10-Q 1 nelnet_10q-093010.htm FORM 10-Q nelnet_10q-093010.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-Q
 
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2010

or

¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             .
 
COMMISSION FILE NUMBER 001-31924

NELNET, INC.
(Exact name of registrant as specified in its charter)
 
NEBRASKA
(State or other jurisdiction of incorporation or organization)
84-0748903
(I.R.S. Employer Identification No.)
   
121 SOUTH 13TH STREET, SUITE 201
LINCOLN, NEBRASKA
(Address of principal executive offices)
 
68508
(Zip Code)
 
(402) 458-2370
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes [X] No [   ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [  ] No [  ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer [  ]                                                   Accelerated filer [X]
Non-accelerated filer [  ]                                                     Smaller reporting company [  ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes [  ]   No [X]

As of October 31, 2010, there were 36,841,793 and 11,495,377 shares of Class A Common Stock and Class B Common Stock, par value $0.01 per share, outstanding, respectively (excluding 11,317,364 shares of Class A Common Stock held by wholly owned subsidiaries).  
 
 
 

 

NELNET, INC.
FORM 10-Q
INDEX
September 30, 2010
 
PART I. FINANCIAL INFORMATION
       
 
Item 1.
Financial Statements
     
2
 
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
32
 
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
 
78
 
Item 4.
Controls and Procedures
   
84
                 
PART II. OTHER INFORMATION
         
 
Item 1.
Legal Proceedings
     
85
 
Item 1A.
Risk Factors
     
86
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
86
 
Item 6.
Exhibits
       
88
                 
Signatures
           
89
 
 

 

PART I. FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS
 
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except share data)
             
   
As of
   
As of
 
   
September 30, 2010
   
December 31, 2009
 
   
(unaudited)
       
Assets:
           
Student loans receivable (net of allowance for loan losses of
           
$50,212 and $50,887 respectively)
  $ 24,436,162       23,926,957   
Student loans receivable - held for sale
    2,109,440        
Cash and cash equivalents:
               
Cash and cash equivalents - not held at a related party
    13,667       12,301  
Cash and cash equivalents - held at a related party
    302,694       325,880  
Total cash and cash equivalents
    316,361       338,181  
Investments - trading securities
    33,082        
Restricted cash and investments
    692,702       625,492  
Restricted cash - due to customers
    54,532       91,741  
Accrued interest receivable
    418,083       329,313  
Accounts receivable (net of allowance for doubtful accounts of
               
$846 and $1,198, respectively)
    68,713       42,043  
Goodwill
    143,717       143,717  
Intangible assets, net
    43,352       53,538  
Property and equipment, net
    28,011       26,606  
Other assets
    113,597       104,940  
Fair value of derivative instruments
    128,827       193,899  
                 
Total assets
  $ 28,586,579       25,876,427  
                 
Liabilities:
               
Bonds and notes payable
  $ 27,391,188       24,805,289  
Accrued interest payable
    19,727       19,831  
Accrued litigation settlement charge
    55,000        
Other liabilities
    175,156       172,514  
Due to customers
    54,532       91,741  
Fair value of derivative instruments
    46,362       2,489  
Total liabilities
    27,741,965       25,091,864  
                 
Shareholders' equity:
               
Preferred stock, $0.01 par value.  Authorized 50,000,000 shares;
               
no shares issued or outstanding
           
Common stock:
               
Class A, $0.01 par value. Authorized 600,000,000 shares;
               
issued and outstanding 36,848,473 shares as of September 30,
               
2010 and 38,396,791 shares as of December 31, 2009
    368        384   
Class B, convertible, $0.01 par value.  Authorized 60,000,000 shares;
               
issued and outstanding 11,495,377 shares as of September 30,
               
2010 and December 31, 2009
    115        115   
Additional paid-in capital
    75,636        109,359   
Retained earnings
    769,665        676,154   
Employee notes receivable
    (1,170 )       (1,449 )  
Total shareholders' equity
    844,614        784,563   
Commitments and contingencies
               
Total liabilities and shareholders' equity
  $ 28,586,579       25,876,427   
                 
See accompanying notes to consolidated financial statements.
               
 
 
2

 
 
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands, except share data)
(unaudited)
                         
   
Three months
   
Nine months
 
   
ended September 30,
   
ended September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Interest income:
                       
Loan interest
  $ 159,287       143,255       449,607       474,587  
Investment interest
    1,169       1,943       3,474       8,810  
Total interest income
    160,456       145,198       453,081       483,397  
Interest expense:
                               
Interest on bonds and notes payable
    68,243       76,016       178,345       328,600  
Net interest income
    92,213       69,182       274,736       154,797  
Less provision for loan losses
    5,500       7,500       16,700       23,000  
Net interest income after provision for loan losses
    86,713       61,682       258,036       131,797  
                                 
Other income (expense):
                               
Loan and guaranty servicing revenue
    33,464       26,006       106,510       81,280  
Tuition payment processing and campus commerce revenue
    14,527       12,987       44,704       40,373  
Enrollment services revenue
    36,439       30,670       105,113       88,188  
Software services revenue
    4,624       4,600       14,467       16,424  
Other income
    9,432       5,846       25,188       20,298  
Gain on sale of loans and debt repurchases, net
    9,885       14,036       28,821       27,571  
Derivative market value and foreign currency
                               
   adjustments and derivative settlements, net
    (35,391 )       7,740       (44,317 )       2,740  
Total other income
    72,980       101,885       280,486       276,874  
                                 
Operating expenses:
                               
Salaries and benefits
    41,085       36,398       122,691       113,322  
Other operating expenses:
                               
Litigation settlement
    55,000             55,000        
Cost to provide enrollment services
    23,709       20,323       69,845       56,208  
Professional and other services
    11,428       6,584       37,820       20,382  
Depreciation and amortization
    7,577       8,769       24,350       28,379  
Restructure expense
    4,751       3,340       6,020       6,628  
Occupancy and communications
    3,632       3,194       10,672       12,330  
Postage and distribution
    2,911       1,958       8,488       7,100  
Advertising and marketing
    2,403       1,936       8,386       5,632  
Trustee and other debt related fees
    1,097       2,387       3,445       7,487  
Other
    6,694       7,773       25,495       25,121  
Total other operating expenses
    119,202       56,264       249,521       169,267  
                                 
Total operating expenses
    160,287       92,662       372,212       282,589  
                                 
Income (loss) before income taxes
    (594 )       70,905       166,310       126,082  
Income tax benefit (expense)
    226       (24,501 )       (62,363 )       (46,020 )  
                                 
Net income (loss)
  $ (368 )     46,404       103,947        80,062   
                                 
Earnings (loss) per common share:
                               
Net earnings (loss) - basic
  $ (0.01 )     0.93       2.09       1.60  
                                 
Net earnings (loss) - diluted
  $ (0.01 )     0.93       2.08       1.60  
                                 
Dividends paid per common share
  $ 0.07             0.21         
                                 
Weighted average common shares outstanding:
                               
Basic
    48,938,333       49,611,423       49,460,625       49,432,165  
Diluted
    48,938,333       49,808,856       49,663,505       49,633,290  
                                 
See accompanying notes to consolidated financial statements.
                               
