Discover Provides Additional Details on Acquisition of Citibank's Student Loan Business

From Discover's 3Q Conference Call on September 20, 2010 (thanks to Seeking Alpha for their transcript):

What are some additional details on the private loan portfolio that Discover is purchasing from Citibank?

• Terms of the deal:  "We plan to acquire The Student Loan Corporation for $600 million or $30 per share, subject to a post closing adjustment pay between Citi and Discover. Immediately prior to the closing of Discover’s transaction, SLC will sell $28 billion of assets to Sallie Mae and $9 billion of assets to Citibank. We will then acquire $4.2 billion of private student loans and related assets at an 8.5% discount, along with assuming $3.4 billion of SLC’s existing asset-backed securitization debt funding against these private loans.  We expect to receive approximately $150 million from Citibank under the purchase price adjustment agreement. The ABS funding has had attractive rates and maturities represented by the trust identified in our 8-K. So funding is largely in place."

• Portfolio characteristics:  "Approximately 65% of the loan balances are in repayment, and greater than 70% of the loans are insured against loss...cosigners on 74% of the loans and weighted average FICO scores of 724. The percent of repayment is also very appealing as it will give us additional portfolio performance data. In my earlier comments I noted that the majority of loans are insured, which helps to significantly derisk the acquisition. The average variable APR in these loans is currently just about 4.5% with established funding attached, and this along with the discounted purchase price is expected to generate attractive returns."

• Other benefits of transaction:  "In addition to the compelling financial and credit characteristics of the included portfolio, the planned acquisition will position us well as we pursue growth opportunities in private student loans. It diversifies Discover’s loan portfolio and adds scale and distribution in private student loans through a proven operating platform. The combined student loan business is expected to remain a top three originator of private student loans, but Discover’s competitive position being significantly enhanced.  The transaction adds management with expertise across all functions, including a sales force that has relationships with over 1000 schools. Finally, the transaction will add approximately 300,000 new customers, providing an opportunity for repeat private student loans, as well as to cross sell our other Direct Banking products. To conclude, the planned acquisition of The Student Loan Corporation represents a financially attractive opportunity for Discover, which enhances our ability to pursue the growth potential of our Direct Banking business."
  • One of the key questions since Preferred Lending Regulations took effect earlier this year is whether school relationships have become less valuable.  Earlier this year an SLA survey found that only one in seven financial aid administrators was planning to go through the process of developing a Preferred Lender List.  An updated SLA flash survey on this issue is forthcoming. 

What are future growth expectations for this business and what factors will impact Discover's originations?

• "We think the demand is there and we think that you know, our 800 schools, there are 1000 schools, the overall franchise, you know, would give us certainly capability of being remaining the number three originator of private student loans.  But we will be watching very closely what happens to pricing, what happens to regulation, things like how they’re treated in bankruptcy, has an impact on how you can price a loan and so we are hopeful that it’s going to continue to be very attractive and you know, if you add the two together, you know, that’s certainly a possible outcome of originations but we are going to continue to make sure that we are approaching it you know, with the right schools, and the right focus on being a prime private student loan lender."

• "I think one of the other wildcards is the securitization market. There is a number of questions open right now on with the FDIC and with the SEC on securitizations in the future and if some of those get into, one of that – one of our advantages is that we can fund these with securitization or and/or with deposits, but certainly if we have securitization available to us in the channel we’re likely to originate more than if we were funding them only with deposits. So we are very focused on trying to minimize the cost to students and maximize the flexibilities, and if we achieve the best possible outcomes, we will and feel we can continue to grow pretty fast even while managing risk in return. We would certainly take advantage of that opportunity."

This Wall Street Journal column recently highlighted the potential impact of bankruptcy legislation on the already depressed private student loan asset-backed market:

"In particular, some private student-loan asset-backed securities, or Slabs, which account for about one-sixth of the total Slabs market, face challenges. Already trading at pennies on the dollar, these securities could suffer bigger losses if political scrutiny of for-profit education companies leads to tough legislation next year.

One proposal on Capitol Hill would make it easier for students to escape private student-loan burdens by filing for bankruptcy."

How will Discover service private student loans acquired from Citibank's Student Loan Corporation?

• "...we have a transition services agreement with Citi. So they will service this portfolio in the near-term, and over time we will look to integrate it into our own business."

• "We will grow the capacity over time. I just want to make a note that we don’t have to move all three trusts at once. So we will have to probably move one at a time, but we will grow gradually and this is going to be over the course of a couple of years."

Why does Discover consider private student loans an attractive market given the sharp declines from peak originations (emphases are mine)?

• "Yes, we believe this is a very attractive business and a close fit to us. It has in fact similar capital to credit card loans or other unsecured loans, and yet it has much lower – done right, it has much lower loan loss characteristics than other kinds of unsecured lending at lower risk. And while to some degree, I would agreed that if you compare to the peak originations of a few years ago, the business has declined. Compared to 10 years ago, it is certainly much larger than it was and as I look at – it has not declined because of demand, but more of supply where some of the players that only could fund through securitizations have exited the market, some of the players who maybe chased the yield places as opposed to going after the prime places that we focus on have changed their underwriting criteria.  And so from this point forward, we expect this is going to be a much faster growing market than other kinds of unsecured credit and a great bit for us, and we expect to have similar returns in terms of return on equity from our student loan businesses as we do on credit cards or personal loans in our other lending businesses. So we think it is an attractive place to allocate capital."

• "And so we see this as fitting with our focus and skills on unsecured loans. The Discover brand has played very well in this space and we see it as a way to – we think it’s a faster growing market over the next 5 to 10 years than that person’s credit cards, but we expect to have similar returns. It’s just a great deal...I mean, it does actually afford us the opportunity to cross sell to them over the life cycle right, and we are making an investment for the long run. So at some point those students are going to own deposit products, they are going to own a credit card and we will offer those products to them."