SLM CORP 10-Q 2005
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Commission File Number: 001-13251
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 ý No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes ý No o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No ý
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date:
Listed below are definitions of key terms that are used throughout this document.
Consolidation LoansUnder both the FFELP and FDLP, borrowers with eligible student loans may consolidate them into one note with one lender and convert the variable interest rates on the loans being consolidated into a fixed rate for the life of the loan. The new note is considered a Consolidation Loan. Typically a borrower can consolidate their student loans only once unless the borrower has another eligible loan to consolidate with the existing Consolidation Loan. FFELP Consolidation Loan borrowers can reconsolidate their FFELP Consolidation Loan into a FDLP Consolidation Loan. The borrower rate on a Consolidation Loan is fixed for the term of the loan and is set by the weighted-average interest rate of the loans being consolidated, rounded up to the nearest 1/8th of a percent, not to exceed 8.25 percent. In low interest rate environments, Consolidation Loans provide an attractive refinancing opportunity to certain borrowers because they allow borrowers to consolidate variable rate loans into a long-term fixed rate loan. Holders of Consolidation Loans are eligible to earn interest under the Special Allowance Payment ("SAP") formula (see definition below).
Consolidation Loan Rebate FeeAll holders of Consolidation Loans are required to pay to the U.S. Department of Education ("ED") an annual 105 basis point Consolidation Loan Rebate Fee on all outstanding principal and accrued interest balances of Consolidation Loans purchased or originated after October 1, 1993, except for loans for which consolidation applications were received between October 1, 1998 and January 31, 1999, where the Consolidation Loan Rebate Fee is 62 basis points.
Constant Prepayment Rate ("CPR")A variable in life of loan estimates that measures the rate at which loans in the portfolio pay before their stated maturity. The CPR is directly correlated to the average life of the portfolio. CPR equals the percentage of loans that prepay annually as a percentage of the beginning of period balance.
Direct LoansStudent loans originated directly by ED under the William D. Ford Federal Direct Student Loan Program ("FDLP").
EDThe U.S. Department of Education.
Embedded Fixed Rate/Variable Rate Floor IncomeEmbedded Floor Income is Floor Income (see definition below) that is earned on off-balance sheet student loans that are in securitization trusts sponsored by us. At the time of the securitization, the option value of Embedded Fixed Rate Floor Income is included in the initial valuation of the Residual Interest (see definition below) and the gain or loss on sale of the student loans. Embedded Floor Income is also included in the quarterly fair value adjustments of the Residual Interest.
Exceptional Performer ("EP") DesignationThe EP designation is determined by ED in recognition of a servicer meeting certain performance standards set by ED in servicing FFELP (see definition below) loans. Upon receiving the EP designation, the EP servicer receives 100 percent reimbursement on default claims on federally guaranteed student loans for all loans serviced for a period of at least 270 days before the date of default and will no longer be subject to the two percent Risk Sharing (see definition below) on these loans. The EP servicer is entitled to receive this benefit as long as it remains in compliance with the required servicing standards, which are assessed on an annual and quarterly basis through compliance audits and other criteria. The annual assessment is in part based upon subjective factors which alone may form the basis for an ED determination to withdraw the designation. If the designation is withdrawn, the two percent Risk Sharing may be applied retroactively to the date of the occurrence that resulted in noncompliance.
FDLPThe William D. Ford Federal Direct Student Loan Program.
FFELPThe Federal Family Education Loan Program, formerly the Guaranteed Student Loan Program.
FFELP Stafford and Other Student LoansEducation loans to students or parents of students that are guaranteed or reinsured under the FFELP. The loans are primarily Stafford loans and also PLUS and HEAL loans.
Fixed Rate Floor IncomeWe refer to Floor Income (see definition below) associated with student loans whose borrower rate is fixed to term (primarily Consolidation Loans) as Fixed Rate Floor Income.
Floor IncomeOur portfolio of FFELP student loans earns interest at the higher of a floating rate based on the Special Allowance Payment or SAP formula (see definition below) set by ED and the borrower rate, which is fixed over a period of time. We generally finance our student loan portfolio with floating rate debt over all interest rate levels. In low and/or declining interest rate environments, when the fixed borrower rate is higher than the rate produced by the SAP formula, our student loans earn at a fixed rate while the interest on our floating rate debt continues to decline. In these interest rate environments, we earn additional spread income that we refer to as Floor Income. Depending on the type of the student loan and when it was originated, the borrower rate is either fixed to term or is reset to a market rate each July 1. As a result, for loans where the borrower rate is fixed to term, we may earn Floor Income for an extended period of time, and for those loans where the borrower interest rate is reset annually on July 1, we may earn Floor Income to the next reset date.
The following example shows the mechanics of Floor Income for a typical fixed rate Consolidation Loan originated after July 1, 2004 (with a commercial paper-based SAP spread of 2.64 percent):
Based on this example, if the quarterly average commercial paper rate is over 2.735 percent, the holder of the student loan will earn at a floating rate based on the SAP formula, which in this example is a fixed spread to commercial paper of 2.64 percent. On the other hand, if the quarterly average commercial paper rate is below 2.735 percent, the SAP formula will produce a rate below the fixed borrower rate of 5.375 percent and the loan holder earns at the borrower rate of 5.375 percent. The difference between the fixed borrower rate and the lender's expected yield based on the SAP formula is referred to as Floor Income. Our student loan assets are generally funded with floating rate debt, so when student loans are earning at the fixed borrower rate, decreases in interest rates may increase Floor Income.
Graphic Depiction of Floor Income:
Floor Income ContractsWe enter into contracts with counterparties under which, in exchange for an upfront fee representing the present value of the Floor Income that we expect to earn on a notional amount of underlying student loans being hedged, we will pay the counterparties the Floor Income earned on that notional amount over the life of the Floor Income Contract. Specifically, we agree to pay the counterparty the difference, if positive, between the fixed borrower rate less the SAP (see definition below) spread and the average of the applicable interest rate index on that notional amount, regardless of the actual balance of underlying student loans, over the life of the contract. The contracts generally do not extend over the life of the underlying student loans. This contract effectively locks in the amount of Floor Income we will earn over the period of the contract. Floor Income Contracts are not considered effective hedges under Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities," and each quarter we must record the change in fair value of these contracts through income.
