SLM Corporation (SLM) Q4 2013 Earnings Report, Transcript and Summary

Good day. My name is Carmen, and I will be your conference operator today. At this time, I would like to welcome everyone to the Sallie Mae Fourth Quarter and Full Year 2013 Financial Results Conference. [Operator Instructions] I will now turn the conference over to Steve McGarry, Senior Vice President of Corporate Finance. Please go ahead.

Thank you, Carmen. Good morning, everybody, and thank you for joining us for our fourth quarter earnings call. With me today are Jack Remondi, our President and Chief Executive Officer; and Joe DePaulo, our EVP for Banking and Finance. After their prepared remarks, we'll open up the call to questions. But before we begin, keep in mind that our discussion today will contain predictions, expectations and forward-looking statements. Actual results in the future may be materially different from those discussed here. This could be due to a variety of factors, and listeners should refer to the discussion of those factors on the company's Form 10-K and other filings with the SEC. During the conference call, we will refer to non-GAAP measures we call our core earnings. A description of core earnings and full reconciliation to GAAP measures and our GAAP results can be found in the fourth quarter 2013 supplemental earnings disclosure. This is posted along with the earnings press release on the Investors page at salliemae.com. Thank you. And I'll now turn the call over to Joe.

Thank you, Steve. Good morning, everyone. I'll be referencing the earnings call presentation available on our website during my prepared remarks, beginning with Slide #3. In 2013, we maintained our leadership position in the education finance market by originating $3.8 billion of new student loans and preserving our high credit standards. We saw charge-offs continue to improve across the portfolio, and this year's loss rates are at the lowest levels since 2007. We remained active in the capital markets while returning $864 million to shareholders through share repurchases and dividends, and we delivered solid earnings. Slide 4 provides a summary of our results. For the quarter, core earnings were $275 million or $0.61 per share, compared with $257 million or $0.55 per share in the year-ago quarter. This quarter's earnings per share includes a gain of $0.14 per share related to the after-tax gain on sale of Upromise investments, which was offset by $0.04 per share of restructuring and reorganization cost expenses and $0.11 per share associated with the compliance remediation reserve that Jack will discuss during his remarks. For the full year, core earnings were $1.3 billion or $2.83 per share, compared to $1.1 billion or $2.16 per share a year ago. At the bottom of Slide 4, we quantified the impact of certain items to earnings during 2013, applying those adjustments to our 2013 earnings results and adjusted core earnings of $2.28. Our 2013 annual operating expenses totaled $1,042,000,000, compared to $897 million in the prior year. For the fourth quarter, operating expenses were $305 million, compared to $226 million in the fourth quarter of 2012. This increase is primarily attributable to the $70 million reserve. After this adjustment, our operating expenses were below $1 billion for the year and as we grew our core business. Management continues to be focused on expense control as the core operating objective. Where we did spend more money this year, we produced corresponding increases in productivity and revenues. We saw a 14% higher origination volume and significantly reduced credit losses in our consumer segment, where we spent $33 million more than last year. We also saw $108 million increase in third-party and contingency revenues as we spent $36 million more in the business services. Now let's turn to Slide 5, our consumer lending metrics. This segment's profitability continues to improve as we maintain our spread and losses continue to decline. Our 2013 loan spread came in at 4.57%, the upper end of our targeted range, leading to an increase in net interest income. We saw improvement in our delinquency rates from the year-ago quarter, and while our charge-off rate at the end of the fourth quarter showed an increase over the prior-quarter's rate, we experienced a sharp decline in losses for the year as we mentioned in the press release. Full year charge-offs were 2.8%, again the lowest levels since 2007. As the graph at the bottom of the page shows, both 30-plus and 90-plus day delinquencies have continued to decline year-over-year. We expect continued improvement in our portfolio performance. The continued improvement in our credit metrics led to a decline in our provision for loan losses from a year ago. On Slide 6, we show our asset quality trends over time. Many of you are familiar with this slide. Our student loan portfolio is dominated by high-quality loans. The green bars and green line represent the highest quality and lowest risk business. These assets now account for nearly 72% of our portfolio. The growth in our Smart Option product will continue to grow this segment. The highest risk segment, what we call nontraditional, represented by the red bars and the red line, is down to 7% of our portfolio. Balances and losses are declining in this segment, and we do not originate these loans anymore. The high-quality loans are what we originate, as you can see on Slide 7. We originated $524 million of Smart Option private credit loans in the quarter. For the full year, the $3.8 billion of new originations represent a 14% growth rate. The loans we originated had average FICO score of 745 and 90% of the loan had a co-borrower. These loans continue to increase the high-quality loan segment we referenced on the prior page. And as many of you know, our private loan product is the only one in the industry that encourages borrowers to make in-school payment. 57% of our customers acquired in 2013 elected to make payments in-school, demonstrating that borrowers continue to respond to our responsible product feature. We will now turn to Slide 8 to review our business services segment. In this segment, core earnings were $184 million in the quarter, compared to $135 million in the fourth quarter of 2012. The major difference was the sale of our 529 college savings plan administration business Upromise investments, which added $62 million after-tax. The company now services 5.7 million accounts under the Department of Education servicing contract. Servicing revenue from this contract was $31 million in the quarter, compared to $22 million in the prior year. In our contingency collection business, we saw an increase in revenue of 14% or $13 million over the year-ago quarter. Now let's turn to Slide 9 to discuss our FFELP segment. FFELP core earnings were $82 million for the fourth quarter, compared with $89 million for the fourth quarter of 2012. The comp student loans spread increased to 99 basis points in 2013 from 95 in the prior year. These assets continue to demonstrate high-quality predictable returns. We expect the spread going forward to be in the mid- to high-90s, and keep in mind that the spread is typically higher in the second half of the year than the first half of the year. Let's now turn to Slide 10 for highlights of our financing activities for the quarter. In 2013, we issued $3.1 billion of private credit ABS and $6.5 billion of FFELP ABS. Our ABS transactions continue to attract strong investor demand. We priced $1 billion of FFELP on -- FFELP beyond Wednesday that priced 5 basis points tighter than our previous transaction. And we continue to execute on our long-term funding strategy of originating new private loans at our bank and term funding more seasoned loans in the ABS market. In 2013, we issued $3.8 billion of unsecured bonds. While we expect total unsecured debt outstanding to decline over time, we will continue to issue debt to better manage our maturity schedule. Last week, we closed on an $8 billion secured borrowing facility, which matures on January of 2016. This facility replaced the existing $5.5 billion facility that was set to expire in January of 2015. The additional $2.5 billion will be available for federally guaranteed loan acquisition or refinancing. And finally, turning to GAAP on Slide 11. We recorded fourth quarter GAAP net income of $270 million or $0.60 per share, compared with net income of $348 million or $0.74 per share in the year-ago quarter. The primary difference between the fourth quarter 2013 core earnings and GAAP results were the marks related to our derivative position. I will now turn the call over to Jack Remondi.

