First Marblehead for Dummies

Awesome post copied from the FMD Motley Fool board:

"First Marblehead for Dummies."

Preface
Students are a subset of humans who never have enough money and a big industry grew up to solve this problem. First Marblehead is one of the companies that operates in this business.

Chapter 1, Loans.
Banks have lots of money and students don't so it makes sense for banks to loan the money to the students.

The problem is that banks are too dumb to know how to do it so they call First Marblehead to help them out. First Marblehead has a lot of very smart people who know how to make lots and lots of money from helping banks make the loans to students.

The smart people at First Marblehead know they will be making out like bandits so they help banks make loans to students for free, just for what it costs them to do it.

Chapter 2, Banks are Fickle.
Banks are fickle. First they get rid of the money they have by lending it to students. But after making the loans banks decide that they prefer to have money instead of loans but, of course, students have 20 years or so to pay back the money. Banks are up the creek without a paddle so they call First Marblehead, where the smart people work, to help them solve the problem.

Chapter 3, Wholesale Loan.
Banks are not the only people who have money to lend. Big institutions like pension funds and others also have too much money that they want to lend but they don't want to do it retail like banks do with students. They want to do the lending wholesale. Since these people are as dumb as bankers they too call on First Marblehead to solve their problem. Being smart really pays off big for First Marblehead, that's why we invest in First Marblehead.

Chapter 4, Loan Sausage Factory.
This is where it gets interesting. The banks give First Marblehead all their student loans and First Marblehead makes a HUGE loan sausage out of them. This sausage is so big that no big institution is big enough to buy a whole loan sausage so First Marblehead slices up the sausage. The people at First Marblehead are so sophisticated that they don't call the slices slices. They use a big French word for slices: "Tranches." This gives First Marblehead at least two big advantages, for one, dummies who don't read this book don't know what tranches are so they stay out of the business. Apparently big institutions are so fascinated by the name tranches that they are more likely to buy them than ordinary slices but that is just speculation on my part.

Chapter 5, Loan Sausage Tranch Ratings.
Big institutions really like the tranches, but the people working there have to protect their jobs so they look for someone to blame should the business go south. This is where the rating agencies come in. They rate the tranches pretty much according to what the smart people at First Marblehead tell them to but they fill the ratings with lots of small print to make sure that, should the business go south, they can pass the blame to someone else.

Chapter 6, Loan Sausage Tranch Handling.
The smart people at First Marblehead know they don't want to get their hand dirty handling tranches so they have this other company called a Trust to do it for them. This is really smart, should the business go south, it's the trust that is going to take the heat.

Chapter 7, Loan Sausage Tranch Guarantees.
Since everyone knows that students are a bunch of deadbeats, the smart people at First Marblehead get yet another company to guarantee the student loans that went into making the huge loan sausage that was sliced into tranches. The people at First Marblehead are double smart at this. For one, TERI, the company doing the guaranteeing, is a non-profit organization leaving more profit for First Marblehead. The double smart comes in because First Marblehead does not pay TERI, the students themselves do with an additional fee. Man, talk about a free ride! This has got to be the Original Free Lunch!

Chapter 8, The Deal Is Done.
Finally we come to the deal itself. Well, not quite. Since the smart people at First Marblehead don't handle the tranches and since the Trust is just a paper company, the smart people at First Marblehead call in yet another group of people to do the actual selling of the tranches. These people are called "underwriters." You probably want to know where they got that funny name. These people, who most likely are bankers but a different kind of banker than the ones who made loans that started this story, write a big document and they sign it at the bottom. Since their name appears under the meat of the document they are underwriters. I suppose if they were to sign at the top of the document they would be called "overwriters" or "topwriters." Maybe "abovewriters" would be better. Anyway, these guys do the actual selling of the tranches.

Chapter 9, The Money Flow.
The big institutions write big checks to get the tranches. The checks go to the Trust and they spread the wealth. The very smart people at First Marblehead make sure they get a very big chunk of it.

Chapter 10, The Denouement.
This is a fancy word that means (I looked it up in the dictionary): "the final part of a play, movie, or narrative in which the strands of the plot are drawn together and matters are explained or resolved."

Who knows? Maybe the students all took off for Katmandu.

