UNITED STATESSECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
(Mark One)
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. Holders of Consolidation Loans are eligible to earn interest under the Special Allowance Payment ("SAP") formula (see definition below).
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 is directly correlated to 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 (see definition below).
Exceptional Performer Designation ("EP")—The EP designation is determined by the DOE in recognition of meeting certain performance standards set by the DOE in servicing FFELP loans. Upon receiving the EP designation, the EP servicer receives 100 percent reimbursement on default claims on federally guaranteed student loans for all loans serviced for a period of at least 270 days before the date of default and will no longer be subject to the two percent Risk Sharing (see definition below) on these loans. The EP servicer is entitled to receive this benefit as long as it remains in compliance with the required servicing standards, which are assessed on an annual and quarterly basis through compliance audits and other criteria.
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 earns interest at the higher of a floating rate based on the Special Allowance Payment or SAP formula (see definition below) 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 the fixed borrower rate is higher than the rate produced by the SAP formula, our student loans earn at a fixed rate while the interest on our floating rate debt continues to decline. In these interest
1
rate environments, we earn additional spread income that we refer to as Floor Income. Depending on the type of the student loan and when it was originated, the borrower rate is either fixed to term or is reset to a market rate each July 1. As a result, for loans where the borrower rate is fixed to term, we may earn Floor Income for an extended period of time, and for those loans where the borrower interest rate is reset annually on July 1, we may earn Floor Income to the next reset date.
The following example shows the mechanics of Floor Income for a fixed rate Consolidation Loan with a T-bill based SAP spread of 3.10 percent:
Based on this example, if the quarterly average 91-day Treasury bill rate is over 5.15 percent, the holder of the student loan will earn at a floating rate based on the SAP formula, which in this example is a fixed spread to Treasury bills of 3.10 percent. On the other hand, if the quarterly average 91-day Treasury bill is below 5.15 percent, the SAP formula will produce a rate below the fixed borrower rate of 8.25 percent and the loan holder earns at the borrower rate of 8.25 percent. The difference between the fixed borrower rate and the lender's expected yield based on the SAP formula is referred to as Floor Income. Our student loan assets are generally funded with floating rate debt, so when student loans are earning at the fixed borrower rate, declines in interest rates increase Floor Income.
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
2
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.
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. All Managed Basis presentations are considered non-GAAP measures of performance.
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 JPMorgan Chase, and are committed for sale to Sallie Mae. (See also "RECENT DEVELOPMENTS—Bank One/JPMorgan Chase Merger" for a discussion related to our lender partners.)
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 Education Loans (formerly, "Private Credit Student Loans")—Education loans to students or parents of students that are not guaranteed or reinsured under the FFELP or any other federal student loan program. Private Education Loans include loans for traditional higher education 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.
3
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. 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. FFELP loans with an EP designation from the DOE are not subject to Risk Sharing.
Special Allowance Payment ("SAP")—FFELP student loans generally earn interest at the greater of the borrower rate or a floating rate determined by reference to the average of the applicable floating rates (91-day Treasury bill rate or commercial paper) in a calendar quarter, plus a fixed spread that is dependent upon when the loan was originated and the loan's repayment status. If the resulting floating rate exceeds the borrower rate, 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.
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.
4
SLM CORPORATION FORM 10-Q INDEX September 30, 2004
5
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.
6
SLM CORPORATION CONSOLIDATED STATEMENTS OF INCOME (Dollars and shares in thousands, except per share amounts)
7
SLM CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Dollars in thousands, except share and per share amounts) (Unaudited)
8
9
SLM CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands)
10
SLM CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Information at September 30, 2004 and for the three and nine months ended September 30, 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 and nine months ended September 30, 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.
Privatization Act—GSE Wind-Down Update
As of September 2004, the Company had substantially completed the Wind-Down of the GSE and, on November 1, 2004, the Company sent notices to the Secretary of Education and the Secretary of the Treasury that it intends to wind-down and dissolve the GSE on December 31, 2004 or as soon as practicable thereafter. On October 28, 2004, as part of the Wind-Down process, the GSE paid a cash dividend of $900 million to the Company.
On June 30, 2004, the Company purchased FFELP student loans through non-GSE affiliates and as a result, the GSE was required by statute to terminate all such activity. As a result, the GSE is no longer a source of liquidity for the Company's purchase of student loans and the Company's GSE related financing activities will primarily consist of refinancing the remainder of its assets through non-GSE sources. All GSE debt that remains outstanding upon completion of these Wind-Down activities will be defeased through the 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 provide for the interest and principal obligations of the defeased debt. Through September 30, 2004, the Company repurchased approximately $1.7 billion of GSE debt through a tender offer and recorded a loss of $103 million. Also in connection with the Wind-Down, the GSE will no longer issue short-term floating rate notes, but will continue to issue other short-term debt, as necessary, until all current GSE assets are refinanced. At September 30, 2004, the GSE had $4.7 billion in assets remaining, primarily consisting of cash and investments. The GSE has no student loans remaining on its balance sheet.
Reclassifications
Certain reclassifications have been made to the balances as of and for the three and nine months ended September 30, 2003 to be consistent with classifications adopted for 2004.
11
Reclassifications of Realized Derivative Transactions
In addition to unrealized gains and losses, the Financial Accounting Standards Board's (the "FASB's") Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities," requires net settlement income/expense on derivatives and realized gains/losses related to derivative dispositions (collectively referred to as "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. The table below summarizes the reclassification of the realized derivative transactions for the three and nine months ended September 30, 2003.
Recently Proposed Accounting Pronouncements
In September 2004, the Emerging Issues Task Force (the "Task Force" or the "EITF") reached a consensus on EITF Issue No. 04-8, "The Effect of Contingently Convertible Debt on Diluted Earnings per Share" ("EITF No. 04-8"), which addresses the timing of the inclusion of the dilutive effect of contingently convertible debt instruments ("Co-Cos") in diluted earnings per share. Co-Cos are generally convertible into the common shares of the issuer after the common stock share price exceeds a predetermined threshold for a specified time period, generally referred to as the market price trigger. EITF No. 04-8 requires the shares underlying the Co-Cos be included in diluted earnings per share computations regardless of whether the market price trigger has been met using the "if-converted" accounting method. EITF No. 04-8 is effective for reporting periods ending after December 15, 2004 with retroactive restatement to all required reporting periods. As a result, the Company will include the common shares underlying its Co-Cos in its diluted earnings per share computations for reporting periods ending after December 15, 2004 and will retroactively restate all required reporting periods at
12
such time. The Company is currently evaluating the impact of EITF No. 04-8 on its consolidated financial statements as it relates to the Company's $2 billion Co-Cos issued in May 2003. The Company believes, however, that no investor would elect to convert this security into common stock when the conversion price is greater than the market price of the common stock.
