First Marblehead Corp. F3Q08 (Qtr End 03/31/08) Earnings Call Transcript

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First Marblehead Corp. (NYSE:FMD) F3Q08 (Qtr End 03/31/08) Earnings Call May 8, 2008 5:00 PM ET


Peter Tarr - Chairman and General Counsel

Jack Kopnisky - President and CEO

John Hupalo - Sr. EVP and CFO

Ken Klipper - Treasurer and CAO


Matt Snowling - FBR Capital Markets

Mike Taiano - Sandler O'Neill


Good day, ladies and gentlemen. Welcome to the First Marblehead Corporation's Third Quarter Fiscal 2008 Earnings Call. My name is Denise and I will be your coordinator for today. At this time, all participants are in listen-only mode. We will be conducting a question and answer session towards the end of this conference. (Operator Instructions) As a reminder this conference is being recorded for replay purposes.

On today's call, we have Mr. Jack Kopnisky, President and Chief Executive Officer, and Mr. John Hupalo, Senior Executive Vice President and Chief Financial Officer.

I would now like to turn the presentation over to your host for today's call, Mr. Peter Tarr, Chairman and General Counsel. Please proceed sir.

Peter Tarr

Thank you. Good afternoon. Welcome to the First Marblehead earnings call for the third quarter of fiscal 2008. Jack Kopnisky, President and CEO; and John Hupalo, CFO will be participating on this call. Ken Klipper, Treasurer and Chief Accounting Officer is also with us.

Various remarks that we make about the company's future expectations, plans, and prospects constitute forward-looking statements for the purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in the company's 10-Q for the quarter ended December 31, 2007, under the caption risk factors, which is on file with the SEC.

Any forward-looking statements represent our views only as of today and should not be relied upon as representing our views as of any subsequent date. While we may elect to update these forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our views change. Therefore, you should not rely upon these forward-looking statements as representing our views as of any date subsequent to today.

I will now turn the call over to Jack.

Jack Kopnisky

Good afternoon, everyone and thank you for joining the call today. In addition to our earnings press release, we have a presentation that accompanies our comments available on the web at

Today my comments will focus on our results for the quarter, the actions we have taken and our strategy for the company moving forward. Then I will turn it over to our CFO, John Hupalo, who will provide more details about our results.

Our operating results in the quarter were very disappointing. The company recorded a net loss of $229.6 million for the quarter or $2.36 per fully diluted share. This loss was largely a result of $315 million pre-tax write-down of the company's service receivables due to changes in certain assumptions used in estimating their fair market value and the write-down of $66 million for certain expenses normally expensed against revenues from securitization. The changes were made to reflect the current consumer credit and capital markets environment.

Net income after taxes would have been $3.8 million or $0.04 per fully diluted share without those adjustments. John will provide additional details relating to this decline in value of the service receivables in a few moments.

Our earnings this fiscal quarter continue to be affected by the market dislocation, which has resulted in our inability to securitized in the third quarter and the bankruptcy filing by our contracted loan guarantor, the education resource institute or TERI on April 7, 2008. The TERI bankruptcy has caused significant challenges to our business that we have been sorting through over the past four weeks and will continue to work through in the coming months.

This has become the most challenging environment many of us have witnessed as the capital markets have been significantly dislocated since late 2007. As a result of this environment capital for new loans is both scarce and if available expensive, without a liquid securitization market to monetize both Federal and private student loans, lenders are forced to retain these assets on their balance sheets.

Demand for all types of student loans is extremely high, but capital to fund loans is scarce leading to a mismatch between demand and supply. While capital for many types of lending is limit, we believe the issue for student lending is acute. In addition, current economic conditions have and will continue to impact the performance of all classes of consumer loans including private student loans.

We have taken significant actions to adjust our business model to deal with the realities of this current environment. We continue to believe the demand for student loans and related service to the support education will continue to increase. This is good for the business we know best, financing student's education.

However, we also recognize that we remain in the extremely challenged situation that has been exasperated by the bankruptcy of our guarantor. The actions we have taken are designed to address the current situation of focusing on liquidity with the goal of achieving profitability in the future.

