Heh, ISM/OSM again

[brewer12345]

Rumor is now that Blackstone is the buyer. That means LBO, right?

Maybe, and that is what the bondholders are obviously afraid of. But if they stack a ton of leverage on SLM, it will get downgraded which will kill their access to cheap financing for student loans. So I don't see how you could do an LBO without killing the business.

A reasonable precedent is probably GMAC. Private equity deal that involved no incremental leverage to finance the transaction. But I think a large bank could afford to pay more if SLM is for sale.

 

[wabmester]

Bloomberg sez:

The perceived risk of owning Sallie Mae's bonds surged. Credit-default swaps based on $10 million of the company's bonds more than doubled to $76,000 from $36,500 yesterday, according to New York-based broker Phoenix Partners Group. The contracts, used to speculate on the company's ability to repay its debt, were the most actively traded today, according to Phoenix.

 

[brewer12345]

Bloomberg sez:

The perceived risk of owning Sallie Mae's bonds surged. Credit-default swaps based on $10 million of the company's bonds more than doubled to $76,000 from $36,500 yesterday, according to New York-based broker Phoenix Partners Group. The contracts, used to speculate on the company's ability to repay its debt, were the most actively traded today, according to Phoenix.

Uhuh. But that implies a 76BP spread to treasuries. ISM is priced more like a 170BP spread.

 

[wabmester]

Uhuh. But that implies a 76BP spread to treasuries. ISM is priced more like a 170BP spread.

Interesting. Thanks for the translation.

 

[brewer12345]

Interesting. Thanks for the translation.

I should also mention that the CDS market is very much not transparent, especially compared to public equity markets. Sometimes funny things happen in the short term in the CDS market that make no fundamental sense. So it can be hard to infer stuff from a given CDS quote.

 

[clifp]

Brewer do you know who would have to approve these transaction? It seems to me that Congressional Democrats who are big fans of expanding Student Loans would less than thrilled about some greedy LBO firm taking over Sallie Mae and creating turmoil for student loans. Or is this just wishful thinking on my part?

Interestingly I was about to put OSM/ISM as a low risk recommendation for a client of mine. I must say when researching this investment, I didn't really consider an LBO as a possible risk. (A Fanne Mae type scandal was certainly a possibility though.)

 

[brewer12345]

Brewer do you know who would have to approve these transaction?

Lots and lots of people. The most stringent of which are probably the FDIC and the commerce department. But no doubt Congress would horn in, and I imagine that a brief trawl of teh regulation section of their annual report woudl net an alphabet soup of agencies that would get to opine on any deal. Since SLM owns an industrial loan complany and there is currently a moratorium on transfers of t hese, I would think that would be issue #1.

 

[FIRE'd@51]

I'm trying to come up the learning curve on CDS. You guys are in bonds 301 and I'm back in bonds 102. Does the 76bp mean if I buy the swap, I pay the seller 76bp per year, and he guarantees me principal and interest (or just principal) in the event of a default?

 

[haha]

I just saw an analyst from Keefe, Bruyette Woods in a video clip from earlier today. I had thought (hoped) that the need for Sallie Mae to retain a good credit rating would be an important business consideration for any acquirer, even PE. This analyst felt however that since most of their loans are securitized and that perhaps more securitizations could be done, this need for a good credit rating in itself might not be a block. He did feel that a bank acquirer might have other business reasons to be able pay more for SLM than this (assumed) current offer.
My memory from their 10 K is that they have a lot of student loans on their own balance sheet, especially the private loans. I suppose however that if jumbo non-compliant mortgages can be securitized, why not private student loans?

Frankly it is beyond my ability to guess. Overall not good news, and possibly somewhat bad. A positive factor, saying Blackstone does succeed with a takeover, is that they have to maintain the business on order for them to come out the other side with a good ipo price.

Ha

 

[brewer12345]

I'm trying to come up the learning curve on CDS. You guys are in bonds 301 and I'm back in bonds 102. Does the 76bp mean if I buy the swap, I pay the seller 76bp per year, and he guarantees me principal and interest (or just principal) in the event of a default?

Exactly. The tenor of the contract can be from 1 to 10+ years, although usually when you see babble from the media about this they are talking about 5 year contracts. Note that the contract may expire before the bond does.