GSEThe Student Loan Marketing Association was a federally chartered government-sponsored enterprise and wholly owned subsidiary of SLM Corporation that was dissolved under the terms of the Privatization Act (see definition below) on December 29, 2004.
HEAThe Higher Education Act of 1965, as amended.
Managed BasisWe generally analyze the performance of our student loan portfolio on a Managed Basis, under which we view both on-balance sheet student loans and off-balance sheet student loans owned by the securitization trusts as a single portfolio, and the related on-balance sheet financings are combined with off-balance sheet debt. When the term Managed is capitalized in this document, it is referring to Managed Basis.
Offset FeeWe were required to pay to ED an annual 30 basis point Offset Fee on the outstanding balance of Stafford and PLUS student loans purchased and held by the GSE after August 10, 1993. The fee did not apply to student loans sold to securitized trusts or to loans held outside of the GSE. This fee no longer applies, as the GSE was dissolved under the terms of the Privatization Act on December 29, 2004.
Preferred Channel OriginationsPreferred Channel Originations are comprised of: 1) student loans that are originated by lenders with forward purchase commitment agreements with Sallie Mae and are committed for sale to Sallie Mae, such that we either own them from inception or acquire them soon after origination, and 2) loans that are originated by internally marketed Sallie Mae brands.
Preferred Lender ListTo streamline the student loan process, most higher education institutions select a small number of lenders to recommend to their students and parents. This recommended list is referred to as the Preferred Lender List.
Private Education Loans (formerly referred to as "Private Credit Student Loans")Education loans to students or parents of students that are not guaranteed or reinsured under the FFELP or any other federal student loan program. Private Education Loans include loans for traditional higher education, undergraduate and graduate degrees, and for alternative education, such as career training, private kindergarten through secondary education schools and tutorial schools. Traditional higher education loans have repayment terms similar to FFELP loans, whereby repayments begin after the borrower leaves school. Repayment for alternative education or career training loans begins immediately.
Privatization ActThe Student Loan Marketing Association Reorganization Act of 1996.
Residual InterestWhen we securitize student loans, we retain the right to receive cash flows from the student loans sold to trusts we sponsor in excess of amounts needed to pay servicing, derivative costs (if any), other fees, and the principal and interest on the bonds backed by the student loans. The Residual Interest (which may also include reserve and other cash accounts), is the present value of these future expected cash flows, which includes the present value of Embedded Fixed Rate Floor Income described above. We value the Residual Interest at the time of sale of the student loans to the trust and at the end of each subsequent quarter.
Retained InterestThe Retained Interest includes the Residual Interest (defined above) and servicing rights (as the Company retains the servicing responsibilities).
Risk SharingWhen a FFELP loan defaults, the federal government guarantees 98 percent of the principal balance plus accrued interest and the holder of the loan generally must absorb the two percent not guaranteed as a Risk Sharing loss on the loan. FFELP student loans acquired after October 1, 1993 are subject to Risk Sharing on loan default claim payments unless the default results from the borrower's death, disability or bankruptcy. FFELP loans serviced by a servicer that has EP designation from ED are not subject to Risk Sharing.
Special Allowance Payment ("SAP")FFELP student loans generally earn interest at the greater of the borrower rate or a floating rate determined by reference to the average of the applicable floating rates (91-day Treasury bill rate or commercial paper) in a calendar quarter, plus a fixed spread that is dependent upon when the loan was originated and the loan's repayment status. If the resulting floating rate exceeds the borrower rate, ED pays the difference directly to us. This payment is referred to as the Special Allowance Payment or SAP and the formula used to determine the floating rate is the SAP formula. We refer to the fixed spread to the underlying index as the SAP spread.
Title IV Programs and Title IV LoansStudent loan programs created under Title IV of the HEA, including the FFELP and the FDLP, and student loans originated under those programs, respectively.
Wind-DownThe dissolution of the GSE under the terms of the Privatization Act (see definition above).
Variable Rate Floor IncomeFor FFELP Stafford student loans whose borrower interest rate resets annually on July 1, we may earn Floor Income or Embedded Floor Income (see definitions above) based on a calculation of the difference between the borrower rate and the then current interest rate. We refer to this as Variable Rate Floor Income because Floor Income is earned only through the next reset date.
Item 1. Financial Statements
See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements.
1. Significant Accounting Policies
Basis of Presentation
The accompanying unaudited, consolidated financial statements of SLM Corporation (the "Company") have been prepared in accordance with generally accepted accounting principles in the United States of America ("GAAP") for interim financial information. Accordingly, they do not include all of the information and footnotes required by GAAP for complete consolidated financial statements. In the opinion of management, all adjustments considered necessary for a fair statement of the results for the interim periods have been included. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Operating results for the three and nine months ended September 30, 2005 are not necessarily indicative of the results for the year ending December 31, 2005. These unaudited financial statements should be read in conjunction with the audited financial statements and related notes included in the Company's 2004 Annual Report on Form 10-K.
Certain reclassifications have been made to the balances as of and for the three and nine months ended September 30, 2004 to be consistent with classifications adopted for 2005.
Recently Issued Accounting Pronouncements
In May 2005, the Financial Accounting Standards Board (the "FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 154, "Accounting Changes and Error Corrections," which is a replacement of Accounting Principles Board ("APB") Opinion No. 20, "Accounting Changes," and SFAS No. 3, "Reporting Accounting Changes in Interim Financial Statements." This statement changes the requirements for the accounting for and reporting of a change in accounting principle. This statement applies to all voluntary changes in accounting principle and applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. This statement requires retrospective application to prior periods' financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. When it is impracticable to determine the period-specific effects of an accounting change on one or more individual prior periods presented, this statement requires that the new accounting principle be applied to the balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable and that a corresponding adjustment be made to the opening balance of retained earnings for that period rather than being reported in an income statement. This statement is effective for accounting changes made in fiscal years beginning after December 15, 2005. The Company will adopt SFAS No. 154 on January 1, 2006. The Company expects that the adoption of SFAS No. 154 will not have a material impact on the Company's financial statements.
