Undergrad and graduate students may soon be feeling the pinch of the subprime mortgage default-induced credit crunch.

Securities tied to student loans have failed to generate investors' interest, leaving roughly $3 billion in a sort of limbo, The Wall Street Journal reported Tuesday (subscription required).

Typically, the banks involved in the deal -- in this case Goldman Sachs (NYSE: GS), J. P. Morgan Chase (NYSE: JPM) and Citigroup (NYSE: C) -- would step in to buy the securities when demand is weak. However, because the major banks are already flush with loans and bonds they're trying to get rid of, they have been allowing the auctions to fail, The Journal reported.

Student loan manager Sallie Mae (NYSE: SLM) fell 42 cents to $19.73 on the news in Tuesday morning trading.

Bond demand is weak

The auction process is similar to those held for municipal bonds, corporate debt and other debt securities. However, Wall Street is not obligated to step in and buy student loan-backed securities when demand is weak.

Thursday, Sallie Mae -- known more formally as SLM Corp. (NYSE: SLM) -- lost $2.36 a share, closing at $20.53. The cause of this dramatic loss, over 10% on the day, was the failure of the firm's new CEO, Albert Lord, to reassure analysts that he is in control of Sallie Mae and has a plan for turning things around. In fact, during an analyst conference call on Wednesday, Lord was downright bizarre, refusing to provide any income projections and, worse, making bad jokes and cursing audibly.

Yesterday wasn't the first bad day for Sallie Mae, not by a long shot. In the last few weeks, news about Sallie Mae has been universally bad. In October, the private equity firm J. C. Flowers lowered the value of its buyout offer by 20%. The ensuing struggle over the buyout, as well as changes in federal law that may make students loans less profitable, helped send the stock down from the $50 range to the $30s. And it's been all downhill ever since.

In Wednesday's conference call, Lord repeatedly refused to answer analyst questions about 2008, despite the fact that SLM lowered guidance last week. He invited analysts to a meeting in New York next month, saying that they should "get there early because I can assure you, you will be going through a metal detector." Then, to make matters worse, at the end of the call he was heard to say, "There's no questions, let's get the [expletive] out of here."

With leadership like that, it looks like Sallie Mae has a long way to go before investors feel secure enough to jump back in.

[Update: There have been more developments this morning, which I will elaborate on soon enough.]

The New York Times [registration required] reports that J.C. Flowers, the private equity firm that announced it was pulling out of its deal to buy SLM Corp. (NYSE: SLM), has changed its mind. Flowers is now offering $50 a share in cash, 10% 16.7% below its original $60 a share offer for the student lender.

But J.C. Flowers has offered a kicker: warrants to buy SLM shares, which it claims could eventually be worth as much as $10 a share if SLM meets or exceeds its earnings projections. Warrants, which give their owners the right to buy shares at a specific price, are sometimes used in bankruptcy cases as a way to repay creditors. The idea is that if the company fares better than expected, warrant holders can share in the profits by exercising the options. But a few hours ago SLM announced it rejected the offer.

According to its statement, J.C. Flowers wanted out because of a law signed by the president which limited government reimbursement of student loans. But SLM countered with a statement reaffirming its rights under the merger contract. So what does the cash and warrants deal mean? It could be seen as a clever way to tie SLM's sale price to its business prospects. Or it may be an attempt to buy SLM on the cheap while claiming to stand by its previous bid