(Operator Instructions) Welcome everyone to SLM Corporation Third Quarter 2009 Earnings Conference Call. I would now like to turn the call over to Steve McGarry, Senior Vice President of Investor Relations.
Thank you for joining us on our third quarter earnings call. With me on the call today 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 to 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 third 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.
I’ll cover a variety of topics, I may actually speak a little longer then I normally do. As you’re well aware this is an incredibly eventful time in the company’s 37 year history. As the company addresses its future it sees a variety of possibilities. I just want to say before we talk about anything with respect to the third quarter or other events that we expect each of our futures to restore value to our beleaguered shareholders.
Let me first talk about our third quarter performance. You’ve seen our earnings and we reported $0.26 per share. There are any number of moving parts in that number but basically there are two stories here. One is the better behavior in the CP Libor indices which have gotten our FELP net interest income a little bit better back on track. Also we had extremely high credit losses that with something like $443 million of charge-offs.
Those charge-offs obviously relate to general economic conditions. Even maybe more precisely what I would call a bad lending bubble that occurred from 2004-2007 timeframe which we refer to and as you’ll hear referred to later as non-traditional lending. That has been totally discontinued as I’m sure you know. There are various other plusses and minuses in the quarter and Jack Remondi will cover them with you very substantively shortly.
Third quarter also marked the end of the ’08-’09 fiscal year for loan originations and again we were up in record numbers up 25% over a year ago. During the course of ’09 and through the third quarter we’ve continued to strengthen our balance sheet. What we think in terms of strengthening in the balance sheet is to get our long term assets funded to maturity and we continue to do that. We’ve also enhanced both short and long term liquidity. Our operating cash flows are strong.
As we project our cash flows over five years they exceed our unsecured debt maturities. As I observe spreads in the marketplace, particularly in the CDS marketplace those spread numbers continue to demonstrate some market anxiety. We prefer that not be the case but the fact is that market anxiety provides opportunity for the company. We are retiring debt at bargain prices and building capital for our shareholders with no dilution.
Certainly noteworthy during the quarter and again the previous quarter is typically the highest origination quarter during the course of the year. Our private credit originations were down sizably from a year ago. Our private credit now consists of our smart option product it’s a very new and a very different product then we’ve offered in the past. It’s a product that continues to need seasoning and marketing. On the positive side the credit of the new borrowers is extraordinarily strong. I think the bottom line on all this is we like this product, we like it a lot. We are confident that it will deliver the asset growth the company is looking for.
Write-offs of $443 million, for what its worth declined actually during the quarter within the quarter. Note also that we project charge-off declines for the next six months which is really the period we can see most clearly. Our forbearance accounts are down nearly $1 billion over the last 12 months. I know you’re all sitting there saying to me and my associates show me. We will do that, that is our responsibility and we will demonstrate better charge-off performance in the future.
I’ll also point out that this has been a difficult charge-off environment and loan credit environment. Enduring the past year we’ve continued to grow in spite of those charge-offs grow our bad debt reserve we will continue to maintain strength in.
Short note on operating expense, they were up slightly. I’ll just tell you there are a variety of reasons, Jack will talk about and I’ll also tell you that they’re very much under control and that they will continue to decline as they did a year ago.
Let me talk about the proverbial elephant in the room. I think what’s going on in Washington qualifies for that. As you know, the current administration supports legislation that would call for 100% take over of student lending by the Federal Government. The purpose of that legislation, as we understand it, is to save money. The President’s proposal does save money. We and others support alternative legislation that we believe saves at least as much money. In fact when all economics, when I say all economics I mean economics in the student loan program that are not counted in the various official scorekeeping methodologies, when all economics are counted we believe the program that we’re supporting cost tax payers less.
It also avoids the transition risk of forcing some 4,000 to 4,500 schools to direct lending. The fact is that the direct lending program that’s being recommended is not new, it’s been around for 15 years, it’s been an option to schools for 15 years. I guess the short answer to why it’s not in place is that 82% of the schools that had the opportunity to join direct lending rejected it over the years.
The legislation that we support retains private sector jobs in a very difficult job market. It will result in lower student loan defaults. In fact our own default experience on the Federal side is about 30% better then the Federal Government’s own record. It’s an industry that’s run by employees who have up to 35 years of irreplaceable student loan experience. I will tell you that getting the facts as we know them to the surface is a frustrating process. We certainly want to make note that the transition risk that’s embedded in the pending legislation is enormous by our math. If the implementation were to be delayed even one year would cost some $12 billion of the government’s proposed $87 billion in savings.
Notwithstanding all what I’ve said we’re optimistic. The benefits of the alternative proposal are operationally and financially compelling. The alternative legislation is in the hands of various financially savvy legislators who understand the arithmetic and so our confidence. The fact is that we operate here; our management operates here against its plans for subsequent periods. We’ve obviously got to have more then one plan in place given the legislation and certainly we are planning to operate without the origination function if need be.
