UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2003
Or
|_| TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to .
COMMISSION FILE NUMBER 001-31924
NELNET, INC.
(Exact name of Registrant as specified in its charter)
NEBRASKA 84-0748903
(State of Incorporation) (I.R.S. Employer Identification No.)
121 SOUTH 13TH STREET, SUITE 201 68508
LINCOLN, NEBRASKA (Zip Code)
(Address of Principal Executive Offices)
Registrant's telephone number, including area code: (402) 458-2370
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
TITLE OF EACH CLASS
Class A Common Stock, Par Value $0.01 per Share
NAME OF EACH EXCHANGE ON WHICH REGISTERED:
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 [X] No [ ]
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. [ ]
Indicate by check mark whether the Registrant is an accelerated filer.
Yes [ ] No [X]
The aggregate market value of the Registrant's voting common stock held by
non-affiliates of the Registrant (assuming for the purposes of this calculation
only, that the Registrant's directors, executive officers and greater than 10%
shareholders are affiliates of the Registrant), based upon the closing sale
price of the Registrant's common stock on February 13, 2004 was $418,219,512.
As of February 13, 2004, there were 39,601,834 and 14,023,454 shares of
Class A Common Stock and Class B Common Stock, par value $0.01 per share,
outstanding respectively.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement to be filed for its
2004 Annual Meeting of Stockholders scheduled to be held May 27, 2004 are
incorporated by reference into Part III of this Form 10-K.
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 "FFEL Program") 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 us. We
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. References to "we," "us," "our" and "the Company" refer to
Nelnet, Inc. and its subsidiaries.
PART I.
ITEM 1. BUSINESS
Overview
We are a vertically integrated education finance company, with over $11.9
billion in total assets as of December 31, 2003, making us one of the leading
education finance companies in the country. We are focused on providing quality
products and services to participants in the education finance process.
Headquartered in Lincoln, Nebraska, we originate, hold and service student
loans, principally loans originated under the FFEL Program. We, together with
our branding partners, originated and acquired approximately $4.3 billion of
student loans in 2003, which includes $1.2 billion of existing loans we
consolidated from our own loan portfolio, making us a leading originator and
acquirer of student loans. A detailed description of the FFEL Program appears in
Appendix A to this annual report on Form 10-K (the "Report").
We offer a broad range of financial services and technology-based products,
including student loan origination and lending, student loan and guarantee
servicing and a suite of software solutions. Our products are designed to
simplify the student loan process by automating financial aid delivery, loan
processing and funds disbursement. Our infrastructure, technological expertise
and breadth of product and service offerings connect the key constituents of the
student loan process, including lenders, financial aid officers, guaranty
agencies, governmental agencies, student and parent borrowers, servicers and the
capital markets, thereby streamlining the education finance process.
Our business is comprised of four primary product and service offerings:
o Asset management, including student loan originations and
acquisitions. We provide student loan sales, marketing, originations,
acquisition and portfolio management. We own a large portfolio of
student loan assets through a series of education lending
subsidiaries. As of December 31, 2003, our student loan portfolio was
$10.3 billion, consisting of over 99% of FFELP loans and less than 1%
of private loans. We generate loans owned in special purpose lending
facilities through direct origination or through acquisition of loans.
We generate the majority of our earnings from the spread between the
yield we earn on our student loan portfolio and the cost of funding
these loans. We also provide marketing and sales support and
managerial and administrative support related to our asset generation
activities, as well as those performed for our branding partners or
other lenders who sell such loans.
o Student loan servicing. We service our student loan portfolio and the
portfolios of third parties. As of December 31, 2003, we serviced or
provided complete outsourcing of servicing activities for more than
$18.7 billion in student loans, including $9.2 billion of loans in our
own portfolio. The servicing activities include loan origination
activities, application processing, borrower updates, payment
processing, claim processing and due diligence procedures. These
activities are performed internally for our own portfolio and generate
fee revenue when performed for third-party clients.
o Guarantee servicing. We provide servicing support to guaranty
agencies, which includes system software, hardware and
telecommunication support, borrower and loan updates, default aversion
tracking services, claim processing services and post-default
collection services. As of December 31, 2003, we provided servicing
support to agencies that guarantee more than $20 billion of FFELP
loans. These activities generate fee revenue in addition to expanding
our relationship with other participants in the education finance
sector.
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o Servicing software. We provide student loan servicing software
internally and to third-party student loan holders and servicers. As
of December 31, 2003, our software was used to service $46 billion in
student loans, which included $27 billion serviced by third parties
using our software. We earn software license and maintenance fees
annually from third-party clients for use of this software. We also
provide computer consulting, custom software applications and customer
service support.
In accordance with accounting principles generally accepted in the United
States, our asset management and student loan servicing offerings constitute
reportable operating segments. Our guarantee servicing and servicing software
offerings are operating segments that do not meet the quantitative thresholds,
and, therefore, are included as other segments that do not meet the reportable
segment criteria. In 2003, our asset management, student loan servicing and
other segments generated 61.8%, 27.3% and 10.9%, respectively, of our total
segment revenues (excluding intersegment revenue) and 72.7%, 23.3% and 4.0%,
respectively, of our segment net income. For additional information, see note 18
of the notes to the consolidated financial statements.
Our earnings and earnings growth are directly affected by the size of our
portfolio of student loans, the interest rate characteristics of our portfolio,
the costs associated with financing and managing our portfolio and the costs
associated with origination and acquisition of the student loans in the
portfolio. We generate the majority of our earnings from the spread between the
yield we receive on our student loan portfolio and the cost of funding these
loans. While the spread may vary due to fluctuations in interest rates, special
allowance payments from the federal government ensure that we receive a minimum
yield on our student loans, so long as certain requirements are met. We also
earn fees from student loan and guarantee servicing and licensing fees from our
servicing software. Earnings growth is primarily driven by the growth in the
student loan portfolio and growth in our fee-based product and service
offerings, coupled with cost-effective financing and expense management. In
2003, we generated net interest income of $178.6 million, total other income,
including loan servicing income, of $117.5 million and net income of $27.1
million. Our earnings in 2003 included $12.8 million of variable-rate floor
income and a mark-to-market loss on derivative instruments of $1.2 million. Our
operating expenses in 2003 included $12.8 million of amortization of intangible
assets resulting from acquisitions prior to 2003, of which $6.7 million is not
deductible for federal income tax purposes.
As of December 31, 2003, over 99% of the student loans in our portfolio were
FFELP loans, as opposed to the less than 1% of private loans in our portfolio
that did not carry federal guarantees. At least 98% of the principal and accrued
interest of FFELP loans is guaranteed by the federal government, provided that
we meet certain procedures and standards specified in the Higher Education Act.
We believe we are in material compliance with the procedures and standards as
required in the Higher Education Act. FFELP loans originated prior to October 1,
1993 carry a 100% guarantee on the principal amount and accrued interest, and
FFELP loans originated after that date are guaranteed for 98% of the principal
amount and accrued interest. As a result, holders of FFELP loan portfolios
historically have experienced minimal losses net of the guarantee. Our net loan
losses on FFELP loans in 2003 were approximately $3.5 million, or less than
0.04% of our average FFELP loan portfolio.
Our History
We have a 26-year history dating back to the formation of UNIPAC Service
Corporation in 1978. UNIPAC was formed to service loans for Union Bank & Trust
Company, or Union Bank, of Lincoln, Nebraska and Packers Service Corporation of
Omaha, Nebraska. It grew its third-party student loan servicing business to
approximately $9.7 billion in loans in 2000, when it was merged with Nelnet. Our
immediate predecessor was formed in 1996 as a student loan acquisition company,
and, prior to the merger, it had built its student loan portfolio through a
series of spot portfolio acquisitions and later through student loan company
acquisitions.
In 2000, we decided to create a vertically integrated platform that would be
able to compete in each sector of the student loan industry. Over the past four
years we have acquired several education finance services companies, including a
student loan secondary market company. In addition, in August 2003, we acquired
a securities company that provides us with broker-dealer services in connection
with our asset-backed securitizations and in January 2004, we acquired a 50%
ownership interest in a collection firm specializing in past due debts for
higher education companies.
We executed these acquisitions to complete our effort to vertically
integrate and add geographic diversity and operational expertise to our
education finance platform. Historically, we have successfully integrated these
companies into the Nelnet platform, and they have increased our profitability as
a result. We now believe that we have all of the key components of our vertical
integration strategy. Going forward, we intend to focus principally on organic
growth while opportunistically making company and student loan portfolio
acquisitions.
Product and Service Offerings
Asset management, including student loan originations and acquisitions
Our asset management business, including student loan originations and
acquisitions, is our largest product and service offering and drives the
majority of our earnings. When we originate FFELP loans on our own behalf or
when we acquire FFELP loans from others,
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we engage one or more "eligible lenders," as defined in the Higher Education
Act, to act as our trustees to hold title to all such originated and acquired
FFELP loans. These eligible lender trustees hold the legal title to our FFELP
loans, and we hold 100% of the beneficial interests in those loans. We
originated and acquired $4.3 billion in student loans in 2003, which includes
$1.2 billion of existing loans we consolidated from our own loan portfolio. We
often originate loans using the Nelnet brand name but, in many cases, we use
well-known, geographically strategic brand names of our branding partners, such
as SunTrust Bank, Education Solutions, Inc. and Union Bank. This strategy gives
us the flexibility to market the brand with the best recognition in a given
region or at a given college or university. We originate and acquire loans
through our direct channel, branding partner channel, forward flow channel and
through spot purchases.
Through our direct channel, we originate student loans in one of our brand
names directly to students and parent borrowers. Of the $4.3 billion of student
loans we originated and acquired in 2003, $2.3 billion were loans consolidated
through our direct channel, $1.2 billion of which were existing loans we
consolidated from our own loan portfolio. We originated, including loans
originated through consolidation, 58.9% of the loans added to our student loan
portfolio in 2003. Excluding loans we consolidated from our own loan portfolio,
we originated 43.4% of the loans added to our student loan portfolio in 2003.
Student loans that we originate through our direct channel are our most
profitable student loans because they typically cost us less than loans acquired
through our other channels and they remain in our portfolio for a longer period
of time. Once a student's loans have entered the grace or repayment period, they
are eligible to be consolidated if they meet certain requirements. Loan
consolidation allows borrowers to make one payment per month and extend the loan
repayment period. In addition to these attributes, in recent years, historically
low interest rates have contributed to demand for consolidation loans. To meet
this demand, we have developed an extensive loan consolidation department to
serve borrowers with loans in our portfolio as well as borrowers whose loans are
held by other lenders.
Through our branding partner channel, we acquire student loans from lenders
to whom we provide marketing and origination services established through our
various contracts with FFELP lenders. In 2003, 19.0% of our loan acquisitions
were attributable to this channel. Excluding loans we consolidated from our own
loan portfolio, 26.2% of our loan acquisitions were attributable to this channel
in 2003. We frequently act as exclusive marketing agent for some branding
partners in specified geographic areas. We ordinarily purchase loans originated
by those branding partners pursuant to a commitment to purchase loans at a
premium above par, shortly following full disbursement of the loans. We
ordinarily retain rights to acquire loans subsequently made to the same
borrowers, or serial loans. Some branding partners, however, retain rights to
portions of their loan originations. Origination and servicing of loans made by
branding partners is performed by us during the lives of loan origination and
servicing agreements so that loans do not need to be changed to a different
servicer upon purchase by us. The marketing agreements and commitments to
purchase loans are ordinarily for the same term, which are commonly three to
five years in duration. These agreements ordinarily contain provisions for
automatic renewal for successive terms, subject to termination by notice at the
end of a term or early termination for breach. We are generally obligated to
purchase all of the loans originated by our branding partners under these
commitments, although our branding partners are not obligated to provide us with
a minimum amount of loans.
In addition to the branding partner channel, we have established a forward
flow channel for acquiring FFELP loans from lenders to whom we provide
origination services, but provide no marketing services, or who agree to sell
loans to us under forward sale commitments. In 2003, 14.2% of our loan
acquisitions were attributable to this channel. Excluding loans we consolidated
from our own loan portfolio, 19.5% of our loan acquisitions were attributable to
this channel in 2003. These forward flow commitments frequently obligate the
lender to sell all loans made by the applicable lender, but in other instances
are limited to sales of loans originated in certain specific geographic regions
or exclude loans that are otherwise committed for sale to third parties. We are
generally obligated to purchase loans subject to forward flow commitments
shortly following full disbursement, although our forward flow lenders are not
obligated to provide us with a minimum amount of loans. We typically retain
rights to purchase serial loans. The loans subject to purchase are generally
subject to a servicing agreement with us for the life of each such loan. Such
forward flow commitments ordinarily are for terms of three to five years in
duration.
In addition, we acquire student loans through spot purchases, which
accounted for 7.9% of the student loans that we originated and acquired in 2003.
Excluding loans we consolidated from our own loan portfolio, 10.9% of our loan
acquisitions were attributable to this channel in 2003.
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As of December 31, 2003, the characteristics of our student loan portfolio,
exclusive of the unamortized cost of acquisition, were as described below.
Composition of Student Loan Portfolio
(As of December 31, 2003)
(loan balances in thousands)
Loans outstanding ............................................ $10,314,874
FFELP loans:
Stafford loans .......................................... $4,901,289
PLUS/SLS loans (a) ...................................... $249,217
Consolidation loans ..................................... $5,073,081
Private loans ................................................ $91,287
Number of borrowers .......................................... 800,520
Average outstanding principal balance per borrower ........... $12,885
Number of loans .............................................. 2,125,027
Average outstanding principal balance per loan ............... $4,854
Weighted average annual interest rate ........................ 4.50%
Weighted average remaining term (months) ..................... 180
- -------
(a) Supplemental Loans for Students, or SLS, are the predecessor to
unsubsidized Stafford loans.
Our capital markets and portfolio administration departments provide
financing options to fund our loan portfolio. As of December 31, 2003, we had a
warehousing capacity of $2.8 billion through 364-day commercial paper conduits.
These transactions provide short-term asset financing for the purchase of
student loan portfolios. The financings are constructed to offer short-term
capital and are annually renewable.
Short-term warehousing allows us to buy and manage student loans prior to
transferring them into more permanent financing arrangements. Our large
warehousing capacity allows us to pool student loans in order to maximize loan
portfolio characteristics for efficient financing and to properly time market
conditions. Generally, loans that best fit long-term financing vehicles are
selected to be transferred into one of our long-term securitizations. We hold
loans in short-term warehousing for a period of time ranging from approximately
one month to as many as 18 months, at which point these loans are transferred
into one of our long-term securitizations. Because transferring those loans to a
long-term securitization includes certain fixed administrative costs, we
maximize our economies of scale by executing large transactions that routinely
price in line with our largest competitor. We are a frequent issuer of
asset-backed securities and benefit from a high level of name recognition by the
asset-backed investment community.
We had approximately $9.3 billion in asset-backed securities issued and
outstanding as of December 31, 2003, including auction-rate notes whose interest
rates are reset periodically. These asset-backed securities allow us to finance
student loan assets over multiple years, thereby reducing the renewal risk
associated with warehouse vehicles.
We rely upon securitization vehicles as our most significant source of
funding for student loans on a long-term basis. The net cash flow we receive
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. In addition, some of the residual interests in
these securitizations may have been pledged to secure additional bond
obligations. Our 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 pay bondholders.
Our original securitization transactions began in 1996, utilizing a master
trust structure, and were privately placed auction-rate note securitizations. As
the size and volume of our securitizations increased, we began publicly offering
asset-backed securities under shelf registration statements, using special
purpose entities. When we deemed long-term interest rates attractive, we issued
fixed-rate debt backed by cash flows from FFELP loans with fixed-rate floors,
which effectively match the funding of our assets and liabilities. In 2002, we
began accessing the term asset-backed securities market by issuing amortizing
multi-tranche LIBOR-indexed variable-rate debt securities. We have utilized
financial guarantees from monoline insurers and senior/subordinate structures to
assist in obtaining "AAA" ratings on our senior securitized debt in addition to
cash reserves and excess spread to assist in obtaining "A" and "AA" ratings on
our subordinated debt. We intend to continue to issue auction rate notes,
variable-rate and fixed-rate term asset-backed securities and debt securities
through other asset funding vehicles in order to minimize our cost of funds and
give us the most flexibility to optimize the return on our student loan assets.
We acquired UFS Securities LLC, or UFS Securities, in August 2003 in order
to enhance our access to broker-dealer services related to our debt securities
offerings. UFS Securities fits into our overall business strategy by effectively
decreasing our costs associated with accessing the asset-backed securitization
market. UFS Securities sells certain tranches of our auction rate securities in
co-broker-dealer arrangements with certain third-party broker-dealers. Since UFS
Securities has become our wholly owned subsidiary, the fees that it receives in
conjunction with sales of our securities reduce our overall costs of issuance
with respect to our auction rate securities. We intend to continue other
business activities of UFS Securities, including providing consulting services
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to financial institutions and broker-dealers, serving as a distributor of
accounts with the College Savings Plan of Nebraska and acting as an underwriter
for mutual funds. The business activities of UFS Securities do not constitute a
material part of our business.
Student Loan Servicing
We specialize in the servicing of FFELP and private student loans. Our
servicing division offers lenders across the country a complete line of
education loan services, including recovery of non-guaranteed loans, application
processing, disbursement of funds, customer service, account maintenance,
federal reporting and billing collections, payment processing, default aversion
and claim filing. Our student loan and guarantee servicing divisions each uses a
proprietary system to manage the servicing process. These systems provide for
automated compliance with most Higher Education Act regulations.
Our quality and experience in student loan servicing is evident in the
historical performance of our entire pool of loan assets, which enjoys a very
low initial claim rejection rate due to servicer error, which is the percent of
claims submitted by us or our servicing customers rejected by a guaranty agency
due to servicer error. In 2003, the initial claim rejection rate due to servicer
error was approximately 0.33% of all claims filed by us or our servicing
customers. The substantial majority of these initial claim rejections are cured,
meaning a payment or the borrower's promise to pay has been received. In 2003,
the aggregate of our losses and those of our servicing customers from rejected
loans and interest denials were less than $500,000, or less than 0.01% of our
average servicing portfolio.
As we expand our student loan origination and acquisition activities, we may
face increased competition with some of our servicing customers. In the past,
including in one case recently, servicing customers have terminated their
servicing relationships with us, and we could in the future lose more servicing
customers as a result. However, due to our life-of-loan servicing agreements, we
do not expect this loss and potential loss of customers to have a material
adverse effect on our results of operations for the foreseeable future.
Guarantee Servicing
We provide servicing support for guaranty agencies, which are the
organizations that serve as the intermediary between the federal government and
the lender of FFELP loans and who are responsible for paying the claims made on
defaulted loans. One of our guarantee servicing customers notified us of its
intention not to renew its servicing contract. The loss of this customer is not
expected to have a material effect on our results of operations.
Servicing Software
Our servicing software is focused on providing technology solutions to
education finance issues. Our subsidiaries, Idaho Financial Associates, Inc. and
Charter Account Systems, Inc. provide student loan software and support for
entities involved in the asset management aspects of the student loan arena. In
addition, 5280 Solutions, Inc., of which we own a 50% voting interest, provides
customized software solutions to help in the administration and management of
the student loan process.
Software Products
Our software products are designed to provide us loan origination access to
colleges and universities, while simplifying the financial aid process. We also
license our servicing software products to third-party student loan holders and
servicers. Our software products include the following:
o Nteract -- an Internet-based, open-architecture student loan
origination and disbursement management system. Nteract provides a
complete solution for processing FFELP and private student loan
certifications, initiating change transactions, and can serve as a
comprehensive loan delivery system. Nteract operates in a real-time
environment and can be accessed for online inquiry at any time 24
hours a day, seven days a week. Nteract is used with our student loan
origination, acquisition and portfolio management offering and our
student loan servicing product offering.
o Ntrust -- a centralized disbursement service. Ntrust is a
comprehensive, open-architecture solution for receiving FFELP and
private student loan funds, reports and the student loan industry's
standardized data files. Ntrust provides a single point of contact for
the college or university's entire electronic loan processing needs
and provides real-time loan disbursement adjustment processing. Ntrust
is used by our student loan origination, acquisition and portfolio
management offering and our student loan servicing product offering.
o Ngenius -- the origination engine that supports the Ntrust and Nteract
products. Used for loan origination initiatives, Ngenius is a
table-driven origination platform which provides flexibility and
scalability. The system interacts with multiple guaranty agencies and
can support an instant guarantee. Ngenius is used by our student loan
origination, acquisition and portfolio
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management offering and our student loan servicing product offering.
o Nservice -- our servicing engine for FFELP and private loans. The
Nservice system is a profile driven system, allowing for easy
implementation of most regulatory changes and rapid development of
custom loan programs. Software development is aided by the use of
high-level application development tools to speed delivery of
enhancements. The Nservice system provides for automated compliance
with most Higher Education Act regulations. Nservice also facilitates
the servicing of FFELP and private loans into a single, integrated
servicing environment, improving service to schools, borrowers and
lenders. Nservice is used by our student loan servicing product
offering, and the software is also licensed to third-party student
loan holders and servicers by our servicing software product offering.
In addition to the products described above, we offer a variety of borrower
services to assist students and parents in navigating the financial aid process.
These services include our unique @theU higher education resource, which
provides free information on college planning and financial aid, paired with a
loyalty program to allow members to earn credit toward reducing the balance of a
student loan regardless of lender or servicer. Another product, Nelnet Notes,
provides online assistance to help borrowers better understand the financial aid
process, as well as broader money management issues.
Our software products, including Web site content and functionality, have
been primarily developed and maintained using internal business and technical
resources. External software consultants are utilized on selected occasions when
circumstances require specific technical knowledge or experience. We capitalize
software costs under the provisions of Statement of Position 98-1, Accounting
for the Costs of Computer Software Developed or Obtained for Internal Use.
Material software developments or enhancements that are considered to have
useful lives of greater than one year are capitalized and amortized over their
useful lives. In addition, purchased software is capitalized and amortized over
the estimated useful life. Costs related to maintaining our existing software
including the costs of programming are expensed as incurred.
Costs associated with research and development related to the development of
computer software to be sold are expensed when incurred in accordance with
Statement of Financial Accounting Standards ("SFAS") No. 86, Accounting for the
Cost of Computer Software to be Sold, Leased or Otherwise Marketed.
Interest Rate Risk Management
Since we generate the majority of our earnings from the spread between the
yield we receive on our portfolio of student loans and the cost of financing
these loans, the interest rate sensitivity of our balance sheet could have a
material effect on our operations. Although the majority of our student loans
have variable-rate characteristics in interest rate environments when the
special allowance payment formula exceeds the borrower rate, some of our student
loans, primarily consolidation loans, have fixed-rate characteristics to them.
We attempt to match the interest rate characteristics of pools of loan
assets with debt instruments of substantially similar characteristics,
particularly in rising interest rate markets. Due to the variability in duration
of our assets and varying market conditions, we do not attempt to perfectly
match the interest rate characteristics of the entire loan portfolio with the
underlying debt instruments. To date, we have financed the majority of our
student loan portfolio with variable-rate debt.
In the current low interest rate environment, our FFELP loan portfolio is
yielding excess income due to the reduction in the interest rates on the
variable-rate liabilities financing student loans at a fixed borrower rate. In
higher interest rate environments, where the interest rate rises above the
borrower rate and fixed-rate loans become variable, the impact of the rate
fluctuations is substantially reduced. We have employed various derivative
instruments to help manage our interest rate risk. We periodically review
mismatched interest rate characteristics of our portfolios of student loans and
those of our underlying debt instruments in order to evaluate utilization of
interest rate swaps and other derivative instruments as part of our overall risk
management strategy. As a result of our interest rate management activities, we
believe we have reduced the volatility and effects of a rising interest rate
environment. For further information, see "Management's Discussion and Analysis
of Financial Condition and Results of Operations -- Risks -- Market and Interest
Rate Risk."
Intellectual Property
We own numerous trademarks and service marks to identify our various
products and services, both by words and logos, or by "design" marks. We have 12
pending and 15 registered marks for such products and services, and we actively
assert our rights to those marks when we believe potential infringement may be
occurring. We believe our marks and logos have developed and continue to develop
strong brand-name recognition in our industry and the consumer marketplace. Each
of these marks has, upon registration, an indefinite duration so long as we
continue to use the mark on or in connection with such goods or services as the
mark identifies. In order to protect the indefinite duration, we make filings to
continue registration of these marks. We own one patent application that has
been published with respect to a customer-loyalty program and have also actively
asserted our rights thereunder in situations
7
where we believe our claims may be infringed upon. If such patent is granted, it
will have a duration and effect of 20 years from the date of application. We own
many copyright-protected works, including our various computer system codes and
displays, Web sites, publications and marketing collateral. We also have trade
secret rights to many of our processes and strategies, and our software product
designs. Our software products are protected by both registered and common law
copyrights. We also protect our software products through strict confidentiality
and ownership provisions placed in license agreements which restrict the ability
to copy, distribute or disclose the software products. We also have adopted
internal procedures designed to preserve trade secrets with respect to our
intellectual property.
We seek federal and/or state protection of intellectual property when deemed
appropriate, including patent, trademark/service mark and copyright. The
decision whether to seek such protection may depend on the perceived value of
the intellectual property, the likelihood of securing protection, the cost of
securing and maintaining that protection and the potential for infringement. Our
employees are trained in the fundamentals of intellectual property, intellectual
property protection and infringement issues, and are also required to sign
agreements requiring, among other things, confidentiality of trade secrets,
assignment of inventions and non-solicitation of other employees
post-termination. Consultants, suppliers and other business partners are also
required to sign nondisclosure agreements to protect our proprietary rights.
Seasonality
Origination of student loans is generally subject to seasonal trends, which
correspond to the beginning of each semester of the school year. Stafford and
PLUS loans are disbursed as directed by the school and are usually divided into
two or three equal disbursements released at specified times during the school
year. The two periods of August through October and December through February
account for 73% of our total annual Stafford and PLUS disbursements. While
applications and disbursements are seasonal, our earnings are generally not tied
to this cycle. Due to our portfolio size and the volume of our acquisitions
through our branding and forward flow channels, new disbursements or run-off for
any given month will not materially change the net interest earnings of the
portfolio. Historically, consolidation loans have primarily been made prior to
or immediately after the July 1 reset in a rising or falling interest rate
environment. This trend in the disbursement of consolidation loan disbursements
has not occurred in the second half of 2003 and first quarter of 2004, as low
interest rate environments and continued solicitation activities have resulted
in a continued increase in our consolidation disbursements.
Customers
As of December 31, 2003, we provided student loan servicing either directly
or through our proprietary software to more than 1.7 million borrowers. We have
direct and indirect relationships with hundreds of colleges and universities
across the nation. As of December 31, 2003, we had servicing agreements with
approximately 280 customers and software license agreements with more than 30
licensees. Notwithstanding the depth of our customer base, our business is
subject to some vulnerability arising from concentrations of loan origination
volume with borrowers attending certain schools, loan origination volume
generated by certain branding partners, loan and guarantee servicing volume
generated by certain loan servicing customers and guaranty agencies, and
software licensing volume generated by certain licensees. Our ability to
maintain strong relationships with significant schools, branding partners,
servicing customers, guaranty agencies and software licensees is subject to a
variety of risks. Termination of such a strong relationship could result in a
material adverse effect on our business. We cannot assure that our forward flow
channel lenders or our branding partners will continue their relationships with
us. Loss of a strong relationship, like that with a significant branding
partner, such as Union Bank, or with schools such as University of Phoenix and
Nova Southeastern University from which we directly or indirectly acquire a
significant volume of student loans, could result in an adverse effect on our
volume derived from our branding partner channel. For example, Nova Southeastern
University, from which we purchased FFELP loans (through its relationship with
Union Bank) comprising approximately 5.6% of our total student loan channel
acquisitions in 2003, has informed us and Union Bank, the direct acquirer of the
student loans, of its intent to not renew its sale commitment starting January
2007, in order to make a request for a proposal to potential purchasers,
including Union Bank and us.
Competition
We face competition from many lenders in the highly competitive student loan
industry. Using our size, we have leveraged economies of scale to gain market
share and compete by offering a full array of FFELP and private loan products
and services. In addition, we differentiate ourselves from other lenders through
our vertical integration, technology and strong relationships with colleges and
universities.
We view SLM Corporation, the parent company of Sallie Mae, as our largest
competitor in loan origination, holding and servicing. SLM Corporation services
nearly half of all outstanding FFELP loans and is the largest holder of student
loans, with a portfolio of over $89 billion of managed and owned student loans
as of December 31, 2003. Large national and regional banks are also strong
competition, although many are involved only in origination. In different
geographic locations across the country, we run into strong competition from the
local tax-exempt student loan secondary markets. The Federal Direct Lending
("FDL") Program has also
8
reduced the origination volume available for FFEL Program participants, which in
2002 accounted for 28% of total volume, although this portion of total volume
has decreased from approximately 33% in 1998. In addition, in the last few
years, low interest rates have attracted many new competitors to the student
loan consolidation business.
Employees
As of December 31, 2003, we had approximately 2,100 employees. Approximately
730 of these employees hold professional and management positions while
approximately 1,370 are in support and operational positions. None of our
employees are covered by collective bargaining agreements. We are not involved
in any material disputes with any of our employees, and we believe that
relations with our employees are good.
Available Information
We maintain a Web site at www.nelnet.net. Copies of our annual report on
Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy
statement and amendments to such reports are available without charge on our Web
site as soon as reasonably practicable after such reports are filed with or
furnished to the United States Securities and Exchange Commission (the "SEC").
We have adopted a Code of Business Conduct and Ethics (the "Code of
Conduct") that applies to directors, officers and employees, including our
principal executive officers and our principal financial and accounting officer,
and have posted such Code of Conduct on our Web site. Amendments to and waivers
granted with respect to our Code of Conduct relating to our executive officers
and directors required to be disclosed pursuant to the applicable securities law
and stock exchange rules and regulations will also be posted on our Web site.
Our Corporate Governance Guidelines, Audit Committee Charter, Compensation
Committee Charter and Nominating and Corporate Governance Committee Charter are
also posted on our Web site and, along with our Code of Conduct, are available
in print without charge to any shareholder who requests them. Please direct all
requests as follows:
Nelnet, Inc.
121 South 13th Street, Suite 201
Lincoln, Nebraska 68508
Attention: Secretary
ITEM 2. PROPERTIES
We maintain 15 principal offices in cities across the United States. We do
not own any of our principal facilities. The following table lists the principal
facilities leased by us.
Lease
Square expiration
Location Primary Function or Segment footage date
- -------- -------------------------------------------------- -------- -------------
Albany, NY........ Charter Servicing Software 3,550 September 2004
Boise, ID......... IFA Servicing Software 9,993 August 2005
Denver, CO........ Student Loan Servicing, Executive Management, Technology 120,663 February 2008
Fredericksburg, VA Loan Consolidations 18,000 May 2007
Honolulu, HI...... Sales 611 October 2004
Indianapolis, IN.. Student Loan Servicing and Loan Generation 58,770 February 2008
Jacksonville, FL.. Student Loan Servicing and Loan Generation, 134,828 January 2007
Guarantee Servicing, Technology
Lincoln, NE....... Corporate Headquarters, Student Loan Servicing and 94,909 December 2010
Loan Generation
Scottsdale, AZ.... Capital Markets 3,129 May 2005
Portland, ME...... Loan Generation, Sales 5,211 January 2010
Tempe, AZ......... Loan Generation 3,431 March 2004
Tucson, AZ........ Loan Generation 426 June 2004
Tulsa, OK......... Loan Generation, Sales 2,500 July 2008
Warwick, RI....... Loan Generation, Sales 5,608 May 2005
Washington, DC.... Government Relations, Sales 6,852 May 2010
We believe that our respective properties are generally adequate to meet our
long-term student loan and new business goals. Our principal office is located
at 121 South 13th Street, Suite 201, Lincoln, Nebraska 68508.
9
ITEM 3. LEGAL PROCEEDINGS
We are subject to various claims, lawsuits and proceedings that arise in the
normal course of business. These matters principally consist of claims by
borrowers disputing the manner in which their loans have been processed. On the
basis of present information, anticipated insurance coverage and advice received
from counsel, it is the opinion of our management that the disposition or
ultimate determination of these claims, lawsuits and proceedings will not have a
material adverse effect on our business, financial position or results of
operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On November 3, 2003, a special shareholders' meeting was held in which the
Company's shareholders unanimously approved the adoption of Second Amended and
Restated Articles of Incorporation, the Directors Stock Compensation Plan and
the Employee Share Purchase Plan. 29,061,876 votes of Class A and Class B
Shareholders were voted in favor of each of the proposals and no votes were
voted against any of the proposals or withheld. There were no abstentions.
On November 17, 2003, a special shareholders' meeting was held in which the
Company's shareholders unanimously approved the adoption of the Restricted Stock
Plan. 28,171,665 votes of Class A and Class B Shareholders were voted in favor
of the proposal and no votes were voted against the proposal or withheld. There
were no abstentions.
On November 25, 2003, a special shareholders' meeting was held in which the
Company's shareholders unanimously approved the adoption of the revised
Directors Stock Compensation Plan. 26,573,475 votes of Class A and Class B
Shareholders were voted in favor of the proposal and no votes were voted against
the proposal or withheld. There were no abstentions.
PART II.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Class A Common Stock is listed and traded on the New York
Stock Exchange under the symbol "NNI," while its Class B Common Stock is not
publicly traded. The number of holders of record of the Company's Class A Common
Stock and Class B Common Stock as of February 13, 2004 was approximately 166 and
six, respectively. For the partial quarter from December 11, 2003 (the initial
public offering date of our Class A Common Stock) until December 31, 2003, the
high and low sales prices for the Company's Class A Common Stock were $22.40 and
$20.86, respectively.
The Company did not pay cash dividends on either class of our Common Stock
for the two most recent fiscal years and does not intend to pay dividends in the
foreseeable future. The Company intends to retain its earnings to finance
operations and future growth, and any decision to pay cash dividends will be
made by the Company's board of directors based on factors such as the Company's
results of operations and working capital requirements. The credit agreement
with the Company's general credit providers restricts payment of dividends or
other distributions to shareholders in the event the Company were to be in
default under the credit agreement or if payment of such a dividend or
distribution would result in such a default. In addition, indentures governing
the education lending subsidiaries limit the amounts of funds that can be
transferred to the Company by its subsidiaries through cash dividends. These
limitations result from the restrictions contained in trust indentures under
debt financing arrangements to which the Company's education lending
subsidiaries are parties.
For information regarding the Company's equity compensation plans, see Part
III, Item 12 of this Report.
In 2003, the Company issued unregistered securities in the transaction
described below.
On March 12, 2003, the Company issued an aggregate of 331,800 shares of
Class A Common Stock to 35 employees for $2.43 per share, or an aggregate of
$806,274. The securities issued in these transactions were issued in reliance on
an exemption from registration under Section 4(2) of the Securities Act of 1933,
as amended (the "Securities Act"), as transactions by an issuer not involving
any public offering. The recipients of the securities represented their
intentions to acquire the securities for investment only and not with a view to,
or for sale or in connection with, any distribution thereof. Appropriate legends
were affixed to the certificates representing the securities in such
transactions.
On August 14, 2003, in connection with the recapitalization effected
pursuant to the Company's amended and restated articles of incorporation, the
Company issued an aggregate of 45,038,488 shares of its Class A and Class B
Common Stock to the holders of its pre-recapitalization Class A Voting Common
Stock and Class B Non-Voting Common Stock. The securities issued in this
transaction were issued in reliance on the exemption from registration under
Section 3(a)(9) of the Securities Act, relating to securities exchanged by an
issuer with its existing security holders exclusively where no commission or
other remuneration is paid or given, directly or indirectly, for soliciting such
exchange.
10
Each of the sales of securities was made without the use of an underwriter
and the certificates evidencing the shares bear a restricted legend permitting
the transfer thereof only upon registration of the shares or an exemption under
the Securities Act.
On December 11, 2003, the Company issued and sold an aggregate of 8,000,000
shares of its Class A Common Stock pursuant to an effective registration
statement under the Securities Act for $21 per share, or an aggregate of
$168,000,000. On December 22, 2003, the Company issued and sold an aggregate of
586,800 shares of its Class A Common Stock pursuant to an effective registration
statement under the Securities Act for $21 per share, or an aggregate of
$12,322,800. We used a portion of the net proceeds of $167.6 million, less $4
million in stock offering costs, from these offerings as follows: $18.3 million
was used to fund the two acquisitions in the first quarter of 2004 as discussed
in "Management's Discussion and Analysis of Financial Condition and Results of
Operations--Acquisitions"; and $30.0 million was used to repay then-outstanding
revolving credit indebtedness. We intend to use the remaining net proceeds from
these offerings to fund the future acquisition as discussed in "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Acquisitions," for general corporate purposes, including capital
expenditures, working capital needs and potential other transactions
complementary to our business.
11
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following table sets forth selected consolidated 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.