On December 16, 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment," which is a revision of SFAS No. 123, "Accounting for Stock-Based Compensation." Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. The new standard will be effective for public entities (excluding small business issuers) for the fiscal year beginning after June 15, 2005. SFAS No. 123(R) allows for two transition alternatives for public companies: (a) modified-prospective transition or (b) modified-retrospective transition. Management is still evaluating both methods, but has tentatively decided to apply the modified-retrospective transition alternative for all periods presented and will recognize compensation cost in the amounts previously reported in the pro forma footnote disclosure under the provisions of SFAS No. 123. Had the Company adopted SFAS No. 123(R) for the first nine months of 2005, its diluted earnings per share would have been $.06 lower, and going forward, the adoption of SFAS No. 123(R) should have a similar effect on diluted earnings per share. The Company plans to adopt SFAS No. 123(R) on January 1, 2006.
In December 2004, the Company adopted Emerging Issues Task Force ("EITF") Issue No. 04-8, "The Effect of Contingently Convertible Debt on Diluted Earnings per Share," which addresses the timing of the inclusion of the dilutive effect of contingently convertible debt instruments ("Co-Cos") in diluted earnings per share ("diluted EPS"). Co-Cos are generally convertible into the common shares of the issuer after the common stock share price exceeds a predetermined threshold for a specified time period, generally referred to as the market price trigger. EITF No. 04-8 requires the shares underlying the Co-Cos be included in diluted EPS computations regardless of whether the market price trigger or the conversion price has been met, using the "if-converted" accounting method. EITF No. 04-8 was effective for reporting periods ending after December 15, 2004 with retroactive restatement to all required reporting periods. As a result, the diluted EPS amounts have been retroactively restated for all prior periods presented to give effect to the application of EITF No. 04-8 as it relates to the Company's $2 billion Co-Cos issued in May 2003. The effect of the adoption of EITF No. 04-8 was to decrease diluted EPS, by $.04 and $.04 per share for the three months ended September 30, 2005 and 2004, respectively, and by $.08 and $.15 per share for the nine months ended September 30, 2005 and 2004, respectively. See Note 5, "Common Stock," for a more detailed calculation of the negative impact of the Co-Cos on diluted EPS.
The Company has elected to continue to follow the intrinsic value method of accounting as prescribed by APB Opinion No. 25, "Accounting for Stock Issued to Employees," to account for employee stock options (see "Recently Issued Accounting PronouncementsShare Based Payment" above). Under APB No. 25, the Company does not recognize compensation expense on fixed award plans unless the exercise price of its employee stock options is less than the market price of the
underlying stock on the date of grant. The Company grants all of its options at the fair market value of the underlying stock on the date of grant. Consequently, the Company has not recorded such expense in the periods presented.
The fair values for the options granted in the three and nine months ended September 30, 2005 and 2004 were estimated at the date of grant using a Black-Scholes option pricing model, with the following weighted average assumptions:
The following table summarizes pro forma disclosures for the three and nine months ended September 30, 2005 and 2004, as if the Company had accounted for employee and Board of Directors stock options granted subsequent to December 31, 1994 under the fair market value method as set forth in SFAS No. 123. The option value is amortized over an assumed vesting period of between one and three years depending on option type or to the actual date of vesting, whichever comes first.
2. Allowance for Student Loan Losses
The provisions for student loan losses represent the periodic expense of maintaining an allowance sufficient to absorb losses, net of recoveries, inherent in the student loan portfolios. The evaluation of the provisions for student loan losses is inherently subjective as it requires material estimates that may
be susceptible to significant changes. The Company believes that the allowance for student loan losses is adequate to cover probable losses in the student loan portfolios.
Third Quarter of 2005 Change in Recovery Methodology
The Company continues to gain experience in analyzing its Private Education Loan portfolios and as a result, it has developed additional data to better estimate the amount of recoveries on defaulted loans. During the third quarter of 2005, the Company changed its methodology for estimating the amount of charged-off student loans that will ultimately be recovered, which resulted in a $49 million reduction in the Company's allowance in the third quarter of 2005 to recognize the effect of this change.
Second Quarter of 2005 Change in Accounting Estimate
In the second quarter of 2005, the Company changed its estimate of the allowance for loan losses and the estimate of uncollectible accrued interest for its 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.
This is a widely used reserving methodology in the consumer finance industry. Previously, the Company calculated the allowance for Private Education Loan losses by estimating the probable losses in the portfolio based primarily on loan characteristics and where pools of loans were in their life with less emphasis on current delinquency status of the loan. Also, in the Company's prior methodology for calculating the allowance, some loss rates were based on proxies and extrapolations of FFELP loan loss data.
The Company also used a migration analysis to revise its estimates surrounding its non-accrual policy for interest income. Under the new methodology, the Company estimates the amount of uncollectible accrued interest on Private Education Loans and writes it off against current period interest income. Under its prior methodology, Private Education Loans continued to accrue interest, including in periods of forbearance, until they were charged off, at which time, the loans were placed on non-accrual status and all accrued interest was reversed against income in the month of charge-off.
This change in reserving methodology has been accounted for as a change in estimate in accordance with the FASB's APB Opinion No. 20, "Accounting Changes." The cumulative effect of this change to the second quarter of 2005 was to increase the value of the allowance by $40 million and to reduce student loan interest income for the estimate of uncollectible accrued interest receivable by $14 million. On the income statement, adjustments to the allowance are recorded through the provision for losses whereas adjustments to accrued interest are recorded in interest income.
The following table summarizes changes in the allowance for student loan losses for both the Private Education Loan and federally insured student loan portfolios for the three and nine months ended September 30, 2005 and 2004.
In addition to the provisions for student loan losses, provisions for losses on other Company loans totaled $3 million for both the three months ended September 30, 2005 and 2004, respectively, and $10 million and $7 million for the nine months ended September 30, 2005 and 2004, respectively.
The following table summarizes changes in the allowance for student loan losses for Private Education Loans for the three and nine months ended September 30, 2005 and 2004.
