Sallie Mae's Blame Game
"In playing the blame game, Sallie Mae should take a long, hard look in the mirror, as a good part of its misfortune is the result of its irresponsible and arrogant leaders."
-Stephen Burd
New America Foundation
Higher Ed Watch
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When student loan giant Sallie Mae announced on Monday that it was removing Al Lord, the company's Chief Executive Officer (CEO), from his position as Executive Chairman of the board a little more than a month after he took the job, it went to great lengths to portray the move as business as usual. But investors, financial analysts, and the news media weren't buying it. The fact Sallie Mae had handed control of its board to an individual who has been touted as "a turnaround specialist" speaks volumes about the degree of panic that has overtaken the company's headquarters in Reston.
Sallie Mae's leaders have good reason to worry. The company's stock has plunged from a high of $58 a share in July to about $17 and that's only after the stock shot up by about 10 percent on Monday after the news that Lord was out as the Board's Executive Chairman (he will remain on in his role as CEO). And the company is desperately scrambling to refinance more than $30 billion in debt it has on its books.
Predictably, Sallie Mae is putting a large measure of the blame for its freefall on legislation Congress approved in September that cut excess lender subsidies to pay for a significant increase in the maximum Pell Grant for low-income students. Never mind that in its legal fight against J.C. Flowers & Co., the private equity firm that backed out of purchasing the company this fall, Sallie Mae has stated that the cuts were only incrementally worse than they had been expecting for months. The company is also blaming its woes -- perhaps with greater justification -- on a tightening of credit markets.
But in playing the blame game, Sallie Mae should take a long, hard look in the mirror, as a good part of its misfortune is the result of its irresponsible and arrogant leaders.
Ever since Al Lord wrested control of the company by leading a shareholder revolt against its former management in 1997, he has run Sallie Mae with a degree of hubris and belligerence that would make former Defense Secretary Donald Rumsfield proud. That fact became painfully clear to investors and financial analysts last month when Lord's disastrous performance during a conference call on the company's earnings sent the company's stock plunging. That call, which ended with Lord berating an analyst and cursing, was eerily reminiscent of one Enron's Jeff Skilling gave only months before that corporation collapsed.
While that conference call is the most obvious example of how the top leaders' arrogance has harmed the company, here are a few others that help explain the dire straits in which Sallie Mae finds itself:
The Collapse of the Buyout Deal
Sure, Lord et. al had every right to be upset when J.C. Flowers & Co. got cold feet on its initial offer to purchase Sallie Mae for $25.3 billion or $60 a share. That would have been quite a deal for Sallie Mae's leaders and investors, as the offer represented almost a 50% premium over its stock price before news of a potential takeover became public. Lord himself was set to make out like a bandit. Had the takeover gone through, he was expected to rake in nearly $225 million from cashing in his stock options.
But while Flowers did pull out of the original deal, he did try to renegotiate. And the terms he offered -- $21 billion, or $50 per share -- look like they would have been a steal for Sallie Mae, given the price at which the stocks are trading now. But in typical fashion, Lord refused to budge and instead decided to take the equity firm to court to demand the $900 million "break up fee." He also took potshots at Flowers in the news media and during an investor conference call that appeared to be aimed at shaming him into following through with the initial deal.
But Flowers got the last laugh. In December, with it stock tanking, officials with the loan company had a change of heart and approached the equity firm saying they were willing to renegotiate after all. This time, Flowers turned them down.
A Bad Wager
In a fitting example of the company's hubris, Sallie Mae has entered into deals with Wall Street bankers in which it has essentially wagered that its stock price would not drop. These deals, known as equity forward contracts, are a cheap but extremely risky way for corporations to raise money by selling their stock to banks and agreeing to buy it back on a date certain at a higher price.
Perhaps the move didn't seem that risky to a company that has been nurtured and protected from birth by the federal government. After all more than 80 percent of the loans that Sallie Mae makes are fully backed by the federal government.
But with the company's stock price plunging, the company has been forced to pay for its misplaced optimism. To raise the $2 billion it needed to cover the costs of the agreements, Sallie Mae recently sold more than 100 million shares of stock. By doing so, the company further diluted shareholder value.
