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NELNET INC - Quarter Report: 2008 September (Form 10-Q)

Filed by Bowne Pure Compliance
Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2008
or
     
o   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 incorporation or organization)   (I.R.S. Employer Identification No.)
     
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 þ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
             
Large accelerated filer þ   Accelerated filer o   Non-accelerated filer o   Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
As of October 31, 2008, there were 37,998,182 and 11,495,377 shares of Class A Common Stock and Class B Common Stock, par value $0.01 per share, outstanding, respectively (excluding 11,058,604 shares of Class A Common Stock held by a wholly owned subsidiary).
 
 

 

 


 

NELNET, INC.
FORM 10-Q
INDEX
September 30, 2008
         
       
 
       
    2  
 
       
    29  
 
       
    66  
 
       
    72  
 
       
       
 
       
    72  
 
       
    74  
 
       
    77  
 
       
    79  
 
       
    80  
 
       
 Exhibit 10.1
 Exhibit 10.2
 Exhibit 10.3
 Exhibit 10.4
 Exhibit 10.5
 Exhibit 10.6
 Exhibit 31.1
 Exhibit 31.2
 Exhibit 32

 

 


Table of Contents

PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except share data)
                 
    As of     As of  
    September 30, 2008     December 31, 2007  
    (unaudited)        
Assets:
               
Student loans receivable (net of allowance for loan losses of $49,070 and $45,592, respectively)
  $ 26,376,269       26,736,122  
Cash and cash equivalents:
               
Cash and cash equivalents — not held at a related party
    16,062       38,305  
Cash and cash equivalents — held at a related party
    308,945       73,441  
 
           
Total cash and cash equivalents
    325,007       111,746  
Restricted cash and investments
    1,082,015       927,247  
Restricted cash — due to customers
    47,859       81,845  
Accrued interest receivable
    530,102       593,322  
Accounts receivable, net
    49,204       49,084  
Goodwill
    175,178       164,695  
Intangible assets, net
    83,565       112,830  
Property and equipment, net
    43,629       55,797  
Other assets
    102,446       107,624  
Fair value of derivative instruments
    154,741       222,471  
 
           
 
               
Total assets
  $ 28,970,015       29,162,783  
 
           
 
               
Liabilities:
               
Bonds and notes payable
  $ 28,004,835       28,115,829  
Accrued interest payable
    92,112       129,446  
Other liabilities
    192,550       220,899  
Due to customers
    47,859       81,845  
Fair value of derivative instruments
    22,929       5,885  
 
           
Total liabilities
    28,360,285       28,553,904  
 
           
 
               
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 37,994,332 shares as of September 30, 2008 and 37,980,617 shares as of December 31, 2007
    380       380  
Class B, convertible, $0.01 par value. Authorized 60,000,000 shares; issued and outstanding 11,495,377 shares as of September 30, 2008 and December 31, 2007
    115       115  
Additional paid-in capital
    101,757       96,185  
Retained earnings
    509,524       515,317  
Employee notes receivable
    (2,046 )     (3,118 )
 
           
Total shareholders’ equity
    609,730       608,879  
 
           
Commitments and contingencies
               
Total liabilities and shareholders’ equity
  $ 28,970,015       29,162,783  
 
           
See accompanying notes to consolidated financial statements.

 

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Table of Contents

NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands, except share data)
(unaudited)
                                 
    Three months     Nine months  
    ended September 30,     ended September 30,  
    2008     2007     2008     2007  
Interest income:
                               
Loan interest
  $ 284,468       437,251       911,140       1,251,391  
Investment interest
    9,118       21,023       29,914       61,231  
 
                       
Total interest income
    293,586       458,274       941,054       1,312,622  
Interest expense:
                               
Interest on bonds and notes payable
    234,016       393,875       791,621       1,112,263  
 
                       
Net interest income
    59,570       64,399       149,433       200,359  
Less provision for loan losses
    7,000       18,340       18,000       23,628  
 
                       
Net interest income after provision for loan losses
    52,570       46,059       131,433       176,731  
 
                       
 
                               
Other income (expense):
                               
Loan and guaranty servicing income
    30,633       33,040       81,650       95,116  
Other fee-based income
    45,887       38,025       132,617       116,316  
Software services income
    4,217       5,426       15,865       17,022  
Other income
    1,242       7,028       4,298       14,048  
Gain (loss) on sale of loans
          492       (47,426 )     3,288  
Derivative market value, foreign currency, and put option adjustments and derivative settlements, net
    6,874       16,113       10,468       18,966  
 
                       
Total other income
    88,853       100,124       197,472       264,756  
 
                       
 
                               
Operating expenses:
                               
Salaries and benefits
    44,739       60,545       142,131       182,010  
Other operating expenses:
                               
Impairment expense
          49,504       18,834       49,504  
Advertising and marketing
    18,388       14,141       50,734       43,590  
Depreciation and amortization
    10,781       15,084       32,218       36,741  
Professional and other services
    10,963       9,336       27,548       28,219  
Occupancy and communications
    4,194       5,931       14,949       16,182  
Postage and distribution
    3,026       4,123       9,586       14,266  
Trustee and other debt related fees
    2,423       3,337       7,277       8,965  
Other
    9,155       11,444       27,151       35,843  
 
                       
Total other operating expenses
    58,930       112,900       188,297       233,310  
 
                       
 
                               
Total operating expenses
    103,669       173,445       330,428       415,320  
 
                       
 
                               
Income (loss) before income taxes
    37,754       (27,262 )     (1,523 )     26,167  
Income tax expense (benefit)
    13,969       (10,664 )     1,793       9,906  
 
                       
 
                               
Income (loss) from continuing operations
    23,785       (16,598 )     (3,316 )     16,261  
Income (loss) from discontinued operations, net of tax
          909       981       (2,416 )
 
                       
 
                               
Net income (loss)
  $ 23,785       (15,689 )     (2,335 )     13,845  
 
                       
 
                               
Earnings (loss) per share, basic and diluted:
                               
Income (loss) from continuing operations
    0.48       (0.34 )     (0.07 )     0.32  
Income (loss) from discontinued operations
          0.02       0.02       (0.04 )
 
                       
 
                               
Net income (loss)
  $ 0.48       (0.32 )     (0.05 )     0.28  
 
                       
See accompanying notes to consolidated financial statements.

 

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Table of Contents

NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS)
(Dollars in thousands, except share data)
(unaudited)
                                                                                         
 
                                                                          Accumulated          
    Preferred                             Class A     Class B     Additional             Employee     other     Total  
    stock     Common stock shares     Preferred     common     common     paid-in     Retained     notes     comprehensive     shareholders’  
    shares     Class A     Class B     stock     stock     stock     capital     earnings     receivable     income     equity  
 
                                                                                       
Balance as of June 30, 2007
          37,661,381       11,495,377     $       377       115       94,473       518,910       (2,697 )           611,178  
 
Comprehensive income:
                                                                                       
Net loss
                                              (15,689 )                 (15,689 )
 
                                                                                     
Total comprehensive income (loss)
                                                                                    (15,689 )
Cash dividend on Class A and Class B common stock — $0.07 per share
                                              (3,453 )                 (3,453 )
Reserve for uncertain income tax provisions
                                        2,519                         2,519  
Issuance of common stock, net of forfeitures
          514,782                   5             1,408             (225 )           1,188  
Compensation expense for stock-based awards
                                        1,575                         1,575  
Repurchase of common stock
          (239,124 )                 (3 )           (5,422 )                       (5,425 )
 
                                                                 
 
                                                                                       
Balance as of September 30, 2007
          37,937,039       11,495,377     $       379       115       94,553       499,768       (2,922 )           591,893  
 
                                                                 
 
                                                                                       
Balance as of June 30, 2008
          37,952,246       11,495,377     $       380       115       99,854       485,739       (2,046 )           584,042  
Comprehensive income:
                                                                                       
Net income
                                              23,785                   23,785  
 
                                                                                     
Total comprehensive income
                                                                                    23,785  
Issuance of common stock, net of forfeitures
          49,650                   1             960                         961  
Compensation expense for stock based awards
                                        1,045                         1,045  
Repurchase of common stock
          (7,564 )                 (1 )           (102 )                       (103 )
 
                                                                 
 
                                                                                       
Balance as of September 30, 2008
          37,994,332       11,495,377     $       380       115       101,757       509,524       (2,046 )           609,730  
 
                                                                 
 
Balance as of December 31, 2006
          39,035,169       13,505,812     $       390       135       177,678       496,341       (2,825 )     131       671,850  
 
Comprehensive income:
                                                                                       
Net income
                                              13,845                   13,845  
Other comprehensive income:
                                                                                       
Foreign currency translation
                                                          (322 )     (322 )
Non-pension postretirement benefit plan
                                                          191       191  
 
                                                                 
Total comprehensive income
                                                                                    13,714  
Cash dividend on Class A and Class B common stock — $0.21 per share
                                              (10,357 )                 (10,357 )
Adjustment to adopt provisions of FASB Interpretation No. 48
                                              (61 )                 (61 )
Reserve for uncertain income tax provisions
                                        2,519                         2,519  
Issuance of common stock, net of forfeitures
          667,055                   7             4,627             (225 )           4,409  
Compensation expense for stock based awards
                                        3,105                         3,105  
Repurchase of common stock
          (3,301,194 )                 (33 )           (80,874 )                       (80,907 )
Conversion of common stock
          2,010,435       (2,010,435 )           20       (20 )                              
Acquisition of enterprise under common control
          (474,426 )                 (5 )           (12,502 )                       (12,507 )
Reduction of employee stock notes receivable
                                                    128             128  
 
                                                                 
 
                                                                                       
Balance as of September 30, 2007
          37,937,039       11,495,377     $       379       115       94,553       499,768       (2,922 )           591,893  
 
                                                                 
 
Balance as of December 31, 2007
          37,980,617       11,495,377     $       380       115       96,185       515,317       (3,118 )           608,879  
Comprehensive income:
                                                                                       
Net loss
                                              (2,335 )                 (2,335 )
 
                                                                                     
Total comprehensive income (loss)
                                                                                    (2,335 )
Cash dividend on Class A and Class B common stock — $0.07 per share
                                              (3,458 )                 (3,458 )
Issuance of common stock, net of forfeitures
          83,337                   1             2,033                         2,034  
Compensation expense for stock based awards
                                        4,308                         4,308  
Repurchase of common stock
          (69,622 )                 (1 )           (769 )                       (770 )
Reduction of employee stock notes receivable
                                                    1,072             1,072  
 
                                                                 
 
Balance as of September 30, 2008
          37,994,332       11,495,377     $       380       115       101,757       509,524       (2,046 )           609,730  
 
                                                                 
See accompanying notes to consolidated financial statements.

 

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Table of Contents

NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
(unaudited)
                 
    Nine months
ended September 30,
 
    2008     2007  
 
Net income (loss)
  $ (2,335 )     13,845  
Income (loss) from discontinued operations
    981       (2,416 )
 
           
Income (loss) from continuing operations
    (3,316 )     16,261  
Adjustments to reconcile income (loss) from continuing operations to net cash provided by operating activities, net of business acquisitions:
               
Depreciation and amortization, including loan premiums and deferred origination costs
    107,944       223,552  
Derivative market value adjustment
    72,399       (93,031 )
Foreign currency transaction adjustment
    (40,360 )     79,020  
Change in value of put options issued in business acquisitions
    3,483       2,145  
Proceeds from termination of derivative instruments
    15,403       50,843  
Payments to terminate derivative instruments
    (3,679 )     (8,100 )
Impairment expense
    18,834       49,504  
Loss on sale of business
          8,132  
Gain on sale of equity method investment
          (3,942 )
Loss (gain) on sale of student loans
    47,426       (3,288 )
Non-cash compensation expense
    5,670       4,595  
Deferred income tax benefit
    (23,979 )     (30,374 )
Provision for loan losses
    18,000       23,628  
Other non-cash items
    1,258       (2,900 )
Decrease (increase) in accrued interest receivable
    63,220       (125,929 )
Decrease (increase) in accounts receivable
    445       (7,045 )
Decrease in other assets
    13,928       7,450  
(Decrease) increase in accrued interest payable
    (37,334 )     64,812  
(Decrease) increase in other liabilities
    (1,765 )     19,785  
 
           
Net cash flows from operating activities — continuing operations
    257,577       275,118  
Net cash flows from operating activities — discontinued operations
          (3,558 )
 
           
Net cash provided by operating activities
    257,577       271,560  
 
           
 
               
Cash flows from investing activities, net of business acquisitions:
               
Originations, purchases, and consolidations of student loans, including loan premiums and deferred origination costs
    (2,368,229 )     (4,509,308 )
Purchases of student loans, including loan premiums, from a related party
    (212,888 )     (232,769 )
Net proceeds from student loan repayments, claims, capitalized interest, participations, and other
    1,538,134       1,740,351  
Proceeds from sale of student loans
    1,267,826       107,673  
Purchases of property and equipment, net
    (5,094 )     (18,375 )
(Increase) decrease in restricted cash and investments, net
    (154,768 )     316,415  
Purchases of equity method investments
    (2,988 )      
Distributions from equity method investments
          747  
Sale of business, net of cash sold
          7,551  
Business acquisitions, net of cash acquired
    (18,000 )     2,211  
Proceeds from sale of equity method investment
          10,000  
 
           
Net cash flows from investing activities — continuing operations
    43,993       (2,575,504 )
Net cash flows from investing activities — discontinued operations
          (294 )
 
           
Net cash provided by (used in) investing activities
    43,993       (2,575,798 )
 
           
 
               
Cash flows from financing activities:
               
Payments on bonds and notes payable
    (5,328,782 )     (4,496,077 )
Proceeds from issuance of bonds and notes payable
    5,225,548       7,022,018  
Proceeds (payments) from issuance of notes payable due to a related party, net
    32,790       (56,917 )
Payments of debt issuance costs
    (14,778 )     (13,951 )
Dividends paid
    (3,458 )     (10,357 )
Payment on settlement of put option
          (15,875 )
Proceeds from issuance of common stock
    566       1,231  
Repurchases of common stock
    (770 )     (75,504 )
Payments received on employee stock notes receivable
    575       128  
 
           
Net cash flows (used in) provided by financing activities — continuing operations
    (88,309 )     2,354,696  
Net cash flows from financing activities — discontinued operations
           
 
           
Net cash (used in) provided by financing activities
    (88,309 )     2,354,696  
 
           
 
               
Effect of exchange rate fluctuations on cash
          548  
 
           
 
               
Net increase in cash and cash equivalents
    213,261       51,006  
 
               
Cash and cash equivalents, beginning of period
    111,746       106,086  
 
           
 
               
Cash and cash equivalents, end of period
  $ 325,007       157,092  
 
           
 
               
Supplemental disclosures of cash flow information:
               
Interest paid
  $ 814,469       920,966  
 
           
Income taxes paid, net of refunds
  $ 24,302       20,908  
 
           
See accompanying notes to consolidated financial statements.

 

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NELNET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Information as of September 30, 2008 and for the three months and nine months ended
September 30, 2008 and 2007 is unaudited)
(Dollars in thousands, except per share amounts, unless otherwise noted)
1. Basis of Financial Reporting
The accompanying unaudited consolidated financial statements of Nelnet, Inc. and subsidiaries (the “Company”) as of September 30, 2008 and for the three and nine months ended September 30, 2008 and 2007 have been prepared on the same basis as the audited consolidated financial statements for the year ended December 31, 2007 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 for the interim periods presented. The preparation of financial statements in conformity with U.S. 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 and nine months ended September 30, 2008 are not necessarily indicative of the results for the year ending December 31, 2008. 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, 2007. Certain amounts from 2007 have been reclassified to conform to the current period presentation.
2. Discontinued Operations
On May 25, 2007, the Company sold EDULINX Canada Corporation (“EDULINX”), a Canadian student loan service provider and a subsidiary of the Company, for initial proceeds of $19.0 million. The Company recognized an initial net loss of $9.0 million related to this transaction. During the three months ended June 30, 2008, the Company earned $2.0 million ($1.0 million net of tax) in additional consideration as a result of the sale of EDULINX. This payment represented contingent consideration earned by the Company based on EDULINX meeting certain performance measures. As a result of the sale of EDULINX, the results of operations for EDULINX, including the contingent payment earned in 2008, are reported as discontinued operations in the accompanying consolidated statements of operations.
The components of income (loss) from discontinued operations are presented below.
                                 
    Three months ended     Nine months ended  
    September 30,     September 30,  
    2008     2007     2008     2007  
 
                               
Operating income of discontinued operations
  $                   9,278  
Income tax on operations
                      (3,562 )
Gain (loss) on disposal
          (6 )     1,966       (8,157 )
Income tax on disposal
          915       (985 )     25  
 
                       
 
                               
Income (loss) from discontinued operations, net of tax
  $       909       981       (2,416 )
 
                       
The following operations of EDULINX have been segregated from continuing operations and reported as discontinued operations through the date of disposition. Interest expense was not allocated to EDULINX and, therefore, all of the Company’s interest expense is included within continuing operations.
         
    Nine months ended  
    September 30, 2007  
 
       
Net interest income
  $ 124  
Other income
    31,511  
Operating expenses
    (22,357 )
 
     
Income before income taxes
    9,278  
Income tax expense
    3,562  
 
     
 
       
Operating income of discontinued operations, net of tax
  $ 5,716  
 
     

 

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As a result of the contingent consideration received during the second quarter 2008, the Company earned $0.8 million of foreign tax credits available to offset future U.S. federal income taxes. Under current tax law, these tax credits expire in 2018. The Company established a valuation allowance for these tax credits due to the Company’s assessment that this deferred tax asset did not meet the more-likely-than-not recognition criteria of Statement of Financial Accounting Standards (“SFAS”) No. 109, Accounting for Income Taxes.
3. Restructuring Charges
Legislative Impact
On September 6, 2007, the Company announced a strategic initiative to create efficiencies and lower costs in advance of the enactment of the College Cost Reduction and Access Act of 2007, which impacted the Federal Family Education Loan Program (the “FFEL Program” or “FFELP”) in which the Company participates. In anticipation of the federally driven cuts to the student loan programs, management initiated a variety of strategies to modify the Company’s student loan business model, including lowering the cost of student loan acquisition, creating efficiencies in the Company’s asset generation business, and decreasing operating expenses through a reduction in workforce and realignment of operating facilities. Implementation of the plan began immediately and was completed as of December 31, 2007. As a result of these strategic decisions, the Company recorded restructuring charges of $15.0 million and $5.3 million in the third and fourth quarters of 2007, respectively, and income of $0.2 million in the first quarter of 2008 to recognize adjustments from initial estimates.
Information related to the remaining restructuring accrual, which is included in “other liabilities” on the consolidated balance sheet, follows:
                         
    Employee              
    termination     Lease        
    benefits     terminations     Total  
 
                       
Restructuring accrual as of December 31, 2007
  $ 1,193       3,682       4,875  
 
                       
Adjustment from initial estimated charges
    (191 )           (191 )
 
                       
Cash payments
    (868 )     (358 )     (1,226 )
 
                 
 
                       
Restructuring accrual as of March 31, 2008
    134       3,324       3,458  
 
                       
Cash payments
    (134 )     (45 )     (179 )
 
                 
 
                       
Restructuring accrual as of June 30, 2008
          3,279       3,279  
 
                       
Cash payments
          (259 )     (259 )
 
                 
 
                       
Restructuring accrual as of September 30, 2008
  $       3,020       3,020  
 
                 
Capital Markets Impact
On January 23, 2008, the Company announced a plan to further reduce operating expenses related to its student loan origination and related businesses as a result of ongoing disruptions in the credit markets. Management developed a restructuring plan related to its asset generation and supporting businesses which reduced marketing, sales, service, and related support costs through a reduction in workforce and realignment of operating facilities. Implementation of the plan began immediately and was completed as of June 30, 2008. As a result of these strategic decisions, the Company recorded restructuring charges of $26.5 million in the first quarter of 2008 and income of $0.4 million in the second quarter of 2008 to recognize adjustments from initial estimates.

 

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Selected information relating to the restructuring charge follows:
                                 
    Employee                    
    termination     Lease     Write-down        
    benefits     terminations     of assets     Total  
 
                               
Restructuring costs recognized during the three month period ended March 31, 2008
  $ 6,095 (a)     1,573 (b)     18,834 (c)     26,502  
 
                               
Write-down of assets to net realizable value
                (18,834 )     (18,834 )
 
                               
Cash payments
    (4,952 )                 (4,952 )
 
                       
 
                               
Restructuring accrual as of March 31, 2008
    1,143       1,573             2,716  
 
                               
Adjustment from initial estimated charges
    (190 )(a)     (175 )(b)             (365 )
 
                               
Cash payments
    (792 )     (369 )             (1,161 )
 
                         
 
                               
Restructuring accrual as of June 30, 2008
    161       1,029             1,190  
 
Cash payments
    (121 )     (265 )           (386 )
 
                       
 
                               
Restructuring accrual as of September 30, 2008
  $ 40       764             804  
 
                       
     
(a)  
Employee termination benefits are included in “salaries and benefits” in the consolidated statements of operations.
 
(b)  
Lease termination costs are included in “occupancy and communications” in the consolidated statements of operations.
 
(c)  
Costs related to the write-down of assets are included in “impairment expense” in the consolidated statements of operations.
Selected information relating to the restructuring charge by operating segment and Corporate Activity and Overhead follows:
                                                         
    Restructuring costs                                              
    recognized during                             Adjustment                
    the three month     Write-down of             Restructuring     from initial             Restructuring  
    period ended     assets to net     Cash     accrual as of     estimated     Cash     accrual as of  
Operating segment   March 31, 2008     realizable value     payments     March 31, 2008     charges     payments     June 30, 2008  
 
                                                       
Student Loan and Guaranty Servicing
  $ 6,010       (5,074 )     (430 )     506       (104 )     (352 )     50  
 
                                                       
Tuition Payment Processing and Campus Commerce
                                         
 
                                                       
Enrollment Services and List Management
    312             (291 )     21       (15 )     (19 )     (13 )
 
                                                       
Software and Technical Services
    518             (472 )     46       (8 )           38  
 
                                                       
Asset Generation and Management
    11,287       (9,351 )     (1,806 )     130       (52 )     (72 )     6  
 
                                                       
Corporate Activity and Overhead
    8,375       (4,409 )     (1,953 )     2,013       (186 )     (718 )     1,109  
 
                                         
 
                                                       
 
  $ 26,502       (18,834 )     (4,952 )     2,716       (365 )     (1,161 )     1,190  
 
                                         
4. Legal, Industry, and Legislative Developments
Legal Proceedings
General
The Company is subject to various claims, lawsuits, and proceedings that arise in the normal course of business. These matters principally consist of claims by student loan borrowers disputing the manner in which their student loans have been processed and disputes with other business entities. On the basis of present information, anticipated insurance coverage, and advice received from counsel, it is the opinion of the Company’s management that the disposition or ultimate determination of these claims, lawsuits, and proceedings will not have a material adverse effect on the Company’s business, financial position, or results of operations.

 

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Municipal Derivative Bid Practices Investigation
As previously disclosed, on February 8, 2008, Shockley Financial Corp. (“SFC”), an indirect, wholly-owned subsidiary of the Company that provides investment advisory services for the investment of proceeds from the issuance of municipal and corporate bonds, received a grand jury subpoena issued by the U.S. District Court for the Southern District of New York upon application of the Antitrust Division of the U.S. Department of Justice. The subpoena seeks certain information and documents from SFC in connection with the Department of Justice’s ongoing criminal investigation of the bond industry with respect to possible anti-competitive practices related to awards of guaranteed investment contracts (“GICs”) and other products for the investment of proceeds from bond issuances. SFC currently has one employee. The Company and SFC are cooperating with the investigation.
On March 5, 2008, SFC received a subpoena from the Securities and Exchange Commission (the “SEC”) related to an ongoing industry-wide investigation concerning the bidding of municipal GICs. In addition, on or about June 6, 2008 and June 12, 2008, SFC received a subpoena from both the New York Attorney General (the “NYAG”) and the Florida Attorney General, respectively, relating to their investigations concerning the bidding of municipal GICs and possible violations of various state and federal laws. The subpoenas seek certain information and documents from SFC relating to its GIC business. The Company and SFC are cooperating with these investigations.
SFC has also been named as a defendant in a number of substantially identical purported class action lawsuits. In each of the lawsuits, a large number of financial institutions and financial service providers, including SFC, are named as defendants. The complaints allege that the defendants engaged in a conspiracy not to compete and to fix prices and rig bids for municipal derivatives (including GICs) sold to issuers of municipal bonds. All the complaints assert claims for violations of Section 1 of the Sherman Act and fraudulent concealment, and three complaints also assert claims for unfair competition and violation of the California Cartwright Act. On June 16, 2008, the United States Judicial Panel on Multidistrict Litigation issued an order transferring the cases then before it to the U.S. District Court for the Southern District of New York which consolidated several cases under the caption Hinds County, Mississippi v. Wachovia Bank, N.A. et al. SFC intends to vigorously contest these purported class action lawsuits.
SFC, the Company, or other subsidiaries of the Company may receive subpoenas from other regulatory agencies. Due to the preliminary nature of these matters as to SFC, the Company is unable to predict the ultimate outcome of the investigations or the class action lawsuits.
Industry Inquiries and Investigations
On January 11, 2007, the Company received a letter from the NYAG requesting certain information and documents from the Company in connection with the NYAG’s investigation into preferred lender list activities. Since January 2007, a number of state attorneys general, including the NYAG, and the U.S. Senate Committee on Health, Education, Labor, and Pensions also announced or are reportedly conducting broad inquiries or investigations of the activities of various participants in the student loan industry, including activities which may involve perceived conflicts of interest. A focus of the inquiries or investigations has been on any financial arrangements among student loan lenders and other industry participants which may facilitate increased volumes of student loans for particular lenders. Like many other student loan lenders, the Company received requests for information from certain state attorneys general and the Chairman of the U.S. Senate Committee on Health, Education, Labor, and Pensions in connection with their inquiries or investigations. In addition, the Company received subpoenas for information from the NYAG, the New Jersey Attorney General, and the Ohio Attorney General. In each case the Company is cooperating with the requests and subpoenas for information that it has received.
On July 31, 2007, the Company announced that it had agreed with the NYAG to adopt the NYAG’s Code of Conduct, which is substantially similar to the Company’s previously adopted Nelnet Student Loan Code of Conduct. As part of the agreement, the Company agreed to contribute $2.0 million to a national fund for educating high school students and their parents regarding the financial aid process (the “NYAG Fund”).
On October 10, 2007, the Company received a subpoena from the NYAG requesting certain information and documents from the Company in connection with the NYAG’s investigation into direct-to-consumer marketing practices of student lenders. On September 9, 2008, the Company announced that it agreed to adopt the NYAG’s Student Loan Direct Marketing Code of Conduct. As part of the agreement, the Company agreed to contribute $200,000 to the NYAG Fund.
While the Company cannot predict the ultimate outcome of any inquiry or investigation, the Company believes its activities have materially complied with applicable law, including the Higher Education Act of 1965 (the “Higher Education Act”), the rules and regulations adopted by the Department of Education (the “Department”) thereunder, and the Department’s guidance regarding those rules and regulations.
Department of Education Review
The Department of Education periodically reviews participants in the FFEL Program for compliance with program provisions. On June 28, 2007, the Department notified the Company that it would be conducting a review of the Company’s administration of the FFEL Program under the Higher Education Act. The Company understands that the Department has selected several schools and lenders for review. Specifically, the Department is reviewing the Company’s practices in connection with the prohibited inducement provisions of the Higher Education Act and the provisions of the Higher Education Act and the associated regulations which allow borrowers to have a choice of lenders. The Company has responded to the Department’s requests for information and documentation and is cooperating with their review.

 

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While the Company cannot predict the ultimate outcome of the review, the Company believes its activities have materially complied with the Higher Education Act, the rules and regulations adopted by the Department thereunder, and the Department’s guidance regarding those rules and regulations.
Department of Justice
In connection with the Company’s settlement with the Department of Education in January 2007 to resolve the Office of Inspector General of the Department of Education (the “OIG”) audit report with respect to the Company’s student loan portfolio receiving special allowance payments at a minimum 9.5% interest rate, the Company was informed by the Department of Education that a civil attorney with the Department of Justice had opened a file regarding the issues set forth in the OIG report, which the Company understands is common procedure following an OIG audit report. The Company has engaged in discussions with and provided information to the Department of Justice in connection with the review.
While the Company is unable to predict the ultimate outcome of the review, the Company believes its practices complied with applicable law, including the provisions of the Higher Education Act, the rules and regulations adopted by the Department of Education thereunder, and the Department’s guidance regarding those rules and regulations.
Internal Revenue Service
In October 2007, the Company received a letter from the Internal Revenue Service (“IRS”) revoking a previously issued Private Letter Ruling retroactive to September 30, 2003 concerning the Company’s arbitrage and excess interest calculations on certain of its tax-exempt bonds. The IRS letter provided procedures for the Company to follow to appeal the retroactive application of the revocation. The Company responded to the IRS in November 2007 requesting relief from retroactivity. In March 2008, the IRS responded with a final determination that the revocation of the Private Letter Ruling would apply prospectively beginning on July 1, 2008. Management believes that the July 1, 2008 prospective application of the Private Letter Ruling revocation will not have a significant impact on the Company’s operating results.
Legislative Developments
On May 7, 2008, the President signed into law the Ensuring Continued Access to Student Loans Act of 2008 (the “Ensuring Continued Access to Student Loans Act”). This legislation contains provisions that expand the federal government’s support of financing the cost of higher education. Among other things, the Ensuring Continued Access to Student Loans Act:
   
Increases statutory limits on annual and aggregate borrowing for FFELP loans; and
 
   
Allows the Department to act as a secondary market and enter into agreements with lenders to purchase certain FFELP loans or participation interests in those loans.
As a result of this legislation, the Departments of Education and Treasury developed a plan to implement the Ensuring Continued Access to Student Loans Act. Among other things, this plan:
   
Allows the Department to purchase certain loans from lenders for the 2008-2009 academic year and offers lenders access to short-term liquidity; and
 
   
Commits to continue working with the FFELP community to explore programs to reengage the capital markets in the long-run.
On May 22, 2008, the Company announced that, as a result of the above plan, it would continue originating new federal student loans for the 2008-2009 academic year to all students regardless of the school they attend.
On July 1, 2008, pursuant to the Ensuring Continued Access to Student Loans Act, the Department of Education announced terms under which it will offer to purchase FFELP student loans and loan participations from lenders. See note 7 for information related to the Department’s programs.
On August 14, 2008, the President signed into law the Higher Education Opportunity Act, which amends the Higher Education Act to revise and reauthorize the Higher Education Act programs. Among other items, this legislation:
   
Contains school code of conduct requirements applicable to FFELP and private education lenders;
   
Contains additional provisions and reporting requirements for lenders and schools participating in preferred lender arrangements; and
   
Contains additional disclosures that FFELP lenders must make to borrowers as well as added FFELP loan servicing requirements for lenders.

 

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On October 7, 2008, legislation was enacted to extend the Department’s authority to address FFELP student loans made for the 2009-2010 academic year. See note 7 for additional information related to this extension.
5. Student Loans Receivable and Allowance for Loan Losses
Student loans receivable consisted of the following:
                 
    As of     As of  
    September 30, 2008     December 31, 2007  
 
               
Federally insured loans
  $ 25,725,893       26,054,398  
Non-federally insured loans
    275,520       274,815  
 
           
 
               
 
    26,001,413       26,329,213  
Unamortized loan premiums and deferred origination costs
    423,926       452,501  
Allowance for loan losses — federally insured loans
    (24,366 )     (24,534 )
Allowance for loan losses — non-federally insured loans
    (24,704 )     (21,058 )
 
           
 
               
 
  $ 26,376,269       26,736,122  
 
           
 
               
Federally insured allowance as a percentage of ending balance of federally insured loans
    0.09 %     0.09 %
Non-federally insured allowance as a percentage of ending balance of non-federally insured loans
    8.97 %     7.66 %
Total allowance as a percentage of ending balance of total loans
    0.19 %     0.17 %
Loan Sales
On March 31, 2008, the Company sold $857.8 million (par value) of federally insured student loans resulting in the recognition of a loss of $30.4 million. In addition, on April 8, 2008, the Company sold $428.6 million (par value) of federally insured student loans. The portfolio of student loans sold on April 8, 2008 was presented as “held for sale” on the March 31, 2008 consolidated balance sheet and was valued at the lower of cost or fair value. The Company recognized a loss of $17.1 million during the three month period ended March 31, 2008 as a result of marking these loans to fair value. Combined, the portfolios sold on March 31, 2008 and April 8, 2008 were sold for a purchase price of approximately 98% of the par value of such loans. As a result of the disruptions in the debt and secondary markets, the Company sold these loan portfolios in order to reduce the amount of student loans remaining under the Company’s multi-year committed financing facility for FFELP loans, which reduced the Company’s exposure related to certain equity support provisions included in this facility (see note 7 for additional information related to these equity support provisions).
As part of the Company’s asset management strategy, the Company periodically sells student loan portfolios to third parties. During the three and nine months ended September 30, 2007, the Company sold $17.7 million (par value) and $103.7 million (par value), respectively, of federally insured student loans resulting in the recognition of gains of $0.5 million and $3.3 million, respectively.

 

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6. Intangible Assets and Goodwill
Intangible assets consist of the following:
                         
    Weighted              
    average              
    remaining              
    useful life as of     As of     As of  
    September 30,     September 30,     December 31,  
    2008     2008     2007  
Amortizable intangible assets:
                       
Customer relationships (net of accumulated amortization of $27,393 and $20,299, respectively)
    109     $ 52,967       60,061  
Trade names (net of accumulated amortization of $4,431 and $1,258, respectively)
    45       12,628       1,609  
Covenants not to compete (net of accumulated amortization of $13,451 and $11,815, respectively)
    22       10,171       15,425  
Database and content (net of accumulated amortization of $4,883 and $3,193, respectively)
    25       4,597       6,287  
Computer software (net of accumulated amortization of $6,839 and $4,898, respectively)
    12       2,163       4,189  
Student lists (net of accumulated amortization of $7,343 and $5,806, respectively)
    5       854       2,391  
Other (net of accumulated amortization of $89 and $71, respectively)
    89       185       203  
Loan origination rights (net of accumulated amortization of $8,180)
                8,473  
 
                 
Total — amortizable intangible assets
  81 months     83,565       98,638  
 
                     
Unamortizable intangible assets — trade names
                  14,192  
 
                   
 
                       
 
          $ 83,565       112,830  
 
                   
As disclosed in note 3, as a result of the disruptions in the debt and secondary markets and the student loan business model modifications the Company implemented due to the disruptions, the Company recorded an impairment charge of $18.8 million during the first quarter of 2008. This charge is included in “impairment expense” in the Company’s consolidated statements of operations. Information related to the impairment charge follows:
                 
    Operating     Impairment  
Asset   segment     charge  
Amortizable intangible assets:
               
Covenants not to compete
  Student Loan and Guaranty Servicing   $ 4,689  
Covenants not to compete
  Asset Generation and Management     336  
Loan origination rights
  Asset Generation and Management     8,336  
Computer software
  Asset Generation and Management     12  
 
               
Goodwill
  Asset Generation and Management     667  
 
               
Property and equipment
  Student Loan and Guaranty Servicing     385  
Property and equipment
  Corporate activities     4,409  
 
             
 
               
Total impairment charge
          $ 18,834  
 
             
The fair value of the intangible assets and reporting unit within the Asset Generation and Management operating segment were estimated using the expected present value of future cash flows.
During the first quarter of 2008, management determined that the trade names not subject to amortization have a finite useful life. As such, these assets will be amortized prospectively over their estimated remaining useful lives.

