10-K 1 w05293e10vk.htm SLM CORPORATION e10vk
 

 
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10-K
     
(Mark One)    
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
    For the fiscal year ended December 31, 2004
 
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 numbers 001-13251
 
SLM Corporation
(Exact Name of Registrant as Specified in Its Charter)
     
Delaware
  52-2013874
(State of Other Jurisdiction of
Incorporation or Organization)
  (I.R.S. Employer
Identification No.)
 
12061 Bluemont Way, Reston, Virginia
(Address of Principal Executive Offices)
  20190
(Zip Code)
(703) 810-3000
(Registrant’s Telephone Number, Including Area Code)
Securities registered pursuant to Section 12(b) of the Act:
Common Stock, par value $.20 per share.
Name of Exchange on which Listed:
New York Stock Exchange
6.97% Cumulative Redeemable Preferred Stock, Series A, par value $.20 per share
Name of Exchange on which Listed:
New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act:
None.
 
      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 an accelerated filer (as defined in Rule 12b-2 of the Act).     Yes þ          No o
      The aggregate market value of voting stock held by non-affiliates of the registrant as of June 30, 2004 was approximately $17,463,295,382.85 (based on closing sale price of $40.45 per share as reported for the New York Stock Exchange — Composite Transactions).
      As of February 28, 2005, there were 421,654,978 shares of common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
      Portions of the Proxy Statement relating to the registrant’s Annual Meeting of Shareholders scheduled to be held May 19, 2005 are incorporated by reference into Part III of this Report.
      Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.     þ
 
 


 

      This report contains forward-looking statements and information that are based on management’s current expectations as of the date of this document. When used in this report, the words “anticipate,” “believe,” “estimate,” “intend” and “expect” and similar expressions are intended to identify forward-looking statements. These forward-looking statements are subject to risks, uncertainties, assumptions and other factors that may cause the actual results to be materially different from those reflected in such forward-looking statements. These factors include, among others, changes in the terms of student loans and the educational credit marketplace arising from the implementation of applicable laws and regulations and from changes in these laws and regulations, which may reduce the volume, average term and costs of yields on student loans under the Federal Family Education Loan Program (“FFELP”) or result in loans being originated or refinanced under non-FFELP programs or may affect the terms upon which banks and others agree to sell FFELP loans to SLM Corporation, more commonly known as Sallie Mae, and its subsidiaries (collectively, “the Company”). The Company could also be affected by changes in the demand for educational financing or in financing preferences of lenders, educational institutions, students and their families; changes in the general interest rate environment and in the securitization markets for education loans, which may increase the costs or limit the availability of financings necessary to initiate, purchase or carry education loans; losses from loan defaults; and changes in prepayment rates and credit spreads.
GLOSSARY
      Listed below are definitions of key terms that are used throughout this document. See also APPENDIX A, “FEDERAL FAMILY EDUCATION LOAN PROGRAM,” for a further discussion of the FFELP.
      Consolidation Loans — Under the FFELP, borrowers with eligible student loans may consolidate them into one note with one lender and convert the variable interest rates on the loans being consolidated into a fixed rate for the life of the loan. The new note is considered a Consolidation Loan. Typically a borrower can consolidate their student loans only once unless the borrower has another eligible loan with which to consolidate with the existing Consolidation Loan. The borrower rate on a Consolidation Loan is fixed for the term of the loan and is set by the weighted-average interest rate of the loans being consolidated, rounded up to the nearest 1/8th of a percent, not to exceed 8.25 percent. In low interest rate environments, Consolidation Loans provide an attractive refinancing opportunity to borrowers because they allow borrowers to consolidate variable rate loans into a long-term fixed rate loan. Holders of Consolidation Loans are eligible to earn interest under the Special Allowance Payment (“SAP”) formula (see definition below).
      Consolidation Loan Rebate Fee — All holders of Consolidation Loans are required to pay to the U.S. Department of Education (“ED”) an annual 105 basis point Consolidation Loan Rebate Fee on all outstanding principal and accrued interest balances of Consolidation Loans purchased or originated after October 1, 1993, except for loans for which consolidation applications were received between October 1, 1998 and January 31, 1999, where the Consolidation Loan Rebate Fee is 62 basis points.
      Constant Prepayment Rate (“CPR”) — A variable in life of loan estimates that measures the rate at which loans in the 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.
      Direct Loans — Student loans originated directly by ED under the William D. Ford Federal Direct Student Loan Program (“FDLP”).
      ED — The U.S. Department of Education.
      Embedded Floor Income — Embedded Floor Income is Floor Income (see definition below) that is earned on off-balance sheet student loans that are in securitization trusts sponsored by us. At the time of the securitization, the option value of Embedded Fixed Rate Floor Income is included in the initial valuation of the Residual Interest (see definition below) and the gain or loss on sale of the student loans. Embedded Floor Income is also included in the quarterly fair value adjustments of the Residual Interest.

2


 

      Exceptional Performer (“EP”) Designation — The EP designation is determined by ED in recognition of meeting certain performance standards set by ED in servicing FFELP loans. Upon receiving the EP designation, the EP servicer receives 100 percent reimbursement on default claims on federally guaranteed student loans for all loans serviced for a period of at least 270 days before the date of default and will no longer be subject to the two percent Risk Sharing (see definition below) on these loans. The EP servicer is entitled to receive this benefit as long as it remains in compliance with the required servicing standards, which are assessed on an annual and quarterly basis through compliance audits and other criteria.
      FDLP — The William D. Ford Federal Direct Student Loan Program.
      FFELP — The Federal Family Education Loan Program (see also APPENDIX A), formerly the Guaranteed Student Loan Program.
      Fixed Rate Floor Income — We refer to Floor Income (see definition below) associated with student loans whose borrower rate is fixed to term (primarily Consolidation Loans) as Fixed Rate Floor Income.
      Floor Income — Our portfolio of FFELP student loans earns interest at the higher of a floating rate based on the Special Allowance Payment or SAP formula (see definition below) set by ED and the borrower rate, which is fixed over a period of time. We generally finance our student loan portfolio with floating rate debt over all interest rate levels. In low and/or declining interest rate environments, when the fixed borrower rate is higher than the rate produced by the SAP formula, our student loans earn at a fixed rate while the interest on our floating rate debt continues to decline. In these interest rate environments, we earn additional spread income that we refer 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 a market rate each July 1. As a result, for loans where the borrower rate is fixed to term, we may earn Floor Income for an extended period of time, and for those loans where the borrower interest rate is reset annually on July 1, we may earn Floor Income to the next reset date.
      The following example shows the mechanics of Floor Income for a typical fixed rate Consolidation Loan originated after July 1, 2004 (with a commercial paper-based SAP spread of 2.64 percent):
         
Fixed Borrower Rate:
    3.375 %
SAP Spread over Commercial Paper Rate:
    (2.640 )%
       
Floor Strike Rate(1)
    0.735 %
       
 
(1)  The interest rate at which the underlying index (Treasury bill or commercial paper) plus the fixed SAP spread equals the fixed borrower rate. Floor Income is earned anytime the interest rate of the underlying index declines below this rate.
      Based on this example, if the quarterly average commercial paper rate is over 0.735 percent, the holder of the student loan will earn at a floating rate based on the SAP formula, which in this example is a fixed spread to commercial paper of 2.64 percent. On the other hand, if the quarterly average commercial paper rate is below 0.735 percent, the SAP formula will produce a rate below the fixed borrower rate of 3.375 percent and the loan holder earns at the borrower rate of 3.375 percent. The difference between the fixed borrower rate and the lender’s expected yield based on the SAP formula is referred to as Floor Income. Our student loan assets are generally funded with floating rate debt, so when student loans are earning at the fixed borrower rate, decreases in interest rates may increase Floor Income.

3


 

Graphic Depiction of Floor Income:
LOGO
      Floor Income Contracts — We enter into contracts with counterparties under which, in exchange for an upfront fee representing the present value of the Floor Income that we expect to earn on a notional amount of student loans being hedged, we will pay the counterparties the Floor Income earned on that notional amount of student loans over the life of the Floor Income Contract. Specifically, we agree to pay the counterparty the difference, if positive, between the fixed borrower rate less the SAP spread and the average of the applicable interest rate index on that notional amount of student loans for a portion of the estimated life of the student loan. This contract effectively locks in the amount of Floor Income we will earn over the period of the contract. Floor Income Contracts are not considered effective hedges under Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and each quarter we must record the change in fair value of these contracts through income.
      GSE — The Student Loan Marketing Association was a federally chartered government-sponsored enterprise and wholly owned subsidiary of SLM Corporation that was dissolved under the terms of the Privatization Act (see definition below) on December 29, 2004.
      HEA — The Higher Education Act of 1965, as amended.
      Managed Basis — We generally analyze the performance of our student loan portfolio on a Managed Basis, under which we view both on-balance sheet student loans and off-balance sheet student loans owned by the securitization trusts as a single portfolio, and the related on-balance sheet financings are combined with off-balance sheet debt. When the term Managed is capitalized in this document, it is referring to Managed Basis.
      Offset Fee — We were required to pay to ED an annual 30 basis point Offset Fee on the outstanding balance of Stafford and PLUS student loans purchased and held by the GSE after August 10, 1993. The fee did not apply to student loans sold to securitized trusts or to loans held outside of the GSE. This fee no longer applies, as the GSE was dissolved under the terms of the Privatization Act on December 29, 2004.
      Preferred Channel Originations — Preferred Channel Originations are comprised of: 1) student loans that are originated by lenders with forward purchase commitment agreements with Sallie Mae and are committed for sale to Sallie Mae, such that we either own them from inception or acquire them soon after

4


 

origination, and 2) loans that are originated by internal Sallie Mae brands. (See also “RECENT DEVELOPMENTS — Bank One/ JPMorgan Chase Relationships” for a discussion related to our lender partners.)
      Preferred Lender List — To streamline the student loan process, most higher education institutions select a small number of lenders to recommend to their students and parents. This recommended list is referred to as the Preferred Lender List.
      Private Education Loans (formerly referred to as “Private Credit Student Loans”) — Education loans to students or parents of students that are not guaranteed or reinsured under the FFELP or any other federal student loan program. Private Education Loans include loans for traditional higher education, undergraduate and graduate degrees, and for alternative education, such as career training, private kindergarten through secondary education schools and tutorial schools. Traditional higher education loans have repayment terms similar to FFELP loans, whereby repayments begin after the borrower leaves school. Repayment for alternative education or career training loans begins immediately.
      Privatization Act — The Student Loan Marketing Association Reorganization Act of 1996.
      Residual Interest — When we securitize student loans, we retain the right to receive cash flows from the student loans sold to trusts we sponsor in excess of amounts needed to pay servicing, derivative costs (if any), other fees, and the principal and interest on the bonds backed by the student loans. The Residual Interest is the present value of the future expected cash flows from off-balance sheet student loans in securitized trusts, which includes the present value of Embedded Fixed Rate Floor Income described above. We value the Residual Interest at the time of sale of the student loans to the trust and at each subsequent quarter.
      Retained Interest — The Retained Interest includes the Residual Interest (defined above) and servicing rights (as the Company retains the servicing responsibilities).
      Risk Sharing — When a FFELP loan defaults, the federal government guarantees 98 percent of the principal balance plus accrued interest and the holder of the loan generally must absorb the two percent not guaranteed as a Risk Sharing loss on the loan. FFELP student loans acquired after October 1, 1993 are subject to Risk Sharing on loan default claim payments unless the default results from the borrower’s death, disability or bankruptcy. FFELP loans serviced by a servicer that has EP designation from ED are not subject to Risk Sharing.
      Special Allowance Payment (“SAP”) — FFELP student loans generally earn interest at the greater of the borrower rate or a floating rate determined by reference to the average of the applicable floating rates (91-day Treasury bill rate or commercial paper) in a calendar quarter, plus a fixed spread that is dependent upon when the loan was originated and the loan’s repayment status. If the resulting floating rate exceeds the borrower rate, ED pays the difference directly to us. This payment is referred to as the Special Allowance Payment or SAP and the formula used to determine the floating rate is the SAP formula. We refer to the fixed spread to the underlying index as the Special Allowance spread.
      Title IV Programs and Title IV Loans — Student loan programs created under Title IV of the HEA, including the FFELP and the FDLP, and student loans originated under those programs, respectively.
      Wind-Down — The dissolution of the GSE under the terms of the Privatization Act (see definition above).
      Variable Rate Floor Income — For FFELP Stafford student loans whose borrower interest rate resets annually on July 1, we may earn Floor Income or Embedded Floor Income (see definitions above) based on a calculation of the difference between the borrower rate and the then current interest rate. We refer to this as Variable Rate Floor Income because Floor Income is earned only through the next reset date.

5


 

PART I.
Item 1. Business
INTRODUCTION TO SLM CORPORATION
      SLM Corporation, more commonly known as Sallie Mae, is the market leader in education finance. SLM Corporation is a holding company that operates through a number of subsidiaries and references in this annual report to “the Company” refer to SLM Corporation and its subsidiaries. We were formed 32 years ago as the Student Loan Marketing Association, a federally chartered government-sponsored enterprise (the “GSE”), with the goal of furthering access to higher education by acting as a secondary market for student loans. In 2004, we completed the historic privatization process that began in 1997 and resulted in the Wind-Down of the GSE. We completed the Wind-Down by defeasing the GSE’s remaining debt obligations and dissolving its federal charter on December 29, 2004.
      We are the largest private source of funding, delivery and servicing support for education loans in the United States primarily through our participation in the FFELP. We originate, acquire and hold student loans, with the net interest income and gains on the sales of student loans in securitization being the primary source of our earnings. We also earn fees for pre- and post- default receivables management services. We have structured the Company to be the premier player in every phase of the student loan life cycle — from originating and servicing student loans to ultimately the debt management of delinquent and defaulted student loans. We also provide a wide range of financial services, processing capabilities and information technology to meet the needs of educational institutions, lenders, students and their families, and guarantee agencies. In 2004, we expanded our brand and geographical reach in the student loan business through two acquisitions.
      In recent years we have diversified our business through the acquisition of several companies that provide default management and loan collections services. Initially these acquisitions were concentrated in the student loan industry, but in 2004 we acquired AFS Holdings, LLC, the parent company of Arrow Financial Services LLC (collectively, “AFS”), a debt management company that services several industries outside of student loans. With a vast array of products and service offerings, we are positioned to meet the growing demand for post-secondary education credit and related services. At the end of 2004, we had over 9,000 employees.
      We believe that what distinguishes us from our competition is the breadth and sophistication of the products and services we offer to colleges, universities and students in addition to FFELP and Private Education Loans. These include the streamlining of the financial aid process through university-branded websites, call centers and other solutions that support the financial aid office.
BUSINESS SEGMENTS
      We provide a comprehensive array of credit products and related services to the higher education community through two primary business segments: our Lending business segment and our Debt Management Operations business segment, which we refer to as our DMO business. Within our Corporate and Other business segment, we also provide a number of complementary products and services to financial aid offices and schools that are managed within smaller operating segments, the most prominent being our Guarantor Servicing and Loan Servicing businesses. Each of these operating businesses has unique characteristics and faces different opportunities and challenges.
      We generate the largest share of earnings in our Lending business from the spread between the yield we receive on our Managed portfolio of student loans, and the cost of funding these loans. This spread income is reported on our income statement as “net interest income” for on-balance sheet loans, and “gains on student loan securitizations” and “servicing and securitization revenue” for off-balance sheet loans. Total revenues for this segment were $3.1 billion in 2004. We incur servicing, selling and administrative expenses in providing these products and services.
      In our DMO business, we earn fee revenue for portfolio management, debt collection and default prevention services on a contingent fee basis concentrated mainly in the education finance marketplace. The acquisition of AFS has expanded our capabilities such that we also purchase delinquent and defaulted

6


 

receivables and earn revenues from collections on these portfolios. Total revenues from the DMO business were $340 million in 2004.
      SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” requires public companies to report financial and descriptive information about their reportable operating segments. In accordance with SFAS No. 131, we included in Note 18 to our consolidated financial statements, “Segment Reporting,” separate financial information about our operating segments that is evaluated regularly by the “chief operating decision makers” in deciding how to allocate resources and in assessing the operating results of the business.
LENDING BUSINESS SEGMENT
      In our Lending business segment, we originate and acquire both federally guaranteed student loans which are administered by ED, and Private Education Loans, which are not federally guaranteed. Private Education Loans are primarily used to supplement FFELP loans in meeting the cost of education. We manage the largest portfolio of student loans in the industry, serving more than seven million borrowers through our ownership and management of $107.4 billion in Managed student loans, of which $96.0 billion or 89 percent are federally insured. We serve a diverse range of clients that includes over 6,000 educational and financial institutions and state agencies. We are also the largest servicer of student loans, servicing more than eight million borrowers totaling $110.5 billion in student loans. In addition to education lending, we also originate mortgage and consumer loans with the intent of selling most of these loans. In 2004 we originated $1.5 billion in mortgage and consumer loans and the mortgage and consumer loan portfolio totaled $449 million at December 31, 2004, of which $167 million pertains to mortgages in the held for sale portfolio.
Student Lending Marketplace
      The following chart shows the estimated sources of funding for attending two-year and four-year colleges for the academic year (“AY”) ended June 30, 2004 (AY 2003-2004). Approximately 35 percent of the funding comes from federally guaranteed student loans and Private Education Loans. The parent/student contribution comes from investments, current period earnings and other loans obtained without going through the normal financial aid process.
LOGO
     Federally Guaranteed Student Lending Programs
      There are two competing programs that provide student loans where the ultimate credit risk lies with the federal government: the FFELP and the FDLP. FFELP loans are provided by private sector institutions and are ultimately guaranteed by ED. FDLP loans are funded by taxpayers and provided to borrowers directly by ED on terms similar to student loans in the FFELP. In addition to these government guaranteed programs,

7


 

Private Education Loans are made by financial institutions where the lender assumes the credit risk of the borrower.
      For the federal fiscal year (“FFY”) ended September 30, 2004 (FFY 2004), ED estimated that the FFELP’s market share in federally guaranteed student loans was 75 percent, up from 74 percent in FFY 2003. See “LENDING BUSINESS SEGMENT — Competition.” Total FFELP and FDLP volume for FFY 2004 grew by 14 percent, with the FFELP portion growing 16 percent. Based on current industry trends, management expects the federal student loan market growth will continue in low double digits over the next three years.
      The HEA includes regulations that cover every aspect of the servicing of a student loan, including communications with borrowers, loan originations and default aversion. Failure to service a student loan properly could jeopardize the guarantee on these federal student loans. This guarantee generally covers 98 percent of the student loan’s principal and accrued interest, except in the case of death, disability, or bankruptcy of the borrower, or when an eligible lender or lender servicer (as agent for the eligible lender) has been designated by ED as an Exceptional Performer (“EP”). In these cases, the guarantee covers 100 percent of the student loan’s principal and accrued interest. In October 2004, we were designated as an EP and since that time all principal and interest on FFELP student loans serviced by us are 100 percent guaranteed.
      FFELP student loans are guaranteed by state or non-profit agencies called guarantors, with ED providing reinsurance to the guarantor. Guarantors are responsible for performing certain functions necessary to ensure the program’s soundness and accountability. These functions include reviewing loan application data to detect and prevent fraud and abuse and to assist lenders in preventing default by providing counseling to borrowers. Generally, the guarantor is responsible for ensuring that loans are being serviced in compliance with the requirements of the HEA. When a borrower defaults on a FFELP loan, we submit a claim form to the guarantor who pays us 100 percent of the principal and accrued interest. See “OTHER RELATED EVENTS AND INFORMATION — Reauthorization and Budget Proposals” for a description of certain HEA reauthorization proposals that would reduce the guarantee and APPENDIX A to this document for a more complete description of the role of guarantors.
     Private Education Loan Products
      In addition to federal loan programs, which have statutory limits on annual and total borrowing, we sponsor a variety of Private Education Loan programs and purchase loans made under such programs to bridge the gap between the cost of education and a student’s resources. Most of our higher education Private Education Loans are made in conjunction with a FFELP Stafford loan, so they are marketed to schools through the same marketing channels as FFELP loans by the same sales force. In 2004, we expanded our direct to consumer loan marketing channel with our Tuition AnswerSM loan program where we originate and purchase loans outside of the traditional financial aid process. We also originate and purchase alternative Private Education Loans, which are marketed by our SLM Financial subsidiary to technical and trade schools, tutorial and learning centers, and private kindergarten through secondary education schools. These loans are primarily made at schools not eligible for Title IV loans. Private Education Loans are discussed in more detail below.
     Drivers of Growth in the Student Loan Industry
      The growth in our Managed student loan portfolio, which includes both on-balance sheet and off-balance sheet student loans, is driven by the growth in the overall student loan marketplace, which has grown due to rising enrollment and college costs, as well as by our own market share gains. The size of the federally insured student loan market has more than doubled over the last ten years with student loan originations growing from $23.4 billion in FFY 1995 to $52.1 billion in FFY 2004.
      According to the College Board, tuition and fees at four-year public institutions and four-year private institutions have increased 36 percent and 51 percent, respectively, in constant, inflation adjusted dollars, since AY 1994-1995. Under the FFELP, there are limits to the amount students can borrow each academic year. These loan limits have not changed since 1992. As a result, more students and parents are turning to Private Education Loans to meet an increasing portion of their education financing needs. See “OTHER RELATED

8


 

EVENTS AND INFORMATION — Reauthorization and Budget Proposals” for a description of proposals that would increase loan limits. Loans — both federal and private — as a percentage of total student aid have increased from 52 percent of total student aid in AY 1993-1994 to 56 percent in AY 2003-2004. Private Education Loans approximated 17 percent of total federally guaranteed student loans and Private Education Loans in AY 2003-2004.
      ED predicts that the college-age population will increase approximately 10 percent from 2004 to 2013. Demand for education credit will also increase due to the rise in non-traditional students (those not attending college directly from high school) and adult education. The following charts show the projected enrollment and average tuition and fee growth for four-year public and private colleges and universities.
LOGO
LOGO

9


 

Sallie Mae’s Lending Business
      Our primary marketing point-of-contact is the school’s financial aid office where we focus on delivering flexible and cost-effective products to the school and its students. Our sales force, which works with financial aid administrators on a daily basis, is the largest in the industry and currently markets the following internal lender brands: Academic Management Services Corp. (“AMS”), Nellie Mae, Sallie Mae Educational Trust, SLM Financial, Student Loan Funding Resources (“SLFR”), Southwest Student Services (“Southwest”) and Student Loan Finance Association (“SLFA”). We also actively market the loan guarantee of United Student Aid Funds, Inc. (“USA Funds”) and its affiliate Northwest Education Loan Association (“NELA”) through a separate sales force.
      We acquire student loans from three principal sources:
  •  our Preferred Channel;
 
  •  Consolidation Loans; and
 
  •  strategic acquisitions.
      Over the past several years we have successfully changed our business model from a wholesale purchaser of loans on the secondary market, to a direct origination model where we control the front-end origination process. This provides us with higher yielding loans that have a longer duration because we originate or purchase them at or immediately after full disbursement. The key measure of this successful transition is the growth in our Preferred Channel Originations, which, in 2004, accounted for 78 percent of Managed student loan acquisitions (exclusive of loans acquired through business acquisitions). These are our most valuable loans because they cost the least to acquire and remain in our portfolio the longest. In 2004, we originated $18.0 billion in student loans through our Preferred Channel, of which a total of $5.7 billion or 32 percent was originated through our owned brands, $6.9 billion or 38 percent was originated through our largest lending partners, Bank One and JPMorgan Chase, and $5.4 billion or 30 percent was originated through other lender partners. Currently, we purchase substantially all student loans originated by JPMorgan Chase through a joint venture arrangement, which resulted in $2.7 billion of origination volume in 2004.
      During 2004, Bank One and JPMorgan Chase completed their merger. Following this merger, we entered into a comprehensive agreement with Bank One under which our previous marketing service and loan purchase agreements were terminated for which we received combined termination fees of $23 million and the ExportSS® loan purchase agreement was extended for three years. Under this agreement we will acquire substantially all of Bank One’s origination volume through 2008.
      The separate joint venture with JPMorgan Chase was not affected by the merger, although JPMorgan Chase has rejected our initial offer to renew the agreements that support the joint venture and has filed a petition in a Delaware Chancery Court seeking to dissolve the joint venture. Under the terms of the joint venture agreements, if by May 31, 2005 the parties are unable to reach an agreement to renew or extend these agreements, then either party may trigger a “Dutch Auction” process. Under the terms of the current joint venture agreements we will continue to acquire all JPMorgan Chase-branded student loans originated through the joint venture through September 2007. The lawsuit seeks to dissolve the joint venture before the other party can invoke the Dutch Auction process. A JPMorgan Chase request with the Chancery Court for an expedited schedule for a final hearing on the merits has been stayed pending settlement discussions among the parties. See “Legal Proceedings” and “RECENT DEVELOPMENTS — Bank One/JPMorgan Chase Joint Venture.”
      Our Preferred Channel Originations growth has been fueled by both FDLP and new school conversions, same school sales growth, and growth in the for-profit sector. Since 1999, we have partnered with over 100 schools that have chosen to return to the FFELP from the FDLP. Our FFELP originations at these schools totaled over $1.4 billion in 2004. In addition to winning new schools, we have also forged broader relationships with many of our existing school clients. Consistent with enrollment trends, our FFELP and private originations at for-profit schools have grown faster than at traditional higher education schools.

