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Over Enrolled: How Sallie Mae Manages Growth in its Balance Sheet

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In a perfect world, Sallie Mae would do the same thing its biggest competitors do: hold on to every student loan that it makes.

But unlike the No. 2 lender, Wells Fargo, Sallie Mae does not have a network of retail branches that collect deposits. Instead, it relies heavily on brokered certificates of deposit, the ‘hot money’ of the banking industry, to fund lending. As a result, the Federal Deposit Insurance Corp. has capped growth in Sallie Mae’s balance sheet at 20% a year.

Lending is growing much faster. In 2014, the year that parent company SLM Corp. completed its split with Navient Corp., Sallie Mae originated $4.1 billion of private student loans, an increase of 7% over the previous year.

(Banks stopped making government guaranteed loans under the Federal Family Education Loan Program in 2010.)

In the first quarter of this year, origination reached $1.7 billion, putting the company on track to reach $4.3 billion by year’s end. 

That makes Sallie Mae one of the fastest growing U.S. banks of its size.

At the end of September, total assets passed the $10 billion mark (a combination of private student loans and Federal Family Education Loan Program loans).

Cap on Balance Sheet Growth

To avoid either running afoul of the FDIC or potentially ceding market share, Sallie Mae has to get some of the loans that it makes off its books, either via whole loan sales or securitization. In April, the company completed a $750 million securitization in which it unloaded all of the tranches, including the most subordinate piece, known as the residual interest.

It’s planning another securitization of same size in the latter half of the year, for a total of $1.5 billion.

In doing so, it is helping to reinvigorate demand for an asset class still tarnished in many people’s eyes by the experience of the financial crisis. Many private lenders, including JPMorgan, Citigroup (i.e. Student Loan Corp.), Keycorp and Bank of America, exited the student loan lending business. Not-for-profit lenders, such as Access Group, also followed suit.

With Wells and No. 3 lender Discover Bank keeping loans on their books, issuance of student loan backed securities has been subdued. Just $2.99 billion of private student loans were securitized in 2014, down from $3.34 billion in 2013 and $5.98 billion in 2012, according to Fitch Ratings.

By comparison, issuance reached $15.79 billion in 2006, the pre-crisis peak.

Lenders still in the game have become much more conservative in their underwriting, making these securities a safer investment. They generally require schools to certify both a borrower’s need for financial assistance and the amount of financial assistance needed. (Cumulative defaults on loans made directly to consumers before the financial crisis reached a whopping 40 to 50%, according to Fitch.)

And private student lenders also generally require higher FICO scores from borrowers than they did pre-crisis and they require a co-signer for most types of loan products.

In addition, lenders are more selective today in terms of the schools where they will offer products.

As a result, private student loans are performing well, in sharp contrast to federally guaranteed loans. As of the end of 2014, just 2.0% of Sallie Mae loans that had entered repayment were delinquent, and loans in forbearance were 2.6% of loans repayment or forbearance.

Investors appreciate this.

In the securitization that Sallie Mae conducted in April, the residual interest, which is unrated and has an estimated average life of 10.79 years, was priced at 96.5% of face value to yield 4.5%.

A $75 million tranche of 9.75-year notes with an ‘A’ rating from Standard & Poor’s pays 3.5%.

There are also four tranches of ‘AAA’ rated notes: a $70 million 8.5-year tranche pays one-month Libor plus 150 basis points; an $82.0 million 5.9-year tranche pays Libor plus 100 basis points; a $164 million 5.9-year tranche pays 2.49% and a $263 million 1.75-year tranche pays Libor plus 60 basis points.

First-Mover Transaction

Sallie Mae expects to realize a pre-tax gain on the sale of $78 million, which it said represents a 10.5% premium over the book value of the loans.

That compares with a gain on sale of around 7.5% for Sallie Mae’s previous private student loan securitization, completed in August 2014.

On conference call discussing its first-quarter earnings, Sallie Mae executives said that than 30 investors took part in the latest notes offering, and the residual tranche was placed with over half a dozen investors, out of a field of some 20.  A number of these, including buy-and-hold investors such as money managers and pension funds, were participating for the first time.

“Securitization opens up the buyer pool up,” noted Michael Tarkan, senior analyst at Compass Point Research & Trading. He said these securities appeal to hedge funds, asset managers, insurance companies, and even other banks that are looking for some asset diversification.

On the conference call, Sallie Mae’s chief financial officer, Steven McGarry expressed confidence that pricing for residuals on future deals will be just as good, if not better, calling this a “first-mover transaction.”

Asked by analysts on the conference call why the company isn’t selling even more private student loans, given the attractive pricing, McGarry said that the company got too late a start to conduct more than two transactions in year, given the lead time involved. 