In March 2004, the EITF reached a consensus on EITF Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" ("EITF No. 03-1"). EITF No. 03-1 provides guidance for determining the meaning of "other-than-temporarily impaired" and its application to certain debt and equity securities within the scope of SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and investments accounted for under the cost method. The guidance requires that investments which have declined in value due to credit concerns or solely due to changes in interest rates must be recorded as other-than-temporarily impaired unless the Company can assert and demonstrate its intention to hold the security for a period of time sufficient to allow for a recovery of fair value up to or beyond the cost of the investment which may include maturity. This issue also requires disclosures assessing the ability and intent to hold investments in instances in which an investor determines that an investment with a fair value less than cost is not other-than-temporarily impaired. To date, the Company has not recorded any impairment related to this pronouncement.
On September 30, 2004, the FASB decided to delay the effective date for the measurement and recognition guidance contained in EITF No. 03-1. This delay does not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature. The disclosure guidance in EITF No. 03-1 was not delayed. The Company is monitoring the outcome of the reconsideration of EITF No. 03-1.
In December 2003, the Accounting Standards Executive Committee ("AcSEC") of the American Institute of Certified Public Accountants issued Statement of Position ("SOP") No. 03-3, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer" ("SOP No. 03-3"). SOP No. 03-3 applies to acquired loans and debt securities where there has been evidence of deterioration in credit quality at the date of purchase and for which it is probable that the investor will not be able to collect all contractually required payments. It addresses the accounting for differences between the contractual cash flows of acquired loans and the cash flows expected to be collected from an investor's initial investment in loans acquired in a transfer if those differences are attributable, at least in part, to credit quality.
SOP No. 03-3 requires purchased loans and debt securities within its scope to be initially recorded at fair value and prohibits the recording of a valuation allowance at the date of purchase. It limits the yield that may be accreted as interest income on such loans to the excess of an investor's estimate of undiscounted expected principal, interest and other cash flows from the loan over the investor's initial investment in the loan. Subsequent increases in estimated future cash flows to be collected would be recognized prospectively in interest income through a yield adjustment over the remaining life of the loan. Decreases in estimated future cash flows to be collected would be recognized as an impairment expense or valuation allowance. SOP No. 03-3 primarily applies prospectively to loans acquired in fiscal
13
years beginning after December 15, 2004. The Company is currently evaluating the effect of the adoption of SOP No. 03-3 on its consolidated financial statements.
Stock-Based Compensation
The Company accounts 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. On March 31, 2004, the FASB issued its exposure draft, "Share-Based Payment, an amendment of FASB Statements No. 123 and 95," that addresses accounting for equity based compensation arrangements. The proposed statement would eliminate the ability to account for share-based compensation transactions using APB Opinion No. 25, and replace some of the existing requirements under SFAS No. 123, "Accounting for Stock-Based Compensation." The proposed statement would require that such arrangements are accounted for using a fair-value-based method of accounting and the related cost expensed over the corresponding service period. The FASB intends to issue the final statement by year-end 2004 which would be effective for interim or annual periods beginning after June 15, 2005.
The fair values for the options granted in the three and nine months ended September 30, 2004 and 2003 were estimated at the date of grant using a Black-Scholes option pricing model, with the following weighted average assumptions:
For pro forma compensation expense calculations, options that have vesting periods tied to the Company's stock price are assumed to vest ratably over the three-year historical vesting period or when the options vest, whichever occurs first.
The following table summarizes pro forma disclosures for the three and nine months ended September 30, 2004 and 2003, as if the Company had accounted for employee and Board of Directors
14
stock options granted subsequent to December 31, 1994 under the fair market value method as set forth in SFAS No. 123.
The decrease in the pro forma stock-based compensation expense is due to lower stock option grants in 2003 and 2004 versus 2002 and 2001, and to lower expected volatility in the Company's common stock share price, which lowered the valuation of the 2004 stock option grants.
2. Allowance for Student Loan Losses
The provisions for student loan losses represent the periodic expense of maintaining an allowance sufficient to absorb losses, net of recoveries, inherent in the student loan portfolios. The evaluation of the provisions for student loan losses is inherently subjective as it requires material estimates that may be susceptible to significant changes. The Company believes that the allowance for student loan losses is adequate to cover probable losses in the student loan portfolios.
15
The following table summarizes changes in the allowance for student loan losses for both the Private Education Loan and federally insured student loan portfolios for the three and nine months ended September 30, 2004 and 2003.
In addition to the provisions for student loan losses, provisions for losses on other Company loans totaled $3 million and $2 million for the three months ended September 30, 2004 and 2003, respectively, and $7 million and $4 million for the nine months ended September 30, 2004 and 2003, respectively.
Allowance for FFELP Student Loan Losses
Effective for a renewable one year period beginning on October 19, 2004, Sallie Mae Servicing, the Company's student loan servicing division was designated as an Exceptional Performer ("EP") by the U.S. Department of Education ("DOE") in recognition of meeting certain performance standards set by the DOE in servicing FFELP loans. As a result of this designation, the Company will receive 100 percent reimbursement on default claims on federally guaranteed student loans that were serviced by Sallie Mae Servicing for a period of at least 270 days before the date of default and will no longer be subject to the two percent Risk Sharing on these loans. The Company is entitled to receive this benefit as long as the Company remains in compliance with the required servicing standards, which are assessed on an annual and quarterly basis through compliance audits and other criteria. The EP designation applies to all FFELP loans that are serviced by the Company as well as default claims on federally guaranteed student loans that the Company owns but are serviced by other service providers with the EP designation. At September 30, 2004, approximately 98 percent of the Company's federally insured loans are no longer subject to Risk Sharing. As a result of this designation, the Company has reduced the balance in the Risk Sharing allowance for loan losses by $32 million with an equal reduction in the third quarter provision for loan losses.