10


 

      In 2004, the 22 percent of Managed student loans we acquired outside of our Preferred Channel was through Consolidation Loans from third parties (12 percent), spot purchases (8 percent) and other forward purchase commitments (2 percent).
     Consolidation Loans
      Over the past three years, we have seen a surge in consolidation activity as a result of historically low interest rates that has contributed to the changing composition of our student loan portfolio. Consolidation Loans earn a lower yield than FFELP Stafford Loans due primarily to the Consolidation Loan Rebate Fee. This negative impact is somewhat mitigated by the longer average life of Consolidation Loans. We have made a substantial investment in consolidation marketing to protect our asset base and grow our portfolio, including targeted direct mail campaigns and web-based initiatives for borrowers. In 2004, this investment resulted in a net Managed portfolio gain of $504 million from consolidation activity. During 2004, $10.7 billion of FFELP Stafford loans in our Managed loan portfolio consolidated either with us ($8.6 billion) or with other lenders ($2.1 billion). Consolidation Loans now represent over 50 percent of our federally guaranteed Managed student loan portfolio and over 60 percent of our on-balance sheet owned portfolio.
     Private Education Loans
      We sponsor a variety of Private Education Loan programs that bridge the gap between the cost of education and a student’s resources, including federally guaranteed loans. Since we bear the full credit risk for Private Education Loans, they are underwritten and priced according to credit risk based upon standardized consumer credit scoring criteria. To mitigate some of the credit risk, we provide price and eligibility incentives for students to obtain a credit-worthy co-borrower. Approximately 48 percent of our Private Education Loans have a co-borrower. Due to their higher risk profile, Private Education Loans earn higher spreads than their FFELP loan counterparts. In 2004, Private Education Loans earned an average spread, after provision for loan losses, of 2.69 percent versus an average spread of 1.59 percent for FFELP loans.
      The rising cost of education has led students and their parents to seek additional private credit sources to finance their education. Private Education Loans are often packaged as supplemental or companion products to FFELP loans and priced and underwritten competitively to provide additional value for our school relationships. In certain situations, the school shares the borrower credit risk. Over the last several years, the growth of Private Education Loans has accelerated due to tuition increasing faster than the rate of inflation coupled with no increase in the FFELP lending limits. This rapid growth coupled with the relatively higher spreads has led to Private Education Loans contributing a higher percentage of our net interest margin in each of the last three years and we expect this trend to continue in the foreseeable future. In 2004, Private Education Loans contributed 17 percent of the overall net interest income after provision, up from 15 percent in 2003.
     Private Education Loan Programs
      Our largest Private Education Loan program is the Signature Loan® offered to undergraduates and graduates through the financial aid offices of colleges and universities and packaged with the traditional FFELP and PLUS loan products. We also offer specialized loan products to graduate and professional students primarily through our MBALoans®,LAWLOANS® and MEDLOANSSM programs. Generally, these loans, which are made by lender partners and sold to the Company, do not require the borrower to begin repaying his or her loan until after graduation and allow a grace period from six to nine months.
      In the third quarter of 2004 we began to offer Tuition AnswerSM loans direct to the consumer through targeted direct mail campaigns and web-based initiatives. Tuition Answer loans are made by a lender-partner and are sold to the Company. Under the Tuition Answer loan program, creditworthy parents, sponsors and students may borrow between $1,500 and $30,000 per year (limit raised to $40,000 per year in 2005) to cover any college-related expense. No school certification is required, although a borrower must provide enrollment documentation. At December 31, 2004, we had $95 million of Tuition Answer loans outstanding.

11


 

      Through SLM Financial, a wholly-owned subsidiary of SLM Corporation, we offer Private Education Loan products to finance the needs of students in career training, lifelong learning programs such as technical and trade schools, tutorial and learning centers, and private kindergarten through secondary schools. The major fields of study for the technical and trade schools include information technology, cosmetology, mechanics, medical/dental/lab, culinary and broadcasting. On average, these training programs typically last fewer than 12 months. Generally, these loans require the borrower to begin repaying his or her loan immediately; however, students can opt to make relatively small payments while enrolled. At December 31, 2004, we had $1.3 billion of SLM Financial Private Education Loans outstanding.
Acquisitions
      An important component of our growth strategy has been strategic acquisitions. Beginning in 1999 with the purchase of Nellie Mae, we have acquired several companies in the student loan industry that have increased our sales and marketing capabilities, added significant new brands and greatly enhanced our product offerings. Strategic student lending acquisitions have included Student Loan Funding Resources and USA Group, Inc. (“USA Group”) in 2000, and AMS in 2003. We continued this strategy in 2004 by acquiring two companies (1) Arizona-based, Southwest Student Services Corporation (“Southwest”) and (2) Student Loan Finance Association that included a controlling interest in the business of Washington Student Loan Finance Association and Idaho Student Loan Finance Association (collectively, “SLFA”). The SLFA acquisition is a two-step transaction that will be completed in 2005. In conjunction with the SLFA transaction, NELA, a non-profit regional guarantor, entered into an affiliation with USA Funds, the nation’s largest guarantor and Sallie Mae’s largest guarantor servicing client. NELA contracted for Sallie Mae to provide comprehensive operational and other guarantor services to NELA.
      In connection with both 2004 acquisitions, we acquired sizable loan portfolios ($4.8 billion from Southwest and $1.4 billion from SLFA). Southwest is among the top 30 originators of federal student loans, issuing approximately $300 million in Stafford and PLUS loans and $1.5 billion in Consolidation Loans annually, and is the nation’s ninth largest holder of federal student loans. Southwest provides student loans and related services nationally with a primary focus on colleges and universities in Arizona and Florida, providing us with an enhanced presence in these fast growing areas of the country. SLFA enhances our presence in the Northwest and enables us to expand our guarantor servicing business.
Financing
      With the completion of the GSE Wind-Down, we now fund our operations exclusively through non-GSE sources, primarily through the issuance of SLM Corporation (“SLM”) student loan asset-backed securities (securitization) and SLM debt securities. We issue these securities in both the domestic and overseas capital markets using both public offerings and private placements. The major objective when financing our business is to minimize interest rate risk on a pooled basis to the extent practicable through match funding of the interest rate characteristics of our assets and liabilities. As part of this process, we use derivative financial instruments extensively to reduce our interest rate and foreign currency exposure. Interest rate risk management helps us to achieve a stable student loan spread irrespective of the interest rate environment and changes in asset mix. We continuously look for ways to minimize funding costs and to provide liquidity for our student loan acquisitions. To that end, we are continually expanding and diversifying our pool of investors by establishing debt programs in multiple markets that appeal to varied investor bases and by educating potential investors about our business. Finally, we take appropriate steps to ensure sufficient liquidity by financing in multiple markets, which include the institutional, retail, floating-rate, fixed-rate, unsecured, asset-backed, domestic and international markets.
      Securitization is and will continue to be our principal source of non-GSE financing, and over time, we expect approximately 70 percent of our annual funding needs will be satisfied by securitizing our loan assets and issuing asset-backed securities.

12


 

Competition
      Our primary competitor for federally guaranteed student loans is the FDLP, which in its first four years of existence (FFYs 1994-1997) grew market share from 4 percent to a peak of 34 percent in 1997, but has steadily declined since then to a 25 percent share in 2004 for the total federally sponsored student loan market. We also face competition for both federally guaranteed and non-guaranteed student loans from a variety of financial institutions including banks, thrifts and state-supported secondary markets. Sallie Mae’s FFY 2004 Preferred Channel FFELP originations totaled $13.4 billion, representing a 26 percent market share.
      In the FFELP student lending marketplace, we are seeing increased use of discounts and borrower benefits, as well as heightened interest in the school-as-lender model in which graduate and professional schools make FFELP Stafford loans directly to eligible borrowers. The schools do not typically hold the loans, preferring to sell them in the secondary market. This greatly increases our cost of acquisition when compared to our Preferred Channel volume. According to ED, 71 institutions used the school-as-lender model for FFY 2004, with total school-as-lender volume of $2.1 billion.
      Certain lenders, state agencies and non-profit organizations offer deeply discounted or zero fee pricing on Stafford loans in which the lender pays the mandatory three percent origination fee on behalf of the borrower. As a result, the lenders have increased their market share of FFELP student lending. To compete more effectively with those lenders, we have launched a zero fee pricing initiative. In addition, on a school-by-school basis, we have begun to offer more competitive pricing solutions that include zero fee options. This competitive strategy is designed to boost our Preferred Channel volume and to protect and grow our volume at specific schools. While the goal of this pricing initiative and the pricing solutions is to grow our FFELP loan volume, this strategy will reduce our margins on the affected student loans.
DEBT MANAGEMENT OPERATIONS BUSINESS SEGMENT
      Through the five operating units that comprise our DMO business segment, we provide a wide range of accounts receivable and collections services including defaulted student loan portfolio management services, contingency collections services for student loans and other asset classes, student loan default aversion services, and accounts receivable management and collection for purchased portfolios of receivables that have been charged off by their original creditors.
      Beginning with the acquisition of USA Group in 2000, our DMO business was built to service the student loan marketplace through a broad array of default management services on a contingency fee or other pay for performance basis. We have since acquired three additional companies that strengthened our presence in the student loan market and diversified our product offerings to include a full range of receivables management and collections services for a diverse customer base including large federal agencies, state agencies, credit card issuers, utilities, and other holders of consumer debt.
      In September 2004, we acquired a majority interest with an option to purchase the remaining shares of AFS. AFS primarily purchases and services defaulted consumer receivables from credit grantors or resellers and then attempts to collect a sufficient amount to cover its investment and earn a return from each purchased portfolio. AFS also collects on behalf of debt owners on a contingency fee basis and provides first-party delinquent and default servicing.
      The acquisition of AFS was important to our DMO business segment for two main reasons. It has further diversified our DMO revenues outside of the education marketplace and provided a servicing platform and a disciplined portfolio pricing approach from years of experience in the purchase of delinquent and defaulted receivables. The addition of AFS also enables us to offer the purchase of distressed or defaulted debt to our partner schools as an additional method of enhancing their receivables management strategies.
      In 2004, our DMO business earned revenues totaling $340 million and net income of $111 million, which represented increases of 31 percent and 32 percent over 2003, respectively. The 2004 results included slightly more than three full months of AFS operating activities. Our largest customer, USA Funds, accounted for over 50 percent of our revenue in 2004. With the AFS acquisition, we expect USA Funds to account for less than 40 percent in 2005.

13


 

Products and Services
     Defaulted Student Loan Portfolio Management Services
      Our DMO business segment manages the defaulted student loan portfolios for six guarantors under long-term contracts. DMO’s largest customer, USA Funds, represents approximately 24 percent of defaulted student loan portfolios in the market. Our portfolio management services include selecting collection agencies and determining account placements to those agencies, processing loan consolidations and loan rehabilitations and managing federal and state offset programs.
     Contingency Collection Services
      Our DMO business segment is also engaged in the collection of defaulted student loans and other debt on behalf of various clients including guarantor agencies, large federal agencies, credit card issuers, utilities, and other retail clients earning fees that are contingent on the amounts collected. We also provide collection services for ED and now control approximately 13 percent of the total market for such services. We also have relationships with more than 1,000 colleges and universities to provide collection services for delinquent student loans and other receivables from various campus-based programs.
     Student Loan Default Aversion Services
      We provide default aversion services for four guarantors, including the nation’s largest, USA Funds. These services are designed to prevent a default once a borrower’s loan has been placed in delinquency status.
     Collection of Purchased Receivables
      Our DMO business purchases delinquent and defaulted receivables from credit originators and other holders of receivables at a significant discount from the face value of the debt instruments. Collections are generated through both internal and external work strategies. Depending on the characteristics of the portfolio, revenue is recognized using either the effective interest method or cost recovery method.
     First-Party Servicing
      We provide accounts receivable outsourcing solutions for credit grantors. The focus of our first-party group is on the collection of delinquent accounts to minimize further delinquency and ultimately prevent accounts from reaching charge off.
Competition
      The private sector collections industry is highly fragmented with few large companies and a large number of small scale companies. The DMO businesses that provide third-party collections services for ED, FFELP guarantors and other federal holders of defaulted debt are highly competitive. In addition to competing with other collection enterprises, we also compete with credit grantors who each have unique mixes of internal collections, outsourced collections, and debt sales. Although the scale, diversification, and performance of our DMO business has been a competitive advantage, increasing acquisition trends in the receivables management industry could bring about greater competition.
      In the purchased portfolio business, the marketplace is trending more toward open market competitive bidding rather than solicitation by sellers to a select group of potential buyers. Price inflation and the availability of capital into the sector contribute to this trend. Unlike many of our competitors, our DMO business does not rely solely on purchased portfolio revenue. This enables us to maintain pricing discipline and purchase only those portfolios that are expected to meet our profitability and strategic goals. Portfolios are purchased individually on a spot basis or through contractual relationships with sellers to purchase regular monthly portfolios at set prices. We compete primarily on price, but also on the basis of our reputation, industry experience and relationships.

14


 

CORPORATE AND OTHER BUSINESS SEGMENT
Guarantor Services
      We earn fees for providing a full complement of administrative services to FFELP guarantors. FFELP student loans are guaranteed by these agencies, with ED providing reinsurance to the guarantor. The guarantors are non-profit institutions or state agencies that, in addition to providing the primary guarantee on FFELP loans, are responsible for other guarantor servicing activities including:
  •  guarantee issuance — the initial approval of loan terms and guarantee eligibility;
 
  •  account maintenance — maintaining and updating of records on guaranteed loans; and
 
  •  guarantee fulfillment — review and processing of guarantee claims.
See in APPENDIX A, “FEDERAL FAMILY EDUCATION LOAN PROGRAM — Guarantor Funding” for details of the fees paid to guarantors.
      Currently, we provide a variety of these services to ten guarantors and, in 2004, we processed $13.5 billion in new FFELP loan guarantees, of which $9.9 billion was for USA Funds, the nation’s largest guarantor. We now process guarantees for approximately 25 percent of the FFELP and FDLP loan market. Guarantor servicing revenue, which included guaranty issuance and account maintenance fees, was $120 million for 2004, 85 percent of which we earned from services performed on behalf of USA Funds.
      Our primary non-profit competitors in guarantor servicing are state and non-profit guarantee agencies that provide third-party outsourcing to other guarantors. Our primary for-profit competitor is GuaranTec, LLP, an outsourcing company that is a subsidiary of Nelnet, Inc.
Loan Servicing
      We earn fees by providing a full complement of activities required to service student loans on behalf of other lenders. Such servicing activities generally commence once a loan has been fully disbursed and include processing correspondence and filing claims, originating and disbursing Consolidation Loans on behalf of the lender, and other administrative activities required by ED. Loan servicing revenue was $55 million for 2004.
REGULATION
      Like other participants in the FFELP program, the Company is subject, from time to time, to review of its student loan operations by ED and guarantee agencies. ED is authorized under its regulations to limit, suspend or terminate lenders from participating in the FFELP, as well as impose civil penalties if lenders violate program regulations. The laws relating to the FFELP program are subject to revision from time to time. See “OTHER RELATED EVENTS AND INFORMATION — Reauthorization and Budget Proposals.” In addition, Sallie Mae, Inc., as a servicer of student loans, is subject to certain ED regulations regarding financial responsibility and administrative capability that govern all third-party servicers of insured student loans. Failure to satisfy such standards may result in the loss of the government guarantee of the payment of principal and accrued interest on defaulted FFELP loans. Also, in connection with our guarantor servicing operations, the Company must comply with, on behalf of its guarantor servicing customers, certain ED regulations that govern guarantor activities as well as agreements for reimbursement between the Secretary of Education and the Company’s guarantor servicing customers. Failure to comply with these regulations or the provisions of these agreements may result in the termination of the Secretary of Education’s reimbursement obligation.
      Our DMO’s consumer debt collection and receivables management activities are subject to federal and state consumer protection, privacy and related laws and regulations that extensively regulate the relationship

15


 

between consumer debt collectors and debtors. Some of the more significant federal laws and regulations that are applicable to our DMO business include:
  •  the Fair Debt Collection Practices Act;
 
  •  the Fair Credit Reporting Act;
 
  •  the Gramm-Leach-Bliley Act, including the Financial Privacy Rule and the Safeguard Rule; and
 
  •  the U.S. Bankruptcy Code.
      In addition, our DMO business is subject to state laws and regulations similar to the federal laws and regulations listed above. Finally, certain DMO subsidiaries are subject to regulation under the HEA and under the various laws and regulations that govern government contractors.
      Hemar Insurance Corporation of America (“HICA”), our South Dakota insurance subsidiary, is subject to the ongoing regulatory authority of the South Dakota Division of Insurance and that of comparable governmental agencies in six other states. Management intends to dissolve HICA by the end of 2005.
PRIVATIZATION
      The GSE was established in 1972 as a for-profit corporation under an Act of Congress for the purpose of creating a national secondary market in federal student loans. Having accomplished our original mission and with the creation of a federal competitor, the FDLP, we obtained congressional and shareholder approval to transform from the GSE to a private sector corporation. As a result, SLM Corporation was formed as a Delaware corporation in 1997. On December 29, 2004, we completed the Wind-Down of the operations of the GSE, defeased the GSE’s remaining obligations and dissolved the GSE’s federal charter.
      During the course of developing the Wind-Down plan, management was advised by its tax counsel that, while the matter is not certain, under current authority, the defeasance of certain GSE bonds that mature after December 29, 2004 could be construed to be a taxable event for taxable holders of those bonds.

16


 

      A significant benefit of shedding our GSE status is the ability to originate student loans directly, reducing our dependence on other student loan originators. Privatization has also facilitated our entry into other credit and fee-based businesses within and beyond the student loan industry. The principal cost of privatization is the elimination of our access to the federal agency funding market.
AVAILABLE INFORMATION
      The Securities and Exchange Commission (the “SEC”) maintains an Internet site (http://www.sec.gov) that contains periodic and other reports such as annual, quarterly and current reports on Forms 10-K, 10-Q and 8-K, respectively, as well as proxy and information statements regarding SLM Corporation and other companies that file electronically with the SEC. Copies of our annual reports on Form 10-K and our quarterly reports on Form 10-Q are available on our website free of charge as soon as reasonably practicable after we electronically file such reports with the SEC. Investors and other interested parties can also access these reports at www.salliemae.com/investors.
      Our Code of Business Conduct, which applies to Board members and all employees, including our chief executive officer, principal financial officer and principal accounting officer, is also available, free of charge, on our website at www.salliemae.com/about/business conduct.html. We intend to disclose any amendments to or waivers from our Code of Business Conduct (to the extent applicable to our chief executive officer, principal financial officer, or principal accounting officer or director) by posting such information on our website.
      In 2004, the Company submitted the annual certification of its chief executive officer regarding the Company’s compliance with the NYSE’s corporate governance listing standards, pursuant to Section 303A.12(a) of the NYSE Listed Company Manual. The Company delivered a supplemental written affirmation to the NYSE in February 2005 following a change in the memberships of both the Company’s Audit Committee and its Nominations Committee.
      In addition, we filed as exhibits to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 and to this Annual Report on Form 10-K, the certifications required under Section 302 of the Sarbanes-Oxley Act of 2002.

17


 

Item 2. Properties
      The following table lists the principal facilities owned by the Company:
             
        Approximate
Location   Function   Square Feet
         
Reston, VA
  Headquarters     240,000  
Fishers, IN
  Loan Servicing and Data Center     450,000  
Wilkes Barre, PA
  Loan Servicing Center     135,000  
Killeen, TX
  Loan Servicing Center     136,000  
Lynn Haven, FL
  Loan Servicing Center     133,000  
Castleton, IN
  Loan Servicing Center     100,000  
Marianna, FL
  Back-up/Disaster Recovery Facility for Loan Servicing     94,000  
Big Flats, NY
  Debt Management and Collections Center     60,000  
Gilbert, AZ
  Southwest Student Services Headquarters     60,000  
Swansea, MA
  AMS Headquarters     36,000  
Arcade, NY
  Debt Management and Collections Center     34,000  
Perry, NY
  Debt Management and Collections Center     20,000  
      In December 2003, the Company sold its prior Reston, Virginia headquarters and leased approximately 229,000 square feet of that building from the purchaser through August 21, 2004. The Company completed the construction of a new headquarters building in Reston, Virginia in August 2004 that has approximately 240,000 square feet of space. All Reston-based employees were moved into the new headquarters in August 2004.
      The Company leases approximately 36,000 square feet for its SLM Financial headquarters and operations in Marlton, New Jersey. The Company also leases approximately 71,000 square feet for its debt management and collections center in Summerlin, Nevada. In addition, the Company leases approximately 80,000 square feet of office space in Cincinnati, Ohio for the headquarters and debt management and collections center for General Revenue Corporation. In the first quarter of 2004, the Company entered into a 10-year lease with the Wyoming County Industrial Development Authority with a right of reversion to the Company for the Arcade and Perry, New York facilities. The Company also leases an additional 10,000 square feet in Perry, New York for Pioneer Credit Recovery, Inc.’s debt management and collections business. In addition, net of the space it subleases, the Company leases approximately 6,000 square feet of office space in Washington, D.C. With the exception of the Pennsylvania loan servicing center, none of the Company’s facilities is encumbered by a mortgage. The Company believes that its headquarters, loan servicing centers data center, back-up facility and data management and collections centers are generally adequate to meet its long-term student loan and new business goals. The Company’s principal office is currently in owned space at 12061 Bluemont Way, Reston, Virginia, 20190.
Item 3. Legal Proceedings
      On February 17, 2005, JPMorgan Chase, through its affiliates, petitioners TCB Education First Marketing Corporation and Chase Education Holdings, Inc., filed a petition in the Delaware Chancery Court for New Castle County seeking to dissolve the limited liability companies that comprise our joint venture with JPMorgan Chase. Those limited liability companies, Chase Education First LLC and Education First Finance LLC, and Sallie Mae, Inc., a wholly owned subsidiary of SLM Corporation, were named as respondents in the petition. JPMorgan Chase’s central claim in the petition is that a change in our business model from a secondary market into an originator of student loans has undermined the business of the joint venture, which is

18


 

to market JPMorgan Chase-branded student loans. We believe that this claim is untenable because we began originating loans approximately four years before the parties comprehensively renegotiated and amended the joint venture effective July 16, 2002. Chase also claims that the dutch auction dissolution provision, which was a negotiated provision in the joint venture agreements, is an inadequate remedy. On February  22, 2005, the petitioners filed a request with the Chancery court seeking an expedited schedule for a final hearing on the merits. That request has been stayed pending settlement discussions among the parties. See “RECENT DEVELOPMENTS — Bank One/ JPMorgan Chase Relationships” and “JPMorgan Chase Joint Venture.”
      The Company and various affiliates are defendants in a lawsuit brought by College Loan Corporation (“CLC”) in the United States District Court for the Eastern District of Virginia alleging various breach of contract and common law tort claims in connection with CLC’s consolidation loan activities. The Complaint sought compensatory damages of at least $60 million. On June 25, 2003, the jury returned a verdict in favor of the Company on all counts. CLC subsequently filed an appeal. On January 31, 2005, the United States Court of Appeals for the Fourth Circuit overturned the jury verdict on the grounds that the trial judge’s pretrial rulings improperly limited CLC’s proof at trial and remanded the case to the District Court for further proceedings. The Court of Appeals decision did not address the merits of the case. We filed a petition for rehearing or alternatively a rehearing en banc, which the Fourth Circuit denied. The Company currently intends to defend this case on the merits at the District Court. Plaintiffs are seeking punitive damages in addition to the compensatory damages.
      The Company was named as a defendant in a putative class action lawsuit brought by three Wisconsin residents on December 20, 2001 in the Superior Court for the District of Columbia. The lawsuit sought to bring a nationwide class action on behalf of all borrowers who allegedly paid “undisclosed improper and excessive” late fees over the past three years. The plaintiffs sought damages of one thousand five hundred dollars per violation plus punitive damages and claimed that the class consisted of two million borrowers. In addition, the plaintiffs alleged that the Company charged excessive interest by capitalizing interest quarterly in violation of the promissory note. On February 27, 2003, the Superior Court granted the Company’s motion to dismiss the complaint in its entirety. On March 4, 2004, the District of Columbia Court of Appeals affirmed the Superior Court’s decision granting our motion to dismiss the complaint, but granted plaintiffs leave to re-plead the first count, which alleged violations of the D.C. Consumer Protection Procedures Act. On September 15, 2004, the plaintiffs filed an amended class action complaint. On October 15, 2004, the Company filed a motion to dismiss the amended complaint with the Superior Court for failure to state a claim and non-compliance with the Court of Appeals’ ruling. On December 27, 2004, the Superior Court granted our motion to dismiss the plaintiffs’ amended compliant. Plaintiffs again appealed the Superior Court’s December 27, 2004 dismissal order to the Court of Appeals. The Company believes that it will prevail on the merits of this case if it becomes necessary to further litigate this matter.
      In July 2003, a borrower in California filed a class action complaint against the Company and certain of its affiliates in state court in San Francisco in connection with a monthly payment amortization error discovered by the Company in the fourth quarter of 2002. The complaint asserts claims under the California Business and Professions Code and other California statutory provisions. The complaint further seeks certain injunctive relief and restitution. On May 14, 2004, the court issued an order dismissing two of the three counts of the complaint. The case is currently in the discovery phase. While management is confident of a favorable outcome in this case, management believes that even an adverse ruling will not have a materially adverse effect on the Company’s financial condition or results of operations.
      The Company continues to cooperate with the SEC concerning an informal investigation that the SEC initiated on January 14, 2004. Although there are currently no data requests outstanding and the SEC has not sought to interview any additional witnesses, discussions with the SEC are ongoing. The investigation concerns certain 2003 year-end accounting entries made by employees of one of the Company’s debt collection agency subsidiaries. The Company’s Audit Committee engaged outside counsel to investigate the matter and management conducted its own investigation. These investigations by the Audit Committee and management have been completed and the amounts in question were less than $100,000.