I’ll say, before I get into any specifics that whether we originate Federal student loans or we don’t originate Federal student loans we expect our earnings to improve through the year 2011. I will talk to you a little bit about the next five quarters shortly. I don’t miss the fact that it’s not so difficult to improve earnings from a low starting point like 2009. I’d say under any operating scenario our operating cash flows that I mentioned earlier would remain unchanged. We would be likely implementing cost reductions in the range of 20% to 25% perhaps as much as another $300 million.
We did get the direct lending servicing contract and that will save some jobs but quite frankly no very many. Direct lending is considerably easier to service then FELP. The employment reductions that we contemplate which are the unfortunate consequences of this legislation are at least 2,000 employees and perhaps more.
The face is the company will continue to operate and exclusively in higher education space. We very likely sell the $120 billion of our FELP loans to shrink our balance sheet to add capital. Of course we would service those loans. In fact those loans as they now exist under contract would provide about $6 billion of servicing income stream over the years. It would also create liquid capital to better capitalize our private loan business. It would likely infuse that capital into our bank.
Not unlike today we will remain a private student loan provider. We would be still an even larger student loan servicer of all types of student loans. We would be very engaged of course in student loan collections business.
Shareholders have told us that with all the moving parts in our earnings that they’d like a little bit of help as we look forward. Certainly our recent operating results besides not being so wonderful have been a bit confusing. As I told you more than one scenario can play out here but certain the earnings as we see them over the near to intermediate term are going to be relatively unaffected by the legislation.
As I said, earnings per share should increase through 2011. More immediately we expect fourth quarter operations at least before any other activities to generate some $0.50 to $0.55 of earnings. I’ll talk about other activities, I can tell you we are aggressively trying to wind down our so called wind down operations and that’s typically that includes our specifically our distressed asset businesses. There’s likely to be a sale or sales or write downs in the fourth quarter on those businesses. Like each of the preceding three quarters its likely we’ll be buying in some debt and that’s not included in my $0.50 to $0.55 projection.
On the 2010 front our core operating earnings we expect to be at least $1.50 a share. We think there’s some upside to that number if the economy and the capital markets hang in at least at the levels they are operating at today and there’s no serious deterioration there.
I will answer your questions later. I’m going to turn this over now to Jack Remondi.
This morning I’m going to review our operating results for the quarter on both a GAAP and core earnings basis. In addition, we’ll review our funding activity, provide an 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 outlook for the remainder of 2009 and give a preliminary view of what we see for 2010.
For the quarter, Sallie Mae reported net income on a core earnings basis of $164 million or $0.26 a share. These results compare to earnings of $0.31 a share in the prior quarter and earnings of $0.19 per share in the year ago quarter. Our earnings recovered this quarter as a result of the correction in the CP Libor spread to 13 basis points, very near the long term average of 10 basis points.
Included in this quarter’s results were gains of $74 million from the repurchase of $1.4 billion in our term unsecured debt, $21 million in revenue from loans put to the Department of Education, $55 million in income resulting from a decline in the Federal student loan repayment speeds, and offsetting these gains was a $51 million increase in our provision for private credit losses, and an accounting loss of $20 million as a result of the early conversion of $137 million of our Series C mandatory convertible preferred. I’ll comment more on this transaction later.
In addition, we earned $36 million of economic floor income in the quarter or $0.05 per share. This is not included in our core earnings. This is down significantly from the prior quarter as the interest rate on our variable rate FELP loans was reset on July 1, therefore these loans did not earn any floor income in the quarter.
We also took advantage of the low interest rate environment to hedge more of our fixed rate floor position, locking in $150 million worth of proceeds which will be earned back over two years. This increased our core floor income by $14 million in the 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 $690 million for the quarter up from $457 million in the second quarter. The net interest margin increased to 1.32% from 0.91% in the second quarter. The increase in both net interest income and the net interest margin is primarily due to the return of the CP Libor spread to more historical levels.
Our provision for private credit loan losses in the quarter increased to $413 million versus $203 million a year ago and $362 million in the second quarter. The provision for Federal loans declined to $22 million versus $29 million in the second quarter. At September 30 our allowance for private credit loan losses covered just under 9% of loans and repayment in both our FELP and private credit allowance continues to be sized to cover eight quarters of expected charge-offs.
Our private credit loan charge-offs increased to $443 million in the third quarter up from $355 million in the second quarter. This quarter’s and this year’s charge-offs were impacted by both the economy and the changes in our collection practices which de-emphasized forbearance. As a result of the changes in our forbearance practices, charge-offs were accelerated, although this did not alter our life of loan default assumptions.
