Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

SLM Corporation (NASDAQ:SLM)

Q2 2009 Earnings Call

July 22, 2009 8:00 am ET

Executives

Steve McGarry - Senior Vice President, Investor Relations

Al Lord – CEO

Jack Remondi - Chief Financial Officer

Analysts

Andrew Wessel – JP Morgan

Lee Cooperman – Omega

Michael Taiano – Sandler O’Neill

Sameer Gokhale – KBW

[Andrew Permatier – Hyatt Analytics]

Matt Snowling – FBR

Brad Ball – Ladenburg SSG

Moshe Orenbuch – Credit Suisse

Mark Giambrone - Barrow Hanley

Kevin Ing – Columbus Hill Capital

Peter Rosenblum - Appaloosa Management

Operator

Operator

(Operator Instructions) Welcome everyone to SLM Corporation Second Quarter 2009 Earnings Conference Call. I would now like to turn the call over to Steve McGarry, Senior Vice President of Investor Relations.

Steve McGarry

Welcome to Sallie Mae’s 2009 Second Quarter earnings conference call. With me today on the call are Al Lord, our CEO, and Jack Remondi, our CFO. After their prepared remarks we will open up the call for questions.

Before we begin let me remind you that in our presentation we will discuss predictions and expectations and make forward looking statements. Actual results in the future may differ from those discussed here, perhaps materially. This could be due to a variety of factors. Listeners should refer the discussion of those factors on the company’s Form 10-K and other filings with the SEC.

During the conference call we will refer to non-GAAP measures that we call our core earnings presentation. The description of core earnings, a full reconciliation to GAAP measures and our GAAP results can be found in the second quarter 2009 supplemental earnings disclosure. This is posted along with the earnings press release on the investor’s page at www.salliemae.com.

Thank you and now I’ll turn the call over to Al.

Al Lord

You’ve all seen our earnings release where Jack and I are going to discuss the quarter with you. The second quarter was a very busy quarter for the company. It was a good quarter particularly from the financing side for Sallie Mae and its shareholders. During the quarter we bought $1.1 billion of our unsecured debt in at a $325 million gain. We dramatically reduced our short term debt situation. We won a contract to service put loans and direct loans from the Department of Education. Although it’s not included in our core earnings, we actually earned $141 million of floor income as a consequence of the dramatically absolute low level of interest rates.

As you know, we did report $0.31 a share. As I said, the debt repurchase created $325 million of earnings. As in the first quarter and through the first half of this year we’ve had earnings pressure from credit losses on our private portfolio and earnings pressure on our FELP portfolio as a consequence of what I’ll call money market displacements in the CP Libor spread.

Also during the quarter you probably have seen that our operating expenses took a little bump up as we have spent to invest in our systems as we adapt for the contract with the Department of Education. I just want you to be aware we have not lost sight of our operating expense reductions.

Although we expect our credit losses to persist over the next several quarters, at least our statistics predict slowing write offs certainly early in 2010. Our early delinquency buckets are showing improvement currently as you’re probably aware from our last several quarters, 50% of our losses come from a small part of our portfolio roughly about a sixth of our portfolio which we refer to as non-traditional loans. Some 75% to 80% of that portfolio is now in repayment and the numbers entering repayment which is typically where we begin to see the losses obviously is slowing dramatically.

On the CP Libor side that spread has narrowed significantly although it began narrowing late in the quarter. The average spread during the quarter was 45 basis points, its now roughly 20 basis points. We expect third quarter FELP net interest income to improve significantly.

I’m sure you’re well aware that Congress is deliberating the future of various student lending programs at the moment. Yesterday the House Education Committee voted a bill that proposes to end FELP after 2010. We and others in the industry have put forward a proposal that saves as much or more money as the House bill would save. We are hopeful that our proposal and others proposals will get a better reception in the Senate which is yet to act on legislation.

As we said, we greatly altered our financing picture during the quarter. We over the last year and a half have been dealing with a very large asset bank commercial paper facility, at one point it reached $34 billion is now down to about $13 billion. We hope to pay it off or nearly pay it off by the end of this year.

Also during the quarter we raised about $8 billion combined FELP and private ABS transactions. I did mention, I think I mentioned that we won a servicing contract with the Department of Education. We expect to begin operating under that contract either this quarter or the fourth quarter. It’s a good contract with fair margins. It will begin to contribute to earnings per share soon. It will only begin to contribute significantly as we build our servicing portfolio. Obviously we’re starting from zero.

I will answer your questions later. I’m going to ask Jack to review the quarter in more detail.

Jack Remondi

This morning I’ll review our operating results for the quarter on both a GAAP and a core earnings basis. In addition I’ll review our funding activity, provide and update on our lending business and review the performance of our private credit portfolio, finally I’ll provide an update on our FELP business opportunities and the outlook for the remainder of 2009.

For the quarter, Sallie Mae reported net income on a core earnings basis of $170 million or $0.31 per share. These results compare to a loss of $0.03 per share in the prior quarter and earnings of $0.27 in the year ago quarter. Included in this quarters results are pre-tax gains of $325 million or $0.44 a share on the repurchase of $1.1 billion of our term unsecured debt.

