Goldman's student loan education could be painful

By Joseph A. Giannone and Tim McLaughlin - Analysis

NEW YORK (Reuters) - Goldman Sachs' $1 billion lifeline to First Marblehead Corp (FMD.N) to protect its newly acquired 20 percent stake might not be enough to revive the struggling student loan company.

Boston-based First Marblehead's bread-and-butter business -- packaging student loans into securities -- has dried up, thanks to prolonged turmoil in global debt markets. And analysts and experts say investors also should be worried about the company's rising loan defaults, its corporate governance and reliance on two banks for 44 percent of its 2007 revenue.

Investors want to see if Goldman's intervention will revive a high-flying finance company whose shares plunged in 2007. The stock peaked near $58 peak last January, more than tripling from their October 2003 debut.

The stock's fall has been steep, though. It was down 6 percent on Friday at $13.57.

First Marblehead said the investment from Goldman Sachs Capital Partners (GS.N), which declined comment, is a vote of confidence.

"Given the volatility in the capital markets, having additional cash on the balance sheet allows us to supply liquidity to the private student loan market," a First Marblehead spokesman said in a statement.

But many analysts say Goldman could be in for a painful learning experience if debt markets don't thaw out soon.

"The $1 billion (credit) line doesn't solve their issues. Ultimately, First Marblehead needs the securitization market to open again," Friedman Billings Ramsey analyst Matt Snowling, who slapped a "sell" rating on First Marblehead.

Most of First Marblehead's revenue comes from fees for creating loan-backed securities for investors. Much of their business is supplied by Bank of America Corp (BAC.N) and JPMorgan Chase & Co (JPM.N) for structuring their loans.

First Marblehead, a top U.S. private student loan company, last month eliminated its dividend. It also backed away from rosy assumptions that boosted results in the past, as more student borrowers were late on loan payments.

Moreover, a nonprofit company that guarantees loans packaged by First Marblehead is in danger of getting a junk credit rating. If that happens, First Marblehead has warned, it could lose business from Bank of America.

HEAD OF CLASS STUMBLES

For Goldman, the credit line and its $260 million equity investment, announced December 21, are a bold bet that these issues can all be overcome -- and soon. Private student loans have been one of the fastest growing segments in consumer finance as tuitions soar past what can be backed by Uncle Sam.

"The next few weeks will give an indication if these issues are going to be a longer term problem," said Mike Taiano, analyst at Sandler O'Neill Partners. He downgraded First Marblehead to a "hold" rating.

If credit markets rebound, First Marblehead can continue to grow and Goldman's funds will reap the benefits.

First Marblehead shares fell 72 percent last year as investors questioned its reliance on two customers -- Bank of America and JPMorgan -- and a dysfunctional asset-backed securities market for the bulk of its earnings.

The decline created an opening for Goldman's private equity arm, scooping up the stock at distressed prices, but with some baggage.

STUDENTS SKIP PAYMENTS

Last month, Moody's Investors Service said Boston nonprofit The Education Resource Institute (TERI) may lose its investment grade rating because of escalating defaults on loans made directly with student borrowers.

TERI guarantees loans funded by big banks and packaged into securities by First Marblehead. The rating agency also said it might lower ratings on $822 million of securities created by First Marblehead since 2003.

If that happens, First Marblehead has warned, a junk rating at TERI could drive away Bank of America as a customer.

First Marblehead says it has tightened its lending standards and said loan approval rates have declined.

Another red flag is the relationships among First Marblehead's directors. The board, for example, allows an investment of nearly $300 million with a money manager controlled by a director's family members, filings show.

There are other business deals involving board members, and some corporate governance experts say it is a conflict of interest for First Marblehead Chairman Peter Tarr to also serve as its general counsel.

"These could be warning signs the board is too inbred and needs more independent directors," said Jay Musoff, a defense lawyer at Orrick, Herrington & Sutcliffe LLP in New York who specializes in white-collar crime cases.

The company said it has no plans to change the board's governance. Goldman will be able to name a director, but will not hold more than 9.9 percent of voting shares at any time.

Moreover, directors and executives sold off about 1 percent of First Marblehead's outstanding stock in more than 80 different trades last year, filings show.

There may also be some accounting issues. From fiscal 2003 to 2007, First Marblehead's annual net income surged more than seven-fold to $222 million, but there are signs those results were lifted, in part, by rosy assumptions set by the company.

U.S. accounting rules say companies that package loans into bonds must recognize upfront revenue from fees that are not realized for years.

When the Goldman deal was announced, First Marblehead said it would reduce the value of some of the fees already booked as income. The company will take a pretax charge of up to $185 million, cutting up to 20 percent of fee-based assets.

First Marblehead is taking steps to reduce its reliance on the big banks. The company generates about a fourth of the loans it packages through its Monticello and Astrive brands.

The company also may seek to hold more loans on its balance sheet, a necessity if capital markets remain shut down. Yet First Marblehead last year derived the lion's share of its revenue from structuring bonds, not easily replaced.

Goldman's $1 billion line buys First Marblehead only a short amount of time before it must either seek new funding options or else stop accepting loans from banks.

"It's unclear if First Marblehead can structure securities in the same way anymore," FBR's Snowling said.

(Editing by Gary Hill)