SLM Corporation ($SLM)

All right. Good morning, everybody. Kicking off day 2 of our financials conference we have with us, Sallie Mae. With me today, I'm joined by Pete Graham, CFO of Sally. Pete, welcome back to our conference.

Very great to be here. Thanks for having me. .

So maybe let's get right into it. You released some slides a little while ago morning. You highlighted some recent loss pressure that's being driven by a specific high ability to pay segment where outcomes appear to be influenced by misaligned debt resolution practices. Can you maybe walk us through what you're seeing here and why it's behaving differently from the broader portfolio? .

Sure, sure. As we started to see the November payment wave come through, we noticed a trend of what we would otherwise think to be customers who had a high ability to pay by various credit metrics, whether it's FICO or other credit lines outstanding, things like that. We're not engaging with us, and we're rolling straight to default. So it's a small -- very small portion of our portfolio, but was driving an outsized kind of impact in terms of our charge-offs. As we dug into that, we realize that there's some sort of players in the debt management space, they are kind of taking advantage of recovery settlement levels that we normally have that we set for people who don't have an ability to pay. And they're basically marketing a product that purports to be a student loan refinance. They're basically writing a new loan to this customer at full loan value plus origination fees, and then they're coming on the back end of our recovery processes and getting that loan at $0.50 on the dollar, call it. And so we feel that's misaligned for a number of reasons, but mainly because we believe the customers are not really understanding fully the product that they're being offered. They're not understanding the long-lasting impact that, that charge-off is going to have on their credit ratings. And so we're going to take some action to kind of close that down in the near term. We're going to -- or we already have terminated our flow contracts that we have in the recovery, sales -- charge-off recovery sales space. And we're going to adjust our settlement floors in our internal processes for a period of time. So we can get a -- kind of get a good handle on that landscape.

Can you talk about when you maybe first noticed this? And how long you think it's been going on? .

Yes. Again, I think there's always some level of settlements that happen in the recovery process, but this sort of elevated level really materialized in this November payment wave that comes into repayment here in the first quarter. And that's where we really noticed the outsized impact on charge-offs. We were expecting again -- and if you look at the charts in the deck on a -- once you normalize for this cohort of customers, like credits actually although the dollars are higher because of the size of the payment wave, the actual performance is only modestly elevated. So like we feel good about broader credit. And when we saw trends in the portfolio that we're going against that, we dug in a little bit and uncovered this.

And you sort of highlighted some of the actions you're taking in response. Can we just dive a little deeper there. What channels you're turning off? How you think that will impact the credit in the near term or over time? I'm assuming -- I noticed in the slide, you mentioned that this would be NPV-positive, but I think there's probably a timing [indiscernible] there. .

Sure. Yes. So we kind of sized it sort of if we don't restart our normal recovery practices before the end of this year, that's kind of like a $25 million impact to recoveries in year. Now we've proven through our sort of champion challenger model that we put in place a couple of years ago that our internal recovery efforts actually drive higher NPV on recoveries. It just happens over a longer period of time. So kind of the trade-off always is, do you get the immediate recognition from the charge-off sale? Or do you work that those accounts over time and kind of build up a layer of payment recoveries coming in. Again, if we don't restart any of those sales this year. That's kind of the full $25 million impact. But still how this unfolds over the coming weeks, months will determine whether we are comfortable restarting this year or it kind of tails into next year. So it's -- again, it's a modest impact. It's not a credit impact because, again, it's the recovery part of it. So it's not kind of like core credit in the book once you isolate for these early straight rollers that we're seeing that otherwise look like they have ability to pay. So we feel like it's well contained, and we're taking action to kind of [indiscernible] and get it under control.

And is there any sort of expense impact to be thinking of that as you sort of bring some of that in-house or... .

Yes. I mean the -- The internal recoveries that we direct are largely using some form of contingent collections. And while that will have an impact on expense, it's variable and like, for instance, a few years ago, when we brought half of our process in-house, we didn't -- we updated our charge-offs guidance for the year, but we didn't have a noticeable impact on expenses. I don't think anybody is going to notice the expense impacts this year. And it will be all within kind of puts and takes that always happen in any given year in a guidance range.