Year ended December 31,
--------------------------------------------------------------------------------
2003 2002 2001 2000 1999
------------ ------------ ------------ ------------ ------------
(dollars in thousands, except share data)
Income Statement Data:
Net interest income .... $ 178,612 $ 190,900 $ 114,565 $ 64,853 $ 59,538
Less provision for
loan losses ........... (11,475) (5,587) (3,925) (1,370) (1,800)
------------ ------------ ------------ ------------ ------------
Net interest income
after provision for
loan losses ........... 167,137 185,313 110,640 63,483 57,738
Loan servicing and
other fee income ...... 99,294 103,899 93,172 66,015 --
Software services and
other income .......... 19,398 21,909 7,713 8,431 5,387
Derivative market
value loss ............ (1,170) (579) (2,962) -- --
Operating expenses ..... (238,370) (234,701) (195,438) (131,196) (47,417)
------------ ------------ ------------ ------------ ------------
Income before income
taxes and minority
interest .............. 46,289 75,841 13,125 6,733 15,708
Net income ............. 27,103 48,538 7,147 4,520 9,671
Earnings per share,
basic and diluted ..... $ 0.60 $ 1.08 $ 0.16 $ 0.11 $ 0.42
Weighted average
shares outstanding .... 45,501,583 44,971,290 44,331,490 41,187,230 22,863,444
Other Data:
Origination and
acquisition volume (a) $ 4,253,014 $ 2,665,786 $ 1,448,607 $ 1,027,498 $ 2,015,263
Average student loans .. $ 9,451,035 $ 8,171,898 $ 5,135,227 $ 3,388,156 $ 1,750,097
Student loans
serviced (at end of
period) ............... $ 18,773,899 $ 17,863,210 $ 16,585,295 $ 11,971,095 $ --
Ratios:
Net interest margin (b) 1.71% 2.15% 2.09% 1.76% 2.60%
Return on average
total assets .......... 0.25% 0.52% 0.12% 0.12% 0.32%
Return on average equity 19.4% 49.2% 11.7% 8.2% 99.6%
Net loan charge-offs
as a percentage of
average student loans . 0.079% 0.047% 0.042% 0.055% 0.033%
As of December 31,
-------------------------------------------------------------------
2003 2002 2001 2000 1999
----------- ----------- ----------- ----------- -----------
(dollars in thousands)
Balance Sheet Data:
Cash and cash equivalents ... $ 198,423 $ 40,155 $ 36,440 $ 23,263 $ 26,497
Student loan receivables, net 10,455,442 8,559,420 7,423,872 3,585,943 2,989,985
Total assets ................ 11,931,509 9,766,583 8,134,560 4,021,948 3,302,098
Bonds and notes payable ..... 11,366,458 9,447,682 7,926,362 3,934,130 3,265,532
Shareholders' equity ........ 305,489 109,122 63,186 54,161 15,380
- ---------------
(a) Initial loans originated and acquired through various channels, including
originations through our direct channel and acquisitions through our
branding partner channel, our forward flow channel and the secondary market.
(b) Net interest margin is computed by dividing net interest income by the sum
of average student loans and the average balance of other interest earning
assets.
12
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
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 FFEL Program 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 us. We 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.
Overview
We are a vertically integrated education finance company, with over $11.9
billion in total assets as of December 31, 2003, making us one of the leading
education finance companies in the country. We are focused on providing quality
products and services to participants in the education finance process.
Headquartered in Lincoln, Nebraska, we originate, hold and service student
loans, principally loans originated under the FFEL Program. We, together with
our branding partners, originated and acquired approximately $4.3 billion of
student loans in 2003, which includes $1.2 billion of existing loans we
consolidated from our own loan portfolio, making us a leading originator and
acquirer of student loans.
Our business is comprised of four primary product and service offerings:
o Asset management, including student loan originations and
acquisitions. We provide student loan sales, marketing, originations,
acquisition and portfolio management. We own a large portfolio of
student loan assets through a series of education lending
subsidiaries. We generate loans owned in special purpose lending
facilities through direct origination or through acquisition of loans.
We also provide marketing and sales support and managerial and
administrative support related to our asset generation activities.
o Student loan servicing. We service our student loan portfolio and the
portfolios of third parties. The servicing activities provided include
loan origination activities, application processing, borrower updates,
payment processing, claim processing and due diligence procedures.
o Guarantee servicing. We provide servicing support to guaranty
agencies, which includes system software, hardware and
telecommunication support, borrower and loan updates, default aversion
tracking services, claim processing services and post-default
collection services.
o Servicing software. We provide student loan servicing software
internally and to third-party student loan holders and servicers.
In accordance with accounting principles generally accepted in the United
States, our asset management and student loan servicing offerings constitute
reportable operating segments. Our guarantee servicing and servicing software
offerings are operating segments that do not meet the quantitative thresholds,
and, therefore, are included as other segments that do not meet the reportable
segment criteria. The following table shows the total segment revenue (excluding
intersegment revenue) and net income of each of our reportable segments for the
years ended December 31, 2003 and 2002. For additional information, see note 18
of the notes to the consolidated financial statements.
Year ended December 31, 2003 Year ended December 31, 2002
---------------------------------- -----------------------------------
Student Student
Asset loan Other Asset loan Other
management servicing segments management servicing segments
---------- --------- -------- ---------- --------- --------
Segment revenue 61.8% 27.3% 10.9% 63.7% 28.2% 8.1%
Segment net income 72.7% 23.3% 4.0% 94.6% 13.5% (8.1%)
13
Our student loan portfolio has grown significantly through origination and
acquisition. With the development of our fully integrated platform, we are
positioned for organic growth. We originated and acquired $4.3 billion of
student loans in 2003, which includes $1.2 billion of existing loans we
consolidated from our own loan portfolio, through various channels, including:
o our direct channel, in which we originate student loans in one of our
brand names directly to student and parent borrowers, which accounted
for 58.9% of the student loans we originated and acquired in 2003
(43.4% when excluding loans we consolidated from our own loan
portfolio);
o our branding partner channel, in which we acquire student loans from
lenders to whom we provide marketing and origination services, which
accounted for 19.0% of the student loans we originated and acquired in
2003 (26.2% when excluding loans we consolidated from our own loan
portfolio); and
o our forward flow channel, in which we acquire student loans from
lenders to whom we provide origination services, but provide no
marketing services, or who have agreed to sell loans to us under
forward sale commitments, which accounted for 14.2% of the student
loans we originated and acquired in 2003 (19.5% when excluding loans
we condolidated from our own loan portfolio).
In addition, we also acquire student loans through spot purchases, which
accounted for 7.9% of student loans that we originated and acquired in 2003
(10.9% when excluding loans we consolidated from our own loan portfolio). We
have increased our student loan portfolio by $6.8 billion over the last three
years, including $2.9 billion of loans acquired in subsidiary acquisitions.
Significant Drivers and Trends
Our earnings and earnings growth are directly affected by the size of our
portfolio of student loans, the interest rate characteristics of our portfolio,
the costs associated with financing and managing our portfolio and the costs
associated with the origination and acquisition of the student loans in the
portfolio. See "-- Student Loan Portfolio."
In addition to the impact of growth of our student loan portfolio, our
results of operations and financial condition may be materially affected by,
among other things, changes in:
o applicable laws and regulations that may affect the volume, terms,
effective yields or refinancing options of education loans;
o demand for education financing and competition within the student loan
industry;
o the interest rate environment, funding spreads on our financing
programs and access to capital markets; and
o prepayment rates on student loans, including prepayments relating to
loan consolidations.
Competition for the supply channel of education financing and the student
loan industry has caused the cost of acquisition related to our student loan
assets to increase. In addition, we have seen significant increases in
consolidation loan activity and consolidation loan volume within our industry.
The increase in competition for consolidation loans has caused us to be
aggressive in our measures to protect and secure our existing portfolio through
internal consolidation efforts. We will generally recognize our cost of
acquisition over the average useful life of the assets; however, we will
generally accelerate recognition of the unamortized cost of acquisition when
loans are consolidated, even if they are consolidated on our balance sheet. The
significant increase in consolidation activity, entrants and competition within
the industry, coupled with our asset retention practices, have caused our yields
to be reduced in recent years through amortization of acquisition costs. If
these trends continue, we could continue to see our yields reduced through the
increase in consolidation loans, which have a lower yield and also result in a
further increase in amortization costs. See "-- Student Loan Portfolio--Student
Loan Spread Analysis." Although our short-term yields may be reduced, we will
have been successful in protecting our assets and stabilizing our balance sheet
for long-term growth.
Our student loan portfolio and asset growth will be significant factors in
determining future growth in our net interest income as our primary source of
income is interest earned on our student loan portfolio. If our student loan
portfolio continues to grow and our net interest margin remains relatively
stable, we expect our net interest income to increase after adjusting for any
variable-rate floor income. Interest income, and to a certain extent our net
income, is also dependent upon the relative level of interest rates. While we
expect our student loan portfolio and interest earning assets to continue to
grow, which should cause interest income and earnings growth, we do not expect
to continue to grow at historical levels. Specifically, our net income in 2003
decreased $21.4 million, or 44.2%, as compared to 2002 primarily because of the
decrease in our variable-rate floor income. Net interest income decreased by
$12.3 million, or 6.4%, in 2003 as compared to 2002. This decrease was a result
of a decrease in variable rate floor income of $37.0 million, which was offset
by an increase in interest income from the growth in our student loan portfolio
and decreased interest rates on our borrowings. Therefore, net interest income,
excluding the effects of variable-rate floor income, increased approximately
$24.7 million, or 17.5%, in 2003 as compared to 2002. This increase in net
interest income, excluding variable-rate floor income, has resulted from the
portfolio growth previously discussed. Variable-rate floor income occurs in
certain declining interest rate environments, and we cannot predict whether
these interest rate
14
environments will occur in the future. We generally do not anticipate receiving
or plan to receive variable-rate floor income.
We reported net income of $27.1 million in 2003, or $0.60 per basic and
diluted share, as compared to $48.5 million, or $1.08 per basic and diluted
share, in 2002. Net interest income includes more than $69.3 million, or 73
basis points, in yield reduction due to amortization of loan acquisition costs
or premiums in 2003, as compared to $55.1 million, or 67 basis points, in 2002.
Despite our solid loan volume growth, our unamortized cost of loan acquisitions
or premiums has been reduced from 1.9% at December 31, 2002 to 1.5% at December
31, 2003. In addition, we recorded approximately $12.8 million of variable-rate
floor income in 2003 as compared to approximately $49.8 million in 2002.
Operating expenses in 2003 included $12.8 million of amortization of intangible
assets resulting from acquisitions prior to 2003, of which $6.7 million is not
deductible for federal income tax purposes. Amortization of intangible assets
totaled $22.2 million in 2002, which included $16.2 million not deductible for
federal income tax purposes. Operating expenses in 2003 also include an
additional $5.1 million in one-time costs to terminate consulting and employment
contracts in 2003. In addition, in preparing for our initial public offering in
December 2003, we incurred a non-recurring, nondeductible, non-cash stock
compensation expense of $5.2 million for stock purchased by employees early in
2003.
Our net income also included a mark-to-market loss on derivative instruments
of $1.2 million in 2003 as compared to $0.6 million in 2002. We maintain an
overall interest rate risk management strategy that incorporates the use of
derivative instruments to minimize the economic effect of interest rate
volatility. Management has structured all of our derivative transactions with
the intent that each is economically effective. However, most of our derivative
instruments do not qualify for hedge accounting under SFAS No. 133 and thus may
adversely impact earnings. In addition, the mark-to-market adjustment recorded
through earnings in our consolidated statements of income may fluctuate from
period to period.
Acquisitions
We have positioned ourselves for growth by building a strong foundation
through mergers and acquisitions of related and unrelated entities. Although our
assets and loan portfolios increased through these transactions, a key aspect of
each transaction was its impact on our prospective organic growth and the
development of our integrated platform of services. As a result of our rapid
growth, the development of our platform and changes in operations,
period-to-period comparability of our results of operations may be difficult.
In 2000, we acquired UNIPAC Service Corporation, a related entity, and
InTuition Holdings, Inc., which added servicing and origination operations. In
2001, we acquired MELMAC, Inc., which increased our FFELP portfolio by $424
million, and GuaranTec LLP, which added guarantee servicing to our activities.
In addition, in December 2001, we acquired EFS, Inc., which increased our loan
servicing operations and added $2.5 billion to our FFELP portfolio. In 2002, we
expanded our product suite by adding loan servicing software products through
the acquisitions of Idaho Financial Associates, Inc. and Charter Account
Systems, Inc. In 2003, we acquired UFS Securities, LLC, which added
broker-dealer services to our services.
In January 2004, we acquired a 50% interest in Premiere Credit of North
America, LLC, or Premiere, a collection services company that specializes in
collection of educational debt. Premiere is based in Indianapolis, Indiana, and
employs approximately 45 persons. In March 2004, we acquired rights, for a term
of ten years, in certain assets of the Rhode Island Student Loan Authority, or
RISLA, including the right to originate student loans in RISLA's name without
competition from RISLA during such time period. RISLA also sold to us a
portfolio of FFELP loans with an aggregate outstanding balance of approximately
$175 million. We have further agreed to provide administrative services in
connection with certain of the indentures governing debt securities of RISLA for
a ten-year period. We have also entered into an agreement to acquire a FFELP
loan secondary market, which holds a FFELP loan portfolio of approximately $130
million. We expect this acquisition to close during the second quarter of 2004.
Net Interest Income
We generate the majority of our earnings from the spread between the yield
we receive on our portfolio of student loans and the cost of funding these
loans. This spread income is reported on our income statement as net interest
income. The amortization and write-offs of premiums or discounts, including
capitalized costs of origination, the consolidation loan rebate fee and yield
adjustments from borrower benefit programs, are netted against loan interest
income on our income statement. The amortization and write-offs of bond issuance
costs are included in interest expense on our income statement.
Our portfolio of FFELP loans generally earns interest at the higher of a
variable rate based on the special allowance payment, or SAP, formula set by the
U.S. Department of Education (the "Department,") and the borrower rate, which is
fixed over a period of time. The SAP formula is based on an applicable index
plus a fixed spread that is dependent upon when the loan was originated and the
loan's repayment status. Depending on the type of student loan and when the loan
was originated, the borrower rate is either fixed to term or is reset to a
market rate each July 1. Loans that reset annually on each July 1 can generate
excess spread income as compared to the rate based on the SAP formula in certain
declining interest rate environments. We refer to this additional income as
15
variable-rate floor income and it is included in loan interest income as
described further in "-- Results of Operations" below. Historically, we have
earned excess spread, or variable-rate floor income, in declining interest rate
environments as recently as our most recent fiscal year. Since the rates are
reset annually, we view these earnings as temporary and not necessarily
sustainable. Our ability to earn variable-rate floor income in the future
periods is dependent upon the interest rate environment following the annual
reset of borrower rates, and we cannot assure that such environment will exist
in the future.
The table below sets forth the weighted average borrower interest rate and
weighted average lender interest rate for all variable-rate student loan assets
for the period indicated.
As of December 31,
-----------------------------
2003 2002 2001
---- ---- ----
Weighted average borrower
interest rate................... 3.76% 4.97% 7.02%
Weighted average lender
interest rate................... 3.49% 4.27% 6.23%
Because we generate the majority of our earnings from the spread between the
yield we receive on our portfolio of student loans and the cost of financing
these loans, the interest rate sensitivity of our balance sheet is very
important to our operations. The current and future interest rate environment
can and will affect our interest earnings, net interest income and net income.
The effects of changing interest rate environments are further outlined in "--
Risks -- Market and Interest Rate Risk" below.
On those FFELP loans with fixed to term borrower rates, primarily
consolidation loans, we earn interest at the greater of the borrower rate or a
variable rate based on the SAP formula. Since we finance the majority of our
student loan portfolio with variable-rate debt, we may earn excess spread on
these loans for an extended period of time.
On most consolidation loans, we must pay a 1.05% per year rebate fee to the
Department. Those consolidation loans which have variable interest rates based
on the SAP formula earn a yield less than that of a Stafford loan. Those
consolidation loans which have fixed interest rates less than the sum of 1.05%
and the variable rate based on the SAP formula also earn a yield less than that
of a Stafford loan. As a result, as consolidation loans matching these criteria
become a larger portion of our loan portfolio, there will be a lower yield on
our loan portfolio in the short term. However, due to the extended terms of
consolidation loans, we expect to earn the yield on these loans for a longer
duration, making them beneficial to us in the long term.
A portion of our FFELP loan portfolio, with an outstanding balance of $2.6
billion as of December 31, 2003, is comprised of loans which were previously
financed with tax-exempt obligations issued prior to October 1, 1993. Based upon
provisions of the Higher Education Act and related interpretations by the
Department, we believe that we may be entitled to receive special allowance
payments on these loans providing us with a 9.5% minimum rate of return. To
date, we have not recognized interest income generated by these loans based on
the 9.5% minimum rate of return. We have asked the Department to confirm that we
are allowed to recognize the income based on the 9.5% minimum rate of return. We
have deferred recognition of this excess interest income pending satisfactory
resolution of this issue. As of December 31, 2003, the amount of excess interest
income deferred totaled approximately $42.9 million which is included in other
liabilities on our consolidated balance sheet. Since we did not refinance loans
with the aforementioned tax-exempt obligations until 2003, all of this deferred
income was recorded this year. Legislation has been proposed to eliminate
variable rate floor income as well as the 9.5% floor interest rate on loans
financed with funds from pre-1993 tax-exempt financings. The enactment of this
legislation might prospectively eliminate floor income on pre-1993 tax-exempt
financings and allow us to recognize our deferred excess interest income.
Conversely, we cannot be assured that any such legislation, if enacted, will
only prospectively eliminate this floor income. At this time, we cannot predict
how any such potential legislation will affect our operations in the future.
In declining interest rate environments, we can earn significant amounts of
variable-rate floor income. The more drastic the reduction in rates subsequent
to the July 1 annual borrower interest rate reset date, the greater our
opportunity to earn such income. Conversely, as the decline in rates abates, or
in environments where interest rates are rising, our opportunity to earn
variable-rate floor income can be reduced, in some cases substantially. Although
we have been in a historically low interest rate environment, interest rates on
which our assets are indexed have been rising since the second quarter of 2003.
As interest rates increase, we incur greater financing costs on our
variable-rate financings. An increase in our financing costs, in turn, decreases
the spread between the rate of our FFELP loans (which reset annually) and the
rate of our financings, ultimately causing a decrease in variable-rate floor
income.
Investment interest income includes income from unrestricted
interest-earning deposits and funds in our special purpose entities for our
asset-backed securitizations.
16
Provision for Loan Losses
We maintain an allowance for loan losses associated with our student loan
portfolio at a level that is based on the performance characteristics of the
underlying loans. We analyze the allowance separately for our FFELP loans and
our private loans.
The loan loss allowance attributable to FFELP loans consists of two
components: a risk sharing reserve and a reserve for rejected guaranty agency
claim losses, caused mainly by servicing defects. The risk sharing reserve is an
estimate based on the amount of loans subject to the 2% risk sharing and on the
historical experience of losses. The rejected claim loss reserve is based on the
historical trend of ultimate losses on loans initially rejected for
reimbursement by guaranty agencies. FFELP loans are guaranteed as to both
principal and interest and, therefore, continue to accrue interest until the
time they are paid by the guaranty agency. Once a FFELP loan is rejected for
claim payment, our policy is to continue to pursue recovery of principal and
interest, whether by curing the reject or collecting from the borrower. We
attempt to cure the rejected claims through our collection efforts. As of
December 31, 2003, we had an allowance for loan losses on FFELP loans of $10.8
million.
In determining the private loan loss allowance, we divide the portfolio into
various categories, such as the type of program, loan status and months into
repayment. We then estimate defaults based on the borrowers' credit profiles,
net of estimated recoveries. We place a private loan on non-accrual status and
charge off the loan when the collection of principal and interest is 120 days
past due. We utilize this data to estimate the amount of losses in the
portfolio, net of subsequent collections, that are probable of occurrence. As of
December 31, 2003, we had an allowance for loan losses on private loans of $5.2
million.
The evaluation of the provision for loan losses is inherently subjective, as
it requires material estimates that may be subject to significant changes. The
provision for loan losses reflects the activity for the applicable period and
provides an allowance at a level which our management believes is adequate to
cover probable losses inherent in the loan portfolio.
The Higher Education Act authorizes the Department to recognize lenders and
lender servicers (as agent for the eligible lender) for an exceptional level of
performance in servicing FFELP loans. A lender or lender servicer designated for
exceptional performance can receive 100 percent reimbursement on all claims
submitted for insurance provided that the lender or lender servicer meets and
maintains all requirements for achieving its designation. On December 29, 2003,
we applied for Exceptional Performance status as a student loan servicer for the
FFEL Program. Our original application was denied by the Department based on two
issues. We believe we have provided sufficient information related to one of the
issues to consider it resolved. The other issue relates to a complaint submitted
to the Department by a former employee in connection with our procedures in
processing certain FFELP loan borrower forbearances. In March 2004, the
Department provided us with a summary of that complaint and also forwarded the
complaint on to the Office of the Inspector General, or OIG. As we understand,
this former employee's complaint alleges that we incorrectly processed certain
forbearances during a limited time period and with respect to a limited number
of borrower accounts. Our management has reviewed the procedures in connection
with this activity and concluded that such procedures did not violate FFELP loan
servicing regulations. We are cooperating with the Department to resolve this
issue. We promptly advised our independent auditors, KPMG LLP, of the issues.
There can be no assurance that the OIG will review the former employee's
complaint without conducting an investigation, or that the outcome of any
investigation will be favorable. If an OIG investigation were to occur, we do
not expect any adverse finding, nor do we believe that this issue will result in
a material adverse financial impact on us even if an investigation were to
result in an adverse finding. A delayed resolution of this matter may delay our
ability to resubmit an application with the Department to become a lender
servicer designated for exceptional performance, and an unfavorable resolution
of this matter may result in an inability to resubmit that application. If we
are able to resubmit our application, we cannot be assured that we will receive
or maintain the designation as exceptional performer. Should we receive and
maintain designation as an exceptional performer under the Higher Education Act,
our cost related to losses on defaulted FFELP loans, specifically the 2% risk
share component that is not guaranteed, could be substantially reduced and would
differ significantly from historical losses and trends.
Other Income
We also earn fees and generate income from other sources, including
principally loan servicing, guarantee servicing and licensing fees on our
software products. Loan servicing fees are determined according to individual
agreements with customers and are calculated based on the dollar value or number
of loans or accounts serviced for each customer. Guarantee servicing fees are
earned as a result of our providing system software, hardware and
telecommunication support, borrower and loan updates, default aversion tracking
services, claim processing services and post-default collection services to
guaranty agencies. Guarantee servicing fees are calculated based on the number
of loans serviced or amounts collected. Software services income includes
software license and maintenance fees associated with student loan software
products as well as certain loan marketing fees. Other income also includes the
derivative market value adjustment as further discussed in "-- Risks -- Market
and Interest Rate Risk" below.
In addition, we earn fee income on some of our securitization transactions
through UFS Securities, our wholly owned broker-dealer, which effectively
decreases our costs associated with accessing this market. UFS Securities sells
certain tranches of our auction rate securities in a co-broker dealer
arrangement with certain third-party broker-dealers. UFS Securities is paid the
same amount
17
of fees as the third-party broker-dealers for selling the auction rate
securities. Since UFS Securities, which was acquired in August 2003, is our
wholly owned subsidiary, these sales and the fees received for the sales by our
wholly owned subsidiary will have the effect of reducing our overall costs on
the sales of our auction rate securities.
As we expand our student loan origination and acquisition activities, we may
face increased competition with some of our servicing customers. In the past,
including one case in 2003, servicing customers have terminated their servicing
relationships with us. Furthermore, we could in the future lose more servicing
customers as a result of such increased competition. However, the vast majority
of our servicing agreements provide for life-of-loan servicing of the existing
loans, and, as such, we do not expect this loss or the potential future loss of
customers to have a material adverse effect on our results of operations for the
foreseeable future.
One of our guarantee servicing customers recently notified us of its
intention not to renew its servicing contract. The loss of this customer is not
expected to have a material effect on our results of operations due to the
relative portion of our earnings attributable to guarantee servicing revenue and
the size of the individual customer.
The income and revenues provided through our servicing software operations
have increased in recent years with the acquisitions of Idaho Financial
Associates, Inc. and Charter Account Systems, Inc. in January 2002 and May 2002,
respectively. This increase was offset by a decrease in other income. To the
extent that our servicing software license and maintenance revenues continue to
increase, we believe that such increase will primarily come from our existing
customer base.
Operating Expenses
Operating expenses include costs incurred to manage and administer our
student loan portfolio and our financing transactions, costs incurred to
generate and acquire student loans and general and administrative expenses,
which include corporate overhead. Operating expenses also include amortization
of intangible assets related to acquisitions. We do not believe inflation has a
significant effect on our operations.
Results of Operations
Year ended December 31, 2003 compared to year ended December 31, 2002
Net interest income. Loan interest income decreased by $45.0 million, or
11.1%, in 2003 as compared to 2002. This decrease was a result of changes in the
interest rate environment and in the pricing characteristics of our student loan
assets, although such decrease was partially offset by an increase in the size
of our student loan portfolio. Lower interest rates in 2003 caused a decrease in
the average net yield on our student loan portfolio to 3.82% from 4.96% in 2002.
Variable-rate floor income decreased approximately $37.0 million to
approximately $12.8 million in 2003 from approximately $49.8 million in 2002,
due to the timing and relative change in interest rates during the periods.
Essentially, prevailing interest rates declined drastically subsequent to the
July 1, 2002 annual borrower interest rate reset date compared to their less
substantial decline following the reset of rates on July 1, 2003. Consequently,
we realized significantly less variable-rate floor income during 2003 than we
did in 2002. The weighted average interest rate on our student loan portfolio
decreased in 2003 due to lower interest rates, together with the increase in the
number of lower yielding consolidation loans. The lower weighted average loan
interest rate resulted in a reduction in loan interest income of approximately
$41.5 million. Consolidation loan activity also increased the amortization and
write-offs of acquisition costs and increased the consolidation rebate fee,
reducing loan interest income an additional approximately $29.9 million in 2003.
The reduction in loan interest income resulting from the decline in interest
rates and reduction in variable-rate floor income was partially offset by an
increase in our portfolio of student loans. The average student loan portfolio
increased by $1.3 billion, or 15.7%, in 2003 as compared to 2002, which
increased loan interest income by approximately $63.1 million in 2003 as
compared to 2002.
Investment interest income decreased $5.6 million, or 26.8%, in 2003 as
compared to 2002. This decrease was due to the termination of a joint venture
with a large financial institution in the second quarter of 2003.
Interest expense on bonds and notes payable decreased $38.3 million, or
16.3%, in 2003 as compared to 2002. This decrease occurred despite an increase
in average total debt of approximately $1.6 billion, specifically an increase in
average variable-rate debt of $1.8 billion, which increased interest expense by
approximately $22.0 million. The reduction in interest rates, specifically LIBOR
and auction rates, decreased our average cost of funds to 1.86% in 2003 from
2.59% in 2002. As a result, interest expense decreased approximately $43.0
million in 2003 as compared to 2002. We reduced average fixed-rate debt by
$212.0 million in 2003, which decreased our overall interest expense by
approximately $12.5 million as compared to 2002. Interest expense on bonds and
notes payable during 2003 includes additional amortization and write-offs of
bond issuance costs of $2.6 million incurred as a result of refinancing certain
debt transactions compared to $5.3 million in 2002.
As a result of the foregoing, net interest income decreased by $12.3
million, or 6.4%, in 2003 as compared to 2002. Our net interest margin decreased
to 1.71% in 2003 from 2.15% in 2002. Net interest income, excluding the effects
of variable-rate floor
18
income of $12.8 million in 2003 and $49.8 million in 2002, increased
approximately $24.7 million, or 17.5%, to approximately $165.8 million in 2003
from approximately $141.1 million in 2002.
Provision for loan losses. The provision for loan losses for FFELP and
private loans increased $5.9 million, or 105.4%, in 2003 as compared to 2002.
The provision for loan losses for FFELP loans increased $1.1 million in 2003
compared to 2002 due to the increase in the size of our FFELP loan portfolio.
The provision for loan losses for private loans increased $4.8 million in 2003
compared to 2002. This increase was due to a provision of $4.3 million for an
identified pool of private loans based on aging, delinquency and performance of
such identified pool. This pool of private loans was limited to borrowers
attending a single school, and, in early 2002, we ceased making private loans to
borrowers attending that school. The remaining increase of $0.5 million was due
to the increase in size of our private loan portfolio. Our net loan charge-offs
as a percentage of average student loans increased to 0.079% in 2003 from 0.047%
in 2002. This increase is directly attributable to the identified pool of
private loans as a result of the continued aging of this portfolio. The Company
periodically re-evaluates the requirements of its provision for loan losses, and
future additions to the provision for our student loans and the identified pool
of private loans may be necessary.
Other income. Total other income decreased $7.7 million, or 6.2%, in 2003 as
compared to 2002. Loan servicing and other fee income decreased $4.6 million, or
4.4%, software services and other income decreased $2.5 million, or 11.5%, and
derivative market value adjustment loss increased $0.6 million, or 102.1%, in
2003 as compared to 2002.
Loan servicing and other fee income decreased due to the reduction in the
number and dollar amount of loans we serviced for third parties. Total
third-party loan servicing volume decreased $1.1 billion, or 10.1%, in 2003 as
compared to 2002. This resulted in a decrease in loan servicing income of $9.4
million in 2003 as compared to 2002. This decrease in income was offset by an
increase of $4.8 million of guarantee servicing income in 2003 due to higher
guarantee volumes.
The decrease in software services and other income was due to additional
income earned of $5.7 million in 2002 on a marketing contract that was
terminated in the fourth quarter of 2002. This decrease was offset by an
increase of $3.4 million due to the acquisitions of Charter Accounts Systems,
Inc. in May 2002 and Idaho Financial Associates in January 2002 and an increase
in other income of $1.3 million due to the acquisition of UFS Securities in
August 2003. In addition, late fee income on borrower payments increased $1.0
million in 2003. In 2002, we recognized marketing income of $2.3 million as a
broker on a loan sale.
The derivative market value adjustment loss increased as we increased our
use of derivative instruments in 2003 to provide economic hedges to protect
against the impact of adverse changes in interest rates. The derivative market
value adjustment loss of $0.6 million in 2002 was due to the interest rate swap
in the notional amount of $500 million entered into in 2001 that expired in the
second quarter of 2002. See "-- Risks -- Market and Interest Rate Risk."
Operating expenses. Total operating expenses increased $3.7 million, or
1.6%, in 2003 as compared to 2002. Salaries and benefits increased $17.4
million, or 16.3%, and total other expenses decreased $13.7 million, or 10.7%,
in 2003 as compared to 2002.
Salaries and benefits increased as a non-cash stock compensation expense of
$5.2 million was recognized in the third quarter of 2003 equal to the difference
between the product of the estimated initial public offering price and the
number of shares issued in March 2003 and the total price paid by the employees.
In addition, salary expense increased $5.1 million in 2003 as compared to 2002
associated with the termination of consulting and employment agreements, of
which $1.8 million was incurred in the fourth quarter of 2003. The remaining
increase of $7.1 million is due to the increased personnel from the acquisitions
previously described and expansion of our marketing efforts.
The net decrease in total other expenses can be attributed to a decrease in
depreciation and amortization expense of $9.3 million, or 28.7%, due to the
decrease in the amortization of intangible assets of $9.5 million as certain
intangible assets were fully amortized in 2002. Trustee and other debt-related
fees increased $2.7 million, or 16.5%, in 2003 as compared to 2002 as a result
of a $1.6 billion increase in average total debt outstanding. Advertising and
marketing expenses decreased $1.3 million, or 11.6%, in 2003 as compared to 2002
due to a $2.4 million expense incurred on a large marketing contract that was
terminated in December 2002. The decrease was offset by an increase in marketing
activities related to consolidation mailings in 2003. Consulting fees and
support services to related parties decreased $9.3 million, or 72.5%, in 2003 as
compared to 2002 as a result of a $1.4 million decrease in consulting fees due
to the termination of a large consulting agreement in December 2002. The
remaining decrease was due to the conversion related fees paid in 2002 for the
systems conversion that occurred in November 2002. Postage and distribution
expenses increased $2.1 million, or 19.3%, in 2003 as compared to 2002 due to an
increase in mass mailings to promote origination of Stafford and consolidation
loans.
Income tax expense. Income tax expense decreased $8.4 million, or 30.3%, in
2003 compared to 2002, due to the decrease in income before income taxes. Our
effective tax rate was 41.7% in 2003 as compared to 36.5% in 2002. The increase
in the effective rate principally was a result of the non-cash stock
compensation expense recognized in 2003 for financial statement purposes that
was not deductible for tax purposes.
19
Net income. Net income decreased to $27.1 million in 2003 from $48.5 million
in 2002, for the reasons discussed above.
Year ended December 31, 2002 compared to year ended December 31, 2001
Net interest income. Loan interest income increased by $86.7 million, or
27.2%, in 2002 as compared to 2001. This increase was the result of changes in
the interest rate environment, in the pricing characteristics of our student
loan assets, and in the size of our student loan portfolio. Lower interest rates
in 2002 caused a decrease in the average net yield on our student loan portfolio
to 4.96% in 2002 from 6.20% in 2001. Variable-rate floor income increased
approximately $19.9 million to approximately $49.8 million in 2002 from
approximately $29.9 million in 2001, due to the timing and relative change in
interest rates during the periods. The weighted average interest rate on our
student loan portfolio decreased in 2002 due to the lower interest rates,
together with the increase in the number of lower yielding consolidation loans.
The lower weighted average loan interest rate resulted in a reduction in loan
interest income of approximately $65.2 million. Consolidation loan activity also
increased the amortization and write-offs of acquisition costs, reducing loan
interest income an additional approximately $40.4 million in 2002. The reduction
in loan interest income resulting from the decline in interest rates and the
reduction in variable-rate floor income was partially offset by an increase in
our portfolio of student loans. The average student loan portfolio increased by
approximately $3.0 billion, or 59.1%, in 2002 as compared to 2001, which
increased loan interest income by $192.1 million in 2002 as compared to 2001,
including the increase related to variable-rate floor income.
Investment interest income increased $4.0 million, or 23.6%, in 2002 as
compared to 2001, due to an approximately $360.1 million increase in average
investment and interest-earning deposits during 2002.
Interest expense on bonds and notes payable increased $14.3 million, or
6.5%, in 2002 as compared to 2001. Average variable-rate debt increased $4.1
billion, which resulted in an increase in interest expense of $85.9 million. The
reduction in short-term interest rates, specifically LIBOR, decreased our
average cost of funds to 2.59% in 2002 from 3.95% in 2001. As a result, interest
expense decreased approximately $83.1 million in 2002 as compared to 2001. We
increased average fixed-rate debt by $199.9 million during 2002, which increased
our overall interest expense by approximately $12.0 million as compared to 2001.
In 2002, we first accessed the term securitization market. While the interest
expense associated with term securitizations is less than that associated with
our other debt instruments, the incremental benefit in 2002 was negligible.
While we expect that we will continue to access the term securitization markets,
we cannot predict whether the benefits of our accessing those markets will be
material to our results of operations in future periods.
As a result of the foregoing, net interest income increased by $76.3
million, or 66.6%, in 2002 as compared to 2001. Our net interest margin
increased to 2.15% in 2002 from 2.09% in 2001. Net interest income, excluding
the effects of variable-rate floor income of $49.8 million in 2002 and $29.9
million in 2001, increased $56.4 million, or 66.6%, to $141.1 million in 2002
from $84.7 million in 2001.
Provision for loan losses. The provision for loan losses for FFELP and
private loans increased $1.7 million, or 43.3%, in 2002 as compared to 2001. The
provision for loan losses for FFELP loans decreased $100,000, or 3.0%, in 2002
as compared to 2001. The provision for loan losses for private loans increased
$1.8 million, or 242.9%, in 2002 as compared to 2001. This increase was due to a
provision of approximately $1.6 million for an identified pool of private loans
based on aging, delinquency and performance of such identified pool. This pool
of private loans was limited to loans to borrowers attending a single school,
and, in early 2002, we ceased making private loans to borrowers attending that
school. The remaining combined increase of $100,000, or 2.5%, was due to the
increase in size of our FFELP and private loan portfolios.
Other income. Total other income increased $27.3 million, or 27.9%, in 2002
as compared to 2001. Loan servicing and other fee income increased $10.7
million, or 11.5%, software services and other income increased $14.2 million,
or 184.1%, and derivative market value adjustment loss decreased $2.4 million,
or 80.5%, in 2002 as compared to 2001.
Loan servicing and other fee income increased due to growth in the loan
servicing portfolio of $817.5 million in 2002 and the acquisition of EFS, Inc.,
which increased the servicing portfolio by an additional $1.0 billion in 2002.
The change in the loan servicing volume resulted in an increase in loan
servicing income of $1.3 million. In addition, we acquired GuaranTec, LLP in
June 2001 resulting in an increase of $8.7 million in guarantee servicing income
in 2002 as compared to 2001.
Software services and other income increased due to the acquisitions of
Charter Account Systems, Inc. in May 2002 and Idaho Financial Associates, Inc.
in January 2002. These acquisitions resulted in an increase in income of
approximately $6.2 million in 2002 compared to 2001. Additional income of $6.6
million was earned on a marketing contract in 2002 that was not in existence in
2001. Other income also included an increase in administrative services income
of $1.2 million in 2002 as compared to 2001 from the support services provided
to FirstMark Services, LLC, which was not in existence in 2001.
The derivative market value adjustment loss decreased as the interest rate
swap entered into in 2001 expired in June 2002.
20
Operating expenses. Total operating expenses increased $39.3 million, or
20.1%, in 2002 as compared to 2001. Salaries and benefits increased $29.5
million, or 38.1%, and total other expenses increased $11.3 million, or 10.1%,
in 2002 as compared to 2001. The increase in salaries and benefits is due to the
following: the acquisition of EFS, Inc. in December 2001, which increased
salaries and benefits by $11.2 million, the acquisition of Idaho Financial
Associates, Inc. in January 2002, which increased salaries and benefits by $7.9
million and the acquisition of Charter Account Systems, Inc. in May 2002, which
increased salaries and benefits by $1.0 million. The remaining increase in
salaries and benefits is due to an increase in support services personnel and
the rising cost of employee benefits.
