Use these links to rapidly review the document TABLE OF CONTENTS APPENDIX A STUDENT LOAN MARKETING ASSOCIATION CONSOLIDATED FINANCIAL STATEMENTS INDEX
UNITED STATESSECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
Commission File Number: 001-13251
SLM CORPORATION (Exact name of registrant as specified in its charter)
(703) 810-3000 (Registrant's telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes 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 the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date:
GLOSSARY
Listed below are definitions of key terms that are used throughout this document.
Consolidation Loans—Under the FFELP, borrowers with eligible student loans may consolidate them into one note with one lender and convert the variable interest rates on the loans being consolidated into a fixed rate for the life of the loan. The new note is considered a Consolidation Loan. Typically a borrower can consolidate their student loans only once unless the borrower has another eligible loan with which to consolidate with the existing Consolidation Loan. The borrower rate on a Consolidation Loan is fixed for the term of the loan and is set by the weighted-average interest rate of the loans being consolidated, rounded up to the nearest 1/8th of a percent, not to exceed 8.25 percent. In low interest rate environments, Consolidation Loans provide an attractive refinancing opportunity because they allow borrowers to consolidate variable rate loans into a long-term fixed rate loan.
Consolidation Loan Rebate Fee—All holders of Consolidation Loans are required to pay to the U.S. Department of Education 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 has a direct effect on the average life of the portfolio.
DOE—The U.S. Department of Education.
Direct Loans—Student loans originated directly by the DOE under the William D. Ford Federal Direct Student Loan Program.
Embedded Floor Income—Embedded Floor Income is Floor Income (see definition below) that is earned on off-balance sheet student loans that are in securitization trusts sponsored by us. At the time of the securitization, the option value of Embedded Fixed Rate Floor Income is included in the initial calculation of the Residual Interest 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.
Fixed Rate Floor Income—We refer to Floor Income associated with student loans whose borrower rate is fixed to term (primarily Consolidation Loans) as Fixed Rate Floor Income.
Floor Income—Our portfolio of FFELP student loans generally earns interest at the higher of a floating rate based on the Special Allowance Payment or SAP (see definition below) formula set by the DOE 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 our student loans are earning at the fixed borrower rate and the interest on our floating rate debt is continuing to decline, we may earn additional spread income and refer to it 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 fixed rate Consolidation Loan:
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Based on this example, if the quarterly average 91-day Treasury bill rate is over 5.15 percent, special allowance payments will be made to ensure that the holder receives at least a specified floating rate based on the Special Allowance Payment formula. On the other hand, if the quarterly average 91-day Treasury bill is below 5.15 percent, the loan holder will earn the minimum floor rate of 8.25 percent from the student loan. The difference between the minimum floor rate of 8.25 percent and the lender's expected yield (i.e., the yield that the lender would have earned if the borrower's rate did not create a floor) is referred to as Floor Income. Because the student loan assets are generally funded with floating rate debt, the net interest income is enhanced during periods of declining interest rates when the student loan is earning at the fixed borrower rate.
Graphic Depiction of Floor Income:
FFELP—The Federal Family Education Loan Program, formerly the Guaranteed Student Loan Program.
FDLP—The William D. Ford Federal Direct Student Loan Program.
Floor Income Contracts—We enter into contracts with counterparties under which, in exchange for an upfront fee representing the present value of the Floor Income that we expect to earn on a notional amount of student loans being hedged, we will pay the counterparties the Floor Income earned on that notional amount of student loans over the life of the Floor Income Contract. Specifically, we agree to pay the counterparty the difference, if positive, between the fixed borrower rate less the SAP spread and the average of the applicable interest rate index on that notional amount of student loans for a portion of the estimated life of the student loan. This contract effectively locks in the amount of Floor Income we will earn over the period of the contract. Floor Income Contracts are not considered effective hedges under Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities," and each quarter we must record the change in fair value of these contracts through income.
GSE—The Student Loan Marketing Association is a federally chartered government-sponsored enterprise and wholly owned subsidiary of SLM Corporation.
HEA—The Higher Education Act of 1965, as amended.
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Managed Basis—We generally analyze the performance of our student loan portfolio on a Managed Basis, under which we view both on-balance sheet student loans and off-balance sheet student loans owned by the securitization trusts as a single portfolio and the related on-balance sheet financings are combined with off-balance sheet debt. When the term Managed is capitalized in this document, it is referring to Managed Basis.
Offset Fee—We are required to pay to the DOE 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 does not apply to student loans sold to securitized trusts or to loans held outside of the GSE.
Preferred Channel Originations—Preferred Channel Originations are comprised of: 1) student loans that are originated or serviced on our proprietary platforms, 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 and serviced on other platforms on behalf of Sallie Mae owned brands and our lending partners, Bank One and JP Morgan Chase, and are committed for sale to Sallie Mae.
Preferred Lender List—To streamline the student loan process, most higher education institutions select a small number of lenders to recommend to their students and parents. This recommended list is referred to as the Preferred Lender List.
Private 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 Credit Student Loans include loans for traditional higher education with repayment terms that begin after graduation, similar to the FFELP, and for alternative education, such as career training, that require repayment immediately.
Privatization Act—The Student Loan Marketing Association Reorganization Act of 1996.
Residual Interest—When we securitize student loans, we retain the right to receive cash flows from the student loans sold in excess of amounts needed to pay servicing and other fees and the principal and interest on the bonds backed by the student loans. The Residual Interest is the present value of the future expected cash flows from off-balance sheet student loans in securitized trusts, which includes the present value of Embedded Fixed Rate Floor Income described above. We value the Residual Interest at the time of sale and at each subsequent quarter.
Retained Interest—In our securitizations the Retained Interest includes the Residual Interest plus reserve and other cash accounts that serve as credit enhancements to asset-backed securities issued in our securitizations.
Risk Sharing—When a FFELP loan defaults, the federal government guarantees 98 percent of the principal balance plus accrued interest and the holder of the loan must absorb the two percent not guaranteed as a Risk Sharing loss on the loan. All FFELP student loans acquired after October 1, 1993 are subject to Risk Sharing on loan default claim payments unless the default results from death, disability or bankruptcy.
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, the DOE pays the difference directly to us. This payment is referred to as the Special Allowance Payment or SAP and the formula used to determine the floating rate is the SAP formula. We refer to the fixed spread to the underlying index as the Special Allowance margin.
Title IV Programs and Title IV Loans—Student loan programs created under Title IV of the HEA, including the FFELP and the FDLP, and student loans originated under those programs, respectively.
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Wind-Down—The dissolution of the Student Loan Marketing Association (the "GSE") under the terms of the Privatization Act.
Wind-Down Period—The period during which the Student Loan Marketing Association is dissolved under the terms of the Privatization Act.
Variable Rate Floor Income—For student loans whose borrower interest rate resets annually on July 1, we may earn Floor Income or Embedded Floor Income 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.
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SLM CORPORATIONFORM 10-QINDEXMarch 31, 2004
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
SLM CORPORATION CONSOLIDATED BALANCE SHEETS (Dollars and shares in thousands, except per share amounts)
See accompanying notes to consolidated financial statements.
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SLM CORPORATIONCONSOLIDATED STATEMENTS OF INCOME(Dollars and shares in thousands, except per share amounts)
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SLM CORPORATIONCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY(Dollars in thousands, except share and per share amounts)(Unaudited)
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SLM CORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOWS(Dollars in thousands)
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SLM CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Information at March 31, 2004 and for the three months endedMarch 31, 2004 and 2003 is unaudited)(Dollars and shares in thousands, except per share amounts, unless otherwise stated)
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 months ended March 31, 2004 are not necessarily indicative of the results for the year ending December 31, 2004. These unaudited financial statements should be read in conjunction with the audited financial statements and related notes included in the Company's 2003 Annual Report on Form 10-K.
Reclassifications
A recent interpretation of the Financial Accounting Standards Board's (the "FASB's") Statement of Financial Accounting Standard ("SFAS") No. 133 requires net settlement income/expense on derivatives and realized gains/losses related to derivative dispositions that do not qualify as hedges under SFAS No. 133 to be included in the derivative market value adjustment on the income statement. The table below summarizes these derivative reclassifications for the three months ended March 31, 2003.
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Stock-Based Compensation
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation—Transition and Disclosure" which amends SFAS No. 123, "Accounting for Stock-Based Compensation," to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require more prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The additional disclosure requirements of SFAS No. 148 are effective for fiscal years ending after December 15, 2002. The Company has elected to continue to account for its employee stock options under the intrinsic value method of accounting as prescribed by Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees." Accordingly, the Company does not recognize compensation expense 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 following table summarizes pro forma disclosures for the three months ended March 31, 2004 and 2003, 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 fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model, with the following weighted average assumptions for the three months ended March 31, 2004 and 2003, respectively: risk-free interest rate of 2.08 percent and 2.31 percent; volatility factor of the expected market price of the Company's common stock of 14.04 percent and 24.99 percent; expected dividend rate of 1.62 percent and 1.04 percent; and the expected life of the option of three years for both periods. Options that have vesting periods tied to the Company's stock price are assumed to vest ratably over the three year historical vesting period.
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2. Allowance for Student Loan Losses
The provision for loan losses represents the periodic expense of maintaining an allowance sufficient to absorb losses, net of recoveries, inherent in the student loan portfolios. The allowance for Private Credit Student Loan losses is an estimate of losses in the portfolio at the balance sheet date that will be charged off in subsequent periods. The evaluation of the provision for loan losses is inherently subjective as it requires material estimates that may be susceptible to significant changes. The Company believes that the allowance for loan losses is adequate to cover probable losses in the student loan portfolio.
The federal government guarantees 98 percent of principal and interest of federally insured student loans, which limits the Company's loss exposure to two percent of the outstanding balance of the Company's federally insured portfolio.
The Company estimates its losses using historical data from its Private Credit Student Loan portfolios, extrapolations of FFELP loan loss data, current trends and relevant industry information. As the Company's Private Credit Student Loan portfolios continue to mature, more reliance is placed on the Company's own historical Private Credit Student Loan charge-off and recovery data. Accordingly, during the fourth quarter of 2003, the Company revised its expected default assumptions to further align the allowance estimate with the Company's collection experience as well as the terms and policies of the individual Private Credit Student Loan programs. The Company uses this data in internally developed models to estimate the amount of losses, net of subsequent collections, projected to occur in the Private Credit Student Loan portfolios.
