SLM CORP 10-K 2009
Documents found in this filing:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Commission file numbers 001-13251
(Registrants Telephone Number, Including Area Code)
Securities registered pursuant to Section 12(b) of the Act
Common Stock, par value $.20 per share.
Name of Exchange on which Listed:
New York Stock Exchange
6.97% Cumulative Redeemable Preferred Stock, Series A, par value $.20 per share
Floating Rate Non-Cumulative Preferred Stock, Series B, par value $.20 per share
Name of Exchange on which Listed:
New York Stock Exchange
Medium Term Notes, Series A, CPI-Linked Notes due 2017
Medium Term Notes, Series A, CPI-Linked Notes due 2018
6% Senior Notes due December 15, 2043
Name of Exchange on which Listed:
New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act:
Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes þ No o
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes o No þ
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark 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 registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
The aggregate market value of voting stock held by non-affiliates of the registrant as of June 30, 2008 was $8.9 billion (based on closing sale price of $19.35 per share as reported for the New York Stock Exchange Composite Transactions).
As of February 27, 2009, there were 467,403,909 shares of voting common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement relating to the registrants Annual Meeting of Shareholders scheduled to be held May 22, 2009 are incorporated by reference into Part III of this Report.
TABLE OF CONTENTS
This report contains forward-looking statements and information based on managements current expectations as of the date of this document. Statements that are not historical facts, including statements about our beliefs or expectations and statements that assume or are dependent upon future events, are forward-looking statements, and are contained throughout this Annual Report on Form 10-K, including under the sections entitled Business and Managements Discussion and Analysis of Financial Condition and Results of Operations. Forward-looking statements are subject to risks, uncertainties, assumptions and other factors that may cause actual results to be materially different from those reflected in such forward-looking statements. These factors include, among others, the occurrence of any event, change or other circumstances that could give rise to our ability to cost-effectively refinance asset-backed financing facilities due April 2009, (collectively, the 2008 Asset-Backed Financing Facilities), including any potential foreclosure on the student loans under those facilities following their termination; increased financing costs; limited liquidity; any adverse outcomes in any significant litigation to which we are a party; our derivative counterparties terminating their positions with the Company if permitted by their contracts and the Company substantially incurring additional costs to replace any terminated positions; changes in the terms of student loans and the educational credit marketplace (including changes resulting from new laws, such as any laws enacted to implement the Administrations 2010 budget proposals as they relate to the Federal Family Education Loan Program (FFELP) and regulations and from the implementation of applicable laws and regulations) which, among other things, may change the volume, average term and yields on student loans under the FFELP, may result in loans being originated or refinanced under non-FFELP programs, or may affect the terms upon which banks and others agree to sell FFELP loans to the Company. The Company could be affected by: various liquidity programs being implemented by the federal government; changes in the demand for educational financing or in financing preferences of lenders, educational institutions, students and their families; incorrect estimates or assumptions by management in connection with the preparation of our consolidated financial statements; changes in the composition of our Managed FFELP and Private Education Loan portfolios; changes in the general interest rate environment, including the rate relationships among relevant money-market instruments, 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; changes in projections of losses from loan defaults; changes in general economic conditions; changes in prepayment rates and credit spreads; and changes in the demand for debt management services and new laws or changes in existing laws that govern debt management services. All forward-looking statements contained in this report are qualified by these cautionary statements and are made only as of the date this Annual Report on Form 10-K is filed. The Company does not undertake any obligation to update or revise these forward-looking statements to conform the statement to actual results or changes in the Companys expectations.
Definitions for capitalized terms used in this document can be found in the Glossary at the end of this document.
SLM Corporation, more commonly known as Sallie Mae, is the market leader in education finance. SLM Corporation is a holding company that operates through a number of subsidiaries. References in this Annual Report to the Company refer to SLM Corporation and its subsidiaries. The Company was formed in 1972 as the Student Loan Marketing Association, a federally chartered government sponsored enterprise (GSE), with the goal of furthering access to higher education by providing liquidity to the student loan marketplace. On December 29, 2004, we completed the privatization process that began in 1997 and resulted in the wind down of the GSE.
Our primary business is to originate, service and collect student loans. We provide funding, delivery and servicing support for education loans in the United States through our participation in the Federal Family Education Loan Program (FFELP) and through our non-federally guaranteed Private Education Loan programs.
We have used internal growth and strategic acquisitions to attain our leadership position in the education finance market. Our sales force is the largest in the student loan industry. The core of our marketing strategy is to generate student loan originations by promoting our brands on campus through the financial aid office. These sales and marketing efforts are supported by the largest and most diversified servicing capabilities in the industry.
In addition to the net interest income generated by our lending activities, we earn fees for a number of services including student loan and guarantee servicing, loan default aversion and defaulted loan collections, and for providing processing capabilities and information technology to educational institutions, as well as, 529 college savings plan program management, transfer and servicing agent services, and administrative services through Upromise Investments, Inc. (UII) and Upromise Investment Advisors, LLC (UIA). We also operate a consumer savings network through Upromise, Inc. (Upromise). References in this Annual Report to Upromise refer to Upromise and its subsidiaries, UII and UIA.
At December 31, 2008, we had approximately 8,000 employees.
Legislative developments, conditions in the capital markets and regulatory actions taken by the federal government over the last eighteen months have had a significant and, in some cases, an unintended impact on the student loan industry. This has caused the Company to make significant changes in the way it conducts its business.
The College Cost Reduction and Access Act of 2007 (CCRAA) resulted in, among other things, a reduction in the yield received by the Company on FFELP loans originated on or after October 1, 2007. A description of the CCRAA can be found in APPENDIX A, FEDERAL FAMILY EDUCATION LOAN PROGRAM.
In the summer of 2007, the global capital markets began to experience a severe dislocation that has persisted to the present. This dislocation, along with a reduction in the Companys unsecured debt ratings caused by the Proposed Merger, resulted in more limited access to the capital markets than the Company has experienced in the past and a substantial increase in its cost of funding.
Historically, the Company relied on the term asset-backed securities (ABS) market for the majority of its funding. In 2006, the Company issued FFELP ABS at an average cost of 14 basis points over LIBOR. In 2007, the average cost rose slightly to 19 basis points over LIBOR. By December 2007, however, we paid in excess of 50 basis points over LIBOR for similar FFELP ABS. In 2008, the cost to issue FFELP ABS rose steadily before access was eliminated for all issuers. In 2008, we issued $18.5 billion of FFELP ABS at an
average spread of 125 basis points over LIBOR. The Company has not accessed the market for Private Education Loan ABS since 2007.
In the past, the Company primarily relied on the unsecured debt market for the balance of its funding. In June 2008, the Company issued a $2.5 billion, ten-year unsecured note at an equivalent cost of 400 basis points over LIBOR. This rate is more than 300 basis points higher than the cost of any previously issued unsecured debt. Subsequent to this debt issuance, the market for unsecured, non-U.S. government guaranteed debt issued by financial services companies materially deteriorated and became unavailable at profitable terms.
The net interest margin earned on a newly-originated FFELP loan came under pressure as the asset yield was cut and funding costs increased, making new lending unprofitable. As a result, over 160 student lenders have exited the business since the implementation of CCRAA, and most remaining issuers significantly reduced their lending activities. By January 2008, it became clear that unless the capital markets recovered there would be a sharp contraction in the number of student loans available. The Company, along with other participants in the student loan industry, began to bring this to the attention of legislators, schools and students. As early as February 2008, members of Congress were writing to the U.S. Department of Education (ED) and the Federal Reserve alerting them to the imminent crisis and urging them to find a solution. Congress acted quickly and passed legislation that authorized ED to take action.
The Ensuring Continued Access to Student Loans Act of 2008 (ECASLA) was passed in both houses of Congress with overwhelming bipartisan support and was signed into law on May 7, 2008. Under ECASLA, ED implemented two programs in 2008, the Loan Participation Program and Loan Purchase Commitment Program (Participation Program and Purchase Program). Through the Participation Program, ED provides interim short-term liquidity to FFELP lenders by purchasing participation interests in pools of FFELP loans. FFELP lenders are charged at the commercial paper (CP) rate plus 0.50 percent on the principal amount of participation interests outstanding. Loans funded under the Participation Program must be either refinanced by the lender or sold to ED pursuant to the Purchase Program prior to its expiration on September 30, 2010. Under the Purchase Program, ED purchases eligible FFELP loans at a price equal to the sum of (i) par value, (ii) accrued interest, (iii) the one-percent origination fee paid to ED, and (iv) a fixed amount of $75 per loan. Generally, loans originated between May 1, 2008 and June 30, 2010 are eligible for these programs. ECASLA also significantly increased student loan limits. A description of ECASLA can be found in APPENDIX A, FEDERAL FAMILY EDUCATION LOAN PROGRAM.
The Participation Program enabled the Company to make a pledge to make every loan to every eligible student on every campus under FFELP and to help the country avoid a major crisis on campuses across the United States. In the first six months of academic year (AY) 2008-2009, the Company originated $9.5 billion of FFELP loans, an increase of 3 percent from the prior year. In addition, it originated $1.4 billion of FFELP loans for third parties.
In addition to the Participation and Purchase Programs, ECASLA authorized funding vehicles for FFELP loans originated after October 1, 2003 through June 30, 2009. On January 15, 2009, ED published summary terms under which it will purchase eligible FFELP Stafford and PLUS loans from a conduit vehicle established to provide funding for eligible student lenders (the ED Conduit Program). Funding for the ED Conduit Program will be provided by the capital markets at a cost based on market rates. The ED Conduit Program will have a term of five years. An estimated $16.0 billion of our Stafford and PLUS loans (excluding loans currently in the Participation Program) were eligible for funding under the ED Conduit Program as of December 31, 2008. We expect to utilize the ED Conduit Program to fund a significant percentage of these assets over time. The initial funding under the ED Conduit Program is expected to occur in the first quarter of 2009.
Interest paid on FFELP loans is set by law and is based on the Federal Reserves Statistical Release H.15 90-day financial CP rate. As of December 31, 2008, on a Managed Basis, the Company had approximately $127.2 billion of FFELP loans indexed to three-month financial CP that are funded with debt indexed or swapped to LIBOR. Due to the unintended consequences of government actions in other areas of the capital markets and limited issuances of qualifying financial CP, the relationship between the three-month financial
CP and LIBOR became distorted and volatile resulting in CP rates being substantially below LIBOR starting in the fall of 2008.
To address this issue for the fourth quarter of 2008, ED announced that for purposes of calculating the FFELP loan index from October 27, 2008 to the end of the fourth quarter, the Federal Reserves CP Funding Facility rates would be used for those days in which no three-month financial CP rate was available. This resulted in a CP/LIBOR spread of 21 basis points in the fourth quarter of 2008 compared to 8 basis points in the third quarter of 2008. The CP/LIBOR spread would have been 62 basis points in the fourth quarter of 2008 if the ED had not addressed the issue by using the Federal Reserves CP Funding Facility rates discussed above. The Company continues to work with Congress and ED to implement an acceptable long-term solution to this issue.
On February 26, 2009, the Administration issued their 2010 budget request to Congress, which included provisions that could impact significantly the FFELP. The Presidents budget overview states: FFEL processors would continue to receive federal subsidies for new loans originated in the 2009-2010 academic year and prior academic years under the regular FFEL program and the emergency programs established by the Ensuring Continued Access to Student Loans Act of 2008. The budget proposal must be passed in the Congress, prior to enactment into law. The Company will work with Congress and ED to assist them in achieving the objectives outlined in the Administrations 2010 budget request.
In 2008, the Company conducted a thorough review of our entire business model and operations with a goal of achieving appropriate risk adjusted returns across all of our business segments and providing cost-effective services. As a result, we have reduced our operating expenses by over 20 percent in the fourth quarter of 2008 compared to the fourth quarter of 2007, after adjusting for restructuring costs, growth and other investments. This reduction was accomplished by lowering our headcount by a total of 2,900 or 26 percent, and consolidating operations through closing several work locations. The Company also curtailed less profitable FFELP student loan acquisitions such as from Lender Partners, spot purchases and consolidation lending. In our private education lending business, we curtailed high default lending programs, tightened credit underwriting standards and increased pricing. We also made the decision to wind down our purchased receivables business in our Asset Performance Group (APG) business segment to focus on our core student loan collection business. These measures are discussed in more detail in the Business Segments discussion below.
Students and their families use multiple sources of funding to pay for their college education including savings, current income, grants, scholarships, and federally guaranteed and private education loans. Historically, one-third of the cost of an education has come from federally guaranteed student loans and private education loans. Over the last five years, these sources of funding for higher education have been relatively stable with a general trend towards an increased use of student loans. Due to the legislative changes described above, a dramatic reduction in other sources of credit such as home equity and private education loans, and a significant decline in personal wealth as a result of declining home prices and equity values, the Company expects to see a substantial increase in borrowing from federal loan programs in the current and future years.
There are two loan delivery programs that provide federal government guaranteed student loans: the FFELP and the Federal Direct Loan Program (FDLP). FFELP loans are provided by private sector institutions and are ultimately guaranteed by ED, except for the Risk Sharing loss. FDLP loans are provided to borrowers directly by ED on terms similar to student loans provided under the FFELP. We participate in and are the largest lender under the FFELP program.
For the federal fiscal year (FFY) ended September 30, 2008 (FFY 2008), ED estimated that the market share of FFELP loans was 76 percent, down from 80 percent in FFY 2007. (See LENDING BUSINESS SEGMENT Competition.) Total FFELP and FDLP volume for FFY 2008 grew by 17 percent, with the FFELP portion growing 12 percent and the FDLP portion growing 40 percent.
As discussed above, in 2008, many lenders exited the FFELP marketplace, creating concerns about the availability of federal loans for students served by this program. As a result, some schools began to decrease their participation in the FFELP program in July 2008 for the stability of the FDLP. ED estimated that the FDLP could double its market share.