 

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The Company recorded amortization expense on its intangible assets of $6.6 million and $10.9 million for the three months ended September 30, 2008 and 2007, respectively, and $19.7 million and $24.0 million for the nine months ended September 30, 2008 and 2007, respectively. The Company will continue to amortize intangible assets over their remaining useful lives. As of September 30, 2008, the Company estimates it will record amortization expense as follows:
         
2008
  $ 6,511  
2009
    22,319  
2010
    15,985  
2011
    10,031  
2012
    9,029  
2013 and thereafter
    19,690  
 
     
 
  $ 83,565  
 
     
The change in the carrying amount of goodwill by operating segment was as follows:
                                                 
            Tuition                          
            Payment     Enrollment     Software     Asset        
    Student Loan     Processing     Services     and     Generation        
    and Guaranty     and Campus     and List     Technical     and        
    Servicing     Commerce     Management     Services     Management     Total  
 
                                               
Balance as of December 31, 2007
  $       58,086       55,463       8,596       42,550       164,695  
Additional contingent consideration paid (a)
                11,150                   11,150  
Impairment charge
                            (667 )     (667 )
 
                                   
Balance as of March 31, 2008 (b)
  $       58,086       66,613       8,596       41,883       175,178  
 
                                   
     
(a)  
In January 2008, the Company paid $18.0 million (of which $6.8 million was accrued as of December 31, 2007) of additional consideration related to its 2005 acquisitions of Student Marketing Group, Inc. and National Honor Roll, L.L.C. This payment satisfies all of the Company’s obligations related to the contingencies per the terms of the purchase agreement.
 
(b)  
During the quarters ended June 30, 2008 and September 30, 2008, there was no change in goodwill.

 

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7. Bonds and Notes Payable
The following tables summarize outstanding bonds and notes payable by type of instrument:
                         
    As of September 30, 2008  
    Carrying     Interest rate        
    amount     range     Final maturity  
 
                       
Variable-rate bonds and notes (a):
                       
Bonds and notes based on indices
  $ 20,891,535       2.79% - 5.07%     09/25/13 - 06/25/41  
Bonds and notes based on auction or remarketing (b)
    2,771,445       0.00% - 9.01%     11/01/09 - 07/01/43  
 
                     
 
                       
Total variable-rate bonds and notes
    23,662,980                  
 
                       
Commercial paper — FFELP facility (c)
    2,525,410       2.54% - 3.94%     05/09/10  
Commercial paper — private loan facility (c)
    132,020       3.14%     03/14/09  
Fixed-rate bonds and notes (a)
    205,435       5.30% - 6.68%     11/01/09 - 05/01/29  
Unsecured fixed rate debt
    475,000     5.13% and 7.40%   06/01/10 and 09/15/61
Unsecured line of credit
    645,000       2.90% - 3.65%     05/08/12  
Department of Education Participation
    263,920       3.25%     09/30/09  
Other borrowings
    95,070       4.09% - 5.10%     05/22/09 - 11/01/15  
 
                     
 
 
  $ 28,004,835                  
 
                     
                         
    As of December 31, 2007  
    Carrying     Interest rate        
    amount     range     Final maturity  
Variable-rate bonds and notes (a):
                       
Bonds and notes based on indices
  $ 17,508,810       4.73% - 5.78%     09/25/12 - 06/25/41  
Bonds and notes based on auction or remarketing
    2,905,295       2.96% - 7.25%     11/01/09 - 07/01/43  
 
                     
 
                       
Total variable-rate bonds and notes
    20,414,105                  
 
                       
Commercial paper — FFELP facility (c)
    6,629,109       5.22% - 5.98%     05/09/10  
Commercial paper — private loan facility (c)
    226,250       5.58%     03/14/09  
Fixed-rate bonds and notes (a)
    214,476       5.20% - 6.68%     11/01/09 - 05/01/29  
Unsecured fixed rate debt
    475,000     5.13% and 7.40%   06/01/10 and 09/15/61
Unsecured line of credit
    80,000       5.40% - 5.53%     05/08/12  
Other borrowings
    76,889       4.65% - 5.20%     09/28/08 - 11/01/15  
 
                     
 
                       
 
  $ 28,115,829                  
 
                     
     
(a)  
Issued in asset-backed securitizations.
 
(b)  
As of September 30, 2008, the Company had $165 million of bonds based on an auction rate of 0%, due to the Maximum Rate auction provisions in the underlying documents for such financings. The Maximum Rate provisions include multiple components, one of which is based on T-bill rates. The T-bill component calculation for these bonds produced negative rates, which resulted in auction rates of zero percent for the applicable period.
 
(c)  
Loan warehouse facilities.
Secured Financing Transactions
The Company has historically relied upon secured financing vehicles as its most significant source of funding for student loans. The net cash flow the Company receives from the securitized student loans generally represents the excess amounts, if any, generated by the underlying student loans over the amounts required to be paid to the bondholders, after deducting servicing fees and any other expenses relating to the securitizations. The Company’s rights to cash flow from securitized student loans are subordinate to bondholder interests and may fail to generate any cash flow beyond what is due to bondholders. The Company’s secured financing vehicles are loan warehouse facilities and asset-backed securitizations.
In August 2008, the Company began to fund FFELP student loan originations for the 2008-2009 academic year pursuant to the Department of Education’s Loan Participation Program (“Participation Program”) and an existing participation agreement with Union Bank and Trust Company (“Union Bank”), an entity under common control with the Company.

 

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Loan warehouse facilities
Student loan warehousing has historically allowed the Company to buy and manage student loans prior to transferring them into more permanent financing arrangements. The Company has historically relied upon three conduit warehouse loan financing vehicles to support its funding needs on a short-term basis: a multi-year committed facility for FFELP loans, a $250.0 million private loan warehouse for non-federally insured student loans, and a single-seller extendible commercial paper conduit for FFELP loans.
FFELP Warehouse facility
The Company’s multi-year committed facility for FFELP loans terminates in May 2010 and was supported by 364-day liquidity which was up for renewal on May 9, 2008. The Company obtained an extension on this renewal until July 31, 2008. On July 31, 2008, the Company did not renew the liquidity provisions of this facility. Accordingly, as of July 31, 2008, the facility became a term facility with a final maturity date of May 9, 2010. Pursuant to the terms of the agreement, since liquidity was not renewed, the Company’s cost of financing under this facility increased 10 basis points. The agreement also includes provisions which allow the banks to charge a rate equal to LIBOR plus 128.5 basis points if they choose to finance their portion of the facility with sources of funds other than their commercial paper conduit. In addition, the FFELP warehouse facility has a provision requiring the Company to refinance or remove 75% of the pledged collateral on an annual basis. The Company believes it has met this requirement for the annual period ending in May 2009. Under the current terms of the facility, the remaining collateral will need to be refinanced or removed by May 9, 2010. As of September 30, 2008 and November 7, 2008, $2.5 billion and $2.1 billion, respectively, was outstanding under this facility.
The terms and conditions of the Company’s warehouse facility for FFELP loans provide for mark-to-market advance rates. On October 22, 2008, the Company posted $165.5 million in additional funds to the facility based on this mark-to-market provision. While the Company does not believe that the loan valuation formula is reflective of the actual fair value of its loans, it is subject to compliance with such mark-to-market provisions of the warehouse facility agreement. As of September 30, 2008 and November 7, 2008, the Company had a cumulative amount of $209.1 million and $374.6 million, respectively, posted as equity funding support for this facility.
The Company has utilized its $750.0 million unsecured line of credit to fund equity advances on its warehouse facility. As of November 7, 2008, the Company has $691.5 million outstanding under this line of credit. The line of credit terminates in May 2012.
Continued dislocations in the credit markets may cause additional volatility in the loan valuation formula. Should a significant change in the valuation of loans result in additional required equity funding support for the warehouse facility greater than what the Company can provide and the Company has not amended the facility as discussed below, the warehouse facility could be subject to an event of default resulting in a termination of the facility and an acceleration of the repayment provisions. A default on the FFELP warehouse facility would result in an event of default on the Company’s unsecured line of credit that would result in the outstanding balance on the line of credit becoming immediately due and payable.
To reduce the Company’s exposure from the mark-to-market advance rate provision included in the FFELP warehouse facility, the Company has signed a letter agreement engaging Banc of America Securities LLC to arrange an amendment of certain of the Company’s credit facilities, including but not limited to an amendment to place a floor on the valuation of collateral in the Company’s FFELP loan warehouse line of credit for which Bank of America, N.A. acts as administrative agent. Banc of America Securities LLC has commenced the amendment process and together with the Company is seeking the approval of the Company’s lenders of a proposed amendment of such credit facilities on mutually agreeable terms. In addition, the Company continues to look at various alternatives to remove loans from the warehouse facility including other financing arrangements and/or selling loans to third parties.
In addition, on November 8, 2008, the Department announced they intend to provide liquidity support to one or more conforming asset backed commercial paper conduits to purchase and provide longer-term financing for FFELP loans. While details of this conduit are forthcoming, it is intended that all fully-disbursed non-consolidation FFELP loans awarded between October 1, 2003 and July 1, 2009 will be eligible for inclusion. As of November 7, 2008, the Company had approximately $900 million of loans included in its warehouse facility that would be eligible for this proposed conduit program.
Private Loan Warehouse Facility
The private loan warehouse facility, which terminates on March 14, 2009, is an uncommitted facility that is offered to the Company by a banking partner. As of September 30, 2008 and November 7, 2008, $132.0 million was outstanding under this facility. New advances are also subject to approval by the sponsor bank, and the Company believes it is unlikely such approval would be granted in the future. The Company guarantees the performance of the assets in the private loan warehouse facility. This facility provides for advance rates on subject collateral which require certain levels of equity enhancement support. As of September 30, 2008 and November 7, 2008, the Company had $50.5 million utilized as equity funding support based on provisions of this agreement. There can be no assurance that the Company will be able to maintain this conduit facility, find alternative funding, or make adequate equity contributions, if necessary. While the Company’s bank supported facilities have historically been renewed for successive terms, there can be no assurance that this will continue in the future. In January 2008, the Company suspended originating private loans.
Commercial Paper Warehouse Program
In August 2006, the Company established a $5.0 billion extendable commercial paper warehouse program for FFELP loans, under which it can issue one or more short-term extendable secured liquidity notes. As of September 30, 2008, no notes were outstanding under this warehouse program. As a result of the disruption of the credit markets, there is no market for the issuance of notes under this facility. Management believes it is currently unlikely a market will exist in the foreseeable future.

 

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Department of Education’s Loan Participation and Purchase Commitment Programs
On July 1, 2008, pursuant to the Ensuring Continued Access to Student Loans Act, the Department of Education announced terms under which it will offer to purchase certain FFELP student loans and participation interests in certain FFELP student loans from FFELP lenders. Under the Department’s Loan Purchase Commitment Program (“Purchase Program”), the Department will purchase loans at a price equal to the sum of (i) par value, (ii) accrued interest, (iii) the one percent origination fee paid to the Department, and (iv) a fixed amount of $75 per loan. Under the Participation Program, the Department provides interim short-term liquidity to FFELP lenders by purchasing participation interests in pools of FFELP loans. FFELP lenders are charged a rate of commercial paper plus 50 basis points on the principal amount of participation interests outstanding. Loans funded under the Participation Program must be either refinanced by the lender or sold to the Department pursuant to the Purchase Program prior to its expiration on September 30, 2009. To be eligible for purchase or participation under the Department’s programs, loans must be FFELP Stafford or PLUS loans made for the academic year 2008-2009, first disbursed between May 1, 2008 and July 1, 2009, with eligible borrower benefits.
On October 7, 2008, legislation was enacted to extend the Department’s authority to address FFELP student loans made for the 2009-2010 academic year and allowing for the extension of the Participation Program and Purchase Program from September 30, 2009 to September 30, 2010. The Department has provided preliminary guidance relating to the extension and has indicated that programs similar to the Participation Program and Purchase Program will be implemented for the 2009-2010 academic year along with providing liquidity support for one or more asset backed commercial paper conduits for FFELP Stafford and PLUS loans awarded between October 1, 2003 and July 1, 2009. The Department has indicated that loans for the 2008-2009 academic year which are funded under the Department’s Participation Program will need to be refinanced or sold to the Department prior to September 30, 2009. Management understands that such loans will not be eligible for participation under the Department’s 2009-2010 Participation Program, but should be eligible for refinancing through the Department’s commercial paper conduit program. Management of the Company is encouraged by these developments; however, until the Department provides additional details regarding the programs, the Company is unable to determine the full impact these programs will have on the Company.
The Company has completed and filed all relevant documents to participate in the Department of Education’s Participation Program and began to utilize the Participation Program in the third quarter of 2008 to fund a significant portion of its loan originations for the 2008-2009 academic year. As of September 30, 2008 and November 7, 2008, $263.9 million and $504.4 million of loans, respectively, were funded using the Participation Program.
Union Bank Participation Agreement
The Company maintains an agreement with Union Bank, as trustee for various grantor trusts, under which Union Bank has agreed to purchase from the Company participation interests in student loans (the “FFELP Participation Agreement”). The Company has the option to purchase the participation interests from the grantor trusts at the end of a 364-day term upon termination of the participation certificate. As of September 30, 2008 and November 7, 2008, $221.6 million and $335.3 million, respectively, of loans were subject to outstanding participation interests held by Union Bank, as trustee, under this agreement. The agreement automatically renews annually and is terminable by either party upon five business days notice. This agreement provides beneficiaries of Union Bank’s grantor trusts with access to investments in interests in student loans, while providing liquidity to the Company on a short-term basis. The Company can participate loans to Union Bank to the extent of availability under the grantor trusts, up to $750 million. Loans participated under this agreement qualify as a sale pursuant to the provisions of SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (“SFAS No. 140”). Accordingly, the participation interests sold are not included on the Company’s consolidated balance sheet.
Asset-backed Securitizations
On March 7, 2008, April 2, 2008, April 22, 2008, and May 19, 2008, the Company completed asset-backed securities transactions of $1.2 billion, $0.5 billion, $1.5 billion, and $1.3 billion, respectively. Notes issued in these transactions carry interest rates based on a spread to LIBOR. As part of the Company’s issuance of asset-backed securitizations in March 2008 and May 2008, due to credit market conditions when these notes were issued, the Company purchased the Class B subordinated notes of $36 million (par value) and $41 million (par value), respectively. These notes are not included on the Company’s consolidated balance sheet. If the credit market conditions improve, the Company anticipates selling these notes to third parties. Upon a sale to third parties, the Company would obtain cash proceeds equal to the market value of the notes on the date of such sale. Upon sale, these notes would be shown as “bonds and notes payable” on the Company’s consolidated balance sheet. Unless there is a significant market improvement, the Company believes the market value of such notes will be less than par value. The difference between the par value and market value would be recognized by the Company as interest expense over the life of the bonds.
Notes issued during 2006 included 773.2 million (950 million in U.S. dollars) with variable interest rates initially based on a spread to EURIBOR (the “Euro Notes”). As of September 30, 2008 and December 31, 2007, the Euro Notes were recorded on the Company’s balance sheet at $1.1 billion. The changes in the principal amount of Euro Notes as a result of the fluctuation of the foreign currency exchange rate were decreases of $128.9 million and $40.4 million for the three and nine months ended September 30, 2008, respectively, and increases of $54.0 million and $79.0 million for the three and nine months ended September 30, 2007, respectively, and are included in the “derivative market value, foreign currency, and put option adjustments and derivative settlements, net” in the consolidated statements of operations. Concurrently with the issuance of the Euro Notes, the Company entered into cross-currency interest rate swaps which are further discussed in note 8.

 

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The interest rates on certain of the Company’s asset-backed securities are set and periodically reset via a “dutch auction” (“Auction Rate Securities”) or through a remarketing utilizing broker-dealers and remarketing agents (“Variable Rate Demand Notes”). The Company is currently sponsor on approximately $1.9 billion of Auction Rate Securities and $0.8 billion of Variable Rate Demand Notes.
For Auction Rate Securities, investors and potential investors submit orders through a broker-dealer as to the principal amount of notes they wish to buy, hold, or sell at various interest rates. The broker-dealers submit their clients’ orders to the auction agent, who then determines the clearing interest rate for the upcoming period. Interest rates on these Auction Rate Securities are reset periodically, generally every 7 to 35 days, by the auction agent or agents. During the first quarter of 2008, as part of the credit market crisis, several auction rate securities from various issuers failed to receive sufficient order interest from potential investors to clear successfully, resulting in failed auction status. Since February 8, 2008, the Company’s Auction Rate Securities have failed in this manner. Under normal conditions, banks have historically stepped in when investor demand is weak. However, banks have been allowing these auctions to fail.
As a result of a failed auction, the Auction Rate Securities will generally pay interest to the holder at a maximum rate as defined by the commercial paper, governing documents, or indenture. While these rates will vary by the trust structure the notes were issued from as well as the class and rating of the security, they will generally be based on a spread to LIBOR, commercial paper, or Treasury Securities. Based on the relative levels of these indices as of September 30, 2008, the rates expected to be paid by the Company range from 91-day T-Bill plus 125 basis points, on the low end, to LIBOR plus 250 basis points, on the high end.
During the three month period ended September 30, 2008, the Company paid favorable interest rates on the majority of its Auction Rate Securities as a result of the application of certain of these maximum rate auction provisions in the underlying documents for such financings.
The Company cannot predict whether future auctions related to its Auction Rate Securities will be successful, but management believes it is likely auctions will continue to fail indefinitely. The Company is currently seeking alternatives for reducing its exposure to the auction rate market, but may not be able to achieve alternate financing for some or all of its Auction Rate Securities.
For Variable Rate Demand Notes, the remarketing agents set the price, which is then offered to investors. If there are insufficient potential bid orders to purchase all of the notes offered for sale, the Company could be subject to interest costs substantially above the anticipated and historical rates paid on these types of securities. The maximum rate for Variable Rate Demand Notes is based on a spread to certain indexes as defined in the underlying documents, with the highest to the Company being Prime plus 200 basis points. Certain of the Variable Rate Demand Notes are secured by financial guaranty insurance policies issued by MBIA Insurance Corporation. These Variable Rate Demand Notes are currently experiencing reduced investor demand and certain of these securities have been put to the liquidity provider, Lloyds TSB Bank, at a cost ranging from Federal Funds plus 150 basis points to LIBOR plus 175 basis points.
Unsecured Lines of Credit
The Company has a $750.0 million unsecured line of credit that terminates in May 2012. As of September 30, 2008, there was $645.0 million outstanding on this line and $105.0 million available for future use. The weighted average interest rate on this line of credit was  3.44% as of September 30, 2008. Upon termination in 2012, there can be no assurance that the Company will be able to maintain this line of credit, find alternative funding, or increase the amount outstanding under the line, if necessary. As discussed previously, the Company may need to fund certain loans or provide additional equity funding support related to advance rates on its warehouse facilities. As of November 7, 2008, the Company has contributed $425.1 million in equity funding support to these facilities. The Company has funded these contributions primarily by advances on its operating line of credit. As of November 7, 2008, the Company has $691.5 million outstanding under this line of credit and $58.5 million available for future uses. The lending commitment on the Company’s unsecured line of credit is provided by multiple banks. Lehman Brothers Bank, FSB (“Lehman Bank”) represents seven percent of the lending commitment under the line of credit. On September 15, 2008, Lehman Brothers Holdings Inc. filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code. Since the bankruptcy filing, the Company has experienced funding delays from Lehman Bank for its portion of the lending commitment under the line of credit. As of November 7, 2008, excluding Lehman Bank’s lending commitment, the Company has $51.2 million available for future use under its unsecured line of credit.
The line of credit agreement contains certain financial covenants that, if not met, lead to an event of default under the agreement. The covenants include maintaining:
  (i)  
A minimum consolidated net worth;
 
  (ii)  
A minimum adjusted EBITDA to corporate debt interest (over the last four rolling quarters);
 
  (iii)  
A limitation on subsidiary indebtedness; and
 
  (iv)  
A limitation on the percentage of non-guaranteed loans in the Company’s portfolio.

 

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As of September 30, 2008, the Company was in compliance with all of these requirements. Many of these covenants are duplicated in the Company’s other lending facilities, including its FFELP and private loan warehouses.
As previously discussed, continued dislocations in the credit markets may cause additional volatility in the loan valuation formula included in the Company’s FFELP warehouse facility. Should a significant change in the valuation of loans result in additional required equity funding support for the warehouse facility greater than what the Company can provide, the warehouse facility could be subject to an event of default resulting in a termination of the facility and an acceleration of the repayment provisions. A default on the FFELP warehouse facility would result in an event of default on the Company’s unsecured line of credit that would result in the outstanding balance on the line of credit becoming immediately due and payable.
The Company’s operating line of credit does not have any covenants related to unsecured debt ratings. However, changes in the Company’s ratings (as well as the amounts the Company borrows) have modest implications on the pricing level at which the Company obtains funding.
Other Borrowings
As of September 30, 2008 and December 31, 2007, bonds and notes payable includes $90.1 million and $57.3 million, respectively, of notes due to Union Bank. The Company has used the proceeds from these notes to invest in student loan assets via a participation agreement. This participation agreement is in addition to the $750 million FFELP Participation Agreement, and participations under this participation agreement do not qualify as sales pursuant to SFAS No. 140. On October 23, 2008, the Company paid Union Bank $89.5 million to pay off the remaining balance on these notes.
8. Derivative Financial Instruments
The Company maintains an overall risk management strategy that incorporates the use of derivative instruments to reduce the economic effect of interest rate volatility and fluctuations in foreign currency exchange rates. Derivative instruments used as part of the Company’s risk management strategy include interest rate swaps, basis swaps, and cross-currency interest rate swaps.
Interest Rate Swaps
FFELP student loans generally earn interest at the higher of a floating rate based on the Special Allowance Payment or SAP formula set by the Department and the borrower rate, which is fixed over a period of time. The Company generally finances its student loan portfolio with variable-rate debt. In low and/or declining interest rate environments, when the fixed borrower rate is higher than the rate produced by the SAP formula, the Company’s student loans earn at a fixed rate while the interest on the variable-rate debt continues to decline. In these interest rate environments, the Company earns additional spread income that it refers to as floor income.
Depending on the type of the student loan and when it was originated, the borrower rate is either fixed to term or is reset to market rate each July 1. As a result, for loans where the borrower rate is fixed to term, the Company earns floor income for an extended period of time, which the Company refers to as fixed rate floor income, and for those loans where the borrower rate is reset annually on July 1, the Company earns floor income to the next reset date, which the Company refers to as variable-rate floor income. In accordance with legislation enacted in 2006, lenders are required to rebate fixed-rate floor income and variable-rate floor income to the Department for all FFELP loans originated on or after April 1, 2006.
Absent the use of derivative instruments, a rise in interest rates will have an adverse effect on earnings due to interest margin compression caused by increasing financing costs, until such time as the federally insured loans earn interest at a variable rate in accordance with the SAP formula. In higher interest rate environments, where the interest rate rises above the borrower rate and fixed-rate loans effectively become variable rate loans, the impact of the rate fluctuations is reduced.

 

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As of September 30, 2008, the Company held the following interest rate swaps to hedge student loan assets earning fixed rate floor income.
                 
            Weighted  
            average fixed  
    Notional     rate paid by  
Maturity   Amount     the Company (a)  
 
               
2009
  $ 500,000       4.08 %
2010
    500,000       3.84  
 
           
 
  $ 1,000,000       3.96 %
 
           
     
(a)  
For all interest rate derivatives for which the Company pays a fixed rate, the Company receives discrete three-month LIBOR.
During the third quarter of 2008, the Company terminated certain interest rate swaps with a total notional amount of $1.4 billion and original maturity dates ranging from 2010 to 2012 for total net proceeds of $5.6 million.
Basis Swaps
The Company has entered into basis swaps in which the Company receives three-month LIBOR set discretely in advance and pays a daily weighted average three-month LIBOR less a spread as defined in the individual agreements. The Company entered into these derivative instruments to better match the interest rate characteristics on its student loan assets and the debt funding such assets. The following table summarizes these derivatives as of September 30, 2008:
         
    Notional  
Maturity   Amounts  
 
       
2008
  $ 1,000,000  
2009
    1,000,000  
2010
    5,500,000  
2011
    2,700,000  
2012
    2,400,000  
 
     
 
       
 
  $ 12,600,000  
 
     
During the first and third quarters of 2008, the Company terminated certain basis swaps with total notional amounts of $2.9 billion and $9.8 billion, respectively, with original maturity dates ranging from 2009 to 2012 for total net proceeds of $7.1 million and total net payments of $1.5 million, respectively. In October 2008, the Company terminated a basis swap with a notional amount of $1.0 billion and an original maturity date in 2010 for proceeds of $0.6 million. This derivative is included in the above table.
Cross-Currency Interest Rate Swaps
The Company entered into derivative instruments in 2006 as a result of the issuance of the Euro Notes as discussed in note 7. Under the terms of these derivative instrument agreements, the Company receives from a counterparty a spread to the EURIBOR index based on a notional amount of 420.5 million and 352.7 million, respectively, and pays a spread to the LIBOR index based on a notional amount of $500.0 million and $450.0 million, respectively. In addition, under the terms of these agreements, all principal payments on the Euro Notes will effectively be paid at the exchange rate in effect as of the issuance of these notes.
Accounting for Derivative Financial Instruments
The Company accounts for derivative instruments under SFAS No. 133, which requires that every derivative instrument be recorded on 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 Company’s derivative instruments do not qualify for hedge accounting under SFAS No. 133. As a result, the change in fair value of derivative instruments is recorded in the consolidated statements of operations at each reporting date. Upon termination of a derivative instrument, any proceeds received or payments made by the Company are included in “derivative market value, foreign currency, and put option adjustments and derivative settlements, net” on the consolidated statements of operations and is accounted for as a change in fair value on such derivative.

 

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The following table summarizes the net fair value of the Company’s derivative portfolio:
                 
    As of     As of  
    September 30, 2008     December 31, 2007  
 
               
Interest rate swaps
  $ (5,579 )     (2,695 )
Basis swaps
    (17,082 )     27,525  
Cross-currency interest rate swaps
    154,473       191,756  
 
           
 
               
Net fair value
  $ 131,812       216,586  
 
           
The change in the fair value of the Company’s derivative portfolio included in “derivative market value, foreign currency, and put option adjustments and derivative settlements, net” on the Company’s consolidated statements of operations resulted in a loss of $119.9 million and income of $72.7 million for the three months ended September 30, 2008 and 2007, respectively, and a loss of $72.4 million and income of $93.0 million for the nine months ended September 30, 2008 and 2007, respectively.
The following table summarizes the net derivative settlements which are included in the “derivative market value, foreign currency, and put option adjustments and derivative settlements, net” in the consolidated statements of operations:
                                 
    Three months ended September 30,     Nine months ended September 30,  
    2008     2007     2008     2007  
 
                               
Interest rate swaps
  $ (3,176 )     1,729       (14,194 )     16,803  
Basis swaps
    (3,999 )     (2,608 )     41,605       (2,489 )
Cross-currency interest rate swaps
    7,963       (1,457 )     18,577       (7,214 )
 
                       
 
Derivative settlements received (paid), net
  $ 788       (2,336 )     45,988       7,100  
 
                       
By using derivative instruments, the Company is exposed to credit and market risk. When the fair value of a derivative contract is positive, this generally indicates that the counterparty owes the Company. If the counterparty fails to perform, credit risk is equal to the extent of the fair value gain in a derivative. When the fair value of a derivative contract is negative, the Company owes the counterparty and, therefore, it has no credit risk. The Company minimizes the credit (or repayment) risk in derivative instruments by entering into transactions with high-quality counterparties that are reviewed periodically by the Company’s risk committee. The Company also maintains a policy of requiring that all derivative contracts be governed by an International Swaps and Derivatives Association, Inc. Master Agreement.
Market risk is the adverse effect that a change in interest rates, or implied volatility rates, has on the value of a financial instrument. The Company manages market risk associated with interest rates by establishing and monitoring limits as to the types and degree of risk that may be undertaken.
9. Fair Value
On January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a consistent framework for measuring fair value, and expands disclosure requirements about fair value measurements. The Company elected to delay the application of SFAS No. 157 to nonfinancial assets and nonfinancial liabilities, as allowed by FASB Staff Position SFAS No. 157-2. SFAS No. 157 applies when other accounting pronouncements require or permit fair value measurements; it does not require new fair value measurements.
Fair value under SFAS No. 157 is defined as the price to sell an asset or transfer a liability in an orderly transaction between willing and able market participants. The Company determines fair value using valuation techniques which are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. Transaction costs are not included in the determination of fair value. When possible, the Company seeks to validate the model’s output to market transactions. Depending on the availability of observable inputs and prices, different valuation models could produce materially different fair value estimates. The values presented may not represent future fair values and may not be realizable. Additionally, there may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values.

 

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Under SFAS No. 157, the Company categorizes its fair value estimates based on a hierarchal framework associated with three levels of price transparency utilized in measuring financial instruments at fair value. Classification is based on the lowest level of input that is significant to the fair value of the instrument. The three levels include:
   
Level 1: Quoted prices for identical instruments in active markets. The types of financial instruments included in Level 1 are highly liquid instruments with quoted prices.
   
Level 2: Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active; and model derived valuations whose inputs are observable or whose primary value drivers are observable.
   
Level 3: Instruments whose primary value drivers are unobservable. Inputs are developed based on the best information available; however, significant judgment is required by management in developing the inputs.
The following table presents the Company’s financial assets and liabilities that are measured at fair value on a recurring basis. All financial assets and liabilities that are measured at fair value are categorized as Level 1 or 2 based on the above hierarchy.
                         
    As of September 30, 2008  
    Level 1     Level 2     Total  
Assets:
                       
Other assets (a)
  $ 5,477       5,129       10,606  
Fair value of derivative instruments (b)
          154,741       154,741  
 
                 
 
                       
Total assets
  $ 5,477       159,870       165,347  
 
                 
 
                       
Liabilities:
                       
Fair value of derivative instruments (b)
  $       22,929       22,929  
Other liabilities (c)
          9,600       9,600  
 
                 
 
                       
Total liabilities
  $       32,529       32,529  
 
                 
                         
    As of December 31, 2007  
    Level 1     Level 2     Total  
Assets:
                       
Fair value of derivative instruments (b)
  $       222,471       222,471  
 
                 
 
                       
Total assets
  $       222,471       222,471  
 
                 
 
                       
Liabilities:
                       
Fair value of derivative instruments (b)
  $       5,885       5,885  
Other liabilities (c)
          6,117       6,117  
 
                 
 
                       
Total liabilities
  $       12,002       12,002  
 
                 
     
(a)  
Other assets includes investments recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices. Level 1 investments include investments traded on an active exchange, such as the New York Stock Exchange, and U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets. Level 2 investments include corporate debt securities.
 
(b)  
All derivatives are accounted for at fair value in the financial statements. The fair values of derivative financial instruments are determined by derivative pricing models using the stated terms of the contracts and observable yield curves, forward foreign currency exchange rates, and volatilities from active markets. It is the Company’s policy to compare its derivative fair values to those received by its counterparties in order to validate the model’s outputs. Fair value of derivative instruments is comprised of market value less accrued interest and excludes collateral.
 
(c)  
Other liabilities includes put options valued using a Black-Scholes pricing model using the stated terms of the contracts and observable inputs including the Company’s common stock volatility and dividend yield and a risk-free interest rate over the expected term of the option.
10. Earnings per Common Share
Basic earnings per common share (“basic EPS”) is computed by dividing net income by the weighted average number of shares of common stock outstanding during each period. SFAS No. 128, Earnings Per Share (“SFAS No. 128”), requires that nonvested restricted stock that vests solely upon continued service be excluded from basic EPS but reflected in diluted earnings per common share (“diluted EPS”) by application of the treasury stock method.