To calculate the Private Credit Student Loan loss allowance, the Company divides the portfolio into categories of similar risk characteristics based on loan program type, underwriting criteria, existence or absence of a co-borrower, repayment begin date and repayment status. The Company then applies default and collection rate projections to each category. The repayment begin date indicates when the borrower is required to begin repaying the loan. The Company's career training Private Credit Student Loan programs (30 percent of the Private Credit Student Loan portfolio at March 31, 2004) generally require borrowers to start repaying their loans immediately. The Company's higher education Private Credit Student Loan programs (70 percent of the Private Credit Student Loan portfolio at March 31, 2004) do not require the borrowers to begin repayment until they have graduated or otherwise left school. Consequently, loss estimates for these programs are minimal while the borrower is in school. At March 31, 2004, 46 percent of the principal balance in the higher education Private Credit Student Loan portfolio relates to borrowers who are still in school and, therefore, not required to make payments. As the current portfolio ages, an increasing percentage of borrowers will leave school and be required to begin to repay their loans. With a higher percentage of borrowers in repayment, the Company expects the allowance for losses to increase accordingly.
The Company's loss estimates include losses that the Company expects to incur over the loss confirmation period, which is the period of the highest concentration of defaults. The loss confirmation period is 2 years for career training loans beginning when the loan is originated and 5 years for higher education loans beginning when the borrower leaves school. The loss confirmation period is in alignment with the Company's typical collection cycle and the Company considers these periods of nonpayment when estimating the allowance. The Company's collection policies allow for periods of
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nonpayment for borrowers experiencing temporary difficulty meeting payment obligations (typically, very early in the repayment term when the borrowers are starting their careers). This is referred to as forbearance status. At March 31, 2004, 4 percent of the Private Credit Student Loan portfolio was in forbearance status.
Private Credit Student Loan principal and accrued interest is charged off against the allowance at 212 days of delinquency. Private Credit Student Loans continue to accrue interest until they are charged off and removed from the active portfolio. Recoveries on loans charged off are recorded directly to the allowance.
The following table summarizes changes in the allowance for student loan losses for both the Private Credit and federally insured student loan portfolios for the three months ended March 31, 2004 and 2003.
In addition to the provisions for student loan losses, provisions for losses on other Company loans totaled $2.0 million and $0.3 million for the three months ended March 31, 2004 and 2003, respectively.
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The table below presents the Company's Private Credit Student Loan delinquency trends as of March 31, 2004 and 2003. Delinquencies have the potential to adversely impact earnings if the account charges off and results in increased servicing and collection costs.
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The following table summarizes changes in the allowance for student loan losses for on-balance sheet Private Credit Student Loans for the three months ended March 31, 2004 and 2003.
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3. Student Loan Securitization
Securitization Activity
The Company actively securitizes its student loan assets and retains a Residual Interest, servicing rights and in some cases, reserve and other cash accounts, all of which are referred to as the Company's Retained Interest in securitized loans.
The following table summarizes the Company's securitization activity for the three months ended March 31, 2004 and 2003.
Key economic assumptions used in estimating the fair value of Residual Interests at the date of securitization for securitization transactions that qualified as sales during the three months ended March 31, 2004 and 2003 were as follows:
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The following table summarizes the fair value of the Company's Retained Interests related to those securitizations that were treated as sales.
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4. Common Stock
The following table summarizes the Company's common share repurchase and equity forward activity for the three months ended March 31, 2004 and 2003.
As of March 31, 2004, the expiration dates and range and average purchase prices for outstanding equity forward contracts were as follows:
The closing price of the Company's common stock on March 31, 2004 was $41.85.
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Earnings per Share
Basic earnings per common share ("basic EPS") are 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 additional common shares that are issuable upon exercise of outstanding stock options, warrants, deferred compensation and shares held in the Employee Stock Purchase Plan ("ESPP"), determined by the treasury stock method, and equity forwards, determined by the reverse treasury stock method. Diluted EPS excludes the potential dilutive effect of senior convertible debt, as management believes conversion is not likely in the near term. The following table reflects basic and diluted EPS for the three months ended March 31, 2004 and 2003.
In May 2003, the Board of Directors approved a three-for-one split of the Company's common stock to be effected in the form of a stock dividend. The additional shares of stock were distributed on June 20, 2003, for all shareholders of record on June 6, 2003. All share and per share amounts presented have been retroactively restated for the stock split. Stockholders' equity has been restated to give retroactive recognition to the stock split for all periods presented by reclassifying from additional paid-in capital to common stock the par value of the additional shares issued as a result of the stock split.
In July 2003, the Board of Directors voted to retire 170 million shares of common stock held in treasury, effective in September 2003. Based on an average price of $18.04 per share, this retirement decreased the balance in treasury stock by $3.1 billion, with corresponding decreases of $34 million in common stock and $3.1 billion in retained earnings.
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5. 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 March 31, 2004 and December 31, 2003, and their impact on other comprehensive income and earnings for the three months ended March 31, 2004 and 2003. At March 31, 2004 and December 31, 2003, $156 million and $158 million (fair value), respectively, of available-for-sale investment securities and $446 million and $31 million, respectively, of cash were pledged as collateral against these derivative instruments.
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The following table presents the components of the change in accumulated other comprehensive income, net of tax, related to derivatives.
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6. Guarantees
The Company has issued lending-related financial instruments including letters of credit and lines of credit to meet the financing needs of its customers. Letters of credit support the issuance of state student loan revenue bonds. They represent unconditional guarantees of the GSE to repay holders of the bonds in the event of a default. In the event that letters of credit are drawn upon, such loans are collateralized by the student loans underlying the bonds. The initial liability recognition and measurement provisions of Financial Accounting Standards Board Interpretation ("FIN") No. 45, "Guarantors' Accounting and Disclosure Requirements for Guarantees Including Indirect Guarantees of the Indebtedness of Others, and Interpretation of FASB Statements No. 5, 57, and 107 and Rescission of FASB Interpretation No. 34," are effective for such guarantees issued or modified after December 31, 2002. During 2003 and the three months ended March 31, 2004, there were no new letters of credit issued or modifications to existing letters of credit. Accordingly, the Company's financial statements do not include a liability for the estimated fair value of these guarantees.
The Company offers a line of credit to certain financial institutions and other institutions in the higher education community for the purpose of buying or originating student loans. In the event that a line of credit is drawn upon, the loan is collaterialized by underlying student loans. The contractual amount of these financial instruments represents the maximum possible credit risk should the counterparty draw down the commitment or the Company fulfill its obligation under the guarantee, and the counterparty subsequently fails to perform according to the terms of its contract with the Company. Under the terms of the Privatization Act, any future activity under lines of credit and letter of credit activity by the GSE is limited to guarantee commitments, which were in place on August 7, 1997.
The following schedule summarizes expirations of the Company's guarantees to the earlier of call date or maturity date outstanding at March 31, 2004.
7. Pension Plans
Under the Company's qualified and supplemental pension plans, participants accrue benefits under 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
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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 for the Company's pension plans for the three months ended March 31, 2004 and 2003 included the following components:
Employer Contributions
The Company previously disclosed in its financial statements for the year ended December 31, 2003 that it did not expect to contribute to its pension plan in 2004. As of March 31, 2004, the Company has made no contributions to its pension plan.
8. Contingencies
The Company and various affiliates were defendants in a lawsuit brought by College Loan Corporation ("CLC") in the United States District Court for the Eastern District of Virginia alleging various breach of contract and common law tort claims in connection with CLC's consolidation loan activities. The Complaint sought compensatory damages of at least $60 million.
On June 25, 2003, after five days of trial, the jury returned a verdict in favor of the Company on all counts. CLC has since filed an appeal. All appellate briefing has been completed and oral argument has been scheduled before the U.S. Court of Appeals for the Fourth Circuit on June 4, 2004.
The Company was named as a defendant in a putative class action lawsuit brought by three Wisconsin residents on December 20, 2001 in the Superior Court for the District of Columbia. The lawsuit sought to bring a nationwide class action on behalf of all borrowers who allegedly paid "undisclosed improper and excessive" late fees over the past three years. The plaintiffs sought damages of one thousand five hundred dollars per violation plus punitive damages and claimed that the class consisted of 2 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 28, 2003, the Court granted the Company's motion to dismiss the complaint in its entirety. The plaintiffs appealed the trial court decision. All appellate briefing has been completed and oral argument was held in April 2004. No decision has been issued on the appeal as of this date.
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In July 2003, a borrower in California filed a class action complaint against the Company and certain of its affiliates in state court in San Francisco in connection with a monthly payment amortization error discovered by the Company in the fourth quarter of 2002. The complaint asserts claims under the California Business and Professions Code and other California statutory provisions. The complaint further seeks certain injunctive relief and restitution.
The Company, together with a number of other FFELP industry participants, filed a lawsuit challenging the DOE's interpretation of and non-compliance with provisions in the HEA governing origination fees and repayment incentives on loans made under the FDLP. The lawsuit, which was filed November 3, 2000 in the United States District Court for the District of Columbia, alleges that the DOE's interpretations of and non-compliance with these statutory provisions are contrary to the statute's unambiguous text, and are arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law, and violate both the HEA and the Administrative Procedure Act. The Company together with the other plaintiffs and the DOE have filed cross-motions for summary judgment. The Court has not ruled on these motions.
The Company has cooperated with the SEC concerning an informal investigation that the SEC initiated on January 14, 2004. There are currently no data requests outstanding and the SEC has not sought to interview any additional witnesses. The investigation concerns certain 2003 year-end accounting entries made by employees of one of the Company's collection agency subsidiaries. The Company's Audit Committee engaged outside counsel to investigate the matter and management conducted its own investigation. These investigations by the Audit Committee and management have been completed and the amounts in question were less than $100,000.
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. Management believes that these claims, lawsuits and other actions will not have a material adverse effect on the Company's business, financial condition or results of operations.
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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Three months ended March 31, 2004 and 2003 (Dollars in millions, except per share amounts, unless otherwise stated)
OVERVIEW
We are the largest private source of funding, delivery and servicing support for education loans in the United States primarily through our participation in the FFELP. Our primary business is to originate, acquire and hold student loans. We also provide a wide range of financial services, processing capabilities and information technology to meet the needs of educational institutions, lenders, students and their families, and guarantee agencies. We earn fees for student loan servicing, guarantee processing, student loan default management and loan collections. SLM Corporation is a holding company that operates through a number of subsidiaries including the Student Loan Marketing Association, a federally chartered government-sponsored enterprise. References in this quarterly report to "the Company" refer to SLM Corporation and its subsidiaries.
