Today, the Sallie Mae saga wore on as the student lender sued JC Flowers led investment consortium who for the $900 breakup fee tied to the soured deal made a few months back. As I see people fight over who wants to hold an investment defined by the future of our country, I have very bothered, and figured I would give some of my thoughts.
When this deal was first announced, it seemed fishy. In this deal, I saw a company, Sallie Mae, whose earnings derive from assets which are student debt collateralized by the the future earning power of the students, being taken over by a private equity consortium that will load it up with tons of debt. Adding to this was the current context of a "crackdown on the student lending industry" led by Andrew Cuomo and Eliot Spitzer. Immediately, I thought that this was an either an incredibly stupid business decision or some much more interesting and far more complex. Then came the credit crunch and down went Sallie Mae shares. In the middle of the credit credit crunch, Congress passed student loan reform to stop subsidizing Sallie Mae's loans, and the deal has since fallen apart.
Since 1988, a company called SLM Corp has seen its stock appreciate over 1500%. This compares to a 500% increase in the S&P 500. Since 2000, in a time where the S&P 500 has been essentially flat this company has managed to return almost 300%. This company earns a return on equity of nearly 30%, has 60% operating margins, and over 30% earnings growth. This company should have been the toast of Wall Street over this time period. Even Goldman Sachs, the Wall Street darling has not even touched those numbers in terms of performance, and SLM's stock has done better than companies such as Wal-Mart and the Oracle of Omaha himself, Warren Buffet during this time period - in fact most time periods. It has basically performed better than most companies not named Apple and Microsoft during its existence. Check the stats yourself. At 14x forward earnings, this company should be fought over and bid up like crazy. But, who is this SLM corp? What do they do? Who runs this company? Where do I buy shares? Ah yes, this company is Sallie Mae and its no surprise that it traded under "SLM Corp" and was more of a Wall Street dirty secret than poster child during this enormous bull market. Below is a chart of its performance compared with the S&P 500:
Before I go any further let me disclose my own personal relationship to this issue in order to air out any biases I'm sure I have. I currently am a borrower from Sallie Mae. I began college in August of 2001 and ended in May of 2005. SLM shareholders enjoyed a return of about 80% in this time period. Over that same time period my college tuition increased from $14,000 a year to about $22,000 an increase of over 50%. I was in a class of students who had the unfortunate situation of having to use their college savings at a time when the market was plummeting dramatically. It is not surprising that SLM performed as well as the S&P 500 years earlier and I guess equally not surprising that it knocked the cover off the ball after the market bubble popped. My situation, I am sure, is not unique. Many people whose parents thought were safe for college found themselves two years short as college costs continued their upward climb. This is not a "woah is me" tale or a cry for sympathy but the reality of the situation. I am providing it both to lend some perspective and to illustrate the role of such a company.
Much like Freddie Mae and Fannie Mae, Sallie Mae gets government subsidies to provide lending to those who could not ordinarily receive it. While on Sallie's tab I took a class in public policy for my econ degree. In this class we focused on public and private goods. A public good is both non-rival and non-exclusive. The cost of passing it on to someone else is essentially zero, and the consumption of it does not exclude anyone else's consumption. Goods usually are associated with externalities - both positive and negative. A public good usually has positive externalities for society. Many people in the field believe that government should step in to provide only public goods and the private sector should handle the rest. One debate in our class (and throughout the field) was the classification of education. I believe that education is a private good. It is both rival (although technology is beginning to change this) and exclusive. It has a very positive impact on society and its consumption benefits us all. Some argue that it is an impure public good, but most get hung up on its positive externalities - which many private goods have. Many lawmakers fall victim to believing it is a public good and many private providers of the goods try to convince them that it is.
GSE's such as Freddie and Fannie deal in houses - which are pure private goods as well, but have positive externalities. The government has chosen to step into these markets and we have seen some of the effects - housing bubbles and foreclosures. I believe the worse case occurs when the Government colludes with the private sector to provide private goods (and vice versa) - far worse than when the Government actually provides them. Education is a private good whose market I believe that the Government should step into, but only because it is essential for the survival of our democracy itself. This should be done on the state level which enables more competition and a much fairer market. If New York was screwing its citizens or its politicians were owned by special interests eventually New Jersey would lure away talent to come go to school there and hopefully add to its economy. If a country was to do this, it would be far more severe and the whole country would be worse off (sound familiar?).