The Higher Education Act (the HEA) regulates every aspect of the federally guaranteed student loan program, including communications with borrowers, loan originations and default aversion. Failure to service a student loan properly could jeopardize the guarantee on federal student loans. This guarantee generally covers 98 and 97 percent of the student loans principal and accrued interest for loans disbursed before and after July 1, 2006, respectively. In the case of death, disability or bankruptcy of the borrower, the guarantee covers 100 percent of the loans principal and accrued interest.
FFELP loans are guaranteed by state agencies or non-profit companies designated as guarantors, with ED providing reinsurance to the guarantor. Guarantors are responsible for performing certain functions necessary to ensure the programs soundness and accountability. These functions include reviewing loan application data to detect and prevent fraud and abuse and to assist lenders in preventing default by providing counseling to borrowers. Generally, the guarantor is responsible for ensuring that loans are serviced in compliance with the requirements of the HEA. When a borrower defaults on a FFELP loan, we submit a claim to the guarantor who provides reimbursements of principal and accrued interest subject to the Risk Sharing (See APPENDIX A, FEDERAL FAMILY EDUCATION LOAN PROGRAM, to this document for a description of the role of guarantors.)
In addition to federal loan programs, which have statutory limits on annual and total borrowing, we sponsor a variety of Private Education Loan programs to bridge the gap between the cost of education and a students resources. The majority of our Private Education Loans are made in conjunction with a FFELP Stafford loan and are marketed to schools through the same marketing channels and by the same sales force as FFELP loans. As a result of the credit market dislocation discussed above, a large number of lenders have exited the Private Education Loan business and only a few of the countrys largest banks continue to offer the product. Private Education Loans are discussed in more detail below.
Growth in our Managed student loan portfolio is driven by the growth in the overall market for student loans, as well as by our own market share gains. Rising enrollment and college costs have resulted in the size of the federally insured student loan market more than doubling over the last 10 years. Federally insured student loan originations grew from $30.0 billion in FFY 1998 to $75.5 billion in FFY 2008.
According to the College Board, tuition and fees at four-year public institutions and four-year private institutions have increased 50 percent and 27 percent, respectively, in constant, inflation-adjusted dollars, since AY 1998-1999. Under the FFELP, there are limits to the amount students can borrow each academic year. The first loan limit increases since 1992 were implemented July 1, 2007. In response to the credit crisis, Congress significantly increased loan limits again in 2008. As a result, we anticipate that students will rely more on federal loans to fund their tuition needs. Both federal and private loans as a percentage of total student aid were 52 percent of total student aid in AY 1997-1998 and 53 percent in AY 2007-2008. Private Education Loans accounted for 22 percent of total student loans both federally guaranteed and Private Education Loans in AY 2007-2008, compared to 7 percent in AY 1997-1998.
The National Center for Education Statistics predicts that the college-age population will increase approximately 10 percent from 2008 to 2017. Demand for education credit is expected to increase due to this population demographic, first-time college enrollments of older students and continuing interest in adult education.
The following charts show the historical and projected enrollment and average tuition and fee growth for four-year public and private colleges and universities.
Source: National Center for Education Statistics
Note: Total enrollment in all degree-granting institutions; middle alternative projections for 2006 onward.
Source: The College Board
We provide credit products and related services to the higher education and consumer credit communities and others through two primary business segments: our Lending business segment and our APG business segment. In addition, within our Corporate and Other business segment, we provide a number of complementary products and services to guarantors and Lender Partners that are managed within smaller operating segments, the most prominent being our Guarantor Servicing and Loan Servicing businesses. Our Corporate and Other business segment also includes the activities of our Upromise subsidiaries. Each of these segments is summarized below. The accounting treatment for the segments is explained in MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
In the Lending business segment, we originate and acquire both federally guaranteed student loans, which are administered by ED, and Private Education Loans, which are not federally guaranteed. Most of our borrowers use Private Education Loans primarily to supplement federally guaranteed loans in meeting the cost of education. We manage the largest portfolio of FFELP and Private Education Loans in the student loan industry, and have 10 million student and parent customers through our ownership and management of $180.4 billion in Managed student loans as of December 31, 2008, of which $147.0 billion or 81 percent are federally insured. We serve over 6,000 clients including educational and financial institutions and state agencies. We are the largest servicer of student loans, servicing a portfolio of $139 billion of FFELP loans and $39 billion of Private Education Loans as of December 31, 2008.
Our primary marketing point-of-contact is the schools financial aid office. We deliver flexible and cost-effective products to the school and its students. The focus of our sales force is to market Sallie Maes suite of education finance products and business office solutions to colleges. These include FFELP and Private Education Loans and our Web-based loan origination and servicing platform OpenNet®. Simply put, our strategy is to provide the financial aid and bursars office with the tools they need to provide their students with the financing students require to pay for their education.
In 2008, we originated $24.2 billion in student loans. FFELP originations for the year ended December 31, 2008 totaled $17.9 billion, an increase of 4 percent from the year ended December 31, 2007. The slowdown in FFELP loan origination growth is due principally to a large decline in loan originations through Lender Partners as a result of the diminished profitability of FFELP loans discussed earlier. Private Education Loan originations totaled $6.3 billion, a decrease of 20 percent from the prior year. The decline in Private Education Loan originations is due to our elimination of non-traditional lending announced earlier in the year and funding pressures which required us to limit our Private Education lending activities.
In the past we relied on Lender Partners, typically national or regional banks, for a large percentage of our loan originations. Our sales force promoted their brands on campuses and we purchased the loans after disbursement. In recent years, we migrated away from this strategy due to the stronger profitability of our internal brands. The increased pressures on the profitability of student loans described above accelerated this shift. In 2007, 34 percent of our loan originations were from Lender Partners. For 2008, lender partner originations declined to 19 percent of total loan originations. They were just 10 percent in the fourth quarter. The Company believes that the contribution to total loan originations from Lender Partners will be immaterial in future years.
Growth in FFELP lending is expected to come from loan limit increases and capturing market share as other participants exit the sector (see APPENDIX A, FEDERAL FAMILY EDUCATION LOAN PROGRAM, for a discussion of the history of student loan limits). In addition, the sharp contraction in household wealth is expected to increase the use of both federal and Private Education Loan programs. Offsetting these factors is an expected increase in participation in the FDLP. The FDLP program, with a market share of 20 percent in FFY 2007, had consistently lost market share since it peaked in FFY 1997 at 34 percent. In 2008, this trend reversed for the first time in over a decade due to the events described above and FDLPs market share rose to 24 percent.
In recent years, consolidation loans were an integral part of the FFELP business. Students were able to fix their interest rate for twenty years or more. Very low interest rates persisted in the early part of this decade, resulting in high levels of loan consolidation. At the end of 2008, 63 percent of our average Managed FFELP loans were consolidation loans, down from 67 percent at the end of 2007. The CCRAA made consolidation loans virtually unprofitable; it also removed the interest rate incentive for borrowers to consolidate their loans. As a result, we no longer offer this product.
We bear the full credit risk for Private Education Loans, which are underwritten and priced according to credit risk based upon customized credit scoring criteria. Due to their higher risk profile, Private Education Loans have higher interest rates than FFELP loans. Over the last several years, there has been significant growth in Private Education Loans as tuition has increased faster than the rate of inflation and FFELP lending limits have not increased. This growth combined with relatively higher spreads led to Private Education Loans contributing a higher percentage of our net interest margin in recent years. We expect this trend to continue in the foreseeable future, despite recent increases in FFELP loan limits, in part due to margin erosion of FFELP student loans.
Our Private Education Loan portfolio grew at a compound annual growth rate of just under 30 percent over the last three years. The current credit environment has created significant challenges funding Private Education Loans and we have become more restrictive in our underwriting criteria. In addition, as discussed above, FFELP lending limits have increased significantly over the last three years. As a result of these factors, we expect originations of Private Education Loans to be lower in 2009 than in 2008.
At the beginning of 2008, we announced the discontinuation of non-traditional lending. Over the course of 2008, we made improvements in the structure, pricing, underwriting, servicing, collecting and funding of Private Education Loans. These changes were made to increase the profitability and decrease the risk of the product. For example, the average FICO score for loans disbursed in the fourth quarter of 2008 was up 26 points to 738 and the percentage of co-signed loans increased to 74 percent from 57 percent in the prior year.
These improvements in portfolio quality are being driven by our more selective underwriting criteria. We have instituted higher FICO cut-offs and require cosigners for borrowers with higher credit scores than in the past. Our experience shows that adding a cosigner to a loan reduces the default rate by more than 50 percent. We are also originating more loans at lower risk schools. We are capturing more data on our borrowers and cosigners and using this data in the credit decision and pricing process. We have also introduced judgmental lending. We plan to deploy up to one hundred credit analysts in our new Delaware credit center who will review applications for private credit.
During 2008, we enhanced our default aversion and collection processes. This included significantly reducing the granting of prospective forbearance as a result of a risk-based eligibility model and better development of a borrowers ability to repay. Our focus is to remain in close contact with delinquent borrowers through our call centers, email and letters in order to improve our cure rates in each stage of delinquency to assist our borrowers in returning to current status.
Our largest Private Education Loan program is the Signature Student Loan®, which is offered to undergraduates and graduates through the financial aid offices of colleges and universities to supplement traditional FFELP loans. We also offer specialized loan products to graduate and professional students primarily through our MBA Loans®, LAWLOANS®, Sallie Mae Medical School Loans® and Sallie Mae DENTALoans® programs. During 2008, as a result of funding pressures, we curtailed the issuance of new Tuition Answer® loans.
The FDLPs market share peaked at 34 percent in FFY 1997. The FDLPs market share had steadily declined since then to 20 percent in FFY 2007. However, as discussed above, schools began to return to the FDLP in FFY 2008, driven by the concern that FFELP lenders were exiting the business, and FDLPs market share rose to 24 percent.
Historically, we have faced competition for both federally guaranteed and non-guaranteed student loans from a variety of financial institutions including banks, thrifts and state-supported secondary markets. However, as a result of the CCRAA and the dislocation in the capital markets, the student loan industry is undergoing a significant transition. A number of student lenders have ceased operations altogether or curtailed activity. The environment of aggressive price competition between FFELP lenders has also lessened dramatically. Many of the FFELP lenders that remain in the business have been adjusting their pricing by reducing
borrower benefits and other costs. As a result of these factors, we believe that as the largest student lender, we are well positioned to increase market share in the coming years. Our FFY 2008 FFELP originations totaled $17.1 billion, representing a 23 percent market share.
In our APG business segment, we provide accounts receivable and collections services including student loan default aversion services, defaulted student loan portfolio management services, and contingency collections services for student loans and other asset classes. In 2008, we decided to wind down our accounts receivable management and collections services on consumer and mortgage receivable portfolios that we purchased because we did not realize the expected synergies between this business and our traditional contingent student loan collection business.
In 2008, our APG business segment had revenues totaling $277 million and net loss of $106 million. Our largest customer, United Student Aid Funds, Inc. (USA Funds), accounted for 37 percent, excluding impairments, of our revenue in this segment in 2008.
We provide default aversion services for five guarantors, including the nations largest, USA Funds. These services are designed to prevent a default once a borrowers loan has been placed in delinquency status.
Our APG business segment manages the defaulted student loan portfolios for six guarantors under long-term contracts. APGs largest customer, USA Funds, represents approximately 17 percent of defaulted student loan portfolios in the market. Our portfolio management services include selecting collection agencies and determining account placements to those agencies, processing loan consolidations and loan rehabilitations, and managing federal and state offset programs.
Our APG business segment is also engaged in the collection of defaulted student loans on behalf of various clients including guarantors, federal and state agencies, and schools. We earn fees that are contingent on the amounts collected. We provide collection services for ED and now have approximately 10 percent of the total market for such services. We have relationships with approximately 900 colleges and universities to provide collection services for delinquent student loans and other receivables from various campus-based programs. We also collected other debt for credit card issuers, federal and state agencies, and retail clients.
The private sector collections industry is highly fragmented with few large companies and a large number of small scale companies. The APG businesses that provide third-party collections services for ED, FFELP guarantors and other federal holders of defaulted debt are highly competitive. In addition to competing with other collection enterprises, we also compete with credit grantors who each have unique mixes of internal collections, outsourced collections and debt sales. The scale, diversification and performance of our APG business segment has been a competitive advantage for the Company.
The Companys Corporate and Other business segment includes the aggregate activity of its smaller operating segments, primarily its Guarantor Servicing, Loan Servicing, and Upromise operating segments. Corporate and Other also includes several smaller products and services, including comprehensive financing and loan delivery solutions to college financial aid offices and students to streamline the financial aid process.
We earn fees for providing a full complement of administrative services to FFELP guarantors. FFELP student loans are guaranteed by these agencies, with ED providing reinsurance to the guarantor. The guarantors are non-profit institutions or state agencies that, in addition to providing the primary guarantee on FFELP loans, are responsible for other activities, including:
Currently, we provide a variety of these services to nine guarantors and, in AY 2007-2008, we processed $21.3 billion in new FFELP loan guarantees, of which $17.2 billion was for USA Funds, the nations largest guarantor. We processed guarantees for approximately 33 percent of the FFELP loan market in AY 2007-2008.
Guarantor servicing fee revenue, which includes guarantee issuance and account maintenance fees, was $121 million for the year ended December 31, 2008, 85 percent of which we earned from services performed on behalf of USA Funds. Under some of our guarantee services agreements, including our agreement with USA Funds, we receive certain scheduled fees for the services that we provide under such agreements. The payment for these services includes a contractually agreed-upon percentage of the account maintenance fees that the guarantors receive from ED.
The Companys guarantee services agreement with USA Funds has a five-year term that will be automatically increased by an additional year on October 1 of each year unless prior notice is given by either party.