16
Allowance for Private Education Loan Losses
The allowance for Private Education Loan losses is an estimate of losses in the portfolio at the balance sheet date that will be charged off in subsequent periods. The Company estimates its losses by analyzing historical data from its Private Education Loan portfolios, extrapolating FFELP loan loss data, and considering current trends and relevant industry information. As the Company's Private Education Loan portfolios continue to mature, more reliance is placed on its own historical charge-off and recovery data. The Company uses this data in internally developed models to estimate losses, net of subsequent collections, projected to occur in the Private Education Loan portfolios.
The following table summarizes changes in the allowance for Private Education Loan losses for the three months and nine months ended September 30, 2004 and 2003.
17
Delinquencies
The table below presents the Company's Private Education Loan delinquency trends as of September 30, 2004 and 2003. Forbearances and delinquencies result in increased servicing and collection costs and have the potential to adversely impact earnings if the account charges off.
18
3. Student Loan Securitization
Changes in Accounting Estimates Affecting the Residual Interest in Securitized Loans
The Company updated certain assumptions during the third quarter of 2004 that it uses in the valuation of the Residual Interest. The following are the significant assumption changes that were made:
The FFELP Stafford CPR assumption was increased to account for the continued high levels of Consolidation Loan activity. The Company lowered its assumption of expected FFELP credit losses to zero percent to reflect the effect of the EP designation on Sallie Mae serviced FFELP loans in the trusts. The EP designation is discussed in more detail above in "Allowance for FFELP Student Loan Losses." In total, the change in the fair value of the Company's Residual Interests due to all assumption changes as of September 30, 2004 when compared to prior assumptions, was a decrease of $11 million.
19
Key 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 and nine months ended September 30, 2004 and 2003 were as follows:
20
Securitization Activity
The Company actively securitizes its student loan assets, and for transactions qualifying as sales, 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 receivables.
The following table summarizes the Company's securitization activity for the three and nine months ended September 30, 2004 and 2003. Those securitizations listed as sales are off-balance sheet transactions and those listed as financings remain on-balance sheet.
21
The following table summarizes the fair value of the Company's Retained Interests along with the underlying student loans that relate to those securitizations that were treated as sales.
In addition to student loans in off-balance sheet trusts, the Company had $30 billion and $16 billion of securitized student loans outstanding (face amount) as of September 30, 2004 and December 31, 2003, respectively, in on-balance sheet securitization trusts.
22
4. Common Stock
The following table summarizes the Company's common share repurchase and equity forward activity for the three and nine months ended September 30, 2004 and 2003.
In October 2004, the Board of Directors voted to authorize the repurchase of up to an additional 30 million shares of the Company's common stock, in addition to the remaining authority at September 30, 2004.
As of September 30, 2004, the expiration dates and purchase prices for outstanding equity forward contracts were as follows:
The closing price of the Company's common stock on September 30, 2004 was $44.60.
23
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.
The following table reflects basic and diluted EPS for the three and nine months ended September 30, 2004 and 2003.
At September 30, 2004, the Company had $2 billion Co-Cos outstanding, that are convertible, under certain conditions, into shares of SLM common stock at an initial conversion price of $65.98. The investors generally can only convert the debentures if the Company's common stock has appreciated to 130 percent of the conversion price for a prescribed period, or the Company calls the debentures. Diluted EPS for all periods presented excludes the potential dilutive effect of the Company's outstanding Co-Cos for the three and nine months ended September 30, 2004 and 2003.
24
EITF No. 04-8 will require the shares underlying the Co-Cos to be included in diluted EPS, effective for reporting periods ending after December 15, 2004 with retroactive restatement to all required reporting periods (see Note 1, "Significant Accounting Policies—Recently Proposed Accounting Pronouncements").
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.
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 September 30, 2004 and December 31, 2003, and their impact on other comprehensive income and earnings for the three and nine months ended September 30, 2004 and 2003. At September 30, 2004 and December 31, 2003, $742 million and $158 million (fair value), respectively, of available-for-sale investment securities and $148 million and $31 million, respectively, of cash were pledged as collateral against these derivative instruments.
25
26
6. Pension Plans
Under the Company's qualified and supplemental pension plans for eligible employees (the "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 prior plans, which uses a final average pay plan method, or the current Pension Plans under the cash balance formula.
Effective July 1, 2004, the Pension Plans were frozen with respect to new entrants and participants with less than five years of service. No further benefits will accrue with respect to such participants under the Pension Plans, other than interest accruals on cash balance accounts. Accordingly, at July 1, 2004, the Company recorded a net curtailment gain of $4.5 million. Over the next five years, the Pension Plans will be frozen with respect to additional participants based on years of service. Employees as of June 30, 2004 who have five to nine years of service will continue to accrue benefits under the Pension Plans until June 30, 2006, while employees as of June 30, 2004 who have ten or more years of service will continue to accrue benefits under the Pension Plans through June 30, 2009. In response to this change in the Company's pension benefits, the Company increased the employer contribution in its defined contribution plan. Management believes that the net benefit from these changes in Pension Plans will mitigate projected increases in health plan costs.
Components of Net Periodic Pension Cost
Net periodic pension cost for the Company's Pension Plans and the Board of Directors supplemental pension plan, which was frozen in 1995, for the three and nine months ended September 30, 2004 and 2003 included the following components:
27
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 qualified pension plan (the "Qualified Plan") in 2004. As of September 30, 2004, the Company had made no contributions to its Qualified Plan.
7. 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, the jury returned a verdict in favor of the Company on all counts. CLC subsequently filed an appeal. Oral argument, before the U.S. Court of Appeals for the Fourth Circuit, was held on June 4, 2004 and on September 26, 2004. The Court of Appeals has not yet issued a decision in the case.
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 two million borrowers. In addition, the plaintiffs alleged that the Company charged excessive interest by capitalizing interest quarterly in violation of the promissory note. On February 28, 2003, the trial court granted the Company's motion to dismiss the complaint in its entirety. The Court of Appeals affirmed the Superior Court's decision granting the Company's motion to dismiss the complaint, but granted the plaintiffs leave to re-plead the first count, which alleged violations of the D.C. Consumer Protection Procedures Act. The Court of Appeals affirmed the dismissal of the remaining two counts with prejudice. On September 15, 2004, the plaintiffs filed an amended class action complaint. On October 14, 2004, the Company filed a motion to dismiss the amended complaint for failure to state a claim and non-compliance with the Court of Appeals' ruling.
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. On May 14, 2004, the court issued an order dismissing two of the three counts of the complaint. The case is currently in the discovery phase.
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
28
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 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.
