UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM _________TO ________.
COMMISSION FILE NUMBER 001-31924
NELNET, INC.
(Exact name of registrant as specified in its charter)
NEBRASKA 84-0748903
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
121 SOUTH 13TH STREET, SUITE 201 68508
LINCOLN, NEBRASKA (Zip Code)
(Address of principal executive offices)
(402) 458-2370 (Registrant's telephone
number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
As of April 30, 2004, there were 39,624,243 and 14,023,454 shares of Class A
Common Stock and Class B Common Stock, par value $0.01 per share, outstanding,
respectively.
NELNET, INC.
FORM 10-Q
INDEX
MARCH 31, 2004
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements...........................................2
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations..................9
Item 3. Quantitative and Qualitative Disclosures about Market Risk....29
Item 4. Controls and Procedures.......................................29
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.............................................29
Item 2. Changes in Securities and Use of Proceeds.....................30
Item 3. Defaults Upon Senior Securities...............................30
Item 4. Submission of Matters to a Vote of Security Holders...........30
Item 5. Other Information.............................................30
Item 6. Exhibits and Reports on Form 8-K..............................30
SIGNATURES....................................................................37
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
March 31, 2004 December 31, 2003
-------------- -----------------
(unaudited)
(dollars in thousands, except share data)
ASSETS:
Student loans receivable (net of allowance for loan losses of
$16,623 and $16,026, respectively).......................... $ 11,206,609 10,455,442
Cash and cash equivalents:
Cash and cash equivalents - not held at a related party..... 81,705 188,272
Cash and cash equivalents - held at a related party......... 15,861 10,151
------------ ------------
Total cash and cash equivalents................................... 97,566 198,423
Restricted cash - held by trustee................................. 763,701 634,263
Restricted investments - held by trustee.......................... 201,316 180,688
Restricted cash - due to loan program customers................... 37,095 141,841
Accrued interest receivable....................................... 210,205 196,633
Accounts receivable, net.......................................... 13,875 17,289
Intangible assets, net............................................ 19,739 11,630
Furniture, equipment and leasehold improvements, net.............. 22,665 19,138
Other assets, including deferred taxes............................ 55,796 76,162
------------ ------------
Total assets................................................ $ 12,628,567 11,931,509
============ ============
LIABILITIES:
Bonds and notes payable........................................... $ 12,140,725 11,366,458
Accrued interest payable.......................................... 20,313 17,179
Other liabilities................................................. 115,797 100,542
Due to loan program customers..................................... 37,095 141,841
------------ ------------
Total liabilities........................................... 12,313,930 11,626,020
------------ ------------
SHAREHOLDERS' EQUITY:
Preferred stock, $0.01 par value. Authorized 50,000,000 shares;
no shares issued or outstanding............................. -- --
Common stock:
Class A, $0.01 par value. Authorized 600,000,000 shares;
issued and outstanding 39,624,243 shares at
March 31, 2004 and 39,601,834 shares at
December 31, 2003....................................... 396 396
Class B, $0.01 par value. Authorized 15,000,000 shares;
issued and outstanding 14,023,454 shares................ 140 140
Additional paid-in capital........................................ 207,359 206,831
Retained earnings................................................. 107,006 97,885
Accumulated other comprehensive income (loss)..................... (264) 237
------------ ------------
Total shareholders' equity.................................. 314,637 305,489
------------ ------------
Total liabilities and shareholders' equity................. $ 12,628,567 11,931,509
============ ============
See accompanying notes to consolidated financial statements.
2
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
Three Months Ended
March 31,
--------------------------
2004 2003
------------- ------------
(dollars in thousands,
except share data)
INTEREST INCOME:
Loan interest........................................... $ 88,727 89,682
Investment interest..................................... 3,651 3,925
------------- -------------
Total interest income................................ 92,378 93,607
INTEREST EXPENSE:
Interest on bonds and notes payable..................... 49,043 51,349
------------- -------------
Net interest income.................................. 43,335 42,258
Less provision for loan losses.............................. 3,115 2,410
------------- -------------
Net interest income after provision for loan losses.. 40,220 39,848
------------- -------------
OTHER INCOME:
Loan servicing and other fee income..................... 25,709 25,837
Software services and other income...................... 5,578 4,640
Derivative market value adjustment and net settlements.. (3,741) --
------------- ------------
Total other income................................... 27,546 30,477
------------- ------------
OPERATING EXPENSES:
Salaries and benefits................................... 27,769 26,505
Other operating expenses:
Depreciation and amortization........................ 4,408 5,836
Trustee and other debt related fees.................. 2,614 3,672
Occupancy and communications......................... 3,082 3,267
Advertising and marketing............................ 2,323 1,586
Professional services................................ 4,460 2,185
Consulting fees and support services to
related parties.................................... -- 2,235
Postage and distribution............................. 3,848 3,753
Other................................................ 4,708 6,195
------------- ------------
Total other operating expenses..................... 25,443 28,729
------------- ------------
Total operating expenses........................... 53,212 55,234
------------- ------------
Income before income taxes and minority interest... 14,554 15,091
Income tax expense.......................................... 5,433 5,622
------------- ------------
Income before minority interest.................... 9,121 9,469
Minority interest in subsidiary loss........................ -- 109
------------- ------------
Net income......................................... $ 9,121 9,578
============ ============
Earnings per share, basic and diluted.............. $ 0.17 0.21
============ ============
Weighted average shares outstanding,
basic and diluted................................ 53,635,631 44,982,490
============ ============
See accompanying notes to consolidated financial statements.
3
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME
(UNAUDITED)
Preferred Common stock shares Class A Class B Additional
stock ---------------------- Preferred common common paid-in Retained
shares Class A Class B stock stock stock capital earnings
--------- ---------- ---------- --------- --------- -------- ---------- ---------
(dollars in thousands, except share data)
BALANCE AT DECEMBER 31, 2002..... -- 30,947,834 14,023,454 $ -- 309 140 37,891 70,782
Comprehensive income:
Net income................... -- -- -- -- -- -- -- 9,578
Total comprehensive income.
Issuance of common stock......... -- 331,800 -- -- 3 -- 803 --
Redemption of common stock....... -- (264,600) -- -- (2) -- (641) --
-------- ----------- ----------- ---------- ------ ------ --------- ---------
BALANCE AT MARCH 31, 2003........ -- 31,015,034 14,023,454 $ -- 310 140 38,053 80,360
======== =========== =========== ========== ====== ====== ========= =========
BALANCE AT DECEMBER 31, 2003..... -- 39,601,834 14,023,454 $ -- 396 140 206,831 97,885
Comprehensive income:
Net income................... -- -- -- -- -- -- -- 9,121
Other comprehensive income,
net of tax, related to
cash flow hedge............ -- -- -- -- -- -- -- --
Total comprehensive income.
Issuance of common stock......... -- 22,409 -- -- -- -- 528 --
-------- ----------- ----------- ---------- ------ ------ --------- ---------
BALANCE AT MARCH 31, 2004........ -- 39,624,243 14,023,454 $ - 396 140 207,359 107,006
======== =========== =========== ========== ====== ====== ========= =========
Continued:
Accumulated
other Total
comprehensive shareholders'
income (loss) equity
------------ ------------
(dollars in thousands, except share data)
BALANCE AT DECEMBER 31, 2002.... $ -- 109,122
Comprehensive income:
Net income.................. -- 9,578
-----------
Total comprehensive income 9,578
Issuance of common stock........ -- 806
Redemption of common stock...... -- (643)
-------- -----------
BALANCE AT MARCH 31, 2003....... -- 118,863
======== ===========
BALANCE AT DECEMBER 31, 2003.... $ 237 305,489
Comprehensive income:
Net income.................. -- 9,121
Other comprehensive income,
net of tax, related to
cash flow hedge........... (501) (501)
-----------
Total comprehensive income 8,620
Issuance of common stock........ -- 528
-------- -----------
BALANCE AT MARCH 31, 2004....... $ (264) 314,637
======== ===========
See accompanying notes to consolidated financial statements.
4
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Three Months Ended
March 31,
----------------------
2004 2003
----------- ----------
(dollars in thousands)
Net income..................................................................$ 9,121 9,578
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization, including premiums..................... 25,788 23,958
Derivative market value adjustment.................................... 2,527 --
Ineffectiveness of cash flow hedge.................................... 24 --
Issuance of common stock to non-employee board members................ 528 --
Deferred income tax expense (benefit)................................. 1,308 (1,108)
Minority interest in subsidiary loss.................................. -- (109)
Provision for loan losses............................................. 3,115 2,410
Increase in accrued interest receivable............................... (13,572) (4,755)
Decrease (increase) in accounts receivable............................ 3,414 (2,358)
Decrease in other assets.............................................. 20,414 14,299
Increase (decrease) in accrued interest payable....................... 3,134 (234)
Increase (decrease) in other liabilities.............................. 15,255 (15,661)
----------- ---------
Net cash provided by operating activities....................... 71,056 26,020
----------- ---------
Cash flows from investing activities:
Originations, purchases and consolidations of student
loans, including premiums.............................. (1,253,316) (876,640)
Purchases of student loans, including premiums, from a related party.. (124,853) (203,520)
Net proceeds from student loan principal payments and
loan consolidations................................................. 604,070 585,725
Net purchases of furniture and equipment, net of acquisition.......... (5,847) (2,919)
Decrease (increase) in restricted cash - held by trustee.............. (129,438) 23,771
Purchases of restricted investments - held by trustee................. (189,773) (86,680)
Proceeds from maturities of restricted invesments - held by trustee... 169,145 91,179
Purchase of origination rights........................................ (7,871) --
Purchase of equity method investment.................................. (5,250) --
----------- ---------
Net cash used in investing activities.......................... (943,133) (469,084)
----------- ---------
Cash flows from financing activities:
Payments on bonds and notes payable................................... (507,197) (632,117)
Proceeds from issuance of bonds and notes payable..................... 1,281,500 1,075,313
Payments for debt issuance costs...................................... (3,083) (2,861)
Payments for redemption of common stock............................... -- (643)
Proceeds from issuance of common stock................................ -- 806
----------- ---------
Net cash provided by financing activities....................... 771,220 440,498
----------- ---------
Net decrease in cash and cash equivalents....................... (100,857) (2,566)
Cash and cash equivalents, beginning of period.............................. 198,423 40,155
----------- ---------
Cash and cash equivalents, end of period....................................$ 97,566 37,589
=========== =========
Supplemental disclosures of cash flow information:
Interest paid.........................................................$ 44,310 49,529
=========== =========
Income taxes received, net............................................$ (2) (126)
=========== =========
See accompanying notes to consolidated financial statements.
