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I wanted to move away from the stock and back to the business for a minute. This is somewhat selfish perhaps because I have long used Marblehead as a vehicle to push my investing boundaries and learn about an industry on the fringes of my comfort zone. It is the generous board contributors that make this possible, so if this message contains more questions than answers, chalk it up as a quest for understanding.

I thought that looking at the press release and trying to read between the lines might be a good way to stimulate a discussion of the evolving nature of this business. I’m starting from the assumption that Marblehead’s management is savvy, well aware of industry conditions, and competent both in its current student loan services business and banking in general.

Due to uneconomic terms in the current capital markets, we have elected not to securitize private student loans this quarter. We are exploring non-securitization and securitization alternatives for future quarters to enhance our business model and provide long-term capacity to the private student loan market in a manner that benefits our shareholders.

To paraphrase Otter – the capital markets are closed. Or perhaps more accurately, fixed income investors are demanding such an elevated risk premium, that the economics are not present to justify reselling assets into the secondary market – not just mortgages, but student loans as well. It seems prudent of Marblehead’s management to not force the issue under unfavorable terms. They have the ability to bide their time, at least for awhile, and should do so. I’m assuming that the majority of what they need to hold on their books is the self-generated loan volume from Astrive, etc. My understanding is that they are allowed a certain grace period (six months?) before being required to take loans off the books of their third-party customers. Reducing the dividend also seems a prudent move until the future comes into better focus.

Let’s hit the securitization alternatives first. Harkening back to a post I wrote in the last few days, recall that the concept of securitization serves two functions. It allows outside investors to have access to a fixed income investment that pays at a coupon rate above what one could garner in something like a treasury bond. This in turn provides a larger pool of capital for lending to those seeking financial assistance, in this case, individuals seeking a higher education. I for one don’t believe that this is the end of securitization as a viable financial instrument. I believe the demand still exists on both sides of the equation and the market is waiting for confidence in the concept to be restored.

Confidence has of course been damaged by excesses in the mortgage markets which are coming home to roost. This has been further exacerbated by the credit rating agencies willingness to assign investment grade ratings to bundles of loans that clearly (in hindsight) didn’t deserve them. So, some confidence has been lost in the validity of these ratings. The agencies themselves have been thrown into self-preservation mode. If folks cease to believe in their ratings, they will no longer have that business to perform. Somewhat perversely, if they sway to the opposite extreme and begin to assign junk ratings to previously investment rated securities, there will be far fewer securities coming into the market and their volume of business derived from the rating process itself will decreased. They are walking a fine line.

That being said, Moody’s is re-evaluating several existing loan portfolios that Marblehead facilitated. Marblehead will be working side-by-side, providing reams of data, as this process plays out. I don’t believe the clouds will part and allow Marblehead to market another securitization on favorable terms until Moody’s new ratings are completed. When this evaluation is complete, then FMD will have a better idea where they stand and further should have an understanding of what they need to do with the next securitization. The economics are likely to be diminished if it is found that the model on which performance estimates have been based is not reflective of reality. I’d expect stricter collateralization terms resulting in lower fees up front and increased reliance on residual cash flows. There may also be some compression in the overall deal economics due to the need to increase the coupon rate being paid to the security investors.

Much of this relies on the analysis of the default and repayment profiles in comparison to earlier assumptions. The fact that FMD is tightening underwriting criteria and modifying the collection and recovery process, indicates that default rates are a concern to the company and they are moving to improve things within their capabilities. They continue to say that things are within the range of expectations, but I’m reading into this that they may be in the high end of the range.

As far as non-securitization alternatives go, this gets somewhat more dicey. My knowledge base also becomes somewhat shallower. I assume what they are talking about is becoming more like a traditional bank. This would be a significant change in the business model, but maybe we have been seeing some of the ground work for this eventuality being experimented with lately. They are certainly gaining experience in direct lending with Astrive and the other brands that are ostensibly experimental in function. All this emphasis on other forms of student service engagement smacks somewhat of an array of fee-based direct businesses.

The issue with this approach of course is where do the funds come from. They would need to borrow money and likely couldn’t get credit as cheaply as the coupon rates currently paid on the securitizations, thereby making the entire business less profitable. I’m shooting in the dark a little here and would appreciate some feedback from one of the resident bank gurus. Yoo hoo, Adrian? Business volume would also be a question and whether they would be able to take on third party loans to the extent they currently do. They do have the student loan knowledge base, given that it is deemed to still be an accurate model. There may be some alternatives in the middle and if anyone has thoughts, please feel free to educate me.

Kopinsky points out that the business environment remains robust. Marblehead just needs to find the proper way to exploit that while making sure it continues to run a profitable business. So, perhaps the fundamental business model will need to change somewhat and the uncertainties surrounding that lead us back the current stock price. I’d love it if others could pitch in some thinking on the business and clear up the cloudy corners of this picture.

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