Our results can be materially affected by changes in:
We have provided the discussion of the GSE within the context of this "Management's Discussion and Analysis of Financial Condition and Results of Operations" ("MD&A") because the GSE's primary function of financing the initial purchase of student loans is a subset of similar operations conducted by the Company. As we wind down the GSE, such operations will constitute less and less of the Company's operations. MD&A disclosures applicable solely to the GSE are included at the end of this MD&A in the section titled "Student Loan Marketing Association." The discussion that follows regarding our interest income and expenses from on-balance sheet assets and liabilities is applicable to both the Company and the GSE. Likewise, because all of our FFELP securitizations to date have originated from the GSE, the discussion of securitization gains for FFELP student loans is applicable to the GSE only. The ongoing servicing and securitization revenue from those securitizations is primarily earned by the Company because the Retained Interests in FFELP securitizations are sold by the GSE to SLM Corporation shortly after completion of the securitization transactions. Discussions of Private Credit Student Loan securitizations are applicable to the Company only. The discussions of off-balance sheet loans, our fee-based businesses, and our operations on a Managed Basis, as well as the discussions set forth below under the headings "Selected Financial Data," "Other Income," "Federal and State Taxes" and "Alternative Performance Measures" do not involve the GSE and relate to the Company on a consolidated basis.
Through the first quarter of 2004, the majority of our student loan purchases were financed in the GSE and were initially financed through the issuance of short-term GSE debt obligations and then
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through student loan securitizations that were conducted through the GSE. Once securitized, the GSE no longer owns the student loans and the bonds issued by the trust are not obligations of the GSE. As the Wind-Down of the GSE continues, the liquidity provided to the Company by the GSE is being replaced by non-GSE financing, including securitizations originated by non-GSE subsidiaries of SLM Corporation. All student loans that the Company directly originates are owned by non-GSE subsidiaries from inception.
The GSE has no employees, so the management of its operations is provided by the Company under a management services agreement. We also service the majority of the GSE's student loans under a servicing agreement between the GSE and Sallie Mae, Inc., a wholly owned non-GSE subsidiary of SLM Corporation which includes the division of Sallie Mae Servicing.
See "STUDENT LOAN MARKETING ASSOCIATION—Privatization Act—GSE Wind-Down" for a more detailed discussion of the GSE and the progress of the Company's Wind-Down effort.
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SELECTED FINANCIAL DATA
Condensed Statements of Income
Condensed Balance Sheets
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RESULTS OF OPERATIONS
NET INTEREST INCOME
Net interest income is derived largely from our portfolio of student loans that remain on-balance sheet. The "Taxable Equivalent Net Interest Income" analysis below is designed to facilitate a comparison of non-taxable asset yields to taxable yields on a similar basis. Additional information regarding the return on our student loan portfolio is set forth under "Student Loans—Student Loan Spread Analysis After Reclassification—Non-GAAP." Information regarding the provision for losses is contained in Note 2 to the consolidated financial statements.
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 months ended March 31, 2004 and 2003.
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The decrease in the net interest margin from the first quarter of 2003 to the first quarter of 2004 was primarily due to the decrease in Floor Income and other student loan spread related items as discussed under "Student Loans—Student Loan Spread Analysis After Reclassification—Non-GAAP." The decrease in the net interest margin was also due to the increase in lower yielding short-term investments caused by the increase in non-GSE funding that is temporarily being held pending future asset transfers from the GSE to SLM Corporation.
Rate/Volume Analysis
The following rate/volume analysis illustrates the relative contribution of changes in interest rates and asset volumes.
Derivative Reclassification—Non-GAAP
A recent interpretation of SFAS No. 133 requires net settlement income/expense on derivatives and realized gains/losses on derivative dispositions ("realized derivative transactions") that do not qualify as hedges under SFAS No. 133 to be recorded in a separate income statement line item below net interest income. In response to this interpretation, we believe that it is helpful to the understanding of our business to include two presentations of net interest income and net interest margin. The first is a GAAP presentation presented above that includes the net settlement income/expense on derivatives and realized gains/losses recorded in the derivative market value adjustment line, which excludes these items from net interest income and margin. The second is a non-GAAP presentation that reflects these net settlements after having been reclassified to the financial statement line item of the economically hedged item, which includes them in net interest income and margin. We believe that this second presentation is meaningful as it reflects how we manage interest rate risk through the match funding of interest sensitive assets and liabilities. The presentations of our taxable equivalent net interest income, average balance sheet, rate volume analysis, student loan spread and funding costs in the following tables will reflect these reclassifications. The table below details the reclassification of the derivative net
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settlements and realized gains/losses related to derivative dispositions that is used in the following non-GAAP presentations as discussed above.
Taxable Equivalent Net Interest Income After Reclassification—Non-GAAP
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Taxable Equivalent Net Interest Income Reconciliation from GAAP to non-GAAP
The following table reconciles the taxable equivalent net interest income from GAAP to non-GAAP.
Average Balance Sheets After Reclassification—Non-GAAP
The 62 basis point difference between the first quarter of 2004 non-GAAP net interest margin of 1.46 percent versus the GAAP net interest margin of 2.08 percent is primarily due to the inclusion of payments on Floor Income Contracts in the non-GAAP presentation which reduced net interest income by 69 basis points (See "Derivative Reclassification—Non-GAAP" above). For a discussion of other
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fluctuations between the first quarter of 2004 net interest margin versus the first quarter of 2003 net interest margin, please see the GAAP Average Balance Sheet above.
Rate/Volume Analysis After Reclassification—Non-GAAP
The following rate/volume analysis shows the relative contribution of changes in interest rates and asset volumes.
Taxable equivalent net interest income after reclassification for the three months ended 2004 versus 2003 decreased by $16 million while the net interest margin decreased by 53 basis points.
Student Loans
For both federally insured and Private Credit Student Loans, we account for premiums paid, discounts received and certain origination costs incurred on the 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 are included in the carrying value of the student loan on the consolidated balance sheet. We recognize income on our student loan portfolio based on the expected yield of the student loan after giving effect to the amortization of purchase premiums and the accretion of student loan discounts, as well as borrower benefit programs. Origination fees charged on Private Credit Student Loans are deferred and amortized to income over the lives of the student loans. In the "Student Loan Spread Analysis After Reclassification—Non-GAAP" table below, this amortization of origination fees is netted with the amortization of the premiums.
Student Loan Spread Analysis After Reclassification—Non-GAAP (see "NET INTEREST INCOME—Derivative Reclassification—Non-GAAP")
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 presented in "Liquidity and Capital Resources—Securitization Activities—Servicing and Securitization Revenue" analyzes the on-going servicing revenue and Residual Interest earned on the securitized portfolios of student loans. For an analysis of our student loan
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spread for the entire portfolio of Managed student loans on a similar basis to the on-balance sheet analysis, see "Alternative Performance Measures—Student Loan Spread Analysis—Managed Basis."
Discussion of On-Balance Sheet Student Loan Spread Exclusive of Floor Income
The decrease in the first quarter 2004 student loan spread, versus the first quarter of 2003, was due to lower Floor Income, higher spreads on our debt funding student loans, the increase in the average balance of Consolidation Loans as a percentage of the on-balance sheet portfolio and higher premium amortization and borrower benefit expenses. The increase in the spreads to the underlying index on the cost of funds is due to the replacement of lower cost GSE funding with non-GSE funding in connection with the GSE Wind-Down. This higher cost is the result of both higher credit spreads on non-GSE funding sources and the significantly longer duration of non-GSE liabilities. Also, we use higher cost, longer-term debt to fund Consolidation Loans.
The average balance of Consolidation Loans increased as a percentage of the average on-balance sheet FFELP student loan portfolio from 55 percent in the first quarter of 2003 to 58 percent in the first quarter of 2004. Consolidation Loans have lower spreads due to the 105 basis point Consolidation Loan Rebate Fee, which is partially offset by the absence of the 30 basis point offset fee on GSE student loans and higher SAP yield.
The higher premium amortization and borrower benefit expense in 2004 is primarily the result of revised life of loan estimates for higher consolidation activity that reduced premium amortization in the first quarter of 2003.
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Floor Income
For on-balance sheet student loans, 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 months ended March 31, 2004 and 2003.
The decrease in Floor Income for the three months ending March 31, 2004 versus the year-ago period is primarily due to the decline in Treasury bill and commercial paper rates from the July 1, 2002 reset of borrower rates to March 31, 2003. Treasury bill and commercial paper rates did not decline as steeply from the July 1, 2003 reset to March 31, 2004 as compared to the same period in 2003.
For off-balance sheet student loans, future Fixed Rate Embedded Floor Income is estimated using a discounted cash flow option pricing model and is included in the Residual Interest valuation which is initially recognized as a gain on sale. Variable Rate Embedded Floor Income is recognized as earned in servicing and securitization revenue.
At March 31, 2004, the notional amount of student loan Floor Income Contracts totaled $43.6 billion of which $19.4 billion are contracts that commence between April 1, 2004 and 2007. The following table analyzes the ability of the FFELP student loans in our Managed student loan portfolio to earn Floor Income after March 31, 2004 and 2003. Three-month Treasury bill loans are based on the last Treasury bill auctions of March 2004 and 2003 of .96 percent and 1.12 percent, respectively. Commercial paper rate loans are based on the last commercial paper rates of 1.04 percent for March 2004 and 1.23 percent for March 2003. One-year Treasury bill loans are based on the last Treasury bill auctions of May 2003 and 2002 of 1.12 percent and 1.76 percent, respectively.
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Activity in the Allowance for On-Balance Sheet Private Credit Student Loan Losses
The increase in the provision for Private Credit Student Loan losses of $4 million for the three months ending March 31, 2004 versus the year-ago period is primarily due to the increase in Private Credit Student Loans entering repayment prior to being securitized as compared to the three months ended March 31, 2003. For the three months ended March 31, 2004, Private Credit Student Loan charge-offs increased by $9 million over the comparable period in 2003, which is due to the increase in securitization activity in 2003 as we primarily securitize loans that are current, leaving a higher percentage of delinquent loans on-balance sheet and to the increase in career training loans as a percentage of the on-balance sheet portfolio.
We charge borrower fees on the majority of Private Credit Student Loans, both at origination and when the loan enters repayment. Such fees are deferred and recognized into income as a component of interest over the life of the related pool of loans. The unamortized balance of deferred origination fee revenue at March 31, 2004 and 2003 was $142 million and $99 million, respectively.
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Delinquencies
The table below presents our on-balance sheet Private Credit Student Loan delinquency trends as of March 31, 2004 and 2003. Delinquencies have the potential to adversely impact earnings if the account charges off and results in increased servicing and collection costs.
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On-Balance Sheet Funding Costs After Non-GAAP Reclassification (see "NET INTEREST INCOME—Derivative Reclassification Presentation")
Our borrowings are generally variable-rate indexed (after the effect of interest rate swaps) principally to LIBOR, the 91-day Treasury bill or the commercial paper rate. The following table summarizes the average balance of on-balance sheet debt (by index, after giving effect to the impact of interest rate swaps) for the three months ended March 31, 2004 and 2003.