Within the quarter we saw a significant improvement in charge-offs as they fell from $160 million in July to $129 million in September and we see this trend continuing into 2010. By example, we see October 2009 charge-offs more then $40 million lower then the month of July. Charge-offs within our private credit portfolio varied significantly from 5.1% of traditional loans to 28.5% in the non-traditional portfolio compared to 3.9% and 24% respectively in the prior quarter. Although only 13% of our total loans in repayment are non-traditional loans they represent nearly 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 lending activity today was 3.4%. Through the first nine months of the year we’ve grown the private credit loan loss allowance by over $100 million. The loan loss provision this quarter was slightly lower then charge-offs as we believe charge-offs peaked this quarter. We expect a similar relationship in the next several quarters. This view is based on the improving quality of loans both in and entering repayment and the full impact of the changes in our forbearance practices. It does not assume an improvement in economic conditions.
On loan mix, for example in 2007 85% of loans entering repayment were traditional loans and 54% of loans had a co-borrower. For 2009 these percentage increased to 88% and 57% respectively and are projected to increase to 90% and 61% in 2010. with loan defaults more then seven times higher for non-traditional loans and more then two times higher for non-cosign loans this improving mix will produce lower charge-offs even if economic conditions remain unchanged. Combined with the full impact of the changes in our forbearance practices we expect to reduce our private credit provision by $300 million plus in 2010.
As a result of the changes in our collection practices loans in forbearance have declined by over $900 million from a year ago to $1.3 billion. Although these changes contribute to the increase in delinquencies and added significantly to charge-offs year to date they do not alter the expected life of loan default rate on the portfolio.
On the delinquency front, in our traditional portfolio 30 to 60 day delinquencies increased to 3.3% from 2.9% in the second quarter while 60 to 90 days delinquencies were unchanged at 1.8% and 90 day plus delinquencies fell to 4.6% from 4.8%. Our reserves for traditional loans at September 30 totaled 5.3% of loans in repayment. We saw similar changes in our non-traditional portfolio where 30 to 60 day delinquencies increased to 8.4% from 7% and 60 to 90 day delinquencies increased to 5.9% from 5.8% while 90 day delinquencies declined to 17.8% from 20.6%. Reserves for our non-traditional portfolio at September 30 totaled just under 33% of loans in repayment. The increase in early stage delinquencies is principally due to seasonal factors.
Fee income in the quarter totaled $331 million compared to $526 million in the second quarter. This quarter’s results included $74 million in gains and debt repurchases versus $325 million in the second quarter. Also included an increase of $23 million in guarantor services related revenues as a result of seasonal volume.
We recorded $21 million in impairments in our purchase paper business, unchanged from the second quarter. While our contingency debt collection business continues its strong record of performance we were able to achieve the number one performance status in both the Department of Ed and IRS contracts. As Al said, we are exploring the sale of our purchase paper mortgage business and may have more to report on this later in the quarter.
Operating expenses excluding restructuring charges of $4 million were $309 million in the quarter a 2% decrease from the third quarter 2008. The $3 million increase in our operating expenses from the second quarter to the third is really the result of costs associated with staffing for the peak origination season as well as some startup costs related to the Department of Education servicing contract.
On the funding front, in the third quarter we continued to materially extend the duration of our liabilities. We completed several term funding facilities including a $1.1 billion private loan securitization in July with an expected spread to the call date of 71 basis points under prime. Another $1.7 billion private loan securitization in August with expected spread to the call date of 55 basis points under prime. Both transactions were eligible under the TALF program.
Also in the quarter we financed an additional $3 billion of federal loans through the five year straight A funding facility. We have another $1.1 billion in Federal loans that are eligible for that program. This facility has been extremely helpful in lowering our funding costs, reducing our borrowings under the bank asset backed CP facility and generating additional liquidity as a result of higher advance rates.
Since we extended the $22 billion asset backed CP facility in April we’ve significantly reduced the outstanding balance of this facility. Just $9.4 billion was outstanding at the end of September which is down by almost $18 million from its peak in 2008 and we still have a goal of reducing it to zero by year end.
At the end of the quarter 86% of our managed student loans were funded for the life of the loan. This is up significantly from just a year ago when 70% were funded to term. Another 9% is funded with fixed spread liabilities with an average life of 4.4 years. At quarter end we had just under $11 billion in primary liquidity consisting of cash and investment and committed lines. We had an additional $2.7 billion in standby liquidity in the form of unencumbered FELP loans.
We expect free cash flow over the next 12 months to exceed our corporate debt maturities of $4.4 billion. Our loan portfolios and our operations generate very strong predictable free cash flow. It comes principally from cash distributions from our securitization trusts, principal payments on our loan portfolio and other cash including net earnings. By example, in the third quarter our securitization trust generated free cash flow of $500 million while principal payments on unencumbered loans totaled almost $440 million. These sizeable and predictable sources of cash flow along with our term funding activity provided adequate liquidity to service our debt.
On the lending side we had a very strong quarter, originating just under $7 billion of FELP loans a very healthy 25% increase from the year ago period. In addition, we originated $727 million of FELP loans for third party clients. In the quarter we sold $840 million worth of FELP loans to the Department of Education as part of its purchase and participation program and an additional $17.6 billion worth of FELP loans were sold to the Department in mid October. Along with these sales we are now servicing over two million accounts under the Department of Education servicing contract.