 
3

 

NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS)
(Dollars in thousands, except share data)
(unaudited)
                                                             
   
Preferred
                     
Class A
   
Class B
   
Additional
         
Employee
   
Total
 
   
stock
   
Common stock shares
   
Preferred
   
common
   
common
   
paid-in
   
Retained
   
notes
   
shareholders’
 
   
shares
   
Class A
   
Class B
   
stock
   
stock
   
stock
   
capital
   
earnings
   
receivable
   
equity
 
                                                             
Balance as of June 30, 2009
      38,325,492     11,495,377     $     383     115     107,959     574,179     (1,449 )     681,187  
Comprehensive income:
                                                             
Net income
                                46,404         46,404  
Issuance of common stock, net of forfeitures
      31,403               1         241             242  
Compensation expense for stock based awards
                            349             349  
Repurchase of common stock
      (7,434 )               (1 )         (107 )             (108 )  
Balance as of September 30, 2009
      38,349,461     11,495,377     $     383     115     108,442     620,583     (1,449 )     728,074  
                                                               
                                                               
Balance as of June 30, 2010
      37,995,006     11,495,377     $     380     115     101,232     773,468     (1,250 )   873,945  
Comprehensive loss:
                                                             
Net loss
                                (368 )         (368 )  
Cash dividend on Class A and Class B
                                                             
common stock - $0.07 per share
                                (3,435 )         (3,435 )  
Issuance of common stock, net of forfeitures
      37,728                       601             602  
Compensation expense for stock based awards
                            405             405  
Repurchase of common stock
      (1,184,261 )               (13 )         (26,602 )             (26,615 )  
Reduction of employee stock notes receivable
                                    80      80  
Balance as of September 30, 2010
      36,848,473     11,495,377     $     368     115     75,636     769,665     (1,170 )     844,614  
                                                               
                                                               
Balance as of December 31, 2008
      37,794,067     11,495,377     $     378     115     103,762     540,521     (1,550 )     643,226  
Comprehensive income:
                                                             
Net income
                                80,062         80,062  
Issuance of common stock, net of forfeitures
      569,937               6         3,539             3,545  
Compensation expense for stock based awards
                            1,310             1,310  
Repurchase of common stock
      (14,543 )               (1 )         (169 )             (170 )  
Reduction of employee stock notes receivable
                                    101     101  
Balance as of September 30, 2009
      38,349,461     11,495,377     $     383     115     108,442     620,583     (1,449 )     728,074  
                                                               
                                                               
Balance as of December 31, 2009
      38,396,791     11,495,377     $     384     115     109,359     676,154     (1,449 )   784,563  
Comprehensive income:
                                                             
Net income
                                103,947         103,947  
Cash dividend on Class A and Class B
                                                             
common stock - $0.21 per share
                                (10,436 )         (10,436 )  
Issuance of common stock, net of forfeitures
      312,322               3         4,834             4,837  
Compensation expense for stock based awards
                            1,096             1,096  
Repurchase of common stock
      (1,860,640 )               (19 )         (39,653 )             (39,672 )  
Reduction of employee stock notes receivable
                                    279     279  
Balance as of September 30, 2010
      36,848,473     11,495,377     $     368     115     75,636     769,665     (1,170 )     844,614  
                                                               
See accompanying notes to consolidated financial statements.

 
4

 

NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
(unaudited)
             
   
Nine months ended September 30,
 
   
2010
   
2009
 
             
Net income
           
Adjustments to reconcile income to net cash provided by operating
       
    activities, net of business acquisition:
  $ 103,947       80,062  
Depreciation and amortization, including loan premiums
               
     and deferred origination costs
    71,696       88,118  
Provision for loan losses
    16,700       23,000  
Derivative market value adjustment
    94,539       (19,912 )
Foreign currency transaction adjustment
    (58,608 )     55,979  
Proceeds received to terminate and/or amend derivative instruments
    15,169       3,820  
Payments to terminate and/or amend derivative instruments
    (763 )     (11,710 )
Gain from repurchase of bonds and notes payable
    (28,821 )     (19,185 )
Originations and purchases of student loans-held for sale
    (97,782 )     (13,345 )
Gain on sale of loans, net
          (8,386 )
Change in investments - trading securities, net
    (33,082 )     (893 )
Deferred income tax benefit
    (4,292 )     (30,654 )
Non-cash compensation expense
    1,719       1,825  
Accrued litigation settlement
    55,000        
Other non-cash items
    (202 )     1,744  
(Increase) decrease in accrued interest receivable
    (88,770 )     82,640  
Increase in accounts receivable
    (26,670 )     (7,180 )
Decrease in other assets
    (7,977 )     10,869  
Decrease in accrued interest payable
    (104 )     (56,717 )
Increase in other liabilities
    4,131       34,575  
Net cash provided by operating activities
    15,830       214,650  
                 
Cash flows from investing activities, net of business acquisition:
         
Originations and purchases of student loans, including loan
               
     premiums/discounts and deferred origination costs
    (2,957,976 )     (2,104,234 )
Purchases of student loans from a related party
    (989,002 )     (39,649 )
Net proceeds from student loan repayments, claims,
               
     capitalized interest, participations, and other
    1,342,963       1,507,981  
Proceeds from sale of student loans
    27,191       550,176  
Proceeds from sale of student loans to a related party
          61,452  
Purchases of property and equipment, net
    (7,496 )     (466 )
(Increase) decrease in restricted cash and investments, net
    (67,210 )     198,636  
Business acquisition, net of cash acquired
    (3,000 )      
Net cash (used in) provided by investing activities
    (2,654,530 )     173,896  
                 
Cash flows from financing activities:
               
Payments on bonds and notes payable
    (2,541,883 )     (3,978,507 )
Proceeds from issuance of bonds and notes payable
    5,104,517       3,761,543  
Payments on bonds payable due to a related party
          (21,520 )
Proceeds from issuance of bonds payable due to a related party
    111,675        
Payments of debt issuance costs
    (7,971 )     (5,876 )
Dividends paid
    (10,436 )      
Repurchases of common stock
    (39,672 )     (170 )
Proceeds from issuance of common stock
    371       329  
Payments received on employee stock notes receivable
    279       101  
Net cash provided by (used in) financing activities
    2,616,880       (244,100 )
                 
                 
Net (decrease) increase in cash and cash equivalents
    (21,820 )     144,446  
                 
Cash and cash equivalents, beginning of period
    338,181       189,847  
                 
Cash and cash equivalents, end of period
  $ 316,361       334,293  
                 
Supplemental disclosures of cash flow information:
               
Interest paid
  $ 171,656       380,543  
                 
Income taxes paid, net of refunds
  $ 77,774       69,924  
           
See accompanying notes to consolidated financial statements.
         