Our primary non-profit competitors in guarantor servicing are state and non-profit guarantee agencies that provide third-party outsourcing to other guarantors.
(See APPENDIX A, FEDERAL FAMILY EDUCATION LOAN PROGRAM Guarantor Funding for details of the fees paid to guarantors.)
Upromise provides a number of programs that encourage consumers to save for college. Upromise has established a consumer savings network which is designed to promote college savings by consumers who are members of this program by encouraging them to purchase goods and services from the companies that participate in the program (Participating Companies). Participating Companies generally pay Upromise transaction fees based on member purchase volume, either online or in stores depending on the contractual arrangement with the Participating Company. Typically, a percentage of the purchase price of the consumer members eligible purchases with Participating Companies is set aside in an account maintained by Upromise on behalf of its members.
Upromise, through its wholly owned subsidiaries, UII, a registered broker-dealer, and UIA, a registered investment advisor, provides program management, transfer and servicing agent services, and administration services for various 529 college-savings plans. UII and UIA manage more than $17.0 billion in 529 college-savings plans.
Like other participants in the FFELP, the Company is subject to the HEA and, from time to time, to review of its student loan operations by ED and guarantee agencies. As a servicer of federal student loans, the Company is subject to certain ED regulations regarding financial responsibility and administrative capability that govern all third-party servicers of insured student loans. In connection with our guarantor servicing operations, the Company must comply with, on behalf of its guarantor servicing customers, certain ED regulations that govern guarantor activities as well as agreements for reimbursement between the Secretary of Education and the Companys guarantor servicing customers.
The Companys originating or servicing of federal and private student loans also subjects it to federal and state consumer protection, privacy and related laws and regulations. Some of the more significant federal laws and regulations that are applicable to our student loan business include:
APGs debt collection and receivables management activities are subject to federal and state consumer protection, privacy and related laws and regulations. Some of the more significant federal laws and regulations that are applicable to our APG business segment include:
Our APG business segment is subject to state laws and regulations similar to the federal laws and regulations listed above. Finally, certain APG subsidiaries are subject to regulation under the HEA and under the various laws and regulations that govern government contractors.
Sallie Mae Bank is subject to Utah banking regulations as well as regulations issued by the Federal Deposit Insurance Corporation, and undergoes periodic regulatory examinations.
UII and UIA, which administer 529 college-savings plans, are subject to regulation by the Municipal Securities Rulemaking Board, the Financial Industry Regulatory Authority (formerly the National Association of Securities Dealers, Inc.) and the Securities and Exchange Commission (SEC) through the Investment Advisers Act of 1940.
The SEC maintains an Internet site (http://www. sec.gov) that contains periodic and other reports such as annual, quarterly and current reports on Forms 10-K, 10-Q and 8-K, respectively, as well as proxy and information statements regarding SLM Corporation and other companies that file electronically with the SEC. Copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q and other periodic reports are available on our website as soon as reasonably practicable after we electronically file such reports with the SEC. Investors and other interested parties can also access these reports at www.salliemae.com/about/investors.
Our Code of Business Conduct, which applies to Board members and all employees, including our Chief Executive Officer and Chief Financial Officer, is also available, free of charge, on our website at www.salliemae.com/about/business_code. htm. We intend to disclose any amendments to or waivers from our
Code of Business Conduct (to the extent applicable to our Chief Executive Officer or Chief Financial Officer) by posting such information on our website.
In 2008, the Company submitted the annual certification of its Chief Executive Officer regarding the Companys compliance with the NYSEs corporate governance listing standards, pursuant to Section 303A.12(a) of the NYSE Listed Company Manual.
In addition, we filed as exhibits to the Companys Annual Report on Form 10-K for the years ended December 31, 2006 and 2007 and to this Annual Report on Form 10-K, the certifications required under Section 302 of the Sarbanes-Oxley Act of 2002.
The Company faces a variety of significant risks that are inherent in our business. Risks that affect the Company may be grouped into the following categories: financial and funding, credit, operations, legislation and regulation, and market competition. Some of the more important risk factors that affect our business are described below.
Our business continues to be affected by the significant funding constraints in the credit market, dependence on various government funding sources, and higher and more volatile funding costs, both in absolute terms and relative to competing market instruments.
2008 was an extraordinarily disruptive year for the financial services sector. Tremendous volatility in the credit markets and significant declines in values affected all asset classes, including FFELP assets, which are no less than 97 percent guaranteed by the federal government. The disruption in the credit markets and legislative changes in the economics of the FFELP resulted in challenges for the Company to fund new loans at positive spreads and re-finance our existing portfolio.
The Company was able to meet the demand for new loan originations under the FFELP through funding and liquidity programs established by the federal government. Several of these programs are described in the LIQUIDITY AND CAPITAL RESOURCES section of this Form 10-K. These programs are not permanent and may not be extended upon their expiration dates. While the Company expects a normalization of market conditions, there is no assurance that the credit markets over time will return to a level that makes FFELP loan originations available or profitable beyond the time these programs are presently scheduled to end.
FFELP loans originated under the government programs mentioned above must be re-financed by the Company or sold to the government by a date determined under the terms of the programs. There is no assurance that the credit markets will return to a level that makes re-financing of these loans available or profitable before that date. If this is the case, the Company may sell these loans to the government, which at the current time could result in the loss of income associated with the ownership and servicing of the loans in the future.
Since the market disruptions began, the Company has funded private, non-federally guaranteed loan originations through term brokered deposits raised by Sallie Mae Bank. While this brokered-deposit funding market has been functioning well, there may be an ultimate limit to the size of this market for Sallie Mae Bank. Also, this source of funding creates certain re-financing risks because the average term of the deposits is shorter than the expected term of the Banks loan assets the deposits are funding. There is no assurance that this source of funding will continue to be available at a level and a cost that makes new private credit loan originations possible or profitable, nor is there any assurance that the loans can be re-financed at profitable margins. If deposit funding is not available at profitable levels, the origination of our Private Education Loans will be limited.
Recent market conditions have reduced our access to and increased the cost of borrowing for student loan asset-backed securities. If the government programs mentioned were to prove ineffective or were terminated and if alternative funding sources were not available, the Company may be compelled to reduce or suspend the origination of new loans. If we were unable to find cost-effective and stable funding alternatives, our funding and liquidity would be negatively impacted and our cost of funds could increase, adversely affecting our results of operations.
The Company expects that current market conditions will not always persist and that access to market funding will eventually improve and become less volatile. Even upon the expected normalization of the capital markets, however, the Company will be exposed to typical financing risks. Factors that could make financing difficult, more expensive or unavailable on any terms include, but are not limited to, financial results and losses of the Company, changes within our organization, events that have an adverse impact on our reputation, changes in the activities of our business partners, disruptions in the capital markets, events that have an adverse impact on the financial services industry, counterparty availability, changes affecting our assets, corporate and regulatory actions, absolute and comparative interest rate changes, ratings agencies actions, general economic conditions and the legal, regulatory, accounting and tax environments governing our funding transactions.
At some time, the Company may decide that it is prudent or necessary to raise additional equity capital through the sale of common stock, preferred stock, or securities that convert into common stock. There are no restrictions on entering into the sale of any equity securities in either public or private transactions, except that any private transaction involving more than 20 percent of shares outstanding requires shareholder approval. Under current market conditions, the terms of an equity transaction may subject existing security holders to potential subordination or dilution and may involve a change in governance.
The interest rate characteristics of our earning assets do not always match the interest rate characteristics of our funding arrangements. This mismatch exposes us to risk in the form of basis risk and repricing risk.
The Companys funding sources do not exactly match the interest rate indices, re-set frequencies, and maturities of the Companys loan assets. While most of such basis risks are hedged using interest rate swap contracts, such hedges are not always perfect matches and, therefore, may result in losses. While the asset and hedge indices are short-term with rate movements that are typically highly correlated, there can be no assurance that the historically high correlation will not be disrupted by capital market dislocations or other factors not within our control. For instance, the spread between 3-month CP and 3-month LIBOR was unusually volatile and wide in the fourth quarter of 2008 due to the unintended consequences of the Federal Reserves operations in the CP market. In such circumstances, our earnings could be adversely affected, possibly to a material extent.
The rating agencies could downgrade our ratings, which could limit our access to financing, increase the cost of financing or trigger obligations under collateralized financing arrangements.
Our credit ratings are important to our liquidity, particularly in times when the asset-backed securitization market is uncertain. A reduction in our credit ratings could adversely affect our liquidity, increase our borrowing costs, limit our access to the markets or trigger obligations under certain provisions in collateralized arrangements. Under these provisions, counterparties may require us to post additional collateral, segregate collateral or terminate certain contracts. Termination of our collateralized financing contracts could cause us to sustain losses and impair our liquidity by necessitating the use of other sources of financing.
There is no assurance that the ABCP Facility of $26 billion, as described in the LIQUIDITY AND CAPITAL RESOURCES section, which has a scheduled maturity date of April 28, 2009, will be extended on cost effective terms.
As reported on February 2, 2009, the Company and the parties to the $26 billion ABCP Facility that provides funding for the Companys federally-guaranteed student loans and private education loans agreed to extend the Facility by 60 days. The new scheduled maturity date of the Facility is April 28, 2009 and the new scheduled termination date is July 27, 2009. There can be no assurance that the Company will be able to cost-effectively refinance the Facility. Furthermore, foreclosure on the student loans securing the Facility might occur if we were not able to refinance the Facility at all. Either event could adversely affect the operations, capital and compliance with other debt/lender covenants of the Company.
Unexpected and sharp changes in the overall economic environment may result in the credit performance of our loan portfolio being materially different from what we expect. In addition, the Company is also subject to the creditworthiness of counterparties to our derivative contracts.
The Companys earnings are critically dependent on the evolving creditworthiness of our student loan customers. We maintain a reserve for credit losses based on current and past charge-offs, levels of past due loans and forbearances and expected economic conditions. However, managements determination of the appropriate reserve level may under- or over-estimate future losses. If the credit quality of our customer base materially decreases, if a market risk changes significantly, or if our reserves for credit losses are not adequate, our business, financial condition and results of operations could suffer.
In addition to customer credit risk, we are exposed to other forms of credit risk, including counterparties to our derivative transactions. For example, the Company has exposure to the financial condition of its various
lending, investment and derivative counterparties. If any of the Companys counterparties is unable to perform its obligations, the Company would, depending on the type of counterparty arrangement, experience a loss of liquidity or an economic loss. In addition, related to derivative exposure, the Company may not be able to cost effectively replace the derivative position depending on the type of derivative and the current economic environment. If the Company was not able to replace the derivative position, the Company may be exposed to a greater level of interest rate and/or foreign currency exchange rate risk which could lead to additional losses. The Companys counterparty exposure is more fully discussed herein in LIQUIDITY AND CAPITAL RESOURCES Counterparty Exposure.
Our businesses are regulated by state and federal laws and regulations and our failure to comply with these laws and regulations may result in significant costs or business sanctions.
The Company is subject to numerous state and federal laws and regulations. Loans originated and serviced under the FFELP are subject to legislative and regulatory changes. A summary of the program, which indicates its complexity and frequent changes, may be found in APPENDIX A, FEDERAL FAMILY EDUCATION LOAN PROGRAM of this Form 10-K. We continually update our FFELP loan originations and servicing policies and procedures and our systems technologies, provide training to our staff and maintain quality control over processes through compliance reviews and internal and external audits. We are at risk, however, for misinterpretation of ED guidance and incorrect application of ED regulations and policies, which could result in fines, the loss of the federal guarantee on FFELP loans, or limits on our participation in the FFELP.
Our private credit lending and debt collection business are subject to regulation and oversight by various state and federal agencies, particularly in the area of consumer protection regulation. Various state attorneys general have been active in this area of consumer protection. We are subject, and may be subject in the future, to inquiries and audits from state and federal regulators. Sallie Mae Bank is subject to state and FDIC regulation and at the time of this filing, was the subject of a cease and desist order for weaknesses in its compliance function. While the issues addressed in the order have largely been remediated, the action has not yet been lifted. We have committed resources to enhance our compliance function. Our failure to comply with various laws and regulations or with the terms of the cease and desist order could result in litigation expenses, fines, business sanctions, limitations on our ability to fund our Private Education Loans, which are currently funded by term deposits issued by Sallie Mae Bank, or restrictions on the operations of Sallie Mae Bank.
A failure of our operational systems or infrastructure, or those of our third-party vendors, could disrupt our business, result in disclosure of confidential customer information, damage our reputation and cause losses.
Our business is dependent on our ability to process and monitor, on a daily basis, a large number of transactions. These transactions must be processed in compliance with legal and regulatory standards and our product specifications, which we change to reflect our business needs. As processing demands change and grow, developing and maintaining our operational systems and infrastructure becomes increasingly challenging. Our reduction in operating expenses and off-shoring of certain processes has also increased challenges in maintaining accurate and efficient operations.
Our loan originations and servicing, financial, accounting, data processing or other operating systems and facilities may fail to operate properly or become disabled as a result of events that are beyond our control, adversely affecting our ability to process these transactions. Any such failure could adversely affect our ability to service our clients, result in financial loss or liability to our clients, disrupt our business, result in regulatory action or cause reputational damage.
Despite the plans and facilities we have in place, our ability to conduct business may be adversely impacted by a disruption in the infrastructure that supports our businesses. This may include a disruption involving electrical, communications, internet, transportation or other services used by us or third parties with which we conduct business. Notwithstanding our efforts to maintain business continuity, a disruptive event impacting our processing locations could negatively affect our business.