The net increase in total other expenses can be attributed to an increase in
depreciation and amortization of $3.9 million, or 13.5%, in 2002 as compared to
2001, which includes an increase in the amortization of intangible assets of
$3.4 million due to acquisitions of EFS, Inc., Idaho Financial Associates, Inc.
and Charter Account Systems, Inc. in December 2001, January 2002 and May 2002,
respectively. The remaining increase in depreciation and amortization was a
result of increased depreciation and amortization of furniture, equipment and
leasehold improvements in 2002 as compared to 2001, due to the acquisitions
previously described. Trustee and other debt related fees increased $3.8
million, or 29.5%, in 2002 as compared to 2001, as a result of the $4.3 billion
increase in average total debt outstanding. Occupancy and communications expense
increased $3.9 million, or 52.6%, in 2002 as compared to 2001 due to the
acquisitions previously described. Advertising and marketing expenses increased
$1.4 million, or 13.7%, in 2002 as compared to 2001 due to an increase in
consolidation loan origination activities. Professional services increased $5.9
million, or 175.3%, in 2002 as compared to 2001 as a result of
technology-related consulting in 2002 that did not exist in 2001. Consulting
fees and support services to related parties decreased $16.6 million, or 56.4%,
in 2002 as compared to 2001. This decrease can be attributed to a $9.7 million
decrease due to the termination of the support services contract for InTuition
Holdings, Inc. and GuaranTec, LLP in December 2001, a $4.8 million decrease in
contracted technology services obtained from 5280 Solutions, Inc. related to the
consolidation of our servicing platform in December 2001 and a $2.1 million
decrease as a result of a reduction in consulting fees for services provided by
related parties. Other expenses increased $4.0 million, or 21.5%, due to the
acquisitions previously described.
Income tax expense. Income tax expense increased to $27.7 million in 2002 as
compared to $5.4 million in 2001 due to the increase in income before income
taxes in 2002. Our effective tax rate was 36.5% in 2002 as compared to 41.0% in
2001. The 2002 effective tax rate was lower than the 2001 rate because other net
items, not deductible for tax purposes, contributed positively to our effective
tax rate in 2002 whereas they contributed negatively in 2001.
Net income. Net income increased to $48.5 million in 2002 from $7.1 million
in 2001, for the reasons discussed above.
Financial Condition
At December 31, 2003 compared to December 31, 2002
Total assets increased $2.1 billion, or 22.2%, from $9.8 billion at December
31, 2002 to $11.9 billion at December 31, 2003. This was due to an increase in
student loans receivable of $1.9 billion, or 22.2%, from $8.6 billion at
December 31, 2002 to $10.5 billion at December 31, 2003. This increase was a
result of net growth in consolidation loans of $2.0 billion in 2003. In
addition, cash and cash equivalents increased $158.3 million, or 394.1%, from
$40.2 million at December 31, 2002 to $198.4 million at December 31, 2003. The
increase is a result of the proceeds received from the public stock offering in
December 2003.
Total liabilities increased $2.0 billion, or 20.4%, from $9.7 billion at
December 31, 2002 to $11.6 billion at December 31, 2003. The growth in
liabilities was a result of an increase in bonds and notes payable of $2.0
billion, or 20.3%, from $9.4 billion at December 31, 2002 to $11.4 billion at
December 31, 2003. The increase in bonds and notes payable resulted from
additional borrowings to fund our growth in student loans in 2003.
Shareholders' equity increased $196.4 million, or 180.0%, from $109.1
million at December 31, 2002 to $305.5 million at December 31, 2003 as a result
of net income of $27.1 million in 2003 and the net proceeds from our public
stock offering of $167.7 million, less $4 million in stock offering costs. In
addition, shareholders' equity also increased as a result of a non-cash stock
compensation expense of $5.2 million in 2003.
Liquidity and Capital Resources
We completed an initial public offering of our Class A Common Stock issuing
8,000,000 shares on December 11, 2003. The underwriters exercised their rights
related to the over-allotment of shares, resulting in an issuance of an
additional 586,800 Class A Common Shares on December 22, 2003. The completion of
our initial public stock offering raised net proceeds of $167.7 million, less $4
million of stock offering costs.
21
We generally finance our operations through operating cash flow, borrowings
under credit facilities and secured financing transactions. We also utilize
secured and unsecured operating lines of credit and financing agreements to fund
operations and student loan acquisitions. Operating activities provided net cash
of $153.0 million in 2003, an increase of approximately $18.8 million from the
net cash provided by operating activities of $134.2 million in 2002 due to
efficiencies and decreases in our operating expenses with the integration of our
acquisitions. Operating cash flows are driven by net income adjusted for various
non-cash items such as the provision for loan losses, depreciation and
amortization and the non-cash stock compensation expense in 2003.
We have a $35.0 million operating line of credit and a $35.0 million
commercial paper conduit under two separate facilities from a group of six large
regional and national financial institutions. We had $12.7 million borrowed
under the commercial paper conduit at December 31, 2003 and subsequently paid
these borrowings off in the first quarter of 2004. The cost of funds associated
with our operating lines of credit is higher than that of the secured financing
transactions used to fund our student loan portfolio. Our operating lines of
credit are generally priced at a spread over LIBOR ranging from 60 to 225 basis
points. We believe our operating lines and credit facilities and the growth in
our cash flow from operating activities and the initial public stock offering
indicates a favorable trend in our available capital resources. As a result of
the proceeds received from the initial public offering, a $30 million operating
line of credit with a national financial institution was not renewed in February
2004 and we chose not to pursue execution of a commitment we had for a $30
million operating line of credit in late 2003.
In the fourth quarter of 2003, we expanded one of our existing short-term
student loan warehousing facilities, which resulted in an increase in the
aggregate of all short-term student loan warehousing facilities from $1.05
billion to $1.8 billion. This increased warehouse facility will allow for
expansion of our liquidity and capacity for student loan growth. We believe that
the expansion of our warehousing capacity and continued access to the
asset-backed securities market will provide adequate liquidity to fund our
student loan operations for the foreseeable future. At December 31, 2003, we had
a loan warehousing capacity of $2.8 billion through 364-day commercial paper
conduit programs. Historically, we have renewed our commercial paper conduit
programs annually and therefore, do not believe the annual renewal of these
contracts present a significant risk to our liquidity.
Our secured financing instruments include commercial paper lines, short-term
student loan warehouse programs, variable-rate tax-exempt bonds, fixed-rate,
tax-exempt bonds and various asset-backed securities. Of the $11.4 billion of
debt outstanding as of December 31, 2003, $9.3 billion was issued under
securitization transactions. In 2003 and 2002, we completed three asset-backed
securities transactions in each period totaling $2.9 billion and $2.8 billion,
respectively. In addition, in January 2004, we completed a $1.0 billion
asset-backed securities transaction. Depending on market conditions, we
anticipate continuing to access the asset-backed securities markets in 2004 and
subsequent years. Securities issued in our securitization transactions are
generally priced off a spread to LIBOR or set under an auction procedure related
to the bonds and notes. The student loans financed are generally priced on a
spread to commercial paper or Treasury bills.
We are limited in the amounts of funds that can be transferred to us by our
subsidiaries through intercompany loans, advances or cash dividends. These
limitations result from the restrictions contained in trust indentures under
debt financing arrangements to which our education lending subsidiaries are
parties. We believe these limitations will not affect our operating cash needs.
The amounts of cash and investments restricted in the respective reserve
accounts of the education lending subsidiaries are shown on the consolidated
balance sheets as restricted cash and investments.
The following table summarizes our bonds and notes outstanding as of
December 31, 2003:
As of December 31, 2003
-----------------------------------------------------
Percent Line of
Carrying of credit Interest rate
amount total amount range Final maturity
---------- ------ ---------- ------------ ------------------
(dollars in thousands)
Variable-rate bonds
and notes (a):
Bond and notes
based on indices........ $3,203,859 28.2% $3,203,859 1.11%--1.87% 05/01/07--01/25/37
Bond and notes
based on auction........ 5,125,270 45.1 5,125,270 1.00%--1.30% 07/01/05--07/01/43
----------- -----------
Total variable-rate
bonds and notes.... 8,329,129 73.3 8,329,129
Commercial paper and
other................. 2,064,400 18.2 2,795,000 1.11%--1.40% 05/14/04--09/25/24
Fixed-rate bonds and
notes(a).............. 927,694 8.1 927,694 5.50%--6.68% 05/01/05--06/01/28
Other secured borrowings 45,235 0.4 110,235 1.30%--6.00% 01/30/04--11/01/05
----------- -----------
Total.............. $11,366,458 $12,162,058
=========== ===========
- -----------
(a) Issued in securitization transactions.
22
Total unused commitments under various commercial paper, warehouse and
operating line of credit agreements totaled $796 million as of December 31,
2003.
The Company is committed under noncancelable operating leases for certain
office and warehouse space and equipment. Our contractual obligations as of
December 31, 2003 are as follows:
Less than More than
Total 1 year 1-3 years 3-5 years 5 years
----------- ----------- ----------- ----------- -----------
Bonds and notes payable $11,366,458 $ 597,575 $ 348,494 $ 294,538 $10,125,851
Operating lease
obligations 16,785 4,950 7,987 3,373 475
----------- ----------- ----------- ----------- -----------
Total $11,383,243 $ 602,525 $ 356,481 $ 297,911 $10,126,326
=========== =========== =========== =========== ===========
We have commitments with our branding partners, from whom we acquire student
loans and to whom we provide marketing and origination services, and forward
flow lenders, from whom we acquire student loans and to whom we provide
origination services only, which obligate us to purchase loans originated under
specific criteria, although our branding partners and forward flow lenders are
not obligated to provide us with a minimum amount of loans. These commitments
generally run for periods ranging from one to five years and are generally
renewable. We are obligated to purchase student loans at current market rates at
the respective sellers' requests under various agreements through September 30,
2004. As of December 31, 2003, $287.4 million of student loans were originated
under these agreements which we were committed to purchase.
Student Loan Portfolio
The table below describes the components of our loan portfolio:
As of December 31,
-------------------------------------------------
2003 2002
----------------------- -----------------------
Percent Percent
of of
Dollars total Dollars total
------------ ----- ------------ -----
(dollars in thousands)
FFELP:
Stafford ............... $ 4,901,289 46.9% $ 4,983,021 58.2%
PLUS/SLS (a) ........... 249,217 2.4 313,100 3.7
Consolidation .......... 5,073,081 48.5 3,033,607 35.4
Non-FFELP:
Private loans .......... 91,287 0.9 74,660 0.9
------------ ----- ------------ -----
Total ............... 10,314,874 98.7 8,404,388 98.2
Unamortized premiums ..... 156,594 1.5 167,032 1.9
Allowance for loan losses:
Allowance -- FFELP ..... (10,795) (0.1) (9,970) (0.1)
Allowance -- Private ... (5,231) (0.1) (2,030) --
------------ ----- ------------ -----
Net ................. $ 10,455,442 100.0% $ 8,559,420 100.0%
============ ===== ============ =====
__________
(a) Supplemental Loans for Students, or SLS, are the predecessor to unsubsidized
Stafford loans.
Activity in the Allowance for Loan Losses
The provision for loan losses represents the periodic expense of maintaining
an allowance sufficient to absorb losses, net of recoveries, inherent in the
portfolio of student loans.
23
An analysis of our allowance for loan losses is presented in the following
table:
Year ended December 31,
--------------------------------------------------
2003 2002 2001
------------ ------------ ------------
(dollars in thousands)
Balance at beginning of year .................. $ 12,000 $ 10,242 $ 3,614
Provision for loan losses:
FFELP loans ................................. 4,275 3,162 3,250
Private loans ............................... 7,200 2,425 675
------------ ------------ ------------
Total provision for loan losses ........... 11,475 5,587 3,925
Transfer from acquisitions .................... -- -- 4,866
Charge-offs:
FFELP loans ................................. (3,450) (2,570) (1,742)
Private loans ............................... (4,132) (1,333) (499)
------------ ------------ ------------
Total charge-offs ......................... (7,582) (3,903) (2,241)
Recoveries, private loans ..................... 133 74 78
------------ ------------ ------------
Net charge-offs ............................... (7,449) (3,829) (2,163)
------------ ------------ ------------
Balance at end of period ...................... $ 16,026 $ 12,000 $ 10,242
============ ============ ============
Allocation of the allowance for loan
losses:
FFELP loans ................................. $ 10,795 $ 9,970 $ 9,378
Private loans ............................... 5,231 2,030 864
------------ ------------ ------------
Total allowance for loan losses ........... $ 16,026 $ 12,000 $ 10,242
============ ============ ============
Net charge-offs as a percentage of
average student loans ......................... 0.079% 0.047% 0.042%
Total allowance as a percentage of
average student loans ......................... 0.170% 0.147% 0.199%
Total allowance as a percentage of
the ending balance of student loans ......... 0.155% 0.143% 0.141%
Private allowance as a percentage of
the ending balance of private loans ......... 5.730% 2.719% 1.413%
Average student loans ......................... $ 9,451,035 $ 8,171,898 $ 5,135,227
Ending balance of student loans ............... $ 10,314,874 $ 8,404,388 $ 7,267,055
Ending balance of private loans ............... $ 91,287 $ 74,660 $ 60,760
The table below shows the student loan delinquency amounts as of December
31, 2003 and 2002. Delinquencies have the potential to adversely impact our
earnings through increased servicing and collection costs and account
charge-offs.
December 31,
---------------------------------------------
2003 2002
---------------------- ---------------------
Balance Percent Balance Percent
----------- -------- ---------- ---------
(dollars in thousands)
FFELP Student Loan Portfolio:
Loans in school/
grace/deferment(1)........................ $ 2,941,228 $2,293,763
Loans in forbearance(2)................. 1,362,335 1,289,606
Loans in repayment status:
Loans current......................... 5,245,316 88.6% 4,002,025 84.3%
Loans delinquent 31-60 days(3)........ 279,435 4.7 307,668 6.5
Loans delinquent 61-90 days........... 130,339 2.2 146,198 3.1
Loans delinquent 91 days or greater(4) 264,934 4.5 290,468 6.1
----------- ----- ---------- -----
Total loans in repayment.............. 5,920,024 100.0% 4,746,359 100.0%
----------- ===== ---------- =====
Total FFELP student loan portfolio.... $10,223,587 $8,329,728
=========== ==========
Private Student Loan Portfolio:
Loans in school/grace/deferment(1)...... $ 25,537 $ 30,545
Loans in forbearance(2)................. 14,776 7,711
Loans in repayment status:
Loans current......................... 45,554 89.4% 31,168 85.6%
Loans delinquent 31-60 days(3)........ 2,531 5.0 2,953 8.1
Loans delinquent 61-90 days........... 1,556 3.0 1,259 3.5
Loans delinquent 91 days or greater(4) 1,333 2.6 1,024 2.8
----------- ----- ---------- -----
Total loans in repayment................ 50,974 100.0% 36,404 100.0%
----------- ===== ---------- =====
Total private student loan portfolio.. $ 91,287 $ 74,660
=========== ==========
- -----------
(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 temporarily ceased making full payments due to
hardship or other factors, according to a schedule approved by the servicer
consistent with the established loan program servicing procedures and
policies.
(3) The period of delinquency is based on the number of days scheduled payments
are contractually past due and relate to repayment loans, that is,
receivables not charged off, and not in school, grace, deferment or
forbearance.
(4) Loans delinquent 91 days or greater include loans in claim status, which are
loans which have gone into default and have been submitted to the guaranty
agency for FFELP loans or the private insurer for private loans to process
the claim for payment.
24
Origination and Acquisition
Our student loan portfolio increases through various channels, including
originations through our direct channel and acquisitions through our branding
partner channel, our forward flow channel, spot purchases and the secondary
market. Our portfolio also increases with the addition of portfolios acquired
through whole company or subsidiary acquisitions.
One of our primary objectives is to focus on originations through our direct
channel and acquisitions through our branding partner channel. We have extensive
and growing relationships with many large financial and educational institutions
which are active in the education finance industry. Our branding relationships
and forward flow relationships include Union Bank, an affiliate of ours, as well
as many schools and national and regional financial institutions. Loss of a
strong relationship, like that with a significant branding partner, such as
Union Bank, or with schools such as University of Phoenix and Nova Southeastern
University from which we directly or indirectly acquire a significant volume of
student loans, could result in an adverse effect on our volume derived from our
branding partner channel. For example, Nova Southeastern University, from which
we purchased FFELP loans (through its relationship with Union Bank) comprising
approximately 5.6% of our total student loan channel acquisitions in 2003, has
informed us and Union Bank, the direct acquirer of the student loans, of its
intent to not renew its sale commitment starting January 2007, in order to make
a request for a proposal to potential purchasers, including Union Bank and us.
The table below sets forth the increase in 2003, 2002 and 2001 of loans
originated or acquired through each of our channels:
Year ended December 31,
------------------------------------------------
2003 2002 2001
------------ ------------ ------------
(dollars in thousands)
Beginning balance .......... $ 8,404,388 $ 7,267,055 $ 3,541,831
------------ ------------ ------------
Direct channel:
Stafford/PLUS loan
originations ........... 236,855 224,827 84,599
Consolidation loan
originations ........... 2,266,499 859,120 55,715
Branding partner channel ... 808,843 521,023 524,964
Forward flow channel ....... 602,777 577,603 484,058
Other channels ............. 338,040 483,213 299,271
------------ ------------ ------------
Total channel acquisitions 4,253,014 2,665,786 1,448,607
------------ ------------ ------------
Loans acquired in
subsidiary acquisitions .... -- -- 2,919,845
Repayments, claims,
capitalized interest and
other(a) ............... (2,342,528) (1,528,453) (643,228)
------------ ------------ ------------
Ending balance ............. $ 10,314,874 $ 8,404,388 $ 7,267,055
============ ============ ============
- ------------
(a) Includes repayments on all consolidation loans.
Student Loan Spread Analysis
The following table analyzes the student loan spread on our portfolio of
student loans in 2003, 2002 and 2001. This table represents the spread on assets
earned in conjunction with the liabilities used to fund the assets. Maintenance
of the spread on assets is a key factor in maintaining and growing our income.
Year ended December 31,
-----------------------------------------------
2003 2002 2001
------------- ------------- -------------
Student loan yield ....... 4.98% 5.94% 6.71%
Consolidation rebate fees (0.43) (0.31) (0.23)
Premium amortization ..... (0.73) (0.67) (0.28)
------------- ------------- -------------
Student loan net yield ... 3.82 4.96 6.20
Student loan cost of funds (1.86) (2.59) (3.95)
------------- ------------- -------------
Student loan spread,
including variable-rate
floor income ........... 1.96 2.37 2.25
Variable-rate floor income (0.14) (0.61) (0.58)
------------- ------------- -------------
Student loan spread,
excluding variable-rate
floor income ........... 1.82% 1.76% 1.67%
============= ============= =============
Average balance of student
loans (in thousands) ..... $ 9,451,035 $ 8,171,898 $ 5,135,227
25
Risks
Risk Related to Consolidation Loans
Our student loan origination and lending activities could be significantly
impacted by the reauthorization of the Higher Education Act relative to the
single holder rule. For example, if the single holder rule, which generally
restricts a competitor from consolidating loans away from a holder that owns all
of a student's loans, were abolished, a substantial portion of our
non-consolidated portfolio would be at risk of being consolidated away by a
competitor. On the other hand, abolition of the rule would also open up a
portion of the rest of the market and provide us with the potential to gain
market share. The portion of the rest of the market that would be opened up to
us, as measured in aggregate principal amount of student loans, would be greater
than the portion of our non-consolidated portfolio that would be at risk of
being consolidated by a competitor. Other potential changes to the Higher
Education Act which could impact us include, without limitation:
o allowing refinancing of consolidation loans, which would open
approximately 49% of our portfolio to such refinancing; and
o allowing for variable-rate consolidation loans and extended repayment
terms of Stafford loans, which would lead to less loans lost through
consolidation of our portfolio, but would also decrease our
consolidation opportunities.
In addition, our efforts to expand into the consolidation market have been
affected by recently amended Federal Trade Commission rules and similar state
regulations providing for so-called "do not call" registries. Under these rules,
consumers may have their phone numbers added to a "do not call" registry, and we
would generally be prohibited from calling any such consumers to market our
products and services. This rule restricts one form of solicitation of new
customers for our products and services.
Political/Regulatory Risk
Pursuant to the terms of the Higher Education Act, the FFEL Program is
periodically amended, and the Higher Education Act must be reauthorized by
Congress every five years in order to prevent sunset of that Act. Changes in the
Higher Education Act made in the two most recent reauthorizations have included
reductions in the student loan yields paid to lenders, increased fees paid by
lenders and a decreased level of federal guarantee. Future changes could result
in further negative impacts on our business. Moreover, there can be no assurance
that the provisions of the Higher Education Act, which is scheduled to expire on
September 30, 2004, will be reauthorized. While Congress has consistently
extended the effective date of the Higher Education Act, it may elect not to
reauthorize the Department's ability to provide interest subsidies, special
allowance payments and federal guarantees for student loans. Such a failure to
reauthorize would reduce the number of federally guaranteed student loans
available for us to originate and/or acquire in the future.
Specific proposed legislation that could have a material effect on our
operations, if enacted, include:
o initiatives aimed at supporting the FDL program to the detriment of
the FFEL program;
o restrictions on payments made under the FFEL program to achieve
reductions in federal spending;
o allowing for increased borrower limits, which may provide
opportunities for increasing the average size of our future loan
originations;
o eliminating variable-rate floor income as well as the 9.5% floor
interest rate on loans financed with funds from pre-1993 tax-exempt
financings;
o changes to the single holder rule and other FFEL program rates and
terms as discussed above under "-- Risk Related to Consolidation
Loans;" and
o changes to the single holder rule as it relates to the FFELP and
Direct loans as discussed below.
The Department has published written correspondence, dated March 15, 2004 to
the National Council of Higher Education Loan Programs ("NCHELP") and also to
us, by a different author at the Department. The two letters are substantially
identical, stating the Department's position that, effective as of May 2004, "a
lender may make a consolidation loan to an eligible borrower only if the lender
holds an outstanding loan of that borrower which is selected by the borrower for
consolidation." The Department further took the position that this requirement
cannot be met if the borrower is only consolidating loans made pursuant to the
Higher Education Act other than FFELP loans. In subsequent discussions with the
Department, the author of the March correspondence to NCHELP made a verbal
clarification that the Department did not intend the March correspondence to
prohibit consolidation of Direct Loans. This
26
clarification has not yet been made in writing. We believe that the
consolidation of Direct Loans, without consolidation of other FFELP loans at the
same time, is legally permissible. However, in the event the Department does not
clarify its intent that the March correspondence does not apply to the
consolidation of Direct Loans, our practice of consolidating Direct Loans could
be significantly limited after May 1, 2004. Likewise, in the event the
Department was to publish an interpretation of the law that a FFELP lender may
not consolidate only Direct Loans, this would also have a significant impact on
our consolidation loan origination volume in the future. Currently,
approximately 60% of our affinity agreements with alumni associations are
schools that participate in Direct Loans.
In addition, the Department oversees and implements the Higher Education Act
and periodically issues regulations and interpretations of that Act. Changes in
such regulations and interpretations could negatively impact our business.
Liquidity Risk
Our primary funding needs are those required to finance our student loan
portfolio and satisfy our cash requirements for new student loan originations
and satisfy our cash requirements for new student loan originations and
acquisitions, operating expenses and technological development. Our operating
and warehousing financings are provided by third parties. The term of each
conduit facility is less than one year and each facility is renewable at the
option of the lender and may be terminated at any time for cause. There can be
no assurance that we will be able to maintain such conduit facilities, find
alternative funding or increase the commitment level of such facilities, if
necessary. While our conduit facilities have historically been renewed for
successive terms, there can be no assurance that this will continue in the
future.
In addition, we have historically relied upon, and expect to continue to
rely upon, asset-backed securitizations as our most significant source of
funding for student loans on a long-term basis. A major disruption in the
auction markets, such as insufficient potential bid orders to purchase all the
notes offered for sale or being repriced, could subject us to interest costs
substantially above the anticipated and historical rates paid on these types of
securities. A change in the capital markets could limit our ability to raise
funds or significantly increase the cost of those funds, affecting our ability
to acquire student loans.
Credit Risk
We bear full risk of losses experienced with respect to the unguaranteed
portion of our FFELP loans. Losses on our private loans will be borne by us,
with the exception of certain privately insured loans, which constitutes a
minority of our private loan portfolio. The loan loss pattern on our private
loan portfolio is not as developed as that on our FFELP loan portfolio. The
performance of student loans in our portfolio is affected by the economy, and a
prolonged economic downturn may have an adverse effect on the credit performance
of these loans. In addition, our private loans are underwritten and priced
according to risk, using credit scoring systems. We have defined underwriting
and collection policies, and ongoing risk monitoring and review processes for
all private loans. Management believes that is has provided sufficient
allowances to cover the losses that may be experienced in both its FFELP and
private loan portfolios. There is, however, no guarantee that such allowances
are sufficient enough to account for actual losses.
Operational Risk
Operational risk can result from regulatory compliance errors, technology
failures, breaches of internal control system, and the risk of fraud or
unauthorized transactions. Operational risk includes failure to comply with
regulatory requirements of the Higher Education Act, rules and regulations of
the agencies that act as guarantors on our student loans and federal and state
consumer protection laws and regulations on our private loans. Such failure to
comply, irrespective of the reason, could subject us to loss of the federal
guarantee on FFELP loans, costs of curing servicing deficiencies or remedial
servicing, suspension or termination of our right to participate in the FFEL
program or to participate as a servicer, negative publicity and potential legal
claims or actions brought by our servicing customers and borrowers.
We have the ability to cure servicing deficiencies and our historical losses
have been small. In addition, our servicing and guarantee servicing activities
are highly depended on our information systems, and we face the risk of business
disruption should there be extended failures of our systems. However, we have
well-developed and tested business recovery plans to mitigate this risk. We also
manage operational risk through our risk management and internal control
processes covering our product and service offerings. These internal control
processes are documented and tested regularly to ensure maintenance of internal
controls over our processes.
27
Market and Interest Rate Risk
Our primary market risk exposure arises from fluctuations in our borrowing
and lending rates, the spread between which could be impacted by shifts in
market interest rates. Because we generate the majority of our earnings from the
spread between the yield we receive on our portfolio of student loans and the
cost of funding these loans, the interest sensitivity of our balance sheet is a
key profitability driver. The majority of student loans have variable-rate
characteristics in certain interest rate environments. Some of our student loans
include fixed-rate components depending upon the rate reset provisions, or, in
the case of consolidation loans, are fixed at the weighted average interest rate
of the underlying loans at the time of consolidation. The table below sets forth
our loan assets and debt instruments by rate characteristics:
As of December 31,
--------------------------------------------
2003 Percent 2002 Percent
----------- ------- ---------- -------
(dollars in thousands)
Fixed-rate loan assets(a) .... $ 5,532,497 53.6% $3,320,121 39.5%
Variable-rate loan assets .... 4,782,377 46.4 5,084,267 60.5
----------- ----- ---------- -----
$10,314,874 100.0% $8,404,388 100.0%
=========== ===== ========== =====
Fixed-rate debt instruments .. $ 927,694 8.2% $1,122,881 11.9%
Variable-rate debt instruments 10,438,764 91.8 8,324,801 88.1
----------- ----- ---------- -----
$11,366,458 100.0% $9,447,682 100.0%
=========== ===== ========== =====
- ------------
(a) Includes approximately $561 million and $430 million of variable-rate loan
assets, which are classified as fixed-rate loan assets as a result of being
financed by variable-rate, tax-exempt bonds subject to a 9.5% minimum yield
as of December 31, 2003 and 2002.
Historically, we followed a policy of funding the majority of our student
loan portfolio with variable-rate debt. In the current low interest rate
environment, our FFELP loan portfolio is yielding excess income primarily due to
the reduction in interest rates on the variable-rate liabilities funding student
loans at the fixed borrower rate and due to consolidation loans earning interest
at a fixed rate to the borrower. Therefore, absent utilizing derivative
instruments, in a low interest rate environment, a rise in interest rates will
have an adverse effect on earnings and fair values. In higher interest rate
environments, where the interest rate rises above the borrower rate and the
fixed-rate loans become variable rate and are effectively matched with
variable-rate debt, the impact of rate fluctuations is substantially reduced.
We attempt to match the interest rate characteristics of pools of loan
assets with debt instruments of substantially similar characteristics,
particularly in rising interest rate markets. Due to the variability in duration
of our assets and varying market conditions, we do not attempt to perfectly
match the interest rate characteristics of the entire loan portfolio with the
underlying debt instruments. We have adopted a policy of periodically reviewing
the mismatch related to the interest rate characteristics of our assets and our
liabilities and our opinion as to current and future market conditions. Based on
those factors, we will periodically use derivative instruments as part of
overall risk management strategy to manage risk arising from our fixed-rate and
variable-rate financial instruments.
Derivative instruments that are used as part of our interest rate risk
management strategy include interest rate swaps and basis swaps. We account for
our derivative instruments in accordance with SFAS No. 133. SFAS No. 133
requires that changes in the fair value of derivative instruments be recognized
currently in earnings unless specific hedge accounting criteria as specified by
SFAS No. 133 are met. Management has structured all of our derivative
transactions with the intent that each is economically effective. However, the
majority of our derivative instruments do not qualify for hedge accounting under
SFAS No. 133; consequently, the change in fair value of these derivative
instruments of $1.2 million are included in the derivative market value
adjustment in other income in the statement of income for the year ended
December 31, 2003 and have reduced our net income. At December 31, 2003, we
accounted for one interest rate swap as a cash flow hedge in accordance with
SFAS No. 133. Gains and losses on the effective portion of this qualifying hedge
is accumulated in other comprehensive income and reclassified to current period
earnings over the period which the stated hedged transactions impact earnings.
Ineffectiveness is recorded to earnings.
The following table summarizes our outstanding derivative instruments as of
December 31, 2003:
Notional amounts by product type
--------------------------------
Fixed/
floating Basis
Maturity swaps(a) swaps(b) Total
------------- ------- ------- -------
(dollars in millions)
2004........ $ 1,000 $ 500 $ 1,500
2005........ 150 1,000 1,150
2006........ -- 500 500
------- ------- -------
Total..... $ 1,150 $ 2,000 $ 3,150
======= ======= =======
Fair value (c) $ 0.6 $ (1.3) $ (0.7)
======= ======= =======
28
- -----------
(a) A fixed/floating swap is an interest rate swap in which we agree to pay a
fixed rate in exchange for a floating rate. The interest rate swap converts
a portion of our variable-rate debt (equal to the notional amount of the
swap) to a fixed rate for a period of time fixing the relative spread
between a portion of our student loan assets and the converted fixed-rate
liability.
(b) A basis swap is an interest rate swap agreement in which we agree to pay a
floating rate in exchange for another floating rate, based upon different
market indices. We have employed basis swaps to limit our sensitivity to
dramatic fluctuations in the underlying indices used to price a portion of
our variable-rate assets and variable-rate debt.
(c) Fair value is determined from market quotes from independent security
brokers. Fair value indicates an estimated amount we would receive (pay) if
the contracts were cancelled or transferred to other parties.
Effective January 14, 2004, we entered into five additional interest rate
swaps with a combined notional amount of $6.0 billion that mature in 2004. These
interest rate swaps do not qualify for hedge accounting under SFAS No. 133.
As a result of our interest rate management activities, we expect the change
in pre-tax net income resulting from 100 basis point and 200 basis point
increases in interest rates will not result in a proportional decrease in net
income due to the effective switch of some variable-rate loans to fixed-rate
loans. The change would also be less dramatic had the interest rate management
strategies and derivative products employed in 2003 been in place for the entire
years ended December 31, 2003, 2002 and 2001.
The following tables summarize the effect on our earnings for the years
ended December 31, 2003, 2002 and 2001, based upon a sensitivity analysis
performed by us assuming a hypothetical increase and decrease in interest rates
of 100 basis points and an increase in interest rates of 200 basis points while
funding spreads remain constant. The effect on earnings was performed on our
variable-rate assets and liabilities and include the effects of our derivative
instruments in existence at December 31, 2003. The following tables do not
include the effects of the derivatives entered into in January 2004.
Year ended December 31, 2003
-------------------------------------------------------------------------
Change from decrease Change from increase Change from increase
of 100 basis points of 100 basis points of 200 basis points
--------------------- --------------------- --------------------
Dollars Percent Dollars Percent Dollars Percent
-------- ------- -------- ------- -------- -------
(dollars in thousands)
Effect on earnings:
Increase (decrease) in
pre-tax income before SFAS
No.133 change in fair value ... $ 34,719 75.0% $(18,256) (39.4)% $(30,356) (65.6)%
SFAS No.133 change in fair value $ (8,382) (18.1)% $ 6,007 13.0% $ 13,202 28.5%
-------- ----- -------- ---- -------- ----
Increase (decrease) in net
income before taxes ........... $ 26,337 56.9% $(12,249) (26.6)% $(17,154) (37.1)%
-------- ----- -------- ---- -------- ----
Increase (decrease) in basic
and diluted earnings per share $ 0.37 $ (0.17) $ (0.24)
======== ======== =========
Year ended December 31, 2002
-------------------------------------------------------------------------
Change from decrease Change from increase Change from increase
of 100 basis points of 100 basis points of 200 basis points
--------------------- --------------------- --------------------
Dollars Percent Dollars Percent Dollars Percent
-------- ------- -------- ------- -------- -------
Effect on earnings:
Increase (decrease) in
pre-tax income before SFAS
No.133 change in fair value ... $ 15,119 18.6% $(11,553) (14.2)% $(20,236) (24.9)%
SFAS No. 133 change in fair value $ -- 0.0 $ -- 0 $ -- 0.0
-------- ----- -------- ---- -------- ----
Increase (decrease) in net
income before taxes ........... $ 15,119 18.6% $(11,553) (14.2)% $(20,236) (24.9)%
-------- ----- -------- ---- -------- ----
Increase (decrease) in basic
and diluted earnings per share $ 0.22 $ (0.16) $ (0.29)
========= ======== ========
Year ended December 31, 2001
-------------------------------------------------------------------------
Change from decrease Change from increase Change from increase
of 100 basis points of 100 basis points of 200 basis points
--------------------- --------------------- --------------------
Dollars Percent Dollars Percent Dollars Percent
-------- ------- -------- ------- -------- -------
Effect on earnings:
Effect on earnings:
Increase (decrease) in
pre-tax income before SFAS
No.133 change in fair value ... $ 2,054 10.3% $ (749) (3.7)% $(1,975) (9.9)%
SFAS No. 133 change in fair value $ -- 0.0 $ -- 0.0 $ -- 0.0%
-------- ----- -------- ---- -------- ----
Increase (decrease) in net
income before taxes ........... $ 2,054 10.3% $ (749) (3.7)% $(1,975) (9.9)%
-------- ----- -------- ---- -------- ----
Increase (decrease) in basic
and diluted earnings per share $ 0.03 $ (0.01) $ (0.03)
======= ======= =======
29
The tables below set forth our variable-rate assets and liabilities
categorized by the reset date of the underlying index. Fixed-rate assets and
liabilities are categorized based on their maturity dates. An interest rate gap
is the difference between volumes of assets and volumes of liabilities maturing
or repricing during specific future time intervals. The following gap analysis
reflects our interest rate-sensitive positions as of December 31, 2003 and 2002
and is not necessarily reflective of the positions that existed throughout the
period.
As of December 31, 2003
-----------------------------------------------------------------------------------------
Interest rate sensitivity period
-----------------------------------------------------------------------------------------
3 months 3 months 6 months 1 to 2 2 to 5 Over 5
or less to 6 months to 1 year years years years
----------- --------- -------- -------- -------- --------
(dollars in thousands)
Interest-sensitive assets:
Student loans .......... $10,455,442 $ -- $ -- $ -- $ -- $ --
Cash and investments ... 1,155,215 -- -- -- -- --
----------- --------- -------- -------- -------- --------
Total interest-
sensitive assets... 11,610,657 -- -- -- -- --
----------- --------- -------- -------- -------- --------
Interest-sensitive
liabilities:
Short-term borrowings .. 10,438,764 -- -- -- -- --
Long-term notes ........ 61,237 54,355 108,167 206,484 311,588 185,863
----------- --------- -------- -------- -------- --------
Total interest-
sensitive liabilities 10,500,001 54,355 108,167 206,484 311,588 185,863
----------- --------- -------- -------- -------- --------
Period gap ............... 1,110,656 (54,355) (108,167) (206,484) (311,588) (185,863)
Cumulative gap ........... 1,110,656 1,056,301 948,134 741,650 430,062 244,199
Ratio of
interest-sensitive
assets to interest-
sensitive liabilities ... 110.6% --% --% --% --% --%
=========== ========= ======== ======== ======== ========
Ratio of cumulative gap
to total interest-sensitive
assets ................... 9.6% 9.1% 8.2% 6.4% 3.7% 2.1%
=========== ========= ======== ======== ======== ========
As of December 31, 2002
-----------------------------------------------------------------------------------------
Interest rate sensitivity period
-----------------------------------------------------------------------------------------
3 months 3 months 6 months 1 to 2 2 to 5 Over 5
or less to 6 months to 1 year years years years
----------- --------- -------- -------- -------- --------
(dollars in thousands)
Interest-sensitive assets:
Student loans ............. $8,559,420 $ -- $ -- $ -- $ -- $ --
Cash and investments ...... 916,572 -- -- -- -- --
----------- --------- -------- -------- -------- --------
Total interest-
sensitive assets ..... 9,475,992 -- -- -- -- --
----------- --------- -------- -------- -------- --------
Interest-sensitive
liabilities:
Short-term borrowings ..... 8,324,801 -- -- -- -- --
Long-term notes ........... 48,645 48,645 97,289 223,759 436,617 267,926
----------- --------- -------- -------- -------- --------
Total interest-
sensitive liabilities ... 8,373,446 48,645 97,289 223,759 436,617 267,926
----------- --------- -------- -------- -------- --------
Period gap .................. 1,102,546 (48,645) (97,289) (223,759) (436,617) (267,926)
Cumulative gap .............. 1,102,546 1,053,901 956,612 732,853 296,236 28,310
Ratio of
interest-sensitive
assets to interest-
sensitive liabilities ..... 113.2% --% --% --% --% --%
=========== ========= ======== ======== ======== ========
Ratio of cumulative gap
to total interest-sensitive
assets .................... 11.6% 11.1% 10.1% 7.7% 3.1% 0.3%
=========== ========= ======== ======== ======== ========
Critical Accounting Policies
This Management's Discussion and Analysis of Financial Condition and Results
of Operations discusses our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States of America, or 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 3 of the notes to the
consolidated financial statements includes a summary of the significant
accounting policies and methods used in the preparation of our consolidated
financial statements.