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. In addition, the collections subsidiaries in the Company's debt management operation group are occasionally named in lawsuits in which the plaintiffs allege that the Company has violated a federal or state law in the process of collecting their account. It is not unusual for these subsidiaries to be named in a class action lawsuit relating to these allegations. 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.
8. Acquisitions
During the third quarter of 2004, the Company completed one acquisition and announced two additional acquisitions. The Company will account for these transactions under the purchase method of accounting as defined in SFAS No. 141, "Business Combinations," and allocate the purchase price to the fair market value of the assets acquired, including identifiable intangible assets and goodwill.
Arrow Financial Services
On September 15, 2004, the Company acquired 64 percent of Arrow Financial Services, a full-service, accounts receivable management company that purchases charged-off debt, conducts contingency collection work and performs third-party receivables servicing across a number of consumer asset classes, for a purchase price of approximately $165 million. Under the terms of the agreement, the Company has the option to purchase the remaining interest in Arrow Financial Services over a three-year period. The acquisition will be accounted for under the purchase accounting method and the purchase price will be allocated to tangible and intangible assets based on their fair market values when the independent appraisal is complete.
Arrow Financial Services employs nearly 1,400 individuals at locations in Niles, Illinois; Gaithersburg, Maryland; San Diego, California; Whitewater, Wisconsin; and Rockville Centre, New York. It will retain its brand and senior management team.
29
Southwest Student Services Corporation
On October 15, 2004, the Company completed its purchase of the outstanding stock of Southwest Student Services Corporation ("Southwest") from the Helios Education Foundation. The transaction includes Southwest's $4.8 billion student loan portfolio, its Phoenix-based loan origination and servicing center and its sales and marketing operations. In addition to the student loan portfolio, the purchase will expand the Company's loan origination capability and broaden its market reach.
Southwest provides for the origination, funding, acquisition and servicing of education loans. It is among the top 30 originators of federal student loans, issuing approximately $300 million in Stafford and PLUS loans and $1.5 billion in Consolidation Loans annually, and it is the nation's ninth largest holder of federal student loans. Southwest provides student loans and related services nationally with a primary focus on colleges and universities in Arizona and Florida. Southwest employs nearly 300 individuals.
Student Loan Finance Association
On September 23, 2004, the Company announced its intent to purchase the secondary market and related businesses of Education Assistance Foundation ("EAF") and its affiliate, Student Loan Finance Association ("SLFA"). SLFA is a Northwest regional leader in education loan funding and acquisition. The transaction includes SLFA's $1.6 billion student loan portfolio and an origination franchise that generates $50 million of student loan volume annually. In addition, as a part of this transaction, the Company will enter into a full service guarantor servicing contract with EAF's affiliate, Northwest Education Association ("NELA"), a guarantee agency for FFELP student loans that serves the Pacific Northwest. In a related transaction, NELA will become an affiliate of United Student Aid Funds ("USAF"), the Company's largest guarantor servicing client. The Company expects to close the transaction in two steps. The first step, which will include NELA and a portion of the SLFA assets, is expected to close by the end of 2004. The balance of the transactions is expected to close in 2005.
9. Bank One/JPMorgan Chase Merger
On July 30, 2004, following the merger of JPMorgan Chase and Bank One, the Company and Bank One entered into a comprehensive agreement under which (i) certain agreements between the parties were terminated in consideration for Bank One agreeing to pay termination fees of $23 million, including a $14 million fee to terminate a marketing services agreement and a $9 million fee to terminate a loan purchase agreement, and (ii) the ExportSS agreement between the parties was extended by more than three years. The separate joint venture agreement with JPMorgan Chase was not affected by the merger. Under its terms, by year end 2004, the Company will offer JPMorgan Chase new loan purchase and servicing terms for a five-year period beginning September 2007. If the Company and JPMorgan Chase are unable to mutually agree upon such terms by May 31, 2005, then either party may trigger a "Dutch auction" process. Under that process, the electing party offers to purchase the other party's 50 percent interest or sell its 50 percent interest in the joint venture at a specified price. The non-electing party then has the right to either sell its interest in the joint venture
30
or purchase the electing party's interest, in either case at the originally offered price. If the Company is the successful purchaser in a Dutch auction, then for a two-year period following the closing:
If JPMorgan Chase is the successful purchaser in a Dutch auction, then for a two-year period following the closing:
31
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 and nine months ended September 30, 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 we have substantially completed the Wind-Down of the GSE and have ceased all operating activities such that the GSE is no longer a source of liquidity for the Company's purchase of student loans. For the remainder of 2004, GSE activities will consist of repurchasing long-term GSE debt and preparing for the completion of the Wind-Down, now scheduled to occur December 31, 2004 or as soon as practicable thereafter. All GSE debt that remains outstanding upon completion of these Wind-Down activities will be defeased through the 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. At September 30, 2004, the GSE had $4.7 billion in assets remaining, consisting primarily of investments, cash and cash equivalents, which represents four percent of total Managed assets. The GSE no longer holds student loans. 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 liquidity provided to the Company by the GSE has been replaced by non-GSE financing, including securitizations originated by non-GSE subsidiaries of SLM Corporation. The GSE will no
32
longer sponsor securitizations of student loans. (See also "LIQUIDITY AND CAPITAL RESOURCES" for further discussion of the effects of the GSE Wind-Down.)
The GSE has no employees, so the management of its operations is provided by the Company under a management services agreement. We also serviced 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.
33
SELECTED FINANCIAL DATA
Condensed Statements of Income
34
Condensed Balance Sheets
35
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 of Realized Derivative Transactions—Non-GAAP Presentation." Information regarding the provisions 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.
36
Average Balance Sheets
The following tables reflect the rates earned on interest earning assets and paid on interest bearing liabilities for the three and nine months ended September 30, 2004 and 2003.
37
The decrease in the net interest margin from the three and nine months ended September 30, 2003 to the three and nine months ended September 30, 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 of Realized Derivative Transactions—Non-GAAP Presentation." The decrease in the net interest margin was also due to the increase in lower yielding short-term investments caused by the build up of non-GSE funding in anticipation of the early completion of the GSE Wind-Down.
Rate/Volume Analysis
The following rate/volume analysis illustrates the relative contribution of changes in interest rates and asset volumes.