Our operations rely on the secure processing, storage and transmission of confidential and other information in our computer systems and networks. Although we take protective measures, our computer systems, software and networks may be vulnerable to unauthorized access, computer viruses or other malicious code and other events that could have a security impact. If one or more of such events occur, this could jeopardize confidential and other information processed and stored in, and transmitted through, our computer systems and networks, or otherwise cause interruptions or malfunctions in our operations which could result in significant losses or reputational damage. We may be required to expend significant additional resources to modify our protective measures or to investigate and remediate vulnerabilities or other exposures, and we may be subject to litigation and financial losses that are either not insured against or not fully covered through any insurance maintained by us.
We routinely transmit and receive personal, confidential and proprietary information. We have put in place secure transmission capability, and may not be able to ensure secure transmissions and we may not be able to ensure that third parties with whom we work have appropriate controls in place to protect the confidentiality of the information. An interception, misuse or mishandling of personal, confidential or proprietary information being sent to or received from a customer or third party could result in legal liability, regulatory action and reputational harm.
Incorrect estimates and assumptions by management in connection with the preparation of our consolidated financial statements could adversely affect the reported amounts of assets and liabilities and the reported amounts of income and expenses.
The preparation of our consolidated financial statements requires management to make certain critical accounting estimates and assumptions that could affect the reported amounts of assets and liabilities and the reported amounts of income and expense during the reporting periods. A description of our critical accounting estimates and assumptions may be found in MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CRITICAL ACCOUNTING POLICIES AND ESTIMATES in this Form 10-K. If we make incorrect assumptions or estimates, we may under- or overstate reported financial results, which could result in actual results being significantly different than current estimates which could adversely affect our business.
Changes in laws and regulations that affect the FFELP in particular and consumer lending in general could affect the profitability of our business.
The FFELP portion of our business is authorized under the HEA, which is amended by Congress from time to time. ED administers the FFELP and modifies its guidance from time to time. We are also subject to various state and federal laws and regulations that govern our private credit lending and debt collection businesses.
Changes in laws and regulations that govern our businesses affect the profitability and viability of our businesses. For example, amendments made to the HEA in 2007 significantly reduced the profitability of our FFELP business. Also, the Administrations budget for the 2010 fiscal year, submitted to Congress on February 26, 2009, includes proposals that could impact significantly the FFELP. It is possible that future changes in laws and regulations could negatively impact our ability to grow and be profitable. The Administrations budget request and the current economic environment may make legislative changes more likely, making this risk to our business greater.
The financial services industry is highly competitive. We compete with banks and other consumer lending institutions, many with strong consumer brand name recognition. The market for federally-guaranteed student loans is shared among the Company and other private sector lenders who participate in the FFELP and the federal government through the FDLP. We compete based on our products and customer service. To the extent our competitors compete aggressively or more effectively, we could lose market share to them.
Our product offerings are primarily concentrated in loan and savings products for higher education expenses. This concentration is both a competitive advantage and a risk.
We are a leading provider of saving- and paying-for-college products and programs. This concentration gives us a competitive advantage in the market place. This concentration also creates risks in our business, particularly in light of our concentration as a FFELP lender. If population demographics result in a decrease in college-age individuals, if demand for higher education decreases, the cost of attendance of higher education decreases, if public support for higher education costs increases, or if the demand for higher education loans decreases or increases from one product to another, our business could be negatively affected. In addition, if we introduce new education loan products, there is a risk that those new products will not be accepted in the marketplace. Because we are not a diversified financial services company, we would not have other product offerings to offset any loss of business in the education credit market.
We may be adversely affected by deterioration in economic conditions.
A recession or downturn in the economy could make it difficult for us to originate new business, given the resultant reduced demand for consumer credit. Credit quality may also be impacted as borrowers may fail to meet their obligations. Adverse economic conditions may result in declines in collateral values. Accordingly, higher credit-related losses could impact our financial position. In addition, weaker credit quality could limit funding options, including capital markets activity, which could adversely impact the Companys liquidity position.
The following table lists the principal facilities owned by the Company:
The following table lists the principal facilities leased by the Company as of December 31, 2008:
None of the Companys facilities is encumbered by a mortgage. The Company believes that its headquarters, loan servicing centers data center, back-up facility and data management and collections centers are generally adequate to meet its long-term student loan and business goals. The Companys principal office is currently in owned space at 12061 Bluemont Way, Reston, Virginia, 20190.
The Company is involved in a number of judicial and regulatory proceedings, including those described below, concerning matters arising in connection with the conduct of our business. We believe, based on currently available information, that the results of such proceedings, in the aggregate, will not have a material adverse effect on the financial condition of the Company.
On January 31, 2008, a putative class action lawsuit was filed against the Company and certain officers in U. S. District Court for the Southern District of New York. This case and other actions arising out of the same circumstances and alleged acts have been consolidated and are now identified as In Re SLM Corporation Securities Litigation. The case purports to be brought on behalf of those who acquired common stock of the Company between January 18, 2007 and January 23, 2008 (the Securities Class Period). The complaint alleges that the Company and certain officers violated federal securities laws by issuing a series of materially false and misleading statements and that the statements had the effect of artificially inflating the market price for the Companys securities. The complaint alleges that defendants caused the Companys results for year-end 2006 and for the first quarter of 2007 to be materially misstated because the Company failed to adequately provide for loan losses, which overstated the Companys net income, and that the Company failed to adequately disclose allegedly known trends and uncertainties with respect to its non-traditional loan portfolio. On July 23, 2008, the court appointed Westchester Capital Management (Westchester) Lead Plaintiff. On December 8, 2008, Lead Plaintiff filed a consolidated amended complaint. In addition to the prior allegations, the consolidated amended complaint alleges that the Company understated loan delinquencies and loan loss reserves by promoting loan forbearances. On December 19, 2008, and December 31, 2008, two rejected lead plaintiffs filed a challenge to Westchester as Lead Plaintiff. That motion is pending. Lead Plaintiff seeks unspecified compensatory damages, attorneys fees, costs, and equitable and injunctive relief.
A similar case is pending against the Company, certain officers, retirement plan fiduciaries, and the Board of Directors, In Re SLM Corporation ERISA Litigation, also in the U.S. District Court for the Southern District of New York. The proposed class consists of participants in or beneficiaries of the Sallie Mae 401(K) Retirement Savings Plan (401K Plan) between January 18, 2007 and the present whose accounts included investments in Sallie Mae stock (401K Class Period). The complaint alleges breaches of fiduciary duties and prohibited transactions in violation of the Employee Retirement Income Security Act arising out of alleged false and misleading public statements regarding the Companys business made during the 401(K) Class Period and investments in the Companys common stock by participants in the 401(K) Plan. On December 15, 2008, Plaintiffs filed a Consolidated Class Action Complaint. The plaintiffs seek unspecified damages, attorneys fees, costs, and equitable and injunctive relief.
On September 17, 2007, the Company became a party to a qui tam whistleblower case, United States ex. Rel. Rhonda Salmeron v. Sallie Mae, in the U.S. District Court for the Northern District of Illinois. The plaintiff alleges that various defendants submitted false claims and/or created records to support false claims in connection with collection activity on federally guaranteed student loans, and specifically that the Company was negligent in auditing the collection practices of one of the defendants. The plaintiffs seek money damages in excess of $12 million plus treble damages on behalf of the federal government. This case was dismissed with prejudice in August 2008 and was appealed to the Seventh Circuit Court of Appeals in September 2008. The appeal is pending.
On December 17, 2007, plaintiffs filed a complaint against the Company, Rodriguez v. SLM Corporation et al., in the U.S. District Court for the District of Connecticut alleging that the Company engaged in underwriting practices which, among other things, resulted in certain applicants for student loans being directed into substandard and expensive loans on the basis of race. The plaintiffs have not stated the relief they seek. Motions to dismiss Sallie Mae, Inc. and for summary judgment as to the Company are pending.
On April 6, 2007, the Company was served with a putative class action suit by several borrowers in U.S. District Court for the Central District of California (Anne Chae et al. v. SLM Corporation et al.) Plaintiffs challenge under California common and statutory law the Companys FFELP billing practices as they relate to the use of the simple daily interest method for calculating interest, the charging of late fees while charging simple daily interest, and setting the first payment date at 60 days after loan disbursement for consolidation and PLUS loans thereby alleging that the Company effectively capitalizes interest. The plaintiffs seek unspecified actual and punitive damages, restitution, disgorgement of late fees, pre-judgment and post-judgment interest, attorneys fees, costs, and equitable and injunctive relief. On June 16, 2008, the Court granted summary judgment to the Company on all counts on the basis of federal preemption. The decision was appealed to the Ninth Circuit Court of Appeals. The appeal is pending.
The Office of the Inspector General (OIG) of ED has been conducting an audit of the Companys billing practices for special allowance payments under what is known as the 9.5 percent floor calculation since September 2007. The audit covers the period from 2003 through 2006 and is focused on the Companys Nellie Mae subsidiaries. While the audit is not yet complete and there has been no definitive determination by the OIG auditors, initial indications are that the OIG disagrees with the Companys billing practices on an immaterial portion of the Companys bills. We continue to believe that our practices are consistent with longstanding ED guidance and all applicable rules and regulations. A final audit report has not been filed. Once a final report is filed, it will be presented to the Secretary of ED for consideration. The OIG has audited other industry participants on this issue and in certain cases the Secretary of ED has disagreed with the OIGs recommendation.
The Company continues to respond to numerous requests from state attorneys general and other government agencies regarding marketing and debt collection practices.
Nothing to report.
The Companys common stock is listed and traded on the New York Stock Exchange under the symbol SLM. The number of holders of record of the Companys common stock as of January 31, 2009 was 833. The following table sets forth the high and low sales prices for the Companys common stock for each full quarterly period within the two most recent fiscal years.
The Company paid quarterly cash dividends of $.22 for the first quarter of 2006, $.25 for the last three quarters of 2006 and $.25 for the first quarter of 2007. There were no cash dividends paid in 2008.
The following table summarizes the Companys common share repurchases during 2008 in connection with the exercise of stock options and vesting of restricted stock to satisfy minimum statutory tax withholding obligations and shares tendered by employees to satisfy option exercise costs (which combined totaled approximately 600 thousand shares for 2008). See Note 11, Stockholders Equity, to the consolidated financial statements.
The following graph compares the yearly percentage change in the Companys cumulative total shareholder return on its common stock to that of Standard & Poors 500 Stock Index and Standard & Poors Financials Index. The graph assumes a base investment of $100 at December 31, 2003 and reinvestment of dividends through December 31, 2008.
Five Year Cumulative Total Shareholder Return
Source: Bloomberg Total Return Analysis
Selected Financial Data 2004-2008
(Dollars in millions, except per share amounts)
The following table sets forth selected financial and other operating information of the Company. The selected financial data in the table is derived from the consolidated financial statements of the Company. The data should be read in conjunction with the consolidated financial statements, related notes, and MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS included in this Form 10-K.
MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Years ended December 31, 2006-2008
(Dollars in millions, except per share amounts, unless otherwise stated)
Some of the statements contained in this Annual Report discuss future expectations and business strategies or include other forward-looking information. Those statements are subject to known and unknown risks, uncertainties and other factors that could cause the actual results to differ materially from those contemplated by the statements. The forward-looking information is based on various factors and was derived using numerous assumptions.
This section provides an overview of the Companys 2008 business results from a financial perspective. Certain financial impacts of funding and liquidity, loan losses, asset growth, fee income, the distressed debt purchased paper business, operating expenses, and capital adequacy are summarized below. The income statement amounts discussed in this Overview section are on a Core Earnings basis.
As discussed in the Business section, legislative changes to the FFELP, the credit markets and the economic downturn impacted the Companys financial results for 2008. The Company reported $526 million in Core Earnings net income, a decrease from $560 million in 2007. (Core Earnings are defined in BUSINESS SEGMENTS Limitations of Core Earnings Pre-tax Differences between Core Earnings and GAAP by Business Segment.)
The Companys results were affected by higher funding costs than in prior periods. The higher costs were, in part, related to the 2008 Asset-Backed Financing Facility; the after-tax fees for this Facility were $225 million for the year. This Facility was reduced from $34 billion at the beginning of the year to $28 billion by year end and was extended by 60 days to mature on April 28, 2009.
Our funding costs were also affected by higher than average interest rate index divergence. Most of our FFELP loans earn interest based on market CP rates; our funding costs are primarily based on LIBOR. Due to government intervention in the CP marketplace and other market dislocations, the spread widened as much as 200 basis points on certain days during the fourth quarter of 2008, compared to an average spread of 8 basis points in the third quarter of 2008. ED established an alternative interest rate calculation for a portion of the fourth quarter to address the issue, which resulted in a 21 basis point spread for the Company for the fourth quarter.
In the fourth quarter, we secured access to stable and profitable funding sources for new FFELP and Private Education Loan originations. ECASLA provides FFELP lenders with access to unlimited funding to meet student demand through AY 2009-2010. Our Private Education Loan originations are being funded by term deposits issued by Sallie Mae Bank.
The Companys primary funding challenge is to replace our short-term funding sources, principally the 2008 Asset-Backed Financing Facility, with longer-term, lower-cost funding. Two federally-sponsored programs, the ED Conduit Program and the Federal Reserve Bank of New Yorks Term Asset-Backed Liquidity Facility, which are discussed in the LIQUIDITY AND CAPITAL RESOURCES section, are under development and offer significant potential. At year end, approximately $30 billion in student loans assets were eligible for these programs, which are expected to be operational in the first quarter of 2009.
In 2008, we issued approximately $26 billion in term funding, including $18.5 billion in term FFELP ABS funding, which carried an average spread of 125 basis points over LIBOR. In early January 2009, we
announced a $1.5 billion, 12.5 year asset-backed securities facility. The cost of this facility is expected to average LIBOR plus 5.75 percent and is expected to fund our Private Education Loans. Though significantly more expensive than historical transactions, this facility demonstrates term funding capability and availability for our Private Education Loan portfolio.
At year end, 70 percent of our Managed student loans were funded for the life of the loans and another 12 percent were funded for an average life of 4.3 years.