 

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A reconciliation of weighted average shares outstanding follows:
                                 
    Three months ended September 30,     Nine months ended September 30,  
    2008     2007     2008     2007  
 
                               
Weighted average shares outstanding
    49,525,674       49,320,629       49,472,020       49,912,506  
Less: Nonvested restricted stock — vesting solely upon continued service
    349,238       302,538       362,680       101,954  
 
                       
 
                               
Weighted average shares outstanding used to compute basic EPS
    49,176,436       49,018,091       49,109,340       49,810,552  
Dilutive effect of nonvested restricted stock
    21,366                   500  
 
                       
 
                               
Weighted average shares used to compute diluted EPS
    49,197,802       49,018,091       49,109,340       49,811,052  
 
                       
No dilutive effect of nonvested restricted stock is presented for the three months ended September 30, 2007 and the nine months ended September 30, 2008 as the Company reported a net loss and including these shares would have been antidilutive for the period. The dilutive effect of these shares if the Company had net income for the period was not significant.
11. Segment Reporting
The Company has five operating segments as defined in SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, as follows: Student Loan and Guaranty Servicing, Tuition Payment Processing and Campus Commerce, Enrollment Services and List Management, Software and Technical Services, and Asset Generation and Management. The Company’s operating segments are defined by the products and services they offer or the types of customers they serve, and they reflect the manner in which financial information is currently evaluated by management. The accounting policies of the Company’s operating segments are the same as those described in the summary of significant accounting policies. Intersegment revenues are charged by a segment to another segment that provides the product or service. Intersegment revenues and expenses are included within each segment consistent with the income statement presentation provided to management. Changes in management structure or allocation methodologies and procedures may result in changes in reported segment financial information.
The management reporting process measures the performance of the Company’s operating segments based on the management structure of the Company as well as the methodology used by management to evaluate performance and allocate resources. Management, including the Company’s chief operating decision maker, evaluates the performance of the Company’s operating segments based on their profitability. As discussed further below, management measures the profitability of the Company’s operating segments based on “base net income.” Accordingly, information regarding the Company’s operating segments is provided based on “base net income.” The Company’s “base net income” is not a defined term within GAAP and may not be comparable to similarly titled measures reported by other companies. Unlike financial accounting, there is no comprehensive, authoritative guidance for management reporting.
In May 2007, the Company sold EDULINX, a Canadian student loan service provider and subsidiary of the Company. As a result of this transaction, the results of operations for EDULINX are reported as discontinued operations for all periods presented. The operating results of EDULINX were included in the Student Loan and Guaranty Servicing operating segment. The Company presents “base net income” excluding discontinued operations since the operations and cash flows of EDULINX have been eliminated from the ongoing operations of the Company. Therefore, the results of operations for the Student Loan and Guaranty Servicing segment exclude the operating results of EDULINX for all periods presented. See note 2 for additional information concerning EDULINX’s detailed operating results that have been segregated from continuing operations and reported as discontinued operations.
Historically, the Company generated the majority of its revenue from net interest income earned in its Asset Generation and Management operating segment. In recent years, the Company has made several acquisitions that have expanded the Company’s products and services and has diversified its revenue — primarily from fee-based businesses. The Company currently offers a broad range of pre-college, in-college, and post-college products and services to students, families, schools, and financial institutions. These products and services help students and families plan and pay for their education and students plan their careers. The Company’s products and services are designed to simplify the education planning and financing process and are focused on providing value to students, families, and schools throughout the education life cycle. The Company continues to diversify its sources of revenue, including those generated from businesses that are not dependent upon government programs, reducing legislative and political risk.

 

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Fee-Based Operating Segments
Student Loan and Guaranty Servicing
The Student Loan and Guaranty Servicing segment provides for the servicing of the Company’s student loan portfolios and the portfolios of third parties and servicing provided to guaranty agencies. The servicing and business process outsourcing activities include loan origination activities, application processing, borrower updates, payment processing, due diligence procedures, and claim processing. These activities are performed internally for the Company’s portfolio in addition to generating fee revenue when performed for third-party clients. The guaranty servicing, servicing support, and business process outsourcing activities include providing software and data center services, borrower and loan updates, default aversion tracking services, claim processing services, and post-default collection services to guaranty agencies. The following are the primary product and service offerings the Company offers as part of its Student Loan and Guaranty Servicing segment:
   
Origination and servicing of FFELP loans;
   
Servicing of non-federally insured student loans; and
   
Servicing and support outsourcing for guaranty agencies.
Tuition Payment Processing and Campus Commerce
The Tuition Payment Processing and Campus Commerce segment provides products and services to help institutions and education seeking families manage the payment of education costs during the pre-college and college stages of the education life cycle. The Company provides actively managed tuition payment solutions, online payment processing, detailed information reporting, financial needs analysis, and data integration services to K-12 and higher educational institutions, families, and students. In addition, the Company provides customer-focused electronic transactions, information sharing, and account and bill presentment to colleges and universities.
Enrollment Services and List Management
The Enrollment Services and List Management segment provides a wide range of direct marketing products and services to help schools and businesses reach the middle school, high school, college bound high school, college, and young adult market places. In addition, this segment offers products and services that are focused on helping (i) students plan and prepare for life after high school and (ii) colleges recruit and retain students.
Software and Technical Services
The Software and Technical Services segment provides information technology products and full-service technical consulting, with core areas of business in educational loan software solutions, business intelligence, technical consulting services, and Enterprise Content Management (ECM) solutions.
Asset Generation and Management Operating Segment
The Asset Generation and Management segment includes the acquisition, management, and ownership of the Company’s student loan assets. Revenues are primarily generated from the Company’s earnings from the spread, referred to as the Company’s student loan spread, between the yield received on the student loan portfolio and the costs associated with originating, acquiring, financing, servicing, and managing the student loan portfolio. The Company generates student loan assets through direct origination or through acquisitions. The student loan assets are held in a series of education lending subsidiaries designed specifically for this purpose. In addition to the student loan portfolio, all costs and activity associated with the generation of assets, funding of those assets, and maintenance of the debt transactions are included in this segment. This includes derivative activity and the related derivative market value and foreign currency adjustments. The Company is also able to leverage its capital market expertise by providing investment advisory services and other related services to third parties through a licensed broker dealer subsidiary. Revenues and expenses for those functions are also included in the Asset Generation and Management segment.
Segment Operating Results — “Base Net Income”
The tables below include the operating results of each of the Company’s operating segments. Management, including the chief operating decision maker, evaluates the Company on certain non-GAAP performance measures that the Company refers to as “base net income” for each operating segment. While “base net income” is not a substitute for reported results under GAAP, the Company relies on “base net income” to manage each operating segment because it believes this measure provides additional information regarding the operational and performance indicators that are most closely assessed by management.

 

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“Base net income” is the primary financial performance measure used by management to develop the Company’s financial plans, track results, and establish corporate performance targets and incentive compensation. Management believes this information provides additional insight into the financial performance of the core business activities of the Company’s operating segments. Accordingly, the tables presented below reflect “base net income,” which is the operating measure reviewed and utilized by management to manage the business. Reconciliation of the segment totals to the Company’s operating results in accordance with GAAP are also included in the tables below.
Segment Results and Reconciliations to GAAP
                                                                                 
    Three months ended September 30, 2008  
    Fee-Based                                              
    Student     Tuition     Enrollment                                             “Base net        
    Loan     Payment     Services     Software             Asset     Corporate             income”        
    and     Processing     and     and     Total     Generation     Activity     Eliminations     Adjustments     GAAP  
    Guaranty     and Campus     List     Technical     Fee-     and     and     and     to GAAP     Results of  
    Servicing     Commerce     Management     Services     Based     Management     Overhead     Reclassifications     Results     Operations  
 
                                                                               
Total interest income
  $ 304       396       6             706       290,039       2,010       (749 )     1,580       293,586  
Interest expense
                1             1       224,272       10,492       (749 )           234,016  
 
                                                           
Net interest income (loss)
    304       396       5             705       65,767       (8,482 )           1,580       59,570  
 
                                                                               
Less provision for loan losses
                                  7,000                         7,000  
 
                                                           
Net interest income (loss) after provision for loan losses
    304       396       5             705       58,767       (8,482 )           1,580       52,570  
 
                                                           
 
                                                                               
Other income (expense):
                                                                               
Loan and guaranty servicing income
    30,769                         30,769       (136 )                       30,633  
Other fee-based income
          11,861       29,859             41,720       4,167                         45,887  
Software services income
                      4,217       4,217                               4,217  
Other income
    6       1                   7       (88 )     1,323                   1,242  
Intersegment revenue
    18,402       58       2       1,660       20,122             15,671       (35,793 )            
Derivative market value, foreign currency, and put option adjustments
                                                    6,085       6,085  
Derivative settlements, net
                                  789                         789  
 
                                                           
Total other income (expense)
    49,177       11,920       29,861       5,877       96,835       4,732       16,994       (35,793 )     6,085       88,853  
 
                                                           
 
                                                                               
Operating expenses:
                                                                               
Salaries and benefits
    13,876       6,236       5,805       4,138       30,055       1,980       14,179       (1,952 )     477       44,739  
Other expenses
    10,632       2,132       20,416       568       33,748       5,354       13,477       (247 )     6,598       58,930  
Intersegment expenses
    11,940       288       1,509       826       14,563       18,200       831       (33,594 )            
 
                                                           
Total operating expenses
    36,448       8,656       27,730       5,532       78,366       25,534       28,487       (35,793 )     7,075       103,669  
 
                                                           
 
                                                                               
Income (loss) before income taxes
    13,033       3,660       2,136       345       19,174       37,965       (19,975 )           590       37,754  
Income tax expense (benefit) (a)
    4,823       1,354       790       128       7,095       14,047       (7,391 )           218       13,969  
 
                                                           
Net income (loss) from continuing operations
    8,210       2,306       1,346       217       12,079       23,918       (12,584 )           372       23,785  
Income from discontinued operations, net of tax
                                                           
 
                                                           
Net income (loss)
  $ 8,210       2,306       1,346       217       12,079       23,918       (12,584 )           372       23,785  
 
                                                           
     
(a)  
Beginning in 2008, the consolidated effective tax rate for each applicable quarterly period is used to calculate income taxes for each operating segment.

 

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    Three months ended September 30, 2007  
    Fee-Based                                              
    Student     Tuition     Enrollment                                             “Base net        
    Loan     Payment     Services     Software             Asset     Corporate             income”        
    and     Processing     and     and     Total     Generation     Activity     Eliminations     Adjustments     GAAP  
    Guaranty     and Campus     List     Technical     Fee-     and     and     and     to GAAP     Results of  
    Servicing     Commerce     Management     Services     Based     Management     Overhead     Reclassifications     Results     Operations  
 
                                                                               
Total interest income
  $ 1,182       990       110             2,282       454,053       1,875       (533 )     597       458,274  
Interest expense
                1             1       384,793       9,614       (533 )           393,875  
 
                                                           
Net interest income (loss)
    1,182       990       109             2,281       69,260       (7,739 )           597       64,399  
 
                                                                               
Less provision for loan losses
                                  18,340                         18,340  
 
                                                           
Net interest income (loss) after provision for loan losses
    1,182       990       109             2,281       50,920       (7,739 )           597       46,059  
 
                                                           
 
                                                                               
Other income (expense):
                                                                               
Loan and guaranty servicing income
    32,870                         32,870       170                         33,040  
Other fee-based income
          10,316       23,471             33,787       3,526       712                   38,025  
Software services income
                169       5,257       5,426                               5,426  
Other income
          31                   31       1,181       5,816                   7,028  
Gain on sale of loans
                                  492                         492  
Intersegment revenue
    22,237       168       (37 )     4,805       27,173             1,492       (28,665 )            
Derivative market value, foreign currency, and put option adjustments
                                                    18,449       18,449  
Derivative settlements, net
                                  (4,065 )     1,729                   (2,336 )
 
                                                           
Total other income (expense)
    55,107       10,515       23,603       10,062       99,287       1,304       9,749       (28,665 )     18,449       100,124  
 
                                                           
 
                                                                               
Operating expenses:
                                                                               
Salaries and benefits
    21,961       5,312       8,095       6,537       41,905       6,154       9,691       2,292       503       60,545  
Restructure expense- severance and contract termination costs
    1,231             737       58       2,026       1,921       1,009       (4,956 )            
Impairment expense
                11,401             11,401       28,291       9,812                   49,504  
Other expenses
    8,565       2,029       13,809       689       25,092       7,429       19,822       168       10,885       63,396  
Intersegment expenses
    1,613       (15 )     67       147       1,812       20,924       3,433       (26,169 )            
 
                                                           
Total operating expenses
    33,370       7,326       34,109       7,431       82,236       64,719       43,767       (28,665 )     11,388       173,445  
 
                                                           
 
                                                                               
Income (loss) before income taxes
    22,919       4,179       (10,397 )     2,631       19,332       (12,495 )     (41,757 )           7,658       (27,262 )
Income tax expense (benefit) (a)
    8,709       1,588       (3,951 )     1,000       7,346       (4,748 )     (16,233 )           2,971       (10,664 )
 
                                                           
Net income (loss) from continuing operations
    14,210       2,591       (6,446 )     1,631       11,986       (7,747 )     (25,524 )           4,687       (16,598 )
Loss from discontinued operations, net of tax
                                                    909       909  
 
                                                           
Net income (loss)
  $ 14,210       2,591       (6,446 )     1,631       11,986       (7,747 )     (25,524 )           5,596       (15,689 )
 
                                                           
     
(a)  
Income taxes are based on 38% of net income (loss) before tax for the individual operating segment.

 

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    Nine months ended September 30, 2008  
    Fee-Based                                              
    Student     Tuition     Enrollment                                             “Base net        
    Loan     Payment     Services     Software             Asset     Corporate             income”        
    and     Processing     and     and     Total     Generation     Activity     Eliminations     Adjustments     GAAP  
    Guaranty     and Campus     List     Technical     Fee-     and     and     and     to GAAP     Results of  
    Servicing     Commerce     Management     Services     Based     Management     Overhead     Reclassifications     Results     Operations  
 
                                                                               
Total interest income
  $ 1,160       1,471       16             2,647       892,690       4,781       (1,389 )     42,325       941,054  
Interest expense
                3             3       762,689       30,318       (1,389 )           791,621  
 
                                                           
Net interest income (loss)
    1,160       1,471       13             2,644       130,001       (25,537 )           42,325       149,433  
 
                                                                               
Less provision for loan losses
                                  18,000                         18,000  
 
                                                           
Net interest income (loss) after provision for loan losses
    1,160       1,471       13             2,644       112,001       (25,537 )           42,325       131,433  
 
                                                           
 
                                                                               
Other income (expense):
                                                                               
Loan and guaranty servicing income
    81,624                         81,624       26                         81,650  
Other fee-based income
          35,975       83,148             119,123       13,494                         132,617  
Software services income
                37       15,828       15,865                               15,865  
Other income
    44       5                   49       293       3,956                   4,298  
Loss on sale of loans
                                  (47,426 )                       (47,426 )
Intersegment revenue
    57,008       242       2       4,993       62,245             46,844       (109,089 )            
Derivative market value, foreign currency, and put option adjustments
                                  466                   (35,987 )     (35,521 )
Derivative settlements, net
                                  55,954                   (9,965 )     45,989  
 
                                                           
Total other income (expense)
    138,676       36,222       83,187       20,821       278,906       22,807       50,800       (109,089 )     (45,952 )     197,472  
 
                                                           
 
                                                                               
Operating expenses:
                                                                               
Salaries and benefits
    40,365       17,450       18,701       14,031       90,547       6,157       41,581       1,323       2,523       142,131  
Restructure expense — severance and contract termination costs
    747             282       487       1,516       1,845       3,746       (7,107 )            
Impairment expense
    5,074                         5,074       9,351       4,409                   18,834  
Other expenses
    27,130       6,743       55,863       1,901       91,637       15,793       42,263       51       19,719       169,463  
Intersegment expenses
    35,040       1,045       4,936       1,562       42,583       57,754       3,019       (103,356 )            
 
                                                           
Total operating expenses
    108,356       25,238       79,782       17,981       231,357       90,900       95,018       (109,089 )     22,242       330,428  
 
                                                           
 
                                                                               
Income (loss) before income taxes
    31,480       12,455       3,418       2,840       50,193       43,908       (69,755 )           (25,869 )     (1,523 )
Income tax expense (benefit) (a)
    10,542       4,081       1,187       902       16,712       15,889       (22,824 )           (7,984 )     1,793  
 
                                                           
Net income (loss) from continuing operations
    20,938       8,374       2,231       1,938       33,481       28,019       (46,931 )           (17,885 )     (3,316 )
Income from discontinued operations, net of tax
                                                    981       981  
 
                                                           
Net income (loss)
  $ 20,938       8,374       2,231       1,938       33,481       28,019       (46,931 )           (16,904 )     (2,335 )
 
                                                           
     
(a)  
Beginning in 2008, the consolidated effective tax rate for each applicable quarterly period is used to calculate income taxes for each operating segment.

 

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    Nine months ended September 30, 2007  
    Fee-Based                                              
    Student     Tuition     Enrollment                                             “Base net        
    Loan     Payment     Services     Software             Asset     Corporate             income”        
    and     Processing     and     and     Total     Generation     Activity     Eliminations     Adjustments     GAAP  
    Guaranty     and Campus     List     Technical     Fee-     and     and     and     to GAAP     Results of  
    Servicing     Commerce     Management     Services     Based     Management     Overhead     Reclassifications     Results     Operations  
 
                                                                               
Total interest income
  $ 4,607       2,670       290       18       7,585       1,301,947       6,230       (3,737 )     597       1,312,622  
Interest expense
          7       5             12       1,084,792       31,196       (3,737 )           1,112,263  
 
                                                           
Net interest income (loss)
    4,607       2,663       285       18       7,573       217,155       (24,966 )           597       200,359  
 
                                                                               
Less provision for loan losses
                                  23,628                         23,628  
 
                                                           
Net interest income (loss) after provision for loan losses
    4,607       2,663       285       18       7,573       193,527       (24,966 )           597       176,731  
 
                                                           
 
                                                                               
Other income (expense):
                                                                               
Loan and guaranty servicing income
    94,828                         94,828       288                         95,116  
Other fee-based income
          31,492       73,341             104,833       10,511       972                   116,316  
Software services income
                456       16,566       17,022                               17,022  
Other income
    11       59                   70       4,329       9,649                   14,048  
Gain on sale of loans
                                  3,288                         3,288  
Intersegment revenue
    58,821       508       891       13,026       73,246             7,608       (80,854 )            
Derivative market value, foreign currency, and put option adjustments
                                                    11,866       11,866  
Derivative settlements, net
                                  (4,950 )     12,050                   7,100  
 
                                                           
Total other income (expense)
    153,660       32,059       74,688       29,592       289,999       13,466       30,279       (80,854 )     11,866       264,756  
 
                                                           
 
                                                                               
Operating expenses:
                                                                               
Salaries and benefits
    66,988       15,312       26,486       18,869       127,655       20,600       34,669       (2,370 )     1,456       182,010  
Restructure expense- severance and contract termination costs
    1,231             737       58       2,026       1,921       1,009       (4,956 )            
Impairment expense
                11,401             11,401       28,291       9,812                   49,504  
Other expenses
    26,219       6,522       42,957       2,224       77,922       22,940       58,762       168       24,014       183,806  
Intersegment expenses
    8,681       384       252       550       9,867       59,594       4,235       (73,696 )            
 
                                                           
Total operating expenses
    103,119       22,218       81,833       21,701       228,871       133,346       108,487       (80,854 )     25,470       415,320  
 
                                                           
 
                                                                               
Income (loss) before income taxes
    55,148       12,504       (6,860 )     7,909       68,701       73,647       (103,174 )           (13,007 )     26,167  
Income tax expense (benefit) (a)
    20,956       4,752       (2,607 )     3,006       26,107       27,986       (40,059 )           (4,128 )     9,906  
 
                                                           
Net income (loss) from continuing operations
    34,192       7,752       (4,253 )     4,903       42,594       45,661       (63,115 )           (8,879 )     16,261  
Loss from discontinued operations, net of tax
                                                    (2,416 )     (2,416 )
 
                                                           
Net income (loss)
  $ 34,192       7,752       (4,253 )     4,903       42,594       45,661       (63,115 )           (11,295 )     13,845  
 
                                                           
     
(a)  
Income taxes are based on 38% of net income (loss) before tax for the individual operating segment.
Corporate Activity and Overhead in the previous tables primarily includes the following items:
   
Income earned on certain investment activities;
   
Interest expense incurred on unsecured debt transactions;
   
Other products and service offerings that are not considered operating segments; and
   
Corporate activities and overhead functions such as executive management, human resources, accounting and finance, legal, marketing, and corporate technology support.

 

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The adjustments required to reconcile from the Company’s “base net income” measure to its GAAP results of operations relate to differing treatments for derivatives, foreign currency transaction adjustments, discontinued operations, and certain other items that management does not consider in evaluating the Company’s operating results. The following tables reflect adjustments associated with these areas by operating segment and Corporate Activity and Overhead:
                                                         
    Student     Tuition     Enrollment                          
    Loan     Payment     Services     Software     Asset     Corporate        
    and     Processing     and     and     Generation     Activity        
    Guaranty     and Campus     List     Technical     and     and        
    Servicing     Commerce     Management     Services     Management     Overhead     Total  
    Three months ended September 30, 2008  
 
                                                       
Derivative market value, foreign currency, and put option adjustments (1)
  $                         (9,030 )     2,945       (6,085 )
Amortization of intangible assets (2)
    1,165       1,889       3,258       286                   6,598  
Compensation related to business combinations (3)
                                  477       477  
Variable-rate floor income, net of settlements on derivatives (4)
                            (1,580 )           (1,580 )
Income (loss) from discontinued operations, net of tax (5)
                                         
Net tax effect (6)
    (432 )     (699 )     (1,205 )     (106 )     3,926       (1,266 )     218  
 
                                         
 
                                                       
Total adjustments to GAAP
  $ 733       1,190       2,053       180       (6,684 )     2,156       (372 )
 
                                         
 
                                                       
    Three months ended September 30, 2007
     
 
                                                       
Derivative market value, foreign currency, and put option adjustments (1)
  $                         (20,017 )     1,568       (18,449 )
Amortization of intangible assets (2)
    1,350       1,434       6,442       287       1,372             10,885  
Compensation related to business combinations (3)
                                  503       503  
Variable-rate floor income, net of settlements on derivatives (4)
                            (597 )           (597 )
Income (loss) from discontinued operations, net of tax (5)
    (909 )                                   (909 )
Net tax effect (6)
    (513 )     (545 )     (2,448 )     (109 )     7,312       (726 )     2,971  
 
                                         
 
                                                       
Total adjustments to GAAP
  $ (72 )     889       3,994       178       (11,930 )     1,345       (5,596 )
 
                                         
 
                                                       
    Nine months ended September 30, 2008
     
 
                                                       
Derivative market value, foreign currency, and put option adjustments (1)
  $                         32,504       3,483       35,987  
Amortization of intangible assets (2)
    3,586       5,937       9,193       858       145             19,719  
Compensation related to business combinations (3)
                                  2,523       2,523  
Variable-rate floor income, net of settlements on derivatives (4)
                            (32,360 )           (32,360 )
Income (loss) from discontinued operations, net of tax (5)
    (981 )                                   (981 )
Net tax effect (6)
    (1,182 )     (1,954 )     (3,045 )     (284 )     548       (2,067 )     (7,984 )
 
                                         
 
                                                       
Total adjustments to GAAP
  $ 1,423       3,983       6,148       574       837       3,939       16,904  
 
                                         
 
                                                       
    Nine months ended September 30, 2007
     
 
                                                       
Derivative market value, foreign currency, and put option adjustments (1)
  $                         (7,801 )     (4,065 )     (11,866 )
Amortization of intangible assets (2)
    3,744       4,372       9,797       904       5,197             24,014  
Compensation related to business combinations (3)
                                  1,456       1,456  
Variable-rate floor income, net of settlements on derivatives (4)
                            (597 )           (597 )
Income (loss) from discontinued operations, net of tax (5)
    2,416                                     2,416  
Net tax effect (6)
    (1,423 )     (1,661 )     (3,723 )     (343 )     1,216       1,806       (4,128 )
 
                                         
 
                                                       
Total adjustments to GAAP
  $ 4,737       2,711       6,074       561       (1,985 )     (803 )     11,295  
 
                                         
     
(1)  
Derivative market value, foreign currency, and put option adjustments: “Base net income” excludes the periodic unrealized gains and losses that are caused by the change in fair value on derivatives used in the Company’s risk management strategy in which the Company does not qualify for “hedge treatment” under GAAP. Included in “base net income” are the economic effects of the Company’s derivative instruments, which includes any cash paid or received being recognized as an expense or revenue upon actual derivative settlements. “Base net income” also excludes the foreign currency transaction gains or losses caused by the re-measurement of the Company’s Euro-denominated bonds to U.S. dollars and the change in fair value of put options issued by the Company for certain business acquisitions.
 
(2)  
Amortization of intangible assets: “Base net income” excludes the amortization of acquired intangibles.
 
(3)  
Compensation related to business combinations: The Company has structured certain business combinations in which the consideration paid has been dependent on the sellers’ continued employment with the Company. As such, the value of the consideration paid is recognized as compensation expense by the Company over the term of the applicable employment agreement. “Base net income” excludes this expense.
 
(4)  
Variable-rate floor income: Loans that reset annually on July 1 can generate excess spread income compared with the rate based on the special allowance payment formula in declining interest rate environments. The Company refers to this additional income as variable-rate floor income. The Company excludes variable-rate floor income, net of settlements paid on derivatives used to hedge student loan assets earning variable-rate floor income, from its base net income since the timing and amount of variable-rate floor income (if any) is uncertain, it has been eliminated by legislation for all loans originated on and after April 1, 2006, and it is in excess of expected spreads. In addition, because variable-rate floor income is subject to the underlying rate for the subject loans being reset annually on July 1, it is a factor beyond the Company’s control which can affect the period-to-period comparability of results of operations.
 
(5)  
Discontinued operations: In May 2007, the Company sold EDULINX. As a result of this transaction, the results of operations for EDULINX are reported as discontinued operations for all periods presented. The Company presents “base net income” excluding discontinued operations since the operations and cash flows of EDULINX have been eliminated from the ongoing operations of the Company.
 
(6)  
Beginning in 2008, tax effect is computed using the Company’s consolidated effective tax rate for each applicable quarterly period. In prior periods, tax effect was computed at 38%. The change in the value of the put options for prior periods (included in Corporate Activities and Overhead) was not tax effected as this is not deductible for income tax purposes.

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
(Management’s Discussion and Analysis of Financial Condition and Results of Operations is for the three and nine months ended September 30, 2008 and 2007. All dollars are in thousands, except per share amounts, unless otherwise noted).
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 included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.
Forward-looking and cautionary statements
This report contains forward-looking statements and information based on management’s current expectations as of the date of this document. When used in this report, the words “anticipate,” “believe,” “estimate,” “expect,” and “intend” 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, the risks and uncertainties set forth in “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q, prior quarterly reports filed by the Company, and the Company’s Annual Report on Form 10-K for the year ended December 31, 2007, and changes in the terms of student loans and the educational credit marketplace arising from the implementation of, or changes in, applicable laws and regulations, which may reduce the volume, average term, special allowance payments, and costs of yields on student loans under the FFEL Program or result in loans being originated or refinanced under non-FFEL programs or may affect the terms upon which banks and others agree to sell FFELP loans to the Company. In addition, a larger than expected increase in third party consolidations of the Company’s FFELP loans could materially adversely affect the Company’s results of operations. 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; the Company’s ability to maintain its credit facilities or obtain new facilities; the ability of lenders under the Company’s credit facilities to fulfill their lending commitments under those facilities; changes to the terms and conditions of the liquidity programs offered by the Department of Education; 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; changes in prepayment rates, guaranty rates, loan floor rates, and credit spreads; the financial strength of contract counterparties; the uncertain nature of the expected benefits from acquisitions and the ability to successfully integrate operations; and the uncertain nature of estimated expenses that may be incurred and cost savings that may result from the Company’s strategic restructuring initiatives. 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. Additionally, financial projections may not prove to be accurate and may vary materially. 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. Although the Company may from time to time voluntarily update its prior forward-looking statements, it disclaims any commitment to do so except as required by securities laws.
Overview
The Company is an education planning and financing company focused on providing quality products and services to students, families, and schools nationwide. The Company is a vertically-integrated organization that offers a broad range of products and services to its customers throughout the education life cycle.
Built through a focus on long-term organic growth and further enhanced by strategic acquisitions, the Company earns its revenues from fee-based revenues related to its diversified education finance and service operations and from net interest income on its portfolio of student loans.

 

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The following provides certain events and operating activities that have impacted the financial condition and operating results of the Company. These items include:
   
Liquidity developments related to the Company’s FFELP warehouse and unsecured line of credit facilities and legislative developments regarding funding new loan originations;
   
Strong student loan spread earned on the Company’s loan portfolio;
   
Increased revenue and operating margins from the Company’s fee-based businesses; and
   
Continued decreases in operating expenses.
Liquidity and Legislative Developments
FFELP Warehouse Facility and Unsecured Line of Credit
On July 31, 2008, the Company did not renew its liquidity provisions on its FFELP loan warehouse facility. Accordingly, the facility became a term facility and no new loan originations can be funded with this facility. As of November 7, 2008, $2.1 billion was outstanding under this facility. The terms and conditions of this facility provides for mark-to-market advance rates. On October 22, 2008, the Company posted $165.5 million in additional funds to the facility based on this mark-to-market formula. As of November 7, 2008, the Company has a cumulative amount of $374.6 million posted as equity funding support for the facility.
The Company has utilized its $750.0 million unsecured line of credit to fund equity advances on its warehouse facility. As of November 7, 2008, the Company has $691.5 million outstanding under this line of credit. The line of credit terminates in May 2012.
Continued dislocations in the credit markets may cause additional volatility in the loan valuation formula. Should a significant change in the valuation of loans result in additional required equity funding support for the warehouse facility greater than what the Company can provide and the Company has not amended the facility as discussed below, the warehouse facility could be subject to an event of default resulting in a termination of the facility and an acceleration of the repayment provisions. A default on the FFELP warehouse facility would result in an event of default on the Company’s unsecured line of credit that would result in the outstanding balance on the line of credit becoming immediately due and payable.
To reduce the Company’s exposure from the mark-to-market advance rate provision included in the FFELP warehouse facility, the Company has signed a letter agreement engaging Banc of America Securities LLC to arrange an amendment of certain of the Company’s credit facilities, including but not limited to an amendment to place a floor on the valuation of collateral in the Company’s FFELP loan warehouse line of credit for which Bank of America, N.A. acts as administrative agent. Banc of America Securities LLC has commenced the amendment process and together with the Company is seeking the approval of the Company’s lenders of a proposed amendment of such credit facilities on mutually agreeable terms. In addition, the Company continues to look at various alternatives to remove loans from the warehouse facility including other financing arrangements and/or selling loans to third parties.
In addition, on November 8, 2008, the Department announced they intend to provide liquidity support to one or more conforming asset backed commercial paper conduits to purchase and provide longer-term financing for FFELP loans. While details of this conduit are forthcoming, it is intended that all fully-disbursed non-consolidation FFELP loans awarded between October 1, 2003 and July 1, 2009 will be eligible for inclusion. As of November 7, 2008, the Company had approximately $900 million of loans included in its warehouse facility that would be eligible for this proposed conduit program.
Funding New Loan Originations
In July 2008, pursuant to the Ensuring Continued Access to Student Loans Act, the Department of Education announced terms under which it would offer to purchase FFELP student loans and loan participations from lenders. Upon not renewing the liquidity provisions on the Company’s FFELP warehouse facility, in August 2008, the Company began to fund FFELP student loan originations for the 2008-2009 academic year pursuant to the Department’s Participation Program and an existing participation agreement with Union Bank. As of September 30, 2008, the Company has funded $263.9 million of FFELP loans using the Department’s Participation Program. The Company plans to continue to use the Participation Program to fund the majority of loans originated for the 2008-2009 academic year.
On October 7, 2008, legislation was enacted to extend the Department’s authority to address FFELP student loans made for the 2009-2010 academic year and allowing for the extension of the Participation Program and Purchase Program from September 30, 2009 to September 30, 2010. The Department has provided preliminary guidance relating to the extension and has indicated that programs similar to the Participation Program and the Purchase Program for the 2009-2010 academic year along with providing liquidity support for one or more asset backed commercial paper conduits for FFELP Stafford and PLUS loans awarded between October 1, 2003 and July 1, 2009. The Department has indicated that loans for the 2008-2009 academic year which are funded under the Department’s Participation Program will need to be refinanced or sold to the Department prior to September 30, 2009. Management understands that such loans will not be eligible for participation under the Department’s 2009-2010 Participation Program, but should be eligible for refinancing through the Department’s commercial paper conduit program. Management of the Company is encouraged by these developments; however, until the Department provides additional details regarding the programs, the Company is unable to determine the full impact these programs will have on the Company.
Student Loan Spread
The Company’s core student loan spread for the three months ended September 30, 2008 was 102 basis points. Excluding fixed-rate floor income, core student loan spread for both the three months ended September 30, 2008 and June 30, 2008 was 92 basis points.

 

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Fee-based businesses
Revenue from the Company’s fee-based businesses increased $4.6 million, or 6.4%, to $76.7 million for the three months ended September 30, 2008 compared to $72.1 million for the three months ended September 30, 2007. Excluding list marketing services, revenue from the Company’s Tuition Payment Processing and Campus Commerce and Enrollment Services and List Management operating segments increased $8.3 million, or 26.5%, to $39.4 million for the three months ended September 30, 2008 compared to $31.1 million for the three months ended September 30, 2007. These operating segments are less impacted by legislation and the student loan industry.
Operating margins for the Company’s fee based businesses, excluding the expenses associated with the variation in allocation methodologies and restructuring and impairment charges, were 27.7% and 27.8% for the three and nine months ended September 30, 2008, respectively, compared to 32.3% and 27.6% for the same periods in 2007.
Operating Expenses
As a result of the restructuring plans implemented in September 2007 and January 2008, as well as the Company’s continued focus on capitalizing on the operating leverage of the Company’s business structure and strategies, operating expenses continued to decrease during the quarter. Excluding restructuring and impairment charges, operating expenses decreased $15.3 million, or 12.9%, and $56.4 million, or 15.6%, for the three and nine months ended September 30, 2008 compared to the same periods in 2007, respectively.
RESULTS OF OPERATIONS
The Company’s operating results are primarily driven by the performance of its existing portfolio, the cost necessary to generate new assets, the revenues generated by its fee based businesses, and the cost to provide those services. The performance of the Company’s portfolio is driven by net interest income and losses related to credit quality of the assets along with the cost to administer and service the assets and related debt.
Net Interest Income
The Company generates a significant portion of its earnings from the spread, referred to as its student loan spread, between the yield the Company receives on its student loan portfolio and the cost of funding these loans. This spread income is reported on the Company’s consolidated statements of operations as net interest income. The amortization of loan premiums, including capitalized costs of origination, the 1.05% per year consolidation loan rebate fee paid to the Department, and yield adjustments from borrower benefit programs, are netted against loan interest income on the Company’s statements of operations. The amortization of debt issuance costs is included in interest expense on the Company’s statements of operations.
The Company’s portfolio of FFELP loans originated prior to April 1, 2006 earns interest at the higher of a variable rate based on the special allowance payment (SAP) formula set by the Department of Education and the borrower rate. The SAP formula is based on an applicable index plus a fixed spread that is dependent upon when the loan was originated, the loan’s repayment status, and funding sources for the loan. As a result of one of the provisions of the Higher Education Reconciliation Act of 2005 (“HERA”), the Company’s portfolio of FFELP loans originated on or after April 1, 2006 earns interest at a variable rate based on the SAP formula. For the portfolio of loans originated on or after April 1, 2006, when the borrower rate exceeds the variable rate based on the SAP formula, the Company must return the excess to the Department.
On September 27, 2007, the President signed into law the College Cost Reduction and Access Act of 2007. This legislation has and will continue to have a significant impact on the Company’s net interest income and should be considered when reviewing the Company’s results of operations. Among other things, this legislation:
   
Reduced special allowance payments to for-profit lenders and not-for-profit lenders by 0.55 percentage points and 0.40 percentage points, respectively, for both Stafford and Consolidation loans disbursed on or after October 1, 2007;
   
Reduced special allowance payments to for-profit lenders and not-for-profit lenders by 0.85 percentage points and 0.70 percentage points, respectively, for PLUS loans disbursed on or after October 1, 2007;
   
Increased origination fees paid by lenders on all FFELP loan types, from 0.5 percent to 1.0 percent, for all loans first disbursed on or after October 1, 2007;
   
Eliminated all provisions relating to Exceptional Performer status, and the monetary benefit associated with it, effective October 1, 2007; and
   
Reduces default insurance to 95 percent of the unpaid principal of such loans, for loans first disbursed on or after October 1, 2012.