19


 

      We are also subject to various claims, lawsuits and other actions that arise in the normal course of business. Most of these matters are claims by borrowers disputing the manner in which their loans have been processed or the accuracy of our reports to credit bureaus. In addition, the collections subsidiaries in our debt management operation group are routinely named in individual plaintiff or class action lawsuits in which the plaintiffs allege that we have violated a federal or state law in the process of collecting their account. Management believes that these claims, lawsuits and other actions will not have a material adverse effect on our business, financial condition or results of operations.
Item 4. Submission of Matters to a Vote of Security Holders
      Nothing to report.
PART II.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
      The Company’s common stock is listed and traded on the New York Stock Exchange under the symbol SLM. The number of holders of record of the Company’s common stock as of March 4, 2005 was 741. The following table sets forth the high and low sales prices for the Company’s common stock for each full quarterly period within the two most recent fiscal years.
Common Stock Prices
                                         
        1st Quarter   2nd Quarter   3rd Quarter   4th Quarter
                     
2004
    High     $ 43.00     $ 42.49     $ 44.75     $ 54.44  
      Low       36.79       36.80       36.43       41.60  
2003
    High     $ 37.72     $ 42.92     $ 42.42     $ 40.11  
      Low       33.73       36.32       37.88       35.70  
      The Company paid quarterly cash dividends of $.08 per share on the common stock for the first quarter of 2003, $.17 for the last three quarters of 2003 and for the first quarter of 2004, $.19 for the last three quarters of 2004, and declared a quarterly cash dividend of $.19 for the first quarter of 2005.
      In May 2003, the Company announced a three-for-one stock split of the Company’s common stock to be effected in the form of a stock dividend. The additional shares were distributed on June 20, 2003 for all shareholders of record on June 6, 2003. All share and per share amounts presented have been retroactively restated for the stock split. Stockholders’ equity has been restated to give retroactive recognition to the stock split for all periods presented, by reclassifying from additional paid-in capital to common stock, the par value of the additional shares issued as a result of the stock split.

20


 

Issuer Purchases of Equity Securities
      The following table summarizes the Company’s common share repurchases during 2004 pursuant to the stock repurchase program (see Note 15 to the consolidated financial statements, “Common Stock”) first authorized in September 1997 by the Board of Directors. Since the inception of the program, which has no expiration date, the Board of Directors has authorized the purchase of up to 308 million shares as of December 31, 2004. Included in this total are 30 million additional shares authorized for repurchase by the Board in October 2004.
                                   
            Total Number of   Maximum Number
            Shares Purchased   of Shares that May
    Total Number       as Part of Publicly   Yet Be Purchased
    of Shares   Average Price   Announced Plans   Under the Plans
(Common shares in millions)   Purchased(1)   Paid per Share   or Programs   or Programs(2)
                 
Period:
                               
January 1 – March 31, 2004
    8.6     $ 31.26       7.9       34.2  
April 1 – June 30, 2004
    6.2       38.08       6.1       20.7  
July 1 – September 30, 2004
    11.5       38.91       11.4       8.4  
 
October 1 – October 31, 2004
        $             36.1  
November 1 – November 30, 2004
    8.4       43.71       7.9       35.8  
December 1 – December 31, 2004
                      35.8  
                         
 
Total fourth quarter
    8.4     $ 43.71       7.9          
                         
 
Year ended December 31, 2004
    34.7     $ 38.03       33.3          
                         
 
(1)  The total number of shares purchased includes: i) shares purchased under the stock repurchase program discussed above, and ii) shares purchased in connection with the exercise of stock options and vesting of performance stock to satisfy minimum statutory tax withholding obligations and shares tendered by employees to satisfy option exercise costs (which combined totaled 1.4 million shares for 2004).
 
(2)  Reduced by outstanding equity forward contracts.

21


 

Item 6. Selected Financial Data
Selected Financial Data 2000-2004
(Dollars in millions, except per share amounts)
      The following table sets forth selected financial and other operating information of the Company. The selected financial data in the table is derived from the consolidated financial statements of the Company. The data should be read in conjunction with the consolidated financial statements, related notes, and “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS” included in this Form 10-K.
                                         
    2004   2003   2002   2001   2000
                     
Operating Data:
                                       
Net interest income
  $ 1,299     $ 1,326     $ 1,425     $ 1,126     $ 642  
Net income
    1,914       1,534       792       384       465  
Basic earnings per common share, before cumulative effect of accounting change
    4.36       3.08       1.69       .78       .95  
Basic earnings per common share, after cumulative effect of accounting change
    4.36       3.37       1.69       .78       .95  
Diluted earnings per common share, before cumulative effect of accounting change
    4.04       2.91       1.64       .76       .92  
Diluted earnings per common share, after cumulative effect of accounting change
    4.04       3.18       1.64       .76       .92  
Dividends per common share
    .74       .59       .28       .24       .22  
Return on common stockholders’ equity
    73 %     66 %     46 %     30 %     49 %
Net interest margin
    1.92       2.53       2.92       2.33       1.52  
Return on assets
    2.80       2.89       1.60       .78       1.06  
Dividend payout ratio
    18       19       17       32       24  
Average equity/average assets
    3.73       4.19       3.44       2.66       2.34  
Balance Sheet Data:
                                       
Student loans, net
  $ 65,981     $ 50,047     $ 42,339     $ 41,001     $ 37,647  
Total assets
    84,094       64,611       53,175       52,874       48,792  
Total borrowings
    78,122       58,543       47,861       48,350       45,375  
Stockholders’ equity
    3,102       2,630       1,998       1,672       1,415  
Book value per common share
    6.93       5.51       4.00       3.23       2.54  
Other Data:
                                       
Off-balance sheet securitized student loans, net
  $ 41,457     $ 38,742     $ 35,785     $ 30,725     $ 29,868  

22


 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Years ended December 31, 2002-2004
(Dollars in millions, except per share amounts)
FORWARD-LOOKING AND CAUTIONARY STATEMENTS
      Some of the statements contained in this annual report discuss future expectations and business strategies or include other “forward-looking” information. Those statements are subject to known and unknown risks, uncertainties and other factors that could cause the actual results to differ materially from those contemplated by the statements. The forward-looking information is based on various factors and was derived using numerous assumptions. We undertake no obligation to publicly update or revise any forward-looking statements.
OVERVIEW
      We are the largest source of funding, delivery and servicing support for education loans in the United States primarily through our participation in the FFELP. Our primary business is to originate, acquire and hold student loans, with the net interest income and gains on the sales of student loans in securitization being the primary source of our earnings. We also earn fees for pre-default and post-default receivables management services. We are now engaged in every phase of the student loan life cycle — from originating and servicing student loans to default prevention and ultimately the collection on defaulted student loans. We also provide a wide range of financial services, processing capabilities and information technology to meet the needs of educational institutions, lenders, students and their families, and guarantee agencies. SLM Corporation, more commonly known as Sallie Mae, is a holding company that operates through a number of subsidiaries and references in this annual report to “the Company” refer to SLM Corporation and its subsidiaries.
      We have used both internal growth and strategic acquisitions to attain our leadership position in the education finance marketplace. We have the largest sales force in the student loan industry that delivers our product offerings on campuses. The core of our marketing strategy is to promote our on-campus brands, which generate student loan originations through our Preferred Channel. Loans generated through our Preferred Channel are more profitable than loans acquired through our forward purchase commitments or the spot market since they are owned earlier in the student loan’s life and we generally incur lower costs on such loans. We have built brand leadership between the Sallie Mae name, the brands of our subsidiaries and those of our lender partners, such that we capture the volume of three of the top five originators of FFELP loans. These sales and marketing efforts are supported by the largest and most diversified servicing capabilities in the industry, providing an unmatched array of servicing capability to financial aid offices.
      In recent years we have diversified our business through the acquisition of several companies that provide default management and loan collections services, all of which are combined in our Debt Management Operations (“DMO”) business segment. Initially these acquisitions concentrated in the student loan industry, but through a 2004 acquisition we expanded our capabilities to include a full range of accounts receivable management services to a number of different industries. The DMO business segment has been expanding rapidly such that revenue grew 31 percent in 2004 and we now employ over 3,000 people in this segment.
      In December 2004, we completed the Wind-Down of the GSE and are now a fully privatized company. We have defeased all remaining GSE debt obligations and dissolved the GSE’s federal charter. The liquidity provided to the Company by the GSE has been replaced by non-GSE financing, including securitizations originated by non-GSE subsidiaries of SLM Corporation. This funding transformation was accomplished by increasing and diversifying our investor base over the last three years. We now have a number of sources of liquidity including the formation of our first asset-backed commercial paper program ($5 billion in available borrowings) and our unsecured revolving credit facilities, which were increased from $3 billion to $5 billion in 2004.

23


 

      See “STUDENT LOAN MARKETING ASSOCIATION — Privatization Act — Completion of the GSE Wind-Down” for a more detailed discussion of the GSE Wind-Down.
      On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. The new standard will be effective for public entities (excluding small business issuers) in the first interim or annual reporting period beginning after June 15, 2005, irrespective of the entity’s fiscal year. Early adoption is permitted in periods in which financial statements have not yet been issued. SFAS No. 123(R) allows for two transition alternatives for public companies: (a) modified-prospective transition or (b) modified-retrospective transition. We are still evaluating both methods, but have tentatively decided to apply the modified-retrospective transition alternative for all periods presented and will recognize compensation cost in the amounts previously reported in the pro forma footnote disclosure under the provisions of SFAS No. 123. Had we adopted SFAS No. 123(R) in 2004, our diluted earnings per share would have been $.08 lower and the effect going forward should have a similar effect on diluted earnings per share.
BUSINESS SEGMENTS
      We manage our business through two primary business segments: the Lending business segment and the DMO business segment. These businesses are considered reportable segments under SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” based on quantitative thresholds applied to the Company’s financial statements. In addition, we provide other complementary products and services, including guarantor and student loan servicing through smaller business units that do not meet such thresholds and are aggregated in the Corporate and Other business segment for financial reporting purposes.
      Since our business segments operate in distinct business environments, the discussion herein of the results of our operations is primarily presented on a segment basis. The Lending business segment includes all discussion of income and related expenses associated with net interest margin, student loan spread and its components, securitization gains and the ongoing servicing and securitization income, derivative market value gains and losses, and other fees earned on our Managed portfolio of student loans.
      The DMO business segment reflects the fees earned and expenses incurred to operate our DMO business. Our Corporate and Other business segment includes our remaining fee businesses and other corporate expenses that do not pertain directly to the primary segments identified above.
      SFAS No. 131 requires public companies to report financial and descriptive information about their reportable operating segments. This is the first year that the Company has been required to present segment information in accordance with SFAS No. 131, and we have included this information for all periods presented in our financial statements as required by SEC rules. The segment information that follows in this “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS” (“MD&A”) includes certain condensed financial information in accordance with generally accepted accounting principles in the United States (“GAAP”). In accordance with SFAS No. 131, in Note 18 to our consolidated financial statements, “Segment Reporting,” we present separate financial information about our operating segments that is used regularly by the “chief operating decision makers” in deciding how to allocate resources and in assessing the operating results of the business. The financial information included in Note 18 reflects certain non-GAAP performance measures, which we refer to as “core cash” measures. These “core cash” measures are discussed in greater detail below in “ALTERNATIVE PERFORMANCE MEASURES.”
Lending Business Segment
      In our Lending business segment, we originate and acquire federally guaranteed student loans, which are administered by the U.S. Department of Education (“ED”), and Private Education Loans, which are not

24


 

federally guaranteed. The majority of our Private Education Loans are made in conjunction with a FFELP Stafford loan and as a result are marketed through the same marketing channels as FFELP Stafford Loans. While FFELP student loans and Private Education Loans have different overall risk profiles due to the federal guarantee of the FFELP student loans, they share many of the same characteristics such as similar repayment terms, the same marketing channel and sales force, and are originated and serviced on the same platform. Finally, where possible, the borrower receives a single bill for both the federally guaranteed and privately underwritten loans.
      The earnings growth in our Lending business segment is a product of the growth in our Managed portfolio of student loans and the earning spread on those loans. In 2004, the Managed portfolio grew by 21 percent to $107 billion at December 31, 2004. As a result of receiving the Exceptional Performer (“EP”) Designation from ED, approximately 93 percent of our Managed FFELP student loans are 100 percent guaranteed by the federal government and as such represent high quality assets with very little credit risk. At December 31, 2004, our Managed FFELP student loan portfolio was $96.0 billion or 89 percent of our total Managed student loans.
     Trends in the Lending Business Segment
      The growth in our Lending business segment has been largely driven by the steady growth in the demand for post-secondary education in the United States over the last decade. This growth is evident in the volume of loans we originated or acquired in 2004. We acquired or originated $29.9 billion of student loans in 2004, a 45 percent increase over the $20.7 billion in 2003. Of this, we originated $18.0 billion of student loans through our Preferred Channel, an increase of 18 percent over the $15.2 billion of student loans originated through our Preferred Channel in 2003. We also acquired $6.2 billion of student loans through two acquisitions.
      We expect the growth in the demand for post-secondary education to continue in the future due to a number of factors. First, the college age population will continue to grow. ED predicts that the college age population will increase 10 percent by 2013. Second, we project an increase in non-traditional students (those not attending college directly from high school) and adult education. Third, tuition costs have risen 36 percent for four-year public institutions and 51 percent for four-year private institutions on an inflation-adjusted basis since the academic year (“AY”) 1993-1994 and are projected to continue to rise at a pace greater than inflation. Management believes that the twin factors of increasing demand for education coupled with rising tuition costs will drive growth in education financing well into the next decade.
      During 2004, we renegotiated our agreement with Bank One. Under the current agreement we will purchase all Bank One student loans originated on our platform through 2008. This volume represents the vast majority of loans originated under that brand name. However, we are no longer obligated to promote the Bank One brand on college campuses, allowing us to increase the marketing of the Sallie Mae family of brands as well as other lending partners.
      Over the past three years, we have seen a surge in Consolidation Loan activity as a result of historically low interest rates which has substantially changed the composition of our student loan portfolio. Consolidation Loans earn a lower yield than FFELP Stafford Loans due primarily to the 105 basis point Consolidation Loan Rebate Fee. This negative impact is somewhat mitigated by higher SAP spreads, the longer average life of Consolidation Loans and the greater potential to earn Floor Income. Since interest rates on Consolidation Loans are fixed to term for the borrower, older Consolidation Loans with higher borrower rates can earn Floor Income over an extended period of time. In 2004, substantially all Floor Income was earned on Consolidation Loans. Borrowers typically do not consolidate loans prior to repayment. During 2004, $10.7 billion of FFELP Stafford loans in our Managed loan portfolio consolidated either with us ($8.6 billion) or with other lenders ($2.1 billion). The net result of consolidation activity in 2004 was a portfolio gain of $504 million. Consolidation Loans now represent over 60 percent of our on-balance sheet federally guaranteed student loan portfolio and over 50 percent of our Managed portfolio.
      FFELP loan limits have not been raised since 1992. See “OTHER RELATED EVENTS AND INFORMATION — Reauthorization and Budget Proposals” for a description of proposals that would increase loan limits. To meet the increasing cost of higher education, students and parents have turned to

25


 

alternative sources of education financing. A large and growing source of this supplemental education financing is provided through campus-based Private Education Loans, of which we are the largest provider. The Private Education Loan portfolio grew by 38 percent in 2004 to $11.5 billion and now represents 11 percent of our Managed student loan portfolio, up from 9 percent in 2003.
      Private Education Loans consist of two general types: those that meet the needs of borrowers of higher education schools and other Title IV eligible schools, and those that are used to meet the needs of students in alternative learning programs such as career training, distance learning and lifelong learning programs. Unlike FFELP loans, Private Education Loans are subject to the full credit risk of the borrower. We manage this additional risk through tested loan underwriting standards and a combination of higher interest rates and loan origination fees that compensate us for the higher risk. As a result, we earn higher spreads on Private Education Loans than on FFELP loans. Private Education Loans will continue to be an important driver of future earnings growth as the demand for post-secondary education grows and costs increase much faster than increases in federal loan limits.
      We also originate lesser quantities of mortgage and consumer loans with the intent of immediately selling the majority of the mortgage loans. Mortgage and consumer loan originations and the mortgage loan portfolio we hold were 8 percent and 1 percent, respectively, of total loan originations and total loans outstanding as of and for the year ended December 31, 2004.
     Student Loan Spread
      An important performance measure closely monitored by management is the student loan spread. The student loan spread is the difference between the interest earned on the student loan assets and the interest paid on the debt funding those loans. A number of factors can affect the overall student loan spread such as:
  •  the mix of student loans in the portfolio, with Consolidation Loans having the lowest spread and Private Education Loans having the highest spread;
 
  •  the premiums paid and capitalized costs incurred to acquire student loans which negatively impact the spread through subsequent amortization;
 
  •  the type and level of borrower benefit programs;
 
  •  the level of Floor Income; and
 
  •  funding and hedging costs.
      The replacement of GSE debt with non-GSE debt has increased our funding costs and, coupled with the rapid growth in Consolidation Loans, has put pressure on our student loan spread. We are actively managing these adverse effects by originating a higher percentage of student loans through our Preferred Channel and by increasing the percentage of Private Education Loans in our Managed portfolio. Absent changes to the spread through government legislation, see “OTHER RELATED EVENTS AND INFORMATION — Reauthorization and Budget Proposals,” we expect the Managed student loan spread to remain close to the 1.80 percent earned in the fourth quarter of 2004.
     Funding and Interest Rate Risk
      We depend on the debt capital markets to support our business plan. We have developed diverse funding sources to ensure continued access to the capital markets now that we can no longer access GSE funding. Our biggest funding challenge going forward is to maintain cost effective liquidity to fund the growth in the Managed portfolio of student loans as well as to refinance previously securitized loans when consolidated back on-balance sheet from our securitization trusts. At the same time, we must maintain earnings spreads and control interest rate risk to preserve earnings growth. Our main source of funding is student loan securitizations and we have built a highly liquid market for such financings, as evidenced by the $29.7 billion of student loans securitized in twelve term securitization transactions in 2004 and $30.1 billion in sixteen term securitization transactions in 2003. While securitizations provide the majority of our funding requirements, we also rely on unsecured debt obligations as a source of liquidity. In 2004, we issued $15 billion of SLM

26


 

Corporation, term, unsecured debt raising the total of such debt to $33.3 billion at December 31, 2004, a 64 percent increase over December 31, 2003. In addition, in 2004, we closed a $5 billion asset-backed commercial paper program and increased our revolving credit facility from $3 billion to $5 billion. We rely heavily on derivative transactions to economically hedge our interest rate risk between our assets and liabilities. Derivatives allow us to efficiently match floating rate assets with floating rate debt and also better match the underlying indices of the variable rate assets and liabilities.
      Over the last three years, we have designed several new securitization structures to enable us to fund the longer average life of Consolidation Loans to terms. In certain Consolidation Loan securitization structures, we do not qualify for off-balance sheet accounting treatment and the Consolidation Loans remain on our balance sheet.
      Even though we believe our derivatives are economic hedges, changes in interest rates can cause volatility in our earnings for the market value of our derivatives that do not qualify for hedge accounting treatment under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” Under SFAS No. 133, these changes in derivative market values are recorded through earnings with no consideration for the corresponding change in the fair value of the hedged item. As a result, our earnings are highly susceptible to changes in interest rates caused by these one-sided marks-to-market. Changes in interest rates can also have a material effect on the amount of Floor Income earned in our student loan portfolio and the valuation of our Retained Interest asset. Our earnings can also be materially affected by changes in our estimate of the rate at which loans may prepay in our portfolios as measured by the Constant Prepayment Rate (“CPR”). The value of the Retained Interests on FFELP Stafford securitizations is particularly affected by the level of Consolidation Loan activity. We face a number of other challenges and risks that can materially affect our future results such as changes in:
  •  applicable laws and regulations, which may change the volume, average term, effective yields and refinancing options of student loans under the FFELP or provide advantages to competing FEELP and non-FFELP loan providers;
 
  •  demand and competition for education financing;
 
  •  financing preferences of students and their families;
 
  •  borrower default rates on Private Education Loans;
 
  •  continued access to the capital markets for funding at favorable spreads particularly for our non-federally insured Private Education Loan portfolio; and
 
  •  our operating execution and efficiencies, including errors, omissions, and effectiveness of internal control.
      Recent Developments — Acquisitions in the Lending Business Segment
      We completed two acquisitions in the Lending business segment in 2004 and two acquisitions in 2003. We accounted for these transactions under the purchase method of accounting as defined in SFAS No. 141, “Business Combinations,” and allocated the purchase price to the fair market value of the assets acquired, including identifiable intangible assets and goodwill.
     Southwest Student Services Corporation
      On October 15, 2004, we completed our purchase of the outstanding stock of Southwest Student Services Corporation (“Southwest”), an originator, holder and servicer of student loans from the Helios Education Foundation for total consideration of approximately $533 million including cash of $525 million and restricted stock of $8 million. The transaction included Southwest’s $4.8 billion student loan portfolio (and the related funding), its Arizona-based loan origination and servicing center and its sales and marketing operations. In addition to increasing our student loan portfolio, the purchase has expanded our loan origination capability and broadened our market reach. Southwest is among the top 30 originators of federal student loans, issuing approximately $300 million in FFELP Stafford and PLUS loans and $1.5 billion in Consolidation Loans

27


 

annually, and it is the nation’s ninth largest holder of federal student loans. Southwest provides student loans and related services nationally with a primary focus on colleges and universities in Arizona and Florida. Southwest employs nearly 300 individuals.
     Education Assistance Foundation and Student Loan Finance Association
      On December 14, 2004, we closed the first step in a two step purchase of the secondary market and related businesses of Education Assistance Foundation (“EAF”) and its affiliate, Student Loan Finance Association (“SLFA”) for a purchase price of approximately $435 million. As specified in the purchase agreement, concurrent with the consummation of the transaction, the sellers used $391 million of the purchase price to defease the debt funding certain loans acquired by the Company as part of this transaction. SLFA is a Northwest regional leader in education loan funding and acquisition. The first step of the transaction included SLFA’s $1.8 billion student loan portfolio (and the related funding) and its origination franchise. In addition, as a part of this transaction, we entered into a full service guarantor servicing contract with EAF’s affiliate, Northwest Education Association (“NELA”), a guarantee agency for FFELP student loans that serves the Pacific Northwest. In a related transaction, NELA became an affiliate of USA Funds, the Company’s largest guarantor servicing client. The second step of the transaction is expected to close in 2005.
     Academic Management Services Corporation
      On November 17, 2003, the Company purchased all of the outstanding stock of Academic Management Services Corporation (“AMS”) for a purchase price of approximately $77 million including cash consideration and certain acquisition costs. We allocated the purchase price primarily to the $1.4 billion student loan portfolio and intangible assets including goodwill. In addition to the student loan portfolio, the purchase expanded our loan origination capability and enhanced our offerings to college and university business offices.
Debt Management Operations (“DMO”) Business Segment
      In our DMO business segment, we have traditionally provided portfolio management, debt collection and default prevention services on a contingency fee basis, concentrating primarily in the education finance marketplace. Our investment in AFS Holdings, LLC, the parent company of Arrow Financial Services (collectively, “AFS”), has expanded our capabilities such that we now purchase delinquent and defaulted receivables and earn revenues from collections on those portfolios.
      Of our service areas, the contingency collections business is the most mature. While student loan contingency collections and other fee services will continue to be the core of DMO fee income, purchased portfolio revenue, primarily from credit card accounts, is expected to account for a larger component of DMO revenue in the future.
      The private sector collections industry is highly fragmented with few large public companies and a large number of small scale privately-held companies. The collections industry segments that provide third-party collections services for ED, FFELP guarantors and other federal holders of defaulted debt are highly competitive. Among the asset classes, credit card collections are the most competitive in both contingency collections and purchased paper activities.
      In the education finance marketplace, we are subject to the political risks associated with the FFELP as they relate to guarantors, our primary customers. An example of this risk is the proposed reduction in collections revenues in the President’s proposed budget for Federal Fiscal Year (“FFY”) 2006. See “OTHER RELATED EVENTS AND INFORMATION — Reauthorization and Budget Proposals.”
      In the purchased receivables business we have experienced increased competition in bidding for portfolio purchases, which has driven up prices in competitive bidding situations. We are responding to this challenge through enhanced servicing efficiencies and continuing to build on customer relationships through value added services.

