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SLM (NASDAQ:SLM)

Q2 2011 Earnings Call

July 21, 2011 8:00 am ET

Executives

Albert Lord - Vice Chairman, Chief Executive Officer and Member of the Executive Committee

Jonathan Clark - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

John Remondi - President and Chief Operating Officer

Steven McGarry - Senior Vice President of Investor Relations

Analysts

Edwin Groshans - Height Analytics, LLC

Eric Beardsley - Barclays Capital

Michael Tarkan - FBR Capital Markets & Co.

Sameer Gokhale - Keefe, Bruyette, & Woods, Inc.

Bradley Ball - Evercore Partners Inc.

Moshe Orenbuch - Crédit Suisse AG

David Hochstim - Buckingham Research Group, Inc.

Michael Taiano - Sandler O'Neill + Partners, L.P.

Alan Straus -

Matt Snowling - Citadel Securities, LLC

Farhad Nanji - Highfields Capital

Operator

Good morning. My name is Tiffany, and I will be your conference operator for today. At this time, I would like to welcome everyone to Sallie Mae's Second Quarter 2011 Earnings Conference Call. [Operator Instructions] I would now like to turn the conference over to Steve McGarry. Please go ahead, sir.

Steven McGarry

Thank you, Tiffany. Good morning, everybody, and welcome to Sallie Mae's 2011 Second Quarter Earnings Call. With me on the call today are Al Lord, our CEO; Jack Remondi, our President and Chief Operating Officer; and John Clark, our CFO. After Albert's prepared remarks, we'll open up the call for questions.

But before we begin, please keep in mind that our discussion today will contain predictions, expectations and forward-looking statements. Actual results in the future may be materially different from those discussed here. 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 we call our core earnings. A description of core earnings, a full reconciliation to GAAP measures and our GAAP results can be found in the second quarter 2011 Supplemental Earnings Disclosure. This is posted along with the earnings press release on the Investors page at salliemae.com. Thank you, and now I'll turn the call over to Al.

Albert Lord

Thanks, Steve. Well, good morning, everyone. By now, you have all seen our earnings of $0.48 for the quarter and $0.96 year-to-date. We say that, by the way, it was a good quarter, not just a good quarter, a very good quarter, particularly and that it had no real surprises, but I guess the possible exception of the obstinacy of the economy, which is slowing a few things now for us. During the quarter, we began to pay the dividend, as we told you, and buy stock. John Clark will talk to you a little more precisely about those things shortly.

Share price, our share price seems to struggle along with other financials, but our operating results were strong. We are well on track today to increase our guidance, and we are increasing our guidance to $1.80 for the full year 2011. I recognize that implies only an $0.84 second half after a $0.96 first half. But as I think some of the analysts have already picked up, we are dealing with the new accounting rule, which will require some third quarter reserve additions. I will discuss that a little later.

Quarter 2 then, otherwise, reasonably represents our -- almost on a line-by-line basis, our second half expectations. I also recognize we have moved guidance fortunately upward, but we've moved guidance several times this year. That's a function, in part, obviously, because we're conservative and attempt to be conservative. But more specifically, we have more net interest income in the first -- in the last quarter and the first quarter than we expected.

Net interest income for Sallie Mae is usually very very predictable. We are virtually perfectly match-funded. That means our variable assets are funded with variable rate liabilities, and our fixed assets -- fixed-rate assets are funded with fixed-rate liabilities. And in fact, we are some 90% or thereabouts funded to term on our assets and liabilities.

Generally, the company only has a minor index exposure. We have index exposure on CP-LIBOR, which has trended very, very tightly for a long period of time with 1 minor -- 1 major exception for a short period of time. And our private loans or what we'll call our legacy private loans, our index time and the prime to LIBOR spread has actually remained wider than expected.

More important to the net interest level or the absolute rates of interest, they've been much lower than we anticipated. In fact, I think, at least for Sallie Mae, they're the only benefit I've seen in this languishing economy or the continued low rates, and the rates are low across the yield curve. These affect loans that Sallie Mae has that have a floor interest rate, and most of those loans are hedged, to the extent they're not hedged that gross amount of net interest income that we earn on unhedged floor loans, and creates more proceeds on the student loans that have floors that we have sold over the course of the year.

Also, a positive loan volume was again above our plan. I remain very confident we'll hit the $2.5 billion originations plan. I am so confident, actually, I'm now thinking about 2012 unless our expectations should be for that. That's largely a function, of course, the economic outlook, and again how much residual chief federal money is still floating about in the marketplace.

We have entered the third quarter, which is our key volume quarter. It's going to answer us -- for us a lot of questions about the real direction of loan demand. I expect for you folks that our quarter 3 results will be very informative in that regard.

Our fee income was up from the first quarter. It's slightly better than we expected. That's good news. You'll notice significantly fewer debt repurchase gains in the second quarter. The fact is our debt spreads are better, and we have fewer opportunities for accounting gains and economic opportunities in the debt market for ourselves.

Operating expense, which all of us are watching, remains headed towards the $250 million target in Q4. At $269 million this quarter, we still have some business to cover to get to $250 million. We will get there. I'll note also that we were -- our expenses in Q2 were $41 million below last year's Q2.

Talk about our credit costs. They, too, are headed very much in the right direction, probably a little slower, well, certainly a lot slower than I would like, but even slower maybe than expected, but they're steady, and they -- and the results really demonstrate the high quality of our internal operation in terms of projecting defaults and delinquencies. Those projections, combined with the delinquency statistics show a very clear downward trend in our credit costs.

Now the bad debt reserves. You'll note that they remain at $2 billion. That's our loss reserve for the next 2 years against the portfolio that we had that is in repayment. We also note that 81% of our portfolio now is in repayment. As we've discussed with you for many years, as I said, the loss reserve is designed to cover 2 years of bad debts. I think if you were to compare that to other consumer finance-type entities, you would see that that's a very substantial coverage. And I am, and our company, is very comfortable against that long held 2-year standard. We're even comfortable with that 2-year standard in the current unemployment situation, and we are and will be careful with our reserve conservatism.