 

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Management estimates the impact of this legislation will reduce the annual yield on FFELP loans originated after October 1, 2007 by 70 to 80 basis points. The Company believes it can mitigate some of the reduction in annual yield by creating efficiencies and lowering costs, modifying borrower benefits, and reducing loan acquisition costs.
Because the Company generates a significant portion of its earnings from its student loan spread, 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 Item 3, “Quantitative and Qualitative Disclosures about Market Risk — Interest Rate Risk.”
Investment interest income, which is a component of net interest income, includes income from unrestricted interest-earning deposits and funds in the Company’s special purpose entities which are utilized for its asset-backed securitizations.
Net interest income also includes interest expense on unsecured debt offerings. The proceeds from these unsecured debt offerings were and have been used by the Company to fund general business operations, certain asset and business acquisitions, and the repurchase of stock under the Company’s stock repurchase plan.
Provision for Loan Losses
Management estimates and establishes an allowance for loan losses through a provision charged to expense. Losses are charged against the allowance when management believes the collectibility of the loan principal is unlikely. Recovery of amounts previously charged off is credited to the allowance for loan losses. Management maintains the allowance for federally insured and non-federally insured loans at a level believed to be adequate to provide for estimated probable credit losses inherent in the loan portfolio. This evaluation is inherently subjective because it requires estimates that may be susceptible to significant changes. The Company analyzes the allowance separately for its federally insured loans and its non-federally insured loans.
Management bases the allowance for the federally insured loan portfolio on periodic evaluations of the Company’s loan portfolios, considering past experience, trends in student loan claims rejected for payment by guarantors, changes to federal student loan programs, current economic conditions, and other relevant factors. One of the changes to the Higher Education Act as a result of HERA’s enactment in February 2006, was to lower the guaranty rates on FFELP loans, including a decrease in insurance and reinsurance on portfolios receiving the benefit of the Exceptional Performance designation by 1%, from 100% to 99% of principal and accrued interest (effective July 1, 2006), and a decrease in insurance and reinsurance on portfolios not subject to the Exceptional Performance designation by 1%, from 98% to 97% of principal and accrued interest (effective for all loans first disbursed on and after July 1, 2006).
In September 2005, the Company was re-designated as an Exceptional Performer by the Department in recognition of its exceptional level of performance in servicing FFELP loans. As a result of this designation, the Company received 99% reimbursement (100% reimbursement prior to July 1, 2006) on all eligible FFELP default claims submitted for reimbursement during the applicable period. Only FFELP loans that were serviced by the Company, as well as loans owned by the Company and serviced by other service providers designated as Exceptional Performers by the Department, were eligible for the 99% reimbursement.
On September 27, 2007, the President signed into law the College Cost Reduction and Access Act of 2007. Among other things, this legislation eliminated all provisions relating to Exceptional Performer status, and the monetary benefit associated with it, effective October 1, 2007. Accordingly, the majority of claims submitted on or after October 1, 2007 are subject to reimbursement at 97% or 98% of principal and accrued interest depending on the disbursement date of the loan. During the three month period ended September 30, 2007, the Company recorded an expense of $15.7 million to increase the Company’s allowance for loan losses related to the increase in risk share as a result of the elimination of the Exceptional Performer program.
In determining the adequacy of the allowance for loan losses on the non-federally insured loans, the Company considers several factors including: loans in repayment versus those in a nonpaying status, months in repayment, delinquency status, type of program, and trends in defaults in the portfolio based on Company and industry data. The Company places a non-federally insured loan on nonaccrual status and charges off the loan when the collection of principal and interest is 120 days past due.
Other Income
The Company also earns fees and generates income from other sources, including principally loan and guaranty servicing income; fee-based income on borrower late fees, payment management activities, and certain marketing and enrollment services; and fees from providing software services.
Loan and Guaranty Servicing Income — Loan servicing fees are determined according to individual agreements with customers and are calculated based on the dollar value of loans, number of loans, or number of borrowers serviced for each customer. Guaranty servicing fees, generally, are calculated based on the number of loans serviced or amounts collected. Revenue is recognized when earned pursuant to applicable agreements, and when ultimate collection is assured.

 

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Other Fee-Based Income — Other fee-based income includes borrower late fee income, payment management fees, the sale of lists and print products, and subscription-based products and services. Borrower late fee income earned by the Company’s education lending subsidiaries is recognized when payments are collected from the borrower. Fees for payment management services are recognized over the period in which services are provided to customers. Revenue from the sale of lists and printed products is generally earned and recognized, net of estimated returns, upon shipment or delivery. Revenues from the sales of subscription-based products and services are recognized ratably over the term of the subscription. Subscription revenue received or receivable in advance of the delivery of services is included in deferred revenue.
Software Services — Software services income is determined from individual agreements with customers and includes license and maintenance fees associated with student loan software products. Computer and software consulting services are recognized over the period in which services are provided to customers.
Operating Expenses
Operating expenses includes indirect costs incurred to generate and acquire student loans, costs incurred to manage and administer the Company’s student loan portfolio and its financing transactions, costs incurred to service the Company’s student loan portfolio and the portfolios of third parties, costs incurred to provide tuition payment processing, campus commerce, enrollment, list management, software, and technical services to third parties, the depreciation and amortization of capital assets and intangible assets, and other general and administrative expenses. Operating expenses also includes employee termination benefits, lease termination costs, and the write-down of certain assets related to the Company’s September 2007 and January 2008 restructuring initiatives.
Three and nine months ended September 30, 2008 compared to the three and nine months ended September 30, 2007
Net Interest Income
                                                 
    Three months ended September 30,     Nine months ended September 30,  
    2008     2007     $ Change     2008     2007     $ Change  
Interest income:
                                               
Loan interest
  $ 284,468       437,251       (152,783 )     911,140       1,251,391       (340,251 )
Investment interest
    9,118       21,023       (11,905 )     29,914       61,231       (31,317 )
 
                                   
Total interest income
    293,586       458,274       (164,688 )     941,054       1,312,622       (371,568 )
Interest expense:
                                               
Interest on bonds and notes payable
    234,016       393,875       (159,859 )     791,621       1,112,263       (320,642 )
 
                                   
Net interest income
    59,570       64,399       (4,829 )     149,433       200,359       (50,926 )
Provision for loan losses
    7,000       18,340       (11,340 )     18,000       23,628       (5,628 )
 
                                   
Net interest income after provision for loan losses
  $ 52,570       46,059       6,511       131,433       176,731       (45,298 )
 
                                   
   
Net interest income decreased for the three and nine months ended September 30, 2008 compared to 2007 as a result of the compression in the core student loan spread as discussed in this Item 2 under “Asset Generation and Management Operating Segment — Results of Operations.” Core student loan spread was 0.93% and 1.20% for the nine months ended September 30, 2008 and 2007, respectively, and 1.02% and 1.05% for the three months ended September 30, 2008 and 2007, respectively. The decrease was also due to an overall decrease in cash held in 2008 compared to 2007 and lower interest rates in 2008. The decreases to net interest income were offset by the amount of variable-rate floor income the Company earned during these periods. During the three and nine months ended September 30, 2008, the Company earned $1.6 million and $41.7 million, respectively, of variable-rate floor income, as compared to $0.6 million of variable-rate floor income earned during both the three and nine months ended September 30, 2007.
   
Excluding an expense of $15.7 million in September 2007 to increase the Company’s allowance for loan losses related to the increase in risk share as a result of the elimination of the Exceptional Performer program in the third quarter of 2007, the provision for loan losses increased for the three and nine months ended September 30, 2008 compared to 2007. The provision for loan losses for federally insured loans increased as a result of the increase in risk share as a result of the loss of Exceptional Performer in September 2007. The provision for loan losses for non-federally insured loans increased primarily due to increases in delinquencies as a result of the continued weakening of the U.S. economy.

 

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Other Income
                                                 
    Three months ended September 30,     Nine months ended September 30,  
    2008     2007     $ Change     2008     2007     $ Change  
Loan and guaranty servicing income
  $ 30,633       33,040       (2,407 )     81,650       95,116       (13,466 )
Other fee-based income
    45,887       38,025       7,862       132,617       116,316       16,301  
Software services income
    4,217       5,426       (1,209 )     15,865       17,022       (1,157 )
Other income
    1,242       7,028       (5,786 )     4,298       14,048       (9,750 )
Gain (loss) on sale of loans
          492       (492 )     (47,426 )     3,288       (50,714 )
Derivative market value, foreign currency, and put option adjustments
    6,085       18,449       (12,364 )     (35,521 )     11,866       (47,387 )
Derivative settlements, net
    789       (2,336 )     3,125       45,989       7,100       38,889  
 
                                   
 
Total other income
  $ 88,853       100,124       (11,271 )     197,472       264,756       (67,284 )
 
                                   
   
“Loan and guaranty servicing income” decreased due to decreases in FFELP loan servicing income, non-federally insured loan servicing income, and guaranty servicing income as further discussed in this Item 2 under “Student Loan and Guaranty Servicing Operating Segment — Results of Operations.”
   
“Other fee-based income” increased due to an increase in the number of managed tuition payment plans and an increase in campus commerce and related clients in the Tuition Payment Processing and Campus Commerce Operating Segment, as well as an increase in lead generation sales volume in the Enrollment Services and List Management Operating Segment.
   
“Software services income” decreased as the result of a reduction in the number of projects for existing customers and the loss of customers due to the legislative developments in the student loan industry throughout 2008 in the Software and Technical Services Operating Segment.
   
“Other income” decreased for the three and nine months ended September 30, 2008 compared to 2007 due to a gain of $3.9 million from the sale of an entity accounted for under the equity method in September 2007. In addition, an agreement with a third party ended during the third quarter of 2007 under which the Company provided administrative services to the third party for a fee. The remaining change is a result of a decrease in income earned on certain investment activities.
   
The Company recognized a loss of $47.5 million during the first quarter of 2008 as a result of the sale of $1.3 billion of student loans as further discussed in this Item 2 under “Asset Generation and Management Operating Segment — Results of Operations.”
   
The change in “derivative market value, foreign currency, and put option adjustments” was caused by the change in the fair value of the Company’s derivative portfolio and foreign currency rate fluctuations which are further discussed in Item 3, “Quantitative and Qualitative Disclosures about Market Risk.”
   
Further detail of the components of derivative settlements is included in Item 3, “Quantitative and Qualitative Disclosures about Market Risk.” The Company maintains an overall risk management strategy that incorporates the use of derivative instruments to reduce the economic effect of interest rate volatility. Management has structured all of the Company’s derivative transactions with the intent that each is economically effective; however, the Company’s derivative instruments do not qualify for hedge accounting under SFAS No. 133. Derivative settlements for each applicable period should be evaluated with the Company’s net interest income.
Operating Expenses
                                                 
    Three months ended September 30,     Nine months ended September 30,  
    2008     2007     $ Change     2008     2007     $ Change  
 
                                               
Salaries and benefits
  $ 44,739       55,757       (11,018 )     136,422       177,222       (40,800 )
Other expenses
    58,930       63,228       (4,298 )     168,065       183,638       (15,573 )
 
                                   
Operating expenses, excluding impairment and restructure charges
    103,669       118,985     $ (15,316 )     304,487       360,860     $ (56,373 )
 
                                           
 
                                               
Impairment expense
          39,444               18,834       39,444          
Restructure expense
          15,016               7,107       15,016          
 
                                       
 
                                               
Total operating expenses
  $ 103,669       173,445               330,428       415,320          
 
                                       
Excluding restructuring and impairment charges, operating expenses decreased $15.3 million and $56.4 million for the three and nine months ended September 30, 2008 compared to the same periods in 2007, respectively. The decreases are the result of cost savings from the September 2007 and January 2008 restructuring plans implemented by the Company. These plans resulted in the net reduction of approximately 700 positions in the Company’s overall workforce, leading to decreases in salaries and benefits and other expenses. The decrease is also a result of the Company capitalizing on the operating leverage of its business structure and strategies.

 

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Operating expenses for the three and nine months ended September 30, 2008 includes $2.8 million of certain severance and retention costs associated with additional strategic decisions made in the third quarter of 2008. These costs are not included in restructure expense in the above table.
Income Taxes
The Company’s effective tax rate was 37.0% and 117.7% for the three and nine months ended September 30, 2008, compared to 39.1% and 37.9% for the same periods in 2007. The 2008 year-to-date tax expense and effective tax rate is the result of the year-to-date pre-tax loss and the various state gross receipts taxes and other items which are not deductible for tax purposes.
Additional information on the Company’s results of operations is included with the discussion of the Company’s operating segments in this Item 2 under “Operating Segments”.
Financial Condition as of September 30, 2008 compared to December 31, 2007
                                 
    As of     As of        
    September 30,     December 31,     Change  
    2008     2007     Dollars     Percent  
Assets:
                               
Student loans receivable, net
  $ 26,376,269       26,736,122       (359,853 )     (1.3 )%
Cash, cash equivalents, and investments
    1,454,881       1,120,838       334,043       29.8  
Goodwill
    175,178       164,695       10,483       6.4  
Intangible assets, net
    83,565       112,830       (29,265 )     (25.9 )
Fair value of derivative instruments
    154,741       222,471       (67,730 )     (30.4 )
Other assets
    725,381       805,827       (80,446 )     (10.0 )
 
                       
Total assets
  $ 28,970,015       29,162,783       (192,768 )     (0.7 )%
 
                       
 
                               
Liabilities:
                               
Bonds and notes payable
  $ 28,004,835       28,115,829       (110,994 )     (0.4 )%
Fair value of derivative instruments
    22,929       5,885       17,044       289.6  
Other liabilities
    332,521       432,190       (99,669 )     (23.1 )
 
                       
Total liabilities
    28,360,285       28,553,904       (193,619 )     (0.7 )
 
                               
Shareholders’ equity
    609,730       608,879       851       0.1  
 
                       
Total liabilities and shareholders’ equity
  $ 28,970,015       29,162,783       (192,768 )     (0.7 )%
 
                       
The Company’s total assets decreased during 2008 primarily due to a decrease in student loans receivable as a result of a sale of $1.3 billion of student loans in 2008 as further discussed in this Item 2 under “Asset Generation and Management Operating Segment — Results of Operations” offset by loan originations and acquisitions, net of repayments and participations. Total liabilities decreased primarily due to a decrease in bonds and notes payable. This decrease is a result of the decrease in student loan funding obligations due to a decrease in the Company’s student loan portfolio offset by increased borrowings on the unsecured line of credit to provide equity funding support related to advances on the Company’s warehouse facilities.
OPERATING SEGMENTS
The Company has five operating segments as defined in SFAS No. 131 as follows: Student Loan and Guaranty Servicing, Tuition Payment Processing and Campus Commerce, Enrollment Services and List Management, Software and Technical Services, and Asset Generation and Management. The Company’s operating segments are defined by the products and services they offer or the types of customers they serve, and they reflect the manner in which financial information is currently evaluated by management. The accounting policies of the Company’s operating segments are the same as those described in the summary of significant accounting policies included in the Company’s consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007. Intersegment revenues are charged by a segment to another segment that provides the product or service. Intersegment revenues and expenses are included within each segment consistent with the income statement presentation provided to management. Changes in management structure or allocation methodologies and procedures may result in changes in reported segment financial information.

 

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The management reporting process measures the performance of the Company’s operating segments based on the management structure of the Company as well as the methodology used by management to evaluate performance and allocate resources. Management, including the Company’s chief operating decision maker, evaluates the performance of the Company’s operating segments based on their profitability. As discussed further below, management measures the profitability of the Company’s operating segments on the basis of “base net income.” Accordingly, information regarding the Company’s operating segments is provided based on “base net income.” The Company’s “base net income” is not a defined term within GAAP and may not be comparable to similarly titled measures reported by other companies. Unlike financial accounting, there is no comprehensive, authoritative guidance for management reporting.
In May 2007, the Company sold EDULINX, a Canadian student loan service provider and subsidiary of the Company. As a result of this transaction, the results of operations for EDULINX are reported as discontinued operations for all periods presented. The operating results of EDULINX were included in the Student Loan and Guaranty Servicing operating segment. The Company presents “base net income” excluding discontinued operations since the operations and cash flows of EDULINX have been eliminated from the ongoing operations of the Company. Therefore, the results of operations for the Student Loan and Guaranty Servicing segment exclude the operating results of EDULINX for all periods presented. See note 2 in the notes to the consolidated financial statements included in this Report for additional information concerning EDULINX’s detailed operating results that have been segregated from continuing operations and reported as discontinued operations.
Historically, the Company generated the majority of its revenue from net interest income earned in its Asset Generation and Management operating segment. In recent years, the Company has made several acquisitions that have expanded the Company’s products and services and has diversified its revenue — primarily from fee-based businesses. The Company currently offers a broad range of pre-college, in-college, and post-college products and services to students, families, schools, and financial institutions. These products and services help students and families plan and pay for their education and students plan their careers. The Company’s products and services are designed to simplify the education planning and financing process and are focused on providing value to students, families, and schools throughout the education life cycle. The Company continues to look for ways to diversify its sources of revenue, including those generated from businesses that are not dependent upon government programs, reducing legislative and political risk.
“Base net income” is the primary financial performance measure used by management to develop the Company’s financial plans, track results, and establish corporate performance targets and incentive compensation. While “base net income” is not a substitute for reported results under GAAP, the Company relies on “base net income” in operating its business because “base net income” permits management to make meaningful period-to-period comparisons of the operational and performance indicators that are most closely assessed by management. Management believes this information provides additional insight into the financial performance of the core business activities of the Company’s operating segments.
Accordingly, the tables presented below reflect “base net income” which is reviewed and utilized by management to manage the business for each of the Company’s operating segments. Reconciliation of the segment totals to the Company’s consolidated operating results in accordance with GAAP are also included in the tables below. Included below under “Non-GAAP Performance Measures” is further discussion regarding “base net income” and its limitations, including a table that details the differences between “base net income” and GAAP net income by operating segment.

 

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Segment Results and Reconciliations to GAAP
                                                                                 
    Three months ended September 30, 2008  
    Fee-Based                                              
    Student     Tuition     Enrollment                                             “Base net        
    Loan     Payment     Services     Software             Asset     Corporate             income”        
    and     Processing     and     and     Total     Generation     Activity     Eliminations     Adjustments     GAAP  
    Guaranty     and Campus     List     Technical     Fee-     and     and     and     to GAAP     Results of  
    Servicing     Commerce     Management     Services     Based     Management     Overhead     Reclassifications     Results     Operations  
 
                                                                               
Total interest income
  $ 304       396       6             706       290,039       2,010       (749 )     1,580       293,586  
Interest expense
                1             1       224,272       10,492       (749 )           234,016  
 
                                                           
Net interest income (loss)
    304       396       5             705       65,767       (8,482 )           1,580       59,570  
 
                                                                               
Less provision for loan losses
                                  7,000                         7,000  
 
                                                           
Net interest income (loss) after provision for loan losses
    304       396       5             705       58,767       (8,482 )           1,580       52,570  
 
                                                           
 
                                                                               
Other income (expense):
                                                                               
Loan and guaranty servicing income
    30,769                         30,769       (136 )                       30,633  
Other fee-based income
          11,861       29,859             41,720       4,167                         45,887  
Software services income
                      4,217       4,217                               4,217  
Other income
    6       1                   7       (88 )     1,323                   1,242  
Intersegment revenue
    18,402       58       2       1,660       20,122             15,671       (35,793 )            
Derivative market value, foreign currency, and put option adjustments
                                                    6,085       6,085  
Derivative settlements, net
                                  789                         789  
 
                                                           
Total other income (expense)
    49,177       11,920       29,861       5,877       96,835       4,732       16,994       (35,793 )     6,085       88,853  
 
                                                           
 
                                                                               
Operating expenses:
                                                                               
Salaries and benefits
    13,876       6,236       5,805       4,138       30,055       1,980       14,179       (1,952 )     477       44,739  
Other expenses
    10,632       2,132       20,416       568       33,748       5,354       13,477       (247 )     6,598       58,930  
Intersegment expenses
    11,940       288       1,509       826       14,563       18,200       831       (33,594 )            
 
                                                           
Total operating expenses
    36,448       8,656       27,730       5,532       78,366       25,534       28,487       (35,793 )     7,075       103,669  
 
                                                           
 
                                                                               
Income (loss) before income taxes
    13,033       3,660       2,136       345       19,174       37,965       (19,975 )           590       37,754  
Income tax expense (benefit) (a)
    4,823       1,354       790       128       7,095       14,047       (7,391 )           218       13,969  
 
                                                           
Net income (loss) from continuing operations
    8,210       2,306       1,346       217       12,079       23,918       (12,584 )           372       23,785  
Income from discontinued operations, net of tax
                                                           
 
                                                           
Net income (loss)
  $ 8,210       2,306       1,346       217       12,079       23,918       (12,584 )           372       23,785  
 
                                                           
 
                                                                               
 
                                                                               
(a)     Beginning in 2008, the consolidated effective tax rate for each applicable quarterly period is used to calculate income taxes for each operating segment.
 
                                                                               
Three months ended September 30, 2008:
                                                                               
Before Tax Operating Margin
    26.3 %     29.7 %     7.2 %     5.9 %     19.7 %     59.8 %                                
 
                                                                               
Three months ended September 30, 2007:
                                                                               
Before Tax Operating Margin — excluding restructure expense, impairment expense, and provision for loan losses related to the loss of Exceptional Performer
    42.9 %     36.3 %     7.3 %     26.7 %     32.3 %     49.2 %                                

 

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    Three months ended September 30, 2007  
    Fee-Based                                              
    Student     Tuition     Enrollment                                             “Base net        
    Loan     Payment     Services     Software             Asset     Corporate             income”        
    and     Processing     and     and     Total     Generation     Activity     Eliminations     Adjustments     GAAP  
    Guaranty     and Campus     List     Technical     Fee-     and     and     and     to GAAP     Results of  
    Servicing     Commerce     Management     Services     Based     Management     Overhead     Reclassifications     Results     Operations  
 
                                                                               
Total interest income
  $ 1,182       990       110             2,282       454,053       1,875       (533 )     597       458,274  
Interest expense
                1             1       384,793       9,614       (533 )           393,875  
 
                                                           
Net interest income (loss)
    1,182       990       109             2,281       69,260       (7,739 )           597       64,399  
 
                                                                               
Less provision for loan losses
                                  18,340                         18,340  
 
                                                           
Net interest income (loss) after provision for loan losses
    1,182       990       109             2,281       50,920       (7,739 )           597       46,059  
 
                                                           
 
                                                                               
Other income (expense):
                                                                               
Loan and guaranty servicing income
    32,870                         32,870       170                         33,040  
Other fee-based income
          10,316       23,471             33,787       3,526       712                   38,025  
Software services income
                169       5,257       5,426                               5,426  
Other income
          31                   31       1,181       5,816                   7,028  
Gain on sale of loans
                                  492                         492  
Intersegment revenue
    22,237       168       (37 )     4,805       27,173             1,492       (28,665 )            
Derivative market value, foreign currency, and put option adjustments
                                                    18,449       18,449  
Derivative settlements, net
                                  (4,065 )     1,729                   (2,336 )
 
                                                           
Total other income (expense)
    55,107       10,515       23,603       10,062       99,287       1,304       9,749       (28,665 )     18,449       100,124  
 
                                                           
 
                                                                               
Operating expenses:
                                                                               
Salaries and benefits
    21,961       5,312       8,095       6,537       41,905       6,154       9,691       2,292       503       60,545  
Restructure expense- severance and contract termination costs
    1,231             737       58       2,026       1,921       1,009       (4,956 )            
Impairment expense
                11,401             11,401       28,291       9,812                   49,504  
Other expenses
    8,565       2,029       13,809       689       25,092       7,429       19,822       168       10,885       63,396  
Intersegment expenses
    1,613       (15 )     67       147       1,812       20,924       3,433       (26,169 )            
 
                                                           
Total operating expenses
    33,370       7,326       34,109       7,431       82,236       64,719       43,767       (28,665 )     11,388       173,445  
 
                                                           
 
                                                                               
Income (loss) before income taxes
    22,919       4,179       (10,397 )     2,631       19,332       (12,495 )     (41,757 )           7,658       (27,262 )
Income tax expense (benefit) (a)
    8,709       1,588       (3,951 )     1,000       7,346       (4,748 )     (16,233 )           2,971       (10,664 )
 
                                                           
Net income (loss) from continuing operations
    14,210       2,591       (6,446 )     1,631       11,986       (7,747 )     (25,524 )           4,687       (16,598 )
Income (loss) from discontinued operations, net of tax
                                                    909       909  
 
                                                           
Net income (loss)
  $ 14,210       2,591       (6,446 )     1,631       11,986       (7,747 )     (25,524 )           5,596       (15,689 )
 
                                                           
     
(a)  
Income taxes are based on 38% of net income (loss) before tax for the individual operating segment.

 

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    Nine months ended September 30, 2008  
    Fee-Based                                              
    Student     Tuition     Enrollment                                             “Base net        
    Loan     Payment     Services     Software             Asset     Corporate             income”        
    and     Processing     and     and     Total     Generation     Activity     Eliminations     Adjustments     GAAP  
    Guaranty     and Campus     List     Technical     Fee-     and     and     and     to GAAP     Results of  
    Servicing     Commerce     Management     Services     Based     Management     Overhead     Reclassifications     Results     Operations  
Total interest income
  $ 1,160       1,471       16             2,647       892,690       4,781       (1,389 )     42,325       941,054  
Interest expense
                3             3       762,689       30,318       (1,389 )           791,621  
 
                                                           
Net interest income (loss)
    1,160       1,471       13             2,644       130,001       (25,537 )           42,325       149,433  
 
                                                                               
Less provision for loan losses
                                  18,000                         18,000  
 
                                                           
Net interest income (loss) after provision for loan losses
    1,160       1,471       13             2,644       112,001       (25,537 )           42,325       131,433  
 
                                                           
 
                                                                               
Other income (expense):
                                                                               
Loan and guaranty servicing income
    81,624                         81,624       26                         81,650  
Other fee-based income
          35,975       83,148             119,123       13,494                         132,617  
Software services income
                37       15,828       15,865                               15,865  
Other income
    44       5                   49       293       3,956                   4,298  
Loss on sale of loans
                                  (47,426 )                       (47,426 )
Intersegment revenue
    57,008       242       2       4,993       62,245             46,844       (109,089 )            
Derivative market value, foreign currency, and put option adjustments
                                  466                   (35,987 )     (35,521 )
Derivative settlements, net
                                  55,954                   (9,965 )     45,989  
 
                                                           
Total other income (expense)
    138,676       36,222       83,187       20,821       278,906       22,807       50,800       (109,089 )     (45,952 )     197,472  
 
                                                           
 
                                                                               
Operating expenses:
                                                                               
Salaries and benefits
    40,365       17,450       18,701       14,031       90,547       6,157       41,581       1,323       2,523       142,131  
Restructure expense — severance and contract termination costs
    747             282       487       1,516       1,845       3,746       (7,107 )            
Impairment expense
    5,074                         5,074       9,351       4,409                   18,834  
Other expenses
    27,130       6,743       55,863       1,901       91,637       15,793       42,263       51       19,719       169,463  
Intersegment expenses
    35,040       1,045       4,936       1,562       42,583       57,754       3,019       (103,356 )            
 
                                                           
Total operating expenses
    108,356       25,238       79,782       17,981       231,357       90,900       95,018       (109,089 )     22,242       330,428  
 
                                                           
 
                                                                               
Income (loss) before income taxes
    31,480       12,455       3,418       2,840       50,193       43,908       (69,755 )           (25,869 )     (1,523 )
Income tax expense (benefit) (a)
    10,542       4,081       1,187       902       16,712       15,889       (22,824 )           (7,984 )     1,793  
 
                                                           
Net income (loss) from continuing operations
    20,938       8,374       2,231       1,938       33,481       28,019       (46,931 )           (17,885 )     (3,316 )
Income from discontinued operations, net of tax
                                                    981       981  
 
                                                           
Net income (loss)
  $ 20,938       8,374       2,231       1,938       33,481       28,019       (46,931 )           (16,904 )     (2,335 )
 
                                                           
 
                                                                               
(a)     Beginning in 2008, the consolidated effective tax rate for each applicable quarterly period is used to calculate income taxes for each operating segment.
 
 
                                                                               
Nine months ended September 30, 2008:
                                                                               
Before Tax Operating Margin — excluding restructure expense, impairment expense, and the loss on sale of loans during the first quarter of 2008
    26.7 %     33.0 %     4.4 %     16.0 %     20.2 %     56.3 %                                
 
                                                                               
Nine months ended September, 2007:
                                                                               
Before Tax Operating Margin — excluding restructure expense, impairment expense, and provision for loan losses related to the loss of Exceptional Performer
    35.6 %     36.0 %     7.0 %     26.9 %     27.6 %     53.7 %                                

 

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    Nine months ended September 30, 2007  
    Fee-Based                                              
    Student     Tuition     Enrollment                                             “Base net        
    Loan     Payment     Services     Software             Asset     Corporate             income”        
    and     Processing     and     and     Total     Generation     Activity     Eliminations     Adjustments     GAAP  
    Guaranty     and Campus     List     Technical     Fee-     and     and     and     to GAAP     Results of  
    Servicing     Commerce     Management     Services     Based     Management     Overhead     Reclassifications     Results     Operations  
Total interest income
  $ 4,607       2,670       290       18       7,585       1,301,947       6,230       (3,737 )     597       1,312,622  
Interest expense
          7       5             12       1,084,792       31,196       (3,737 )           1,112,263  
 
                                                           
Net interest income (loss)
    4,607       2,663       285       18       7,573       217,155       (24,966 )           597       200,359  
 
                                                                               
Less provision for loan losses
                                  23,628                         23,628  
 
                                                           
Net interest income (loss) after provision for loan losses
    4,607       2,663       285       18       7,573       193,527       (24,966 )           597       176,731  
 
                                                           
 
                                                                               
Other income (expense):
                                                                               
Loan and guaranty servicing income
    94,828                         94,828       288                         95,116  
Other fee-based income
          31,492       73,341             104,833       10,511       972                   116,316  
Software services income
                456       16,566       17,022                               17,022  
Other income
    11       59                   70       4,329       9,649                   14,048  
Gain on sale of loans
                                  3,288                         3,288  
Intersegment revenue
    58,821       508       891       13,026       73,246             7,608       (80,854 )            
Derivative market value, foreign currency, and put option adjustments
                                                    11,866       11,866  
Derivative settlements, net
                                  (4,950 )     12,050                   7,100  
 
                                                           
Total other income (expense)
    153,660       32,059       74,688       29,592       289,999       13,466       30,279       (80,854 )     11,866       264,756  
 
                                                           
 
                                                                               
Operating expenses:
                                                                               
Salaries and benefits
    66,988       15,312       26,486       18,869       127,655       20,600       34,669       (2,370 )     1,456       182,010  
Restructure expense- severance an dcontract termination costs
    1,231             737       58       2,026       1,921       1,009       (4,956 )              
Impairment expense
                11,401             11,401       28,291       9,812                   49,504  
Other expenses
    26,219       6,522       42,957       2,224       77,922       22,940       58,762       168       24,014       183,806  
Intersegment expenses
    8,681       384       252       550       9,867       59,594       4,235       (73,696 )            
 
                                                           
Total operating expenses
    103,119       22,218       81,833       21,701       228,871       133,346       108,487       (80,854 )     25,470       415,320  
 
                                                           
 
                                                                               
Income (loss) before income taxes
    55,148       12,504       (6,860 )     7,909       68,701       73,647       (103,174 )           (13,007 )     26,167  
Income tax expense (benefit) (a)
    20,956       4,752       (2,607 )     3,006       26,107       27,986       (40,059 )           (4,128 )     9,906  
 
                                                           
Net income (loss) from continuing operations
    34,192       7,752       (4,253 )     4,903       42,594       45,661       (63,115 )           (8,879 )     16,261  
Income (loss) from discontinued operations, net of tax
                                                    (2,416 )     (2,416 )
 
                                                           
Net income (loss)
  $ 34,192       7,752       (4,253 )     4,903       42,594       45,661       (63,115 )           (11,295 )     13,845  
 
                                                           
     
(a)  
Income taxes are based on 38% of net income before tax for the individual operating segment.
Non-GAAP Performance Measures
In accordance with the rules and regulations of the Securities and Exchange Commission (“SEC”), the Company prepares financial statements in accordance with generally accepted accounting principles (“GAAP”). In addition to evaluating the Company’s GAAP-based financial information, management also evaluates the Company’s operating segments on a non-GAAP performance measure referred to as “base net income” for each operating segment. While “base net income” is not a substitute for reported results under GAAP, the Company relies on “base net income” to manage each operating segment because management believes these measures provide additional information regarding the operational and performance indicators that are most closely assessed by management.