Thanks, Joe. Good morning, everyone. We completed the fourth quarter, as Joe described, and we were executing on each of our objectives for the year. Our results continue to demonstrate the value of our franchise, to continue to help our customers successfully manage their loan payments. We maintained our focus on continuing to improve our operating efficiency and most importantly, we made substantial progress in preparing for the upcoming separation of our businesses. I'm particularly proud of the immense effort and commitment of our employees and our ability to accomplish as much as we did this past quarter. Some highlights from the year. We increased private education loan originations by 14% to $3.8 billion. We reduced credit losses to $878 million with the total year charge-off rate falling to 2.8% from 3.4%. We returned $864 million to shareholders through dividends and share purchases. We completed our planned succession, and we announced our plan to separate into 2 separate companies. These contributed to a total shareholder return of 57% and an increase in equity market capitalization of 45% to $11.3 billion in 2013. The year, however, was not without its challenges. We saw and continue to see intense media coverage of the student loan and student loan indebtedness topic, coverage that does not -- does not always and, in fact, rarely reflect our customer's success. As the largest provider of private education loans and the largest servicer of both federal and private loans, we have a unique insight into loan performance. Our extensive experience allows us to help more borrowers successfully manage their loans. In fact, federal loan customers serviced by Sallie Mae defaulted a 30% lower rate than the national average. And our private loan defaults are at record lows since the Great Recession. In 2013, our efforts helped over 2 million borrowers enroll in manageable payment programs that help them avoid default. In addition to the media commentary, we're in a heightened regulatory environment. As you are aware, regulators are taking much more aggressive positions and actions on a wide variety of consumer protection issues, and student lending is no exception. To be clear, our top priority is to provide high-quality service to our customers, including full compliance with relevant regulations as we understand them. If we make a mistake, we not only work hard to fix it, but we also work to prevent it from happening again. As Joe mentioned, our results this quarter include a reserve of $70 million for potential compliance remediation efforts relating to pending regulatory inquiries. We are in ongoing discussions with regulators regarding a number of issues and given where we are, we believe it was prudent to set this reserve as of year end. We'll continue to monitor this reserve and we hope to be able to resolve these matters in the near future. Throughout this process, we have and will continue to work hard to meet our customers' needs and help them successfully manage their loans. For 2014, we're focused on continuing to add value for our customers and shareholders. Our outlook includes increasing loan originations to $4 billion. With flat enrollment and tuition pricing pressure occurring throughout the higher education industry, we expect the average loan amount to remain flat, leading to our estimate of 5% growth in originations. We see improving loan quality as the total portfolio reflects a higher percentage of Smart Option loans. And we expect to see continued improvement in credit performance, which will reduce our private loan provision to close to $700 million for the year. In addition, we expect an estimated $60 million reduction in E revenue as a result of recent budget legislation that will reduce the revenue earned from helping previously defaulted federal loan borrowers rehabilitate their loans. The new reduced fee structure is effective July 1, 2014. We continue to make progress in executing our plan to separate our businesses. We made substantial progress last quarter, and we fully expect to complete the separation in the first half of 2014. And although we have substantial work to do, all major decisions have been made and we are now in full execution mode on this project. To assist with the success of the consumer lending business post-separation, yesterday we announced the hiring of Ray Quinlan. Upon the separation, Ray will assume the role of Chairman and CEO of the bank parent. Prior to that, he will serve as Vice Chairman of the company, reporting to me. Ray has extensive banking experience, most recently at CIT. His experience will help enhance the management team as it begins operations for the first time as a standalone entity. Overall, I'm very pleased with our results this quarter and for 2013. More importantly, we are well prepared for our pending separation, and I am confident that our plans will allow both companies to best serve their customers, provide the right corporate structure for future success and ultimately create increased value for shareholders. With that, let's open the call for your questions. Operator?