So I mentioned an accounting change. Now the FASB has changed or issued a new rule, which wants life of loan reserves, not 2-year reserves, on certain loans. These are loans that are so called troubled debt restructurings, which is a defined term, and the definition has either been clarified or enlarged, but in effect, what it's done is it's brought some of our forbearance loans to be redefined as troubled loans.

So you're all well aware to the extent you follow this company at all that forbearance is a very significant lending feature in our asset, in our student loan asset. It is so prevalent and in fact, that today's federal loans have a lifetime of forbearance as an entitlement. And so we now need to add reserves that go beyond the 2 years for certain of our forbearance loans. The good news on this is that notwithstanding the new rule, we're already very well reserved for forbearance loans, and for the next 2 years, and now that is a major part of the total reserve that would be necessary.

Implementation of this accounting rule is well underway. It orders pieces of the portfolio. Some pieces go up, some pieces go down. But in total, it will require a net increase to our reserve. The effect of this is that adoption of this accounting standard will bring credit cost that would have otherwise been in 2013, '14, '15, '16, et cetera, et cetera, into our third quarter. Nonetheless, and though we're not totally wrapped up on this adjustment, I'm still comfortable with the $1.84 year estimated earnings per share.

Let me wrap up. I mean, I think I've covered at least the highlights of the third quarter. Sallie Mae is on the road, well on its road to earnings growth. That growth is solid. It is not dramatic. We're rolling the private credit portfolio in 2011, intend to grow it more in 2012, which means we will begin to grow private net interest income. We will continue to reduce our credit costs. We are -- we will embellish our fee businesses, as I tell you, probably, every time we are seeking M&A opportunities that fit our expertise.

On the financial front, we will maintain strong and strengthen our balance sheet. It means a strong and strengthening capital position, strong cash flow, strong liquidity. It's no secret and certainly no secret to the rating agencies that we want our investment grade rating back. I wanted to say that we appreciate the folks on the call, the company's debt and equity investors and particularly their confidence in us.

Sallie Mae is not an easy equity story, but it's a story well worth understanding. And until the number of confident investors grow in this company, Sallie Mae will buy debt and equity securities at today's attractive prices. You can know well that we understand the values in these securities. I will now turn it over to Mr. Clark.

Jonathan Clark

Thank you, Al. Good morning, everyone. I'm going to review our financial and operating results for the second quarter on a GAAP and core earnings basis. I'll also discuss the performance of our 3 business segments, and review the performance of our lending portfolio, and provide you with an update of our funding activity.

Core earnings were $260 million or $0.48 per share compared to $211 million or $0.39 per share in the year ago quarter. On a sequential quarter basis, earnings were unchanged at $0.48 per share. However, the prior quarter included an $0.08 per share gain in debt repurchases. Q2 was a very strong quarter that demonstrates this company's earnings power.

Turning to FFELP loan segment. FFELP core earnings were $108 million compared to $95 million in the year ago quarter. The FFELP net interest margin improved to 98 basis points from 95 basis points in the year ago quarter. Earnings from the FFELP loan segment continued to be very predictable due to the high quality and consistent prepayment characteristics of the portfolio. FFELP operating expenses, excluding restructuring charges, were $192 million compared to $187 million a year ago. The increase in operating expenses was primarily a result of the increase in servicing revenue associated with portfolio acquisition.

Earnings from the Consumer Lending segment were $49 million compared to a loss of $12 million in the year ago quarter. Net interest income increased to $401 million for the quarter, driven primarily by the net interest margin, which improved to 4.05% from 3.79% in the year ago quarter. This improvement was a result of significant decline in the other interest earnings assets, which are down primarily as a result of planned decline in cash balances at the bank. Other interest earning assets generate a negative spread, and therefore caused a drag on earnings.

As for loan performance, the loans that entered repayment in the fourth quarter of 2010 will drive delinquency trends in the first half of 2011 charge-off in the second half. This cohort of loan was smaller, and a higher quality than previous repayment cohorts. It has a higher average cycle, and it comprise of significantly smaller amounts of higher risks, non-traditional and non-cosigned loans. Through the first 6 months, these loans were showing a lower delinquency rate, and making more payments when compared to loans that entered into repayment in the fourth quarter of 2009. The 31-plus day delinquency rate for these loans is 10.8% compared to 13.7% one year ago. These are leading indicators of performance, and would suggest lower charge-offs going forward.

Looking beyond the loans that entered into repayment in the fourth quarter, our overall private credit portfolio characteristic continued to improve. Early-stage delinquencies remained flat compared to the prior quarter. 31 to 60 day delinquency has decreased to 3.3% from 3.7% in the prior year, and 61 to 90-day delinquencies decreased to 2.0% from 2.3%. Late stage delinquencies declined to 4.7% from 5.1% in the prior quarter, and 5.8% from the year ago period. Forbearances increased slightly from the prior quarter to 4.7% from 4.6%, but decreased from 5.3% in the prior year. Net charge-off, as a percentage of loans in repayment for our entire portfolio, improved significantly to 3.7% from 5.3% in the year ago quarter. This rate represents our lowest quarterly net charge-off rate in Q4 '08.

The continued improvement in our charge-off rate is a direct result of the increase in the quality of loans that are entering repayment. The provision for private credit loan losses reflects the improved performance of the portfolio. At $265 million, it is down significantly from $349 million in the year ago quarter. We expect the positive trends in our delinquency and charge-off metrics to continue.

Turning to originations. We originated $264 million in private credit loans in the quarter, an increase of 21% from the $219 million originated in the year ago quarter. Loans underwritten in the quarter had an average FICO score of 736, and 81% of loans made had a co-borrower. In March, we expanded the repayment options offered to students to include the ability to deferred payments until after school. We are well-positioned for this academic year with a private education loan that offers both repayment choice and competitive pricing, and companion products that helps families cover other education-related financial matters.

In the Business Services segment, core earnings were $140 million compared to $127 million in the year ago quarter. The servicing fees we received from our FFELP portfolio totaled $187 million in the quarter compared to $165 million in the year ago quarter. The increase in fees in earnings are primarily a result of the additional FFELP loans acquired on December 31.