Reclassification of Realized Derivative Transactions—Non-GAAP Presentation
In addition to unrealized gains and losses, the Financial Accounting Standards Board's ("FASB's") Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities," requires net settlement income/expense on derivatives and realized gains/losses on derivative dispositions ("realized derivative transactions") that do not qualify as accounting hedges under SFAS No. 133 to be recorded in a separate income statement line item below net interest income. We believe that it is also helpful to the understanding of our business to include two presentations of net interest income and net interest margin. The first is the GAAP presentation presented above that includes the net settlement income/expense on trading 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 reclassifies these derivative net settlements and realized gains and losses to the financial statement line item of the economically hedged item, where they are primarily included in net interest income and margin. This second presentation 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 sheets, rate/volume analysis, student loan spread and funding costs in the following tables reflect the
38
reclassifications. The table below details the reclassification of the derivative net 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 of Realized Derivative Transactions—Non-GAAP Presentation
39
Reconciliation of Taxable Equivalent Net Interest Income as Presented in Accordance with GAAP to the Non-GAAP Presentation for Realized Derivative Transactions
Average Balance Sheets After Reclassification of Realized Derivative Transactions—Non-GAAP Presentation
40
The 50 basis point and 57 basis point differences between the three and nine months ended September 30, 2004 non-GAAP net interest margins, respectively, versus the GAAP net interest margins in the same periods is primarily due to the inclusion of payments on Floor Income Contracts in the non-GAAP presentation which reduced net interest income by 50 and 59 basis points, respectively.
41
Rate/Volume Analysis After Reclassification of Realized Derivative Transactions—Non-GAAP Presentation
The following rate/volume analysis shows the relative contribution of changes in interest rates and asset volumes.
Student Loans
For both federally insured and Private Education 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 Education Loans are deferred and amortized to income over the lives of the student loans. In the "Student Loan Spread Analysis After Reclassification of Realized Derivative Transactions—Non-GAAP Presentation" table below, this amortization of origination fees is netted with the amortization of the premiums.
Student Loan Spread Analysis After Reclassification of Realized Derivative Transactions—Non-GAAP Presentation (see "Reclassification of Realized Derivative Transactions—Non-GAAP Presentation")
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 spread for the entire portfolio of Managed student loans on a similar basis to the
42
on-balance sheet analysis, see "ALTERNATIVE PERFORMANCE MEASURES—Student Loan Spread Analysis—Managed Basis."
Discussion of On-Balance Sheet Student Loan Spread, Non-GAAP Presentation
When compared with the third quarter of 2003, the decrease in the student loan spread is primarily due to lower Floor Income, higher spreads on our debt funding student loans and the increase in the average balance of Consolidation Loans as a percentage of the on-balance sheet portfolio. The increase in the spread to the index on our debt is due to 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. In addition, we use higher cost, longer-term debt to fund Consolidation Loans.
Consolidation Loans have lower spreads than other FFELP loans due to the 105 basis point Consolidation Loan Rebate Fee and the higher funding costs discussed above. 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 below. 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 Consolidation Loans representing an increasing percentage of our federally guaranteed student loan portfolio.
The year-over-year increase in the premium amortization and borrower benefit expenses is primarily the result of revised life of loan estimates for higher consolidation activity in the fourth quarter of 2003.
43
Floor Income
For on-balance sheet student loans, gross Floor Income is included in student loan income. The following table summarizes the components of Floor Income from on-balance sheet student loans, net of payments under Floor Income Contracts, for the three and nine months ended September 30, 2004 and 2003.
The decrease in Floor Income for the three months ending September 30, 2004 versus the year-ago period is primarily due to the increase in Floor Income Contracts and to the increase in interest rates since September 30, 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.
The following table analyzes the ability of the FFELP student loans in our Managed student loan portfolio to earn Floor Income after September 30, 2004 and 2003. Three-month Treasury bill loans are based on the last Treasury bill auctions of September 2004 and 2003 of 1.74 percent and .95 percent, respectively. Commercial paper rate loans are based on the last commercial paper rates of 1.90 percent
44
for September 2004 and 1.05 percent for September 2003. One-year Treasury bill loans are based on the last Treasury bill auctions of May 2004 and 2003 of 1.07 percent and 1.12 percent, respectively.
Floor Income Contracts with a notional value of $9.4 billion expired on September 30, 2004 and, therefore, were not economically hedging Floor Income at September 30, 2004. New contracts totaling $8.3 billion were entered into on October 1, 2004. The following table shows the average balance of Consolidation Loans whose Floor Income is economically hedged as of October 1, 2004 through the end of 2008. These loans are both on and off-balance sheet and the related hedges do not qualify as effective SFAS No. 133 hedges.
45
Activity in the Allowance for On-Balance Sheet Private Education Loan Losses
The following table summarizes changes in the allowance for Private Education Loan losses for the three and nine months ended September 30, 2004 and 2003.
The increase in the provision for Private Education Loan losses of $13 million for the three months ending September 30, 2004 versus the year-ago period is primarily due to the increase in Private Education Loans entering repayment prior to being securitized as compared to the three months ended September 30, 2003. The increase in net charge-offs as a percentage of average loans in repayment can mainly be attributed to the mix of Private Education Loans remaining on-balance sheet, because we primarily securitize loans that are current, leaving a higher percentage of delinquent loans on-balance sheet. Also career training loans, which tend to have higher charge-off rates, have increased as a percentage of the on-balance sheet Private Education Loan portfolio because none of them have been securitized.
We charge borrower fees on the majority of Private Education 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 September 30, 2004 and 2003 was $170 million and $102 million, respectively.
46
Forbearance and Delinquencies—On-Balance Sheet Private Education Loan Basis
The table below presents our on-balance sheet Private Education Loan delinquency trends as of September 30, 2004 and 2003. Delinquencies have the potential to adversely impact earnings through increased servicing and collection costs and if the delinquent accounts charge off.
Effective for a renewable one year period beginning on October 19, 2004, Sallie Mae Servicing, the Company's student loan servicing division, was designated as an EP by the DOE in recognition of meeting certain performance standards set by the DOE in servicing FFELP loans. As a result of this designation, the Company will receive 100 percent reimbursement on default claims on federally guaranteed student loans that were serviced by Sallie Mae Servicing for a period of at least 270 days before the date of default and will no longer be subject to the two percent Risk Sharing on these loans. The Company is entitled to receive this benefit as long as we remain in compliance with the required servicing standards, which are assessed on an annual and quarterly basis through compliance audits and other criteria. The EP designation applies to all FFELP loans that are serviced by the Company as well as default claims on federally guaranteed student loans that the Company owns but are serviced by other service providers with the EP designation. At September 30, 2004, approximately 98 percent of the Company's federally insured loans are no longer subject to Risk Sharing. As a result of this designation, the Company has reduced the balance in the Risk Sharing allowance for loan losses by $32 million with an equal reduction in the third quarter provision for loan losses.