On an on-going basis, management evaluates its estimates and judgments,
particularly as they relate to accounting policies that management believes are
most "critical" -- that is, they are most important to the portrayal of our
financial condition and results of operations and they require management's most
difficult, subjective or complex judgments, often as a result of the need to
make estimates about the effect of matters that are inherently uncertain. These
accounting policies include securitization accounting,
30
determining the level of the allowance for loan losses and determining the level
of the program reimbursement reserve.
Securitization Accounting
We use the issuance of asset-backed securities, commonly called
securitization transactions, as a key component of our financing strategy. In
conjunction with these transactions, we transfer student loans to a trust, which
issues bonds backed by the student loans. Our securitization transactions do not
qualify for sale treatment under SFAS No. 140, Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities-a Replacement
of SFAS No. 125, as the trusts continue to be under our effective control and as
such we do not record or recognize gain on sale in conjunction with the
transaction, but rather treat the transfers as secured borrowings. All of the
financial activities and related assets and liabilities, including debt, of the
securitizations are reflected and consolidated in our financial statements.
Servicing, administrative support services and other intercompany activities
have been eliminated in accordance with generally accepted accounting
principles.
Allowance for Loan Losses
The allowance for loan losses represents management's estimate of probable
losses on student loans. This evaluation process is subject to numerous
estimates and judgments. In making such estimates and judgments, management
considers such things as the value and character of loans outstanding, past loan
loss experience and general economic conditions. We evaluate the adequacy of the
allowance for losses on our FFELP loan portfolio separately from our private
loan portfolio. Historical delinquencies and credit loss experience are also
considered when reviewing the current aging of the portfolio, together with
analyses that reflect current trends and conditions.
In contrast to the determination of our allowance for loan losses for our
private loan portfolio, when we determine the allowance for our FFELP loan
portfolio, we consider trends in student loan claims rejected for payment by
guaranty agencies and the amount of FFELP loans subject to the 2% risk sharing.
The allowance is based on periodic evaluations of our loan portfolio considering
past experience, changes to federal student loan programs, current economic
conditions and other relevant factors.
In determining the adequacy of the allowance for loan losses on private
loans, we consider several factors including: loans in repayment versus those in
non-paying status; months in repayment; delinquency status; type of program;
current economic conditions; and trends in defaults in the portfolio based on
our experience and industry data.
The allowance for FFELP and private loans is maintained at a level
management believes is adequate to provide for estimated probable credit losses
inherent in the loan portfolio. This evaluation is inherently subjective, as it
requires estimates that may be susceptible to significant changes.
Program Reimbursement Reserve
The program reimbursement reserve represents the amount that management
estimates we will be required to repay to lenders due to our failure to follow
prescribed due diligence procedures and servicing activities prescribed by the
Higher Education Act. Failure to meet certain due diligence requirements that
must be followed to maintain the Department guarantee on the loans will cause a
loss of the guarantee on the loans and potential loss to us if we are unable to
cure the deficiency under procedures prescribed by the federal government.
This evaluation process is subject to numerous estimates and judgments. In
making these estimates and judgments, management considers such factors as the
outstanding loan volume that we service, servicing loss experience, cure
experience, portfolio default rates and general economic conditions. The program
reimbursement reserve is determined based on a process that begins with an
estimate of the probable losses on serviced student loans. This estimate is
based on the weighted average historical loss rates for the past ten years,
current portfolio delinquency rates and other economic conditions that provide
information on the expected servicing losses. The estimated loss rate is applied
to the student loans currently serviced to derive a gross estimated servicing
loss. The estimated servicing loss is then reduced by the estimated cure rate on
such claims. The estimated cure rate is based on the weighted average historical
cure rates for the past ten years to derive a reasonable estimate of the
expected cure rate. The gross servicing losses net of the estimated cures will
provide the estimated servicing reimbursement reserve that we recognize.
The program reimbursement reserve reflects assumptions and estimates we
believe are reasonable in light of historical servicing errors and known trends
with respect to student loans serviced. However, these estimates and assumptions
are inherently subjective and may be susceptible to significant changes.
Management continually measures expected losses against actual losses and
assumptions are revised accordingly. Management believes that the program
reimbursement reserve is adequate to cover probable losses in the portfolio of
student loans serviced.
31
Recent Accounting Pronouncements
Early Extinguishment of Debt
In April 2002, the Financial Accounting Standard Board, or FASB, issued SFAS
No. 145, Rescission of FASB Statements Nos. 4, 44 and 64, Amendment of FASB
Statement No. 13, and Technical Corrections. This statement rescinds FASB
Statement No. 4, Reporting Gains and Losses from Extinguishment of Debt and an
amendment of that statement, FASB Statement No. 64, Extinguishments of Debt Made
to Satisfy Sinking-Fund Requirements. The statement also rescinds FASB Statement
No. 44, Accounting for Intangible Assets of Motor Carriers and amends FASB
Statement No. 13, Accounting for Leases to eliminate an inconsistency between
the required accounting for sale-leaseback transactions and the required
accounting for certain lease modifications that have economic effects that are
similar to sale-leaseback transactions. This statement also amends other
existing authoritative pronouncements to make various technical corrections,
clarify meanings or describe their applicability under changed conditions. The
provisions of SFAS No. 145 related to the rescission of FASB No. 4 are effective
for fiscal years beginning after May 15, 2002. The provisions of SFAS No. 145
related to FASB No. 13 are effective for transactions occurring after May 15,
2002. All other provisions of SFAS No. 145 are effective for financial
statements issued on or after May 15, 2002. The adoption of SFAS No. 145 did not
have a material impact on our financial statements.
Accounting for Costs Associated with Exit or Disposal Activities
In June 2002, FASB issued SFAS No. 146, Accounting for Costs Associated with
Exit or Disposal Activities. SFAS No. 146 requires that a liability for costs
associated with exit or disposal activities be recognized when the liability is
incurred. Previously, generally accepted accounting principles provided for the
recognition of such costs at the date of management's commitment to an exit
plan. In addition, SFAS No. 146 requires that the liability be measured at fair
value and be adjusted for changes in estimated cash flows. The provisions of the
new standard are effective for exit or disposal activities initiated after
December 31, 2002. It is not expected that SFAS No. 146 will materially affect
our financial statements.
Accounting for Stock-Based Compensation
In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based
Compensation -- Transition and Disclosure, an Amendment to FASB Statement No.
123. SFAS No. 148 requires annual disclosures about the method of accounting for
stock-based compensation and tabular information about the effect of the method
accounting for stock-based compensation on net income and earnings per share,
including pro forma amounts, in the "Summary of Significant Accounting
Policies." On a quarterly basis, SFAS No. 148 requires prominent disclosure in
tabular form of the effect of the method of stock-based compensation on net
income and earnings per share for all periods presented as accounted for under
APB Opinion No. 25. The disclosures required by SFAS 148 will be made in the
financial statements to the extent required for shares when issued under the
recently adopted Employee Share Purchase Plan.
Accounting for Guarantees
In November 2002, the FASB issued FASB Interpretation (FIN) No. 45,
Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others. FIN No. 45 identifies
characteristics of certain guarantee contracts and requires that a liability be
recognized at fair value at the inception of such guarantees for the obligations
undertaken by the guarantor. Additional disclosures also are prescribed for
certain guarantee contracts. The initial recognition and initial measurement
provisions of FIN No. 45 are effective for those guarantees issued or modified
after December 31, 2002. The disclosure requirements of FIN No. 45 were
effective for us as of December 31, 2002. Disclosures required by FIN No. 45 are
included in note 16 of the notes to the consolidated financial statements
related to the guarantee of an affiliate's liabilities to an unrelated third
party. We do not believe such guarantee required a liability to be recognized
under FIN No. 45. The adoption of FIN No. 45 did not have a material effect on
our financial statements.
Consolidation of Variable Interest Entities
In January 2003, the FASB issued FIN No. 46, Consolidation of Variable
Interest Entities. FIN No. 46 clarifies the application of Accounting Research
Bulletin No. 51, Consolidated Financial Statements, to certain entities in which
equity investors do not have the characteristics of a controlling financial
interest or do not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support from other parties,
which are referred to as variable interest entities. Variable interest entities
are required to be consolidated by their primary beneficiaries. The primary
beneficiary of a variable interest entity is the party that absorbs a majority
of the entity's expected losses, receives a majority of its expected residual
returns, or both, as a result of holding variable interests. FIN No. 46 also
requires new disclosures about variable interest entities. The implementation
date was deferred until December 31, 2003 for calendar year companies. In
December 2003, the FASB issued revised interpretation No. 46 (FIN 46R), which
addresses how a business enterprise should evaluate whether it has a controlling
financial interest in an entity through means
32
other than voting rights and accordingly should consolidate this entity. The
clarifications and modifications would apply to periods ending after December
31, 2003. FIN No. 46 and 46R will not have a material effect on our financial
statements.
Statement of Financial Accounting Standards No. 149 -- Amendment of Statement
133 on Derivative Instruments and Hedging Activities
This Statement amends and clarifies financial accounting and reporting for
derivative instruments, including certain derivative instruments embedded in
other contracts (collectively referred to as derivatives) and for hedging
activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging
Activities. This Statement is effective for contracts entered into or modified
after June 30, 2003, except as stated below and for hedging relationships
designated after June 30, 2003. In addition, except as stated below, all
provisions of this Statement should be applied prospectively. The provisions of
this Statement that relate to SFAS No. 133 implementation issues that have been
effective for fiscal quarters that began prior to June 15, 2003, should continue
to be applied in accordance with their respective effective dates. In addition,
paragraphs 7(a) and 23(a) of SFAS No. 133, which relate to forward purchases or
sales of when-issued securities or other securities that do not yet exist,
should be applied to both existing contracts and new contracts entered into
after June 30, 2003. The adoption of SFAS No. 149 did not have a significant
impact on our financial statements.
Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity
In May 2003, the FASB issued SFAS No 150, Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150
establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities and equity. It
requires that an issuer classify a financial instrument that is within its scope
as a liability, or an asset in some circumstances. SFAS No. 150 is effective for
financial instruments entered into or modified after May 31, 2003, and otherwise
is effective at the beginning of the first interim period beginning after June
15, 2003. We have adopted the standard effective July 1, 2003. The adoption of
SFAS No. 150 did not have a significant impact on our financial statements.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Included within Item 7, Management's Discussion and Analysis of Financial
Condition and Results of Operations.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Reference is made to the consolidated financial statements listed under the
heading "(a) 1. Consolidated Financial Statements" of Item 15 of this Report,
which consolidated financial statements are incorporated into this Report by
reference in response to this Item 8.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9a. CONTROLS AND PROCEDURES
Under supervision and with the participation of certain members of the
Company's management, including the co-chief executive officers and the chief
financial officer, the Company completed an evaluation of the effectiveness of
the design and operation of its disclosure controls and procedures (as defined
in Rules 13a-15(e) and 15d-15(e) to the Securities Act). Based on this
evaluation, the Company's co-chief executive officers and chief financial
officer believe that the disclosure controls and procedures were effective as of
the end of the period covered by this Report with respect to timely
communication to them and other members of management responsible for preparing
periodic reports and material information required to be disclosed in this
Report as it relates to the Company and its consolidated subsidiaries.
There was no change in the Company's internal control over financial
reporting during the Company's last fiscal quarter that has materially affected,
or is reasonably likely to materially affect, the Company's internal control
over financial reporting.
The effectiveness of the Company's or any system of disclosure controls and
procedures is subject to certain limitations, including the exercise of judgment
in designing, implementing and evaluating the controls and procedures, the
assumptions used in identifying the likelihood of future events, and the
inability to eliminate misconduct completely. As a result, there can be no
assurance that the Company's disclosure controls and procedures will prevent all
errors or fraud or ensure that all material information will be made known to
appropriate management in a timely fashion. By their nature, the Company's or
any system of disclosure controls and procedures can provide only reasonable
assurance regarding management's control objectives.
33
PART III.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information as to the directors and executive officers of the Company
set forth under the captions "PROPOSAL 1--ELECTION OF DIRECTORS--Nominees" and
"Executive Officers" in the Proxy Statement to be filed on Schedule 14A, no
later than 120 days after the end of it's the Company's fiscal year with the
SEC, relating to the Company's Annual Meeting of Shareholders scheduled to be
held on May 27, 2004 (the "Proxy Statement") is incorporated into this Report by
reference.
ITEM 11. EXECUTIVE COMPENSATION
The information set forth under the caption "EXECUTIVE COMPENSATION" in the
Proxy Statement is incorporated into this Report by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information set forth under the caption "SECURITY OWNERSHIP OF
DIRECTORS, EXECUTIVE OFFICERS, AND PRINCIPAL SHAREHOLDERS--Stock Ownership" in
the Proxy Statement is incorporated into this Report by reference. There are no
arrangements known to the Company, the operation of which may at a subsequent
date result in a change in the control of the Company.
The following table summarizes, as of December 31, 2003, information about
compensation plans under which equity securities are authorized for issuance.
Equity Compensation Plan Information
Number of shares
remaining available for
Number of shares to future issuance under
be issued upon Weighted-average equity compensation
exercise of exercise price of plans (excluding
outstanding options, outstanding options, securities reflected in
warrants and rights warrants, and rights column (a))
Plan category (a) (b) (c)
--------------------------- ------------------- -------------------- -----------------------
Equity compensation plans
approved by shareholders 0 $0 2,100,000
Equity compensation plans
not approved by
shareholders 0 $0 0
------------ ------------ ---------------
Total 0 $0 2,100,000
============ ============ ===============
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information set forth under the caption "CERTAIN RELATIONSHIPS AND
RELATED TRANSACTIONS" in the Proxy Statement is incorporated into this Report by
reference.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information set forth under the caption "PROPOSAL 2--APPOINTMENT OF
INDEPENDENT AUDITOR--Independent Accountant Fees and Services" in the Proxy
Statement is incorporated into this Report by reference.
34
PART IV.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) 1. Consolidated Financial Statements
The following consolidated financial statements of Nelnet, Inc. and its
subsidiaries and the Independent Auditors' Report thereon are included in Item 8
above:
Page
----
Independent Auditors' Report.............................................................. F-2
Consolidated Financial Statements for the Years Ended December 31, 2003, 2002 and 2001:
Consolidated Balance Sheets as of December 31, 2003 and 2002.............................. F-3
Consolidated Statements of Income for the Years Ended December 31, 2003, 2002 and 2001.... F-4
Consolidated Statements of Shareholders' Equity and Comprehensive Income for the Years
Ended December 31, 2003, 2002 and 2001.................................................. F-5
Consolidated Statements of Cash Flows for the Years Ended December 31, 2003, 2002 and 2001 F-6
Notes to the Consolidated Financial Statements............................................ F-7
2. Financial Statement Schedules
All schedules are omitted because they are not applicable or the
required information is shown in the consolidated financial statements or notes
there.
3. Exhibits
The exhibits listed in the accompanying index to exhibits are filed or
incorporated by reference as part of this annual report.
4. Appendix
Appendix A - Federal Family Education Loan Program
(b) Reports on Form 8-K.
On January 30, 2004, the Company filed a current report on Form 8-K
announcing its financial results for the quarter and year ended December 31,
2003.
(c) Exhibits
EXHIBIT INDEX
Exhibit
No. Description
-------- ------------------------------------------------------------------
2.1 Plan of Reorganization, Plan of Merger and Merger Agreement, dated
as of October 14, 1999, by and between Union Financial Services,
Inc. and National Education Loan Network, Inc. (Incorporated by
reference to Exhibit 2.1 to the registrant's Form S-1 Registration
Statement.)
2.2 Articles of Merger certified by Union Financial Services, Inc.,
dated October 15, 1999. Incorporated by reference to Exhibit 2.2
to the registrant's Form S-1 Registration Statement.
2.3 Agreement and Plan of Reorganization, dated as of March 1, 2000,
by and among UNIPAC Service Corporation, NelNet, Inc.
(subsequently renamed National Education Loan Network, Inc.) and
National Education Loan Network, Inc. Incorporated by reference to
Exhibit 2.3 to the registrant's Form S-1 Registration Statement.
2.4 Plan of Merger, dated as of March 1, 2000, by and among NelNet,
Inc. (subsequently renamed National Education Loan Network, Inc.),
National Education Loan Network, Inc. and UNIPAC Service
Corporation. Incorporated by reference to Exhibit 2.4 to the
registrant's Form S-1 Registration Statement.
2.5 Articles of Merger certified by NelNet, Inc., dated March 1, 2000.
Incorporated by reference to Exhibit 2.5 to the registrant's Form
S-1 Registration Statement.
2.6 Letter Agreement relating to the purchase of the stock of
InTuition Holdings, Inc., dated as of June 15, 2000, between
NELnet, Inc. (subsequently renamed National Education Loan
Network, Inc.) and Farmers & Merchants Investment Inc.
Incorporated by reference to Exhibit 2.6 to the registrant's Form
S-1 Registration Statement.
2.7 Transfer Agreement with Irrevocable Power of Attorney, dated as of
June 28, 2001, by and between InTuition Development Holdings, LLC
and InTuition Guarantee Services II, Inc. (which subsequently
became Nelnet Guarantee Services Inc.) relating to the membership
interests in InTuition Guarantee Services, LLC (which subsequently
became GuaranTec LLP). Incorporated by reference to Exhibit 2.7 to
the registrant's Form S-1 Registration Statement.
35
2.8 Master Stock Purchase Agreement, dated as of December 12, 2001, by
and between EFS, Inc. and NELnet, Inc. (subsequently renamed
National Education Loan Network, Inc.). Incorporated by reference
to Exhibit 2.8 to the registrant's Form S-1 Registration
Statement.
2.9 Stock Purchase Agreement, dated as of January 24, 2002, by and
among NELnet, Inc. (subsequently renamed National Education Loan
Network, Inc.) and Hilario Arguinchona. Incorporated by reference
to Exhibit 2.9 to the registrant's Form S-1 Registration
Statement.
2.10 Purchase Agreement, dated as of February 14, 2002, by and between
InTuition Guarantee Services, LLC and NELnet, Inc. (subsequently
renamed National Education Loan Network, Inc.). Incorporated by
reference to Exhibit 2.10 to the registrant's Form S-1
Registration Statement.
2.11 Stock Purchase Agreement, dated May 1, 2002, by and among Nelnet
Loan Services, Inc. (subsequently renamed Nelnet, Inc.) and
Nelnet, Inc. (subsequently renamed National Education Loan
Network, Inc.). Incorporated by reference to Exhibit 2.11 to the
registrant's Form S-1 Registration Statement.
2.12 Stock Purchase Agreement, dated as of May 1, 2002, by and between
Farmers & Merchants Investment Inc. and Nelnet Loan Services, Inc.
(subsequently renamed Nelnet, Inc.). Incorporated by reference to
Exhibit 2.12 to the registrant's Form S-1 Registration Statement.
2.13 Stock Purchase Agreement, dated May 2, 2002, by and among Packers
Service Group, Inc. and Infovisa, Inc. Incorporated by reference
to Exhibit 2.13 to the registrant's Form S-1 Registration
Statement.
2.14 Stock Purchase Agreement, dated as of May 9, 2002, among Thomas
Morrill, James Callier, Michael Cruskie, DominicRotondi and
Nelnet, Inc. (subsequently renamed National Education Loan
Network, Inc.) concerning Charter Account Systems, Inc.
Incorporated by reference to Exhibit 2.14 to the registrant's Form
S-1 Registration Statement.
2.15 Senior Stock Purchase (Call) Option Agreement by and between
NELnet, Inc. (subsequently renamed National Education Loan
Network, Inc.) and Maine Educational Loan Marketing Corporation
dated as of June 30, 2000. Incorporated by reference to Exhibit
2.15 to the registrant's Form S-1 Registration Statement.
2.16 Purchase Agreement, dated as of July 3, 2003, by and between
Nelnet Loan Services, Inc. (subsequently renamed Nelnet, Inc.),
Union Financial Services, Inc. and Packers Service Group, Inc.
Incorporated by reference to Exhibit 2.16 to the registrant's Form
S-1 Registration Statement.
2.17* Agreement for Purchase of LLC Membership Interest among David A.
Hoeft, Todd J. Wolfe, Tina D. Mercer, Premier Credit of North
America, LLC and Nelnet, Inc., dated as of January 28, 2004.
3.1 Second Amended and Restated Articles of Incorporation of Nelnet,
Inc. Incorporated by reference to Exhibit 3.1 to the registrant's
Form S-1 Registration Statement.
3.2 Second Amended and Restated Bylaws of Nelnet, Inc. Incorporated by
reference to Exhibit 3.2 to the registrant's Form S-1 Registration
Statement.
4.1 Form of Class A Common Stock Certificate of Nelnet, Inc.
Incorporated by reference to Exhibit 4.1 to the registrant's Form
S-1 Registration Statement.
4.2 Indenture of Trust by and between Nelnet Student Loan
Corporation-2 and Zions First National Bank, as Trustee, dated as
of June 1, 2000. Incorporated by reference to Exhibit 4.2 to the
registrant's Form S-1 Registration Statement.
4.3 Series 2000 Supplemental Indenture of Trust by and between Nelnet
Student Loan Corporation-2 and Zions First National Bank, as
Trustee, authorizing the issuance of $1,000,000,000 NELNET Student
Loan Corporation-2 Taxable Student Loan Asset-Backed Notes Series
2000, dated as of June 1, 2000. Incorporated by reference to
Exhibit 4.3 to the registrant's Form S-1 Registration Statement.
4.4 Indenture of Trust by and between Nelnet Student Loan Trust 2002-1
and Zions First National Bank, as Trustee, dated as of May 1,
2002. Incorporated by reference to Exhibit 4.4 to the registrant's
Form S-1 Registration Statement.
4.5 Indenture of Trust by and between Nelnet Student Loan Trust 2002-2
and Zions First National Bank, as Trustee, dated as of September
1, 2002. Incorporated by reference to Exhibit 4.5 to the
registrant's Form S-1 Registration Statement.
4.6 Indenture of Trust between Nelnet Student Loan Trust 2003-1 and
Zions First National Bank, as Trustee, dated as of January 1,
2003. Incorporated by reference to Exhibit 4.6 to the registrant's
Form S-1 Registration Statement.
4.7 Indenture of Trust by and among Nelnet Education Loan Funding,
Inc., Wells Fargo Bank Minnesota, National Association, as
Indenture Trustee, and Wells Fargo Bank Minnesota, National
Association, as Eligible Lender Trustee, dated as of June 1, 2003.
Incorporated by reference to Exhibit 4.7 to the registrant's Form
S-1 Registration Statement.
4.8 Series 2003-1 Supplemental Indenture of Trust by and between
Nelnet Education Loan Funding, Inc. and Wells Fargo Bank
Minnesota, National Association, as Indenture Trustee, authorizing
the issuance of $1,030,000,000 Nelnet Education Loan Funding, Inc.
Student Loan Asset-Backed Notes Series 2003-1, dated as of June 1,
2003. Incorporated by reference to Exhibit 4.8 to the registrant's
Form S-1 Registration Statement.
4.9 Option Agreement, dated as of January 24, 2002, by and between
NELnet, Inc. (subsequently renamed National Education Loan
Network, Inc.) and Hilario Arguinchona. Incorporated by reference
to Exhibit 4.10 to the registrant's Form S-1 Registration
Statement.
36
4.10 Registration Rights Agreement, dated as of December 16, 2003, by
and among Nelnet, Inc. and the shareholders of Nelnet, Inc.
signatory thereto. Incorporated by reference to Exhibit 4.11 to
the registrant's Form S-1 Registration Statement.
4.11* Indenture of Trust among Nelnet Education Loan Funding, Inc. and
Wells Fargo Bank Minnesota, National Association, as Indenture
Trustee and Eligible Lender Trustee, dated as of January 1, 2004.
4.12 Trust Agreement, dated as of April 1, 2001, among NELNET Student
Loan Corporation-1, as Depositor, MELMAC LLC, as Depositor,
NELnet, Inc. (subsequently renamed National Education Loan
Network, Inc.), as Administrator, The Chase Manhattan Bank, as
Collateral Agent, Note Registrar and Note Paying Agent, and
Wilmington Trust Company, as Trustee, Certificate Registrar and
Certificate Paying Agent. Incorporated by reference to Exhibit
10.59 to the registrant's Form S-1 Registration Statement.
4.13 Trust Agreement, dated as of December 1, 2001, among EMT Corp., as
Depositor, NELnet, Inc. (subsequently renamed National Education
Loan Network, Inc.), as Administrator, JPMorgan Chase Bank, as
Collateral Agent, Note Registrar and Note Paying Agent, and
Wilmington Trust Company, as Trustee, Certificate Registrar and
Certificate Paying Agent. Incorporated by reference to Exhibit
10.60 to the registrant's Form S-1 Registration Statement.
10.2 Agreement to Terminate Stockholders Agreement, dated as of August
4, 2003, by and among Nelnet Loan Services, Inc. (f/k/a UNIPAC
Service Corporation) (subsequently renamed Nelnet, Inc.) and those
stockholders party to the Stockholders Agreement dated as of March
2, 2000. Incorporated by reference to Exhibit 10.2 to the
registrant's Form S-1 Registration Statement.
10.3 Warehouse Loan and Security Agreement among NHELP-I, Inc., as the
Borrower, Norwest Bank Minnesota, National Association, as the
Trustee, and Concord Minutemen Capital Company, LLC, as the
Lender, dated as of September 30, 1998. Incorporated by reference
to Exhibit 10.3 to the registrant's Form S-1 Registration
Statement.
10.4 First Amendment to Warehouse Loan and Security Agreement, among
NHELP-I Inc., as the Borrower, Norwest Bank Minnesota, National
Association, as the Trustee, and Concord Minutemen Capital
Company, LLC, as the Lender, dated as of December 15, 1998.
Incorporated by reference to Exhibit 10.4 to the registrant's Form
S-1 Registration Statement.
10.5 Second Amendment to Warehouse Loan and Security Agreement among
NHELP-I, Inc., as the Borrower, Norwest Bank Minnesota, National
Association, as the Trustee, and Concord Minutemen Capital
Company, LLC, as the Lender, dated as of September 29, 1999.
Incorporated by reference to Exhibit 10.5 to the registrant's Form
S-1 Registration Statement.
10.6 Third Amendment to Warehouse Loan and Security Agreement, dated as
of November 16, 1999, among NHELP-I, Inc., Concord Minutemen
Capital Company, LLC and Norwest Bank Minnesota, National
Association. Incorporated by reference to Exhibit 10.6 to the
registrant's Form S-1 Registration Statement.
10.7 Fourth Amendment to Warehouse Loan and Security Agreement, dated
as of February 1, 2000, among NHELP-I, Inc., Concord Minutemen
Capital Company, LLC and Norwest Bank Minnesota, National
Association. Incorporated by reference to Exhibit 10.7 to the
registrant's Form S-1 Registration Statement.
10.8 Fifth Amendment to Warehouse Loan and Security Agreement among
NHELP-I, Inc., as the Borrower, Wells Fargo Bank Minnesota,
National Association, as the successor Trustee, and Concord
Minutemen Capital Company, LLC, as the Lender, dated as of
September 1, 2000. Incorporated by reference to Exhibit 10.8 to
the registrant's Form S-1 Registration Statement.
10.9 Sixth Amendment to Warehouse Loan and Security Agreement, dated as
of September 24, 2002, among NHELP-I, Inc., Concord Minutemen
Capital Company, LLC and Wells Fargo Bank Minnesota, National
Association. Incorporated by reference to Exhibit 10.9 to the
registrant's Form S-1 Registration Statement.
10.10 Warehouse Note Purchase and Security Agreement among NHELP-III,
Inc., as the Issuer, Norwest Bank Minnesota, National Association,
as the Trustee, Delaware Funding Corporation, as a Note Purchaser,
Three Rivers Funding Corporation, as a Note Purchaser, Morgan
Guaranty Trust Company of New York, as DFC Agent and
Administrative Agent, and Mellon Bank, N.A., as TRFC Agent, dated
as of September 1, 1999. Incorporated by reference to Exhibit
10.10 to the registrant's Form S-1 Registration Statement.
10.11 First Amendment to Warehouse Note Purchase and Security Agreement
among NHELP-III, Inc., as the Issuer, Wells Fargo Bank Minnesota,
National Association, as the successor Trustee, Delaware Funding
Corporation, as a Note Purchaser, Three Rivers Funding
Corporation, as a Note Purchaser, Morgan Guaranty Trust Company of
New York, as DFC Agent and Administrative Agent, and Mellon Bank,
N.A., as TRFC Agent, dated as of September 1, 2000. Incorporated
by reference to Exhibit 10.11 to the registrant's Form S-1
Registration Statement.
10.12 Second Amendment to Warehouse Note Purchase and Security Agreement
among NHELP-III, Inc., as the Issuer, Wells Fargo Bank Minnesota,
National Association, as the successor Trustee, Delaware Funding
Corporation, as a Note Purchaser, Three Rivers Funding
Corporation, as a Note Purchaser, JPMorgan Chase Bank, as DFC
Agent and Administrative Agent, and Mellon Bank, N.A., as TRFC
Agent, dated as of September 12, 2002. Incorporated by reference
to Exhibit 10.12 to the registrant's Form S-1 Registration
Statement.
10.13 Amendment to Warehouse Note Purchase and Security Agreement, dated
as of June 1, 2003, by and among NHELP-III, Inc., as the Issuer,
Delaware Funding Corporation, as Note Purchaser, Three Rivers
Funding Corporation, as Note Purchaser, JPMorgan Chase Bank
(successor to Morgan Guaranty and Trust Company of New York), as
DFC Agent and Administrative Agent, and Mellon Bank, N.A., as TRFC
Agent. Incorporated by reference to Exhibit 10.13 to the
registrant's Form S-1 Registration Statement.
37
10.14 Warehouse Loan and Security Agreement among NELnet Student Loan
Warehouse Corporation-1, as Borrower, Zions First National Bank,
as Trustee, Thunder Bay Funding Inc., as Lender, and Royal Bank of
Canada, as Facility Agent and Alternate Lender, dated as of
February 1, 2002. Incorporated by reference to Exhibit 10.14 to
the registrant's Form S-1 Registration Statement.
10.15 Amended and Restated Warehouse Loan and Security Agreement among
Nelnet Education Loan Funding, Inc., as Borrower, Wells Fargo Bank
Minnesota, National Association, as Eligible Lender Trustee, Zions
First National Bank, as Trustee, Thunder Bay Funding Inc., as
Lender, and Royal Bank of Canada, as Facility Agent and Alternate
Lender, dated as of April 28, 2003. Incorporated by reference to
Exhibit 10.15 to the registrant's Form S-1 Registration Statement.
10.16 Warehouse Note Purchase and Security Agreement among Nelnet
Education Loan Funding, as Borrower, Wells Fargo Bank Minnesota,
National Association, as Trustee, Wells Fargo Bank Minnesota,
National Association, as Eligible Lender Trustee, Quincy Capital
Corporation, as Bank of America Conduit Lender, Bank of America,
N.A., as Bank of America Alternate Lender, Bank of America, N.A.,
as Bank of America Facility Agent, Gemini Securitization Corp., as
Deutsche Bank Conduit Lender, Deutsche Bank AG, New York Branch,
as Deutsche Bank Alternate Lender, Deutsche Bank AG, New York
Branch, as Deutsche Bank Facility Agent, Barton Capital
Corporation, as Societe Generale Conduit Lender, Societe Generale,
as Societe Generale Alternate Lender, Societe Generale, as Societe
Generale Facility Agent, and Bank of America, N.A., as
Administrative Agent, dated as of May 1, 2003. Incorporated by
reference to Exhibit 10.16 to the registrant's Form S-1
Registration Statement.
10.17 Credit Agreement, dated as of January 11, 2002, by and among
Nelnet Loan Services, Inc. (subsequently renamed Nelnet, Inc.),
Nelnet, Inc. (subsequently renamed National Education Loan
Network, Inc.) and Bank of America, N.A. Incorporated by reference
to Exhibit 10.17 to the registrant's Form S-1 Registration
Statement.
10.18 First Amendment to Credit Agreement, dated as of January 24, 2003,
by and among Nelnet Loan Services, Inc. (subsequently renamed
Nelnet, Inc.), Nelnet, Inc. (subsequently renamed National
Education Loan Network, Inc.) and Bank of America, N.A.
Incorporated by reference to Exhibit 10.18 to the registrant's
Form S-1 Registration Statement.
10.19 Second Amendment to Credit Agreement and First Amendment to
Application and Agreement for Standby Letter of Credit, dated as
of August 18, 2003, by and among National Education Loan Network,
Inc. (formerly known as Nelnet, Inc.), Nelnet, Inc. (formerly
known as Nelnet Loan Services, Inc.) and Bank of America, N.A.
Incorporated by reference to Exhibit 10.19 to the registrant's
Form S-1 Registration Statement.
10.20 Security Agreement, dated as of January 11, 2002, by and between
Nelnet Loan Services, Inc. (subsequently renamed Nelnet, Inc.) and
Bank of America, N.A. Incorporated by reference to Exhibit 10.20
to the registrant's Form S-1 Registration Statement.
10.21 Guaranty Agreement, dated as of January 11, 2002, by and among
Nelnet Loan Services, Inc. (subsequently renamed Nelnet, Inc.),
Nelnet, Inc. (subsequently renamed National Education Loan
Network, Inc.), Nelnet Corporation (subsequently renamed Nelnet
Corporate Services, Inc.), Nelnet Marketing Solutions, Inc.,
ClassCredit, Inc., Nelnet Guarantee Services, Inc., InTuition,
Inc., EFS, Inc., EFS Services, Inc., EFS Finance Co., GuaranTec
LLP and National Higher Education Loan Program, Inc. Incorporated
by reference to Exhibit 10.21 to the registrant's Form S-1
Registration Statement.
10.22 Intercreditor Agreement, dated as of January 11, 2002, by and
among Farmers & Merchants Investment Inc., Bank of America, N.A.
and Nelnet, Inc. (subsequently renamed National Education Loan
Network, Inc.) Incorporated by reference to Exhibit 10.22 to the
registrant's Form S-1 Registration Statement.
10.23 Irrevocable Letter of Credit in the amount of $50,000,000, dated
as of May 23, 2003, by and between Nelnet, Inc. (subsequently
renamed National Education Loan Network, Inc.) and Bank of
America, N.A. Incorporated by reference to Exhibit 10.23 to the
registrant's Form S-1 Registration Statement.
10.24 Continuing Guaranty, dated as of May 23, 2003, by and between
Nelnet Loan Services, Inc. (subsequently renamed Nelnet, Inc.) and
Bank of America, N.A. Incorporated by reference to Exhibit 10.24
to the registrant's Form S-1 Registration Statement.
10.25 Agreement Between 5280 Solutions and Nelnet/Unipac, dated as of
April 12, 2001. Incorporated by reference to Exhibit 10.25 to the
registrant's Form S-1 Registration Statement.
10.26+ Employment Contract, dated as of May 1, 2001, by and between
NHELP, Inc. and Richard H. Pierce. Incorporated by reference to
Exhibit 10.26 to the registrant's Form S-1 Registration Statement.
10.27 Marketing Expense Reimbursement Agreement, dated as of January 1,
1999, by and between Union Bank and Trust Company and National
Education Loan Network, Inc. Incorporated by reference to Exhibit
10.27 to the registrant's Form S-1 Registration Statement.
10.28 First Amendment of Marketing Expense Reimbursement Agreement,
dated as of April 1, 2001, by and between Union Bank and Trust
Company and NELnet, Inc. (f/k/a National Education Loan Network,
Inc.) (subsequently renamed National Education Loan Network,
Inc.). Incorporated by reference to Exhibit 10.28 to the
registrant's Form S-1 Registration Statement.
10.29 Second Amendment of Marketing Expense Reimbursement Agreement,
dated as of December 21, 2001, by and between Union Bank and Trust
Company and NELnet, Inc. (f/k/a National Education Loan Network,
Inc.) (subsequently renamed National Education Loan Network,
Inc.). Incorporated by reference to Exhibit 10.29 to the
registrant's Form S-1 Registration Statement.
38
10.30 Amended and Restated Participation Agreement, dated as of June 1,
2001, by and between NELnet, Inc. (subsequently renamed National
Education Loan Network, Inc.) and Union Bank and Trust Company.