The company now services 3 million accounts in the Department of Education servicing contract compared to 2 million accounts 1 year ago. Through the first 3 quarters, we have been the best performer in the category of the FFELP reduction, and are determined to improve our rankings in the other aspects of the score card.

We recently launched Sallie Mae Insurance Services, which we'll offer directly to college students and higher education institutions, tuition insurance, renters insurance, and student health insurance. In conjunction with this initiative, on June 30, 2011, we acquired a 45% stake in Next Generation Insurance Company (sic) [Next Generation Insurance Group], a nationally licensed insurance agency. During the quarter, we began to offer a new tuition insurance benefit to the Smart Option student loan, which will differentiate it from our competitor's products.

Our no-fee checking account, which we announced this year, is an attractive option for students to gain access to their tuition refund as part of our Campus Solutions business. We see significant opportunity to grow this business, and added 18 new refund disbursement clients in the second quarter, including Portland Community College.

Total operating expenses for the company, excluding restructuring charges, were $268 million in the quarter compared to $303 million in the first quarter of 2011, and $309 million in the year ago quarter. Second quarter operating expenses included a $2 million reserve for potential litigation, and $13 million for additional servicing expenses on purchase assets, which will be significantly lower once the loan are transferred to our platform. Reducing our operating expenses is the primary focus of this company. Operating expenses will be higher in the third quarter because it is our peak loan origination season. However, in the fourth quarter of this year, we expect to receive a run rate of $250 million.

Turning to funding. At June 30, 2011, 89% of our managed assets were funded for life compared to 88% a year ago. In the second quarter, we paid our first common stock dividends in 2007, and repurchased $9.6 million common shares in the open market at an average price of $16.25. We utilized $156 million of our $300 million share repurchase program in the quarter. We heeded our share repurchase program in a formulaic and disciplined manner. We also continued to repurchase our unsecured debt in the market in the quarter at a much lower pace than we have in the past.

In the quarter, we repurchased $60 million of our unsecured debt, generating gains of less than $1 million. In the second quarter, we issued 1 FFELP and 2 private credit ABS transactions. We continue to see increased demand for both products. We priced an $821 million FFELP consolidation loan ABS transaction on May 26. This transaction priced at an all-in LIBOR equivalent cost of 1 month LIBOR plus 115 basis points. Our private credit transactions were met with good demand. We issued $562 million on April 26. And on June 30, we issued $825 million at a weighted average cost of LIBOR plus 189 basis points, which is 10 basis points higher than the previous transaction. Going forward, we will continue to be a programmatic issuer of private credit ABS, and bring deals to the market on a regular basis. We believe this will create a more durable and liquid market for our securities.

While we are very comfortable with our maturity profile and pleased with the outcome of our most recent transactions, we will not be fully satisfied until we see our credit ratings and our funding costs improve meaningfully. Total equity at June 30 was $5 billion, resulting in tangible capital ratio of 2.3% of assets, an increase from 1.9% at June 30, 2010. We believe we are currently holding excess levels of capital.

Turning to GAAP. We recorded a second quarter GAAP net loss of $6 million or $0.02 per share compared to net income of $338 million or $0.63 diluted earnings per share in the year ago quarter. The primary difference between our core earnings and GAAP results was the impact of a $414 million unrealized mark-to-market pretax loss on certain derivative contract, which was recognized in GAAP but not in core earnings.

Turning to guidance, as Al said, we expect core earnings per share to be $1.80 in the full year 2011. And at this point, I'd like to open the call for your questions. Operator, would you please open the line for any questions?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question is from the line of Mike Taiano of Sandler O'Neill.

Michael Taiano - Sandler O'Neill + Partners, L.P.

I guess the first question I had was on the credit side. In terms of the receivable that you guys broke on the potential expectation for recoveries, it's about $1.1 billion, so that's been picking up for a while, and I just was curious. So as you kind of think about credit going forward, at what point does that receivable start to sort of level off and then ultimately decline? Is it something you expect in the next year, or is it probably going to be longer than that?

Jonathan Clark

I expect it will be longer than a year. But you're right, it will start to tick down.

Michael Taiano - Sandler O'Neill + Partners, L.P.

Okay. And where are the recoveries coming in relative to -- like what your expectations have been, are they fairly closed or...

John Remondi

Yes, this is Jack, Mike. And the -- and when you look at some of the recovery periods in this -- in our collections unit, what we're seeing is some of the older cohorts are performing exceptionally well in terms of recovery as you'd expect. They're aging through the collections cycle better. Loans that charged off in 2008 and '09 are underperforming our expectations. They're more heavily weighted towards the nontraditional portfolios. But overall, we're pretty close. And I will remind you that if we are below expectations, we do charge off the difference in that month, so that we're not building any gap that would have to be adjusted later on.

Michael Taiano - Sandler O'Neill + Partners, L.P.

That's helpful. And then, I guess, in terms of Private Student Loan business, just curious as to -- it seems like you guys are running ahead of schedule on the $2.5 billion. Just curious as to what -- I know it's early in the sort of the enrollment fees, but what you're seeing in terms of pricing, competition? Are you seeing some increase relative to last year or relatively stable? Any color on that will be helpful.

Jonathan Clark

On the competition side, we're not doing any material changes. We feel very good about our $2.5 million number. You're right, we are running strong. But as Al pointed out, we're coming to our peak season now, and we'll see where -- in terms of competitive landscape, and I see us in a better position now than we were several years ago because any of these players in the market, perhaps, who are a bit more aggressive, are no longer out there as competitors. So the competitive landscape is only as good as we've seen it for a while.

Michael Taiano - Sandler O'Neill + Partners, L.P.

And then just a final question on just sort of the regulatory front. And I know you guys are doing a sort of active dialogue with regulators with respect to potentially being classified as a SIFI sort of the rules under Dodd-Frank. And just was curious, as I know you can't probably comment specifically on the discussions, but just curious if there is a sort of a timeframe over which you think there could be some resolution on that?