28


 

      Recent Developments — Acquisitions in the DMO Business Segment
     AFS Holdings, LLC
      On September 16, 2004, we acquired 64 percent of AFS, a full-service, accounts receivable management company that purchases charged-off debt, conducts contingency collection work and performs first-party receivables servicing across asset classes, for a purchase price of approximately $165 million including cash consideration and certain acquisition costs. Under the terms of the agreement, we have the option to purchase the remaining interest in AFS Holdings, LLC over a three-year period. The acquisition was accounted for under the purchase accounting method. AFS employs nearly 1,300 individuals at locations in Niles, Illinois; Gaithersburg, Maryland; San Diego, California; Whitewater, Wisconsin; and Rockville Centre, New York. It will retain its brand and senior management team.
      AFS primarily purchases and services defaulted consumer receivables from credit grantors or resellers and then focuses its collection efforts to cover its investment and earn a sufficient return from the purchased portfolio. AFS also collects on behalf of debt owners on a contingency fee basis and provides first-party delinquent and default receivables servicing.
      The purchased receivables business has potential for greater profitability than the contingency fee business due in large part to the maturity of the contingency business and the pricing risks and rewards associated with purchasing delinquent or defaulted debt. Our acquisition of AFS was important for two main reasons. It has further diversified our DMO revenues outside of the education marketplace and provides a disciplined pricing framework and servicing platform as well as years of experience in the purchase of delinquent and defaulted receivables. The addition of AFS also enables us to offer the purchase of distress or defaulted debt to our partner schools as an additional method of enhancing their receivables management strategies.
Corporate and Other Business Segment
      Our Corporate and Other business segment reflects the aggregate activity of our smaller operating units including our Guarantor Servicing and Loan Servicing business units, other products and services, as well as corporate expenses that do not pertain directly to our business segments.
      In our Guarantor Servicing business unit, we provide a full complement of administrative services to FFELP guarantors including guarantee issuance, processing, account maintenance, and guarantee fulfillment. In our Loan Servicing business unit, we originate and service student loans on behalf of lenders who are unrelated to SLM Corporation. Such activities include processing correspondence and filing claims, originating and disbursing Consolidation Loans on behalf of the lender, and other administrative activities required by ED.

29


 

CRITICAL ACCOUNTING POLICIES AND ESTIMATES
      The MD&A discusses our consolidated financial statements, which have been prepared in accordance with GAAP. 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. We base our estimates and judgments on historical experience and on various other factors that we believe are reasonable under the circumstances. Actual results may differ from these estimates under varying assumptions or conditions. Note 2 to the consolidated financial statements, “Significant Accounting Policies,” includes a summary of the significant accounting policies and methods used in the preparation of our consolidated financial statements.
      On an ongoing basis, management evaluates its estimates, particularly those that include the most difficult, subjective or complex judgments and are often about matters that are inherently uncertain. These estimates relate to the following accounting policies that are discussed in more detail below: securitization accounting and Retained Interests, loan effective interest method (premium/borrower benefits), provision for loan losses, and derivative accounting. Also, as part of our regular quarterly evaluation of the critical estimates used by the Company, we have updated a number of estimates to account for the increase in Consolidation Loan activity.
Premiums, Discounts and Borrower Benefits
      For both federally insured and Private Education Loans, we account for premiums paid, discounts received and certain origination costs incurred on the origination and acquisition of student loans in accordance with SFAS No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases.” The unamortized portion of the premiums and the discounts is included in the carrying value of the student loan on the consolidated balance sheet. We recognize income on our student loan portfolio based on the expected yield of the student loan after giving effect to the amortization and accretion of purchase premiums and student loan discounts, as well as the borrower benefit discount. In arriving at the expected yield, we must make a number of estimates that when changed must be reflected in the balance from the inception of the student loan. The most sensitive estimate for premium and discount amortization is the estimate of the CPR, which measures the rate at which loans in the portfolio pay before their stated maturity. The CPR is used in calculating the average life of the portfolio. A number of factors can affect the CPR estimate such as the rate of Consolidation Loan activity, securitization activity and default rates. Changes in CPR estimates are discussed in more detail below.
      In addition to the CPR, the estimate of the borrower benefit discount is dependent on the estimate of the number of borrowers who will eventually qualify for these benefits. For competitive purposes, we frequently change the borrower benefit programs in both amount and qualification factors. These programmatic changes must be reflected in the estimate of the borrower benefit discount.
Effects of Consolidation Loan Activity on Estimates
      The combination of aggressive marketing in the student loan industry and the ability to obtain a long-term, fixed rate loan at low interest rates has led to continued high levels of Consolidation Loan volume, which, in turn, has had a significant effect on a number of accounting estimates in recent years. As long as interest rates remain at historically low levels, and absent any changes in the HEA, we expect the Consolidation Loan program to continue to be an attractive option for borrowers. We have updated our assumptions that are affected primarily by Consolidation Loan activity and updated the estimates used in developing the cash flows and effective yield calculations as they relate to the amortization of student loan premiums and discounts, borrower benefits, residual interest income and the valuation of the Residual Interest.
      Loan consolidation activity affects each estimate differently depending on whether the original FFELP Stafford loans being consolidated were on-balance sheet or off-balance sheet and whether the resulting Consolidation Loan is retained by us or consolidated with a third party. When we consolidate a FFELP Stafford loan that was in our portfolio, the term of that loan is extended and the term of the amortization of

30


 

the capitalized acquisition costs (premium) is likewise extended to match the new term of the loan. In that process the premium must be adjusted from inception to reflect the new term of the consolidated loan. The schedule below summarizes the impact of loan consolidation on each affected financial statement line item.
     Consolidation Loans in Securitizations
      The estimate of the CPR also affects the estimate of the average life of securitized trusts and therefore affects the valuation estimate of the Residual Interest. Prepayments shorten the average life of the trust, and if all other factors remain equal, will reduce the value of the Residual Interest asset, the securitization gain on sale and the effective yield used to recognize interest income. Prepayments on student loans in securitized trusts are primarily driven by the rate at which securitized FFELP Stafford loans are consolidated. When a loan is consolidated from the trust either by us or a third party, the loan is treated as a prepayment. In cases where the loan is consolidated by us, it will be recorded as an on-balance sheet asset. We discuss the effects of changes in our CPR estimates in “RESULTS OF OPERATIONS — LENDING BUSINESS SEGMENT — Student Loans” and “RESULTS OF OPERATIONS — LIQUIDITY AND CAPITAL RESOURCES — Securitization Activities.”
     Effect of Increasing Consolidation Activity
On-Balance Sheet Student Loans
                 
 
    Consolidating    
 Estimate   Lender   Effect on Estimate   CPR   Accounting Effect
 
Premium
  Sallie Mae   Term extension   Decrease   Estimate Adjustment(1) — increase unamortized balance of premium. Reduced annual amortization expense going forward.
Premium
  Other lenders   Stafford loan prepaid   Increase   Estimate Adjustment(1) — decrease unamortized balance of premium or accelerated amortization of premium.
Borrower Benefits
  Sallie Mae   Term extension   N/A   Original Stafford loan expected benefit expense reversed — new Consolidation Loan benefit amortized over a longer term. (2)
Borrower Benefits
  Other lenders   Stafford loan prepaid   N/A   Borrower benefit reserve reversed into income.(2)
(1)  As estimates are updated, in accordance with SFAS No. 91, the premium balance must be adjusted from inception to reflect the new expected term of the loan.
 
(2)  Consolidation estimates also affect the estimates of borrowers who will eventually qualify for borrower benefits.

31


 

Off-Balance Sheet Student Loans
                 
 
    Consolidating    
 Estimate   Lender   Effect on Estimate   CPR   Accounting Effect
 
Residual Interest
  Sallie Mae or other lenders   FFELP Stafford loan is prepaid   Increase   • Reduction in fair market value of Residual Interest asset resulting in either an impairment charge or reduction in prior market value gains recorded in other comprehensive income.
                • Decrease in prospective effective yield used to recognize interest income.
Securitization Accounting and Retained Interests
      We regularly engage in securitization transactions as part of our financing strategy. As described in more detail in “ RESULTS OF OPERATIONS — LIQUIDITY AND CAPITAL RESOURCES — Securitization Activities,” in a securitization we sell student loans to a trust that issues bonds backed by the student loans as part of the transaction. When our securitizations meet the sale criteria of SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities — a Replacement of SFAS No. 125,” we record a gain on the sale of the student loans which is the difference between the allocated cost basis of the assets sold and the relative fair value of the assets received. The primary judgment in determining the fair value of the assets received is the valuation of the residual interest.
      The Retained Interests in each of our securitizations are treated as available-for-sale securities in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and therefore must be marked-to-market with temporary unrealized gains and losses recognized, net of tax, in accumulated other comprehensive income in stockholders’ equity. Since there are no quoted market prices for our Retained Interests, we estimate their fair value both initially and each subsequent quarter using the key assumptions listed below:
  •  the projected net interest yield from the underlying securitized loans, which can be impacted by the forward yield curve;
 
  •  the calculation of the Embedded Floor Income associated with the securitized loan portfolio;
 
  •  the CPR;
 
  •  the discount rate used, which is intended to be commensurate with the risks involved; and
 
  •  the expected credit losses from the underlying securitized loan portfolio.
      We recognize interest income and periodically evaluate our Retained Interests for other than temporary impairment in accordance with the Emerging Issues Task Force (“EITF”) Issue No. 99-20 “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets.” Under this standard, on a quarterly basis we estimate the cash flows to be received from our Retained Interests and these revised cash flows are used prospectively to calculate a yield for income recognition. In cases where our estimate of future cash flows results in a decrease in the yield used to recognize interest income compared to the prior quarter, the Retained Interest is written down to fair value, first to the extent of any unrealized gain in accumulated other comprehensive income, then through earnings as an other than temporary impairment. These estimates are the same as those used for the valuation of the Residual Interest discussed above.
      We also receive income for servicing the loans in our securitization trusts. We assess the amounts received as compensation for these activities at inception and on an ongoing basis to determine if the amounts

32


 

received are adequate compensation as defined in SFAS No. 140. To the extent such compensation is determined to be no more or less than adequate compensation, no servicing asset or obligation is recorded.
Provision 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 student loan portfolios. The allowance for Private Education Loan losses is an estimate of probable losses in the portfolio at the balance sheet date that will be charged off in subsequent periods. We estimate our losses using historical data from our Private Education Loan portfolios, extrapolations of FFELP loan loss data, current trends and relevant industry information. As our Private Education Loan portfolios continue to mature, more reliance is placed on our own historic Private Education Loan charge-off and recovery data. Accordingly, during the third quarter of 2004, we updated our expected default assumptions to further align the allowance estimate with our collection experience and the terms and policies of the individual Private Education Loan programs. We use this data in internally developed models to estimate the amount of losses, net of subsequent collections, projected to occur in the Private Education Loan portfolios.
      When calculating the Private Education Loan loss reserve, we divide the portfolio into categories of similar risk characteristics based on loan program type, underwriting criteria, existence or absence of a co-borrower, repayment begin date, repayment status, and aging. We then apply default and collection rate projections to each category. The repayment begin date indicates when the borrower is required to begin repaying their loan. Our career training Private Education Loan programs (13 percent of the Managed Private Education Loan portfolio at December 31, 2004) generally require the borrowers to start repaying their loans immediately. Our higher education Private Education Loan programs (87 percent of the Managed Private Education Loan portfolio at December 31, 2004) do not require the borrowers to begin repayment until six months after they have graduated or otherwise left school. Consequently, our loss estimates for these programs are minimal while the borrower is in school. At December 31, 2004, 45 percent of the principal balance in the higher education Managed Private Education Loan portfolio related to borrowers who are still in-school and not required to make payments. As the current portfolio ages, an increasing percentage of the borrowers will leave school and be required to begin payments on their loans. The allowance for losses will change accordingly with the percentage of borrowers in repayment.
      Our loss estimates include losses to be incurred over the loss confirmation period, which is two years for career training loans beginning when the loan is originated and five years for higher education loans beginning when the borrower leaves school. Similar to the rules governing FFELP payment requirements, our collection policies allow for periods of nonpayment for borrowers requesting additional payment grace periods upon leaving school or experiencing temporary difficulty meeting payment obligations. This is referred to as forbearance status. The vast majority of forbearance occurs early in the repayment term when borrowers are starting their careers (see “RESULTS OF OPERATIONS — LENDING BUSINESS SEGMENT — Student Loans — Delinquencies”). At December 31, 2004, 4 percent of the Managed Private Education Loan portfolio was in forbearance status. The loss confirmation period is in alignment with our typical collection cycle and takes into account these periods of nonpayment.
      Private Education Loan principal is charged off against the allowance at 212 days delinquency. Private Education Loans continue to accrue interest, including in periods of forbearance, until they are charged off and removed from the active portfolio, at which time the accrued interest is charged off against interest income. Recoveries on loans charged off are recorded directly to the allowance.
      Effective for a renewable one-year period beginning on October 19, 2004, Sallie Mae, Inc.’s loan servicing division, Sallie Mae Servicing, was designated as an Exceptional Performer (“EP”) by ED in recognition of meeting certain performance standards set by ED in servicing FFELP loans. As a result of this designation, the Company receives 100 percent reimbursement on default claims on federally guaranteed student loans that are serviced by Sallie Mae Servicing for a period of at least 270 days before the date of default and will no longer be subject to the two percent Risk Sharing on these loans. The Company is entitled to receive this

33


 

benefit as long as the Company remains in compliance with the required servicing standards, which are assessed on an annual and quarterly basis through compliance audits and other criteria. The 100 percent reimbursement applies to all FFELP loans that are serviced by the Company as well as default claims on federally guaranteed student loans that the Company owns but are serviced by other service providers with the EP designation. At December 31, 2004, approximately 88 percent of the Company’s on-balance sheet federally insured loans are no longer subject to Risk Sharing. As a result of this designation, the Company has reduced the balance in the allowance for loan losses by $33 million.
      Accordingly, the evaluation of the provision for loan losses is inherently subjective, as it requires material estimates that may be susceptible to significant changes. Management believes that the allowance for loan losses is appropriate to cover probable losses in the student loan portfolio.
Derivative Accounting
      We use interest rate swaps, foreign currency swaps, interest rate futures contracts, Floor Income Contracts and interest rate cap contracts as an integral part of our overall risk management strategy to manage interest rate risk arising from our fixed rate and floating rate financial instruments. We account for these instruments in accordance with SFAS No. 133 which requires that every derivative instrument, including certain derivative instruments embedded in other contracts, be recorded at fair value on the balance sheet as either an asset or liability. We determine the fair value for our derivative instruments using pricing models that consider current market values and the contractual terms of the derivative contracts. Pricing models and their underlying assumptions impact the amount and timing of unrealized gains and losses recognized; the use of different pricing models or assumptions could produce different financial results. As a matter of policy, we compare the fair values of our derivatives that we calculate to those provided by our counterparties on a monthly basis. Any significant differences are identified and resolved appropriately.
      We make certain judgments in the application of hedge accounting under SFAS No. 133. The most significant judgment relates to the application of hedge accounting in connection with our forecasted debt issuances. Under SFAS No. 133, if the forecasted transaction is probable to occur then hedge accounting may be applied. We regularly update our probability assessment related to such forecasted debt issuances. This assessment includes analyzing prior debt issuances and assessing changes in our future funding strategies.
      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. We believe that all of our derivatives are effective economic hedges and are a critical element of our interest rate risk management strategy. However, under SFAS No. 133, some of our derivatives, primarily Floor Income Contracts, certain Eurodollar futures contracts, certain basis swaps and equity forwards, do not qualify for “hedge treatment” under SFAS No. 133. Therefore, changes in market value along with the periodic net settlements must be recorded through the derivative market value adjustment in the income statement with no consideration for the corresponding change in fair value of the hedged item. The derivative market value adjustment is primarily caused by interest rate volatility and changing credit spreads during the period and the volume and term of derivatives not receiving hedge accounting treatment. See also “ALTERNATIVE PERFORMANCE MEASURES — Derivative Accounting” for a detailed discussion of our accounting for derivatives.

34


 

SELECTED FINANCIAL DATA
Condensed Statements of Income
                                                         
                Increase (decrease)
                 
    Years Ended December 31,   2004 vs. 2003   2003 vs. 2002
             
    2004   2003   2002   $   %   $   %
                             
Net interest income
  $ 1,299     $ 1,326     $ 1,425     $ (27 )     (2 )%   $ (99 )     (7 )%
Less: provision for losses
    111       147       117       (36 )     (24 )     30       26  
                                           
Net interest income after provision for losses
    1,188       1,179       1,308       9       1       (129 )     (10 )
Gains on student loan securitizations
    375       744       338       (369 )     (50 )     406       120  
Servicing and securitization revenue
    561       667       839       (106 )     (16 )     (172 )     (21 )
Losses on securities, net
    (49 )     (10 )     (2 )     (39 )     (390 )     (8 )     (400 )
Derivative market value adjustment
    849       (238 )     (1,082 )     1,087       457       844       78  
Guarantor servicing fees
    120       128       106       (8 )     (6 )     22       21  
Debt management fees and collections revenue
    340       259       186       81       31       73       39  
Other income
    289       249       220       40       16       29       13  
Operating expenses
    895       795       690       100       13       105       15  
Loss on GSE debt extinguishment and defeasance
    221                   221       100              
Income taxes
    642       779       431       (137 )     (18 )     348       81  
Minority interest in net earnings of subsidiaries
    1                   1       100              
Cumulative effect of accounting change
          130             (130 )     (100 )     130        
                                           
Net income
    1,914       1,534       792       380       25       742       94  
Preferred stock dividends
    12       12       12                          
                                           
Net income attributable to common stock
  $ 1,902     $ 1,522     $ 780     $ 380       25 %   $ 742       95 %
                                           
Basic earnings per common share, before cumulative effect of accounting change
  $ 4.36     $ 3.08     $ 1.69     $ 1.28       42 %   $ 1.39       82 %
                                           
Basic earnings per common share, after cumulative effect of accounting change
  $ 4.36     $ 3.37     $ 1.69     $ .99       29 %   $ 1.68       99 %
                                           
Diluted earnings per common share, before cumulative effect of accounting change
  $ 4.04     $ 2.91     $ 1.64     $ 1.13       39 %   $ 1.27       77 %
                                           
Diluted earnings per common share, after cumulative effect of accounting change
  $ 4.04     $ 3.18     $ 1.64     $ .86       27 %   $ 1.54       94 %
                                           
Dividends per common share
  $ .74     $ .59     $ .28     $ .15       25 %   $ .31       111 %
                                           

35


 

Condensed Balance Sheets
                                                 
            Increase (decrease)
             
    December 31,   2004 vs. 2003   2003 vs. 2002
             
    2004   2003   $   %   $   %
                         
Assets
Federally insured student loans, net
  $ 60,561     $ 45,577     $ 14,984       33 %   $ 8,413       23 %
Private Education Loans, net
    5,420       4,470       950       21       (705 )     (14 )
Academic facilities financings and other loans, net
    1,048       1,031       17       2       (171 )     (14 )
Cash and investments
    6,975       6,896       79       1       2,382       53  
Restricted cash and investments
    2,211       1,106       1,105       100       630       132  
Retained Interest in securitized receivables
    2,316       2,476       (160 )     (6 )     330       15  
Goodwill and acquired intangible assets
    1,066       592       474       80       6       1  
Other assets
    4,497       2,463       2,034       83       551       29  
                                     
Total assets
  $ 84,094     $ 64,611     $ 19,483       30 %   $ 11,436       22 %
                                     
 
Liabilities and Stockholders’ Equity
Short-term borrowings
  $ 2,207     $ 18,735     $ (16,528 )     (88 )%   $ (6,884 )     (27 )%
Long-term notes
    75,915       39,808       36,107       91       17,566       79  
Other liabilities
    2,798       3,438       (640 )     (19 )     122       4  
                                     
Total liabilities
    80,920       61,981       18,939       31       10,804       21  
                                     
Minority interest in subsidiaries
    72             72       100                  
Stockholders’ equity before treasury stock
    5,129       3,180       1,949       61       (1,523 )     (32 )
Common stock held in treasury at cost
    2,027       550       1,477       269       (2,155 )     (80 )
                                     
Total stockholders’ equity
    3,102       2,630       472       18       632       32  
                                     
Total liabilities and stockholders’ equity
  $ 84,094     $ 64,611     $ 19,483       30 %   $ 11,436       22 %
                                     

36


 

RESULTS OF OPERATIONS
      As discussed in detail above in the “OVERVIEW” section, we have two primary business segments, Lending and DMO, plus a Corporate and Other business segment. Since these business segments operate in distinct business environments, after a general discussion of the consolidated results of operations, the discussion herein of the results of our operations is primarily presented on a segment basis. The Lending business segment includes all discussion of income and related expenses associated with net interest margin, student loan spread and its components, securitization gains and the ongoing servicing and securitization income, derivative market value gains and losses, and other fees earned on our Managed portfolio of student loans.
      The DMO business segment reflects the fees earned and expenses incurred to operate our DMO business. Our Corporate and Other business segment includes our ancillary fee businesses and other corporate expenses that do not pertain directly to the primary segments identified above. Unless otherwise noted, the financial information contained herein is in accordance with GAAP. We also present financial information for our reportable operating segments in Note 18 to our consolidated financial statements, “Segment Reporting,” which reflects “core cash” measures. “Core cash” measures are discussed in detail below in “ALTERNATIVE PERFORMANCE MEASURES.”
CONSOLIDATED EARNINGS SUMMARY
      The main drivers of our net income are the growth in our Managed student loan portfolio, which drives net interest income and securitization transactions, market value gains and losses on derivatives that do not receive hedge accounting treatment, the timing and size of securitization gains, growth in our fee-based business and expense control.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003
      For the year ended December 31, 2004, our net income was $1.9 billion ($4.04 diluted earnings per share) versus net income of $1.5 billion ($3.18 diluted earnings per share) in 2003. The increase in net income from 2003 to 2004 is due to several factors. The principal driver of the growth in net income was a $1.1 billion pre-tax increase in the derivative market value adjustment. The derivative market value gain can primarily be attributed to the positive effect that the increase in forward interest rates had on the valuation of our Floor Income Contracts and to gains on our equity forward contracts caused by the increase in the market value of our common stock. In 2004, other income (which includes guarantor servicing fees, debt management fees and collections revenue, and other fee-based income) increased by 18 percent to $749 million versus 2003. This increase can mainly be attributed to an increase in revenue from our DMO segment, late and other borrower fees and to termination fees from Bank One. In 2003, other income benefited from a $40 million gain on the sale of our prior headquarters building. The year-over-year increases in other income were offset by $369 million in lower securitization gains due to 2004 Consolidation Loan securitizations not qualifying for off-balance sheet treatment and $106 million in lower servicing and securitization revenue due to primarily lower Embedded Floor Income.
      Net income in 2004 was also negatively impacted by a $221 million pre-tax loss related to the repurchase and defeasance of $3.0 billion of GSE debt in connection with the GSE Wind-Down and a 13 percent increase in other operating expenses to $895 million versus 2003. This increase can be attributed to acquisitions and increased servicing and debt management expenses consistent with the growth in borrowers and the growth in the debt management business. Also, in 2004, net interest income after provision for loan losses was relatively flat versus 2003 caused by two offsetting factors: the increase in net interest income, driven by an $11 billion increase in our average balance of on-balance sheet student loans, and offset by the reduction in Floor Income caused by higher interest rates.
      Our Managed student loan portfolio grew by $18.6 billion, from $88.8 billion at December 31, 2003 to $107.4 billion at December 31, 2004. This growth was fueled by the $29.9 billion in new Managed student loans acquired in 2004, a 45 percent increase over the $20.7 billion acquired in 2003. In 2004, we originated

37


 

$18.0 billion of student loans through our Preferred Channel, an increase of 18 percent over the $15.2 billion originated in 2003.
Year Ended December 31, 2003 Compared to Year Ended December 31, 2002
      Net income for the year ended December 31, 2003 was $1.5 billion ($3.18 diluted earnings per share) versus $792 million ($1.64 diluted earnings per share) in 2002. The increase in net income from 2002 to 2003 is mainly due to an increase in securitization gains, a pre-tax $844 million reduction in the loss on the derivative market value adjustment, an increase in fee-based income, and a $130 million unrealized gain on our equity forward positions, which was reflected as a cumulative effect of accounting change for the adoption of SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” These increases were offset by decreases in student loan income, decreases in servicing and securitization revenue resulting from changes in accounting estimates in the fourth quarter of 2003, reduced levels of Floor Income, an increase in operating expenses due to the acquisitions, and increases in debt management and servicing expenses consistent with the growth in the debt management business.
      For the year ended December 31, 2003, managed student loans increased 14 percent in 2003 to $88.8 billion at December 31, 2003. In 2003, we acquired $20.7 billion of student loans, a 25 percent increase over the $16.5 billion acquired in 2002. Of the student loans acquired, we originated $15.2 billion through our Preferred Channel, an increase of 23 percent over the $12.4 billion originated in 2002.
LENDING BUSINESS SEGMENT
      The following table includes the results of operations for our Lending business segment.
Condensed Statements of Income
                                         
    Year Ended December 31,   % Increase (Decrease)
         
    2004   2003   2002   2004 vs. 2003   2003 vs. 2002
                     
Net interest income
  $ 1,299     $ 1,326     $ 1,425       (2 )%     (7 )%
Less: provision for loan losses
    111       147       117       (25 )     26  
                               
Net interest income after provision for loan losses
    1,188       1,179       1,308       1       (10 )
Other income, net
    1,899       1,289       203       47       535  
Operating expenses
    681       431       367       58       17  
                               
Income before income taxes and cumulative effect of accounting change
    2,406       2,037       1,144       18       78  
Income taxes
    585       729       403       (20 )     81  
                               
Income before cumulative effect of accounting change
    1,821       1,308       741       39       77  
Cumulative effect of accounting change
          130             (100 )     100  
                               
Net income
  $ 1,821     $ 1,438     $ 741       27 %     94 %
                               

38


 

      The following table includes asset information for our Lending business segment.
                         