This quarter’s earnings were negatively impacted by the continued dislocation of the CP Libor relationship and although improved from the first quarter the CP Libor spread was 35 basis points wider than normal which reduced our net interest income by $105 million and earnings by $0.13 a share.

Our results were also impacted by the terms of the DOE participation program. This facility which pays interest on the par quarter CP rate incurred $13 million in higher funding costs as the result of the quarters declining interest rate environment, and reduce core earnings per share by $0.02. Offsetting these items and particularly the CP Libor spread was $141 million of economic floor income or $0.17 per share which is not included in our core earnings. It is genuine cash earnings earned on a managed student loan portfolio and can be viewed as a direct offset to the CP Libor dislocation.

For example in periods where the loan is earning at its floor rate it becomes a fixed rate loan and is no longer impacted by the CP Libor spread. Seventy one million of this floor income was earned on what we call variable rate loans. The interest rate on these loans is reset each July 1st and so these loans will not earn floor income in the third quarter. Finally, this quarter’s results include $21 million in impairments on our purchase paper portfolio or $0.03 a share.

Net interest income was $457 million for the quarter versus $587 million in the prior year period and the net interest margin decreased to 0.91% from 1.28% in the year ago quarter. If included in core earnings the $141 million in floor income would have added 28 basis points to the net interest margin. Net interest income for our Federal loan portfolio was $89 million and $105 million lower than the year ago quarter due to the CP issue I described earlier. Our private credit portfolio generated net interest income of $396 million in the quarter.

The provision for private credit loan losses increased to $362 million versus $163 million a year ago and $297 million in the first quarter. In addition, we provided $29 million for our Federal loan portfolio versus $40 million in the prior quarter. At June 30th our allowance for private credit loans covered 8.8% of loans in repayment and as is our policy our FELP and private credit allowance covers eight quarters of expected charge offs.

Charge offs within our private credit portfolio did vary significantly from 3.9% of our traditional loans to 24% in the non-traditional portfolio and that compares to 2.2% and 14.5% respectively in the prior quarter. Although only 13% of loans in repayment are non-traditional loans they represented approximately 50% of charge offs. In addition, within our traditional portfolio the charge off rate for loans with a co-borrower which is the primary focus of our new lending activity was 2.5% this quarter.

Despite these elevated levels of charge offs our private credit portfolio earned a positive spread of 0.47% after the provision for loan losses. Looking forward we expect charge offs to peak in the third quarter of 2009. This view is based on the improving quality of loans both in and entering repayment. It is not based on an expectation of improvement in economic conditions.

For example, in 2007 85% of the loans entering repayment were traditional loans and 54% of loans had a co-borrower. For 2009 these percentages increased to 88% and 57% respectively and are projected to increase to 90% and 61% respectively in 2010. With loan defaults concentrated in the first two years of repayments this improving mix would produce lower charge offs even if economic conditions remain unchanged.

In addition, our loan loss allowance is based on a two year loss emergence period. This means that if we forecast accurately the current quarters provision will equal our forecast of expected charge off in the quarter two years out. With a significant improvement in the quality of loans entering repayment and our delinquency statistic supporting this reduction future period charge offs are expected to exceed the provision in the same period.

As the result of several changes in our collection processes, loans in forbearance have declined from 13% a year ago to 6.5% this quarter. These changes contributed to the increase in delinquencies and charge offs year to date. We reported last quarter that we started to see improvement in early stage delinquencies, a trend that has continued.

For example, in our traditional portfolio 30 to 60 day delinquencies declined to 2.9% from 3.2% in the first quarter and 60 to 90 day delinquencies declined to 1.8% from 2.2%. Forbearance usage at quarter end also declined to 6.1% from 6.3% and 90 day plus delinquencies increased to 4.8% from 4.3%. Reserves for our traditional loans at June 30th totaled 5.1% of loans in repayment.

We saw similar improvement in our non-traditional portfolio where 30 to 60 day delinquencies declined to 7% from 8.1% in the first quarter and 60 to 90 day delinquencies declined to 5.8% from 7.9%. Forbearance usage at quarter end increased slightly to 8.9% from 8.5% and 90 day plus delinquencies increased to 20.6% from 19.1%. Reserves for the non-traditional loans at June 30th totaled just under 33% of loans in repayment.

The improvement we have begun to see in the early stage delinquency rate last quarter has extended to later stages this quarter and is related to both the passing through the delinquency and charge off of trouble loans and the higher quality of loans entering repayment.

Over 75% of our non-traditional portfolio and our non-cosigned loans are now or will soon be in repayment. The loans we have underwritten in the last several quarters have FICO scores and co-signer rates well in excess of the portfolio averages and there are two characteristics that have demonstrated significantly lower default experience in this environment. In fact, the charge off rate for loans that meet our current underwriting criteria was 1.7% year to date.