At year end, we held approximately $11 billion in primary liquidity, consisting of cash and short-term investments and committed lines of credit. We have $5.2 billion in standby liquidity in the form of unencumbered FFELP loans.
On a Core Earnings basis, the loan loss provision for the year was $1 billion, of which $127 million was for FFELP loans. The provision for Private Education Loans in the fourth quarter was $348 million, approximately double the average of the first three quarters of the year. We began significantly increasing the Private Education Loan allowance for loan loss in the fourth quarter of 2007 and throughout 2008 primarily related to the continued weakening of the U.S. economy, which in particular impacts our non-traditional loans which are now moving into repayment status. At year end, our Private Education Loan allowance for loan loss covered approximately two years of expected losses for Private Education Loans.
In 2008, the Company originated $17.9 billion in FFELP loans, a four percent increase over 2007. We refocused our FFELP originations on our internal lending brands, which grew 48 percent over 2007. We expect FFELP volume to exceed $20 billion in AY 2008-2009.
Private Education Loan originations for 2008 were $6.3 billion, a 20 percent decline from 2007. In 2008, the Company increased its underwriting standards and as a result, average FICO scores and loans with cosigner have increased. The Company expects to continue to increase its underwriting standards, shorten the term of Private Education Loans, and require interest payments while students are attending school. The impact of these product changes and the overall economy may impact future Private Education Loan asset growth.
Fee income from our contingency business was relatively stable, increasing $4 million from $336 million in 2007 to $340 million in 2008.
Fee income from our guarantor servicing business was $121 million for the year, a $35 million decrease from last year. The decrease was primarily due to legislative changes that reduce by 40 percent the account maintenance fee paid to guarantee agencies, and a one-time non-recurring increase to 2007 revenue of $15 million related to a contingency resolution.
A possible source of additional fee income for 2009 is an increase in third-party servicing. We originated $0.5 billion of FFELP loans for third parties in the fourth quarter, a 14 percent increase from the year-ago quarter. The Company will seek to be a loan servicer for ED under the Loan Purchase Program.
We have decided to exit the debt purchased paper business (see ASSET PERFORMANCE GROUP BUSINESS SEGMENT). This line of business reported a $203 million after-tax loss for the year, primarily due to a $368 million pre-tax impairment charge. The economy and changes in real estate values will continue to impact this line of business.
Excluding restructuring expenses, fourth quarter 2008 operating expenses on a Core Earnings basis were $270 million, a 26 percent decrease from the year-ago period, exceeding the Companys 20 percent cost reduction target. For 2008, operating expenses on a Core Earnings basis were $1.3 billion, compared to $1.4 billion in 2007.
At year end, the Companys tangible capital ratio was 1.8 percent of Managed assets, compared to 2 percent at 2007 year end. With 81 percent of our Managed loans carrying an explicit federal government guarantee and with 70 percent of our Managed loans funded for the life of the loan, we currently believe that our capital levels are appropriate. In the current economic environment, we cannot predict the availability nor cost of additional capital, should the Company determine that additional capital is necessary.
Managements Discussion and Analysis of Financial Condition and Results of Operations addresses our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States of America (GAAP). Note 2 to the consolidated financial statements, Significant Accounting Policies, includes a summary of the significant accounting policies and methods used in the preparation of our consolidated financial statements. 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. Actual results may differ from these estimates under varying assumptions or conditions. On a quarterly basis, management evaluates its estimates, particularly those that include the most difficult, subjective or complex judgments and are often about matters that are inherently uncertain. The most significant estimates and assumptions relate to the following critical accounting policies that are discussed in more detail below.
We maintain an allowance for loan losses at an amount sufficient to absorb losses incurred in our FFELP loan and Private Education Loan portfolios at the reporting date based on a projection of estimated probable net credit losses incurred in the portfolio. We analyze those portfolios to determine the effects that the various stages of delinquency have on borrower default behavior and ultimate net charge-off. We estimate the allowance for loan losses for our loan portfolio using a migration analysis of delinquent and current accounts. A migration analysis is a technique used to estimate the likelihood that a loan receivable may progress through the various delinquency stages and ultimately charge off, net of recoveries, and is a widely used reserving methodology in the consumer finance industry. We also use the migration analysis to estimate the amount of uncollectible accrued interest on Private Education Loans and write-off that amount against current period interest income. The evaluation of the allowance for loan losses is inherently subjective, as it requires material estimates that may be susceptible to significant changes. Our default estimates are based on a loss confirmation period of generally two years (i.e., our allowance for loan loss covers the next two years of expected losses). The two-year estimate of the allowance for loan losses is subject to a number of assumptions. If actual future performance in delinquency, charge-offs and recoveries are significantly different than estimated, this could materially affect our estimate of the allowance for loan losses and the related provision for loan losses on our income statement. We believe that the Private Education Loan and FFELP allowance for loan losses are appropriate to cover probable losses incurred in the student loan portfolio.
When calculating the allowance for loan losses on Private Education Loans, we divide the portfolio into categories of similar risk characteristics based on loan program type, loan status (in-school, grace, forbearance, repayment, and delinquency), underwriting criteria (FICO scores), and existence or absence of a cosigner. As noted above, we use historical experience of borrower default behavior and charge-offs to estimate the probable credit losses incurred in the loan portfolio at the reporting date. Also, we use historical borrower payment behavior to estimate the timing and amount of future recoveries on charged off loans. We then apply the default and collection rate projections to each category of loans. Once the quantitative calculation is
performed, management reviews the adequacy of the allowance for loan losses and determines if qualitative adjustments need to be considered. One technique for making this determination is through projection modeling, which is used to determine if the allowance for loan losses is sufficient to absorb net credit losses anticipated during the loss confirmation period. Projection modeling is an independent forward-looking projection of net charge-offs. Assumptions that are utilized in the projection modeling include (but are not limited to) historical experience, recent changes in collection policies and procedures, collection performance, and macroeconomic indicators. Additionally, management considers changes in laws and regulations that could potentially impact the allowance for loan losses.
The majority of our Private Education Loan programs do not require that borrowers begin repayment until six months after they have graduated or otherwise left school. Consequently, our loss estimates for these programs are generally low while the borrower is in school. At December 31, 2008, 38 percent of the principal balance in the higher education Managed Private Education Loan portfolio is related to borrowers who are in in-school or grace status and not required to make payments. As the current portfolio ages, an increasing percentage of the borrowers will leave school and be required to begin payments on their loans. The allowance for losses will change accordingly.
Similar to the rules governing FFELP payment requirements, our collection policies allow for periods of nonpayment for borrowers requesting additional payment grace periods upon leaving school or experiencing temporary difficulty meeting payment obligations. This is referred to as forbearance status and is considered separately in our allowance for loan losses. The loss confirmation period is in alignment with our typical collection cycle and takes into account these periods of nonpayment.
In general, Private Education Loan principal is charged off against the allowance when the loan exceeds 212 days delinquency. As further discussed in LENDING BUSINESS SEGMENT Private Education Loan Losses Activity in the Allowance for Private Education Loan Losses, this period we corrected our charge-off methodology.
In the fourth quarter of 2007, we recorded provision expense of $667 million related to the Managed Private Education Loan portfolio. This significant increase in provision primarily related to the non-traditional portion of our loan portfolio (education loans made to certain borrowers that have or are expected to have a high default rate) which we had been expanding over the past few years. We have taken actions in 2008 to terminate these non-traditional loan programs because the performance of these loans is materially different from our original expectations and from the rest of our Private Education Loan programs. However, there can be no assurance that our non-traditional loans outstanding will not require additional significant loan provisions or have any further adverse effect on the overall credit quality of our Managed Private Education Loan portfolio.
Also, we have seen higher delinquencies and continued deterioration of the overall portfolio in 2008 due primarily to the weakening U.S. economy, which has resulted in increased provisioning for expected losses. If the economy continues to weaken beyond our expectations, the expected losses resulting from our default and collection estimates embedded in the allowance for loan losses could continue to increase.
FFELP loans are guaranteed as to their principal and accrued interest in the event of default subject to a Risk Sharing level set based on the date of loan disbursement. For loans disbursed after October 1, 1993, and before July 1, 2006, we receive 98 percent reimbursement on all qualifying default claims. For loans disbursed on or after July 1, 2006, we receive 97 percent reimbursement. The CCRAA reduces the Risk Sharing level for loans disbursed on or after October 1, 2012 to 95 percent reimbursement, which will impact the allowance for loan losses in the future.
Similar to the Private Education allowance for loan losses, the FFELP allowance for loan losses uses historical experience of borrower default behavior and a two year loss confirmation period to estimate the credit losses incurred in the loan portfolio at the reporting date. We divide the portfolio into categories of similar risk characteristics based on loan program type, school type and loan status. We then apply the default rate projections, net of applicable Risk Sharing, to each category for the current period to perform our
quantitative calculation. Once the quantitative calculation is performed, management reviews the adequacy of the allowance for loan losses and determines if qualitative adjustments need to be considered.
The 2007 FFELP provision included one-time adjustments for the repeal of the Exceptional Performer program (and the resulting increase in our Risk Sharing percentage) due to the passage of the CCRAA, which was effective October 1, 2007, as well as increased provision related to the increase in our default expectations due to an increase in recent delinquencies and claim filings. The provision in 2008 increased due to an increase in delinquencies and claim filings from the weakening of the U.S. economy, as well as the portfolio transitioning to FFELP loans, which are subject to more Risk Sharing. Since we are impacted by changes in the laws and regulations of the FFELP, any changes made to the Risk Sharing levels could have a material impact on our FFELP allowance for loan losses. Also, if the economy continues to weaken beyond our expectations, the losses embedded in the FFELP allowance for loan losses could continue to increase.
For both federally insured and Private Education Loans, we account for premiums paid, discounts received, and capitalized direct origination costs incurred on the origination of student loans in accordance with the Financial Accounting Standards Boards (FASB) Statement of Financial Accounting Standard (SFAS) No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases. The unamortized portion of the premiums and the discounts is included in the carrying value of the student loans on the consolidated balance sheet. We recognize income on our student loan portfolio based on the expected yield over the estimated life of the student loan after giving effect to the amortization of purchase premiums and accretion of student loan discounts. In arriving at the expected yield, we make a number of estimates that when changed are reflected as a cumulative adjustment to interest income in the current period. The most critical estimates for premium and discount amortization are incorporated in the Constant Prepayment Rate (CPR), which measures the rate at which loans in the portfolio pay down principal compared to their stated terms. The CPR estimate is based on historical prepayments due to consolidation activity, defaults, and term extensions from the utilization of forbearance, as well as, managements qualitative expectation of future prepayments and term extensions.
In the development of the CPR estimates, the effect of consolidation activity can be a significant assumption. Between 2003 and 2006, we experienced a surge in FFELP Stafford loan consolidation activity as a result of aggressive marketing and historically low interest rates. This, in turn, has had a significant effect on premium and discount amortization in our financial statements. More recently, as a result of the CCRAA and the current U.S. economic and credit environment, we, as well as many other industry competitors, have suspended our FFELP consolidation program. In lieu of consolidation, we may offer a term extension option for FFELP loans based on the borrowers total indebtedness.
Based upon these market factors, we have updated our CPR assumptions that are affected by consolidation activity, and we have updated the estimates used in developing the cash flows and effective yield calculations as they relate to the amortization of student loan premium and discount amortization.
Consolidation activity affects estimates differently depending on whether the original loans being consolidated were on-balance sheet or off-balance sheet and whether the resulting consolidation is retained by us or consolidated with a third party. When we consolidate a loan that was in our portfolio, the term of that loan is generally extended and the term of the amortization of associated student loan premiums and discounts is likewise extended to match the new term of the loan. In that process, the unamortized premium balance must be adjusted to reflect the new expected term of the consolidated loan as if it had been in place from inception.
At the beginning of 2008, when we evaluated our estimates by taking into consideration the suspension of our FFELP consolidation program, there was an expectation of increased external consolidations to third parties, but an overall decrease in total consolidation activity (when taking into account both internal consolidations and consolidations to third parties) due to a lack of financial incentive for lenders to continue offering a consolidation product. External consolidations did not significantly increase as expected; therefore,
the consolidation assumptions implemented in the first quarter of 2008 were reduced during the third quarter of 2008, as we made the decision to lower the consolidation rate as additional information became available.
Additionally, in previous years, the increased activity in FFELP Consolidation Loans had led to demand for the consolidation of Private Education Loans. Private Education Consolidation Loans provide an attractive refinancing opportunity to certain borrowers because they allow borrowers to lower their monthly payments by extending the life of the loan and/or lowering their interest rate. The private loan consolidation assumption was established in 2007 and was changed to explicitly consider private loan consolidation in the same manner as for FFELP. Because of limited historical data on private loan consolidation, the assumption primarily relies on near term plan data and timing assumptions. In the second quarter of 2008, we suspended making private consolidation loans due to funding limitations which impacted this assumption.
The consolidation, default, term extension and other prepayment factors affecting our CPR estimates are impacted by changes in our business strategy, FFELP legislative changes, and changes to the current economic and credit environment. If our accounting estimates, especially CPRs, are different as a result of changes to our business environment or actual consolidation or default activity, the previously recognized interest income on our student loan portfolio based on the expected yield of the student loan would potentially result in a material adjustment in the current period.
On January 1, 2008, we adopted SFAS No. 157, Fair Value Measurements. This statement defines fair value, establishes a framework for measuring fair value within GAAP, and expands disclosures about fair value measurements. Accordingly, this statement does not change which types of instruments are carried at fair value, but rather establishes the framework for measuring fair value.
On February 12, 2008, the FASB issued FASB Staff Position (FSP) SFAS No. 157-2, Effective Date of SFAS No. 157, which deferred the effective date of SFAS No. 157 for nonfinancial assets and liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis. This FSP delayed the implementation of SFAS No. 157 for our accounting of goodwill, acquired intangibles, and other nonfinancial assets and liabilities that are measured at the lower of cost or market until January 1, 2009.