5
NELNET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(INFORMATION AT MARCH 31, 2004 AND FOR THE THREE MONTHS ENDED
MARCH 31, 2004 AND 2003 IS UNAUDITED)
1. BASIS OF FINANCIAL REPORTING
The accompanying unaudited consolidated financial statements of Nelnet, Inc.
and subsidiaries (the "Company") as of March 31, 2004 and for the three months
ended March 31, 2004 and 2003 have been prepared on the same basis as the
audited consolidated financial statements for the year ended December 31, 2003
and, in the opinion of the Company's management, the unaudited consolidated
financial statements reflect all adjustments, consisting of normal recurring
adjustments, necessary for a fair presentation of results of operations which
might be expected for the entire year. The preparation of financial statements
in conformity with generally accepted accounting principles requires management
to make estimates and assumptions that affect the amounts reported in the
consolidated financial statements and accompanying notes. Actual results could
differ from those estimates. Operating results for the three months ended March
31, 2004 are not necessarily indicative of the results for the year ending
December 31, 2004. The unaudited consolidated financial statements should be
read in conjunction with the Company's Annual Report on Form 10-K for the year
ended December 31, 2003. Certain amounts from 2003 have been reclassified to
conform to the current period presentation.
2. ACQUISITIONS
On January 28, 2004, the Company acquired 50 percent of the membership
interests in Premiere Credit of North America, LLC ("Premiere"). Premiere is a
collection services company that specializes in collection of educational debt.
Total consideration paid by the Company for Premiere was $5.3 million, $2.3
million of which represents excess purchase price which will not be amortized.
Included in the Premiere purchase agreement is a "call" option, which expires 6
years after the purchase date, that allows the Company to purchase 100 percent
ownership of Premiere at a price as determined per the agreement. In addition,
Premiere has a "put" option, which expires 5 years after the purchase date, to
require the Company to purchase 100 percent ownership of Premiere at a price as
determined per the agreement. The Company is accounting for Premiere using the
equity method of accounting. At March 31, 2004, the investment in Premiere and
excess purchase price is included in other assets and intangible assets,
respectively, on the consolidated balance sheet.
Effective March 11, 2004, the Company acquired rights, title, and interest
in certain assets of the Rhode Island Student Loan Authority ("RISLA"),
including the right to originate student loans in RISLA's name without
competition from RISLA for a term of ten years. Total consideration paid by the
Company for the rights to originate student loans was $7.9 million, which will
be amortized over ten years. At March 31, 2004, these origination rights are
included in intangible assets on the consolidated balance sheet. The Company
also purchased certain net assets, consisting primarily of furniture and
equipment from RISLA for $0.3 million and a portfolio of Federal Family
Education Loan Program ("FFELP" or "FFEL Program") loans with an aggregate
outstanding balance of approximately $175 million. The Company further agreed to
provide administrative services in connection with certain of the indentures
governing debt securities of RISLA for a ten-year period.
On April 19, 2004, the Company purchased SLAAA Acquisition Corp. ("SLAAA")
for $11.0 million. SLAAA is a FFELP loan secondary market maker. This
acquisition was accounted for under purchase accounting and the results of
operations will be included in the consolidated financial statements from the
date of acquisition. No allocation of purchase price for SLAAA has been made
because the Company has not been able to obtain all of the data required to
complete the allocation for this recently acquired business.
On April 20, 2004, the Company purchased 50 percent of the issued and
outstanding capital stock of INFINET Integrated Solutions, Inc. ("INFINET") for
$4.9 million. INFINET provides customer-centric electronic transactions,
information sharing, and account and bill presentment for colleges,
universities, and healthcare organizations. The Company will account for INFINET
using the equity method of accounting. No allocation of purchase price for
INFINET has been made because the Company has not been able to obtain all of the
data required to complete the allocation for this recently acquired business.
3. BONDS AND NOTES PAYABLE
On January 15, 2004 and April 29, 2004, the Company consummated debt
offerings of student loan asset-backed notes of $1.0 billion each, with final
maturity dates ranging from 2009 through 2039. The majority of notes issued in
these transactions have variable interest rates based on a spread to LIBOR or
reset under auction procedures. Included in the January 2004 issuance was $210
million of notes with a fixed interest rate which resets August 25, 2005. The
Company entered into a derivative financial instrument to convert this fixed
interest rate to a variable rate until the August reset date. (See note 4).
6
4. DERIVATIVE FINANCIAL INSTRUMENTS
The Company maintains an overall interest rate risk management strategy
that incorporates the use of derivative instruments to minimize the economic
effect of interest rate volatility. The Company's goal is to manage interest
rate sensitivity by modifying the repricing or maturity characteristics of
certain balance sheet assets and liabilities so that the net interest margin is
not, on a material basis, adversely affected by movements in interest rates. The
Company views this strategy as a prudent management of interest rate
sensitivity. The Company accounts for derivative instruments under Statement of
Financial Accounting Standards ("SFAS") No. 133, ACCOUNTING FOR DERIVATIVE
INSTRUMENTS AND HEDGING ACTIVITIES ("SFAS No. 133"), which requires that every
derivative instrument be recorded in the balance sheet as either an asset or
liability measured at its fair value. Management has structured all of the
Company's derivative transactions with the intent that each is economically
effective; however, the majority do not qualify for hedge accounting under SFAS
No. 133.
Effective January 14, 2004, the Company entered into five interest rate
swaps with a combined notional amount of $6.0 billion that mature in the third
and fourth quarters of 2004. In addition, in connection with the January 2004
debt offering, the Company entered into an interest rate swap with a notional
amount of $210 million that effectively converted debt with a fixed rate to a
variable rate (see note 3). These interest rate swaps do not qualify for hedge
accounting under SFAS No. 133.
The following table summarizes the Company's outstanding derivative
instruments as of March 31, 2004:
Notional Amounts by Product Type
----------------------------------------------
Fixed/ Floating/
floating Basis fixed
Maturity swap swaps swaps Total
------------------ ----------------------------------------------
(dollars in millions)
2004.............. $ 7,000 500 -- 7,500
2005.............. 400 1,000 210 1,610
2006.............. -- 500 -- 500
---------- -------- ---------- ---------
Total........... $ 7,400 2,000 210 9,610
========== ======== ========== =========
The following is a summary of the amounts included in derivative market
value adjustment and net settlements on the consolidated income statements:
Three Months Ended
March 31,
----------------------
2004 2003
----------- ---------
(dollars in thousands)
Change in fair value of derivative instruments.... $ (2,527) --
Settlements, net................................. (1,214) --
---------- ----------
Derivative market value adjustment and net
settlements....................................... $ (3,741) --
=========== ==========
5. DIRECTORS STOCK COMPENSATION PLAN
On February 19, 2004, the Company issued 22,409 shares of its Class A
common stock under the Nelnet, Inc. Directors Stock Compensation Plan to
non-employee members of the Board. These shares were issued in consideration for
the Board members' 2004 annual retainer fees. The number of shares issued to the
Board members was determined by dividing the amount of the annual retainer fee
by 85% of the price paid per share by the underwriters in the Company's initial
public offering of its Class A common stock. The Company recognized a $0.5
million expense as a result of issuing these shares.
6. DEFERRED INCOME
A portion of the Company's FFELP loan portfolio, with an outstanding balance of
$3.1 billion as of March 31, 2004, is comprised of loans which were previously
financed with tax-exempt obligations issued prior to October 1, 1993. Based upon
7
provisions of the Higher Education Act of 1965, as amended, and related
interpretations by the U.S. Department of Education, the Company believes it may
be entitled to receive special allowance payments on these loans providing the
Company with a 9.5% minimum rate of return. The Company has asked the Department
to confirm that the Company is allowed to recognize the income based on the 9.5%
minimum rate of return. To date, the Company has deferred recognition of this
excess interest income generated by these loans pending satisfactory resolution
of this issue. As of March 31, 2004, the amount of excess interest income
deferred totaled approximately $79 million, which is included in other
liabilities on the Company's balance sheet. Legislation has recently been
introduced to eliminate the 9.5% floor interest rate on loans financed with
funds from these pre-1993 tax-exempt financings and then refinanced subsequent
to May 5, 2004 with funds other than from such tax-exempt financings. If this
legislation is enacted as introduced, it would appear to prospectively eliminate
floor income on loans in such manner. This legislation does not, however, affect
special allowance payments on loans which are financed now or in the future with
these tax-exempt obligations or which have been refinanced prior to May 5, 2004
with funds other than from such tax-exempt obligations. However, because this is
pending legislation only and is subject to revisions, the Company cannot be
assured the legislation, if enacted, will only prospectively eliminate this
floor income. At this time, the Company cannot predict how the potential
legislation will affect its operations in the future.