 
 
5

 
 
NELNET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Information as of September 30, 2010 and for the three and nine months ended
September 30, 2010 and 2009 is unaudited)
(Dollars in thousands, except per share amounts, unless otherwise noted)

1.    Basis of Financial Reporting

The accompanying unaudited consolidated financial statements of Nelnet, Inc. and subsidiaries (the “Company”) as of September 30, 2010 and for the three and nine months ended September 30, 2010 and 2009 have been prepared on the same basis as the audited consolidated financial statements for the year ended December 31, 2009 and, in the opinion of the Company’s management, the unaudited consolidated financial statements reflect all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of results of operations for the interim periods presented.  The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Operating results for the three and nine months ended September 30, 2010 are not necessarily indicative of the results for the year ending December 31, 2010.  The unaudited consolidated financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.

Reclassifications

Certain amounts previously reported have been reclassified to conform to the current period presentation. The reclassifications were made to change the income statement presentation to provide the users of the financial statements additional information related to the operating results of the Company. These reclassifications include:

 
·
Reclassifying the Company’s gains on debt repurchases to “gain on sale of loans and debt repurchases, net” which were previously included in “other income.”

 
·
Reclassifying costs incurred by the Company related to restructuring activities to “restructure expense,” which were previously included in “salaries and benefits” and “occupancy and communications.” See note 13 for information related to the restructuring activity including additional information related to the types of costs incurred.

The reclassifications had no effect on consolidated net income or consolidated assets and liabilities.

2.      Recent Developments

Litigation Settlement

On August 13, 2010, the Company reached an agreement in principal to pay $55.0 million to settle all claims associated with the previously disclosed “qui tam” action brought by Jon H. Oberg on behalf of the United States of America. The settlement agreement was finalized on October 25, 2010. As a result of the settlement, the Company recorded a $55.0 million pre-tax charge ($34.1 million after tax) during the third quarter of 2010. The Company expects that the Internal Revenue Service (the “IRS”) will review the settlement as part of its normal procedures for settlements with government agencies, to determine if the payments are deductible as ordinary and necessary business expenses. While the Company believes that the payments are fully deductible under the applicable tax laws, the IRS may not agree with that position. The settlement expense is reported as a separate line item on a pre-tax basis in the consolidated statement of operations and the accrual is reported as a separate line item on the consolidated balance sheet. On November 3, 2010, the Company paid the $55.0 million settlement.

The Company believed it had strong defenses to the Oberg Complaint, but entered into the settlement agreement in order to eliminate the uncertainty, distraction, and expense of a trial.

See note 14 for additional information related to this settlement.

Legislation – FFELP

On March 30, 2010, President Obama signed into law the Health Care and Education Reconciliation Act of 2010 (the “Reconciliation Act of 2010”).  Effective July 1, 2010, this law prohibits new loan originations under the Federal Family Education Loan Program (“FFELP” or “FFEL Program”) and requires that all new federal loan originations be made through the Direct Loan Program.  If a first disbursement has been made on a FFELP loan prior to July 1, 2010, subsequent disbursements of that loan may still be made under the FFELP.  The new law does not alter or affect the terms and conditions of existing FFELP loans.
 
 
6

 

As a result of the Reconciliation Act of 2010, the Company no longer originates new (first disbursement) FFELP loans after June 30, 2010.  As such, subsequent to 2010, the Company will no longer recognize a gain from originating and subsequently selling FFELP loans to the Department of Education (the “Department”) under the Department’s Purchase Program. During the third and fourth quarters of 2009, the Company recognized a pre-tax gain of $9.7 million and $26.9 million, respectively, from selling $427.7 million and $1.6 billion, respectively, of 2008-2009 academic year loans to the Department under the Purchase Program. As of September 30, 2010, the Company had $2.1 billion of 2009-2010 academic year loans classified as held for sale funded in the Department’s Participation Program that were sold to the Department under the Purchase Program during October 2010. Upon selling the $2.1 billion in loans held for sale, the Company recognized a pre-tax gain during the fourth quarter of 2010 of $33.8 million. The Company earned approximately $1 million in 2009 and approximately $6 million during the nine months ended September 30, 2010 in net interest income on the 2009-2010 academic year loans prior to selling them to the Department.

In addition, as a result of the Reconciliation Act of 2010, net interest income on the Company’s existing FFELP loan portfolio, as well as fee-based revenue from guarantee and third-party FFELP servicing and education loan software licensing and consulting fees, will decline over time as the Company and its customers’ FFELP loan portfolios are paid down.  During the nine month period ended September 30, 2010 and year ended December 31, 2009, the Company recognized approximately $280 million and approximately $247 million, respectively, of net interest income on its FFELP loan portfolio; approximately $80 million and approximately $100 million, respectively, in guarantee and third-party FFELP servicing revenue; and approximately $6 million and approximately $12 million, respectively, in education loan software licensing and consulting fees related to the FFEL Program.

Due to the legislative changes in the student loan industry, the Company believes there will be opportunities to purchase FFELP loan portfolios and/or expand its current level of guarantee and third-party FFELP servicing volume on behalf of current FFELP participants looking to modify their involvement in FFELP and/or exit that business.  For example, during the first nine months of 2010, the Company purchased $2.5 billion of FFELP student loans from various third-parties.

Direct Loan Servicing Contract

In June 2009, the Company was one of four private sector companies awarded a student loan servicing contract by the Department of Education to provide additional servicing capacity for loans owned by the Department. These loans include Direct Loan Program loans and FFEL Program loans purchased by the Department under the authority granted in the Ensuring Continued Access to Student Loans Act of 2008 (“ECASLA”) legislation. In September 2009, the Department began assigning FFEL purchased loans to the four servicers. Beginning with the second year of servicing in July 2010, the Department began allocating new loan volume among the four servicers based on certain performance metrics. As of September 30, 2010, the Company was servicing $21.8 billion of loans under this contract. For the three and nine months ended September 30, 2010, the Company earned $8.7 million and $18.4 million, respectively, in revenue under this contract.