Fee income in the quarter totaled $526 million compared to $239 million in the first quarter. This quarter’s results include $325 million in gains on debt repurchases versus $64 million in the first quarter and $21 million in impairments in our purchase paper portfolios versus $77 million in the prior quarter. Our purchase paper, mortgage and property portfolio is carried at 68% of the estimated collateral value and does assume an additional 7% decline in the price of residential real estate through the estimated collection date.

In addition, the size of the portfolio has declined substantially from over $1 billion a year ago to just $437 million today. In addition, our contingency debt collection business continues its record of strong performance, achieving the number one performance in the Department of Education collection contract.

Operating expenses excluding restructuring charges of $4 million were $305 million in the quarter, a 10% decrease from the second quarter 2008. The $13 million increase in our operating expenses from the first to the second quarter was the result of costs related to prepare for the Department of Education servicing contract, an increase in marketing expenses as we re-launch our direct to consumer initiative for private credit loans and an increase in costs associated with higher deposit insurance premiums at Sallie Mae Bank and a system wide FDIC special assessment which added $4 million to expenses.

Operating expenses in the lending segment declined significantly to $141 million in the quarter from $151 million a year ago, improving our efficiency ratio from 35 to 30 basis points of managed average student loans.

In the second quarter 2009 we continue to see positive developments in the capital markets. In May we completed a $2.6 billion private loan securitization with an expected spread to the call date 360 basis points over Libor. In the second week of July we completed an additional $1.1 billion private loan securitization with an expected spread to the call date of 71 basis points under prime, which is more than 160 basis points higher than the last deal. Both transactions were eligible under the TALF program.

During the quarter we completed three FELP securitization transactions totaling $5.1 billion. Together these transactions had an average life in excess of 7.5 years and spreads of 225 to 280 basis points over Libor. These transactions provide life of loan funding for assets that are not eligible for the Department of Education conduit program or under TALF.

Also in this quarter we issued over $11 billion in term liabilities through the use of the straight ‘A’ funding facility. We have about $4 billion worth of loans remaining that are eligible for this program. This facility is of significant importance to the company since it is a lower cost funding facility and it provides for higher advance rate and has a five year term.

At Sallie Mae Bank we raised $3.4 billion in term bank deposits during the quarter with an average life of 39 months and a fixed average cost of 3.2%. At the end of April we extended the $22 billion bank led asset backed CP FELP facility for one year. Since then we have reduced the outstanding balance of this facility to $12.5 billion at the end of June and have a goal of zero by year end.

During the quarter we paid off the private loan asset backed CP facility of $2.7 billion and a separate $2 billion secured FELP loan facility. At the end of the quarter 82% of our managed student loans were funded for the life of the loan. This is a significant improvement from just three months ago when just 72% were funded to term. Another 11% is funded with fixed spread liabilities with an average life of 4.3 years.

At quarter end we had $13.1 billion in primary liquidity consisting of cash and investments and committed lines. In addition, we had $3.1 billion in stand by liquidity in the form of unencumbered FELP loans. We expect free cash flow over the next 12 months to total approximately $4.3 billion versus corporate debt maturities of $4.2 billion, including $1.8 billion that matures this month.

Our loan portfolios and our operations generate very strong consistent free cash flow. This cash is principally generated from principal payments from our loan portfolios, cash distributions from our securitization trust, and other cash flows including net earnings.

On the lending side we originated $3.7 billion of FELP loans in the quarter, an impressive increase of 53% from the year ago quarter. For the academic year just ended we originated a record $19.8 billion of FELP loans, an estimated 24% of all Federal loans made. In addition, we originated $2.7 billion of FELP loans to third party clients.

We will put eligible loans through the Department of Education under the participation of put program in either the third or fourth quarter of this year. We expect to service all of these loans which represent over two million accounts of 4.5 million loans as the result of the servicing contract we were awarded in June.

For the current academic year that just began we expect to originate over $25 billion of FELP loans which we also expect to put in service in 2010. Private education loan originations totaled $387 million in the quarter, a sharp but not unexpected decrease from year ago. We have significantly increased the quality of loans we are underwriting. In the most recent quarter, for example, the average FICO score was up 21 points to 747 and over 76% of the loans we made had a co-borrower.

In April of this year we launched our new private loan product, the Smart Option Loan. The loan requires interest only payments during in school period, allowing for shorter repayment terms. As a result, the typical borrower will save over 60% in finance charges over the life of the loan, dramatically improving loan affordability for students and parents. This new product was redesigned, programmed and launched in record time. It is yet another example of our operational expertise.

Total equity at June 30th was $4.9 billion resulting in a tangible capital ratio of 1.7% of managed assets compared to 1.8% at year end. With 82% of our managed loans carrying explicit government guarantee and with 82% of managed loans funded for the life of the loan, we believe our capital levels are appropriate given our asset and funding mix.

On a GAAP basis we recorded a second quarter 2009 net loss of $123 million or $0.32 per share compared to net income of $266 million or $0.50 per share in the year ago quarter. Our GAAP results include $484 million in unrealized mark to market pre-tax losses on derivative and hedging activities. They are the result of one sided marks that do not qualify for hedge treatment and are hedges that are treated as ineffective under GAAP.