[Operator Instructions] Your first question comes from the line of Sanjay Sakhrani with KBW. Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc., Research Division: I just have a few questions, but let me start with the first one. On the regulatory items, it seems like whenever we've seen this happen in other places in consumer lending, these types of chargers are taken when the damages are kind of estimable and probable. So it seems to me like you guys are probably pretty far down the road in terms of your discussions with the regulators. Is that kind of how we should think about it? And then when we just think about the ongoing impacts of these discussions, do you contemplate any additional charges going forward? And maybe any changes in business practices?

Yes, I think your summary of the accounting requirements is right. So we are making good progress with them on a variety of topics here, and we hope to bring this to resolution. We -- the number includes what we think are the -- is the full estimates. So, to the -- of course, it is an estimate, so it could be subject to change, but I'm going to leave my comments at that at this point. Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc., Research Division: Okay, and then just as far as ongoing business practice changes?

Well, certainly the regulatory environment does require a more intense oversight activities. I don't think our business practices in terms of how we perform tasks necessarily change because we were always geared and structured to full compliance. Certainly, in some instances, in some programs, a topic like SCRA, for example, is an incredibly complex benefit to apply to a borrower's account. Oftentimes -- no, not often, the majority of times, those transactions are retroactive by more than a year. And the activity associated with that is very complex, but it is not a -- going to be a change in business practice. Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc., Research Division: Okay, great. And then you guys gave a lot of color on the separation, and thank you, but if we think about what other boxes need to be checked before the separation occurs, kind of where are we with that?

So most of -- as I said, we are in full execution mode at this stage in the game, and we fully expect to be able to complete the separation in the first half. We still have some regulatory issues with the SEC and the IRS to resolve, but those are moving along as expected, and we don't see any delays on that front. And the rest of it is more operational. How do we move certain functions from what is outside of the bank today to inside of the bank and setting up the right infrastructure. And as I said, those are -- we're now in full execution mode and expect to be ready to complete the separation on-schedule as we originally indicated. Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc., Research Division: Okay. And then just finally, on capital management, I guess the share buyback was resumed this quarter. I guess, what should we infer from the notion that banks are in the market selling portfolios based on your commentary last quarter? Should we -- has that trend changed?

