Making Money The Sallie Mae Way
[Ed. note: We’re republishing this piece this morning as it had the unfortunate challenge of competing with the final hockey game last night. The student loan system is an emerging topic of importance to students, faculty, staff and relevance to the financial industry and to a number of politicians — like Sen. Evan Bayh.]
Sallie Mae, the nation’s largest student loan company, is fighting to defeat President Obama’s plan to cut subsidies to private lenders of student loans. Currently, private lenders get all kinds of government subsidies, and Sallie Mae wants them all, even if it means less money for Pell Grants for our kids. To help us understand what’s at stake, I’ve been reading their SEC filings.
Sallie Mae (ticker symbol SLM) is a giant finance company. It borrows money from banks and investors, and gets more from its wholly-owned bank, and lends it to students at public and private schools at fixed interest rates. Much of its borrowing bears interest at floating rates, and some of the money it borrows is from overseas, in Euros, for example. It hedges the risk of floating rates and currency fluctuations with derivatives, primarily interest rate swaps and currency swaps.
SLM makes money in two ways: a) it profits if the total interest it pays to borrow money is less than the total interest it gets from the loans it makes to students; and b) it earns servicing fees on loans it has made and for servicing loans other companies make. In its most recent 10-K covering the year 2008, Sallie Mae says it is the nation’s largest servicer of student loans. P.6.
This .pdf document shows on lines 4-24 the income statement for the full year 2009 from SLM’s Earnings Release. SLM doesn’t report its earnings for its servicing business separately from its loan business. Making it even harder to understand, it classifies a remarkably large amount of revenue as “Other” (line 23 on the .pdf), which includes income that is attributable to the loan portfolio and to servicing income (10-K, Note 14, P. F-73). I have allocated “Other”, in part by annualizing the results on the 9/30/09 10-Q, showing my work on the .pdf.
Surprisingly, servicing income for 2009 is about $266 million greater than income from the loan portfolio. One big reason is losses from derivatives and hedging of its borrowings, $604.5 million in 2009 (line 19). That loss exceeds its net interest income after provision for loan losses of $603.8 million (line 15). Unimpressive.
It is easy to see the nature of the loan business in the financial statements. SLM borrows from a number of sources, including banks, the federal government, foreign lenders, and the shadow banking system. 10-K, P. F-44. A large part of its loans have been transferred to securitized asset trusts. SLM consolidates a number of these trusts on its own financial statements, despite the sale. The rest probably will be consolidated going forward. 10-Q, Note 1, P. 7-8.
The goal of the loan business is to lend at a higher rate than the rate it pays to borrow. That proved to be a serious problem, beginning in 2008. Its sources of borrowing were drying up, and SLM was in trouble. It was saved by the federal government, which created several programs to help student loan companies, as part of the TARP bailout and under a separate law, the Ensuring Continued Access to Student Loans Act. 10-Q P. 113 et seq.
Even so, there are problems with the business model of Sallie Mae. An S&P research report estimates that in 2010, SLM will have an interest rate spread, the difference between the rate at which it borrows and the rate at which it lends, of 1.6%, before expenses. That is higher than 2009, which will help profits. But, in order to protect itself, the company will have to continue its practice of hedging and use of swaps. The only way it can grow this part of the business is to make more loans. That will not be easy in this environment. Fitch downgraded the stock last September, citing problems with the company’s business model.
The company hasn’t paid a dividend since 2007, and hasn’t bought back its stock. In fact, it lost $2 billion trying to hedge the price of its own stock for repurchase. 10-K, P. F-64-5.
With profitability in question, and concerns about its business model, and no money for shareholders, why does SLM want to stay in this business? The answer is cash flow. At the end of 2009, the company had total loans on its books of about $144 billion. This number, and the interest income flow that it creates, justifies the outlandish salaries paid to its management. With all that money sloshing around, there is plenty for the massive lobbying effort.
No wonder SLM is resisting the effort to cut back its subsidies. How will its President, Al Lord, be able to afford clubs for his new golf course if he all he has is the profitable but boring and low-margin servicing business?