SLM Corp Q2 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by and welcome to the SLM Corporation Second Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today Matthew Santora, Director of Investor Relations. Thank you. Please go ahead sir.

Thank you, Ashley. Good morning and welcome to Sallie Mae’s second quarter 2020 earnings call. It is my pleasure to be here today with Jon Witter, our CEO; and Steve McGarry, our CFO. After the prepared remarks, we will open up the call for questions. Before we begin, keep in mind, our discussions will contain predictions, expectations and forward-looking statements. Actual results in the future may be materially different than those discussed here. This could be due to a variety of factors. Listeners should refer to the discussion of these factors on the company’s Form 10-Q and other filings with the SEC. For Sallie Mae, these factors include, among others, the potential impact of the COVID-19 pandemic on our business, results of operations, financial conditions and/or cash flows. During this conference call, we will refer to non-GAAP measures we call our core earnings. A description of core earnings, a full reconciliation to GAAP measures and our GAAP results can be found in the Form 10-Q for the quarter ended June 30, 2020. This is posted along with the earnings press release on the Investors page at salliemae.com. Thank you. And now I'll turn the call over to Jon.

Ashley, Matt, thank you, and good morning, everyone. Thank you for joining us for a discussion of Sallie Mae's second quarter results. During the quarter, we booked a GAAP loss of $0.23 per share and a core earnings loss of $0.22 per share. This was almost entirely driven by our substantial increase in our allowance for loan losses with some impact from our liquidity portfolio. While the economic environment continues to be challenging and is having a significant impact on our results, I would like to highlight several factors that give us confidence in our business. We are focused on controlling the factors we can control and driving our core business. We're aggressively managing our expenses. We're continuing to develop and hone our loss mitigation strategies. We're reviewing our underwriting standards to determine any changes warranted by these new economic realities. We're caring for our teammates in this new work-from-home reality while continuing to securely service our customers. And, of course, we're taking steps to build our allowance for loan losses. We see some early and encouraging signs. Our borrowers are transitioning from the forbearance granted at the beginning of the pandemic back into repayment. Our ASR program continues to run its natural and preset course. Our current stock price only increases the value of this program as we anticipate our counterparty will be able to buy back more of the shares outstanding with the proceeds of the Q1 loan sale. Steve and I will now discuss each of these in turn. Let's begin with our core business. Liberty Street Economics, which is the research arm of the Federal Reserve Bank of New York, frequently reports on the value of a college degree. This week, they put out a research piece that concludes that starting and/or finishing college in normal course during the pandemic rather than taking a gap year, for example, creates a better economic outcome. This is because students have fewer good options with low wage growth and higher unemployment. Our own How America Pays for College research confirms how resilient and undeterred families are about continuing their education. Furthermore, as a society, we are beginning to understand the educational and social limitations of distance learning. As a result, there is a significant effort to open colleges and universities this fall in some form of a residential model. We have collected return-to-campus plans for our top schools. At this point, 80% of those schools have reported their fall plans. Of those, 96% of the schools have decided to either physically return to campus or do a hybrid residential model while only 4% of schools have announced a virtual-only approach. We are seeing schools change their plans as cases spread, and it is possible that these numbers will shift in the coming weeks. I do want to say we applaud the innovative steps schools are taking to creatively and smartly blend technology and public health practices to maximize the value of the educational experience while protecting the safety of the on-campus population. There is no doubt that some students will not enroll who otherwise would have either because of health concerns, a reluctance to pay full price for a hybrid experience, or for other reasons. In addition, we know that the university's reaction to the pandemic is causing the peak season to lengthen. Not all schools have announced plans, and many have not even sent out bills for the fall semester. We are seeing both effects in our application flows with volumes down 21.8% year-over-year. How much of this is the result of the longer peak season versus a real decline in enrollment is difficult to predict at this point, but we are monitoring it closely. While originations are expected to decline, we are seeing a 5.5% increase in the average loan size we are approving. We believe declining state subsidies combined with the reluctance of families to use their savings to pay for college in this economic environment is contributing to this increased borrowing. Through June 30, we have originated $2.8 billion of private education loans that look very similar in credit characteristics to past vintages. We believe we will originate in excess of $2 billion of loans in the second half of the year, bringing full year originations to $5 billion. In Q1, we estimated that the declining economic environment would reduce originations by $700 million to $1 billion. And based on the factors I just described, we believe we'll be at the upper end of this range. Not factored into these numbers is the departure or retrenchment of competitors from the business. These moves have only been recently announced and competitors have not provided full information, making any prediction of impact hard to quantify. However, given our commitment to the business and strength of our balance sheet, we look forward to competing to serve the needs of their customers going forward. Next, we are seeing some positive balance sheet trends. Third-party consolidations were $284 million. This was $181 million lower than the previous quarter and down $30 million from the year-ago quarter. Additionally, we are seeing a reduction of voluntary prepayments but not as sharply as we would expect given the magnitude of this economic downturn. We still expect our student loan balances to end the year largely unchanged from year-end 2019. Helping our customers navigate the pandemic remains our top priority. In response to the pandemic in the second quarter, we issued disaster forbearance to borrowers who stated that they were impacted. During Q2, forbearance peaked in the mid-teens of loans outstanding. I am pleased to report that the trend of borrowers transitioning back to making scheduled payments on their loans is positive. Allowance build in the quarter was significant. We booked an additional $243 million in COVID-related loss reserves. We are determined to build reserves that cover all expected future defaults in our portfolio. Our loan loss reserve represents a life of loan loss of more than 11% of our portfolio. Given the uncertainty of the environment, we over-weighted Moody's more stress scenarios in establishing this reserve. Even with this large build, however, it is important to note that we still have $1.6 billion in loss absorption capacity while remaining well capitalized. Steve will provide further detail on our reserving methodology. As promised on our first-quarter earnings call in April, we took a hard look at expenses to identify opportunities to enhance performance. At this point, we have identified $18 million worth of expense savings for the rest of the year. We will begin the budgeting process for 2021 in the next few weeks, with the intention of looking for further opportunities to create efficiencies. The next topic I'd like to cover is our capital return program. There has been a great deal of conversation around capital return given recent stress test results and directives from the Fed. We remain well capitalized with significant liquidity and reserves. We continue to pay our common and preferred dividends. Our $525 million accelerated share repurchase program is fully funded, reflected in our capital ratios and remains in place. Our counterparty continues to repurchase shares to satisfy the terms of the ASR. As of July 17, 40% of the $525 million has been utilized. At the current stock price, it will take the remainder of 2020 for our counterparty to complete the program. We already reduced the outstanding share count 11% this year. Given current stock price trends and market conditions, the ASR program will repurchase 72 million total shares or 17% of the company – 17% of the shares we had outstanding at the beginning of the year. Let me now turn it over to Steve to go deeper into our results.