As such, SFAS No. 157 applies to the recurring fair value measurements of our investment portfolio accounted for under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities; our derivative portfolio and designated hedged assets or liabilities accounted for under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities; and our Residual Interest in off-balance sheet securitization trusts accounted for under SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of FASB Statement No. 115. In general, changes in the fair value of items measured at fair value on a recurring basis will affect the consolidated statement of income and capital each period. In addition, SFAS No. 157 applies to FFELP student loans accounted for as held-for-sale loans under Statement of Position 01-6, Accounting by Certain Entities (Including Entities with Trade Receivables) That Lend to or Finance the Activities of Others. These loans are accounted for at the lower of cost or fair value and as such affect the consolidated statements of income and capital on a non-recurring basis. Lastly, the valuation principles set forth in SFAS No. 157 apply to all financial instruments disclosed at fair value under SFAS No. 107, Disclosures about Fair Value of Financial Instruments in Note 16, Fair Values of Financial Instruments, to the consolidated financial statements.
Liquidity is impacted to the extent that a decrease in fair value would result in less cash being received upon a sale of an investment. Liquidity is also impacted to the extent that changes in capital and net income affect compliance with principal financial covenants in our unsecured revolving credit facilities. Noncompliance with these covenants also impacts our ability to use our 2008 ABCP Facilities (see LIQUIDITY AND CAPITAL RESOURCES Additional Funding Sources for General Corporate Purposes). Additionally, liquidity is impacted to the extent that changes in the fair value of derivative instruments result in the movement of collateral between us and our counterparties. Collateral agreements are bilateral and are based on the derivative fair values used to determine the net exposure between us and individual counterparties. For a
general description of valuation techniques and models used for the above items, see Note 16, Fair Values of Financial Instruments, to the consolidated financial statements. For a discussion of the sensitivity of fair value estimates, see Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
In light of the recent economic turmoil occurring in the U.S., the FASB released FSP No. 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active, on October 10, 2008. This FSP clarified, among other things, that quotes and other market inputs need not be solely used to determine fair value if they do not relate to an active market. The FSP points out that when relevant observable market information is not available, an approach that incorporates managements judgments about the assumptions that market participants would use in pricing the asset in a current sale transaction would be acceptable (such as a discounted cash flow analysis). Regardless of the valuation technique applied, entities must include appropriate risk adjustments that market participants would make, including adjustments for non-performance risk (credit risk) and liquidity risk. In determining the fair value of the instruments that fall under SFAS No. 157, we have specifically taken into account both credit risk and liquidity risk as of December 31, 2008.
Significant assumptions used in fair value measurements including those related to credit and liquidity risk are as follows:
We regularly engage in securitization transactions as part of our Lending segment financing strategy (see also LIQUIDITY AND CAPITAL RESOURCES Securitization Activities). In a securitization, we sell student loans to a trust that issues bonds backed by the student loans as part of the transaction. When our securitizations meet the sale criteria of SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities a Replacement of SFAS No. 125, we record a gain on the sale of the student loans, which is the difference between the allocated cost basis of the assets sold and the relative fair value of the assets received including the Residual Interest component of the Retained Interest in the securitization transaction. The Residual Interest is the right to receive cash flows from the student loans and reserve accounts in excess of the amounts needed to pay servicing, derivative costs (if any), other fees, and the principal and interest on the bonds backed by the student loans. We have not structured any securitization transaction to meet the sale criteria since March 2007 and all securitizations settled since that date have been accounted for on-balance sheet as secured financings as a result.
We adopted SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of FASB Statement 115, effective January 1, 2008, whereby we elected to carry all existing Residual Interests at fair value with subsequent changes in fair value recorded in servicing and securitization revenue. Since there are no quoted market prices for our Residual Interests, we estimate their fair value both initially and each subsequent quarter using the key assumptions listed below:
We also receive income for servicing the loans in our securitization trusts. We assess the amounts received as compensation for these activities at inception and on an ongoing basis to determine if the amounts received are adequate compensation as defined in SFAS No. 140. To the extent such compensation is determined to be no more or less than adequate compensation, no servicing asset or obligation is recorded.
We use interest rate swaps, cross-currency interest rate swaps, interest rate futures contracts, Floor Income Contracts and interest rate cap contracts as an integral part of our overall risk management strategy to manage interest rate and foreign currency risk arising from our fixed rate and floating rate financial instruments. We account for these instruments in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, which requires that every derivative instrument, including certain derivative instruments embedded in other contracts, be recorded at fair value on the balance sheet as either an asset or liability. We determine the fair value for our derivative instruments primarily by using pricing models that consider current market conditions and the contractual terms of the derivative contracts. Market inputs into the model include interest rates, forward interest rate curves, volatility factors, forward foreign exchange rates, and the closing price of our stock (related to our equity forward contracts). Inputs are generally from active financial markets; however, as mentioned under Fair Value Measurements above, adjustments are made for inputs from illiquid markets and to adjust for credit risk. In some instances, counterparty valuations are used in determining the fair value of a derivative when deemed a more appropriate estimate of the fair value. Pricing models and their underlying assumptions impact the amount and timing of unrealized gains and losses recognized and, as such, the use of different pricing models or assumptions could produce different financial results. As a matter of policy, we compare the fair values of our derivatives that we calculate to those provided by our counterparties on a monthly basis. Any significant differences are identified and resolved appropriately.
SFAS No. 133 requires that changes in the fair value of derivative instruments be recognized currently in earnings unless specific hedge accounting criteria as specified by SFAS No. 133 are met. We believe that all of our derivatives are effective economic hedges and are a critical element of our interest rate risk management strategy. However, under SFAS No. 133, some of our derivatives, primarily Floor Income Contracts, certain Eurodollar futures contracts, basis swaps and equity forwards, do not qualify for hedge treatment under SFAS No. 133. Therefore, changes in market value along with the periodic net settlements must be recorded through the gains (losses) on derivative and hedging activities, net line in the consolidated statement of income with no consideration for the corresponding change in fair value of the hedged item. The derivative market value adjustment is primarily caused by interest rate and foreign currency exchange rate volatility, changing credit spreads during the period, and changes in our stock price (related to equity forwards), as well as, the volume and term of derivatives not receiving hedge accounting treatment. See also BUSINESS SEGMENTS Limitations of Core Earnings Pre-tax Differences between Core Earnings and GAAP by Business Segment Derivative Accounting for a detailed discussion of our accounting for derivatives.
SELECTED FINANCIAL DATA
We present the results of operations first on a consolidated basis in accordance with GAAP. As discussed in Item 1. Business, we have two primary business segments, Lending and APG, plus a Corporate and Other business segment. Since these business segments operate in distinct business environments, the discussion following the Consolidated Earnings Summary is primarily presented on a segment basis. See BUSINESS SEGMENTS for further discussion on the components of each segment. Securitization gains and the ongoing servicing and securitization income are included in LIQUIDITY AND CAPITAL RESOURCES Securitization Activities. The discussion of derivative market value gains and losses is under BUSINESS SEGMENTS Limitations of Core Earnings Pre-tax Differences between Core Earnings and GAAP by Business Segment Derivative Accounting. The discussion of goodwill and acquired intangible amortization and impairment is discussed under BUSINESS SEGMENTS Limitations of Core Earnings Pre-tax Differences between Core Earnings and GAAP by Business Segment Acquired Intangibles.
The main drivers of our net income are the growth in our Managed student loan portfolio, which drives net interest income and securitization transactions, the spread we earn on student loans, unrealized gains and losses on derivatives that do not receive hedge accounting treatment, the timing and size of securitization gains, growth in our fee-based business, and expense control.
For the year ended December 31, 2008, our net loss was $213 million or $.69 diluted loss per share, compared to a net loss of $896 million, or $2.26 diluted loss per share, for the year December 31, 2007. The effective tax rate for those periods was 45 percent and (86) percent, respectively. The movement in the effective tax rate was primarily driven by the permanent tax impact of excluding non-taxable gains and losses on equity forward contracts which were marked to market through earnings under SFAS No. 133 in 2007. Pre-tax loss decreased by $106 million versus the year-ago period primarily due to a decrease in net losses on derivative and hedging activities from $1.4 billion for the year ended December 31, 2007 to $445 million for the year ended December 31, 2008, which was primarily a result of the mark-to-market on the equity forward contracts in the fourth quarter of 2007.
There were no gains on student loan securitizations in the year ended December 31, 2008 compared to gains of $367 million in the year-ago period. We did not complete any off-balance sheet securitizations in the year ended December 31, 2008, versus one Private Education Loan securitization in the year-ago period. We adopted SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of FASB Statement No. 115, on January 1, 2008, and elected the fair value option on all of the Residual Interests effective January 1, 2008. We made this election in order to simplify the accounting for Residual Interests by having all Residual Interests under one accounting model. Prior to this election, Residual Interests were accounted for either under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, with changes in fair value recorded through other comprehensive income or under SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, with changes in fair value recorded through income. We reclassified the related accumulated other comprehensive income of $195 million into retained earnings and as a result equity was not impacted at transition on January 1, 2008. Changes in fair value of Residual Interests on and after January 1, 2008 are recorded through servicing and securitization income. We have not elected the fair value option for any other financial instruments at this time. Servicing and securitization revenue decreased by $175 million from $437 million in the year ended December 31, 2007 to $262 million in the year ended December 31, 2008. This decrease was primarily due to a $425 million unrealized mark-to-market loss recorded under SFAS No. 159 in the current year compared to a $278 million unrealized mark-to-market loss in the prior year, which included both impairment and an unrealized mark-to-market gain recorded under SFAS No. 155. The increase in the unrealized mark-to-market loss in 2008 versus 2007 was primarily due to increases in the discount rates used to value the Residual Interests. See LIQUIDITY AND CAPITAL RESOURCES Residual Interest in Securitized Receivables for further discussion of the factors impacting the fair values.
Net interest income after provisions for loan losses increased by $72 million in the year ended December 31, 2008 from the prior year. This increase was due to a $296 million decrease in provisions for loan losses, offset by a $224 million decrease in net interest income. The decrease in net interest income was primarily due to a decrease in the student loan spread (see LENDING BUSINESS SEGMENT Net Interest Income Net Interest Margin On-Balance Sheet), an increase in the 2008 Asset-Backed Financing Facilities Fees, partially offset by a $25 billion increase in the average balance of on-balance sheet student loans. The decrease in provisions for loan losses relates to the higher provision amounts in the fourth quarter of 2007 for Private Education Loans, FFELP loans and mortgage loans, primarily due to a weakening U.S. economy. The significant provision in the fourth quarter of 2007 primarily related to the non-traditional portfolio which was particularly impacted by the weakening U.S. economy (see LENDING BUSINESS SEGMENT Private Education Loan Losses Private Education Loan Delinquencies and Forbearance and Activity in the Allowance for Private Education Loan Losses).
For the year ended December 31, 2008, fee and other income and collections revenue totaled $790 million, a $359 million decrease from $1.1 billion in the prior year. This decrease was primarily the result of $368 million of impairment related to both declines in the fair value of mortgage loans and real estate held by our mortgage purchased paper subsidiary and related to our non-mortgage purchased paper subsidiary recorded in 2008 compared to $21 million in 2007 (see ASSET PERFORMANCE GROUP BUSINESS SEGMENT).
Losses on loans and securities, net, totaled $186 million for the year ended December 31, 2008, a $91 million increase from $95 million incurred in the year ended December 31, 2007. Prior to the fourth quarter of 2008, these losses were primarily the result of our repurchase of delinquent Private Education Loans from our off-balance sheet securitization trusts. When Private Education Loans in our off-balance sheet securitization trusts that settled before September 30, 2005 became 180 days delinquent, we previously exercised our contingent call option to repurchase these loans at par value out of the trusts and recorded a loss for the difference in the par value paid and the fair market value of the loans at the time of purchase. We do not hold the contingent call option for any trusts that settled after September 30, 2005. Beginning in October 2008, we decided to no longer exercise our contingent call option. The loss in the fourth quarter of 2008 primarily relates to the sale of approximately $1.0 billion FFELP loans to ED under the ECASLA, which resulted in a $53 million loss. See LIQUIDITY AND CAPITAL RESOURCES ED Funding Programs for further discussion.
We are restructuring our business in response to the impact of CCRAA and current challenges in the capital markets. In conjunction with our restructuring plan, we are refocusing our lending activities, exiting certain customer relationships and product lines, and winding down our debt purchase paper businesses. As a result, during 2008 we have reduced our operating expenses by over 20 percent in the fourth quarter of 2008 compared to the fourth quarter of 2007, after adjusting for restructuring costs, growth and other investments. As part of our cost reduction efforts, restructuring expenses of $84 million and $23 million were recognized in the years ended December 31, 2008 and 2007, respectively. Restructuring expenses from the fourth quarter of 2007 through the fourth quarter of 2008 totaled $106 million. The majority of these restructuring expenses were severance costs related to the completed and planned elimination of approximately 2,900 positions, or approximately 26 percent of the workforce. We estimate approximately $8 million to $15 million of additional restructuring expenses associated with our current cost reduction efforts will be incurred and our current restructuring plan will be substantially complete by the end of 2009. During 2009, we will continue to review our business to determine whether there are other opportunities to further streamline the business.
Operating expenses totaled $1.4 billion and $1.5 billion for the years ended December 31, 2008 and 2007, respectively. The year-over-year reduction is primarily due to our cost reduction efforts discussed above. Of these amounts, $91 million and $112 million, respectively, relate to amortization and impairment of goodwill and intangible assets.
