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First Marblehead Corp.
SLM Deal: The Economics of Walking Away

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By Puck50
October 10, 2007

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While everyone knows about the $900 million break-up fee, there has been little discussion about the potential losses both BofA and JPM would immediately incur if the deal were consummated resulting from their guarantees to provide $20 billion in debt financing.

Back in early April when the deal was struck, both institutions would have had the realistic expectation that they would be able to sell, or pass on, that debt to other investors. (In the past, the company undergoing an LBO would have issued high yield debt directly to pay for the transaction, but recently as a result of competition for investment banking business from private equity investors, investment banks tied to large money center banks have offered this financing on a guaranteed basis as an incentive with the expectation that it would be interim, or bridge, financing that they could hand off to other investors after the deal had closed.) Since April, the credit markets have re-calibrated risk premiums and are now requiring much more generous terms to buyers of this class of debt. The first big sale of LBO debt since the credit markets became chaotic beginning in late July occurred two weeks ago for debt from the sale of First Data. In order to attract buyers, the banks financing the deal offered debt a 4% discount to par value, or 96 cents on the dollar, for the highest grade tranche of that debt. Using these terms as a rough guide for what BofA and JPM might expect to have to offer in order to relieve their balance sheets of the $20 billion in loans related to the deal that they have guaranteed to make, they would expect to incur at least an immediate $800 million loss, or $400 million each, almost twice the $225 million that each bank's quarter share of the break-up fee would cost. For JPM and BofA, paying the break-up fee, if it comes to that, is clearly and by far the less costly option, at least in the near term. Flowers would obviously be the big loser because not only would Flowers have to pay twice as much in break-up fees as its partners, but Flowers would also have to forfeit the $200 million deal closure fee.

Jamie Dimon has reportedly been in favor of letting the deal collapse and made widely publicized comments on JPM's last conference call as wishing that this type of financing incentive to draw underwriting business would become extinct. Because JPM is known to be partnering with Flowers as well as Credit Suisse and Wachovia in a bid for Northern Rock, a deal even bigger than SLM's at approximately $30 billion, I infer that Flowers and JPM are still on good terms and speculate that the two have reached an understanding that JPM will make Flowers whole for the losses that it will incur for letting the SLM deal fail by supporting Flowers in future (and presumably better) deals, such as this one; and I will be looking to see if BofA pops up in the future as another recurring Flowers partner. I interpret Flowers bid for Northern Rock as a signal to SLM management that Flowers and JPM have already moved on--to bigger and better things.