Jonathan Clark

Yes, I'm not -- we've talked about a number of timeframe. As you're probably aware, when we talk about a date and people think there's going to be some clarity, we haven't really gotten any material clarity. I think this will take some time to play out. Obviously, I'm sure along with many others financial institutions, we'd like clarity too or output later, but this just will take some time.

John Remondi

But we are confident that -- I mean, it's hard to see how we would be classified in a negative way at this stage in the game.

Operator

Your next question is from the line of Matt Snowling of Citadel Securities.

Matt Snowling - Citadel Securities, LLC

I'm wondering if you could quantify that reserve adjustment you expect in the third quarter?

Albert Lord

We're not quite there, Matt. We're not quite there. It's a -- I mean, there's ongoing conversations. We've done a number of calculations. Let's just say that it is within a range that -- we'll be quite satisfied that we're going to generate $1.80 this year. And keep in mind, that's $0.12 below where the first half was.

John Remondi

As we've told you, too, Matt, I mean, 70% of charge-offs take place in the first year of repayment. So it's the lion share of activities taking place within our 2-year window.

Matt Snowling - Citadel Securities, LLC

Okay. Well, let me ask in a different then. It apply to a certain number of those loans and forbearance. Can you quantify that?

Albert Lord

Say that again. I'm sorry. I didn't hear it, Matt.

Matt Snowling - Citadel Securities, LLC

Sorry. You said this accounting change applies only to a certain amount of the loans and forbearance.

Albert Lord

Right.

Matt Snowling - Citadel Securities, LLC

How much of those loans or how many of those loans?

Albert Lord

Well, the last thing I wanted was for this conversation to turn into an accounting conversation. But the rule applies only back to January of this year, and it relates to loans as we see it that are in the forbearance -- keep in mind, maybe half of our loan portfolio or at least 40% of it has a 1.1 through a forbearance status. Forbearance, the range of forbearances in our portfolio is pretty extensive. And keep in mind also that we grant forbearance to improve the collectibility of an account, not to weaken it. But there are accounts that go into forbearance because the borrower is struggling. And obviously, that could increase the propensity of that borrower to default. So there's a definitional issue about which of the forbearance accounts enter this conversation. As Jack Remondi mentioned a couple of minutes ago, keep in mind that most of our -- having a 2-year reserve covers the lion share of bad debts. And we have been much, much, much more prudent in this -- through this difficult economy of granting forbearance. So the forbearances that we're talking about are those folks that are just struggling to make their payments, not those that have been granted forbearance, almost as a feature of the loan that we've made. And so that definitional aspect has caused some of the delay. But the fact is I am pretty well zeroed-in on the number, and it's a number that, as I said, leaves me comfortable at $1.80 level. This is a little bit last-minute, and I would say I wanted people to understand that I have never been more satisfied with the loan loss reserve the company has. I've never been more satisfied with it. As I look at our projections for charge-offs, and I look at them, we project them month by month out for several years, and we support those with delinquency statistics. This loan loss reserve, even without an increase is quite, quite sufficient. So I guess with a risk of incurring minor rats from our friends with the FASB, this -- and I don't mind having an even bigger reserve because I like big reserves, but I liked it a lot at $2 billion.

Matt Snowling - Citadel Securities, LLC

Let me ask a different question, if I may, you've been cutting costs for probably 4 quarters now. I'm just wondering if you're seeing any opportunities at this point that would allow you to get maybe down the road, take that $1 billion expense target down another notch or so, or is that the right run rate?

Albert Lord

Matt, could you ask us that question in 6 months?

Operator

Your next question is from the line of Mike Tarkan of FBR.

Michael Tarkan - FBR Capital Markets & Co.

Just real quick regarding FFELP portfolio acquisitions. And I guess, one of your competitors reached a deal during the quarter and you guys are obviously on the hunt for more deals. I'm just wondering if you guys looked at that opportunity. Can you maybe talk about the size of the deals you're looking at, when we can expect more activity on your front. Something like that will be helpful.

Jonathan Clark

Yes, that's true. Yes, we saw that transaction. And in that particular case, we didn't see as much value than someone else. We don't expect we're going to win every deal we enter into. But there is a constant flow. We are in -- I probably participated in 1 to 2 conference calls a week updating various bids and where they stand. Some are more formal processes, some are less so, but there is a constant flow. And we purchased their -- I'll remind you that we bought the biggest one out there when we bought student loan core. There are some -- the next step done is materially smaller. So we're in discussions with many of those big portfolios and many smaller ones as well. So I think you can expect a lot of what we will get done with an occasional big one will be what I'll call a lot of singles and doubles. But there is reasonably good flow, and I expect the vast majority of the dollars to move in the next couple of years, but there will be a pretty good tail on this as well. So I can easily see us out 2, 3, 4 years from now still buying portfolios.

Michael Tarkan - FBR Capital Markets & Co.

Okay. Great. That's helpful. And then I guess on the same lines regarding capital, you guys are clearly blowing through the $300 million authorization relatively quickly. I'm just wondering if we can expect that pace to continue and then if not, maybe some more activity along with debt pay down.

Jonathan Clark

I might respectfully take some issue with your characterization of flowing through. Listen, we have a -- we've taken, I believe, a very sober and pragmatic approach in repurchasing stock. We've been very formulaic, and I won't share the formula. But we've been very formulaic and very -- some may argue with it in how we approach it. But our belief is, you don't want to be try to be the smartest guy in the room. We do want to repurchase stock. Our metrics indicated a time some purchases and our purchases at a level, which were a bit higher than we expected, quite frankly, but we stayed the course. And I think we're doing what's prudent. I can tell you the pace, necessarily, which we will buy in this coming quarter. It could very well be on a similar kind of pace. And then when we exhaust our $30 million allocation, we will enter into discussions with our board, and figure out where we go from there.

Operator

Your next question comes is from the line of Kenneth Bruce of Bank of America Merrill Lynch.

[Technical Difficulty]

Operator

Your next question is from the line of Farhad Nanji of Highfields Capital.