Now I want to outline the specific plan related to each action. First, we continue to work with GS Capital Partners to obtain the regulatory approvals and determination necessary for its additional investment into our company. The first step was its investment of $59.8 million in December 2007. The total investment by GS Capital Partners including its initial $59.8 million investment is capped by the terms of our investment agreement at an amount equal to 25% of our total stockholders equity.

Second, we announced on Monday, May 5th, a significant reduction in our overall cost structure. This is the second cost alignment initiative in the past six months. In December, we froze all open positions. In February, reduced the overall cost structure on an annualized basis by 20% by eliminating a 130 positions and other costs.

Our announcement this week reduced cost on an annualized basis by an additional 40% and resulted in the elimination of 500 positions. In total over the past five months a cost reduction of 60% on an annualized basis.

This was a necessary decision taken to preserve cash and to align expenses with revenue in light of the challenges we face. We maintain a core operating team that will utilize the significant investments we have made in marketing, processing and capital markets to drive this company forward. The level of cost reduction is targeted with design to generate positive cash.

Third, given the TERI bankruptcy, we are working with our clients to provide an alternative to the TERI-guaranteed private student loan in the future. Because of the TERI bankruptcy and challenges in funding incremental loan volumes by lenders, a majority of our clients have decided to stop processing loans over the past four weeks. A number of clients have terminated their agreements including Bank of America, which has chosen to exit the private student lending market.

We are in discussions with RBS and Chase regarding ongoing business opportunities. However, they may elect to terminate their agreements in light of the TERI reorganization. For each of our clients, we are selling an alternative structure and value proposition for private loans that we expect will enable them to offer a product to borrowers in the school season. The product we have developed over the last two to three months is designed to be customized to the needs of each client and may include a third-party guarantor.

Fourth, we continue to seek alternative sources of funding. We will review warehouse options again once the GS investment is completed. However, in all frankness, we continue to struggle with the costs of these facilities in the current environment and the corporate risk they impose with mark-to-mark provisions and other terms.

We are also looking at options to reduce loans on the balance sheet of UFSB most likely facilitated through whole loan sales. We continue to work with each lender to define their balance sheet capacity to hold loans for a longer period of time.

Fifth, we continue to take actions on two fronts to improve delinquency and default levels in the portfolio. With regard to recently originated loans in December and again in March many clients increased the credit criteria for our loan origination. As a result, we observed average FICO scores for decision borrowers or co-borrowers moving from 709 in December to 726 in March.

Clients also increased pricing and are evaluating loan products designed by us which have incentives for immediate versus deferred repayment. Immediate repay loans default at approximately half the rate of deferred loans and as you would expect provide cash flow just after the loan is made instead of years into the life of the loan.

We have also been assertive in changing our collection processes. Professional collection firms are now contacting both borrowers and co-borrowers early in the process, in some cases even before they had a repayment. We have seeing early indications have reduced delinquency levels and early stage delinquency as a result of these actions. Overall, though delinquency levels are higher than previous years given the economic environment.

Defaults are also occurring earlier and at higher levels over the current quarter compared to prior years. We expect the underwriting changes we have made will affect future volume and that our new collection practices will improve performance in the existing portfolio overtime. We have allocated significant resources to manage the collections function to improve performance and remain committed to doing so in the future. We are also working with TERI to minimize disruption of the collection process during the bankruptcy.

Lastly while we continue to support high quality business-to-business client relationships, we are rapidly enhancing our business to consumer capabilities. Through the third fiscal quarter our proprietary brands originated $1 billion in volume or 24% of loans available for securitization. We are in discussions with the additional lenders to provide ongoing support for our proprietary originations.

Overall loan facilitation volume for the quarter was $1.25 billion up 23% over last year. The volume was significant given the underwriting changes. On a year-to-date basis volume was $4.7 billion up 37% over prior year. Given the continued challenges in credit markets and limited funding from lenders, we expect volumes to be down significantly over the next six months.

John Hupalo, will take you through more details of the quarter. Following his comments, I will share our vision for the future.

John Hupalo

Thank you, Jack and thank you to everyone who has taken the time to join the call today. This afternoon, I will discuss First Marblehead's financial performance for the third fiscal quarter and the nine month period ended March 31, 2008. I will begin now with some brief comments about the asset backed securities and auction rate markets, as well as the impact on the company of the TERI bankruptcy.