Of this, $361 million relates to the reversal of prior period gains and cross currency swaps, hedging our foreign currency debt. The net impact of derivative accounting under 133 is recognizing GAAP but not in our core earnings results.

The GAAP provision for loan losses was $278 million for the quarter including $242 million for our private credit loans and our GAAP net interest income was $384 million in the second quarter. Under GAAP the provision for loan losses and our net interest income are based only on, on balance sheet loans, whereas our current earnings figures are based on our managed loan portfolio.

On the legislative front, over the next several months Congress will pass legislation that will dramatically change the federal student loan programs. The House Education Committee approved its bill yesterday. While we agree with the committee that reforming the student loan program is important and are in agreement with many of the provisions of the bill, we along with a broad community group, and a separate group of over 1,700 college financial aid administrators, continue to focus on enhancements that will better serve students, schools, and tax payers.

We will continue to advocate for final legislation that would preserve choice for students and schools, assure competition in both loan delivery and servicing, materially lower student loan defaults and save tens of thousands of jobs, all while generating more savings.

During the quarter the Department of Education named Sallie Mae as one of four private sector entities awarded a contract to service federal student loans, including a portion of the $550 billion in outstanding federal student loans. The contract specifically covers the servicing of all Department of Education owned student loans. This includes the servicing of FELP loans purchased by the Department pursuant to ECASLA.

The contract will also cover the servicing on new direct loans which will begin in August 2010. We expect the contract to begin in the second half of 2009 and span five years with a one five year renewal option. The Department has not yet announced its plans for allocating servicing accounts other then that Sallie Mae can expect it will service loans put under ECASLA that on our systems today. Today there are over two million accounts that will be serviced under this contract. Given our cost structure we expect the terms of this contract to be profitable and produce an acceptable risk adjusted return.

For 2009 there remain many variables that could have a material impact on our results. These include the CP Libor spread which is averaging 18 basis points month to date versus 45 in the second quarter, credit costs, and the timing and volume of loans that we will service for the Department of Education. We are optimistic about the fundamentals of our business and believe that the community proposal is both superior in design and potential savings. The political outcome, however, is difficult to predict.

Once these items become more visible which we expect to happen in the third quarter, we will be able to provide a more specific outlook.

At this point we’ll now open the call to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Andrew Wessel – JP Morgan

Andrew Wessel – JP Morgan

On the debt repurchases, given the amount of cash and liquidity you have, what are your thoughts on continuing that in the third quarter and fourth quarter this year?

Jack Remondi

We obviously had a great quarter repurchasing debt in the open market in a non-tendered kind of fashion, be able to achieve that kind of level at the price we did, we were very pleased with that. Obviously prices have tightened since then and we continue to focus on opportunities in the nearer term maturities, obviously 2009 is a candidate but also 2010 as well.

Andrew Wessel – JP Morgan

Looking at expenses, with Miller Bill passing yesterday in the House what are your thoughts in terms, is there any way you can ballpark what you’re expense reduction would be if that bill were to go through more or less as is and is one paid to originate or market on campuses is there a ballpark estimate you can give from an expense savings standpoint?

Al Lord

You’re asking if the legislation as constructed by the House yesterday were to pass.

Andrew Wessel – JP Morgan

Were to go through.

Al Lord

Obviously some redesign of our business would be appropriate. We are very well along in assessing that. I think it really is premature at this point to dig into those numbers. As you would expect we’re very, very much aware of what the affect of this legislation would create.

Operator

Your next question comes from Lee Cooperman – Omega

Lee Cooperman – Omega

I think you just actually declined to answer the question but it seems to me there are two approaches to valuation of Sallie Mae. One is the capitalizing of earnings and the second is sum of the parts approach where you look at the run off value, the valuation of debt collection business, the valuation of third party servicing, and then the other assets of the company.

Assuming for the moment we go into this new world of direct lending do you guys have a view of what your normalized earnings would be with a normalized CP Libor spread, normalized credit losses? You have such command of numbers; Jack goes through these numbers like it’s very impressive. I would assume somewhere within the company you guys have a view if direct lending is adopted what the earning capacity of the company is. Can you share that with us or are you unwilling to do so?

Jack Remondi

When we talked about what the enterprise value of the company was on the last call that was our attempt to look at that over a multi-year period. We also published protected cash flows at a conference last quarter that laid out some of the expectations there. I think when you look at the company in terms of its valuation its not an either/or it’s a sum of two parts.

The FELP loan portfolio in terms of a managed net interest income earning asset is likely to end here even under our proposal we would not be owning the loans we would be a fee for service provider. That portfolio has a discounted cash flow component to it. Some of it certainly depends on CP Libor and I don’t know if folks noticed, in the House Committee bill there was a fix to that issue by converting the CP index to a one month Libor index which would obviously be helpful.