For the current academic year that began last quarter we expect to originate over $25 billion worth of FELP loans which we will put to the Department of Education in the fall of 2010. We expect to retain servicing on these loans. The FELP student loan spread in the quarter after adjusting for the cumulative accounting change from the slowdown in retainment speed and before asset backed CP fees was 76 basis points. At quarter end, 91% of our FELP portfolio was funded for the life of the loan or long term in the straight A conduit facility.
In private credit we originated just under $900 million worth of loans in the quarter a sharp decrease from a year ago as we exited some segments of the market, tightened credit standards and saw a reduced demand as a result of increased Federal loan limits. The quality of the loans we dispersed in the quarter was very strong with the average FICO score of 746 and 88% of the loans made had a co-borrower.
Total equity at September 30 was $5 billion resulting in a tangible capital ratio of 1.7% of managed assets and that’s unchanged from June 30 with 82% of our managed loans carrying explicit government guarantee and 86% of managed loans funded for the life of the loan we believe our capital levels are appropriate give our asset and funding mix.
As I mentioned earlier, we converted a portion of our Series C mandatory convertible preferred ahead of schedule. This was done in response to a reverse inquiry. While we booked an accounting loss of $20 million which is really the present value of the expected dividend stream the conversion will be both earnings and cash flow positive including this quarters loss through December 2010 the mandatory conversion date.
On a GAAP basis we recorded third quarter net income of $159 million or $0.25 a diluted share compared to a $0.40 diluted loss per share in the year ago quarter. Our GAAP results included $6 million in unrealized mark to market pre-tax gains on derivative or hedging activities. They are primarily the result of one sided marks that do not qualify for hedge treatment or hedges that are treated as ineffective under GAAP. The net impact of derivative accounting under FAS-133 is recognized in GAAP but not in core earnings results.
The GAAP provision for loan losses was $321 million for the quarter including $287 million for private credit loans and GAAP net interest income was $525 million in the second quarter. Under GAAP accounting the provision for loan losses and net interest income are based only on, on balance sheet loans whereas core earnings figures are based on total managed loans.
On the legislative front, over the next several weeks congress will consider legislation that will dramatically change the Federal student loan programs. The House Education Committee has already approved its version of the bill in July. We, along with a broad community group and a separate group of college financial aid administrators continue to advocate for final legislation that would preserve choice for students and schools, assure competition in both loan delivery and servicing, deliver materially lower student loan defaults, and save tens of thousands of jobs, all while generating similar official savings and as Al said, we believe more real savings for taxpayers.
As the legislative process continues the risks associated with transitioning over 4,000 schools to the Department of Education run origination platform becomes more obvious. We believe schools and students should not face the uncertainty this late in the cycle of how the student loan program will work next year.
Looking forward, we see continued improvement in our financial results for the fourth quarter and into 2010. Improvement is based on a normal CP Libor spread, reduced provisions for credit losses, and the revenue from loan sales. More specifically, for the fourth quarter we see a 15% to 20% reduction in the private credit provision from the third quarter and revenue from loan sales of $270 million. Combined we see operating earning at $0.50 to $0.55 in the fourth quarter.
For 2010 we see these trends, particularly lower bad debt expense, continuing with earnings per share potential north of $1.50 a share. Most importantly we continue to see adequate liquidity to service our maturing unsecured debt.
With that I’d now like to open the call to your questions.
(Operator Instructions) Your first question comes from Andrew Wessel – JP Morgan
Andrew Wessel – JP Morgan
You mentioned at the very beginning selling the interest in the sell portfolio $120 billion. Can you provide any; frame it for us and how that would transpire, who the natural buyers might be, how it might be structured?
I could, Jack could probably do it even better but it’s a transaction that we’ve looked at in a variety of ways and haven’t answered all the questions that you’re asking particularly with respect to natural buyers. It’s a transaction that we like; that we believe is very doable. Ultimately what we have about $150 or $160 billion of FELP assets which will not increase other then in the short term with the assets that we originate and then put. It represents a diminishing earnings stream and obviously creates an impediment to growing aggregate earnings.
Frankly we’d like to get it off the balance sheet, it weighs very heavily in a lot of different capital calculations that some of which we think are all that relevant, certainly not relevant to us but they are relevant to others. We want to lighten the balance sheet and effectively provide more capital for the remaining businesses. If you’re interested, you obviously are interested because you asked the question, I would recommend that you give Jack a call separately.
Andrew Wessel – JP Morgan
In terms of debt repurchases that appear to be ongoing obviously you had a lot of success with your 2010 tender. The repurchases you’re going to be doing on the open market are you looking out to 2011 now as being the obviously next year for a pretty big hump of corporate debt maturities and with that debt trading in the high 80s it seems like there’s good accretion there for you if you do it or is there nothing really targeted all relative value.