Farhad Nanji - Highfields Capital

Al, I just want to clarify something that you had said about guidance. The $1.80, as you estimated now, does that include the estimated reserve charge?

Albert Lord

Yes, it does.

Farhad Nanji - Highfields Capital

So if I annualize this quarter, which I will admit is wrong for now, but if I annualize this quarter, it looks like that the charge is somewhere in the order of 12-ish cents. So really, you're taking guidance from $1.70 to north of $1.90, and then saying there's a one-time charge for an accounting change?

Albert Lord

I'm going to -- I think I'm going to -- Farhad, since you're better at this than I am, I'm just going to leave my comments where they are. Based on what we know about Q3 specifically, I'm comfortable with $1.80. I wouldn't -- based on what you just said, I wouldn't quibble with your arithmetic, I might quibble a little bit with some of your conclusions. But as I said, and what I was attempting to make clear early on, that we've earned $0.96. It's a number that would otherwise be annualize-able, where it's not most specifically for this accounting change.

Farhad Nanji - Highfields Capital

Got you. And that accounting change, is that going to affect the level of ongoing reserves after this adjustments?

Albert Lord

I would say not noticeably. We issue fewer and fewer forbearances with the passage of the time and the -- the fact is that we have reserved this portfolio in a variety of different ways, in a variety of different segments, and these forbearance accounts actually sit in every single segment of the company's portfolio. And so if we put a bigger reserve on those, we can actually put lower reserves on others. As I said, it substantially changes the mix. And it really alters, to some extent, the way we assess this thing. But the fact is, and I'll go back to my comment, and I think, Farhad, you and I and some of the other guys over the years have debated what's the message when we talk about these reserves. There's no message here at all except that the guys who made the rules change the rules. And it does not alter by any number, right on the right -- even on the right-hand side of decimal point, the economics of our business or the cash flow of our business or the value of our franchise. And to me, I look at capital and reserves, at least economically, as the same number. And all we're doing is taking -- we're taking some amount of capital and putting a back up in reserves, pretax. There's an exercise here that almost is counterproductive, but in fact, we do what we need to do in accordance with the rules.

Farhad Nanji - Highfields Capital

That's helpful. Switching gears a little. Could we talk about some of that fee streams? Over the course of the last 6 months, we've seen several announcements from the company about new products, new services being offered on campus, and it would be helpful to understand. So how you guys think about the size of that opportunity and the timeline for achieving it?

John Remondi

This is Jack, Farhad. We're looking at that consumer segment as helping -- as we've said, we've defined it as helping students and families save, paying plan for college. And the products and services that we're bringing to the campus is really designed to help on that front. The recent launch of the insurance product is designed to help students and families protect the substantial investment they make when they pay the semester's tuition bill. In the event of some health-related issue, if they have to leave school, at most places, they lose a substantial part of that investment. And we think this is a natural product place for us to be. We'll also offer students and families insurance products to protect their belongings in their dorm, as well as some health-related insurance product that are kind of a natural fit. We do see some significant opportunities to cross sell products to our existing customer base, and we're starting to see -- we've seen that grow in our Upromise rewards feature, as we started to link products, that feature to our customers. Just this year to date, we've seen over $17 million transfer from Upromise rewards that have accumulated, go back to products. For example, in the 529 space, the average person who redeemed in the first half of this year put over $500 into their 529 account from Upromise reward that they've accumulated. On a smaller scale, we're just starting to see that same benefit apply to our student loan borrowers. This quarter, the average reward that was redeemed was over $120. We think these types of things can help link our products together more closely and really expand the relationship we have with customers. So we're pretty excited about it.

Operator

Your next question is from the line of Moshe Orenbuch of Crédit Suisse.

Moshe Orenbuch - Crédit Suisse AG

Could you talk a little bit about the margin on private student loans? I guess you had both the yield down and cost of funds up, and then you had kind of your, I guess, your collateralization requirements down, so you had a little bit of a benefit. And I guess I was surprised that the number swung just because you didn't originate a lot of new loans. So I guess, it must have been rough. Well, could you just talk about what the trends are going to be and how your current offerings, kind of price and fund relative to the averages that are in there?

Jonathan Clark

Our current pricing is -- on an inflation basis, we're probably in the -- expecting we're in L plus [indiscernible]. And like I said, on our most recent issuance or securitization, our funding was, all-in, L plus 189. As you stick through the comparison to where we've been historically, we probably -- in our historical book, right, you've got a much lower yield on the underlying asset. But your underlying financing cost were lower, but the delta was not as significant as the -- the increase in your cost of funding was -- now is less than the increase in the yield on your asset. So we're getting a better net spread now than we did on our historical book.

Moshe Orenbuch - Crédit Suisse AG

I guess, John, the June average yield was actually less than the March average yield. You didn't originate all that much, so it must have been that actually the existing loans kind of rolled up in higher yields is what...

John Remondi

It was the gross yields and so there, you're looking at interest rates, because interest rates declined in the LIBOR prime. If the LIBOR rate on the loans reset, the yield would have come down.

Moshe Orenbuch - Crédit Suisse AG

Got it. Okay. And I mean, could you talk a little bit about the securitizations and -- because obviously, you've got better both over collateralization requirements and spread. I mean how did that kind of look in terms of your funding plans or for the $2.5 billion originations?

Jonathan Clark

So I think I expect in terms of our go-forward, our over collateralization level should improve, continue to improve. Obviously, in our $2.5 billion that originate today are Smart Option loans. We have like a loan loss expectation of 6%. We're looking at a -- and if you compare that to, obviously, to our historical loans, we're in a much better position. A significant percentage of our loans recently in Smart Option will continue to be full interest payment loan school, which shortens the average life of the loan, and which in turn allows you to shorten the average life of your bonds that you sell, which obviously leads to an even better execution level. So going forward, all of the things being the same, let's call it market environment the same, one should expect better execution levels in terms of spread and lower OC.

Operator

Your next question is from the line of Brad Ball of Evercore.

Bradley Ball - Evercore Partners Inc.