7. SEGMENT REPORTING
The Company is a vertically integrated education finance organization which
has four operating segments as defined in SFAS No. 131, DISCLOSURES ABOUT
SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION ("SFAS No. 131"), as follows:
Asset Management, Student Loan Servicing, Guarantee Servicing, and Servicing
Software. The Asset Management and Student Loan Servicing operating segments
meet the quantitative thresholds identified in SFAS No. 131 as reportable
segments and therefore the related financial data is presented below. The
Guarantee Servicing and Servicing Software operating segments do not meet the
quantitative thresholds and therefore are included as other segments that do not
meet the reportable segment criteria. The accounting policies of the reportable
segments are the same as those described in the summary of significant
accounting policies in the consolidated financial statements included in the
Company's Annual Report on Form 10-K for the year ended December 31, 2003. Costs
excluded from segment net income primarily consist of unallocated corporate
expenses, net of miscellaneous revenues. Thus, net income of the segments
includes only the costs that are directly attributable to the operations of the
individual segment.
The Asset Management segment includes the acquisition, management, and
ownership of the student loan assets. Revenues are primarily generated from net
interest income on the student loan assets. The Company generates student loan
assets through direct origination or through acquisition of the loans from
branding and forward purchase relationships. The student loan assets are held in
a series of student lending subsidiaries designed specifically for this purpose.
The Student Loan Servicing segment provides for the servicing of our own and
third parties' student loan portfolios. The servicing activities include
application processing, borrower updates, payment processing, claim processing,
and due diligence procedures. These activities are performed internally for our
own portfolio in addition to generating fee revenue when performed for
third-party clients.
Substantially all of the Company's revenues are earned from customers in the
United States and no single customer accounts for a significant amount of any
reportable segment's revenues. Intersegment revenues are charged by a segment to
another segment that provides the product or service. The amount of
inter-segment revenue is based on comparable fees charged in the market.
Segment data is as follows:
Asset Student Loan Total
Management Servicing Other Segments
----------- ------------ --------- ---------
(dollars in thousands)
THREE MONTHS ENDED MARCH 31, 2004:
Net interest income................ $ 44,663 278 3 44,944
Other income....................... 936 16,596 7,712 25,244
Intersegment revenues.............. -- 18,962 979 19,941
----------- --------- --------- ---------
Total revenue................... 45,599 35,836 8,694 90,129
Provision for loan losses.......... 3,115 -- -- 3,115
Depreciation and amortization...... -- -- 1,763 1,763
Income tax expense (benefit)....... 3,417 3,514 (531) 6,400
Net income......................... 11,303 3,913 1,557 16,773
Total assets (at period end)....... $12,356,384 221,791 22,856 12,601,031
=========== ========= ========= ==========
8
Asset Student Loan Total
Management Servicing Other Segments
------------ ------------ ---------- ----------
(dollars in thousands)
THREE MONTHS ENDED MARCH 31, 2003:
Net interest income............. $ 43,407 345 4 43,756
Other income.................... 871 20,840 8,046 29,757
Intersegment revenues........... -- 14,945 378 15,323
----------- ----------- --------- ------------
Total revenue.................. 44,278 36,130 8,428 88,836
Provision for loan losses........ 2,410 -- -- 2,410
Depreciation and amortization.... 536 484 1,783 2,803
Income tax expense............... 2,153 3,288 457 5,898
Net income....................... 11,080 5,544 238 16,862
Total assets (at period end).....$ 9,983,709 91,256 24,961 10,099,926
============ =========== ========= ============
Reconciliation to the unaudited consolidated financial statements is as
follows:
Three Months
Ended March 31,
------------------------
2004 2003
----------- -----------
(dollars in thousands)
Total segment revenues.................................$ 90,129 88,836
Elimination of intersegment revenues................... (19,941) (15,323)
Corporate revenues (expenses), net..................... 4,434 (778)
Derivative market value adjustment and net settlements. (3,741) --
--------- -----------
Total consolidated revenues........................$ 70,881 72,735
========= ===========
Total net income of segments...........................$ 16,773 16,862
Corporate expenses, net................................ (7,652) (7,284)
--------- -----------
Total consolidated net income......................$ 9,121 9,578
========= ===========
As of March 31,
---------------------------
2004 2003
------------ -------------
(dollars in thousands)
Total segment assets.................. $12,601,031 10,099,926
Elimination of intercompany assets.... (14,013) (18,999)
Assets of other operating activities.. 41,549 27,712
------------ -------------
Total consolidated assets......... $12,628,567 10,108,639
============ =============
Corporate revenues (expenses), net, included in the above table relate to
activities that are not related to the four identified operating segments. The
net corporate revenues include investment earnings and nonrecurring revenue for
marketing services. The net corporate expenses include expenses for marketing,
capital markets, and other unallocated support services, including income taxes.
The net corporate revenues and expenses are not associated with an ongoing
business activity as defined by SFAS No. 131 and, therefore, have not been
included within the operating segments.
The derivative market value adjustment and net settlements is the change in
the fair value of the Company's derivative instruments, as the majority of the
Company's derivative instruments do not qualify for hedge accounting, and the
net settlements associated with these instruments. These derivative instruments
are not included in the Company's operating segments as they are not related to
specific segment assets or liabilities. These risk management agreements are
part of corporate activities.
The assets held at the corporate level are not identified with any of the
operating segments. Accordingly, these assets are included in the reconciliation
of segment assets to total assets. These assets consist primarily of cash,
investments, fixed assets, income tax receivables, and other deferred assets.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis provides information that the Company's
management believes is relevant to an assessment and understanding of the
consolidated results of operations and financial condition of the Company. The
discussion should be read in conjunction with the Company's consolidated
financial statements for the year ended December 31, 2003 included in the
Company's Annual Report on Form 10-K for the year ended December 31, 2003.
9
This report contains forward-looking statements and information that are
based on management's current expectations as of the date of this document. When
used in this report, the words "anticipate," "believe," "estimate," "intend,"
"expect," and similar expressions are intended to identify forward-looking
statements. These forward-looking statements are subject to risks,
uncertainties, assumptions, and other factors that may cause the actual results
to be materially different from those reflected in such forward-looking
statements. These factors include, among others, changes in the terms of student
loans and the educational credit marketplace arising from the implementation of
applicable laws and regulations and from changes in these laws and regulations,
which may reduce the volume, average term and costs of yields on student loans
under the Federal Family Education Loan Program ("FFEL Program" or "FFELP") or
result in loans being originated or refinanced under non-FFELP programs or may
affect the terms upon which banks and others agree to sell FFELP loans to the
Company. The Company could also be affected by changes in the demand for
educational financing or in financing preferences of lenders, educational
institutions, students, and their families; changes in the general interest rate
environment and in the securitization markets for education loans, which may
increase the costs or limit the availability of financings necessary to
initiate, purchase, or carry education loans; losses from loan defaults; and
changes in prepayment rates and credit spreads. The reader should not place
undue reliance on forward-looking statements, which speak only as of the date of
this Quarterly Report on Form 10-Q. The Company is not obligated to publicly
release any revisions to forward-looking statements to reflect events after the
date of this Quarterly Report on Form 10-Q or unforeseen events.
The Company is subject to certain risks related to its business and industry.
See "- Risks."
OVERVIEW
The Company is a vertically integrated education finance company, with over
$12.6 billion in total assets as of March 31, 2004. The Company is focused on
providing quality products and services to participants in the education finance
process. Headquartered in Lincoln, Nebraska, the Company originates, holds, and
services student loans, principally loans originated under the FFEL Program. The
Company, together with its branding partners, originated and acquired $1.4
billion of student loans during the three months ended March 31, 2004, which
included $321 million of existing loans the Company consolidated from its own
loan portfolio. During the three months ended March 31, 2004, the Company
generated new loan volume of more than $485 million through its consolidation
programs.
The Company's business is comprised of four primary product and service
offerings:
o ASSET MANAGEMENT, INCLUDING STUDENT LOAN ORIGINATIONS AND ACQUISITIONS.
The Company provides student loan sales, marketing, originations,
acquisition, and portfolio management. The Company owns a large portfolio
of student loan assets through a series of education lending subsidiaries.
The Company generates loans owned in special purpose lending facilities
through direct origination or through acquisition of loans. The Company
also provides marketing and sales support and managerial and
administrative support related to its asset generation activities.
o STUDENT LOAN SERVICING. The Company services its student loan portfolio
and the portfolios of third parties. The servicing activities provided
include loan origination activities, application processing, borrower
updates, payment processing, due diligence procedures, and claim
processing.
o GUARANTEE SERVICING. The Company provides servicing support to guaranty
agencies, which includes system software, hardware and telecommunication
support, borrower and loan updates, default aversion tracking services,
claim processing services, and post-default collection services.
o SERVICING SOFTWARE. The Company provides student loan servicing software
internally and to third-party student loan holders and servicers.
In accordance with accounting principles generally accepted in the United
States, the Company's asset management and student loan servicing offerings
constitute reportable operating segments. The guarantee servicing and servicing
software offerings are operating segments that do not meet the quantitative
thresholds, and, therefore, are included as other segments that do not meet the
reportable segment criteria. The following table shows the percent of total
segment revenue (excluding intersegment revenue) and net income of each of the
Company's reportable segments for the three months ended March 31, 2004 and
2003:
Three Months Ended March 31, Three Months Ended March 31,
2004 2003
-------------------------------- --------------------------------
Student Student
Asset loan Other Asset loan Other
management servicing segments management servicing segments
---------- --------- -------- ---------- --------- --------
Segment revenue 65.0% 24.0% 11.0% 60.2% 28.8% 11.0%
Segment net income 67.4% 23.3% 9.3% 65.7% 32.9% 1.4%
10
The Company's student loan portfolio has grown significantly through
origination and acquisition. With the development of a fully integrated
platform, the Company is positioned for organic growth. The Company originated
and acquired $1.4 billion of student loans during the three months ended March
31, 2004, which included $321 million of existing loans consolidated from the
Company's own loan portfolio, through various channels, including:
o the direct channel, in which the Company originates student loans in one
of its brand names directly to student and parent borrowers, which
accounted for 66.1% of the student loans originated and acquired during
the three months ended March 31, 2004 (55.7% when excluding loans the
Company consolidated from its own loan portfolio);
o the branding partner channel, in which the Company acquires student loans
from lenders to whom it provides marketing and origination services, which
accounted for 26.1% of the student loans originated and acquired during
the three months ended March 31, 2004 (34.1% when excluding loans the
Company consolidated from its own loan portfolio); and
o the forward flow channel, in which the Company acquires student loans from
lenders to whom it provides origination services, but provides no
marketing services, or who have agreed to sell loans to the Company under
forward sale commitments, which accounted for 6.3% of the student loans
originated and acquired during the three months ended March 31, 2004 (8.2%
when excluding loans the Company consolidated from its own loan
portfolio).
