Wednesday, April 18, 2007

Sallie Mae does not mean Others Will

Speculators seem to be herding around underperforming financial services stocks since the announcement of the Sallie Mae proposed takeover. The $25 billion takeover orchestrated by J Christopher Flowers is a unique offer for a unique set of assets.

Sallie (SLM), despite the existing leverage ($112 billion in debt currently with a $4.4 billion equity base) can afford the leverage with its gold-plated assets consisting primarily (about 85%) of government guaranteed student loans. Despite the bad rap that student loans carry regarding their default rates, this is not Sallie's problem...defaults are essentially Uncle Sam's problem.A federal student loan goes into default when it is 270 days delinquent, at which point a government guarantee agent purchases the loan from SLM and is reimbursed by the Department of Education.

The management team which has been in place since 1995 has done a sterling job in reducing the capital intensity of the business by increased securitization of these high quality loans and reduction of the equity base by a concerted effort to buyback stock. Previous management, in my view, luxuriated under the GSE banner, and spent its well-compensated time operating in fear of Congressional intervention with little appreciation of the securitization markets.

JP Morgan and Bankamerica will achieve better economics for their student lending operations than were feasible under their existing bank capital requirements. As well, they will pick up substantial income from the fees derived from arranging securitizations.

The financing facility of $200 billion (almost twice the loan portfolio) should assure credit agencies that SLM will have ample liquidity from two of the biggest banks in the land to backstop any potential crisis .

The terms for this LBO are very aggressive with interest coverage of only about 1.6 times.Debt will be over 8 times EBITDA. That is huge and scary. But don't forget about the backstop funding that $200 billion brings.

Sallie is no longer a GSE (government sponsored enterprise,) courtesy of the forethought of the existing management team. This flexibility has worked out in ways that are unimaginable. Had this remained a GSE, this deal could never have been contemplated.

The FFELP lending program operates very efficiently and effectively and at remarkably low cost. Under the Clinton administration, the direct lending competitor operated as one would expect any government agency high cost, and ineffectively. Snarled application processes left financial aid offices at colleges around the country wondering when they were going to get paid.

Will government allow this deal? Politically, student lending has always been an easy target, but remember this is no longer a GSE. Theoretically, this should be no more difficult than allowing a Bankone, JP Morgan merger which united two of the largest student loan originators in the country.

But because Sallie Mae does not mean others will. In my opinion, this should not open the floodgates to widespread LBO's of financial services companies. Deposit taking banks have a lot of hoops to pass through for a takeover, and the equity cushion is very important to people that offer deposit insurance, namely the FDIC. Freddie and Fannie (and I like them both) are ensconced as GSE's and will not have the flexibility to do this kind of a deal. CIT has a loan portfolio that is much more complex and less fungible than that of Sallie. It is possible but it won't be easy.

Needless to say, I like the Sallie deal from the perspective of a long time shareholder. Bondholders may feel more than a little chagrined.

Disclaimer: I, my family, or clients own a current position in SLM , BAC, JPM, and FRE, but do not own a position in any of the other securities mentioned.


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