Obviously the market for near term debt is a little tighter then the out year markets. I’m going to let Jack answer the question but I think typically it relates to the source of the cash flows that we have.
It depends on where the cash is coming from and what our alternatives are. The 2010 tender was attractive simply because we were sitting on the cash earning basically nothing and you could buy back debt earning 6% or 7% so it was an easy trade to make. We look at those kinds of opportunities all along in terms of cash management as well as opportunities to finance unencumbered loans to term and then use that to buy back longer term debt.
Your next question comes from Michael Taiano – Sandler O’Neill
Michael Taiano – Sandler O’Neill
Could you give us a little bit more color on the guidance for next year the $1.50 is that just largely a function of lower provision for next year, is there also expecting from spread compression could you give us a little more detail on that?
Compared to 2009 the two biggest drivers are clearly the debt provision expense coming down and improvement in the CP Libor spread. There are other factors there, we paid a hefty price for that asset backed CP facility, that facility does not extend into 2010, we get the benefit of the straight A funding cost which is a lower cost to fund so you see some spread improvement on FELP relative to ’09. We certainly continue to expand the spread margin in our private credit portfolio as well which will contribute to earnings growth in 2010.
Michael Taiano – Sandler O’Neill
The gain as well on the put would also be in that number also right?
Correct. That comparison that’s not a material increase over 2009 and some of those other numbers.
Michael Taiano – Sandler O’Neill
A question on the private student loan business, originations obviously were down a lot compared to last year and you talked about the tightening of your underwriting standards as well as the increase in the Federal loan limit. Is there also to any degree a function of the bank regulators and what they will allow you to do in terms of originations in the bank? Is there increasing pressure on limiting the amount of growth in the ILC and also to the extent you talked about selling the residual on FELP? How much capital do you ultimately think you’ll need at the bank level?
The reason that originations were down was because while application flow was not down significantly the underwriting, the more difficult, more strenuous underwriting standards really reduced the approval rate. If we could have originated $4.5 or $5 billion of these loans at the quality that we originated them we would have done so. It had nothing to do with the regulators, although we pay very close attention to the regulators and we are in communication with them all the time. We would expect, I think your last question really related to capital, is it 12% or 15% we’re maintaining there.
The bank is 15%.
We’re maintaining 15%. I think if we were to give you an economic number of the capital that we would like to see against those assets it’s probably in the 10% to 12% range. Today we’re capitalizing the bank at 15% and that is where we are originating those assets at this point.
Michael Taiano – Sandler O’Neill
Is that 15% a minimum requirement by the regulators or you just…
That’s our get started rate and that’s what we’ve talked to the regulators about and I think for the foreseeable future we’re going to look at 15% there.
To be clear, that’s our number, not a mandatory number.
Your next question comes from Brad Ball – Ladenburg SSG
Brad Ball – Ladenburg SSG
I can see how you get to the $1.50 plus for 2010 with the put and the combination of lower provision and improved spreads. I’m looking out to 2011 and Al had mentioned expectations for further increases in 2011. In the absence of the put what are the assumptions driving the higher earnings in 2011 versus 2010?
We’re doing five quarters of guidance.
Brad Ball – Ladenburg SSG
Too much to ask for.
We intend for this company to grow and grow all of its revenue sources over this time period and there are a variety of assumptions it’s not a stretch to increase earnings in 2011. I’m barely ready to give you a lot of details about 2010 with all the moving parts we’ve got but you and others have sought some details. I knew as soon as I mentioned 2011 I figured maybe there would be a question about 2012 later.
Brad Ball – Ladenburg SSG
Jack’s response to the prior question about 2010 I don’t think he mentioned the expense cuts and I think your prepared comments you mentioned potential to lower 2010 expenses by about $300 million.
As I said, there are a variety of paths and there’s a fork in the road obviously with this legislation. I said that if we were to lose the origination function and who knows if and when that happens that we have $300 million of cuts that we have mapped out and would be put into place over a period of time.
That’s a post ending of FELP originations.
That really relates to much more to the FELP origination function.
Brad Ball – Ladenburg SSG
In our scenario work we could assume that in the absence of those originations available to be put there would be cost cuts that would be available to offset some of that long term.
Our operating expenses are very well under control at the moment and in fact if you were to purify the number in the operating expenses they’re basically about flat right now and we are pushing for cuts. The idea is not to have operating expense increases except specific investments that we’re going to make for various things that we want to grow here. I think you can look at 2010 with basically flat operating expenses if you’re trying to find input for your model.
I think it’s important to note, we’re not looking to make these operating expense reductions, these are being forced upon us by a change in the Federal student loan program and the thousands of jobs that would be lost would come from the changes to that program. These are people who are doing origination work, debt counseling, financial aid awareness and most importantly default prevention that are not covered for under the direct lending program.
Brad Ball – Ladenburg SSG
Following up on the private loan conversation, I think you mentioned that the private loan product, the new smart option product needs to be a more developed, needs to be better marketed. Could you talk a little bit about what you think that takes and whether or not you see that in terms of direct to consumer as a viable replacement to the school channel which has been the driver of private loan growth in the past?