Denny (Chief Dummy) Schlesinger

FMD Lowers Concentration Risk

I'm really impressed with this latest securitization, 2007-3. The huge size, Ambac insurance, auction rate structure and lower concentration all speak to strong growth and excellent management.

One confusing thing in the prospectus is that they don't list the lenders that are 10% or below. When you factor in the smaller lenders, you get the true picture of concentration which shows that BofA and JPM are at about 35%-36% of the total. For a detailed explanation, see here.

I'm ready for the oil bubble to burst

From Mike:

*OPEC's meeting is underway and at the center of debate is a Saudi-led proposal to formally raise the current output ceiling of 25.8 mm b/d by somewhere between 0.5 and 1.0 mm b/d

*With the cartel already producing more than 900,000 b/d above the current ceiling, it might seem pretty simple to just formalize existing quota cheating - all but one member are, in fact, above allocation.

*As we wrote yesterday, we think the bigger story behind the scenes here is the concern about high oil prices doing further damage to the global oil balance.

*Some countries (Iran, Nigeria and Venezuela) opposing a ceiling hike have been more than happy to watch Saudi Arabia cut back production by over a million b/d this past year as increased non-OPEC supply and weaker than expected world demand growth eroded the "call on OPEC crude."

*Based on our oil balance work, it seems the Saudis will be under further pressure next year to make room for non-OPEC capacity and the gains in non-OPEC. This seems eerily similar to what we saw in the mid '80s which led to the '85-'86 price crash.

Just imagine for a minute that you are Saudi. You are the low cost producer in the world, prices are near record-highs and yet you've had to voluntarily cut back production to allow other countries to sell their higher cost crude oil. How would you feel? Why would you allow that? Why not say, "Fuck you Venezuela and fuck you Iran and fuck Nigeria!! We are the most efficient producer in the world with the biggest reserves and we should be selling more crude, not you." This whole OPEC structure is mightly flawed on several levels. All of the countries are cheating and producing more than their quotas while Saudi gets the shaft. This has to be enraging the Saudi Kingdom and creating severe tension within OPEC. Yet, Saudi knows that the price of oil is being held up on nothing more than misconceptions about supply (it's not really tight and the world is not running out of oil), thus they have to be careful what they say. They don't really want the world to know that they are only producing from 25 of 75 huge oil fields. I would love to see the system and price totally collapse.

Matt Snowling was dead wrong on FMD securitization

Matt Snowling estimated FMD’s first-quarter securitization at $1.25 billion. Well, the company announced this morning that it’s going to be $2.8 billion, so he was only off by a mere $1.55 billion. It is highly likely in my opinion that Snowling has been overly pessimistic on FMD because his hedge fund client(s) are short the stock. Matt Snowling is the one who should be investigated by NY Attorney General Andrew Cuomo, not FMD. Not only was his volume assumption not even in the park, but his prepayment and default assumptions have been pulled from thin air. Yet, since there is so little analyst coverage of the stock, it’s his opinion that is often reported in Barron’s, Forbes, the New York Times, thestreet.com and other media sources.

FMD

Tom Brown destroys the long-term bear case for the stock in his Sept 7, 2007 article:

A Bear's View of First Marblehead

One of the great things about running a site like this is the negative feedback we occasionally get. It can be a wonderful reality check. Take, for instance, the following, which arrived on Wednesday:

Tom,

While I don’t pretend to know First Marblehead as well as you, I do know it very well. I think their “output” is an awesome thing--helping kids go to college.

However, how do you not address the current land mines?

1. The securitization market is currently closed.

2. Thus, gain-on-sale margins have totally peaked out.

3. There’s the potential for a writedown, as Marblehead’s discount assumption on its residuals seems aggressive if the company can’t sell the BBBs. (Also, how about the company’s shadiness in avoiding the question of how many buyers there are of the BBBs? There’s just 1, Dillon Read, and it’s gone.)

4. While not expensive on a P/E basis, the stock trades at 3 times book value, including residuals. Nobody in his right mind should pay that.

5. There are no buyers that could take the company private, because it can’t lever up, and is losing its two largest clients in J.P. Morgan Chase and Bank of America.

6. And then there’s the slimy factor: the company only disclosed the N.Y. A.G. subpoena because of the NYT article. They purposely omitted it from their 10K a few days before because they didn’t think it was a big deal. But because the NYT was going to break it, they disclosed it on a Friday before a long weekend the last day of August? Come on. . . .