Well, there are 2 different issues here, Sanjay, that I think you need to keep in mind. On the federal side of the equation, the capital requirements are very small and so our ability to absorb significant portfolios within our capital generation rates are very, very easy. The private loan side of the equation is where you see there's a much more significant capital requirement, and those opportunities are frankly much more limited. That just happened to be one that we saw last quarter. Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc., Research Division: Okay. And then as far as when we could -- I mean, are there banks in the market actively trying to sell federal assets?

Yes.

Your next question comes from the line of Michael Tarkan with Compass Point. Michael Tarkan - Compass Point Research & Trading, LLC, Research Division: On the private originations side, you mentioned slowing enrollment and tuition increases leading to basically flat average loan levels. Assuming we don't see tuition rates ticking back up substantially and enrollment growth kind of remains in this relatively muted 1% to 2% growth territory, is that 5% growth rate, is that what we should expect beyond 2014? Is that sort of more of a sustainable growth rate at this point?

I think this is actually a function of a resetting of demand expectations to some extent. People make the adjustments in terms of cost side of the equation and enrollment levels, and it kind of forms a new base. I will say the other thing that we saw is the application growth that we saw in 2013 remained strong in our core segment of high-quality, 4-year institutions, where we saw the biggest drop-off was kind of middle-tier schools, and of course, the for-profit side. Joe, do you want to add more color to that or...

Well, I think Jack's description of the demand is accurately good [ph]. We definitely see in -- across the board that customers are more sensitive to pricing, and we saw that in our surveys, in our How America Pays for College surveys, and then we saw it in the amount of loan they drew, which was average balance is flat this year, which is the first year in 3 or 4 years that happened. So I think people are being more conservative, and I think schools are pricing slightly more conservatively. I do agree with Jack, it's a reset. It's ultimately the cost structures drive these -- drive prices up by 2% to 3% a year.

Do you need to see 5% or more tuition growth to really get back to that double-digit or high-teens origination growth?

No, I think the way you think about it is the market is $400 billion. $436 billion is what America spends on college. So even a 2% or 3% increase in net tuition or net cost, net pricing call it, is $8 billion to $12 billion. The private segment is $8 billion of the $400 billion. So you don't need a lot of growth to get -- you don't need a lot of growth in tuition and net tuition to drive up the size of that market that's private. Remember, the other 3 sources of funds in the $436 billion are federal loans; grants, which are often driven by endowments, which have lower returns right now; and then family resources, which, of course, are not exactly growing right now. So we see -- even in a lower pricing environment, we see the ability for private to grow beyond 5%. I think we're conservative this year because we saw lower -- flat balance growth.

Did the federal student loan interest rate fix have anything to do with maybe the slowdown this year and then maybe some of the conservatism for next year? And if it did have a role, would you expect, from a competitive standpoint, private students loans to look a little bit better in 2014 given the uptick in rates?

I think that's one of the points of Jack's resetting. So you saw the one -- so we initially said we'd do $4 billion, we came in at $3.8 billion, so we had 14% growth, which is obviously very healthy. The 2 factors that we saw that kept us probably from getting to $4 billion, number one, is the flat average balance; and number two, is we did think we would get a little bit more of the graduate segment, and that one, as you recall, was when the government changed the pricing on Grad PLUS. That went into effect in July, but the anticipation was set in May. So we thought we would get a -- initially, when we planned the year, we thought we'd get a little bit more of the Grad segment, and we got a little bit less than we had planned, but still we had a healthy share there. Michael Tarkan - Compass Point Research & Trading, LLC, Research Division: Okay. And then lastly, can you just elaborate a little bit more about the management changes going on there on the private side. I guess I was just a little surprised to see a little bit of a shakeup heading into the spin.

So this is really -- as we were beginning the separation of the bank, it's really looking to add to the bench and -- of the team that's there and bringing in some resources that had some standalone kind of banking experience. So we're excited and looking forward to Ray joining the company. But I think if you look at the quality of the team that is planning to go there and what they have accomplished over the past several years, it's very strong. Joe has been a key part of that success of building our consumer lending business, and he's going to continue to lead that post-spin. So we hope this will be and look forward to this being a net positive.

Your next question comes from the line of Mahmood Reza with Omega Advisors.

So could you just give us an update -- Sanjay, I think, asked on capital allocation, you guys used $200 million of buyback in the quarter. One, do you expect to utilize the full remainder of your authorization? And when does the board review the dividend?