Incorporated by reference to Exhibit 10.30 to the registrant's
Form S-1 Registration Statement.
10.31 First Amendment of Amended and Restated Participation Agreement,
dated as of December 19, 2001, by and between Union Bank and Trust
Company and NELnet, Inc. (subsequently renamed National Education
Loan Network, Inc.). Incorporated by reference to Exhibit 10.31 to
the registrant's Form S-1 Registration Statement.
10.32 Second Amendment of Amended and Restated Participation Agreement,
dated as of December 1, 2002, by and between Union Bank and Trust
Company and Nelnet, Inc. (f/k/a NELnet, Inc.) (subsequently
renamed National Education Loan Network, Inc.). Incorporated by
reference to Exhibit 10.32 to the registrant's Form S-1
Registration Statement.
10.33 Alternative Loan Participation Agreement, dated as of June 29,
2001, by and between NELnet, Inc. (subsequently renamed National
Education Loan Network, Inc.) and Union Bank and Trust Company.
Incorporated by reference to Exhibit 10.33 to the registrant's
Form S-1 Registration Statement.
10.34 Amended and Restated Agreement, dated as of January 1, 1999, by
and between Union Bank and Trust Company and National Education
Loan Network, Inc. Incorporated by reference to Exhibit 10.34 to
the registrant's Form S-1 Registration Statement.
10.36 Guaranteed Purchase Agreement, dated as of March 19, 2001, by and
between NELnet, Inc. (subsequently renamed National Education Loan
Network, Inc.) and Union Bank and Trust Company. Incorporated by
reference to Exhibit 10.36 to the registrant's Form S-1
Registration Statement.
10.37 First Amendment of Guaranteed Purchase Agreement, dated as of
February 1, 2002, by and between NELnet, Inc. (subsequently
renamed National Education Loan Network, Inc.) and Union Bank and
Trust Company. Incorporated by reference to Exhibit 10.37 to the
registrant's Form S-1 Registration Statement.
10.38 Second Amendment of Guaranteed Purchase Agreement, dated as of
December 1, 2002, by and between Nelnet, Inc. (f/k/a/ NELnet,
Inc.) (subsequently renamed National Education Loan Network, Inc.)
and Union Bank and Trust Company. Incorporated by reference to
Exhibit 10.38 to the registrant's Form S-1 Registration Statement.
10.39 Agreement For Use of Revolving Purchase Facility, dated as of
January 1, 1999, by and between Union Bank and Trust Company and
National Education Loan Network, Inc. Incorporated by reference to
Exhibit 10.78 to the registrant's Form S-1 Registration Statement.
10.40+ Nelnet, Inc. Executive Officers' Bonus Plan. Incorporated by
reference to Exhibit 10.79 to the registrant's Form S-1
Registration Statement.
10.41+ Share Retention Policy. Incorporated by reference to Exhibit 10.83
to the registrant's Form S-1 Registration Statement.
10.42+ Nelnet, Inc. Restricted Stock Plan. Incorporated by reference to
Exhibit 4.12 to the registrant's Form S-1 Registration Statement.
10.43+ Nelnet, Inc. Directors Stock Compensation Plan. Incorporated by
reference to Exhibit 4.13 to the registrant's Form S-1
Registration Statement.
10.44+ Nelnet, Inc. Employee Share Purchase Plan. Incorporated by
reference to Exhibit 4.14 to the registrant's Form S-1
Registration Statement.
10.45 Operating Agreement of FirstMark Services, LLC, dated as of March
31, 2002. Incorporated by reference to Exhibit 10.84 to the
registrant's Form S-1 Registration Statement.
10.46 Credit Agreement by and among Nelnet, Inc., National Education
Loan Network, Inc., M&I Marshall Ilsley Bank, SunTrust Bank, First
National Bank of Omaha and Fifth Third Bank, Indiana, dated as of
September 25, 2003. Incorporated by reference to Exhibit 10.85 to
the registrant's Form S-1 Registration Statement.
10.47 Guaranty Agreement, by and among Charter Account Systems, Inc.,
ClassCredit, Inc., EFS, Inc., EFS Services, Inc., GuaranTec, LLP,
Idaho Financial Associates, Inc., InTuition, Inc., National Higher
Educational Loan Program, Inc., Nelnet Canada, Inc., Nelnet
Corporation (subsequently renamed Nelnet Corporate Services,
Inc.), Nelnet Guarantee Services, Inc., Nelnet Marketing
Solutions, Inc., Student Partner Services, Inc., UFS Securities,
LLC and Shockley Financial Corp., dated as of September 25, 2003.
Incorporated by reference to Exhibit 10.86 to the registrant's
Form S-1 Registration Statement.
10.48 Security Agreement, dated as of September 25, 2003, by and between
Nelnet, Inc. and M&I Marshall & Ilsley Bank, as Agent.
Incorporated by reference to Exhibit 10.87 to the registrant's
Form S-1 Registration Statement.
10.49 Security Agreement, dated as of September 25, 2003, by and between
National Education Loan Network, Inc. and M&I Marshall & Ilsley
Bank, as Agent. Incorporated by reference to Exhibit 10.88 to the
registrant's Form S-1 Registration Statement.
10.50 Intercreditor Agreement, dated as of September 25, 2003, by and
among M&I Marshall & Ilsley Bank, SunTrust Bank, First National
Bank of Omaha, Fifth Third Bank, Indiana and Bank of America, N.A.
Incorporated by reference to Exhibit 10.89 to the registrant's
Form S-1 Registration Statement.
10.51 Letter Agreement by and between Nelnet Education Loan Funding,
Inc. and Bank of America, N.A., dated as of June 25, 2003,
relating to the increase of the Warehouse Note Purchase and
Security Agreement dated as of May 1, 2003. Incorporated by
reference to Exhibit 10.90 to the registrant's Form S-1
Registration Statement.
10.52 Letter Agreement by and between Nelnet Education Loan Funding,
Inc. and Deutsche Bank AG, New York Branch, dated as of June 25,
2003, relating to the increase of the Warehouse Note Purchase and
Security Agreement dated as of May 1, 2003. Incorporated by
reference to Exhibit 10.91 to the registrant's Form S-1
Registration Statement.
39
10.53 Letter Agreement by and between Nelnet Education Loan Funding,
Inc. and Societe Generale, dated as of June 25, 2003, relating to
the increase of the Warehouse Note Purchase and Security Agreement
dated as of May 1, 2003. Incorporated by reference to Exhibit
10.92 to the registrant's Form S-1 Registration Statement.
10.54 Third Amendment to Credit Agreement, dated effective September 26,
2003, by and among National Education Loan Network, Inc., Nelnet,
Inc. and Bank of America, N.A. Incorporated by reference to
Exhibit 10.93 to the registrant's Form S-1 Registration Statement.
10.55 Amendment to Application and Agreement for Standby Letter of
Credit, Loan Purchase Agreements and Standby StudentLoan Purchase
Agreements, dated effective October 21, 2003, by and among
National Education Loan Network, Inc., Nelnet, Inc., Nelnet
Education Loan Funding, Inc., Union Bank and Trust Company and
Bank of America, N.A. Incorporated by reference to Exhibit 10.94
to the registrant's Form S-1 Registration Statement.
10.56* Letter Agreement between Nelnet Education Loan Funding, Inc. and
Deutsche Bank AG, dated as of February 20, 2004.
10.57* Letter Agreement between Nelnet Education Loan Funding, Inc. and
Bank of America, N.A., dated as of February 20, 2004.
10.58* Letter Agreement between Nelnet Education Loan Funding, Inc. and
Societe Generale, dated as of February 20, 2004.
10.59* Lease Assignment and Assumption Agreement between MES - Maine
Education Services as assignor and Nelnet Corporate Services, Inc.
as assignee, dated as of February 1, 2004.
10.60* Operating Agreement for Premiere Credit of North America, LLC
among Nelnet, Inc., Todd J. Wolfe, David A. Hoeft and Tina D.
Mercer, dated as of January 28, 2004.
10.61* Third Amendment to Amended and Restated Participation Agreement
between National Education Loan Network, Inc. and Union Bank and
Trust Company, dated as of February 5, 2004.
10.62* February 2004 Amendment to Application and Agreement for Standby
Letter of Credit, Loan Purchase Agreements and Standby Student
Loan Purchase Agreements, dated as of February 20, 2004, among
National Education Loan Network, Inc., Nelnet, Inc., Nelnet
Education Loan Funding, Inc., Union Bank and Trust Company and
Bank of America, N.A.
10.63* Amendment to Application and Agreement for Standby Letter of
Credit, Loan Purchase Agreements and Standby Student Loan Purchase
Agreements, dated effective November 20, 2003, by and among
National Education Loan Network, Inc., Nelnet, Inc., Nelnet
Education Loan Funding, Inc., Union Bank and Trust Company and
Bank of America, N.A.
10.64* Amendment to Application and Agreement for Standby Letter of
Credit, Loan Purchase Agreements and Standby Student Loan Purchase
Agreements, dated effective December 19, 2003, by and among
National Education Loan Network, Inc., Nelnet, Inc., Nelnet
Education Loan Funding, Inc., Union Bank and Trust Company and
Bank of America, N.A.
10.65* Agreement of Lease Renewal among Marianne B. Jardine, Trustee of
National Education Loan of New England as assignee, dated as of
June 1, 2002.
14.1* Nelnet, Inc. Code of Ethics.
14.2* Nelnet Education Loan Funding, Inc. Code of Ethics.
21.1* Subsidiaries of Nelnet, Inc.
23.1* Consent of KPMG LLP, Independent Auditors.
31.1* Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 of Co-Chief Executive Officer Michael S. Dunlap.
31.2* Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 of Co-Chief Executive Officer Stephen F. Butterfield.
31.3* Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 of Chief Financial Officer Terry J. Heimes.
32.** Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
- -----------
* Filed herewith
** Furnished herewith
+ Indicates a compensatory plan or arrangement contemplated by Item
15(a)(3) of Form 10-K
40
SIGNATURES
Pursuant to the requirements of the Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the Registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized, in the
city of Lincoln, State of Nebraska, on March 26, 2004.
NELNET, INC.
By: /s/ MICHAEL S. DUNLAP
----------------------------------------
Name: Michael S. Dunlap
Title: Chairman and Co-Chief Executive
Officer (Co-Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities indicated on the dates indicated.
Signature Title Date
--------- ----- ----
/s/ MICHAEL S. DUNLAP Chairman and March 26, 2004
- ------------------------------------ Co-Chief Executive Officer
Michael S. Dunlap (Co-Principal Executive Officer)
/s/ STEPHEN F. BUTTERFIELD Vice Chairman and March 26, 2004
- ------------------------------------ Co-Chief Executive Officer
Stephen F. Butterfield (Co-Principal Executive Officer)
/s/ TERRY J. HEIMES Chief Financial Officer March 26, 2004
- ------------------------------------ (Principal Financial Officer and
Terry J. Heimes Principal Accounting Officer)
/s/ DON R. BOUC President and Director March 26, 2004
- ------------------------------------
Don R. Bouc
/s/ JAMES P. ABEL Director March 26, 2004
- ------------------------------------
James P. Abel
/s/ THOMAS E. HENNING Director March 26, 2004
- ------------------------------------
Thomas E. Henning
/s/ ARTURO MORENO Director March 26, 2004
- ------------------------------------
Arturo Moreno
/s/ BRIAN J. O'CONNOR Director March 26, 2004
- ------------------------------------
Brian J. O'Connor
/s/ MICHAEL REARDON Director March 26, 2004
- ------------------------------------
Michael Reardon
/s/ JAMES H. VAN HORN Director March 26, 2004
- ------------------------------------
James H. Van Horn
41
NELNET, INC. AND SUBSIDIARIES
Index to Consolidated Financial Statements
Page
Independent Auditors' Report F-2
Consolidated Balance Sheets as of December 31, 2003 and 2002 F-3
Consolidated Statements of Income for the years ended
December 31, 2003, 2002 and 2001 F-4
Consolidated Statements of Shareholders' Equity and
Comprehensive Income for the years ended
December 31, 2003, 2002 and 2001 F-5
Consolidated Statements of Cash Flows for the years ended
December 31, 2003, 2002 and 2001 F-6
Notes to Consolidated Financial Statements F-7
F-1
Independent Auditors' Report
The Board of Directors
Nelnet, Inc.:
We have audited the accompanying consolidated balance sheets of Nelnet, Inc. and
subsidiaries as of December 31, 2003 and 2002, and the related consolidated
statements of income, shareholders' equity and comprehensive income, and cash
flows for each of the years in the three-year period ended December 31, 2003.
These consolidated financial statements are the responsibility of Nelnet, Inc.
and subsidiaries' management. Our responsibility is to express an opinion on
these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. These standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Nelnet, Inc. and
subsidiaries as of December 31, 2003 and 2002, and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 2003, in conformity with accounting principles generally
accepted in the United States of America.
/s/ KPMG LLP
Lincoln, Nebraska
February 27, 2004
F-2
NELNET, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
December 31, 2003 and 2002
Assets 2003 2002
----------- -----------
(Dollars in thousands, except share data)
Student loans receivable (net of allowance for loan losses
of $16,026 in 2003 and $12,000 in 2002) $10,455,442 8,559,420
Cash and cash equivalents:
Cash and cash equivalents - not held at a related party 188,272 27,294
Cash and cash equivalents - held at a related party 10,151 12,861
----------- -----------
Total cash and cash equivalents 198,423 40,155
Restricted cash - held by trustee 634,263 570,703
Restricted investments - held by trustee 180,688 173,339
Restricted cash - due to loan program customers 141,841 132,375
Accrued interest receivable 196,633 177,015
Accounts receivable, net 17,289 14,838
Intangible assets, net 11,630 23,909
Furniture, equipment and leasehold improvements, net 19,138 12,910
Other assets, including deferred taxes 76,162 61,919
----------- -----------
Total assets $11,931,509 9,766,583
=========== ===========
Liabilities and Shareholders' Equity
Liabilities:
Bonds and notes payable $11,366,458 9,447,682
Accrued interest payable 17,179 20,251
Other liabilities 100,542 57,529
Due to loan program customers 141,841 132,375
----------- -----------
Total liabilities 11,626,020 9,657,837
----------- -----------
Minority interest -- (376)
----------- -----------
Shareholders' equity:
Preferred stock, $0.01 par value.
Authorized 50,000,000 shares; no shares issued or outstanding -- --
Common stock:
Class A, $0.01 par value. Authorized 600,000,000 shares;
issued and outstanding 39,601,834 shares in 2003 and 30,947,834
shares in 2002 396 309
Class B, convertible, $0.01 par value. Authorized 15,000,000 shares;
issued and outstanding 14,023,454 shares 140 140
Additional paid-in capital 206,831 37,891
Retained earnings 97,885 70,782
Accumulated other comprehensive income 237 --
----------- -----------
Total shareholders' equity 305,489 109,122
Commitments and contingencies
----------- -----------
Total liabilities and shareholders' equity $11,931,509 9,766,583
=========== ===========
See accompanying notes to consolidated financial statements.
F-3
NELNET, INC. AND SUBSIDIARIES
Consolidated Statements of Income
Years ended December 31, 2003, 2002 and 2001
2003 2002 2001
--------- --------- ---------
(Dollars in thousands, except share data)
Interest income:
Loan interest $ 360,101 405,149 318,453
Investment interest 15,203 20,759 16,794
--------- --------- ---------
Total interest income 375,304 425,908 335,247
Interest expense:
Interest on bonds and notes payable 196,692 235,008 220,682
--------- --------- ---------
Net interest income 178,612 190,900 114,565
Less provision for loan losses 11,475 5,587 3,925
--------- --------- ---------
Net interest income after provision for loan losses 167,137 185,313 110,640
--------- --------- ---------
Other income:
Loan servicing and other fee income 99,294 103,899 93,172
Software services and other income 19,398 21,909 7,713
Derivative market value adjustment (1,170) (579) (2,962)
--------- --------- ---------
Total other income 117,522 125,229 97,923
--------- --------- ---------
Operating expenses:
Salaries and benefits 124,273 106,874 77,370
Other operating expenses:
Depreciation and amortization 23,124 32,449 28,592
Trustee and other debt related fees 19,358 16,617 12,836
Occupancy and communications 12,101 11,424 7,488
Advertising and marketing 10,182 11,512 10,122
Professional services 9,437 9,237 3,355
Consulting fees and support services to related parties 3,519 12,800 29,350
Postage and distribution 13,241 11,095 7,647
Other 23,135 22,693 18,678
--------- --------- ---------
Total other operating expenses 114,097 127,827 118,068
--------- --------- ---------
Total operating expenses 238,370 234,701 195,438
--------- --------- ---------
Income before income taxes and minority interest 46,289 75,841 13,125
Income tax expense 19,295 27,679 5,380
--------- --------- ---------
Income before minority interest 26,994 48,162 7,745
Minority interest in subsidiary (income) loss 109 376 (598)
--------- --------- ---------
Net income $ 27,103 48,538 7,147
========= ========= =========
Earnings per share, basic and diluted $ 0.60 1.08 0.16
========= ========= =========
See accompanying notes to consolidated financial statements.
F-4
Preferred Common stock shares Class A Class B
stock ----------------------- Preferred common common
shares Class A Class B stock stock stock
------ ---------- ---------- ------- ---------- ----------
(Dollars in thousands, except share data)
Balance at December 31, 2000 -- 29,412,314 14,023,454 $ -- 295 140
Net income -- -- -- -- -- --
Issuance of common stock -- 1,535,520 -- -- 14 --
Minority interest loss in excess
of minority interest capital -- -- -- -- -- --
----- ---------- ---------- ------- --------- ----------
Balance at December 31, 2001 -- 30,947,834 14,023,454 -- 309 140
Net income -- -- -- -- -- --
Dividend distribution -- -- -- -- -- --
Recapture of minority interest
loss in excess of minority
interest capital -- -- -- -- -- --
----- ---------- ---------- ------- --------- ----------
Balance at December 31, 2002 -- 30,947,834 14,023,454 -- 309 140
Comprehensive income:
Net income -- -- -- -- -- --
Other comprehensive income,
net of tax, related to cash
flow hedge -- -- -- -- -- --
Total comprehensive income
Non-cash compensation expense -- -- -- -- -- --
Issuance of common stock -- 331,800 -- -- 3 --
Issuance of common stock in initial
public offering, net of direct offering
expenses of $16,600 -- 8,586,800 -- -- 86 --
Redemption of common stock -- (264,600) -- -- (2) --
----- ---------- ---------- ------- --------- ----------
Balance at December 31, 2003 -- 39,601,834 14,023,454 $ -- 396 140
===== ========== ========== ======= ========= ==========
Accumulated
Additional other Total
paid-in Retained comprehensive shareholders'
capital earnings income equity
---------- ---------- ---------- ----------
Balance at December 31, 2000 35,635 18,091 -- 54,161
Net income -- 7,147 -- 7,147
Issuance of common stock 1,996 -- -- 2,010
Minority interest loss in excess
of minority interest capital (132) -- -- (132)
---------- ---------- ---------- ----------
Balance at December 31, 2001 37,499 25,238 -- 63,186
Net income -- 48,538 -- 48,538
Dividend distribution -- (2,994) -- (2,994)
Recapture of minority interest
loss in excess of minority
interest capital 392 -- -- 392
---------- ---------- ---------- ----------
Balance at December 31, 2002 37,891 70,782 -- 109,122
Comprehensive income:
Net income -- 27,103 -- 27,103
Other comprehensive income,
net of tax, related to cash
flow hedge -- -- 237 237
----------
Total comprehensive income 27,340
Non-cash compensation expense 5,166 -- -- 5,166
Issuance of common stock 803 -- -- 806
Issuance of common stock in initial
public offering, net of direct offering
expenses of $16,600 163,612 -- -- 163,698
Redemption of common stock (641) -- -- (643)
---------- ---------- ---------- ----------
Balance at December 31, 2003 206,831 97,885 237 305,489
========== ========== ========== ==========
See accompanying notes to consolidated financial statements.
F-5
NELNET, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Years ended December 31, 2003, 2002 and 2001
2003 2002 2001
----------- ----------- -----------
(Dollars in thousands)
Net income $ 27,103 48,538 7,147
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization, including premiums 101,375 93,864 45,301
Derivative market value adjustment 1,170 579 2,962
Ineffectiveness of cash flow hedge (118) -- --
Non-cash compensation expense 5,166 -- --
Deferred income tax benefit (3,197) (8,475) (11,363)
Minority interest in subsidiary (loss) income (109) (376) 598
Provision for loan losses 11,475 5,587 3,925
Decrease (increase) in accrued interest receivable (19,618) 3,619 (14,661)
Decrease (increase) in accounts receivable (2,451) 918 13,286
Decrease (increase) in other assets (7,738) (7,608) 18,107
Decrease in accrued interest payable (3,072) (894) (3,554)
Increase (decrease) in other liabilities 43,013 (1,542) 19,744
----------- ----------- -----------
Net cash provided by operating activities 152,999 134,210 81,492
----------- ----------- -----------
Cash flows from investing activities:
Originations, purchases and consolidations of student loans, including premiums (3,566,803) (2,541,071) (774,959)
Purchases of student loans, including premiums, from a related party (735,540) (377,788) (666,350)
Net proceeds from student loan principal payments and loan consolidations 2,325,531 1,724,077 529,190
Net purchases of furniture and equipment (16,361) (13,408) (6,264)
Increase in restricted cash - held by trustee (63,560) (357,045) (50,186)
Purchases of restricted investments - held by trustee (449,959) (318,822) (302,050)
Proceeds from maturities of restricted investments - held by trustee 442,610 267,089 296,405
Acquisitions of subsidiaries, net of cash acquired (1,760) (20,809) (102,184)
----------- ----------- -----------
Net cash used in investing activities (2,065,842) (1,637,777) (1,076,398)
----------- ----------- -----------
Cash flows from financing activities:
Payments on bonds and notes payable (2,350,860) (2,259,769) (324,561)
Proceeds from issuance of bonds and notes payable 4,269,849 3,781,474 1,338,959
Payment of debt issuance costs (11,739) (11,429) (8,325)
Cash distributions to shareholders -- (2,994) --
Payments for redemption of common stock (643) -- --
Proceeds from issuance of common stock 164,504 -- 2,010
----------- ----------- -----------
Net cash provided by financing activities 2,071,111 1,507,282 1,008,083
----------- ----------- -----------
Net increase in cash and cash equivalents 158,268 3,715 13,177
Cash and cash equivalents, beginning of period 40,155 36,440 23,263
----------- ----------- -----------
Cash and cash equivalents, end of period $ 198,423 40,155 36,440
=========== =========== ===========
Supplemental disclosures of cash flow information:
Interest paid $ 190,615 222,528 227,198
=========== =========== ===========
Income taxes paid $ 21,635 40,098 14,777
=========== =========== ===========
Supplemental disclosures of noncash operating, investing and financing
activities regarding acquisitions and cash flow hedges are contained in notes 1
and 13, respectively.
See accompanying notes to consolidated financial statements.
F-6
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2003, 2002 and 2001
(1) Corporate Structure
(a) Corporate Organization
Nelnet, Inc. ("Nelnet" or the "Company") is a vertically
integrated education finance company, which, together with its
subsidiaries, is focused on providing quality products and
services to participants in the education finance process. Nelnet
is an originator, holder, and servicer of education loans and
offers a broad range of financial services and technology-based
products, including student loan origination and lending, student
loan and guarantee servicing and a suite of software solutions.
The Company owns the stock of various corporations which are
engaged in the securitization of education finance assets. The
Company's student lending subsidiaries described below are
separate entities holding beneficial interests in eligible loans,
subject to creditors with specific interests. The liabilities of
the Company's student lending subsidiaries are not the liabilities
of the Company or any of its other subsidiaries and cannot be
consolidated in the event of bankruptcy. The transfers of student
loans to the eligible lender trusts do not qualify as sales under
the provisions of Statement of Financial Accounting Standards
("SFAS") No. 140, Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities ("SFAS No.
140"), as the trusts continue to be under the effective control of
the Company. All the financial activities and related assets and
liabilities, including debt, of the securitizations are reflected
in the Company's consolidated financial statements. The following
subsidiaries of the Company hold the financial assets
(collectively referred to as the "Student Lending Subsidiaries"):
<c>
NELNET Student Loan Corporation-1 ("Nelnet-1")
NELNET Student Loan Corporation-2 ("Nelnet-2")
Nelnet Student Loan Funding LLC ("Nelnet SLF")
Nelnet Education Loan Funding, Inc. (formerly known as NEBHELP, Inc.) ("NELF")
MELMAC, Inc. and subsidiaries ("MELMAC")
NHELP-I, Inc. ("NHELP-I")
NHELP-II, Inc. and subsidiary ("NHELP-II")
NHELP-III, Inc. ("NHELP-III")
Nelnet Student Loan Warehouse Corporation-1 ("Nelnet SLWC-1")
NELnet Private Student Loan Corporation-1 ("Nelnet Private-1")
EFS Finance Co. ("EFS Fin Co.") and its subsidiary, EMT Corporation ("EMT Corp.")
Nelnet-1, Nelnet-2, Nelnet SLF, NELF, NHELP-II, Nelnet Private-1,
MELMAC, and EMT Corp. finance eligible student loan assets on a
more permanent basis, as the assets are funded with bonds and
notes payable, which have longer maturities. NHELP-I, NHELP-III,
Nelnet SLWC-1, select operating lines within NELF, and EFS Fin Co.
are warehouse facilities designed to fund student loan assets on a
temporary basis until the assets are moved to another Student
Lending Subsidiary to provide more permanent financing.
The Company also provides managerial, administrative support, loan
servicing, origination processing, computer software development,
broker-dealer activities and marketing to the Student Lending
Subsidiaries through the following wholly owned subsidiary
management companies: National Education Loan Network, Inc.
("NELN"); Nelnet Marketing Solutions, Inc. ("NMS") and
subsidiaries, including its 100% owned subsidiary (80% owned
through February 28, 2003), Student Partner Services, Inc ("SPS");
Nelnet Guarantee Services, Inc. and GuaranTec LLP (collectively,
"NGS"); EFS Services, Inc. ("EFS Services"); Charter Account
Systems, Inc. ("Charter"); Idaho Financial Associates, Inc.
("IFA"); UFS Securities, LLC ("UFS Securities") and its 100% owned
subsidiary, Shockley Financial Corp.; and Nelnet Corporate
Services, Inc. (formerly known as Nelnet Corporation).
Nelnet is the legal parent of NELN. Through May 15, 2002, Nelnet
also owned 91.43% of Infovisa, Inc. and its subsidiary
("Infovisa"). Infovisa primarily developed and provided software
systems for financial institutions. Effective May 15, 2002, Nelnet
sold its ownership of Infovisa to Farmers & Merchants Investment
Inc. ("F&M") at carrying value, which approximated fair value.
F-7
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
(b) Description of Business
The Student Lending Subsidiaries are organized as special-purpose
bankruptcy remote entities which primarily invest in eligible
student loans, through an eligible lender trustee, issued under
Title IV of the Higher Education Act of 1965, as amended (the
"Act"). Nelnet Private-1 also invests in self-insured or
privately-insured student loan programs through an eligible lender
trustee.
Student loans beneficially owned by the Student Lending
Subsidiaries include those originated under the Federal Family
Education Loan Program ("FFELP" or "FFEL program"), including the
Stafford Loan Program ("SLP"), the Parent Loan Program for
Undergraduate Students ("PLUS") program, the Supplemental Loans
for Students ("SLS") program, and loans which consolidate certain
borrower obligations ("Consolidation"). Title to the student loans
is held by eligible lender trustees under the Act for the benefit
of the Student Lending Subsidiaries. The financed eligible loan
borrowers are geographically located throughout the United States.
The bonds and notes payable outstanding are payable primarily from
interest and principal payments on the student loans, as specified
in the resolutions authorizing the sale of the bonds and notes.
The Company's business is comprised of four primary product and
service offerings:
o Asset management, including student loan originations and
acquisitions. The Company provides student loan sales,
marketing, originations, acquisition, and portfolio
management. The Company owns a large portfolio of student
loan assets through the Student Lending Subsidiaries. The
Company generates loans owned in special purpose lending
facilities through direct origination or through acquisition
of loans. The Company generates the majority of its earnings
from the spread between the yield it earns on its student
loan portfolio and the cost of funding these loans. The
Company also provides marketing and sales support and
managerial and administrative support related to its asset
generation activities, as well as those performed for its
branding partners or other lenders who sell such loans.
o Student loan servicing. The Company services its student
loan portfolio and the portfolios of third parties. As of
December 31, 2003, the Company serviced or provided complete
outsourcing of servicing activities for more than $18.7
billion in student loans, including $9.2 billion of loans in
its portfolio. The servicing activities provided include
loan origination activities, application processing,
borrower updates, payment processing, claim processing and
due diligence procedures. These activities are performed
internally for the Company's own portfolio, in addition to
generating fee revenue when performed for third-party
clients.
o Guarantee servicing. The Company provides servicing support
to guaranty agencies, which includes system software,
hardware and telecommunication support, borrower, and loss
updates, default aversion tracking services, claim
processing services and post-default collection services. As
of December 31, 2003, the Company provided servicing support
to agencies that guarantee more than $20 billion of FFELP
loans. These activities generate fee revenue in addition to
expanding the Company's relationship with other participants
in the education finance sector.
o Servicing software. The Company provides student loan
servicing software internally and to third-party student
loan holders and servicers. As of December 31, 2003, the
software products were used to service $46 billion in
student loans, which included $27 billion serviced by third
parties using the Company's software. The Company earns
software license and maintenance fees annually from third
party clients for use of this software. The Company also
provides computer consulting, custom software applications
and customer service support.
F-8
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
(c) Acquisitions
Nelnet Guarantee Services, Inc., a wholly owned subsidiary of
NELN, commenced its business operations in June 2001. On June 30,
2001, it acquired 51% of the voting control of GuaranTec, LLP
("GuaranTec") for $2.6 million. On January 1, 2002, NELN acquired
the remaining 49% of GuaranTec for $4.5 million from F&M. The
excess purchase price over F&M's carrying value was $3.0 million.
As the 49% interest was acquired from an entity under common
control with the Company, the excess purchase price was recorded
as a dividend distribution in the consolidated statement of
shareholders' equity in 2002.
On January 1, 2001, NELN acquired MELMAC and its wholly owned
subsidiaries, MELMAC LLC and MELMAC Enterprises, Inc., for
approximately $30 million. The acquisition was accounted for under
purchase accounting. The assets and liabilities of MELMAC and its
subsidiaries were recorded at fair value. An intangible asset,
representing loan origination rights, of approximately $6.4
million was recorded and is being amortized over its estimated
useful life of three years. The results of operations of MELMAC
have been included in the consolidated financial statements since
the date of acquisition.
On December 21, 2001, NELN acquired all of the outstanding stock
of EFS, Inc. ("EFS") and its wholly owned subsidiaries, EMT Corp.,
EFS Services, EFS Fin Co. and Advantage Network, Inc., for
approximately $141 million. The acquisition was accounted for
under purchase accounting. The assets and liabilities of EFS and
its subsidiaries were recorded at fair value. An intangible asset,
representing lender relationships and loan origination rights, of
approximately $4 million was recorded and is being amortized over
its estimated useful life of three years. The results of
operations of EFS have been included in the consolidated financial
statements since the date of acquisition.
NELN acquired MELMAC and EFS to increase its market share in the
student lending industry. The allocation of the purchase price for
the MELMAC and EFS acquisitions is shown below (dollars in
thousands):
Loans $ 3,021,791
Other assets 219,068
Intangible assets 10,385
Bonds and notes payable (3,055,403)
Other liabilities (24,455)
-----------
Total purchase price $ 171,386
===========
On January 2, 2002, NELN acquired IFA for approximately $17
million. The acquisition was accounted for under purchase
accounting. The assets and liabilities of IFA were recorded at
fair value. An intangible asset, representing servicing system
software and other intellectual property, of $14.2 million was
recorded and is being amortized over its estimated useful life of
three years. The results of operations of IFA have been included
in the consolidated financial statements since the date of
acquisition.
On May 9, 2002, NELN acquired Charter for approximately $7
million. The acquisition was accounted for under purchase
accounting. The assets and liabilities of Charter were recorded at
fair value. An intangible asset, representing servicing system
software and other intellectual property, of $6.8 million was
recorded and is being amortized over its estimated useful life of
three years. Goodwill of $2.6 million was also recorded. The
results of operations of Charter have been included in the
consolidated financial statements since the date of acquisition.
F-9
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
NELN acquired IFA and Charter to provide student loan servicing
software solutions to the student lending industry. The allocation
of the purchase price for the IFA and Charter acquisitions is
shown below (dollars in thousands):
Cash and investments $ 2,972
Accounts receivable 1,390
Intangible assets 23,612
Deferred revenue and other liabilities (4,193)
--------
Total purchase price $ 23,781
========
On August 7, 2003, the Company acquired UFS Securities for $2.6
million from affiliated parties. The acquisition was accounted for
under purchase accounting. The results of operations of UFS
Securities have been included in the consolidated financial
statements since the date of acquisition. This acquisition is
immaterial to the consolidated financial statements.
The following unaudited pro forma information presents the
combined results of the Company as though the 2002 and 2001
acquisitions occurred on January 1, 2001. The pro forma financial
information does not necessarily reflect the results of operations
if the acquisitions had been in effect at the beginning of the
period or which may be attained in the future.
Year ended
December 31, 2001
-------------------
(Dollars in thousands)
(Unaudited)
Net interest income $ 153,764
Other income 125,985
Net income $ 11,905
===========
Weighted average shares outstanding, basic and diluted 44,331,490
Earnings per share, basic and diluted $ 0.27
===========
The pro forma information presenting the combined operations of
the Company as though the 2003 and 2002 acquisitions occurred on
January 1, 2003 and January 1, 2002, respectively, is not
significantly different than actual 2003 or 2002 results.
In June 2001, the Financial Accounting Standards Board issued SFAS
No. 141, Business Combinations ("SFAS No. 141"), and SFAS No. 142,
Goodwill and Other Intangible Assets ("SFAS No. 142"). SFAS No.
141 requires that the purchase method of accounting be used for
all business combinations. SFAS No. 141 specified criteria that
intangible assets acquired in a business combination must meet to
be recognized and reported separately from goodwill. SFAS No. 142
requires that goodwill and intangible assets with indefinite
useful lives no longer be amortized, but instead tested for
impairment at least annually in accordance with the provisions of
SFAS No. 142. SFAS No. 142 also requires that intangible assets
with estimable useful lives be amortized over their respective
estimated useful lives to their estimated residual values.
The Company adopted the provisions of SFAS No. 141 as of July 1,
2001 and SFAS No. 142 as of January 1, 2002. Upon adoption of SFAS
No. 142, the Company was required to evaluate its existing
intangible assets and goodwill that were acquired in purchase
business combinations and to make any necessary reclassifications
in order to conform with the new classification criteria in SFAS
No. 141 for recognition separate from goodwill. The Company was
also required to reassess the useful lives and residual values of
all intangible assets acquired and make any necessary amortization
period adjustments by the end of the first interim period after
adoption. Based on this evaluation, no reclassifications or
changes to useful lives or residual values were made.
F-10
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
(2) Recapitalization
Effective August 14, 2003, the shareholders of the Company approved
amended and restated articles of incorporation. The amended and
restated articles of incorporation effected a recapitalization of the
Company whereby each share of Class A voting common stock, and each
share of Class B nonvoting common stock held by two principal
shareholders and a related entity (the "Principal Shareholders"), was
converted into 210 shares of new Class B common stock, and each share
of Class B nonvoting common stock (other than these owners by the
Principal Shareholders) was converted into 210 shares of new Class A
common stock. Also, effective with the conversion of the Class B shares
to Class A, certain former Class B shareholders converted their new
Class B shares into new Class A shares. The new Class B common stock
has ten votes per share, and the new Class A common stock has one vote
per share. Each Class B share is convertible at any time at the
holder's option into one Class A share. With the exception of the
voting rights and the conversion feature, the Class A and Class B
shares are identical in terms of other rights, including dividend and
liquidation rights. The Company's shareholders' equity has been
restated to reflect the new capital stock structure for all periods
presented.
On December 11, 2003, the Company consummated an initial public
offering. The Company sold 8,000,000 shares of Class A common stock at
a price of $21 per share for net proceeds of $152.2 million. On
December 22, 2003, the underwriters exercised their over-allotment
option and purchased an additional 586,800 shares at $21 per share
which yielded net proceeds to the Company of $11.5 million.
(3) Summary of Significant Accounting Policies and Practices
(a) Consolidation
The consolidated financial statements include the accounts of the
Company and its subsidiaries. All significant intercompany
balances and transactions have been eliminated in consolidation.
As discussed in note 1(a), the Company consolidates all special
purpose entities in accordance with SFAS No. 140. Unconsolidated
entities which the Company does not control are recorded using the
equity method of accounting.
(b) Student Loans Receivable
Investments in student loans, including premiums, are recorded at
cost, net of premium amortization and the allowance for loan
losses. Student loans consist of federally insured student loans,
private student loans, and student loan participations.
(c) Allowance for Loan Losses
The allowance for loan losses is estimated and established through
a provision charged to expense. Losses are charged against the
allowance when management believes the collectibility of the loan
principal is unlikely. Recovery of amounts previously charged off
is credited to the allowance for loan losses.