I am not sure where this thing is going, but to give the bull case on Marblehead without highlighting these very material risks seems unfair.


The sender of the above is a fellow I’ll call “Bubba;” he covers financials for a large, well-known hedge fund here in New York that is said to be short First Marblehead. (I’ve cleaned up the message to fix the grammar and typos.)

I was pleased that Bubba was forthright enough to e-mail me, but was struck by how weak his objections to the company are. If this is what the Marblehead bears are left with by now, they're on shakier ground than I thought. Let’s go through Bubba’s points one at a time, and you’ll see what I mean:

1. The securitization market is currently closed.

Actually, the securitization markets aren’t closed. Just last week, NelNet completed a $1.5 billion deal. And Phoenix-based NextStudent is set to come to market next week with a $1.4 billion offering. Yes, the market has been disrupted and is challenging. That happens from time to time. But the disruption won’t last forever. It never does. In fact, I expect Marblehead will come to market with a deal of its own any day.

But even if the market were frozen solid, as Bubba seems to think, I still wouldn’t be too concerned. Granted, Bubba’s and my investment time horizons are different. I am a long-term investor and can wait these things out, while Bubba’s fund has a demonstrated record of being quite short-term oriented. A frozen market could be a disaster for Bubba. But unless the freeze lasts for years, Marblehead won’t have to change its business model an iota. As long as the company keeps facilitating loan volume at its current rapid (like, 40%-plus) rate at attractive spread to Treasuries, the company is creating a huge amount of economic value.

2. Gain-on-sale margins have totally peaked out.

Good Lord. Bears on Marblehead have been calling for margins to collapse since at least 2003—during which time margins have risen to 18% from 12%. Eventually, though, the bears will be right: margins will peak. They have to. So what? This fixation on margins to the exclusion of all other metrics (like, say, earnings per share growth) is idiotically myopic. It’s especially myopic, in my view, since the bears seem to refuse to take into account the margin expectation likely built into the stock’s valuation. With Marblehead lately trading at 7 times current-year earnings, the market apparently isn’t just looking for margins to decline a little bit; it’s looking for them to collapse. I don’t buy it.

In the meantime, lower gain-on-sale margins will not prevent First Marblehead from reporting earnings per share growth of 15% or more in fiscal (June) 2008, after a 59% E.P.S. rise in fiscal 2007. With Marblehead trading at a single-digit P/E as it is, it’s hard to see why the prospect of lower margins should be a compelling reason to be short the stock.

3. There’s the potential for a writedown, as Marblehead’s discount assumption on its residuals seems aggressive.

Bubba apparently doesn’t understand the difference between actual cash flow and the present-value accounting for future cash flows. Either that, or the details of the accounting arcana are more important to him than actual cash is.

First Marblehead assumes a discount rate of Libor plus 175 basis points in valuing the cash flows related to the BBB tranche of the student loans it securitizes. Given risk-phobia prevalent in the credit markets today, the company clearly can’t sell a BBB tranche at Libor plus 175. Who cares? The company doesn’t need the cash from the sale to run its business. (One of the biggest “problems” at Marblehead is figuring out how to deploy huge vats of free cash it’s generating as it is.) Besides, the market’s illiquidity won’t last forever. In the meantime, Marblehead can (and should) retain the BBB tranche. But changing the discount rate, up or down, doesn’t change the underlying excess cash flow the loans will eventually throw off.

4. While not expensive on a P/E basis, the stock trades at 3 times book value, including residuals. Nobody in his right mind should pay that.

Bubba, it’s hard for me to imagine how you could be more wrong. The people who’ve known the company longest and know it the best, like founder and former CEO Dan Meyers and board member and longtime fixed-income whiz Dort Cameron, would gladly purchase the First Marblehead’s residuals at the value the company holds them on its balance sheet.

Remember, these are very long-term assets (25 years), with the BBB residuals discounted at Libor plus 175. The other residuals, meanwhile, are being discounted at 13%! Bubba and the other short sellers, who believe that the residuals are either overvalued or outright worthless, will be scrambling when these supposedly overblown assets start throwing off rising levels of excess cash beginning in fiscal 2009.