 

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“Base net income” is the primary financial performance measure used by management to develop financial plans, allocate resources, track results, evaluate performance, establish corporate performance targets, and determine incentive compensation. Accordingly, financial information is reported to management on a “base net income” basis by operating segment, as these are the measures used regularly by the Company’s chief operating decision maker. The Company’s board of directors utilizes “base net income” to set performance targets and evaluate management’s performance. The Company also believes analysts, rating agencies, and creditors use “base net income” in their evaluation of the Company’s results of operations. While “base net income” is not a substitute for reported results under GAAP, the Company utilizes “base net income” in operating its business because “base net income” permits management to make meaningful period-to-period comparisons by eliminating the temporary volatility in the Company’s performance that arises from certain items that are primarily affected by factors beyond the control of management. Management believes “base net income” provides additional insight into the financial performance of the core business activities of the Company’s operations.
Limitations of “Base Net Income”
While GAAP provides a uniform, comprehensive basis of accounting, for the reasons discussed above, management believes that “base net income” is an important additional tool for providing a more complete understanding of the Company’s results of operations. Nevertheless, “base net income” is subject to certain general and specific limitations that investors should carefully consider. For example, as stated above, unlike financial accounting, there is no comprehensive, authoritative guidance for management reporting. The Company’s “base net income” is not a defined term within GAAP and may not be comparable to similarly titled measures reported by other companies. Investors, therefore, may not be able to compare the Company’s performance with that of other companies based upon “base net income”. “Base net income” results are only meant to supplement GAAP results by providing additional information regarding the operational and performance indicators that are most closely monitored and used by the Company’s management and board of directors to assess performance and information which the Company believes is important to analysts, rating agencies, and creditors.
Other limitations of “base net income” arise from the specific adjustments that management makes to GAAP results to derive “base net income” results. These differences are described below.

 

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The adjustments required to reconcile from the Company’s “base net income” measure to its GAAP results of operations relate to differing treatments for derivatives, foreign currency transaction adjustments, discontinued operations, and certain other items that management does not consider in evaluating the Company’s operating results. The following table reflects adjustments associated with these areas by operating segment and Corporate Activity and Overhead:
                                                         
    Student     Tuition     Enrollment                          
    Loan     Payment     Services     Software     Asset     Corporate        
    and     Processing     and     and     Generation     Activity        
    Guaranty     and Campus     List     Technical     and     and        
    Servicing     Commerce     Management     Services     Management     Overhead     Total  
    Three months ended September 30, 2008  
     
Derivative market value, foreign currency, and put option adjustments
  $                         (9,030 )     2,945       (6,085 )
Amortization of intangible assets
    1,165       1,889       3,258       286                   6,598  
Compensation related to business combinations
                                  477       477  
Variable-rate floor income, net of settlements on derivatives
                            (1,580 )           (1,580 )
Income (loss) from discontinued operations, net of tax
                                         
Net tax effect (a)
    (432 )     (699 )     (1,205 )     (106 )     3,926       (1,266 )     218  
 
                                         
 
Total adjustments to GAAP
  $ 733       1,190       2,053       180       (6,684 )     2,156       (372 )
 
                                         
 
                                                       
    Three months ended September 30, 2007
     
 
                                                       
Derivative market value, foreign currency, and put option adjustments
  $                         (20,017 )     1,568       (18,449 )
Amortization of intangible assets
    1,350       1,434       6,442       287       1,372             10,885  
Compensation related to business combinations
                                  503       503  
Variable-rate floor income, net of settlements on derivatives
                            (597 )           (597 )
Income (loss) from discontinued operations, net of tax
    (909 )                                   (909 )
Net tax effect (a)
    (513 )     (545 )     (2,448 )     (109 )     7,312       (726 )     2,971  
 
                                         
 
Total adjustments to GAAP
  $ (72 )     889       3,994       178       (11,930 )     1,345       (5,596 )
 
                                         
 
                                                       
    Nine months ended September 30, 2008
     
 
                                                       
Derivative market value, foreign currency, and put option adjustments
  $                         32,504       3,483       35,987  
Amortization of intangible assets
    3,586       5,937       9,193       858       145             19,719  
Compensation related to business combinations
                                  2,523       2,523  
Variable-rate floor income, net of settlements on derivatives
                            (32,360 )           (32,360 )
Income (loss) from discontinued operations, net of tax
    (981 )                                   (981 )
Net tax effect (a)
    (1,182 )     (1,954 )     (3,045 )     (284 )     548       (2,067 )     (7,984 )
 
                                         
 
Total adjustments to GAAP
  $ 1,423       3,983       6,148       574       837       3,939       16,904  
 
                                         
 
                                                       
    Nine months ended September 30, 2007
     
 
                                                       
Derivative market value, foreign currency, and put option adjustments
  $                         (7,801 )     (4,065 )     (11,866 )
Amortization of intangible assets
    3,744       4,372       9,797       904       5,197             24,014  
Compensation related to business combinations
                                  1,456       1,456  
Variable-rate floor income, net of settlements on derivatives
                            (597 )           (597 )
Income (loss) from discontinued operations, net of tax
    2,416                                     2,416  
Net tax effect (a)
    (1,423 )     (1,661 )     (3,723 )     (343 )     1,216       1,806       (4,128 )
 
                                         
 
Total adjustments to GAAP
  $ 4,737       2,711       6,074       561       (1,985 )     (803 )     11,295  
 
                                         
     
(a)  
Beginning in 2008, tax effect is computed using the Company’s consolidated effective tax rate for each applicable quarterly period. In prior periods, tax effect was computed at 38%. The change in the value of the put options for prior periods (included in Corporate Activity and Overhead) was not tax effected as this is not deductible for income tax purposes.
Differences between GAAP and “Base Net Income”
Management’s financial planning and evaluation of operating results does not take into account the following items because their volatility and/or inherent uncertainty affect the period-to-period comparability of the Company’s results of operations. A more detailed discussion of the differences between GAAP and “base net income” follows.

 

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Derivative market value, foreign currency, and put option adjustments: “Base net income” excludes the periodic unrealized gains and losses that are caused by the change in fair value on derivatives used in the Company’s risk management strategy in which the Company does not qualify for “hedge treatment” under GAAP. Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”), requires that changes in fair value of derivative instruments be recognized currently in earnings unless specific hedge accounting criteria, as specified by SFAS No. 133, are met. 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. Derivative instruments primarily used by the Company include interest rate swaps, basis swaps, and cross-currency interest rate swaps. Management has structured all of the Company’s derivative transactions with the intent that each is economically effective. However, the Company does not qualify its derivatives for “hedge treatment” as defined by SFAS No. 133, and the stand-alone derivative must be marked-to-market in the income statement with no consideration for the corresponding change in fair value of the hedged item. The Company believes these point-in-time estimates of asset and liability values that are subject to interest rate fluctuations make it difficult to evaluate the ongoing results of operations against its business plan and affect the period-to-period comparability of the results of operations. Included in “base net income” are the economic effects of the Company’s derivative instruments, which includes any cash paid or received being recognized as an expense or revenue upon actual derivative settlements. These settlements are included in “Derivative market value, foreign currency, and put option adjustments and derivative settlements, net” on the Company’s consolidated statements of operations.
“Base net income” excludes the foreign currency transaction gains or losses caused by the re-measurement of the Company’s Euro-denominated bonds to U.S. dollars. In connection with the issuance of the Euro-denominated bonds, the Company has entered into cross-currency interest rate swaps. Under the terms of these agreements, the principal payments on the Euro-denominated notes will effectively be paid at the exchange rate in effect at the issuance date of the bonds. The cross-currency interest rate swaps also convert the floating rate paid on the Euro-denominated bonds (EURIBOR index) to an index based on LIBOR. Included in “base net income” are the economic effects of any cash paid or received being recognized as an expense or revenue upon actual settlements of the cross-currency interest rate swaps. These settlements are included in “Derivative market value, foreign currency, and put option adjustments and derivative settlements, net” on the Company’s consolidated statements of operations. However, the gains or losses caused by the re-measurement of the Euro-denominated bonds to U.S. dollars and the change in market value of the cross-currency interest rate swaps are excluded from “base net income” as the Company believes the point-in-time estimates of value that are subject to currency rate fluctuations related to these financial instruments make it difficult to evaluate the ongoing results of operations against the Company’s business plan and affect the period-to-period comparability of the results of operations. The re-measurement of the Euro-denominated bonds correlates with the change in fair value of the cross-currency interest rate swaps. However, the Company will experience unrealized gains or losses related to the cross-currency interest rate swaps if the two underlying indices (and related forward curve) do not move in parallel.
“Base net income” also excludes the change in fair value of put options issued by the Company for certain business acquisitions. The put options are valued by the Company each reporting period using a Black-Scholes pricing model. Therefore, the fair value of these options is primarily affected by the strike price and term of the underlying option, the Company’s current stock price, and the dividend yield and volatility of the Company’s stock. The Company believes these point-in-time estimates of value that are subject to fluctuations make it difficult to evaluate the ongoing results of operations against the Company’s business plans and affects the period-to-period comparability of the results of operations.
The gains and/or losses included in “Derivative market value, foreign currency, and put option adjustments and derivative settlements, net” on the Company’s consolidated statements of operations are primarily caused by interest rate and currency volatility, changes in the value of put options based on the inputs used in the Black-Scholes pricing model, as well as the volume and terms of put options and of derivatives not receiving hedge treatment. “Base net income” excludes these unrealized gains and losses and isolates the effect of interest rate, currency, and put option volatility on the fair value of such instruments during the period. Under GAAP, the effects of these factors on the fair value of the put options and the derivative instruments (but not the underlying hedged item) tend to show more volatility in the short term.
Amortization of intangible assets: “Base net income” excludes the amortization of acquired intangibles, which arises primarily from the acquisition of definite life intangible assets in connection with the Company’s acquisitions, since the Company feels that such charges do not drive the Company’s operating performance on a long-term basis and can affect the period-to-period comparability of the results of operations.
Compensation related to business combinations: The Company has structured certain business combinations in which the consideration paid has been dependent on the sellers’ continued employment with the Company. As such, the value of the consideration paid is recognized as compensation expense by the Company over the term of the applicable employment agreement. “Base net income” excludes this expense because the Company believes such charges do not drive its operating performance on a long-term basis and can affect the period-to-period comparability of the results of operations. If the Company did not enter into the employment agreements in connection with the acquisition, the amount paid to these former shareholders of the acquired entity would have been recorded by the Company as additional consideration of the acquired entity, thus, not having an effect on the Company’s results of operations.
Variable-rate floor income, net of settlements on derivatives: Loans that reset annually on July 1 can generate excess spread income compared with the rate based on the special allowance payment formula in declining interest rate environments. The Company refers to this additional income as variable-rate floor income. The Company excludes variable-rate floor income, net of settlements paid on derivatives used to hedge student loan assets earning variable-rate floor income, from its “base net income” since the timing and amount of variable-rate floor income (if any) is uncertain, it has been eliminated by legislation for all loans originated on and after April 1, 2006, and it is in excess of expected spreads. In addition, because variable-rate floor income is subject to the underlying rate for the subject loans being reset annually on July 1, it is a factor beyond the Company’s control which can affect the period-to-period comparability of results of operations.
Discontinued operations: In May 2007, the Company sold EDULINX. As a result of this transaction, the results of operations for EDULINX are reported as discontinued operations for all periods presented. The Company presents “base net income” excluding discontinued operations since the operations and cash flows of EDULINX have been eliminated from the ongoing operations of the Company.

 

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STUDENT LOAN AND GUARANTY SERVICING OPERATING SEGMENT — RESULTS OF OPERATIONS
The Student Loan and Guaranty Servicing segment provides for the servicing of the Company’s student loan portfolios and the portfolios of third parties and servicing provided to guaranty agencies. The servicing and business process outsourcing activities include loan origination activities, application processing, borrower updates, payment processing, due diligence procedures, and claim processing. These activities are performed internally for the Company’s portfolio in addition to generating fee revenue when performed for third-party clients. The guaranty servicing, servicing support, and business process outsourcing activities include providing software and data center services, borrower and loan updates, default aversion tracking services, claim processing services, and post-default collection services to guaranty agencies.
Student Loan Servicing Volumes
                                 
    As of     As of  
    September 30,     September 30,  
    2008     2007  
    Dollar     Percent     Dollar     Percent  
    (dollars in millions)  
Company
  $ 25,248 (a)     70.3 %   $ 25,491       76.1 %
Third Party
    10,661 (b)     29.7       8,026       23.9  
 
                       
 
                               
 
  $ 35,909       100.0 %   $ 33,517       100.0 %
 
                       
     
(a)  
Approximately $410 million of these loans were disbursed on or after May 1, 2008 and are eligible to be sold to the Department of Education pursuant to its Purchase Commitment Program. The Department obtains all rights to service loans which it purchases as part of this program.
 
(b)  
Approximately $671 million of these loans were disbursed on or after May 1, 2008 and may be eligible to be sold to the Department of Education pursuant to its Purchase Commitment Program. The Department obtains all rights to service loans which it purchases as part of this program.
Three and nine months ended September 30, 2008 compared to the three and nine months ended September 30, 2007
                                                 
    Three months ended September 30,     Nine months ended September 30,  
    2008     2007     $ Change     2008     2007     $ Change  
Net interest income after the provision for loan losses
  $ 304       1,182       (878 )     1,160       4,607       (3,447 )
 
                                               
Loan and guaranty servicing income
    30,769       32,870       (2,101 )     81,624       94,828       (13,204 )
Other income
    6             6       44       11       33  
Intersegment revenue
    18,402       22,237       (3,835 )     57,008       58,821       (1,813 )
 
                                   
Total other income
    49,177       55,107       (5,930 )     138,676       153,660       (14,984 )
 
                                               
Salaries and benefits
    13,876       21,961       (8,085 )     40,365       66,988       (26,623 )
Restructure expense — severance and contract termination costs
          1,231       (1,231 )     747       1,231       (484 )
Impairment expense
                      5,074             5,074  
Other expenses
    10,632       8,565       2,067       27,130       26,219       911  
Intersegment expenses
    11,940       1,613       10,327       35,040       8,681       26,359  
 
                                   
Total operating expenses
    36,448       33,370       3,078       108,356       103,119       5,237  
 
                                   
 
“Base net income” before income taxes
    13,033       22,919       (9,886 )     31,480       55,148       (23,668 )
Income tax expense
    4,823       8,709       (3,886 )     10,542       20,956       (10,414 )
 
                                   
 
“Base net income”
  $ 8,210       14,210       (6,000 )     20,938       34,192       (13,254 )
 
                                   
 
                                               
Before Tax Operating Margin
    26.3 %     40.7 %             22.5 %     34.8 %        
 
                                               
Before Tax Operating Margin — excluding restructure expense and impairment expense
    26.3 %     42.9 %             26.7 %     35.6 %        
Net interest income after the provision for loan losses. Investment income decreased as a result of an overall decrease in cash held in 2008 compared to 2007, as well as lower interest rates.

 

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Loan and guaranty servicing income. Loan and guaranty servicing income for the three and nine months ended September 30, 2008 decreased from the same periods in 2007 as follows:
                                                                 
    Three months ended September 30,     Nine months ended September 30,  
    2008     2007     $ Change     % Change     2008     2007     $ Change     % Change  
 
Origination and servicing of FFEL Program loans
  $ 14,041       14,785       (744 )     (5.0 )%   $ 38,854       42,689       (3,835 )     (9.0 )%
 
                                                               
Origination and servicing of non-federally insured student loans
    2,016       3,173       (1,157 )     (36.5 )     6,159       7,830       (1,671 )     (21.3 )
 
                                                               
Servicing and support outsourcing for guaranty agencies
    14,712       14,912       (200 )     (1.3 )     36,611       44,309       (7,698 )     (17.4 )
 
                                               
 
                                                               
Loan and guaranty servicing income to external parties
  $ 30,769       32,870       (2,101 )     (6.4 )%   $ 81,624       94,828       (13,204 )     (13.9 )%
 
                                               
   
FFELP loan servicing income decreased due to new servicing contracts being priced at lower rates and the loss of clients following the legislative developments in September 2007. This decrease is partially offset by an increase in loan servicing volume due to entering into new servicing contracts.
 
   
Non-federally insured loan servicing income decreased due to a significant customer ceasing to originate non-federally insured loans.
 
   
Servicing and support outsourcing for guaranty agencies decreased due to the termination of the Voluntary Flexible Agreement between the Department of Education and College Assist offset by an increase in the volume of guaranteed loans serviced and an increase in collections revenue. For the three months ended September 30, 2008, the change remained relatively flat due to an increase in collections revenue from rehabilitated loans.
Intersegment revenue. The decrease in intersegment revenue for the three and nine months ended September 30, 2008 compared to the same periods in 2007 was the result of a decrease in internal call center revenue due to the Company’s reduction in direct-to-consumer marketing offset by an increase in servicing volume and rates for internal customers.
Operating expenses. Operating expenses increased $3.1 million and $5.2 million for the three and nine months ended September 30, 2008 compared to the same period in 2007 as a result of the allocation of additional corporate overhead expenses, which were included in Corporate Activity and Overhead for the three and nine months ended September 30, 2007. Excluding restructuring and impairment charges and the increase in expenses associated with the variation in allocation methodologies, operating expenses decreased $1.7 million and $15.4 million for the three and nine months ended September 30, 2008 compared to the same period in 2007 as a result of cost savings from the Company’s September 2007 and January 2008 restructuring plans. Operating margins, excluding restructuring and impairment charges and the expenses associated with the variation in allocation methodologies, were 38.4% and 38.5% for the three and nine months ended September 30, 2008.

 

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TUITION PAYMENT PROCESSING AND CAMPUS COMMERCE OPERATING SEGMENT — RESULTS OF OPERATIONS
The Company’s Tuition Payment Processing and Campus Commerce operating segment provides products and services to help institutions and education seeking families manage the payment of education costs during the pre-college and college stages of the education life cycle. The Company provides actively managed tuition payment solutions, online payment processing, detailed information reporting, financial needs analysis, and data integration services to K-12 and higher educational institutions, families, and students. In addition, the Company provides customer-focused electronic transactions, information sharing, and account and bill presentment to colleges and universities.
Three and nine months ended September 30, 2008 compared to the three and nine months ended September 30, 2007
                                                 
    Three months ended September 30,     Nine months ended September 30,  
    2008     2007     $ Change     2008     2007     $ Change  
Net interest income after the provision for loan losses
  $ 396       990       (594 )     1,471       2,663       (1,192 )
Other fee-based income
    11,861       10,316       1,545       35,975       31,492       4,483  
Other income
    1       31       (30 )     5       59       (54 )
Intersegment revenue
    58       168       (110 )     242       508       (266 )
 
                                   
Total other income
    11,920       10,515       1,405       36,222       32,059       4,163  
 
                                   
 
Salaries and benefits
    6,236       5,312       924       17,450       15,312       2,138  
Other expenses
    2,132       2,029       103       6,743       6,522       221  
Intersegment expenses
    288       (15 )     303       1,045       384       661  
 
                                   
Total operating expenses
    8,656       7,326       1,330       25,238       22,218       3,020  
 
                                   
 
“Base net income” before income taxes
    3,660       4,179       (519 )     12,455       12,504       (49 )
Income tax expense
    1,354       1,588       (234 )     4,081       4,752       (671 )
 
                                   
 
“Base net income”
  $ 2,306       2,591       (285 )     8,374       7,752       622  
 
                                   
 
                                               
Before Tax Operating Margin
    29.7 %     36.3 %             33.0 %     36.0 %        
Net interest income after the provision for loan losses. Investment income decreased as a result of decreases in interest rates on cash held in 2008 compared to 2007.
Other fee-based income. Other fee-based income increased for the three and nine months ended September 30, 2008 compared to the same period in 2007 as a result of an increase in the number of managed tuition payment plans as well as an increase in campus commerce clients.
Operating expenses. Operating expenses increased for the three and nine months ended September 30, 2008 compared to the same period in 2007 as a result of incurring additional costs associated with salaries and benefits, as well as other expenses, to support the increase in the number of managed tuition payment plans and campus commerce clients. In addition, the Company continues to invest in products, services, and technology to meet customer needs and support continued revenue growth. These investments increased 2008 operating expenses compared to 2007.

 

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ENROLLMENT SERVICES AND LIST MANAGEMENT OPERATING SEGMENT — RESULTS OF OPERATIONS
The Company’s Enrollment Services and List Management segment provides a wide range of direct marketing products and services to help schools and businesses reach the middle school, high school, college bound high school, college, and young adult market places. In addition, this segment offers products and services that are focused on helping (i) students plan and prepare for life after high school and (ii) colleges recruit and retain students.
Three and nine months ended September 30, 2008 compared to the three and nine months ended September 30, 2007
                                                 
    Three months ended September 30,     Nine months ended September 30,  
    2008     2007     $ Change     2008     2007     $ Change  
Net interest income after the provision for loan losses
  $ 5       109       (104 )     13       285       (272 )
 
                                               
Other fee-based income
    29,859       23,471       6,388       83,148       73,341       9,807  
Software services income
          169       (169 )     37       456       (419 )
Intersegment revenue
    2       (37 )     39       2       891       (889 )
 
                                   
Total other income
    29,861       23,603       6,258       83,187       74,688       8,499  
 
                                   
 
Salaries and benefits
    5,805       8,095       (2,290 )     18,701       26,486       (7,785 )
Restructure expense — severance and contract termination costs
          737       (737 )     282       737       (455 )
Impairment expense
          11,401       (11,401 )           11,401       (11,401 )
Other expenses
    20,416       13,809       6,607       55,863       42,957       12,906  
Intersegment expenses
    1,509       67       1,442       4,936       252       4,684  
 
                                   
Total operating expenses
    27,730       34,109       (6,379 )     79,782       81,833       (2,051 )
 
                                   
 
“Base net income (loss)” before income taxes
    2,136       (10,397 )     12,533       3,418       (6,860 )     10,278  
Income tax expense (benefit)
    790       (3,951 )     4,741       1,187       (2,607 )     3,794  
 
                                   
 
“Base net income (loss)”
  $ 1,346       (6,446 )     7,792       2,231       (4,253 )     6,484  
 
                                   
 
                                               
Before Tax Operating Margin
    7.2 %     (43.8 %)             4.1 %     (9.1 %)        
 
                                               
Before Tax Operating Margin — excluding restructure and impairment expense
    7.2 %     7.3 %             4.4 %     7.0 %        
Other fee-based income. Other fee-based income increased as a result of an increase in lead generation volume and an increase in other enrollment products and services, such as test preparation study guides and online courses, admissions consulting, and essay and resume editing services. This increase in income was offset by a decrease due to the impacts of the legislative developments in the student loan industry on the list marketing services offered by this segment. In addition, the Company reduced the number of student recognition publications it plans to offer. Excluding the income associated with the list marketing services and student recognition publications, other fee-based income increased approximately $6.7 million, or 32.3%, and $18.4 million, or 31.6%, for the three and nine months ended September 30, 2008 compared to the same periods in 2007.
Operating expenses. Excluding restructure and impairment charges, operating expenses increased $5.8 million, or 26.2%, and $9.8 million, or 14.1%, for the three and nine months ended September 30, 2008 compared to the same periods in 2007 as a result of an increase in costs associated with providing lead generation services and the allocation of additional corporate overhead expenses, which were included in Corporate Activity and Overhead for the three and nine months ended September 30, 2007. The increases in operating expenses were offset as a result of cost savings from the September 2007 and January 2008 restructuring plans, resulting in the decrease in salaries and benefits of $2.3 million and $7.8 million for the three and nine months ended September 30, 2008 compared to the same periods in 2007. Excluding intersegment expenses and restructure and impairment charges, the before tax operating margin was 12.2% and 10.4% for the three and nine months ended September 30, 2008.

 

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SOFTWARE AND TECHNICAL SERVICES OPERATING SEGMENT — RESULTS OF OPERATIONS
The Software and Technical Services segment provides information technology products and full-service technical consulting, with core areas of business in educational loan software solutions, business intelligence, technical consulting services, and Enterprise Content Management (ECM) solutions.
Many of the Company’s customers receiving services in this segment have been negatively impacted as a result of the passage of the College Cost Reduction Act and the recent disruption in the capital markets. This impact could decrease the demand for products and services and affect this segment’s future revenue and profit margins.
Three and nine months ended September 30, 2008 compared to the three and nine months ended September 30, 2007
                                                 
    Three months ended September 30,     Nine months ended September 30,  
    2008     2007     $ Change     2008     2007     $ Change  
Net interest income after the provision for loan losses
  $                         18       (18 )
 
Software services income
    4,217       5,257       (1,040 )     15,828       16,566       (738 )
Intersegment revenue
    1,660       4,805       (3,145 )     4,993       13,026       (8,033 )
 
                                   
Total other income
    5,877       10,062       (4,185 )     20,821       29,592       (8,771 )
 
                                   
 
Salaries and benefits
    4,138       6,537       (2,399 )     14,031       18,869       (4,838 )
Restructure expense — severance and contract termination costs
          58       (58 )     487       58       429  
Other expenses
    568       689       (121 )     1,901       2,224       (323 )
Intersegment expenses
    826       147       679       1,562       550       1,012  
 
                                   
Total operating expenses
    5,532       7,431       (1,899 )     17,981       21,701       (3,720 )
 
                                   
 
“Base net income” before income taxes
    345       2,631       (2,286 )     2,840       7,909       (5,069 )
Income tax expense
    128       1,000       (872 )     902       3,006       (2,104 )
 
                                   
 
“Base net income”
  $ 217       1,631       (1,414 )     1,938       4,903       (2,965 )
 
                                   
 
                                               
Before Tax Operating Margin
    5.9 %     26.1 %             13.6 %     26.7 %        
 
                                               
Before Tax Operating Margin — excluding restructure expense
    5.9 %     26.7 %             16.0 %     26.9 %        
Software services income. Software services income decreased for the three and nine months ended September 30, 2008 compared to the same period in 2007 as the result of a reduction in the number of projects for existing customers and the loss of customers due to the legislative developments in the student loan industry throughout 2008.
Intersegment revenue. Intersegment revenue decreased for the three and nine months ended September 30, 2008 compared to the same periods in 2007 as a result of a decrease in projects for internal customers.
Operating expenses. The decrease in operating expenses was driven by a decrease in costs associated with salaries and benefits as a result of the decrease in projects for customers and the loss of customers due to legislative developments in the student loan industry. These decreases were partially offset by increases in operating expenses as a result of the allocation of additional corporate overhead expenses, which were included in Corporate Activity and Overhead for the three and nine months ended September 30, 2007. In addition, the Company continues to invest in new products and services to meet customer needs and expand product and service offerings. These investments increased 2008 operating expenses compared to 2007.

 

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ASSET GENERATION AND MANAGEMENT OPERATING SEGMENT — RESULTS OF OPERATIONS
The Asset Generation and Management segment includes the acquisition, management, and ownership of the Company’s student loan assets. Revenues are primarily generated from the Company’s earnings from the spread, referred to as the Company’s student loan spread, between the yield received on the student loan portfolio and the costs associated with originating, acquiring, financing, servicing, and managing the student loan portfolio. The Company generates student loan assets through direct origination or through acquisitions. The student loan assets are held in a series of education lending subsidiaries designed specifically for this purpose.
In addition to the student loan portfolio, all costs and activity associated with the generation of assets, funding of those assets, and maintenance of the debt transactions are included in this segment. This includes derivative activity and the related derivative market value and foreign currency adjustments. The Company is also able to leverage its capital market expertise by providing investment advisory services and other related services to third parties through a licensed broker-dealer subsidiary. Revenues and expenses for those functions are also included in the Asset Generation and Management segment.
Student Loan Portfolio
The table below outlines the components of the Company’s student loan portfolio:
                                 
    As of September 30, 2008     As of December 31, 2007  
    Dollars     Percent     Dollars     Percent  
Federally insured: (a) (b)
                               
Stafford
                               
Originated prior to 10/1/07
  $ 6,780,214       25.7 %   $ 6,624,009       24.8 %
Originated on or after 10/1/07
    689,097       2.6       101,901       0.4  
PLUS/SLS
                               
Originated prior to 10/1/07
    428,037       1.6       414,708       1.5  
Originated on or after 10/1/07
    85,066       0.3       15,233       0.1  
Consolidation
                               
Originated prior to 10/1/07
    17,427,448       66.2       18,646,993       69.8  
Originated on or after 10/1/07
    316,031       1.2       251,554       0.9  
Non-federally insured
    275,520       1.0       274,815       1.0  
 
                       
 
                               
Total
    26,001,413       98.6       26,329,213       98.5  
 
                               
Unamortized premiums and deferred origination costs
    423,926       1.6       452,501       1.7  
Allowance for loan losses:
                               
Allowance — federally insured
    (24,366 )     (0.1 )     (24,534 )     (0.1 )
Allowance — non-federally insured
    (24,704 )     (0.1 )     (21,058 )     (0.1 )
 
                       
 
  $ 26,376,269       100.0 %   $ 26,736,122       100.0 %
 
                       
     
(a)  
The College Cost Reduction Act reduced the yield on federally insured loans originated on or after October 1, 2007. As of September 30, 2008 and December 31, 2007, $221.6 million and $278.9 million, respectively, of federally insured student loans are excluded from the above table as these loans are accounted for as participation interests sold under an agreement with Union Bank which is further discussed in note 7 of the Company’s consolidated financial statements included in this Quarterly Report. As of September 30, 2008, $172.6 million of the loans accounted for as participation interests sold under this agreement were originated on or after October 1, 2007.
 
(b)  
As of September 30, 2008, $429.2 million of federally insured student loans were eligible to be sold or participated to the Department under the Department’s Loan Purchase Commitment and Participation Programs, of which $263.9 million were participated to the Department under the Participation Program.
Origination and Acquisition
The Company originates and acquires loans through various methods and channels including: (i) direct-to-consumer channel (in which the Company originates student loans directly with student and parent borrowers), (ii) campus based origination channels, and (iii) spot purchases.
The Company will originate or acquire loans through its campus based channel either directly under one of its brand names or through other originating lenders. In addition to its brands, the Company acquires student loans from lenders to whom the Company provides marketing and/or origination services established through various contracts. Branding partners are lenders for which the Company acts as a marketing agent in specified geographic areas. A forward flow lender is one for whom the Company provides origination services but provides no marketing services or whom simply agrees to sell loans to the Company under forward sale commitments.

 

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The following table sets forth the activity of loans originated or acquired through each of the Company’s channels:
                                 
    Three months ended September 30,     Nine months ended September 30,  
    2008     2007     2008     2007  
 
Beginning balance
  $ 25,612,126       25,746,000       26,329,213       23,414,468  
Direct channel:
                               
Consolidation loan originations
    44       914,842       69,073       2,815,791  
Less consolidation of existing portfolio
    (27 )     (537,539 )     (28,474 )     (1,450,326 )
 
                       
Net consolidation loan originations
    17       377,303       40,599       1,365,465  
Stafford/PLUS loan originations
    416,721       426,740       952,050       923,450  
Branding partner channel
    334,685       125,220       935,992       583,213  
Forward flow channel
    114,488       178,226       517,548       946,342  
Other channels
          24,373       55,922       791,087  
 
                       
 
                               
Total channel acquisitions
    865,911       1,131,862       2,502,111       4,609,557  
 
Repayments, claims, capitalized interest, participations, and other
    (369,940 )     (479,512 )     (1,255,183 )     (1,112,878 )
Consolidation loans lost to external parties
    (106,684 )     (200,719 )     (282,951 )     (627,473 )
Loans sold
          (17,661 )     (1,291,777 )     (103,704 )
 
                       
 
                               
Ending balance
  $ 26,001,413       26,179,970       26,001,413       26,179,970  
 
                       
The Company has significant financing needs that it meets through the capital markets, including the debt and secondary markets. Since August 2007, these markets have experienced unprecedented disruptions, which has had an adverse impact on the Company’s earnings and financial condition. Since the Company could not determine nor control the length of time or extent to which the capital markets would remain disrupted, it reduced its direct and indirect costs related to its asset generation activities and was more selective in pursuing origination activity, in both the school and direct to consumer channels. Accordingly, in January 2008, the Company suspended Consolidation and private student loan originations and, during the second quarter of 2008, exercised contractual rights to discontinue, suspend, or defer the acquisition of student loans in connection with substantially all of its branding and forward flow relationships. Prior to and in conjunction with exercising this right, during the first quarter of 2008, the Company accelerated the purchase of loans from certain branding partner and forward flow lenders of approximately $511 million.
During July 2008, the Company purchased approximately $440 million of student loans from certain branding partner and forward flow lenders of which such purchases were previously deferred. These loans were financed in the Company’s FFELP warehouse facility prior to the term-out of this agreement.
On May 7, 2008, the President signed into law the Ensuring Continued Access to Student Loans Act. This legislation contains provisions that expand the federal government’s support of financing the cost of higher education. Among other things, the Ensuring Continued Access to Student Loans Act :
   
Increases statutory limits on annual and aggregate borrowing for FFELP loans; and
 
   
Allows the Department to act as a secondary market and enter into agreements with lenders to purchase certain FFELP loans or participation interests in those loans.
As a result of this legislation, the Departments of Education and Treasury developed a plan to implement the Ensuring Continued Access to Student Loans Act. Among other things, this plan:
   
Allows the Department to purchase certain loans from lenders for the 2008-2009 academic year and offers lenders access to short-term liquidity; and
   
Commits to continue working with the FFELP community to explore programs to reengage the capital markets in the long-run.
On May 22, 2008, the Company announced that, as a result of the above plan, it would continue originating new federal student loans for the 2008-2009 academic year to all students regardless of the school they attend. On October 7, 2008, legislation was enacted to extend the Department’s authority to address FFELP student loans made for the 2009-2010 academic year and allowing for the extension of the Department’s Participation Program and Purchase Program from September 30, 2009 to September 30, 2010. Management of the Company is encouraged by these developments; however, until the Department provides additional details regarding the programs, the Company is unable to determine the full impact these programs will have on the Company’s origination volume.