Thank you, Jon. Good morning, everyone. I will continue this morning's discussion with what is on everyone's mind, a deeper dive into the details of our reserve build, followed by a discussion of our credit metrics and where we think they're headed. I will then discuss the rest of the drivers of the income statement and end up highlighting our strong capital and reserve position. At the quarter end, our loan loss reserve totaled $2 billion. The private education loan reserve, including a reserve for unfunded commitments, was $1.85 billion or 7.7% of our total student loan exposure which under CECL includes not only on-balance sheet portfolio loans. It also includes the accrued interest receivable of $1.4 billion and unfunded loan commitments of $1.1 billion. As discussed previously, we use a discounted cash flow methodology to determine our reserve. The discount factor is approximately 70%. And that is how we get to the 11% coverage of life of loan defaults on the portfolio that Jon just mentioned. The provision for credit losses was $352 million in the quarter. The major components of the provision were an additional $243 million for expected economic impact from our CECL model and $99 million for loans originated but not yet funded on the balance sheet. We took a cautious approach to our loan loss allowance in the second quarter. Our CECL implementation reserve built at the end of 2019, as well as the first-quarter reserve, run through our model using a Moody's baseline, near-term improvement and recession scenario, weighted 40%, 30% and 30% respectively. For this quarter, given the uncertainties around the economy, we used a baseline and a more severe economic downturn forecast than used in the past, each weighted 50%. The weighted average unemployment rate from these scenarios are 11.3% in Q2 of 2021 and 10.6% in Q4 2021. This is an increase of nearly 4% for each period from what we used in the first quarter. In addition, we have added $50 million to the reserve to account for lower charge-offs than expected in the quarter due to granting forbearance as a result of the pandemic. For the next few minutes, I will be discussing our credit metrics, all of which can be found on Page 6 of our investor presentation. Private education loans and forbearance were 9.3% of loans in repayment and forbearance. This was up from Q1 and the year-ago quarter, all of course due to the pandemic. While the reported number is down significantly from its peak in the mid-teens, we are still working through the backlog of borrowers exiting forbearance. In April, we issued disaster forbearance to a large number of borrowers, who stated that they were impacted by the pandemic, which postponed their April, May and June loan payments. These borrowers are no longer technically in disaster forbearance and have payments scheduled this month. As of July 15, 49% of these borrowers resolved their forbearance status favorably, 24% of these borrowers reenrolled in forbearance and 27% of these borrowers are continuing to work with us and will either reenroll in the forbearance program, make a payment, or enter a delinquency status. But keep in mind I'm reporting as of July 15, and many of these borrowers had not even reached their payment date. We are very encouraged, however, by what we have seen so far from borrowers exiting forbearance. And based on the performance of these borrowers to date, we expect 35% of the total population to reenroll, in excess of 50% to make a payment and low single digits to enter delinquency. If this trend holds, we would expect forbearance to drop to 7% at the end of July and then move lower by the end of the quarter, likely in the 5% to 6% range. In the early stages of the pandemic, forbearance was granted without determining if it was truly needed. This was absolutely the correct approach at the time. Going forward, to remain in a forbearance status, a borrower must demonstrate that they and the cosigner are unemployed due to the current economic conditions, or will be able to make a payment in the future. Another change is we will be granting forbearance for just one month at a time going forward. This will enable us to stay in close contact and work with our borrowers during this time. The characteristics of the loans in forbearance are positive and the source of encouragement. At the end of May, the average current FICO score was 727 and less than 2% of these borrowers had been delinquent greater than 90 days in the last 12 months. A large component of the loans in forbearance recently went into repayment. Our listeners are all familiar with our repay waves. So just three months before the pandemic began, $2.5 billion went into repayment for the first time. And in