    December 31,
     
    2004   2003   2002
             
Federally insured student loans, net
  $ 60,561     $ 45,577     $ 37,164  
Private Education Loans, net
    5,420       4,470       5,175  
Academic facilities financings and other loans, net
    1,048       1,031       1,202  
Investments(1)
    8,914       7,741       4,794  
Retained Interest in securitized receivables
    2,315       2,472       2,137  
Other(2)
    4,792       2,600       1,926  
                   
Total assets
  $ 83,050     $ 63,891     $ 52,398  
                   
 
(1)  Investments include cash and cash equivalents, short and long term investments, restricted cash and investments, leveraged leases, and municipal bonds.
 
(2)  Other assets include accrued interest receivable, goodwill and acquired intangible assets and other non-interest earning assets.
Net Interest Income
      Net interest income, including interest income and interest expense, is derived primarily from our portfolio of student loans that remain on-balance sheet and to a lesser extent from other loans, cash and investments. The “Taxable Equivalent Net Interest Income” analysis below is designed to facilitate a comparison of non-taxable asset yields to taxable yields on a similar basis. Additional information regarding the return on our student loan portfolio is set forth under “Student Loans — Student Loan Spread Analysis.” Information regarding the provision for losses is contained in Note 4 to the consolidated financial statements, “Allowance for Student Loan Losses.”
      Taxable Equivalent Net Interest Income
      The amounts in the following table are adjusted for the impact of certain tax-exempt and tax-advantaged investments based on the marginal federal corporate tax rate of 35 percent.
                                                           
                Increase (decrease)
                 
    Years Ended December 31,   2004 vs. 2003   2003 vs. 2002
             
    2004   2003   2002   $   %   $   %
                             
Interest income
                                                       
 
Student loans
  $ 2,426     $ 2,121     $ 2,450     $ 305       14 %   $ (329 )     (13 )%
 
Academic facilities financings and other loans
    74       77       96       (3 )     (4 )     (19 )     (20 )
 
Investments
    233       150       88       83       55       62       70  
 
Taxable equivalent adjustment
    9       16       18       (7 )     (44 )     (2 )     (11 )
                                           
Total taxable equivalent interest income
    2,742       2,364       2,652       378       16       (288 )     (11 )
Interest expense
    1,434       1,022       1,210       412       40       (188 )     (16 )
                                           
Taxable equivalent net interest income
  $ 1,308     $ 1,342     $ 1,442     $ (34 )     (3 )%   $ (100 )     (7 )%
                                           

39


 

      Average Balance Sheets
      The following table reflects the rates earned on interest earning assets and paid on interest bearing liabilities for the years ended December 31, 2004, 2003 and 2002. This table reflects the net interest margin for the entire Company on a consolidated basis. It is included in the Lending segment discussion because that segment includes substantially all interest earning assets and interest bearing liabilities.
                                                 
    Years Ended December 31,
     
    2004   2003   2002
             
    Balance   Rate   Balance   Rate   Balance   Rate
                         
Average Assets
                                               
Federally insured student loans
  $ 51,091       4.09 %   $ 40,108       4.52 %   $ 38,023       5.55 %
Private Education Loans
    4,795       7.00       5,019       6.13       5,059       6.69  
Academic facilities financings and other loans
    1,004       7.72       1,129       7.27       1,460       7.19  
Cash and investments
    11,321       2.11       6,840       2.36       4,885       1.98  
                                     
Total interest earning assets
    68,211       4.02 %     53,096       4.45 %     49,427       5.37 %
                                     
Non-interest earning assets
    6,497               5,950               4,758          
                                     
Total assets
  $ 74,708             $ 59,046             $ 54,185          
                                     
Average Liabilities and Stockholders’ Equity
                                               
Six month floating rate notes
  $ 1,586       1.23 %   $ 2,988       1.14 %   $ 3,006       1.76 %
Other short-term borrowings
    9,010       2.07       22,007       1.64       27,159       1.97  
Long-term notes
    58,134       2.11       28,407       2.21       19,757       3.15  
                                     
Total interest bearing liabilities
    68,730       2.09 %     53,402       1.91 %     49,922       2.42 %
                                     
Non-interest bearing liabilities
    3,195               3,169               2,397          
Stockholders’ equity
    2,783               2,475               1,866          
                                     
Total liabilities and stockholders’ equity
  $ 74,708             $ 59,046             $ 54,185          
                                     
Net interest margin
            1.92 %             2.53 %             2.92 %
                                     
      Rate/Volume Analysis
      The following rate/volume analysis shows the relative contribution of changes in interest rates and asset volumes.
                         
        Increase
        (decrease)
    Taxable   attributable to
    equivalent   change in
    increase    
    (decrease)   Rate   Volume
             
2004 vs. 2003
                       
Taxable equivalent interest income
  $ 378     $ (201 )   $ 579  
Interest expense
    412       (16 )     428  
                   
Taxable equivalent net interest income
  $ (34 )   $ (185 )   $ 151  
                   
2003 vs. 2002
                       
Taxable equivalent interest income
  $ (288 )   $ (409 )   $ 121  
Interest expense
    (188 )     (358 )     170  
                   
Taxable equivalent net interest income
  $ (100 )   $ (51 )   $ (49 )
                   

40


 

      The decrease in the net interest margin from the year ended December 31, 2003 to the year ended December 31, 2004 was primarily due to the decrease in Floor Income and other student loan spread related items as discussed under “Student Loans — Student Loan Spread Analysis.” The decrease in the net interest margin was also due to the effect of the GSE Wind-Down. Without the low funding cost provided by the GSE, the margin on our highly liquid, short-term investments turns negative. Also, we have replaced short-term GSE financing with longer term more expensive non-GSE financing.
Student Loans
      For both federally insured student loans and Private Education Loans, we account for premiums paid, discounts received and certain origination costs incurred on the origination and acquisition of student loans in accordance with SFAS No. 91. The unamortized portion of the premiums and discounts are included in the carrying value of the student loan on the consolidated balance sheet. We recognize income on our student loan portfolio based on the expected yield of the student loan after giving effect to the amortization of purchase premiums and the accretion of student loan discounts, as well as the discount expected to be earned through borrower benefit programs. Discounts on Private Education Loans are deferred and accreted to income over the lives of the student loans. In the table below, this accretion of discounts is netted with the amortization of the premiums.
      Student Loan Spread Analysis — On-Balance Sheet
      The following table analyzes the reported earnings from student loans both on-balance sheet and those off-balance sheet in securitization trusts. For student loans off-balance sheet, we will continue to earn securitization and servicing fee revenues over the life of the securitized loan portfolios. The off-balance sheet information is discussed in more detail in “LIQUIDITY AND CAPITAL RESOURCES — Securitization Activities — Servicing and Securitization Revenue” where we analyze the on-going servicing revenue and Residual Interest earned on the securitized portfolios of student loans. For an analysis of our student loan

41


 

spread for the entire portfolio of Managed student loans on a similar basis to the on-balance sheet analysis, see “Student Loan Spread Analysis — Managed Basis.”
                         
    Years Ended December 31,
     
    2004   2003   2002
             
On-Balance Sheet
                       
Student loan yield, before Floor Income
    4.53 %     4.28 %     4.98 %
Floor Income
    .73       1.23       1.48  
Consolidation Loan Rebate Fees
    (.58 )     (.50 )     (.40 )
Offset Fees
    (.03 )     (.07 )     (.10 )
Borrower benefits
    (.18 )     (.06 )     (.08 )
Premium and discount amortization
    (.13 )     (.18 )     (.19 )
                   
Student loan net yield
    4.34       4.70       5.69  
Student loan cost of funds
    (2.01 )     (1.70 )     (2.30 )
                   
Student loan spread
    2.33 %     3.00 %     3.39 %
                   
Off-Balance Sheet
                       
Servicing and securitization revenue, before Floor Income
    1.17 %     1.27 %     1.49 %
Floor Income, net of Floor Income previously recognized in gain on sale calculation
    .21       .47       1.11  
                   
Servicing and securitization revenue
    1.38 %     1.74 %     2.60 %
                   
Average Balances
                       
On-balance sheet student loans
  $ 55,885     $ 45,127     $ 43,082  
Off-balance sheet student loans
    40,558       38,205       32,280  
                   
Managed student loans
  $ 96,443     $ 83,332     $ 75,362  
                   
      The primary driver of fluctuations in our on-balance sheet student loan spread is the level of Floor Income earned in the period. In 2004, 2003 and 2002, we earned gross Floor Income of $408 million (73 basis points), $554 million (123 basis points) and $636 million (148 basis points), respectively. The reduction in Floor Income is due to the increase in short-term interest rates in 2004. We believe that we have economically hedged most of the Floor Income through the sale of Floor Income Contracts. When we sell a Floor Income Contract we receive an upfront fee and agree to pay the counterparty the Floor Income earned on a notional amount of student loans. These contracts do not qualify for accounting hedge treatment and as a result are excluded from net interest income and from the above student loan spread analysis. Instead, payments of Floor Income under these contracts are required to be reported with other cumulative realized and unrealized gains and losses in the derivative market value adjustment line in the income statement. For the years ended December 31, 2004, 2003 and 2002, net Floor Income for on-balance sheet student loans was $40 million (7 basis points), $146 million (32 basis points) and $219 million (51 basis points), respectively. Payments on Floor Income Contracts associated with on-balance sheet student loans for the years ended December 31, 2004, 2003 and 2002 totaled $368 million (66 basis points), $408 million (91 basis points) and $417 million (97 basis points), respectively.
      In addition to Floor Income Contracts, we also extensively use basis swaps to manage our basis risk associated with interest rate sensitive assets and liabilities. These swaps also do not qualify as accounting hedges and are likewise required to be accounted for in the derivative market value adjustment and not part of the cost of funds in the above table. Had net settlements of these swaps been included with the associated debt, our on-balance sheet cost of funds would have been 2.02 percent, 1.65 percent and 2.31 percent, respectively, for the years ended December 31, 2004, 2003 and 2002.

42


 

      Discussion of the Year-over-Year Effect of Changes in Accounting Estimates on the On-Balance Sheet Student Loan Spread
      As discussed in detail and summarized in a table under “CRITICAL ACCOUNTING POLICIES AND ESTIMATES,” we periodically update our estimates for changes in the student loan portfolio. Under SFAS No. 91, these changes in estimates must be reflected in the balance of the student loan from inception. We have also updated our estimates to reflect programmatic changes in our borrower benefit and Private Education Loan programs and have made modeling refinements to better reflect current and future conditions. The effects of the changes in estimates on the student loan spread are summarized in the table below:
                                     
    Years Ended December 31,
     
    2004   2003
         
(Dollars in millions)   Dollar Value   Basis Points   Dollar Value   Basis Points
                 
Changes in critical accounting estimates:
                               
 
Effect on premium/discount:
                               
   
FFELP Stafford and Consolidation Loans
  $           $ (19 )     (4 )
   
Private Education Loans
    (8 )     (1 )     (23 )     (5 )
                         
 
Total effect on premium/discount
    (8 )     (1 )     (42 )     (9 )
 
Borrower benefits
    5       1       10       2  
                         
Total changes in estimates
  $ (3 )         $ (32 )     (7 )
                         
      In 2004, based on our ongoing analysis of our Private Education Loan portfolio, we determined that the portfolio was repaying slower than previously estimated, and in response we increased the period for which we amortize student loan discounts resulting in an increase to the unamortized student loan discount balance of $8 million during 2004. In response to the continued high rate of Consolidation Loan activity, we lowered our estimate of the number of Stafford borrowers who will eventually qualify for borrower benefits and revised the term over which benefits are expected to be realized. As a result, we recorded a $5 million reduction in the liability for borrower benefits. The net effect of these updates to our estimates in 2004 was a $3 million or 1 basis point reduction in the student loan spread.
      In 2003, we updated our estimates to reflect the increase in Consolidation Loan activity. We decreased the CPR for FFELP Stafford loans to reflect the extension of the term of these loans when consolidated into a Sallie Mae Consolidation Loan, which results in an increase to the unamortized student loan premium. At the same time, we increased the CPR for the Consolidation Loan portfolio, which had the opposite effect on the premium balance and premium amortization. The net effect of these changes was a $19 million adjustment to decrease the unamortized student loan premium and increase current period amortization expense. We also decreased our estimate of the CPR associated with our Private Education Loan program to reflect slower than anticipated repayments resulting in a $23 million increase in the unamortized student loan discount. Also, in 2003, we reduced our estimate of the number of borrowers who eventually qualify for FFELP Stafford borrower benefits resulting in a $10 million estimate adjustment to reduce the estimated borrower benefit liability and increase student loan income. The net effect of these updates to our estimates in 2003 was a $32 million or 7 basis point reduction in the student loan spread.
      Discussion of Year-over-Year Fluctuations in On-Balance Sheet Student Loan Spread in Addition to Changes in Accounting Estimates
      The decrease in the 2004 student loan spread versus the prior year is primarily due to the higher average balance of Consolidation Loans as a percentage of the on-balance sheet portfolio. Consolidation Loans have lower spreads than other FFELP loans due to the 105 basis point Consolidation Loan Rebate Fee, more robust borrower benefits, and higher funding costs due to their longer terms. These negative effects are partially offset by lower student loan premium amortization due to the extended term and a higher SAP yield. The average

43


 

balance of Consolidation Loans grew as a percentage of the average on-balance sheet FFELP student loan portfolio from 56 percent in 2003 to 62 percent in 2004.
      Other factors that negatively impacted the student loan spread are lower Floor Income due to higher average interest rates, higher spreads on our debt funding student loans as a result of the GSE Wind-Down, and higher borrower benefit costs. These negative factors were partially offset by the absence of Offset Fees on GSE financed loans and higher student loan yields. The increase in funding costs is due to the replacement of lower cost, primarily short-term GSE funding with longer term, higher cost non-GSE funding. In 2004, GSE liabilities were heavily weighted to short term in anticipation of the GSE Wind-Down. The increase in borrower benefit costs can be attributable to an increase in the estimate of borrowers qualifying for the benefit and to changes to certain programs that shorten the periods required to qualify, primarily as they relate to Consolidation Loans. These changes had a greater effect on the on-balance sheet student loan spread due to the higher percentage of Consolidation Loans. These negative effects were partially offset by the increase in Private Education Loans in the on-balance sheet student loan portfolio and lower net premium/ discount amortization.
      In addition to the effects of estimate adjustments, the student loan spread decreased by 32 basis points from 2002 to 2003. This decrease was primarily due to the higher average balance of Consolidation Loans, lower Floor Income and higher funding spreads on the debt. These negative effects were partially offset by the increase in Private Education Loans in the on-balance sheet student loan portfolio.
      Student Loan Spread Analysis — Managed Basis
      The following table analyzes the earnings from our portfolio of Managed student loans on a “core cash” basis (see “ALTERNATIVE PERFORMANCE MEASURES”). This analysis includes both on-balance sheet and off-balance sheet loans in securitization trusts and derivatives economically hedging these line items and excludes Floor Income while including the amortization of upfront payments on Floor Income Contracts.
                         
    Years Ended December 31,
     
    2004   2003   2002
             
Managed Basis student loan yield
    4.59 %     4.26 %     4.94 %
Consolidation Loan Rebate Fees
    (.42 )     (.36 )     (.26 )
Offset Fees
    (.02 )     (.04 )     (.06 )
Borrower benefits
    (.08 )     (.05 )     (.11 )
Premium and discount amortization
    (.13 )     (.10 )     (.25 )
                   
Managed Basis student loan net yield
    3.94       3.71       4.26  
Managed Basis student loan cost of funds
    (2.06 )     (1.71 )     (2.38 )
                   
Managed Basis student loan spread
    1.88 %     2.00 %     1.88 %
                   
Average Balances
                       
On-balance sheet student loans
  $ 55,885     $ 45,127     $ 43,082  
Off-balance sheet student loans
    40,558       38,205       32,280  
                   
Managed student loans
  $ 96,443     $ 83,332     $ 75,362  
                   
      Discussion of the Year-over-Year Effect of Changes in Accounting Estimates on the Managed Student Loan Spread
      As discussed in detail and summarized in a table at “CRITICAL ACCOUNTING POLICIES AND ESTIMATES,” we periodically update our estimates for changes in the student loan portfolio. Under SFAS No. 91, these changes in estimates must be reflected in the balance from inception of the student loan. We have also updated our estimates to reflect programmatic changes in our borrower benefit and Private

44


 

Education Loan programs and have made modeling refinements to better reflect current and future conditions. The effects of the changes in estimates are summarized in the table below:
                                     
    Years Ended December 31,
     
    2004   2003
         
(Dollars in millions)   Dollar Value   Basis Points   Dollar Value   Basis Points
                 
Changes in critical accounting estimates:
                               
 
Effect on premium/discount:
                               
   
FFELP Stafford and Consolidation Loans
  $ 36       4     $ 51       6  
   
Private Education Loans
    (24 )     (3 )     (23 )     (3 )
                         
 
Total effect on premium/discount
    12       1       28       3  
 
Borrower benefits
    22       2       39       5  
                         
Total changes in estimates
  $ 34       3     $ 67       8  
                         
      In 2004, we updated our estimates of average life associated with our FFELP Stafford and Consolidation Loan programs. The net effect of these changes was a $36 million adjustment to increase the unamortized student loan premium. The difference between the effect for on-balance sheet and off-balance sheet was primarily due to a refinement in our estimates for off-balance sheet loans that did not have the same effect on-balance sheet and to the different mix of FFELP Stafford and Consolidation Loans on-balance sheet versus the mix on a Managed Basis.
      In 2004, based on our ongoing analysis of our Managed Private Education Loan portfolio, we determined that the portfolio was repaying at a slower rate than previously estimated. In response, we increased the period for which we amortize student loan discounts resulting in an increase to the unamortized student loan discount balance of $24 million during 2004.
      Additionally, the continued high rate of Consolidation Loan activity results in fewer Stafford borrowers qualifying for borrower benefits. In response to this trend, we lowered our estimate of the number of Stafford borrowers who will eventually qualify for borrower benefits and revised the term over which benefits are expected to be realized. As a result, we recorded a $22 million reduction in the liability for borrower benefits during 2004. The net effect of these updates to our estimates in 2004 was a $34 million or 3 basis point increase in the Managed student loan spread.
      In 2003, we made similar updates to our estimates of the CPR to reflect the effect of the increase in Consolidation Loan activity on our FFELP Stafford and Consolidation Loan portfolios. The net effect of these changes was a $51 million adjustment to increase the unamortized student loan premium and decrease current period amortization expense. We also updated our estimate of the CPR associated with our Private Education Loan program which resulted in a $23 million adjustment to increase the unamortized student loan discount and decrease current period discount amortization. Also, in 2003, we reduced our estimate of the number of borrowers who eventually qualify for FFELP Stafford borrower benefits resulting in a $39 million adjustment to reduce the estimated borrower benefit liability and increase student loan income. The net effect of these updates to our estimates in 2003 was a $67 million or 8 basis point increase in the student loan spread.
Discussion of Year-over-Year Fluctuations in Managed Student Loan Spread in Addition to Changes in Accounting Estimates
      The decrease in the 2004 student loan spread versus 2003, in addition to the changes in estimates disclosed above, is primarily due to the higher average balance of Consolidation Loans as a percentage of the Managed portfolio. Consolidation Loans have lower spreads than other FFELP loans due to the 105 basis point Consolidation Loan Rebate Fee, higher qualification rates for borrower benefits, and higher funding costs due to their longer terms. These negative effects are partially offset by lower student loan premium amortization due to the extended term and a higher SAP yield. The average balance of Consolidation Loans

45


 

grew as a percentage of the average Managed FFELP student loan portfolio from 39 percent in 2003 to 46 percent in 2004.
      Our student loan spread was negatively impacted by higher spreads on our debt funding student loans, which was partially offset by the absence of Offset Fees on GSE financed loans. The increase in funding costs is due to the replacement of lower cost primarily short-term GSE funding with longer term, higher cost non-GSE funding in connection with the GSE Wind-Down.
      The 2004 student loan spread benefited from the increase in the average balance of Managed Private Education Loans as a percentage of the average Managed student loan portfolio from 9 percent in 2003 to 11 percent in 2004. Private Education Loans are subject to credit risk and therefore earn higher spreads which averaged 4.29 percent for the year ended December 31, 2004 versus a spread of 1.59 percent for the Managed guaranteed student loan portfolio.
      In addition to the estimate adjustments discussed above, the increase in the 2003 student loan spread versus 2002 was due to the increase in the percentage of Private Education Loans in the Managed student loan portfolio partially offset by the higher credit spreads on the debt funding student loans due to the GSE Wind-Down, and the increase of Consolidation Loans as a percentage of the total portfolio.
     Floor Income
      For on-balance sheet student loans, gross Floor Income is included in student loan income whereas payments on Floor Income Contracts are included in the derivative market value adjustment line in other income. The following table summarizes the components of Floor Income from on-balance sheet student loans, net of payments under Floor Income Contracts, for the years ended December 31, 2004, 2003 and 2002.
                                                                         
    Years Ended December 31,
     
    2004   2003   2002
             
    Fixed   Variable       Fixed   Variable       Fixed   Variable    
    borrower   borrower       borrower   borrower       borrower   borrower    
    Rate   Rate   Total   Rate   Rate   Total   Rate   Rate   Total
                                     
Floor Income:
                                                                       
Gross Floor Income
  $ 406     $ 2     $ 408     $ 523     $ 31     $ 554     $ 513     $ 123     $ 636  
Payments on Floor Income Contracts
    (368 )      —       (368 )     (408 )      —       (408 )     (409 )     (8 )     (417 )
                                                       
Net Floor Income
  $ 38     $ 2     $ 40     $ 115     $ 31     $ 146     $ 104     $ 115     $ 219  
                                                       
Net Floor Income in basis points
    7        —       7       25       7       32       24       27       51  
                                                       
      The decrease in net Floor Income for the year ended December 31, 2004 versus the prior year is due to higher interest rates reducing gross Floor Income and a higher percentage of Floor Income eligible student loans economically hedged through Floor Income Contracts offsetting the increase in Consolidation Loans eligible to earn fixed rate Floor Income.
      As discussed in more detail under “LIQUIDITY AND CAPITAL RESOURCES — Securitization Activities,” when we securitize a portfolio of student loans, we estimate the future Fixed Rate Embedded Floor Income earned on off-balance sheet student loans using a discounted cash flow option pricing model and recognize the fair value of such cash flows in the initial gain on sale and subsequent valuations of the Residual Interest. Variable Rate Embedded Floor Income is recognized as earned in servicing and securitization revenue.
      The decrease in Variable Rate Floor Income in 2003 versus 2002 is primarily due to the decline in Treasury bill and commercial paper rates from the July 1, 2001 reset of borrower rates, which resulted in $106 million of Variable Rate Floor Income earned in the first half of 2002. Treasury bill and commercial paper rates did not decline as steeply in the second half of 2002 or in 2003. The increase in Fixed Rate Floor

46


 

Income is primarily due to the increase in the average balance of Consolidation Loans, partially offset by slightly higher Treasury bill rates.
     Student Loan Floor Income Contracts
      The following table analyzes the ability of the FFELP student loans in our Managed student loan portfolio to earn Floor Income after December 31, 2004 and 2003.
                                                   
    December 31, 2004   December 31, 2003
         
    Fixed   Variable       Fixed   Variable    
    borrower   borrower       borrower   borrower    
(Dollars in billions)   Rate   Rate   Total   Rate   Rate   Total
                         
Student loans eligible to earn Floor Income:
                                               
 
On-balance sheet student loans
  $ 40.5     $ 14.0     $ 54.5     $ 26.7     $ 12.5     $ 39.2  
 
Off-balance sheet student loans
    7.4       24.6       32.0       8.1       23.5       31.6  
                                     
Managed student loans eligible to earn Floor Income
    47.9       38.6       86.5       34.8       36.0       70.8  
Less: Economically hedged Floor Income
    (27.8 )      —       (27.8 )     (14.7 )      —       (14.7 )
                                     
Net Managed student loans eligible to earn Floor Income
  $ 20.1     $ 38.6     $ 58.7     $ 20.1     $ 36.0     $ 56.1  
                                     
Net Managed student loans earning Floor Income
  $ 2.4     $  —     $ 2.4     $ 16.6     $ 31.2     $ 47.8  
                                     
      The following table shows the average Managed balance of Consolidation Loans whose Fixed Rate Floor Income is economically hedged as of January 1, 2005 through the end of 2008 through Floor Income Contracts. These loans are both on and off-balance sheet and the related hedges do not qualify as effective SFAS No. 133 hedges.
                                 
