Bank of America Corp (BAC), Discover Financial Services (DFS), Wells Fargo & Co (WFC): Three Potential Suitors for a Sallie Mae Spinoff

SLM Corp (NASDAQ:SLM), the nation’s largest non-government student loan lender, is considering splitting itself into two entities via an IPO later this year. But a private buyer might get to Sallie Mae first.

Why split the company?
Executives at SLM Corp (NASDAQ:SLM) have recently been discussing spinning off one of its $9.9 billion subsidiaries into a new entity, Sallie Mae Bank. SLM Corp (NASDAQ:SLM) would retain $195 billion of existing government guaranteed, private, and serviced loans, while the new entity would hold assets accumulated over the past eight years. While much of the legacy portfolio does have government guarantees, executives contend that the poor repayment performance of those loans is weighing down the value of the better-performing, newer loans held by the Sallie Mae Bank subsidiary.

In 2010, the Department of Education began lending directly to students, bypassing the traditional bank middleman. The government makes these loans without overly emphasizing credit scores or repayment ability. As a result, private lenders like Sallie Mae can pick and choose the best loans and leave the government to shoulder the bigger risks. In theory, spinning off Sallie Mae Bank would unlock shareholder value by freeing the new entity of legacy problem loans originated with government guarantees, leaving only the newer, low-risk portfolio.

Sallie Mae Bank, the subsidiary to be spun off, earned $334 million in profit in 2012, driven by 20% growth in its loan portfolio. The subsidiary bank’s loan portfolio has more than doubled over the past four years, to its present $7 billion size as of year’s end 2012.

With talk of spinoffs also comes talk of acquisitions. Considering the size of the proposed Sallie Mae Bank spinoff, a number of players big and small might want to snap it up.

Bank of America Corp (NYSE:BAC)

Who could be considering an offer?
Bank of America Corp (NYSE:BAC)
has been intentionally shrinking under CEO Brian Moynihan, but the megabank must transition back to growth if it intends to remain one of the world’s elite banks. Student loans at Bank of America Corp (NYSE:BAC) decreased $200 million to $4.6 billion from Q4 2012 to Q1 2013. Pursuing Sallie Mae could, beyond growing the loan portfolio, be seen as a broader signal to the markets that Bank of America Corp (NYSE:BAC) is at last emerging from the shadow of the financial crisis and returning to sound, profitable growth.

Discover Financial Services (NYSE:DFS) entered the student loan market with a splash in 2011 when it purchased a $2.5 billion portfolio from Citigroup Inc (NYSE:C). As of Q1, Discover Financial Services (NYSE:DFS) had $8 billion in total student loans, an increase of $400 million year over year, but still just 13% of its total portfolio. (Credit cards account for more than 80% of Discover Financial Services (NYSE:DFS)’s holdings). Acquiring Sallie Mae could immediately propel Discover into the upper echelon of the market, and simultaneously balance out its concentration in credit card debt.

Wells Fargo & Co (NYSE:WFC) is the nation’s second-largest private student loan lender, with just less than $23 billion in student loans as of Q1. Wells Fargo & Co (NYSE:WFC) reported in its first-quarter earnings supplement that the average student loan borrower has a credit score of 764, and that 78% of new originations in the quarter were co-signed with another adult. Acquiring Sallie Mae would propel Wells head and shoulders above the competition in the student loan marketplace. Wells Fargo & Co (NYSE:WFC)’ challenge would be finding efficiencies after the purchase to maximize the return on investment.

Student loans are no sure thing
To be clear, buying all or part of Sallie Mae won’t guarantee success in the student loan market. A study released earlier this year by FICO Labs found that students today have on average 58% more debt than in 2005, with a 22% greater chance of defaulting.

But these headline numbers can be misleading because of the government’s role in the market. Sallie Mae reports that just 3.9% of its borrowers with average or better credit scores — “average” defined here as a FICO score between 640-670 — were more than 90 days past due as of year-end. This compares to 12.6% delinquency for borrowers below those thresholds in the Sallie Mae portfolio.

Because the government is the primary lender for borrowers with low credit scores, it is reasonable to expect that an independent — or acquired — Sallie Mae Bank would have very low delinquency rates thanks to its hand-selected borrowers’ high credit scores.

For an acquirer, the bottom line is growth
Student loans remain an attractive class of consumer debt. Since the Great Recession, households have been reducing consumer debt virtually across the board, with student loans being the one significant outlier.

As banks continue the search for growth, student loans are an attractive option. Acquiring Sallie Mae Bank could be a quick way to find that growth.

The article 3 Potential Suitors for a Sallie Mae Spinoff originally appeared on Fool.com and is written by Jay Jenkins.

Fool contributor Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Bank of America and Wells Fargo.

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