Friday, February 01, 2008

SLM Corp: We've got to give him more time!

I'm going to give you four companies. I'll give you their business, but not the name of the company. I'll also give you their credit default swap level. The level quoted indicates the cost, in basis points, of buying protection against the company defaulting. The higher (wider) the spread, the riskier the market perceives that company. Quotes are as of January 29.

#1 Largest U.S. home builder by market cap. CDS is at 400bps.
#2 West coast Regional bank which was once one of the largest sub-prime lenders. CDS level is 325bps.
#3 Monoline credit card company, marketed primarily to modest income consumers. CDS is 330bps.
#4 Dominant lender in a growing market, unrelated to housing. 87% of their loan portfolio is 97% U.S. Government guaranteed. CDS spread is 420bps.

The companies? #1 is D.R. Horton, #2 is Washington Mutual, #3 is Capital One, and #4 is good old Sallie Mae.

Sallie has sure put bond holders through some tough times over the last 12 months. The now defunct LBO, originally announced in April of last year, slammed Sallie's credit costs. In between then and now, Sallie has suffered some very real operating problems, namely changes in the FFELP program which renders the Department of Education program less profitable. On top of that, the securitization market has fallen apart. While its still possible to securitize student loans (Sallie did a new deal in January), the spread has gone from LIBOR flat to something in the area of LIBOR +65. This is all pinching margins, and slowing earnings growth.

Its time for the markets to separate the slower earnings story (stock holder's problem) with credit worthiness (bond holder's problem.) The earnings growth story is weak. The credit story is still pretty strong, especially given the fat spread available on the credit.

Sallie Mae has a lot going for it in terms of liquidity. First is SLM's large FFELP student loan portfolio, currently $109 billion. This could easily be securitized or pledged to a bank should the company need liquidity. Second, SLM just announced a new $31 billion liquidity facility, which replaces the one provided by J.P. Morgan and Bank of America in conjunction with the LBO. SLM's total debt is currently $147 billion, or only about $7 billion more than the sum of the liquidity facility and the student loan portfolio.

Will SLM face higher loan losses in the next couple years? Probably. Look, all consumer lenders benefited from rising home prices, as consumers who got into debt trouble were often able to HELOC their way out of it. Now all consumer lenders are going to see higher defaults as the housing market takes the Home Equity option away. But given that private loans are only 13% of SLM's business, it seems like a manageable problem.

It seems especially manageable when you compare SLM's situation to that of other credits trading tighter, and yet more directly impacted by weaker housing and weaker consumer balance sheets. It just seems the macro picture for Capital One, Washington Mutual, and D.R. Horton is much weaker compared with Sallie Mae.

Perhaps the wide spread is a simple case of bond vigilantism. Bond holders are refusing to get back into the SLM pool after being burned by the proposed LBO. But does anyone seriously expect another LBO? Remember that the original LBO banked entirely on SLM's ability to securitize new loans at cheap levels. That was theory behind why SLM could get away with a junk rating, as it would have recieved had the LBO been consummated. Cheap securitization now seems like something out of a dream.

To top it all off, SLM management has a stated goal of getting back to an "A" rating. The liquidity situation in the market generally probably has to improve in order for that to happen, so an upgrade in bond rating might be a little ways off. But still, at these prices, SLM bonds/CDS look very attractive.

(Disclosure, I own SLM bonds through client portfolios.)


the cds trader said...

i like your rationale.

long SLMA, long COF, short WM, short DRH

WM will suffer more than COF for a while, as home "owners" walk from their mortgages but keep paying their credit cards (for now), and and DRH will widen once a few of the homebuilders start filing for bankruptcy (there is no way that all the major ones avoid it).

in the meantime, i'm actually gonna short some COF stock...$54, up from lows of $37, it's still got issues...

fred said...

just like to ask whether it's better (from yr experience) to analyze the cos using their 10Q or do you rely on other sources? Esp. if time is a limiting factor (as usual).

many thanks

Tony said...

I agree with your overall outlook regarding SLM. I think that SLM will go private in about a year or so because who they brought in to turnaround the company: Anthony Terracciano. Tony the Tiger, as he's known, had an important role in SLM's recent credit facility agreement. This guy is not drawing a huge salary, but he's loaded to the gills with stock options. Disclosure I too own SLM stock and in addition, JSM, the preferred.

Colin said...

good post as usual. your logic on the spreads certainly seems sound. one question, though: does 'him' in the headline refer to al lord? maybe not. it seems hard to imagine why we'd want to give him more time.

BlueCollaHero said...

Quick question. Don't you think compared to Washington Mutual or Capital One, SLM is bound to suffer more. If a debt laden individual has three loans, home mortgage, car loan and student loans. Which loan do you think will keep getting serviced? I would say the mortgage and the car loan, and if you had to miss payments, it would be the student loan. Also, seeing as that SLM will securitize less loans and hold onto more, I think they will take on more losses than WM or Capital One. Also, from your analysis I think this goes back to the whole argument that this is an insolvency crisis for them and not a liquidity.