Subprime Lending
Over the last decade, as Sallie Mae has made a huge push to become the predominant player in the private loan market, financial analysts have repeatedly warned the company to be careful about making loans to subprime borrowers. They worried that the company, which is used to having government backing on its loans, would not properly assess the risks in lending "unsecured [private] loans to people without jobs," as Bethany McLean of Fortune Magazine put it in a 2005 article about analysts' concerns.
But Sallie Mae's leaders did not heed these warnings. Instead, they pioneered the "opportunity pool," an arrangement that allows lenders to leverage private loans to get a larger share of a college's federal student loan business. Under these types of deals, a lender gives a college a fixed amount of private loan money that the institution can provide to students who otherwise would not qualify for the loans. In return, the insitution agrees to make the loan provider "a preferred lender," or even an exclusive lender of federal loans on its campus.
Some loan industry officials acknowledge that these deals are "loss leaders," meaning that the companies are willing to risk having a certain number of private loans go into default in order to expand their presence on a campus. This especially appears to be the case with deals Sallie Mae has forged with some of the largest for profit higher education companies in the country, like Career Education Corporation and the University of Phoenix, which have been widely accused of engaging in aggressive and misleading recruiting and admissions tactics. According to a recent Senate report on improper marketing practices by lenders participating in the Federal Family Education Loan (FFEL) program, Sallie Mae calculated that Opportunity Loans it offered to one such college had an expected default rate of 70 percent.
Conclusion
Sallie Mae is paying the price for its harmful policies. Facing growing loan defaults, the company alarmed its investors last week when it announced that it is planning in the coming year to become "more selective" in making both federal and private student loans. News that the company was cutting into its core business sent the company's stock down 13 percent in one day.
So Sallie Mae can continue to lay the blame for its problems on everybody else. But if it wants to solve them, it must first heal itself.
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The Blame Game Part Deux
Hey look NAF, I found another student loan company playing the “blame game” (I took this from Goal’s website: http://www.goalfinancial.net/announcement.aspx):
Due to the recently passed College Cost Reduction and Access Act of 2007, Goal Financial, LLC is no longer accepting applications for any new loans. Students and families who have taken STAFFORD and PLUS loans from Goal Financial for the 2007/2008 school year should rest assured that we will honor those commitments and issue the second disbursement as scheduled. For those customers who are currently in repayment on a Goal Financial loan, this decision does not affect your status. Please continue to make your regularly scheduled payments. If you have additional questions, please do not hesitate to call us at 1-800-869-1538.
Goal Financial is proud to serve over 200,000 students and families. Over the past six years, we have provided the financial support that has helped them achieve their educational goals.
One small difference between the employees of Goal and Sallie, is that Goal’s employees will be doing the introspection you recommended at the unemployment line! How dare they blame our benevolent Congress for putting them out of business!
Goal not in same market niche as SLM
The straw that broke the camel's back
Jim, your points are all valid, however, the straw that broke the camel's back for Goal was most certainly the reduction in SAP that resulted from the CCRAA. In today's enviroment, they simply don't make any money on consolidation loans. Here's the math (annual yield):
264 SAP
(55) CCRAA Reduction
(105) Rebate Fee
(11) Lender Fee (1% / 9 years)
(3) Defaults (10% * 3% risk sharing / 9 years)
(25) Servicing (this comes down the higher the loan balance)
(5) LIBOR vs. 90 day CP difference
(55) Cost of Funds (this is where FFELP securitizations are pricing in today's market over 3-month LIBOR)
5 Net Spread
At a 5 bps annual spread, Goal doesn't cover its costs to acquire and originate a consolidation loan. It's a raw deal for Goal and others, and Congress does deserve a large measure of the blame. Loopholes and Al's comments aside, consolidation was a good deal for many students and brought needed competition into the FFELP space. You do the math on what that means for the future of FFELP.
The bottom line
The bottom line here is for the benefit of the student. The student is the only reason there are student loans. Student loans are for the betterment of the individual, not for the betterment of the lenders. We seem to forget what it is all about, the student. The entire system was brought about to ensure that students had funds to better themselves by way of higher education.