47
On-Balance Sheet Funding Costs After Non-GAAP Reclassification (see "Reclassification of Realized Derivative Transactions—Non-GAAP 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 and nine months ended September 30, 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 Education Loans indexed to the Prime rate become a larger percentage of our portfolio. We expect daily reset LIBOR indexed debt to remain highly correlated with daily reset commercial paper indexed assets, so we fund a portion of our daily reset commercial paper indexed assets with LIBOR-based debt, swapped to the daily reset LIBOR index. The reduction in discount notes as a source of funding is due to the Wind-Down of the GSE as these instruments were primarily issued in the Agency credit markets by the GSE.
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."
Losses on Securities
The increase in losses on securities versus the prior quarter and year-ago quarter is primarily due to the $27 million leveraged lease impairment of the leveraged lease portfolio recorded in the third quarter (see "Leveraged Leases" below).
48
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 and nine months ended September 30, 2004 and 2003.
The $7 million decrease in guarantor servicing fees versus the year-ago quarter is due to the decrease in issuance fee per disbursement from 65 basis points to 40 basis points.
When compared to the third quarter of 2003, the decrease in the growth rate in debt management fees is due to a revision of our estimate of the amortization period for Default Aversion Fees ("DAF") to account for the effect of continued Consolidation Loan activity on the portfolio. This resulted in an $8 million reduction in DAF revenue in the third quarter of 2004. Exclusive of DAF revenue, the decrease in the quarter over quarter growth rate in debt management fees was also negatively impacted by the greater emphasis being placed on rehabilitating defaulted FFELP loans versus consolidating them with other lenders, as this collection strategy has higher margins but a longer revenue cycle. These negative factors in the growth in debt management fees have been offset by the growth in the business, principally at the Company's General Revenue Corporation and Pioneer Credit Recovery subsidiaries.
The increase in other income versus the prior quarter and year-ago quarter is due to higher marketing service fees and a $14 million termination fee received from Bank One (see also "RECENT DEVELOPMENTS—Bank One/JPMorgan Chase Merger"). In addition, in the third quarter of 2003, we changed the method of accounting for fees earned for performing information technology enhancements under an agreement with USAF, that resulted in an $18 million deferral of revenue previously recognized.
Loss on GSE Debt Extinguishment
In the third quarter of 2004, we recognized a $103 million loss on the repurchase of approximately $1.7 billion of GSE debt through a tender offer in August 2004 in connection with the Wind-Down of the GSE. Based on current interest rates on October 13, 2004, we estimate that additional losses related to future debt repurchases and the eventual defeasance of the debt will be between $117 million and $127 million.
49
OPERATING EXPENSES
The following table summarizes the components of operating expenses for the three and nine months ended September 30, 2004 and 2003.
The increase in operating expenses for the three and nine months ended September 30, 2004 versus the year-ago periods is mainly attributable to the operating expenses of Academic Management Services Corp. ("AMS") acquired in the fourth quarter of 2003, increased servicing and debt management expenses consistent with the growth in borrowers and the growth in the debt management business. 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 September 30, 2004 and 2003, respectively, and .15 percent and .16 percent for the nine months ended September 30, 2004 and 2003, respectively.
50
STUDENT LOAN ACQUISITIONS
In the nine months ended September 30, 2004, 76 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 and nine months ended September 30, 2004 and 2003.
51
Preferred Channel Originations
We originated $5.9 billion and $14.0 billion in student loan volume through our Preferred Channel in the three and nine months ended September 30, 2004, respectively, versus $5.0 billion and $11.8 billion in the three and nine months ended September 30, 2003.
In the third quarter of 2004, we grew the Sallie Mae brand Preferred Channel Originations by 30 percent versus the year-ago quarter. For the three months ended September 30, 2004, our own brands constituted 32 percent of our Preferred Channel Originations, up from 29 percent in the year-ago period. The pipeline of loans that we currently service and are committed to purchase was $6.4 billion and $5.9 billion at September 30, 2004 and 2003, respectively. The following tables further break down our Preferred Channel Originations by type of loan and source. (See also "RECENT
52
DEVELOPMENTS—Bank One/JPMorgan Chase Merger" for a discussion related to our lender partners.)
The following table summarizes the activity in our Managed portfolio of student loans for the three and nine months ended September 30, 2004 and 2003.
LEVERAGED LEASES
At September 30, 2004, we had investments in leveraged and direct financing leases, net of impairments, totaling $167 million that are general obligations of two commercial airlines and Federal Express Corporation. The aircraft financing business for traditional airlines continues to be adversely affected by the slowdown in the commercial aircraft industry, higher fuel costs and increased competition from new discount carriers. In recognition of this trend and the deteriorating financial condition of Delta Airlines, we recorded an impairment of $27 million in the third quarter of 2004. Based on an analysis of the potential losses on certain leveraged leases plus the increase in incremental tax obligations related to forgiveness of debt obligations and/or the taxable gain on the sale of the aircraft, our remaining after-tax accounting exposure to the two commercial airlines totaled $80 million at September 30, 2004.
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 and nine months ended September 30, 2004 was 21 percent and 30 percent, respectively, versus 37 percent and 36 percent, respectively, for the three and nine months ended September 30, 2003. The effective tax
53
rate for the period ended September 30, 2004 reflects the permanent benefit of the exclusion of the gains on equity forward contracts under SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity," adopted in the third quarter of 2003.
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 stand-alone derivative must be marked-to-market in the income statement with no consideration for the corresponding change in fair value of the hedged item. The 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, 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 derivatives in accordance with SFAS
54
No. 133 and mark them to market through earnings. They do not qualify as effective SFAS No. 133 hedges as a requirement to achieve hedge accounting is the hedged item must impact net income. The purchase of our own stock does not impact net income.
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 and nine months ended September 30, 2004 and 2003.
55
The table below separates the effect of the unrealized derivative marks-to-market included in the derivative market value adjustment under SFAS No. 133 from realized derivative transactions for the three and nine months ended September 30, 2004 and 2003, respectively, and accounts for them and other derivative adjustments, 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 Eurodollar futures contracts, 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 and nine months ended September 30, 2004 and 2003.