Anonymous said...

Long SLM bonds (CMT floaters - retail Notes) and Series B Preferred.

Agree with comments. Since 85%+ of loans are govt guaranteed, do we care if borrower defaults? JSM, BTW, is a 35-year unsecured senior Note not a preferred. It has also done quite well lately. SLM has a reasonable plan for the future and the people to execute it(beyond AL). Remondi and T-squared have already made contributions (reconciled with BOA/JPM) in the first 4 weeks. But I'd rather be a bond holder at 9-10% yield per year than a stockholder, although they may do fine as well.

Anonymous said...

Absolutely fascinating post, containing a terrific one-liner:

Cheap securitization now seems like something out of a dream.

But there's a problem. Gramps pointed out in the last comment section (and I must say that I would invite Gramps to dinner in a second), that the only real effect of lowering rates was destroying the dollar.

So, I ask you:

Wouldn't a German government bond which has absolutely no default risk whatsoever paying 4% be a better investment?

If the dollar falls by another 20%, than that bond is yielding 4.8% in dollar terms, and the principal is $1,200.

Okay, that's only 80 basis points and you're talking about hundreds, but there's the issue of sleeping at night and whether the dollar will fall by a lot more than 20% ($1.68 to the euro).

gramps said...

From a pure relative value standpoint, I can't argue with your analysis-- but I would probably argue the market is underpricing risk in the west coast lenders, and not over pricing risk in SLM.

Part of the change in govt subsidies that scuttled the LBO was that the govt guarantees principal, but no longer guarantees interest (not in full anyway) -- in another words, the govt finally realized they shouldn't subsidize a very fat lending spread.

Second important caveat: student loans are guaranteed, not SLM loans. This is a subtle but important distinction for SLM's own debt (as opposed to securitized student loans).

Going forward, it is SLM's earnings power (or lack thereof) that guarantees the debt will be paid in a timely manner.

There are plenty of reasons to argue that the govt guarantee is not worth 100 cents on the dollar: FDIC insurance on your bank account is great, but they neglect to mention that you don't get your money back the day the bank fails; you get it back several months later after a lot of paperwork and red tape. When FSLIC failed the govt did step in, but it was not instantaneous. If Uncle Sam is already distracted by a mortgage problem, and an entitlement spending crisis awaits the next lucky Oval office occupant -- it seems fair to say student loans will not be paid any faster than FSLIC (and an argument could be made for slower payments). Anyone want to talk about the value of govt guarantees to Katrina victims? Watch CSPAN for a few minutes and then ask yourself if Congress does anything in a timely manner.

If it came down to it, I think the govt would indeed make good on the guarantees, but I would, at minimum, discount it by 6-12 months. The guarantee is really worth only 97-98 cents on the dollar.

As AI and the aborted LBO point out, future earnings will be hurt by a much thinner profit margin.

The second issue is that college costs continue to climb by 2-3 times the rate of CPI, and much faster than Treasury bond yields. More importantly, they are growing faster than many paychecks.

Historically, going to college was a "no brainer". Pay whatever price, because your future earnings will be so much higher.

Many students now already attend state schools for the first two years, and then transfer to a "name brand" school for junior/senior years. Others do semesters away (at cheaper places). American students are now looking at Canadian and European(UK esp) schools that are vastly cheaper. Harvard and Yale have now extended financial aid to families making as much as $150,000...

I am not arguing that college is no longer worth it, but I am arguing that the decision is no longer a no brainer decision. At the margin, it is making less and less sense.

I doubt people will stop going to college, but I would argue that total loan/portfolio size is not going to increase at anywhere near the rate it did in the past. By necessity (not choice), people were already looking for ways to control college costs even before the current credit situation.

Slower portfolio growth plus shrinking profit margins does not spell earnings strength. SLM's own credit worthiness really is strained. And as argued above, the govt guarantee probably isn't worth 100 cents on the dollar.

So SLM is legitimately a much bigger credit risk than it was historically. Maybe you want to argue the other credit spreads you mention should be wider...

Anonymous said...

Gramps: when were the FDIC or FSLIC ever slow to pay insured depositors? People with uninsured deposits may have gotten their money back only after waiting for the FDIC/FSLIC/RTC to dispose of the failed bank's assets -- but I am unaware of any instances where insured depositors did not get their money back in a few days, usually it was/is available the next business day.

gramps said...

Anon 10:13

When S&Ls failed, they had to be seized (a legal proceeding which is not always an overnight process).

Once seized, new bank officers from the FSLIC had to asses the S&Ls liquid assets (which were obviously in bad shape, but they had to figure out how bad). That didn't happen overnight either.