 

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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 September 30,     Nine months ended September 30,  
    2008     2007     2008     2007  
 
Balance at beginning of period
  $ 47,909       27,140       45,592       26,003  
Provision for loan losses:
                               
Federally insured loans
    4,500       17,040       12,000       20,158  
Non-federally insured loans
    2,500       1,300       6,000       3,470  
 
                       
Total provision for loan losses
    7,000       18,340       18,000       23,628  
Charge-offs, net of recoveries:
                               
Federally insured loans
    (4,218 )     (1,327 )     (11,418 )     (3,852 )
Non-federally insured loans
    (1,621 )     (139 )     (2,354 )     (594 )
 
                       
Net charge-offs
    (5,839 )     (1,466 )     (13,772 )     (4,446 )
Sale of federally insured loans
                (750 )      
Sale of non-federally insured loans
                      (1,171 )
 
                       
Balance at end of period
  $ 49,070       44,014       49,070       44,014  
 
                       
Allocation of the allowance for loan losses:
                               
Federally insured loans
  $ 24,366       23,907       24,366       23,907  
Non-federally insured loans
    24,704       20,107       24,704       20,107  
 
                       
Total allowance for loan losses
  $ 49,070       44,014       49,070       44,014  
 
                       
 
                               
Net loan charge-offs as a percentage of average student loans
    0.090 %     0.023 %     0.070 %     0.024 %
Total allowance as a percentage of average student loans
    0.188 %     0.170 %     0.187 %     0.177 %
Total allowance as a percentage of ending balance of student loans
    0.189 %     0.168 %     0.189 %     0.168 %
Non-federally insured allowance as a percentage of the ending balance of non-federally insured loans
    8.966 %     7.995 %     8.966 %     7.995 %
Average student loans
  $ 26,035,006       25,866,660       26,220,486       24,799,585  
Ending balance of student loans
    26,001,413       26,179,970       26,001,413       26,179,970  
Ending balance of non-federally insured loans
    275,520       251,503       275,520       251,503  
The allowance for loan losses increased during the three and nine months ended September 30, 2008 compared to the same period in 2007 as a result of the elimination of the Exceptional Performer program. Due to the elimination of this program, the Company recorded an expense of $15.7 million in September 2007 to increase the Company’s allowance for loan losses related to the increase in risk share.
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 Company’s student loan delinquency amounts:
                                 
    As of September 30, 2008     As of December 31, 2007  
    Dollars     Percent     Dollars     Percent  
Federally Insured Loans:
                               
Loans in-school/grace/deferment(1)
  $ 8,250,265             $ 7,115,505          
Loans in forebearance(2)
    2,527,052               3,015,456          
Loans in repayment status:
                               
Loans current
    13,171,661       88.1 %     13,937,702       87.5 %
Loans delinquent 31-60 days(3)
    557,788       3.7       682,956       4.3  
Loans delinquent 61-90 days(3)
    267,665       1.8       353,303       2.2  
Loans delinquent 91 days or greater(4)
    951,462       6.4       949,476       6.0  
 
                       
Total loans in repayment
    14,948,576       100.0 %     15,923,437       100.0 %
 
                       
Total federally insured loans
  $ 25,725,893             $ 26,054,398          
 
                           
Non-Federally Insured Loans:
                               
Loans in-school/grace/deferment(1)
  $ 103,833             $ 111,946          
Loans in forebearance(2)
    8,921               12,895          
Loans in repayment status:
                               
Loans current
    154,130       94.7 %     142,851       95.3 %
Loans delinquent 31-60 days(3)
    3,005       1.9       3,450       2.3  
Loans delinquent 61-90 days(3)
    2,325       1.4       1,247       0.8  
Loans delinquent 91 days or greater(4)
    3,306       2.0       2,426       1.6  
 
                       
Total loans in repayment
    162,766       100.0 %     149,974       100.0 %
 
                       
Total non-federally insured loans
  $ 275,520             $ 274,815          
 
                           

 

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(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 that have gone into default and have been submitted to the guaranty agency for FFELP loans, or, if applicable, the insurer for non-federally insured loans, to process the claim for payment.
Student Loan Spread Analysis
The following table analyzes the student loan spread on the Company’s portfolio of student loans and represents the spread on assets earned in conjunction with the liabilities and derivative instruments used to fund the assets:
                                 
    Three months ended September 30,     Nine months ended September 30,  
    2008     2007     2008     2007  
Student loan yield
    5.38 %     7.83 %     5.69 %     7.87 %
Consolidation rebate fees
    (0.72 )     (0.76 )     (0.74 )     (0.77 )
Premium and deferred origination costs amortization
    (0.33 )     (0.36 )     (0.35 )     (0.36 )
 
                       
Student loan net yield
    4.33       6.71       4.60       6.74  
Student loan cost of funds (a)
    (3.29 )     (5.65 )     (3.50 )     (5.54 )
 
                       
Student loan spread
    1.04       1.06       1.10       1.20  
Variable-rate floor income, net of settlements on derivatives (b)
    (0.02 )     (0.01 )     (0.17 )      
 
                       
 
                               
Core student loan spread
    1.02 %     1.05 %     0.93 %     1.20 %
 
                       
 
                               
Average balance of student loans
  $ 26,035,006       25,866,660       26,220,486       24,799,585  
Average balance of debt outstanding
    26,769,955       27,321,874       27,120,342       26,293,342  
     
(a)  
The student loan cost of funds includes the effects of net settlement costs on the Company’s derivative instruments (excluding the net settlements of $1.7 million and $12.1 million, for the three and nine months ended September 30, 2007, respectively, on those derivatives no longer hedging student loan assets).
 
(b)  
The Company entered into interest rate swaps with effective dates beginning in January 2008 to hedge a portion of the variable-rate floor income. Settlements on these derivatives are presented as part of the Company’s statutory calculation of variable-rate floor income. The maturity date for these derivatives was June 30, 2008.
As noted in Item 3, “Quantitative and Qualitative Disclosures about Market Risk”, the Company has a portfolio of student loans that are earning interest at a fixed borrower rate which exceeds the statutorily defined variable lender rate creating fixed rate floor income which is included in its core student loan spread. The majority of these loans are consolidation loans that earn the greater of the borrower rate or 2.64% above the average commercial paper rate during the calendar quarter. When excluding fixed rate floor income, the Company’s core student loan spread was 0.92% and 0.80% for the three and nine months ended September 30, 2008, respectively, and 1.04% and 1.16% for the three and nine months ended September 30, 2007, respectively.

 

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The compression of the Company’s core student loan spread during the three and nine months ended September 30, 2008 compared to 2007 was the result of the following items:
   
Historically, the movement of the various interest rate indices received on the Company’s student loan assets and paid on the debt to fund such loans was highly correlated. As shown in Item 3, “Quantitative and Qualitative Disclosures about Market Risk,” the short-term movement of the indices was dislocated beginning in August 2007. This dislocation has had a negative impact on the Company’s student loan net interest income.
 
   
The spread to LIBOR on asset-backed securities transactions has increased significantly since August 2007. Since August 2007, the Company has issued $6.0 billion of notes in asset-backed securities transactions ($1.5 billion in August 2007, $1.2 billion in March 2008, $1.9 billion in April 2008, and $1.3 billion in May 2008). The increase in costs on these transactions from historical levels have had and will continue to have a negative impact on the Company’s student loan net interest income. The increased spread to LIBOR on asset-backed securities transactions is shown in the below table:
(LINE GRAPH)
   
As a result of the passage of the College Cost Reduction and Access Act of 2007, the yield on FFELP loans originated after October 1, 2007 was reduced. As of September 30, 2008, the Company had $1.1 billion of FFELP loans originated after October 1, 2007. The core student loan spread on FFELP loans originated after October 1, 2007 for both the three and nine months ended September 30, 2008 was approximately 40 to 50 basis points.
The decrease in the Company’s core student loan spread was offset by a non-recurring benefit related to the Company’s cost of funds related to certain of its asset-backed securities. The interest rates on approximately $2.0 billion of the Company’s asset-backed securities are set and periodically reset via a “dutch auction” (“Auction Rate Securities”). As previously disclosed, the auction process to establish the rates on the Auction Rate Securities has failed. As a result of a failed auction, the Auction Rate Securities will generally pay interest to the holder at a maximum rate as defined by the governing documents. During the three and nine month periods ended September 30, 2008, the Company paid favorable interest rates on the majority of its Auction Rate Securities as a result of the application of certain of these maximum rate auction provisions in the underlying documents for such financings.

 

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Three and nine months ended September 30, 2008 compared to the three and nine months ended September 30, 2007
                                                 
    Three months ended September 30,     Nine months ended September 30,  
    2008     2007     $ Change     2008     2007     $ Change  
Net interest income after the provision for loan losses
  $ 58,767       50,920       7,847       112,001       193,527       (81,526 )
 
Loan and guaranty servicing income
    (136 )     170       (306 )     26       288       (262 )
Other fee-based income
    4,167       3,526       641       13,494       10,511       2,983  
Other income
    (88 )     1,181       (1,269 )     293       4,329       (4,036 )
Gain (loss) on sale of loans
          492       (492 )     (47,426 )     3,288       (50,714 )
Derivative market value, foreign currency, and put option adjustments
                      466             466  
Derivative settlements, net
    789       (4,065 )     4,854       55,954       (4,950 )     60,904  
 
                                   
Total other income
    4,732       1,304       3,428       22,807       13,466       9,341  
 
                                               
Salaries and benefits
    1,980       6,154       (4,174 )     6,157       20,600       (14,443 )
Restructure expense — severance and contract termination costs
          1,921       (1,921 )     1,845       1,921       (76 )
Impairment expense
          28,291       (28,291 )     9,351       28,291       (18,940 )
Other expenses
    5,354       7,429       (2,075 )     15,793       22,940       (7,147 )
Intersegment expenses
    18,200       20,924       (2,724 )     57,754       59,594       (1,840 )
 
                                   
Total operating expenses
    25,534       64,719       (39,185 )     90,900       133,346       (42,446 )
 
                                   
 
                                               
“Base net income (loss)” before income taxes
    37,965       (12,495 )     50,460       43,908       73,647       (29,739 )
Income tax expense (benefit)
    14,047       (4,748 )     18,795       15,889       27,986       (12,097 )
 
                                   
 
                                               
“Base net income (loss)”
  $ 23,918       (7,747 )     31,665       28,019       45,661       (17,642 )
 
                                   
 
                                               
Before Tax Operating Margin
    59.8 %     (23.9 %)             32.6 %     35.6 %        
 
Before Tax Operating Margin — excluding restructure expense, impairment expense, provision for loan losses related to the loss of Exceptional Performer, and the loss on sale of loans during the first quarter 2008
    59.8 %     49.2 %             56.3 %     53.7 %        
Net interest income after the provision for loan losses
                                 
    Three months ended September 30,     Change  
    2008     2007     Dollars     Percent  
 
Loan interest
  $ 351,331       509,596       (158,265 )     (31.1 )%
Consolidation rebate fees
    (47,105 )     (49,492 )     2,387       4.8  
Amortization of loan premiums and deferred origination costs
    (21,338 )     (23,450 )     2,112       9.0  
 
                       
Total loan interest
    282,888       436,654       (153,766 )     (35.2 )
Investment interest
    7,151       17,399       (10,248 )     (58.9 )
 
                       
Total interest income
    290,039       454,053       (164,014 )     (36.1 )
 
                       
Interest on bonds and notes payable
    223,523       384,793       (161,270 )     (41.9 )
Intercompany interest
    749             749       N/A  
Provision for loan losses
    7,000       18,340       (11,340 )     (61.8 )
 
                       
Net interest income after provision for loan losses
  $ 58,767       50,920       7,847       15.4 %
 
                       

 

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The average student loan portfolio increased $0.2 billion, or 0.7%, for the three months ended September 30, 2008 compared to the same period in 2007. The increase in average loans was offset by a decrease in the yield earned on student loans. Loan interest income decreased $158.3 million as a result of these factors.
 
   
Consolidation rebate fees decreased due to the $0.9 billion, or 4.6%, decrease in the average consolidation portfolio.
 
   
The amortization of loan premiums and deferred origination costs decreased as a result of reduced costs to acquire or originate loans.
 
   
Investment income decreased as a result of an overall decrease in average cash held in 2008 as compared to 2007, as well as lower interest rates.
 
   
Interest expense decreased as a result of a decrease in interest rates on the Company’s variable rate debt which lowered the Company’s cost of funds (excluding net derivative settlements) to 3.32% for the three months ended September 30, 2008 compared to 5.59% for the same period a year ago. In addition, average debt decreased by $0.6 billion, or 2.0%, for the three months ended September 30, 2008 compared to the same period in 2007.
 
   
Excluding an expense of $15.7 million in September 2007 to increase the Company’s allowance for loan losses related to the increase in risk share as a result of the elimination of the Exceptional Performer program in the third quarter of 2007, the provision for loan losses increased for the three months ended September 30, 2008 compared to 2007. The provision for loan losses for federally insured loans increased as a result of the increase in risk share as a result of the loss of Exceptional Performer in September 2007. The provision for loan losses for non-federally insured loans increased primarily due to increases in delinquencies as a result of the continued weakening of the U.S. economy.
                                 
    Nine months ended September 30,     Change  
    2008     2007     Dollars     Percent  
 
Loan interest
  $ 1,083,078       1,461,594       (378,516 )     (25.9 )%
Consolidation rebate fees
    (144,680 )     (143,657 )     (1,023 )     (0.7 )
Amortization of loan premiums and deferred origination costs
    (69,583 )     (67,143 )     (2,440 )     (3.6 )
 
                       
Total loan interest
    868,815       1,250,794       (381,979 )     (30.5 )
Investment interest
    23,875       51,153       (27,278 )     (53.3 )
 
                       
Total interest income
    892,690       1,301,947       (409,257 )     (31.4 )
 
                       
Interest on bonds and notes payable
    761,300       1,081,588       (320,288 )     (29.6 )
Intercompany interest
    1,389       3,204       (1,815 )     (56.6 )
Provision for loan losses
    18,000       23,628       (5,628 )     (23.8 )
 
                       
Net interest income after provision for loan losses
  $ 112,001       193,527       (81,526 )     (42.1 )%
 
                       
   
The average student loan portfolio increased $1.4 billion, or 5.7%, for the nine months ended September 30, 2008 compared to the same period in 2007. The increase in average loans was offset by a decrease in the yield earned on student loans. Loan interest income decreased $378.5 million as a result of these factors.
   
Consolidation rebate fees increased due to the $0.5 billion, or 2.8%, increase in the average consolidation loan portfolio.
   
The amortization of loan premiums and deferred origination costs increased as a result of an increase in the average student loan portfolio offset as a result of reduced costs to acquire or originate loans.
   
Investment income decreased as a result of an overall decrease in average cash held in 2008 as compared to 2007, as well as lower interest rates.
   
Interest expense decreased as a result of a decrease in interest rates on the Company’s variable rate debt which lowered the Company’s cost of funds (excluding net derivative settlements) to 3.75% for the nine months ended September 30, 2008 compared to 5.52% for the same period a year ago. This was offset by a $0.8 billion, or 3.2%, increase in average debt for the nine months ended September 30, 2008 compared to the same period in 2007.
   
Excluding an expense of $15.7 million in September 2007 to increase the Company’s allowance for loan losses related to the increase in risk share as a result of the elimination of the Exceptional Performer program in the third quarter of 2007, the provision for loan losses increased for the nine months ended September 30, 2008 compared to 2007. The provision for loan losses for federally insured loans increased as a result of the increase in risk share as a result of the loss of Exceptional Performer in September 2007. The provision for loan losses for non-federally insured loans increased primarily due to increases in delinquencies as a result of the continued weakening of the U.S. economy.
Other fee-based income. Borrower late fees increased $0.7 million and $2.5 million for the three and nine months ended September 30, 2008 compared to the same periods in 2007.

 

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Other income. Other income decreased due to the elimination of an agreement with a third party during the third quarter of 2007 under which the Company provided administrative services to the third party for a fee.
Gain (loss) on sale of loans. The Company sold $857.8 million (par value) of federally insured student loans resulting in the recognition of a loss of $30.4 million on March 31, 2008. In addition, on April 8, 2008, the Company sold $428.6 million (par value) of federally insured student loans. The Company recognized a loss of $17.1 million during the three month period ended March 31, 2008 as a result of marking these loans to fair value. Combined, the portfolios sold on March 31, 2008 and April 8, 2008 sold for a purchase price of approximately 98% of the par value of such loans. As a result of the disruptions in the debt and secondary markets, the Company sold these loan portfolios in order to reduce the amount of student loans remaining under the Company’s multi-year committed financing facility for FFELP loans which reduced the Company’s exposure to certain equity support provisions included in this facility.
Operating expenses. Excluding the restructure and impairment charges, operating expenses decreased $9.0 million, or 26.0%, and $23.4 million, or 22.7%, for the three and nine months ended September 30, 2008 compared to same periods in 2007. This decrease is a result of the September 2007 and January 2008 restructuring plans.
LIQUIDITY AND CAPITAL RESOURCES
The Company’s fee-based businesses are not capital intensive businesses and all of these businesses produce positive operating cash flows. As such, a minimal amount of debt and equity capital is allocated to these segments. Therefore, the majority of the Liquidity and Capital Resources discussion is concentrated on the Company’s Asset Generation and Management operating segment. The Company has historically utilized operating cash flow, secured financing transactions (which include warehouse facilities and asset-backed securitizations), operating lines of credit, and other borrowing arrangements to fund its Asset Generation and Management operations and student loan acquisitions. In addition, the Company uses operating cash flow, borrowings on its unsecured line of credit, and unsecured debt offerings to fund corporate activities, business acquisitions, and repurchases of common stock. The Company has also used its common stock to partially fund certain business acquisitions. The Company has a universal shelf registration statement with the SEC which allows the Company to sell up to $750.0 million of securities that may consist of common stock, preferred stock, unsecured debt securities, warrants, stock purchase contracts, and stock purchase units. The terms of any securities are established at the time of the offering. This shelf registration statement expires in December 2008.
The following table summarizes the Company’s bonds and notes outstanding as of September 30, 2008:
                         
    As of September 30, 2008  
    Carrying     Interest rate        
    amount     range     Final maturity  
 
Variable-rate bonds and notes (a):
                       
Bonds and notes based on indices
  $ 20,891,535     2.79% - 5.07%     09/25/13 - 06/25/41  
Bonds and notes based on auction or remarketing (b)
    2,771,445     0.00% - 9.01%     11/01/09 - 07/01/43  
 
                     
 
                       
Total variable-rate bonds and notes
    23,662,980                  
 
                       
Commercial paper — FFELP facility (c)
    2,525,410     2.54% - 3.94%     05/09/10  
Commercial paper — private loan facility (c)
    132,020     3.14%     03/14/09  
Fixed-rate bonds and notes (a)
    205,435     5.30% - 6.68%     11/01/09 - 05/01/29  
Unsecured fixed rate debt
    475,000     5.13% and 7.40%   06/01/10 and 09/15/61
Unsecured line of credit
    645,000     2.90% - 3.65%     05/08/12  
Department of Education Participation
    263,920     3.25%     09/30/09  
Other borrowings
    95,070     4.09% - 5.10%     05/22/09 - 11/01/15  
 
                     
 
 
  $ 28,004,835                  
 
                     
     
(a)  
Issued in asset-backed securitizations.
 
(b)  
As of September 30, 2008, the Company had $165 million of bonds based on an auction rate of 0%, due to the Maximum Rate auction provisions in the underlying documents for such financings. The Maximum Rate provisions include multiple components, one of which is based on T-bill rates. The T-bill component calculation for these bonds produced negative rates, which resulted in auction rates of zero percent for the applicable period.
 
(c)  
Loan warehouse facilities.

 

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Secured Financing Transactions
The Company has historically relied upon secured financing vehicles as its most significant source of funding for student loans. The net cash flow the Company receives from the securitized student loans generally represents the excess amounts, if any, generated by the underlying student loans over the amounts required to be paid to the bondholders, after deducting servicing fees and any other expenses relating to the securitizations. The Company’s rights to cash flow from securitized student loans are subordinate to bondholder interests and may fail to generate any cash flow beyond what is due to bondholders. The Company’s secured financing vehicles are loan warehouse facilities and asset-backed securitizations.
On July 31, 2008, the Company did not renew its liquidity provisions on its FFELP loan warehouse facility. Accordingly, the facility became a term facility and no new loan originations could be funded with this facility. In August 2008, the Company accessed alternative sources of funding to originate new FFELP student loans, including the Department of Education’s Loan Participation Program (“Participation Program”), and an existing facility with Union Bank which are further discussed below.
Loan warehouse facilities
Student loan warehousing has historically allowed the Company to buy and manage student loans prior to transferring them into more permanent financing arrangements. The Company has historically relied upon three conduit warehouse loan financing vehicles to support its funding needs on a short-term basis: a multi-year committed facility for FFELP loans, a $250.0 million private loan warehouse for non-federally insured student loans, and a single-seller extendible commercial paper conduit for FFELP loans.
FFELP Warehouse Facility
The Company’s multi-year committed facility for FFELP loans terminates in May 2010 and was supported by 364-day liquidity which was up for renewal on May 9, 2008. The Company obtained an extension on this renewal until July 31, 2008. On July 31, 2008, the Company did not renew the liquidity provisions of this facility. Accordingly, as of July 31, 2008, the facility became a term facility with a final maturity date of May 9, 2010. Pursuant to the terms of the agreement, since liquidity was not renewed, the Company’s cost of financing under this facility increased 10 basis points. The agreement also includes provisions which allow the banks to charge a rate equal to LIBOR plus 128.5 basis points if they choose to finance their portion of the facility with sources of funds other than their commercial paper conduit. In addition, the FFELP warehouse facility has a provision requiring the Company to refinance or remove 75% of the pledged collateral on an annual basis. The Company believes it has met this requirement for the annual period ending in May 2009. However, the Company does have an obligation to remove approximately $30 million of loans by December 31, 2008 because these loans were partially disbursed when the facility was termed-out on July 31, 2008. Under the current terms of the facility, the remaining collateral will need to be refinanced or removed by May 9, 2010. As of September 30, 2008 and November 7, 2008, $2.5 billion and $2.1 billion, respectively, was outstanding under this facility.
The terms and conditions of the Company’s warehouse facility for FFELP loans provide for mark-to-market advance rates. On October 22, 2008, the Company posted $165.5 million in additional funds to the facility based on this mark-to-market provision. While the Company does not believe that the loan valuation formula is reflective of the actual fair value of its loans, it is subject to compliance with such mark-to-market provisions of the warehouse facility agreement. As of September 30, 2008 and November 7, 2008, the Company had a cumulative amount of $209.1 million and $374.6 million, respectively, posted as equity funding support for this facility.
The Company has utilized its $750.0 million unsecured line of credit to fund equity advances on its warehouse facility. As of November 7, 2008, the Company has $691.5 million outstanding under this line of credit. The line of credit terminates in May 2012.
Continued dislocations in the credit markets may cause additional volatility in the loan valuation formula. Should a significant change in the valuation of loans result in additional required equity funding support for the warehouse facility greater than what the Company can provide and the Company has not amended the facility as discussed below, the warehouse facility could be subject to an event of default resulting in a termination of the facility and an acceleration of the repayment provisions. A default on the FFELP warehouse facility would result in an event of default on the Company’s unsecured line of credit that would result in the outstanding balance on the line of credit becoming immediately due and payable.
To reduce the Company’s exposure from the mark-to-market advance rate provision included in the FFELP warehouse facility, the Company has signed a letter agreement engaging Banc of America Securities LLC to arrange an amendment of certain of the Company’s credit facilities, including but not limited to an amendment to place a floor on the valuation of collateral in the Company’s FFELP loan warehouse line of credit for which Bank of America, N.A. acts as administrative agent. Banc of America Securities LLC has commenced the amendment process and together with the Company is seeking the approval of the Company’s lenders of a proposed amendment of such credit facilities on mutually agreeable terms. In addition, the Company continues to look at various alternatives to remove loans from the warehouse facility including other financing arrangements and/or selling loans to third parties.
In addition, on November 8, 2008, the Department announced they intend to provide liquidity support to one or more conforming asset backed commercial paper conduits to purchase and provide longer-term financing for FFELP loans. While details of this conduit are forthcoming, it is intended that all fully-disbursed non-consolidation FFELP loans awarded between October 1, 2003 and July 1, 2009 will be eligible for inclusion. As of November 7, 2008, the Company had approximately $900 million of loans included in its warehouse facility that would be eligible for this proposed conduit program.
Private Loan Warehouse Facility
The private loan warehouse facility, which terminates on March 14, 2009, is an uncommitted facility that is offered to the Company by a banking partner. As of September 30, 2008 and November 7, 2008, $132.0 million was outstanding under this facility. New advances are also subject to approval by the sponsor bank, and the Company believes it is unlikely such approval would be granted in the future. The Company guarantees the performance of the assets in the private loan warehouse facility. This facility provides for advance rates on subject collateral which require certain levels of equity enhancement support. As of September 30, 2008 and November 7, 2008, the Company had $50.5 million utilized as equity funding support based on provisions of this agreement. There can be no assurance that the Company will be able to maintain this conduit facility, find alternative funding, or make adequate equity contributions, if necessary. While the Company’s bank supported facilities have historically been renewed for successive terms, there can be no assurance that this will continue in the future. In January 2008, the Company suspended originating private loans.

 

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The Company has an obligation to reduce the amount outstanding in this facility approximately $30 million by December 15, 2008. The Company plans to sell loans in the facility and/or other unencumbered private loan assets and/or use operating cash to satisfy this obligation.
Commercial Paper Warehouse Program
In August 2006, the Company established a $5.0 billion extendable commercial paper warehouse program for FFELP loans, under which it can issue one or more short-term extendable secured liquidity notes. As of September 30, 2008, no notes were outstanding under this warehouse program. As a result of the disruption of the credit markets, there is no market for the issuance of notes under this facility. Management believes it is currently unlikely a market will exist in the foreseeable future.
Asset-backed securitizations
Of the $28.0 billion of debt outstanding as of September 30, 2008, $23.9 billion was issued under term asset-backed securitizations. Depending on market conditions, the Company anticipates continuing to access the asset-backed securities market. As a result of the disruptions in the credit markets, the Company may not be able to issue asset-backed financings at rates historically achieved by the Company, at levels equal to or less than other financing agreements, or at levels otherwise considered beneficial to the Company. Accordingly, the Company’s operational and financial results may be negatively impacted. Securities issued in the securitization transactions are generally priced based upon a spread to LIBOR or set under an auction or remarketing procedure.
LIBOR based notes
As of September 30, 2008, the Company had $20.9 billion of notes issued under asset-backed securitizations that primarily reprice at a fixed spread to three month LIBOR and are structured to substantially match the maturity of the funded assets. These notes fund FFELP student loans that are predominantly set based on a spread to three month commercial paper. The three month LIBOR and three month commercial paper indexes have been highly correlated historically. Based on cash flows developed to reflect management’s current estimate of, among other factors, prepayments, defaults, deferment, forbearance, and interest rates, the Company currently expects future undiscounted cash flows from these transactions will be approximately $1.4 billion. These cash flows consist of net spread and servicing and administrative revenue in excess of estimated cost.
The Company has certain LIBOR-indexed notes that match the maturity of the funded assets, however, must periodically be remarketed by the Company. Upon remarketing, the interest rates on the notes are reset. The Company also has the option to repurchase the notes prior to a failed remarketing and hold the notes as an investment until such time they can be remarketed. In the event the notes cannot be remarketed and they are not repurchased by the Company, the interest rate steps up to and remains at 3-month LIBOR plus 75 basis points until such time they can be successfully remarketed or purchased by the Company. The Company has $130 million and $200 million of notes due to be remarketed on November 25, 2008 and May 25, 2009, respectively, and an additional $950 million and $115 million to be remarketed in 2016 and 2018, respectively.
Auction or remarketing based notes
The interest rates on certain of the Company’s asset-backed securities are set and periodically reset via a “dutch auction” (“Auction Rate Securities”) or through a remarketing utilizing broker-dealers and remarketing agents (“Variable Rate Demand Notes”). The Company is currently sponsor on approximately $1.9 billion of Auction Rate Securities and $0.8 billion of Variable Rate Demand Notes.
For Auction Rate Securities, investors and potential investors submit orders through a broker-dealer as to the principal amount of notes they wish to buy, hold, or sell at various interest rates. The broker-dealers submit their clients’ orders to the auction agent, who then determines the clearing interest rate for the upcoming period. Interest rates on these Auction Rate Securities are reset periodically, generally every 7 to 35 days, by the auction agent or agents. During the first quarter of 2008, as part of the credit market crisis, several auction rate securities from various issuers failed to receive sufficient order interest from potential investors to clear successfully, resulting in failed auction status. Since February 8, 2008, the Company’s Auction Rate Securities have failed in this manner. Under normal conditions, banks have historically stepped in when investor demand is weak. However, banks have been allowing these auctions to fail.
As a result of a failed auction, the Auction Rate Securities will generally pay interest to the holder at a maximum rate as defined by the commercial paper, governing documents, or indenture. While these rates will vary by the trust structure the notes were issued from as well as the class and rating of the security, they will generally be based on a spread to LIBOR, commercial paper, or Treasury Securities. Based on the relative levels of these indices as of September 30, 2008, the rates expected to be paid by the Company range from 91-day T-Bill plus 125 basis points, on the low end, to LIBOR plus 250 basis points, on the high end.

 

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During the three month period ended September 30, 2008, the Company paid favorable interest rates on the majority of its Auction Rate Securities as a result of the application of certain of these maximum rate auction provisions in the underlying documents for such financings.
The Company cannot predict whether future auctions related to its Auction Rate Securities will be successful, but management believes it is likely auctions will continue to fail indefinitely. The Company is currently seeking alternatives for reducing its exposure to the auction rate market, but may not be able to achieve alternate financing for some or all of its Auction Rate Securities.
For Variable Rate Demand Notes, the remarketing agents set the price, which is then offered to investors. If there are insufficient potential bid orders to purchase all of the notes offered for sale, the Company could be subject to interest costs substantially above the anticipated and historical rates paid on these types of securities. The maximum rate for Variable Rate Demand Notes is based on a spread to certain indexes as defined in the underlying documents, with the highest to the Company being Prime plus 200 basis points. Certain of the Variable Rate Demand Notes are secured by financial guaranty insurance policies issued by MBIA Insurance Corporation. These Variable Rate Demand Notes are currently experiencing reduced investor demand and certain of these securities have been put to the liquidity provider, Lloyds TSB Bank, at a cost ranging from Federal Funds plus 150 basis points to LIBOR plus 175 basis points.
Funding New FFELP Student Loan Originations
Department of Education’s Loan Participation and Purchase Commitment Programs
On July 1, 2008, pursuant to the Ensuring Continued Access to Student Loans Act, the Department of Education announced terms under which it will offer to purchase certain FFELP student loans and participation interests in certain FFELP student loans from FFELP lenders. Under the Department’s Purchase Program, the Department will purchase loans at a price equal to the sum of (i) par value, (ii) accrued interest, (iii) the one percent origination fee paid to the Department, and (iv) a fixed amount of $75 per loan. Under the Participation Program, the Department provides interim short-term liquidity to FFELP lenders by purchasing participation interests in pools of FFELP loans. FFELP lenders are charged a rate of commercial paper plus 50 basis points on the principal amount of participation interests outstanding. Loans funded under the Participation Program must be either refinanced by the lender or sold to the Department pursuant to the Purchase Program prior to its expiration on September 30, 2009. To be eligible for purchase or participation under the Department’s programs, loans must be FFELP Stafford or PLUS loans made for the academic year 2008-2009, first disbursed between May 1, 2008 and July 1, 2009, with eligible borrower benefits.
On October 7, 2008, legislation was enacted to extend the Department’s authority to address FFELP student loans made for the 2009-2010 academic year and allowing for the extension of the Participation Program and Purchase Program from September 30, 2009 to September 30, 2010. The Department has provided preliminary guidance relating to the extension and has indicated that programs similar to the Participation Program and Purchase Program will be implemented for the 2009-2010 academic year along with providing liquidity support for one or more asset backed commercial paper conduits for FFELP Stafford and PLUS loans awarded between October 1, 2003 and July 1, 2009. The Department has indicated that loans for the 2008-2009 academic year which are funded under the Department’s Participation Program will need to be refinanced or sold to the Department prior to September 30, 2009. Management understands that such loans will not be eligible for participation under the Department’s 2009-2010 Participation Program, but should be eligible for refinancing through the Department’s commercial paper conduit program. Management of the Company is encouraged by these developments; however, until the Department provides additional details regarding the programs, the Company is unable to determine the full impact these programs will have on the Company.
The Company has completed and filed all relevant documents to participate in the Department of Education’s Participation Program and began to utilize the Participation Program in the third quarter of 2008 to fund a significant portion of its loan originations for the 2008-2009 academic year. As of September 30, 2008 and November 7, 2008, $263.9 million and $504.4 million of loans, respectively, were funded using the Participation Program.
Union Bank Participation Agreement
The Company maintains an agreement with Union Bank, as trustee for various grantor trusts, under which Union Bank has agreed to purchase from the Company participation interests in student loans (the “FFELP Participation Agreement”). The Company has the option to purchase the participation interests from the grantor trusts at the end of a 364-day term upon termination of the participation certificate. As of September 30, 2008 and November 7, 2008, $221.6 million and $335.3 million, respectively, of loans were subject to outstanding participation interests held by Union Bank, as trustee, under this agreement. The agreement automatically renews annually and is terminable by either party upon five business days notice. This agreement provides beneficiaries of Union Bank’s grantor trusts with access to investments in interests in student loans, while providing liquidity to the Company on a short-term basis. The Company can participate loans to Union Bank to the extent of availability under the grantor trusts, up to $750 million. Loans participated under this agreement qualify as a sale pursuant to the provisions of SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (“SFAS No. 140”). Accordingly, the participation interests sold are not included on the Company’s consolidated balance sheet.

 

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Operating Lines of Credit
The Company has a $750.0 million unsecured line of credit that terminates in May 2012. As of September 30, 2008, there was $645.0 million outstanding on this line and $105.0 million available for future use. The weighted average interest rate on this line of credit was 3.44% as of September 30, 2008. Upon termination in 2012, there can be no assurance that the Company will be able to maintain this line of credit, find alternative funding, or increase the amount outstanding under the line, if necessary. As discussed previously, the Company may need to fund certain loans or provide equity funding support related to advance rates on its warehouse facilities. As of November 7, 2008, the Company has contributed $425.1 million in equity funding support to these facilities. The Company has funded these contributions primarily by advances on its operating line of credit. As of November 7, 2008, the Company has $691.5 million outstanding under this line of credit and $58.5 million available for future uses. The lending commitment on the Company’s unsecured line of credit is provided by multiple banks. Lehman Brothers Bank, FSB (“Lehman Bank”) represents seven percent of the lending commitment under the line of credit. On September 15, 2008, Lehman Brothers Holdings Inc. filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code. Since the bankruptcy filing, Lehman Bank has experienced funding delays for its portion of the lending commitment under the line of credit. As of November 7, 2008, excluding Lehman Bank’s lending commitment, the Company has $51.2 million available for future use under its unsecured line of credit.
The line of credit agreement contains certain financial covenants that, if not met, lead to an event of default under the agreement. The covenants include maintaining:
  (v)  
A minimum consolidated net worth;
 
  (vi)  
A minimum adjusted EBITDA to corporate debt interest (over the last four rolling quarters);
 
  (vii)  
A limitation on subsidiary indebtedness; and
 
  (viii)  
A limitation on the percentage of non-guaranteed loans in the Company’s portfolio.
As of September 30, 2008, the Company was in compliance with all of these requirements and believes it has the ability to maintain the covenants in future periods. Many of these covenants are duplicated in the Company’s other lending facilities, including its FFELP and private loan warehouses.
As previously discussed, continued dislocations in the credit markets may cause additional volatility in the loan valuation formula included in the Company’s FFELP warehouse facility. Should a significant change in the valuation of loans result in additional required equity funding support for the warehouse facility greater than what the Company can provide, the warehouse facility could be subject to an event of default resulting in a termination of the facility and an acceleration of the repayment provisions. A default on the FFELP warehouse facility would result in an event of default on the Company’s unsecured line of credit that would result in the outstanding balance on the line of credit becoming immediately due and payable.
The Company’s operating line of credit does not have any covenants related to unsecured debt ratings. However, changes in the Company’s ratings (as well as the amounts the Company borrows) have modest implications on the pricing level at which the Company obtains funding.
Universal Shelf Offerings
In May 2005, the Company consummated a debt offering under its universal shelf consisting of $275.0 million in aggregate principal amount of Senior Notes due June 1, 2010 (the “Notes”). The Notes are unsecured obligations of the Company. The interest rate on the Notes is 5.125%, payable semiannually. At the Company’s option, the Notes are redeemable in whole at any time or in part from time to time at the redemption price described in the Company’s prospectus supplement.