(Dollars in billions)   2005   2006   2007   2008
                 
Average balance of Consolidation Loans whose Floor Income is economically hedged (Managed Basis)
  $ 26     $ 24     $ 9     $ 8  
                         
      Activity in the Allowance for Private Education Loan Losses
      As discussed in detail under “CRITICAL ACCOUNTING POLICIES AND ESTIMATES,” the provision for student loan losses represents the periodic expense of maintaining an allowance sufficient to absorb losses, net of recoveries, inherent in the portfolio of Private Education Loans.

47


 

      The following table summarizes changes in the allowance for Private Education Loan losses for the years ended December 31, 2004, 2003 and 2002.
                                                                         
    Activity in Allowance for Private Education Loan Losses
     
    On-Balance Sheet   Off-Balance Sheet   Managed Basis
             
    Years Ended December 31,   Years Ended December 31,   Years Ended December 31,
             
    2004   2003   2002   2004   2003   2002   2004   2003   2002
                                     
Allowance at beginning of year
  $ 166     $ 181     $ 194     $ 93     $ 13     $  —     $ 259     $ 194     $ 194  
Provision for loan losses
    130       107       94       28       10        —       158       117       94  
Other
     —       21       (27 )      —       (1 )      —        —       20       (27 )
Charge-offs
    (110 )     (83 )     (76 )     (6 )      —        —       (116 )     (83 )     (76 )
Recoveries
    14       11       9        —        —        —       14       11       9  
                                                       
Net charge-offs
    (96 )     (72 )     (67 )     (6 )      —        —       (102 )     (72 )     (67 )
                                                       
Balance before securitization of Private Education Loans
    200       237       194       115       22        —       315       259       194  
Reduction for securitization of Private Education Loans
    (28 )     (71 )     (13 )     28       71       13        —        —        —  
                                                       
Allowance at end of year
  $ 172     $ 166     $ 181     $ 143     $ 93     $ 13     $ 315     $ 259     $ 194  
                                                       
Net charge-offs as a percentage of average loans in repayment
    3.57 %     2.59 %     2.40 %     .22 %      — %      — %     1.92 %     1.85 %     2.25 %
Allowance as a percentage of the ending total loan balance
    3.07 %     3.57 %     3.38 %     2.31 %     2.37 %     1.93 %     2.67 %     3.02 %     3.22 %
Allowance as a percentage of ending loans in repayment
    6.05 %     6.50 %     6.05 %     4.27 %     4.99 %     3.50 %     5.08 %     5.86 %     5.77 %
Allowance coverage of net charge-offs
    1.79       2.30       2.72       24.81        —        —       3.09       3.60       2.91  
Average total loans
  $ 4,795     $ 5,018     $ 5,059     $ 5,495     $ 2,284     $ 139     $ 10,290     $ 7,303     $ 5,198  
Ending total loans
  $ 5,592     $ 4,636     $ 5,356     $ 6,205     $ 3,928     $ 660     $ 11,797     $ 8,564     $ 6,016  
Average loans in repayment
  $ 2,697     $ 2,772     $ 2,774     $ 2,611     $ 1,116     $ 182     $ 5,307     $ 3,888     $ 2,955  
Ending loans in repayment
  $ 2,842     $ 2,551     $ 2,992     $ 3,352     $ 1,870     $ 364     $ 6,194     $ 4,421     $ 3,356  
      The allowance for Private Education Loan losses is an estimate of probable losses in the portfolio at the balance sheet date that will be charged off in subsequent periods. We estimate our losses using historical data from our Private Education Loan portfolios, extrapolations of FFELP loan loss data, current trends and relevant industry information. As our Private Education Loan portfolios continue to mature, more reliance is placed on our own historic Private Education Loan charge-off and recovery data. We use this data in internally developed models to estimate losses, net of subsequent collections, projected to occur in the Private Education Loan portfolios.
     On-Balance Sheet versus Managed Presentation
      All Private Education Loans are initially acquired on-balance sheet. When we securitize Private Education Loans, we reduce the on-balance sheet allowance for amounts previously provided for in the allowance and then provide for these loans in the Managed presentation only as they are no longer legally owned by the Company.
      When Private Education Loans in securitized trusts become 180 days delinquent, we typically exercise our contingent call option to repurchase these loans at par value out of the trust and record a loss for the difference in the par value paid and the fair market value of the loan at the time of purchase. If these loans reach the 212-day delinquency, a charge-off for the remaining balance of the loan is triggered. On a Managed Basis, the losses recorded under GAAP at the time of repurchase of delinquent Private Education Loans are

48


 

considered charge-offs when the delinquent Private Education Loans reach the 212-day charge-off date. These charge-offs are shown in the off-balance sheet section in the above table.
      The off-balance sheet allowance is increasing as more loans are securitized but is lower than the on-balance sheet percentage when measured as a percentage of ending loans in repayment because of the different mix of loans on-balance sheet and off-balance sheet. Certain loan types with higher expected default rates, such as career training, have not yet been securitized. Additionally, a larger percentage of the off-balance sheet loan borrowers are still in-school status and not required to make payments on their loans. Once repayment begins, the allowance requirements increase to reflect the increased risk of loss as loans enter repayment.
     Managed Basis Private Education Loan Loss Allowance Discussion
      The increase in the provision for Managed Private Education Loans of $41 million from 2003 to 2004 is primarily due to the $2.3 billion increase in Managed Private Education Loans that have transitioned to out-of-school status over the prior year. For the year ended December 31, 2004, Private Education Loan charge-offs increased by $33 million over the prior year, which is due primarily to the continued growth and maturity of loans in repayment. As discussed further below, while the delinquency and forbearance amounts fluctuate from quarter to quarter, they will increase with the growth in the repayment portfolio. We utilize the expertise of our collection organization, including our debt management operation, to minimize charge-offs in our own portfolio and to increase recoveries on charged-off loans. The allowance as a percentage of loans in repayment decreased year-over-year from 5.86 percent to 5.08 percent. This reduction is primarily attributable to the changing mix of the portfolio and the updates in our default assumptions in the third quarter of 2004.
     Delinquencies
      The table below presents our Private Education Loan delinquency trends as of December 31, 2004, 2003 and 2002. Delinquencies have the potential to adversely impact earnings through increased servicing and collection costs in the event the delinquent accounts charge off.
                                                   
    On-Balance Sheet Private Education Loan Delinquencies
     
    December 31,
     
    2004   2003   2002
             
    Balance   %   Balance   %   Balance   %
                         
Loans in-school/grace/deferment(1)
  $ 2,787             $ 1,970             $ 2,171          
Loans in forbearance(2)
    166               236               285          
Loans in repayment and percentage of each status:
                                               
 
Loans current
    2,555       89.9 %     2,268       88.9 %     2,776       92.8 %
 
Loans delinquent 31-60 days(3)
    124       4.4       115       4.5       102       3.4  
 
Loans delinquent 61-90 days
    56       2.0       62       2.4       43       1.4  
 
Loans delinquent greater than 90 days
    107       3.7       106       4.2       71       2.4  
                                     
 
Total Private Education Loans in repayment
    2,842       100 %     2,551       100.0 %     2,992       100 %
                                     
Total Private Education Loans, gross
    5,795               4,757               5,448          
Private Education Loan unamortized discount
    (203 )             (121 )             (92 )        
                                     
Total Private Education Loans
    5,592               4,636               5,356          
Private Education Loan allowance for losses
    (172 )             (166 )             (181 )        
                                     
Private Education Loans, net
  $ 5,420             $ 4,470             $ 5,175          
                                     
Percentage of Private Education Loans in repayment
    49.0 %             53.6 %             54.9 %        
                                     
Delinquencies as a percentage of Private Education Loans in repayment
    10.1 %             11.1 %             7.2 %        
                                     

49


 

                                                   
    Off-Balance Sheet Private Education Loan Delinquencies
     
    December 31,
     
    2004   2003   2002
             
    Balance   %   Balance   %   Balance   %
                         
Loans in-school/grace/deferment(1)
  $ 2,622             $ 1,858             $ 222          
Loans in forbearance(2)
    334               255               80          
Loans in repayment and percentage of each status:
                                               
 
Loans current
    3,191       95.2 %     1,796       96.0 %     350       96.2 %
 
Loans delinquent 31-60 days(3)
    84       2.5       39       2.1       7       1.9  
 
Loans delinquent 61-90 days
    28       .8       15       .8       3       .8  
 
Loans delinquent greater than 90 days
    49       1.5       20       1.1       4       1.1  
                                     
 
Total Private Education Loans in repayment
    3,352       100 %     1,870       100.0 %     364       100 %
                                     
Total Private Education Loans, gross
    6,308               3,983               666          
Private Education Loan unamortized discount
    (103 )             (55 )             (6 )        
                                     
Total Private Education Loans
    6,205               3,928               660          
Private Education Loan allowance for losses
    (143 )             (93 )             (13 )        
                                     
Private Education Loans, net
  $ 6,062             $ 3,835             $ 647          
                                     
Percentage of Private Education Loans in repayment
    53.1 %             46.9 %             54.7 %        
                                     
Delinquencies as a percentage of Private Education Loans in repayment
    4.8 %             4.0 %             3.8 %        
                                     
                                                   
    Managed Basis Private Education Loan Delinquencies
     
    December 31,
     
    2004   2003   2002
             
    Balance   %   Balance   %   Balance   %
                         
Loans in-school/grace/deferment(1)
  $ 5,409             $ 3,828             $ 2,393          
Loans in forbearance(2)
    500               491               365          
Loans in repayment and percentage of each status:
                                               
 
Loans current
    5,746       92.8 %     4,064       91.9 %     3,126       93.2 %
 
Loans delinquent 31-60 days(3)
    208       3.3       154       3.5       109       3.3  
 
Loans delinquent 61-90 days
    84       1.4       77       1.7       46       1.3  
 
Loans delinquent greater than 90 days
    156       2.5       126       2.9       75       2.2  
                                     
 
Total Private Education Loans in repayment
    6,194       100 %     4,421       100.0 %     3,356       100 %
                                     
Total Private Education Loans, gross
    12,103               8,740               6,114          
Private Education Loan unamortized discount
    (306 )             (176 )             (98 )        
                                     
Total Private Education Loans
    11,797               8,564               6,016          
Private Education Loan allowance for losses
    (315 )             (259 )             (194 )        
                                     
Private Education Loans, net
  $ 11,482             $ 8,305             $ 5,822          
                                     
Percentage of Private Education Loans in repayment
    51.2 %             50.6 %             54.9 %        
                                     
Delinquencies as a percentage of Private Education Loans in repayment
    7.2 %             8.1 %             6.8 %        
                                     
 
(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.
 
(2)  Loans for borrowers who have requested extension of grace period during employment transition or who have temporarily ceased making full payments due to hardship or other factors, consistent with the established loan program servicing policies and procedures.
 
(3)  The period of delinquency is based on the number of days scheduled payments are contractually past due.

50


 

      The improvement in the percentage of delinquent loans is primarily due to enhanced default efforts that commenced in the second quarter of 2004.
     Forbearance — Managed Basis Private Education Loans
      Private Education Loans are made to parent and student borrowers by our lender partners in accordance with our underwriting policies. These loans generally supplement federally guaranteed student loans, which are subject to federal lending caps. Private Education Loans are not guaranteed or insured against any loss of principal or interest. Traditional student borrowers use the proceeds of these loans to obtain higher education, which increases the likelihood of obtaining employment at higher income levels than would be available without the additional education. As a result, the borrowers’ repayment capability improves between the time the loan is made and the time they enter the post-education work force. We generally allow the loan repayment period on traditional Private Education Loans, except those generated by SLM Financial loans, to begin six to nine months after the student leaves school. This provides the borrower time to obtain a job to service his or her debt. For borrowers that need more time or experience other hardships, we permit additional payment deferments or partial payments (both referred to as forbearances) when we believe additional time will improve the borrower’s ability to repay the loan. Our policy does not grant any reduction in the repayment obligation (principal or interest) but does allow the borrower to stop or reduce monthly payments for an agreed period of time. Forbearance is used most heavily immediately after the loan enters repayment. At December 31, 2004, approximately 90 percent of borrowers currently in forbearance have deferred their loan repayment less than 24 months. Further, approximately 70 percent have been in repayment less than 24 months. These borrowers are essentially extending their grace period as they transition to the workforce. Forbearance continues to be a positive collection tool for the Private Education Loans as we believe it can provide the borrower with sufficient time to obtain employment and income to support his or her obligation. We consider the potential impact of forbearance in the determination of the loan loss reserves.
      Loans in forbearance status decreased from 10.0 percent of loans in repayment and forbearance status at December 31, 2003 to 7.5 percent of loans in repayment and forbearance status at December 31, 2004. The decrease in the percentages of loans in forbearance status is primarily due to enhanced collection and default prevention efforts.
      The table below breaks down the Managed Private Education Loan portfolio loans in forbearance by the cumulative number of months of forbearance the borrower has used as of December 31, 2004, 2003 and 2002 respectively:
                                                 
    December 31,
     
    2004   2003   2002
             
    Forbearance       Forbearance       Forbearance    
    Balance   % of Total   Balance   % of Total   Balance   % of Total
                         
Cumulative number of months borrower has used forbearance
                                               
Less than 13 months
  $ 334       66 %   $ 326       67 %   $ 223       61 %
13 to 24 months
    117       24       119       24       88       24  
25 to 36 months
    30       6       26       5       28       8  
More than 36 months
    19       4       20       4       26       7  
                                     
Total
  $ 500       100 %   $ 491       100 %   $ 365       100 %
                                     

51


 

     The tables below show the composition and status of the Managed Private Education Loan portfolio by number of months aged from the first date of repayment:
                                         
    Months since entering repayment
     
        After    
    1 to 24   25 to 48   More than   Dec. 31,    
December 31, 2004   Months   Months   48 Months   2004(1)   Total
                     
Loans in-school/grace/deferment
  $  —     $  —     $  —     $ 5,409     $ 5,409  
Loans in forbearance
    350       103       47        —       500  
Loans in repayment — current
    3,228       1,401       1,117        —       5,746  
Loans in repayment — delinquent 31-60 days
    110       59       39        —       208  
Loans in repayment — delinquent 61-90 days
    43       26       15        —       84  
Loans in repayment — delinquent greater than 90 days
    67       56       33        —       156  
                               
Total
  $ 3,798     $ 1,645     $ 1,251     $ 5,409     $ 12,103  
                               
Unamortized discount
                                    (306 )
Allowance for loan losses
                                    (315 )
                               
Total Managed Private Education Loans, net
                                  $ 11,482  
                               
                                         
    Months since entering repayment
     
        After    
    1 to 24   25 to 48   More than   Dec. 31,    
December 31, 2003   Months   Months   48 Months   2003(1)   Total
                     
Loans in-school/grace/deferment
  $  —     $  —     $  —     $ 3,828     $ 3,828  
Loans in forbearance
    342       100       49        —       491  
Loans in repayment — current
    2,192       1,074       798        —       4,064  
Loans in repayment — delinquent 31-60 days
    75       46       33        —       154  
Loans in repayment — delinquent 61-90 days
    34       27       16        —       77  
Loans in repayment — delinquent greater than 90 days
    48       42       36        —       126  
                               
Total
  $ 2,691     $ 1,289     $ 932     $ 3,828     $ 8,740  
                               
Unamortized discount
                                    (176 )
Allowance for loan losses
                                    (259 )
                               
Total Managed Private Education Loans, net
                                  $ 8,305  
                               

52


 

                                         
    Months since entering repayment
     
        After    
    1 to 24   25 to 48   More than   Dec. 31,    
December 31, 2002   Months   Months   48 Months   2002(1)   Total
                     
Loans in-school/grace/deferment
  $  —     $  —     $  —     $ 2,393     $ 2,393  
Loans in forbearance
    239       75       51        —       365  
Loans in repayment — current
    1,413       798       915        —       3,126  
Loans in repayment — delinquent 31-60 days
    43       23       43        —       109  
Loans in repayment — delinquent 61-90 days
    15       13       18        —       46  
Loans in repayment — delinquent greater than 90 days
    17       19       39        —       75  
                               
Total
  $ 1,727     $ 928     $ 1,066     $ 2,393     $ 6,114  
                               
Unamortized discount
                                    (98 )
Allowance for loan losses
                                    (194 )
                               
Total Managed Private Education Loans, net
                                  $ 5,822  
                               
 
(1)  Includes all loans in-school/grace/deferment.
Allowance for FFELP Student Loan Losses
      Effective for a renewable one-year period beginning on October 19, 2004, Sallie Mae, Inc., which includes the Company’s student loan servicing division (Sallie Mae Servicing), was designated as an Exceptional Performer by ED in recognition of meeting certain performance standards set by ED in servicing FFELP loans. As a result of this designation, the Company receives 100 percent reimbursement on default claims on federally guaranteed student loans that are serviced by Sallie Mae Servicing for a period of at least 270 days before the date of default. We are entitled to receive this benefit as long as we remain in compliance with the required servicing standards, which are assessed on an annual and quarterly basis through compliance audits and other criteria. The Exceptional Performer Designation also applies to all FFELP loans that we own but are serviced by other service providers with the Exceptional Performer Designation. At December 31, 2004, approximately 93 percent of our Managed federally insured loans are no longer subject to Risk Sharing. As a result of this designation, in the third quarter of 2004, we reduced the balance in the on-balance sheet allowance for loan losses by $33 million and reduced the Managed Risk Sharing allowance for loan losses by $63 million.
Other Income, Net
      The following table summarizes the components of other income, net, for our Lending business segment for the years ended December 31, 2004, 2003 and 2002.
                         
    Years Ended December 31,
     
    2004   2003   2002
             
Gains on student loan securitizations
  $ 375     $ 744     $ 338  
Servicing and securitization revenue
    561       667       839  
Losses on securities, net
    (49 )     (10 )     (2 )
Derivative market value adjustment
    849       (238 )     (1,082 )
Other income
    163       126       110  
                   
Total other income, net
  $ 1,899     $ 1,289     $ 203  
                   

53


 

Gains on Student Loan Securitizations and Servicing and Securitization Revenue
      Gains on sales of student loans to securitizes trusts and servicing and securitization revenue, the ongoing revenue from securitized loan pools, are discussed in detail in “LIQUIDITY AND CAPITAL RESOURCES — Securitization Activities.”
Losses on Securities, Net
      The increase in losses on securities, net, versus the prior years is primarily due to the $27 million impairment of the leveraged lease portfolio recorded in the third quarter of 2004. The aircraft financing business for traditional airlines continues to be adversely affected by the slowdown in the commercial aircraft industry, higher fuel costs and increased competition from new discount carriers. In recognition of these trends and the deteriorating financial condition of Delta Airlines in particular, we recorded the leveraged lease impairment noted above.
      At December 31, 2004, we had remaining investments in leveraged and direct financing leases, net of impairments, totaling $169 million that are general obligations of two commercial airlines and Federal Express Corporation. Based on an analysis of the potential losses on certain leveraged leases plus the increase in incremental tax obligations related to forgiveness of debt obligations and/or the taxable gain on the sale of the aircraft, our remaining after-tax accounting exposure to the two commercial airlines and Federal Express Corporation totaled $80 million at December 31, 2004.
Derivative Market Value Adjustment
      See “ALTERNATIVE PERFORMANCE MEASURES — Derivative Accounting.”
Other Income
                         
    Years Ended
    December 31,
     
    2004   2003   2002
             
Late fees
  $ 94     $ 65     $ 56  
Gains on sales of mortgages and other loan fees
    22       29       13  
Other
    47       32       41  
                   
Total other income
  $ 163     $ 126     $ 110  
                   
      When compared to the prior year, other income in 2004 benefited from a $29 million increase in late fees due to higher loan volume and an update in our estimate of uncollected late fees in the second quarter of 2004. Gains on sales of mortgages and other loan fees decreased by $7 million from 2003 to 2004. The decrease was primarily due to higher interest rates causing a slowdown in mortgage refinancings. Gains on sales of mortgages and other loan fees increased by $16 million from 2002 to 2003. This increase was due to the acquisition of Pioneer Mortgage in 2003 and to lower interest rates causing a surge in mortgage refinancings.

54


 

Student Loan Acquisitions
      In 2004, 78 percent of our Managed student loan acquisitions (exclusive of loans acquired through business acquisitions) were originated through our Preferred Channel. The following tables summarize the components of our student loan acquisition activity for the years ended December 31, 2004, 2003 and 2002.
                         
    December 31, 2004
     
    FFELP   Private   Total
             
Preferred Channel
  $ 12,756     $ 3,982     $ 16,738  
Other commitment clients
    368       45       413  
Spot purchases
    1,804       4       1,808  
Consolidations from third parties
    2,609             2,609  
Acquisitions from off-balance sheet securitized trusts, primarily consolidations
    5,554             5,554  
Acquisition of Southwest Student Services
    4,776       4       4,780  
Acquisition of Student Loan Financing Association
    1,435             1,435  
Capitalized interest and deferred origination fees
    1,398       (2 )     1,396  
                   
Total on-balance sheet student loan acquisitions
    30,700       4,033       34,733  
Consolidations to SLM Corporation from off-balance sheet securitized trusts
    (5,554 )           (5,554 )
Capitalized interest and other — off-balance sheet securitized trusts
    565       172       737  
                   
Total Managed student loan acquisitions
  $ 25,711     $ 4,205     $ 29,916  
                   
                         
    December 31, 2003
     
    FFELP   Private   Total
             
Preferred Channel
  $ 10,884     $ 2,901     $ 13,785  
Other commitment clients
    344       33       377  
Spot purchases
    864       2       866  
Consolidations from third parties
    2,158       92       2,250  
Acquisitions from off-balance sheet securitized trusts, primarily consolidations
    6,156             6,156  
Capitalized interest and deferred origination fees
    1,024       16       1,040  
Acquisition of AMS
    1,246       177       1,423  
                   
Total on-balance sheet student loan acquisitions
    22,676       3,221       25,897  
Consolidations to SLM Corporation from off-balance sheet securitized trusts
    (6,156 )           (6,156 )
Capitalized interest and other — off-balance sheet securitized trusts
    842       79       921  
                   
Total Managed student loan acquisitions
  $ 17,362     $ 3,300     $ 20,662  
                   

55


 

                         
    December 31, 2002
     
    FFELP   Private   Total
             
Preferred Channel
  $ 9,261     $ 2,132     $ 11,393  
Other commitment clients
    428       35       463  
Spot purchases
    924       7       931  
Consolidations from third parties
    1,938             1,938  
Acquisitions from off-balance sheet securitized trusts, primarily consolidations
    4,121             4,121  
Capitalized interest and deferred origination fees
    1,073       (4 )     1,069  
                   
Total on-balance sheet student loan acquisitions
    17,745       2,170       19,915  
Consolidations to SLM Corporation from off-balance sheet securitized trusts
    (4,121 )           (4,121 )
Capitalized interest and other — off-balance sheet securitized trusts
    721       10       731  
                   
Total Managed student loan acquisitions
  $ 14,345     $ 2,180     $ 16,525  
                   
Preferred Channel Originations
      In 2004, we originated $18.0 billion in student loan volume through our Preferred Channel, an 18 percent increase over the $15.2 billion originated in 2003. In 2004, we grew the Sallie Mae brand Preferred Channel Originations by 34 percent and our own brands now constitute 32 percent of our Preferred Channel Originations, up from 28 percent in 2003. The pipeline of loans that we currently service and are committed to purchase was $7.2 billion and $6.6 billion at December 31, 2004 and 2003, respectively. The following tables further break down our Preferred Channel Originations by type of loan and source.
                           
    Years Ended December 31,
     
    2004   2003   2002
             
Preferred Channel Originations — Type of Loan
                       
 
Stafford
  $ 11,383     $ 10,077     $ 8,537  
 
PLUS
    2,303       1,882       1,482  
                   
 
Total FFELP
    13,686       11,959       10,019  
 
Private
    4,307       3,270       2,352  
                   
 
Total
  $ 17,993     $ 15,229     $ 12,371  
                   
Preferred Channel Originations — Source
                       
 
Sallie Mae brands
  $ 5,670     $ 4,233     $ 3,082  
 
Lender partners
    12,323       10,996       9,289  
                   
    $ 17,993     $ 15,229     $ 12,371  
                   

56


 

      The following table summarizes the activity in our Managed portfolio of student loans for the years ended December 31, 2004, 2003 and 2002.
                         