 

[brewer12345]

I just saw an analyst from Keefe, Bruyette Woods in a video clip from earlier today. I had thought (hoped) that the need for Sallie Mae to retain a good credit rating would be an important business consideration for any acquirer, even PE. This analyst felt however that since most of their loans are securitized and that perhaps more securitizations could be done, this need for a good credit rating in itself might not be a block. He did feel that a bank acquirer might have other business reasons to be able pay more for SLM than this (assumed) current offer.
My memory from their 10 K is that they have a lot of student loans on their own balance sheet, especially the private loans. I suppose however that if jumbo non-compliant mortgages can be securitized, why not private student loans?

Frankly it is beyond my ability to guess. Overall not good news, and possibly somewhat bad. A positive factor, saying Blackstone does succeed with a takeover, is that they have to maintain the business on order for them to come out the other side with a good ipo price.

Ha

A fair chunk of SLM's student loans are already securitized. In fact, they account for about half of the entire market for securitizations of student loans. But there is a limit to the size of that market, so SLM has endeavored to tap other sources of funding, especially the unsecured debt market. So it is conceivable that they could get away with just doing seciritizations, but that's frankly a bit of a stretch IMO. Student loans are considerably more idiosyncratic tahn even subprime mortgages.

We will see what happens. The private equity bid might conceivably flush out bidders on the bank side, since this will be their one chance to buy the largest student lender in the nation (by far), and I imagine taht a buyer taht would commit to playing nice would have an easier time getting a deal OK'd than a private equity shop.

At current prices for the bonds, I am content to wait and see.

 

[FIRE'd@51]

Exactly. The tenor of the contract can be from 1 to 10+ years, although usually when you see babble from the media about this they are talking about 5 year contracts. Note that the contract may expire before the bond does.

If I subtract the 76bp from the approximate 170bp spread between ISM/OSM and TIPS, I get 94bp (not zero). I would think they would be much closer. It would seem that a broker/dealer would be able to buy ISM/OSM, buy a CDS, short TIPS, and arbitrage this. What am I missing here?

 

[haha]

I am not sure about the facts on this, but when I woke up this morning I thought-hey, if this goes private, they no longer have responsibility to publish 10k, 10Q and many other SEC filings.

NYSE won't allow non-filers to be listed.

This seems to point to delisting of ISM, OSM, JSM and the SLM preferred SLMa.

Now if we think the trading market for ISM and OSM is thin now, wait until it is delisted!

Holy Spaghetti-O's, this would not be a good thing!

Along these lines it occurs to me that SLM is a type of bank. It both originates and buys loans, securitizes some, and keeps some on its balance sheet.

A real bank has strict capital requirements. When Bank One takes over a bank it can't load it up with debt. IMO the regulators here had better be careful. For my sake if for no other!

BTW, yesterday Brewer mentioned that the FDIC will have to pass on this. Seems completely reasonable and I hope this is true; but what would require FDIC oversight? I thought FDIC only regulated depository institutions and SLM doesn't take consumer deposits does it?

Ha

 

[Texas Proud]

Ha...

I don't see how they can 'delist' the stocks when they are publicly owned..

And would they still have to file to the SEC on those securities They are not under (can't remember the name or number...) that rule of 'rich investor' which does not require SEC filings.... so I think they are stuck with filing for these securites unless they can buy them all... or call them all..

And who in thier right mind would want to cut off a funding source like this??

 

[FIRE'd@51]

There was an article in the WSJ this morning which said besides Blackstone, the other interested party is JC Flowers/JPM Chase. There is already some Congressional opposition forming since if taken private, SLM would not have to disclose publicly as much information, and, of course, SLM would need government insurance to issue debt for the student loans at lower rates. The article said the probability of a deal was 50/50.

 

[brewer12345]

Ha, even if the company went private in an LBO, they would remain an SEC filer. Take a look at any number of privately held LBOs and you will see that virtually all of them are still filing with the SEC. They do so for two reasons: 1) they have to under the terms of the bonds they issued, 2) most of these companies will eventually either be sold to another buyer or will be IPOd again once whatever channlenge they are facing has been dealt with. So lets not get hysterical here.