the current quarter, an additional $1 billion went into repayment. I call this out because it is not unusual for borrowers in early stages of repayment and interest to use forbearance. Typically 10% of a cohort will. In addition, we are working closely with a segment of borrowers that have used forbearance frequently in the past. And for these individuals, we are offering a 12-month interest-only payment program to help them manage their payments. Turning to credit performance. Private education loans, delinquent 30-plus days, were 2.7% of loans in repayment and delinquent forbearance. This is down from Q1 and in line with the year-ago quarter. Ordinarily, delinquent loans do not receive forbearance and are therefore not in our delinquency tables. However, as a result of the pandemic, we granted forbearance to certain delinquent customers, that will return to their delinquent status when the forbearance period ends if they do not make a payment. Forbearance is clearly dampening delinquency more broadly and we expect delinquency to rise in future quarters. Again, if the forbearance resolution trends we just discussed hold, we think 31-plus day delinquency at the end of August could increase to over 4% and basically remain between 4% and 5% for the rest of the year. Net charge-offs for average loans in repayment were just 0.8%. This was down from Q1 and also down from the year-ago quarter. Again, the use of forbearance is dampening charge-offs as well as delinquencies. We now expect net charge-offs for the full year of 2020 to total 1.7%. This is lower than what we forecast at the end of Q1. This is simply because forbearance usage has pushed back charge-offs into 2021. We expect net charge-offs for the full year of 2021 to total 2.5% based on the forecast discussed during this conversation. This is consistent with what we saw in our stress testing exercises, using the Fed's CCAR severely adverse scenarios. And it's also consistent with how the highest quality private student loans performed during the 2008-2009 financial crisis. Back then, losses peaked at 2.7% for loans similar to our smart option portfolio. Loan origination stats are on page five of the deck. As you can see, we originated $497 million of private student loans in the second quarter and $2.8 billion year-to-date. Originations are down 7% from the second quarter compared to the year-ago quarter. 74% of these loans were cosigned with an average FICO score of 747. This compares to 77% and 745 in the prior year. Seasonally, Q2 has lower cosign rates due to a higher mix of non-traditional students. We are already seeing an increase in FICO scores and cosigner rates in our early peak season results. This will continue. And as Jon has already discussed, we have taken steps to tighten our underwriting and stress our expected returns in the current environment. Net interest margin stats are reported on page 4 of the deck. As you can see, net interest margin on our interest-earning assets came in at 4.55%, down from the prior quarter and the prior year. The decline in the quarter was principally driven by our liquidity portfolio. While cash and liquid assets declined to $6.6 billion from $7.6 billion at the end of the quarter, average cash and liquid assets in Q2 were still slightly higher than Q1. So in response to actions taken by the Federal Reserve and the impacts of the pandemic, we saw yields on risk-free assets such as treasuries and Federal Reserve deposits, which is where our cash is invested decline much faster than bank deposits and LIBOR-indexed liabilities during the first quarter of the month, and this pressured our NIM as well. Spreads have now normalized and we do still expect our full-year NIM to come in right around 4.9%. A few quick words on operating expenses in the quarter that came in at $142 million, compared to $147 million in the prior quarter and $139 million in the year-ago quarter. OpEx in our core student loan business increased 7% from the year-ago quarter, while average customers increased 5.5% and delinquent borrowers declined 14.1%. Ultimately, full-year operating expenses will come in around $565 million and that is just below full-year 2019 OpEx. Finally, let me comment on our strong capital position. At the end of the second quarter, total risk-based capital was at 13.7% and CET1 to risk-weighted assets came in at 12.4%. Both of these ratios are significantly in excess of regulatory well-capitalized ratios. In the post-CECL world, we also look at GAAP equity plus loan loss reserves over risk assets and that came in at a very strong 15.7%. In conclusion, our balance sheet remains rock solid in terms of liquidity, capital and loan loss reserves. I'll now turn the call back to Jon.