For the FFELP loan portfolio, the Company considers trends in
student loan claims rejected for payment by guarantors and the
amount of FFELP loans subject to the 2% risk sharing. The
allowance is based on periodic evaluations of the Company's loan
portfolios considering past experience, changes to federal student
loan programs, current economic conditions and other relevant
factors. FFELP loans are guaranteed as to both principal and
interest, and, therefore, continue to accrue interest until the
time they are paid by the guaranty agency. The allowance is
maintained at a level management believes is adequate to provide
for estimated probable credit losses inherent in the loan
portfolio. This evaluation is inherently subjective as it requires
estimates that may be susceptible to significant changes.
F-11
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
In determining the adequacy of the allowance for loan losses on
the private loans, the Company considers several factors
including: loans in repayment versus those in a nonpaying status,
months in repayment, delinquency status, type of program, and
trends in defaults in the portfolio based on Company and industry
data. The Company places a private loan on nonaccrual status and
charges off the loan when the collection of principal and interest
is 120 days past due.
Management believes that the allowance for loan losses is
adequate. While management uses available information to recognize
probable loan losses, future additions to the allowance for loan
losses may be necessary based on changes in economic and other
conditions.
(d) Cash and Cash Equivalents
For purposes of the consolidated statements of cash flows, the
Company considers all investments with maturities when purchased
of three months or less to be cash equivalents.
(e) Restricted Cash and Restricted Investments - Held by Trustee
The Company's restricted cash and restricted investments are held
by the trustees in various accounts, subject to use restrictions
imposed by the trust indenture. The Company recognizes all
restricted cash and restricted investments held by trustees on the
consolidated balance sheets.
(f) Restricted Cash-Due to Loan Program Customers/Due to Loan Program
Customers
As a servicer of student loans, Nelnet collects student loan
remittances and subsequently disburses these remittances to the
appropriate lending entities. In addition, Nelnet requests funding
from lenders and subsequently disburses loan funds to borrowers
and schools on behalf of borrowers. Cash collected for customers
and the related liability are included in the accompanying
consolidated balance sheets. Interest income earned, net of
service charges, by the Company on this cash for the years ended
December 31, 2003, 2002 and 2001 was $213,000, $930,000 and $2.1
million, respectively.
(g) Intangible Assets
Intangible assets, consisting of loan servicing contracts, lender
relationships and loan origination rights, and servicing system
software and other intellectual property, are being amortized on a
straight-line basis over the expected periods to be benefited,
ranging from 30 to 36 months. Goodwill resulting from acquisitions
is not being amortized.
(h) Furniture, Equipment, and Leasehold Improvements
Furniture and equipment are carried at cost, net of accumulated
depreciation. Maintenance and repairs are charged to expense as
incurred, and major improvements, including leasehold
improvements, are capitalized. Gains and losses from retirement of
furniture, equipment and leasehold improvements are included in
determining net income. The Company uses accelerated and
straight-line methods for recording depreciation and amortization.
Accelerated methods are used for certain equipment and software
when this method is believed to provide a better matching of
income and expenses.
(i) Software Development Costs
Certain direct development costs associated with internal-use
software are capitalized, including external direct costs of
services and payroll costs for employees devoting time to the
software projects. These costs are included in furniture,
equipment and leasehold improvements and are amortized over a
period of three years beginning when the asset is placed into
service. During the years ended December 31, 2003 and 2001, the
Company capitalized $1.4 million and $1.2 million, respectively,
in costs related to internal-use software development. No costs
were capitalized for the year ended December 31, 2002.
F-12
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
Maintenance costs and research and development costs relating to
software to be sold or leased are expensed as incurred.
(j) Other Assets
Other assets are recorded at cost or amortized cost and consist
primarily of prepaid bond insurance, debt issuance costs, deferred
tax assets and income taxes receivable. Prepaid bond insurance and
debt issuance costs are amortized using the straight-line method
and effective interest methods, respectively, over the estimated
lives of the bonds and notes payable.
(k) Program Reimbursement Reserve
The program reimbursement reserve, which is included in other
liabilities, represents the amount of student loans that
management estimates the Company will be required to repay to
lenders, for which the Company performs servicing, due to the
Company's failure to follow prescribed due diligence procedures.
The program reimbursement reserve is established through a
provision for losses charged to expense. The amount of provision
is based on management's evaluation of the servicing portfolio as
it relates to the complex due diligence requirements that must be
followed to maintain the Department of Education (the
"Department") guarantee on the loans. Failure to meet certain due
diligence requirements will cause a loss of guarantee on the loans
and potential loss to the Company if it is unable to cure the
condition under procedures prescribed by the federal government.
Serviced student loans are charged against the allowance when they
lose their Department guarantee and the Company is required to
reimburse the lender. Loans that are subsequently returned to a
repayment status can reacquire their guaranteed status, and such
amounts are then credited to the program reimbursement reserve as
recoveries.
Management believes that the program reimbursement reserve is
adequate. While management uses available information to determine
the adequacy of the reserve and to recognize losses, future
additions to the reserve may be necessary based on changes in
federal policy, economic conditions, or management's performance
relating to compliance with the Department's due diligence
requirements.
(l) Revenue Recognition - Software Services
Charter and IFA account for software revenues in accordance with
the AICPA's Statement of Position 97-2, Software Revenue
Recognition ("SOP 97-2"). SOP 97-2 provides guidance on when and
in what amounts income should be recognized for licensing,
selling, leasing or otherwise marketing computer software. Income
for contracts with customers that does not require significant
production, modification, or customization of software is
recognized when all the following criteria are met: persuasive
evidence of an arrangement exists, delivery has occurred, vendors
fee is fixed and determinable, and collectibility is probable.
Income paid on maintenance and enhancement agreements for services
to be performed in subsequent periods is deferred and recognized
in income over the life of the agreements. Deferred revenue of
approximately $1.3 million and $0.9 million is included in other
liabilities on the accompanying consolidated balance sheets at
December 31, 2003 and 2002, respectively.
(m) Minority Interest
In 2001, minority interest reflects the proportionate share of
shareholders' equity and income of GuaranTec's minority
stockholder. In 2003 and 2002, minority interest reflects the
proportionate share of shareholders' equity and loss of SPS's
minority stockholders.
F-13
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
Nelnet allocated Infovisa's income or loss proportionately between
Nelnet's percentage interest and the remaining percentage minority
interest. When losses applicable to the minority interest exceeded
the minority interest in equity capital, such excess was charged
against Nelnet's interest as a charge to retained earnings in
Nelnet's shareholders' equity. When earnings were generated
applicable to the minority interest, Nelnet's interest was
credited through retained earnings to the extent of losses
previously charged to retained earnings. For purposes of reporting
on the Company, these changes are reflected in additional paid-in
capital, as retained earnings are those of NELN. During 2002,
Infovisa was sold to F&M and the minority interest loss was
recaptured through additional paid-in capital at the date of sale.
(n) Accounting for Derivatives and Hedging Activities
Effective January 1, 2001, the Company adopted SFAS No. 133,
Accounting for Derivative Instruments and Hedging Activities, as
amended by SFAS No. 138, Accounting for Certain Derivative
Instruments and Certain Hedging Activities, an Amendment of FASB
Statement No. 133 ("SFAS No. 133"). These statements establish
accounting and reporting standards for derivative instruments and
hedging activities, as defined, including certain derivative
instruments embedded in other contracts, and requires that an
entity recognize all derivatives as either assets and liabilities
in the balance sheet and measure them at fair value. The fair
value of the Company's derivative instruments is determined from
market quotes from independent security brokers.
The Company has entered into certain derivative instruments such
as interest rate swaps, caps, and basis swaps as part of managing
its interest rate risk. Interest rate swaps are used to exchange
fixed and floating rate interest payment obligations while caps
are used to protect the Company's income statement from
unfavorable movements in interest rates while allowing benefit
from favorable movements. Basis swaps are used to convert
variable-rate debt from one interest rate index to another to
match the interest rate characteristics of the assets. The Company
uses basis swaps to change the index of the LIBOR-based debt to
better match the cash flows of student loan assets.
All derivative instruments that qualify for hedge accounting
pursuant to SFAS No. 133, as amended, are recorded at fair value
and classified either as a hedge of the fair value of a recognized
asset or liability ("fair value hedge") or as a hedge of the
variability of cash flows to be received or paid to a recognized
asset or liability or a forecasted transaction ("cash flow
hedge"). For all hedging relationships, the Company formally
documents the hedging relationship and its risk-management
objective and strategy for undertaking the hedge, the hedging
instrument, the items hedged, the nature of the risk being hedged,
how the hedging instrument's effectiveness in offsetting the
hedged risk will be assessed, and a description of the method of
measuring effectiveness. This process includes linking all
derivatives that are designated as fair value or cash flow hedges
to specific assets and liabilities on the balance sheet or to
specific forecasted transactions. The Company also formally
assesses, both at the hedge's inception and on an ongoing basis,
whether the derivatives that are used in hedging transactions are
highly effective in offsetting changes in fair values or cash
flows of hedged items.
Changes in the fair value of a derivative instrument that is
highly effective and designated and qualifies as a fair value
hedge and the offsetting changes in the fair value of the hedged
item are recorded in the income statement. Changes in the fair
value of a derivative instrument that is highly effective and
designated and qualifies as a cash flow hedge are recognized in
other comprehensive income to the extent that the derivative is
effective as a hedge, until earnings are affected by the
variability in cash flows of the designated hedged item. The
Company performs an assessment, both at inception of the hedge and
on a quarterly basis thereafter, to determine whether these
derivative instruments are highly effective in offsetting changes
in the value of the hedged items. Any change in fair value
resulting from hedge ineffectiveness is immediately recorded in
the income statement.
F-14
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
The Company discontinues hedge accounting prospectively when it is
determined that the derivative is no longer effective in
offsetting changes in the fair value or cash flows of the hedged
item, the derivative expires or is sold, terminated or exercised,
the derivative is dedesignated as a hedging instrument, because it
is unlikely that a forecasted transaction will occur, or
management determines that designation of the derivative as a
hedging instrument is no longer appropriate.
Changes in the fair value of derivative instruments that do not
qualify for hedge accounting are reported in current period
earnings.
(o) Impairment of Long-Lived Assets
Long-lived assets, such as furniture and equipment, purchased
intangibles subject to amortization and goodwill, are reviewed for
impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable.
Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to estimated
undiscounted future cash flows expected to be generated by the
asset. If the carrying amount of an asset exceeds its estimated
future cash flows, an impairment charge is recognized by the
amount by which the carrying amount of the asset exceeds the fair
value of the asset. There were no impairments of long-lived assets
in 2003, 2002 or 2001.
(p) Student Loan Income
The Company recognizes student loan income using the interest
method, net of amortization of premiums and capitalized direct
origination and acquisition costs. Loan income is recognized based
on the expected yield of the loan after giving effect to borrower
utilization of incentives for timely payment ("borrower benefits")
and other yield adjustments. The effect of the borrower benefits
on student loan yield are based on borrowers who are eligible for
the incentives. The interest is paid by the Department or the
borrower, depending on the status of the loan at the time of the
accrual. In addition, the Department makes quarterly interest
subsidy payments on certain qualified FFELP loans until the
student is required under the provisions of the Act to begin
repayment. Repayment of FFELP loans normally begins within six
months after completion of the loan holders course of study,
leaving school or ceasing to carry at least one-half the normal
full-time academic load as determined by the educational
institution. Repayment of PLUS loans normally begins within 60
days from the date of loan disbursement, and repayment of SLS
loans begins within one month after completion of course study,
leaving school or ceasing to carry at least the normal full-time
academic load as determined by the educational institution.
Repayment on private loans typically begins six months following a
borrower's graduation from a qualified institution and the
interest is either paid by the borrower or capitalized annually or
at repayment.
The Department provides a special allowance to lenders
participating in the FFEL program. The special allowance is
accrued using the interest method based upon the average rate
established in the auction of 13-week Treasury Bills in the
previous quarter relative to the yield of the student loan. Under
certain circumstances, the special allowance is reduced by
approximately one-half for loans which were originated or
purchased from funds obtained from issuance of tax-exempt
obligations, depending upon the issuance date of the obligation.
Premiums and capitalized direct origination and acquisition costs
are amortized over the estimated lives of the related loans in
accordance with SFAS No. 91, Accounting for Non-Refundable Fees
and Costs Associated with Originating or Acquiring Loans and
Initial Direct Costs of Leases. The Company periodically evaluates
the assumptions used to estimate the life of the loans. The
Company also pays an annual 105 basis point rebate fee on
Consolidation loans to the Department. The amortization and fees
are netted against student loan income.
F-15
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
(q) Loan Servicing Income
Loan servicing fees are determined according to agreements with
customers and are calculated based on the dollar value or number
of loans serviced for each customer. Fees are accrued as earned as
income on a monthly basis. As of December 31, 2003 and 2002, the
Company serviced more than $18.7 billion and $17.9 billion,
respectively, of loans, including $9.2 billion and $7.5 billion of
Company-owned loans.
(r) Income Tax Expense
Income taxes are accounted for under the asset and liability
method. Deferred income tax assets and liabilities are recognized
for the future tax consequences attributable to temporary
differences between the consolidated financial statement carrying
amounts of existing assets and liabilities and their respective
income tax basis. Deferred income tax assets and liabilities are
measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are
expected to be recovered or settled.
(s) Earnings Per Share
The basic earnings per common share ("EPS") is computed by
dividing net income by the weighted average number of common
shares outstanding for the periods presented. The weighted average
number of shares used for the years ended December 31, 2003, 2002
and 2001, adjusted to reflect the recapitalization referred to in
note 2, were 45,501,583, 44,971,290 and 44,331,490, respectively.
Nelnet had no common stock equivalents and no potentially dilutive
common shares during the periods presented.
(t) Use of Estimates
The preparation of the consolidated financial statements in
conformity with accounting principles generally accepted in the
United States of America requires management to make a number of
estimates and assumptions that affect the reported amounts of
assets and liabilities, reported amounts of revenues and expenses,
and other disclosures. Actual results could differ from those
estimates. The most significant estimates made by management
relate to the adequacy of the program reimbursement reserve and
allowance for loan losses.
(u) Reclassification
Certain amounts have been reclassified to conform to the 2003
consolidated financial statement presentation.
(4) Restricted Investments - Held by Trustee
NELF and MELMAC's restricted investments are held by a trustee in various
accounts subject to use restrictions and consist of guaranteed investment
contracts, commercial banking deposits, and repurchase agreements, which
are classified as held-to-maturity. Due to the characteristics of the
investments, there is no available or active market for these types of
financial instruments. These investments are guaranteed and are purchased
and redeemed at par value, which equals their cost at December 31, 2003
and 2002. The carrying value of these investments by contractual maturity
is shown below:
December 31
---------------------
2003 2002
-------- --------
(Dollars in thousands)
Over 1 year through 5 years $ 1,714 2,709
After 5 years through 10 years 30,038 20,729
After 10 years 148,936 149,901
-------- --------
$180,688 173,339
======== ========
F-16
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
(5) Student Loans Receivable and Concentration of Credit Risk
Student loans receivable at December 31, 2003 and 2002 consisted of the
following:
December 31
----------------------------
2003 2002
----------- -----------
(Dollars in thousands)
FFELP loans $10,380,181 8,496,760
Privately-insured private loans 29,706 23,108
Self-insured private loans 61,581 51,552
----------- -----------
10,471,468 8,571,420
Less allowance for loan losses - FFELP loans 10,795 9,970
Less allowance for loan losses - Private loans 5,231 2,030
----------- -----------
$10,455,442 8,559,420
=========== ===========
FFELP allowance as a percentage of ending balance of FFELP loans 0.10% 0.12%
Private allowance as a percentage of ending balance of private loans 5.73% 2.72%
Total allowance as a percentage of ending balance of total loans 0.15% 0.14%
FFELP loans may be made under the FFEL program by certain lenders as
defined by the Act. These loans, including related accrued interest, are
guaranteed at their maximum level permitted under the Act by an
authorized guaranty agency which has a contract of reinsurance with the
Department. The terms of the loans, which vary on an individual basis,
generally provide for repayment in monthly installments of principal and
interest over a period of up to 20 years. Interest rates on loans may be
fixed or variable, will vary based on the average of the 91-day U.S.
Treasury bill rate, and currently range from 2.9% to 12.0% (the weighted
average rate was 4.5% and 5.3% at December 31, 2003 and 2002,
respectively) dependent upon type, terms of loan agreements and date of
origination. For FFELP loans, the Student Lending Subsidiaries have
entered into trust agreements in which unrelated financial institutions
serve as the eligible lender trustees. As eligible lender trustees, the
financial institutions act as the eligible lender in acquiring certain
eligible student loans as an accommodation to the subsidiaries, which
hold beneficial interests in the student loan assets as the beneficiaries
of such trusts.
Substantially all FFELP loan principal and related accrued interest is
guaranteed as defined by the Act. These guarantees are made subject to
the performance of certain loan servicing procedures stipulated by
applicable regulations. If these due diligence procedures are not met,
affected student loans may not be covered by the guarantees should the
borrower default. The Company and its Student Lending Subsidiaries retain
and enforce recourse provisions against servicers and lenders under
certain circumstances. Such student loans are subject to "cure"
procedures and reinstatement of the guarantee under certain
circumstances. Also, in accordance with the Student Loan Reform Act of
1993, student loans disbursed prior to October 1, 1993 are fully insured,
and loans disbursed subsequent to October 1, 1993 are insured up to 98%
of their principal amount and accrued interest.
Student loans receivable also includes private loans. The private loan
portfolio consists of privately-insured and self-insured loans. The terms
of the private loans, which vary on an individual basis, generally
provide for repayment in monthly installments of principal and interest
over a period of up to 20 years. Interest rates on the loans will vary
based on the average of the 91-day U.S. Treasury Bill or the prime rate.
The private loans primarily represent student borrowers in the medical,
dental, or physical sciences fields of study. The self-insured private
loans are not covered by guarantees or collateral should the borrower
default. The privately-insured private loans are insured for 90% of
principal and interest.
F-17
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
The Company has provided for an allowance for loan losses related to the
private loans and FFELP loans. Activity in the allowance for loan losses
for the years ended December 31, 2003, 2002 and 2001 is shown below:
2003 2002 2001
-------- -------- --------
(Dollars in thousands)
Beginning balance $ 12,000 10,242 3,614
Transfer from acquisitions -- -- 4,866
Provision for loan losses 11,475 5,587 3,925
Loans charged off, net of recoveries (7,449) (3,829) (2,163)
-------- -------- --------
Ending balance $ 16,026 12,000 10,242
======== ======== ========
(6) Guaranty and Insurance Agencies
At December 31, 2003 and 2002, Nebraska Student Loan Program, Inc.,
United Student Aid Funds, Inc., Pennsylvania Higher Education Assistance
Authority, California Student Aid Commission, New York State Higher
Education Services Corporation, Tennessee Student Assistance Corporation,
Florida Department of Education Office of Student Financial Assistance,
Colorado Student Loan Program and the Finance Authority of Maine were the
primary guarantors of the student loans beneficially owned by the Student
Lending Subsidiaries. Management periodically reviews the financial
condition of its guarantors and does not believe the level of
concentration creates an unusual or unanticipated credit risk. In
addition, management believes that based on amendments to the Act as a
result of reauthorization, the security for and payment of any of the
Student Lending Subsidiaries' obligations would not be materially
adversely affected as a result of legislative action or other failure to
perform on its obligations on the part of any guaranty agency. The
Student Lending Subsidiaries, however, offer no absolute assurances to
that effect.
Nelnet Private-1 also has a student loan indemnification agreement with a
private insurer, under which a portion of the private loans are insured.
The agreement indemnifies Nelnet Private-1 for 90% of losses incurred
resulting from borrower default. Upon default, all rights of recovery are
subrogated to a private insurer. As of December 31, 2003 and 2002, a
private insurer insured 33% and 31%, respectively, of the private loans
owned by Nelnet Private-1.
(7) Intangible Assets
Intangible assets at December 31, 2003 and 2002 consist of the following:
December 31
Useful ------------------------
life 2003 2002
-------------- ----------- -----------
(Dollars in thousands)
Lender relationship and loan origination rights
(net of accumulated amortization of $9,613 and $5,655,
respectively) 36 months $ 1,292 4,765
Loan servicing contracts (net of accumulated amortization
of $43,610 and $41,824, respectively) 30-36 months -- 1,786
Servicing systems software and other intellectual property
(net of accumulated amortization of $13,273 and $6,253,
respectively) 36 months 7,787 14,807
Goodwill, nonamortizable 2,551 2,551
----------- -----------
$ 11,630 23,909
=========== ===========
F-18
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
The Company recorded amortization of $12.8 million, $22.2 million and
$18.8 million for the years ended December 31, 2003, 2002 and 2001,
respectively. The Company will continue to amortize intangible assets
over their remaining useful lives and will record amortization of $8.3
million and $0.8 million in 2004 and 2005, respectively.
(8) Furniture, Equipment and Leasehold Improvements
Furniture, equipment and leasehold improvements at December 31, 2003 and
2002 consist of the following:
December 31
Useful ------------------------
life 2003 2002
------------ ----------- ----------
(Dollars in thousands)
Computer equipment and software 3-7 years $ 39,418 33,155
Office furniture and equipment 3-10 years 11,794 9,739
Leasehold improvements 1-10 years 6,073 4,507
----------- ----------
57,285 47,401
Accumulated depreciation and amortization 38,147 34,491
----------- ----------
$ 19,138 12,910
=========== ==========
Depreciation and amortization expense for the years ended December 31,
2003, 2002 and 2001 related to furniture, equipment and leasehold
improvements was $10.1 million, $10.1 million and $8.0 million,
respectively.
(9) Bonds and Notes Payable
The Student Lending Subsidiaries periodically issue bonds, commercial
paper, short-term variable auction rate notes, taxable student loan
asset-backed notes and other credit facilities to finance the acquisition
of student loans or to refinance existing debt. Most 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. The student loan interest margin ("SLIMS") notes are secured
by the rights to residual cash flows from certain variable-rate bonds and
notes and fixed rate notes. Certain variable-rate bonds and notes and
fixed rate bonds of $1.2 billion and $1.0 billion at December 31, 2003
and 2002, respectively, are secured by financial guaranty insurance
policies issued by Municipal Bond Investors Assurance Corporation
("MBIA") and Ambac Assurance Corporation.
F-19
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
The following table summarizes outstanding bonds and notes payable at
December 31, 2003 and 2002 by type of instrument:
December 31, 2003
------------------------------------------------------
Carrying Interest rate
amount range Final maturity
------------------------------------------------------
(Dollars in thousands)
Variable-rate bonds and notes:
Bonds and notes based on indices $ 3,203,859 1.17% - 1.87% 05/01/07 - 01/25/37
Bonds and notes based on auction 5,125,270 1.00% - 1.30% 07/01/05 - 07/01/43
------------
Total variable-rate bonds and notes 8,329,129
Commercial paper and other 2,064,400 1.11% - 1.40% 05/14/04 - 09/25/24
Fixed-rate bonds and notes 927,694 5.50% - 6.68% 05/01/05 - 06/01/28
Other secured borrowings 45,235 1.30% - 6.00% 01/30/04 - 11/01/05
------------
Total $ 11,366,458
============
December 31, 2002
-----------------------------------------------------
Carrying Interest rate
amount range Final maturity
-----------------------------------------------------
(Dollars in thousands)
Variable-rate bonds and notes:
Bonds and notes based on indices $ 2,307,013 1.43% - 1.92% 05/01/07 - 12/25/33
Bonds and notes based on auction 4,563,135 1.40% - 2.77% 07/01/05 - 10/01/36
-----------
Total variable-rate bonds and notes 6,870,148
Commercial paper and other 1,388,579 1.36% - 1.64% 05/01/03 - 12/15/06
Fixed-rate bonds and notes 1,122,881 5.48% - 6.90% 11/01/03 - 06/01/28
Other secured borrowings 66,074 1.60% - 6.00% 01/10/03 - 11/01/05
-----------
Total $ 9,447,682
===========
Variable-rate bonds are long-term bonds with interest rate reset dates
ranging from weekly to quarterly based upon auction rates and national
indices.
The Company had a $30 million line of credit from an unrelated bank.
There was no amount outstanding on this line at December 31, 2003. At
December 31, 2002, $30 million was outstanding under this line of credit.
The line of credit bore interest at the prime rate (4.00% and 4.25% at
December 31, 2003 and 2002, respectively) and was not renewed in February
2004. Interest was payable quarterly or monthly depending on the term of
the borrowing.
The Company entered into a commercial paper placement program with an
unrelated bank on September 25, 2003. The program allows for issuance up
to $35 million. As of December 31, 2003, $12.7 million was outstanding
under the commercial paper placement program. The commercial paper
placement program bears interest at the current commercial paper rate
plus 0.25% or LIBOR plus 2.25% depending on the unrelated bank's ability
to place the commercial paper (weighted average rate of 1.40% at December
31, 2003). Interest is payable at maturity of the commercial paper.
Additionally, this unrelated bank coordinated a $35 million line of
credit with three other unrelated banks. There was no amount outstanding
on this line as of December 31, 2003. The commercial paper placement
program and the line of credit expire on September 25, 2004.
F-20
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
In May 2002 and October 2002, Nelnet SLF consummated debt offerings of
student loan asset-backed notes of $1.0 billion and $1.2 billion,
respectively. In connection with these debt offerings, the Company
entered into agreements with certain investment banks pursuant to which
the Company will pay the investment banks a fee equal in the aggregate to
0.01% and 0.0075% per annum of the principal balance of the May 2002 and
October 2002 notes, respectively. These fees are for credit enhancements
to the notes whereby the investment banks will provide liquidity advances
to the Company in the instance of disintermediation in the spread between
student loan interest rates and the notes' interest rates as defined in
the agreement. The total amount paid by the Company under these
agreements was approximately $155,000 and $72,000 during the years ended
December 31, 2003 and 2002, respectively.
Certain warehouse lines are assumed to renew automatically; therefore,
the maturities on these warehouse lines are deemed to be greater than
five years. Bonds and notes outstanding at December 31, 2003 are due
(based on final maturities) in varying amounts as follows (dollars in
thousands):
2004 $ 597,575
2005 221,484
2006 127,010
2007 212,923
2008 81,615
2009 and thereafter 10,125,851
-----------
$11,366,458
===========
Generally, bonds bearing interest at variable rates can be redeemed on
any interest payment date at par plus accrued interest. Subject to
conversion provisions, all bonds and notes are subject to redemption
prior to maturity at the option of certain Student Lending Subsidiaries
without a prepayment penalty. These provisions include price, conditions
precedent, and limitations.
A Student Lending Subsidiary has irrevocably escrowed funds to make the
remaining principal and interest payments on previously issued bonds and
notes. Accordingly, neither these obligations nor the escrowed funds are
included on the accompanying consolidated balance sheets. At December 31,
2003 and 2002, $22.2 million and $20.6 million, respectively, of defeased
debt remained outstanding.
The Student Lending Subsidiaries have unused commitments under the
various commercial paper and warehouse agreements of $708 million and
$416 million at December 31, 2003 and 2002, respectively. At December 31,
2003 and 2002, certain Student Lending Subsidiaries had various
short-term borrowing agreements with a maximum aggregate stated amount of
$2.8 billion and $1.9 billion, respectively.
Certain bond resolutions contain, among other requirements, covenants
relating to restrictions on additional indebtedness, limits as to direct
and indirect administrative expenses and maintaining certain financial
ratios. Management believes the Company is in compliance with all
covenants of the bond indentures and related credit agreements.
(10) Program Reimbursement Reserve
For the years ended December 31, 2003, 2002 and 2001, a provision for
losses on program reimbursements of $1.7 million, $1.6 million and $1.2
million, respectively, was recognized, which is included in other
expenses in the accompanying consolidated statements of income. Other
liabilities in the accompanying consolidated balance sheets include $7.3
million and $6.1 million as an allowance for program reimbursements at
December 31, 2003 and 2002, respectively.
F-21
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
(11) Income Taxes
Income tax expense for the years ended December 31, 2003, 2002 and 2001
consists of the following components:
2003 2002 2001
-------- -------- --------
(Dollars in thousands)
Current:
Federal $ 20,742 33,204 15,440
State 1,750 2,950 1,303
-------- -------- --------
22,492 36,154 16,743
-------- -------- --------
Deferred:
Federal (2,982) (7,717) (10,445)
State (215) (758) (918)
-------- -------- --------
(3,197) (8,475) (11,363)
-------- -------- --------
$ 19,295 27,679 5,380
======== ======== ========
The actual income tax expense differs from the "expected" income tax
expense, computed by applying the 35% federal statutory corporate tax
rate to income before income tax expense for the years ended December 31,
2003, 2002 and 2001, as shown below:
2003 2002 2001
-------- -------- --------
(Dollars in thousands)
"Expected" income tax expense $ 16,201 26,544 4,594
Increase (decrease) resulting from:
State tax, net of federal income tax benefit 998 1,425 250
Noncash compensation expense 1,808 -- --
Other, net 288 (290) 536
-------- -------- --------
$ 19,295 27,679 5,380
======== ======== ========
Effective tax rate 41.7% 36.5% 41.0%
F-22
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
The Company's deferred income tax assets and liabilities, which are
included in other assets as of December 31, 2003 and 2002, consists of
the following components:
December 31
--------------------
2003 2002
------- -------
(Dollars in thousands)
Deferred tax liabilities:
Loan origination services $ 5,819 1,866
Intangible assets -- 2,206
Partnership income 161 --
Furniture, equipment and leasehold improvements 599 --
Mark-to-market adjustment - derivative instruments 139 --
Other 350 696
------- -------
Deferred tax liabilities 7,068 4,768
------- -------
Deferred tax assets:
Student loans 10,539 6,118
Accrued expenses not currently deductible 1,566 1,007
Partnership income -- 1,235
Basis in swap contracts 389 214
Intangible assets 1,348 --
Securitization transaction 1,837 1,057
Unearned revenue 1,103 941
Furniture, equipment and leasehold improvements -- 400
Other -- 452
------- -------
Deferred tax assets 16,782 11,424
------- -------
Net deferred income tax asset $ 9,714 6,656
======= =======
No valuation allowance was considered necessary for the deferred tax
assets at December 31, 2003 and 2002. In assessing the realizability of
the Company's deferred tax assets, management considers whether it is
more likely than not that some portion or all of the deferred tax assets
will be realized. The ultimate realization of deferred tax assets is
dependent upon the generation of future taxable income during the period
in which those temporary differences become deductible. Management
considers the scheduled reversals of deferred tax liabilities, projected
taxable income, carryback opportunities and tax planning strategies in
making the assessment of the amount of the valuation allowance.
F-23
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
(12) Fair Value of Financial Instruments
The following table summarizes the fair values of the Company's financial
instruments at December 31, 2003 and 2002:
December 31
------------------------------------------------------------
2003 2002
----------------------------- ----------------------------
Fair value Carrying value Fair value Carrying value
(Dollars in thousands)
Financial assets:
Student loans receivable $10,628,895 10,455,442 8,659,613 8,559,420
Cash and cash equivalents 198,423 198,423 40,155 40,155
Restricted cash - held by trustee 634,263 634,263 570,703 570,703
Restricted investments - held by trustee 180,668 180,688 173,339 173,339
Restricted cash - due to loan program customers 141,841 141,841 132,375 132,375
Accrued interest receivable 196,633 196,633 177,015 177,015
Financial liabilities:
Bonds and notes payable 11,417,810 11,366,458 9,471,710 9,447,682
Accrued interest payable 17,179 17,179 20,251 20,251
Due to loan program customers 141,841 141,841 132,875 132,375
Derivative instruments 677 677 -- --
(a) Cash and Cash Equivalents, Restricted Cash - Due to Loan Program
Customers, Restricted Cash - Held by Trustee, Accrued Interest
Receivable/Payable and Due to Loan Program Customers
The carrying amount approximates fair value due to the
variable-rate of interest and/or the short maturities of these
instruments.
(b) Student Loans Receivable
The fair value of student loans receivable is estimated at amounts
recently paid by the Company to acquire a similar portfolio of
loans in the market.
(c) Restricted Investments - Held by Trustee
Due to the characteristics of the investments, there is no
available or active market for these types of financial
instruments. These investments are guaranteed and are purchased
and redeemed at par value, which equals their cost.
(d) Bonds and Notes Payable
The fair value of the bonds and notes payable is based on market
prices for securities that possess similar credit risk and
interest rate risk.
(e) Derivative Instruments
The fair value of the derivative instruments, obtained from market
quotes from independent security brokers, was the estimated amount
that would have been paid to terminate the respective agreements.
F-24
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
(f) Limitations
The fair value of a financial instrument is the current amount
that would be exchanged between willing parties, other than in a
forced liquidation. Fair value is best determined based upon
quoted market prices. However, in many instances, there are no
quoted market prices for the Company's various financial
instruments. In cases where quoted market prices are not
available, fair values are based on estimates using present value
or other valuation techniques. Those techniques are significantly
affected by the assumptions used, including the discount rate and
estimates of future cash flows. Accordingly, the fair value
estimates may not be realized in an immediate settlement of the
instrument. SFAS No. 107, Disclosures About Fair Value of
Financial Instruments, excludes certain financial instruments and
all nonfinancial instruments from its disclosure requirements.
(13) Derivative Financial Instruments
The Company maintains an overall interest rate risk management strategy
that incorporates the use of derivative instruments to minimize the
economic effect of interest rate volatility. The Company's goal is to
manage interest rate sensitivity by modifying the repricing or maturity
characteristics of certain balance sheet assets and liabilities so that
the net interest margin is not, on a material basis, adversely affected
by movements in interest rates. As a result of interest rate
fluctuations, hedged assets and liabilities will appreciate or depreciate
in market value. Income or loss on the derivative instruments that are
linked to the hedged assets and liabilities will generally offset the
effect of this unrealized appreciation or depreciation. The Company views
this strategy as a prudent management of interest rate sensitivity.
Management believes all derivative transactions are economically
effective; however, the majority do not qualify for hedge accounting
under SFAS No. 133 and thus may adversely impact earnings.
By using derivative instruments, the Company is exposed to credit and
market risk. If the counterparty fails to perform, credit risk is equal
to the extent of the fair value gain in a derivative. When the fair value
of a derivative contract is positive, this generally indicates that the
counterparty owes the Company. When the fair value of a derivative
contract is negative, the Company owes the counterparty and, therefore,
it has no credit risk. The Company minimizes the credit (or repayment)
risk in derivative instruments by entering into transactions with
high-quality counterparties that are reviewed periodically by the
Company's risk committee. The Company also maintains a policy of
requiring that all derivative contracts be governed by an International
Swaps and Derivative Association Master Agreement.
Market risk is the adverse effect that a change in interest rates, or
implied volatility rates, has on the value of a financial instrument. The
Company manages market risk associated with interest rates by
establishing and monitoring limits as to the types and degree of risk
that may be undertaken.
Derivative instruments that are used as part of the Company's interest
rate risk management strategy include interest rate swaps, caps and basis
swaps. The following table summarizes the Company's derivative
instruments as of December 31, 2003.
Notional amounts
by product type
-------------------------------
Fixed/
floating Basis
Maturity swaps (a) swaps (b) Total
- --------------------------- --------- ----------- -------
(Dollars in millions)
2004 $1,000 500 1,500
2005 150 1,000 1,150
2006 -- 500 500
------ ------ ------
Total $1,150 2,000 3,150
====== ====== ======
Fair value (c) $ 0.6 (1.3) (0.7)
====== ====== ======
- ----------
F-25
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
(a) During August and October 2003, the Company entered into interest
rate swap agreements with notional amounts of $1 billion and $150
million, respectively. Under the terms of the agreements, the
Company receives payments based on a variable interest rate tied
to the 30-day LIBOR and makes payments based on fixed interest
rates of 1.18% and 1.68%, respectively. The interest rate swap
agreements expire in July 2004 and September 2005, respectively.
(b) During August 2003, the Company entered into three basis swap
agreements with notional amounts of $500 million, $1 billion and
$500 million which expire in May 2004, August 2005 and August
2006, respectively. The basis swap agreements provide for the
Company to pay a floating interest rate based on the U.S. Treasury
bill rate and receive a floating interest rate based on the
3-month LIBOR rate. This arrangement allows the Company to limit
the interest rate sensitivity of the interest rate spread between
the hedged assets (student loans) and liabilities (notes payable).
(c) Fair value indicates an estimated amount the Company would receive
(pay) if the contracts were cancelled or transferred to other
parties.
The Company accounts for derivative instruments under SFAS No. 133, which
requires that every derivative instrument be recorded in the balance
sheet as either an asset or liability measured at its fair value.
Management has structured all of the Company's derivative transactions
with the intent that each is economically effective. As more fully
described below, if certain criteria are met, derivative instruments are
classified and accounted for by the Company as either fair value or cash
flow hedges. If these criteria are not met, the derivative financial
instruments are accounted for as trading.
Fair Value Hedges
At December 31, 2003, there were no outstanding derivative instruments
accounted for as fair value hedges.
Cash Flow Hedges
Cash flow hedges are generally used by the Company to hedge the exposure
of variability in cash flows of a forecasted debt issuance. This strategy
is used primarily to minimize the exposure to volatility from future
interest rate changes. Gains and losses on the effective portion of a
qualifying hedge are accumulated in other comprehensive income (net of
tax) and reclassified to current period earnings over the period which
the stated hedged transactions impact earnings. Ineffectiveness is
recorded immediately to earnings.
In 2003, the Company accounted for one interest rate swap with a notional
amount of $150 million that matures in September 2005 as a cash flow
hedge. At December 31, 2003, the fair market value for this derivative
was approximately $0.5 million. For the year ended December 31, 2003, the
ineffectiveness arising from differences between the critical terms of
this interest rate swap and the hedged debt obligation was not material
to the consolidated financial statements. In addition, the deferred gains
for this derivative accumulated in other comprehensive income that are
expected to be reclassed to earnings during the next 12 months are not
material to the consolidated financial statements.