56
For the three and nine months ended September 30, 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 earnings from our portfolio of Managed student loans on a "core cash" basis. This analysis includes both on-balance sheet and off-balance sheet loans in securitization trusts and derivatives economically hedging these line items (see "NET INTEREST INCOME—Reclassification of Realized Derivative Transactions—Non-GAAP Presentation") and excludes Floor Income while including the amortization of upfront payments on Floor Income Contracts.
Discussion of Managed Student Loan Spread
The third quarter 2004 Managed student loan spread equaled the third quarter 2003 student loan spread; however, there were a number of items that impacted the quarter-to-quarter spread analysis. The third quarter of 2004 benefited from a decrease in the borrower benefit reserve caused by a change in estimate to reflect the effect of the continued high rate of early Consolidation Loans on the
57
FFELP Stafford portfolio. Early consolidations result in fewer Stafford borrowers qualifying for borrower benefits as their loans consolidate before they are eligible. In response to this trend, we lowered our estimate of the number of Stafford borrowers who will eventually qualify for borrower benefits and revised the term over which Consolidation Loan benefits are expected to be realized. As a result, we recorded a $22 million or nine basis point reduction in the borrower benefits reserve. These positive effects were offset by the increase in the average balance of Consolidation Loans as a percentage of the Managed portfolio and higher spreads on our debt funding student loans. The increase in the spread to the index on our debt is due to 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. The higher credit spreads on non-GSE debt is partially offset by the absence of Offset Fees applicable only to loans financed by the GSE. In addition, we use higher cost, longer-term debt to fund Consolidation Loans.
Consolidation Loans have lower spreads than other FFELP loans due to the 105 basis point Consolidation Loan Rebate Fee and higher costs of funds for reasons discussed above. The negative effect of this fee is partially offset by the absence of the 30 basis point Offset Fee on GSE funded student loans in 2003, higher SAP yield and lower student loan premium amortization discussed below. 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 Consolidation Loans representing an increasing percentage of our federally guaranteed student loan portfolio.
The third quarter 2004 Managed student loan spread also benefited from the increase in the average balance of Managed Private Education Loans as a percentage of the average Managed student loan portfolio from 9 percent in the third quarter 2003 to 11 percent in the third quarter 2004. Private Education Loans are subject to credit risk and therefore earn higher spreads which averaged 4.40 percent in the third quarter of 2004 for the Managed Private Education Loan portfolio versus a spread of 1.51 percent for the Managed guaranteed student loan portfolio.
Allowance for Private Education Loan Losses—Managed Basis
The allowance for Private Education Loan losses is an estimate of probable losses in the portfolio at the balance sheet date that will be charged off in subsequent periods. We estimate our losses by analyzing historical data from our Private Education Loan portfolios, extrapolating FFELP loan loss data, and considering current trends and relevant industry information. As our Private Education Loan portfolios continue to mature, more reliance is placed on our own historical charge-off and recovery data. We use this data in internally developed models to estimate losses, net of subsequent collections, projected to occur in the Private Education Loan portfolios.
58
An analysis of our allowance for loan losses for Managed Private Education Loans for the three and nine months ended September 30, 2004 and 2003 is presented in the following table.
The increase in the provision for Managed Private Education Loan losses for the third quarter of 2004 versus the year-ago quarter is primarily attributed to the growth in the portfolio of Managed Private Education Loans and to updates to our default assumptions in the third quarter of 2004.
The increase in charge-offs is primarily due to the continued growth and maturity of loans in repayment. Reserves and charge-offs will continue to increase with the growth in the repayment portfolio. As discussed further below, the delinquency and forbearance amounts will also increase with the growth in the repayment portfolio. We utilize the expertise of our collection organization, including our debt management operation, to minimize charge-offs in our own portfolio and to increase recoveries on charged-off loans.
We charge borrower fees on the majority of Managed Private Education 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 on a Managed Basis at September 30, 2004 and 2003 was $266 million and $137 million, respectively.
Forbearance and Delinquencies—Managed Basis
The tables below show our Managed Private Education Loan forbearance and delinquency trends at September 30, 2004 and 2003. Forbearances and delinquencies result in increased servicing and collection costs and have the potential to adversely impact earnings if the account charges off. Based on the timing of graduation, there are peak times when loans enter repayment which creates seasonal increases in delinquency and forbearance in the first and third quarters of the fiscal year.
59
Loans in forbearance status increased from 11.2 percent of loans in repayment and forbearance status at September 30, 2003 to 11.3 percent of loans in repayment and forbearance status at September 30, 2004.
Private Education Loans are made to parent and student borrowers in accordance with our underwriting policies. These loans generally supplement the federally guaranteed student loans, which are subject to federal lending caps and are not guaranteed or insured against any loss of principal or interest. Student borrowers generally use the proceeds of these loans to obtain education and training, which increases the likelihood of obtaining employment at higher income levels. As a result, the loan generally results in the borrowers' repayment capability improving between the time the loan is made and the time they enter the post-education work force. Consistent with the federal guaranteed student loan program, we allow the loan repayment period on all Private Education Loans, except career training loans, to begin six months after the student borrower leaves school. This provides the borrower time to obtain employment and improves his or her ability to service the debt. For borrowers that need more than six months or experience other hardships, we may permit additional payment deferments or partial payments (both referred to as forbearances) when we believe additional time will improve the borrower's ability to repay the loan. Our current policy does not grant any reduction in the repayment obligation (principal or interest) but does allow the borrower to stop or reduce monthly payments for an agreed period of time. If appropriate, we grant forbearance in three to six month increments. During repayment, borrowers may request and obtain forbearances multiple times. Payment deferments can have the effect of reducing delinquencies and delaying charge-offs; however, the potential impact is appropriately considered in the determination of the loan loss reserves.
60
The table below breaks down the loans in forbearance by the cumulative number of months of forbearance the borrower has used as of September 30, 2004:
The table below shows the composition and status of the Private Education Loan portfolio by number of months aged from the first date of repayment:
Allowance for FFELP Student Loan Losses—Managed Basis
As a result of Sallie Mae Servicing receiving the EP designation by the DOE, we have reduced the balance in the Managed Risk Sharing allowance for loan losses by $62 million with an equal reduction in the third quarter provision for loan losses. At September 30, 2004, approximately 99 percent of our Managed federally insured loans are no longer subject to Risk Sharing. (See "Allowance for FFELP Student Loan Losses" above for a further discussion of the EP designation.)