We continue to shift our financing from Treasury bill indexed debt to commercial paper and LIBOR indexed debt as FFELP student loans with interest rates indexed to the commercial paper rate and Private Credit Student Loans indexed to the Prime rate become a larger percentage of our portfolio. LIBOR-based debt, swapped to the daily reset LIBOR index, funds a portion of our daily reset commercial paper indexed assets, as we expect daily reset LIBOR indexed debt to remain highly correlated with daily reset commercial paper indexed assets.
OTHER INCOME
Servicing and Securitization Revenue
Servicing and securitization revenue, the ongoing revenue from securitized loan pools, which includes interest earned on the Residual Interest asset, revenue we receive for servicing the loans in the securitization trusts, and Embedded Floor Income on securitized student loans not previously included in the gain on sale calculation, is discussed in detail in "LIQUIDITY AND CAPITAL RESOURCES—Securitization Activities."
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Guarantor Servicing Fees, Debt Management Fees and Other Income
The following table summarizes the components of guarantor servicing fees, debt management fees and other income for the three months ended March 31, 2004 and 2003.
The $21 million increase in guarantor servicing and debt management fees for the three months ended March 31, 2004 versus the year-ago period is mainly due to growth across all segments of our debt management businesses. Specifically, portfolio management fees increased $8 million, or 35 percent over the prior year-ago period due to higher volume from United Student Aid Funds, Inc. ("USA Funds"), and to the increase in the percentage of collections via rehabilitation versus other less economic collection options. There was also strong growth from our collection subsidiaries General Revenue Corporation ("GRC") and Pioneer Credit Recovery ("PCR"), related to collections on behalf of USA Funds ($6 million) and collections on campus-based student loans ($5 million).
OPERATING EXPENSES
The following table summarizes the components of operating expenses for the three months ended March 31, 2004 and 2003.
The $30 million increase in operating expenses for the three months ended March 31, 2004 versus the year-ago period is mainly attributable to the operating expenses of Pioneer Mortgage acquired in the second quarter of 2003 and Academic Management Services Corp. ("AMS") acquired in the fourth quarter of 2003. Exclusive of these acquisitions, operating expenses increased in debt management and student loan servicing and origination consistent with revenue growth and borrowers serviced. In addition, in the first quarter of 2003, we recognized $9 million for servicing adjustments related to an underbilling error. Student loan servicing expenses as a percentage of the average balance of student loans serviced was .15 percent and .16 percent for the three months ended March 31, 2004 and 2003, respectively.
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STUDENT LOAN ACQUISITIONS
In the first quarter of 2004, 75 percent of our Managed student loan acquisitions were originated through our Preferred Channel. The following tables summarize the components of our student loan acquisition activity for the three months ended March 31, 2004 and 2003.
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Preferred Channel Originations
In the first quarter of 2004, we originated $5.8 billion in student loan volume through our Preferred Channel, a 19 percent increase over the $4.9 billion originated in the year-ago period. In the first quarter of 2004, we grew the Sallie Mae brand Preferred Channel Originations by 33 percent. As of March 31, 2004, our own brands constitute 32 percent of our Preferred Channel Originations, up from 28 percent in the year-ago period. The pipeline of loans that we currently service and are committed to purchase was $7.3 billion and $6.2 billion at March 31, 2004 and 2003, respectively. The following tables further break down our Preferred Channel Originations by type of loan and source.
The following table summarizes the activity in our Managed portfolio of student loans for the three months ended March 31, 2004 and 2003.
FEDERAL AND STATE TAXES
The Company is subject to federal and state income taxes, while the GSE is exempt from all state, local and District of Columbia income taxes. Our effective tax rate for the three months ended March 31, 2004 and 2003 was 23 percent and 35 percent, respectively. The effective tax rate for the period ended March 31, 2004 reflects the permanent benefit of the exclusion of the gains on equity forward contracts under SFAS No. 150, adopted in the third quarter of 2003. As SFAS No. 150 was implemented in the third quarter of 2003, the effective tax rate for the three months ended March 31, 2003 does not include any impact from equity forward contracts.
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EFFECTS OF SFAS NO. 133—DERIVATIVE ACCOUNTING
SFAS No. 133 requires the Company to recognize changes in the fair value of derivative instruments 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 they are a critical element of our interest rate risk management strategy. However, under SFAS No. 133, some of our derivatives, primarily Floor Income Contracts, Eurodollar futures contracts, certain basis swaps and equity forward contracts (discussed in detail below), do not qualify for "hedge treatment" under SFAS No. 133. Consequently, the standalone derivative must be marked-to-market in the income statement with no consideration for the corresponding change in fair value of the hedged item. The derivative market value adjustment is primarily caused by interest rate volatility and changing credit spreads during the period and the volume and term of derivatives not receiving hedge accounting treatment.
Our Floor Income Contracts are written options. SFAS No. 133's hedge criteria regarding effectiveness when using written options is more stringent than other hedging relationships. Because the paydown of principal of the student loans underlying the Floor Income embedded in those student loans does not exactly match the change in the notional amount of our written Floor Income Contracts, the written Floor Income Contracts do not qualify as effective hedges under SFAS No. 133. The Floor Income Contracts effectively fix the amount of Floor Income we will earn over the contract period, thus eliminating the timing and uncertainty associated with 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. Under SFAS No. 133, the upfront payment is deemed a liability and changes in fair value are recorded through income throughout the life of the contract. The change in the value of Floor Income Contracts is caused by changing interest rates that cause the amount of Floor Income earned on the underlying student loans and transferred to the counterparties to vary. The change in the market value of the Floor Income Contracts is economically offset by the change in value of the student loan portfolio earning Floor Income, but that offsetting change in value is not recognized under SFAS No. 133.
Basis swaps are used to convert the floating rate debt from one interest rate index to another to match the interest rate characteristics of the assets financed by that debt. We primarily use basis swaps to change the index of our fixed rate and LIBOR-based debt to better match the cash flows of our student loan assets that are primarily indexed to commercial paper or the Treasury bill. SFAS No. 133 requires that the change in the cash flows of the hedge effectively offset both the change in the cash flows of the asset and the change in the cash flows of the liability. Our basis swaps hedge variable interest rate risk and do not meet this effectiveness test because student loans can earn at either a variable or a fixed interest rate depending on market interest rates. We also have basis swaps that do not meet the SFAS No. 133 effectiveness test that economically hedge off-balance sheet instruments. As a result, these swaps are recorded at fair value with subsequent changes in value reflected in the income statement.
Generally, a decrease in current interest rates and the respective forward interest rate curves results in an unrealized loss related to our written Floor Income Contracts and Eurodollar futures contracts. Related to our basis swaps, if the two underlying indexes (and related forward curve) do not move in parallel we will experience unrealized gains/losses.
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 Company's stock are required to be accounted for in accordance with SFAS No. 133 as derivatives. As a result, we now account for our equity forward contracts as stand-alone derivatives in accordance with SFAS No. 133 and mark them to market through earnings.
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ALTERNATIVE PERFORMANCE MEASURES
In addition to evaluating the Company's GAAP-based financial information, management, credit rating agencies, lenders and analysts also evaluate the Company on certain non-GAAP performance measures that we refer to as "core cash" measures. While "core cash" measures are not a substitute for reported results under GAAP, we rely on "core cash" measures in operating our business because we believe they provide additional information on the operational and performance indicators that are most closely assessed by management.
We report pro forma "core cash" measures, which are the primary financial performance measures used by management not only in developing financial plans and tracking results, but also in establishing corporate performance targets and determining incentive compensation. Management believes this information provides additional insight into the financial performance of the Company's core business activities. Our "core cash" measures are not defined terms within GAAP and may not be comparable to similarly titled measures reported by other companies. "Core cash" measures reflect only current period adjustments to GAAP as described below. Accordingly, the Company's "core cash" measures presentation does not represent another comprehensive basis of accounting. A more detailed discussion of the differences between GAAP and "core cash" measures follows.
The following table summarizes "core cash" securitization adjustments for the three months ended March 31, 2004 and March 31, 2003.
The table below quantifies the effect of a derivative market value transactions adjustment under SFAS No. 133 and non-Floor Income related realized derivatives transactions on our net income
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for the three months ended March 31, 2004 and 2003, respectively, in accordance with the accounting principles employed in all years prior to the SFAS No. 133 implementation.
We employ derivatives, primarily Floor Income Contracts and futures, to economically hedge Floor Income. As discussed under "EFFECTS OF SFAS NO. 133—DERIVATIVE ACCOUNTING," these derivatives do not qualify as effective accounting hedges and therefore are marked-to-market through the derivative market value adjustment. For "core cash" measures, we reverse the fair value adjustments on the Floor Income Contracts and include the amortization of net premiums received (net of Eurodollar futures contracts' realized gains or losses) in income. Since we exclude Floor Income that is not economically hedged, we also exclude net settlements on derivative contracts, primary payments on Floor Income Contracts, and certain gains and losses on derivatives and financial instruments that were economically hedging Floor Income. The following table summarizes the Floor Income adjustments for the three months ended March 31, 2004 and 2003.
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For the three months ended March 31, 2004 and 2003, the pre-tax effect of these non-GAAP performance measures was as follows:
Student Loan Spread Analysis—Managed Basis
The following table analyzes the reported earnings from our portfolio of Managed student loans, which includes both on-balance sheet and off-balance sheet loans in securitization trusts, and excludes Floor Income and includes derivatives economically hedging these line items (see "NET INTEREST INCOME—Derivative Reclassification—Non-GAAP").
Discussion of Managed Student Loan Spread
The first quarter of 2004 student loan spread was affected both positively and negatively by a number of factors as compared to the first quarter of 2003. Positive changes to the spread included lower premium amortization and borrower benefit expenses associated with increased Consolidation Loan activity, an increase in the average balance of Managed Private Credit Student Loans as a percentage of the average Managed student loan portfolio to 10 percent of the average Managed Student Loan Portfolio, and higher amortization of upfront premiums received on Floor Income Contracts. Negative changes to the spread included higher spreads on our debt funding student loans and an increase in the average balance of lower spread Consolidation Loans as a percentage of the Managed portfolio. The net effect of these changes was a 2 basis point reduction in the Managed student loan spread. The details of these fluctuations are discussed further below.