Just one more clarification on the reserves in the third quarter. Are we talking about really a one-time adjustment to the reserve upward and then it will be sustained at that level going forward? And is that adjustment reflecting really 2 components? One is the reserve for forbearance loans and the another is higher reserve to cover life of credit losses on the rest of the portfolio, or is that not actually applicable?

Albert Lord

So we're back to accounting. Brad, in answer to your first question, I look at it -- it is not totally a one-time adjustment, but the major piece of it is a one-time adjustment. And so I -- and the question came up earlier. I would say, you're pushing me back into my accounting days, but I would say it's -- I would look at it is a one-time adjustment. And from that point forward, it really depends on the number of loans we put through forbearance. I mean interestingly, we can alter the reserve accounting just by changing our behavior. I truly think that it's for purposes of our investors, they can think of this as one time. Because I think, to the extent that we put additional reserves, in other words, reserve life of loan for some loans, we will be -- we will actually be finding that our loss experience on our other loans, loans that have not been through forbearance, will shrink. As I said, we worked on this thing for -- we worked on it for 10 years, and incredible detail in the last 3 years. We know exactly how these loans behave in every one of their categories. And so to some to the extent, this is just a shifting in the mix. It's putting a higher reserve on loans with a higher propensity to default. And in effect, the accountants are asking us to be even more specific with our reserve methodology instead of just gross percentages. So I've already said more than I wanted to say. But let me just summarize by saying in answer to your other question, yes, we will have a 2-year reserve for good accounts, which may not ever charge off, right? And then in the life of loan for the loans that have what we think is a higher propensity to default, and which qualify under the revised or so-called clarification of accounting rules that we've recently gotten. I would -- if I could order the way you think about this, and it's hard to do since I don't know how you think about it. But if I could alter that way, I'll say, think of it as onetime, and think of it as making the reserve even more adequate. It is not a substantive change. It is not a reason to make any decisions, whatsoever, if you're an investor.

Bradley Ball - Evercore Partners Inc.

Okay. Very helpful. And then just a follow-up, I think, John, did you mention that the co-borrower percentage on new private credits is 81%? And but I think that's down from what it had been previously. I think you were running in the high 80s, like 87% previously. Is that true, and does that reflect any change in strategy or approach?

Jonathan Clark

No, actually, there's a -- it's not necessarily an intuitive thing, but it's a little bit of a mix issue depending on its position, seasonality, which is tied to a mix. And so if you actually -- when you look quarter -- year-on-year analogous year to '10, to '11, you won't see the same decline. You'll see this number move around a little bit down, and then you'll see it come back up. That's the expectation.

Bradley Ball - Evercore Partners Inc.

Do you have a sort of ultimate goal for the portfolio? I think you probably -- what co-signed now in the 60% range or so?

Jonathan Clark

Yes. We don't have a target for that percentage. It comes out the way it comes out because of the way we do our underwriting to that. So it's pretty hard to if you're -- to answer your question, do I expect that we're going to go back to going -- our go-forward rate will be anything like our legacy portfolio, i.e., 55%, 60%? No, I don't expect that. I expect that we'll be in the same ZIP code that you're seeing today.

Albert Lord

Brad, in terms of cosigner policy, it's not in terms of overall percentages at all, as John said. I'd ask you to think about it this way, we underwrite to improve -- to be sure we improve the collectibility of loans. So we have come to the conclusion, as you'll well aware and it's really part of the secret sauce of our business, that young people who graduate pay their loans, repay their loans. Those who don't have a far lower propensity to pay. So we are less demanding of cosigners in a student's junior and senior year than we are a freshman, as you might guess. And so the extent that number may move around, it probably moves around with respect to the mix of the assets that we're putting on in a given period. And how that number turns out, whether it's 81 or 85 or 72, really will depend on the mix of assets that we're adding. And that mix changes over time as our borrowers effectively serialize going through school.

John Remondi

Just one more detail. The second quarter's -- the co-borrower rate in the second quarter 2011 was actually higher than the second quarter 2010 to Jon's seasonality.

Bradley Ball - Evercore Partners Inc.

What was it in 2Q '10?

John Remondi

77 versus 80.

Operator

Your next question is from the line of Alan Straus of Omega.

Alan Straus -

When you know what the true-up will be on the reserve, will you prerelease or give us a conference to give us a better understanding so we're not surprised when you put out third quarter earnings and have to understand it?

Albert Lord

Yes, Alan, I see that you guys brought out the A team today. If we're surprised and if we had to alter our guidance in any way, shape or form, yes, we would make the appropriate disclosure. But otherwise, I think you'll get to see this at the end of the quarter. But I don't see any -- I don't intend to be surprised.

Alan Straus -

No, it just gives us all further understanding of how to focus on that, just as a one-time event instead of a complete focus during the third quarter call.

Albert Lord

Well, it's starting to dominate the second quarter call, isn't it?

Alan Straus -

Great. Okay, the other question is just given that the company is returning totally back to like a normalized level, is there some seasonality we should be aware of for the second half of the year?

Albert Lord

That's a good question. That's a very good question, Alan. What's the answer, Jack?

John Remondi

I mean, absolutely. We've got operating -- I mean, third quarter is our peak operating expense year, and operating expenses are higher in Q3 than you'll see in Q2 or 4. Loan volume will come in a little bit in that area, but you won't get the earnings contribution until Q4 for new originations.

Operator

Your next question is from the line of Sameer Gokhale of KBW.

Sameer Gokhale - Keefe, Bruyette, & Woods, Inc.

I think most of my questions have been answered. Just a couple of them. Firstly, in terms of the loan products that you're offering, I know a couple of companies came out with a fixed-rate private student loan product held [ph] in U.S. bank, I think. Are you offering those kinds of products currently? What kind of scope do you see for those kind of products if students are going to be protected from a rising rate environment? Just a bit curious on what your thoughts are regarding that kind of offering.