Okay. So I guess maybe more to come on the actions you're taking, the results of those actions. .

Yes. Again, I think we'll know more by the time we get to earnings, and we'll update on what's happened since. And we'll probably have a little sharper view on exactly timing and duration of change in process.

Okay. Great. And you also shared some new and encouraging data on modifications as well. Can you just walk us through what you're seeing and what gives you confidence that these borrowers will continue to perform as they step out of their lower payment period? .

Yes, sure. We've been really pleased with the performance in the modification programs. We've been giving sort of payment success rates over time in the different cohorts at different sort of slices of how long have they been successfully making payments. And I think we updated that data in the 8-K, we filed this morning. I think if you look at it over time, what it shows is, although there is some variability by enrollment cohort, there's a really high success rate of the people in -- when they're actually in the modification period of making payments over 80% in all the cohorts. And because we started these new programs in the fourth quarter of 2023, there generally 2-year programs. What we've seen this year is sort of the graduation of the first cohorts that entered. And we've been really pleased with the early performance. We put some data in the charts around success rates after 3 months being back in -- or stepping back into their contractual payments. And those success rates are approaching 80%, which is higher than what we had anticipated when we designed the program. So again, all really positive signs about success of the MODS programs, and we'll continue to update that exit success rates as we build more data points moving forward, but feel really good about early signs.

Okay. Great. And as you step back, I think, from some of these near-term dynamics we're talking about today, how are you thinking about the durability of your loss profile? And what gives you confidence in maintaining outcomes around your current range? .

Yes. I think certainly, the success of the loan mod programs is a big piece of that. I think that's an important tool that helps us manage the peak stress period in our portfolio, which is that new to repayment. The other thing that we have also updated information in the 8-K is the fact that we made some significant underwriting changes a few years ago. And those underwriting changes are now flowing through into new repayment -- people rolling through into repayment status. And the portion of borrowers that are subject to the old underwriting standards continues to sort of dramatically shrink. So in the current year, that's going to be 5% roughly of borrowers and entering repayment are under the old criteria, and that shrinks pretty dramatically as you move into the next couple of years. So that again, is a little bit of a credit tailwind of having made some cuts to underwriting to sort of optimize against what we saw as poor loss performance of certain cohorts.

Maybe shifting away from credit. There's a lot happening for Sallie Mae lately, not the least of which includes increased opportunity in private lending as grabs plus retrenches. So I think it's still early days, but how do you view your competitive position in the market? What differentiates your new graduate products? I think you also included some nice stats around early uptake of those 2 new products you highlighted. Maybe just talk about that. .

Yes. We've been really focused on analyzing customer demand as we've thought about leaning into grad. We really took a position that we wanted to get insights into what features we're really going to resonate with the different programs of study, tried to be really thoughtful and gather data around what kind of deferral periods we needed to offer just to sort of tailor that because what a medical school student needs given residency periods and the like is very different than what a law school student needs, et cetera. So we've been very thoughtful about product design. I think that's resonating somewhat in our early launch of these programs. And again, it's early days, but we're really happy with the uptake on that. And we think that is a promising sign towards our readiness for really being in the heart of peak season this year.

And how do you expect the competitive dynamics in the grad market to really evolve relative to what you've seen in undergrad. I mean you've had the long-standing relationships with schools. Are they giving you any feedback on this dynamic? .

Yes. I think the broader expectation around competitive landscape is kind of the same as we've talked about. We haven't seen any evidence of major new entrants or the like. I think the established players in the undergrad space are the same folks that are competing in the grad space. And they're not kind of uniformly leaning in. Some are sort of being very measured about what they're doing. Others are being a little more aggressive on like marketing spend and things like that. So we expect it to be a pretty competitive market still, we expect for there to be a stable sort of set of participants in the way that there has been in the undergrad. I think the feedback we're getting from the colleges is, they really appreciate the sort of level of effort we've put into really tailoring our programs to meet defined needs of different student cohorts. And so we feel like that's probably a differentiator for us as we go into a competitive peak season.