Thanks, Steve. Before we go to Q&A, I would like to spend just a few minutes lifting our gaze and talking about a few things beyond the current COVID situation and its resulting impacts on performance. First, in just 103 days, Americans will go to the polls to vote in the presidential and congressional elections. And as you can imagine, we continue to spend significant effort understanding the potential implications of likely student lending reform proposals. I'd like to touch on a few of these including free college, debt forgiveness and bankruptcy reform. Let's begin with free college. We appreciate that there is a strong public policy benefit of subsidizing college tuition for those who would otherwise not be able to attend. This helps promote a quality of opportunity and economic mobility, two real cornerstones of a healthy society and economy. During the previous presidential campaign, both Senators Clinton and Sanders campaigned on this approach. And it has been adopted by the Biden campaign. Interestingly, it has already been implemented in several states with New York's Excelsior program being the most prominent example. Under this gold-standard program, New York state residents who earn less than $125,000 received free tuition if they enroll full-time, maintain a minimum GPA and make post-graduation New York residency commitments. It is important to point out that statewide programs already exist in 19 states and 18 additional states have programs with variations on this theme. In the first year of the New York program, our originations in the SUNY system went down 3% and have grown every year since then. We also recognize that borrowers sometimes get overextended and need relief. To that end, federal debt forgiveness and bankruptcy reforms are two other common proposals. The cost of forgiving all federal student loans is approximately $1.5 trillion, making it hard to imagine that such a policy would have a life beyond the campaign trail. This is especially true given other democratic priorities such as clean energy, infrastructure and healthcare access. However, one might envision programs more focused on those individuals experiencing deep financial difficulty. These targeted proposals would likely have little impact on our business as they would be directed at high-risk customers who are already struggling to make their payments and likely expect to default. As for bankruptcy, we have long been supportive of prospectively allowing the discharge of student loan debt in bankruptcy, provided there is some reasonable period of post-graduation payment to guard against the moral hazard of declaring bankruptcy simply to discharge student loans. We believe Sallie Mae will continue to operate and thrive alongside programs, whether state or federal, that provide much-needed assistance to lower-income families. As has been the case for decades, we believe it will require a combination of federal and state government programs and private offerings to meet the diverse needs of millions of students. As such, we believe we have a key role to play in higher education finance and our business will perform well regardless of the results of the election in November. While I've already commented on this year's ASR program, I would also like to discuss capital return more broadly. The recent news around stress tests in the Fed have investors wondering if our future buyback plans are in jeopardy. Looking ahead to 2021 and beyond, we are committed to our hybrid model of originating loans, maintaining a core balance sheet and selling loans to free up capital to return to shareholders. This strategy raises two obvious questions. First, is the whole loan sale market robust; and second, whether regulators will object to such a strategy. On the whole loan side, you can make your own determination, but we have been impressed by the resiliency of the whole loan market even during these most difficult economic conditions. On the regulatory side, let me start by saying our interests and those of our regulators are well aligned when it comes to maintaining capital adequacy. We believe, though, that there is traditionally less resistance to capital return when the proceeds come from a conscious strategy to manage the size of the balance sheet versus stretching existing capital ratios. While we can't make a guarantee, we would expect our hybrid strategy to be viewed in this light. Assuming market conditions are conducive in 2021, which I believe they will be, we expect to continue a strong capital return strategy. I would also like to talk briefly about our emerging areas of focus. You will remember at our last call, I have been on the job for four days. However, at that time, I suggested several priorities including: first maximizing the profitability and growth of our core business; second, maintaining a predictable capital return program to create shareholder value; third, optimizing the value of our brand and our very attractive client base; and fourth, changing the narrative around private student lending to help reduce real and perceived political risk. Now, 90-plus days into the job, I am more convinced that these are the right priorities. I believe, if we execute against these objectives, we will increase earnings, reduce risk and reduce required capital, all of which are proven to have a positive impact on valuation. We are just now building our bottom-up plans in each area and I look forward to discussing our progress with you during future calls. Finally, I want to recognize the incredibly painful but productive conversation that has come to the forefront in this country around race, systemic discrimination and inclusion more broadly. The pandemic and recent events have brought the inequities faced by the African-American community and all people of color even more starkly into focus. At Sallie Mae, we have intensified our dialogue on these important topics and reiterated our zero tolerance policy for discrimination or racism of any kind. During the quarter, we assessed several options to determine the best way for us to take action in our communities that is consistent with our core mission of facilitating education. As a result, we announced that the Sallie Mae Fund, which is the charitable arm of Sallie Mae, will contribute $4.5 million in scholarships and grants over the next three years to increase higher education access and completion among minority students and underserved communities and to support educational programs that advance social justice diversity inclusion and equality. This is a first step of many and diversity and inclusion will be an ongoing focus of ours in the months, quarters and years ahead. Thank you. And with that, let's open it up for questions.

