First Marblehead Showing Cracks?

On Tuesday, Moody's (NYSE: MCO  ) expressed concerns about student loan performance in securitizations facilitated by First Marblehead (NYSE: FMD  ) . While the bond rating agency has not issued any downgrades, it noted higher-than-expected defaults, and consequently a slower-than-expected buildup of assets inside the securitization trusts. As a result, Moody's is reviewing its ratings on the lower slices of these deals.

What's worrying Moody's?
At first glance, the cause of Moody's consternation may not be entirely obvious. After all, these aren't subprime loans used to buy snowmobiles; the borrowers are students paying for an education, an achievement that generally improves their willingness and ability to repay. By and large, the loans are co-signed by parents with excellent credit, and for borrowers who do default, the obligations are not dischargeable in bankruptcy. A partner of First Marblehead's The Educational Resources Institute (TERI) guarantees full payment of principal, and funds are escrowed to cover the expected amount of defaults.

But Moody's fears that defaults will increase beyond what was expected and escrowed, causing noteholders to ask TERI to break into its own coffers for restitution. TERI doesn't really have the financial resources to handle too many such claims, should losses spike simultaneously in many of the securitizations it has guaranteed. This scenario (which has also spurred Moody's to consider downgrading TERI's own credit rating) would leave no guarantee that noteholders lower down in the securitization structure would get back their principal. Any realistic prospect of permanent losses would involve ratings downgrades below investment-grade. That's it in a nutshell.

What does Fitch say?
Moody's competitor Fitch, which downgraded TERI last week, is also concerned that the guarantor has stretched itself a bit thin. However, Fitch is taking a more sanguine view of prospective losses in First Marblehead's securitizations. While acknowledging that the 2005 and 2006 vintages show some leading indicators of stress, Fitch reaffirmed its ratings of all notes, saying, "At present, the trusts have generated sufficient cash flow to cover any losses and pay note principal to build credit enhancement at levels sufficient to maintain the current ratings despite the TERI downgrade."

Moody's is the more worried of the two agencies, because it had projected that losses would occur more slowly than they have, and because First Marblehead's pools appear to be performing worse than similar loans from competitor Sallie Mae (NYSE: SLM). Though these losses aren't yet a serious problem, Moody's is concerned that its assumptions have been off the mark. Clearly, the rating agency is worried that rapid expansion has caused underwriting discipline to slip as First Marblehead's marketing efforts have moved out of the financial aid office. The company is now pitching directly to students; you may have seen ads for the company's "Astrive" brand on MTV, The Daily Show, and the Internet.

What's the impact on FMD shareholders?
The stock market has severely punished First Marblehead's shares, slashing them 20% just yesterday and more than 50% year to date. That's discounting some seriously bad news for this company. What might shareholders expect for the future?

  • No deal this quarter. These announcements from Moody's, issued into already frozen-up securitization market conditions, are likely the final nail in the coffin of First Marblehead's hopes to securitize another pool of loans this quarter. In itself, this is no disaster. First Marblehead accelerated its schedule to execute one securitization every quarter just last year. The company's longer-term shareholders are used to waiting out some seasonality of profits.

  • Less favorable terms on new deals. Historically, the ratings agencies have found First Marblehead's numbers so compelling that the company has enjoyed access to capital on stunningly favorable terms. If Moody's and others are now becoming more cautious, First Marblehead will be able to extract less cash up front, leaving more assets in the trusts to cover losses. That will hurt the company's bottom line, but in fact, nobody expected FMD's post-IPO honeymoon to last forever.

    Even the company's most vocal bull -- Second Curve's Tom Brown -- has always conceded that sooner or later, FMD's gravity-defying results would return to earth. Recent events may deflate the company's profitability to a more sustainable level, but that was always more a question of "when," not "if."

  • Portfolio writedowns. The company claims that current default experience lies within its own prior estimates (8% cumulative defaults with 40% recovery over the life of the loans). If default experience continues to worsen, or if market values for related assets deteriorate, it would not be surprising to see First Marblehead take some writedowns on its fairly substantial portfolio of securitization residuals.

Taking all of this into account, though, the current price action in the stock certainly seems overdone. To pose some reasonable estimates, suppose that First Marblehead securitizes $4 billion worth of loans in the coming 12 months. Suppose that, to achieve its target ratings, the company must capitalize the trusts with an additional 3% collateral (above and beyond the additional 3% collateral hike needed to execute September's securitizations amid awful credit conditions). Assuming First Marblehead took the entire hit, leaving its clients to collect the full amount of their customary 5.5%-6% marketing fee, FMD's profit margin would drop to 12%, of which 5.7 percentage points would be cash up front.

Those figures would have the company booking revenues of $480 million (including $228 million in cash). Grossed up for processing fees and such, this would be more like $600 million ($348 million in cash). At 35% net margins -- well below recent years' figures -- on 95 million shares, that works out to diluted earnings per share of $2.53. More than $1 per share of that would be cash, taking deferred taxes into account.

This analysis assigns zero value to FMD's existing portfolio of residuals and structural advisory fees, which the company recently valued at $928 million, on what look like reasonably conservative assumptions. No class of securities is yet in distress, but just to hedge against rising defaults, let us apply a modest 50% valuation discount to management estimates. That would make FMD's portfolio worth $4.88 per share. Backing that figure out of yesterday's closing price of $19.93 leaves just more than $15, producing a P/E of 6.

I don't know about you, but to me, that sounds very, very cheap. First Marblehead enjoys a leading market position and serious competitive advantages in an asset class with high secular growth trends. Even if First Marblehead's thus-far-phenomenal growth is beginning to slow, those trends aren't going anywhere.

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