Then there’s a second piece of our business which is our ongoing activities which includes our private credit lending, our contingency collection businesses, our You Promise, and of course the new federal loan service business. The big question there is whether or not we have origination, we play a role in the delivery of loans to students and schools across the country or not. We certainly have ideas as to what that looks like but as we said in the past it’s a little premature to know exactly how it goes because the results are in fact very different.

Lee Cooperman – Omega

In the past two calls I think you’ve been quoted both on the call and I believe in writings by the company that you have a belief that the run off value of the company is in the teens. Have events over the last few months anyway changed that positively or negatively or do you still have a view that run off value is in the teens?

Jack Remondi

I don’t think we’ve changed our view of that at all.

Operator

Your next question comes from Michael Taiano – Sandler O’Neill

Michael Taiano – Sandler O’Neill

On the credit side, I recall at the beginning of the year I think you gave guidance for the loan loss provision of the private credit portfolio of a little more than $1 billion. It looks like you’re running a bit ahead of that. Can you maybe give us some comments about where that stands and just looking forward it sounds as if you’re saying you expect charge offs so in the next two years to be $2 billion but that the provision will likely come at a lower rate then that as the mix shift takes place. Any color would be helpful.

Jack Remondi

We do expect charge offs to increase and peak into the third quarter of this year. Because of the mix issues and you can see the conveyor belt of delinquent accounts rolling forward that charge offs could in fact be lower in subsequent periods. The best look at this if you look at 90 day or 30 to 60 days or 60 to 90 days delinquencies they are lower in both the percentage and absolute dollar terms then they were a quarter ago despite the fact that there’s about $1.2 billion more in repayment during this timeframe and forbearances are not up.

I would refer people to the tables on page 40 of the supplemental which give you a picture of how the portfolio breaks out its various repayment segments by aging. As was said in the past our charge offs are very much concentrated in the first two years of repayment and you can see how that has ballooned up but that its not being replenished anywhere near the same rate that it was earlier this year as we changed our forbearance and collection processes.

Clearly charge offs this year are going to be north of the $1 billion that we had looked at, at the beginning of the year and that was really a conscious decision of the company I guess to refocus its collection efforts and do a far more analytical work in terms of the long term ability of borrowers to repay their debt obligations versus near term relief through programs like forbearance.

Michael Taiano – Sandler O’Neill

There used to be a seasonality in the second quarter in the past, does that still take place because you have more loans entering repayment in the second quarter and fourth quarter, I believe.

Jack Remondi

The peak period of loans entering repayment is actually the first quarter of the year. What you do see is you see later stage delinquencies peak up in Q2 as loans have now been in repayment for 90 days. It’s pretty clear to us when we see loans entering repayment almost immediately whether we’re going to have a problem account or not on our hands.

The vast majority of borrowers who default go through without ever making a payment. These are people who either borrowed more than the education will produce in value for them or they borrowed and dropped out and just don’t have the ability to make payments. You definitely see those statistics as you look at the portfolio in detail.

Michael Taiano – Sandler O’Neill

I know it’s still early in the process but the Obama proposal regulatory reform proposal talks about ILCs and potentially having to convert to a bank holding company. Have you guys thought about what impact that could potentially be for you guys. I know in the past you said becoming a bank holding company would hurt you because of the capital requirements on the sell side. I know it’s early in the process but any thoughts on how you’re approaching that.

Al Lord

Obviously we don’t know how that regulation is going to evolve. Certainly becoming a bank holding company is a possibility that we have considered. Obviously there’s some distance between where we are and where we’d have to be to become a bank holding company, just because of the massive amount of FELP assets that we have. I think there’s no question that the ILCs are getting a lot more attention, certainly we got a fair amount of attention a year ago and some of the other financial institutions are being looked at pretty closely on the ILC front.

At the moment we don’t foresee any significant change there. As we evaluate our operating structure, as we go forward, as we mentioned earlier, a bank holding company is certainly one of the things we will be considering.

Operator

Your next question comes from Sameer Gokhale – KBW

Sameer Gokhale – KBW

The plan that you submitted the alternative plan submitted by the association and student lenders, have those plans been scored by the CBO yet or is that still pending?

Jack Remondi

They have been submitted for scoring but they do not have a score yet.

Sameer Gokhale – KBW

Is there any expectation of when we could expect to get something back from the CBO; is there a timeline for that?

Jack Remondi

Unfortunately they don’t operate too specific timelines. We’re obviously very eager to see that. It’s a little hard to understand how you can vote for proposals for vote down alternative proposals without knowing the scores of each of the programs. In fact, the President’s proposal, I’ll just point out, has not yet been scored itself either, it’s an estimated number not a final score.

Al Lord

We actually have a couple folks inside who are pretty good at scoring things and we believe that we score very, very closely and in fact if our proposal works and play out, particularly our treatment of defaulted loans would result in savings versus the President’s proposal. We very much think that our numbers scored fairly would surpass the savings that the President’s proposal is toting up to. With respect to the question you asked Jack about when, one thing I can tell you for sure is they don’t check their timing with us.