The table below presents the Company's Private Education Loan delinquency trends as of September 30, 2005 and 2004. Delinquencies have the potential to adversely impact earnings through increased servicing and collection costs in the event the delinquent accounts charge off.
3. Goodwill and Acquired Intangible Assets
Intangible assets include the following:
The Company recorded amortization of $16 million and $8 million for the three months ended September 30, 2005 and 2004, respectively, and $44 million and $22 million for the nine months ended September 30, 2005 and 2004, respectively.
A summary of changes in the Company's goodwill by reportable segment (see Note 9, "Segment Reporting") is as follows:
In the third quarter of 2005, the Company closed on the second step in a two step purchase of the secondary market and related businesses of Education Assistance Foundation ("EAF") and its affiliate, Student Loan Finance Association ("SLFA") and its subsidiaries, which were initially acquired on December 13, 2004. The initial purchase price for the second closing transaction was approximately $61 million, which resulted in an excess purchase price over the fair value of net assets acquired, or goodwill, of approximately $6 million.
On August 31, 2005, the Company acquired 100 percent of GRP Financial Services ("GRP"), a debt management company that acquires and manages portfolios of sub-performing and non-performing mortgage loans, substantially all of which are secured by one-to-four family residential real estate, for an initial purchase price of approximately $137 million including cash consideration and certain acquisition costs.
Acquisitions are accounted for under the purchase method of accounting as defined in SFAS No. 141, "Business Combinations." The Company allocates the purchase price to the fair value of the acquired tangible assets, liabilities and identifiable intangible assets as of the acquisition date as determined by an independent appraiser. Goodwill associated with the Company's acquisitions is reviewed for impairment in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets," addressed further in Note 2, "Significant Accounting Policies," within the Company's 2004 Annual Report on Form 10-K.
4. Student Loan Securitization
The Company securitizes its student loan assets and for transactions qualifying as sales retains a Residual Interest and servicing rights (as the Company retains the servicing responsibilities), all of which are referred to as the Company's Retained Interest in off-balance sheet securitized loans. 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. The investors of the securitization trusts have no recourse to the Company's other assets should there be a failure of the student loans to pay when due.
The following table summarizes the Company's securitization activity for the three and nine months ended September 30, 2005 and 2004. Those securitizations listed as sales are off-balance sheet transactions and those listed as financings remain on-balance sheet.
The increase in the gain as a percentage of the amount securitized for the 2005 Private Education Loan securitization versus the prior year's transaction is primarily impacted by higher earnings spreads on the mix of loans securitized, improved funding spreads, and a decrease in the Constant Prepayment Rate ("CPR") assumption used in the calculation of the gain on sale.
The table below presents the key assumptions used in estimating the fair value of Residual Interests at the date of securitization resulting from the student loan securitization sale transactions completed during the three and nine months ended September 30, 2005 and 2004.
The following table summarizes the fair value of the Company's Retained Interests along with the underlying off-balance sheet student loans that relate to those securitizations in transactions that were treated as sales.
The Company recorded $195 million and $61 million of impairment related to the Retained Interests for the nine months ended September 30, 2005 and 2004, respectively. These impairment charges were primarily the result of continued record levels of consolidation activity as well as the Company increasing its expected future CPR assumptions used to value the Residual Interest. FFELP Stafford loans prepaid faster than projected due to the record amount of Consolidation Loan applications received in the second quarter of 2005 that were processed through the Company's securitizations in the third quarter of 2005. This surge in Consolidation Loan activity in 2005 was due to FFELP Stafford borrowers locking in lower interest rates by consolidating their loans prior to the July 1 interest rate reset for FFELP Stafford loans. The level and timing of Consolidation Loan activity is highly volatile, and in response the Company continues to revise its estimate of the effects of Consolidation Loan activity on the Company's Retained Interests. The Company updated its FFELP Stafford CPR assumptions in the third quarter of 2005 as follows:
In 2004, the Company's Retained Interests were also impaired by the effect of higher market interest rates on the Embedded Floor Income. The impairments are recorded as a reduction in securitization revenue. The level and timing of Consolidation Loan activity remains highly volatile which may result in an additional impairment recorded in future periods if Consolidation Loan activity remains higher than projected.
In addition to student loans in off-balance sheet trusts, the Company had $38.9 billion and $31.5 billion of securitized student loans outstanding (face amount) as of September 30, 2005 and December 31, 2004, respectively, in on-balance sheet securitization trusts.
5. Common Stock
The following table summarizes the Company's common share repurchases, issuances and equity forward activity for the three and nine months ended September 30, 2005 and 2004.
As of September 30, 2005, the expiration dates and purchase prices for outstanding equity forward contracts were as follows:
The closing price of the Company's common stock on September 30, 2005 was $53.64.
Earnings per Share
Basic earnings per common share ("basic EPS") is calculated using the weighted average number of shares of common stock outstanding during each period. Diluted earnings per common share ("diluted EPS") reflect the potential dilutive effect of (i) additional common shares that are issuable upon exercise of outstanding stock options, deferred compensation, restricted stock units, and the outstanding commitment to issue shares under the Employee Stock Purchase Plan ("ESPP"), determined by the treasury stock method, (ii) the assumed conversion of convertible debentures, determined by the "if-converted" method, and (iii) equity forwards, determined by the reverse treasury stock method. Equity forwards are dilutive to EPS when the Company's average stock price is lower than the equity forward's strike price.
At September 30, 2005, the Company had $2 billion contingently convertible debentures ("Co-Cos") outstanding that are convertible, under certain conditions, into shares of SLM common stock at an initial conversion price of $65.98. The investors generally can only convert the debentures if the Company's common stock has appreciated for a prescribed period to 130 percent of the conversion price, which would amount to $85.77, or the Company calls the debentures. Per EITF No. 04-8, diluted EPS for all periods presented includes the potential dilutive effect of the Company's outstanding Co-Cos for the three and nine months ended September 30, 2005 and 2004. (See Note 1, "Significant Accounting PoliciesRecently Issued Accounting Pronouncements.")