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When we consolidate a Managed FFELP Stafford loan, the term of the loan is extended and the amortization of the premium is likewise extended to match the new term of the loan. Conversely, if a Managed FFELP Stafford student loan consolidates with another lender, it is treated as a prepayment, and unamortized premium balance must be written off. We calculate a Constant Prepayment Rate ("CPR") to estimate the effect of term extensions and prepayments on the average life of the student loan portfolio; the CPR is used to calculate premium amortization. Under SFAS No. 91, when actual Consolidation Loan activity differs from predicted results, we must adjust the premium balance from inception to reflect the new term of the loan portfolio. In the first quarter of 2004, the pace of Consolidation Loan activity was higher than predicted resulting in lower than expected premium amortization. Additionally, the overall longer amortization terms from Consolidation Loans decreased premium amortization in the first quarter of 2004 versus the first quarter of 2003 as the average balance of Consolidation Loans grew as a percentage of the average Managed FFELP student loan portfolio from 36 percent in the first quarter of 2003 to 44 percent in the first quarter of 2004. Additionally, based on further analysis of student loans in our trust portfolios and Private Credit Student Loans, we increased the term for amortizing premiums and discounts related to those loans. The net effect of these items lowered premium amortization expense by $16 million.
The increase in Consolidation Loan activity also reduced our estimate of the number of borrowers who qualify for borrower benefits. As loans consolidate the benefit remaining on the original FFELP Stafford loan is written off and replaced by a lower benefit on the Consolidation Loan that is recognized over a longer term.
In the first quarter of 2004, Private Credit Student Loans increased. Private Credit Student Loans are subject to credit risk and therefore earn higher spreads which averaged 4.50 percent in the first quarter of 2004 before the effect of a change in estimate adjustment that extended the term of the loans and lowered discount amortization as discussed below for the Managed Private Credit Student Loan portfolio, versus a spread of 1.54 percent for the Managed guaranteed student loan portfolio before Floor Income and estimate adjustments.
The decrease in the student loan spread from the higher cost of funds is mainly due to increased spreads to the index on our debt caused by the replacement of lower cost GSE funding with non-GSE funding in connection with the GSE Wind-Down. GSE debt generally has lower credit spreads than non-GSE funding sources and our non-GSE liabilities are significantly longer in duration than our GSE liabilities. Also, we use higher cost, longer-term debt to fund Consolidation Loans.
Absent the effects of Consolidation Loan activity on our premium amortization and borrower benefits, Consolidation Loans have lower spreads than other FFELP loans due to the 105 basis point Consolidation Loan Rebate Fee. The negative effect of this fee is partially offset by the absence of the 30 basis point offset fee on GSE student loans, higher SAP yield and lower student loan premium amortization discussed above. As long as interest rates remain at historically low levels and absent a program change in the next HEA reauthorization, we expect Consolidation Loans to be actively marketed by the student loan industry and remain an attractive refinancing option for borrowers, resulting in an increasing percentage of our federally guaranteed student loan portfolio.
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Allowance for Private Credit Student Loan Losses—Managed Basis
An analysis of our Managed allowance for loan losses for Private Credit Student Loans for the three months ended March 31, 2004 and 2003 is presented in the following table.
The increase in the provision for Managed Private Credit Student Loans of $5 million for the three months ended March 31, 2004 versus the year-ago period is primarily due to the increase in Managed Private Credit Student Loans entering repayment over the prior year and to the effect of the revision of our default assumptions in the fourth quarter of 2003. For the three months ended March 31, 2004, Private Credit Student Loan charge-offs increased by $9 million over the prior year, which is due primarily to the increase in Managed Private Credit Student Loans in repayment and the aging of the loans.
Delinquencies—Managed Basis
The table below presents our Private Credit Student Loan delinquency trends as of March 31, 2004 and 2003 on a Managed Basis. Delinquencies have the potential to adversely impact earnings if the account charges off and results in increased servicing and collection costs.
Loans in forbearance status increased from 11 percent of loans in repayment and forbearance status at March 31, 2003 to 12 percent of loans in repayment and forbearance status at March 31, 2004. The increase is due to a temporary spike in forbearances granted on career training loans during a loan
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system conversion in the second quarter of 2003. The career training ratio has been gradually declining but is not yet back down to the March 31, 2003 level. For all other categories of Private Credit Student Loans, the forbearance ratio decreased when compared to March 31, 2003.
LIQUIDITY AND CAPITAL RESOURCES
We depend on the debt capital markets to support our business plan and we have developed deep and diverse funding sources to ensure continued access to the capital markets as we transition from GSE funding to SLM Corporation non-GSE funding. Our biggest funding challenge going forward is to maintain cost effective liquidity to fund the growth in the Managed Portfolio of student loans as well as refinancing previously securitized loans when consolidated back on-balance sheet. At the same time we must maintain earnings spreads and control interest rate risk to preserve earnings growth. The main source of non-GSE funding is student loan securitizations. In the first quarter of 2004, we securitized $9.3 billion in student loans in four transactions versus $6.3 billion in four transactions in the first quarter of 2003. Our securitizations backed by FFELP loans are unique securities in the asset-backed class as they are backed by student loans with an explicit guarantee on 98 percent of principal and interest. This guarantee is subject to service compliance, but is not related to the Company's GSE subsidiary. At March 31, 2004, we financed 83 percent of our Managed student loans from non-GSE sources versus 57 percent at March 31, 2003. As evidenced by the 2003 volume, we have built a highly liquid and deep market for student loan securitizations by broadening our investor base worldwide.
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Securitizations will continue to grow and are expected to comprise approximately 70 percent of total Managed debt by 2006, versus 60 percent at March 31, 2004.
In addition to securitizations, we also significantly increased and diversified other non-GSE financing through the issuance of $5.3 billion in SLM Corporation, term, unsecured non-GSE debt. In total, at March 31, 2004, non-GSE on-balance sheet debt, exclusive of on-balance sheet securitizations, totaled $25.5 billion, a 211 percent increase over March 31, 2003.
Another major objective when financing our business is to minimize interest rate risk through match funding of our assets and liabilities. Generally, on a pooled basis to the extent practicable, we match the interest rate and reset characteristics of our Managed assets and liabilities. In this process, we use derivative financial instruments extensively to reduce our interest rate and foreign currency exposure. This interest rate risk management helps us to achieve a stable student loan spread irrespective of the interest rate environment. (See also "Interest Rate Risk Management" below.)
The following tables present the ending and average balances and average interest rates of our Managed borrowings for the three months ended March 31, 2004 and 2003. The average interest rates include derivatives that are economically hedging the underlying debt, but do not qualify for hedge accounting treatment under SFAS No. 133. (See "Derivative Reclassification—non-GAAP").
As the GSE is wound down, stand-alone liquidity at SLM Corporation will become increasingly important over time. SLM Corporation's stand-alone liquidity is derived from our modest debt maturities and use of commercial paper, $3 billion in committed bank lines of credit, short-term investment portfolio and broad market acceptance of our principal asset, government guaranteed student loans.
GSE Financing Activities
The GSE secures financing to fund its on-balance sheet portfolio of student loans, along with its other operations, by issuing debt securities in the domestic and overseas capital markets, through public offerings and private placements of U.S. dollar-denominated and foreign currency-denominated debt of varying maturities and interest rate characteristics. The GSE's debt securities are currently rated at the
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highest credit rating level by both Moody's and S&P. Historically, the rating agencies' ratings of the GSE have been largely a factor of its status as a government-sponsored enterprise. Since the Privatization Act did not modify the attributes of debt issued by the GSE, management anticipates that the GSE will retain its current credit ratings.
The GSE's unsecured financing requirements are driven by the following factors: liquidity to meet the short-term funding of new student loan acquisitions; refinancing of existing GSE liabilities as they mature and are not replaced by non-GSE funding sources; the level of securitization activity; and the transfer and refinancing of GSE assets by the Company's non-GSE entities.
Non-GSE Unsecured On-Balance Sheet Financing Activities
As discussed above, we continue to diversify our non-GSE funding sources such as commercial paper, bank lines of credit, underwritten long-term debt, and global and medium-term note programs. The following table presents the senior unsecured credit ratings on our non-GSE debt from major rating agencies.
The table below presents our non-GSE unsecured on-balance sheet funding by funding source for the three months ended March 31, 2004 and 2003.
Securitization Activities
Securitization Program
Our FFELP Stafford, Private Credit Student Loan and certain Consolidation Loan securitizations are off-balance sheet transactions that are structured to meet the sale criteria of SFAS No. 140 by using a two-step transaction with a qualifying special purpose entity ("QSPE") that legally isolates the transferred assets from the Company, even in the event of bankruptcy, and are accounted for off-balance sheet. Each of these transactions is structured to ensure that the holders of the beneficial interests issued by the QSPE are not constrained from pledging or exchanging their interests and that we do not maintain effective control over the transferred assets. In all of our off-balance sheet securitizations, we retain the right to receive the cash flows from the securitized student loans in excess of cash flows required to pay interest and principal on the bonds issued by the trust and servicing and administration fees.
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Prior to 2003, all of our securitization structures were off-balance sheet transactions. In certain 2003 and 2004 Consolidation Loan securitization structures, we hold certain rights that can affect the remarketing of certain bonds. These remarketing rights are not significantly limited in nature. Therefore, these securitizations did not qualify as QSPEs. Accordingly, they are accounted for on-balance sheet as variable interest entities ("VIEs") with the securitized federally insured student loans reflected in the balance sheet as "federally insured student loans in trust." These securitization structures were developed to broaden and diversify the investor base for Consolidation Loan securitizations by allowing us to issue bonds with non-amortizing, fixed rate and foreign currency denominated tranches.
The following table summarizes our securitization activity for the three months ended March 31, 2004 and 2003.
The increase in the Private Credit securitization gain for the first quarter of 2004 is due to the underlying student loans having higher spreads and lower cost of funds.
At March 31, 2004 and December 31, 2003, securitized student loans outstanding totaled $61.8 billion and $55.1 billion, respectively.
The asset-backed securities issued by our trusts generally have a higher net cost to fund our student loans than our GSE on-balance sheet financing because the asset-backed securities are term match-funded to the assets securitized and do not benefit from the implicit guarantee of the federal government that investors attribute to GSE debt. The GSE's funding advantage over our securitizations is somewhat mitigated by the absence of Offset Fees on securitized loans. Our securitizations to date have been structured to achieve a triple "AAA" credit rating on over 96 percent of the asset-backed securities sold. Securities issued in our typical FFELP student loan securitizations are issued with a variety of interest rate terms and in multiple currencies while the index on our securitized loans are either indexed to the 91-day or 52-week Treasury bill, commercial paper or the Prime rate. We manage this interest rate and currency risk with derivatives, principally interest rate and currency swaps, which can either be on-balance sheet or embedded in the securitization trust.
In 2004, we expect to maintain the 2003 level of securitization activity to fund new student loan purchases and continue the refinancing of GSE debt. We expect our term asset-backed securities issuance to be $25 billion versus $30 billion with our asset-backed commercial paper program adding another $5 billion.