Trading Activities
When instruments do not qualify as hedges under SFAS No. 133, they are
accounted for as trading. All outstanding derivative instruments at
December 31, 2003, with the exception noted previously, were accounted
for as trading. In addition, the Company accounted for its twelve-month
interest rate swap which expired in June 2002 as trading. The change in
fair value of trading derivative instruments is recorded in the
consolidated statements of income at each reporting date. This derivative
market value adjustment was $(1.2) million, $(0.6) million and $(3.0)
million for the years ended December 31, 2003, 2002 and 2001,
respectively.
(14) Employee Benefit Plans
(a) 401(k) Plans
NELN has a 401(k) savings plan which covers substantially all of
their employees. Employees may contribute up to 100% of their
pre-tax salary, subject to IRS limitations. The Company made
contributions to the plan of approximately $1.7 million, $1.4
million and $518,000 in the years ended December 31, 2003, 2002
and 2001,
F-26
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
respectively. Union Bank & Trust Company ("UB&T") serves as the
trustee for the plan. NMS had a separate 401(k) savings plan in
2001. NMS made contributions to the plan of approximately $154,000
for 2001. GuaranTec also had a separate 401(k) savings plan in
2001. GuaranTec made contributions to the plan of approximately
$65,000 for the period July 1, 2001 to December 31, 2001.
Effective January 1, 2002, employees participating in the NMS and
GuaranTec plans became eligible to participate in the NELN 401(k)
plan.
EFS maintained two retirement plans which covered substantially
all employees. The first was a 401(k) savings plan and the second
was a defined contribution pension plan, which is an employee
stock ownership plan ("ESOP"). Upon acquisition by NELN, the ESOP
sold its shares to NELN and distribution of the cash occurred in
2003. EFS made contributions to the plan of approximately $208,000
for the year ended December 31, 2002. Effective April 1, 2002,
employees participating in the EFS 401(k) savings plan became
eligible to participate in the NELN 401(k) plan.
(b) Employee Share Purchase Plan
In 2003, the Company adopted an employee share purchase plan
pursuant to which employees are entitled to purchase common stock.
The employee share purchase plan is intended to enhance the
Company's ability to attract and retain employees and to better
enable such persons to participate in the Company's long-term
success and growth.
A total of 1,000,000 Class A common stock shares are reserved for
issuance under the employee share purchase plan, subject to
equitable adjustment by the compensation committee in the event of
stock dividends, recapitalizations and other similar corporate
events. All employees, other than those whose customary employment
is 20 hours or less per week, who have been employed for at least
six months, or another period determined by the Company's
compensation committee not in excess of two years, will be
eligible to purchase Class A common stock under the plan. As of
December 31, 2003, no shares have been purchased by employees
under this plan.
(c) Restricted Stock Plan
In 2003, the Company adopted a restricted stock plan. The
restricted stock plan is intended to provide incentives to
attract, retain and motivate employees in order to achieve
long-term growth and profitability objectives. The restricted
stock plan provides for the grant to eligible employees of awards
of restricted shares of Class A common stock. An aggregate of
1,000,000 shares of Class A common stock have been reserved for
issuance under the restricted stock plan, subject to antidilution
adjustments in the event of certain changes in capital structure.
Shares of Class A common stock issued pursuant to the restricted
stock plan will be either authorized but unissued shares or
treasury shares. Unless earlier terminated, the restricted stock
plan will expire on November 13, 2013, and no further awards may
be granted there under after such date. As of December 31, 2003,
no shares have been granted under the restricted stock plan.
(d) Book Value Stock Plan
In March 2003, the Company issued 331,800 shares of Class A common
stock at a formula price based on book value to employees of the
Company. Each new shareholder was required to sign a shareholder
agreement which restricts the sale, assignment, pledge or
otherwise transfer of any interest in any of the shares of stock
without obtaining the prior written consent of the holders of an
aggregate of more than 50% of the Class A shareholders. The
Company has the option to redeem the outstanding stock in the
event of termination of employment, divorce or change in control
at the formula price based on book value at the redemption date.
The Company accounted for the stock issuance by applying the
provisions of EITF 88-6, Book Value Stock Plans in an Initial
Public Offering ("EITF 88-6"). Because the shareholder agreements
did not provide any mechanism that converted the book value stock
to market value stock upon completion of an initial public
F-27
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
offering ("IPO"), the Company accounted for the transaction as
book value stock that remains book value stock. The book value
stock issued in March 2003 was presumed to have been issued in
contemplation of the IPO and, thus, was subject to variable-plan
("SAR") accounting for actual changes in the book value of those
shares from the date of issuance in accordance with the provisions
of EITF 88-6.
Upon the consummation of the IPO, the shareholder agreements were
terminated in accordance with an agreement entered into by all
shareholders in August 2003. As a result, in the third quarter of
2003 the Company recognized a compensation charge of $5.2 million
equal to the difference between the estimated initial public
offering price (estimated fair value) of that number of shares and
the total price paid by the employees.
(e) Director's Share-Based Compensation Plan
In 2003, the Company adopted a share-based compensation plan for
nonemployee directors pursuant to which nonemployee directors will
have an election to receive their annual retainer fees in the form
of cash or Class A common stock. Up to 100,000 shares may be
issued under the plan, subject to antidilution adjustments in the
event of certain changes in capital structure. If a nonemployee
director elects to receive Class A common stock, the number of
shares of Class A common stock that will be awarded will be equal
to the amount of the annual retainer fee otherwise payable in cash
divided by 85% of the fair market value of a share of Class A
common stock on the date the fee is payable. Nonemployee directors
who choose to receive Class A common stock may also elect to defer
receipt of the Class A common stock until termination of their
service on the board of directors. Any dividends paid in respect
of deferred shares during the deferral period will also be
deferred in the form of additional shares and paid out at
termination from the board of directors. The plan may be amended
or terminated by the board of directors at any time, but no
amendment or termination will adversely affect a nonemployee
director's rights with respect to previously deferred shares
without the consent of the nonemployee director. As of December
31, 2003, no shares have been granted under the director's
share-based compensation plan.
(15) Commitments
The Student Lending Subsidiaries acquire eligible loans on a regular
basis from lending institutions as part of their normal business
operations. At December 31, 2003 and 2002, the Student Lending
Subsidiaries and NELN were committed to purchase up to $287.4 million and
$292.7 million, respectively, in student loans at current market rates
upon the sellers' request under various agreements through September 30,
2004. Commitments to extend credit are agreements to lend to a borrower
as long as there is no violation of any condition established in the
commitment agreement. Commitments generally have fixed expiration dates
or other termination clauses.
The Company is committed under noncancelable operating leases for office
and warehouse space and equipment. Total rental expense incurred by the
Company in the years ended December 31, 2003, 2002 and 2001, was $6.1
million, $6.9 million and $3.2 million, respectively. Minimum future
rentals under noncancelable operating leases are shown below (dollars in
thousands):
2004 $ 4,950
2005 4,437
2006 3,550
2007 2,680
2008 693
2009 and thereafter 475
-------
$16,785
=======
The Company had shareholder agreements with the holders of the vast
majority of its common stock. These shareholder agreements restricted the
transfer of common stock through sale, pledge, encumbrance or other
transfer by
F-28
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
the shareholder, without the written consent of the holders of a majority
of the pre-recapitalization common stock. The Company had an option to
redeem all or a portion of a shareholder's interest in the event that,
among other things, the shareholder ceased to be an officer, director, or
employee of the Company. The purchase price, if the Company elected to
exercise its redemption option, was the book value of the shares being
redeemed. The shareholder agreements terminated upon the consummation of
the Company's initial public offering in accordance with an agreement
entered into by all shareholders in August 2003.
(16) Related Parties
The Company serviced loans of a related bank of $544 million and $720
million at December 31, 2003 and 2002, respectively. Income earned by
Nelnet from this loan servicing in the years ended December 31, 2003,
2002 and 2001 was $5.4 million, $5.5 million and $4.7 million,
respectively. At December 31, 2003 and 2002, accounts receivable includes
approximately $1.1 million and $371,000, respectively, from this bank for
loan servicing.
The Company incurred a consulting management fee for services provided by
an entity that is a minority stockholder of the Company. The Company
incurred management fee expenses of $1.73 million, $1.75 million and $1.8
million for the years ended December 31, 2003, 2002 and 2001,
respectively. This agreement terminated in 2003.
The Company participates in the Short-Term Federal Investment Trust
("STFIT") of the Student Loan Trust Division of a related bank which is
included in cash and cash equivalents held at a related party and
restricted cash - due to loan program customers on the accompanying
consolidated balance sheets. As of December 31, 2003 and 2002, the
Company had approximately $71.1 million and $49.3 million, respectively,
invested in the STFIT or deposited at this bank in operating accounts, of
which approximately $60.9 million and $36.5 million, respectively, is
cash collected for customers. The Company's participation in the STFIT
had similar terms and investment yields as those prevailing for other
nonaffiliated customers. Interest income earned by the Company on the
amounts invested in the STFIT for the years ended December 31, 2003, 2002
and 2001 was $1.0 million, $1.7 million and $3.5 million, respectively.
In 2001, the Company entered into an agreement with 5280 Solutions, Inc.
("5280"), an entity with 50% voting interest owned by NELN, to provide
certain software development and technology support services. During the
years ended December 31, 2003, 2002 and 2001, the Company incurred
contract programming expenses of $4.7 million, $7.0 million and $11.8
million, respectively, for these services. At December 31, 2003 and 2002,
$496,000 and $1.1 million, respectively, was payable to 5280 and is
included in other liabilities in the accompanying consolidated balance
sheets.
In March 2002, the Company acquired a 50% ownership interest in FirstMark
Services LLC ("FirstMark"). FirstMark agreed to provide subcontracting
servicing functions on the Company's behalf with respect to private loan
servicing. During the years ended December 31, 2003 and 2002, the Company
paid FirstMark fees of approximately $5.5 million and $4.6 million,
respectively. FirstMark owed the Company $565,000 and $700,000 at
December 31, 2003 and 2002, respectively.
During the years ended December 31, 2003, 2002 and 2001, the Student
Lending Subsidiaries purchased student loans of $726 million, $378
million and $666 million, respectively, from a related bank. Premiums
paid on these loans totaled approximately $9.5 million, $6.4 million and
$8.6 million, respectively. The purchases from this bank were made on
terms similar to those made with unrelated entities. During the years
ended December 31, 2003, 2002 and 2001, this bank reimbursed the Company
for approximately $1.0 million, $519,000 and $1.1 million, respectively,
for student loan marketing services. During 2001, the Company also
incurred $750,000 for software advisory, consulting services and
management fees provided by this bank. The Company has sold to this bank,
as trustee, participation interests with balances of approximately $223
million and $149 million as of December 31, 2003 and 2002, respectively.
During the year ended December 31, 2003, this bank reimbursed the Company
approximately $458,000 and during the years ended December 31, 2002 and
2001, the Company reimbursed this bank approximately $219,000 and
$538,000, respectively, for marketing services related to the Nebraska
College Savings Plan.
F-29
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
During the year ended December 31, 2002, a related bank paid the Company
marketing income of $2.3 million as a broker on a loan sale.
In August 2001, the Company provided a guarantee of liabilities of a bank
affiliated with the Company through certain common shareholders and a
director in the amount of $10 million. The Company is paid a fee for this
indemnification. The Company does not believe it is probable that the
Company will be required to make payments on the guarantee. Thus, no
liability has been accrued for a loss related to the Company's obligation
under this guarantee arrangement.
During the years ended December 31, 2003, 2002 and 2001, the Company paid
UFS Securities $1.4 million, $1.4 million, and $0.5 million,
respectively, for services related to financings. All payments were made
before the acquisition of UFS Securities. These payments have been
recorded as debt issuance costs and are included in other assets in the
accompanying consolidated balance sheets.
During the years ended December 31, 2002 and 2001, the Company incurred
consulting fees of $1.65 million and $3 million, respectively, for
services provided by a related party through common ownership in
connection with eligible loan purchases. This agreement terminated in
2003. During the years ended December 31, 2003, 2002 and 2001, the
Company incurred consulting fees of $1.8 million, $2.4 million and $2.3
million, respectively, for services provided by a significant
shareholder. This agreement terminated in 2003. During 2001, NMS and
GuaranTec had a service agreement with InTuition Services, Inc.
(Services), an entity related through common shareholders prior to
acquisition, whereby Services provided certain management and other
operational support services for NMS and GuaranTec. Amounts paid by NMS
and GuaranTec for such services, including certain occupancy related
expenses allocated to NMS and GuaranTec, were $9.7 million in 2001.
During 2002, Nelnet Corporate Services provided these operational support
services.
During 2001, NELN owned $10 million in preferred stock of a majority
owned subsidiary of a significant shareholder. The preferred stock paid a
2% annual cumulative dividend. During 2002, NELN sold the preferred stock
to Nelnet at carrying value. Nelnet transferred its ownership in the
preferred stock to Infovisa and subsequently sold Infovisa to a
significant shareholder at carrying value, which approximated fair value.
The operating results of Infovisa were not significant to the
consolidated financial statements.
F-30
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
(17) Condensed Parent Company Financial Statements
The following represents the condensed balance sheets as of December 31,
2003 and 2002 and condensed statements of income and cash flows for each
of the years in the three-year period ended December 31, 2003 for Nelnet,
Inc.
The Company is limited in the amount of funds that can be transferred to
it by its subsidiaries through intercompany loans, advances or cash
dividends. These limitations relate to the restrictions by trust
indentures under the Student Lending Subsidiaries debt financing
arrangements. The amounts of cash and investments restricted in the
respective reserve accounts of the Student Lending Subsidiaries are shown
on the consolidated balance sheets as restricted cash and investments.
Balance Sheets
(Parent Company Only)
December 31
---------------------
Assets 2003 2002
-------- --------
(Dollars in thousands)
Cash and cash equivalents $157,723 1,137
Restricted cash - due to loan program customers 141,841 132,375
Investment in subsidiaries 135,035 71,064
Accounts receivable 20,714 20,151
Other assets 19,008 29,482
-------- --------
Total assets $474,321 254,209
======== ========
Liabilities and Shareholders' Equity
Liabilities:
Bonds and notes payable $ 12,662 --
Other liabilities 14,329 12,712
Due to loan program customers 141,841 132,375
-------- --------
Total liabilities 168,832 145,087
-------- --------
Shareholders' equity:
Common stock:
Class A 396 309
Class B 140 140
Additional paid-in capital 206,831 52,714
Retained earnings 97,885 55,959
Accumulated other comprehensive income 237 --
-------- --------
Total shareholders' equity 305,489 109,122
-------- --------
Total liabilities and shareholders' equity $474,321 254,209
======== ========
Statements of Income
(Parent Company Only)
Year Ended December 31
----------------------------------
2003 2002 2001
-------- -------- --------
(Dollars in thousands)
Operating revenues $146,952 118,189 87,522
Operating expenses 118,815 109,853 96,329
-------- -------- --------
Net operating income (loss) 28,137 8,336 (8,807)
Net interest income 740 1,515 2,121
Equity in earnings of subsidiaries 12,076 42,137 11,056
Income tax expense (benefit) 13,850 3,450 (2,777)
-------- -------- --------
Net income $ 27,103 48,538 7,147
======== ======== ========
F-31
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
Statements of Cash Flows
(Parent Company Only)
Year Ended December 31
---------------------------------------
2003 2002 2001
--------- --------- ---------
(Dollars in thousands)
Cash flows from operating activities:
Net income $ 27,103 48,538 7,147
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation and amortization 870 10,635 17,973
Noncash compensation expense 5,166 -- --
Equity in earnings of subsidiaries (12,076) (42,137) (11,056)
Decrease in accounts receivable (563) (6,564) (228)
Decrease (increase) in other assets 10,277 (1,181) (17,695)
Increase (decrease) in other liabilities 1,617 (3,294) 2,382
--------- --------- ---------
Net cash provided by (used in)
operating activities 32,394 5,997 (1,477)
--------- --------- ---------
Cash flows from investing activities:
Cash received on sale of subsidiary -- 6,051 --
Acquisition of subsidiaries, net of cash acquired (1,760) (1,776) --
Purchase of preferred stock of affiliate -- (10,000) --
Capital contributions to subsidiary (50,571) -- --
--------- --------- ---------
Net cash flows used in
investing activities (52,331) (5,725) --
--------- --------- ---------
Cash flows from financing activities:
Proceeds from issuance of notes payable 12,662 -- --
Payments for redemption of common stock (643) -- --
Proceeds from issuance of common stock 164,504 -- 2,010
--------- --------- ---------
Net cash flows provided by
financing activities 176,523 -- 2,010
--------- --------- ---------
Net increase in cash and
cash equivalents 156,586 272 533
Cash and cash equivalents, beginning of year 1,137 865 332
--------- --------- ---------
Cash and cash equivalents, end of year $ 157,723 1,137 865
========= ========= =========
Supplemental cash flow information:
Cash paid for income tax $ 21,635 6,677 13,709
========= ========= =========
Cash paid for interest $ 124 -- --
========= ========= =========
F-32
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
(18) Segment Reporting
The Company is a vertically integrated education finance organization
which has four operating segments as defined in SFAS No. 131, Disclosures
about Segments of an Enterprise and Related Information ("SFAS No. 131"),
as follows: Asset Management, Student Loan Servicing, Guarantee Servicing
and Servicing Software. The Asset Management and Student Loan Servicing
operating segments meet the quantitative thresholds identified in SFAS
No. 131 as reportable segments and therefore the related financial data
is presented below. The Guarantee Servicing and Servicing Software
operating segments do not meet the quantitative thresholds and therefore
are included as other segments that do not meet the reportable segment
criteria. The accounting policies of the reportable segments are the same
as those described in the summary of significant accounting policies.
Costs excluded from segment net income primarily consist of unallocated
corporate expenses, net of miscellaneous revenues. Thus, net income of
the segments includes only the costs that are directly attributable to
the operations of the individual segment.
The Asset Management segment includes the acquisition, management and
ownership of the student loan assets. Revenues are primarily generated
from net interest income on the student loan assets. The Company
generates student loan assets through direct origination or through
acquisition of the loans from branding and forward purchase
relationships. The student loan assets are held in a series of student
lending subsidiaries designed specifically for this purpose.
The Student Loan Servicing segment provides for the servicing of our own
and third parties' student loan portfolios. The servicing activities
include application processing, borrower updates, payment processing,
claim processing and due diligence procedures. These activities are
performed internally for our own portfolio in addition to generating fee
revenue when performed for third-party clients.
Substantially all of the Company's revenues are earned from customers in
the United States and no single customer accounts for a significant
amount of any reportable segment's revenues. Inter-segment revenues are
charged by a segment to another segment that provides the product or
service. The amount of inter-segment revenue is based on comparable fees
charged in the market.
Segment data is as follows:
Asset Student loan Total
management servicing Other segments
----------- ----------- ----------- -----------
(Dollars in thousands)
Year ended December 31, 2003:
Net interest income $ 184,903 740 10 185,653
Other income 66 81,087 32,542 113,695
Intersegment revenues -- 65,596 2,708 68,304
----------- ----------- ----------- -----------
Total revenue 184,969 147,423 35,260 367,652
Provision for loan losses 11,475 -- -- 11,475
Depreciation and amortization 2,146 872 7,131 10,149
Income tax expense (benefit) 8,657 13,850 (113) 22,394
Net income 46,975 15,027 2,617 64,619
Total assets (at period end) $11,497,693 339,286 23,918 11,860,897
=========== =========== =========== ===========
F-33
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
Asset Student loan Total
management servicing Other segments
---------- ---------- ---------- ----------
(Dollars in thousands)
Year ended December 31, 2002:
Net interest income $ 190,667 1,427 42 192,136
Other income 1,724 83,866 24,409 109,999
Intersegment revenues -- 55,217 1,553 56,770
---------- ---------- ---------- ----------
Total revenue 192,391 140,510 26,004 358,905
Provision for loan losses 5,587 -- -- 5,587
Depreciation and amortization 2,146 12,313 6,473 20,932
Income tax expense (benefit) 24,988 3,094 (2,528) 25,554
Net income (loss) 63,909 9,128 (5,479) 67,558
Total assets (at period end) $9,552,699 192,921 29,211 9,774,831
========== ========== ========== ==========
Asset Student loan Total
management servicing Other segments
---------- ---------- ---------- ----------
(Dollars in thousands)
Year ended December 31, 2002:
Year ended December 31, 2001:
Net interest income $ 117,809 2,365 -- 120,174
Other income 926 88,379 8,770 98,075
Intersegment revenues -- 29,948 -- 29,948
---------- ---------- ---------- ----------
Total revenue 118,735 120,692 8,770 248,197
Provision for loan losses 3,925 -- -- 3,925
Depreciation and amortization 2,146 19,854 132 22,132
Income tax expense (benefit) 14,751 (942) 224 14,033
Net income (loss) 29,837 (3,367) 996 27,466
Total assets (at period end) $7,913,099 127,283 5,766 8,046,148
========== ========== ========== ==========
Reconciliation to the consolidated financial statements is as follows.
2003 2002 2001
--------- --------- ---------
(Dollars in thousands)
Total segment revenues $ 367,652 358,905 248,197
Elimination of intersegment revenues (68,304) (56,770) (29,948)
Corporate revenues, net (2,044) 14,573 (2,799)
Derivative market value adjustment (1,170) (579) (2,962)
--------- --------- ---------
Total consolidated revenues $ 296,134 316,129 212,488
========= ========= =========
Total net income of segments $ 64,619 67,558 27,466
Corporate expenses, net (37,516) (19,020) (20,319)
--------- --------- ---------
Total consolidated net income $ 27,103 48,538 7,147
========= ========= =========
F-34
2003 2002
------------ ------------
(Dollars in thousands)
Total segment assets $ 11,860,897 9,774,831
Elimination of intercompany assets (30,140) (96,727)
Assets of other operating activities 100,752 88,479
------------ ------------
Total consolidated assets $ 11,931,509 9,766,583
============ ============
Net corporate revenues and expenses included in the above table relate to
activities that are not related to the four identified operating
segments. The net corporate revenues include investment earnings and
nonrecurring revenue for marketing services. The net corporate expenses
include expenses for marketing, capital markets and other unallocated
support services, including income taxes. The net corporate revenues and
expenses are not associated with an ongoing business activity as defined
by SFAS No. 131 and, therefore, have not been included within the
operating segments.
The derivative market value adjustment is the change in the fair value of
the Company's derivative instruments, as the majority of the Company's
derivative instruments do not qualify for hedge accounting, as discussed
in note 13 of the notes to consolidated financial statements. These
derivative instruments are not included in the Company's operating
segments as they are not related to specific segment assets or
liabilities. These risk management agreements are part of corporate
activities.
The assets held at the corporate level are not identified with any of the
operating segments. Accordingly, these assets are included in the
reconciliation of segment assets to total assets. These assets consist
primarily of cash, investments, fixed assets, income tax receivables and
other deferred assets.
(19) Quarterly Financial Information (Unaudited)
2003
--------------------------------------------------
First Second Third Fourth
quarter quarter quarter quarter
-------- -------- -------- --------
(Dollars in thousands)
Net interest income $ 44,255 47,668 41,904 44,785
Less provision for loan losses (2,410) (2,450) (4,015) (2,600)
-------- -------- -------- --------
Net interest income after provision for loan losses 41,845 45,218 37,889 42,185
Derivative market value adjustment -- -- (4,632) 3,462
Other income 28,709 29,052 30,697 30,234
Operating expenses (55,464) (60,103) (63,260) (59,543)
Income taxes (5,621) (5,841) (1,827) (6,006)
Minority interest in net earnings of subsidiary 109 -- -- --
-------- -------- -------- --------
Net income (loss) $ 9,578 8,326 (1,133) 10,332
======== ======== ======== ========
Basic and diluted earnings (loss) per common share $ 0.21 0.19 (0.03) 0.22
======== ======== ======== ========
Certain unusual items occurred in 2003. In the second quarter of 2003,
the Company had additional amortization and write-offs of debt issuance
costs of $2.6 million as a result of refinancing certain debt
transactions. In the third quarter of 2003, the Company recognized a
non-cash stock compensation charge of $5.2 million equal to the
difference between the product of the estimated initial public offering
price and the number of shares issued in March 2003 and the total price
paid by the employees. Additionally, in the third quarter of 2003, the
Company paid $3.3 million as a result of certain related party contract
terminations. In the fourth quarter of 2003, bonuses of $1.8 million
related to the termination of employee contracts for IFA were expensed.
F-35
APPENDIX A
THE FEDERAL FAMILY EDUCATION LOAN PROGRAM
The Federal Family Education Loan Program
The Higher Education Act provides for a program of direct federal insurance
for student loans as well as reinsurance of student loans guaranteed or insured
by state agencies or private non-profit corporations.
The Higher Education Act currently authorizes certain student loans to be
covered under the Federal Family Education Loan Program ("FFELP" or "FFEL
Program"). The 1998 Amendments to the Higher Education Act extended the
authorization for the FFEL Program through September 30, 2004. Congress has
extended similar authorization dates in prior versions of the Higher Education
Act. However, the current authorization dates may not again be extended and the
other provisions of the Higher Education Act may not be continued in their
present form.
Generally, a student is eligible for loans made under the FFEL Program only
if he or she:
o has been accepted for enrollment or is enrolled in good standing at an
eligible institution of higher education;
o is carrying or planning to carry at least one-half the normal
full-time workload for the course of study the student is pursuing as
determined by the institution;
o has agreed to promptly notify the holder of the loan of any address
change; and
o meets the applicable "needs" requirements.
Eligible institutions include higher educational institutions and vocational
schools that comply with specific federal regulations. Each loan is to be
evidenced by an unsecured note.
The Higher Education Act also establishes maximum interest rates for each of
the various types of loans. These rates vary not only among loan types, but also
within loan types depending upon when the loan was made or when the borrower
first obtained a loan under the FFEL Program. The Higher Education Act allows
lesser rates of interest to be charged.
Regulations authorize the Department of Education (the "Department") to
limit, suspend or terminate lenders' participation in the FFEL Program, as well
as to impose civil penalties, if lenders violate certain program regulations.
The regulations also authorize the Department to impose penalties on the
servicer and/or limit, suspend or terminate the servicer's eligibility to
contract to service FFELP loans if the servicer fails to meet standards of
financial responsibility or administrative capability included in the
regulations or violates certain other FFELP requirements. The Department
conducts frequent on-site audits of our loan servicing activities. Guaranty
agencies conduct similar audits on a regular basis. In addition, we engage
independent third parties to conduct compliance reviews, as required by the
Department, with respect to our own student loan portfolio and the portfolios of
our third-party servicing clients.
Types of Loans
Four types of loans are currently available under the FFEL Program:
o Stafford loans,
o Unsubsidized Stafford loans,
o PLUS loans, and
o Consolidation loans.
These loan types vary as to eligibility requirements, interest rates, repayment
periods, loan limits and eligibility for interest subsidies and special
allowance payments. Some of these loan types have had other names in the past.
References to these various loan types include, where appropriate, their
predecessors.
The primary loan under the FFEL Program is the subsidized Stafford loan.
Students who are not eligible for subsidized Stafford loans based on their
economic circumstances may be able to obtain unsubsidized Stafford loans.
Parents of students may be able to obtain PLUS loans. Consolidation loans are
available to borrowers with existing loans made under the FFEL Program and other
A-1
federal programs to consolidate repayment of the borrower's existing loans.
Prior to July 1, 1994, the FFEL Program also offered SLS loans to graduate and
professional students and independent undergraduate students and, under certain
circumstances, dependent undergraduate students, to supplement their Stafford
loans.
Subsidized Stafford Loans
General. Subsidized Stafford loans are eligible for reinsurance under the
Higher Education Act if the eligible student to whom the loan is made has been
accepted or is enrolled in good standing at an eligible institution of higher
education or vocational school and is carrying at least one-half the normal
full-time workload at that institution. Subsidized Stafford loans have limits as
to the maximum amount which may be borrowed for an academic year and in the
aggregate for both undergraduate and graduate/professional study. Both aggregate
limitations exclude loans made under the SLS and PLUS programs. The Secretary of
Education has discretion to raise these limits to accommodate students
undertaking specialized training requiring exceptionally high costs of
education.
Subsidized Stafford loans are generally made only to student borrowers who
meet the needs tests provided in the Higher Education Act. Provisions addressing
the implementation of needs analysis and the relationship between unmet need for
financing and the availability of subsidized Stafford loan funding have been the
subject of frequent and extensive amendment in recent years. Further amendment
to such provisions may materially affect the availability of subsidized Stafford
loan funding to borrowers or the availability of subsidized Stafford loans for
secondary market acquisition.
Interest rates for subsidized Stafford loans. For a Stafford loan made prior
to July 1, 1994, the applicable interest rate for a borrower who, on the date
the promissory note was signed, did not have an outstanding balance on a
previous FFELP loan:
(1) is 7% per annum for a loan covering a period of instruction
beginning before January 1, 1981;
(2) is 9% per annum for a loan covering a period of instruction
beginning on or after January 1, 1981, but before September 13, 1983;
(3) is 8% per annum for a loan covering a period of instruction
beginning on or after September 13, 1983, but before July 1, 1988;
(4) is 8% per annum for the period from the disbursement of the loan to
the date which is four years after the loan enters repayment, for a loan
made prior to October 1, 1992, covering a period of instruction beginning on
or after July 1, 1988, and thereafter shall be adjusted annually, and for
any 12-month period commencing on a July 1 shall be equal to the bond
equivalent rate of 91-day U.S. Treasury bills auctioned at the final auction
prior to the preceding June 1, plus 3.25% per annum (but not to exceed 10%
per annum); or
(5) for a loan made on or after October 1, 1992 shall be adjusted
annually, and for any 12-month period commencing on a July 1 shall be equal
to the bond equivalent rate of 91-day U.S. Treasury bills auctioned at the
final auction prior to the preceding June 1, plus 3.1% per annum (but not to
exceed 9% per annum).
For a Stafford loan made prior to July 1, 1994, the applicable interest rate
for a borrower who, on the date the promissory note evidencing the loan was
signed, had an outstanding balance on a previous loan made insured or guaranteed
under the FFEL Program:
(6) for a loan made prior to July 23, 1992 is the applicable interest
rate on the previous loan or, if the previous loan is not a Stafford loan,
8% per annum or
(7) for a loan made on or after July 23, 1992 shall be adjusted
annually, and for any twelve month period commencing on a July 1 shall be
equal to the bond equivalent rate of 91-day U.S. Treasury bills auctioned at
the final auction prior to the preceding June 1, plus 3.1% per annum but not
to exceed:
o 7% per annum in the case of a Stafford loan made to a borrower who has
a loan described in clause (1) above;
o 8% per annum in the case of:
-- a Stafford loan made to a borrower who has a loan described in
clause (3) above,
-- a Stafford loan which has not been in repayment for four years and
which was made to a borrower who has a loan described in clause
(4) above,
-- a Stafford loan for which the first disbursement was made prior to
December 20, 1993 to a borrower whose previous loans do not
include a Stafford loan or an unsubsidized Stafford loan;
A-2
o 9% per annum in the case of a Stafford loan made to a borrower who has
a loan described in clauses (2) or (5) above or a Stafford loan for
which the first disbursement was made on or after December 20, 1993 to
a borrower whose previous loans do not include a Stafford loan or an
unsubsidized Stafford loan; and
o 10% per annum in the case of a Stafford loan which has been in
repayment for four years or more and which was made to a borrower who
has a loan described in clause (4) above.
The interest rate on all Stafford loans made on or after July 1, 1994 but
prior to July 1, 1998, regardless of whether the borrower is a new borrower or a
repeat borrower, is the rate described in clause (7) above, except that the
interest rate shall not exceed 8.25% per annum. For any Stafford loan made on or
after July 1, 1995, the interest rate is further reduced prior to the time the
loan enters repayment and during any deferment periods. During deferment
periods, the formula described in clause (7) above is applied, except that 2.5%
is substituted for 3.1%, and the rate shall not exceed 8.25% per annum.
For Stafford loans made on or after July 1, 1998 but before July 1, 2006,
the applicable interest rate shall be adjusted annually, and for any twelve
month period commencing on a July 1 shall be equal to the bond equivalent rate
of 91-day U.S. Treasury bills auctioned at the final auction prior to the
proceeding June 1, plus 1.7% per annum prior to the time the loan enters
repayment and during any deferment periods, and 2.3% per annum during repayment,
but not to exceed 8.25% per annum.
For loans the first disbursement of which is made on or after July 1, 2006,
the applicable interest rate will be 6.8%. There can be no assurance that the
interest rate provisions for these loans will not be further amended.
Unsubsidized Stafford Loans
General. Unsubsidized Stafford loans were created by Congress in 1992 for
students who do not qualify for subsidized Stafford loans due to parental and/or
student income and assets in excess of permitted amounts. These students are
entitled to borrow the difference between the Stafford loan maximum and their
subsidized Stafford eligibility. The general requirements for unsubsidized
Stafford loans are essentially the same as those for subsidized Stafford loans.
The interest rate, the annual loan limits and the special allowance payment
provisions of the unsubsidized Stafford loans are the same as the subsidized
Stafford loans. However, the terms of the unsubsidized Stafford loans differ
materially from subsidized Stafford loans in that the federal government will
not make interest subsidy payments and the loan limitations are determined
without respect to the expected family contribution. The borrower will be
required to either pay interest from the time the loan is disbursed or
capitalize the interest until repayment begins. Unsubsidized Stafford loans were
not available before October 1, 1992. A student meeting the general eligibility
requirements for a loan under the FFEL Program is eligible for an unsubsidized
Stafford loan without regard to need.
Interest rates for unsubsidized Stafford loans. Unsubsidized Stafford loans
are subject to the same interest rate provisions as subsidized Stafford loans.
PLUS Loans
General. PLUS loans are made only to borrowers who are parents and, under
certain circumstances, spouses of remarried parents, of dependent undergraduate
students. For PLUS loans made on or after July 1, 1993, the parent borrower must
not have an adverse credit history as determined pursuant to criteria
established by the Department. The basic provisions applicable to PLUS loans are
similar to those of subsidized Stafford loans with respect to the involvement of
guaranty agencies and the Secretary of Education in providing federal
reinsurance on the loans. However, PLUS loans differ significantly from
subsidized Stafford loans, particularly because federal interest subsidy
payments are not available under the PLUS loan program and special allowance
payments are more restricted.
Interest rates for PLUS loans. The applicable interest rate depends upon the
date of issuance of the loan and the period of enrollment for which the loan is
to apply. The applicable interest rate on a PLUS loan:
o made on or after January 1, 1981, but before October 1, 1981, is 9%
per annum;
o made on or after October 1, 1981, but before November 1, 1982, is 14%
per annum;
o made on or after November 1, 1982, but before July 1, 1987, is 12% per
annum;
o made on or after July 1, 1987, but before October 1, 1992 shall be
adjusted annually, and for any 12-month period beginning on July 1
shall be equal to the bond equivalent rate of 52-week U.S. Treasury
bills auctioned at the final auction prior to the
A-3
preceding June 1, plus 3.25% per annum (but not to exceed 12% per
annum);
o made on or after October 1, 1992, but before July 1, 1994, shall be
adjusted annually, and for any 12-month period beginning on July 1
shall be equal to the bond equivalent rate of 52-week U.S. Treasury
bills auctioned at the final auction prior to the preceding June 1,
plus 3.1% per annum (but not to exceed 10% per annum);
o made on or after July 1, 1994, but before July 1, 1998, is the same as
that for a loan made on or after October 1, 1992, but before July 1,
1994, except that such rate shall not exceed 9% per annum;
o made on or after July 1, 1998, but before July 1, 2006, shall be
adjusted annually, and for any 12-month period beginning on July 1
shall be equal to the bond equivalent rate of 91-day U.S. Treasury
bills auctioned at the final auction prior to the preceding June 1,
plus 3.1% per annum (but not to exceed 9% per annum); or
o the first disbursement of which is made on or after July 1, 2006 will
be 7.9%.
For any 12-month period beginning on July 1, 2001 or any succeeding year,
the weekly average 1-year constant maturity Treasury yield, as published by the
Board of Governors of the Federal Reserve System, for the last calendar week
before such June 26, will be substituted for the 52-week Treasury bill as the
index for interest rate calculations.
SLS loans
General. SLS loans were limited to graduate or professional students,
independent undergraduate students, and dependent undergraduate students, if the
students' parents were unable to obtain a PLUS loan and were also unable to
provide the students' expected family contribution. Except for dependent
undergraduate students, eligibility for SLS loans was determined without regard
to need. SLS loans are similar to subsidized Stafford loans with respect to the
involvement of guaranty agencies and the Secretary of Education in providing
federal reinsurance on the loans. However, SLS loans differ significantly from
subsidized Stafford loans, particularly because federal interest subsidy
payments are not available under the SLS loan program and special allowance
payments are more restricted.
Interest rates for SLS loans. The applicable interest rates on SLS loans
made prior to October 1, 1992 are identical to the applicable interest rates on
PLUS loans made at the same time. For SLS loans made on or after October 1,
1992, the applicable interest rate is the same as the applicable interest rate
on PLUS loans, except that the ceiling is 11% per annum instead of 10% per
annum.