    Years Ended December 31,
     
    2004   2003   2002
             
Beginning balance
  $ 88,789     $ 78,124     $ 71,726  
Acquisitions, including capitalized interest
    29,916       20,662       16,525  
Repayments, claims, and other
    (8,548 )     (7,517 )     (7,672 )
Charge-offs to reserves and securitization trusts
    (135 )     (108 )     (96 )
Loan sales
    (479 )     (38 )      
Loans consolidated from SLM Corporation
    (2,105 )     (2,334 )     (2,359 )
                   
Ending balance
  $ 107,438     $ 88,789     $ 78,124  
                   
Operating Expenses
      The following table summarizes the components of operating expenses for our Lending business segment for the years ended December 31, 2004, 2003 and 2002.
                         
    Years Ended
    December 31,
     
    2004   2003   2002
             
Servicing and acquisition expenses
  $ 205     $ 188     $ 146  
General and administrative expenses
    228       221       199  
Amortization of acquired intangible assets
    27       22       22  
Loss on GSE debt extinguishment and defeasance
    221              
                   
Total operating expenses
  $ 681     $ 431     $ 367  
                   
      Operating expenses include costs incurred to service our Managed student loan portfolio and acquire student loans, as well as other general and administrative expenses and the amortization of acquired intangible assets.
      For the year ended 2004, we recognized a $221 million loss related to the repurchase and defeasance of approximately $3.0 billion of GSE debt in connection with the Wind-Down of the GSE.
2004 versus 2003
      Operating expenses for the year ended December 31, 2004 were $681 million versus $431 million in the prior year. The increase versus the prior year is mainly due to the growth in the number of accounts serviced and to the general and administrative expenses of our recent acquisitions in the lending segment: Southwest Student Services Corporation ($5 million) which the Company acquired in October 2004, and a full year of expenses of AMS ($22 million) acquired in the fourth quarter of 2003.
      Student loan servicing expenses as a percentage of the average balance of student loans serviced was 0.15 percent, and 0.16 percent for the years ended December 31, 2004 and 2003, respectively.
2003 versus 2002
      The $42 million increase in servicing and acquisition costs for the year ended December 31, 2003 versus 2002 is mainly attributable to an increase in mortgage operating expenses due to the acquisition of Pioneer Mortgage in the second quarter of 2003 and to increased servicing expenses consistent with the growth in the business. In addition, in the first quarter of 2003, we recognized $9 million for servicing adjustments related to an underbilling error. Student loan servicing expenses as a percentage of the average balance of student loans serviced was 0.16 percent and 0.20 percent for the years ended December 31, 2003 and 2002, respectively.

57


 

DEBT MANAGEMENT OPERATIONS (“DMO”) BUSINESS SEGMENT
      Through the five operating units that comprise our DMO business segment, we provide a wide range of accounts receivable and collections services including defaulted student loan portfolio management services, contingency collections services for student loans and other asset classes, student loan default aversion services, and accounts receivable management and collection for purchased portfolios of receivables that have been charged off by their original creditors.
      The majority of our revenues are generated through our contingency fee business in which we provide default management services to guarantor agencies, colleges and universities, ED, and other consumer credit companies.
      In the purchased receivables business, we focus on all types of consumer debt with an emphasis on charged-off credit card receivables. We purchase these portfolios at a substantial discount to their face value. We then use both our internal collections operations and external collections efforts to maximize the recovery on these receivables. Effectively pricing the portfolio is a major success factor in the purchased receivables business. We conduct a quantitative and qualitative analysis using our proprietary models to appropriately price each portfolio to yield a return consistent with our earnings hurdles. We account for our investments in charged-off receivables in accordance with Practice Bulletin 6, “Amortization of Discounts on Certain Acquired Loans,” whereby we establish static pools of relatively homogeneous accounts and initially record them at cost. We then recognize income each month based on each static pool’s effective interest rate. Monthly cash collections are all allocated to revenue and principal reduction based on the estimated internal rate of return. The static pools are tested monthly for impairment.
      Revenues from USA Funds represented 56 percent, 65 percent, and 62 percent, respectively, of total DMO revenue in 2004, 2003, and 2002. We expect the percentage of revenue generated from services provided to USA Funds to decrease considerably in 2005 due primarily to the impact of our acquisition of AFS and the inclusion of the purchased receivables business revenues.
      At December 31, 2004, 2003, and 2002, the DMO business segment had total assets of $519 million, $272 million, and $268 million, respectively.
      The following table includes the results of operations for our DMO business segment.
Condensed Statements of Income
                                         
    Year Ended December 31,   % Increase (Decrease)
         
    2004   2003   2002   2004 vs. 2003   2003 vs. 2002
                     
Fee income and collections revenue
  $ 340     $ 259     $ 186       31 %     39 %
Operating expenses
    166       131       112       27       17  
                               
Income before income taxes and minority interest in net earnings of subsidiaries
    174       128       74       36       73  
Income taxes
    63       44       26       43       69  
                               
Income before minority interest in net earnings of subsidiaries
    111       84       48       32       75  
Minority interest in net earnings of subsidiaries
    1                   100        
                               
Net income
  $ 110     $ 84     $ 48       31 %     75 %
                               
Fee Income and Collections Revenue
      Fee income and collections revenue increased $81 million or 31 percent to $340 million for the year ended December 31, 2004, an $81 million or 31 percent increase over 2003. In 2004, we earned $302 million in fee income generated by our contingency collections services, a 17 percent increase over 2003. The growth in our contingency fee business is due primarily to an increase of $26 million or 14 percent in fees earned from guarantor agencies for both default collection and portfolio management. Our 2004 growth rate was slowed by the greater emphasis on rehabilitating defaulted FFELP loans versus consolidating them with other lenders. This strategy ultimately produces higher margins but initially it lengthens the revenue cycle.

58


 

      We earned $38 million of collections revenue from the purchased portfolios of AFS for the period from September 15, 2004 to December 31, 2004. During this period, AFS acquired charged-off consumer receivables portfolios with an aggregate face amount of $426 million at a cost of $19 million.
Operating Expenses
      The following table summarizes the components of operating expenses for the DMO business segment for the years ended December 31, 2004, 2003 and 2002.
                         
    Years Ended
    December 31,
     
    2004   2003   2002
             
General and administrative expenses
  $ 161     $ 128     $ 109  
Amortization of acquired intangible assets
    5       3       3  
                   
Total operating expenses
  $ 166     $ 131     $ 112  
                   
      General and administrative expenses increased by $33 million, or 26 percent, to $161 million for the year ended December 31, 2004. A significant portion of this increase is attributable to the inclusion of AFS expenses. The increase in DMO contingency fee expenses is consistent with the growth in revenue and accounts serviced, as a high percentage of DMO expenses are variable contributing to our stable margins. We continue to make substantial investments in the infrastructure of the DMO business to accommodate current and future growth and we believe this will provide significant operating efficiencies in the future.
CORPORATE AND OTHER BUSINESS SEGMENT
      At December 31, 2004, 2003, and 2002, the Corporate and Other business segment had total assets of $524 million, $447 million, and $509 million, respectively.
      The following table includes the results of operations for our Corporate and Other business segment.
Condensed Statements of Income
                                         
    Year Ended December 31,   % Increase (Decrease)
         
    2004   2003   2002   2004 vs. 2003   2003 vs. 2002
                     
Fee income
  $ 120     $ 128     $ 106       (6 )%     21 %
Other income
    126       123       110       2       12  
Operating expenses
    269       233       211       15       10  
                               
Income (loss) before income taxes
    (23 )     18       5       (228 )     260  
Income taxes
    (6 )     6       2       (200 )     200  
                               
Net income (loss)
  $ (17 )   $ 12     $ 3       (242 )%     300 %
                               
Fee and Other Income
      The following table summarizes the components of fee and other income for the years ended December 31, 2004, 2003 and 2002.
                         
    Years Ended
    December 31,
     
    2004   2003   2002
             
Guarantor servicing fees
  $ 120     $ 128     $ 106  
Loan servicing fees
    55       58       57  
Other income
    71       65       53  
                   
Total fee and other income
  $ 246     $ 251     $ 216  
                   

59


 

      USA Funds represented 85 percent, 86 percent, and 82 percent, respectively, of guarantor servicing fees and 8 percent, 1 percent, and 14 percent, respectively, of revenues associated with other products and services for the years ended December 31, 2004, 2003, and 2002.
2004 versus 2003
      The $8 million decrease in guarantor servicing fees in 2004 versus the prior year is due to a $13 million decrease in issuance fees caused by the reduction in the issuance fee from 65 basis points to 40 basis points, which was partially offset by higher account maintenance fees.
      The increase in other income in 2004 versus 2003 is primarily due to a $14 million fee received from Bank One in the third quarter of 2004 in connection with the termination of the marketing services agreement, $13 million in fees earned on the tuition payment plan business that was acquired in connection with the November 2003 AMS acquisition, and $9 million in higher marketing servicing fees. Items that affected 2003 that did not recur in 2004 were a $42 million gain recognized in the fourth quarter of 2003 for the sale of our prior headquarters building, partially offset by an $18 million deferral in 2003 of previously recognized income earned for performing information technology enhancements.
2003 versus 2002
      The growth in the guarantor servicing business is due to the growth in accounts serviced for our largest customer, USA Funds. The increase in other income in 2003 was due to a $42 million gain on the sale of our headquarters building, partially offset by a deferral of previously recognized income earned from performing information technology enhancements.
Operating Expenses
      The following table summarizes the components of operating expenses for the Corporate and Other business segment for the years ended December 31, 2004, 2003 and 2002.
                         
    Years Ended
    December 31,
     
    2004   2003   2002
             
Servicing and acquisition expenses
  $ 34     $ 36     $ 44  
General and administrative expenses
    231       195       165  
Amortization of acquired intangible assets
    4       2       2  
                   
Total operating expenses
  $ 269     $ 233     $ 211  
                   
      Operating expenses include costs incurred to service loans for unrelated third parties and to perform guarantor servicing on behalf of guarantor agencies, and general and administrative expenses associated with these businesses. Operating expenses also include unallocated corporate overhead expenses totaling $151 million. These costs include centralized headquarters functions such as executive management, accounting and finance, human resources and marketing. Our corporate overhead also includes a portion of information technology expenses related to these functions.
2004 versus 2003
      The 18 percent increase in general and administrative expenses from 2003 to 2004 is primarily due to the growth in the business and additional administrative costs related to compliance with the Sarbanes-Oxley Act of 2002. We also incurred additional expenses related to AMS, acquired in December of 2003, primarily to manage the tuition payment plan product.
2003 versus 2002
      The $30 million increase in general and administrative expenses from 2002 to 2003 is primarily attributed to a contribution to the Sallie Mae Fund.

60


 

FEDERAL AND STATE TAXES
      The Company is subject to federal and state income taxes, while the GSE was exempt from all state and local income taxes. Our effective tax rate for the years ended December 31, 2004, 2003 and 2002 was 25 percent, 36 percent and 35 percent, respectively. The effective tax rate for the period ended December 31, 2004 reflects the full-year permanent impact of the exclusion of the gains on equity forward contracts recognized under SFAS No. 150 adopted in the third quarter of 2003.
ALTERNATIVE PERFORMANCE MEASURES
      In accordance with the Rules and Regulations of the SEC, we prepare financial statements in accordance with GAAP. In addition to evaluating the Company’s GAAP-based financial information, management, credit rating agencies, lenders and analysts also evaluate the Company on certain non-GAAP performance measures that we refer to as “core cash” measures. While “core cash” measures are not a substitute for reported results under GAAP, we rely on “core cash” measures in operating our business because we believe they provide additional information regarding the operational and performance indicators that are most closely assessed by management.
      Our pro forma “core cash” measures are the primary financial performance measures used by management to evaluate performance and to allocate resources. Accordingly, financial information is reported to management on a “core cash” basis by reportable segment. In Note 18 to our consolidated financial statements, “Segment Reporting,” we provide a consolidated statement of income by reportable segment on a “core cash” basis, as these are the measures used regularly by our “chief operating decision makers.” Our “core cash” measures are used in developing our financial plans and tracking results, and also in establishing corporate performance targets and determining incentive compensation. Management believes this information provides additional insight into the financial performance of the Company’s core business activities. Our “core cash” measures are not defined terms within GAAP and may not be comparable to similarly titled measures reported by other companies. “Core cash” measures reflect only current period adjustments to GAAP as described below. Accordingly, the Company’s “core cash” measures presentation does not represent another comprehensive basis of accounting. A more detailed discussion of the differences between GAAP and “core cash” measures follows.
      1) Securitization: Under GAAP, certain securitization transactions are accounted for as sales of assets. Under “core cash,” we present all securitization transactions as long-term non-recourse financings. The upfront “gains” on sale from securitization transactions as well as ongoing “servicing and securitization revenue” presented in accordance with GAAP are excluded from the “core cash” measures and replaced by the interest income, provision for loan losses, and interest expense as they are earned or incurred on the securitization loans. We also exclude transactions with our off-balance sheet trusts which would be considered intercompany on a Managed Basis.
      The following table summarizes “core cash” securitization adjustments for the years ended December 31, 2004, 2003 and 2002.
                         
    Years Ended December 31,
     
    2004   2003   2002
             
“Core cash” securitization adjustments:
                       
Net interest income on securitized loans, after provisions for losses
  $ 1,065     $ 1,104     $ 895  
Gains on student loan securitizations
    (375 )     (744 )     (338 )
Servicing and securitization revenue
    (561 )     (667 )     (839 )
Intercompany transactions with off-balance sheet trusts
    23       7       (9 )
                   
Total “core cash” securitization adjustments
  $ 152     $ (300 )   $ (291 )
                   
      2) Derivative Accounting: “Core cash” measures exclude the periodic unrealized gains and losses caused primarily by the one-sided mark-to-market derivative valuations prescribed by SFAS No. 133 and recognize the economic effect of these hedges, which results in any cash paid or received being recognized

61


 

ratably as an expense or revenue over the hedged item’s life. We also exclude the gain or loss on equity forward contracts that are required to be accounted for in accordance with SFAS No. 133 as derivatives and are marked to market through earnings.
      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. We believe that our derivatives are effective economic hedges, and as such, are a critical element of our interest rate risk management strategy. However, some of our derivatives, primarily Floor Income Contracts, certain Eurodollar futures contracts, certain basis swaps and equity forward contracts (discussed in detail below), do not qualify 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 derivative market value adjustment is primarily caused by interest rate volatility, changing credit spreads and change in our stock prices during the period and the volume and term of derivatives not receiving hedge treatment. “Core cash” measures exclude the periodic unrealized gains and losses primarily caused by the one-sided derivative valuations, and recognize the economic effect of these hedges, which results in any cash paid or received being recognized ratably as an expense or revenue over the hedged item’s life.
      Our Floor Income Contracts are written options which must meet more stringent requirements than other hedging relationships to achieve hedge effectiveness under SFAS No. 133. Specifically, our Floor Income Contracts do not qualify for hedge accounting treatment because the paydown of principal of the student loans underlying the Floor Income embedded in those student loans does not exactly match the change in the notional amount of our written Floor Income Contracts. Under SFAS No. 133, the upfront payment is deemed a liability and changes in fair value are recorded through income throughout the life of the contract. The change in the value of Floor Income Contracts is caused by changing interest rates that cause the amount of Floor Income earned on the underlying student loans and transferred to the counterparties to vary. This is economically offset by the change in value of the student loan portfolio earning Floor Income but that offsetting change in value is not recognized under SFAS No. 133. We believe the Floor Income Contracts are economic hedges because they effectively fix the amount of Floor Income earned over the contract period, thus eliminating the timing and uncertainty that changes in interest rates can have on Floor Income for that period. Prior to SFAS No. 133, we accounted for Floor Income Contracts as hedges and amortized the upfront cash compensation ratably over the lives of the contracts.
      Basis swaps are used to convert the floating rate debt from one interest rate index to another to better match the interest rate characteristics of the assets financed by that debt. We primarily use basis swaps to change the index of our fixed rate and LIBOR-based debt to better match the cash flows of our student loan assets that are primarily indexed to a commercial paper, Prime or Treasury bill index. SFAS No. 133 requires that the change in the cash flows of the hedge effectively offset both the change in the cash flows of the asset and the change in the cash flows of the liability. Our basis swaps hedge variable interest rate risk, however they do not meet this effectiveness test because student loans can earn at either a variable or a fixed interest rate depending on market interest rates. We also have basis swaps that do not meet the SFAS No. 133 effectiveness test that economically hedge off-balance sheet instruments. As a result, these swaps are recorded at fair value with subsequent changes in value reflected in the income statement.
      Generally, a decrease in current interest rates and the respective forward interest rate curves results in an unrealized loss related to our written Floor Income Contracts. We will experience unrealized gains/losses related to our basis swaps, if the two underlying indices (and related forward curve) do not move in parallel.
      Under SFAS No. 150, equity forward contracts that allow a net settlement option either in cash or the Company’s stock are required to be accounted for in accordance with SFAS No. 133 as derivatives. As a result, we account for our equity forward contracts as derivatives in accordance with SFAS No. 133 and mark them to market through earnings. They do not qualify as effective SFAS No. 133 hedges as a requirement to achieve hedge accounting is the hedged item must impact net income, and the settlement of these contracts through the purchase of our own stock does not impact net income.

62


 

      The table below quantifies the adjustments for derivative accounting under SFAS No. 133 on our net income for the years ended December 31, 2004, 2003 and 2002 when compared with the accounting principles employed in all years prior to the SFAS No. 133 implementation.
                         
    Years Ended December 31,
     
    2004   2003   2002
             
SFAS No. 133 income statement items:
                       
Derivative market value adjustment in other income
  $ (849 )   $ 238     $ 1,082  
Less: Realized derivative market value transactions
    (713 )     (739 )     (878 )
                   
Unrealized derivative market value adjustment
    (1,562 )     (501 )     204  
Other pre-SFAS No. 133 accounting adjustments
    9       (1 )     (4 )
                   
Total net impact of SFAS No. 133 derivative accounting
  $ (1,553 )   $ (502 )   $ 200  
                   
Reclassification of Realized Derivative Transactions
      SFAS No. 133, requires net settlement income/expense on derivatives and realized gains/losses related to derivative dispositions (collectively referred to as “realized derivative transactions”) that do not qualify as hedges under SFAS No. 133 to be recorded in a separate income statement line item below net interest income. The table below summarizes the realized derivative transactions and where they are reclassified to on a “core cash” basis for the years ended December 31, 2004, 2003 and 2002.
                         
    Years Ended December 31,
     
    2004   2003   2002
             
Reclassification of realized derivative market value adjustments:
                       
Net settlement expense on Floor Income Contracts reclassified to net interest income
  $ (562 )   $ (603 )   $ (540 )
Net settlement income/expense on interest rate swaps reclassified to net interest income
    (88 )     (22 )     (84 )
Realized gain/loss on closed Eurodollar futures contracts and terminated derivative contracts reclassified to other income
    (63 )     (114 )     (254 )
                   
Total reclassifications of realized derivative transactions
    (713 )     (739 )     (878 )
Add: Unrealized derivative market value adjustment
    1,562       501       (204 )
                   
Derivative market value adjustment as reported
  $ 849     $ (238 )   $ (1,082 )
                   
      3) Floor Income: The timing and amount (if any) of Floor Income earned is uncertain and in excess of expected spreads and, therefore, we exclude such income when it is not economically hedged from “core cash” measures. We employ derivatives, primarily Floor Income Contracts and futures, to economically hedge Floor Income. As discussed above under “Derivative Accounting,” these derivatives do not qualify as effective accounting hedges and therefore are marked-to-market through the derivative market value adjustment with no offsetting mark of the economically hedged items. For “core cash” measures, we reverse the fair value adjustments on the Floor Income Contracts and futures economically hedging Floor Income and include the amortization of net premiums received (net of Eurodollar futures contracts’ realized gains or losses) in

63


 

income. The following table summarizes the Floor Income adjustments for the years ended December 31, 2004, 2003, and 2002.
                         
    Years Ended December 31,
     
    2004   2003   2002
             
“Core cash” Floor Income adjustments:
                       
Floor Income earned on Managed loans, net of payments on Floor Income Contracts
  $ (88 )   $ (292 )   $ (474 )
Amortization of net premiums on Floor Income Contracts and futures in net interest income
    194       161       134  
Net losses related to closed Eurodollar futures contracts economically hedging Floor Income
    50       14       202  
Losses on sales of derivatives hedging Floor Income
          94       46  
                   
Total “core cash” Floor Income adjustments
  $ 156     $ (23 )   $ (92 )
                   
      4) Other items: We exclude amortization of acquired intangibles.
      For the years ended December 31, 2004, 2003 and 2002, the pre-tax effect of these non-GAAP performance measures were as follows:
                         
    Years Ended December 31,
     
    2004   2003   2002
             
Non-GAAP Performance Measures:
                       
Net impact of securitization accounting
  $ 152     $ (300 )   $ (291 )
Net impact of derivative accounting(1)
    (1,553 )     (502 )     200  
Net impact of Floor Income
    156       (23 )     (92 )
Amortization of acquired intangibles
    36       27       27  
                   
Total non-GAAP performance measures
  $ (1,209 )   $ (798 )   $ (156 )
                   
 
(1)  In addition to the derivative accounting adjustment noted here, for the year ended December 31, 2003, upon the adoption of SFAS No. 150, adjustments also included the reversal of a gain of $130 million which was reflected as a “cumulative effect of accounting change” in the GAAP consolidated statements of income.
LIQUIDITY AND CAPITAL RESOURCES
      Our DMO and Corporate and Other business segments are not capital intensive businesses and as such only an immaterial amount of debt and equity capital is included in these segments. Therefore, the following liquidity and capital resource discussion is concentrated on our Lending business segment.
      We depend on the debt capital markets to support our business plan. We have developed deep and diverse funding sources to ensure continued access to funding now that the GSE has been dissolved. Our biggest funding challenge going forward is to maintain cost effective liquidity to fund the growth in the Managed portfolio of student loans as well as to refinance previously securitized loans when borrowers choose to refinance their loans through a Consolidation Loan with the Company. At the same time, we must maintain earnings spreads and control interest rate risk to preserve earnings growth. Our main source of funding is student loan securitizations and in 2004, we securitized $33.8 billion in student loans in thirteen transactions (including the amount funded through our asset-backed commercial paper program transaction) versus $30.1 billion in sixteen transactions in 2003. Our securitizations backed by FFELP loans are unique securities in the asset-backed class as they are backed by student loans with an explicit guarantee on 100 percent of principal and interest. This guarantee is subject to service compliance. As evidenced by the 2003 and 2004 volume, we have built a highly liquid and deep market for student loan securitizations by broadening our investor base worldwide. Securitizations now comprise 66 percent of our financing, versus 58 percent at December 31, 2003.

64


 

      In addition to securitizations, we also significantly increased and diversified our sources of funds through the issuance of $15 billion in SLM Corporation term, unsecured debt in 2004. In 2003 and 2004, we strategically introduced several new SLM Corporation long-term issuances to further diversify our funding sources and substantially increased our fixed income investor base. In total, at December 31, 2004, on-balance sheet debt, exclusive of on-balance sheet securitizations and on-balance sheet secured indentured trusts, totaled $33.3 billion versus $20.3 billion at December 31, 2003.
      Without the GSE, stand-alone liquidity at SLM Corporation is very important to enable us to effectively fund our student loan acquisitions and operations. Our main sources of liquidity include our $5 billion unsecured revolving credit facility, cash and short-term investments, a $5 billion revolving asset-backed commercial paper program and our portfolio of readily securitizable student loans, particularly the government guaranteed portion of the portfolio.
      In addition to liquidity, a major objective when financing our business is to minimize interest rate risk through match funding of our assets and liabilities. Generally, on a pooled basis to the extent practicable, we match the interest rate and reset characteristics of our Managed assets and liabilities. In this process we use derivative financial instruments extensively to reduce our interest rate and foreign currency exposure. This interest rate risk management helps us to achieve a stable student loan spread irrespective of the interest rate environment. (See also “RISKS — Interest Rate Risk Management” below.)
      The following tables present the ending and average balances and average interest rates of our Managed borrowings for the years ended December 31, 2004, 2003 and 2002. The average interest rates include derivatives that are economically hedging the underlying debt, but do not qualify for hedge accounting treatment under SFAS No. 133. (See “ALTERNATIVE PERFORMANCE MEASURES — Reclassification of Realized Derivative Transactions.”)
                                                                         
    Years Ended December 31,
     
    2004 Ending Balance   2003 Ending Balance   2002 Ending Balance
             
        Total       Total       Total
        Managed       Managed       Managed
    Short Term   Long Term   Basis   Short Term   Long Term   Basis   Short Term   Long Term   Basis
                                     
GSE borrowings (unsecured)
  $     $  —     $     $ 16,678     $ 3,414     $ 20,092     $ 23,332     $ 15,298     $ 38,630  
Non-GSE borrowings (unsecured)
    1,830       31,465       33,295       1,855       18,472       20,327       1,290       5,795       7,085  
Indentured trusts (on-balance sheet)
    377       6,873       7,250       134       1,362       1,496       5       1,149       1,154  
Securitizations (on-balance sheet)
          35,769       35,769             16,346       16,346                    
Securitizations (off-balance sheet)
          43,814       43,814             40,606       40,606             37,262       37,262  
                                                       
Total
  $ 2,207     $ 117,921     $ 120,128     $ 18,667     $ 80,200     $ 98,867     $ 24,627     $ 59,504     $ 84,131  
                                                       
                                                 
    Years Ended December 31,
     
    2004   2003   2002
             
    Average   Average   Average   Average   Average   Average
    Balance   Rate   Balance   Rate   Balance   Rate
                         
GSE borrowings (unsecured)
  $ 9,967       2.21 %   $ 32,847       1.80 %   $ 44,141       2.33 %
Non-GSE borrowings (unsecured)
    28,241       2.29       13,305       2.01       4,223       2.88  
Indentured trusts (on-balance sheet)
    2,168       2.47       1,221       2.68       1,558       2.97  
Securitizations (on-balance sheet)
    28,354       1.79       6,026       1.40              
Securitizations (off-balance sheet)
    42,606       2.09       39,524       1.79       32,385       2.57  
                                     
Total
  $ 111,336       2.08 %   $ 92,923       1.81 %   $ 82,307       2.47 %
                                     

65


 

Unsecured On-Balance Sheet Financing Activities
      The following table presents the senior unsecured credit ratings on our debt from major rating agencies.
                         
