Background of case Study
Rick Melnick is an Associate Director of Financial Management at Harvard Business School (HBS). He had decision to make regarding the new funding policy under the management of Student Educational Loan Fund (SELF). SELF was established in 1961 to fund loans to HBS. Traditionally, HBS student loans required the borrower to pay semi-annually with variable interest rate policy. Under the new plan, the students would receive monthly paid plus fixed-rate interest. With this new plan the management believed that it will reduce the rate of delinquency among the students. Basically in 1996, the tuition fee for two-year MBA program at HBS was $42,000. The cost is estimated to achieve up to $45,372 when it is comply with health insurance and living expenses. This high expense forces most of the student to obtain some form of student loan. There are many types of loan that students can choose from. Some of the loan is offered by U.S Federal Government under Stafford and Perkins loans. Students also have a choice to borrow from the bank. But because of these loans are only eligible for U.S residence, many foreign students at HBS School obtained loan under the school itself. (See table 1 for alternatives student loans)
When SELF established in 1961 it was actually set up to accommodate the rapid expansion of the loan by students. To operate, SELF bought the loans outstanding under the HBS loan program and received the right of future cash flow from the student’s prepayment. The prepayments are then used by SELF to purchase the HBS loan. To fund the loan’s purchasing, SELF borrowed from its two banks identically, 7.5million each. Interest on the loans was charged at the prime-rate and paid monthly. The credit lines have a term of 1 year and thus had to be renewed annually. Figure 1 show structure of payment to the bank and received prepayment from the students.
Figure 1: SELF payment structure
If the management wants to implement the new fixed-rate, mortgage style, the above structure will be changing. When the asset received by SELF will be in the fixed-rate with monthly payment, but still SELF had to paid the bank in prime-rate monthly basis. This will create problems as the new policy will not match the existing prime-rate funding. To solve the problem, Melnick had entered into derivatives market to do the Interest rate Swap.
What is SELF? What should be its objectives? What is the problem faced by Rick Melnick?
SELF is a School Student Education Loan Fund which separately incorporated but related unit of Harvard Business School (HBS).It is a non-profit organisation because all the money they get from bank is used to purchase loan from HBS. They do swap to be protected from making losses from unmatched event because students pay them at fixed rate and their loan is floating rate. This unmatched situation may cause problems because SELF have obligation to the bank to maintain certain amount in their balance sheet in order to continuously received loans from the bank. SELF main objectives are to accommodate HBS students in terms of fund loans and at the same time to finance the purchase of student loans each year since the annual aggregate value of HBS loans made had grown rapidly and the student body had become increasingly diverse. Meanwhile, Melnick had to find a solution by finding new interest rate derivatives product in order to address the unmatched between SELF’s new loans and its funding. The problems may occur if the floating interest rate rise and SELF fixed rate income may not being able to compensate the liability. Furthermore, it is never easy to find the correct pattern of student’s prepayment and make it hard to predict the SELF cash in flow
Table 1: Summary and comparison of alternative student loans | Stafford | Perkins | Bank | HBS (Traditional)...