Sallie Mae Sallies Forth

A government-sponsored corporation learns to love the free market.

Last week, the Wall Street Journal reported that Golden State Bancorp, a California-based savings and loan that is in the process of merging with Citigroup, apparently ignored a more lucrative acquisition offer from another financial institution.

The implication was that Golden State’s board had been derelict in not considering this offer, but the controversy fizzled when the other putative bidder—SLM Corp., commonly known as Sallie Mae—said it was never seriously interested in Golden State.

But the real story was: Why was government-sponsored Sallie Mae bidding on a large savings and loan?

After all, the company’s raison d’être since its creation in 1972 has been to service and process federally guaranteed student loans. Spending $4.8 billion on a thrift might seem a huge and strange departure for Sallie Mae. In fact, it wouldn’t have been such a change. In an age when Amtrak is collapsing and the U.S. Postal Service is hiking rates every few minutes, Sallie Mae is the rare government-connected enterprise that is thriving and seeking less rather than more government support.

Like its larger siblings Fannie Mae and Freddie Mac, Sallie Mae is a government-sponsored enterprise (GSE). GSEs are created by—and partially governed by—the federal government but are owned by public investors. The large GSEs have a mandate to further public policy goals like increasing home ownership, or helping people pay for college. They make loans and purchase loans made by others, which they in turn package and sell to investors. The market tends to regard the bonds and notes issued by GSEs as contingent government liabilities. If ever Fannie Mae were in danger of defaulting on its debts, investors reason, Washington would intervene to prevent an economic disaster.

That implicit government guarantee and their direct competition with large financial services companies have made GSEs, especially Fannie Mae, controversial. But Sallie Mae has never been much of a target. After all, the market for student loans—about $40 billion annually—is a tiny fraction of the $2 trillion annual home-mortgage market. And while Fannie Mae clings fiercely to its GSE status, Sallie Mae has lobbied to shed its government-conferred competitive advantage.

Congress created Sallie Mae to provide financing in a relatively untested market where banks feared to tread: lending to college students. In the beginning, Sallie Mae served primarily as a back-office processor of student loans. Sallie Mae would purchase loans from banks—using funds borrowed at favorable rates from a Treasury Department entity called the Federal Financing Bank—and then collect the payments from students down the road. Profitable from its earliest days, Sallie Mae went public in 1984.

Sallie Mae suffered a blow in 1994, when the Clinton administration’s Department of Education began making loans directly to students, thus bypassing the banks who were Sallie Mae’s clients. Within a couple of years, the department garnered a 35 percent market share of new loans issued; Sallie Mae’s stock fell to the single digits.

Rather than throw in the towel, Sallie Mae lobbied to be liberated from the federal charter that restricted its operations to servicing and processing loans. In 1996, Congress passed a law that would require Sallie Mae to shed its GSE status by September 2008 and transform into an independent company.

In 1997, new CEO Al Lord began to push Sallie Mae into related fields like loan origination. Sallie Mae spent more than $1 billion in 1999 and 2000 to acquire several student-lending companies. It also established a joint venture with Chase to originate student loans. The result: Sallie Mae last year originated more than $10 billion in loans, about 30 percent of the market. About 80 percent of its revenues derive from loan origination—as opposed to processing and servicing.

The market for student loans is expected to grow as higher education costs escalate. But ultimately they will remain a small plot in the vast field of financial services. Eager to expand beyond its niche, Sallie Mae earlier this year announced it would shed its GSE status two years earlier than required, in 2006.

For while it counts some $75 billion in assets—about as much as a decent-sized regional bank—Sallie Mae’s most valuable possession is its list of 8 million active customers. College-educated and mostly younger, they sport higher-than-average incomes and credit-worthiness. So, in recent years, Sallie Mae has started to work with companies interested in marketing things like credit cards and travel discounts to this audience. It also launched a job Web site,, and set up a consumer credit unit that offers home mortgages and car loans in several states.

But it is far easier to buy large consumer-oriented businesses than to build them from scratch.And with a market capitalization of $14 billion, and a stock that has risen dramatically throughout this bear market, Sallie Mae is in a position to digest larger deals. Add it all up and you can see why Golden State popped up on Sallie Mae’s radar screen. Such an acquisition would have allowed it to lend billions more and would have aided efforts to market auto and home loans to existing Sallie Mae customers.And owning an institution that can accept deposits would permit Sallie Mae to get in on the burgeoning market for college-savings plans.

Is there anything wrong with this? Sallie Mae’s student-loan business is now segregated into a subsidiary that maintains its traditional GSE status. The units engaged in new businesses don’t have any government connection, implied or explicit. But Sallie Mae’s earnings and its stock price—the currency that will allow it to diversify—remain almost entirely dependent on the performance of the student-loan business.

And in that arena Sallie Mae continues to reap certain advantages over its competitors. Like other GSEs, it pays no state or local taxes except for property taxes. Holders of its debt don’t pay state taxes on the interest they receive. Its cost of capital is also lower than that of many competitors, in large part because of the residual government links. It can continue to obtain cash from the Federal Financing Bank at rates that its competitors can’t. Meanwhile, Sallie Mae’s debt securities bear the highest credit ratings awarded by both Moody’s and S&P. The company concedes that these ratings have historically “been largely a factor of its status as a government-sponsored enterprise.”

But in many ways Sallie Mae’s real competitive advantage derives from its size and status as the industry pioneer. It is six times larger than its next-largest competitor, Citigroup-controlled Student Loan Corp., and it  dwarfs the state-run agencies that can compete with it on price. And instead of simply meeting its mandate to provide liquidity to lenders, the company’s management over the past few decades has pioneered new practices and opened new markets. Like Ralph Lauren’s daughter Dylan, who runs a chain of candy stores, Sallie Mae has combined the name recognition and seed money it got from a powerful daddy with savvy marketing in order to create a new business.

The good news for Sallie Mae’s competitors is that, come 2006, it will no longer enjoy its current GSE advantages. The good news for Sallie Mae is that, by then, it probably won’t require them. It will have parlayed the assets created by the government link into a larger, more diversified company—one that doesn’t need government support to compete with Citigroup.