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Liquidity Risk
As non-GSE financing replaces GSE financing and becomes an ever-larger percentage of our long-term funding, our credit spread and liquidity exposure to the capital markets shifts from the government agency capital markets to the corporate and asset-backed markets. A major disruption in the fixed income capital markets that limits our ability to raise funds or significantly increases the cost of those funds could have a material impact on our ability to acquire student loans or on our results of operations and the timely and effective completion of the GSE Wind-Down. Our securitizations are structured such that we do not provide any level of financial, credit or liquidity support to any of the trusts, and our exposure is limited to the recovery of the Retained Interest asset on the balance sheet. Our Retained Interests are subject to prepayment risk primarily from consolidating loans that could materially impair their value. Our FFELP securitizations have minimal credit and interest rate risk and as a result, outside of the prepayment risk, we believe that, even in times of great stress in the capital markets, the likelihood is remote that any of these off-balance sheet arrangements could be impaired to the point at which they could result in a material adverse impact on the Company.
Retained Interest on Securitized Loans
The Residual Interest plus any reserve or cash accounts constitute the Retained Interest asset on-balance sheet. The Retained Interests are recorded at fair value at the time of sale and each subsequent quarter using a discounted cash flow analysis. At March 31, 2004 and December 31, 2003, the fair value of the Retained Interest was $2.5 billion and $2.5 billion, respectively. The average balance of the Retained Interest for the three months ended March 31, 2004 and 2003 was $2.4 billion and $2.2 billion, respectively. The deferred tax liability associated with these assets was $333 million and $275 million at March 31, 2004 and December 31, 2003, respectively.
Embedded Fixed Rate Floor Income
Included in the gain on student loan securitizations of Consolidation Loans is an estimate of the Embedded Fixed Rate Floor Income from the loans securitized. Depending on interest rate levels, the ongoing re-evaluation of this estimate of Embedded Fixed Rate Floor Income can cause volatility in the fair value of the Retained Interest asset. The fair value of the Embedded Fixed Rate Floor Income included in the Retained Interest asset as of March 31, 2004 and December 31, 2003 was $801 million and $727 million, respectively.
Servicing and securitization revenue is the ongoing revenue from securitized loan pools accounted for off-balance sheet as QSPEs, and includes the interest earned on the Residual Interest, the revenue we receive for servicing the loans in the securitization trusts, and Embedded Floor Income on securitized student loans not previously included in the gain on sale calculation. Interest income recognized on the Residual Interest is based on our anticipated yield, determined by periodically estimating future cash flows.
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The following table summarizes the components of servicing and securitization revenue for the three months ended March 31, 2004 and 2003.
Fluctuations in servicing and securitization revenue are generally driven by the amount of and the difference in the timing of Floor Income recognition on off-balance sheet student loans, as well as the impact of Consolidation Loan activity which can result in an impairment of the Residual Interest asset and negatively impact yields used to recognize subsequent income. In the first quarter of 2004, we recognized impairment of the Residual Interest asset of $13.7 million due to higher than anticipated Consolidation Loan activity. We receive annual servicing fees of 90 basis points, 50 basis points and 70 basis points of the outstanding securitized loan balance related to our Stafford, Consolidation Loan and Private Credit Student Loan securitizations, respectively.
In off-balance sheet securitizations that qualify as sales, we recognize a gain on the sale, which is calculated as the difference between the allocated cost basis of the assets sold and the relative fair value of the assets received. The carrying value of the student loan portfolio being securitized includes the applicable accrued interest, unamortized student loan premiums, loan loss reserves and borrower benefits reserves. We recognize no gain or loss or servicing and securitization revenue associated with on-balance sheet securitizations.
Interest Rate Risk Management
Interest Rate Gap Analysis
We manage our interest rate risk on a Managed Basis. As a result, we use on and off-balance sheet derivatives to hedge the basis, interest rate and foreign currency risk in our securitization trusts as the trusts typically issue asset-backed securities with a variety of interest rate terms and in multiple currencies to fund student loans indexed to either the 91-day Treasury bill, commercial paper or in the case of Private Credit Student Loans, the Prime rate.
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In the table below, the Company's variable rate assets and liabilities are categorized by reset date of the underlying index. Fixed rate assets and liabilities are categorized based on their maturity dates. An interest rate gap is the difference between volumes of assets and volumes of liabilities maturing or repricing during specific future time intervals. The following gap analysis reflects rate-sensitive positions at March 31, 2004 and is not necessarily reflective of positions that existed throughout the period.
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Weighted Average Life
The following table reflects the weighted average life for our Managed earning assets and liabilities at March 31, 2004.
In the above table, Treasury receipts and variable rate asset-backed securities, although generally liquid in nature, extend the weighted average remaining term to maturity of cash and investments to 1.3 years. Long-term debt issuances likely to be called have been categorized according to their call dates rather than their maturity dates. Long-term debt issuances which are putable by the investor are categorized according to their put dates rather than their maturity dates.
COMMON STOCK
We repurchased 7.9 million shares during the first quarter of 2004 through equity forward settlements and issued a net 3.1 million shares related to benefit plans. At March 31, 2004, the total common shares that could potentially be acquired over the next four years under outstanding equity forward contracts was 39.8 million shares at an average price of $38.10 per share. We have remaining authority to enter into additional share repurchases and equity forward contracts for 34.2 million shares.
In May 2003, the Board of Directors approved a three-for-one split of our common stock to be effected in the form of a stock dividend. The additional shares were distributed on June 20, 2003, for all shareholders of record on June 6, 2003. All share and per share amounts presented have been retroactively restated for the stock split. Stockholders' equity has been restated to give retroactive recognition to the stock split for all periods presented by reclassifying from additional paid-in capital to common stock the par value of the additional shares issued as a result of the stock split.
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The following table summarizes our common share repurchase and equity forward activity for the three months ended March 31, 2004 and 2003.
STUDENT LOAN MARKETING ASSOCIATION
Privatization Act—GSE Wind-Down
Under the Privatization Act, the GSE must Wind-Down its operations and dissolve on or before September 30, 2008, and until the GSE is dissolved, the Privatization Act places a number of limitations on the GSE. Management, however, plans to accelerate the Wind-Down of the GSE to no later than June 2006 and is well ahead of the periodic milestones. Any GSE debt obligations outstanding at the date of such dissolution are required to be defeased through creation of a fully collateralized trust, consisting of cash or financial instruments backed by the full faith and credit of the U.S. government with cash flows that match the interest and principal obligations of the defeased debt. The Privatization Act requires that on the dissolution date, the GSE shall repurchase or redeem, or make proper provisions for repurchase or redemption of any outstanding preferred stock. The GSE redeemed its Series A, Adjustable Rate Cumulative Preferred Stock, its only outstanding preferred stock, in the fourth quarter of 2001. Also upon the GSE's dissolution, all of its remaining assets will be transferred to the Company.
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The Privatization Act requires that the GSE maintain a minimum statutory capital adequacy ratio (the ratio of the GSE's stockholders' equity to total assets plus 50 percent of the credit equivalent amount of certain off-balance sheet items) of at least 2.25 percent or be subject to certain "safety and soundness" requirements designed to restore compliance. While the GSE may not finance or guarantee the activities of its non-GSE affiliates, it may, subject to its minimum capital requirements, dividend retained earnings and surplus capital to SLM Corporation, which in turn may contribute such amounts to its non-GSE subsidiaries. At March 31, 2004, the GSE's statutory capital adequacy ratio was 5.76 percent.
The GSE has also received guidance from the U.S. Department of the Treasury's Office of Sallie Mae Oversight ("OSMO") regarding safety and soundness considerations affecting its Wind-Down. As a result, in connection with any dividend declarations, the GSE will supplement the statutory minimum capital ratio requirement with a risk-based capital measurement formula. At March 31, 2004, the GSE's capital ratio under this measurement formula was 18.32 percent, which was above OSMO's minimum recommended level of 4.00 percent. Management does not expect the capital levels of our consolidated balance sheet to change as a result of this supplemental formula.
The Privatization Act imposes certain restrictions on intercompany relations between the GSE and its affiliates during the Wind-Down Period. The GSE may, however, continue to issue new debt obligations maturing on or before September 30, 2008 although, because of the accelerated Wind-Down described above, we are limiting the maturity on any new GSE debt to six months. The GSE has not issued any long-term debt since July 2003. The legislation further provides that the legal status and attributes of the GSE's debt obligations, including the exemptions from Securities and Exchange Commission registration and state taxes, will be fully preserved until their respective maturities. Such debt obligations will remain GSE debt obligations, whether such obligations were outstanding at the time of, or issued subsequent to, the reorganization of the GSE into the current holding company structure.
In connection with the Wind-Down of the GSE, we must either securitize, sell, transfer or defease the GSE's assets by the Wind-Down date and retire or defease the GSE's debt obligations. For loans securitized, the GSE retains an interest in the loans, which is recognized on the balance sheet as Retained Interest in securitized receivables. In connection with the GSE Wind-Down, in 2003 the GSE sold its Retained Interests to a non-GSE subsidiary of the Company for $2.1 billion. The GSE will continue to finance student loans through securitizations in 2004, and intends to sell its Retained Interest in such securitizations as soon as practical after the sale.
During the course of developing the Wind-Down plan, management was advised by its tax counsel that, while the matter is not certain, under current authority, the defeasance of certain GSE bonds that mature after the dissolution of the GSE, could be construed to be a taxable event for taxable holders of those bonds. Management intends to commence discussions on this matter with the Internal Revenue Service and may seek a private letter ruling that the defeasance does not trigger a taxable event for such bondholders in the context of the GSE's privatization.
Given the GSE's current exemption from state income taxes, management is continually evaluating the potential impact (if any) upon the Company's overall state tax position resulting from planned sales and transfers of GSE assets.
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The following table summarizes the GSE's asset sales and transfers for the three months ended March 31, 2004 and 2003 (carrying value includes accrued interest).
We will continue to securitize, sell, transfer or defease the GSE's assets throughout the Wind-Down Period. All intercompany transactions between the GSE and the Company and its non-GSE subsidiaries have been eliminated in the Company's consolidated financial statements. In connection with the acquisition of AMS, SLM Corporation contributed to the GSE $40 million of assets, net of liabilities assumed. The assets contributed consisted primarily of student loans.
The following table shows the percentage of certain assets and income held by the GSE versus non-GSE as of and for the three months ended March 31, 2004.
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Average Balance Sheets—GSE
The following table reflects the GSE's rates earned on interest earning assets and paid on interest bearing liabilities for the three months ended March 31, 2004 and 2003.
OTHER RELATED EVENTS AND INFORMATION
Congress reauthorizes the Higher Education Act every five years. The Higher Education Act was originally scheduled to expire on September 30, 2003, but by its terms was automatically extended to September 30, 2004. We now expect that Congress will actively debate provisions of the Higher Education Act that govern the FFELP and the FDLP during 2004 and final action on the next reauthorization may not occur until 2005 (following another short extension of the current Act).