A reconciliation of the numerators and denominators of the basic and diluted EPS calculations is as follows for the three and nine months ended September 30, 2005 and 2004:
6. Derivative Financial Instruments
Summary of Derivative Financial Statement Impact
The following tables summarize the fair values and notional amounts or number of contracts of all derivative instruments at September 30, 2005 and December 31, 2004 and their impact on other comprehensive income and earnings for the three and nine months ended September 30, 2005 and 2004. At September 30, 2005 and December 31, 2004, $572 million and $524 million (fair value),
respectively, of available-for-sale investment securities and $135 million and $222 million, respectively, of cash were pledged as collateral against these derivative instruments.
7. Pension Plans
Effective July 1, 2004, the Company's qualified and supplemental pension plans (the "Pension Plans") were frozen with respect to new entrants and participants with less than five years of service. Accordingly, at July 1, 2004, the Company recorded a net curtailment gain of $4.5 million. No further benefits will accrue with respect to such participants under the Pension Plans, other than interest accruals on cash balance accounts. These participants were fully vested as of June 30, 2004.
For those participants continuing to accrue benefits under the Pension Plans, benefits are credited using a cash balance formula. Under the formula, each participant has an account, for record keeping purposes only, to which credits are allocated each payroll period based on a percentage of the participant's compensation for the current pay period. The applicable percentage is determined by the participant's number of years of service with the Company. If an individual participated in the Company's prior pension plan as of September 30, 1999 and met certain age and service criteria, the participant ("grandfathered participant") will receive the greater of the benefits calculated under the prior plan, which uses a final average pay plan method, or the current plan under the cash balance formula.
Components of Net Periodic Pension Cost
Net periodic pension cost included the following components:
The Company previously disclosed in its financial statements for the year ended December 31, 2004 that it did not expect to contribute to its qualified pension plan (the "Qualified Plan") in 2005. As of September 30, 2005, the Company had made no contributions to its Qualified Plan.
The Company was named as a defendant in a putative class action lawsuit brought by three Wisconsin residents on December 20, 2001 in the Superior Court for the District of Columbia. The plaintiffs sought to represent a nationwide class action on behalf of all borrowers who allegedly paid
"undisclosed improper and excessive" late fees over the past three years. The plaintiffs sought damages of one thousand five hundred dollars per violation plus punitive damages and claimed that the class consisted of two million borrowers. In addition, the plaintiffs alleged that the Company charged excessive interest by capitalizing interest quarterly in violation of the promissory note. On February 27, 2003, the Superior Court granted the Company's motion to dismiss the complaint in its entirety. On March 4, 2004, the District of Columbia Court of Appeals affirmed the Superior Court's decision granting the Company's motion to dismiss the complaint, but granted plaintiffs leave to re-plead the first count, which alleged violations of the D.C. Consumer Protection Procedures Act. On September 15, 2004, the plaintiffs filed an amended class action complaint. On December 27, 2004, the Superior Court granted the Company's motion to dismiss the plaintiffs' amended compliant. Plaintiffs have appealed the Superior Court's December 27, 2004 dismissal order to the District of Columbia Court of Appeals. All appellate briefing has been completed. The Company believes that it will prevail on the merits of this case if it becomes necessary to further litigate this matter.
The Company is also subject to various claims, lawsuits and other actions that arise in the normal course of business. Most of these matters are claims by borrowers disputing the manner in which their loans have been processed or the accuracy of the Company's reports to credit bureaus. In addition, the collections subsidiaries in the Company's debt management operation group are named in individual plaintiff or class action lawsuits in which the plaintiffs allege that the Company has violated the Fair Debt Collection Practices Act or state law in the process of collecting their account. Management believes that these claims, lawsuits and other actions will not have a material adverse effect on its business, financial condition or results of operations.
9. Segment Reporting
The Company has two primary operating segments as defined in SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information"the Lending and Debt Management Operations ("DMO") segments. The Lending and DMO operating segments meet the quantitative thresholds for reportable segments identified in SFAS No. 131. Accordingly, the results of operations of the Company's Lending and DMO segments are presented below. The Company has smaller operating segments including the Guarantor Servicing and Student Loan Servicing operating segments as well as certain other products and services provided to colleges and universities which do not meet the quantitative thresholds identified in SFAS No. 131. Therefore, the results of operations for these operating segments and the revenues and expenses associated with these other products and services are combined with corporate overhead and other corporate activities within the Corporate and Other reporting segment.
The management reporting process measures the performance of the Company's operating segments based on the management structure of the Company as well as the methodology used by management to evaluate performance and allocate resources. Management, including the Company's chief operating decision maker, evaluates the performance of the Company's operating segments based on their profitability. As discussed further below, management measures the profitability of the Company's operating segments based on "core earnings." Accordingly, information regarding the Company's reportable segments is provided based on "core earnings." The Company's "core earnings"
are not defined terms within GAAP and may not be comparable to similarly titled measures reported by other companies. "Core earnings" reflect only current period adjustments to GAAP as described below. Unlike financial accounting, there is no comprehensive, authoritative guidance for management reporting. The management reporting process measures the performance of the operating segments based on the management structure of the Company and is not necessarily comparable with similar information for any other financial institution. The Company's operating segments are defined by the products and services they offer or the types of customers they serve, and they reflect the manner in which financial information is currently evaluated by management. 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.
The Company's principal operations are located in the United States, and its results of operations and long-lived assets in geographic regions outside of the United States are not significant. In the Lending segment, no individual customer accounted for more than ten percent of its total revenue during the three months and nine months ended September 30, 2005 and 2004. United Student Aid Funds, Inc. ("USA Funds") is the Company's largest customer in both the DMO and Corporate and Other segments. During the three months ending September 30, 2005 and 2004, it accounted for 42 percent and 45 percent, respectively, of the aggregate revenues generated by the Company's DMO and Corporate and Other segments. During the nine months ending September 30, 2005 and 2004, USA Funds accounted for 38 percent and 47 percent, respectively, of the aggregate revenues generated by the Company's DMO and Corporate and Other segments. No other customers accounted for more than ten percent of total revenues in those segments for the years mentioned.