 

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In September 2006, the Company consummated a debt offering under its universal shelf consisting of $200.0 million aggregate principal amount of Junior Subordinated Hybrid Securities (“Hybrid Securities”). The Hybrid Securities are unsecured obligations of the Company. The interest rate on the Hybrid Securities from the date they were issued through the optional redemption date, September 28, 2011, is 7.40%, payable semi-annually. Beginning September 29, 2011 through September 29, 2036, the “scheduled maturity date”, the interest rate on the Hybrid Securities will be equal to three-month LIBOR plus 3.375%, payable quarterly. The principal amount of the Hybrid Securities will become due on the scheduled maturity date only to the extent that the Company has received proceeds from the sale of certain qualifying capital securities prior to such date (as defined in the Hybrid Securities’ prospectus). If any amount is not paid on the scheduled maturity date, it will remain outstanding and bear interest at a floating rate as defined in the prospectus, payable monthly. On September 15, 2061, the Company must pay any remaining principal and interest on the Hybrid Securities in full whether or not the Company has sold qualifying capital securities. At the Company’s option, the Hybrid Securities are redeemable in whole at any time or in part from time to time at the redemption price described in the prospectus supplement.
The proceeds from these unsecured debt offerings were or will be used by the Company to fund general business operations, certain asset and business acquisitions, and the repurchase of stock under the Company’s stock repurchase plan.
Contractual Obligations
The Company is committed under noncancelable operating leases for certain office and warehouse space and equipment. The Company’s contractual obligations as of September 30, 2008 were as follows:
                                         
            Less than                     More than  
    Total     1 year     1 to 3 years     3 to 5 years     5 years  
 
Bonds and notes payable
  $ 28,004,835       501,742       2,914,569       790,422       23,798,102  
Operating lease obligations
    41,607       9,278       16,398       11,976       3,955  
Other
    62,520       30,300       32,220              
 
                             
Total
  $ 28,108,962       541,320       2,963,187       802,398       23,802,057  
 
                             
As of September 30, 2008, the Company had a reserve of $8.8 million for uncertain income tax positions per the provisions of FIN 48. This obligation is not included in the above table as the timing and resolution of the income tax positions cannot be reasonably estimated at this time.
The Company has an obligation to purchase $51.9 million of private loans from an unrelated financial institution in eight quarterly installments beginning in the fourth quarter of 2008. The first seven installments will equal approximately $5 million and the eighth and final installment will include the remaining outstanding balance of loans to be purchased. This obligation is included in “other” in the above table.
The Company has commitments with its branding partners and forward flow lenders which obligate the Company to purchase loans originated under specific criteria, although the branding partners and forward flow lenders are typically 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 has significant financing needs that it meets through the capital markets, including the debt and secondary markets. Since August 2007, these markets have experienced unprecedented disruptions, which are having an adverse impact on the Company’s earnings and financial condition. The Company cannot determine nor control the length of time or extent to which the capital markets will remain disrupted. Accordingly, the Company has the ability to exercise contractual rights to discontinue, suspend, or defer the acquisition of student loans in connection with its branding and forward flow relationships. Commitments to purchase loans under these arrangements are not included in the table above.
As a result of the Company’s recent acquisitions, the Company has certain contractual obligations or commitments as follows:
   
LoanSTAR Funding Group, Inc. (“LoanSTAR”) — As part of the agreement for the acquisition of the capital stock of LoanSTAR from the Greater Texas Foundation (“Texas Foundation”), the Company agreed to sell student loans in an aggregate amount sufficient to permit the Texas Foundation to maintain a portfolio of loans equal to no less than $200 million through October 2010. The sales price for such loans is the fair value mutually agreed upon between the Company and the Texas Foundation. To satisfy this obligation, the Company is obligated to sell loans to the Texas Foundation on a quarterly basis; however, the Foundation recently has chosen not to purchase such loans.
 
   
infiNET Integrated Solutions, Inc. (“infiNET”) — Stock price guarantee of $104.8375 per share on 95,380 shares of Class A Common Stock (less the greater of $41.9335 or the gross sales price such seller obtains from a sale of the shares occurring prior to February 28, 2011 as defined in the agreement) issued as part of the original purchase price. The obligation to pay this guaranteed stock price is due February 28, 2011 and is not included in the table above. Based upon the closing sale price of the Company’s Class A Common Stock as of September 30, 2008 of $14.20 per share, the Company’s obligation under this stock price guarantee would have been $6.0 million (($104.8375 — $41.9335) x 95,380 shares). Any cash paid by the Company in consideration of satisfying the guaranteed value of stock issued for this acquisition would be recorded by the Company as a reduction to additional paid-in capital.
 
   
5280 Solutions, Inc. — 258,760 shares of Class A Common Stock issued as part of the original purchase price is subject to a put option arrangement whereby during the 30-day period ending November 30, 2008, the holders may require the Company to repurchase all or part of the shares at a price of $37.10 per share. The value of this put option as of September 30, 2008 was $9.6 million and is included in “other” in the above table. The Company paid $9.6 million on November 10, 2008 to satisfy its obligation related to these agreements.

 

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Sources of Liquidity
Sources of Liquidity Available for New FFELP Stafford and PLUS Loans
On July 31, 2008, the Company did not renew the liquidity provisions of its FFELP warehouse facility. Accordingly, on July 31, 2008, the facility became a term facility with a final maturity date of May 9, 2010. No new student loan originations can be funded under this program. In addition, the Company has $5.0 billion authorized for future issuance under its FFELP Commercial Paper Program. As a result of the disruption of the credit markets, there is no market for the issuance of notes under this facility. Management believes it is unlikely a market will exist in the future. However, the Company has unlimited sources of primary liquidity available for new FFELP Stafford and PLUS loan originations for the 2008-2009 academic year under the Department’s Participation and Purchase Programs. In addition, the Company maintains an agreement with Union Bank, as trustee for various grantor trusts, under which Union Bank has agreed to purchase from the Company participation interests in student loans. See “Union Bank Participation Agreement” discussed earlier in this section.
Sources of Liquidity Available for General Corporate Purposes
The following table details the Company’s primary sources of liquidity and the available capacity at November 7, 2008 for general corporate purposes:
         
Sources of primary liquidity: (a)
       
Cash and cash equivalents (b)
  $ 117,894  
Unencumbered private student loan assets
    93,437  
Unused unsecured line of credit (c)
    51,200  
 
     
 
       
Total sources of primary liquidity
  $ 262,531  
 
     
     
(a)  
The sources of primary liquidity table above does not include the following:
   
Asset-backed security investments — As part of the Company’s issuance of asset-backed securitizations in March 2008 and May 2008, due to credit market conditions when these notes were issued, the Company purchased the Class B subordinated notes of $36 million (par value) and $41 million (par value), respectively. These notes are not included on the Company’s consolidated balance sheet. If the credit market conditions improve, the Company anticipates selling these notes to third parties. Upon a sale to third parties, the Company would obtain cash proceeds equal to the market value of the notes on the date of such sale. Upon sale, these notes would be shown as “bonds and notes payable” on the Company’s consolidated balance sheet. Unless there is a significant market improvement, the Company believes the market value of such notes will be less than par value. The difference between the par value and market value would be recognized by the Company as interest expense over the life of the bonds.
     
(b)  
The Company also has restricted cash and investments, however, 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 significantly 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.
 
(c)  
As of November 7, 2008, the Company has $691.5 million outstanding under this line of credit and $58.5 million available for future uses. The lending commitment on the Company’s unsecured line of credit is provided by multiple banks. Lehman Bank represents seven percent of the lending commitment under the line of credit. On September 15, 2008, Lehman Brothers Holdings Inc. filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code. Since the bankruptcy filing, the Company has experienced funding delays from Lehman Bank for its portion of the lending commitment under the line of credit. As of November 7, 2008, excluding Lehman Bank’s lending commitment, the Company has $51.2 million available for future use under its unsecured line of credit.
Dividends
In the first quarter of 2007, the Company began paying dividends of $0.07 per share on the Company’s Class A and Class B Common Stock which were paid quarterly through the first quarter of 2008. On May 21, 2008, the Company announced that it was temporarily suspending its quarterly dividend program. The Company will continue to evaluate its dividend policy, which is subject to future earnings, capital requirements, financial condition, and other factors.

 

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CRITICAL ACCOUNTING POLICIES
This Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of income and expenses during the reporting periods. The Company bases its estimates and judgments on historical experience and on various other factors that the Company believes are reasonable under the circumstances. Actual results may differ from these estimates under varying assumptions or conditions. Note 3 of the consolidated financial statements, which are included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007, includes a summary of the significant accounting policies and methods used in the preparation of the consolidated financial statements.
On an on-going basis, management evaluates its estimates and judgments, particularly as they relate to accounting policies that management believes are most “critical” — that is, they are most important to the portrayal of the Company’s financial condition and results of operations and they require management’s most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Management has identified the following critical accounting policies that are discussed in more detail below: allowance for loan losses, revenue recognition, purchase price accounting related to business and certain asset acquisitions, and income taxes.
Allowance for Loan Losses
The allowance for loan losses represents management’s estimate of probable losses on student loans. This evaluation process is subject to numerous estimates and judgments. The Company evaluates the adequacy of the allowance for loan losses on its federally insured loan portfolio separately from its non-federally insured loan portfolio.
The allowance for the federally insured loan portfolio is based on periodic evaluations of the Company’s loan portfolios considering past experience, trends in student loan claims rejected for payment by guarantors, changes to federal student loan programs, current economic conditions, and other relevant factors. Should any of these factors change, the estimates made by management would also change, which in turn would impact the level of the Company’s future provision for loan losses.
In determining the adequacy of the allowance for loan losses on the non-federally insured loans, the Company considers several factors including: loans in repayment versus those in a nonpaying status, months in repayment, delinquency status, type of program, and trends in defaults in the portfolio based on Company and industry data. Should any of these factors change, the estimates made by management would also change, which in turn would impact the level of the Company’s future provision for loan losses. The Company places a non-federally insured loan on nonaccrual status and charges off the loan when the collection of principal and interest is 120 days past due.
The allowance for federally insured and non-federally insured loans is maintained at a level management believes is adequate to provide for estimated probable credit losses inherent in the loan portfolio. This evaluation is inherently subjective because it requires estimates that may be susceptible to significant changes.
Revenue Recognition
Student Loan Income — The Company recognizes student loan income as earned, net of amortization of loan premiums and deferred origination costs. Loan income is recognized based upon the expected yield of the loan after giving effect to borrower utilization of incentives such as principal reductions for timely payments (“borrower benefits”) and other yield adjustments. The estimate of the borrower benefits discount is dependent on the estimate of the number of borrowers who will eventually qualify for these benefits. For competitive purposes, the Company frequently changes the borrower benefit programs in both amount and qualification factors. These programmatic changes must be reflected in the estimate of the borrower benefit discount. Loan premiums, deferred origination costs, and borrower benefits are included in the carrying value of the student loan on the consolidated balance sheet and are amortized over the estimated life of the loan in accordance with SFAS No. 91, Accounting for Non-Refundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases. The most sensitive estimate for loan premiums, deferred origination costs, and borrower benefits is the estimate of the constant prepayment rate (“CPR”). CPR is a variable in the life of loan estimate that measures the rate at which loans in a portfolio pay before their stated maturity. The CPR is directly correlated to the average life of the portfolio. CPR equals the percentage of loans that prepay annually as a percentage of the beginning of period balance. A number of factors can affect the CPR estimate such as the rate of consolidation activity and default rates. Should any of these factors change, the estimates made by management would also change, which in turn would impact the amount of loan premium and deferred origination cost amortization recognized by the Company in a particular period.
Other Fee-Based Income — Other fee-based income is primarily attributable to fees for providing services and the sale of lists and print products. Fees associated with services are recognized in the period services are rendered and earned under service arrangements with clients where service fees are fixed or determinable and collectibility is reasonably assured. The Company’s service fees are determined based on written price quotations or service agreements having stipulated terms and conditions that do not require management to make any significant judgments or assumptions regarding any potential uncertainties. Revenue from the sale of lists and print products is generally earned and recognized, net of estimated returns, upon shipment or delivery.

 

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The Company assesses collectibility of revenues and its allowance for doubtful accounts based on a number of factors, including past transaction history with the customer and the credit-worthiness of the customer. An allowance for doubtful accounts is established to record accounts receivable at estimated net realizable value. If the Company determines that collection of revenues is not reasonably assured at or prior to delivery of the Company’s services, revenue is recognized upon the receipt of cash.
Purchase Price Accounting Related to Business and Certain Asset Acquisitions
The Company has completed several business and asset acquisitions which have generated significant amounts of goodwill and intangible assets and related amortization. The values assigned to goodwill and intangibles, as well as their related useful lives, are subject to judgment and estimation by the Company. Goodwill and intangibles related to acquisitions are determined and based on purchase price allocations. Valuation of intangible assets is generally based on the estimated cash flows related to those assets, while the initial value assigned to goodwill is the residual of the purchase price over the fair value of all identifiable assets acquired and liabilities assumed. Useful lives are determined based on the expected future period of the benefit of the asset, the assessment of which considers various characteristics of the asset, including historical cash flows. Due to the number of estimates involved related to the allocation of purchase price and determining the appropriate useful lives of intangible assets, management has identified purchase price accounting as a critical accounting policy.
Goodwill and Intangible Assets — Impairment Assessments
The Company reviews goodwill for impairment annually and whenever triggering events or changes in circumstances indicate its carrying value may not be recoverable in accordance with SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS No. 142”). The provisions of SFAS No. 142 require that a two-step impairment test be performed on goodwill. In the first step, the Company compares the fair value of each reporting unit to its carrying value. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that unit, goodwill is considered not impaired and the Company is not required to perform further testing. If the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, then the Company must perform the second step of the impairment test in order to determine the implied fair value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then the Company would record an impairment loss equal to the difference.
Determining the fair value of a reporting unit involves the use of significant estimates and assumptions. These estimates and assumptions include revenue growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates, future economic and market conditions, and determination of appropriate market comparables. Actual future results may differ from those estimates.
The Company makes judgments about the recoverability of purchased intangible assets annually and whenever triggering events or changes in circumstances indicate that an other than temporary impairment may exist. Each quarter the Company evaluates the estimated remaining useful lives of purchased intangible assets and whether events or changes in circumstances warrant a revision to the remaining periods of amortization. In accordance with FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, recoverability of these assets is measured by comparison of the carrying amount of the asset to the future undiscounted cash flows the asset is expected to generate. If the asset is considered to be impaired, the amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired asset.
Assumptions and estimates about future values and remaining useful lives of the Company’s intangible and other long-lived assets are complex and subjective. They can be affected by a variety of factors, including external factors such as industry and economic trends, and internal factors such as changes in the Company’s business strategy and internal forecasts. Although the Company believes the historical assumptions and estimates used are reasonable and appropriate, different assumptions and estimates could materially impact the reported financial results.
Income Taxes
The Company is subject to the income tax laws of the U.S and its states and municipalities in which the Company operates. These tax laws are complex and subject to different interpretations by the taxpayer and the relevant government taxing authorities. In establishing a provision for income tax expense, the Company must make judgments and interpretations about the application of these inherently complex tax laws. The Company must also make estimates about when in the future certain items will affect taxable income in the various tax jurisdictions. Disputes over interpretations of the tax laws may be subject to review/adjudication by the court systems of the various tax jurisdictions or may be settled with the taxing authority upon examination or audit. The Company reviews these balances quarterly and as new information becomes available, the balances are adjusted, as appropriate.

 

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RECENT ACCOUNTING PRONOUNCEMENTS
In December 2007, the FASB issued SFAS No. 141R, Business Combinations (“SFAS No. 141R”), which changes the accounting for business acquisitions. SFAS No. 141R requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction and establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed in a business combination. Certain provisions of this standard will, among other things, impact the determination of acquisition-date fair value of consideration paid in a business combination (including contingent consideration); exclude transaction costs from acquisition accounting; and change accounting practices for acquired contingencies, acquisition-related restructuring costs, in-process research and development, indemnification assets, and tax benefits. For the Company, SFAS No. 141R is effective for business combinations and adjustments to an acquired entity’s deferred tax asset and liability balances occurring after December 31, 2008. The Company is currently evaluating the future impacts and disclosures related to SFAS No. 141R.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS No. 157”). This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. The provisions of SFAS No. 157 are effective as of the beginning of the first fiscal year that begins after November 15, 2007 (January 1, 2008 for the Company) and is to be applied prospectively. The Company adopted SFAS No. 157 on January 1, 2008. The Company elected to delay the application of SFAS No. 157 to nonfinancial assets and nonfinancial liabilities, as allowed by FASB Staff Position SFAS No. 157-2. The Company is currently evaluating the impacts and disclosures related to SFAS No. 157-2, but would not expect SFAS No. 157-2 to have a material impact on the Company’s consolidated results of operations or financial condition. In light of the recent economic turmoil occurring in the United States, the FASB released FSP SFAS No. 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active (“SFAS No. 157-3”), on October 10, 2008. SFAS No. 157-3 clarified, among other things, that quotes and other market inputs need not be solely used to determine fair value if they do not relate to an active market. SFAS No. 157-3 points out that when relevant observable market information is not available, an approach that incorporates management’s judgments about the assumptions that market participants would use in pricing the asset in a current sale transaction would be acceptable (such as a discounted cash flow analysis). Regardless of the valuation technique applied, entities must include appropriate risk adjustments that market participants would make, including adjustments for nonperformance risk (credit risk) and liquidity risk.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115 (“SFAS No. 159”), which permits an entity to choose, at specified election dates, to measure eligible financial instruments and certain other items at fair value that are not currently required to be measured at fair value. An entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. SFAS No. 159 allows entities to achieve an offset accounting effect for certain changes in fair value of related assets and liabilities without having to apply complex hedge accounting provisions, and is expected to expand the use of fair value measurement consistent with the Board’s long-term objectives for financial instruments. SFAS No. 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007 (January 1, 2008 for the Company). At the effective date, an entity may elect the fair value option for eligible items that exist at that date. The entity shall report the effect of the first remeasurement to fair value as a cumulative-effect adjustment to the opening balance of retained earnings. Upon the effective date of SFAS No. 159, the Company has elected not to measure any items at fair value that were not currently required to be measured at fair value. Accordingly, the adoption of SFAS No. 159 had no impact on the Company’s financial statements.
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51 (“SFAS No. 160”), which establishes new standards governing the accounting for and reporting of noncontrolling interests (“NCIs”) in partially owned consolidated subsidiaries and the loss of control of subsidiaries. Certain provisions of this standard indicate, among other things, that NCIs (previously referred to as minority interests) be treated as a separate component of equity, not as a liability; that increases and decreases in the parent’s ownership interest that leave control intact be treated as equity transactions, rather than as step acquisitions or dilution gains or losses; and that losses of a partially owned consolidated subsidiary be allocated to the NCI even when such allocation might result in a deficit balance. This standard also requires changes to certain presentation and disclosure requirements. For the Company, SFAS No. 160 is effective beginning January 1, 2009. The provisions of the standard are to be applied to all NCIs prospectively, except for the presentation and disclosure requirements, which are to be applied retrospectively to all periods presented. The Company is currently evaluating the future impacts and disclosures related to SFAS No. 60.
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, which is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand the effects of derivative instruments and hedging activities on an entity’s financial position, financial performance, and cash flows. The new standard also improves transparency about the location and amounts of derivative instruments in an entity’s financial statements, how derivative instruments and related hedged items are accounted for under SFAS No. 133, and how derivative instruments and related hedged items affect its financial position, financial performance, and cash flows. The standard is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. The Company is currently evaluating the future impacts and disclosures related to SFAS No. 161.
In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles (“SFAS No. 162”). This standard is intended to improve financial reporting by identifying a consistent framework, or hierarchy, for selecting accounting principles to be used in preparing financial statements that are presented in conformity with generally accepted accounting principles in the United States for non-governmental entities. SFAS No. 162 is effective 60 days following approval by the U.S. Securities and Exchange Commission (“SEC”) of the Public Company Accounting Oversight Board’s amendments to AU Section 411, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles. The Company does not expect SFAS No. 162 to have a material impact on the preparation of its consolidated financial statements.

 

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In December 2007, the FASB ratified the Emerging Issues Task Force consensus on EITF Issue No. 07-1, Accounting for Collaborative Arrangements (“EITF No. 07-1”), that discusses how parties to a collaborative arrangement (which does not establish a legal entity within such arrangement) should account for various activities. The consensus indicates that costs incurred and revenues generated from transactions with third parties (i.e. parties outside of the collaborative arrangement) should be reported by the collaborators on the respective line items in their income statements pursuant to EITF Issue No. 99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent. Additionally, the consensus provides that income statement characterization of payments between the participants in a collaborative arrangement should be based upon existing authoritative pronouncements; analogy to such pronouncements if not within their scope; or a reasonable, rational, and consistently applied accounting policy election. EITF No. 07-1 is effective for the Company beginning January 1, 2009 and is to be applied retrospectively to all periods presented for collaborative arrangements existing as of the date of adoption. The Company is currently evaluating the impacts and disclosures related to EITF No. 07-1.
In April 2008, the FASB issued FSP SFAS 142-3, Determination of the Useful Life of Intangible Assets (“FSP 142-3”). This guidance is intended to improve the consistency between the useful life of a recognized intangible asset under SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS 142”), and the period of expected cash flows used to measure the fair value of the asset under SFAS 141R when the underlying arrangement includes renewal or extension of terms that would require substantial costs or result in a material modification to the asset upon renewal or extension. Companies estimating the useful life of a recognized intangible asset must now consider their historical experience in renewing or extending similar arrangements or, in the absence of historical experience, must consider assumptions that market participants would use about renewal or extension as adjusted for SFAS 142’s entity-specific factors. FSP 142-3 is effective for the Company beginning January 1, 2009. The Company is currently evaluating the potential impact of the adoption of FSP 142-3 on its consolidated financial position, results of operations, and cash flows.
In September 2008, the FASB issued FSP SFAS 133-1 and FIN 45-4, Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45, and Clarification of the Effective Date of FASB Statement No. 161 (“FSP 133-1 and FIN 45-4”), that require additional disclosures for sellers of credit derivative instruments and certain guarantees. FSP 133-1 and FIN 45-4 amend FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, and FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, by requiring additional disclosures for certain guarantees and credit derivatives sold including: maximum potential amount of future payments, the related fair value, and the current status of the payment/performance risk. The standard is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. The Company is currently evaluating the impacts and disclosures related to FSP 133-1 and FIN 45-4.
In June 2008, the FASB issued FSP EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions are Participating Securities (“EITF 03-6-1”). EITF 03-6-1 defines participating securities as those that are expected to vest and are entitled to receive nonforfeitable dividends or dividend equivalents. Unvested share-based payment awards that have a right to receive dividends on common stock (restricted stock) will be considered participating securities and included in earnings per share using the two-class method. The two-class method requires net income to be reduced for dividends declared and paid in the period on such shares. Remaining net income is then allocated to each class of stock (proportionately based on unrestricted and restricted shares which pay dividends) for calculation of basic earnings per share. Diluted earnings per share would then be calculated based on basic shares outstanding plus any additional potentially dilutive shares, such as options and restricted stock that do not pay dividends or are not expected to vest. This FSP is effective in the first quarter 2009. The Company is currently evaluating the impacts and disclosures relating to EITF 03-6-1.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate Risk
The Company’s primary market risk exposure arises from fluctuations in its borrowing and lending rates, the spread between which could impact the Company due to shifts in market interest rates. Because the Company generates a significant portion of its earnings from its student loan spread, the interest sensitivity of the balance sheet is a key profitability driver.

 

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The following table sets forth the Company’s loan assets and debt instruments by rate characteristics:
                                 
    As of September 30, 2008     As of December 31, 2007  
    Dollars     Percent     Dollars     Percent  
Fixed-rate loan assets
  $ 2,240,539       8.6 %   $ 1,136,544       4.3 %
Variable-rate loan assets
    23,760,874       91.4       25,192,669       95.7  
 
                       
Total
  $ 26,001,413       100.0 %   $ 26,329,213       100.0 %
 
                       
 
                               
Fixed-rate debt instruments
    680,435       2.4 %     689,476       2.5 %
Variable-rate debt instruments
    27,324,400       97.6       27,426,353       97.5  
 
                       
Total
  $ 28,004,835       100.0 %   $ 28,115,829       100.0 %
 
                       
FFELP student loans generally earn interest at the higher of a floating rate based on the Special Allowance Payment or SAP formula set by 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 dependant upon when the loan was originated, the loan’s repayment status, and funding sources for the loan. The Company generally finances its student loan portfolio with variable-rate debt. In low and/or declining interest rate environments, when the fixed borrower rate is higher than the rate produced by the SAP formula, the Company’s student loans earn at a fixed rate while the interest on the variable-rate debt continues to decline. In these interest rate environments, the Company earns additional spread income that it refers to as floor income.
Depending on the type of the student loan and when it was originated, the borrower rate is either fixed to term or is reset to market rate each July 1. As a result, for loans where the borrower rate is fixed to term, the Company earns floor income for an extended period of time, which the Company refers to as fixed rate floor income, and for those loans where the borrower rate is reset annually on July 1, the Company earns floor income to the next reset date, which the Company refers to as variable-rate floor income. In accordance with legislation enacted in 2006, lenders are required to rebate floor income and variable-rate floor income to the Department for all FFELP loans originated on or after April 1, 2006.
For the three and nine months ended September 30, 2008, loan interest income includes approximately $6.8 million and $25.2 million of fixed rate floor income, respectively. For the three and nine months ended September 30, 2007, loan interest income includes approximately $0.8 million and $7.0 million of fixed rate floor income, respectively. For the three and nine months ended September 30, 2008, loan interest income includes approximately $1.6 million and $42.3 million of variable-rate floor income, respectively. The Company earned $0.6 million of variable-rate floor income during both the three and nine months ended September 30, 2007.
Absent the use of derivative instruments, a rise in interest rates may reduce the amount of floor income received and this may have an impact on earnings due to interest margin compression caused by increasing financing costs, until such time as the federally insured loans earn interest at a variable rate in accordance with the special allowance payment formula. In higher interest rate environments, where the interest rate rises above the borrower rate and fixed-rate loans effectively become variable rate loans, the impact of the rate fluctuations is reduced.
The following graph depicts fixed rate floor income for a borrower with a fixed rate of 6.75% and a SAP rate of 2.64%:
(LINE GRAPH)

 

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The following table shows the Company’s student loan assets that are earning fixed rate floor income as of September 30, 2008:
                         
    Borrower/     Estimated     Balance of  
Fixed   lender     variable     assets earning fixed-rate  
interest   weighted     conversion     floor income as of  
rate range   average yield     rate (a)     September 30, 2008 (b)  
 
4.5 - 4.99%
    4.84 %     2.20 %   $ 1,274  
5.0 - 5.49%
    5.08 %     2.44 %     7,614  
5.5 - 5.99%
    5.74 %     3.10 %     245,169  
6.0 - 6.49%
    6.19 %     3.55 %     419,291  
6.5 - 6.99%
    6.70 %     4.06 %     375,929  
7.0 - 7.49%
    7.17 %     4.53 %     130,684  
7.5 - 7.99%
    7.71 %     5.07 %     224,331  
8.0 - 8.99%
    8.16 %     5.52 %     512,938  
> 9.0%
    9.04 %     6.40 %     323,309  
 
                     
 
 
                  $ 2,240,539  
 
                     
     
(a)  
The estimated variable conversion rate is the estimated short-term interest rate at which loans would convert to variable rate.
 
(b)  
As of September 30, 2008, the Company had $204.8 million of fixed rate debt that was used by the Company to hedge fixed-rate student loan assets. The weighted average interest rate paid by the Company on this debt as of September 30, 2008 was 6.17%.
The following table summarizes the outstanding derivative instruments as of September 30, 2008 used by the Company to hedge fixed-rate student loan assets.
                 
            Weighted  
            average fixed  
    Notional     rate paid by  
Maturity   Amount     the Company (a)  
 
2009
  $ 500,000       4.08 %
2010
    500,000       3.84  
 
  $ 1,000,000       3.96 %
     
(a)  
For all interest rate derivatives for which the Company pays a fixed rate, the Company receives discrete three-month LIBOR.
As of September 30, 2008, the Company had $3.8 billion of student loan assets that were eligible to earn variable-rate floor income. As a result of the decrease in short-term interest rates subsequent to September 30, 2008, the Company anticipates earning additional variable-rate floor income in the fourth quarter.
The Company is exposed to interest rate risk in the form of basis risk and repricing risk because the interest rate characteristics of the Company’s assets do not match the interest rate characteristics of the funding. The Company attempts to match the interest rate characteristics of certain pools of loan assets with debt instruments of substantially similar characteristics. Due to the variability in duration of the Company’s assets and varying market conditions, the Company does not attempt to perfectly match the interest rate characteristics of the entire loan portfolio with the underlying debt instruments. The Company has adopted a policy of periodically reviewing the mismatch related to the interest rate characteristics of its assets and liabilities together with the Company’s outlook as to current and future market conditions. Based on those factors, the Company uses derivative instruments as part of its overall risk management strategy. Derivative instruments used as part of the Company’s interest rate risk management strategy currently include interest rate swaps, basis swaps, and cross-currency swaps.

 

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The following table presents the Company’s student loan assets and related funding arranged by underlying indices as of September 30, 2008:
                         
                    Debt  
                    outstanding  
                    that funded  
    Frequency of             student loan  
Index (e)   Variable Resets     Assets     assets (a)  
 
3 month H15 financial commercial paper (b)
  Daily   $ 24,422,798       354,003  
3 month Treasury bill
  Varies     1,303,095        
Private student loans
            275,520        
3 month LIBOR (c)
  Quarterly           20,891,535  
Auction-rate or remarketing
  Varies           2,771,445  
Asset-backed commercial paper
  Varies           2,657,430  
Fixed rate
                  205,435  
Other (d)
            878,435        
 
                   
 
 
          $ 26,879,848       26,879,848  
 
                   
     
(a)  
During 2007, the Company entered into basis swaps in which the Company receives three-month LIBOR set discretely in advance and pays a daily weighted average three-month LIBOR less a spread as defined in the individual agreements. The Company entered into these derivative instruments to better match the interest rate characteristics on its student loan assets and the debt funding such assets. The following table summarizes these derivatives as of September 30, 2008:
         
    Notional  
Maturity   Amount  
 
2008
  $ 1,000,000  
2009
    1,000,000  
2010 (1)
    5,500,000  
2011
    2,700,000  
2012
    2,400,000  
 
     
 
       
 
  $ 12,600,000  
 
     
     
(1)  
In October 2008, the Company terminated a basis swap with a notional amount of $1.0 billion and an original maturity date in 2010 for proceeds of $0.6 million. This derivative is included in the above table.
 
(b)  
The Company’s FFELP student loans earn interest based on the daily average H15 financial commercial paper index calculated on a fiscal quarter. The Company’s funding includes $90.1 million funding private student loans under a participation agreement with Union Bank and $263.9 million funding FFELP student loans under the Department’s Participation Program.
 
(c)  
The Company has Euro-denominated notes that reprice on the EURIBOR index. The Company has entered into derivative instruments (cross-currency interest rate swaps) that convert the EURIBOR index to 3 month LIBOR. As a result, these notes are reflected in the 3 month LIBOR category in the above table. See “Foreign Currency Exchange Risk.”

 

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(d)  
Assets include restricted cash and investments and other assets.
 
(e)  
Historically, the movement of the various interest rate indices received on the Company’s student loan assets and paid on the debt to fund such loans was highly correlated. As shown below, the short-term movement of the indices was dislocated beginning in August 2007. This dislocation has had a negative impact on the Company’s student loan net interest income.
(LINE GRAPH)
Financial Statement Impact of Derivative Instruments
The Company accounts for its derivative instruments in accordance with SFAS No. 133. SFAS No. 133 requires that changes in the fair value of derivative instruments be recognized currently in earnings unless specific hedge accounting criteria as specified by SFAS No. 133 are met. Management has structured all of the Company’s derivative transactions with the intent that each is economically effective. However, the Company’s derivative instruments do not qualify for hedge accounting under SFAS No. 133; consequently, the change in fair value of these derivative instruments is included in the Company’s operating results. Changes or shifts in the forward yield curve and fluctuations in currency rates can significantly impact the valuation of the Company’s derivatives. Accordingly, changes or shifts to the forward yield curve and fluctuations in currency rates will impact the financial position and results of operations of the Company. The change in fair value of the Company’s derivatives are included in “derivative market value, foreign currency, and put option adjustments and derivative settlements, net” in the Company’s consolidated statements of operations and resulted in an expense of $119.9 million and $72.4 million for the three and nine months ended September 30, 2008, respectively, and income of $72.7 million and $93.0 million for the three and nine months ended September 30, 2007, respectively.
The following summarizes the derivative settlements included in “derivative market value, foreign currency, and put option adjustments and derivative settlements, net” on the consolidated statements of operations:
                                 
    Three months ended     Nine months ended  
    September 30,     September 30,  
    2008     2007     2008     2007  
 
Interest rate swaps — loan portfolio
  $ (3,176 )           (14,195 )     4,753  
Basis swaps — loan portfolio
    (3,999 )     (2,608 )     41,606       (2,489 )
Interest rate swaps — other (a)
          1,729             12,050  
Cross-currency interest rate swaps
    7,963       (1,457 )     18,577       (7,214 )
 
                       
 
                               
Derivative settlements received (paid), net
  $ 788       (2,336 )     45,988       7,100  
 
                       

 

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(a)  
During the fourth quarter 2006, in consideration of not receiving 9.5% special allowance payments on a prospective basis, the Company entered into a series of off-setting interest rate swaps that mirrored the $2.45 billion in pre-existing interest rate swaps that the Company had utilized to hedge its loan portfolio receiving 9.5% special allowance payments against increases in interest rates.
 