    S&P   Moody’s   Fitch
             
Short-term unsecured debt
    A-1       P-1       F-1+  
Long-term unsecured debt
    A       A2       A+  
      The table below presents our unsecured on-balance sheet funding by funding source for the years ended December 31, 2004 and 2003.
                                 
    Debt Issued    
    For the Years   Outstanding at
    Ended December 31,   December 31,
         
    2004   2003   2004   2003
                 
Commercial paper
  $ 272     $ 8,285     $     $  
Convertible debentures
          1,980       1,988       1,983  
Retail medium-term notes (EdNotes)
    509       356       863       357  
Foreign currency denominated(1)
    4,179       597       4,780       598  
Extendible notes
    2,496       1,747       4,246       1,747  
Global notes
    7,629       9,844       18,686       11,549  
Medium-term notes
                2,732       4,093  
                         
Total
  $ 15,085     $ 22,809     $ 33,295     $ 20,327  
                         
 
(1)  All foreign currency denominated notes are swapped back to U.S. dollars.
      In 2003, we issued approximately $2 billion Contingently Convertible Debentures (“Co-Cos”). The CoCos are convertible, under certain conditions, into shares of SLM common stock at an initial conversion price of $65.98. The investors generally can only convert the debentures if the Company’s common stock has appreciated to 130 percent of the conversion price (or $85.77) for a prescribed period, or if we call the debentures. Per EITF No. 04-8, “The Effect of Contingently Convertible Debt on Diluted Earnings per Share,” we have included the potential dilutive effect of the Company’s outstanding Co-Cos in diluted earnings per share calculations for the years ended December 31, 2004, 2003 and 2002.
Securitization Activities
Securitization Program
      Our FFELP Stafford, Private Education Loan and certain Consolidation Loan securitizations are structured such that they meet the sale criteria of SFAS No. 140 by using a two-step transaction with a qualifying special purpose entity (“QSPE”) that legally isolates the transferred assets from the Company, even in the event of bankruptcy. The holders of the beneficial interests issued by the QSPE are not constrained from pledging or exchanging their interests and we do not maintain effective control over the transferred assets. In all of our off-balance sheet securitizations, we retain the right to receive the cash flows from the securitized student loans in excess of cash flows required to pay interest and principal on the bonds issued by the trust and servicing and administration fees.
      Prior to 2003, all of our securitization structures were off-balance sheet transactions. In certain 2003 and 2004 Consolidation Loan securitization structures, we hold rights that can affect the remarketing of the bonds, such that these trusts did not qualify as QSPEs and as a result were required to be accounted for on-balance sheet as variable interest entities (“VIEs”). These securitization structures were developed to broaden and diversify the investor base for Consolidation Loan securitizations by allowing us to issue bonds with non-amortizing, fixed rate and foreign currency denominated tranches. As of December 31, 2004, we had $31.5 billion of securitized student loans in on-balance sheet securitization trusts. These securitizations are included as financings in the table below.

66


 

      In off-balance sheet securitizations that qualify as sales, we recognize a gain on the sale, which is calculated as the difference between the allocated cost basis of the assets sold and the relative fair value of the assets received. The carrying value of the student loan portfolio being securitized includes the applicable accrued interest, unamortized student loan premiums, loan loss reserves and borrower benefits reserves. The fair value of the Residual Interest is determined using a discounted cash flow methodology using assumptions discussed in more detail below. We recognize no gain or loss or servicing and securitization revenue associated with on-balance sheet securitizations.
      The following table summarizes our securitization activity for the years ended December 31, 2004, 2003 and 2002. Those securitizations listed as sales are off-balance sheet transactions and those listed as financings remain on-balance sheet.
                                                                                                 
    Years Ended December 31,
     
    2004   2003   2002
             
        Pre-           Pre-           Pre-    
    No. of   Amt   Tax   Gain   No. of   Amt   Tax   Gain   No. of   Amt   Tax   Gain
    Trans.   Securitized   Gain   %   Trans.   Securitized   Gain   %   Trans.   Securitized   Gain   %
                                                 
FFELP Stafford loans
    4     $ 10,002     $ 134       1.3 %     4     $ 5,772     $ 73       1.3 %     7     $ 11,033     $ 101       .9 %
Consolidation Loans
                            2       4,256       433       10.2       1       1,976       194       9.8  
Private Education Loans
    2       2,535       241       9.5       3       3,503       238       6.8       1       690       43       6.2  
                                                                         
Total securitizations — sales
    6       12,537     $ 375       3.0 %     9       13,531     $ 744       5.5 %     9       13,699     $ 338       2.5 %
                                                                         
Asset-backed commercial paper(1)
    1       4,186                                                                          
Consolidation Loans
    6       17,124                       7       16,592                                              
                                                                         
Total securitizations — financings
    7       21,310                       7       16,592                                              
                                                                         
Total securitizations
    13     $ 33,847                       16     $ 30,123                       9     $ 13,699                  
                                                                         
 
(1)  In the second quarter of 2004, we closed our first asset-backed commercial paper program. The program is a revolving 364-day multi-seller conduit that allows us to borrow up to $5 billion through the sale of student loans subject to annual extensions. We may purchase student loans out of this trust at our discretion and as a result, the trust does not qualify as a QSPE and is accounted for on-balance sheet as a VIE.
      The increase in the Private Education Loan securitization gain percentage in 2004 is due to the underlying student loans having higher spreads and the related bonds having a lower funding cost due primarily to the maturing of the Private Education Loan marketplace. The decrease in the overall gain as a percentage of loans securitized in 2004 versus 2003 is mainly due to the 2004 Consolidation Loan securitizations not qualifying for off-balance sheet treatment. Off-balance sheet Consolidation Loan securitizations generally have higher gains than FFELP securitizations due to higher Embedded Fixed Rate Floor Income and longer average lives. The higher gain percentage in 2003 versus 2002 is due to the higher level of both Consolidation Loan and Private Education Loan securitizations.
      In 2004 and 2003, we had record levels of securitization transactions due to funding new student loan purchases, record levels of loan consolidation and the refinancing of GSE debt in connection with the Wind-Down. In 2005, we expect our securitization activity to decline and correlate with the volume of student loan purchases.
Long-Term
Liquidity Risk
      With the dissolution of the GSE, our long-term funding, credit spread and liquidity exposure to the corporate and asset-backed capital markets has increased significantly. A major disruption in the fixed income capital markets that limits our ability to raise funds or significantly increases the cost of those funds could have a material impact on our ability to acquire student loans, or on our results of operations. Going forward,

67


 

securitizations will continue to be the primary source of long-term financing. Our securitizations are structured such that we do not provide any level of financial, credit or liquidity support to any of the trusts. Our exposure is limited to the recovery of the Retained Interest asset on the balance sheet for off-balance sheet securitizations. While all of our Retained Interests are subject to some prepayment risk, Retained Interests from our FFELP Stafford securitizations have significant prepayment risk primarily from Consolidation Loans that could materially impair their value.
Retained Interest in Securitized Receivables
      The following table summarizes the fair value of our Retained Interests along with the underlying student loans that relate to those securitizations that were treated as sales.
                                   
    As of December 31, 2004   As of December 31, 2003
         
        Underlying       Underlying
    Retained   Securitized   Retained   Securitized
    Interest   Loan   Interest   Loan
    Fair Value   Balance   Fair Value   Balance
                 
FFELP Stafford loans
  $ 1,037     $ 27,444     $ 1,023     $ 26,420  
Consolidation Loans(1)
    585       7,393       994       8,076  
Private Education Loans
    694       6,309       459       3,983  
                         
 
Total(2)
  $ 2,316     $ 41,146     $ 2,476     $ 38,479  
                         
 
(1)  Includes $399 million and $727 million related to the fair value of the Embedded Floor Income as of December 31, 2004 and 2003, respectively.
 
(2)  Unrealized gains (pre-tax) included in accumulated other comprehensive income related to the Retained Interests totaled $445 million and $443 million as of December 31, 2004 and 2003, respectively.
      Accounting Estimates’ Effect on the Residual Interest in Securitized Trusts
      We updated certain assumptions during 2004 that we use in the valuation of the Residual Interest. The following are the significant assumption changes that were made:
         
    As of December 31,   As of December 31,
    2004   2003
         
FFELP Stafford loan CPR(1)
  20% - 2005   20% - 2004
    15% - 2006   15% - 2005
    6% - thereafter   6% - thereafter
Private Education Loan CPR(2)
  3%   6%
FFELP expected credit losses (as a % of securitized loan balance outstanding)(3)
  0%   .17%
 
(1)  We increased the FFELP Stafford loan CPR assumption to account for the record levels of Consolidation Loan volume over the past three years. Unless there is a legislative change to the Consolidation Loan program through HEA reauthorization, we believe that high levels of Consolidation Loan activity will continue.
 
(2)  We decreased the Private Education Loan CPR assumption because these loans are repaying slower than originally projected, including slower prepayments.
 
(3)  We lowered our assumption of expected FFELP credit losses to zero percent to reflect the effect of the EP designation on Sallie Mae serviced FFELP loans in the trusts. The EP designation is discussed in more detail in “LENDING BUSINESS SEGMENT — Student Loans — Allowance for FFELP Student Loan Losses.”

68


 

     Servicing and Securitization Revenue
      Servicing and securitization revenue, the ongoing revenue from securitized loan pools accounted for off-balance sheet as QSPEs, includes the interest earned on the Residual Interest asset and the revenue we receive for servicing the loans in the securitization trusts. Interest income recognized on the Residual Interest is based on our anticipated yield determined by estimating future cash flows each quarter.
      The following table summarizes the components of servicing and securitization revenue for the years ended December 31, 2004, 2003 and 2002.
                         
    Years Ended December 31,
     
    2004   2003   2002
             
Servicing revenue
  $ 326     $ 314     $ 278  
Securitization revenue, before Embedded Floor Income
    150       173       203  
                   
Servicing and securitization revenue, before Embedded Floor Income
    476       487       481  
                   
Embedded Floor Income
    241       337       364  
Less: Floor Income previously recognized in gain calculation
    (156 )     (157 )     (6 )
                   
Net Embedded Floor Income
    85       180       358  
                   
Total servicing and securitization revenue
  $ 561     $ 667     $ 839  
                   
Average off-balance sheet student loans
  $ 40,558     $ 38,205     $ 32,280  
                   
Average balance of Retained Interest
  $ 2,434     $ 2,615     $ 1,746  
                   
      Fluctuations in servicing and securitization revenue are generally driven by the amount of and the difference in the timing of Embedded Floor Income recognition on off-balance sheet student loans, as well as the impact of Consolidation Loan activity on FFELP Stafford student loan securitizations. When FFELP Stafford loans consolidate, they are a prepayment to the trust and as a result shorten the life of the trust. We estimate the trust prepayments through consolidation with our CPR assumption. When consolidation activity is higher than forecasted, the Residual Interest asset can be impaired and the yield used to recognize subsequent income from the trust is negatively impacted, though we typically retain the value of the asset on-balance sheet versus in the trust. For the year ended December 31, 2004, we recorded an impairment charge of $80 million due primarily to (a) FFELP Stafford loans continuing to consolidate at levels faster than projected ($47 million) and (b) rising interest rates during the second quarter of 2004, which decreased the value of the Embedded Floor Income component of our Retained Interest ($33 million). We recorded impairment charges of $96 million and $40 million in 2003 and 2002, respectively, due primarily to FFELP Stafford loans prepaying faster through consolidation than projected. The impairment charges were recorded as losses and were included as a reduction in securitization revenue.
      We receive annual servicing fees of 90 basis points, 50 basis points and 70 basis points of the outstanding securitized loan balance related to our FFELP Stafford, Consolidation Loan and Private Education Loan securitizations, respectively.
CONTRACTUAL CASH OBLIGATIONS
      The following table provides a summary of our obligations associated with long-term notes and equity forward contracts at December 31, 2004. For further discussion of these obligations, see Note 8, “Long-Term

69


 

Debt,” Note 10, “Derivative Financial Instruments,” and Note 15, “Common Stock,” to the consolidated financial statements.
                                         
    1 Year   2 to 3   4 to 5   Over 5    
    or less   Years   Years   Years   Total
                     
Long-term notes(1)(2)
    2,473       22,248       11,418       37,968       74,107  
Equity forward contracts(3)
          951       1,205             2,156  
                               
Total contractual cash obligations
  $ 2,473     $ 23,199     $ 12,623     $ 37,968     $ 76,263  
                               
 
(1)  Excludes SFAS No. 133 derivative market value adjustments of $1.8 billion for long-term notes.
 
(2)  Includes FIN No. 46 long-term beneficial interests of $35.8 billion of notes issued by consolidated variable interest entities in conjunction with our on-balance sheet securitization transactions and included in long-term notes in the consolidated balance sheet.
 
(3)  Our obligation to repurchase shares under equity forward contracts is calculated using the average purchase prices for outstanding contracts in the year the contracts expire. At or prior to the maturity date of the agreements, we can purchase shares at the contracted amount plus or minus an early break fee, or we can settle the contract on a net basis with either cash or shares. If our stock price declines to a certain level, the third party with whom we entered into the contract can liquidate the position prior to the maturity date.
OFF-BALANCE SHEET LENDING ARRANGEMENTS
      The following table summarizes the commitments associated with student loan purchases and contractual amounts related to off-balance sheet lending related financial instruments and guarantees at December 31, 2004.
                                         
    1 Year   2 to 3   4 to 5   Over 5    
    or less   Years   Years   Years   Total
                     
Student loan purchases(1)(2)
  $ 7,846     $ 1,878     $ 14,120     $ 23,404     $ 47,248  
Lines of credit(2)
    150       34       327       377       888  
Letters of credit(2)
    157                         157  
                               
    $ 8,153     $ 1,912     $ 14,447     $ 23,781     $ 48,293  
                               
 
(1)  Includes amounts committed at specified dates under forward contracts to purchase student loans and anticipated future requirements to acquire student loans from lending partners (discussed below) estimated based on future originations at contractually committed rates.
 
(2)  Expiration of commitments and guarantees reflect the earlier of call date or maturity date as of December 31, 2004.
      We have forward purchase commitments to acquire student loans from various lenders, including our largest lending partners, Bank One and JPMorgan Chase. With respect to JPMorgan Chase, we entered into a joint venture established solely to facilitate our acquisition of student loans originated by JPMorgan Chase. Under a renewable multi-year agreement, we service and purchase a significant share of Bank One’s volume. For further discussion of our relationships with JPMorgan Chase and Bank One, see “BUSINESS — LENDING BUSINESS SEGMENT — Sallie Mae’s Lending Business” in Item 1 of this Annual Report.
      We have issued lending-related financial instruments including letters of credit and lines of credit to meet the financing needs of our customers. The contractual amount of these financial instruments represents the maximum possible credit risk should the counterparty draw down the commitment and the counterparty subsequently fails to perform according to the terms of our contract. Most of these commitments and guarantees expire without being drawn. As a result, the total contractual amount of these instruments is not, in our view, representative of our actual future credit exposure or funding requirements.

70


 

      To the extent that letters of credit and lines of credit are drawn upon, the balance outstanding is collateralized by student loans. We earn fees associated with the maintenance of these financial instruments which totaled $2 million, $7 million and $10 million in 2004, 2003, and 2002, respectively. At December 31, 2004, draws on lines of credit were approximately $227 million, which amount is reflected in other loans in the consolidated balance sheet. For additional information, see Note 13, “Commitments, Contingencies and Guarantees,” to the consolidated financial statements.
RISKS
Overview
      Managing risks is an essential part of successfully operating a financial services company. Our most prominent risk exposures are operational, market and interest rate, political and regulatory, liquidity, credit, and Consolidation Loan refinancing risk.
Operational Risk
      Operational risk can result from regulatory compliance errors, other servicing errors (see further discussion below), technology failures, breaches of the internal control system, and the risk of fraud or unauthorized transactions by employees or persons outside the Company. This risk of loss also includes the potential legal actions that could arise as a result of an operational deficiency or as a result of noncompliance with applicable regulatory standards and contractual commitments, adverse business decisions or their implementation, and customer attrition due to potential negative publicity.
      The federal guarantee on our student loans and our designation as an Exceptional Performer by ED is conditioned on compliance with origination and servicing standards set by ED and guarantor agencies. A mitigating factor is our ability to cure servicing deficiencies and historically our losses have been small. Should we experience a high rate of servicing deficiencies, the cost of remedial servicing or the eventual losses on the student loans that are not cured could be material. Our servicing and operating processes are highly dependent on our information system infrastructure, and we face the risk of business disruption should there be extended failures of our information systems, any number of which could have a material impact on our business. We have a number of back-up and recovery plans in the event of systems failures. These plans are tested regularly and monitored constantly.
      We manage operational risk through our risk management and internal control processes, which involve each business line including independent cost centers, such as servicing, as well as executive management. The business lines have direct and primary responsibility and accountability for identifying, controlling, and monitoring operational risk, and each business line manager maintains a system of controls with the objective of providing proper transaction authorization and execution, proper system operations, safeguarding of assets from misuse or theft, and ensuring the reliability of financial and other data. In 2004, we further strengthened our operational controls by centralizing certain staff functions such as accounting, human resources and legal. While we believe that we have designed effective methods to minimize operational risks, our operations remain vulnerable to natural disasters, human error, technology and communication system breakdowns and fraud.
Market and Interest Rate Risk
      Market risk is the risk of loss from adverse changes in market prices and/or interest rates of our financial instruments. Our primary market risk is from changes in interest rates and interest spreads. We have an active interest rate risk management program that is designed to reduce our exposure to changes in interest rates and maintain consistent earning spreads in all interest rate environments. We use derivative instruments extensively to hedge our interest rate exposure, but in our hedging activities is a risk that we are not hedging all potential interest rate exposures or that the hedges do not perform as designed. We measure interest rate risk by calculating the variability of net interest income in future periods under various interest rate scenarios using projected balances for interest earning assets, interest-bearing liabilities and derivatives used to hedge interest rate risk. Many assumptions are utilized by management to calculate the impact that changes in interest rates

71


 

may have on net interest income, the more significant of which are related to student loan volumes and pricing, the timing of cash flows from our student loan portfolio, particularly the impact of Floor Income and the rate of student loan consolidations, basis risk, credit spreads and the maturity of our debt and derivatives. (See also “Interest Rate Risk Management.”)
      We are also subject to market risk relative to our equity forward contracts that allow us to repurchase our common stock in the future from a third party at the market price at the time of entering the contract. Should the market value of our stock fall below certain predetermined levels, the counterparty to the contract has a right to terminate the contract and settle all or a portion at the original contract price. We are required to mark our equity forwards to market, so decreases in our stock price could result in material losses.
Political/Regulatory Risk
      Because we operate in a federally sponsored loan program, we are subject to political and regulatory risk. As part of the HEA, the student loan program is periodically amended and must be “reauthorized” every six years. Past changes included reduced loan yields paid to lenders in 1993 and 1998, increased fees paid by lenders in 1993, decreased level of the government guaranty in 1993 and reduced fees to guarantors and collectors, among others. The program is scheduled to be reauthorized in 2005 and management expects reauthorization to be completed no earlier than in the second half of 2005. There can be no assurances that the reauthorization will not result in changes that may have a materially adverse impact to the Company. See “OTHER RELATED EVENTS AND INFORMATION — Reauthorization and Budget Proposals.”
      The Secretary of Education oversees and implements the HEA and periodically issues regulations and interpretations that may impact our business.
Liquidity Risk (See also “LIQUIDITY AND CAPITAL RESOURCES — Securitization Activities — Long-Term — Liquidity Risk”)
Credit Risk
Short-Term
      We bear the full risk of borrower and closed school losses experienced in our Private Education Loan portfolio. These loans are underwritten and priced according to risk, generally determined by a commercially available consumer credit scoring system, FICOtm. Additionally, for borrowers who do not meet our lending requirements or who desire more favorable terms, we require credit-worthy co-borrowers. When schools close, losses may be incurred when student borrowers have not completed their education. We have defined underwriting and collection policies, and ongoing risk monitoring and review processes for all Private Education Loans. The performance of the Private Education Loan portfolio may be affected by the economy, and a prolonged economic downturn may have an adverse effect on its credit performance. Management believes that it has provided sufficient allowances to cover the losses that may be experienced in both the federally guaranteed and Private Education Loan portfolios over the next 2 to 5 years depending on the portfolio. There is, however, no guarantee that such allowances are sufficient enough to account for actual losses. (See “LENDING BUSINESS SEGMENT — Student Loans — Activity in the Allowance for Private Education Loan Losses.”)
      We have credit risk exposure to the various counterparties with whom we have entered into derivative contracts. We review the credit standing of these companies. Our credit policies place limits on the amount of exposure we may take with any one party and in most cases, require collateral to secure the position. The credit risk associated with derivatives is measured based on the replacement cost should the counterparties with contracts in a gain position to the Company fail to perform under the terms of the contract. We also have credit risk with two commercial airlines related to our portfolio of leveraged leases. (See “LENDING BUSINESS SEGMENT — Losses on Securities, Net.”)

72


 

Consolidation Loan Refinancing Risk
      The consolidation of our loan portfolio can have detrimental effects. First, we may lose student loans in our portfolio that are consolidated with other lenders. In 2003, we experienced a net run-off of $84 million of student loans from Consolidation Loan activity as more of our FFELP Stafford student loans were consolidated with other lenders than were consolidated by us. In 2004, our increased marketing focus on Consolidation Loans generated a net gain of $504 million, a trend we expect to continue into the future. Second, Consolidation Loans have lower net yields than the FFELP Stafford loans they replace. This is somewhat offset by the longer average lives of Consolidation Loans. Third, we must maintain sufficient, short-term liquidity to enable us to cost-effectively refinance previously securitized FFELP Stafford loans as they are consolidated back on to our balance sheet.
      ED has taken the position that a borrower may consolidate his or her FFELP Consolidation Loan with the FDLP irrespective of whether that borrower’s FFELP holder offers a Consolidation Loan with income-sensitive repayment terms. Based upon an analysis of the applicable law and regulations, we disagree with ED’s interpretations. If ED’s interpretations are formally adopted and not successfully challenged, our Managed portfolio could be subject to further consolidation risk.
Interest Rate Risk Management
     Asset and Liability Funding Gap
      The tables below present our assets and liabilities (funding) arranged by underlying indices as of December 31, 2004. In the following GAAP presentation, the funding gap only includes derivatives that qualify as effective SFAS No. 133 hedges (those derivatives which are reflected in net interest margin, as opposed to in the derivative market value adjustment). The difference between the asset and the funding is the funding gap, which represents our exposure to interest rate risk in the form of basis risk and repricing risk, which is the risk that the different indices may reset at different frequencies or may not move in the same direction or at the same magnitude.
      Management analyzes interest rate risk on a Managed basis, which consists of both on-balance sheet and off-balance sheet assets and liabilities and includes all derivatives that are economically hedging our debt whether they qualify as effective hedges under SFAS No. 133 or not. Accordingly, we are also presenting the asset and liability funding gap on a Managed basis in the table that follows the GAAP presentation.

73


 

     GAAP Basis
                             
    Frequency of Variable           Funding
Index   Resets   Assets   Funding(1)   Gap
                 
(Dollars in billions)                
                 
3 month Commercial paper
  daily   $ 46.0     $     $ 46.0  
3 month Treasury bill
  weekly     11.3       .3       11.0  
Prime
  annual     .9             .9  
Prime
  quarterly     1.3             1.3  
Prime
  monthly     2.9             2.9  
PLUS Index
  annual     1.9       2.0       (0.1 )
3-month LIBOR
  daily                  
3-month LIBOR
  quarterly     2.2       55.3       (53.1 )
1-month LIBOR
  monthly           2.0       (2.0 )
CMT/CPI index
  monthly/quarterly           1.2       (1.2 )
Non Discreet reset(2)
  monthly           10.1       (10.1 )
Non Discreet reset(3)
  daily/weekly     5.9             5.9  
Fixed Rate(4)
        11.7       13.2       (1.5 )
                       
Total
      $ 84.1     $ 84.1     $  
                       
 
(1)  Includes all derivatives that qualify as hedges under SFAS No. 133.
 
(2)  Consists of asset-backed commercial paper and auction rate securities, which are discount note type instruments that generally roll over monthly.