You mentioned you're probably seeing the same competition as you see in the undergrad. I guess one question we get a lot is, there are some players in the grad market or the refi market consolidation market that have a different a little bit of a different footprint. Are you expecting any competition there? Or is there a difference in the marketing strategy and how that...

Yes. I think there are certain players that have a different view on efficiency of marketing spend, and they will tend to drive costs higher in the overall environment, but we're set up to sort of compete in that sort of commercial backdrop. We can sort of target where we want to spend our dollars and focus on things that we think are going to generate a higher throughput and higher efficiency. And we've been really focused on that in terms of our digital outreach, in terms of sort of recognizing that grad students are a different -- completely different customer than undergrad, and really trying to tailor our outreach on grad for that consumer.

And just relatedly, as you've leaned into that grad opportunity, where have you made the most meaningful upfront investments? And how should we think about those investments over time?

Sure, sure. Kind of as we've talked about, the expense build for this year was really about being ready for peak. So things like developing the new products that we've been launching successfully in the recent weeks, building out the sort of underwriting models and things like that, that go behind that, the tech improvements that enable those product features because, again, you've got to make that come to life in all of your systems and processes and make sure it's well controlled. So that's been a big area of focus. The other, obviously, is the marketing spend that we need to make to -- the investment we need to make to go after a new to firm customer. And it's been a very competitive environment just in the broader sort of digital marketing space costs across the board have increased. So that's been the sort of main areas this year that have been an area of focus. And again, it's kind of like a build before the actual volume comes. And we believe very strongly that as we scale into next year and beyond that will start to drive efficiency, particularly in the marketing processes and get to, hopefully, as good or better sort of efficiency rates as what we've had in the undergrad marketing. .

Can you just help us understand like what makes you think you can get that same level of historic efficiency as you sort of think about the efficiency ratio popping up and then getting back down to the...

Well, I think there's a piece of it which is tied to kind of like serialization. Again, we demonstrate in the undergrad space that it costs more to get them in the door the first time, but then serialization over time sort of normalizes that out. I think there's also an element of learning about an entirely new customer segment, tailoring strategies to go after that customer and you learn something by doing that and you sort of rinse and repeat and always refine your processes. So you are always looking at efficiency and trying to drive better throughput from your activities over time.

Okay. Great. And the other major development at Sallie Mae is the new strategic partnership business. You've been talking about a second partnership. How are you thinking about timing there? And how might that structure differ from the original transaction you did last year? .

Yes. So we kicked off that business last year with the first partnership with KKR. The KKR partnership is going great, working as intended and coming up on the 1-year anniversary because again, based on an academic year. So as we start the new academic year, we'll be starting the new sort of next year of commitment. We ran a sort of competitive process internally with a lot of the same participants that participated in our process last year, and went into bilateral negotiations with one of those parties in the last few weeks. Still anticipate working through that process before the end of the year. And initial conversations are going well. I think I would think about this as probably a similar sort of construct in terms of structure and economics as the KKR deal, not exactly the same, but similar. And we believe we'll -- based on the engagement so far that we'll get that done in short order. And I think the important thing is the -- both KKR and this second partner are both also very interested in building on the undergrad contracts that we have. And and building capacity for grad flow originations as we're scaling into that going into next year.

So this one might have a little bit more of a grad focus as you...

This one will be primarily underground as the prior. Again, we -- because we're creating these new products and in market largely for the first time in this peak season. We need to get some data about the actual originations before we can build the the various components of a partnership program. But I think the important thing is that the investors are interested in expanding to cover grad. So whether that's an add-on to the existing contracts or another sort of contract with the same partners. I'm sure we'll get that done. We just need some more data about what the thing is that's going to be in the flow contract before we can build the contract.

And apologies if I missed this, but when you think about the structure, is it -- is there typically going to be an upfront sale? Or is that unique to be original? .

I think for any of these partnerships, there likely will be -- we refer to it as kind of like a seed portfolio because if you think about new flow originations. It's going to be a couple of years before you start to get cash flow into the structure. And so having some element of seasoned portfolio sale into the structure will be preferred, I think, by the investor and result in a sort of a better overall construct. So we're anticipating that to be part of the next partnership and quite frankly, any new partnerships we would create in the future. .