   
During the second quarter 2007, the Company entered into a series of off-setting interest rate swaps that mirrored the remaining interest rate swaps utilized to hedge the Company’s student loan portfolio against increases in interest rates.
 
   
The net effect of the offsetting derivatives discussed above was to lock in a series of future income streams on underlying trades through their respective maturity dates. The net settlements on these derivatives are included in “interest rate swaps — other.” In August 2007, the Company terminated these derivatives for net proceeds of $50.8 million.
Sensitivity Analysis
The following tables summarize the effect on the Company’s earnings, based upon a sensitivity analysis performed by the Company assuming a hypothetical increase and decrease in interest rates of 100 basis points and an increase in interest rates of 200 basis points while funding spreads remain constant. The effect on earnings was performed on the Company’s variable-rate assets and liabilities. The analysis includes the effects of the Company’s interest rate and basis swaps in existence during these periods. As a result of the Company’s interest rate management activities, the Company expects such a change in pre-tax net income resulting from a 100 basis point increase or decrease or a 200 basis point increase in interest rates would not result in a proportional decrease in net income.
                                                 
    Three months ended September 30, 2008  
    Change from decrease of 100     Change from increase of 100     Change from increase of 200  
    basis points     basis points     basis points  
    Dollar     Percent     Dollar     Percent     Dollar     Percent  
    (dollars in thousands)  
Effect on earnings:
                                               
Increase (decrease) in pre-tax net income before impact of derivative settlements
  $ 8,803       23.3 %     (2,299 )     (6.1 )%     (3,170 )     (8.4 )%
Impact of derivative settlements
    (3,101 )     (8.2 )     3,100       8.2       6,201       16.4  
 
                                   
Increase in net income before taxes
  $ 5,702       15.1 %     801       2.1 %     3,031       8.0 %
 
                                   
Increase in basic and diluted earning per share
  $ 0.07               0.01               0.04          
 
                                         
                                                 
    Three months ended September 30, 2007  
    Change from decrease of 100     Change from increase of 100     Change from increase of 200  
    basis points     basis points     basis points  
    Dollar     Percent     Dollar     Percent     Dollar     Percent  
    (dollars in thousands)  
Effect on earnings:
                                               
Increase in pre-tax net income before impact of derivative settlements
  $ 7,557       27.7 %     159       0.6 %     1,395       5.1 %
Impact of derivative settlements
                                   
 
                                   
Increase in net income before taxes
  $ 7,557       27.7 %     159       0.6 %     1,395       5.1 %
 
                                   
Increase in basic and diluted earning per share
  $ 0.09                             0.02          
 
                                         
                                                 
    Nine months ended September 30, 2008  
    Change from decrease of 100     Change from increase of 100     Change from increase of 200  
    basis points     basis points     basis points  
    Dollar     Percent     Dollar     Percent     Dollar     Percent  
    (dollars in thousands)  
Effect on earnings:
                                               
Increase (decrease) in
pre-tax net income before impact of derivative settlements
  $ 33,585       2,205.2 %     (33,585 )     (2,205.2 )%     (46,123 )     (3,028.4 )%
Impact of derivative settlements
    (8,141 )     (534.5 )     8,141       534.5       16,282       1,069.1  
 
                                   
Increase (decrease) in net income before taxes
  $ 25,444       1,670.7 %     (25,444 )     (1,670.7 )%     (29,841 )     (1,959.3 )%
 
                                   
Increase (decrease) in basic and diluted earning per share
  $ 0.33               (0.33 )             (0.38 )        
 
                                         
                                                 
    Nine months ended September 30, 2007  
    Change from decrease of 100     Change from increase of 100     Change from increase of 200  
    basis points     basis points     basis points  
    Dollar     Percent     Dollar     Percent     Dollar     Percent  
    (dollars in thousands)  
Effect on earnings:
                                               
Increase in pre-tax net income before impact of derivative settlements
  $ 15,170       58.0 %     8,858       33.9 %     20,980       80.2 %
Impact of derivative settlements
                                   
 
                                   
Increase in net income before taxes
  $ 15,170       58.0 %     8,858       33.9 %     20,980       80.2 %
 
                                   
Increase in basic and diluted earning per share
  $ 0.20               0.12               0.27          
 
                                         

 

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Foreign Currency Exchange Risk
During 2006, the Company completed separate debt offerings of student loan asset-backed securities that included 420.5 million and 352.7 million Euro-denominated notes with interest rates based on a spread to the EURIBOR index. As a result of this transaction, the Company is exposed to market risk related to fluctuations in foreign currency exchange rates between the U.S. and Euro dollars. The principal and accrued interest on these notes is re-measured at each reporting period and recorded on the Company’s balance sheet in U.S. dollars based on the foreign currency exchange rate on that date. Changes in the principal and accrued interest amounts as a result of foreign currency exchange rate fluctuations are included in the “derivative market value, foreign currency, and put option adjustments and derivative settlements, net” in the Company’s consolidated statements of operations.
The Company entered into cross-currency interest rate swaps in connection with the issuance of the Euro Notes. Under the terms of these derivative instrument agreements, the Company receives from a counterparty a spread to the EURIBOR index based on notional amounts of 420.5 million and 352.7 million and pays a spread to the LIBOR index based on notional amounts of $500.0 million and $450.0 million, respectively. In addition, under the terms of these agreements, all principal payments on the Euro Notes will effectively be paid at the exchange rate in effect as of the issuance of the notes. The Company did not qualify these derivative instruments as hedges under SFAS No. 133; consequently, the change in fair value is included in the Company’s operating results.
For the three and nine months ended September 30, 2008, the Company recorded income of $128.9 million and $40.4 million, respectively, as a result of re-measurement of the Euro Notes and losses of $129.0 million and $37.3 million, respectively, for the change in the fair value of the related derivative instrument. For the three and nine months ended September 30, 2007, the Company recorded losses of $54.0 million and $79.0 million, respectively, as a result of the re-measurement of the Euro Notes, and income of $58.8 million and $85.8 million, respectively, for the change in the fair value of the related derivative instrument. Both of these amounts are included in “derivative market value, foreign currency, and put option adjustments and derivative settlements, net” on the Company’s consolidated statements of operations.
ITEM 4. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
Under supervision and with the participation of certain members of the Company’s management, including the chief executive and the chief financial officers, the Company completed an evaluation of the effectiveness of the design and operation of its disclosure controls and procedures (as defined in SEC Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based on this evaluation, the Company’s chief executive and chief financial officers believe that the disclosure controls and procedures were effective as of the end of the period covered by this Quarterly Report on Form 10-Q with respect to timely communication to them and other members of management responsible for preparing periodic reports and material information required to be disclosed in this Quarterly Report on Form 10-Q as it relates to the Company and its consolidated subsidiaries.
The effectiveness of the Company’s or any system of disclosure controls and procedures is subject to certain limitations, including the exercise of judgment in designing, implementing, and evaluating the controls and procedures, the assumptions used in identifying the likelihood of future events, and the inability to eliminate misconduct completely. As a result, there can be no assurance that the Company’s disclosure controls and procedures will prevent all errors or fraud or ensure that all material information will be made known to appropriate management in a timely fashion. By their nature, the Company’s or any system of disclosure controls and procedures can provide only reasonable assurance regarding management’s control objectives.
Changes in Internal Control over Financial Reporting
There was no change in the Company’s internal control over financial reporting during the Company’s last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
General
The Company is subject to various claims, lawsuits, and proceedings that arise in the normal course of business. These matters principally consist of claims by student loan borrowers disputing the manner in which their student loans have been processed and disputes with other business entities. On the basis of present information, anticipated insurance coverage, and advice received from counsel, it is the opinion of the Company’s management that the disposition or ultimate determination of these claims, lawsuits, and proceedings will not have a material adverse effect on the Company’s business, financial position, or results of operations.

 

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Municipal Derivative Bid Practices Investigation
As previously disclosed, on February 8, 2008, Shockley Financial Corp. (“SFC”), an indirect, wholly-owned subsidiary of the Company that provides investment advisory services for the investment of proceeds from the issuance of municipal and corporate bonds, received a grand jury subpoena issued by the U.S. District Court for the Southern District of New York upon application of the Antitrust Division of the U.S. Department of Justice. The subpoena seeks certain information and documents from SFC in connection with the Department of Justice’s ongoing criminal investigation of the bond industry with respect to possible anti-competitive practices related to awards of guaranteed investment contracts (“GICs”) and other products for the investment of proceeds from bond issuances. SFC currently has one employee. The Company and SFC are cooperating with the investigation.
On March 5, 2008, SFC received a subpoena from the Securities and Exchange Commission (the “SEC”) related to an ongoing industry-wide investigation concerning the bidding of municipal GICs. In addition, on or about June 6, 2008 and June 12, 2008, SFC received a subpoena from both the New York Attorney General (the “NYAG”) and the Florida Attorney General, respectively, relating to their investigations concerning the bidding of municipal GICs and possible violations of various state and federal laws. The subpoenas seek certain information and documents from SFC relating to its GIC business. The Company and SFC are cooperating with these investigations.
SFC has also been named as a defendant in a number of substantially identical purported class action lawsuits. In each of the lawsuits, a large number of financial institutions and financial service providers, including SFC, are named as defendants. The complaints allege that the defendants engaged in a conspiracy not to compete and to fix prices and rig bids for municipal derivatives (including GICs) sold to issuers of municipal bonds. All the complaints assert claims for violations of Section 1 of the Sherman Act and fraudulent concealment, and three complaints also assert claims for unfair competition and violation of the California Cartwright Act. On June 16, 2008, the United States Judicial Panel on Multidistrict Litigation issued an order transferring the cases then before it to the U.S. District Court for the Southern District of New York which consolidated several cases under the caption Hinds County, Mississippi v. Wachovia Bank, N.A. et al. SFC intends to vigorously contest these purported class action lawsuits.
SFC, the Company, or other subsidiaries of the Company may receive subpoenas from other regulatory agencies. Due to the preliminary nature of these matters as to SFC, the Company is unable to predict the ultimate outcome of the investigations or the class action lawsuits.
Industry Investigations
On January 11, 2007, the Company received a letter from the NYAG requesting certain information and documents from the Company in connection with the NYAG’s investigation into preferred lender list activities. Since January 2007, a number of state attorneys general, including the NYAG, and the U.S. Senate Committee on Health, Education, Labor, and Pensions also announced or are reportedly conducting broad inquiries or investigations of the activities of various participants in the student loan industry, including activities which may involve perceived conflicts of interest. A focus of the inquiries or investigations has been on any financial arrangements among student loan lenders and other industry participants which may facilitate increased volumes of student loans for particular lenders. Like many other student loan lenders, the Company received requests for information from certain state attorneys general and the Chairman of the U.S. Senate Committee on Health, Education, Labor, and Pensions in connection with their inquiries or investigations. In addition, the Company received subpoenas for information from the NYAG, the New Jersey Attorney General, and the Ohio Attorney General. In each case the Company is cooperating with the requests and subpoenas for information that it has received.
On July 31, 2007, the Company announced that it had agreed with the NYAG to adopt the NYAG’s Code of Conduct, which is substantially similar to the Company’s previously adopted Nelnet Student Loan Code of Conduct. As part of the agreement, the Company agreed to contribute $2.0 million to a national fund for educating high school students and their parents regarding the financial aid process (the “NYAG Fund”).
On October 10, 2007, the Company received a subpoena from the NYAG requesting certain information and documents from the Company in connection with the NYAG’s investigation into direct-to-consumer marketing practices of student lenders. On September 9, 2008, the Company announced that it agreed to adopt the NYAG’s Student Loan Direct Marketing Code of Conduct. As part of the agreement, the Company agreed to contribute $200,000 to the NYAG Fund.
While the Company cannot predict the ultimate outcome of any inquiry or investigation, the Company believes its activities have materially complied with applicable law, including the Higher Education Act, the rules and regulations adopted by the Department of Education thereunder, and the Department’s guidance regarding those rules and regulations.
Department of Education Review
The Department of Education periodically reviews participants in the FFEL Program for compliance with program provisions. On June 28, 2007, the Department notified the Company that it would be conducting a review of the Company’s administration of the FFEL Program under the Higher Education Act. The Company understands that the Department has selected several schools and lenders for review. Specifically, the Department is reviewing the Company’s practices in connection with the prohibited inducement provisions of the Higher Education Act and the provisions of the Higher Education Act and the associated regulations which allow borrowers to have a choice of lenders. The Company has responded to the Department’s requests for information and documentation and is cooperating with their review.

 

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While the Company cannot predict the ultimate outcome of the review, the Company believes its activities have materially complied with the Higher Education Act, the rules and regulations adopted by the Department of Education thereunder, and the Department’s guidance regarding those rules and regulations.
Department of Justice
In connection with the Company’s settlement with the Department of Education in January 2007 to resolve the Office of Inspector General of the Department of Education (the “OIG”) audit report with respect to the Company’s student loan portfolio receiving special allowance payments at a minimum 9.5% interest rate, the Company was informed by the Department of Education that a civil attorney with the Department of Justice had opened a file regarding the issues set forth in the OIG report, which the Company understands is common procedure following an OIG audit report. The Company has engaged in discussions with and provided information to the Department of Justice in connection with the review.
While the Company is unable to predict the ultimate outcome of the review, the Company believes its practices complied with applicable law, including the provisions of the Higher Education Act, the rules and regulations adopted by the Department of Education thereunder, and the Department’s guidance regarding those rules and regulations.
ITEM 1A. RISK FACTORS
Except as set forth below and except as disclosed in the Company’s Quarterly Reports on Form 10-Q for the quarters ended March 31, 2008 and June 30, 2008, there have been no material changes from the risk factors described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007 in response to Item 1A of Part I of such Form 10-K.
The recent credit and financial market crisis has had an adverse effect on the Company’s liquidity and poses counterparty risks.
The recent unprecedented disruptions in the credit and financial markets, and the related crisis affecting the banking system which resulted in the enactment of the Emergency Economic Stabilization Act of 2008 in October 2008, have had and may continue to have an adverse effect on the cost and availability of financing for the Company’s student loan portfolios and, as a result, have had and may continue to have an adverse effect on the Company’s liquidity, results of operations, and financial condition. Such adverse conditions may continue or worsen in the future.
The Company has historically relied on a multi-seller bank provided conduit warehouse facility to fund the origination and acquisition of FFELP student loans. The facility for FFELP loans terminates in May 2010 and was supported by 364-day liquidity which was up for renewal on May 9, 2008. The Company obtained an extension of the renewal until July 31, 2008. On July 31, 2008, the Company did not renew the liquidity provisions of this facility. Accordingly, as of July 31, 2008, the facility became a term facility with an outstanding balance of approximately $2.8 billion and a final maturity of May 9, 2010. As of November 7, 2008, the outstanding balance under this facility was $2.1 billion. Pursuant to the terms of the agreement, since liquidity was not renewed, the Company’s cost of financing under this facility increased 10 basis points. The agreement also includes provisions which allow the banks to charge a rate equal to LIBOR plus 128.5 basis points if they choose to finance their portion of the facility with sources of funds other than their commercial paper conduit. In addition, the FFELP warehouse facility has a provision requiring the Company to refinance or remove 75% of the pledged collateral on an annual basis. The Company believes it has met this requirement for the annual period ending in May 2009. However, the Company does have an obligation to remove approximately $30 million of loans by December 31, 2008 because these loans were partially disbursed when the facility was termed-out on July 31, 2008. Under the current terms of the facility, the remaining collateral will need to be refinanced or removed by May 9, 2010.
The warehouse facility for FFELP loans also currently provides for mark-to-market advance rates related to the valuation of financed loans. On October 22, 2008, the Company posted $165.5 million in additional funds to the facility based on this mark-to-market provision. While the Company does not believe that the loan valuation formula is reflective of the actual fair value of its loans, it is subject to compliance with the current mark-to-market provisions of the warehouse facility agreement. As of November 7, 2008, the Company has a cumulative amount of $374.6 million posted as equity funding support for the facility.
The Company has utilized its $750.0 million unsecured line of credit to fund equity advances on its warehouse facility. As of November 7, 2008, the Company had $691.5 million outstanding under the line of credit and $58.5 million available for future use. The lending commitment under the line of credit is provided by a total of thirteen banks, with no individual bank representing more than 11% of the total lending commitment. The bank lending group includes Lehman Bank, which represents approximately 7% of the lending commitment under the line of credit. On September 15, 2008, Lehman Brothers Holdings Inc. filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code. Since the bankruptcy filing, the Company has experienced funding delays from Lehman Bank for its portion of the lending commitment under the line of credit.

 

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Continued disruptions in the credit and financial markets may cause additional volatility in the mark-to-market loan valuation formula under the warehouse facility. Should a significant change in the valuation of loans result in additional required equity funding support for the warehouse facility greater than what the Company can provide and the Company has not amended the facility as discussed below, the warehouse facility could be subject to an event of default resulting in a termination of the facility and an acceleration of the repayment provisions. A default on the FFELP warehouse facility would result in an event of default on the Company’s unsecured line of credit that would result in the outstanding balance on the line of credit becoming immediately due and payable.
To reduce the Company’s exposure from the mark-to-market advance rate provision included in the FFELP warehouse facility, the Company has signed a letter agreement engaging Banc of America Securities LLC to arrange an amendment of certain of the Company’s credit facilities, including but not limited to an amendment to place a floor on the valuation of collateral in the Company’s FFELP loan warehouse line of credit for which Bank of America, N.A. acts as administrative agent. Banc of America Securities LLC has commenced the amendment process and together with the Company is seeking the approval of the Company’s lenders of a proposed amendment of such credit facilities on mutually agreeable terms. In addition, the Company continues to look at various alternatives to remove loans from the warehouse facility including other financing arrangements and/or selling loans to third parties.
In addition, on November 8, 2008, the Department announced they intend to provide liquidity support to one or more conforming asset backed commercial paper conduits to purchase and provide longer-term financing for FFELP loans. While details of this conduit are forthcoming, it is intended that all fully-disbursed non-consolidation FFELP loans awarded between October 1, 2003 and July 1, 2009 will be eligible for inclusion. As of November 7, 2008, the Company had approximately $900 million of loans included in its warehouse facility that would be eligible for this proposed conduit program.
The Company has historically used its warehouse facility to pool student loans in order to maximize loan portfolio characteristics for efficient financing and to properly time market conditions for movement of the loans into an asset-backed securitization. In addition, the Company has historically relied on asset-backed securitizations as a significant source of funding for student loans on a long-term basis. Since late September 2008, the severe disruptions in the credit and financial markets have made asset-backed securitization financing generally unavailable. The Company is currently unable to predict when market conditions will allow for future asset-backed securitization financing. If the Company were unable to continue to securitize student loans on favorable terms, it could use alternative funding sources to meet liquidity needs, including (i) the Department of Education’s new financing programs as discussed below for loans disbursed after April 30, 2008, (ii) an existing FFELP loan participation facility with Union Bank, an entity under common control with the Company, and (iii) the Company’s unsecured line of credit; however, such alternatives may result in the sale of loans by the Company and a loss of the accompanying servicing rights. If the Company is unable to obtain cost-effective and stable funding alternatives, its funding capabilities and liquidity would be negatively impacted and its cost of funds could increase, adversely affecting the Company’s results of operations. In addition, the Company’s ability to originate and acquire student loans would be limited or could be eliminated. With respect to the origination of new FFELP student loans, the Company currently expects to utilize the Department of Education’s new financing programs as discussed below, the participation facility with Union Bank, and the Company’s unsecured line of credit.
On July 1, 2008, pursuant to the Ensuring Continued Access to Student Loans Act, the Department of Education announced terms under which it will offer to purchase certain FFELP student loans and participation interests in certain FFELP student loans from FFELP lenders. Under the Department’s Purchase Program, the Department will purchase loans at a price equal to the sum of (i) par value, (ii) accrued interest, (iii) the one percent origination fee paid to the Department, and (iv) a fixed amount of $75 per loan. Lenders will have until September 30, 2009 to sell loans to the Department. Under the Department’s Participation Program, the Department will provide interim short-term liquidity to FFELP lenders by purchasing participation interests in pools of FFELP loans. FFELP lenders will be charged a rate of commercial paper plus 50 basis points on the principal amount of participation interests outstanding. Loans funded under the Participation Program must be either refinanced by the lender or sold to the Department pursuant to the Purchase Program prior to its expiration on September 30, 2009. To be eligible for purchase or participation under the Department’s programs, loans must be FFELP Stafford or PLUS loans made for the academic year 2008-2009, first disbursed between May 1, 2008 and July 1, 2009, with eligible borrower benefits. On August 14, 2008, the Company received notification that the Department had approved the Master Participation Agreement the Company submitted to enable the Company to begin participating in the Participation Program. The Company expects to utilize the Participation Program to fund a significant portion of its loan originations for the 2008-2009 academic year.
On October 7, 2008, legislation was enacted to extend the Department’s authority to address FFELP student loans made for the 2009-2010 academic year and allowing for the extension of the Participation Program and Purchase Program from September 30, 2009 to September 30, 2010. The Department has provided preliminary guidance relating to the extension and has indicated that programs similar to the Participation Program and Purchase Program will be implemented for the 2009-2010 academic year along with providing liquidity support for one or more asset backed commercial paper conduits for FFELP Stafford and PLUS loans awarded between October 1, 2003 and July 1, 2009. The Department has indicated that loans for the 2008-2009 academic year which are funded under the Department’s Participation Program will need to be refinanced or sold to the Department prior to September 30, 2009. Management understands that such loans will not be eligible for participation under the Department’s 2009-2010 Participation Program, but should be eligible for refinancing through the Department’s commercial paper conduit program. Management of the Company is encouraged by these developments; however, until the Department provides additional details regarding the programs, the Company is unable to determine the full impact these programs will have on the Company.
There can be no assurance that the Department’s Participation Program and Purchase Program, the participation facility with Union Bank, or the Company’s unsecured line of credit will be adequate to fund the Company’s student loan origination and acquisition obligations. As such, the Company’s ability to originate and acquire student loans could be limited or eliminated.

 

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The recent credit and financial market crisis has increased the risk that a lending, investment, or derivative counterparty will not be able to meet its obligations to the Company. As discussed above, since the bankruptcy filing of Lehman Brothers Holdings Inc. in September 2008, the Company has experienced funding delays from Lehman Bank for its portion of the Company’s borrowing requests under its line of credit, and the Company anticipates that Lehman Bank may not fund future borrowing requests by the Company. In addition, as of September 30, 2008, the Company had a total of $658.4 million invested in guaranteed investment contracts (“GICs”), for which there is no available or active market. Approximately $118.3 million of these GICs are with foreign banks, which receive support from the governments. The remaining $540.1 million of these GICs are with a total of three banks, all of which are currently AA rated, and with one such bank representing 88% of this amount. A default by the counterparties under the GICs could lead to a loss of the Company’s investment and have a material adverse effect on the Company’s results of operations and financial condition.
The recent reductions in the Company’s student loan purchases from branding and forward flow partners could have an adverse impact on its business.
The Company has historically acquired student loans through forward flow commitments and branding partner arrangements with other student loan lenders. The enactment of the College Cost Reduction Act in September 2007 resulted in a reduction in the yields on student loans and, accordingly, a reduction in the amount of the premium the Company could pay lenders under its forward flow commitments and branding partner arrangements. In addition, the current capital market disruptions have rendered origination or acquisition of student loans through these channels uneconomical. Accordingly, the Company has recently reduced the acquisition of student loans through its branding and forward flow relationships. As a result, the Company has and will continue to experience a decrease in its forward flow and branding partner loan volume. The Company can give no assurance that it will be successful in renegotiating or renewing, on economically reasonable terms, its branding and forward flow agreements once those agreements expire. Loss of a strong branding or forward flow partner, or relationships with schools from which a significant volume of student loans is directly or indirectly acquired, could result in an adverse effect on the Company’s business.
Recent changes in legislation may affect the Company’s business and profitability.
On August 14, 2008, the Higher Education Opportunity Act became law. The Higher Education Opportunity Act amends the Higher Education Act to revise and reauthorize Higher Education Act programs. In addition, among other items, this legislation:
   
Contains lender and school code of conduct requirements applicable to FFELP and private education lenders;
 
   
Contains additional provisions and reporting requirements for lenders and schools participating in preferred lender arrangements; and
 
   
Contains additional disclosures that FFELP lenders must make to borrowers as well as added FFELP loan servicing requirements for lenders.
The Higher Education Opportunity Act may affect the Company’s profitability by increasing costs as a result of required changes to the Company’s operations.

 

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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Stock Repurchases
The following table summarizes the repurchases of Class A common stock during the third quarter of 2008 by the Company or any “affiliated purchaser” of the Company, as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934.
                                 
                    Total number of     Maximum number  
                    shares purchased     of shares that may  
    Total number     Average     as part of publicly     yet be purchased  
    of shares     price paid     announced plans     under the plans  
Period   purchased (1)     per share     or programs (2) (3)     or programs (4)  
 
July 1 - July 31, 2008
    843     $ 10.64       843       8,006,039  
August 1 - August 31, 2008
    4,581       13.22       4,581       6,938,898  
September 1 - September 30, 2008
    2,140       15.67       2,140       7,184,957  
 
                         
Total
    7,564     $ 13.63       7,564          
 
                         
     
(1)  
The total number of shares includes: (i) shares purchased pursuant to the 2006 Plan discussed in footnote (2) below; and (ii) shares purchased pursuant to the 2006 ESLP discussed in footnote (3) below, of which there were none for the months of July, August, or September 2008. Shares of Class A common stock purchased pursuant to the 2006 Plan included (i) 843 shares, 363 shares, and 2,140 shares in July, August, and September, respectively, that had been issued to the Company’s 401(k) plan and allocated to employee participant accounts pursuant to the plan’s provisions for Company matching contributions in shares of Company stock, and were purchased by the Company from the plan pursuant to employee participant instructions to dispose of such shares, and (ii) 4,218 shares purchased in August 2008 from employees upon cancellation of loans associated with shares originally acquired pursuant to the 2006 ESLP.
 
(2)  
On May 25, 2006, the Company publicly announced that its Board of Directors had authorized a stock repurchase program to repurchase up to a total of five million shares of the Company’s Class A common stock (the “2006 Plan”). On February 7, 2007, the Company’s Board of Directors increased the total shares the Company is allowed to repurchase to 10 million. The 2006 Plan had an initial expiration date of May 24, 2008, which was extended until May 24, 2010 by the Company’s Board of Directors on January 30, 2008.
 
(3)  
On May 25, 2006, the Company publicly announced that the shareholders of the Company approved an Employee Stock Purchase Loan Plan (the “2006 ESLP”) to allow the Company to make loans to employees for the purchase of shares of the Company’s Class A common stock either in the open market or directly from the Company. A total of $40 million in loans may be made under the 2006 ESLP, and a total of one million shares of Class A common stock are reserved for issuance under the 2006 ESLP. Shares may be purchased directly from the Company or in the open market through a broker at prevailing market prices at the time of purchase, subject to any conditions or restrictions on the timing, volume, or prices of purchases as determined by the Compensation Committee of the Board of Directors and set forth in the Stock Purchase Loan Agreement with the participant. The 2006 ESLP shall terminate May 25, 2016.
 
(4)  
The maximum number of shares that may yet be purchased under the plans is calculated below. There are no assurances that any additional shares will be repurchased under either the 2006 Plan or the 2006 ESLP. Shares under the 2006 ESLP may be issued by the Company rather than purchased in open market transactions.
                                         
                            (B / C)     (A + D)  
            Approximate dollar     Closing price on the     Approximate     Approximate  
    Maximum number of     value of shares that     last trading     number of shares     number of shares  
    shares that may yet be     may yet be     day of the     that may yet be     that may yet be  
    purchased under the     purchased under     Company’s Class A     purchased under     purchased under  
    2006 Plan     the 2006 ESLP     Common Stock     the 2006 ESLP     the 2006 Plan and  
As of   (A)     (B)     (C)     (D)     2006 ESLP  
July 31, 2008
    4,624,777       36,450,000       10.78       3,381,262       8,006,039  
August 31, 2008
    4,620,196       36,450,000       15.72       2,318,702       6,938,898  
September 30, 2008
    4,618,056       36,450,000       14.20       2,566,901       7,184,957  

 

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Working capital and dividend restrictions/limitations
The Company’s credit facilities, including its revolving line of credit which is available through May of 2012, impose restrictions on the Company’s minimum consolidated net worth, the ratio of the Company’s Adjusted EBITDA to corporate debt interest, the indebtedness of the Company’s subsidiaries, and the ratio of Non-FFELP loans to all loans in the Company’s portfolio. In addition, trust indentures and other financing agreements governing debt issued by the Company’s education lending subsidiaries may have general limitations on the amounts of funds that can be transferred to the Company by its subsidiaries through cash dividends.
On September 27, 2006 the Company consummated a debt offering of $200.0 million aggregate principal amount of Junior Subordinated Hybrid Securities (“Hybrid Securities”). So long as any Hybrid Securities remain outstanding, if the Company gives notice of its election to defer interest payments but the related deferral period has not yet commenced or a deferral period is continuing, then the Company will not, and will not permit any of its subsidiaries to:
   
declare or pay any dividends or distributions on, or redeem, purchase, acquire or make a liquidation payment regarding, any of the Company’s capital stock;
 
   
except as required in connection with the repayment of principal, and except for any partial payments of deferred interest that may be made through the alternative payment mechanism described in the Hybrid Securities indenture, make any payment of principal of, or interest or premium, if any, on, or repay, repurchase, or redeem any of the Company’s debt securities that rank pari passu with or junior to the Hybrid Securities; or
 
   
make any guarantee payments regarding any guarantee by the Company of the subordinated debt securities of any of the Company’s subsidiaries if the guarantee ranks pari passu with or junior in interest to the Hybrid Securities.
In addition, if any deferral period lasts longer than one year, the limitation on the Company’s ability to redeem or repurchase any of its securities that rank pari passu with or junior in interest to the Hybrid Securities will continue until the first anniversary of the date on which all deferred interest has been paid or cancelled.
If the Company is involved in a business combination where immediately after its consummation more than 50% of the surviving entity’s voting stock is owned by the shareholders of the other party to the business combination, then the immediately preceding sentence will not apply to any deferral period that is terminated on the next interest payment date following the date of consummation of the business combination.
However, at any time, including during a deferral period, the Company will be permitted to:
   
pay dividends or distributions in additional shares of the Company’s capital stock;
 
   
declare or pay a dividend in connection with the implementation of a shareholders’ rights plan, or issue stock under such a plan, or redeem or repurchase any rights distributed pursuant to such a plan; and
 
   
purchase common stock for issuance pursuant to any employee benefit plans.

 

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ITEM 6. EXHIBITS
     
10.1*  
Fourth Amendment of Amended and Restated Participation Agreement, dated as of August 1, 2005, by and between Union Bank and Trust Company and Nelnet, Inc. (f/k/a NELnet, Inc.) (subsequently renamed National Education Loan Network, Inc.).
   
 
10.2*  
Fifth Amendment of Amended and Restated Participation Agreement, dated as of November 1, 2005, by and between Union Bank and Trust Company and Nelnet, Inc. (f/k/a NELnet, Inc.) (subsequently renamed National Education Loan Network, Inc.).
   
 
10.3*  
Sixth Amendment of Amended and Restated Participation Agreement, dated as of December 12, 2005, by and between Union Bank and Trust Company and Nelnet, Inc. (f/k/a NELnet, Inc.) (subsequently renamed National Education Loan Network, Inc.).
   
 
10.4*  
Master Participation Agreement, dated as of August 14, 2008, by and between the United States Department of Education and Nelnet, Inc.
   
 
10.5*  
Master Loan Sale Agreement, dated as of August 14, 2008, by and between the United States Department of Education and Nelnet, Inc.
   
 
10.6*+  
Separation Agreement, dated as of July 21, 2008, by and between Matthew D. Hall and Nelnet, Inc.
   
 
31.1*  
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Chief Executive Officer Michael S. Dunlap.
   
 
31.2*  
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Chief Financial Officer Terry J. Heimes.
   
 
   32**  
Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
     
*  
Filed herewith
 
**  
Furnished herewith
 
+  
Indicates a compensatory plan or arrangement

 

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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
         
  NELNET, INC.
 
 
Date: November 10, 2008  By:   /s/ MICHAEL S. DUNLAP    
    Name:   Michael S. Dunlap   
    Title:   Chairman and Chief Executive Officer   
     
  By:   /s/ TERRY J. HEIMES    
    Name:   Terry J. Heimes   
    Title:   Chief Financial Officer   

 

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EXHIBIT INDEX
     
10.1*  
Fourth Amendment of Amended and Restated Participation Agreement, dated as of August 1, 2005, by and between Union Bank and Trust Company and Nelnet, Inc. (f/k/a NELnet, Inc.) (subsequently renamed National Education Loan Network, Inc.).
   
 
10.2*  
Fifth Amendment of Amended and Restated Participation Agreement, dated as of November 1, 2005, by and between Union Bank and Trust Company and Nelnet, Inc. (f/k/a NELnet, Inc.) (subsequently renamed National Education Loan Network, Inc.).
   
 
10.3*  
Sixth Amendment of Amended and Restated Participation Agreement, dated as of December 12, 2005, by and between Union Bank and Trust Company and Nelnet, Inc. (f/k/a NELnet, Inc.) (subsequently renamed National Education Loan Network, Inc.).
   
 
10.4*  
Master Participation Agreement, dated as of August 14, 2008, by and between the United States Department of Education and Nelnet, Inc.
   
 
10.5*  
Master Loan Sale Agreement, dated as of August 14, 2008, by and between the United States Department of Education and Nelnet, Inc.
   
 
10.6*+  
Separation Agreement, dated as of July 21, 2008, by and between Matthew D. Hall and Nelnet, Inc.
   
 
31.1*  
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Chief Executive Officer Michael S. Dunlap.
   
 
31.2*  
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Chief Financial Officer Terry J. Heimes.
   
 
   32**  
Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
     
*  
Filed herewith
 
**  
Furnished herewith
 
+  
Indicates a compensatory plan or arrangement

 

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