In the Company's Lending business segment, the Company originates and acquires both federally guaranteed student loans, which are administered by ED, and Private Education Loans, which are not federally guaranteed. Private Education Loans are primarily used by borrowers to supplement FFELP loans to meet the rising cost of education. The Company manages student loans for over 8 million borrowers totaling $120.6 billion at September 30, 2005, of which $105.2 billion or 87 percent are federally insured. In addition to education lending, the Company also originates mortgage and consumer loans with the intent of selling the majority of such loans. During the three and nine months ended September 30, 2005, the Company originated $602 million and $1.5 billion, respectively, in mortgage and consumer loans and its mortgage and consumer loan portfolio totaled $603 million at September 30, 2005, of which $259 million pertained to mortgages in the held for sale portfolio.
The Company provides a wide range of accounts receivable and collections services through six operating units that comprise its DMO operating segment. These services include defaulted student loan portfolio management services, contingency collections services for student loans and other asset classes, student loan default aversion services, and accounts receivable management and investment in purchased portfolios of receivables that have been charged off by their original creditors. The
Company's DMO operating segment primarily serves the student loan marketplace through a broad array of default management services on a contingency fee or other pay for performance basis to ten FFELP guarantors and for campus based programs.
In addition to collecting on its own purchased receivables, the DMO operating segment purchases charged-off debt. The DMO operating segment provides receivable management and collection services for large federal agencies, credit card clients and other holders of consumer debt.
Corporate and Other
The Company's Corporate and Other business segment includes the aggregate activity of its smaller operating segments including its Guarantor Servicing and Loan Servicing business segments, other products and services as well as corporate overhead.
The tables below include the condensed operating results for each of the Company's reportable segments. Management, including the "chief operating decision maker," evaluates the Company on certain non-GAAP performance measures that the Company refers to as "core earnings" for each business segment. While "core earnings" are not a substitute for reported results under GAAP, the Company relies on "core earnings" in operating each business segment because it believes these measures provide additional information regarding the operational and performance indicators that are most closely assessed by management.
"Core earnings" are the primary financial performance measures used by management to develop the Company's financial plans, track results, and establish corporate performance targets and incentive compensation. Management believes this information provides additional insight into the financial performance of the core business activities of its operating segments. Accordingly, the tables presented below reflect "core earnings" operating measures reviewed and utilized by management to manage the business. Reconciliation of the segment totals to the Company's consolidated operating results in accordance with GAAP are also included in the tables below.
Segment Results and Reconciliations to GAAP
The adjustments required to reconcile from the Company's segment totals to its GAAP results of operations relate to differing treatments for securitization transactions, derivatives, Floor Income related to the Company's student loans, and certain other items that management does not consider in evaluating the Company's operating results. The following table reflects aggregate adjustments associated with these areas for the three and nine months ended September 30, 2005 and 2004.
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
FORWARD-LOOKING AND CAUTIONARY STATEMENTS
Some of the statements contained in this quarterly report discuss future expectations and business strategies or include other "forward-looking" information. Those statements are subject to known and unknown risks, uncertainties and other factors that could cause the actual results to differ materially from those contemplated by the statements. The forward-looking information is based on various factors and was derived using numerous assumptions. We undertake no obligation to publicly update or revise any forward-looking statements.
We are the largest source of funding, delivery and servicing support for education loans in the United States. Our primary business is to originate, acquire and hold both federally guaranteed student loans and Private Education Loans, which are not federally guaranteed. The primary source of our earnings is from net interest income earned on those student loans as well as gains on the sales of them in securitization transactions. We also earn fees for pre-default and post-default receivables management services on student loans, such that we are engaged in every phase of the student loan life cyclefrom originating and servicing student loans to default prevention and ultimately the collection on defaulted student loans. We also provide a wide range of other financial services, processing capabilities and information technology to meet the needs of educational institutions, lenders, students and their families, and guarantee agencies. SLM Corporation, more commonly known as Sallie Mae, is a holding company that operates through a number of subsidiaries and references in this report to the "Company" refer to SLM Corporation and its subsidiaries.
We have used both internal growth and strategic acquisitions to attain our leadership position in the education finance marketplace. Our sales force, which delivers our products on campuses across the country, is the largest in the student loan industry. The core of our marketing strategy is to promote our on-campus brands, which generate student loan originations through our Preferred Channel. Loans generated through our Preferred Channel are more profitable than loans acquired through other acquisition channels because we own them earlier in the student loan's life and generally incur lower costs to acquire such loans. We have built brand leadership among the Sallie Mae name, the brands of our subsidiaries and those of our lender partners. These sales and marketing efforts are supported by the largest and most diversified servicing capabilities in the industry, providing an unmatched array of servicing capability to financial aid offices.
In recent years we have diversified our business through the acquisition of several companies that provide default management and loan collections services, all of which are combined in our Debt Management Operations ("DMO") business segment. Initially these acquisitions were concentrated in the student loan industry, but through our acquisitions of Arrow Financial Services ("AFS") in September 2004 and GRP Financial Services ("GRP") in August 2005, we expanded our capabilities to include a full range of accounts receivable management services to a number of different industries. The DMO business segment has been expanding rapidly such that revenue grew 71 percent and 66 percent in the three and the nine months ended September 30, 2005, respectively, compared to the same periods in 2004, and we now employ over 3,000 people in this segment.
In December 2004, we completed the Wind-Down of the GSE through the defeasance of all remaining GSE debt obligations and dissolution of the GSE's federal charter. The liquidity provided to the Company by the GSE has been replaced primarily by securitizations. In addition to securitizations, we have also increased and diversified our investor base over the last three years to enable us to access a number of additional sources of liquidity including an asset-backed commercial paper program, unsecured revolving credit facilities, and other unsecured corporate debt and equity security issuances.
We manage our business through two primary operating segments: the Lending operating segment and the DMO operating segment. Accordingly, the results of operations of the Company's Lending and DMO segments are presented separately below under "BUSINESS SEGMENTS." These operating segments are considered reportable segments under the Financial Accounting Standards Board's ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 131, "Disclosures about Segments of an Enterprise and Related Information," based on quantitative thresholds applied to the Company's financial statements.