In addition, the Company also acquires student loans through spot purchases,
which accounted for 1.5% of student loans originated and acquired during the
three months ended March 31, 2004 (2.0% when excluding loans the Company
consolidated from its own loan portfolio).
SIGNIFICANT DRIVERS AND TRENDS
The Company's earnings and earnings growth are directly affected by the size
of its portfolio of student loans, the interest rate characteristics of its
portfolio, the costs associated with financing and managing its portfolio, and
the costs associated with the origination and acquisition of the student loans
in the portfolio. See "-- Student Loan Portfolio." In addition to the impact of
growth of the Company's student loan portfolio, the Company's results of
operations and financial condition may be materially affected by, among other
things, changes in:
o applicable laws and regulations that may affect the volume, terms,
effective yields, or refinancing options of education loans;
o demand for education financing and competition within the student
loan industry;
o the interest rate environment, funding spreads on the Company's
financing programs, and access to capital markets; and
o prepayment rates on student loans, including prepayments relating to loan
consolidations.
Competition for the supply channel of education financing and the student
loan industry has caused the cost of acquisition related to the Company's
student loan assets to increase. In addition, the Company has seen significant
increases in consolidation loan activity and consolidation loan volume within
the industry. The increase in competition for consolidation loans has caused the
Company to be aggressive in its measures to protect and secure the Company's
existing portfolio through internal consolidation efforts. The Company will
generally recognize its cost of acquisition over the average useful life of the
assets; however, the Company will generally accelerate recognition of the
unamortized cost of acquisition when loans are consolidated, even if they are
consolidated on the Company's balance sheet. The significant increase in
consolidation activity, entrants and competition within the industry, coupled
with the Company's asset retention practices, have caused the Company's yields
to be reduced in recent years through amortization of acquisition costs. If
these trends continue, the Company could continue to see its yields reduced
through the increase in consolidation loans, which have a lower yield and also
could result in a further increase in amortization costs. If our cost of
acquisition remains consistent with historical trends, the reduction in yield
could be offset by a reduction in our amortization as our portfolio grows both
through consolidation and acquisition. See "-- Student Loan Portfolio--Student
Loan Spread Analysis." Although the Company's short-term yields may be reduced
if these trends continue, the Company will have been successful in protecting
its assets and stabilizing its balance sheet for long-term growth.
The Company's student loan portfolio and asset growth will be significant
factors in determining future growth in its net interest income as the Company's
primary source of income is interest earned on its student loan portfolio. If
the Company's student loan portfolio continues to grow and its net interest
margin remains relatively stable, the Company expects its net interest income to
increase after adjusting for any variable-rate floor income. Interest income,
and to a certain extent the Company's net income, is also dependent upon the
relative level of interest rates. The Company's net income during the three
months ended March 31, 2004 decreased $457,000, or 4.8%, as compared to the
11
comparable period in 2003 primarily because of the decrease in its variable-rate
floor income. Net interest income increased by $1.1 million, or 2.5%, during the
three months ended March 31, 2004 as compared to the comparable period in 2003.
This increase was a result of an increase in interest income from the growth in
the Company's student loan portfolio and decreased interest rates on its
borrowings offset by a decrease in variable-rate floor income of $5.5 million.
Net interest income, excluding the effects of variable-rate floor income,
increased approximately $6.5 million, or 17.9%, during the three months ended
March 31, 2004 as compared to the comparable period in 2003. Variable-rate floor
income occurs in certain declining interest rate environments, and the Company
cannot predict whether these interest rate environments will occur in the
future. The Company generally does not anticipate receiving or plan to receive
variable-rate floor income. This increase in net interest income, excluding
variable-rate floor income, has resulted from portfolio growth. Net student
loans receivable increased by $2.2 billion to $11.2 billion at March 31, 2004 as
compared to $9.0 billion at March 31, 2003.
The Company reported net income of $9.1 million during the three months ended
March 31, 2004, or $0.17 per basic and diluted share, as compared to $9.6
million, or $0.21 per basic and diluted share, during the comparable period in
2003. Net interest income includes $19.8 million, or 76 basis points, in yield
reduction due to the amortization of loan acquisition costs or premiums during
the three months ended March 31, 2004, as compared to $16.1 million, or 77 basis
points, during the comparable period in 2003. As a result, the Company's
unamortized cost of loan acquisitions or premiums, as a percent of student
loans, decreased from 1.8% at March 31, 2003 to 1.4% at March 31, 2004. Despite
the growth of almost 24% in loan assets, the Company's unamortized loan
acquisitions costs or premiums have dropped by $9.6 million in the past year.
Net interest income also includes $14.5 million of consolidation rebate fees
during the three months ended March 31, 2004 as compared to $8.5 million during
the comparable period in 2003, an increase of $6.0 million. This, combined with
the lower borrower rates associated with the consolidation loans the Company is
originating, has resulted in student loan interest spread compression from 1.89%
during the three months ended March 31, 2003 to 1.70% during the three months
ended March 31, 2004. In addition, the Company recorded approximately $350,000
of variable-rate floor income during the three months ended March 31, 2004 as
compared to approximately $5.8 million during the comparable period in 2003.
Operating expenses during the three months ended March 31, 2004 included $2.1
million of amortization of intangible assets resulting from acquisitions as
compared to $3.7 million during the comparable period in 2003.
The Company's net income also included net settlements on derivatives of $1.2
million and a mark-to-market loss on derivative instruments of $2.5 million
during the three months ended March 31, 2004. There were no derivatives
outstanding during the three months ended March 31, 2003. The Company maintains
an overall interest rate risk management strategy that incorporates the use of
derivative instruments to reduce the economic effect of interest rate
volatility. The Company's management has structured all of its derivative
instruments with the intent that each is economically effective. However, most
of the Company's derivative instruments do not qualify for hedge accounting
under SFAS No. 133 and thus may adversely impact earnings. In addition, the
mark-to-market adjustment recorded through earnings in the Company's
consolidated statements of income may fluctuate from period to period.
ACQUISITIONS
The Company has positioned itself for growth by building a strong foundation
through acquisitions. Although the Company's assets and loan portfolios increase
through such transactions, a key aspect of each transaction is its impact on the
Company's prospective organic growth and the development of its integrated
platform of services. As a result of these acquisitions, the Company's rapid
organic growth, the development of its platform, and changes in operations,
period-to-period comparability of the Company's results of operations may be
difficult.
In January 2004, the Company acquired 50 percent of the membership interests
in Premiere Credit of North America, LLC ("Premiere"), a collection services
company that specializes in collection of educational debt. Premiere is based in
Indianapolis, Indiana. In March 2004, the Company acquired rights, title, and
interest in certain assets of the Rhode Island Student Loan Authority ("RISLA"),
including the right to originate student loans in RISLA's name without
competition from RISLA for a period of ten years. The Company also purchased a
portfolio of FFELP loans from RISLA with an aggregate outstanding balance of
approximately $175 million. The Company further agreed to provide administrative
services in connection with certain of the indentures governing debt securities
of RISLA for a ten-year period.
In April 2004, the Company purchased SLAAA Acquisition Corp. ("SLAAA"), a
FFELP loan secondary market maker. Also in April 2004, the Company purchased 50
percent of the issued and outstanding stock of INFINET Integrated Solutions,
Inc. ("INFINET"), an ecommerce services provider for colleges, universities, and
healthcare organizations. INFINET provides customer-centric electronic
transactions, information sharing and account and bill presentment.
12
NET INTEREST INCOME
The Company generates the majority of its earnings from the spread between
the yield the Company receives on its portfolio of student loans and the cost of
funding these loans. This spread income is reported on the Company's income
statement as net interest income. The amortization and write-offs of premiums or
discounts, including capitalized costs of origination, the consolidation loan
rebate fee, and yield adjustments from borrower benefit programs, are netted
against loan interest income on the Company's income statement. The amortization
and write-offs of bond issuance costs are included in interest expense on the
Company's income statement.
The Company's portfolio of FFELP loans generally earns interest at the higher
of a variable rate based on the special allowance payment, or SAP, formula set
by the U.S. Department of Education (the "Department,") and the borrower rate,
which is fixed over a period of time. The SAP formula is based on an applicable
index plus a fixed spread that is dependent upon when the loan was originated
and the loan's repayment status. Depending on the type of student loan and when
the loan was originated, the borrower rate is either fixed to term or is reset
to a market rate each July 1. The more drastic the reduction in rates subsequent
to the July 1 annual borrower interest rate reset date, the greater the
Company's opportunity to earn variable-rate floor income. In declining interest
rate environments, the Company can earn significant amounts of such income.
Conversely, as the decline in rates abates, or in environments where interest
rates are rising, the Company's opportunity to earn variable-rate floor income
can be reduced, in some cases substantially. Since the borrower rates are reset
annually, the Company views earnings on variable-rate floor income as temporary
and not necessarily sustainable. The Company's ability to earn variable-rate
floor income in the future periods is dependent upon the interest rate
environment following the annual reset of borrower rates, and the Company cannot
assure that such environment will exist in the future.
