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No. of Recommendations: 68

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.

Savvy they may be, but the last CC was remarkable for its lack of discussion about the concessions made to get the securitization to market

For the most part the remarks were focused on the size of deal rather than the terms.
Finally, I'll turn toward the securitization activity for the quarter. The specific issues related to the quarter's disruptive debt
markets are well documented. So I won't retell them here. In short, we're very proud to have executed our largest securitization
in one of the most challenging markets ever. We accomplished this by following the game plan laid out on the August earnings

We valuated many structures and concluded our clients and shareholders would benefit most if the trust issued a combination of floating rate notes and auction rate notes wrapped by Ambac. The trust did not offer any securities rated below Triple-A.

Our ability to successfully execute in this extremely challenging market is testimony to the strength of our business model and the dedication and hard work of every member of the company. Investors, credit providers, and others value the high quality and consistency of the underlying collateral we securitize, the track record and flexibility of our securitization program, and the creativity of our transaction teams.
At the end of September, First Marblehead stood as the largest issuer of private student loan asset-backed securities, the second largest student loan issuer generally, and the tenth largest issuer of non-mortgage asset-backed securities since January 1st.

Only one other issuer, an auto issuer, did a transaction larger than ours in the third calendar quarter.

Management really failed to present the securitization the way it was--a necessity, not an opportunity and filled with concessions to a tough market to get it done. Of course at a CC the positive is always the best tack but I think the concessions--the Ambac wrap, the auction rate notes, the lack of lower rated tranches, the flat year over year up front fee, the nearly 100% increase in residuals---all foretold an almost impossible market in December if the market continued to slide. And it did

In their defense the September deal had to be done because if the loans are not securitized a premium must be paid to the lenders on the loans not bought in 180 days. FMD would be paying 1% of the loan principal and 1% of $2.2 billion would be $22 million.

Which brings us to December and some of the consequences of not securitizing

At the end of September, FMD had about $1.1 billion in loans at the end of the first quarter available to securitize. That was almost 3 mos ago and the clock is ticking. Of course, new loans are being facilitated this quarter and the deadline 180 days is counting down. By March, it will be 180 days on the first quarter loans. The $11 million "fine" would not be the end of the world but the company will be scrambling to find a few extra million with not much income in Q2.I expect them to feel the pressure to get another deal done no matter what. If the market has not improved, we can expect another securitization of great size but with nearly the same terms as Q1

Looking ahead Q2 is going to be tight. Look at Q1 as an example of where the income is coming from.

Service Revenues:
Up-front structural advisory fees $177,542
Additional structural advisory fees:
From new securitizations 24,304
Trust updates 2,859

Total additional structural advisory fees 27,163
From new securitizations 116,972
Trust updates (14,108)
Total residuals 102,8564
Processing fees from TERI 46,249
Administrative and other fees 21,761
Total service revenues 375,579
Net interest income 4,383

Total revenues 379,962

What is left without a securitization is interest income and some advisory fees--around $25 million

**Also note the $14 million write down on the residuals due to the change in discount rate

I suspect we will see negative earnings in Q2. Expenses like compensation and SG&A are somewhat fixed since I doubt FMD will be cutting jobs and expenses for one bad Q and those expenses in Q1 were around $95 million. The market appears to be pricing the earnings in. I doubt it will be a big surprise to most investors.

The other concern is what has been happening to cash flow with reduced up front fees and bigger residuals. CFFO is way down

Cash flows from operating activities:
Q1 2008 Q1 2007

Net income $168,820 $141,008

Depreciation and amortization 4,422 3,877
Deferred income tax expense 41,598 17,308
Stock-based compensation 2,378 1,542

(Increase) loans held for sale ( 164,106) —
(Increase) in structural
advisory fees (27,163) (18,551)
(Increase) in residuals (102,864) (68,663)
(Increase) in processing fees
from TERI (3,395) (1,884)
Net change in income taxes 107,512 75,328
Decrease in other prepaid
expenses 1,363 761
(Increase) decrease in other assets (7,366) 685
(Decrease) in accounts payable,
accrued expenses,other liabilities (9,135) (5,127)

cash provided by operating activities 12,064 146,284

If FMD has to dig up $11 million or more for 180 day late fees, finances are going to be tight until March.

I don't know what other sources of revenue they can explore between now and March. Short term paper seems very unlikely and highly unprofitable.This is a market that has had its own problems and buyers are demanding big premiums on an asset class that was supposed to provide returns to investors around short term treasury levels. Demand is down, yields are up and terms are unattractive.

