Fitch Ratings took several rating actions on SLM Corp. or Sallie Mae.

The student loan firm's long-term Issuer Default Rating (IDR) was downgraded to 'BBB-' from 'BBB' while its short-term IDR affirmed at 'F3.' SLM's senior debt was downgraded to 'BBB-' from 'BBB' while its short-term debt was affirmed at 'F3.' Meanwhile, the company's preferred Stock downgraded to 'BB' from 'BB+.'

Fitch's Rating Outlook for the student loan lender is Negative. Around $34.4 billion of debt and preferred stock is affected by these actions.

According to Fitch, the downgrade reflects the expectation that SLM will still be transitioning into a fee-for-service business model with a bank subsidiary that originates higher-risk private education loans. If the pending education legislation is passed in its current form, Fitch would expect the student loan firm to be a meaningful participant in the servicing and collection of government-guaranteed loans under the Department of Education's (DOE) servicing contract.

This should generate comparatively stable earnings performance over time given the firm's cost structure and scalable business model, the rating agency said. If the legislation is changed to retain the FFELP program, the agency thinks SLM will remain one of the biggest originators of the product, which will offer a boost to fee income and could allow for a greater share of the DOE's servicing contract. Either way, Fitch thinks the funding of government guaranteed student loans will continue to be outsourced to the Treasury, as is the current practice under the Ensuring Continued Access to Student Loans Act (ECASLA).

The current ratings also reflect Fitch's expectation that unsecured debt outstanding will be repaid as it comes due with available liquidity and cash flows from the legacy business model. Fitch thinks the portfolio cash flows are sizeable and comparatively predictable and include ABS trust servicing cash flows, ABS residual cash flows, which are backed largely by lower-risk FFELP loan collateral, loan principal repayments, as well as other operating cash flows.

On June 30,  non-bank liquidity included about $4 billion of cash and unrestricted investments and unencumbered FFELP loans amounted to $3.2 billion. The most meaningful unsecured debt maturities occur in 2010 and 2011, at $6.9 billion and $6.6 billion, respectively. The student lender's capitalization is expected to increase materially over time as unsecured debt is repaid.

SLM is expected to still be an originator of private education loans, which will be funded out of its subsidiary Sallie Mae Bank. According to Fitch, the profitability of this product should increase modestly from more recent levels as market yields rise partly because of a reduction in competition as well the provision expense eventually stabilizing.

Management expects credit losses on the product to peak in the 3Q09, as non-traditional loans and loans without a co-borrower account for a lower number of loans entering repayment. The rating agency is still cautious about near-term asset quality trends and thinks it will be some time before it can assess the credit quality of more recent originations. All new loans are expected to be funded in the bank, initially with bank deposits, but longer-term Fitch will look for the company to develop more funding flexibility through term ABS issuance, although the economics of these transactions are currently unclear.

Rating constraints still have legislative and political risk in the sector, as the servicing contract is subject to a renewal in five years and the ED has discretion over the distribution of servicing volume.

Should the FFELP program be retained, the benefits for SLM include an added fee stream from FFELP loan origination and a potential boost to its market share on the servicing side since SLMhas the most considerable school channel relationships, would likely be able to retain servicing on all loans it originated. Fitch believes the retention of FFELP would serve to solidify the company's ratings at their current level.

While the rating agency has outlined its expectations for the business, certain factors continue to develop. In the shorter term, negative rating action could result from an inability to refinance the ABCP facility ahead of its April 2010 maturity, or the uneven distribution of the DOE servicing contract, which impairs the company's profitability prospects. Resolution of these issues could result in rating stability.

Longer-term, negative rating momentum could cause free cash flow generation below Fitch's expectations, impairing SLM's ability to meet its debt service obligations, continued deterioration in private education loan asset quality metrics, and/or legislative change that eliminates private sector involvement from government-guaranteed student lending.

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