Borrowed Time for Student Loans?

Proposals for deep cuts in federal student-loan subsidies are percolating about Washington and causing Wall Street to shy away from lenders' shares

Ever since the Democrats took control of Congress last fall, investors have worried that the government might start trimming the largesse it gives educational lenders such as Sallie Mae. On Jan. 17, the House of Representatives passed legislation that would trim rates on need-based subsidized federal student loans by 50% over five years. The Senate has yet to move on the measure, but President Bush weighed in Feb. 5 with a proposed 2008 budget that aims to bolster grant funds, partly with a huge cut for federal loan subsidies. Stunned Wall Street players quickly unloaded shares of lenders such as Sallie Mae.

Private lenders like Sallie Mae help most student borrowers struggle through their college tuition these days. The largest originator of federal student loans, Sallie Mae began in 1972 as a government-sponsored entity. Uncle Sam still guarantees most of the loans the company provides, such as Stafford loans, so that it isn't hit financially when students fail to repay their debts. Taxpayer money also typically contributes to a portion of the interest students must pay on their federal loans.

If the government enacts the cuts Bush is seeking, it would wipe out one-third to a half of the net interest a typical student lender receives on a government-backed loan, Morningstar (MORN) analyst Ryan Batchelor said in a research note Feb. 5. Given such terms, Batchelor thinks private lenders would essentially stop making such loans. "We don't believe the government would be doing taxpayers or students any favors by killing off the industry, so we expect that there will eventually be some compromise," Batchelor wrote.

Wall Street Reacts

Prudential Equity Group (PRU) downgraded Sallie Mae from overweight to neutral weight. "The fact that a Republican President has proposed such a steep reduction in margin (which is therefore likely to form a base for additional proposals from Democratic Congress) has made the near-term political landscape very unclear," analyst Matthew Park said in a research note.

Shares of SLM (SLM), Sallie Mae's parent company, sank 8.8% to $42.37 per share on Feb. 5, eroding some of the recovery after a dip following the November elections. Nelnet (NNI) plummeted 9.6% to $25.05 per share, and Student Loan (STU) fell 5.9% to $187.50 per share. "People were thinking this (reduction proposal) may not happen, but this is putting more validation into the argument that it'll take place," Standard & Poor's analyst Stuart Plesser said. He kept a hold opinion on the stock, explaining that it will trade on legislative news rather than Sallie Mae's business fundamentals. (S&P, like, is owned by the McGraw-Hill Cos. (MHP).)

Private Lenders vs. Government

Sallie Mae decried the president's proposal. The Reston (Va.)-based company argued that the cuts would reduce the number of lenders in the industry, shifting the field closer to a government-run student loan monopoly supported by bureaucracy. "Students and families will have less choice and more expensive loans, and taxpayers will carry the burden and cost of higher student loan defaults," Sallie Mae said in a statement Feb. 5.

The House bill would reduce the interest rate on subsidized student loans from 6.8% to 3.4% over five years. Proponents say its costs are offset by changes in payments to lenders, fees paid by lenders, and a reduction in the share of default collections retained by guaranty agencies (see, 1/17/07, "Relief for Student Borrowers?").

Meanwhile, Sallie Mae has already taken steps to prepare for a future with less government aid. For example, the company has recently been doing more business in private loans, which have higher interest rates and yield heftier profits. About 16% of the $138.7 billion of student loans Sallie Mae managed during the fourth quarter were private ones, up from 13% during the same period of 2005.

William Blair & Co. kept an outperform rating on the stock. "Sallie Mae continues to build its franchise and capitalize on strong secular growth in the education market, which is supported by rising tuition costs, increasing enrollment, and Americans' desire for education," analyst David Long said in a research note. (William Blair and Prudential do business with companies covered in their research reports.)

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