We were -- as you know, we had $400 million authorized at the beginning of the year and an additional $400 million at midyear, and we've used $600 million of that $800 million. So as we enter the first quarter of 2014, we still have $200 million of authority. We do intend to use that authority and we -- and the dividend policy -- though the dividend policy is for SLM Corp, that will be the bank. So NewCo, we'll establish a new policy after the spin.

Got it. And then just one unrelated follow-up. Just on expenses, you guys have been investing in the business on both the private and the FFELP side. And I'm wondering just of the year-over-year increase in expenses, I think it was $235 million in Q4 and $226 million, and I'm excluding the $70 million compliance remediation effort. How much of that is investments in technology versus collection activity? So I guess I'm trying to get a sense of what order of magnitude should we expect to sort of drop-off? At some point, these investments in technology, I assume, would sort of abate or wind down, right?

Yes, I think if you look at the total -- let's look at the total expense, and you have to remove our restructuring and reorganization expenses first, which we normally report below operating expenses. And then in the operating expenses, which went up about $140 million, you take out the reserve that we announced this quarter and you have about $70 million increase, and it's split between consumer and business services. And while we don't breakout how much is technology, both pieces have technology as one of the components. But in both cases, we had an increase in, as I mentioned, productivity, if you want to call it that. In the private segment, of course, we increased originations, and we continue to significantly reduce losses. So a lot of the investment goes into that type of better performance. And of course, in the business services, you call it FFELP, but we really see that as a business services segment, where our contingency and our third-party servicing revenues continue to increase. They went up $108 million while we spent about $35 million there. So while both components have technology throughout, because the collection's function, the originating function and the servicing functions all are technology-based and require investment. At the heart of it is a lot of investment that essentially translates into more staff, more units, et cetera, to drive better revenue, drive lower losses, drive more loan volume.

Your next question comes from the line of Scott Valentin from FBR Capital Markets. Scott Valentin - FBR Capital Markets & Co., Research Division: Just, Joe, you mentioned on the FFELP portfolio, the core spread, I think you've kind of reiterated the guidance of mid-, high-90s. Did you mention the private student loan spread expected to be -- if there's any guidance there?

We didn't give any guidance on that, but you can expect that to improve gradually over time because remember, what we do each year is we add $4 billion of Smart Option loans, which have a higher margin than our traditional signature loans. So that normally inches up year-over-year. Simply from the fact that the signature loans are more mature and they pay back faster obviously than the new Smart Option loans. But generally speaking, that's a slow movement because you're adding $4 billion to $40 billion. Scott Valentin - FBR Capital Markets & Co., Research Division: Okay. And then just a follow-up on kind of the regulatory agreement. In terms of the cost structure, I think it sounds like your basic business practices are not going to change much, maybe require some more oversight and some more monitoring. But I mean, did you foresee big impact on expenses from the settlement?

Well, I mean, the reserve is, I think, is our statement on that side of the equation. The environment itself, I don't think there's any financial services company that's not spending more today on compliance oversight, regulatory issues than it has in the past. I don't think this process is in response to things, in many instances, that we have been working on and addressing over time. So I don't expect it to change post settlement. Scott Valentin - FBR Capital Markets & Co., Research Division: Okay. And then just with regard to overall cost control, I know you guys had kind of targeted around $1 billion of kind of core -- core expenses, core OpEx in the past. I mean, where when do you see that kind of moving? You hope to hold that level or do we expect a slight increase given all the investment going on?

Well, we haven't given guidance for the year. However, we've said, in the context of the spin, we are targeting a 5% increase of overall spend next year. And that is obviously the managed 2 companies. So that's our general direction. And that's a challenging goal, but we believe we can achieve that.

And Scott, I think people, on the OpEx side of the equation, both businesses are growing in terms of the units that we're processing. Joe mentioned the -- on the private side, the origination volumes, the total amount of loans outstanding are increasing. On the federal loan servicing side of the equation, we're servicing more loans than we ever have, including both the FFELP portfolio we own and the Department of Ed loans we service. And our contingency collection book continues to increase as well. So there's good OpEx increases and there's bad OpEx increases, and I think in Joe's comments at the beginning of the call, he tried to put those in light and showed that although we were spending more money in some segments, like $36 million more in business services, we saw $108 million increase in revenue in that segment. Scott Valentin - FBR Capital Markets & Co., Research Division: Okay. So the way we look at it maybe, from an efficiency perspective, the revenue versus expense.