Lenders must also realize there is risk involved for them as just as for the student. Life is a gamble. Students are gambling that by attending college they will end up with that dream job they are educating themselves for. Lenders should be gambling they are going to be paid back for the funds they lent the student. In the end, all MUST understand there are times when there are loosers in this game. Lenders MUST understand there are going to be students that will be unable to repay the loans, and be ACCEPTING of this fact. Insted, they lobby Congress to have the laws changed in their favor so the students can be hounded in some case, for the rest of their lives and in the end, paying on these loans when they can't even afford food and shelter.
It all sickens me to no end. Congress needs to reevaluate their position on this subject and remove all the special protections these lenders have been given over the past years. These loans need no more special protections as any other private loan would have.
Net yield calculations
Companies like Goal and CLC are free to publish voluntarily their financials just like the SEC standards. All the public can go on, however, are the publicly-traded cos., as well as some state lenders which are required under state law to publish GAAP financials. The official numbers showed net yield of well over 100 bp (for consolidation loans as well) prior to CCRAA. An ROE of well over 20%. This is what Congress was looking at. While consolidation loans have the rebate fee, they also have lower OSB (origination, servicing and benefits) costs than Staffords. On the eve of CCRAA, ROE was down from historical highs, but was still the envy of other industries. As one example, Morningstar wrote earlier this month, "Guaranteed loans historically allowed Sallie Mae to produce returns on equity in excess of 40%. We expect legislative changes and increased capital needs to reduce future returns on equity to an average of 20% after 2007." (And this was part of a generally negative assessment of the situation.)
????
Jim, the fundamental issue here is that in FFELP you have a marriage of capitalism and socialism and the two aren’t good bedfellows. You point to Sallie Mae’s 40% return on equity as the reason for the cuts. Well, Sallie earned 40% on equity because it has the scale that generates economies of scale that are the envy of the rest of the industry (don’t forget how it got that scale either-Congress). They have a $100+ billion dollar portfolio. Goal, CLC, and others don’t have $100 billion dollar portfolios. They aren’t going to earn 40% on equity. Servicing and origination cost Goal and CLC more. In addition, it’s much cheaper to originate Stafford loans than it is to originate Consolidation loans (especially when you are assured of less competition via the preferred lender list when making Stafford loans). What marginal work (cost) does Sallie Mae have to do once it is on a preferred lender list to attract volume? Virtually NONE! It pays the salary and commission of the salesperson that covers the school, and uses its origination platform (a fixed cost that is amortized over all the other schools it does business with) to make the loans.
A consolidation company on the other hand, has to compete with other marketing companies for business. It has to send out millions of mailers that generate infinitesimal responses. Those responses get smaller with more competition, therefore the origination costs get much higher per loan that is generated from the marketing. Why more competition for direct to consumer products like consolidation loans? The barriers to entry for direct marketing companies are no where near the barriers to entry for school channel companies (preferred lender list companies). There’s simply no comparing the two. By the way Jim, the consolidation companies on the eve of the CCRA were not earning 20% returns on equity.
And so to my point, Congress treats all FFELP companies the same, takes 55 bps from them all-but they are not the same! Congress decided who the winners and losers would be-not the consumer! Are 20% returns on equity obscene? I don’t think so. Look around Jim at other companies. The good retailers generate these types of returns. Technology companies generate them and more. Do Google, Oracle, Microsoft, and Apple ring a bell? Congress wouldn’t dare socialize or regulate technology companies! These companies are the key to our global competitiveness-what hypocrisy! Something else to think about Jim….as an investor, making an investment in a student loan company, knowing that the Democrats are threatening the dissolution of FFELP, aren’t you going to demand high returns on your investment? I frankly don’t think Sallie’s 40% return on equity was obscene given the fact that as an investor, you could loose all your investment at the drop of the political hat. FFELP over the years has been bastardized into something it was never meant to be-an entitlement for the 30% or so of Americans who are fortunate enough to get a college degree. All this other nonsense is designed to obscure that fact (although not so obscure here recently).