3.    Student Loans Receivable and Allowance for Loan Losses

Student loans consist of federally insured and non-federally insured student loans. If the Company has the ability and intent to hold loans for the foreseeable future, such loans are held for investment and carried at amortized cost. Amortized cost includes the unamortized premium or discount and capitalized origination costs and fees, all of which are amortized to interest income. Loans which are held for investment also have an allowance for loan loss as needed. Any loans the Company has the ability and intent to sell are classified as held for sale and are carried at the lower of cost or fair value. Loans which are held for sale do not have the associated premium or discount and origination costs and fees amortized into interest income and there is also no related allowance for loan losses.

As of September 30, 2010, the Company had $2.1 billion of FFELP loans classified as held for sale.  These loans were funded using the Department’s Participation Program and were sold to the Department during October 2010 under the Purchase Program. Under the Purchase Program, the Department purchased the loans at a price equal to the sum of (i) par value, (ii) accrued interest, (iii) the one percent origination fee paid to the Department, and (iv) a fixed amount of $75 per loan.  Upon selling the $2.1 billion in loans held for sale, the Company recognized a pre-tax gain in the fourth quarter of 2010 of $33.8 million. See note 4 for additional information related to the Department’s Participation and Purchase Programs.
 
 
7

 

Student loans receivable consisted of the following:
 
   
As of September 30, 2010
   
As of December 31, 2009
 
   
Held for investment
   
Held for sale
   
Held for investment
 
Federally insured loans
  $ 24,132,245       2,081,827       23,472,553  
Non-federally insured loans
    126,923             163,321  
      24,259,168       2,081,827       23,635,874  
Unamortized loan premiums/discounts and deferred origination costs, net
    227,206       27,613       341,970  
Allowance for loan losses – federally insured loans
    (32,962 )             (30,102 )  
Allowance for loan losses – non-federally insured loans
    (17,250 )             (20,785 )  
    $ 24,436,162       2,109,440       23,926,957  
Allowance for federally insured loans - held for investment as a percentage of such loans
    0.14 %             0.13 %
Allowance for non-federally insured loans as a percentage of such loans
    13.59 %             12.73 %

The Company has provided for an allowance for loan losses related to its student loan portfolio. Activity in the allowance for loan losses is shown below:
 
   
Three months ended September 30,
   
Nine months ended September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Beginning balance
  $ 50,797       50,000       50,887       50,922  
Provision for loan losses
    5,500       7,500       16,700       23,000  
Loans charged off, net of recoveries
    (6,085 )       (4,380 )       (18,305 )       (13,482 )  
Purchase of loans
                2,930        
Sale of loans
          (3,000 )       (2,000 )       (10,320 )  
Ending balance
  $ 50,212       50,120       50,212       50,120  

As of September 30, 2010, the Company has participated a cumulative amount of $120.5 million of non-federally insured loans to third parties, including $20.0 million, $1.0 million, and $6.0 million during the first, second, and third quarters of 2010, respectively. Loans participated under these agreements have been accounted for by the Company as loan sales. Accordingly, the participation interests sold are not included on the Company’s consolidated balance sheets.  The loss on the sale of these loans for the three and nine months ended September 30, 2010 was not material.  Per the terms of the servicing agreements, the Company’s servicing operations are obligated to repurchase loans subject to the participation interests in the event such loans become 60 or 90 days delinquent.  The activity in the accrual account related to this repurchase obligation, which is included in “other liabilities” in the accompanying consolidated balance sheets, is detailed below.
 
   
Three months ended September 30,
   
Nine months ended September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Beginning balance
  $ 12,600       7,600       10,600        
Transfer from allowance for loan losses
          3,000       2,000       9,800  
Reserve for repurchase of delinquent loans (a)
                      800  
Ending balance
  $ 12,600       10,600       12,600       10,600  
 
(a) The reserve for repurchase of delinquent loans is included in "other" under other operating expenses in the accompanying consolidated statements of operations.
 
Related Party Loan Activity

During 2008 and 2009, the Company sold $611.9 million of FFELP student loans (the “FFELP Loans”) to Union Bank & Trust Company (“Union Bank”), an entity under common control with the Company. These loans were sold pursuant to an affiliate transaction exemption granted by the Federal Reserve Board which allowed Union Bank to purchase FFELP loans from the Company. In connection with the exemption and the loan purchases by Union Bank, an Assurance Commitment Agreement (the “Commitment Agreement”) was also entered into, by and among, the Company, Union Bank, and Michael S. Dunlap, the Company’s Chairman, Chief Executive Officer, and a principal shareholder of the Company. Per the terms of the Commitment Agreement, the Company provided certain assurances to Union Bank designed to mitigate potential losses related to the FFELP Loans, including holding amounts in escrow equal to the unguaranteed portion and reimbursing Union Bank for losses, if any, related to the portfolio.  As part of this agreement, the Company was also obligated to buy back loans once they were 30 days delinquent. During the first quarter 2010, the Company purchased $535.9 million (par value) of federally insured student loans from Union Bank, which represented all outstanding FFELP loans remaining under the provisions of the Commitment Agreement. As a result of this loan purchase, the Company no longer has a commitment to hold amounts in escrow, reimburse Union Bank for losses, and buy back delinquent loans related to this portfolio.
 
 
8

 

During the first nine months of 2010, the Company purchased $2.5 billion of FFELP student loans from third parties, including $989 million (par value) from Union Bank and approximately $900 million from a state agency.  In conjunction with the Company’s purchase of loans from the state agency, Union Bank purchased loans from the state agency under similar terms.

4.     Bonds and Notes Payable

The Company has historically utilized operating cash flow, secured financing transactions (which include warehouse facilities, asset-backed securitizations, and the government’s Participation and Conduit Programs), operating lines of credit, and other borrowing arrangements to fund its Asset Generation and Management operations and student loan acquisitions. In addition, the Company has used operating cash flow, borrowings on its unsecured line of credit, and unsecured debt offerings to fund corporate activities, business acquisitions, and repurchases of common stock.