And your first question comes from Moshe Orenbuch with Credit Suisse.

Great. Can you hear me okay?

We can.

We can hear you fine.

Thank you for the overview regarding the loans coming out of forbearance and your expectations moving forward, specifically regarding charge-offs. I assume that all of this is included in your existing reserve. Could you discuss what factors might lead to changes in your reserving? Considering the complexities of volume and balance growth, how should we approach the rest of the year in terms of evaluating the performance of individual borrowers and your loan portfolio as it relates to the reserve levels going forward?

Sure. So Moshe look, the key to our CECL reserve and the biggest driver is really the economic forecast that we use to calculate that reserve. And given the uncertainties, as I mentioned, we went from a baseline S1, S3 type of a mix of forecast to a baseline S4. And that results in some pretty trying economic conditions. So the simple answer to your question would really be if the economy deteriorates significantly more than some of the really dire forecasts that are out there. And I guess, one of the reasons why we chose to go with that mix was simply because we do have these loans coming out of forbearance, difficult to do a management overlay over that. If those loans started to all of a sudden perform worse than what we're seeing coming out, that could obviously result in stepping up our reserve game as well. However, based on everything that we're seeing that population is performing even a little bit better on what's today's date, July 22, than they were on July 15. So we feel like we are very adequately reserved at this point in time.

Thank you, Steve, that clarifies a lot. When considering a 1.7% charge-off rate this year and a projected 2.5% next year, those figures don't seem particularly high compared to the reserves you've established. I assume that most of the charge-offs related to the pandemic would have been addressed by the end of 2021. I'm curious to know your thoughts on this; it appears there are substantial reserves in relation to the expected losses over the next six quarters.

I would like to take a moment to agree that we do have a very high-quality loan portfolio, and 2.7% doesn't appear extreme. However, considering that we are reporting charge-offs in the range of 1.1% to 1.2%, that represents a significant increase. The 2.7% figure is somewhat elevated as it includes loans that should have defaulted in 2020. Furthermore, the economic outlook that the reserve is based on does not predict a rapid recovery after 2021. Unemployment rates remain quite high, and we anticipate additional losses will arise.

Understood. And maybe just a little bit of a fleshing out on the competitive environment. I mean we've seen some comments from one very large bank and one mid-sized bank some of the private companies I think are a little less aggressive on the refi front. Anything you'd call out specifically with respect to the competitive environment?

I’ll briefly comment on the refinancing market before handing it over to Jon to discuss the competitive landscape. While the ABS market has seen some recovery, the market for the equity tranches remains uncertain. I believe the refinancing market will not recover quickly, which could be a positive advantage for us. Now, I’ll let Jon share his insights on the current environment.

Sure. And look, I think competitively this is a story where we probably just don't have enough information yet. Many of these announcements have literally been made in the last couple of weeks. And I think it's probably too early to really discern what is the likely impact of that by sort of school and kind of market share type numbers. What I will say is we are doing everything we can, as I said in my prepared remarks, to continue to serve this market. It is our core business. We have the balance sheet to grow here and to continue to thrive. We have the liquidity position. So, we are being very proactive with schools and reiterating our commitment to this marketplace. We are being sort of very proactive in our marketing efforts to make sure we are putting sort of our best foot forward with all of the sort of high-return loans that we think we can reasonably compete for. And I think given the newness of this and just the lengthening of peak season in general, it will probably take a few months for us to really discern what is the true impact of some of those exits and retrenchments from the market. But I think overall we believe that that will net-net in the future be a positive thing for the company.

Okay. Thanks very much.

Your next question comes from Sanjay Sakhrani with KBW.

This is actually Steven Kwok filling in for Sanjay. Thanks for taking my question. I guess just to go back to the competitive environment. Could you just remind us of your market share that you have? And then how we should think about some of the peers that have either departed or retrenched? And how much additional market share that's potentially up for grabs?

Yes, it's a little bit of a question of how you measure it and over what time period, but I think you can think about our market share as roughly 52%, 53% year in and year out. If you're sort of asking specifically about the Wells Fargo announcement, we don't normally sort of discuss what competitors are doing. But they're typically sort of a top three player in the market and they might have something like 15% market share, again, recognizing those are internal estimates and different people could have slightly different numbers.

Got it. And then you mentioned staying the course in terms of originating and selling. Just wanted to get a sense of given where the stock is trading today, are there opportunities for perhaps to accelerate that pace and be able to take advantage of the current environment? If you were to sell today what type of yield would you be able to get at and versus the payback of buying back your stock?

Sure. So, Steve look the market for student loans is very resilient. We could certainly sell at a premium today. I'm reluctant to cuff it too much, but you drew me in. It would be a couple of percentage points probably below where we most recently sold. We would rather not sell our loans in this environment because we think we are getting penalized for the uncertainties of the forbearance situation which we think will resolve pretty well. And I'll let Jon comment on share buyback opportunities.