In 1989, the FSLIC failed altogether, they weren't making people whole overnight then. Also, remember that S&Ls are/were not part of the Federal Reserve system, so the S&L's couldn't get temporary liquidity through the discount window -- there is/was no lender of last resort for S&Ls.

After the FSLIC failed-- Congress created the Resolution Trust Corp (RTC). The RTC had to secure funding (both from Congress and by issuing its own bonds).

Depositors were allowed to withdraw a preset amount (whatever the govt decided were "living expenses") in a matter of days, but full balances were most definitely not available.

If the bank assets were available and liquid, it wouldn't have failed in the first place. The RTC never had unlimited funding, and could not monetize all assets overnight even if they wanted to.

Watch "Its a Wonderfull Life" and listen to George explain why its not possible for any bank (even a solvent one) to make all deposits available "the next day" as you suggest. Or google what a fractional reserve system is.

There were loads of news stories from the S&L period of insured depositors not getting their money bank immediately (they wanted to pull all their money at once).

How long a given depositor had to wait for funds depended on when their S&L failed (during FSLIC or RTC), what sort of liquidity the FSLIC or RTC had at the time of failure, the assets of the S&L (some were obviously worse than others), and obviously the balance each depositor had (the regulators tried to make sure people had living expenses). Once the federal regulators seized a bank, it was usually days (plural) and in a few instances weeks before full (insured) balances were available.

At any rate, S&L depositors isn't a perfect analogy. Regulators want to demand deposits available as quickly as possible -- because they know people are counting on that money for day to day expenses. Paying back "rich" bond holders does not have anywhere near the same urgency, either logistically or politically.

When I said it might take 6-12 months (and the value should be discounted), that was a shot in the dark... its anyone's guess how fast Congress would act.

For loans issued right now, Uncle Sam guarantees 99% of the the loan (assuming one includes the 3% "exceptional performer" incentive). For loans issued after 2012 (I think 2012, I am not sure on that part), the guarantee drops to 95% of the principal. That 95% was George Bush's idea-- Ted Kennedy and others wanted the guarantee dropped to 85%. So after Bush goes, there might be some political risk to the guarantee as well.

Accrued Interest said...

Fred: I always start credit analysis by reading the 10K, then the 10Q's. Then I read street/ratings agency research. Then I read the 10K and 10Q again (maybe not in whole, but in part.)

Accrued Interest said...

Gramps: Can't argue with you that SLM is riskier than it once was. A key element of my analysis is that SLM can securitize their FFELP paper to raise capital, even if their earnings growth is mediocre. My analysis of the new government program doesn't result in FFELP being unprofitable, but it does squeeze margins. I think this pushes secondary student lenders out of the market. Which over time gives SLM the pricing power to recoup lost margins.

Accrued Interest said...

Colin: The HIM is SLM as a corp.

Bluecolla: I'm basing my analysis on the fact that the overwhelming majority of SLM's loans are mostly govt gtd, so they could suffer relatively high defaults and still be fine.

Also, who is going to have an easier time securitizing both existing and new loans? WaMu, who can realistically only securitize conforming first mortgages? Or SLM who has recently securitized new FFELP deals?

Look at WaMu's current loan portfolio. The majority of their "prime" portfolio is option-ARMS. Now, I'm not a chicken little on option-ARMS, but I sure think that product will default at a higher rate than fixed-rate product. Especially in California, where WaMu has a lot of exposure.

So while the overwhelming majority of SLM's portfolio are loans for which the market is happy to securitize, the majority of WaMu's portfolio is not. That gives SLM much better overall liquidity.

Consider that before the CFC deal, WaMu prefs were trading at 50c on the dollar. WaMu's current level is based entirely on an assumption of a merger, which may or may not happen.

fred said...

thanks ttdg, appreciate yr reply even if my question is pretty mundane.

Bond investor said...

TD: I disagree with your analysis of SLM Corp's future profitability. The govt guarantees on FFELP debt drop to 95% in 2010, and if a Democrat wins the White House, s/he and Sen. Kennedy will gang up on SLM further, cutting the subsidy or simply disintermediating them by expanding the FDLP (Federal Direct Loan Program).

Second, in a time when nearly all quant models of credit and prepayment risk are failing, why do we think SLM's historical stats have any bearing on future trends? People are preferring to default on their home loans before auto and credit cards. As another commenter mentioned, people may not be able to avoid repaying student loan debt through bankruptcy, but they sure can slow down. After all, no one can "take away" the human capital you built up from an education, but they can take your car, house or credit card purchasing power.

Next, I think SLM is unlikely to be acquired by a deep-pocketed firm like BAC or JPM because the firm's margins are so thin. I mean, SLM wants to expand into BAC's and JPM's (and FMD's) market share in private student loans. What does that say about the prospects of its main line FFELP biz?

Finally, is Albert "swear on the conference call" Lord really the person to lead SLM into this new era?

(No disclosures, but would short SLM equity if I could)