As with past Higher Education Act reauthorizations, there are many legislative proposals being advanced by schools, industry participants and other interested stakeholders. Sallie Mae has joined the "Coalition for Better Student Loans," a group of organizations representing colleges, universities, financial aid administrators, parents and other loan providers that has advanced a series of proposals designed to strengthen federal student loan programs, including:
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The President's budget also contains proposals to increase first-year loan limits, expand extended repayment options for FFELP borrowers, mandate a one percent guaranty fee for borrowers, and phase out higher special allowance payments associated with certain tax-exempt student loan bonds. Other proposals have already been announced by Presidential hopefuls or introduced by Members of Congress, including proposals to provide financial incentives to schools to join the FDLP, repeal the "single holder rule," permit borrowers who already completed their higher education studies to refinance or reconsolidate previously consolidated loans, require lenders to win student loan contracts by bidding at an auction and eliminate floor income on variable rate student loans. Under the single holder rule, if only one lender holds all of a borrower's loans, then another lender cannot consolidate the loans away from the current holder unless the current holder declines to consolidate loans for the borrower or is unwilling to offer income-sensitive repayment terms. If the single holder rule is repealed, the Company's student loan portfolio could be subject to an increased level of consolidation activity. In addition, if the reconsolidation proposal is enacted, the Company could experience a significant increase in refinancing activity, which, in turn, would have a material adverse effect on the Company's financial condition and results of operations. If the student loan auction proposal is adopted, it could have a material adverse effect on the Company's student loan spread. Finally, enactment of the proposal to eliminate floor income would decrease the Company's interest income in certain interest rate environments.
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Item 3. Quantitative and Qualitative Disclosures about Market Risk
Interest Rate Sensitivity Analysis
The effect of short-term movements in interest rates on our results of operations and financial position has been limited through our interest rate risk management. The following tables summarize the effect on earnings for the three months ended March 31, 2004 and 2003 and the effect on fair values at March 31, 2004 and December 31, 2003, based upon a sensitivity analysis performed by us assuming a hypothetical increase in market interest rates of 100 basis points and 300 basis points while funding spreads remain constant. We have chosen to illustrate the effects of a hypothetical increase in interest rates, as an increase gives rise to a larger absolute value change to the financial statements. The effect on earnings was performed on our variable rate assets, liabilities and hedging instruments while the effect on fair values was performed on our fixed rate assets, liabilities and hedging instruments.
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A primary objective in our funding is to minimize our sensitivity to changing interest rates by generally funding our floating rate student loan portfolio with floating rate debt. However, as discussed under "Student Loans—Floor Income," in the current low interest rate environment, we can have a fixed versus floating mismatch in funding as the student loan earns at the fixed borrower rate and the funding remains floating. Therefore, absent other hedges, in a low interest rate environment, the hypothetical rise in interest rates in the above table has a greater adverse effect on earnings and fair values due to the reduction in potential Floor Income than in higher interest rate environments where the interest rate formula rises above the borrower rate and the student loans become a floating rate asset that is matched with floating rate debt.
During the three months ended March 31, 2004, certain FFELP student loans were earning Floor Income and we locked-in a portion of that Floor Income through the use of futures and Floor Income Contracts. The result of these hedging transactions was to convert a portion of floating rate debt into fixed rate debt, matching the fixed rate nature of the student loans and fixing the relative spread between the student loan asset rate and the converted fixed rate liability.
In the above table under the scenario where interest rates increase 100 basis points, the decrease in pre-tax net income before SFAS No. 133 reflects lower Floor Income on the unhedged portion of our student loan portfolio. Under the scenario where interest rates increase 300 basis points, the change in pre-tax net income before SFAS No. 133 is not proportional to the change under the scenario where interest rates increase 100 basis points because of the additional spread earned on loans hedged with futures and swaps mentioned above and the greater proportion of loans earning at a floating rate under a 300 basis point increase in rates.
Item 4. Controls and Procedures
The Company carried out an evaluation, as required by the Securities Exchange Act of 1934 (the "Exchange Act") Rule 13a-15(b), under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer, Executive Vice President, Finance and Executive Vice President, Accounting and Risk Management, of the effectiveness of the design and operation of the Company's disclosure controls and procedures as of the end of the period covered by this report.
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Disclosure controls and procedures include internal controls and other procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act, such as this Annual Report, is properly recorded, processed, summarized and reported within the time periods required by the Securities and Exchange Commission's (the "SEC") rules and forms. Management does not expect that its disclosure controls and procedures will prevent all errors and fraud. A control system, irrespective of how well it is designed and operated, can only provide reasonable assurance—and cannot guarantee—that it will succeed in its stated objectives.
We monitor our disclosure controls and procedures and our internal controls and make modifications as necessary. By monitoring our control systems, we intend that they be maintained as dynamic systems that change as conditions warrant. The evaluation of our disclosure controls and procedures as of the end of the period covered by this report is performed on a quarterly basis so that the conclusions of management (including the Chief Executive Officer, Executive Vice President, Finance and Executive Vice President, Accounting and Risk Management) concerning controls effectiveness can be reported in our Quarterly Reports on Form 10-Q and Annual Reports on Form 10-K. In addition, our disclosure controls and procedures are evaluated on an ongoing basis by our internal auditors, by our Corporate Finance and Corporate Accounting Departments. As a result of such ongoing evaluations, we periodically make changes to our disclosure controls and procedures to improve the quality of our financial statements and related disclosures. Since the date of the last evaluation, we have taken, and continue to take, steps to improve the design and operation of our internal controls.
Based upon their evaluation, the Chief Executive Officer, Executive Vice President, Finance and Executive Vice President, Accounting and Risk Management, concluded that, as of the end of the period covered by this report, our disclosure controls and procedures are effective in timely alerting them to material information and in providing reasonable assurance that our financial statements are fairly presented in conformity with generally accepted accounting principles. In addition, during the period covered by this quarterly report, there have been no changes to our internal controls over financial reporting that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
In July 2003, a borrower in California filed a class action complaint against the Company and certain of its affiliates in state court in San Francisco in connection with a monthly payment amortization error discovered by the Company in the fourth quarter of 2002 (see "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS—OTHER RELATED EVENTS AND INFORMATION"). The complaint asserts claims under the California Business and Professions Code and other California statutory provisions. The complaint further seeks certain injunctive relief and restitution.
The Company, together with a number of other FFELP industry participants, filed a lawsuit challenging the DOE's interpretation of and non-compliance with provisions in the HEA governing origination fees and repayment incentives on loans made under the FDLP. The lawsuit, which was filed November 3, 2000 in the United States District Court for the District of Columbia, alleges that the Department's interpretations of and non-compliance with these statutory provisions are contrary to the statute's unambiguous text, and are arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law, and violate both the HEA and the Administrative Procedure Act. The Company together with the other plaintiffs and the DOE have filed cross-motions for summary judgment. The Court has not ruled on these motions.
The Company has cooperated with the SEC concerning an informal investigation that the SEC initiated on January 14, 2004. There are currently no data requests outstanding and the SEC has not sought to interview any additional witnesses. The investigation concerns certain 2003 year-end accounting entries made by employees of one of the Company's debt collection agency subsidiaries. The Company's Audit Committee engaged outside counsel to investigate the matter and management conducted its own investigation. These investigations by the Audit Committee and management have been completed and the amounts in question were less than $100,000.
We are also subject to various claims, lawsuits and other actions that arise in the normal course of business. Most of these matters are claims by borrowers disputing the manner in which their loans have been processed. Management believes that these claims, lawsuits and other actions will not have a material adverse effect on our business, financial condition or results of operations.
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Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
The following table summarizes the Company's common share repurchases during the first quarter of 2004 pursuant to the stock repurchase program first authorized in September 1997 by the Board of Directors. Since the inception of the program, the Board of Directors have authorized the purchase of up to 227.5 million shares.
Item 3. Defaults Upon Senior Securities
Nothing to report.
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits and Reports on Form 8-K
Attached as Exhibit 3.2 are the Company's amended By-laws. The Company's By-laws provide that the By-laws may be amended by the Board of Directors and that any amendments will become effective on the date of the next shareholder meeting provided that notice is provided to shareholders before the date of the meeting.
The amendment will change the definition of "independence" for members of the Board of Directors of the Company to comply with the listing requirements of the New York Stock Exchange. Certain, more restrictive criteria established by the Board continues in effect, as well.
The amendment will provide that a director will not be considered independent if, within the preceding three years, the director or their immediate family members have certain relationships with the Company, the Company's internal or external auditor, a significant supplier or customer of the Company, a charitable organization to which the Company makes contributions or certain interlocking compensation committee relationships.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.
Date: May 10, 2004
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APPENDIX A STUDENT LOAN MARKETING ASSOCIATION CONSOLIDATED FINANCIAL STATEMENTS INDEX
A-1
STUDENT LOAN MARKETING ASSOCIATION CONSOLIDATED BALANCE SHEETS (Dollars and shares in thousands, except per share amounts)
A-2
STUDENT LOAN MARKETING ASSOCIATION CONSOLIDATED STATEMENTS OF INCOME (In thousands, except share and per share amounts) (Unaudited)
A-3
STUDENT LOAN MARKETING ASSOCIATION CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDER'S EQUITY (Dollars in thousands) (Unaudited)
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STUDENT LOAN MARKETING ASSOCIATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) (Unaudited)
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STUDENT LOAN MARKETING ASSOCIATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Information at March 31, 2004 and for the three months ended March 31, 2004 and 2003 is unaudited)(Dollars in thousands, unless otherwise stated)
The accompanying unaudited consolidated financial statements of the Student Loan Marketing Association ("SLMA" or the "GSE") 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 in the United States of America for complete consolidated financial statements. In the opinion of management, all adjustments considered necessary for a fair statement 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 months ended March 31, 2004 may not necessarily be indicative of the results for the year ending December 31, 2004. These unaudited financial statements should be read in conjunction with the audited financial statements and related notes included in the Company's 2003 Annual Report on Form 10-K.
A recent interpretation of the Financial Accounting Standards Board's (the "FASB's") Statement of Financial Accounting Standards ("SFAS") No. 133 requires net settlement income/expense on derivatives and realized gains/losses related to derivative dispositions that do not qualify as hedges under SFAS No. 133 to be included in the derivative market value adjustment on the income statement. The table below summarizes these derivative reclassifications for the three months ended March 31, 2003:
A-6
2. Student Loans
SLMA purchases student loans from originating lenders. SLMA's portfolio consists principally of loans originated under two federally sponsored programs—the Federal Family Education Loan Program ("FFELP") and the Health Education Assistance Loan Program ("HEAL"). SLMA also purchases Private Credit Student Loans.