Consolidation Loans
General. The Higher Education Act authorizes a program under which certain
borrowers may consolidate their various student loans into a single loan insured
and reinsured on a basis similar to subsidized Stafford loans. Consolidation
loans may be obtained in an amount sufficient to pay outstanding principal,
unpaid interest and late charges on federally insured or reinsured student loans
incurred under the FFEL Program, excluding PLUS loans made to "parent
borrowers," selected by the borrower, as well as loans made pursuant to the
Perkins (formally National Direct Student Loan) and Health Professional Student
Loan Programs. To be eligible for a consolidation loan, a borrower must:
o have outstanding indebtedness on student loans made under the FFEL
Program and/or certain other federal student loan programs, and
o be in repayment status or in a grace period, or
o be a defaulted borrower who has made arrangements to repay any
defaulted loan satisfactory to the holder of the defaulted loan.
If requested by the borrower, an eligible lender may consolidate SLS or PLUS
loans of the same borrower held by the lender under a single repayment schedule.
The repayment period for each included loan shall be based on the commencement
of repayment of the most recent loan. The consolidated loan shall bear interest
at a rate equal to the weighted average of the rates of the included loans. In
addition, at the request of the borrower, a lender may refinance an existing
fixed-rate SLS or PLUS loan, including a SLS or PLUS loan held by a different
lender who has refused to refinance the loan, at a variable interest rate. In
this case, proceeds of the new loan are used to discharge the original loan.
A married couple who agree to be jointly liable on a consolidation loan, for
which the application is received on or after January 1, 1993, may be treated as
an individual for purposes of obtaining a consolidation loan. For consolidation
loans disbursed prior to July 1, 1994 the borrower was required to have
outstanding student loan indebtedness of at least $7,500. Prior to the adoption
of the Higher
A-4
Education Technical Amendments Act of 1993, PLUS loans could not be included in
the consolidation loan. For consolidation loans for which the applications were
received prior to January 1, 1993, the minimum student loan indebtedness was
$5,000 and the borrower could not be delinquent more than 90 days in the payment
of such indebtedness. For applications received on or after January 1, 1993,
borrowers may add additional loans to a consolidation loan during the 180-day
period following the origination of the consolidation loan.
Interest rates for consolidation loans. A consolidation loan made prior to
July 1, 1994 bears interest at a rate equal to the weighted average of the
interest rates on the loans retired, rounded to the nearest whole percent, but
not less than 9% per annum. Except as described in the next sentence, a
consolidation loan made on or after July 1, 1994 bears interest at a rate equal
to the weighted average of the interest rates on the loans retired, rounded
upward to the nearest whole percent, but with no minimum rate. For a
consolidation loan for which the application is received by an eligible lender
on or after November 13, 1997 and before October 1, 1998, the interest rate
shall be adjusted annually, and for any twelve-month period commencing on a July
1 shall be equal to the bond equivalent rate of 91-day U.S. Treasury bills
auctioned at the final auction prior to the preceding June 1, plus 3.1% per
annum, but not to exceed 8.25% per annum. Notwithstanding these general interest
rates, the portion, if any, of a consolidation loan that repaid a loan made
under title VII, Sections 700-721 of the Public Health Services Act, as amended,
has a different variable interest rate. Such portion is adjusted on July 1 of
each year, but is the sum of the average of the T-Bill Rates auctioned for the
quarter ending on the preceding June 30, plus 3.0%, without any cap on the
interest rate. Consolidation loans made on or after October 1, 1998 and before
July 1, 2006 will bear interest at a per annum rate equal to the lesser of 8.25%
or the weighted average of the interest rates on the loans being consolidated,
rounded to the nearest higher 1/8 of 1%. Consolidation loans for which the
application is received on or after July 1, 2006, will bear interest also at a
rate per annum equal to the lesser of 8.25% or the weighted average of the
interest rates on the loans being consolidated, rounded to the nearest higher
1/8 of 1%. For a discussion of required payments that reduce the return on
consolidation loans, see "Fees -- Rebate Fees on Consolidation Loans" in this
Appendix.
Maximum Loan Amounts
Each type of loan is subject to limits on the maximum principal amount, both
with respect to a given year and in the aggregate. Consolidation loans are
limited only by the amount of eligible loans to be consolidated. All of the
loans are limited to the difference between the cost of attendance and the other
aid available to the student. Stafford loans are also subject to limits based
upon needs analysis. Additional limits are described below.
Loan limits for Stafford and unsubsidized Stafford loans. Stafford and
unsubsidized Stafford loans are generally treated as one loan type for loan
limit purposes. A student who has not successfully completed the first year of a
program of undergraduate education may borrow up to $2,625 in an academic year.
A student who has successfully completed the first year, but who has not
successfully completed the second year may borrow up to $3,500 per academic
year. An undergraduate student who has successfully completed the first and
second year, but who has not successfully completed the remainder of a program
of undergraduate education, may borrow up to $5,500 per academic year. For
students enrolled in programs of less than an academic year in length, the
limits are generally reduced in proportion to the amount by which the programs
are less than one year in length. A graduate or professional student may borrow
up to $8,500 in an academic year. The maximum aggregate amount of Stafford and
unsubsidized Stafford loans, including that portion of a consolidation loan used
to repay such loans, which an undergraduate student may have outstanding is
$23,000. The maximum aggregate amount for a graduate and professional student,
including loans for undergraduate education, is $65,500. The Secretary of
Education is authorized to increase the limits applicable to graduate and
professional students who are pursuing programs which the Secretary of Education
determines to be exceptionally expensive.
Prior to the enactment of the Higher Education Amendments of 1992, an
undergraduate student who had not successfully completed the first and second
year of a program of undergraduate education could borrow Stafford loans in
amounts up to $2,625 in an academic year. An undergraduate student who had
successfully completed the first and second year, but who had not successfully
completed the remainder of a program of undergraduate education could borrow up
to $4,000 per academic year. The maximum for graduate and professional students
was $7,500 per academic year. The maximum aggregate amount of Stafford loans
which a borrower could have outstanding, including that portion of a
consolidation loan used to repay such loans, was $17,250. The maximum aggregate
amount for a graduate or professional student, including loans for undergraduate
education, was $54,750. Prior to the 1986 changes, the annual limits were
generally lower.
Loan limits for PLUS loans. For PLUS loans made on or after July 1, 1993,
the amounts of PLUS loans are limited only by the student's unmet need. Prior to
that time PLUS loans were subject to limits similar to those of SLS loans
applied with respect to each student on behalf of whom the parent borrowed.
Loan limits for SLS loans. A student who had not successfully completed the
first and second year of a program of undergraduate education could borrow a SLS
loan in an amount of up to $4,000. A student who had successfully completed the
first and second year, but who had not successfully completed the remainder of a
program of undergraduate education could borrow up to $5,000 per year. Graduate
and professional students could borrow up to $10,000 per year. SLS loans were
subject to an aggregate maximum of
A-5
$23,000 ($73,000 for graduate and professional students). Prior to the 1992
changes, SLS loans were available in amounts of $4,000 per academic year, up to
a $20,000 aggregate maximum. Prior to the 1986 changes, a graduate or
professional student could borrow $3,000 of SLS loans per academic year, up to a
$15,000 maximum, and an independent undergraduate student could borrow $2,500 of
SLS loans per academic year minus the amount of all other FFELP loans to such
student for such academic year, up to the maximum amount of all FFELP loans to
that student of $12,500. In 1989, the amount of SLS loans for students enrolled
in programs of less than an academic year in length were limited in a manner
similar to the limits described above under "Subsidized Stafford Loans."
Disbursement Requirements
The Higher Education Act now requires that virtually all Stafford loans and
PLUS loans be disbursed by eligible lenders in at least two separate
installments. The proceeds of a loan made to any undergraduate first-year
student borrowing for the first time under the program must be delivered to the
student no earlier than thirty days after the enrollment period begins.
Repayment
Repayment periods. Loans made under FFEL Program, other than consolidation
loans, must provide for repayment of principal in periodic installments over a
period of not less than five nor more than ten years. After the 1998 Amendments,
lenders are required to offer extended repayment schedules to new borrowers who
accumulate outstanding loans of more than $30,000, in which case the repayment
period may extend up to 25 years subject to certain minimum repayment amounts. A
consolidation loan must be repaid during a period agreed to by the borrower and
lender, subject to maximum repayment periods which vary depending upon the
principal amount of the borrower's outstanding student loans, but may not be
longer than 30 years. For consolidation loans for which the application was
received prior to January 1, 1993, the repayment period could not exceed 25
years. Repayment of principal on a Stafford loan does not commence while a
student remains a qualified student, but generally begins upon expiration of the
applicable grace period. Grace periods may be waived by borrowers. For Stafford
loans for which the applicable rate of interest is 7% per annum, the repayment
period commences not more than twelve months after the borrower ceases to pursue
at least a half-time course of study. For other Stafford loans and unsubsidized
Stafford loans, the repayment period commences not more than six months after
the borrower ceases to pursue at least a half-time course of study. The six
month or 12 month periods are the "grace periods."
In the case of SLS, PLUS and consolidation loans, the repayment period
commences on the date of final disbursement of the loan, except that the
borrower of a SLS loan who also has a Stafford loan may defer repayment of the
SLS loan to coincide with the commencement of repayment of the Stafford or
unsubsidized Stafford loan. During periods in which repayment of principal is
required, payments of principal and interest must in general be made at a rate
of not less than the greater of $600 per year or the interest that accrues
during the year, except that a borrower and lender may agree to a lesser rate at
any time before or during the repayment period. A borrower may agree, with
concurrence of the lender, to repay the loan in less than five years with the
right subsequently to extend his minimum repayment period to five years.
Borrowers may accelerate, without penalty, the repayment of all or any part of
the loan.
Income-sensitive repayment schedules. Since 1992, lenders of consolidation
loans have been required to establish graduated or income-sensitive repayment
schedules and lenders of Stafford and SLS loans have been required to offer
borrowers the option of repaying in accordance with graduated or
income-sensitive repayment schedules. A trust may implement graduated repayment
schedules and income-sensitive repayment schedules. Use of income-sensitive
repayment schedules may extend the ten-year maximum term for up to five years.
In addition, if the repayment schedule on a loan that has been converted to a
variable interest rate does not provide for adjustments to the amount of the
monthly installment payments, the ten-year maximum term may be extended for up
to three years.
Deferment periods. No principal repayments need be made during certain
periods of deferment prescribed by the Higher Education Act. For loans to a
borrower who first obtained a loan which was disbursed before July 1, 1993,
deferments are available:
o during a period not exceeding three years while the borrower is a
member of the Armed Forces, an officer in the Commissioned Corps of
the Public Health Service or, with respect to a borrower who first
obtained a student loan disbursed on or after July 1, 1987, or a
student loan to cover the cost of instruction for a period of
enrollment beginning on or after July 1, 1987, an active duty member
of the National Oceanic and Atmospheric Administration Corps;
o during a period not in excess of three years while the borrower is a
volunteer under the Peace Corps Act;
o during a period not in excess of three years while the borrower is a
full-time volunteer under the Domestic Volunteer Act of 1973;
o during a period not exceeding three years while the borrower is in
service, comparable to the service described above as a full-time
volunteer for an organization which is exempt from taxation under
Section 501(c)(3) of the Code;
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o during a period not exceeding two years while the borrower is serving
an internship necessary to receive professional recognition required
to begin professional practice or service, or a qualified internship
or residency program;
o during a period not exceeding three years while the borrower is
temporarily totally disabled, as established by sworn affidavit of a
qualified physician, or while the borrower is unable to secure
employment by reason of the care required by a dependent who is so
disabled;
o during a period not to exceed twenty-four months while the borrower is
seeking and unable to find full-time employment;
o during any period that the borrower is pursuing a full-time course of
study at an eligible institution (or, with respect to a borrower who
first obtained a student loan disbursed on or after July 1, 1987, or a
student loan to cover the cost of instruction for a period of
enrollment beginning on or after July 1, 1987, is pursuing at least a
half-time course of study for which the borrower has obtained a loan
under the FFEL Program), or is pursuing a course of study pursuant to
a graduate fellowship program or a rehabilitation training program for
disabled individuals approved by the Secretary of Education;
o during a period, not in excess of 6 months, while the borrower is on
parental leave; and
o only with respect to a borrower who first obtained a student loan
disbursed on or after July 1, 1987, or a student loan to cover the
cost of instruction for a period of enrollment beginning on or after
July 1, 1987, during a period not in excess of three years while the
borrower is a full-time teacher in a public or nonprofit private
elementary or secondary school in a "teacher shortage area" (as
prescribed by the Secretary of Education), and during a period not in
excess of 12 months for mothers, with preschool age children, who are
entering or re-entering the work force and who are compensated at a
rate not exceeding $1 per hour in excess of the federal minimum wage.
For loans to a borrower who first obtains a loan on or after July 1, 1993,
deferments are available:
o during any period that the borrower is pursuing at least a half-time
courseof study at an eligible institution or a course of study
pursuant to a graduate fellowship program or rehabilitation training
program approved by the Secretary of Education;
o during a period not exceeding three years while the borrower is
seeking and unable to find full-time employment; and
o during a period not in excess of three years for any reason which the
lender determines, in accordance with regulations under the Higher
Education Act, has caused or will cause the borrower economic
hardship. Economic hardship includes working full time and earning an
amount not in excess of the greater of the minimum wage or the poverty
line for a family of two. Additional categories of economic hardship
are based on the relationship between a borrower's educational debt
burden and his or her income.
Prior to the 1992 changes, only certain of the deferment periods described
above were available to PLUS loan borrowers, and only certain deferment periods
were available to consolidation loan borrowers. Prior to the 1986 changes, PLUS
loan borrowers were not entitled to certain deferment periods. Deferment periods
extend the ten-year maximum term.
Forbearance period. The Higher Education Act also provides for periods of
forbearance during which the borrower, in case of temporary financial hardship,
may defer any payments. A borrower is entitled to forbearance for a period not
to exceed three years while the borrower's debt burden under Title IV of the
Higher Education Act (which includes the FFEL Program) equals or exceeds 20% of
the borrower's gross income, and also is entitled to forbearance while he or she
is serving in a qualifying medical or dental internship program or in a
"national service position" under the National and Community Service Trust Act
of 1993. In addition, mandatory administrative forbearances are provided in
exceptional circumstances such as a local or national emergency or military
mobilization, or when the geographical area in which the borrower or endorser
resides has been designated a disaster area by the President of the United
States or Mexico, the Prime Minister of Canada, or by the governor of a state.
In other circumstances, forbearance is at the lender's option. Forbearance also
extends the ten-year maximum term.
Interest payments during grace, deferment and forbearance periods. The
Secretary of Education makes interest payments on behalf of the borrower of
certain eligible loans while the borrower is in school and during grace and
deferment periods. Interest that accrues during forbearance periods and, if the
loan is not eligible for interest subsidy payments, while the borrower is in
school and during the grace and deferment periods, may be paid monthly or
quarterly or capitalized not more frequently than quarterly.
A-7
Fees
Guarantee fee. A guaranty agency is authorized to charge a premium, or
guarantee fee, of up to 1% of the principal amount of the loan, which must be
deducted proportionately from each installment payment of the proceeds of the
loan to the borrower. Guarantee fees may not currently be charged to borrowers
of consolidation loans. However, borrowers may be charged an insurance fee to
cover the costs of increased or extended liability with respect to consolidation
loans. For loans made prior to July 1, 1994, the maximum guarantee fee was 3% of
the principal amount of the loan, but no such guarantee fee was authorized to be
charged with respect to unsubsidized Stafford loans.
Origination fee. An eligible lender is authorized to charge the borrower of
a Stafford loan, an unsubsidized Stafford loan or PLUS loan an origination fee
in an amount not to exceed 5% of the principal amount of the loan, and is
required to charge the borrower of an unsubsidized Stafford loan or a PLUS loan
an origination fee in the amount of 3% of the principal amount of the loan.
These fees must be deducted proportionately from each installment payment of the
loan proceeds prior to payment to the borrower. These fees are not retained by
the lender, but must be passed on to the Secretary of Education.
Lender origination fee. The lender of any loan under the FFEL Program made
on or after October 1, 1993 is required to pay to the Secretary of Education a
fee equal to 0.5% of the principal amount of such loan.
Rebate fee on Consolidation Loans. The holder of any consolidation loan made
on or after October 1, 1993 is required to pay to the Secretary of Education a
monthly fee equal to .0875% (1.05% per annum) of the principal amount of, and
accrued interest on the consolidation loan. For loans made pursuant to
applications received on or after October 1, 1998, and on or before January 31,
1999 the fee on consolidation loans of 1.05% is reduced to 0.62%.
Interest Subsidy Payments
Interest subsidy payments are interest payments paid with respect to an
eligible loan before the time that the loan enters repayment and during grace
and deferment periods. The Secretary of Education and the guaranty agencies
enter into interest subsidy agreements whereby the Secretary of Education agrees
to pay interest subsidy payments to the holders of eligible guaranteed loans for
the benefit of students meeting certain requirements, subject to the holders'
compliance with all requirements of the Higher Education Act. Only Stafford
loans and consolidation loans for which the application was received on or after
January 1, 1993, are eligible for interest subsidy payments. Consolidation loans
made after August 10, 1993 are eligible for interest subsidy payments only if
all loans consolidated thereby are Stafford loans, except that consolidation
loans for which the application is received by an eligible lender on or after
November 13, 1997 and before October 1, 1998, are eligible for interest subsidy
payments on that portion of the Consolidation loan that repays Stafford loans or
similar subsidized loans made under the direct loan program. In addition, to be
eligible for interest subsidy payments, guaranteed loans must be made by an
eligible lender under the applicable guaranty agency's guarantee program, and
must meet requirements prescribed by the rules and regulations promulgated under
the Higher Education Act.
The Secretary of Education makes interest subsidy payments quarterly on
behalf of the borrower to the holder of a guaranteed loan in a total amount
equal to the interest which accrues on the unpaid principal amount prior to the
commencement of the repayment period of the loan or during any deferment period.
A borrower may elect to forego interest subsidy payments, in which case the
borrower is required to make interest payments.
Special Allowance Payments
The Higher Education Act provides for special allowance payments to be made
by the Secretary of Education to eligible lenders. The rates for special
allowance payments are based on formulas that differ according to the type of
loan, the date the loan was originally made or insured and the type of funds
used to finance the loan (taxable or tax-exempt).
Subsidized and unsubsidized Stafford loans. The effective formulas for
special allowance payment rates for Stafford and unsubsidized Stafford loans are
summarized in the following chart. The T-Bill Rate mentioned in the chart refers
to the average of the bond equivalent yield of the 91-day Treasury bills
auctioned during the preceding quarter.
Date of Loans Annualized SAP Rate
- ----------------------------------- ----------------------------------------------------
On or after October 1, 1981........ T-Bill Rate less Applicable Interest Rate + 3.5%
On or after November 16, 1986...... T-Bill Rate less Applicable Interest Rate + 3.25%
On or after October 1, 1992........ T-Bill Rate less Applicable Interest Rate + 3.1%
On or after July 1, 1995........... T-Bill Rate less Applicable Interest Rate + 3.1%(1)
On or after July 1, 1998........... T-Bill Rate less Applicable Interest Rate + 2.8%(2)
On or after January 1, 2000 and
before July 1, 2003.............. 3 Month Commercial Paper Rate less
Applicable(3) Interest Rate + 2.34%
A-8
- ------------
(1) Substitute 2.5% in this formula while loans are in-school, grace or
deferment status.
(2) Substitute 2.2% in this formula while such loans are in-school, grace or
deferment status.
(3) Substitute 1.74% in this formula while such loans are in-school, grace or
deferment status.
Federal PLUS, SLS and consolidation loans. The formula for special allowance
payments on PLUS, SLS and Consolidation loans are as follows:
Date of Loans Annualized SAP Rate
-------------------------------- ---------------------------------------------
On or after October 1, 1992.... T-Bill Rate less Applicable Interest Rate +
3.1%
On or after January 1, 2000.... 3 Month Commercial Paper Rate less Applicable
Interest Rate + 2.64%
For PLUS and SLS loans which bear interest at rates adjusted annually,
special allowance payments are made only in years during which the interest rate
ceiling on such loans operates to reduce the rate that would otherwise apply
based upon the applicable formula. See "Interest rates for PLUS loans" and
"Interest rates for SLS loans" in this Appendix. Special allowance payments are
paid with respect to PLUS loans made on or after October 1, 1992 only if the
rate that would otherwise apply exceeds 10% per annum. For PLUS loans made after
July 1, 1998 and before July 1, 2006, special allowance is paid only if the sum
of the 91-day Treasury bill rate determined at an auction held on June 1 of each
year plus 3.1% exceeds 9.0%. For PLUS loans first disbursed on or after July 1,
2006, special allowance is paid for such loans in any 12-month period beginning
on July 1 and ending on June 30 only if the sum of the average of the bond
equivalent rates of the quotes of the 3-month commercial paper rate for the last
calendar week ending on or before such July 1 plus 2.64% exceeds 9.0%. The
portion, if any, of a consolidation loan that repaid a loan made under Title
VII, Sections 700-721 of the Public Health Services Act, as amended, is
ineligible for special allowance payments.
Special allowance payments for loans financed by tax-exempt bonds. The
effective formulas for special allowance payment rates for Stafford Loans and
unsubsidized Stafford Loans differ depending on whether loans to borrowers were
acquired or originated with the proceeds of tax-exempt obligations. The formula
for special allowance payments for loans financed with the proceeds of
tax-exempt obligations originally prior to October 1, 1993 is:
T Bill Rate less Applicable Interest Rate + 3.5%
------------------------------------------------
2
provided that the special allowance applicable to the loans may not be less than
9 1/2% less the Applicable Interest Rate. Loans acquired with the proceeds of
tax-exempt obligations originally issued after October 1, 1993 receive special
allowance payments made on other loans.
Adjustments to special allowance payments. Special allowance payments and
interest subsidy payments are reduced by the amount which the lender is
authorized or required to charge as an origination fee. In addition, the amount
of the lender origination fee is collected by offset to special allowance
payments and interest subsidy payments. The Higher Education Act provides that
if special allowance payments or interest subsidy payments have not been made
within 30 days after the Secretary of Education receives an accurate, timely and
complete request therefore, the special allowance payable to such holder shall
be increased by an amount equal to the daily interest accruing on the special
allowance and interest subsidy payments due the holder.
Description of the Guaranty Agencies
The following discussion relates to guaranty agencies under the FFELP.
A guaranty agency guarantees loans made to students or parents of students
by lending institutions such as banks, credit unions, savings and loan
associations, certain schools, pension funds and insurance companies. A guaranty
agency generally purchases defaulted student loans which it has guaranteed with
its reserve fund. A lender may submit a default claim to the guaranty agency
after the student loan has been delinquent for at least 270 days. The default
claim package must include all information and documentation required under the
FFELP regulations and the guaranty agency's policies and procedures.
A-9
In general, a guaranty agency's reserve fund has been funded principally by
administrative cost allowances paid by the Secretary of Education, guarantee
fees paid by lenders, investment income on moneys in the reserve fund, and a
portion of the moneys collected from borrowers on guaranteed loans that have
been reimbursed by the Secretary of Education to cover the guaranty agency's
administrative expenses.
Various changes to the Higher Education Act have adversely affected the
receipt of revenues by the guaranty agencies and their ability to maintain their
reserve funds at previous levels, and may adversely affect their ability to meet
their guarantee obligations. These changes include:
o the reduction in reinsurance payments from the Secretary of Education
because of reduced reimbursement percentages;
o the reduction in maximum permitted guarantee fees from 3% to 1% for
loans made on or after July 1, 1994;
o the replacement of the administrative cost allowance with a student
loan processing and issuance fee equal to 65 basis points (40 basis
points for loans made on or after October 1, 1993) paid at the time a
loan is guaranteed, and an account maintenance fee of 12 basis points
(10 basis points for fiscal years 2001-2003) paid annually on
outstanding guaranteed student loans;
o the reduction in supplemental preclaims assistance payments from the
Secretary of Education; and
o the reduction in retention by a guaranty agency of collections on
defaulted loans from 27% to 24% (23% beginning on October 1, 2003).
Additionally, the adequacy of a guaranty agency's reserve fund to meet its
guarantee obligations with respect to existing student loans depends, in
significant part, on its ability to collect revenues generated by new loan
guarantees. The Federal Direct Student Loan Program discussed below may
adversely affect the volume of new loan guarantees. Future legislation may make
additional changes to the Higher Education Act that would significantly affect
the revenues received by guaranty agencies and the structure of the guaranty
agency program.
The Higher Education Act gives the Secretary of Education various oversight
powers over guaranty agencies. These include requiring a guaranty agency to
maintain its reserve fund at a certain required level and taking various actions
relating to a guaranty agency if its administrative and financial condition
jeopardizes its ability to meet its obligations. These actions include, among
others, providing advances to the guaranty agency, terminating the guaranty
agency's federal reimbursement contracts, assuming responsibility for all
functions of the guaranty agency, and transferring the guaranty agency's
guarantees to another guaranty agency or assuming such guarantees. The Higher
Education Act provides that a guaranty agency's reserve fund shall be considered
to be the property of the United States to be used in the operation of the FFEL
Program or the FDL Program, and, under certain circumstances, the Secretary of
Education may demand payment of amounts in the reserve fund.
The 1998 Amendments mandate the recall of guaranty agency reserve funds by
the Secretary of Education amounting to $85 million in fiscal year 2002, $82.5
million in fiscal year 2006, and $82.5 million in fiscal year 2007. However,
certain minimum reserve levels are protected from recall, and under the 1998
Amendments, guaranty agency reserve funds were restructured to provide guaranty
agencies with additional flexibility in choosing how to spend certain funds they
receive. The new recall of reserves for guaranty agencies increases the risk
that resources available to guaranty agencies to meet their guarantee obligation
will be significantly reduced. Relevant federal laws, including the Higher
Education Act, may be further changed in a manner that may adversely affect the
ability of a guaranty agency to meet its guarantee obligations.
Student loans originated prior to October 1, 1993 are fully guaranteed as to
principal and accrued interest. Student loans originated after October 1, 1993
are guaranteed as to 98% of principal and accrued interest.
Under the Higher Education Act, if the Department has determined that a
guaranty agency is unable to meet its insurance obligations, the holders of
loans guaranteed by such guaranty agency must submit claims directly to the
Department, and the Department is required to pay the full guarantee payment due
with respect thereto in accordance with guarantee claims processing standards no
more stringent than those applied by the guaranty agency.
There are no assurances as to the Secretary of Education's actions if a
guaranty agency encounters administrative or financial difficulties or that the
Secretary of Education will not demand that a guaranty agency transfer
additional portions or all of its reserve fund to the Secretary of Education.
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Federal Agreements
General. A guaranty agency's right to receive federal reimbursements for
various guarantee claims paid by such guaranty agency is governed by the Higher
Education Act and various contracts entered into between guaranty agencies and
the Secretary of Education. Each guaranty agency and the Secretary of Education
have entered into federal reimbursement contracts pursuant to the Higher
Education Act, which provide for the guaranty agency to receive reimbursement of
a percentage of insurance payments that the guaranty agency makes to eligible
lenders with respect to loans guaranteed by the guaranty agency prior to the
termination of the federal reimbursement contracts or the expiration of the
authority of the Higher Education Act. The federal reimbursement contracts
provide for termination under certain circumstances and also provide for certain
actions short of termination by the Secretary of Education to protect the
federal interest.
In addition to guarantee benefits, qualified student loans acquired under
the FFEL Program benefit from certain federal subsidies. Each guaranty agency
and the Secretary of Education have entered into an Interest Subsidy Agreement
under the Higher Education Act which entitles the holders of eligible loans
guaranteed by the guaranty agency to receive interest subsidy payments from the
Secretary of Education on behalf of certain students while the student is in
school, during a six to twelve month grace period after the student leaves
school, and during certain deferment periods, subject to the holders' compliance
with all requirements of the Higher Education Act.
United States Courts of Appeals have held that the federal government,
through subsequent legislation, has the right unilaterally to amend the
contracts between the Secretary of Education and the guaranty agencies described
herein. Amendments to the Higher Education Act in 1986, 1987, 1992, 1993, and
1998, respectively:
o abrogated certain rights of guaranty agencies under contracts with the
Secretary of Education relating to the repayment of certain advances
from the Secretary of Education,
o authorized the Secretary of Education to withhold reimbursement
payments otherwise due to certain guaranty agencies until specified
amounts of such guaranty agencies' reserves had been eliminated,
o added new reserve level requirements for guaranty agencies and
authorized the Secretary of Education to terminate the Federal
Reimbursement Contracts under circumstances that did not previously
warrant such termination,
o expanded the Secretary of Education's authority to terminate such
contracts and to seize guaranty agencies' reserves, and
o mandated the additional recall of guaranty agency reserve funds.
Federal Insurance and Reimbursement of Guaranty Agencies
Effect of annual claims rate. With respect to loans made prior to October 1,
1993, the Secretary of Education currently agrees to reimburse the guaranty
agency for up to 100% of the amounts paid on claims made by lenders, as
discussed in the formula described below, so long as the eligible lender has
properly serviced such loan. The amount of reimbursement is lower for loans
originated after October 1, 1993, as described below. Depending on the claims
rate experience of a guaranty agency, such reimbursement may be reduced as
discussed in the formula described below. The Secretary of Education also agrees
to repay 100% of the unpaid principal plus applicable accrued interest expended
by a guaranty agency in discharging its guarantee obligation as a result of the
bankruptcy, death, or total and permanent disability of a borrower, or in the
case of a PLUS loan, the death of the student on behalf of whom the loan was
borrowed, or in certain circumstances, as a result of school closures, which
reimbursements are not to be included in the calculations of the guaranty
agency's claims rate experience for the purpose of federal reimbursement under
the Federal Reimbursement Contracts.
The formula used for loans initially disbursed prior to October 1, 1993 is
summarized below:
Claims Rate Federal Payment
---------------- --------------------------------------
0% up to 5%..... 100%
5% up to 9%..... 100% of claims up to 5%; 90% of
claims 5% and over
9% and over..... 100% of claims up to 5%; 90% of
claims 5% and over, up to 9%; 80% of
claims 9% and over
The claims experience is not accumulated from year to year, but is
determined solely on the basis of claims in any one federal fiscal year compared
with the original principal amount of loans in repayment at the beginning of
that year.
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The 1993 Amendments reduce the reimbursement amounts described above,
effective for loans initially disbursed on or after October 1, 1993 as follows:
100% reimbursement is reduced to 98%, 90% reimbursement is reduced to 88%, and
80% reimbursement is reduced to 78%, subject to certain limited exceptions. The
1998 Amendments further reduce the federal reimbursement amounts from 98% to
95%, 88% to 85%, and 78% to 75% respectively, for student loans first disbursed
on or after October 1, 1998.
The reduced reinsurance for federal guaranty agencies increases the risk
that resources available to guaranty agencies to meet their guarantee obligation
will be significantly reduced.
Reimbursement. The original principal amount of loans guaranteed by a
guaranty agency which are in repayment for purposes of computing reimbursement
payments to a guaranty agency means the original principal amount of all loans
guaranteed by a guaranty agency less:
o the original principal amount of such loans that have been fully
repaid, and
o the original amount of such loans for which the first principal
installment payment has not become due.
Guaranty agencies with default rates below 5% are required to pay the Secretary
of Education annual fees equivalent to 0.51% of new loans guaranteed, while all
other such agencies must pay a 0.5% fee. The Secretary of Education may withhold
reimbursement payments if a guaranty agency makes a material misrepresentation
or fails to comply with the terms of its agreements with the Secretary of
Education or applicable federal law.
Under the guarantee agreements, if a payment on a FFELP loan guaranteed by a
guaranty agency is received after reimbursement by the Secretary of Education,
the guaranty agency is entitled to receive an equitable share of the payment.
Any originator of any student loan guaranteed by a guaranty agency is
required to discount from the proceeds of the loan at the time of disbursement,
and pay to the guaranty agency, an insurance premium which may not exceed that
permitted under the Higher Education Act.
Under present practice, after the Secretary of Education reimburses a
guaranty agency for a default claim paid on a guaranteed loan, the guaranty
agency continues to seek repayment from the borrower. The guaranty agency
returns to the Secretary of Education payments that it receives from a borrower
after deducting and retaining: a percentage amount equal to the complement of
the reimbursement percentage in effect at the time the loan was reimbursed, and
an amount equal to 24% of such payments for certain administrative costs. The
Secretary of Education may, however, require the assignment to the Secretary of
defaulted guaranteed loans, in which event no further collections activity need
be undertaken by the guaranty agency, and no amount of any recoveries shall be
paid to the guaranty agency.
A guaranty agency may enter into an addendum to its Interest Subsidy
Agreement that allows the guaranty agency to refer to the Secretary of Education
certain defaulted guaranteed loans. Such loans are then reported to the IRS to
"offset" any tax refunds which may be due any defaulted borrower. To the extent
that the guaranty agency has originally received less than 100% reimbursement
from the Secretary of Education with respect to such a referred loan, the
guaranty agency will not recover any amounts subsequently collected by the
federal government which are attributable to that portion of the defaulted loan
for which the guaranty agency has not been reimbursed.
Rehabilitation of defaulted loans. Under the Higher Education Act, the
Secretary of Education is authorized to enter into an agreement with a guaranty
agency pursuant to which the guaranty agency shall sell defaulted loans that are
eligible for rehabilitation to an eligible lender. The guaranty agency shall
repay the Secretary of Education an amount equal to 81.5% of the then current
principal balance of such loan, multiplied by the reimbursement percentage in
effect at the time the loan was reimbursed. The amount of such repayment shall
be deducted from the amount of federal reimbursement payments for the fiscal
year in which such repayment occurs, for purposes of determining the
reimbursement rate for that fiscal year.
For a loan to be eligible for rehabilitation, the guaranty agency must have
received consecutive payments for 12 months of amounts owed on such loan. Upon
rehabilitation, a loan is eligible for all the benefits under the Higher
Education Act for which it would have been eligible had no default occurred
(except that a borrower's loan may only be rehabilitated once).
Eligibility for federal reimbursement. To be eligible for federal
reimbursement payments, guaranteed loans must be made by an eligible lender
under the applicable guaranty agency's guarantee program, which must meet
requirements prescribed by the rules and regulations promulgated under the
Higher Education Act, including the borrower eligibility, loan amount,
disbursement, interest rate, repayment period and guarantee fee provisions
described herein and the other requirements set forth in the Higher Education
Act.
Prior to the 1998 Amendments, a FFELP loan was considered to be in default
for purposes of the Higher Education Act when the
A-12
borrower failed to make an installment payment when due, or to comply with the
other terms of the loan, and if the failure persists for 180 days in the case of
a loan repayable in monthly installments or for 240 days in the case of a loan
repayable in less frequent installments. Under the 1998 Amendments, the
delinquency period required for a student loan to be declared in default is
increased from 180 days to 270 days for loans payable in monthly installments on
which the first day of delinquency occurs on or after the date of enactment of
the 1998 Amendments and from 240 days to 330 days for a loan payable less
frequently than monthly on which the delinquency occurs after the date of
enactment of the 1998 Amendments.
The guaranty agency must pay the lender for the defaulted loan prior to
submitting a claim to the Secretary of Education for reimbursement. The guaranty
agency must submit a reimbursement claim to the Secretary of Education within 45
days after it has paid the lender's default claim. As a prerequisite to
entitlement to payment on the guarantee by the guaranty agency, and in turn
payment of reimbursement by the Secretary of Education, the lender must have
exercised reasonable care and diligence in making, servicing and collecting the
guaranteed loan. Generally, these procedures require:
o that completed loan applications be processed;
o a determination of whether an applicant is an eligible borrower
attending an eligible institution under the Higher Education Act be
made;
o the borrower's responsibilities under the loan be explained to him or
her;
o the promissory note evidencing the loan be executed by the borrower;
and
o that the loan proceeds be disbursed by the lender in a specified
manner.
After the loan is made, the lender must establish repayment terms with the
borrower, properly administer deferments and forbearances and credit the
borrower for payments made. If a borrower becomes delinquent in repaying a loan,
a lender must perform certain collection procedures, primarily telephone calls,
demand letters, skip tracing procedures and requesting assistance from the
applicable guaranty agency, that vary depending upon the length of time a loan
is delinquent.
Direct Loans
The 1993 Amendments authorized a program of "direct loans," to be originated
by schools with funds provided by the Secretary of Education. Under the FDL
Program, the Secretary of Education is directed to enter into agreements with
schools, or origination agents in lieu of schools, to disburse loans with funds
provided by the Secretary of Education. Participation in the program by schools
is voluntary. The goals set forth in the 1993 Amendments call for the direct
loan program to constitute 5% of the total volume of loans made under the FFEL
Program and the FDL Program for academic year 1994-1995, 40% for academic year
1995-1996, 50% for academic years 1996-1997 and 1997-1998 and 60% for academic
year 1998-1999. No provision is made for the size of the FDL Program thereafter.
Based upon information released by the General Accounting Office, participation
by schools in the FDL Program has not been sufficient to meet the goals for the
1995-1996 or 1996-1997 academic years. The 1998 Amendments removed references to
the "phase-in" of the FDL Program, including restrictions on annual limits for
FDL Program volume and the Secretary's authority to select additional
institutions to achieve balanced school representation.
The loan terms are generally the same under the FDL Program as under the
FFEL Program, though more flexible repayment provisions are available under the
FDL Program. At the discretion of the Secretary of Education, students attending
schools that participate in the FDL Program (and their parents) may still be
eligible for participation in the FFEL Program, though no borrower could obtain
loans under both programs for the same period of enrollment.
It is difficult to predict the impact of the FDL Program. There is no way to
accurately predict the number of schools that will participate in future years,
or, if the Secretary authorizes students attending participating schools to
continue to be eligible for FFEL Program loans, how many students will seek
loans under the FDL Program instead of the FFEL Program. In addition, it is
impossible to predict whether future legislation will eliminate, limit or expand
the FDL Program or the FFEL Program.
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