Sameer Gokhale – KBW

In terms of the deposits, you gave some commentary but the deposits within your bank you seemed to have ramped those up pretty significantly a lot more than the amount of loans that you originated in the quarter which I assume were originated in the bank. Is that an anticipation of a large ramp up in privates through loan originations here in the third quarter or what other reason might there be for the increase in deposits?

Jack Remondi

Two things, clearly we’re entering the peak origination and disbursement season for private credit loans so it’s building deposits in anticipation of that. We did see some unique opportunities to raise, in particular, very long term deposits at attractive levels this quarter and took advantage of that as well. We are looking at some opportunities that the bank might have to actually acquire some student loan assets.

Sameer Gokhale – KBW

As you mentioned, the bill voted on by the Committee in the House includes some sort fixed CP Libor mismatch. I believe that the bill proposes that the one month Libor index be used for pricing the loans. If I recall correctly your loan portfolio is priced, the funding cost is based off of three month Libor primarily. Those two indices do have diverging basis risk over time, is this an easier index for you to hedge or how should we think about the elimination of this basis risk based on the new index if it is in fact adopted.

Jack Remondi

You are correct in your description there, our liabilities are principally three month Libor and you’re also correct in that it is a substantially easier basis risk to hedge. That market is extremely deep and very consistently priced. That’s part of the process of picking one month Libor versus getting off of the commercial paper index

Operator

Your next question comes from [Andrew Permatier – Hyatt Analytics]

[Andrew Permatier – Hyatt Analytics]

On the Senate and savings and why this safra outlook is more positive. On the scoring, the question I have deals with the offsets by making the origination servicing fees discretionary rather than mandatory. There seemed to be some objection to that by the Miller staff in the House and I wanted to know what was leading to this optimism in the Senate because obviously it’s a core part of I think a lot of people’s outlook on the company and I want to just be clear on why you’re so optimistic on both scoring and political outlook.

Al Lord

I want Jack to answer this because he’s been dealing face to face with most of these folks. We are hopeful; I don’t think you would characterize our view as very optimistic. With respect to the scoring how they score it obviously is what counts. What I have put forward here today is our own scoring and based on what we know about the variables in the calculation.

What we would very much like is a side by side analysis of our proposal and the President’s proposal item by item. I don’t know that we will ever see that but certainly that’s the kind of transparency that we would like to see and I would say that my optimism or my belief about those numbers comes from 40 years of keeping score on a variety of other fronts.

This isn’t rocket science, 90% of the cost of the two loan programs is the cost of funds and if they are the same you’re only talking about 10% other costs and they relate to defaults and they relate to operating efficiencies. We feel we perform quite well on both of those fronts. I’ll ask Jack to answer the political side of that question.

Jack Remondi

Our optimism is that the design of this community proposal is we think clearly superior because it does provide for choice, competition, particularly in the loan delivery side of the equation and we think provides the proper incentives to reduce defaults. It’s not just us who are saying that, we’ve got a broad community group of lenders that have done it and earlier this week a group of, I think its now 1,700 financial aid administrators just signed up with a similar concept.

Its also important to note that the DL and FELP have been operating side by side competing with one another for 16 years and 75% of schools have chosen to be in FELP which its not as if its some new concept they haven’t had the ability to evaluate yet. That is valid.

In terms of how we structured the presentation we were told and made very clear that any proposal that we submitted as an alternative would have to produce similar savings to the President’s proposal. We went through that proposal, looked at how the cost of running that program were dealt with and noticed that those operating costs all of the operating costs at DL are on the discretionary side of the equation and so therefore in order to have an apples to apples comparison we put the operating expenses of the community proposal on the same side of the ledger. It’s done to create an apple to apples comparison it is not done to create any budgetary.

[Andrew Permatier – Hyatt Analytics]

You guys have clearly done a good job and I think Al is right the CBO is kind of at the core of this thing. I wanted to make sure that we were clear on what you guys think that you put forward and sentiment around it so I appreciate that.

Operator

Your next question comes from Matt Snowling – FBR

Matt Snowling – FBR

Has the Department of Education notified you as to how many loans they expect to buy from the industry? Second question, it looks like you picked up your spot purchase activity during the quarter, can you give us a sense of how you view the opportunity in that market versus potentially buying back debt or even stock at some point in the future.

Jack Remondi

On the first question, the Department of Ed. has not provided any real guidance as to how much loan volume we can expect to receive for loans put under ECASLA. We know we are the dominant holder of loans eligible to be put under ECASLA and we have been led to believe that we should expect that we will retain all of those loans for servicing on our system.

Matt Snowling – FBR

Do you have a sense of how many loans will be actually put to the Government rather than just the loans you’re going to put?

Jack Remondi

No, we are expecting the vast majority of loans that were eligible to be put. It would be hard to believe that people would hold on to these loans.

Matt Snowling – FBR

In terms of borrowers.

Jack Remondi

We did 24% of originations this academic year and that represents about a little over two million accounts. Accounts meaning the units that we’ll get paid on contract.

The second question in terms of spot purchases. Those were purchases made under our existing forward purchase contracts; we did not many any open market trades. I do think there’s opportunity for that in the future though.