I think it’s important to note that notwithstanding what happens on Capital Hill we intend and will keep our school channel open and grow it and strengthen it. That is underway at the moment. We also do some direct to consumer marketing and did so this year. We are studying the results of our marketing efforts. The fact is that we put this product together in record time. We knew what the basic structure of it needed to be, we put it together in a very short period of time, developed systems around it, but it was extraordinarily inflexible but we wanted to have that product to go to market this year, we didn’t want to go another year without making these assets cash flow early.
Now we’ve got to put some whistles and bells on it, we’ve got to market it better and frankly we’ve done a better understand why we didn’t originate more. As I said, we had decent application flow in a year where we don’t really understand all the macro economics of that marketplace and we get a variety of disparate kinds of reports on that marketplace about what it really was during the course of the year and so we really understand it, it’s a little bit difficult for me to comment on what we need to do to change the product.
Change itself is necessary. It’s going to take people a while to get used to a product like this which is 180 degrees different from all the ones that we offered in the past and our competitors continue to offer.
The big message point that we’re working with students and families and schools is that it’s a better product for the borrowers. It will result in substantially lower finance charges, almost 60% lower versus deferring and capitalizing interest which will make the program and college more affordable to students and families.
Jack’s actually going to be part of the marketing efforts.
Your next question comes from Lee Cooperman – Omega
Lee Cooperman – Omega
I was talking to a tax expert and explained my investment in the company. It occurred to him, I don’t know if this is practical whether you could take the run off business and possibly put it into a more efficient tax structure such an MLP to maximize the after tax returns to shareholders. Have you looked to something like this, is it practical or have you considered other tax efficient strategies?
The second question is do we still feel comfortable with the notion that run off value is in the teens?
The answer to the second question is yes. I think for the next earnings call we’re going to put you on this side of the microphone. You asked about tax efficient structures and in fact that is a significant part of what we’re looking at. I’m going to let Jack more specifically address the question. The answer to your second question is yes and I guess the answer to your first question is yes.
The FELP loans that Al referred to in his comments have technically been sold, they’re in securitization and trust today. What we own is the residual interest of the excess spread on that. We are in fact looking for different ways to create a more tax efficient vehicle to distribute that to investors as well as how we can generate cash or capital, free up cash or capital from that stream of income to do alternative things with it. For example, buying back more debt.
The different structures that one would employ here and how one might get at that are pretty varied and we still haven’t reached a full conclusion on what’s the best structure. We also know that we would get more value from this to the extent that the basis issues can be fully addressed and put to bed and so we’re working on that front as well.
Your next question comes from [Andrew Permatier – Hyatt Analytics]
[Andrew Permatier – Hyatt Analytics]
Do you guys have a thought on what your net spread is going to be on your DOE servicing contract this year and beyond?
We’re just starting to ramp this program up and it’s a little hard to know exactly what the margins will be in total as we learn about the different servicing requirement and the de-conversion and conversion what they call on-boarding of loans. That’s our main concentration at the moment. The almost $18 billion of loans that we moved in October moved in one weekend which was a pretty remarkable event. We can’t come up with anything even remotely close to that in terms of loans being transferred in ownership in such a short period of time.
We like the contract, obviously when we bid on it we bid on it knowing what the margins would be. We think the margins that we can earn in this are attractive to us its just the gross revenues are much lower then what we’ve done in the past. In particular a lot of the servicing issues that we do today on FELP loans aren’t called for under the direct loan contract. For example the FELP prevention stuff. These are things we advocated for and hopefully we’ll see change down the road but they’re not in there at the moment.
[Andrew Permatier – Hyatt Analytics]
You recently mentioned at an investor conference that the worst case scenario for FELP elimination by mid 2010 was around 25%. Does that remain accurate in your view? Secondly, is there any recognition at all on the logistical challenges of transitioning 4,000 plus schools to the DLP in 2010 and 2011?
I’ve been advised by Mr. Remondi that I tend to be too quantitative and he should talk. What I said at an investor conference was that I was a 50% profitability that the results of the legislation would be somewhere less bad then the worse and less good then the best and intended to be somewhere in the middle. I think I’m still there but I hope we’re getting close to some resolution to this. I have to say; just as an individual it’s frustrating. I also feel that we and others have had the opportunity to get the story on the table in front of the right people and that the facts are on the table. We’ve learned a lot about the process, some of us could probably be teaching civics courses at this point. I feel okay about this.
We get frustrated because we know, we’ve been in this business for 35 years, we understand the micro and macro economics of the business and we understand that the Congressional Budget Office or the GAO or the OMB or the various other entities that keep score don’t proport to measure a thousand percent of the economic costs. They measure what they measure. It’s really in the hands of the legislators to understand the other inputs that they need for these decisions. As I said, its frustrating to us that we pay a fair amount of Federal tax and that the government doesn’t receive that Federal tax if we’re not in that business.