Jonathan Clark

We're currently investigating that as an alternative. And if we -- and evaluating -- what we'd like to do is offer a full suite of products to our students, provided that there is -- that we think there really is demand for it, then we think it's a good product to offer. We are currently looking at that. We very well may offer that product. But at the end of the day, it will be, as I think you'll see if you look at the pricing of the folks who are offering it, they are clearly pricing it to appropriately enough to cover the risks and costs associated with originating a product like that. And after we complete the analysis, we'll figure out whether it makes sense to offer a product like that as well.

Sameer Gokhale - Keefe, Bruyette, & Woods, Inc.

Thanks, Jon. And then maybe a question for Jack on

the new product offerings, as far as the credit card business, that you were trying to market those credit cards for your own portfolio. I know it's a pretty recent program. But what kind of traction are you getting there in terms of your cross-selling efforts?

John Remondi

Well, the first big effort on that front is going to occur as we enter the peak origination season and market cross-sell credit cards to our new -- to parents of our new private student loan borrowers. So we'll have better information and flow on that coming up in the next quarter's call. We're also just getting ready to launch on the 529 side of the equation, linked cards, and that I think will show some results there. Where we have seen very tremendous success in the past is on the Upromise card, and how that gets linked to Upromise accounts. And those people who use the card in combination with that service are amongst the highest savers. So we would expect to see pretty good traction once people become aware of the products. And just the balances that I mentioned earlier of how much the average account holder redeemed from the Upromise account last quarter. I think those are not insignificant dollar amounts. Those are not charges to the company either, those are rewards that are earned in our programs that are earnings generators for us, not expense generators for us. So we're pretty pleased with the way that's working out, and I think we've got a lot of -- we can get a lot of mileage out of that with customers who begin to disclose that data.

Sameer Gokhale - Keefe, Bruyette, & Woods, Inc.

That's pretty helpful color, Jack. And then maybe a question for Al because I know he loves to talk about the accounting book. Say there's $95 million or so charged for the additional provisioning, the one-time charge -- I mean, what I'm curious about is the release talked about how the provision would be applied retrospectively to January 1. But it looks like you expect to take the provisioning charge actually in Q3. So is it just going to be a change in accounting estimate? Or it seems like it's going to be a reinstatement of prior Q1 results or anything like that, is that right?

Albert Lord

You're probably ahead of me on the actual accounting structure here, but I'm told -- because we became aware of this in the first quarter, but it hasn't been clear -- frankly, it's not all that clear at the moment. It's not 100% clear. But I'm also told that you couldn't do this before the third quarter, and that it related only to Q1 through Q2. Now ultimately, a lot of our loans have forbearance. And if, in fact, we were to grant additional forbearance to any loans that have already been through there, it brings them into the mix. I really want to caveat all of this, though, by reminding you and everyone else that this is a nice reserve that we have now. It gets nicer. I view it -- notwithstanding the fact that subsequent forbearances might have to have a higher reserves, I view it as a one-time adjustment. And I would also caution you, Sameer, not to just to do the fundamental arithmetic of the differences in earnings per share on a kind of an extrapolated basis and assign it all to this accounting adjustment.

Operator

Your next question is from the line of David Hochstim of Buckingham Research.

David Hochstim - Buckingham Research Group, Inc.

I wonder, could you just give us some color on the growth in loan origination year-over-year in the quarter and how much the new deferred interest product contributed to that?

John Remondi

Well, we think there's been a variety of factors. I think it's not just the product mix that we are offering. And I would say that most of the deferred side of the equation is going to be disbursed component versus actually disbursed during the quarter. It helped application flows that will come and be disbursed in August and September. Most, I think, of what we've seen in terms of applications is a better quality mix of applicants. So we're seeing a higher percentage of applications coming from the schools that are in our sweet spot and in customers coming with qualified co-borrowers. We recently revamped our online application process to make that work more smoothly with fewer steps, and so completion rates in that area have been higher. We also changed our pricing to have better pricing across the board, with the biggest impacts coming in kind of the middle. And so acceptance rates of our offers have increased substantially as well. So the combination of those factors have been the big drivers for volume in Q2, and we expect will be contributors in Q3 as well.

David Hochstim - Buckingham Research Group, Inc.

Should we see the same kind of year-over-year growth then in Q3?

John Remondi

That part's hard to say at this early stage. I mean, last year, we saw that was still -- at the end of the academic year, we saw that there was still a fair amount of capacity in the FFELP or the federal loan program, so borrowers were not at, on average, weren't hitting their maximum dollar amount. So we'll have to see how that translates. We're just in the first few weeks of application flows for peak season. And generally, we're very happy with what we see so far. But 20% is a big number.

Albert Lord

David, this is Al. Your question is the $64 question. And we don't know the answer to it, and we're delighted with the results of the recent quarters. But we don't know that they're totally representative quarters. If they were representative quarters, it'd be a lot easier to extrapolate. So the answer to your question, as I suggested earlier, is going to be learned throughout this quarter. I only hope the answer to your question is, yes, you can extrapolate those growth rates.

David Hochstim - Buckingham Research Group, Inc.

Okay. And then you were kind enough to remind us that about 70% of charge-offs occur within the first year, can you provide us what the percentages after 2 years?

Jonathan Clark

Well, if you look at our -- we do provide some information on that front in the quarterly spreadsheets under the loan seasoning. You can see in that report that -- where the charge-off rate, for example, was 6.2% for loans in the first year of repayment and 3.6% the next year. So we're seeing -- you see a dramatic dropoff in those levels overall.

David Hochstim - Buckingham Research Group, Inc.

So the cumulative charge-offs through year 2 would be 80% or 90% then?

Jonathan Clark

It would be another 50 -- it will be about 85%.

Operator

Your next question is from the line up Eric Beardsley of Barclays Capital.

Eric Beardsley - Barclays Capital

It looks like you stopped growing the retail deposits this past quarter. I was wondering if there's anything strategic there, if it was just seasonal due to, I guess, the weak quarter in originations typically in Q2.