SLM itself is not a bank, so their capital requirements, etc. are driven by what the rating agencies, unsecured bondholders and the securitization markets require. However, SLM owns a small industrial loan company - a type of bank. They have said that they intend to do an increasing amount of their business via this entity because it can be deposit funded, which is yet anotyher source of funds. However, because they own an ILC, they have to get approval from the FDIC in order to engage in any mergers, etc. Currently, there is a moratorium on transfers of ILCs because WalMart and Home Depot tried to buy one and get into the banking business (a big no-no to mix commerce and banking, at least historically). WalMart has given up, but Home Depot has not. So while there can be exceptions and ways around the problem, on its face this represents a significant problem for anyone looking to buy SLM, especially a non-bank.

I would not get in too much of a tizzy just yet. It is likely to be months before we know who (if anyone) will be the intended buyer, and then it will take a long time to get approvals, etc. There will be plenty of time to make a decision on these bonds. In the meantime, they are already priced as if they are marginally investment grade, so I don't think the downside is likely to be that far. If you panic, you will do stupid things and lose money. So I plan on sitting tight and waiting on events, especially if retail shmoes dump the bonds and knock the price down. In fact, if they approach 18, you will ssee me hoovering up more of the bonds, as well as JSM.

 

[clifp]

I noticed that the WSJ article pointed out pretty much everything Brewer said yesterday about the challenges of the takeover, although it missed the part about the Industrial loan company. (Maybe that falls into the complex financial transactions that article alluded to.)

I know Berkshire was also trying to open an industrial bank and that appears to on hold.

 

[Texas Proud]

I noticed that the WSJ article pointed out pretty much everything Brewer said yesterday about the challenges of the takeover, although it missed the part about the Industrial loan company. (Maybe that falls into the complex financial transactions that article alluded to.)

I know Berkshire was also trying to open an industrial bank and that appears to on hold.

Maybe Brewer WROTE the article.... come on Brewere fess up

 

[clifp]

Well even if he didn't write it, he could have written it . Brewer in case nobody has thanked you recently for your contributions to the board... A big Mahalo from me.

 

[brewer12345]

Well even if he didn't write it, he could have written it . Brewer in case nobody has thanked you recently for your contributions to the board... A big Mahalo from me.

You're more than welcome. What else would I do for fun? Besides, if I ever decide to start an investment newsletter, I know where I could get some favorable endorsements.

 

[Gone4Good]

If I subtract the 76bp from the approximate 170bp spread between ISM/OSM and TIPS, I get 94bp (not zero). I would think they would be much closer. It would seem that a broker/dealer would be able to buy ISM/OSM, buy a CDS, short TIPS, and arbitrage this. What am I missing here?

1) Duration differences 2) If the bonds trade at a dollar price above par you need to hedge with a greater amount of CDS 3) CDS is a floating rate contract that needs to be swapped to fixed to do the arbitrage you are talking about 4) Repo rate on the shorted securities. If you adjust for duration, bond premium (if any), swap spread, and borrowing costs you'll probably find their isn't much of an arb to do here.

 

[FIRE'd@51]

1) Duration differences 2) If the bonds trade at a dollar price above par you need to hedge with a greater amount of CDS 3) CDS is a floating rate contract that needs to be swapped to fixed to do the arbitrage you are talking about 4) Repo rate on the shorted securities. If you adjust for duration, bond premium (if any), swap spread, and borrowing costs you'll probably find their isn't much of an arb to do here.

Could you elaborate on (3)? What is the floating rate (or spread) that the 76bp is added to?

 

[haha]

Latest news-

"NEW YORK, April 16 (Reuters) - Sallie Mae (SLM.N: Quote, Profile , Research), the largest U.S. student loan company, agreed to be bought by two private-investment funds, JPMorgan Chase & Co.(JPM.N: Quote, Profile , Research) and Bank of America Corp. (BAC.N: Quote, Profile , Research) for $25 billion, the Wall Street Journal reported on its Web site on Monday.

JC Flowers & Co. and Friedman Fleischer & Lowe LLC plan to take a 50.2 percent stake in Sallie Mae, also known as SLM Corp., the paper reported, citing unnamed sources.

JPMorgan and Bank of America each would take 24.9 percent stakes in the company, the Journal reported.

