First Marblehead Corp.
"Until securitization comes back FMD is a dead duck."

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By captainccs
July 10, 2008

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Over on the NPI board Tinker asked:

Denny, what are your thoughts on FMD and its future these days? Certainly not priced as if it has much of a future at the moment.


Easy question. Long complicated answer. A lot of factors to consider.

1.- The market has thrown out all the financial babies with the bath water. If you have a look at the BMWM buy screen you'll find that there are over three times as many picks as usual and a large number of them are financial stocks. I was looking at ACAS (a non BMWM stock) and it has a dividend yield of 18% which is ludicrous (maybe it isn't if truly management has fudged the real value of assets). The best bargains you'll find in a decade are financial stocks, if only one knew which ones. The problem is the uncertainty because financials are typically information black holes, you don't know what is happening to them. Bear Stearns was "healthy" until the day it died, at least, so management said which, of course, was a lie.

2.- More specifically, the student lending industry is in disarray because poor mortgage lending practices plus the subsequent issue of toxic waste tranches killed the securitization market. The student loan industry is suffering from collateral damage but "friendly fire" is as deadly as enemy fire. Until securitization comes back FMD is a dead duck.

3.- There are lingering doubts whether First Marblehead's original business model is/was sustainable. Initially they acted as a service agent for lenders and as middlemen between students, schools, lenders, and fixed income investors earning fabulous fees. Since the hay days they have lost principal lending customers and they have become more of a bank. Had First Marblehead been a lender or a bank to start with, I would never have invested in the stock.

4.- TERI is being reorganized which is a good idea. There were two major issues with TERI, the restricted funds and the default model. TERI is insurance and insurance works based on the law of large numbers. For some reason many of the deals TERI insured had "private" or restricted reserve funds to back them. In other words, if deal "A" had a million bucks in its restricted reserve fund and deal "B" went sour, TERI could not use "A's" reserves to rescue "B." This is the same as saying that my insurance company cannot used my premiums to pay damages to my neighbors house. It's a total absurdity! The whole idea behind insurance is to spread, to dilute, the risk. Apparently this issue is being resolved by the bankruptcy court. The other issue is that probably TERI used the wrong distribution model to calculate student defaults. More than likely they used the industry standard "normal distribution" which would work if students were not in a larger economic environment. The normal distribution does not take into account "black swans" and the meltdown of the economy is such a black swan. Simply said, all ships rise and fall with the tide and student defaults will rise in a falling economic environment. This was probably not accounted for in the default models.

5.- My best guesstimate is that FMD is trading below book value. There are a lot of residuals to be collected over the years but these become ever more uncertain if First Marblehead does not live to fight another day. The good news is that First Marblehead has been battening down the hatches to conserve working capital.

Tinker, those are my thoughts. My actions are that I'm holding on to my FMD shares. I doubt that the old First Marblehead will ever come back but I do believe the shares should trade at more reasonable levels once the new First Marblehead is back in business. At that point I'm likely to sell my shares if First Marblehead is mostly a lender.

Denny Schlesinger