Sure. And look as you can imagine Steve, this is a topic that Steve and I talk about a lot. We are very pleased with the ASR program. As I said before, it is in force in the marketplace. It still has more than halfway to go. And in discussions with our counterparty, we feel like we are in the market regularly sort of buying up to the reasonable limit of what we could buy up to given both sort of practical and regulatory sort of guidance around share repurchases. And I think as we said earlier, even with that active buying, it's probably going to take through the end of the year for the ASR program to end. So, could we do more? Maybe. I think our strong sort of preference at this point is to let the ASR continue its course and to sort of move on from there. It is important also I think in these times where there's just a lot of scrutiny on capital return for banks in general. The ASR program is really unique in that it's a preset program. If we wanted to do something different, we would have to go back and sort of undo that program and that's obviously a complicated thing to do. And again, I think that just raises and introduces risk to the equation. So we like the ASR program. We like how it's running. We think it's active in the marketplace. We think it's doing exactly what we want which is buying back a lot of our shares outstanding during a time where the stock price is depressed. And again, I think our view is, we want to sustain that far into the future in addition to let it run its course this year.

Great. Thank you for taking my question.

Your next question comes from Michael Kaye with Wells Fargo.

Hi. The first question I had was, I wanted to see if I could get any thoughts on how we should think directionally about the provision expense in Q3 particularly as it relates to the provision on new loan commitments in Q3 just given Q3 typically has a large percentage of your total commitments for the year?

Yes sure Michael. I'd be happy to comment on that part of the reserve build in Q3. We're hoping that we are taking a big provision for beating our loan origination targets. And rule of thumb is going to be right around 7% of the volume that we originate. So, you can expect to see a continued reserve build in Q3.

Okay. And then I had a follow-up question just Jon the competitive environment. I want to compare you to your largest peer Discover. It seems that Sallie Mae is much more sales force-driven, while Discover is more focused on direct-to-consumer marketing. And I would think that the sales force approach is a bit hindered now just given the coronavirus. So I was wondering how your go-to-market peak season strategy is changing given the coronavirus perhaps you need to lean harder on direct-to-consumer marketing?

Yes. First of all, I think we've always had a good blend of sales force and direct-to-consumer. And we've certainly talked in past quarters about sort of the enhanced capabilities and investments that we're making in the direct-to-consumer side of things. With that said, I think as I've talked to our sales force, the role that financial aid offices are playing in these decisions is as important as it has ever been. And truthfully, I think the number one question that I think our sales force is getting right now is, are you still committed to this marketplace? Are you still open for business? Are you still going to be there for our students? And as you can imagine, we are the lifeblood for these universities in many cases and they can't do and fulfill their important mission unless we do our job and fulfill our important mission. So, I would say, I think the sales force approach is every bit as important in my mind as it has ever been, maybe more so in terms of really cementing our overall commitment to the marketplace. Of course, the way that we're going and sort of contacting and engaging with those financial aid offices is different. I think it's following the same patterns that all of us are living in our lives every day. But just like we're figuring out ways to make it work, I think our great salespeople are figuring out ways to make it work.

Thank you.

Your next question comes from Rick Shane with JPMorgan.

Good morning, and thank you for taking my questions. I want to follow up on what Michael was asking. The provision for new commitments during the quarter was about $98 million, or almost $99 million. Did you change the reserving policy on unfunded commitments due to changes in your economic outlook?

So, I guess, the answer is yes, because the life of loan reserve for new loans also includes the impact of the economic forecast as well. So, yes, it would. And on that front, Rick, when we price our peak season originations, basically we're looking for a life of loan return on equity. And I bring this up, because we also stressed our pricing model, by increasing our losses by as much as 25% over the first couple of years of being in repayment. So, we're actually feeling pretty good about the changes that we made to our underwriting practices and we're feeling very good about the loans that we're going to originate in the current quarter.

Thank you. When we consider the $2 billion origination target for the third quarter and the $1.1 billion of unfunded commitments, a significant portion of the $2 billion will likely come from these commitments, as they are already reserved. How should we understand the relationship here? Steve, you mentioned that regarding Michael's question, we should assume a 7% reserve rate on the $2 billion. Is there anything we should take into account about the transition from unfunded to funded concerning the reserve rate?

So, Rick, basically what's going to happen is, your point about the $1.1 billion that we've already reserved for is accurate. And there will be some fallout from those loans originated. But particularly in the third quarter, there is a big second disbursement included in those originations. So we will be reserving for unfunded commitments again. And I want to try and avoid giving you numbers here that you can model on, because quite frankly, I don't have good clear numbers to provide you as we sit here right now, during this conversation, in terms of what the second disbursement is going to be, et cetera.

Got it. Okay. I understand and I appreciate it. If you would indulge one last question. When we look at that $1.2 billion of unfunded commitments, I'm assuming that those are contracts that people enter into over the summer in anticipation of drawing as they enroll. And are those loans typically drawn all in the first semester, or are those loans drawn in the first and second semester? And then, to your prior point, does it sort of get reloaded as people draw, they also get commitments for the second semester?