For a company to outperform over a period of time like Sallie Mae has, it must either be a either very innovative, command a monopoly, or not be playing by the same rules. In Sallie Mae's case it has been the latter. They have been able to receive tons of extra government tax dollars out price the rest of the market and funnel the rest to their shareholders. These shareholders provide capital to Sallie Mae and are willing to take the risk of the loans that they underwrite - as there are not too many more complexities to their business. This risk is then made smaller through the subsidies. A subsidy by nature encourages production by cutting the cost to produce something. By subsidizing the loans, the government is in essence taking risk away from those who would have provided capital for Sallie Mae to do so in a completely free market - ie the shareholders and bondholders. Just as it does with farm subsidies in paying farmers to grow corn, the government pays lenders to make loans. In both cases this causes the subsidized industry to produce more than it could otherwise. For a farmer, the majority of the cost is in labor and supplies, for lenders this is default risk. Investors in SLM during any given time period, therefore should have been in the situation of taking on less risk than an equivalent investment with about the same return. This risk can be measure through either beta or the default rate during a time period. The chart above shows that SLM had about market risk up until 2001 and moved quite well with the S&P 500. After that, they deviate quite wildly. In the latter example, the student loan default rate has been around 5% over time and this is about equal to that of a B-rated corporate issue - most high yield investors would give their first born to find a piece of B -rated paper that could give them a 75% annualized return. This tells me that either Sallie Mae took on much more risk than default rates during that time period would show, or they charged too much for the risk that they did take on. I'm going to go with the latter (although the former may still come to fruition, but is unlikely).
Sallie Mae basically reaped the benefits of low interest rates and government subsidies for education. Whether or not, Sallie Mae execs or government officials, or both, were responsible may someday come out. I'm guessing that they received enough subsidies to capture almost an entire market, establish a monopoly, and offer loans that are risk free to them. What is crazier is that college loan securitization is very popular - further adding to performance (and lack of ethics). This illustrates the problem with Federal government involvement. If after the tech bubble, many middle class and lower class students could not afford to go to school, colleges would have to entice them through scholarships or lower tuitions or else they would not be able to attract the talent they wanted if anyone. Lenders would most likely become much more selective and college tuition would not have increased and most likely would have decreased. Fed easing then would have enabled cheap loans to be issued - possibly at higher rates than they were, but on much less principal. The net affect would have been more competition, MUCH less earnings for Sallie Mae and students coming out with far less debt. Instead, the shareholders of Sallie Mae received this benefit - a benefit that appears to have gone by the wayside.
This brings us to the situation we have today. Both Sallie Mae and the government, although probably acting legally, have been very unethical. In the court of criminal law, there is a clear line between ethical and legal. In the court of civil law, the line is fuzzy at best. The fact that many former politicians go into private equity leads me to believe that there are some very strong ties between the two areas. JC Flowers is notorious for buying up distressed financial services firms, usually ripe with scandal and wrongdoing, but at its time, SLM was far from distressed - but beginning to ripple with some wrongdoing. Flowers has pulled out of deals before (see Refco). His political connection appear to run deep and ties with Goldman are much deeper. His bid on Refco ushered in many more bidders and he appears to be doing the same with Northern Rock (upon which the UK Government has appointed Goldman Sachs to advise upon). My guess is he bid on it, knowing that this bill would pass and hoped for this scenario to play out so that he could jump back in at a discount without assuming the risk. If it did not he was left with a decent portfolio of loans that he could sell to a market that buys them up nicely. His contacts over at Goldman, who may or may not be involved directly with the company and any ethical wrongdoings most likely would be happy to not have anything negative in any loan business in the news and Sallie Mae would most certainly be a news maker if things began to fall apart. They probably would be very happy to get the company out of Flowers' hands and buy up the individual assets and not risk any headline exposure. As a continuing entity, Sallie Mae is probably screwed. I can not see it growing like it can, but during a credit turnover, it still has tons of student loans that are probably fine, very salable and offered on the cheap.