Got it. And speaking of other partnerships in the future, how should we think about the long-term role of partnerships in your model and how that platform evolves over the next couple of years? And any sort of thought process around cadence of new partners? .

Yes. I wouldn't think about it so much as a cadence. It's more -- we need to build capacity for the level of underwriting that or originations that we expect to occur. And as you know, we are expecting a pretty dramatic ramp and particularly grad originations moving into next year. So like that will be the next thing we're really focused on is getting the contract structured around what that grad opportunity is. I think over time, our view is we'll probably have a handful of partners as we get to scale, we'll have private credit firms like the KKR arrangement in this second one that we're working on now. We'll probably have some contracts directly with some insurance companies. We'll probably have some contracts directly with some of the big institutional money managers. And because we're sort of building these programs over time, you'll get to a point where you naturally have staggered maturities of the various flow contracts and different sort of pricing reset time periods and the like. And our view is that will build kind of a more durable and resilient sort of funding profile that has less sort of episodic things built into it.

And I think one, maybe more longer-term aspect you've highlighted in prior calls is despite the fact that you've maybe restricted how much you're willing to take on balance sheet, you've hinted that maybe some potential to underwrite a little deeper for those partners down the line? Like is that -- yes, once you get...

Yes. I think that's always an option for us as we go into negotiations with a partner as to what their credit appetite is and whether that's setting the sort of concentration limits for our existing underwriting box that they want to take into a structure or whether it's they're comfortable with something that's beyond our current underwriting box that we're comfortable putting into our bank. I think that's always something that's open for discussion. And all of the partners, to a various degree, over the course of the last couple of years as we've been talking with potential investors, they all -- all the firms are different and they have different sort of risk appetites and different profiles that they're looking for. We feel pretty confident that over time, we'll build the capability also to expand credit box, particularly in the undergrad space beyond what we've currently been putting into these flow contracts and what we currently put into our bank. .

And I guess from a profitability standpoint, how should we think about partnerships in the kind of low to 20 return framework you've put out there? And how does that maybe compare to what you're doing for the on-balance sheet business?

Yes. So I think it's important when talking about these kind of comparators to note that like we intend to always have a well-functioning, well controlled and very profitable bank book. I think that that's kind of something that is going to be important to maintain over time because markets change and appetites change, and we want to be able to have that balance. Our focus on the bank side has been on optimizing our operations and making sure that we're driving really strong returns into the bank held for investment book, that carries over to into the partnership structure because, again, currently, we're selling a slice of those originations into these new structures. So the partners benefit from the improvements we're making in the core business. The return profile of on book obviously, is very different than the return profile of what you're going to get through a partnership flow type structure. But the capital efficiency of the partnerships really is an enhancer to the overall ROE of the company. Because if you think about sort of monthly flow originations, we're recycling that capital month after month after month and putting that into the -- as we put those assets into the partnership structure. So it's a pretty exponential increase to ROE, although it blends into the overall return profile of the company.

Okay. Great. And maybe if we could just take it back to credit for a bit here as we come into the last 10 minutes of our conversation, as you think about the credit outlook we discussed earlier, how are you assessing the potential impact of AI, and I'm employing outcomes for recent grads. I know you've highlighted an improvement in the trend for the unemployment rate on recently graduated folks. So maybe just what you're seeing today? .

Yes, I think there's been like -- there's been lots of opinions over the last 12 months and even going back longer than that on the potential impact of AI and the economy, et cetera. I think last summer, there was a big focus on the grads from last year were never going to get jobs. So I think that's been disproven by the data and the actual experience over the course of a year. I think the most recent sort of announcements by companies around grad hiring really is sort of dispelling that myth. And I think companies are realizing that if they want to have a workforce that's fluent in how to use these AI models, the best way to do that is to hire new college grads because they've kind of grown up as AI natives. So I think the whole narrative around AI sort of crushing jobs in an immediate fashion is really a little bit overblown. I don't think the data supports that. And I think it's going to be like any other technological innovation where, yes, there is some job destruction, but there's more job creation as a result of it and as a result of the productivity that comes from...

And maybe with rising costs and token costs, companies will realize that...