For the year ended December 31, 2007, our net loss was $896 million, or $2.26 diluted loss per share, compared to net income of $1.2 billion, or $2.63 diluted earnings per share, in the year-ago period. The effective tax rate in those periods was (86) percent and 42 percent, respectively. The movement in the effective tax rate was primarily driven by the permanent tax impact of excluding non-taxable gains and losses on equity forward contracts which are marked to market through earnings under the FASBs SFAS No. 133. Pre-tax income decreased by $2.5 billion versus the year ended December 31, 2006 primarily due to a $1.0 billion increase in net losses on derivative and hedging activities, which was mostly comprised of losses on our equity forward contracts. Losses on derivative and hedging activities were $1.4 billion for the year ended December 31, 2007 compared to $339 million for the year ended December 31, 2006.
Pre-tax income for the year ended December 31, 2007 also decreased versus the year ended December 31, 2006 due to a $535 million decrease in gains on student loan securitizations. The securitization gain in 2007 was the result of one Private Education Loan securitization that had a pre-tax gain of $367 million or 18.4 percent of the amount securitized. In the year-ago period, there were three Private Education Loan securitizations that had total pre-tax gains of $830 million or 16.3 percent of the amount securitized. For the year ended December 31, 2007, servicing and securitization income was $437 million, a $116 million decrease from the year ended December 31, 2006. This decrease was primarily due to a $97 million increase in impairment losses which was mainly the result of FFELP Stafford Consolidation Loan activity exceeding expectations, increased Private Education Consolidation Loan activity, increased Private Education Loan expected default activity, and an increase in the discount rate used to value the Private Education Loan
Residual Interests (see LIQUIDITY AND CAPITAL RESOURCES Residual Interest in Securitized Receivables).
Net interest income after provisions for loan losses decreased by $594 million versus the year ended December 31, 2006. The decrease was due to the year-over-year increase in the provisions for loan losses of $728 million, which offset the year-over-year $134 million increase in net interest income. The increase in net interest income was primarily due to an increase of $30.8 billion in the average balance of on-balance sheet interest earning assets offset by a decrease in the student loan spread (see LENDING BUSINESS SEGMENT Net Interest Income Net Interest Margin-On-Balance SheetStudent Loan Spread On-Balance Sheet). The increase in provisions for loan losses relates to higher provision amounts for Private Education Loans, FFELP loans, and mortgage loans primarily due to a weakening U.S. economy (see LENDING BUSINESS SEGMENT Activity in the Allowance for Private Education Loan Losses; and Total Provisions for Loan Losses).
Fee and other income and collections revenue increased $42 million from $1.11 billion for the year ended December 31, 2006 to $1.15 billion for the year ended December 31, 2007.
As noted above, we began restructuring our business in the fourth quarter of 2007 in response to the impact of the CCRAA and current challenges in the capital markets. As part of our cost reduction efforts, $23 million of severance costs related to the elimination of approximately 400 positions across all areas of the Company were incurred in the fourth quarter of 2007.
Operating expenses increased by $183 million year-over-year. This increase in operating expenses was primarily due to $56 million in the Proposed Merger-related expenses incurred in 2007. Operating expenses in 2007 also included $93 million related to a full year of expenses for Upromise, acquired in August 2006, compared to $33 million incurred in 2006.
Our Managed student loan portfolio grew by $21.5 billion (or 15 percent), from $142.1 billion at December 31, 2006 to $163.6 billion at December 31, 2007. In 2007 we acquired $40.3 billion of student loans, an 8 percent increase over the $37.4 billion acquired in the year-ago period. The 2007 acquisitions included $9.3 billion in Private Education Loans, an 11 percent increase over the $8.4 billion acquired in 2006. In the year ended December 31, 2007, we originated $25.2 billion of student loans through our Preferred Channel, an increase of 8 percent over the $23.4 billion originated in the year-ago period.
The following table summarizes the components of Other income in the consolidated statements of income for the years ended December 31, 2008, 2007 and 2006.
The results of operations of the Companys Lending and APG operating segments are presented below. These defined business segments operate in distinct business environments and are considered reportable segments under SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, based on quantitative thresholds applied to the Companys financial statements. In addition, we provide other complementary products and services, including guarantor and student loan servicing, through smaller
operating segments that do not meet such thresholds and are aggregated in the Corporate and Other reportable segment for financial reporting purposes.
The management reporting process measures the performance of the Companys operating segments based on the management structure of the Company as well as the methodology used by management to evaluate performance and allocate resources. In accordance with the Rules and Regulations of the Securities and Exchange Commission (SEC), we prepare financial statements in accordance with GAAP. In addition to evaluating the Companys GAAP-based financial information, management, including the Companys chief operation decision maker, evaluates the performance of the Companys operating segments based on their profitability on a basis that, as allowed under SFAS No. 131, differs from GAAP. We refer to managements basis of evaluating our segment results as Core Earnings presentations for each business segment and we refer to these performance measures in our presentations with credit rating agencies and lenders. Accordingly, information regarding the Companys reportable segments is provided herein based on Core Earnings, which are discussed in detail below.
Our Core Earnings are not defined terms within GAAP and may not be comparable to similarly titled measures reported by other companies. Core Earnings net income reflects only current period adjustments to GAAP net income as described below. Unlike financial accounting, there is no comprehensive, authoritative guidance for management reporting and as a result, our management reporting is not necessarily comparable with similar information for any other financial institution. The Companys operating segments are defined by the products and services they offer or the types of customers they serve, and they reflect the manner in which financial information is currently evaluated by management. Intersegment revenues and expenses are netted within the appropriate financial statement line items consistent with the income statement presentation provided to management. Changes in management structure or allocation methodologies and procedures may result in changes in reported segment financial information.
Core Earnings are the primary financial performance measures used by management to develop the Companys financial plans, track results, and establish corporate performance targets and incentive compensation. While Core Earnings are not a substitute for reported results under GAAP, the Company relies on Core Earnings in operating its business because Core Earnings permit management to make meaningful period-to-period comparisons of the operational and performance indicators that are most closely assessed by management. Management believes this information provides additional insight into the financial performance of the core business activities of our operating segments. Accordingly, the tables presented below reflect Core Earnings which is reviewed and utilized by management to manage the business for each of the Companys reportable segments. A further discussion regarding Core Earnings is included under Limitations of Core Earnings and Pre-tax Differences between Core Earnings and GAAP by Business Segment.
The LENDING BUSINESS SEGMENT section includes all discussion of income and related expenses associated with the net interest margin, the student loan spread and its components, the provisions for loan losses, and other fees earned on our Managed portfolio of student loans. The APG BUSINESS SEGMENT section reflects the fees earned and expenses incurred in providing accounts receivable management and collection services. Our CORPORATE AND OTHER BUSINESS SEGMENT section includes our remaining fee businesses and other corporate expenses that do not pertain directly to the primary operating segments identified above.
While GAAP provides a uniform, comprehensive basis of accounting, for the reasons described above, management believes that Core Earnings are an important additional tool for providing a more complete understanding of the Companys results of operations. Nevertheless, Core Earnings are subject to certain general and specific limitations that investors should carefully consider. For example, as stated above, unlike financial accounting, there is no comprehensive, authoritative guidance for management reporting. Our Core Earnings are not defined terms within GAAP and may not be comparable to similarly titled measures reported by other companies. Unlike GAAP, Core Earnings reflect only current period adjustments to GAAP. Accordingly, the Companys Core Earnings presentation does not represent a comprehensive basis of accounting. Investors, therefore, may not compare our Companys performance with that of other financial services companies based upon Core Earnings. Core Earnings results are only meant to supplement GAAP results by providing additional information regarding the operational and performance indicators that are most closely used by management, the Companys board of directors, rating agencies and lenders to assess performance.
Other limitations arise from the specific adjustments that management makes to GAAP results to derive Core Earnings results. For example, in reversing the unrealized gains and losses that result from
SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, on derivatives that do not qualify for hedge treatment, as well as on derivatives that do qualify but are in part ineffective because they are not perfect hedges, we focus on the long-term economic effectiveness of those instruments relative to the underlying hedged item and isolate the effects of interest rate volatility, changing credit spreads and changes in our stock price on the fair value of such instruments during the period. Under GAAP, the effects of these factors on the fair value of the derivative instruments (but not on the underlying hedged item) tend to show more volatility in the short term. While our presentation of our results on a Core Earnings basis provides important information regarding the performance of our Managed portfolio, a limitation of this presentation is that we are presenting the ongoing spread income on loans that have been sold to a trust managed by us. While we believe that our Core Earnings presentation presents the economic substance of our Managed loan portfolio, it understates earnings volatility from securitization gains. Our Core Earnings results exclude certain Floor Income, which is real cash income, from our reported results and therefore may understate earnings in certain periods. Managements financial planning and valuation of operating results, however, does not take into account Floor Income because of its inherent uncertainty, except when it is economically hedged through Floor Income Contracts.
Our Core Earnings are the primary financial performance measures used by management to evaluate performance and to allocate resources. Accordingly, financial information is reported to management on a Core Earnings basis by reportable segment, as these are the measures used regularly by our chief operating decision makers. Our Core Earnings are used in developing our financial plans and tracking results, and also in establishing corporate performance targets and incentive compensation. Management believes this information provides additional insight into the financial performance of the Companys core business activities. Core Earnings net income reflects only current period adjustments to GAAP net income, as described in the more detailed discussion of the differences between Core Earnings and GAAP that follows, which includes further detail on each specific adjustment required to reconcile our Core Earnings segment presentation to our GAAP earnings.
1) Securitization Accounting: Under GAAP, certain securitization transactions in our Lending operating segment are accounted for as sales of assets. Under Core Earnings for the Lending operating segment, we present all securitization transactions on a Core Earnings basis as long-term non-recourse financings. The upfront gains on sale from securitization transactions, as well as ongoing servicing and securitization revenue presented in accordance with GAAP, are excluded from Core Earnings and are replaced by interest income, provisions for loan losses, and interest expense as earned or incurred on the securitization loans. We also exclude transactions with our off-balance sheet trusts from Core Earnings as they are considered intercompany transactions on a Core Earnings basis.
The following table summarizes Core Earnings securitization adjustments for the Lending operating segment for the years ended December 31, 2008, 2007 and 2006.
Intercompany transactions with off-balance sheet trusts in the above table relate primarily to losses that result from the repurchase of delinquent loans from our off-balance sheet securitization trusts. When Private Education Loans in our securitization trusts settling before September 30, 2005 became 180 days delinquent, we previously exercised our contingent call option to repurchase these loans at par value out of the trust and recorded a loss for the difference in the par value paid and the fair market value of the loan at the time of purchase. We do not hold the contingent call option for any trusts settled after September 30, 2005. In October 2008, the Company decided to no longer exercise its contingent call option.
2) Derivative Accounting: Core Earnings exclude periodic unrealized gains and losses that are caused primarily by the one-sided mark-to-market derivative valuations prescribed by SFAS No. 133 on derivatives that do not qualify for hedge treatment under GAAP. These unrealized gains and losses occur in our Lending operating segment, and occurred in our Corporate and Other reportable segment related to equity forward contracts prior to 2008. In our Core Earnings presentation, we recognize the economic effect of these hedges, which generally results in any cash paid or received being recognized ratably as an expense or revenue over the hedged items life. Core Earnings also exclude the gain or loss on equity forward contracts that under SFAS No. 133, are required to be accounted for as derivatives and are marked-to-market through earnings.
SFAS No. 133 requires that changes in the fair value of derivative instruments be recognized currently in earnings unless specific hedge accounting criteria, as specified by SFAS No. 133, are met. We believe that our derivatives are effective economic hedges, and as such, are a critical element of our interest rate risk management strategy. However, some of our derivatives, primarily Floor Income Contracts, certain basis swaps and equity forward contracts (discussed in detail below), do not qualify for hedge treatment as defined by SFAS No. 133, and the stand-alone derivative must be marked-to-market in the income statement with no consideration for the corresponding change in fair value of the hedged item. The gains and losses described in Gains (losses) on derivative and hedging activities, net are primarily caused by interest rate and foreign currency exchange rate volatility, changing credit spreads and changes in our stock price during the period as well as the volume and term of derivatives not receiving hedge treatment.
Our Floor Income Contracts are written options that must meet more stringent requirements than other hedging relationships to achieve hedge effectiveness under SFAS No. 133. Specifically, our Floor Income Contracts do not qualify for hedge accounting treatment because the pay down of principal of the student loans underlying the Floor Income embedded in those student loans does not exactly match the change in the notional amount of our written Floor Income Contracts. Under SFAS No. 133, the upfront payment is deemed
a liability and changes in fair value are recorded through income throughout the life of the contract. The change in the value of Floor Income Contracts is primarily caused by changing interest rates that cause the amount of Floor Income earned on the underlying student loans and paid to the counterparties to vary. This is economically offset by the change in value of the student loan portfolio, including our Retained Interests, earning Floor Income but that offsetting change in value is not recognized under SFAS No. 133. We believe the Floor Income Contracts are economic hedges because they effectively fix the amount of Floor Income earned over the contract period, thus eliminating the timing and uncertainty that changes in interest rates can have on Floor Income for that period. Prior to SFAS No. 133, we accounted for Floor Income Contracts as hedges and amortized the upfront cash compensation ratably over the lives of the contracts.
Basis swaps are used to convert floating rate debt from one floating interest rate index to another to better match the interest rate characteristics of the assets financed by that debt. We primarily use basis swaps to change the index of our floating rate debt to better match the cash flows of our student loan assets that are primarily indexed to a commercial paper, Prime or Treasury bill index. In addition, we use basis swaps to convert debt indexed to the Consumer Price Index to three-month LIBOR debt. SFAS No. 133 requires that when using basis swaps, the change in the cash flows of the hedge effectively offset both the change in the cash flows of the asset and the change in the cash flows of the liability. Our basis swaps hedge variable interest rate risk; however, they generally do not meet this effectiveness test because the index of the swap does not exactly match the index of the hedged assets as required by SFAS No. 133. Additionally, some of our FFELP loans can earn at either a variable or a fixed interest rate depending on market interest rates. We also have basis swaps that do not meet the SFAS No. 133 effectiveness test that economically hedge off-balance sheet instruments. As a result, under GAAP these swaps are recorded at fair value with changes in fair value reflected currently in the income statement.