Unfortunately, the dislocation in the structured debt capital markets has persisted far longer than many of us could anticipate. This continued market dislocation has prevented us from accessing the securitization markets for second consecutive quarter with little relief seen in the near term. Generally, securitization market has been difficult for all who depend on it to fund consumer loan origination, but has been even more challenging to the originators of private student loans.

Volume in the first calendar quarter of 2008, for all asset backed securities was 73% below the first calendar quarter of 2007. From January 1st, through March 31st, 2008, five student loan transactions all collateralized by federally guaranteed student loans were completed for a par value issuance of $8 billion. For the same period in 2007, 17 transactions were completed with a par value of $22 billion. In April, self lenders completed four more transactions with a par value of $7 billion.

Our investment bankers tell us that the 2008 investor base for student loan backed securities is very thin. Sometimes, only one or two investors in the multi billion dollar self-transactions that have been done. Issuers are infusing capital into these transactions and were purchasing some of the offered securities to bring those deals to a successful conclusion.

Despite the onerous issuance requirements, our market does appear to be developing for federally guaranteed student loans. Structures are becoming more uniform and spread levels have begun to stabilize, albeit at very wide levels from a historical perspective.

Since our September transactions, we know of only one completed private student loan financing. Last week, the Rhode Island Student Authority offered $64 million of fixed rate tax exempt bonds to fund a state based private student loan program. Again, this is a relatively small tax exempt fixed rate transaction sold to an investor base that is substantially different from the typical buyers of private student loans asset backed securities.

Although as I just noted, there is some evidence of buying in the self student loan securitization market. The company is not likely to complete its securitization in the fourth fiscal quarter and cannot predict at this time when our next securitization will occur.

My last comment on the capital market is focused on the auction rate securities market. On the second quarter earnings call in January, we noted that deterioration in the auction rate securities market accelerated through year-end 2007 and was not improving at the time of the call on January 31. Since that time, the auction rate market has failed, with very little, if any, trading occurring on regularly scheduled auctions and many believe the impairment could well be permanent.

Five trusts facilitated by the company include some component of auction rate securities. In these transactions, the auction rate classes are now trading at the maximum rate on their current rating. Generally, the maximum rate is LIBOR plus 150 basis points for securities rated AA minus or better and LIBOR plus 250 basis points for securities rated less that AA minus. The maximum rate could increase if the ratings decrease.

Turning for a moment to TERI. The company is obviously very concerned with protecting the interest of our various constituencies during the TERI bankruptcy proceedings. The TERI reorganization has had significant implications for the company, including the following; the willingness of clients to continue to originate loans utilizing a TERI guarantee, the valuation of our service receivables, the ability to put in place permanent financing arrangements for loans originated but not yet securitized, the reimbursement of monthly origination costs that we receive under the master service agreement with TERI, the payment of default claims from segregated trust accounts, the payment of collection agency cost and also we are an unsecured creditor in the proceedings for approximately $15 million of pre-petition claims.

This background provides the necessary context for me to comment on First Marblehead's financial performance for the third fiscal quarter and the nine months ended March 31st, 2008. As Jack noted, First Marblehead posted a disappointing quarterly loss of $229.6 million or $2.36 per share. For the nine month period, the company lost $178 million or $1.88 per share. These results were driven predominantly by our inability to access the securitization markets, impact of the TERI bankruptcy and continued deterioration of consumer credit.

The largest component of a loss is a write-down of our service receivables. Please refer to slide 6, for details of these write-downs. As I have done in the past, I will review the package of key assumptions we use to determine the fair value of the service receivables.

For the third quarter, we did not change the assumptions regarding recovery rates or prepayment rates. Investors will recall that in the last fiscal quarter, we modify the shape of the prepayment curve, which have the effect of increasing the aggregate prepayment rate assumed for the entire portfolio from 8.4% to 8%.

We noted at the time that prepayment rates had been declining over the course of the prior calendar year, a trend that has not continued into early 2008 and we continue to evaluate this data. By far, the largest write-down of our service receivables resulted from TERI's sudden announcement of its filing for reorganization.