That’s not counted the fact that we are prepared to pay 3% of all defaults just on the surface a highly computable number especially against a trillion dollars of loan originations over the next 10 years does not get counted nor do the benefits of having that risk sharing get counted. They’re all very frustrating but at the same time we’ve had access to the folks that make these decisions. I’m satisfied with that process, I’m satisfied that they understand that the CBO does not measure everything.
The former head of the CBO whose name I can’t pull off the top of my head just recently said that this was not the only element of the score and that the judgment shouldn’t be made just on specific numbers that they measure, that there are other factors. That’s probably a long winded answer to a question I can’t remember.
The second part of your question which was the transition risk is in fact extremely real. When this legislation was announced or offered up we didn’t think that they could transfer over 4,000 schools in the year that they had to get it done. Now that they’ve got less than four or five months to do it I think it just becomes more obvious.
Schools and students are the ones who suffer the consequences of that. They’re the ones who are wondering how we are going to process loans next year, how am I going to transfer my systems when the department is telling me there will be no extension of ECASLA. We are hopeful that Congress will see that transition risk as we get closer and closer to the beginning of the next academic year and take the uncertainty out of the equation for students and schools.
Your next question comes from Matt Snowling – FBR
Matt Snowling – FBR
Credit spreads have been tightening to the point where I guess we saw competitor do a FELP consolidation deal last week. I’m wondering where you stand in terms of testing the waters for non-TALF private loan deals? If I read this correctly it seems like you’re servicing about $19 billion of the loans sold back to the Government but that’s essentially all Sallie Mae, all the ones that you sold back. Are you actually servicing non-Sallie Mae loans under that contract currently?
Yes we are servicing some loans for the Department. The majority of loans that were put were put earlier ahead of the four contractors being effective. We were made effective to service loans in September or late August and so loans that were put ahead of that were transferred for servicing to a CS. We certainly expect to get a share of that third party volume over time on that contract.
In terms of the securitization market the credit spreads are definitely getting tighter. We did in fact do FELP deals $5 billion worth of non-TALF deals in 2009 we would certainly see the opportunity to do more of that today. We’ve got a re-marketing going on and some reset notes for example that we think can get re-marketed in this process as well. We see opportunities there.
For private credit we don’t control whether an investor buys those facilities, participates in TALF or not. The program is just eligible for that. We’re certainly starting to see on shorter duration transaction that are TALF eligible investors not taking advantage of that in other asset classes. When our next securitization of private credit loans comes up we’ll be watching for that with investors.
I would argue the ability to get private credit securitization deals done whether they are TALF funded or not it reintroduces the asset class to investors get them doing the work on the private credit asset and we think when they do the math and do the analysis they see the strong characteristics of the portfolio how it performs, how its held up in this credit environment and the margins that can be earned relative to alternatives. We’re very pleased with what we’re seeing so far.
Your next question comes from Sameer Gokhale – KBW
Sameer Gokhale – KBW
You’ve talked a little bit about the transition risk for schools switching to the FELP and there being a relatively few number of months left in terms of schools being forced to switch to the FELP potentially. Can you talk a little bit about the schools and your latest discussions with them? Have there been a lot of schools in recent months that have actually switched over to the FELP has there really been a rush to do that given the transition risk or schools just taking a wait and see approach still in saying let’s just see how this shakes out then we’ll decide? What are they thinking currently in terms of that?
I think it varies significantly from school to school. We conduct what we call straight talk calls with our college and university customers on a periodic basis and the last call we had I think there were 500 different schools on the call. There was a wide range of positions as to where people were. Part of it I think is a function of do the schools have the resources to be doing multiple things at once. Most financial aid offices, particularly in this economic environment are narrowly staffed. They were busy processing loans for the academic year and didn’t have and only started to turn their attention to what they would next year once all that processing was complete.
Then they’re looking at it saying I can’t get there in time from where I am today and that’s where the pressure is starting to ratchet up and you’re seeing schools reach out to Congress saying I need help with this transition, I can’t flip a switch and get there by the February, March timeframe that’s required.
Sameer Gokhale – KBW
I was thinking if schools just start switching on to the FELP then the whole legislative bid becomes a non-issue because all the schools have already switched over. It sounds like the schools really haven’t yet.
I don’t mean to imply that schools have not been switching, there have been schools switching. Direct loan volume is up but so is FELP and our share within FELP is also up.
Sameer Gokhale – KBW
In terms of this new smart option loan product clearly its too early to say with any degree of certainty but just in terms of the way the product is structured what kind of cumulative loss rates have you, net charge-off rates have you forecast or built into your profitability models for the smart option relative to your historical product in a traditional private student loan product. If the availability of funding is not really a limiting factor for the private originations over the smart option product its more the underwriting, what kind of growth do you expect from this sort of current quarter run rate in your private student loan originations going forward?