More generally, book value just isn’t relevant to this company. Marblehead’s business model simply isn’t capital intensive. The company could even operate with a negative book value—which, come to think about it, J.C. Flowers plans to do with Sallie Mae should its deal ever close.

5. There are no buyers that could take the company private, because it can’t lever up and is losing its two largest clients in J.P. Morgan Chase and Bank of America.

First Marblehead can’t lever up? Why not? The company has $842 million in shareholders equity, and essentially nothing in the way of capital spending needs. (Capex will run just $27 million or so in fiscal 2008.) Marblehead is certainly not constrained by any capital requirement related to overcollateralization levels of its securitizations, since the rating agencies don’t require that Marblehead’s securitizations be overcollateralized in the first place.

The eventual departure of BofA and Chase, meanwhile, is a non-issue. The two companies have been of diminishing importance at Marblehead for years. Three years ago, they accounted for 65% of the company’s revenue. Last year, that had fallen to 41%; we estimate their share of revenues will fall again, to between 31% and 36% this fiscal year. Why, BofA isn’t even one of Marblehead’s “Big Two” anymore. The company’s in-house Astrive brand, which is considerably more profitable to Marblehead than BofA is, took that spot as of the fourth quarter of fiscal 2007. Astrive's revenues grew by 364% last fiscal year.

In addition to the growing importance of Marblehead’s internal brands, its non-top 2 clients are growing loan volumes at four times the pace of BofA and Chase.

Don’t forget, too, that the bears have been looking for the imminent departure of Chase and BofA for the past three years. (During which time, recall, Chase renewed its deal with the company through 2010.) Yes, the two will likely eventually leave at some point. But by the time that happens, Marblehead’s own brands and its other partners will more than make up for any lost business.

As for a sale of the company, First Marblehead’s board is just not interested given stock’s depressed price, the company’s record-setting performance, and the wave of excess cash that will begin to flow to the company in 2009. I don’t blame them.

I continue to believe First Marblehead has a great business model. (Notably, recent federal student loan legislation that had the bears so concerned has turned out to be a positive for Marblehead. First, student loan pricing should go up because federal lenders can no longer offer schools cut-rate private loans in return for their federal loan volume. In addition, the legislation didn't raise federal loan limits.) Macro demand for private student loans is strong and growing fast. The company has a durable competitive advantage in its ability to underwrite loans and tailor loan products for individual schools. What’s more, the company has done a great job of signing up new partners and developing its internal brands. Its earnings outlook is bright.

I also believe First Marblehead at today’s $32 stock price is exceptionally attractive. As noted, the stock trades at just 7 times current-year earnings. And the negative case on the company, if Bubba’s e-mail is an accurate and complete summary, just isn’t that strong.

Peter Lynch has two great quotes that summarizes some of my feelings about First Marblehead:

“Perhaps there’s some poetic justice in the fact that the stock you take the furthest in the long run gives you the most bumps and bruises along the way.”

and

“You need to find only a few good stocks to make a lifetime of investing worthwhile.”

Both those thoughts are relevant to First Marblehead. Yes, there have been some bumps and bruises. But by the time we’re done, I expect that this is one company that will have taken us a long, long way.

Still Trimming

Jeff's comments:

"Volume expanded fractionally over Tuesday's reading, as the % of issues above their own 20 day moving average came very close to the 80% threshold. This market is challenging the natural resistance level of 1500, and with libor at a 7-yr high and 2yr swap spreads widening, there appears to be a disconnect between equities and fixed income. We continue to stress that we have seen little evidence supporting a new bull phase in recent price data, and our latest sentiment work shows bullishness seeping back into this market as investors seem to believe the worst is over. To us, this all looks distributive, and if that scenario is right, and credit markets are a more accurate reflection than equities, stocks become a more natural sale at this juncture."

I also just read about some legislating being drafted by Chris Dodd and Barney Frank that will be very bad for lenders and investment banks. The legislation goes well beyond fee caps and requiring more paperwork. It will impose FIDUCIARY duty on mortgage lenders and allow borrowers that got foreclosed on to SUE the investment bank that securitized their mortgage if it included predatory features such as a prepayment penalty. Yes, I'm serious. The easy money is going away and a tougher credit chapter is beginning.