First Marblehead's previous assumption that TERI would pay trust for claims in excess of monies available in each trust segregated reserve from its general reserve is no longer appropriate. With TERI's bankruptcy, the company will now assume that the defaults occurring within each trust will only be reimbursed to the extent monies are available in each of the trust segregated reserves and associated recoveries.

In addition, certain trust require that as long as TERI is unable to pay the full claims and if the full rate exceeds certain thresholds, monies that would have been released as additional structure or advisory fees or residuals instead would be redirected to pay down outstanding debt. This has the impact of deferring the company's receipt of cash and extending materially to projected average life of the additional structural advisory fees and residuals.

As a result of these changes, we have projected the average life of the additional structural advisory fees will increase from six years to 12 years. We have projected that the average life of the residual will increase from 9 years to 15 years. The resulting write-down of the service receivables, because that this assumption change is approximately $220 million. Although, this is an appropriate adjustment in this period, we will view it as the reorganization progresses and we see the longer-term impact of our new collections initiatives.

The second largest negative adjustment to our service receivable results from the collapse of the auction rate securities market as previously discussed. We now assume the cost of debt for our outstanding auction rate securities will be at the maximum rates previously described for the life of the outstanding securities. The resulting write-down of the service receivables from this change in our assumption is $60 million.

With regard to defaults, we did not make a change in the aggregate weighted average net default rate. We believe the 7.7% cumulative net default rate end point, which was the result of the change last quarter, remains appropriate. Recently, we have observed that the shape of the default timing curve is changing. Like other consumer lenders portfolios, our private student loan portfolio is feeling the stress of the current negative economic climate.

For trusts that have a substantial quantity of loans in repayment, we would expect the end point default rate to exceed our previous assumption as our more rigorous collections practices had not had the time to fully effect those trusts in the short-run. We have therefore revised those end-point assumptions upward.

For portfolios more recently originated, we lowered the end-point default assumptions to account for what we expect to be better prevailing economic condition, once those loans enter repayment and more substantial default litigation resulting from our improved collection practices in place from the time the majority of those loans enter repayment.

The carrying value of our service receivables declined $6 million as a result of the modifications we made to the default timing curve. We will continue to evaluate our methodology for structuring the default timing curve as well as the default end points. We have also reduced the carrying value of our service receivables by approximately $36 million as a result of our decision to increase by 50 basis points and 100 basis points, respectively. The discount rates apply to our residuals and additional structural advisory fees.

We now apply a 13.5% discount rate for trust that did not issue BBB rated securities and a 14.5% discount rate to the trust that did offer BBB securities. We also increased the discount rate applied to the additional structural advisory fee by 100 basis points to the 10 year treasury plus 400 basis points. These adjustments were made due to the increase in our assumption about the weighted average life of the service receivables resulting from the change in the timing of the cash flows I mentioned earlier.

This is the second consecutive quarter for which we have increased the discount rates applied to the service receivables. The final adjustment to the valuation of the service receivables in this quarter was a positive adjustment of approximately $7 million to better align our assumption for certain cost and trust expenses that is other than loan servicing and trust administration fees with their actual costs.

Before concluding my remarks, I will comment on a few other items of note on the financial statements. First the parent company continues to benefit from a strong balance sheet with virtually no unsecured debt and approximately $162 million of unrestricted cash. As Jack indicated, upon receipt of regulatory approvals, we look forward to receiving the remaining equity infusion from Goldman Sachs Capital Partners. At that point, we would expect to have approximately $300 million of unrestricted cash on the balance sheet.

In light of our significantly reduced cash expense run rate for fiscal 2009, preliminarily projected to be in the range of approximately $100 million. The company expects to have sufficient cash available to fund operations. However, we also note that additional cash expenditures may be required to fund non-operating activities, such as further capitalizing UFSB, or completing loan financing activity, such as securitizations and our whole loan sales.

The amount or timing of these potential cash expenditures is unknown at this time. Our goal of course is to restructure the company to generate positive cash flows in the near term and restore long-term profitability. Second, given the events in the auction rate market, I simply note that First Marblehead does not hold any auction securities in its investment portfolio.