The following tables summarize the Company’s outstanding debt obligations by type of instrument:

   
As of September 30, 2010
   
Carrying
   
Interest rate
   
   
amount
   
range
 
Final maturity
Variable-rate bonds and notes (a):
             
Bonds and notes based on indices
  $ 20,349,202       0.30% - 6.90%  
5/26/14 - 7/27/48
Bonds and notes based on auction or remarketing
    1,172,335       0.23% - 1.76%  
5/1/11 - 7/1/43
Total variable-rate bonds and notes
    21,521,537            
Commercial paper - FFELP facility (b)
    29,976       0.28% - 0.41%  
7/29/13
Unsecured debt - Junior Subordinated Hybrid Securities
    163,255       7.40%  
9/15/61
Unsecured line of credit
    691,500       0.79%  
5/8/12
Department of Education Participation
    2,049,227       0.91%  
10/15/10
Department of Education Conduit
    2,799,180       0.37%  
5/8/14
Related party debt
    111,675       0.73%  
5/20/11
Other borrowings
    24,838       0.26% - 5.10%  
11/14/10 - 11/1/15
    $ 27,391,188            
 
   
As of December 31, 2009
   
Carrying
   
Interest rate
   
   
amount
   
range
 
Final maturity
Variable-rate bonds and notes (a):
             
Bonds and notes based on indices
  $ 20,187,356       0.26% - 6.90%  
5/26/14 - 4/25/42
Bonds and notes based on auction or remarketing
    1,726,960       0.21% - 3.73%  
5/1/11 - 7/1/43
Total variable-rate bonds and notes
    21,914,316            
Commercial paper - FFELP facility (b)
    305,710       0.21% - 0.32%  
8/3/12
Fixed-rate bonds and notes (a)
    8,940       6.15% - 6.34%  
7/2/20 - 5/1/29
Unsecured debt - Senior Notes
    66,716       5.125%  
6/1/10
Unsecured debt - Junior Subordinated Hybrid Securities
    198,250       7.40%  
9/15/61
Unsecured line of credit
    691,500       0.73%  
5/8/12
Department of Education Participation
    463,912       0.79%  
9/30/10
Department of Education Conduit
    1,125,929       0.27%  
5/8/14
Other borrowings
    30,016       0.24% - 5.10%  
1/1/10 - 11/1/15
    $ 24,805,289            
 
(a)
Issued in asset-backed securitizations
 
(b)
Loan warehouse facility
 
Secured Financing Transactions

The Company has historically relied upon secured financing vehicles as its most significant source of funding for student loans. The net cash flow the Company receives from the securitized student loans generally represents the excess amounts, if any, generated by the underlying student loans over the amounts required to be paid to the bondholders, after deducting servicing fees and any other expenses relating to the securitizations. The Company’s rights to cash flow from securitized student loans are subordinate to bondholder interests and may fail to generate any cash flow beyond what is due to bondholders.
 
 
9

 

The majority of the bonds and notes payable are primarily secured by the student loans receivable, related accrued interest, and by the amounts on deposit in the accounts established under the respective bond resolutions or financing agreements. Certain variable rate bonds and notes are secured by a letter of credit and reimbursement agreement issued by State Street.

Historically, the Company funded loan originations and acquisitions using loan warehouse facilities and asset-backed securitizations. Student loan warehousing allows the Company to buy and manage student loans prior to transferring them into more permanent financing arrangements. In August 2008, the Company began funding FFELP Stafford and PLUS student loan originations for the 2008-2009 and 2009-2010 academic years pursuant to the Department’s Participation Program and a participation agreement with Union Bank. In 2009, the Company began funding loans under the Department’s Conduit Program.

Loan warehouse facility

On July 30, 2010, the Company renewed its FFELP warehouse facility (the “2009/2010 FFELP Warehouse Facility”). The 2009/2010 FFELP Warehouse Facility has a maximum financing amount of $500.0 million, with a revolving financing structure supported by 364-day liquidity provisions, which expire on July 29, 2011. The final maturity date of the facility is July 29, 2013. In the event the Company is unable to renew the liquidity provisions by July 29, 2011, the facility would become a term facility at a stepped-up cost, with no additional student loans being eligible for financing, and the Company would be required to refinance the existing loans in the facility by July 29, 2013.

The 2009/2010 FFELP Warehouse Facility provides for formula based advance rates depending on FFELP loan type, up to a maximum of 85 percent to 98 percent of the principal and interest of loans financed. The advance rates for collateral may increase or decrease based on market conditions, but they are subject to a minimum advance of 75 to 80 percent based on loan type. The facility contains financial covenants relating to levels of the Company’s consolidated net worth, ratio of adjusted EBITDA to corporate debt interest, and unencumbered cash. Any violation of these covenants could result in a requirement for the immediate repayment of any outstanding borrowings under the facility. As of September 30, 2010, $30.0 million was outstanding under the FFELP Warehouse Facility and $470.0 million was available for future use.

Asset-backed securitizations

As part of the Company’s issuance of asset-backed securities in March 2008 and May 2008, due to credit market conditions when these notes were issued, the Company purchased the Class B subordinated notes of $36 million (par value) and $41 million (par value), respectively.  These notes are not included on the Company’s consolidated balance sheet.  If the credit market conditions continue to improve, the Company anticipates selling these notes to third parties.  Upon a sale to third parties, the Company would obtain cash proceeds equal to the market value of the notes on the date of such sale.  Upon sale, these notes would be shown as “bonds and notes payable” on the Company’s consolidated balance sheet.  The Company believes the market value of such notes is currently less than par value.  The difference between the par value and market value would be recognized by the Company as interest expense over the life of the bonds.

On February 17, 2010, March 9, 2010, and August 3, 2010 the Company completed asset-backed securities transactions of $523.3 million, $660.0 million, and $378.3 million, respectively. Notes issued in these transactions carry interest rates based on a spread to LIBOR. The Company used the proceeds from the sale of these notes to purchase principal and interest on student loans, including loans which were previously financed in other asset-backed securitizations and the 2009/2010 FFELP Warehouse Facility.

Department of Education’s Loan Participation and Purchase Commitment Programs

In August 2008, the Department implemented the Purchase Program and the Participation Program pursuant to ECASLA. Under the Participation Program, the Department provided interim short term liquidity to FFELP lenders by purchasing participation interests in pools of FFELP loans. FFELP lenders were charged a rate of commercial paper plus 50 basis points on the principal amount of participation interests outstanding. Loans funded under the Participation Program for the 2009-2010 academic year had to be either refinanced by the lender by September 30, 2010 or sold to the Department pursuant to the Purchase Program on or prior to October 15, 2010. As of September 30, 2010, the Company had $2.0 billion borrowed under the Participation Program.  During October 2010, the Company sold $2.1 billion of FFELP loans funded under the Participation Program to the Department using the Department’s Purchase Program and paid off all advances outstanding ($2.0 billion) under the Participation Program.

