Sallie Forth to a BB Rating

If you bought the rumor on Friday that Sallie Mae was about to go private, you're feeling pretty smug this morning. Sure, SLM shares closed at $46.76 on Friday, up almost 15% on the day. But now it turns out that Christopher Flowers and his consortium are willing to pay $60 for them, valuing the student lender at $25 billion.

There are echoes of the TXU buyout here: both companies are in politically fraught and unpopular industries, and private equity is stepping up where public shareholders have proved themselves fearful. (Sallie Mae was trading at $55 per share last summer.)

Flowers, along with fellow-bidders JP Morgan Chase, Bank of America, and Friedman Fleischer & Lowe, is making a long-term bet on Sallie Mae and trusting that the political firestorm in New York and Washington will blow over sooner or later.

Flowers is probably right, but it's a risky bet all the same. Sallie Mae makes a lot of money by lending money to students and then getting Uncle Sam to pay it back in the event of default. If the government ever tires of subsidizing the private sector in this way, no amount of "private student loans" – loans made outside the federal guarantee program – are likely to be able to justify the $25 billion price tag.

The most interesting part of the deal, however, is not the politics so much as the financial engineering. Sallie Mae, like most lenders, has relatively little debt, mainly because it feels it needs a rock-solid credit rating in order to minimize its borrowing costs. But all that is about to change now: this deal is being done with $16.5 billion in new debt, which could well bring Sallie Mae all the way down to junk high-yield status.

And where will Sallie find the money to lend out if it has a double-B credit rating? Why, its shareholders, of course: JP Morgan and BofA have promised a credit line of as much as $200 billion if the bond markets prove recalcitrant.

In 1997, Sallie Mae was a government agency with a triple-A rating. Five years later, it was down to single-A. Five years after that, it's likely to be down to BBB at the highest. That's progress, that is.