SLM

I am returning to SLM. I think there is clearly upside for the stock. I get $14 in a runoff scenario, with $12 from the loan portfolio, with fairly elevated private credit losses (2% per annum on the whole portfolio, not just in school). I also get $14/share or 1.7X BVPS of $8.37. Current quarter run rate eps of $0.36 still translates to a 17% ROE, which correlates to a 1.7X P/B. One would assume that a run-off scenario would be a bottom for the stock, however it is currently at $7.45/share below book.
In this situation, I think more time needs to be spent on the things than could go wrong. Why such a large discount to "intrinsic" value.
Clearly, the #1 concern is rolling the ABCP facility. Unfortunately for SLM, collateral in the ABCP is marked to market, focing SLM to inject additional equity (extra collateral) in the facility. As of Q3 SLM had $29.1B of assets at book value backstopping $24.7B in liabilities. The facility is supposedly non recourse, but with such a large variance between assets and liabilities, if the facility was terminated, SLM's equity would basically be wiped out. Another interesting point on this facility is that SLM reduced the borrowing terms. However, my sense is that this was forced on SLM. The new limits are $21.9B for FFEL with a maximum borrow of $20.8B, and for private $3.6B with a maximum borrow of $3.2B. On the NNI call, NNI disclosed that their FFEL loans are currently mark to market at $0.83/$1 in their warehouse line, with significant deterioration in October. If SLM's FFEL were marked at NNI's level, that would be an additional $2.8B of collateral, that SLM would need to post. Moreover, the private loan marks would have deteriorated even further.
Signs of the impact of this ABCP vortex are evident with unencumbered FFEL loans declining from $14B to $9B sequentially, and unrestricted cash falling $3B sequentially to $4.7B ($1.4b of that cash is collateral for derivatives gains). Net liquidity declined $12B in one quarter. The saving grace here, is the new directive from the DOE that sets up a means to offload Stafford loans back to May 2003. This would provide a funding source for $16B, and would help SLM reduce its ABCP draw by double digit billions. The DOE will provide a liquidity backstop in the form of a forward purchase agreement to the ABCP investor. According to NNI, the set price should be close to or at par. I think this facility will give significant benefit to SLM. However, until that facility is renewed, there will be doubt, as banks, should they decide to play hardball, can get a great deal on these loans (can sell them to the FED at $0.90 for example).

#2 is the lack of funding for private loans. SLM has ramped up deposit gathering, and was able to do a term loan earlier in the year, and though this is something, it is certainly not ideal in terms of matched funding. As SLM cannot pass along its cost of funds to consumers, it has opted to improve returns by seeking lower credit costs with a much higher level of co-signers, as well as higher credit scores. Still at this point, the economics, or the form of private student loan market is in doubt. There is talk of increasing Stafford loan limits in a 2nd stimulus package, which would relieve pressure, but also reduce the size of the private loan market.

#3 is private loan credit. Though the company notes that charge-offs have been inline, the company did increase provisions in Q3 with expectations of further deterioration from the economic situation. Delinquencies for traditional private loans rose to 6.3%,and total delinquencies were at 9.4%. However forbearances were down, so the total bucket was only up slightly. A significant deterioration would impact earnings and could impact capital levels.

#4 is the FFEL program beyond 2009-2010. What is the plan beyond 2010? Will SLM retain servicing when it puts the loans to the DOE? Will there continue to be a shift to the Direct loan program? Will further chances to the SAP be made in the future?

#5 is the APG purchased paper program. SLM took a large impairment this past quarter, but additional impairments are possible - leading to further capital strains.

#6 slower prepayment speeds could impact cash flow needed for debt paydown if capital markets remain closed.

#7 Residual interests have been marked down largely due to higher discount rates. SLM has $2.3B in residual interests on balance sheet. This is another source of potential capital strain.

#8 Rating agencies and capital requirments for private loans, and for FFEL. There may be pressure for SLM to hold more capital vs. managed assets. Will SLM participate in TARP, will the government pull a AIG in a worst case?

#9 Future of the wholesale funded model? can SLM compete as a standalone, what form will the ABS market return in and when.

All these concerns are weighing on the stock. However, they fall into two buckets. Can the company survive without additional capital? what is the future earnings power of SLM? If the answer to question #1 is yes? then the stock should trade in the mid-teens. If we get reasonable clarity on #2, then we could have a recovery to the 20s. As the source of earnings growth in the past few years has come from private loans, a resolution there is key. Continued cost cutting provides opportunities, and SLM has opportunities in servicing, including the 2010 contract for servicing the direct loan portfolio for the DOE.

I need to see if this liquidity extension back to 2003 is working, but the big question is this ABCP facility. I think it will get renewed in a slimmed down fashion. I also think that pricing for FFEL loans will improve slowly further reducing strain going forward. That makes me a buy on the stock at this price. With that being said, it seems that NNI is in a more enviable position. Yes they have a warehouse line that is causing them similar angst, but they are in discussion with BAC to amend it. And yes Moody’s downgraded Nelnet’s senior unsecured debt to Ba1 from Baa2,with review for possible further downgrade. Nelnet has $275 million of unsecured debt
maturing 2010. The ratings downgrade resulted in a 30 bp step-up in cost of Nelnet’s
$750 million unsecured credit line. However, they have limited private loans ($1B of a $26B portfolio) so the tail of credit risk is not there, and have a larger fee component from non- FFEL related programs. That stock is also trading below book value per share, and may well be better value than SLM.

This new funding facility, where the government is providing a liquidity backstop but not directly purchasing the loans, may well be a model for the future. It could result in lower funding costs but also in retained servicing since the loans are not sold to the government at any point. Looks like the structure is for cash for 97% and the lenders financing the other 3%. Much better than the curent situation, but still worst than the past. If lenders cannot sell the lower tranches and have to retain them going forward, then capital needs will have to go up.