More on Sallie Mae

First a correction. Tuesday I claimed that Sallie Mae's leverage would decrease because of contributed equity. If I had actually thought about what I was saying for a minute I would have realized that's not right. As an Anonymous commenter pointed out, the company is being purchased for $25 billion, so all that purchase cash is going out the door. That includes the $8.5 billion in equity contributed. So debt increases by $16.5 billion and leverage increases accordingly.

Commenter mOOm asked whether equity goes negative here, since the company only had around $4 billion before the transaction and if they increase liabilities by $16.5 billion, but decrease cash asset by $25 billion, that'd seem like negative equity. I think the way the accounting of this works is that the premium paid for the company over book value goes in as a credit to goodwill. My knowledge of merger accounting is limited to the CFA exam 6 years ago, so I could be rusty on this. Anyone who knows this better than I is encouraged to leave a comment. Now, mOOm's may ultimately be right in a way, since goodwill is an intangible asset anyway. I tend to use interest coverage ratios of various types when analyzing a company's leverage anyway, since the "real" value of a company's assets is always questionable.

Now on to the merger itself. That's right, I'm calling it a merger. Because this does not walk or talk like your typical financial engineering-type LBO. By extending a huge credit line to Sallie Mae, JP Morgan and Bank of America are acting more like strategic buyers. Think about it, Sallie currently has $112 billion in debt outstanding. Would these two banks, in the normal course of business, extend a $200 billion credit line to a company like Sallie? I seriously doubt it. They are only doing so because they have a strategic interest in the company. I think what JP Morgan and Bank of America are doing here is trying to better tap the large student loan market. They realized they couldn't do it organically, and they didn't want to buy up SLM themselves and suffer the drastic increase in leverage on their own balance sheets.

So they get JC Flowers and Friedman Fleischer & Lowe together and buy SLM jointly. The two banks essentially benefit from the fee income stream of Sallie's student loan business, but keep the whole thing off balance sheet. GAAP accounting (and bank regulators) will not consider SLM's debt load as part of either bank because its theoretically non-recourse. De facto, the credit line changes the recourse story entirely. If SLM struggles with all that leverage, they'll take down the credit line and JP Morgan and Bank of America will be holding the bag. Again, this smells a lot more like a strategic merger than a typical LBO.

But this is a bond blog not a private equity blog. So let's talk credit ratings. I've heard different theories. One is that SLM will wind up going to a B-rating. Ugly. Under that scenario, they can get away with the low rating by simply securitizing everything. Here's what I don't get about that theory. Once they securitize the student loans, there is no liability or asset on their books. They've simply collected a fee and then sold off the risk to someone else. They may retain a servicing fee (I'm assuming, I don't know much about student loan securitization), but student loans are floating, so there isn't the same hedging risk that mortgage servicers face. But in that scenario, I'm not sure why they'd suffer a big credit downgrade. I mean, they'd simply be transitioning from a S&L type model (borrow at X, lend at X+200bps), to a conduit model (collect fee for facilitating the loan, then sell the risk to the public). One isn't necessarily more risky than the other. Obviously there could be more to the plan, I'm just saying, altering their core financial strategy doesn't automatically mean they should have a weaker rating.

Another theory for a junk-rating is that their current debt is subordinated to the new debt. To me, whether that justifies a junk rating or not depends on how much of that credit line they've tapped. Typically, subordinated debt is notched from the senior debt. If the credit line isn't used at all, there is going to be a small amount of secured debt and a large amount of unsecured debt. I think in the absence of the credit line, the ratings agencies would simply notch the old debt one notch, maybe two. The company has $96 billion in student loans, so to secure $16.5 billion doesn't put the old loans in such bad shape. Obviously if SLM takes down $100 billion of the credit line, then that's all out the window. But why would they do that right off the bat? And I don't think the rating agencies will rate the company's leverage based on the credit lines they might use. If they did that, then why not rate every company on the bonds they might sell to the public at any time? I think they will only consider the credit line to the extent that the company says they intend to use it.

So I could be wrong about all this, but my read on this is that the credit downgrade won't be as bad as what's priced in right now. There is current a rush to the exit, as a downgrade to junk would cause massive forced selling. Again, I could be wrong, but I think patience will be rewarded here.