He added, “We like these assets just as much as the people who value them at 110 [percent of book value]. We can realize value if we hold them or sell them.”

Sallie Mae is also in no hurry to sell its holdings of FFELP loans, which also provide a nice return on equity, McGarry said.

Hot Money

For the time being, the bank has no choice, given its heavy reliance on brokered deposits. These accounted for 63.3% of total deposits at March 31, down just two ticks from 63.5% year earlier, according to regulatory filings.

“It is really, really hard to get long-term deposits into a bank; it takes a long time,” says Joseph Lynyak, a partner in the finance and restructuring group  at law firm  Dorsey & Whitney LLP.

“The easy way [to grow a deposit base] is through a deposit broker. You call up and say, ‘Come on down, we’ll pay a quarter percent more than anyone else,’ and you get all the money you want as quickly as you want,” he said.

“In most cases, deposit brokers are very reputable… but it’s hot money.”

Lynyak said that the FDIC “always takes a very hard line on this.” If deposits go south or there’s a problem on the asset side, “suddenly there’s an enormous liquid problem and institutional failure.”

Concentration of assets can also trigger regulatory concerns, and Sallie Mae‘s balance sheet consists almost entirely of student loans, although it does offer other banking products, such as credit cards. Tarkan says that, for now, the company wants to prove to regulators that it can originate what it said it could without loosening credit, that the underwriting characteristics of loans will be consistent.

“Longer term, they would prefer to diversify; 2016 and 2017 are potentially the years it will look to start diversifying into other products like credit cards,” he says.

Sallie Mae did not respond to requests for comment.

There have only been a handful of other private student loan securitizations to date this year, many of them much smaller than Sallie Mae’s and backed by loans that are more geographically concentrated. In early May, New Jersey’s Higher Education Student Assistance Authority launched an offering of $180 million of bonds to fund the purchase of new loans over the next year and a half. All of the loans to be acquired will be originated under the NJCLASS program, which means that borrowers will be New Jersey residents or attend school in the state.

In April, the Rhode Island Student Loan Authority completed a $41 million deal backed by private student loans to residents and borrowers studying in the state.

In January SoFi sold $313.8 million of securities backed by private consolidation loans. Also in January Navient did a $689.0 million deal that was backed by loans originated by Sallie Mae.

Risk Retention

After December 2016, when risk retention rules take effect, it will no longer be possible to use securitization to get student loans off a lender’s books, though Sallie Mae will be sell its loans in the whole loan market.  The rule, enacted as part of the Dodd-Frank Act, requires sponsors of deals to retain the standard 5% exposure. This can be done either by holding on the residual interest, or by holding on to 5% of each tranche of a deal, including the residual interest. And so long as the sponsor holds the residual interest, the loans used as collateral remain on its books.

But by the time risk retention takes effect, Sallie Mae may not need to get as many loans off of its books, simply because asset base will be larger.

“They are now probably in a position to sell $1.5 billion a year,” says Tarkan. “As the portfolio continues to grow, they will strive to retain as many loans as possible to maintain spread income over the long term.”

Also, “it’s easier to grow at less than 20% a year when you have a bigger asset base.”

And Sallie Mae may still use the securitization market to free up cash to make more loans. In its 2014 annual report, the company estimates that, by the end of 2017, asset-backed transactions will provide approximately one third of funding, reducing its reliance on deposits to fund growth.

At that size, Sallie Mae will also get economies of scale in servicing, improving the economics of deals. After splitting with Navient, the bank has opted to service its own private student loans, including those that it sells, either in the whole loan market or via securitization.

“For all intents, they’ll be at $15 billion at the end 2017; at that point they are really close to getting scale on the servicing side that will drive further operating leverage,” says Tarkan.

Clean Slate for Servicing

There’s another benefit to bringing servicing in house, rather than outsourcing it to Navient, post-spinoff: it gives Sallie Mae a relatively clean slate with regulators, which have been closely scrutinizing servicing of pre-crisis loans, as opposed to those originated since 2009.

In May 2013, Sallie Mae reached settlements with the FDIC and the Department of Justice regarding disclosures and assessments of certain late fees, as well as compliance with the Servicemembers Civil Relief Act (SCRA). It agreed to pay $3.3 million in fines and oversee the refund of up to $30 million in late fees assessed on loans originated by the bank since its inception in November 2005.

(Under the terms of the separation agreement, Navient is responsible for funding all liabilities under the regulatory orders, other than fines levied directly against the bank. And under the Department of Justice order, Navient is responsible for reimbursing SCRA benefits and related compensation on behalf of both its subsidiary, Navient Solutions, and Sallie Mae Bank.)  

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