The group plans to pay $60 per share for the student lender, the Journal said."

The purchase will be funded with $16.5 billion in debt and $8.5 billion in equity, the Journal said.

50% premium over the price prior to the offer! However this works out for the bondholders, it sure is sweet for the stockholders! Seems to suggest that people with a lot of money to swing are not too worried about the current political flaps in Washington or in New York State.

Here's a bit more-

"The deal represents a turning point for both the private-equity industry and the student-lending business. Leveraged-buyout firms have generally shied from making big investments in financial-services companies, because these investments can't withstand the same debt levels normally placed on leveraged-buyout targets. But JC Flowers, named for its well-regarded chief J. Christopher Flowers, has chipped away at this for problem for years, first buying banks in Japan and Germany, and now the 35-year-old Sallie Mae.

Indeed, some shibboleths of the lending industry may soon fall by the wayside in this transaction. While Wall Street has long believed that such lenders must maintain an investment-grade credit rating, there is the possibility that the newly private Sallie Mae won't receive one, company officials said last night. The purchase will be funded with $16.5 billion in debt and $8.5 billion in equity.
To ensure low-cost access to capital, Bank of America and J.P. Morgan have committed to some five years' worth of backup financing -- some $200 billion worth -- in the event Sallie Mae can't tap the overall financing markets, Sallie Mae said. "

So looks like enough debt to wipe out SLM stockholder equity . OTOH, there is back-up fionancing in place from the 2 banks.

What will tomorrow bring?

Ha

 

[brewer12345]

Looks like the buyers and sellers on the deal, although I have my doubts about regulatory approval. Be that as it may, let's look at this as if the deal is a 100% lock (not the case, IMO).

The buyers will borrow $16.2B and refinance it by securitizing student loans currently on the balance sheet that are unencumbered. This will significantly reduce free asset coverage for unsecured bondholders and put more cash flow strain on the company. Between the ability to securitize stident loans and committed back-up financing from Bof A and Chase, it sounds like the funding strategy going forward is to skip the senior unsecured markets, which means they don't much care about teh credit rating of teh unsecured bonds. Moody's has already issued a review for downgrade and indicated that they may cut the ratigs to junk (likely Ba-something if I am any judge). All this adds up to not being very good for bondholders.

Having said that, the buyers aren't putting up $8.8 billion to flush it down the drain, so its not like this is a phantom business with no assets or equity. I don't actually think that there is a material likelihood of bankruptcy, and I think the eventual exit strategy for the buyers will be to re float it as a public company or sell it to a big bank.

Practically speaking, what should we do with the bonds? I think it really depends on price and your risk tolerance. These bonds are no longer suitable for the risk averse. If you choose to unload the bonds, I would wait for a reasonable price, as bond markets over-react just as much as stock markets do. The market may dump the bonds down to silly prices, and its not like the underlying company just evaporated (plus teh deal may not ever close). If you have a stomach for volatility, I would imagine that we may see a solid opportunity to make some coin today or later this week. I think that 18 a "share" for ISM, OSM or JSM would be an attractive price, as that would incorporate enough bad news t hat it is hard to imagine the bonds going much lower for long. Hard to say just how irrational a market can get, but I wuld hazard a guess that 18 is a reasonable estimate of max downside.

I also have a hard time believing that the deal will actually get done. Never say never, I suppose, but there is a long line of regulatory approvals required in a politically sensitive business. Since the buyer isn't a large, highly rated bank, I think that there is an elevated amount of completion risk in the deal. If the deal falls apart or another, more creditworthy buyer buyer emerges, the bonds will rebound from any slump.

Regardless of what you eventually choose to do, do not do yourself a disservice and dump bonds in a panic. If you do so, you will almost certainly do so at teh wrong time. Take your time and wait for markets to stabilize before you sell, assuming you want to get out.

I personally plan to sit on my bonds. I think the burden of proof to get the deal done is on JC Flowers, et al. In the meantime, I will be a buyer if any of the three bonds approach 18.

 

[clifp]

I am surprised at the markets modest reaction to news on OSM/ISM both trading around 21.10 at the opening. With SLM trading at 55+ I guess there is a hedge opportunity to buy SLM and if the deal goes through make money on the stock, while losing money on the bonds.