Because the Company generates the majority of its earnings from the spread
between the yield the Company receives on its portfolio of student loans and the
cost of financing these loans, the interest rate sensitivity of the Company's
balance sheet is very important to its operations. The current and future
interest rate environment can and will affect the Company's interest earnings,
net interest income and net income. The effects of changing interest rate
environments are further outlined in "-- Risks -- Market and Interest Rate Risk"
below.
On those FFELP loans with fixed to term borrower rates, primarily
consolidation loans, the Company earns interest at the greater of the borrower
rate or a variable rate based on the SAP formula. Since the Company finances the
majority of its student loan portfolio with variable-rate debt, the Company may
earn excess spread on these loans for an extended period of time.
On most consolidation loans, the Company must pay a 1.05% per year rebate fee
to the Department. Those consolidation loans, which have variable interest rates
based on the SAP formula, earn a yield less than that of a Stafford loan. Those
consolidation loans, which have fixed interest rates less than the sum of 1.05%
and the variable rate based on the SAP formula, also earn a yield less than that
of a Stafford loan. As a result, as consolidation loans matching these criteria
become a larger portion of the Company's loan portfolio, there will be a lower
yield on the Company's loan portfolio in the short term. However, due to the
extended terms of consolidation loans, the Company expects to earn the yield on
these loans for a longer duration, making them beneficial to the Company in the
long term.
As discussed in the unaudited financial statements included in this Quarterly
Report, a portion of the Company's FFELP loan portfolio, with an outstanding
balance of $3.1 billion as of March 31, 2004 is comprised of loans which were
previously financed with tax-exempt obligations issued prior to October 1, 1993.
Based upon provisions of the Higher Education Act and related interpretations by
the Department, the Company believes it may be entitled to receive special
allowance payments on these loans providing the Company with a 9.5% minimum rate
of return. The Company has asked the Department to confirm that the Company is
allowed to recognize the income based on the 9.5% minimum rate of return. To
date, the Company has deferred recognition of this excess interest income
generated by these loans pending satisfactory resolution of this issue. As of
March 31, 2004, the amount of excess interest income deferred totaled
approximately $79 million, which is included in other liabilities on the
Company's balance sheet.
Legislation has recently been introduced to eliminate the 9.5% floor
interest rate on loans financed with funds from these pre-1993 tax-exempt
financings and then refinanced subsequent to May 5, 2004 with funds other than
from such tax-exempt financings. If this legislation is enacted as introduced,
it would appear to prospectively eliminate floor income on loans in such manner.
This legislation does not, however, affect special allowance payments on loans
which are financed now or in the future with these tax-exempt obligations or
which have been refinanced prior to May 5, 2004 with funds other than from such
tax-exempt obligations. However, because this is pending legislation only and is
subject to revisions, the Company cannot be assured the legislation, if enacted,
will only prospectively eliminate this floor income. At this time, the Company
cannot predict how the potential legislation will affect its operations in the
future.
Investment interest income includes income from unrestricted interest-earning
deposits and funds in the Company's special purpose entities for its
asset-backed securitizations.
13
PROVISION FOR LOAN LOSSES
The Company maintains an allowance for loan losses associated with its
student loan portfolio at a level that is based on the performance
characteristics of the underlying loans. The Company analyzes the allowance
separately for its FFELP loans and its private loans.
Substantially all FFELP loan principal and related accrued interest is
guaranteed (as defined by the Higher Education Act). These guarantees are made
subject to the performance of certain loan servicing procedures stipulated by
applicable regulations. If these due diligence procedures are not met, affected
student loans may not be covered by the guarantees should the borrower default.
In accordance with the Student Loan Reform Act of 1993, student loans disbursed
prior to October 1, 1993 are fully insured, and loans disbursed subsequent to
October 1, 1993 are insured up to 98% of their principal amount and accrued
interest. The loan loss allowance attributable to FFELP loans consists of two
components: a risk sharing reserve and a reserve for rejected guaranty agency
claim losses, caused mainly by servicing defects. The risk sharing reserve is an
estimate based on the amount of loans subject to the 2% risk sharing and on the
historical experience of losses. The rejected claim loss reserve is based on the
historical trend of ultimate losses on loans initially rejected for
reimbursement by guaranty agencies. Since FFELP loans are guaranteed as to both
principal and interest, they continue to accrue interest until the time they are
paid by the guaranty agency. Once a FFELP loan is rejected for claim payment,
the Company's policy is to continue to pursue recovery of principal and
interest, whether by curing the reject or collecting from the borrower. As of
March 31, 2004, the Company had an allowance for loan losses on FFELP loans of
$11.2 million.
In determining the private loan loss allowance, the Company divides the
portfolio into various categories, such as the type of program, loan status, and
months into repayment. The Company then estimates defaults based on the
borrowers' credit profiles, net of estimated recoveries. The Company places a
private loan on non-accrual status and charges off the loan when the collection
of principal and interest is 120 days past due. The Company utilizes this data
to estimate the amount of losses in the portfolio, net of subsequent collections
that are probable of occurrence. As of March 31, 2004, the Company had an
allowance for loan losses on private loans of $5.4 million.
The evaluation of the provision for loan losses is inherently subjective, as
it requires material estimates that may be subject to significant changes. The
provision for loan losses reflects the activity for the applicable period and
provides an allowance at a level that management believes is adequate to cover
probable losses inherent in the loan portfolio.
The Higher Education Act authorizes the Department to recognize lenders and
lender servicers (as agent for the eligible lender) for an exceptional level of
performance in servicing FFELP loans. A lender or lender servicer designated for
exceptional performance can receive 100 percent reimbursement on all claims
submitted for insurance provided that the lender or lender servicer meets and
maintains all requirements for achieving its designation. On December 29, 2003,
the Company applied for Exceptional Performance status as a student loan
servicer for the FFEL Program. The Company's original application was denied by
the Department based on two issues. The Company believes it has provided
sufficient information related to both of the issues to consider them resolved.
The primary issue related to a complaint submitted to the Department by a former
employee in connection with the Company's procedures in processing certain FFELP
loan borrower forbearances. In March 2004, the Department provided the Company
with a summary of that complaint and also forwarded the complaint on to the
Office of the Inspector General, or OIG. As the Company understands, this former
employee's complaint alleges that the Company incorrectly processed certain
forbearances during a limited time period and with respect to a limited number
of borrower accounts. The Company's management has reviewed the procedures in
connection with this activity and concluded that such procedures did not violate
FFELP loan servicing regulations. The Company has cooperated with the Department
to resolve this issue. The Company also promptly advised its independent
auditors, KPMG LLP, of the issues. The Department has recently advised the
Company that the OIG investigation of the matter has been closed with respect to
the Company and that no adverse findings were made regarding the Company.
Accordingly, the Company has resubmitted an application with the Department to
become a lender servicer designated for exceptional performance. However, the
Company cannot be assured that it will receive or maintain the designation as
exceptional performer. Should the Company receive and maintain designation as an
exceptional performer under the Higher Education Act, the Company's cost related
to losses on defaulted FFELP loans, specifically the 2% risk share component
that is not guaranteed, could be substantially reduced and would differ
significantly from historical losses and trends.
14
OTHER INCOME
The Company also earns fees and generates income from other sources,
including principally loan servicing, guarantee servicing, and licensing fees on
its software products. Loan servicing fees are determined according to
individual agreements with customers and are calculated based on the dollar
value or number of loans or accounts serviced for each customer. Guarantee
servicing fees are earned as a result of providing system software, hardware and
telecommunication support, borrower and loan updates, default aversion tracking
services, claim processing services, and post-default collection services to
guaranty agencies. Guarantee servicing fees are calculated based on the number
of loans serviced or amounts collected. Software services income includes
software license and maintenance fees associated with student loan software
products as well as certain loan marketing fees. Other income also includes the
derivative market value adjustment and net settlements as further discussed in
"-- Risks -- Market and Interest Rate Risk" below.
OPERATING EXPENSES
Operating expenses include costs incurred to manage and administer the
Company's student loan portfolio and its financing transactions, costs incurred
to generate and acquire student loans, and general and administrative expenses,
which include corporate overhead. Operating expenses also include amortization
of intangible assets related to acquisitions. The Company does not believe
inflation has a significant effect on its operations.