Cheaper to originate
It is cheaper to originate consolidations than Stafford loans. Schools don't just hand over their student lending business to a lender. Even if you get on the preferred lender list with a number of other lenders, you have to compete again and again to remain there. The marketing costs are substantial. There are barriers to entry that do not exist in consolidations. There are also operational and systems costs, which, while exaggerated by the anti-consol forces, do exist (also raises the issue of why it would be inefficient from a national viewpoint to have thousands of separate disbursement IT systems; I'm sure your neighbors would not support having 1000 coal burning plants over the hill just so that you can have more "competition" in the utilities arena). If there are not good bedfellows in the FFEL program, then what is the alternative? 100% alternative loans? Military contracting is the same way. The free market pundits do not consider military contractors or FFEL lenders to be taxpayers because they earn their way out of other peoples' taxes. Yet during the 2000s, the stock prices of military contractors have increased significantly. It is clearly a mixture of capitalism with statism. While many candidates have ideas to improve military contracting, no one (except for Paul) is talking about getting rid of the concept. Similarly, the direct loan contractors are the epitome of capitalism; folks that call DL more socialist than FFEL have an agenda (to fatten their own bottom lines) in making those statements.
If Congress treated different companies differently, the cries of protest would be loud. (Set aside for the moment that CCRA did treat the inefficient state agency sector of the program preferentially.) This has already been proposed, multiple times. Yes, under a perfect auction system, firms with large economies of scale would receive less taxpayer subsidy than other firms. However, this type of approach has been criticized as "penalizing the winners" and penalizing success. And what is this "Congress" stuff? The Administration proposed deep cuts in taxpayer subsidies last February and got what it wanted. We are at war, and, during times of crisis, the education programs are often used for "savings."
How could you have a program where taxpayers invest so much and have no regulation, no govt involvement? Technology companies benefit from govt policies but it is not the same. Even if you are one of those pundits who believe that all great American fortunes, from the railroads on down the line, have been made from govt preferences and subsidies, it would be difficult to compare Windows to guaranteed student loans. Yet, Microsoft faced a costly antitrust case. And arguably the govt would have been approaching the high tech industry for more taxes and regulation if the market had not crashed.
Again, we don't know how well most of the consolidation lenders were doing as far as ROE and ROA because they did not publish this info. We do know that a major international financial services company, one not known for poor decisions, paid a fortune for CFS. Risk of government regulation did not cause investors to demand high returns from traditional lenders or consolidators. While the handful that were required to file with SEC did include boilerplate on the "risk" of competition from DL, the analysts on the Street were cheerleaders. They clearly had to be getting that from somewhere. They didn't think of it themselves. The lenders were telling the analysts that grants were too costly for the govt and loans were indispensible. They used unrealistic projections of growth in student populations. Most importantly, they told the analysts that there was no serious risk to the program from the govt. All the risks faced by regular lenders are absent from guaranteed student lending. Go through them one-by-one. Even basis risk was eliminated by the change to commercial paper (shifting basis risk to the taxpayer at a cost which has never been measured). Yes, maybe they should have shouted 'legislative risk' much louder than they did. Can you blame them? Competition. With the competition, what was the incentive for anyone to step up and say, "I'm not going to do these types of consolidations because they are not kosher." or "I'm not going to use a 950bp floor on new loans because it doesn't smell right" or "I'm not going to apply for exceptional performer because it doesn't smell right." or "Despite the fact that no one is going to complain about getting a much-lower monthly payment, the method of doing so (going from 10yr to 30yr repayment term via consolidation) is not good for most borrowers, so let's stop."
Why should the taxpayer care about subsidizing the consumer's joy level? Wouldn't the only thing the taxpayer care about is that there be a very bare-bones process for getting the right amount of aid to the right students within a reasonable timeframe for attending school? Spend what is needed to get the job done while at the same time minimizing fraud, waste and abuse. If you think that the idea of the good-credit students getting better customer service than the bad-credit students is capitalistic, then there is no point to govt involvement in the programs at all. A program only for bad-credit students will soon lose public support and will not last long.Post new comment