First Marblehead: Mea Culpa

The recent, dramatic gyrations in the stock price of First Marblehead (FMD) have prompted me to re-evaluate the company. FMD's stock price first declined when an FBR analyst delivered a report which stated that TERI may not have enough cash to cover its obligations in the face of losses which are running above expectations in some of FMD's previously securitized trusts. The stock price took a further dive when the CEO announced that a securitization is unlikely in the fourth quarter due to a challenging market and further cut FMD's dividend (the dividend has since been completely eliminated after the next quarter). Clearly, I have severely underestimated the market's reaction to the subprime crisis in my last analysis. I have failed to anticipate that the market will be scared off student loans, because I was misled by the fact that the latest securitization by FMD was a large one executed after the subprime crisis broke, and failed to consider that the terms were probably fixed before the crisis. A second development that I failed to foresee is the uptick in credit losses in the loan trusts; I had felt that the student loans were substantially different in nature from mortgages that the same crisis will not be repeated in the student loan market.

Will the fundamentals of the student loan market deteriorate along the lines of the mortgage market? I do not think so. The mortgage market faced a sudden dramatic rise in defaults as a result of a combination of looser underwriting standards in 2005-2006, and more importantly, the resetting of the teaser loan rates. There is no evidence of looser underwriting standards in the student loan market, and student loans are floating interest rate loans, so there will not be a sudden payment shock unless the Fed dramatically raises short-term rates. When a home-owner cannot make mortgage payments, and the current house value has dropped below the value of the loan, he is financially incentivized to hand the house over to the bank and just walk away from the loan. Student loans are not dischargeable even in bankruptcy, so the only real way to avoid payment is to earn only a subsistence level income for the rest of one's life (otherwise lenders can simply garnish interest from income). Because of these financial characteristics, I believe that student loans will not deteriorate in the same dramatic all-or-none fashion that the mortgage market had, and the recent uptick in credit losses is probably just short-term noise, and unsupported by fundamentals. Indeed Tom Brown has pointed out that FMD's loan trusts may not actually be underperforming as the FBR analyst Matt Snowling has alleged. This line of reasoning is supported by the fact that the FMD stock price did not take an immediate dive after Fitch lowered TERI's rating from A+ to A back in October 2007; the market probably perceived that as mainly showmanship and believed that losses to FMD's trusts are unlikely. The only scenario where I see FMD's trusts substantially underperforming is in a full blown recession with increasing unemployment rates, and even then, the losses are unlikely to be dramatic and sharp, but rather slight and incremental. Student loans are typically made out to those majoring in fields most likely to land a job and survive a recession.

Will the student loan market thaw eventually? In all previous episodes where investors have suffered dramatic losses in bonds (the junk bond crisis of the 1980s, the Russian bond default of the 1990s, the periodic Asian currency crises leading to severe losses in their bonds), the markets have subsequently recovered as the investors learnt to reprice risk. In this particular case, investors have not even begun to suffer any appreciable losses in their investments. Furthermore, this is not just any bond market, it is a securitization market the government itself started by setting up Sallie Mae, because it felt that investing in human capital is important enough an aim to deserve governmental intervention. While the government later decided that private markets will serve the same aim more efficiently (and hence privatized Sallie Mae), it is likely that the government will intervene once again if it sees that a critical source of funding required to maximize human potential has dried up. Hence, I see the question of unfreezing as a matter of when, not if. Especially after the recent cash infusion by Goldman Sachs, it is clear that FMD will be able to cover operating expenses until the market thaws.

How will FMD fare once the markets have unfrozen? Even after the recent bounce in the stock price, the market is applying such a low PE to future earnings that it is essentially discounting a large probability that the market will never recover, or that revenues will be severely impacted. Regarding FMD's future revenue and profit margins, as well as the time frame over which revenues recovers, this is an area where reasonable people can disagree. However, given FMD's proprietary database required to price student loans, its tested technology platform over which loans can be processed, and its ongoing relationship with bankers, it is likely that FMD will continue to play a major role in the student loan market (especially considering SLM's recent dismal performance). Though the upside is difficult to predict, I think that it is unlikely that the stock price will breach the book value of around $10 on the downside. There may be a slight decline at the end of the year as capital losses are taken for tax reasons, but there should be a bounce in January 2008, especially if there are signs that the recent Fed auctions have succeeded in resolving the credit crunch, hence lowering the risk of recession.

The FMD situation has taught me a lesson in money management. In hindsight, I was foolish and greedy to increase my FMD holdings to double my usual portfolio position, simply because I deemed it to be very attractive from a value perspective. The only redeeming fact is that FMD is the only financial in my portfolio, so while its recent dramatic decline is painful, at least I have not sustained the very large losses of concentrated portfolios like Tom Brown's Second Curve. It appears that the bears have won the day (in the short term), and have realized a return of over 50% in a few months. Nonetheless, I believe that the stock will recover from its recent lows. From a fundamentals viewpoint, as long as the economy doesn't enter a recession and educational costs continue to spiral, I see no reason why FMD will not be a good investment in the long term.

Disclosure: Author has a long position in FMD

Comments

[valuenut]

Where was this dude Friday when the stock went back to 19?

FMD is a buy here for investors with even a minimal time horizon.

[User 135308]

"There is no evidence of looser underwriting standards in the student loan market..."

Those Astrive and Monticello ads on TV look an awful lot like teaser loans for mortgages. "Hey, deferred repayment! Get a loan! Buy a new laptop! Don't worry about making any payments until after college! Yes, live for the moment!"

This looks fairly insane to me considering the absurd laxity in lending standards this country has experienced over the last couple of years.