Commercial paper is supposed to pay out a smaller yield to investors over a period of several months(up to 270 days)allowing the bank that issues the paper to take the proceeds and invest in longer term higher yielding investments and profit from the spread. With 30 day cpbas at around 6.06%, it makes it hard for the issuer to make the spread. Its an unattractive asset class at present and I don't see FMD going this way

Outstandings Tumble

The U.S. asset-backed commercial paper market fell the most in five weeks, during the seven days ended Dec. 5, extending a four-month slump, as investors shunned the debt.

Commercial paper, which matures in 270 days or less and is backed by mortgages, credit-card loans and other holdings, fell 2.8 percent, to a seasonally adjusted $801.2 billion, the Federal Reserve in Washington said yesterday.

The slide is prompted in part by the retreat by structured investment vehicles, which sell commercial paper to finance purchases of higher-yielding securities.

Moody's Investors Service on Dec. 3 said it may downgrade $105 billion of SIV debt after the average net asset value of the funds declined to about half of what it was in June.

FMD and shareholders may be in for a couple of disappointing quarters until the markets improve. It's hard to see what else they can do.What other business opportunities are there for them? They have made their business facilitating and securitizing private student loans and that's all they do at present. The single focus of the business model is undeniably brilliant but prone to weakness in times like these with the lack of diversity. You may notice SLM continues to be able to place government loans--reviled though it is by Tom Brown and others.

One final note regarding Moody's

The downgrade has some far reaching implications.

First and foremost is the possibility the ratings companies are going to be less generous with the upfront fees and this will be detrimental to cash flow as we saw in the above CFFO declines Q1 2007 compared to Q1 2006. The decline was largely due to less upfront income and higher residuals. The other big contributor was the loans originated by the bank that tie up cash and produce little income. A clear demonstration of why banks want to get student loans off the books as fast as possible.

Downgrading of tranches will also have an effect. While the rating of tranches does not figure as a direct input of valuing the residuals, the rating has a big influence on the discount rate. Those of you that follow every move of FMD will have noticed that the introduction of BBB rated tranches took the discount rate from 12% to 13%. When that happens the value of the residuals will decrease and that will show up as a charge on the income statement decreasing earnings.

Discount rate has the biggest impact on value as it moves 1%-2%--more than prepayments and defaults.

The possible Moody's downgrades if they happen will hurt.

Discount rate: up 10% Up20%
Change in receivables balance (8.08)% (15.34)%

Any further TERI downgrades will also hurt the business

From the 10Q

TERI had a Baa3 counterparty rating from Moody's Investors Service, which is the lowest investment grade rating, and an insurer financial strength rating of A+ from Fitch Ratings, which was subsequently downgraded to a rating of A, outlook negative on October 25, 2007.

If TERI's ratings were downgraded, including as a result of increased defaults on the loans held in the securitization trusts we have facilitated, our clients may not wish to enter into guarantee arrangements with TERI, our upfront structural advisory fee yields could decline, or market conditions could dictate that we obtain additional credit enhancement for the asset-backed securitizations that we structure, the cost of which could result in lower revenues.

This last sentence has already happened sort of as Ambac wrap was required on the last securitization

In addition, the inability of TERI as student loan guarantor to meet its guaranty obligations could reduce the amount of principal or interest paid to the holders of asset-backed securities, which could adversely affect our residual interests in securitization trusts or harm our ability to structure securitizations in the future.

I have a lot more work to do on TERI, but my initial scan shows them to be feeling the effects of much increased default claims being paid. Cash flow is significantly down. Recovery rates on their cash flow statements show about an 8% decline year over year. The pledges are running down quickly and as additional guaranty fees are funneled in to these TERI may start to feel a bit pinched. So i can understand the downgrade with the increased defaults. Things may get better if models hold up but we are so early into these trusts--just 3 years on the 2004 vintages with 20 years to go.

That's about it. Interesting company.The future long term is bright, but the near term pain is undeniable.

These financial inventions have become an inextricable and necessary part of getting business done. i can't imagine the mortgage market trying to function without real estate mortgage backed securities. Its just not possible. The same goes for student loans. Banks want to make them but they don't want to keep them and they have to have the sales to facilitators like FMD and its trusts to stay in the student loan business. The FMD business concept was brilliant and it will no doubt prevail. It is early in the industry and there are a few more growing pains to live through
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