SELECTED FINANCIAL DATA
Condensed Statements of Income
Condensed Balance Sheets
CONSOLIDATED EARNINGS SUMMARY
Three Months Ended September 30, 2005 Compared to Three Months Ended September 30, 2004
For the three months ended September 30, 2005, net income of $431 million ($.95 diluted earnings per share) was a 21 percent increase over net income of $357 million for the three months ended September 30, 2004. On a pre-tax basis, third quarter of 2005 income of $582 million was a 28 percent increase over $454 million earned in the third quarter of 2004. The smaller percentage increase in year-over-year, after-tax net income versus pre-tax net income is due to the increase in the effective tax rate from 21 percent in the third quarter of 2004 to 26 percent in the third quarter of 2005. Fluctuations in the effective tax rate are driven by the permanent impact of the exclusion of the unrealized gains and losses on equity forward contracts for tax purposes. In the third quarter of 2005 an unrealized gain of $163 million on our outstanding equity forward contracts was excluded from taxable income versus an unrealized gain of $198 million in the third quarter of 2004.
The increase in pre-tax income in the third quarter of 2005 versus the third quarter of 2004 is due to a number of factors, the largest of which is a $243 million increase in the gain on derivative and hedging activities. Quarter-to-quarter income statement fluctuations in derivative and hedging activities are primarily driven by the effect of changes in interest rates on open derivative positions that do not qualify for hedge accounting treatment. The year-over-year increase in the gain on derivatives was primarily caused by higher forward interest rates reducing the mark-to-market value of our outstanding Floor Income Contracts at September 30, 2005, resulting in an unrealized gain of $257 million versus an unrealized loss of $58 million in the same period of 2004. Our Floor Income Contracts are liabilities so decreases in the value results in unrealized gains.
Third quarter income also benefited from the higher average balance of student loans on-balance sheet that increased net interest income by $148 million, partially offset by lower earning spreads on our student loans. The quarter also benefited from a change in methodology for estimating the amount of charged-off student loans that will ultimately be recovered, which resulted in a $49 million reduction in our provisions for loan losses.
In the third quarter of 2005, we incurred impairment losses on our Retained Interest in off-balance sheet securitized loans of $171 million versus $12 million in the year-ago quarter. The third quarter Retained Interest impairments were primarily the result of FFELP Stafford loans prepaying faster than projected due to the record amount of Consolidation Loan applications that were processed in the third quarter of 2005. There were no off-balance sheet securitization transactions in the third quarter of 2005 and therefore, there were no securitization gains versus gains of $64 million in the third quarter of 2004.
Net income for the three months ended September 30, 2004 was negatively impacted by a $103 million pre-tax loss related to the repurchase and defeasance of $3.0 billion of GSE debt in connection with the GSE Wind-Down in fiscal year 2004, of which $1.7 billion was repurchased in the third quarter of 2004.
The year-over-year increase in fee income and collections revenue of $56 million is primarily due to collections revenue from AFS, acquired in September 2004. Positive impacts to pre-tax income were offset by the year-over-year increase in operating expenses of $81 million, primarily attributable to the expenses associated with three subsidiaries acquired in September 2004 and the fourth quarter of 2004: AFS, Southwest Student Services Corporation ("Southwest") and Student Loan Finance Association ("SLFA").
During the third quarter of 2005, we acquired $8.4 billion in student loans, including $2.3 billion in Private Education Loans. In the third quarter of 2004, we acquired $6.1 billion in student loans, of
which $1.2 billion were Private Education Loans. In the third quarter of 2005, we originated $7.2 billion of student loans through our Preferred Channel, an increase of 23 percent over the $5.9 billion originated in the third quarter of 2004.
Nine Months Ended September 30, 2005 Compared to Nine Months Ended September 30, 2004
For the nine months ended September 30, 2005, our net income of $951 million ($2.10 diluted earnings per share) decreased 25 percent from net income of $1.3 billion ($2.65 diluted earnings per share) in 2004. Pre-tax income for the nine months ended September 30, 2005 decreased by 18 percent to $1.5 billion from $1.8 billion in the first nine months of 2004. The larger percentage decrease in year-over-year, after-tax net income versus pre-tax net income from 2004 to 2005 is primarily due to the increase in the effective tax rate from 30 percent in the first nine months of 2004 to 35 percent in the first nine months of 2005, caused by the exclusion of unrealized gains and losses on equity forward contracts from pre-tax income for tax purposes, as discussed above. In the first nine months of 2005, when calculating tax expense, we excluded unrealized gains on our outstanding equity forward contracts of $65 million versus unrealized gains of $335 million in the first nine months of 2004.
The decrease in pre-tax income is primarily due to lower gains on derivative and hedging activities of $166 million, caused primarily by market value changes in open derivative positions that do not receive hedge accounting treatment. In the first nine months of 2004, we recorded a gain on derivative and hedging activities of $342 million versus a gain on derivative and hedging activities of $176 million for the same period in 2005.
Results for the first nine months of 2005 were negatively affected by impairment losses on our Retained Interest in off-balance sheet securitized loans of $195 million versus $61 million for the first nine months of 2004. This was primarily due to the third quarter of 2005 impairment of $171 million discussed above.
The year-over-year increase in fee income and collections revenue of $153 million is primarily due to collections revenue from AFS, acquired in the third quarter of 2004. Positive impacts to pre-tax income were offset by the year-over-year increase in operating expenses of $216 million, primarily attributable to the expenses associated with three subsidiaries acquired in the second half of 2004: AFS, Southwest and SLFA.
Net income for the nine months ended September 30, 2004 was also negatively impacted by a $103 million pre-tax loss related to the repurchase and defeasance of $3.0 billion of GSE debt in connection with the GSE Wind-Down in fiscal year 2004, of which $1.7 billion was repurchased in the third quarter of 2004.