Yes. I mean that's another element that nobody ever really talked about, but it sounds like companies are starting to get a focus on that as they've seen their OpEx impact of just letting AI loose amongst everybody in their companies. So yes. .

And I think for our last topic, just capital, you have the new capital reproposal and focus. I think Sallie Mae has been a little overlooked in that regard. They still apply to you -- go through. So how are you thinking about the potential impact to your capital profile and risk-weighted assets? .

Yes. I think, look, there's a roughly 10% change in how student loans are rated and that's the bulk of the assets in our balance sheet. So again, the final rules are now, and we don't have implementation time lines, but that's kind of simple math in terms of kind of scaling the impact on us. Yes, go ahead.

Does that change how you think about capital return? I mean if we assume this is a final rule, would you...

If anything, we've proven that we're very focused on returning value to shareholders. I think our outlook on that really hasn't changed dramatically. We are very good stewards of capital. I think you've seen that over the time period that Jon has been the CEO. Since 2020, we've returned or bought back roughly 58% of the total flow to the company. I think as we move into this next phase with the partnerships, with the growth that's really coming from this sort of increased origination opportunity with Grad PLUS, you'll see us continue to have that discipline. It's a growth story, both on the core held-for-investment book but also a growth story over time as we build these partnership fee streams that will be supportive of generation of high return on capital, and we'll continue to focus on that. .

And does the partnership business, given the capital-light nature of that model, does that -- does that alter your framework at all down the line for how you think about mix of buybacks, dividends or any sort of preference?

Yes. Again, I think we're attuned to what our investors' preference is. And I think we've heard loud and clear that all things equal, they'd prefer capital return to come be a share buyback, just given the tax efficiency of that. And so that we'll maintain, obviously, a base level of dividends over time, but I don't think the nature of where the earnings are coming from really necessarily changes our point of view on capital allocation and return to shareholders. It just -- again, this is a really important point to make, like the growth whether it's coming from bank balance sheet growth and NIM earnings or whether it's coming from the fee-based earnings coming out of the partnerships is still earnings growth, and it is a big pool of capital that we have to return to shareholders. .

Okay. Perfect. And one question we've gotten a little bit more recently has been just around consolidation activity. I think there's been a little bit of an uptick recently. As you sort of think about your flat to down balance sheet this year with modest growth next year, how much of an increase in that are you factoring in? And maybe what are you seeing? .

Yes. Again, we've anticipated for a period of time that consolidations would tick back up. I would say our actual experience, although it's elevated, has been -- they're running below what our expectations were. So like, again, I think that's kind of -- we're getting back to more of a normal state. I think the period of time immediately prior to the sort of rise in interest rates was probably an abnormal period because the rates were held low for so long. And that product is really a rate arbitrage game. And so as long as rates are relatively stable and don't move violently in one direction or another. I think the level of consolidation activity will largely be stable and very manageable in the context of the overall book. .

And maybe just last one for me as we sort of wrap up here. You put some positive news in the slides. You had an update on.

I think most of the news in the slides is positive.

Yes. you're killing it on the new grad product. .

Yes. I mean we've got a lot going on in the company right now. We've got a once in a generation opportunity in terms of volume increase of originations. If you think about from '25 to when this scales in kind of the '28 time frame. a 70% increase in originations. That's a lot of growth, like not many industries or companies have an opportunity to go after something like that. So we're laser-focused on going after that in a good way. I think the early signs in terms of the new products we've launched are making us feel good about our readiness to really go and compete and win in that environment. So we feel good about that. The progress we've made around sort of our funding capability for that origination growth, again, we haven't built the specific grad programs, but we've had enough discussions with investors that we're confident that we will be able to scale into next year as that starts to build. And so that's kind of a winning solution. .

Okay. Great. Any closing messages from you on the outlook or... .

No, again, I appreciate the opportunity to be here and talk about our company. Again, I think we've got a really positive story to tell. I think notwithstanding some of the broader environmental concerns around AI and the other things, we feel great about our commercial position. We feel great about the growth opportunities. We feel great about credit performance in our book and look forward to being back on stage in future conferences with you and telling about our success.

Great. Well, we look forward to an update on your progress next quarter. Talking you a month or so. Thanks for coming.

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