The following table reflects the distribution of SLMA's student loan portfolio by program as of March 31, 2004 and 2003.
At March 31, 2004 and 2003, 3 percent and 7 percent, respectively, of SLMA's total student loan portfolio was Private Credit.
3. Allowance for Student Loan Losses
The provision for loan losses represents the periodic expense of maintaining an allowance sufficient to absorb losses, net of recoveries, inherent in the student loan portfolios. The allowance for Private Credit Student Loan losses is an estimate of losses in the portfolio at the balance sheet date that will be charged off in subsequent periods. The evaluation of the provision for loan losses is inherently subjective as it requires material estimates that may be susceptible to significant changes. SLMA believes that the allowance for loan losses is adequate to cover probable losses in the student loan portfolio.
SLMA estimates its losses using historical data from its Private Credit Student Loan portfolios, extrapolations of FFELP loan loss data, current trends and relevant industry information. As SLMA's Private Credit Student Loan portfolios continue to mature, more reliance is placed on SLMA's own historical Private Credit Student Loan charge-off and recovery data. Accordingly, during the fourth quarter of 2003, SLMA revised its expected default assumptions to further align the allowance estimate with SLMA's collection experience as well as the terms and policies of the individual Private Credit
A-7
Student Loan programs. SLMA uses this data in internally developed models to estimate the amount of losses, net of subsequent collections, projected to occur in the Private Credit Student Loan portfolios.
To calculate the Private Credit Student Loan loss allowance, SLMA divides the portfolio into categories of similar risk characteristics based on loan program type, underwriting criteria, existence or absence of a co-borrower, repayment begin date and repayment status. SLMA then applies default and collection rate projections to each category. The repayment begin date indicates when the borrower is required to begin repaying the loan. SLMA's Private Credit Student Loan programs do not require borrowers to begin repayment until they have graduated or otherwise left school. Consequently, loss estimates for these programs are minimal while the borrower is in school. At March 31, 2004, 73 percent of the principal balance in the Private Credit Student Loan portfolio relates to borrowers who are still in-school and, therefore, not required to make payments. As the current portfolio ages, an increasing percentage of the borrowers will leave school and be required to begin to repay their loans. With a higher percentage of borrowers in repayment, SLMA expects the allowance for losses to increase accordingly.
SLMA's loss estimates include losses that SLMA expects to incur over the loss confirmation period, which is the period of the highest concentration of defaults. The loss confirmation period is 5 years for higher education loans beginning when the borrower leaves school. The loss confirmation period is in alignment with SLMA's typical collection cycle and SLMA considers these periods of nonpayment when estimating the allowance. SLMA's collection policies allow for periods of nonpayment for borrowers experiencing temporary difficulty meeting payment obligations (typically, very early in the repayment term when borrowers are starting their careers). This is referred to as forbearance status. At March 31, 2004, 3 percent of the Private Credit Student Loan portfolio was in forbearance status.
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The following table summarizes changes in the allowance for student loan losses for SLMA's Private Credit and federally insured student loan portfolios for the three months ended March 31, 2004 and 2003.
SLMA receives certain fees related to originated loans at both origination and the commencement of repayment. These origination fees are charged to cover, in part, anticipated loan losses. Such fees are deferred and recognized into income as a component of interest over the average life of the related pool of loans.
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The table below presents SLMA's Private Credit Student Loan delinquency trends as of March 31, 2004 and 2003. Delinquencies have the potential to adversely impact earnings if the account charges off and results in increased servicing and collection costs.
4. Student Loan Securitization
When SLMA sold student loans in securitizations prior to September 30, 2003, it retained a Residual Interest and, in some cases, a cash reserve account, all of which are Retained Interests in the securitized receivables. In 2003, SLMA sold its Retained Interests in securitizations to SLM Corporation in a cash transaction. SLMA will continue to sell loans in securitizations in 2004 and recognize Retained Interests as a result of these future transactions. Gains or losses realized at the settlement of these future transactions will continue to be based upon the carrying amount of the
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financial assets involved in the transfer, allocated between the assets sold and the Retained Interests based on their relative fair values at the date of transfer, as they have with past transactions.
The following table summarizes securitization activity for the three months ended March 31, 2004 and 2003.
Key economic assumptions used in estimating the fair value of the Retained Interests at the date of securitization related to those securitization transactions that qualify as sales during the three months ended March 31, 2004 and 2003 were as follows:
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The following tables summarize the fair values and notional amounts of all derivative instruments at March 31, 2004 and December 31, 2003, and their impact on other comprehensive income and earnings for the three months ended March 31, 2004 and 2003. At March 31, 2004 and December 31, 2003, $148 million and $156 million (fair value), respectively, of available-for-sale investment securities were pledged as collateral against these derivative instruments.
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The following table presents the components of the change in accumulated other comprehensive income, net of tax, for derivatives.
The Company offers a line of credit to certain financial institutions and other institutions in the higher education community for the purpose of buying or originating student loans. In the event that a line of credit is drawn upon, the loan is collaterialized by underlying student loans. The contractual
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amount of these financial instruments represents the maximum possible credit risk should the counterparty draw down the commitment or the Company fulfill its obligation under the guarantee, and the counterparty subsequently fails to perform according to the terms of its contract with the Company. Under the terms of the Privatization Act, any future activity under lines of credit and letter of credit activity by the GSE is limited to guarantee commitments, which were in place on August 7, 1997.
The following schedule summarizes expirations of the GSE's guarantees to the earlier of call date or maturity date outstanding at March 31, 2004.
7. Related Parties
SLMA is a member of a group of affiliated companies and has significant transactions with members of the group. Accordingly, the terms of such transactions may not necessarily be indicative of transactions amongst wholly unrelated companies.
In connection with the Wind-Down of the GSE, SLM Corporation must either securitize, sell, transfer or defease SLMA's assets by the Wind-Down date and retire or defease SLMA's debt
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obligations. The following table summarizes SLMA's asset sales and transfers for the three months ended March 31, 2004 and 2003 (carrying value includes accrued interest).
As described above, such transactions were among a group of related parties. Such transactions were conducted at estimated market value, which was determined using discounted cash flow models and other estimation techniques. Different assumptions or changes in future market conditions could significantly affect the estimates of fair value.
In connection with the transfer of employees from SLMA to SLM Corporation and its non-GSE subsidiaries, SLMA and SLM Corporation and various of its non-GSE subsidiaries entered into Management Services Agreements ("MSAs") whereby all management and administrative support would be provided to SLMA for a monthly fee. Intercompany expenses under the MSAs for the three months ended March 31, 2004 and 2003 totaled $17 million and $21 million, respectively. Effective January 1, 2003, only third party loan acquisition costs are being booked directly to SLMA and are included in other operating expenses.
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Intercompany expenses under the servicing contract between SLMA and Sallie Mae, Inc., a wholly owned non-GSE subsidiary of SLM Corporation which includes the division of Sallie Mae Servicing, for the three months ended March 31, 2004 and 2003 totaled $38 million and $45 million, respectively.
At March 31, 2004 and December 31, 2003, SLMA had net intercompany liabilities of $288 million and $530 million, respectively, with SLM Corporation and various of its non-GSE subsidiaries, incurred in the normal course of business, exclusive of the intercompany promissory note owed to Hemar Insurance Corporation of America ("HICA") discussed below.
SLMA purchases insurance for its Private Credit Student Loan portfolio from HICA. SLMA pays HICA insurance premiums in return for HICA's guarantee of payment of principal and interest on Private Credit Student Loans. In connection with this arrangement, HICA invests its insurance reserves related to SLMA's HICA insured loans in a Master Promissory Note of SLMA to HICA. In addition to the intercompany balances between SLMA and SLM Corporation, at March 31, 2004 and December 31, 2003, SLMA owed HICA $69 million under this note at the end of each period.
SLMA and various affiliates were defendants in a lawsuit brought by College Loan Corporation ("CLC") in the United States District Court for the Eastern District of Virginia alleging various breach of contract and common law tort claims in connection with CLC's consolidation loan activities. The Complaint sought compensatory damages of at least $60 million.
On June 25, 2003, after five days of trial, the jury returned a verdict in favor of SLMA on all counts. CLC has since filed an appeal. All appellate briefing has been completed and oral argument has been scheduled before the U.S. Court of Appeals for the Fourth Circuit on June 4, 2004.
SLMA was named as a defendant in a putative class action lawsuit brought by three Wisconsin residents on December 20, 2001 in the Superior Court for the District of Columbia. The lawsuit sought to bring a nationwide class action on behalf of all borrowers who allegedly paid "undisclosed improper and excessive" late fees over the past three years. The plaintiffs sought damages of one thousand five hundred dollars per violation plus punitive damages and claimed that the class consisted of 2 million borrowers. In addition, the plaintiffs alleged that SLMA charged excessive interest by capitalizing interest quarterly in violation of the promissory note. On February 28, 2003, the Court granted SLMA's motion to dismiss the complaint in its entirety. The plaintiffs appealed the trial court decision. All appellate briefing has been completed and oral argument was held in April 2004. No decision has been issued on the appeal as of this date.
In July 2003, a borrower in California filed a class action complaint against SLMA and certain of its affiliates in state court in San Francisco in connection with a monthly payment amortization error discovered by SLMA in the fourth quarter of 2002. The complaint asserts claims under the California Business and Professions Code and other California statutory provisions. The complaint further seeks certain injunctive relief and restitution.
SLMA, together with a number of other FFELP industry participants, filed a lawsuit challenging the Department of Education's interpretation of and non-compliance with provisions in the Higher
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Education Act governing origination fees and repayment incentives on loans made under the FDLP. The lawsuit, which was filed November 3, 2000 in the United States District Court for the District of Columbia, alleges that the Department's interpretations of and non-compliance with these statutory provisions are contrary to the statute's unambiguous text, and are arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law, and violate both the HEA and the Administrative Procedure Act. SLMA together with the other plaintiffs and the Department of Education have filed cross-motions for summary judgment. The Court has not ruled on these motions.
The Company has cooperated with the Securities and Exchange Commission (the "SEC") concerning an informal investigation that the SEC initiated on January 14, 2004. There are currently no data requests outstanding and the SEC has not sought to interview any additional witnesses. The investigation concerns certain 2003 year-end accounting entries made by employees of one of the Company's collection agency subsidiaries. The Company's Audit Committee engaged outside counsel to investigate the matter and management conducted its own investigation. These investigations by the Audit Committee and management have been completed and the amounts in question were less than $100,000.
SLMA 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. Management believes that these claims, lawsuits and other actions will not have a material adverse effect on SLMA's business, financial condition or results of operations.
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