Third, I will briefly comment on Union Federal Savings Bank. From FMD's balance sheet perspective loans held for sale are UFSB's TERI-guaranteed private student loans. They are held at the lower cost to the market and are currently financed approximately 50% by UFSB deposits and 50% by the warehouse. As a result of the TERI bankruptcy, this warehouse facility is no longer available to UFSB to finance future loans.

The bank is trying to remove loans from its balance sheet. We continue to work diligently to identify potential opportunities to achieve this important goal which was made more difficult by TERI's bankruptcy.

With regard to non-interest expenses the $96 million of general and administrative expenses includes approximately $66 million of non-core expenses, some of which are related to our view that is appropriate to now expense items that would have been reimbursed through the securitization.

The items include $39 million of non-recoverable marketing costs, $8 million of guaranteed marketing premium payments to third party marketers, $5.8 million reserve related to un-reimbursed origination fees at UFSB and approximately $3.5 million of costs associated with losses on subleased space.

As a result of our decision not to close the Goldman Sachs warehouse commitment we also expensed the $10 fee in this quarter. Before concluding I would like to point out that we have updated the supplemental data that we discussed last time. We have also added information regarding our Master Trust and 2003-1 securitization both of which are private transactions.

We sold added FICO score distributions for calendar year 2007 as well as the first three months of 2008, and we have also added a compilation of trust payment status across the portfolio. We hope investors will find this information useful. Thank you again for participating in the call. I look forward to your questions.

Jack Kopnisky

Thanks, John, now moving on to the final slide. The events of the past six months have accelerated our transition from a mono line student loan provider to a more diversified education finance products and services company. This transition involves two over arching strategies. First; we expect to continue to be a leader in providing private student loans solutions.

Our primary emphasis has changed to providing student loans through the direct to consumer and school channel through our proprietary brands. To support this strategy, we continue to seek funding necessary to ensure students receive the right financing for their needs after accessing federal loans, grants, and scholarships. We will also continue to work with targeted lenders to support their brands by utilizing on a facilitation and private label process.

Our products will be flexible to support the needs of borrowers and lenders. We believe our customized process in developing value added consumer centric payment solution has and will continue to be a competitive advantage. Our goal is to continue to leverage our capital markets expertise as ABS investors return to the market in order to receive the maximum benefit from future transaction.

The second strategy is to leverage our core confidences in the areas of marketing, processing, and capital markets to drive incremental growth in revenue across the customer experience and value chain. Through our distinct marketing expertise, we plan to bring various product alternatives to our strive side, which has 3 million unique visitors annually.

We expect our marketing team will bring incremental fee income into the company by delivering a series of initiatives targeted at students in fiscal year 2009. Our processing platform is built to facilitate in excess of $10 billion of volume annually. We are now offering the processing services at non-profit schools, poor profit schools and to lenders who want to leverage their capital resources to provide loan solutions to students. We believe that there is a significant number of interested potential clients who want processing capabilities along with our ability to support the structuring of loan program and securitizations in the future.

Lastly, our capital markets group has proven their expertise over many years and transactions. As the model has shifted, our team will seek to use this expertise to generate incremental fee income. The transition of this company to a more diversified education finance products and services company will not happen overnight, but we have a great sense of urgency to drive change in this model.

Our competitive advantages are a strong balance sheet, which we expect to strengthen further after receiving Goldman Sachs Capital Partners final committed capital infusion, employees who are committed to aggressively growing the business, expertise in student loan marketing, robust loan processing capacity and a strong capital markets team, combined with a very strong consumer demand for private student loans and substantially less competition in this space, First Marblehead advantages in this position as well for the future. We anticipate that in the near term, we will continue to be, we anticipate that the near term will continue to be very challenging, but we look forward to improve results in the future.

Now let's open the line for questions.

Question-and-Answer Session


(Operator Instructions)Your first question comes from the line of Matt Snowling from FBR Capital Markets. Please proceed.

Matt Snowling - FBR Capital Markets

Yes. Hi. Good evening. Kenneth, I guess I have two questions. One, given the issues around liquidity and the growing backlog of loans that you need to sell, I guess I am just curious as to why you ended up facilitating so many loans this quarter. Is not it better to preserve cash at this point?