Under SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, equity forward contracts that allow a net settlement option either in cash or the Companys stock are required to be accounted for as derivatives in accordance with SFAS No. 133. As a result, we account for our equity forward contracts as derivatives in accordance with SFAS No. 133 and mark them to market through earnings. They do not qualify as effective SFAS No. 133 hedges, as a requirement to achieve hedge accounting is the hedged item must impact net income and the settlement of these contracts through the purchase of our own stock does not impact net income. The Company settled all of its equity forward contracts in January 2008.
The table below quantifies the adjustments for derivative accounting under SFAS No. 133 on our net income for the years ended December 31, 2008, 2007 and 2006 when compared with the accounting principles employed in all years prior to the SFAS No. 133 implementation.
Reclassification of Realized Gains (Losses) on Derivative and Hedging Activities
SFAS No. 133 requires net settlement income/expense on derivatives and realized gains/losses related to derivative dispositions (collectively referred to as realized gains (losses) on derivative and hedging activities) that do not qualify as hedges under SFAS No. 133 to be recorded in a separate income statement line item below net interest income. The table below summarizes the realized losses on derivative and hedging activities, and the associated reclassification on a Core Earnings basis for the years ended December 31, 2008, 2007 and 2006.
Unrealized gains and losses on Floor Income Contracts are primarily caused by changes in interest rates. In general, an increase in interest rates results in an unrealized gain and vice versa. Unrealized gains and losses on equity forward contracts fluctuate with changes in the Companys stock price. Unrealized gains and losses on basis swaps result from changes in the spread between indices and on changes in the forward interest rate curves that impact basis swaps hedging repricing risk between quarterly reset debt and daily reset assets. Other unrealized gains are primarily the result of ineffectiveness on cross-currency interest rate swaps hedging foreign currency denominated debt related to differences between forward and spot foreign currency exchange rates.
3) Floor Income: The timing and amount (if any) of Floor Income earned in our Lending operating segment is uncertain and in excess of expected spreads. Therefore, we exclude such income from Core Earnings when it is not economically hedged. We employ derivatives, primarily Floor Income Contracts and futures, to economically hedge Floor Income. As discussed above in Derivative Accounting, these derivatives do not qualify as effective accounting hedges, and therefore, under GAAP, they are marked-to-market through the gains (losses) on derivative and hedging activities, net line in the consolidated statement of income with no offsetting gain or loss recorded for the economically hedged items. For Core Earnings, we reverse the
fair value adjustments on the Floor Income Contracts and futures economically hedging Floor Income and include the amortization of net premiums received in income.
The following table summarizes the Floor Income adjustments in our Lending operating segment for the years ended December 31, 2008, 2007 and 2006.
4) Acquired Intangibles: Our Core Earnings exclude goodwill and intangible impairment and the amortization of acquired intangibles. These amounts totaled $91 million, $112 million and $94 million, respectively, for the years ended December 31, 2008, 2007 and 2006. As discussed in ASSET PERFORMANCE GROUP BUSINESS SEGMENT, the Company decided to wind down its purchased paper businesses. This decision resulted in $36 million of impairment of intangible assets for the year ended December 31, 2008, of which $28 million related to the impairment of two trade names and $8 million related to certain banking customer relationships. In 2007, we recognized impairments related principally to our mortgage origination and mortgage purchased paper businesses including approximately $20 million of goodwill and $10 million of value attributable to certain banking relationships. In connection with our acquisition of Southwest Student Services Corporation and Washington Transferee Corporation, we acquired certain tax exempt bonds that enabled us to earn a 9.5 percent SAP rate on student loans funded by those bonds in indentured trusts. In 2007 and 2006, we recognized intangible impairments of $9 million and $21 million, respectively, due to changes in projected interest rates used to initially value the intangible asset and to a regulatory change that restricts the loans on which we are entitled to earn a 9.5 percent yield.
In our Lending business segment, we originate and acquire federally guaranteed student loans and Private Education Loans, which are not federally guaranteed. Typically a Private Education Loan is made in conjunction with a FFELP Stafford loan and as a result is marketed through the same marketing channels as FFELP loans. While FFELP loans and Private Education Loans have different overall risk profiles due to the federal guarantee of the FFELP loans, they currently share many of the same characteristics such as similar repayment terms, the same marketing channel and sales force, and are originated and serviced on the same servicing platform. Finally, where possible, the borrower receives a single bill for both FFELP and Private Education Loans.
An overview of this segment and recent developments that have significantly impacted this segment are included in the Item 1. Business, section of this document.
The following table summarizes the Core Earnings results of operations for our Lending business segment.
Changes in net interest income are primarily due to fluctuations in the student loan and other asset spread discussed below, the growth of our student loan portfolio, and changes in the level of cash and investments we hold on our balance sheet for liquidity purposes.
Average Balance Sheets On-Balance Sheet
The following table reflects the rates earned on interest-earning assets and paid on interest-bearing liabilities for the years ended December 31, 2008, 2007 and 2006. This table reflects the net interest margin for the entire Company for our on-balance sheet assets. It is included in the Lending business segment discussion because the Lending business segment includes substantially all interest-earning assets and interest-bearing liabilities.
The following rate/volume analysis shows the relative contribution of changes in interest rates and asset volumes.
The following table reflects the net interest margin of on-balance sheet interest-earning assets, before provisions for loan losses. (Certain percentages do not add or subtract down as they are based on average balances.)
The student loan spread is impacted by changes in its various components, as reflected in footnote (2) to the Net Interest Margin On-Balance Sheet table above. Gross Floor Income is impacted by interest rates and the percentage of the FFELP portfolio eligible to earn Floor Income. The spread impact from Consolidation Loan Rebate Fees fluctuates as a function of the percentage of FFELP Consolidation Loans on our balance sheet. Repayment Borrower Benefits are generally impacted by the terms of the Repayment Borrower Benefits being offered as well as the payment behavior of the underlying loans. Premium and discount amortization is generally impacted by the prices previously paid for loans and amounts capitalized related to such purchases or originations. Premium and discount amortization is also impacted by prepayment behavior of the underlying loans.
The student loan spread, before 2008 Asset-Backed Financing Facilities fees, for 2008 decreased 16 basis points from the prior year. The decrease was primarily due to an increase in our cost of funds, which was partially offset by an increase in Floor Income due to a decrease in interest rates in 2008 compared to 2007. The cost of funds for on-balance sheet student loans excludes the impact of basis swaps that are intended to economically hedge the re-pricing and basis mismatch between our funding and student loan asset indices; these swaps do not receive hedge accounting treatment under SFAS No. 133. We extensively use basis swaps to manage our basis risk associated with our interest rate sensitive assets and liabilities. These swaps generally do not qualify as accounting hedges, and as a result, are required to be accounted for in the gains (losses) on derivatives and hedging activities, net line on the income statement, as opposed to being accounted for in interest expense. As a result, these basis swaps are not considered in the calculation of the cost of funds in the table above and therefore, in times of volatile movements of interest rates like those experienced in 2008, the student loan spread can significantly change. See Core Earnings Net Interest Margin in the following table, which reflects these basis swaps in interest expense and demonstrates the economic hedge effectiveness of these basis swaps.
The decrease in our student loan spread, before the 2008 Asset-Backed Financing Facilities fees, for 2007 versus 2006 was primarily due to an increase in our cost of funds. The increase in the cost of funds is due to the same reason discussed above related to 2008. See Core Earnings Net Interest Margin Core Earnings Basis Student Loan Spread, which reflects these basis swaps in interest expense, and demonstrates the economic hedge effectiveness of these basis swaps. The decrease in the student loan spread was also due to an increase in the estimate of uncollectible accrued interest related to our Private Education Loans (see Core Earnings Net Interest Margin Core Earnings Basis Student Loan Spread).
The other asset spread is generated from cash and investments (both restricted and unrestricted) primarily in our liquidity portfolio and other loans. The Company invests its liquidity portfolio primarily in short-term securities with maturities of one week or less in order to manage counterparty credit risk and maintain available cash balances. The other asset spread decreased 11 basis points from 2007 to 2008, and decreased 43 basis points from 2006 to 2007. Changes in the other asset spread primarily relate to differences in the index basis and reset frequency between the asset indices and funding indices. A portion of this risk is hedged with derivatives that do not receive hedge accounting treatment under SFAS No. 133 and will impact the other asset spread in a similar fashion as the impact to the on-balance sheet student loan spread as discussed above. In volatile interest rate environments, these spreads may move significantly from period to period and differ from the Core Earnings basis other asset spread discussed below.
The net interest margin, before 2008 Asset-Backed Financing Facilities fees, for 2008 decreased 9 basis points from the year-ago period and decreased 27 basis points from 2006 to 2007. The increase in the student loan portfolio as a percentage of the overall interest-earning asset portfolio from 2007 to 2008 resulted in an increase to net interest margin of 7 basis points due to the student loan portfolio earning a higher spread than the other asset portfolio. A decrease of 16 basis points relates primarily to the previous discussions of changes
in the on-balance sheet student loan and other asset spreads. The student loan portfolio as a percentage of the overall interest earning asset portfolio did not change substantially from 2006 to 2007. The decrease in spread from 2006 to 2007 primarily related to the previously discussed changes in the on-balance sheet student loan and other asset spreads.
The 2008 Asset-Backed Financing Facilities closed on February 29, 2008. Amortization of the upfront commitment and liquidity fees began on that date.
The following table analyzes the earnings from our portfolio of Managed interest-earning assets on a Core Earnings basis (see BUSINESS SEGMENTS Limitations of Core Earnings Pre-tax Differences between Core Earnings and GAAP by Business Segment). The Core Earnings Net Interest Margin presentation and certain components used in the calculation differ from the Net Interest Margin On-Balance Sheet presentation. The Core Earnings presentation, when compared to our on-balance sheet presentation, is different in that it:
The following table reflects the Core Earnings net interest margin, before provisions for loan losses. (Certain percentages do not add or subtract down as they are based on average balances.)
The Core Earnings basis student loan spread, before the 2008 Asset Backed Financing Facilities fees, for 2008 decreased 4 basis points from the prior year which was primarily due to an increase in the Companys cost of funds. The increase in the Companys cost of funds was due to an increase in the credit spreads on the Companys debt issued during the past year due to the current credit environment. These decreases to the student loan spread were partially offset by the growth in the Private Education Loan portfolio which earns a higher margin than FFELP.
The Core Earnings basis student loan spread, before the 2008 Asset-Backed Financing Facilities fees, for 2007 decreased 17 basis points from the prior year primarily due to the interest income reserve on our Private Education loans. We estimate the amount of Private Education Loan accrued interest on our balance sheet that is not reasonably expected to be collected in the future using a methodology consistent with the
status-based migration analysis used for the allowance for Private Education Loans. We use this estimate to offset accrued interest in the current period through a charge to student loan interest income. As our provision for loan losses increased significantly in 2007 compared to 2006, we had a similar rise in the estimate of uncollectible accrued interest receivable. The Company also experienced a higher cost of funds in 2007 primarily due to the disruption in the credit markets, as previously discussed.
The Core Earnings basis FFELP loan spread for 2008 declined from 2007 and 2006 primarily as a result of the increase in the cost of funds previously discussed, as well as the mix of the FFELP portfolio shifting towards loans originated subsequent to October 1, 2007 which have lower yields as a result of the CCRAA. The Core Earnings basis Private Education Loan spread before provision for loan losses for 2008 was relatively consistent with 2007 and 2006. The changes in the Core Earnings basis Private Education Loan spread after provision for loan losses for all periods presented was primarily due to the timing and amount of provision associated with our allowance for Private Education Loan Losses as discussed below (see Private Education Loan Losses Activity in the Allowance for Private Education Loan Losses).
The Core Earnings basis other asset spread is generated from cash and investments (both restricted and unrestricted) primarily in our liquidity portfolio, and other loans. The Company invests its liquidity portfolio primarily in short-term securities with maturities of one week or less in order to manage counterparty credit risk and maintain available cash balances. The Core Earnings basis other asset spread for 2008 decreased 40 basis points from 2007. The 2007 spread decreased by 41 basis points from 2006. Changes in this spread primarily relate to differences between the index basis and reset frequency of the asset indices and funding indices. In volatile interest rate environments, the asset and debt reset frequencies will lag each other. Changes in this spread are also a result of the increase in our cost of funds as previously discussed.
The Core Earnings net interest margin, before 2008 Asset-Backed Financing Facilities fees, for 2008 was unchanged from the prior year and decreased 20 basis points from 2006 to 2007. The increase in the Managed student loan portfolio as a percentage of the overall Managed interest-earning asset portfolio from 2007 to 2008 resulted in an increase to Core Earnings net interest margin of 6 basis points due to the Managed student loan portfolio earning a higher spread than the Managed other interest-earning asset portfolio. This was offset by a decrease of 6 basis points primarily due to the previously discussed changes in the student loan and other asset spreads. The student loan portfolio as a percentage of the overall interest earning asset portfolio did not change substantially from 2006 to 2007. The decrease in spread from 2006 to 2007 primarily related to the previously discussed changes in the on-balance sheet student loan and other asset spreads.
The 2008 Asset-Backed Financing Facilities closed on February 29, 2008. Amortization of the upfront commitment and liquidity fees began on that date.
The following tables summarize the components of our Managed student loan portfolio and show the changing composition of our portfolio.
Ending Managed Student Loan Balances, net
Student Loan Average Balances (net of unamortized premium/discount)
The following tables summarize the components of our Managed student loan portfolio and show the changing composition of our portfolio.