Department of Education’s Conduit Program

In May 2009, the Department implemented a program under which it financed eligible FFELP Stafford and PLUS loans in a conduit vehicle established to provide funding for student lenders (the “Conduit Program”).  Loans eligible for the Conduit Program had to be first disbursed on or after October 1, 2003, but not later than June 30, 2009, and fully disbursed before September 30, 2009, and meet certain other requirements. Funding for the Conduit Program is provided by the capital markets at a cost based on market rates, with the Company being advanced 97 percent of the student loan face amount. Excess amounts needed to fund the remaining 3 percent of the student loan balances were contributed by the Company. The Conduit Program expires on May 8, 2014. The Student Loan Short-Term Notes (“Student Loan Notes”) issued by the Conduit Program are supported by a combination of  (i) notes backed by FFELP loans, (ii) a liquidity agreement with the Federal Financing Bank, and (iii) a put agreement provided by the Department.  If the conduit does not have sufficient funds to pay all Student Loan Notes, then those Student Loan Notes will be repaid with funds from the Federal Financing Bank.  The Federal Financing Bank will hold the notes for a short period of time and, if at the end of that time, the Student Loan Notes still cannot be paid off, the underlying FFELP loans that serve as collateral for the Conduit Program will be sold to the Department through a put agreement at a price of 97 percent of the face amount of the loans.  As of September 30, 2010 and December 31, 2009, the Company had $2.8 billion and $1.1 billion, respectively, borrowed under the facility and $95.9 million and $66.8 million, respectively, advanced as equity support in the facility. Beginning July 1, 2010, no additional loans can be funded using the Conduit Program.
 
 
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Unsecured Line of Credit

The Company has a $750.0 million unsecured line of credit that terminates in May 2012.  As of September 30, 2010, there was $691.5 million outstanding on this line.  Upon termination in 2012, there can be no assurance that the Company will be able to maintain this line of credit, find alternative funding, or increase the amount outstanding under the line, if necessary.  The lending commitment under the Company’s unsecured line of credit is provided by a total of thirteen banks, with no individual bank representing more than 11% of the total lending commitment. The bank lending group includes Lehman Brothers Bank (“Lehman”), a subsidiary of Lehman Brothers Holdings Inc., which represents approximately 7% of the lending commitment under the line of credit. In September 2008, Lehman Brothers Holdings Inc. filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code. The Company does not expect that Lehman will fund future borrowing requests. As of September 30, 2010, excluding Lehman’s lending commitment, the Company has $51.2 million available for future use under its unsecured line of credit.

The line of credit agreement contains certain financial covenants that, if not met, lead to an event of default under the agreement.  The covenants include maintaining:

 
·
A minimum consolidated net worth

 
·
A minimum adjusted EBITDA to corporate debt interest (over the last four rolling quarters)

 
·
A limitation on subsidiary indebtedness

 
·
A limitation on the percentage of non-guaranteed loans in the Company’s portfolio

As of September 30, 2010, the Company was in compliance with all of these requirements. Many of these covenants are duplicated in the Company’s other lending facilities, including its FFELP warehouse facility.

The Company’s operating line of credit does not have any covenants related to unsecured debt ratings.  However, changes in the Company’s ratings (as well as the amounts the Company borrows) have modest implications on the pricing level at which the Company obtains funding. A default on the 2009/2010 FFELP Warehouse Facility would result in an event of default on the Company’s unsecured line of credit that would result in the outstanding balance on the line of credit becoming immediately due and payable.

Related Party Transactions

Union Bank Participation Agreement

The Company maintains an agreement with Union Bank, as trustee for various grantor trusts, under which Union Bank has agreed to purchase from the Company participation interests in student loans (the “FFELP Participation Agreement”). The Company has the option to purchase the participation interests from the grantor trusts at the end of a 364-day term upon termination of the participation certificate.  As of September 30, 2010 and December 31, 2009, $360.2 million and $613.3 million, respectively, of loans were subject to outstanding participation interests held by Union Bank, as trustee, under this agreement. The agreement automatically renews annually and is terminable by either party upon five business days notice. This agreement provides beneficiaries of Union Bank’s grantor trusts with access to investments in interests in student loans, while providing liquidity to the Company on a short-term basis.  The Company can participate loans to Union Bank to the extent of availability under the grantor trusts, up to $750 million or an amount in excess of $750 million if mutually agreed to by both parties.  Loans participated under this agreement have been accounted for by the Company as loan sales.  Accordingly, the participation interests sold are not included on the Company’s consolidated balance sheet.

Related Party Debt

The Company has from time to time repurchased certain of its own asset-backed securities (bonds and notes payable). For accounting purposes, these notes have been effectively retired and are not included on the Company’s consolidated balance sheet. However, these securities are legally outstanding at the trust level and the Company could sell these notes to third parties or redeem the notes at par as cash is generated by the trust estate. During the three months ended September 30, 2010, the Company participated $111.7 million of these securities to Union Bank, as trustee for various grantor trusts, and obtained cash proceeds equal to the par value of the notes. The Company has entered into a Guaranteed Purchase Agreement with Union Bank whereby the Company must purchase these notes back from the trust at par upon the request of Union Bank. As of September 30, 2010, these notes are included in “bonds and notes payable” on the Company’s consolidated balance sheet.
 
 
11

 

Debt Repurchases

The Company has repurchased outstanding debt as summarized below. Gains recorded by the Company from the repurchase of debt are included in “gain on sale of loans and debt repurchases, net” on the Company’s consolidated statements of operations.
 
 
Three months ended September 30, 2010
   
Nine months ended September 30, 2010
 
 
Notional amount
   
Purchase price
   
Gain
   
Notional amount
   
Purchase price
   
Gain
 
                                   
Unsecured debt - Junior Subordinated Hybrid Securities
$ 34,995       30,073       4,922       34,995       30,073       4,922  
Asset-backed securities
  85,675       80,712       4,963       477,700       453,801       23,899  
  $ 120,670       110,785       9,885       512,695       483,874       28,821  

 
Three months ended September 30, 2009
   
Nine months ended September 30, 2009
 
 
Notional amount
   
Purchase price
   
Gain
   
Notional amount
   
Purchase price
   
Gain
 
                                   
Unsecured debt - Senior Notes due 2010
$ 137,898       138,505       (607 )     208,284       196,376       11,908  
Unsecured debt - Junior Subordinated Hybrid Securities
                    1,750       350       1,400  
Asset-backed securities
  44,950       39,095       5,855       46,050       40,173       5,877  
  $ 182,848       177,600       5,248       256,084       236,899       19,185  

Subsequent to September 30, 2010, the Company repurchased an additional $107.8 million (notional amount) of asset-backed securities resulting in a gain of approximately $4 million.

5.  Derivative Financial Instruments

The Company is exposed to certain risks relating to its ongoing business operations.  The primary risks managed by using derivative instruments are interest rate risk and foreign currency exchange risk.

Interest Rate Risk

The Company’s primary market risk exposure arises from fluctuations in its borrowing and lending rates, the spread between which could impact the Company due to shifts in market interest rates. Because the Company generates a significant portion of its earnings from its student loan spread, the interest rate sensitivity of the balance sheet is a key profitability driver.  The Company has adopted a policy of periodically reviewing the mismatch related to the interest rate characteristics of its assets and liabilities together with the Company's assessment of current and future market conditions. Based on those factors, the Company uses derivative instruments as part of its overall risk management strategy.

