Marblehead's Golden Opportunity

Last week, loan servicer First Marblehead (NYSE: FMD  ) announced that Goldman Sachs (NYSE: GS  ) is providing it with $1 billion of debt financing. Meanwhile, a Goldman-affiliated fund plans to invest $260.5 million in FMD shares, which effectively buys that company a 16.7% stake in First Marblehead.

Why raise all that money?
This transaction poses an interesting question. First Marblehead is a middleman -- it mainly provides expertise to the student lending process, not capital. With its agency business model, First Marblehead has so little need for cash that it never even spent the proceeds of its initial public offering. Apparently, the only reason the company even went public at all was to provide a market for its founders and executives to cash out stock and options -- not unlike Microsoft (Nasdaq: MSFT  ) in that regard. So why sell another big block of stock right now, near all-time lows for the share price, thereby diluting value for stockholders? Why raise all that debt?

The answer is likely twofold. In the short term, the company is playing defense, reacting to the credit crunch. Over the long term, it's playing offense, as First Marblehead's continued growth requires that its business evolve from a pure agency into something more capital-intensive.

Credit crunch
First Marblehead sells student loans into the market for asset-backed securities (ABS), which has been rocked by loan defaults. The two largest sectors of the ABS market are home equity loans and collateralized debt obligations (CDOs) -- the very same types of assets causing severe damage to buyers like E*Trade (Nasdaq: ETFC  ) , whose toxic ABS portfolio was the proximate cause of one of the most shareholder-value-destroying refinancings of a major company in recent memory.

Besides mortgages and CDOs, there are indications that defaults are also creeping up in credit cards, auto loans, and -- most germane to FMD shareholders -- student loans. Confidence in the bond ratings agencies is in tatters, and bond insurers' very solvency is being called into question. Amid these conditions, the ABS market has practically shut down.

The ABS freeze has scotched First Marblehead's plans for a securitization this quarter, and it's unclear how long the crunch may last. FMD's contracts with its clients specify that if it doesn't execute another securitization by about March 2008, Marblehead will start to be liable for penalty payments of as much as $50 million. In order to avoid these penalties, the company may instead choose to buy the backed-up loans from clients and hold them on its own balance sheet. A sizable debt and equity investment from GS is a strong signal that First Marblehead can marshal the financial resources to handle worst-case scenarios.

Should the world fail to fall apart ...
While preparing for the worst, First Marblehead seems to be planning for the best.

Despite the current woes, banks still possess ample cash reserves, and in the long term, there should be demand for rates higher than the stingy 3.0% to 3.5% currently obtainable in short-duration Treasuries. If history is any guide, this holiday "buyer's strike" in the ABS markets should break once investors get a chance to perform a thorough year-end audit of their own balance-sheet exposures, and monitor the extent of rising loan defaults. Much-needed confidence in the credit markets should also be shored up by structural reforms, such as tightened requirements by ratings agencies and capital injections at bond insurers.

Meanwhile, First Marblehead says it continues to underwrite the loans it hopes will drive future profits. This pipeline of loans needs a home for the "warehouse" period pending securitization. Should FMD's clients have a reduced appetite for these loans amidst the current troubles, Goldman's capital can help Marblehead ramp up its fledgling business of self-funded loans, and thus allow it to continue squirreling away loans to securitize on better terms once the ABS markets thaw a bit.

FMD 2.0
Looking past the credit crunch, the steps FMD is currently taking to navigate the present storm also chart a course for the future. The current crisis provides a catalyst for First Marblehead to step up to the major leagues alongside the big banks, lending for its own portfolio rather than simply acting as an agent for others -- thereby dramatically reducing First Marblehead's dependence upon its largest clients, which has always been one of the hardest knocks against the company. The equity dilution entailed by Goldman's investment is a bit stiff, but in the long run, it heralds the arrival of First Marblehead as a franchise with definite staying power.

News of the GS financing set off a frenzy in the stock market, which bid FMD shares up more than 66% in a single day. However, this rise came on the heels of a truly vertiginous plunge, and at last week's close of $16.90, the stock still remains well below its price as of my last article, in early December. While earnings per share will be diluted by cutting in Goldman Sachs for a piece of the action, this will be offset by greater certainty and extra profits from portfolio lending.

On balance, First Marblehead still seems exceptionally undervalued for a stock whose prospects remain very bright.

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