The surprising profits of student loans
Sallie Mae's buyers may make a ton of profit. But taxpayers and students will be paying the bill, says Fortune's Bethany McLean.
NEW YORK (Fortune) -- Late Sunday night, student loan giant Sallie Mae, or SLM Corp. as the company is officially known, became the latest major American corporation to succumb to the advances of private equity. Sallie will be sold to a consortium of two private equity firms - JC Flowers and Friedman Fleischer & Lowe - and two banks that have their own student loan businesses - JP Morgan (Charts) and Bank of America (Charts) - for some $60 a share, or $25 billion. That represents a premium of almost 50 percent based on Sallie's stock price before word of the deal began to leak.
Already, there's chatter that this deal, should it happen, could signify a top in the private equity mania. The buyout of Sallie, a financial firm that already has a significant amount of debt, is a creative move - creative, of course, being Street parlance for risky and aggressive.
The potential buyout of Sallie comes at a time when the exponential rise in student debt is hitting the headlines. During the 1990s, the average student-loan debt doubled, according to the College Board; by 2004, the average loan debt was $17,600, says the Center for Economic and Policy Research. Books such as "Strapped" and "Generation Debt" are devoted to the rise in debt, and Internet sites post the sad tales of those whose lives have been destroyed by their student loans. (Check out studentloanjustice.org.)
Critics might label the complainers deadbeats, and in some cases, that may well be true. But student loan debt is different than credit card debt. People take out loans to pay for education in order to improve their lot in life, often at an age when most of us are too unsophisticated to understand the ramifications. And student loan debt never goes away: Even in bankruptcy, it rarely can be expunged.
Although Sallie Mae is a private company, the bulk of its profitability is determined by Congress - using taxpayer dollars, of course. Almost 85 percent of Sallie's $142 billion student loan portfolio is federally insured. Most of these are so-called FFELP loans, named for the Federal Family Education Loan Program. Under existing student loan law, the government pays a lender 96 percent to 98 percent of the interest and principal it is owed should a student default on a loan. The government also guarantees lenders a certain level of income.
In recent years, lenders like Sallie Mae have gotten much of their growth from so-called "private loans," which are not guaranteed by the government. These loans often carry double-digit interest rates to compensate lenders for the additional risk, making them apparently more profitable for lenders. (Investors, however, have begun to worry about the default rate on these loans.) Such loans contributed 23 percent of Sallie's "core" earnings in 2006.
Overall, student lending has been an extraordinarily profitable business. Sallie's return on equity, which was over 30 percent in 2006, is one of the highest among American companies, and its executives are compensated lavishly. From 1999 through 2004, former CEO and current chairman Albert Lord took home over $200 million. In 2006, current CEO Tim Fitzpatrick was paid $16.6 million in salary, bonuses and stock.
Sallie markets itself as friendly to students ("Helping millions of Americans achieve their dream of a higher education," reads its Web site), but critics have long charged that the opposite is true. Until recently, though, no one - save students and their advocates - seemed to care. When the Democrats took over Congress, they spotted an opportunity, and announced that they would chop the interest rates on student loans, and pay for it in part by reducing subsidies paid to lenders. Sallie, along with the rest of the industry, cried poor - and said that their real concern was not their own profit margins, but the well being of those they serve.
"When you continue to cut and cut again, eventually who you're hurting is not the banks but the students and parents themselves," said Sallie spokesman Tom Joyce.
Sallie's stock has been sliding ever since the elections, from $50 to just over $40 before the news of the potential buyout, so in a way, the timing, which sent the stock up almost 15 percent, makes sense. But in another way, it's odd, because the climate still seems to be getting worse.
The $25 billion question is, how much worse will it get? New York Attorney General Andrew Cuomo has been investigating corruption in the student loan business, and just days before word of the deal leaked, Sallie reached a $2 million settlement with Cuomo and promised to abide by Cuomo's new code of conduct. It's unclear, though, how much Sallie's practices will actually change.
Although Sallie has come out of Cuomo's investigation relatively unscathed, Congress is another matter. At the end of last week, Senator Edward Kennedy, the chairman of the Senate committee that oversees student lending, began circulating a draft bill that was tougher on the lenders than many had expected. It would cut the profitability of loans, and also reduce the reimbursement that lenders get on defaulted loans, to 85 percent. Charles Gabriel, an analyst at Prudential, wrote in a recent report that that could reduce Sallie's earnings by 10 percent to 12 percent.
The negative political environment is why critics say there is such risk to this deal. If Sallie's federally subsidized profits come under pressure while the cost of its debt rises, then its income shrinks. Sallie is already highly leveraged, with shareholder's equity representing just 3 percent of total capitalization.
And so, news of the deal caused the cost of insuring Sallie's debt against default to soar. As analyst Kathleen Shanley at Gimme Credit writes, "The buyout looks very sweet for current management, who will remain in place to run the company." Of course, Sallie's management team will also receive a large takeover premium on the shares they own. As Shanley notes: "The deal is not so sweet for bondholders, who will receive no such premium." Both Moody's and S&P put Sallie's debt on review for downgrade, with Moody's even saying that it might cut Sallie to "junk."
But while the buyers may be many things, they probably aren't dumb. (The "probably" is because there's nothing like easy money to make smart people lose their heads.) So the deal may tell you a few things. It may be that Sallie's management knows something the public does not. After all, Sallie is a powerful political machine, and the threats of a cut in the subsidies it receives are just that right now - threats. In Washington, there's a long distance between threat and reality.
The deal may also mean that despite Sallie's cries that Congress's cuts will send it and the nation's students to the poorhouse, there is still a ton of profit in its business - enough for it to absorb a significant cut in profits, add to its debt pile, and still make its executives and its new owners even richer. Reportedly the buyers believe that Sallie will benefit from any action Congress takes, because its market share will grow as weaker players fall by the wayside. That's great for all of those parties. Just keep in mind who is paying the bills: Taxpayers and students.
Back to school: Companies that make money in education have had good friends in Congress. That may change under the Democrats.