Basis Swaps

The Company funds the majority of its student loan assets with three-month LIBOR indexed floating rate securities. Meanwhile, the interest earned on the Company’s student loan assets is indexed to commercial paper and treasury bill rates. The different interest rate characteristics of the Company’s loan assets and liabilities funding these assets results in basis risk. The Company also faces repricing risk due to the timing of the interest rate resets on its liabilities, which may occur as infrequently as once a quarter, in contrast to the timing of the interest rate resets on its assets, which generally occurs daily. In a declining interest rate environment, this may cause the Company’s student loan spread to compress, while in a rising rate environment, it may cause the spread to increase.  As of September 30, 2010, the Company had $25.2 billion and $1.0 billion of FFELP loans indexed to the three-month financial commercial paper rate and the three-month treasury bill rate, respectively, both of which reset daily, and $20.3 billion of debt indexed to three-month LIBOR, which resets quarterly.

Because of the different index types and different index reset frequencies, the Company is exposed to interest rate risk in the form of basis risk and repricing risk, which, as noted above, is the risk that the different indices may reset at different frequencies, or will not move in the same direction or with the same magnitude. While these indices are all short term in nature with rate movements that are highly correlated over a longer period of time, there have been points in recent history when volatility has been high and correlation has been reduced.
 
 
12

 

The Company has used derivative instruments to hedge both the basis and repricing risk on certain student loans in which the Company earns interest based on a treasury bill rate that resets daily and are funded with debt indexed to primarily three-month LIBOR.  To hedge these loans, the Company has entered into basis swaps in which the Company receives three-month LIBOR set discretely in advance and pays a weekly treasury bill rate plus a spread as defined in the agreement (“T-Bill/LIBOR Basis Swaps”).

However, the Company does not generally hedge the basis risk on those assets indexed to the commercial paper rate that are funded with liabilities in which the Company pays primarily on the LIBOR index, since the derivatives needed to hedge this risk are generally illiquid or non-existent and the relationship between these indices has been highly correlated over a long period of time.

The Company has also used derivative instruments to hedge the repricing risk due to the timing of the interest rate resets on its assets and liabilities.  The Company has entered into basis swaps in which the Company:

 
·
receives three-month LIBOR set discretely in advance and pays a daily weighted average three-month LIBOR less a spread as defined in the agreements (the “Average/Discrete Basis Swaps”)

 
·
receives three-month LIBOR set discretely in advance and pays one-month LIBOR plus or minus a spread as defined in the agreements (the “1/3 Basis Swaps”)

The following table summarizes the Company’s basis swaps outstanding:
 
   
As of September 30, 2010
   
Notional Amounts
 
Maturity
 
1/3 Basis Swaps
   
T-Bill/LIBOR
Basis Swaps
             
2011
  $       225,000
(a)
2021
    250,000        
2023
    1,250,000        
2024
    250,000        
2028
    100,000        
2039
    150,000        
2040
    200,000        
                 
    $ 2,200,000       225,000  
 
   
As of December 31, 2009
   
Notional Amounts
Maturity
 
1/3 Basis Swaps
   
T-Bill/LIBOR
Basis Swaps
             
             
             
2010
  $ 1,000,000        
2011
          225,000
(a)
2013
    500,000        
2014
    500,000        
2018
    1,300,000        
2019
    500,000        
2021
    250,000        
2023
    1,250,000        
2024
    250,000        
2028
    100,000        
2039
    150,000        
                 
    $ 5,800,000       225,000  
   
(a) The effective start dates on these derivatives are in October 2010 ($75 million), November 2010 ($75 million), and December 2010 ($75 million).
 
 
13

 

Interest rate swaps – floor income hedges

FFELP loans originated prior to April 1, 2006 generally earn interest at the higher of a floating rate based on the Special Allowance Payment (or SAP) formula set by the Department and the borrower rate, which is fixed over a period of time. The SAP formula is based on an applicable index plus a fixed spread that is dependent upon when the loan was originated, the loan’s repayment status, and funding sources for the loan. The Company generally finances its student loan portfolio with variable rate debt. In low and/or declining interest rate environments, when the fixed borrower rate is higher than the rate produced by the SAP formula, the Company’s student loans earn at a fixed rate while the interest on the variable rate debt typically continues to decline. In these interest rate environments, the Company may earn additional spread income that it refers to as floor income.

Depending on the type of loan and when it was originated, the borrower rate is either fixed to term or is reset to an annual rate each July 1. As a result, for loans where the borrower rate is fixed to term, the Company may earn floor income for an extended period of time, which the Company refers to as fixed rate floor income, and for those loans where the borrower rate is reset annually on July 1, the Company may earn floor income to the next reset date, which the Company refers to as variable rate floor income. In accordance with legislation enacted in 2006, lenders are required to rebate fixed rate floor income and variable rate floor income to the Department for all FFELP loans first originated on or after April 1, 2006.

Absent the use of derivative instruments, a rise in interest rates may reduce the amount of floor income received and this may have an impact on earnings due to interest margin compression caused by increasing financing costs, until such time as the federally insured loans earn interest at a variable rate in accordance with their special allowance payment formulas. In higher interest rate environments, where the interest rate rises above the borrower rate and fixed rate loans effectively become variable rate loans, the impact of the rate fluctuations is reduced.

As of September 30, 2010 and December 31, 2009, the Company had $8.6 billion and $10.3 billion, respectively, of student loan assets that were earning fixed rate floor income. The following tables summarize the outstanding derivative investments used by the Company to economically hedge these loans.
 
   
As of September 30, 2010
         
Weighted
         
average fixed
   
Notional
   
rate paid by
Maturity
 
Amount
   
the Company (a)
             
2010
  $ 3,750,000       0.48 %
2011
    5,750,000       0.54  
2012
    950,000       1.08  
2013
    650,000       1.07  
2015
    100,000       2.26  
2020
    100,000       3.23  
                 
    $ 11,300,000       0.64 %
 
   
As of December 31, 2009
         
Weighted
 
         
average fixed
 
   
Notional
   
rate paid by
 
Maturity
 
Amount
   
the Company (a)
             
2010
  $ 4,750,000       0.54 %
2011
    150,000       1.03  
                 
    $ 4,900,000       0.55 %
                 
(a) For all interest rate derivatives, the Company receives discrete three-month LIBOR.
 
Subsequent to September 30, 2010, the Company entered into additional derivatives to hedge loans earning fixed rate floor income. The following table summarizes these derivatives.