RESULTS OF OPERATIONS
THREE MONTHS ENDED MARCH 31, 2004 COMPARED TO THE THREE MONTHS ENDED MARCH 31, 2003
Three Months Ended
March 31,
----------------------
2004 2003 $ Change % Change
----------- --------- -------- ---------
(dollars in thousands)
INTEREST INCOME:
Loan interest, excluding variable-rate floor income....... $ 108,196 $ 100,009 $8,187 8.2.%
Variable-rate floor income................................ 348 5,800 (5,452) (94.0)
Amortization of loan premiums............................. (19,817) (16,127) (3,690) 22.9
Investment interest....................................... 3,651 3,925 (274) (7.0)
---------- ---------- --------- ---------
Total interest income................................... 92,378 93,607 (1,229) (1.3)
INTEREST EXPENSE:
Interest on bonds and notes payable....................... 49,043 51,349 (2,306) (4.5)
---------- --------- --------- ---------
Net interest income..................................... 43,335 42,258 1,077 2.5
Less provision for loan losses................................ 3,115 2,410 705 29.3
---------- --------- --------- ---------
Net interest income after provision for loan losses..... 40,220 39,848 372 0.9
---------- --------- --------- ---------
OTHER INCOME:
Loan servicing and other fee income....................... 25,709 25,837 (128) (0.5)
Software services and other income........................ 5,578 4,640 938 20.2
Derivative market value adjustment and net settlements.... (3,741) -- (3,741) (100.0)
---------- --------- --------- ---------
Total other income...................................... 27,546 30,477 (2,931) (9.6)
---------- --------- --------- ---------
OPERATING EXPENSES:
Salaries and benefits..................................... 27,769 26,505 1,264 4.8
Other operating expenses:
Depreciation and amortization, excluding amortization
of intangible assets.................................. 2,330 2,140 190 8.9
Amortization of intangible assets....................... 2,078 3,696 (1,618) (43.8)
Trustee and other debt related fees..................... 2,614 3,672 (1,058) (28.8)
Occupancy and communications............................ 3,082 3,267 (185) (5.7)
Advertising and marketing............................... 2,323 1,586 737 46.5
Professional services................................... 4,460 2,185 2,275 104.1
Consulting fees and support services to related partie -- 2,235 (2,235) (100.0)
Postage and distribution................................ 3,848 3,753 95 2.5
Other................................................... 4,708 6,195 (1,487) (24.0)
---------- --------- --------- ---------
Total other operating expenses........................ 25,443 28,729 (3,286) (11.4)
---------- --------- --------- ---------
Total operating expenses.............................. 53,212 55,234 (2,022) (3.7)
---------- --------- --------- ---------
Income before income taxes and minority interest...... 14,554 15,091 (537) (3.6)
Income tax expense............................................ 5,433 5,622 (189) (3.4)
---------- ---------- --------- ---------
Income before minority interest....................... 9,121 9,469 (348) (3.7)
Minority interest in subsidiary loss.......................... -- 109 (109) (100.0)
---------- --------- --------- ---------
NET INCOME............................................ $ 9,121 $ 9,578 $ (457) (4.8)%
=========== ========= ========= =========
15
NET INTEREST INCOME. Total loan interest, including variable-rate floor
income and amortization of loan premiums, decreased as a result of changes in
the interest rate environment and in the pricing characteristics of the
Company's student loan assets, although such decrease was offset by an increase
in the size of the student loan portfolio. Lower interest rates during the three
months ended March 31, 2004 caused a decrease in the average net yield on the
Company's student loan portfolio to 3.40% from 4.30% for the comparable period
in 2003. Variable-rate floor income decreased due to the timing and relative
change in interest rates during the periods. Essentially, prevailing interest
rates declined drastically subsequent to the July 1, 2002 annual borrower
interest rate reset date compared to their less substantial decline following
the reset of rates on July 1, 2003. Consequently, the Company realized
significantly less variable-rate floor income during the three months ended
March 31, 2004 as compared to the comparable period in 2003. The weighted
average interest rate on the student loan portfolio decreased during the three
months ended March 31, 2004 due to lower interest rates, together with the
increase in the number of lower yielding consolidation loans. The lower weighted
average loan interest rate resulted in a reduction in loan interest income of
approximately $10.6 million. Consolidation loan activity also increased the
amortization and write-offs of acquisition costs and increased the consolidation
rebate fee, reducing loan interest income approximately $9.5 million during the
three months ended March 31, 2004. The reduction in loan interest income
resulting from the decline in interest rates, reduction in variable-rate floor
income, and increased consolidation activity was partially offset by an increase
in the Company's portfolio of student loans. The average student loan portfolio
increased by $2.1 billion, or 25.2%, at March 31, 2004 as compared to the
comparable period in 2003, which increased loan interest income by approximately
$24.8 million.
Interest expense on bonds and notes payable decreased despite an increase in
average total debt of approximately $2.0 billion. Average variable-rate debt
during the three months ended March 31, 2004 increased $2.2 billion over the
comparable period in 2003, which increased interest expense by approximately
$6.0 million as compared to the comparable period in 2003. The Company reduced
average fixed-rate debt by $210.6 million during the three months ended March
31, 2004 as compared to the comparable period in 2003, which decreased the
Company's overall interest expense by approximately $3.1 million. The reduction
in interest rates, specifically LIBOR and auction rates, decreased the Company's
average cost of funds to 1.69% during the three months ended March 31, 2004 from
2.13% during the comparable period in 2003, which decreased interest expense
approximately $5.1 million
The Company's net interest margin decreased to 1.50% during the three months
ended March 31, 2004 from 1.85% during the comparable period in 2003. Net
interest income, excluding the effects of variable-rate floor income, increased
approximately $6.5 million, or 17.9%, to approximately $43.0 million during the
three months ended March 31, 2004 from approximately $36.5 million during the
comparable period in 2003.
PROVISION FOR LOAN LOSSES. The provision for loan losses for student loans
increased due to the increase in the size of the Company's student loan
portfolio.
OTHER INCOME. Loan servicing and other fee income decreased due to the
reduction in the number and dollar amount of loans the Company serviced for
third parties. Total third-party loan servicing volume decreased $1.1 billion,
or 10.4%, during the three months ended March 31, 2004 as compared to the
comparable period in 2003, which resulted in a decrease in loan servicing income
of $528,000. This decrease in income was offset by an increase of $400,000 in
guarantee servicing income during the three months ended March 31, 2004 due to
higher guarantee volumes.
The increase in software services and other income was primarily due to the
addition of the Company's broker dealer subsidiary in August 2003 and the fee
income generated from these activities.
The Company began utilizing derivative instruments in July 2003 to provide
economic hedges to protect against the impact of adverse changes in interest
rates. The derivative market value adjustment loss was $2.5 million and net
settlements representing realized interest costs were $1.2 million during the
three months ended March 31, 2004. See "-- Risks -- Market and Interest Rate
Risk."
OPERATING EXPENSES. Salaries and benefits and advertising and marketing
increased during the three months ended March 31, 2004, due to the expansion of
the Company's marketing efforts, especially in the consolidations area. The
decrease in depreciation and amortization expense is due to the decrease in the
amortization of intangible assets, as certain intangible assets were fully
amortized in 2003. The decrease in trustee and other debt-related fees relates
to the reduced broker-dealer fees from the acquisition of Nelnet Capital LLC
(formerly UFS Securities LLC) in August 2003. Professional services increased
due to additional costs related to operations as a public company. No costs were
incurred in 2004 relating to consulting fees and support services to related
parties due to the termination of these agreements in July 2003. Other expenses
decreased due to efficiencies in operations through continued integration of
company acquisitions.
INCOME TAX EXPENSE. Income tax expense decreased due to the decrease in
income before income taxes. The Company's effective tax rate was 37.3% during
each of the three months ended March 31, 2004 and 2003.
16
FINANCIAL CONDITION
AT MARCH 31, 2004 COMPARED TO MARCH 31, 2003
As of
-------------------------
March 31, December 31,
2004 2003 $ Change % Change
------------ ------------ --------- ---------
(dollars in thousands)
ASSETS:
Student loans receivable, net....................$11,206,609 $10,455,442 $ 751,167 7.2 %
Other assets..................................... 1,421,958 1,476,067 (54,109) (3.7)
------------ ------------ ---------- ---------
Total assets................................$12,628,567 $11,931,509 $ 697,058 5.8 %
============ ============ ========== =========
LIABILITIES:
Bonds and notes payable..........................$12,140,725 $ 11,366,458 $ 774,267 6.8 %
Other liabilities................................. 173,205 259,562 (86,357) (33.3)
------------ ------------ ---------- ---------
Total liabilities........................... 12,313,930 11,626,020 687,910 5.9
SHAREHOLDERS' EQUITY:
Shareholders' equity............................. 314,637 305,489 9,148 3.0
------------ ------------ --------- ---------
Total liabilities and shareholders' equity..$12,628,567 $11,931,509 $ 697,058 5.8 %
============ ============ ========== =========
Total assets increased primarily due to an increase in student loans
receivable. This increase was a result of net growth in consolidation loans of
$821.5 million during the three months ended March 31, 2004. Total liabilities
increased primarily as a result of an increase in bonds and notes payable. The
increase in bonds and notes payable resulted from additional borrowings to fund
the Company's growth in student loans. Shareholders' equity increased primarily
as a result of net income of $9.1 million during the three months ended March
31, 2004.
LIQUIDITY AND CAPITAL RESOURCES
The Company utilizes operating cash flow, unsecured operating lines of
credit, and secured financing transactions to fund operations and student loan
acquisitions. In addition, in December 2003, the Company consummated an initial
public offering of its Class A common stock, which yielded the Company net
proceeds of $163.7 million. Operating activities provided net cash of $71.1
million during the three months ended March 31, 2004, an increase of $45.1
million from the net cash provided by operating activities of $26.0 million
during the comparable period in 2003. Of this increase, $35.9 million is due to
excess interest income deferred by the Company on loans previously financed with
tax-exempt obligations issued prior to October 1, 1993. Operating cash flows are
also driven by net income adjusted for various non-cash items such as the
provision for loan losses, depreciation and amortization, and the derivative
market value adjustment. These non-cash items resulted in an increase in cash
provided by operating activities of $5.1 million during the three months ended
March 31, 2004 as compared to the comparable period in 2003.
The Company has a $35.0 million operating line of credit and a $35.0 million
commercial paper facility under two separate facilities from a group of six
large regional and national financial institutions. These facilities are
unsecured lines used by the Company primarily for general operating purposes.
The Company did not have any borrowings under these facilities at March 31,
2004. These facilities expire on September 25, 2004. The Company believes these
facilities, the growth in the cash flow from operating activities, and the
initial public stock offering indicates a favorable trend in the Company's
available capital resources. Due to the proceeds received from the initial
public offering, a $30 million operating line of credit with a national
financial institution was not renewed in February 2004.