Ken Klipper

Well, we actually, by the nature of the underwriting changes we made. We were trying to turn down volume and as we had a very large portfolio of applications in December and January, the growth rates continue to decline as the months went on in that quarter.

Matt Snowling - FBR Capital Markets

So, should we see that the drop off happen this following quarter in the June quarter?

Ken Klipper


Matt Snowling - FBR Capital Markets

Okay. In terms of the announcement to cut $200 million of cost, can you tell us how much of that is really related to the TERI reimbursement fees?

Ken Klipper

Well, it does not relate to the TERI reimbursement fees at all. It is actually all class associated with pure expenses, the people, marketing, professional fees and other expenses.

Matt Snowling - FBR Capital Markets

I mean, do not you have roughly $150 million of cost that you are reimbursed for, from TERI?

Ken Klipper

It is based on what volume you have. So, it is a product of the volume that comes in.

Matt Snowling - FBR Capital Markets

Right, I guess my question is, if you are not working with TERI going forward, are you, the cost that you are taking out has nothing to do with those reimbursed fees, I guess.

Ken Klipper

Correct. What we are doing though understand the way these loans work as the fees that the borrowers pay fund part of the reserve and find operating cost. As we move forward with increased fees, there will be operating cost reimbursement as well as loan loss reserve reimbursement.

Matt Snowling - FBR Capital Markets

Okay. I can follow up later on that.

Peter Tarr

Feel free to do that Matt.

Matt Snowling - FBR Capital Markets



Your next question comes from the line of Mike Taiano from Sandler O'Neill. Please proceed.

Mike Taiano - Sandler O'Neill

Hi guys. Couple questions. First John, did you see any change at all in the way the pricing in the secondary market was following the Fed action last week on to allow to AAA, APS to be posted as collateral in the term facility.

John Hupalo

Yes, Mike, we are really supportive of all these different actions to increase liquidity. I think it is a little early though to see direct impact on particularly secondary market trading. We saw a very little secondary market trading over the course of last few months, although I think as you are suggesting last week, we did try to hear from some the dealers that there were some increased appetite for that kind of trading. I think, once the facility really takes hold and the dealers move in and clutch that collateral, we could see some increase trading there. It is a little early to tell.

Mike Taiano - Sandler O'Neill

Okay and then secondly, could you maybe just clarify what happened with the warehouse facilities that Goldman had committed to? It sound like in the press release as though that you had advised them in order to facilitate the regulatory approval and along the same lines could you maybe just update us on where that stands the regulatory approval at this point.

John Hupalo

That is it exactly. What you just said is exactly what we did. So we decided to not accept the offer to facilitate the approval. The regulatory approval we understand is fits with the OTF and FEIC and we await their approval on the transaction.

Mike Taiano - Sandler O'Neill

Okay. Well, I guess I have just, some trouble understanding why that Goldman providing a warehouse facility would have held up the approval, I would have thought that would be a good thing.

John Hupalo

No, we are not going to comment on that. It is really Goldman's comment to make.

Mike Taiano - Sandler O'Neill

Okay. Then just lastly on, you talked about potentially recapitalizing the drift, is that something that you are, the regulators have approached you about or is it something, you are anticipating having to write down private loans further or what, how would that come about?

John Hupalo

Mike what we are trying to indicate there is that, we have capitalized a drifts at the levels that are appropriate at this point, and if there are additional loans that can be funded at the bank, that is might require additional capital to keep those ratios in line. So, it is not a matter of recapitalizing the bank. The bank is appropriately capitalized at this point.

Mike Taiano - Sandler O'Neill

Okay. So, it will just be related to new loans that you put in the banks?

John Hupalo

At this point, that would be our anticipation. That is right.

Mike Taiano - Sandler O'Neill

Okay. Great, thanks a lot.


(Operator Instructions) At this time, we have no further questions in queue. I will now turn the call over to Mr. Kopnisky for closing remarks.

Jack Kopnisky

Just, thank you for joining the call. Thanks.


Thank you for your participations in today's conference. This concludes the presentation and you may now disconnect. Have a great day.

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