Last week, we wrote that Sallie Mae and its promoters on Wall Street claim the company was "blind-sided" by the rising default and delinquency rates on subprime private loans it made to low-income and working class students at poor performing higher education trade schools. It's a convenient argument considering that the loan giant is facing at least one, and possibly several, class action lawsuits by angry shareholders who accuse the company of deliberately misleading them about the amount of risk it was assuming. But the argument is disingenuous at best.
Financial analysts have long raised red flags about Sallie Mae's private lending practices. During earnings calls and at shareholder meetings and investment conferences, analysts regularly peppered Sallie Mae officials with questions about whether the company, which is used to having government backing on its loans, had the expertise needed to assess the risks associated with lending unsecured, private loan debt to financially-needy students.
Of particular concern to these analysts have been the sweetheart deals that Sallie Mae forged with some of the most scandal-ridden chains of for-profit colleges, such as Career Education Corporation and Corinthian Colleges. Under these Orwellian-sounding "opportunity pool" or "recourse loan" arrangements, Sallie Mae agreed to provide funds for private student loans, with interest rates and fees totaling more than 20 percent per year, to financially-needy students who normally wouldn't qualify for them because of their subprime credit scores. Sallie Mae apparently viewed these loans as "loss leaders," meaning that the company was willing to make these loans, many of which were likely to go into default, in exchange for becoming the exclusive provider of federal and private loans for the tens of thousands of subprime and non-subprime students these huge chains serve.
In 2005, Fortune Magazine brought attention to the analysts' worries in an article entitled, "When Sallie Met Wall Street."That piece specifically raised concerns about the loan company's dealings with schools owned by Career Education Corporation, which it noted had had been accused "in multiple lawsuits in several states of using hard-sell tactics to recruit students, promising them high-paying jobs that don't materialize and leaving them with mountains of debt that they can't pay off."
The article's author -- Bethany McLean (who, by the way, helped break the Enron scandal) -- proved prescient in predicting the predicament in which Sallie Mae now finds itself. McLean wrote:
[A] big question looms in Sallie Mae's private credit business: How many students who take out these high-interest loans will end up defaulting? After all, private credits are basically unsecured loans to people without jobs. Sallie argues that there won't be a problem. Each quarter it books a reserve for potential losses; at this time its loss on private credit loans in repayment are running at only 2.4%. Plus, Sallie says, almost half its private credit loans are guaranteed by a parent.
But because private credit is a new business and because students are taking on unprecedented levels of debt, there are no historical measurements by which to gauge potential defaults. As Sallie's financials note, "the provision for loan losses is inherently subjective as it requires material estimates that may be susceptible to significant changes." And the current low delinquency rate may be misleading, because as of the end of 2004 nearly half the students to whom Sallie has lent private money hadn't left school yet.
The Fortune article also raised a question that is central to the class action lawsuit filed by shareholders in the Federal District Court in Southern New York: Was Sallie Mae deliberately not putting enough money in reserve to cover anticipated losses on "uncollectible loans" so that it could artificially boost its earnings?
Some worry that Sallie may already be struggling to deliver on its promises to Wall Street. The company encourages investors to look at a measure it calls "core cash" earnings, which, among other adjustments, strips out the gain Sallie books when it sells loans to an off-balance-sheet trust and replaces it with Sallie's estimate of the spread those loans are earning. In other words, Sallie's "core cash" results are affected by the reserve it books on those off-balance-sheet loans. Over the past year the company has reduced its reserves, thereby boosting the earnings measure that it encourages investors to watch. Currently, Sallie's allowance for losses on the private credit loans that are in repayment is 3.9%, down from 6.2% a year ago. Sallie attributes the reduction to an improvement in its portfolio's credit quality and says that the idea that reducing reserves helps earnings is wrong.
How did Sallie Mae officials react to the story? Did they reexamine their business practices? No, they lashed out at the magazine. "In short, your article was a baseless attack on a company that has helped million of Americans who, without our financing tools, may not have had an alternative to attend college and improve their lives," Tim Fitzpatrick, the company's then-CEO, wrote in a letter to the editor.
Sallie Mae officials were warned of the dangers ahead and chose to ignore the warnings. The truth is company officials took a huge gamble. They believed that that all the new business they would get from forging deals with these gigantic for-profit school chains would more than make up for the losses they would endure from making available high-cost private student loans for high-risk borrowers. They were wrong.
The people actually blind-sided were students pressured by aggressive recruiters at dubious for-profit trade schools to take out high-cost loans to pursue an expensive, high-risk program with dubious graduation and job placement track records.
As we have noted, serious questions have been raised about whether some of these companies such as Career Education Corporation have duped disadvantaged students into taking on private loan debt without making them aware of their cheaper loan options first.
Perhaps Sallie Mae's shareholders were duped as well. They may at least get their day in court to air their grievances. Company officials will argue that they never could have anticipated the dangers of providing high-cost loans to subprime borrowers. Don't believe them.