Our Managed student loan portfolio grew by $22.3 billion, from $98.3 billion at September 30, 2004 to $120.6 billion at September 30, 2005. This growth was fueled by the acquisition of $23.7 billion of student loans in the first nine months of 2005, a 31 percent increase over the $18.1 billion acquired in the first nine months of 2004. In the first nine months of 2005, we originated $16.8 billion of student loans through our Preferred Channel, an increase of 20 percent over the $14.0 billion originated in the first nine months of 2004.
NET INTEREST INCOME
Net interest income, including interest income and interest expense, is derived primarily from our portfolio of student loans that remain on-balance sheet and to a lesser extent from other loans, cash and investments. The "Taxable Equivalent Net Interest Income" analysis below is designed to facilitate a comparison of non-taxable asset yields to taxable yields on a similar basis. Additional information regarding the return on our student loan portfolio is set forth under "Student LoansStudent Loan
Spread Analysis." Information regarding the provisions for losses is included in Note 3 to the consolidated financial statements, "Allowance for Student Loan Losses."
Taxable Equivalent Net Interest Income
The amounts in the following table are adjusted for the impact of certain tax-exempt and tax-advantaged investments based on the marginal federal corporate tax rate of 35 percent.
Average Balance Sheets
The following table reflects the rates earned on interest earning assets and paid on interest bearing liabilities for the three and nine months ended September 30, 2005 and 2004. This table reflects the net interest margin for the entire Company on a consolidated basis.
The following rate/volume analysis illustrates the relative contribution of changes in interest rates and asset volumes.
The decrease in the net interest margin versus the year-ago quarter is primarily due to fluctuations in the student loan spread as discussed under "Student LoansStudent Loan Spread Analysis." In addition to student loan spread related items, the net interest margin in the year-ago quarter was negatively impacted by the higher average balances of lower yielding short-term investments which were being built up during 2004 as additional liquidity in anticipation of the GSE Wind-Down.
For both federally insured and Private Education Loans, we account for premiums paid, discounts received and certain origination costs incurred on the origination and acquisition of student loans in accordance with SFAS No. 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases." The unamortized portion of the premiums and 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 of the student loan after giving effect to the amortization of purchase premiums and the accretion of student loan discounts, as well as interest rate reductions and rebates expected to be earned through borrower benefit programs.
Student Loan Spread Analysis
The following table analyzes the reported earnings from student loans both on-balance sheet and those off-balance sheet in securitization trusts. For student loans off-balance sheet, we will continue to earn securitization and servicing fee revenues over the life of the securitized loan portfolios. The off-balance sheet information is discussed in more detail in "LIQUIDITY AND CAPITAL RESOURCESSecuritization ActivitiesServicing and Securitization Revenue" where we analyze the on-going servicing revenue and Residual Interest earned on the securitized portfolios of student loans. For an analysis of our student loan spread for the entire portfolio of Managed student loans on a similar basis to the on-balance sheet analysis, see "LENDING BUSINESS SEGMENTStudent Loan Spread AnalysisManaged Basis."
Discussion of Student Loan SpreadEffects of Floor Income and Derivative Accounting
The primary driver of fluctuations in our on-balance sheet student loan spread is the level of gross Floor Income (Floor Income earned before payments on Floor Income Contracts) earned in the period. For the three months ended September 30, 2005 and September 30, 2004, we earned gross Floor Income of $40 million (20 basis points), and $92 million (67 basis points), respectively. The reduction in gross Floor Income is primarily due to the increase in short-term interest rates. We believe that we have economically hedged most of the Floor Income through the sale of Floor Income Contracts, under which we receive an upfront fee and agree to pay the counterparty the Floor Income earned on a notional amount of student loans. These contracts do not qualify for hedge accounting treatment and as a result the payments on the Floor Income Contracts are included on the income statement with "gains (losses) on derivative and hedging activities, net" rather than in student loan interest income. Payments on Floor Income Contracts associated with on-balance sheet student loans for the three months ended September 30, 2005 and September 30, 2004 totaled $38 million (19 basis points) and $86 million (63 basis points), respectively.
In addition to Floor Income Contracts, we also extensively use basis swaps to manage our basis risk associated with interest rate sensitive assets and liabilities. These swaps generally do not qualify as accounting hedges and are likewise required to be accounted for in the "gains (losses) on derivative and hedging activities, net" line on the income statement. As a result, they are not considered in the calculation of the cost of funds in the above table.
Discussion of Student Loan SpreadEffects of Significant Events in the Quarter
In the third quarter of 2005, we revised our method for estimating the qualification for borrower benefits and updated our estimates to account for programmatic changes as well as the effect of continued high levels of consolidations. These updates resulted in a reduction of $16 million or 8 basis points in our borrower benefits reserve in the third quarter.
Discussion of Student Loan SpreadOther Fluctuations
The student loan spread, exclusive of items discussed above, increased in the third quarter 2005 when compared to the year-ago quarter. The increase was due primarily to the increase in the higher yielding Private Education Loans as a percentage of the on-balance sheet portfolio outweighing the negative effect of the increase in lower yielding Consolidation Loans as a percentage of the on-balance sheet portfolio.
For the nine months ended September 30, 2005 versus the year-ago period, the student loan spread was relatively unchanged after considering the effects of Floor Income and significant events discussed above.
On-Balance Sheet Floor Income
For on-balance sheet student loans, gross Floor Income is included in student loan income. The following table summarizes the components of Floor Income from on-balance sheet student loans, net of payments under Floor Income Contracts, for the three and nine months ended September 30, 2005 and 2004.
The decrease in Floor Income for the periods presented for 2005 versus the periods presented for 2004 is due to an increase in short-term interest rates.
As discussed in more detail under "LIQUIDITY AND CAPITAL RESOURCESSecuritization Activities," when we securitize a portfolio of student loans, we estimate the future Fixed Rate Embedded Floor Income earned on off-balance sheet student loans using a discounted cash flow option pricing model and recognize the fair value of such cash flows in the initial gain on sale and subsequent valuations of the Residual Interest. Variable Rate Embedded Floor Income is recognized as earned in servicing and securitization revenue.
Student Loan Floor Income Contracts
The following table analyzes the ability of the FFELP student loans in our Managed student loan portfolio to earn Floor Income after September 30, 2005 and 2004.