore this Basis swap should be combined with other derivative solutions. Scenario 2 : Basis Swap & Coupon SWAP Net cost will be 8,56%, if we see exhibit 5 (US Capital Market Data, the net cost of 8,56% cannot compare with any type of US Treasuries or rated companies, because its too high. Scenario 3 : Basis swap & Buy Cap Since we are now exposed to fluctuations in the LIBOR rate, whereas we were first exposed to fluctuations in the Prime-rate. This basis swap should be combined with buy a cap (the right to borrow funds at a set interest rate) in the money if interest rates go up, so it protects the LIBOR payments SELF must make along loan tenor. Conclusions Mismatch between semi-annual and balloon payment with the regular pattern of salaries, make students unable to meet the requirement. With the new structure, this risk will be reduced because students will have a fixed rate and monthly payments, which is in better line with their future income, so it's the right decision to change loan policy. Recommendations 1. Conduct the basis swap only (swap Prime for LIBOR +2,80%) and continue to borrow at floating rates. a.Receive fixed payments from students b.Make payments at LIBOR (not Prime) It might just benefit the bank (LIBOR historically been less than 2,80% under the prime rate), but it can compensate the advantage of the possibility prepayment with existing bank 2. Combine basis swap contract (swap Prime for LIBOR +2,80%) and a Caps at 6% (because SELF pays 5,76%) Historically LIBOR has mostly fluctuated between 10% and, more recently, at 3,50%. In previous slide we have assumed that SELFs WACC and therefore the break-even point should be around 9,13% Exhibit 1 Alternative Student Loan Program Exhibit 2 SELF Financial Statement ($ thousands) Exhbit 3 Representative Terms of Selected Financial Instruments, November 21, 1995