There will be a combination of loans for the fall semester and for the upcoming spring semester. This serves as a preparation for the peak season and also includes summer school loans. We hope that all our disbursements will also enroll for their second disbursement when they apply for the fall semester, but at that time, the serialization is not nearly at 100%.

Okay, great. Thank you for taking my extra questions. I really appreciate the time.

No problem.

Thank you.

And your next question comes from Arren Cyganovich with Citi.

Thanks. I wanted to discuss the expectation that your loan balance in PEL will remain flat year-over-year compared to 2019. I just wanted to clarify that this is before the loan sale, which suggests a good amount of growth. I believe you were at around 23.2% gross loans at the end of last year and you're at 21.5% now. It seems you're expecting slower originations, primarily due to a significant slowdown in prepayment.

Yeah. We're seeing a big runoff in both full consolidations. And we are seeing a slowdown in typical curtailments and prepayments as well. So yes, we think that the balances at the end of 2020 are going to be very close to the balances at the end of 2019.

Okay. And on the forbearance side, can you just talk a little bit about, the length that you're allowed from a regulatory perspective to continue the forbearances? And then, the other aspect of adding a one-month option I guess, of just continuing to do this. How difficult does that make it for you and the borrower to continuing to do that option, given that it's relatively quick each time?

So Arren, the disaster forbearance is essentially something that regulators want us to utilize to assist borrowers who are experiencing difficulties due to the current environment. Looking back to March when we launched the disaster forbearance program, it was introduced alongside a complete suspension of federal loan payments. Most of our borrowers, who primarily have federal loans, quickly took advantage of the disaster forbearance as a sort of safety net. The unemployment rate among college-educated individuals is significantly lower than that of those without a college degree, so we believe our client base is in relatively good shape amid the current economic situation. We are observing that many individuals are transitioning back into repayment regularly. Our call centers and collection centers are equipped to assist every customer who requires extra help as they move from the initial three-month forbearance into the subsequent one-month forbearance. From an operational and regulatory standpoint, this program is functioning well. You may be recalling our announcement from October regarding changes to our forbearance plans, which we decided to pause until the end of 2020. We will evaluate the economic and regulatory environment at that point. However, we anticipate reintroducing the previously discussed changes in 2021, which include a six-month payment period between forbearance intervals, capped at 12 months, and so on. I've covered a lot here, and I hope I've addressed your question. Please let me know if you have any further inquiries on this subject.

I guess just what is the maximum amount of forbearance that you're willing to give right now, consecutively? And second, is it 12 months?

So it's capped basically at 12 months. And we give it in three-month intervals.

Okay, all right. That's good. Thank you.

Your next question comes from Vincent Caintic with Stephens.

Hi. Thank you. Just two quick follow-up questions, so first, on the reserve level and covering 11% lifetime loss expectations, so I was wondering if you could give, context around what an 11% would be, maybe using some historical experience like how things were in 2008, or any kind of context to be able to size how much 11% is?

So look, for cumulative losses, 11% on the current portfolio is pretty significant. Because when you put it into perspective, when we originate a cohort of new loans, we basically expect about a 9% default rate. So right off the bat, we're adding more than 20% to new cohorts. However, we've got basically $10 billion of loans in various stages of seasoning that have already charged off. So I'll take the 2015 repay cohort as an example. Charge-offs on that cohort have already been close to 6%. So what I'm trying to say is, if you do the weighted average expected defaults on the entire portfolio, the 11% probably captures something like a new origination cohort expectation of I don't know 15%. And I'm sort of doing this back-of-the-envelope math as we talk here. Long story short is, this is a very significant reserve that we have on our books.

Okay. That's really helpful. Yes, that's really helpful, especially when you separate out the stuff that's already seasoned versus the new originations are very helpful. Next question just on the origination guidance. So still very good origination results with that guidance. Just wondering if you could flesh out what assumptions are in there? Like maybe what sort of levels of students would need to come back? And also it doesn't seem like you have the competitive benefits from others exiting built into that guidance. Any other metrics and assumptions you could give?

Yes. I mean, as we've done our scenarios there and as you can imagine, we've looked at a number of different pieces. I think the primary variable that we've looked at is actually just total experience and what is happening in the year-over-year flows. We have then sort of looked at and stressed that for changes in assumed ticket price or average loan size, knowing that some schools are going back on a hybrid model, where maybe the room and board and other commitments would not be as high. But I think the primary driver is actually our year-to-date experience and what we're seeing in our flows.

Okay. Great. Thank you very much.

And to the second part of your question, I think we said it in the comments. No, we have not included anything at this point for competitive sort of reactions or implications from retrenchment or people exiting the marketplace.

Great. Thank you.

Your next question comes from Henry Coffey with Wedbush.