Yes.

Your next question is from that line of Mark DeVries with Barclays.

On the last call, you mentioned the delinquency rate increase due to migration of your customer servicing systems. I mean, you expect that to normalize. You saw a pretty nice drop Q-over-Q this quarter. But did this quarter still include some customers that were delinquent due to that servicing transition?

Well, we -- so let's talk about it this way, so for the most part, our early delinquencies, as you noted, has been cured. We saw a slight tick up in our 90-day and that really was putting more resources on the inbound calls that we get in our earlier section. So ultimately, the majority of the problem is remediated, but you will have customers, even into the first quarter and beyond, whose payments have -- it's just -- I will say -- or have not changed. So typically, a big part of this is we've had to sell customers to make 2 payments instead of 1. Those who don't follow that direction, we correct it for them. So ultimately, that problem will persist in a small, small portion, but we don't see it as a structural loss, a credit quality issue, it's just -- it's literally processing time.

I also think there's a little bit of a chipping of the seasonal default curves that we experienced in the past, as our collection efforts and our customer outreach is more successful. We see fewer borrowers who we are unable to contact when they enter repayment and go into delinquencies and straight to default. So that basically stretches out or pushes the peak default period out from what might have been more heavily concentrated in the third quarter to pieces in the third and fourth quarter.

Okay, that's helpful. Is the $50 million fee reduction that you alluded to earlier, is that -- that's an annual number not a quarterly one, right?

That's the 2014 impact. So it if it's half a year, you'd have to annualize that.

Okay, got it. And then finally, can you remind us of what your expectations were for restructuring costs from the spin and how much has already been charged off at this point?

We expect $64 million and -- so far. And you might have noted, when we filed the Form 10, we put our range at $125 million to $135 million.

And your next question comes from the line of Sameer Gokhale with Janney Capital.

Just curious about the non-compete between NewCo and the bank, and I don't recall there being anything specific mentioned in the Form 10. And I was wondering if -- how we should frame our thinking around the non-compete. Is it 2-year, 5-year, longer duration than that? I mean, where are you in the process of trying to determine the length of that non-compete?

Well, I think the length will be -- that is one of the items that will be formally voted on and approved by the board later this quarter. The concepts of what we're looking to do here, I think, are pretty straightforward. The businesses are separating upon fairly distinct business activities and lines, and each entity is going to have restrictions. I think you can look at this as being a 3- to 5-year type of period for not competing in the other's business segments.

Okay. 3 to 5 years, that's exactly what I needed. That's helpful. And then in terms of the charge-offs for your private student loan portfolio, you may have mentioned this and I missed it, but the increase sequentially -- I know there's been some seasonality, some effect on your delinquencies from technology changes, change in forbearance policy earlier. So I'm just trying to figure out the increase in the charge-off rate sequentially, even though the other forward metrics have -- continue to improve. Is that driven more by seasonality or seasoning of more of your newer vintages? Can you just provide some color on that?

Sure. So if you're looking, Sameer, at third quarter to fourth quarter, typically we see second to third quarter increase. And year-over-year, we've always seen an increase between the second and the third quarter, which meant the fourth quarter was down off that third quarter. This year, we saw the third quarter's charge-off actually reduced over the second quarter. And that's really a function of 2 factors. One, we did perform very well in collections and second of all, typically the third quarter is driven by customers entering repayment in January and going -- and that pool charging off 6 months later if they're under a lot of stress. The percentage of customers who fit that bill as a percentage of our portfolio are declining because more and more of our customers are already in full P&I, or full payment principal and interest. So that segment keeps getting smaller. So the third quarter went down instead of up, part structurally and part performance. And so when you see the third quarter down over the fourth quarter, it's -- and the fourth quarter up, it's more of a function of what happened in the third, not what happened in the fourth.

Okay, that's also very helpful because it did look like some of the trends were a little different from what we've seen in the past.

[Operator Instructions] And your next question is from that line of Moshe Orenbuch with Credit Suisse. Moshe Orenbuch - Crédit Suisse AG, Research Division: Just a follow-up on that change in the servicing. Could you talk of whether there are expense reductions that you're going to be able to take in order to cushion that flow somewhat? And I've got a follow-up.

