First Marblehead Fights to Free Itself from Credit Market Whims

The future of First Marblehead (NYSE: FMD), as most investors already realize, is tied to the reopening of the student loan ABS market, GS Capital’s investments and the company’s ability to expand its direct to consumer lending platform. Another incredibly important development for the company will be whether or not it is successful in its quest to expand its wholly owned bank subsidiary company.

Union Federal Savings Bank is a community bank out of Rhode Island that First Marblehead acquired in late 2006. While a detailed analysis of the bank’s financial position cannot be found in First Marblehead’s annual or quarterly report, one can be found by going to the Federal Financial Institutions Examination Council's website, which can be found here, and by searching for “Union Federal Savings Bank.”

The most recent report for the quarter ended 3/31/08, put online this last week, shows startling signs of a management team that is acutely aware of the struggles First Marblehead is facing. The manner in which management is using the bank shows a glimmer of hope for the company’s future. With the current student loan ABS market unavailable for securitization, the company, in order to keep originating its private label student loans, must have stable funding sources. The deposits down at the subsidiary bank along with the easily accessible loans under the category “other borrowings” (which are most likely borrowings from other financial institutions), have allowed First Marblehead to begin working towards a secure funding source free from the whims of the credit market.

If management can keep up what they have been doing at the bank during the last quarter for the remainder of the year, they just might get through this dark period in the company’s history.

Companies like First Marblehead are offered two sources when originating loans. They can either place them on warehouse loan facilities or fund them through deposits at subsidiary institutions. Using warehouse loan facilities is considerably riskier than using deposits-based funding methods. Generally, warehouse loan facilities require large upfront fees, carry considerably higher interest rates than bank deposits and can be pulled by the lending institution relatively easily, leaving a company like First Marblehead exposed. Deposits at a bank subsidiary, especially if they are longer term CDs, pose none of these dangers.

First Marblehead first began to seriously exploit the benefits offered by having a bank subsidiary late last year. This can be seen in the report for the period ended on 12/31/07. During the last quarter of 2007, the company borrowed $240 odd million dollars in the form of “other borrowings” (which is likely borrowings from another financial institution). When these borrowings (which are practically the same as deposits) are coupled with the $150 million in deposits already at the bank, First Marblehead was able to have the bank raise the number of student loans it held to nearly $350 million.

In a curious side note that should not be unexpected, Union Federal Savings holds only student loans on its balance sheet with commercial and residential loans virtually nonexistent. It is safe to say that Union Federal is not exactly your local community bank. The bank’s equity stood at about $52 million at 12/31/07, giving Union Federal a tier one capital ratio of 10.95%, with cash on hand of about $76 million.

In the most recent report filed with FFIEC and posted online earlier this week, the bank’s balance sheet showed significant growth. The report shows that management is aware of the issues that the company is facing and has begun to work towards a long-term stable funding source in the form of bank deposits. For the quarter ended 3/31/08, the bank had “other borrowings” of about $240 million. While “other borrowings” was flat for the quarter, deposits soared to over $270 million, an increase of over $120 million from the previous quarter.

It is unclear where these deposits have come from, but I would imagine that they have been brokered. I would not be surprised to find out the Goldman Sachs (GS) helped with this, as they have already completed their first investment in First Marblehead and certainly don’t want to see that $50+ million dollars turn out to be a total loss. In addition, Union Federal showed an equity increase of $66 million for the quarter, bringing the bank’s total equity to $118 million, as opposed to $52 million in the quarter ended 12/31/07. First Marblehead likely contributed this capital to appease bank regulators and support further deposit and loan growth.

The new deposits and equity contribution allowed the bank to expand the number of student loans that it held at the quarter ended 3/31/08 to nearly $500 million, $150 million more than the quarter ended 12/31/07. The bank’s tier one capital ratio stood at 17.98% for the quarter, up substantially from 10.95% the previous quarter and well above the bare minimum of 6%. This leaves the bank with ample room to increase its balance sheet, especially with cash on hand of nearly $120 million.

While owning a bank stuffed full of student loans may seem strange, it could potentially prove to be a unique advantage for First Marblehead. While student loans do become delinquent, they are for the most part fairly safe, as they cannot be wiped off by bankruptcy. In the quarter ended 3/31/08, the bank had net income of over $2.5 million, driven by the substantially higher interest rates on student loans as compared to other forms of bank loans. As the loans age, the students who hold the loans leave college and enter the workforce, and the deferment on their student loans stop, the cash flow at the bank subsidiary should soar.

With the addition of further brokered deposits in the current quarter, First Marblehead should find itself as well positioned as could be hoped for given the circumstances in the credit market. The current deposit base and the future growth that will likely occur over the next several quarters at a minimum signals First Marblehead’s survival as a private consumer based student lender. While the deposit base leaves much to be desired, it is a start in the right direction. I only wish that the company had the ability to purchase Fremont’s bank division, sold to CapitalSource (NYSE: CSE) at a fire sale price earlier this year.

Please check the next report filed with the FFIEC in mid August, as it should tell an interesting story and will likely go a long way to letting us know whether or not First Marblehead will survive as an independent company. In the meantime, we can as investors in First Marblehead only hope that the remainder of Goldman Sach’s investment closes in June and that the student loan ABS market begins to open.

For Further Review: FFIEC Website

Disclosure: Long FMD

Comments

[highalpine]

Interesting article and analysis. The Savings bank must be providing a temporary haven for loan origination, however, it's capital base is insufficient to allow FMD to return to the origination volume that used to drive it's eranings. Further, the allowance for loan losses on Union's balance sheet is probably way low for the losses that the student loan portfolio will eventually show. Just look at the delinquincies revealed in the company's disclosures of it's securitization trusts (in Jan). That's probably why the T-1 capital has been raised so high at the savings bank. I agree that Goldie is probably helping to direct brokered deposits (a.k.a. Hot Money) to the savings bank. In my opinion, it's a good TEMPORARY tactic to gain some time, however, if the capital markets don't open up eveneually, FMD unfortunately will probably not make it. Finally, I thought the CapitalSource-Fremont deal cratered. I could be wrong, or do I have my faxed mixed up with the ier One acquisition?

[PrudentSpeculations]

Thanks for your comment. You are right, the bank is really only a temporary fix until the credit markets open up. If the surge in deposits that occurred last quarter is a sign of things to come then they may just survive to originate another day.

In regards to CapitalSource, the Tier One deal fell through and the Fremont deal took its place. The Fremont deal will be huge for CapitalSource.

[maz]

I'm not so sure that you can look at defaults/delinquencies in the 2005-7 Trusts and extrapolate them to the loans on the banks books as underwriting standards from August 2007 on were tightened up considerably plus the interest rates are higher. Still they could be under-reserved