Good morning, everyone. This detail is extremely helpful. So thank you. When we – all of this reminds me of going through other cycles, where instead of the price of oil, we're talking about Moody's. As their forecast change month-to-month, whether it gets worse or better, how much impact is that going to have on future reserve requirements, or have you built in technically – and maybe you don't want to call it a buffer but by going to the worst-case scenario, have you left some room for some level of flexibility in terms of how responsive you have to be to that change in forecast either good or bad either reserve build or reserve release?

So, look, there is a governance process around the construction of the loan loss reserve. There's a loan loss allowance committee made up of individuals from around credit finance, enterprise risk management, etc. We meet. We assess the facts. We assess the knowns and the unknowns. And we document the case that we make for using, whether it's 40-30-30 or 50-50. At some point in time, we will revert back to 40-30-30, because in normal times that is best practices. But basically, Henry, the fact of the matter is, in the CECL world, the most impactful variable on a CECL model or the economic forecasts that we use for our predictable and supportable period, which is the next two years. So, the bottom line is whether we use 40-30-30 or 50-50 of any combination of scenario, the reserve is going to be dictated essentially by the economic environment. Of course, we put management overlays onto the reserve for things that we know and the model would not pick up. But that is the state of play in the current accounting environment.

And Henry, it's Jon. I think the only thing I would add to what Steve said is, of course, the volatility and the fast-moving nature of the current environment is one of the key factors that led that governance committee that Steve described, to think differently about our weighting. I think we were trying to be sort of understanding of just how the world was changing and what the implications of that would likely be.

No, I think we all understand the situation regarding forbearance. Is the expected reduction more of a mechanical process, where you have a group of individuals who are attempting to exit forbearance, but it involves going through a specific process with each of them? Is it as simple as making phone calls, or is it linked more to your statistical models? Also, what percentage of your loans in forbearance are currently making payments?

So Henry, unfortunately there is no past experience to base a statistical model on. What we are seeing is that a large percentage of borrowers just start making payments automatically again. The forbearance's over. They get back into bill pay. They make the ACH, et cetera, et cetera. There are borrowers that call and see what they qualify for. And then there is, of course, a population where we initiate the call. But basically, the projections that I gave for the level of forbearance and the resolution of forbearance is basically straight out of the trends that we are seeing to date, and they are pretty consistent and continuing at pace. And the borrowers in forbearance, as I mentioned, average FICO score of 727, less than 2% have been 90-plus delinquent in the last 12 months. These are good consistent borrowers that basically make their payment but were confronted with an economic situation they had never encountered before. And then there is the chunk of borrowers that are recently in repayment. And again, it's not unusual for them to use forbearance. And those are the borrowers that need a little handholding and cajoling from time to time. But we have the resources, we have the patience and we are working closely with one and all to get them back into the right status.

And Henry, I couldn't tell from your question. But it's highly dependent on the cycle dates for billing statements and payment date. So we work through these in a predictable pattern. There's a time where it's natural for customers to engage with us or us with them. And that's why it doesn't happen all at once.

You know, in the mortgage business there's a high percentage of people who are in forbearance, but still paying and you're saying that's not what you're seeing with the student loan business.

No. We did not see a high percentage of people that actually went into forbearance continue to make payments.

Super. Thank you very much for answering my questions.

You’re welcome.

Your next question comes from Lance Jessurun with Jefferies.

Good morning, guys. Thank you for taking my question. I got two quick ones. Most of mine have already been answered. With the liability costs have they fully reset, or is there still more room for them to decrease?

Lance, they have pretty much fully reset. So when Fed funds dropped down to 10 basis points, LIBOR stayed up at 80, 90 for a month or so. One month LIBOR, which is our biggest index is now I think 18 basis points so pretty close to where Fed funds and bills and treasuries are trading. So that has normalized for the most part. And we have $6 billion of money market deposits that we have inched down to just under 100 basis points now from I think they were at 175 or 180 at the start of the pandemic. So we feel like we are in pretty good shape from a cost of funds and an NIM standpoint.

Awesome. Thanks. And then are there any other opportunities to optimize liquidity and capture back some of the contraction that you've seen in the NIM?

I think the good news is the worst of the decline is over from the liquidity build, but the liquidity is what it is. And quite frankly, I felt pretty good waking up on March 25 and having $7 billion in the bank. So I think we'll hold on to that type of liquidity position for the foreseeable future.

Sounds good. Thank you.

Great. Well, first of all, let me say, thank you for everyone joining us this morning. I absolutely appreciate the interest in Sallie Mae. I hope the call and the information provided was useful. And until we talk again in the next quarter, I hope everyone and their families remain safe and well. And with that, I think I'll turn Matt, the call back over to you.

Sure. Thank you, Jon. Thank you for your time and questions today. A replay of this call and the presentation will be available on the Investors page at salliemae.com. If you have any further questions feel free to contact Brian or I directly. This concludes today's call.

That concludes today's conference. Thank you for your participation. You may now disconnect.