Well, I think it's change in the servicing platforms you're referring to? Moshe Orenbuch - Crédit Suisse AG, Research Division: No, the $60 million servicing revenue for the second half of the year.

Okay. So that is in the collections business, I'm not sure it's -- it has to do with the rehabilitation fee that we earn. When a federal loan borrower defaults, the government hires entities like us to help those borrowers get back in the repayment and then we earn a fee for that. Our goal is -- as you know, we've been one of the top -- we have been the top performer in that segment and we help resolve more delinquent borrowers than any other entity get back into good standing. Why this is important is when you rehabilitate a loan, the charge-off is removed on the account and so the borrower becomes eligible again to participate in the federal programs, and that's important because the #1 reason for a default is they drop out of school. So they can actually go back to school and complete their degree. This was pure budget issues unfortunately, and we are working to find ways to increase the share that we get in this space so that we can help offset some of this revenue. Today, we have about less than a 7% share from the Department of Ed, despite our top-performing status, as an example. Moshe Orenbuch - Crédit Suisse AG, Research Division: So I mean, do you anticipate that there'll consolidation as a result, that others will get out?

I do think it will make it more difficult for others to participate in this space, and we would expect our market share to increase, yes. Moshe Orenbuch - Crédit Suisse AG, Research Division: Okay. All right, that means basically -- my follow-up was actually going to be kind of like how do you kind of lever that skill set in terms of -- because this change seems kind of odd because it does seem like they're reducing the revenues on an activity that actually provides some value, right?

I think that speaks for itself.

Your next question comes from the line of David Hochstim with Buckingham Research.

I wonder if you could just clarify a couple of things. Is the loss revenue that you were just talking to Moshe about, is that $50 million for a half year or $60 million?

6-0.

6-0. Okay. And are there other budget changes that might have a beneficial effect on your business? I mean, you mentioned you might be able to gain share in this case, but are there other things that kind of happen that may create some opportunities and reduce some funds...

No, there was nothing else in this budget. This, as I said, this was purely a -- they were trying to find ways to cover spending increases elsewhere in the budget. They went through different line items and this unfortunately made it onto the list. So it's not connected to the spend side of the equation. There was nothing else in the budget that has an impact, positive or negative.

That's good news in a way compared to prior budgets. And then could you just -- I mean, is there any more color you can give on the compliance reserve in terms of kind of what it's focused on? Is that things you have alluded to in the -- in your filings in the past about payment posting or is it government loan?

I think the comments that we made in the disclosures in the past, along with this reserve, do fit together. But given the fact that we don't have any -- we're not -- we haven't completed the process yet, I think that's all we can say.

Okay, And then I guess, is it -- I want to make sure I understood. You were saying that this is not something that would impede your progress on the separation. This is...

That's right.

Okay. And then, is there any update that you talked in the past about trying to help the Department of Education make more rational decisions in allocating servicing in the direct loan servicing contract? Have you made any headway there?

Well, this contract, our Department of Education loan servicing contract is 5 years old now, and it's going through a renewal process. The Department of Ed has, as any owner of loans would do, is looking to make sure that the structure of the program is achieving the results in the areas that they're looking for. So we have a close relationship with them, and we work collaboratively with them to find ways to make the program work better. And ultimately, that goal is the same one that we have, which is helping borrowers successfully manage their loans. And as we said, we do a better job at that than anyone else. So when you look at some -- you look at not just the default numbers but the fact that we enrolled 2 million borrowers this year, 2 million customers into repayment programs that they can manage so that they avoid default, those are the types of things that work -- that they and we are working on.

And then finally, just -- when you're talking about kind of increasing expenses associated with increases in revenues. When they think about the bank after the split up, and we're talking about a $4 billion increase in balances on kind of starting with $6 billion, is that still the right number on private loans?

You can still use that math, $6 billion, that's what we disclosed in our bank 8-K. You look at the year-end balance sheet of the bank, it's a little bit higher after the fourth quarter disbursement from private. But it is a $6 billion or $7 billion asset based on private at year end, $7 billion today, and $4 billion of new originations. Now, remember, we won't keep all $4 billion in the bank. We'll keep about $2 billion on the balance sheet, and we will sell the other $2 billion, approximately.

You'll sell some of the new originations, not securitizing some of the seasoned payment [ph]?

