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Stock Strategist Industry Reports

Will Student Lenders Still Make the Grade?

The worst has passed, but we think student lenders' glory days are done.

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As recently as 2007, student lenders were some of the most profitable financial services companies in our coverage universe. With guaranteed loan spreads and up to 100% of losses reimbursed by the government, companies could lever up and achieve extremely high returns on equity. However, relatively small changes in legislation passed during the summer of 2007 put student lenders on the defensive, and the simultaneous credit crunch amounted to nearly a knockout blow. So far, the companies have survived the assault, but we don't think they will ever be the same. In fact, with Congress debating a proposal to end the Federal Family Education Loan Program ("FFELP") and originate all loans directly from the government, student lenders are increasingly turning to new sources of income. Unfortunately, none of these seem poised to produce the profits that lending once did.

Servicing Contracts Only a Consolation Prize
FFELP loans still make up most balance sheet assets for  Sallie Mae (SLM),  Nelnet (NNI), and  Student Loan Corporation (STU), but this will probably not be the case for long. With the securitization market shut down, student lenders were nearly unable to finance even guaranteed loans during the credit crisis. Congress and the Department of Education came to their rescue with the Ensuring Continued Access to Student Loans Act (ECASLA) in late 2008, providing funding through the Department of Education and allowing lenders to continue originating loans. Later, during the summer of 2009, the Department of Education announced that Sallie Mae and Nelnet were two of the companies awarded servicing contracts for loans sold to the Department under this program. While clearly a win for these companies, the contract was neither a windfall nor a long-term solution, in our opinion. We doubt that these servicing contracts will prove to be extremely profitable, and are concerned that financial success for the servicers will result in unfavorable changes to future arrangements. Indeed, changes are already afoot in Congress that will have major effects on the future of student lending.

The Student Aid and Fiscal Responsibility Act, which was passed by the House of Representatives, would end private lenders' role in originating government-backed loans, leaving them to compete against each other and similar non-profit companies for future servicing rights. Lenders, on the other hand, are proposing long-term solutions along the lines of those enacted under the ECASLA legislation. Under these proposed solutions, lenders would still originate loans, with the government paying fees to the lenders for origination, and with the Department of Education providing long-term liquidity. In our opinion, the prospects for the proposals put forth by lenders are dim, though the behavior of Congress is difficult to predict. It seems to us that the most likely scenario is passage of a law that will result in all federally supported student loans being made through the Direct Loan program, leaving the lenders we cover with one less source of income.

Private Loans Not a Cure for the Industry's Ills
In recent years, private student loans became a larger portion of the business for lenders, as growth in the cost of education outpaced dollars available to students from the federal government. However, as with many other types of credit, lenders went overboard, especially with regard to loans to students at "non-traditional" schools�trade schools and other for-profit educational institutions. In the third quarter of 2009, charge-offs in Sallie Mae's "non-traditional" portfolio reached an annualized rate of 28.5% of loans in repayment. Lenders have tightened standards as a result, but we think students will also be more reluctant to borrow in the aftermath of the current recession.

As a result, while the rise in education costs does not appear set to slow down any time soon, we expect that future growth in the private loan market will be far less aggressive. Furthermore, funding for this type of loan will be harder to come by without a healthy market for securitizations. While private loans can be financed by deposits, capital requirements are fairly high. None of the student lenders we cover is currently a bank holding company, though Sallie Mae is rapidly growing its deposit base with brokered deposits obtained via its Utah industrial bank subsidiary. Finally, there is the risk of government interference in the private loan market. The tide of public opinion has turned against lenders, and high-rate loans to college students would be an obvious area for further reforms.

Overall, we're not enthusiastic on prospects for student lenders. For the most part, the factors that allowed lenders to achieve returns in excess of their costs of capital are gone, and we don't see many sources of long-term competitive advantage. We therefore would demand a sizable discount to fair value before investing in any of these companies. The plight of the student lenders, like that of  Fannie Mae (FNM) and  Freddie Mac (FRE), aptly demonstrates the risk of investing in companies whose success depends on cooperative governments and healthy capital markets.

Jim Sinegal does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.