Operator

Your next question comes from Brad Ball – Ladenburg SSG

Brad Ball – Ladenburg SSG

You mentioned in response to an earlier question that you haven’t changed your view on the run off value being in the mid teens. I wonder if you could give us an update or remind us how you get to that mid teens value.

Jack Remondi

It was principally a discounted, that valuation assumes no new business activity so it’s just a pure discounted cash flow analysis of the existing portfolio taking into consideration default expectations on the private credit portfolio it did assume a normalized CP Libor spread of 10 basis points beginning in 2010. In a typical equity like discount rate on those cash flows.

Brad Ball – Ladenburg SSG

How much value are you attributing to the FELP portfolio and run off roughly?

Jack Remondi

We did not break that out we just gave a total number.

Brad Ball – Ladenburg SSG

What are you using for margins for the FELP and the private loan portfolios in run off?

Jack Remondi

The vast majority as we said, 82% of our assets are funded to term today so we’re using existing cost of funds and to the extent that we had refinancing related requirements although they are very small the assumption is that the current term ABS spreads were used on all of those refinancing activities and that was back in first quarter so they were higher then they are today.

Brad Ball – Ladenburg SSG

In terms of credit, this is a broader question about your expectations for private loan credit, the traditional portfolio showed net charge offs of 3.9% of loans in repayment. I think you said that the new underwriting is running at about 1.7% net charge offs. Where do you think the normalized net charge off rate for the private loan portfolio will be?

Jack Remondi

We would even argue that the 1.7% is elevated for the economic environment so we would be looking for a number lower than that.

Brad Ball – Ladenburg SSG

Going back to the run off question you’re using a lower net charge off ratio than 1.7%.

Jack Remondi

Those are new originations. What we use for the run off valuation is charge off expectations on the existing portfolio which is obviously going to be higher than that.

Brad Ball – Ladenburg SSG

You’re not disclosing what that is?

Jack Remondi

You get a picture; we say we’re going to charge off roughly $2 billion of private credit loans over the next two years. That gives you a little bit of insight into those numbers. Again I would point you to the portfolio characteristics on page 40 then we also provided some characteristics of the different mix of loans that are going to be entering repayment over the next several years in the supplemental earnings disclosure that was posted on the web this morning. Those will give you some good indications of the quality of loans coming into repayment over that timeframe.

Brad Ball – Ladenburg SSG

A question on capital adequacy, your capital ratio came down a bit this quarter. In the context of GAAP losses and expected higher credit losses at least next quarter what do you feel the appropriate levels of capital are going forward?

Jack Remondi

When we look at our GAAP capital, we allocate capital on a managed asset perspective so we’re looking at the total assets of the company not just a GAAP balance sheet. When we look at the economic capital available we are adjusting for FAS 133 gains or losses that are going to revert to zero over the life of the contract. In particular, this quarter’s GAAP loss was driven by a reversal of prior period gains and some of our derivative transactions. Those would not have been available capital for us because we would have assumed that those would go away as those contracts mature.

I think the things that are important to look at here are the mix of loans, 82% of our managed loans have an explicit government guarantee and have very different capital requirements. The fact that 82% of all loans including FELP and private are financed to term to us at least, particularly in this market, capital is as much a function of access to liquidity as it is credit related issues and the access to capital in that 82% of the portfolio is 100% solved.

Brad Ball – Ladenburg SSG

Roughly 50 basis points of capital against the FELP portfolio used to be the rule of thumb is that sort of how you look at it.

Jack Remondi

That rule is going to be changing and its going to depend on how the loans are financed. If you’ve got a FELP loan and a 364 day warehouse facility it’s going to require a whole lot more capital than 50. If it’s in a securitization transaction funded to term 50 is more than enough. Also don’t forget, on our balance sheet there’s roughly $17 billion worth of student loans today that are eligible to be put to the Department of Education at a premium, the capital requirement on that portfolio I would argue would be zero.

Brad Ball – Ladenburg SSG

Trying to be a little precise with your statement that the acceptable risk adjusted return from the servicing business that it is acceptable. I’m trying to get a sense as whether acceptable is just an amount that exceeds your cost of capital or is acceptable in a range of returns that you talked about in the past as being desirable for the business overall.

Jack Remondi

We would be signing up for this contract even if we weren’t in the FELP loan business.

Brad Ball – Ladenburg SSG

So we’re talking acceptable then being mid teens ROEs?

Al Lord

Are you doing your whole model today?

Brad Ball – Ladenburg SSG

Just trying to take advantage of your availability.

Operator

Your next question comes from Moshe Orenbuch – Credit Suisse

Moshe Orenbuch – Credit Suisse

I was just wondering if you could talk a little bit about the private loan growth. I know that you had launched your products that you asked the students to pay interest during the life of the loan. Is that the reason the level of originations declined and how should we think about that in the second half.

Jack Remondi

The product launch of Smart Option just started for academic year July 1st so we haven’t seen disbursements made under that program yet, just application flows. Two things happen in terms of the reduction in actual disbursements that impacted disbursements. One is we withdrew from the non-traditional lending component which was a little bit more than 15% of originations back in the first half of 2008. Remember even though we exited the business there was still a tail that was getting disbursed for applications that had been processed and approved.