Jonathan Clark

Yes, candidly, the strategic part of it is that we're sitting on way too much cash. So I expect going forward -- but going forward, we will be increasing our retail deposits. And if you've noticed that we also have not been as involved in the brokered CD market. And going forward, I expect we will begin to reaccess that as well. But candidly, we were just sitting on a lot of cash that we had put in place in anticipation of some volume, and then we layered on the retail deposits, a segment, which we strategically wanted to grow. And then we got the point where we were quite frankly just sitting on so much cash, we just had to bleed off some before we could move forward.

Eric Beardsley - Barclays Capital

Got it. And I guess, how much brokerage do you plan on putting to the deferred loan products during the season?

Jonathan Clark

Not a question of how much focus. I'm actually very excited about our product set because if you go on to our website, you'll see that when the student gets to the end of the process and they've been under there, and they have a choice, that's a critical choice of several products. And they choose to select a deferred product, but they are presented with all the information they should need to make a truly informed decision about which loan product to take. So they will see how much it costs, how much more it might cost to do a full deferral versus paying interest fully in school, as an example. Their monthly payment, there are cumulative financial charges when they pay us using one alternative versus another. So we're not targeting one, we're just trying to provide a palette of alternatives to our customer base, and it's been very well-received.

Albert Lord

It's still early in the season, but we're seeing the deferred -- people who are choosing deferred are really coming from the fixed payoffs and the $25 monthly payment, so we're still seeing very strong participation and the interest of people choosing interest-only. I think it's because of what Jon mentioned, they're seeing the total finance charges be substantially lower for that product.

Operator

Your next question is from the line of Ed Groshans of Height.

Edwin Groshans - Height Analytics, LLC

Today is July 21, and we're getting the Consumer Financial Protection Bureau coming into fruition today. And Elizabeth Warren, who is the adviser to this new bureau, consistently talks about student lending as one of the areas that she wants to address going forward. I was wondering if you have had any conversations with the new agency, what those conversations revolved around. And then what are the some of the things that they might be looking at that they think is consumer-unfriendly about the private student loan business?

Albert Lord

And I forgot that this is a monumental day, that they start their operation today. And we hear about student loans all the time in this realm, and we know that student loans are on the radar screen. And quite honestly if, in fact, this agency issues or sets parameters, whatever parameters and whatever issues they have -- and I'm going to ask Jack to explain it. He has actually talked with Elizabeth Warren about this. This is a company that has absolutely nothing to hide. It discloses everything. The compliance issues that this company and others tend to have are confusion with the rules. If there is more explicit guidance about what it is that we do with respect to our relationships with our customers and our customers' ability to expect what we are delivering to them, I see this as a positive. Now that's my view of it, my common sense answer. That's not the way things always work out with the various and sundry regulatory bodies. But at this stage, let's hope for the best. And let's hope that this operation actually maybe consolidates some authority and can give us crystal-clear guidance. We've been through a raft of issues over a long period of time, where we thought we were doing exactly the right thing based on trying to have a lifelong relationship with young people. We don't think that it's in our interest to deal with them in some way, other than the most forthright way. If there's some guidance and there's something for us to be gained or there's something to be gained for us and for the rest of the student lending community, I welcome it, I truly welcome it. And thanks for reminding me that today's the day. Jack?

John Remondi

I think our conversations had been along what we've been doing all along. And I think we start with the premises, we don't make money when we make a bad loan. So we try to remind people of that as a starting point. All of the rest of the way, what we've really got designed, what we've done is show how we are responsibly advising borrowers, students and their families about the cost of various products and how to finance their education. So even today, we've always followed this process of 1, 2, 3, for example. Take free money first; grants, other forms of aid, federal student loan, second; and if you need to borrow, additionally, you borrow private loans. We still follow that same approach, even though that we're not making federal loans today. I think the disclosures that Jon mentioned, so that when a borrower and their parent come in and apply for a loan, before they choose which rate, which option they want, they see the cost of all 3 products. They see the lower interest rate for interest-only, they see the lower finance charges, they can make a more informed decision on that front. We offer borrowers and students a product called the education investment plan, which allows them to go in and map out the full cost of whatever education they're pursuing. And we encourage them to think about the full 4 years, not the current semester's bill. And we give them guidance as to whether or not that total amount of debt that they plan on taking on is appropriate for the program or study that they're in and the school that they're attending. So I think, when you kind of look at that, that really, the watchword that we use is responsible. We want our customers -- we make money, when our customers borrow and use finance products responsibly, and that's the approach that we've been following.

Edwin Groshans - Height Analytics, LLC

And I appreciate that, Jack. It's just in many of her speeches, and we did attend a meeting with her earlier this week, the consistent theme is student lending and payday lending. And now one, it's not good to be lumped into the same bucket with the payday lenders, right? I think the products are significantly different and the clientele and how they're being serviced is significantly different. But it does seem like there is something in student lending that raises the eyebrow and continues to be spoken about by Elizabeth Warren that, I guess, raises a concern at least in my mind.

Albert Lord

So, look, we have the same uneasiness about such things. And there's no question that there are certain things in society that, whether it's healthcare or education or other things, that get -- where there are widely divergent points of view about the business in those areas. I mean, we're all talking about what someone might do. It's my point of view that we should give them every chance to do the right things. You've used some of words that already sort of tightened the throat when you put student loans and payday loans within a couple of words of one another.

Edwin Groshans - Height Analytics, LLC

Not me, Al.

Albert Lord

Well, yes, but you reminded me. The company has been -- we've been -- next year, we will celebrate our 40th year of being in business. This company and other companies do well when they earn reasonable margins for a long period of time, not deceptive margins for a short period of time. That is not the nature of this business. And I know you're not the one that needs to be convinced. My feeling is that this will force a clarification of what it is that some may think needs to be adjusted. We think we set the standard for, as Jack said, responsibility and reliability. And that's who we are and that's who we've been for 40 years.

Operator

That was our final question. Presenters, do you have any closing remarks?

Steven McGarry

Thank you very much, Tiffany. No, we have no closing remarks. That concludes our call. If you have any follow-up questions, please contact myself or Joe Fisher. Thank you, everybody.

Operator

This concludes today's conference call. You may now disconnect.

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