In terms of loss rates we’ve been modeling our traditional lending in private credit to about a 6% number and we think that’s a conservative estimate. It could certainly; with an improving economy could be lower then that. There are a lot of issues with the demand for private credit loans and we just completed peak processing seasons so we’re still sorting through the analysis there. You have factors of not just credit involved in the process you also have a significant increase in federal loan limits both last academic year and this academic year.
You had the whole consumer behavior issues that’s the hardest part to assess. We all heard instances of students and families choosing lower cost institutions to attend as a way of saving money in this process so that consumers aversion to taking on more debt then they need to is probably the biggest macro event that we still need to understand a little bit more. When we look at our volume we look at the application volume that Al mentioned, where we are in terms of where our competitors are we think because the product is the right product for students and families that the demand we will get our share of whatever demand is out there for this, for private credit borrowing.
Sameer Gokhale – KBW
In your traditional loans at 6%, cum loss rate is what have based on your trust data. For the smart option product you’d be giving the tightened underwriting, the characteristics of the cash flow the elimination of the neg am element or would you anticipate 4% cum loss rates there or 3% or is it just too early to say. I want to get a sense for what you modeled in also for that product.
Its fall rates we’re talking about here a life of loan default rates. There’s no question that loans with a co-borrower exhibit superior performance to loans without. Our traditional portfolio charge-off rate in Q3 was 5.1% it was 3.4% for loans with a co-borrower. I don’t think you should read a whole lot into 2009 as a trend because of the forbearance policy changes. In effect what you see in ’09 it’s the wrong terminology perhaps but a doubling up of defaults as forbearance fell by over $900 million year over year. Those numbers are elevated relative to what you would see even in this economic environment.
The confidence that we have in terms of looking forward into 2010 and loss rates is because of the changing mix, higher quality loans coming into repayment and this forbearance and collection process changes that took place in ’08 and ’09 not repeating in 2010.
Your next question comes from Moshe Orenbuch – Credit Suisse
Moshe Orenbuch – Credit Suisse
They say imitation is the most sincere form of flattery. Are you seeing any competitors trying to copy the smart option product?
We’re not feeling all that flattered at the moment.
We came to market in record time. By the time we announced it there was no ability of any competitor to match it for this academic year.
Moshe Orenbuch – Credit Suisse
The comments you just made about forbearance is that infection point already past or is it coming. How does it work in your view in terms of when the peak impact of that forbearance change hits the loss numbers?
We think the inflection point was July. October’s number look like they’re going to be $40 million less then July’s charge-offs. We see that trend continuing. I doesn’t obviously go from 100 to zero but we think we’ve clearly passed that trend. Again this goes to why we’ve been so confident in terms of the loss forecast here is moving in a different direction because of the doubling up and because of the quality issues that I mentioned.
Both Jack and I and others of our executive officer group are cautioned constantly by our Board and actually by some of you guys about appearing Pollyannaish about bad debt outlook. I don’t think we are Pollyannaish about it at all. What Jack is suggesting is really basic arithmetic of the assets. We do not anticipate a significant strengthening of the economy what we’re projecting. We can see six months pretty clearly, we’re pleased with the quality of the projections that we’ve been getting over the last year. I would also say that we’re being very candid with you this is how we see it. They’re just Jack’s views and my views.
Moshe Orenbuch – Credit Suisse
Would you consider actually going back in the other direction if you saw the economic weakness persisting or some other factor?
I’m not sure what that means.
Moshe Orenbuch – Credit Suisse
In other words, would you be more lenient in terms of forbearance, in terms of reversing some of the changes?
We have our private credit guys here and I think they would tell you that we like forbearance as a tool that we should have used other tools in addition to forbearance and we’ve been purifying if you will the forbearance but we will continue to use it. It’s highly unlikely however that we would increase the usage of forbearance, that we would probably use other tools.
I would describe the forbearance practice change as being one more automatic eligibility for forbearance to match what went on in the FELP program so that borrowers and schools understood the consistency there to one or more analytics. A borrow has got to demonstrate to us that they can actually benefit from a forbearance before it’s granted. Putting someone into a forbearance mode and capitalizing the interest when they cannot afford the monthly payment because they either dropped out of school or borrowed too much that doesn’t make any sense. Loan modification for that borrower is a far better tool to manage that.
If 10% of borrowers qualified for forbearance because they could benefit from it we wouldn’t have a problem granting them forbearance its just we don’t want to give it to people who can’t benefit from it.
Moshe Orenbuch – Credit Suisse
Have you given an update on the FAS-166,167 impact?
Its about $670 million is the current estimate.
Moshe Orenbuch – Credit Suisse
That’s assuming at book value, at fair value.
That’s at book value and that’s bringing every off balance sheet transaction on balance sheet.
We have no further questions. I’ll now turn today’s call back over to management for closing remarks.
That concludes this morning’s call. If you have any follow up questions please call myself or Joe Fisher.
This concludes today’s conference call you may now disconnect.
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