The Company's secured financing instruments include commercial paper lines,
short-term student loan warehouse programs, variable-rate tax-exempt bonds,
fixed-rate bonds, fixed-rate tax-exempt bonds, and various asset-backed
securities. Of the $12.1 billion of debt outstanding as of March 31, 2004, $9.9
billion was issued under securitization transactions. On January 15, 2004 and
April 22, 2004, the Company completed asset-backed securities transactions
totaling $1.0 billion each. Depending on market conditions, the Company
anticipates continuing to access the asset-backed securities markets in 2004 and
subsequent years. Securities issued in the securitization transactions are
generally priced off a spread to LIBOR or set under an auction procedure related
to the bonds and notes. The student loans financed are generally priced on a
spread to commercial paper or Treasury bills.
The Company's warehouse facilities allow for expansion of liquidity and
capacity for student loan growth and should provide adequate liquidity to fund
the Company's student loan operations for the foreseeable future. At March 31,
2004, the Company had a loan warehousing capacity of $2.8 billion through
364-day commercial paper conduit programs. These conduit programs mature in 2004
17
through 2009, however, must be renewed annually by underlying liquidity
providers. Historically, the Company has been able to renew its commercial paper
conduit programs, including the underlying liquidity agreements, and therefore,
does not believe the renewal of these contracts present a significant risk to
its liquidity.
The Company is limited in the amounts of funds that can be transferred from
its subsidiaries through intercompany loans, advances, or cash dividends. These
limitations result from the restrictions contained in trust indentures under
debt financing arrangements to which the Company's education lending
subsidiaries are parties. The Company does not believe these limitations will
not affect its operating cash needs. The amounts of cash and investments
restricted in the respective reserve accounts of the education lending
subsidiaries are shown on the balance sheets as restricted cash and investments.
The following table summarizes the Company's bonds and notes outstanding as
of March 31, 2004:
As of March 31, 2004
----------------------------------------------------
Interest rate
Line of range of
Carrying Percent of credit carrying Final
amount total amount amount maturity
--------- ----------- -------- -------------- ----------
(dollars in thousands)
Variable rate bonds and notes (a):
Bond and notes based on indices..........$ 3,959,535 32.7 % $ 3,959,535 1.13% - 1.91% 05/01/07 - 01/25/37
Bond and notes based on auction.......... 5,116,070 42.1 5,116,070 0.93% - 1.20% 07/01/05 - 07/01/43
------------ -------- ------------
Total variable rate bonds and notes... 9,075,605 74.8 9,075,605
Commerical paper and other................... 2,183,681 18.0 2,750,000 1.04% - 1.08% 05/13/05 - 09/02/09
Fixed-rate bonds and notes (a)............... 866,439 7.1 866,439 5.50% - 6.68% 05/01/05 - 06/01/28
Other secured borrowings..................... 15,000 0.1 85,000 6.00% 11/1/2005
------------ -------- ------------
Total....................................$12,140,725 100.0 % $ 12,777,044
============ ======== ============
- ----------
(a) Issued in securitization transactions.
Total unused commitments under various commercial paper, warehouse, and
operating line of credit agreements totaled $636.3 million as of March 31, 2004.
The Company is committed under noncancelable operating leases for certain
office and warehouse space and equipment. The Company's contractual obligations
as of March 31, 2004 were as follows:
As of March 31, 2004
------------------------------------------------------------
Less than More than
Total 1 year 1-3 years 3-5 years 5 years
------------------------------------------------------------
(DOLLARS IN THOUSANDS)
Bonds and notes payable.......$12,140,725 438,702 306,953 282,063 11,113,007
Operating lease obligations... 15,911 5,000 7,665 2,721 525
------------ ---------- ----------- ----------- ------------
Total......................$12,156,636 443,702 314,618 284,784 11,113,532
============ ========== =========== =========== ============
The Company has commitments with its branding partners, from whom the Company
acquires student loans and to whom the Company provides marketing and
origination services, and forward flow lenders, from whom the Company acquires
student loans and to whom the Company provides origination services only, which
obligate the Company to purchase loans originated under specific criteria,
although the branding partners and forward flow lenders are not obligated to
provide the Company with a minimum amount of loans. These commitments generally
run for periods ranging from one to five years and are generally renewable. The
Company is obligated to purchase student loans at current market rates at the
respective sellers' requests under various agreements. As of March 31, 2004,
$250.3 million of student loans were originated under these agreements which the
Company was committed to purchase.
18
STUDENT LOAN PORTFOLIO
The table below describes the components of the Company's loan portfolio as
of March 31, 2004 and December 31, 2003:
As of March 31, 2004 As of December 31, 2003
------------------------ --------------------------
Dollars Percent Dollars Percent
------------- ---------- -------------- ----------
(dollars in thousands)
FFELP:
Stafford...............$ 4,821,308 43.0 % $ 4,901,289 46.9 %
PLUS/SLS (a)........... 258,406 2.3 249,217 2.4
Consolidation.......... 5,894,594 52.6 5,073,081 48.5
Non-FFELP:
Private loans.......... 91,557 0.8 91,287 0.9
------------ ---------- -------------- ----------
Total.............. 11,065,865 98.7 10,314,874 98.7
Unamortized premiums....... 157,367 1.4 156,594 1.5
Allowance for loan losses:
Allowance - FFELP...... (11,225) (0.1) (10,795) (0.1)
Allowance - Private.... (5,398) (0.0) (5,231) (0.1)
------------ ---------- -------------- ----------
Net.............. $ 11,206,609 100.0 % $ 10,455,442 100.0 %
============ ========== ============== ==========
- ----------
(a) Supplemental Loans for Students, or SLS, are the predecessor to unsubsidized
Stafford loans.
ACTIVITY IN THE ALLOWANCE FOR LOAN LOSSES
The provision for loan losses represents the periodic expense of maintaining
an allowance sufficient to absorb losses, net of recoveries, inherent in the
portfolio of student loans.
An analysis of the Company's allowance for loan losses is presented in the
following table:
Three Months Ended
March 31,
----------------------------
2004 2003
------------- ------------
(dollars in thousands)
Balance at beginning of year...................................$ 16,026 $ 12,000
Provision for loan losses:
FFELP loans............................................... 1,415 660
Private loans............................................. 1,700 1,750
------------- ------------
Total provision for loan losses........................ 3,115 2,410
Charge-offs:
FFELP loans............................................... (986) (538)
Private loans............................................. (1,628) (667)
------------- ------------
Total charge-offs...................................... (2,614) (1,205)
Recoveries, private loans...................................... 96 17
------------- ------------
Net charge-offs................................................ (2,518) (1,188)
------------- ------------
Balance at end of period.......................................$ 16,623 $ 13,222
============= ============
Allocation of the allowance for loan losses:
FFELP loans...............................................$ 11,225 $ 10,092
Private loans............................................. 5,398 3,130
------------- ------------
Total allowance for loan losses...................... $ 16,623 $ 13,222
============= ============
Net loan charge-offs as a percentage of average student loans.. 0.096 % 0.057 %
Total allowance as a percentage of average student loans....... 0.159 % 0.158 %
Total allowance as a percentage of ending balance of
student loans................................................ 0.150 % 0.149 %
Private allowance as a percentage of the ending balance
of private loans............................................. 5.896 % 3.523 %
Average student loans..........................................$ 10,453,826 $ 8,348,923
Ending balance of student loans................................$ 11,065,865 $ 8,881,560
Ending balance of private loans................................$ 91,557 $ 88,839
19
Delinquencies have the potential to adversely impact the Company's earnings
through increased servicing and collection costs and account charge-offs. The
table below shows the student loan delinquency amounts as of March 31, 2004 and
December 31, 2003:
As of March 31, 2004 As of December 31, 2003
---------------------- -----------------------
Balance Percent Balance Percent
------------ ------- ------------- -------
(dollars in thousands)
FFELP Student Loan Portfolio:
Loans in-school/grace/deferment(1)........$ 3,192,065 $ 2,941,228
Loans in forebearance(2).................. 1,489,119 1,362,335
Loans in repayment status:
Loans current.......................... 5,666,130 90.1 % 5,245,316 88.6 %
Loans delinquent 31-60 days(3)......... 227,935 3.6 279,435 4.7
Loans delinquent 61-90 days(3)......... 127,373 2.0 130,339 2.2
Loans delinquent 91 days or greater(4). 271,686 4.3 264,934 4.5
------------ -------- ------------ -------
Total loans in repayment............. 6,293,124 100.0 % 5,920,024 100.0 %
=========== ======== ============ =======
Total FFELP student loan portfolio...$10,974,308 $10,223,587
============ ============
PRIVATE STUDENT LOAN PORTFOLIO:
Loans in-school/grace/deferment(1)........$ 21,598 $ 25,537
Loans in forebearance(2).................. 13,934 14,776
Loans in repayment status:
Loans current.......................... 51,541 92.0 % 45,554 89.4 %
Loans delinquent 31-60 days(3)......... 1,689 3.0 2,531 5.0
Loans delinquent 61-90 days(3)......... 1,391 2.5 1,556 3.0
Loans delinquent 91 days or greater(4). 1,404 2.5 1,333 2.6
------------ ------- ----------- ------
Total loans in repayment............. 56,025 100.0 % 50,974 100.0 %
------------ ======= ----------- ======
Total private student loan portfolio $ 91,557 $ 91,287
============ ===========
- ----------
(1) Loans for borrowers who still may be attending school or engaging in other
permitted educational activities and are not yet required to make payments
on the loans, E.G., residency periods for medical students or a grace period
for bar exam preparation for law students.
(2) Loans for borrowers who have temporarily ceased making full payments due to
hardship or other factors, according to a schedule approved by the servicer
consistent with the established loan program servicing procedures and
policies.
(3) The period of delinquency is based on the number of days scheduled payments
are contractually past due and relate to repayment loans, that is,
receivables not charged off, and not in school, grace, deferment, or
forbearance.
(4) Loans delinquent 91 days or greater include loans in claim status, which are
loans which have gone into default and have been submitted to the guaranty
agency for FFELP loans or the private insurer for private loans, to process
the claim for payment.