We'll do both. But in terms of true sale, think of it these way. The balance sheet of the bank is about $10 billion, and you put in cash and you put in the FFELP assets there. And generally speaking, we'll grow that by about 20% a year. So if you add $4 billion, that's where we get the approximate $2 billion in the balance sheet and then $2 billion gets sold.

I guess, I thought before you might be replacing some other assets with private loans, is that a possibility?

The only thing else on the bank balance sheet is that FFELP asset and cash. So there's really -- it really, truly is a single asset balance sheet.

Your next question comes from the line of Alan Straus with Schroders.

I have 2 questions. First is you had a small clean-up of a one-time gain, it looks like on a leverage lease. Is there more of that to be cleaned up? I guess you took a small loss -- a small gain, we should expect [indiscernible]?

Yes, that was one-time, that was the one lease we cleaned up right there.

Okay. And the second question, as servicing is becoming more complicated on the student loan side, are any of the banks thinking about just outsourcing the servicing to you and keeping the asset, sort of like what they've done on the mortgage business?

We would agree, I think, that's the logical outcome. Most federal loan lenders in the past did not service their own portfolio. So that is clearly a direction that things would head. The regulatory environment, the service requirements, really straight from the originations through servicing is very different than the education lending world than it is in other consumer products. And so specialized systems and compliance routines and efforts are definitely the requirement here.

And your next question is from that line of Brad Ball with Evercore.

Joe, you talked about the asset size and mix of the bank being consistent with what you previously and originally foresaw. Are you still thinking that the sort of 16% to 20% ROE is the right target range or could you be above that given plans to sell a portion of your originated private loans?

No, the 16% to 20% contemplates some sale of assets. Remember, in the early days of the bank, the expense structure will be unusually tilted towards acquisition. Today, when we report the consumer segment, we have $4 billion of originations on top of a $38 billion base. So that mix between what you spend on servicing your assets versus what you spend on originating, let's just call it more normal than most types of mature businesses. The bank will have $4 billion of new assets on top of a $6 billion base of private loans or $7 billion at year end if you look it that way. So the expense burden in the early days will be a little bit heavier, offset by the gain on sale from selling -- cash gain on sale from selling loans.

And in terms of your long-term outlook for the credit quality of the Smart Option book, are you still talking sort of 6% life-of-loan losses to 1% to 1.5% annual loss rates?

Yes, yes, we still feel very confident on that. We looked at our early loss rate on even the portion of the Smart Option that is in full P&I. So the older segments are now 30, 35 months in full P&I. They are outperforming even the best of the signature, and they're our best segments from our prior days, so we feel very good about that.

Okay. And then in terms of the compliance remediation, can you tell us if the inquiries are directed at the bank or are they really directed at the servicing enterprise? And would you have expected to have to make these kind of remediations, set aside this reserve, even if you weren't contemplating a split of the company?

They're both. I mean, they're -- the issues are where the loans are. And so we have loans in both the bank and outside of the bank. And this has -- this process has nothing to do with the spin.

Okay, and I think you said, you would not expect that this process, that these inquiries would delay or get in the way of the spin in any way?

That's right.

Okay, good. And then just finally, so you raised your expected spin-related, one-time expenses, $125 million to $135 million now. What is that mainly attributable to? What are the main drivers of the increase versus -- I think your prior guidance was $75 million to $90 million?

It just really -- it relates to the -- to some of the complexity-related issues associated with setting up systems and capabilities as we split the company. And then I think a big chunk of this is also related to the review oversight of the comprehensiveness of the solutions as we move functions into the bank. And [indiscernible] consulting costs.

So these are things that you could have projected back in May when you announced the deal, you just underestimated those costs?

Yes, and I think the environment has changed too. We're just wanting to be, as we move functions into the bank, to be absolutely positive that they are been both reviewed internally and by kind of a seal of -- a good housekeeping seal, that they move into the bank and are ready to be there.

Okay, and then just finally, is the hiring of Ray Quinlan in any way related to the regulatory inquiries? Are they in any way pressuring you to get a bank industry veteran to come on board to help run the company?

No.

And I will now turn the conference back over to Steve McGarry for any closing remarks.

Thank you very much, Carmen. And thank you, everybody, for joining us this morning. That concludes our call. If you have any follow-up questions, please call Steve McGarry or Joe Fisher.

Thank you again for joining us today. This concludes today's conference. You may now disconnect.