The second piece is under both the 2007 higher education act amendments and again in 2008 the Congress raised the loan limits for federal loans and that obviously decreases demand for private education loans and those two factors are the big drivers.

Applications flows in the second quarter and even in June under our Smart Option loan are towards schools that we target are certainly lower than we were last year but are single digit percentage points lower. Not what I would argue. It is very early still in the cycle, people are still I think figuring out how they’re going to pay for college in the upcoming academic year.

Moshe Orenbuch – Credit Suisse

I went through the supplement, not sure if missed it, can you discuss the impact of FAS 140 going away next year what that would mean to SPEs coming back on balance sheet.

Jack Remondi

We have analyzed and it is something that we are paying attention to. We do have, I think when you look at the balance sheet you want to look at not only the residual asset that we own but the deferred tax liability that exists corresponding with that. Our estimate today that if we were to implement this as of June 30th you would see a $640 million loss on transition to that.

Remember from an economic capital basis we actually allocate more capital to our residual assets than that $640 million so net net it doesn’t really impact how we look at the company from a capital adequacy perspective but obviously it will have an impact on GAAP.

Moshe Orenbuch – Credit Suisse

That would include the one time adjustment to the reserve as well?

Jack Remondi

It does include both.

Operator

Your next question comes from Mark Giambrone - Barrow Hanley

Mark Giambrone - Barrow Hanley

Related to the private loan production, I’m curious now that you’ve implemented all this new stuff what do you think the level of loans that you may write on an annual basis will be going forward?

Jack Remondi

For this calendar year we’re looking at originations that will total around $5 billion in the private credit book. As I said, there are two factors at play here that are different from prior periods. Clearly exiting the non-traditional space has had an impact. Although given our loss experience in that portfolio it’s a positive impact, and the increase in higher loan limits.

We’re leading the industry right now in the re-design of our private loan offering in the Smart Option loan. The reception from financial aid officers has been strong; the application flow doesn’t indicate any kind of levels of concern in terms of acceptance. We think that when students and parents do the math and see the material reduction in finance charges that they’ll incur over the life of the loan people will understand that this is a better product.

The positive of launching this product in this kind of environment is most Americans may not know what negative amortization is but they know it’s bad. That’s the positive re-design of the product.

Mark Giambrone - Barrow Hanley

Would there be any negative implications if for some reason FELP originations did go away and you just became a servicer. Is there any implication to the private loan originations or your access to these people relative to your FELP infrastructure?

Jack Remondi

We actually get a similar percentage of our private loan originations from direct lending schools today, similar to the share that these schools have in direct lending so about 25%.

Operator

Your next question comes from Kevin Ing – Columbus Hill Capital

Kevin Ing – Columbus Hill Capital

I wanted to get a little bit more detail on some of the legislative puzzles regarding the CP Libor affects. I know some of those details were included in the Miller bill that passed the house. My question is how far back would the help go, would it only be from here on out or would it retroactive to the beginning of the year, could you provide some detail on that.

Jack Remondi

What’s in the legislative language that passed the committee is effective date of 10/1/2009 so it does not go back retroactively.

Kevin Ing – Columbus Hill Capital

What do you think is likely to passage and what do you think is likely to potentially getting the bill massaged to be more inclusive of the previous periods.

Jack Remondi

We think the proposal is a fair one and we’re told that it has no score impact. We think that should make it, that’s obviously issue that’s going to make it easy or hard to pass. I don’t think there’s anyone around in Washington or the capital markets who doesn’t believe the CP Libor relationship is permanently broken. That should help passage. Obviously we don’t like the bill that it’s in and we’re working to change that. That’s a separate discussion.

Operator

Your next question comes from Peter Rosenblum - Appaloosa Management

Peter Rosenblum - Appaloosa Management

The private unencumbered loans you have at $17 billion how many of them are actually at the bank?

Jack Remondi

3.8

Peter Rosenblum - Appaloosa Management

As you build deposits at the bank is there an opportunity to buy loans from the parent company rather than originating them? I would think you would get a better advance rate then what you’ve been getting on the TALF.

Jack Remondi

To transfer loans from the parent to a bank is a fairly complicated process that requires waivers from both the Federal Reserve and the FDIC. We think we’ve just got better placed to go at this stage in the game for private credit transfers.

Peter Rosenblum - Appaloosa Management

The ABCP that’s left now is it pretty much all consolidation loans?

Jack Remondi

Yes it would be. The $5.1 billion of loans that we securitized earlier in the quarter were either consolidation loans or they were securities backed by consolidation loans.

Operator

You have no further questions.

Steve McGarry

Thank you. That ends our conference call. If you have any follow up questions please call myself, Steve McGarry or Joe Fisher.

Operator

This concludes today’s SLM Corporation Second Quarter 2009 Earnings Conference Call. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: SLM Corporation Q2 2009 Earnings Call Transcript
This Transcript
All Transcripts