ORIGINATION AND ACQUISITION
The Company's student loan portfolio increases through various channels,
including originations through the direct channel and acquisitions through the
branding partner channel, the forward flow channel, spot purchases and the
secondary market. The Company's portfolio also increases with the addition of
portfolios acquired through whole company or subsidiary acquisitions.
One of the Company's primary objectives is to focus on originations through
the direct channel and acquisitions through the branding partner channel. The
Company has extensive and growing relationships with many large financial and
educational institutions which are active in the education finance industry. The
Company's branding relationships and forward flow relationships include Union
Bank, an affiliate of the Company, as well as many schools and national and
regional financial institutions. Loss of a strong relationship, like that with a
significant branding partner, such as Union Bank, or with schools from which the
Company directly or indirectly acquires a significant volume of student loans,
could result in an adverse effect on the volume derived from the branding
partner channel.
20
The table below sets forth the activity during the three months ended March
31, 2004 and 2003 of loans originated or acquired through each of the Company's
channels:
Three Months Ended
March 31,
--------------------------
2004 2003
------------- ------------
(dollars in thousands)
Beginning balance.................................... $ 10,314,874 $ 8,404,388
Direct channel:
Consolidation loan originations.................. 806,565 444,224
Less consolidation of existing portfolio......... (321,009) (235,000)
------------- ------------
Net consolidation loan originations........... 485,556 209,224
Stafford/PLUS loan originations.................. 92,927 86,116
Branding partner channel............................. 354,503 366,322
Forward flow channel................................. 85,204 140,607
Other channels....................................... 20,996 28,620
------------- ------------
Total channel acquisitions....................... 1,039,186 830,889
Repayments, claims, capitalized interest, and other.. (288,195) (353,717)
------------- ------------
Ending balance....................................... $ 11,065,865 $ 8,881,560
============= ============
STUDENT LOAN SPREAD ANALYSIS
Maintenance of the spread on assets is a key factor in maintaining and
growing the Company's income. The following table analyzes the student loan
spread on the Company's portfolio of student loans during the three months ended
March 31, 2004 and 2003 and represents the spread on assets earned in
conjunction with the liabilities used to fund the assets:
Three Months Ended
March 31,
---------------------------
2004 2003
------------- ------------
(dollars in thousands)
Student loan yield........................................ 4.71 % 5.48 %
Consolidation rebate fees................................. (0.55) (0.41)
Premium amortization...................................... (0.76) (0.77)
------------- ------------
Student loan net yield.................................... 3.40 4.30
Student loan cost of funds................................ (1.69) (2.13)
------------- ------------
Student loan spread, including variable rate floor income. 1.71 2.17
Variable rate floor income................................ (0.01) (0.28)
------------- ------------
Student loan spread, excluding variable rate floor income. 1.70 % 1.89 %
============= ============
Average balance of student loans (in thousands)...........$ 10,453,826 $ 8,348,923
RISKS
RISK RELATED TO CONSOLIDATION LOANS
The Company's student loan origination and lending activities could be
significantly impacted by the reauthorization of the Higher Education Act
relative to the single holder rule. For example, if the single holder rule,
which generally restricts a competitor from consolidating loans away from a
holder that owns all of a student's loans, were abolished, a substantial portion
of the Company's non-consolidated portfolio would be at risk of being
consolidated away by a competitor. On the other hand, abolition of the rule
would also open up a portion of the rest of the market and provide the Company
with the potential to gain market share. The portion of the rest of the market
that would be opened up to the Company, as measured in aggregate principal
amount of student loans, would be greater than the portion of the Company's
non-consolidated portfolio that would be at risk of being consolidated by a
competitor. Other potential changes to the Higher Education Act relating to
consolidation loans which could impact the Company include, without limitation:
o allowing refinancing of consolidation loans, which would open almost 53%
of the Company's portfolio to such refinancing; and
o allowing for variable-rate consolidation loans and extended repayment
terms of Stafford loans, which would lead to less loans lost through
consolidation of the Company's portfolio, but would also decrease
consolidation opportunities.
21
POLITICAL/REGULATORY RISK
Pursuant to the terms of the Higher Education Act, the FFEL Program is
periodically amended, and the Higher Education Act must be reauthorized by
Congress every five years in order to prevent sunset of that Act. Changes in the
Higher Education Act made in the two most recent reauthorizations have included
reductions in the student loan yields paid to lenders, increased fees paid by
lenders and a decreased level of federal guarantee. Future changes could result
in further negative impacts on the Company's business. Moreover, there can be no
assurance that the provisions of the Higher Education Act, which is scheduled to
expire on September 30, 2004, will be reauthorized. While Congress has
consistently extended the effective date of the Higher Education Act, it may
elect not to reauthorize the Department's ability to provide interest subsidies,
special allowance payments and federal guarantees for student loans. Such a
failure to reauthorize would reduce the number of federally guaranteed student
loans available for the Company to originate and/or acquire in the future.
Specific proposed legislation that could have a material effect on the
Company's operations, if enacted, include:
o initiatives aimed at supporting the FDL program to the detriment
of the FFEL program;
o restrictions on payments made under the FFEL program to achieve
reductions in federal spending;
o allowing for increased borrower limits, which may provide opportunities
for increasing the average size of the Company's future loan
originations;
o eliminating variable-rate floor income as well as the 9.5% floor
interest rate on loans refinanced with funds from pre-1993 tax-exempt
financings;
o changes to the single holder rule and other FFEL program rates and terms
as discussed above under "-- Risk Related to Consolidation Loans;" and
o changes to the single holder rule as it relates to the FFELP and Direct
loans as discussed below.
As previously disclosed in the Company's Annual Report on Form 10-K for the
year ended December 31, 2003, the Department has published written
correspondence, dated March 15, 2004 to the National Council of Higher Education
Loan Programs ("NCHELP") and also to the Company, by a different author at the
Department. The two letters are substantially identical, stating the
Department's position that, effective as of May 2004, "a lender may make a
consolidation loan to an eligible borrower only if the lender holds an
outstanding loan of that borrower which is selected by the borrower for
consolidation." The Department further took the position that this requirement
cannot be met if the borrower is only consolidating loans made pursuant to the
Higher Education Act other than FFELP loans. In subsequent discussions with the
Department, the author of the March correspondence to NCHELP made a verbal
clarification that the Department did not intend the March correspondence to
prohibit consolidation of Direct Loans. The Company believes that the
consolidation of Direct Loans, without consolidation of other FFELP loans at the
same time, is legally permissible. By published correspondence to the industry,
dated April 29, 2004, the Department extended the May 2004 effective date of the
correspondence to September 1, 2004. The April 29, 2004 correspondence further
explained that the March 15, 2004 correspondence applied to "instances where a
borrower had one or more FFEL loans held by a single FFEL holder and also
non-FFEL loans, the borrower could obtain a FFEL Consolidation loan only from
that single FFEL holder." It is the Company's interpretation of the April 29,
2004 correspondence that it would permit a FFEL lender to consolidate only
Direct loans. In addition, the web site of the Department expressly permits a
FFEL lender to consolidate only direct loans. There are some Guarantee agencies,
however, that have a concern about reinsurance of these loans. There are other
Guarantors that are willing to guaranty a consolidation of Direct Loans only by
a FFEL lender. Some in the student loan, college, and university community have
asked for further guidance from the Department. It is our understanding that the
Department has taken this issue under further advisement. However, in the event
the Department does not clarify its intent in the correspondence of March and
April, the Company's practice of consolidating Direct Loans could be
significantly limited after September 1, 2004. Likewise, in the event the
Department was to publish an interpretation of the law that a FFELP lender may
not consolidate only Direct Loans, this would also have a significant impact on
the Company's consolidation loan origination volume in the future. Currently,
approximately 60% of the Company's affinity agreements with alumni associations
are schools that participate in Direct Loans.
In addition, the Department oversees and implements the Higher Education Act
and periodically issues regulations and interpretations of that Act. Changes in
such regulations and interpretations could negatively impact the Company's
business.
22
LIQUIDITY RISK
The Company's primary funding needs are those required to finance the student
loan portfolio and satisfy the Company's cash requirements for new student loan
originations and acquisitions, operating expenses, and technological
development. The Company's operating and warehouse financings are provided by
third parties. The term of each conduit facility is less than one year and each
facility is renewable at the option of the lender and may be terminated at any
time for cause. There can be no assurance that the Company will be able to
maintain such conduit facilities, find alternative funding or increase the
commitment level of such facilities, if necessary. While the Company's conduit
facilities have historically been renewed for successive terms, there can be no
assurance that this will continue in the future.
In addition, the Company has historically relied upon, and expects to
continue to rely upon, asset-backed securitizations as the Company's most
significant source of funding for student loans on a long-term basis. A major
disruption in the auction markets, such as insufficient potential bid orders to
purchase all the notes offered for sale or being repriced, could subject the
Company to interest costs substantially above the anticipated and historical
rates paid on these types of securities. A change in the capital markets could
limit the Company's ability to raise funds or significantly increase the cost of
those funds, affecting its ability to acquire student loans.
CREDIT RISK
The Company bears full risk of losses experienced with respect to the
unguaranteed portion of its FFELP loans. Losses on the private loans will be
borne by the Company, with the exception of certain privately insured loans,
which constitutes a minority of the Company's private loan portfolio. The loan
loss pattern on the Company's private loan portfolio is not as developed as that
on its FFELP loan portfolio. The performance of student loans in the portfolio
is affected by the economy, and a prolonged economic downturn may have an
adverse effect on the credit performance of these loans. In addition, the
Company's private loans are underwritten and priced according to risk, using
credit scoring systems. The Company has defined underwriting and collection
policies, as well as ongoing risk monitoring and review processes for all
private loans. Management believe