This is all speculation, however, but I wanted to write my thoughts on it because I feel like there is no deal that personifies the last five or six years on Wall Street and in America better than this one. It involves something that should be of national and public interest that puts money in our pockets in the long run - education. Instead of trying to foster a system and policy that works well in the long run, we have tried to cash in on it in the short run. The leaders of our country have then enabled corporations to swoop in and provide these things to our citizens with little or no competition, transferring money from taxpayers to the owners of the companies. Taxpayers are paying money to the government who simply puts it into the hands of people tax free. It is wealth distribution at its finest and only different than socialism in how the wealth is distributed. In a time when our "children is not reading", jobs are moving overseas, and America is losing its competitive advantage we are allowing people to engage in stealing our education dollars. The problem with many of the Federal Spending programs the Democrats (and now many Republicans) put into place is that they are just and noble causes, but they are very susceptible to corruption. Education for everyone is great in an ideal world, but we do not live in one. I fear that when Democrats get into power that they will try to rebuild many entitlement programs again, just to see them get used improperly. State powers foster competition, and lower the costs of government for everyone. Federal power is a monopoly.
We must decide whether we want to be a country with 60% taxes and a large Federal Government or 15% taxes and a very small Federal Government - either one would be much more equitable and prosperous than the one we have today. Corporate interest want a government with low taxes and lots of Federal Spending, that is how they are able to exercise their influence. Democrats can't complain about corporate interests and then put into place a system that enables corporations to exert their interests very easily. Republicans can't complain about Federal Entitlement programs, when they enact their own through wars and no-bid contracts. We are a greedy nation that has gotten too far away from pragmatism and moved too much towards idealism. Yes, ideally we should all have health care, and ideally we should not be able to live in fear of being attacked. But realistically we can not have these things without giving up something else.
Ideally government subsidies combined with public capital help spread the costs of education out to make it cheaper for everyone. Realistically, it enables a government to be bid into power and the highest bidder reap billions under the guise of public good.
Sallie Mae's primary competitor *is* the federal government. Sallie does the FFELP (Ford Federal Education Loan Program) and the feds do the FDLP (Federal Direct Loan Program). The cuts in subsidies favored by House and Senate can also be viewed as a Democratic grab for more federal power and jobs for the FDLP.
The counterpoint is that Sallie has been more innovative and flexible in meeting the needs of universities and working with them.
I think your discussion of education as a private vs. public good is interesting, but let's distinguish between "knowledge" and "education." Education is a process for getting knowledge. Knowledge is a very special good in economic parlance: it can often be shared easily, creating more of it doesn't typically reduce the value of existing knowledge, it can be used repeatedly without depreciation.
Based on the differentials between student-loan interest rates, market rates of interest, and the rate of growth for college graduates' salaries, I would say that a rational person would buy postsecondary education at market rates of interest because it's an excellent investment. We shouldn't need any subsidy for something that the free market shows us we should get.
People without the resources to borrow for an education (children, the poor) should receive a subsidy for primary and secondary education. Which brings us to a point you may want to consider...
The education process (the delivery of knowledge) is a means of control. I sung the praises of knowledge above, but incorrect knowledge, bad theories, opinion masquerading as fact, or faith-based knowledge that lacks positive societal externalities can all poison the value of knowledge. Just look at the proportions of left-wing people in education. Or look at the mullahs in charge of the madrassa religious schools in Pakistan, Iran and Saudi. Controlling the flow of knowledge in education processes is a clever form of censorship when used wrongly. The solution is to encourage debate about what "correct knowledge" is. Don't only teach established "facts" -- you'll get automatons without useful skills who can be obseleted. And established "facts" in 1980 included global cooling and Carternomics.
Maybe I'm convincing myself that "education" should be learning "how to think," not just accumulation of "knowledge stock."
Back to researching bonds....
Posted by: Bond investor | October 12, 2007 at 01:20 PM