         
Weighted
 
         
average fixed
 
   
Notional
   
rate paid by
 
Maturity
 
Amount
   
the Company (a)
             
2012
  $ 3,000,000       0.54 %
                 
(a) For all interest rate derivatives, the Company receives discrete three-month LIBOR.
 
 
14

 
 
Interest rate swaps – unsecured debt hedges

On September 27, 2006, the Company issued $200.0 million aggregate principal amount of Junior Subordinated Hybrid Securities (“Hybrid Securities”). The interest rate on the Hybrid Securities from the date they were issued through September 28, 2011 is 7.40%, payable semi-annually. Beginning September 29, 2011 through September 29, 2036, the interest rate on the Hybrid Securities will be equal to three-month LIBOR plus 3.375%, payable quarterly. The Company has entered into the following derivatives to effectively convert the future variable interest rate on a portion of the Hybrid Securities to a fixed rate.
 
         
Weighted
 
         
average fixed
 
Derivatives
 
Notional
   
rate paid by
 
outstanding as of:
 
Amount (a)
   
the Company (b)
             
September 30, 2010
  $ 100,000       4.27 %
                 
December 31, 2009
  $ 25,000       4.24 %
                 
(a)  The effective start date on $75 million (notional amount) of the derivatives outstanding as of September 30, 2010 is March 2012.  The maturity on $75 million (notional amount) of the derivatives outstanding as of September 30, 2010 is September 29, 2036. $25 million (notional amount) of the derivatives outstanding as of September 30, 2010 are cancelable on September 29, 2011 at the Company’s discretion.
     
(b)   For all interest rate derivatives, the Company receives discrete three-month LIBOR.

Foreign Currency Exchange Risk

During 2006, the Company completed separate debt offerings of student loan asset-backed securities that included €420.5 million and €352.7 million Euro Notes with interest rates based on a spread to the EURIBOR index. As a result of this transaction, the Company is exposed to market risk related to fluctuations in foreign currency exchange rates between the U.S. dollar and Euro. The principal and accrued interest on these notes is re-measured at each reporting period and recorded on the Company’s balance sheet in U.S. dollars based on the foreign currency exchange rate on that date. Changes in the principal and accrued interest amounts as a result of foreign currency exchange rate fluctuations are included in the “derivative market value and foreign currency adjustments and derivative settlements, net” in the Company’s consolidated statements of operations.

The Company entered into cross-currency interest rate swaps in connection with the issuance of the Euro Notes. Under the terms of these derivative instrument agreements, the Company receives from a counterparty a spread to the EURIBOR index based on notional amounts of €420.5 million and €352.7 million and pays a spread to the LIBOR index based on notional amounts of $500.0 million and $450.0 million, respectively. In addition, under the terms of these agreements, all principal payments on the Euro Notes will effectively be paid at the exchange rate in effect as of the issuance of the notes.

The following table shows the income statement impact as a result of the re-measurement of the Euro Notes and the change in the fair value of the related derivative instruments. These items are included in “derivative market value and foreign currency adjustments and derivative settlements, net” on the accompanying consolidated statements of operations.
 
   
Three months ended September 30,
   
Nine months ended September 30,
 
   
2010
   
2009
   
2010
   
2009
 
                         
Re-measurement of Euro Notes   $ (106,468 )     (39,356 )       58,608       (55,979 )  
Change in fair value of cross currency interest rate swaps     107,531       44,773       (52,491 )       28,871  
   Total impact to statements of operations - income (expense)
  $ 1,063       5,417       6,117       (27,108 )  

The re-measurement of the Euro-denominated bonds generally correlates with the change in fair value of the cross-currency interest rate swaps. However, the Company will experience unrealized gains or losses related to the cross-currency interest rate swaps if the two underlying indices (and related forward curve) do not move in parallel. Management intends to hold the cross-currency interest rate swaps through the maturity of the Euro-denominated bonds.

Accounting for Derivative Financial Instruments

The Company records derivative instruments on the consolidated balance sheet as either an asset or liability measured at its fair value. Management has structured the majority of the Company’s derivative transactions with the intent that each is economically effective; however, the Company’s derivative instruments do not qualify for hedge accounting.  As a result, the change in fair value of the Company’s derivatives at each reporting date are included in “derivative market value and foreign currency adjustments and derivative settlements, net” in the Company’s consolidated statements of operations. Changes or shifts in the forward yield curve and fluctuations in currency rates can significantly impact the valuation of the Company’s derivatives. Accordingly, changes or shifts to the forward yield curve and fluctuations in currency rates will impact the financial position and results of operations of the Company.
 
 
15

 

Any proceeds received or payments made by the Company to terminate a derivative in advance of its expiration date, or to amend the terms of an existing derivative, are included in “derivative market value and foreign currency adjustments and derivative settlements, net” on the consolidated statements of operations and are accounted for as a change in fair value on such derivative. During the nine month periods ended September 30, 2010 and 2009, the Company terminated and/or amended certain derivatives for net proceeds of $14.4 million and net payments of $7.9 million, respectively.

The following table summarizes the fair value of the Company’s derivatives not designated as hedging:
 
   
Fair value of asset derivatives
   
Fair value of liability derivatives
 
   
As of September 30, 2010
   
As of December 31, 2009
   
As of September 30, 2010
   
As of December 31, 2009
 
                         
Average/discrete basis swaps
  $                    
1/3 basis swaps
    11,453       17,768       129        
T-Bill/LIBOR basis swaps
                86       259  
Interest Rate swaps - floor income hedges
    47       4,497       32,063       2,230  
Interest Rate swaps - hybrid debt hedges
          1,817       10,390        
Cross-currency interest rate swaps
    117,327       169,817              
Other
                3,694        
                                 
Total
  $ 128,827       193,899       46,362       2,489  
 
The following table summarizes the effect of derivative instruments in the consolidated statements of operations. All gains and losses recognized in income related to the Company’s derivative activity are included in “derivative market value and foreign currency adjustments and derivative settlements, net”, on the consolidated statements of operations.
 
   
Amount of gain (or loss) recognized
   
Amount of gain (or loss) recognized
 
Derivatives not designated as hedging
 
in income on derivatives
   
in income on derivatives
 
   
Three months ended September 30,
   
Nine months ended September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Settlements:
                       
Average/discrete basis swaps
  $       646              11,707   
1/3 basis swaps
    893        3,071        974        20,473   
T-Bill/LIBOR basis swaps
                       
Interest rate swaps - floor income hedges
    (4,040 )       (436 )       (12,183 )       (447 )  
Interest rate swaps - hybrid debt hedges
    (242 )             (242 )        
Cross-currency interest rate swaps
    1,025        1,633        3,243        7,074   
Other
    (222 )