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Stock Strategist

Student Lenders Fall From Grace

Shaking hands with the government is often riskier than it appears.

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The student lending industry is an interesting case study on the risks of investing in a business that depends on the government's continued benevolence in order to generate high profits. For more than a decade after its full privatization in 1995,  Sallie Mae (SLM) generated exceptional returns for shareholders, benefiting from its status as the leading participant in the Federal Family Education Loan Program (FFELP), under which lenders received generous guarantees of both interest spreads and credit quality on loans made to college students. Other companies jumped on the bandwagon as well, such as  Nelnet (NNI) and The Student Loan Corporation, which was 80% owned by  Citigroup (C) until its recent sale to  Discover Financial Services (DFS) as part of Citigroup's restructuring efforts.

Unfortunately, all good things must come to an end, and the student lenders were no exception. Their extreme leverage and dependence on the securitization markets would have been a large enough problem as the credit crisis began, but it was adverse legislative developments--first the College Cost Reduction and Access Act in 2007, followed by the Health Care and Education Reconciliation Act in 2010--that dealt a permanent blow to the companies, reducing their guaranteed payments before finally eliminating the FFELP program altogether.  Along the way, we reduced Sallie Mae's moat rating from wide to narrow in mid-2007, before cutting it from narrow to none in early 2009, as legislators slowly destroyed the source of the company's competitive advantage.

While core earnings at Sallie Mae rebounded in 2010 thanks to government intervention (in the form of a "rescue" funding program) and a normalization of the interest rates on which their interest income is based, we don't think the long-term outlook for these companies is nearly as rosy. With The Student Loan Corporation now a part of Discover, and Sallie Mae and Nelnet ceasing origination of government-backed loans, it is becoming clear that stand-alone student lenders are a dying breed.

Return on equity for Sallie Mae and Nelnet has fallen from exorbitantly high figures early in the decade to far less impressive totals during the last five years as credit losses, funding problems, and adverse legislation have taken a toll on profits. Legacy interest income from FFELP loans made up about half of gross recurring revenue for both of these companies, a figure that will gradually fall during the next two decades as loans made in the past run off the companies' balance sheets.

In response to falling lending income, both Nelnet and Sallie Mae are refocusing on their service businesses. Sallie Mae, having won a loan-servicing contract from the Department of Education (DOE), is now the number-one servicer and collector of student loans, servicing more than $200 billion--including more than $40 billion for the DOE and several billion dollars for other third parties. Contingency, collections, and servicing revenue made up the bulk of Sallie Mae's fee income in 2010. Although Nelnet derives proportionately less income from lending than Sallie Mae, thanks to early efforts to diversify, even more of its total revenue is currently attributable to the now-defunct FFELP program. And while Nelnet also obtained a DOE loan-servicing contract, we estimate that the company derived a majority of its 2010 fee income from tuition-payment processing and enrollment services. While the companies' service businesses are not capital-intensive, we think the two companies will be hard-pressed to grow noninterest income at a rate sufficient to replace declining FFELP revenue. Furthermore, although we think Sallie Mae's scale provides some advantages in the servicing business, we don't expect the company to generate extremely impressive long-term returns under a competitive bidding process. We therefore expect both fee income growth and profitability at both companies to remain relatively muted during the next several years.

Unlike Nelnet, Sallie Mae is still in the lending business, originating $2.3 billion in private (nongovernment guaranteed) student loans in 2010. We don't dislike this business, but think Sallie Mae faces a few obstacles in this endeavor as well. First, the company will no longer benefit from its status as a large FFELP lender. When students received a FFELP loan through Sallie Mae, they were much more likely to choose the company for any additional funding needs. Sallie Mae is now competing on a more level playing field with banks, which may have an edge now due to other pre-existing lending relationships and potentially cheaper funding costs. Furthermore, Sallie Mae is now funding private loans with deposits gathered by its relatively small bank subsidiary, Sallie Mae Bank. It's possible that banks with well-established, low-cost deposit bases may be able to fund these loans more cheaply, eating into Sallie Mae's market share and profitability. It's possible that private student lending could come under pressure from the government as well. In an era of increasing focus on consumer protection, high-cost, high-interest student loans would be an easy target for legislators�total student debt in the U.S. is rapidly approaching $1 trillion. Additionally, according to the nonprofit Project on Student Debt, many private loan borrowers fail to maximize lower-cost sources of funds, and private loans are more common among students at for-profit institutions, another recent target of legislators. Finally, the cost of education itself might not sustain its current trajectory�at some point, the rate of tuition increases is likely to approach the general inflation rate.

In conclusion, we think the fall of the student lenders along with other former beneficiaries of government largesse, like Fannie Mae and Freddie Mac, provides a cautionary tale for investors in other industries exposed to legislative risk, especially once the tide of public opinion turns against such companies. When the source of high margins is a single government decree rather than more durable advantages like intangible assets, high switching costs, network effects, or cost advantages, a company may be far more vulnerable than it appears upon first glance.

 

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