Thursday, April 19, 2007

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.


Anonymous said...

I suspect what JP Morgan and Bank of America want is to keep the loan flow coming now that subprime and alt-A sources are less fecund so I'd vote for SLM as conduit. Securitization and derivatives based upon that general product line appears to be the 'hot' business (spelled hugely lucrative) of the 21st Century's first decade; it will be interesting to see if the same can be said in the second decade.

Anonymous said...

hi, i was the anon who pointed out leverage goes up not down y'day...

think you still have some flaws in your arguments.

yes, they are technically insolvent cos they have more debt than assets, but as a private unregulated company they can get away with that because they have enough liquidity (once they do the new financing of ~$16bn).

its not a merger, as the "credit lines" that JP/BoA are putting in place will be for securitization (ie they will guarantee to give sallie mae cash in exchange for assets (loans) they source). there will be no recourse to JP/BoA where Sallie Mae could draw down on an unsecured credit line.

the business is being bought and leveraged for just the reason you say, where they source loans and securitise them, taking out fees & spread differences on where they source the assets and where they securitise them. so they will become more of an arranger than a financier of loans.

the bet they are taking is that they can make enough money doing this to finance the extra debt. leverage ratios very high, new bonds will have first claim on the assets they have on their balance sheet, and so will be structurally senior to existing bonds. so expect the old ones to be junked for sure, and maybe/probably the new ones also. the 2 types of debt COULD rank quite a lot of notches apart, depending on the details of how they do it.

so existing bonds to junk, and $16bn of better bonds to issue, current bond pricing may not be conservative enough.

Anonymous said...

Beautiful analysis. I am impatient to see new posts. Expert opinion is always a grateful read.

Accrued Interest said...


Thanks a lot for your comment. I love the fact that people who know their shit read my blog.

It isn't literally a merger, obviously, since SLM remains a separate company. I'm saying the economics of this are much different than many private transactions. For example, a company like Hertz that was taken private then reoffered to the public in short order. That's financial engineering. I don't think this is like that at all. I see JPM and BAC holding SLM as part of their general line of business for the forseeable future.

As for the accounting of it all, I defer to you on that, as my accounting knowledge is limited. I plan on hunting down my corporate accounting textbook to look it up, because I'm that kind of geek. In my mind, its academic anyway. If we assume you are right and they have negative equity, so what? Does it change anything?

Let's agree for a moment that SLM can only borrow from those credit lines to the extent that they have loans to pledge against the line. Lets also assume that their outstanding public debt is cheaper than the credit line. I don't think that's a stretch. Most of their floating debt was issued at LIBOR+20ish, and the credit line has to be more expensive than that.

They would therefore only use the credit line as they have opportunities to grow their business and/or old bonds mature. So they continue to borrow more and more but only as they are also adding assets.

So where does the massive new leverage come from? I'm open to hearing the answer, but I haven't heard it yet.

Anonymous said...

agree that it could be a nice earning stream for JP/BoA, although am sure JC Flowers is looking to turn it round for a 4x gain on his 4bn over a few years.

leverage is going up for sure though, cant deny that? lets say they have $67bn in unsecured debt, and $71bn of assets (i think thats about the number), then with this LBO they are issuing another $16bn of debt, but not increasing their asset base. And on top of that they are pledging any assets on their balance sheet that they haven't securitised at the time of any default would pay back these new bondholders first, then the old bondholders second.

so if they went bust the day after the new financing is done, the new bonds would get paid PAR, and the old bonds would get back about 82 cents on the dollar ((71bn - 16bn)/67bn).

and that ratio will only get worse for the old bondholders as they start securitising and running down the balance sheet.

so if new bonds are issued cheap, then old bonds have to get EVEN cheaper.

of course, the one advantage may be that new bonds have a longer maturity than most/all of the old bonds, so you'll get paid back on old bonds before new bonds mature, so you could say you are technically SENIOR on the old stuff! But bet the rating agencies don't see it that way...forced selling awaits...

Anonymous said...

No one has mentioned the increasing political risk. Just on April 17, two articles on the Bloomberg:

Education Department Stops Student Loan Data Access: employee that oversaw database placed on leave, held at least $100K in shares of a student loan provider.

California Attorney General Seeks Student Loan Data: Sallie not mentioned particularly here, but note that even though they settled with NYAG Cuomo for $2 MM shortly before the LBO announcement, the article says "Today, Cuomo asked attorneys general from more than 40
states to coordinate enforcement efforts in the expanding
investigation of deceptive practices in the $85 billion student loan industry."

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