The Business of Sallie Mae Political Risk for Investors and Taxpayers

The group buying Sallie Mae says it wants to renegotiate the deal in light of legislation passed by Congress and signed into law last week that changes the government subsidy level provided to student loan banks. The buyers argue that the new law changes the student loan program to such a degree that Sallie Mae is not worth what they agreed to pay earlier this year.

Politics

It's not surprising that the Sallie Mae buyers are claiming recent political action has changed the companys value. Sallie Maes business model is subject to an unusual amount of political risk and uncertainty. Why? Well, (1) Sallie Mae derives much of its income from running a government program, and (2) Congress arbitrarily decides how much it will pay Sallie Mae to run the program.

Sallie Mae originates, services, and collects loans as per the federal governments guaranteed student loan program. Over 80 percent of Sallie Maes portfolio is made up of federal student loans. In fact, Sallie Mae is by far the single largest participant in the Federal Family Education Loan program.

The goal of the federal student loan program is to ensure that everyone who wants to go to college has access to a minimum level of below-market interest rate loans. The government sets all of the terms of the loans in law, guarantees them against default and interest rate risk, and then pays Sallie Mae and others to originate, service, and collect those loans.

How much should Congress pay banks for this service? Well, Congress has no idea, so it just makes up a number. And of course the banks provide an awful lot of help when Congress gets in the mood to change that number. Right now the number is 2.34 percentage points over the cost of commercial borrowing. With the new law it will be 1.79 percentage points over the cost of commercial borrowing. Where did those numbers come from? A little bit of guesswork and a lot of lobbying. (Its worth a good laugh that the members of Congress who picked that number out of thin air thought to add that last decimal place to make it look like an exact number with some sort of defensible rationale behind it).

Fortunately, the recently enacted student loan bill will for the first time take Congress out of the business of setting student loan bank subsidy rates arbitrarily. PLUS loans (loans to parents and independent graduate students) will have their lender subsidy rates set at auction. Sallie Mae will have to bid for the right to make the loans. No more political uncertainty there just a market process setting the subsidy levels. Frankly, the auction concept should be expanded to the rest of the federal student loan program.

Without a market mechanism to set student loan provider subsidy rates, banks will continue to inundate Congress and its staff with papers, meetings and phone calls pleading that a cut in that arbitrary subsidy rate would be "catastrophic" to the lending business and that a lender subsidy reduction means loans will no longer be made available to students.

In fact, when Congress began considering this most recent round of subsidy cuts, Sallie Mae representatives told me and other Congressional staffers that for the company to continue making federal student loans at the proposed lower subsidy rates, Sallie Mae would have to make the loans through its charity organization. In other words, the proposed and now enacted subsidy cut makes the federal student loan business unprofitable.

Hmm. Square that position articulated to Congressional staff with Sallie Maes comment last week to the buyout group balking because of the new subsidy cuts. Reports have those close to Sallie Mae saying the subsidy changes in the new law are not material and their effects on the company's earnings will be "de minimis."

Looks like Sallie Maes got a different line for buyers and investors than it does for the members of Congress and Congressional staff who set the companys pay. All the more reason to push ahead with the auction pilot program for PLUS loans and expand the concept to the rest of the student loan program. Get Congress (and Sallie Maes lobbyists) out of the business of setting the banks subsidy rate on student loans. The current system is arbitrary, inefficient, and subject to a dangerous amount of political influence. It should go.