61
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. Our biggest funding challenge 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 funding is student loan securitizations. In the first nine months of 2004, we securitized $29.9 billion in student loans in twelve transactions versus $22.1 billion in twelve transactions in the first nine months of 2003. Securitizations now comprise approximately 69 percent of total Managed debt at September 30, 2004. We expect approximately 75 percent of our student loan funding to come through securitizations by 2006. Our securitizations backed by FFELP loans are unique securities in the asset-backed class as they are backed by student loans with an explicit federal guarantee on 98 percent of principal and interest, 100 percent after October 19, 2004 (see "Allowance for FFELP Student Loan Losses" for a discussion of EP designation). This guarantee is subject to service compliance but is not related to the Company's GSE subsidiary. As evidenced by the 2004 volume, we have built a highly liquid and deep market for student loan securitizations by broadening our investor base worldwide. At September 30, 2004, we financed 100 percent of our Managed student loans from non-GSE sources versus 70 percent at September 30, 2003. In addition to securitizations, in the first nine months of 2004 we also significantly increased and diversified other financing through the issuance of $11.7 billion in SLM Corporation, term unsecured debt. In total, at September 30, 2004, non-GSE on-balance sheet debt, exclusive of on-balance sheet securitizations, totaled $32.2 billion, an 81 percent increase over September 30, 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 balances at September 30, 2004 and 2003 and average balances and average interest rates of our Managed borrowings for the three and nine months ended September 30, 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.
62
(See "NET INTEREST INCOME—Reclassification of Realized Derivative Transactions—Non-GAAP Presentation.")
SLM Corporation's stand-alone liquidity is derived from our asset-backed commercial paper program, the issuance of unsecured commercial paper, $5 billion in committed bank lines of credit as of October 21, 2004, and our short-term investment portfolio. In addition, our Managed student loan assets are a source of liquidity due mainly to broad market acceptance of our principal asset of government guaranteed student loans.
GSE Financing Activities
As of September 30, 2004, we have substantially completed the Wind-Down of the GSE. The GSE will no longer finance the purchase of student loans and will have minimal debt issuances through the completion of the Wind-Down, now scheduled to occur December 31, 2004 or as soon as practicable thereafter. In August 2004, the Company repurchased approximately $1.7 billion of GSE debt through a tender offer and recorded a loss of $103 million. Any GSE debt securities not tendered must be defeased under the terms of the Privatization Act in an irrevocable defeasance trust that is collateralized by cash, U.S. Treasury securities and agency securities that are backed by the full faith and credit of the U.S. government. Based on current interest rates on October 13, 2004, management estimates that additional losses related to future debt repurchases and the eventual defeasance of the debt will be between $117 million and $127 million. Management expects to defease any GSE debt that is remaining outstanding after the tender offer to occur December 31, 2004 or as soon as practicable thereafter. (See also "STUDENT LOAN MARKETING ASSOCIATION—Privatization Act—GSE Wind-Down.")
63
Non-GSE Unsecured On-Balance Sheet Financing Activities
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 and nine months ended September 30, 2004 and 2003.
Liquidity Risk
Except for minor short-term debt issuances by the GSE in connection with the Wind-Down, all of our future financing activity will come from non-GSE sources, and as a result, our long-term funding, credit spreads and liquidity exposure to the capital markets have shifted from the government agency capital markets to the corporate and asset-backed capital 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. Going forward, securitizations will continue to be the primary source of long-term financing. Except for our asset-backed commercial paper conduit, our securitizations are structured such that we do not provide any level of financial, credit or liquidity support to any of the trusts. Our exposure is limited to the recovery of the Retained Interest asset on the balance sheet related to our off-balance sheet deals. Our FFELP Stafford 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.
64
Securitization Activities
We updated certain assumptions during the third quarter of 2004 used in the valuation of the Residual Interest. The following are the significant assumption changes that were made:
The FFELP Stafford CPR assumption was increased to account for the continued high levels of Consolidation Loan activity. We lowered our assumption of expected FFELP credit losses to zero percent to reflect the effect of the EP designation on Sallie Mae serviced FFELP loans in the trusts. The EP designation is discussed in more detail above in "Allowance for FFELP Student Loan Losses." In total, the change in the fair value of the Company's Residual Interests due to all assumption changes as of September 30, 2004, when compared to prior assumptions, was a decrease of $11 million.
Securitization Program
Our FFELP Stafford, Private Education Loan and certain Consolidation Loan securitizations are structured such that they meet the sale criteria of SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities—a Replacement of SFAS No. 125," 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 as a sale. The holders of the beneficial interests issued by the QSPE are not constrained from pledging or exchanging their interests and 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.
Prior to 2003, all of our securitization structures were off-balance sheet transactions. In certain 2003 and 2004 Consolidation Loan securitization structures, we hold rights that can affect the remarketing of the bonds, such that these securitizations did not qualify as QSPEs and must therefore be accounted for on-balance sheet as variable interest entities ("VIEs"). 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. As of September 30, 2004, we had $30 billion of securitized student loans in on-balance sheet securitization trusts. These securitizations are included with financings in the table below.
65
At September 30, 2004 and December 31, 2003, securitized student loans outstanding totaled $74.5 billion and $55.1 billion, respectively.
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
66
subsequent quarter using a discounted cash flow methodology. At September 30, 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 September 30, 2004 and 2003 was $2.4 billion and $2.9 billion, respectively, and for the nine months ended September 30, 2004 and 2003 was $2.4 billion and $2.7 billion, respectively. The deferred tax liability associated with these assets was $311 million and $275 million at September 30, 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 September 30, 2004 and December 31, 2003 was $549 million and $727 million, respectively.
The following table summarizes the components of servicing and securitization revenue for the three and nine months ended September 30, 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 on FFELP Stafford student loan securitizations. When FFELP Stafford loans consolidate they are bought out of the trust, which shortens the life of the trust. We estimate the trust prepayments through consolidation with our CPR assumption. When consolidation activity is higher than forecasted, the Residual Interest asset can be impaired and the yield used to recognize subsequent income from the trust is negatively impacted. Impairments related to the Retained Interests for the three months ended September 30, 2004 and 2003, respectively, were $12 million and $12 million. These impairment charges were recorded as a loss and are included as a reduction in securitization revenue. The impairment charge of $61 million for the nine months ended
67
September 30, 2004 is primarily the result of (a) FFELP Stafford loans continuing to consolidate at levels faster than projected, resulting in $28 million of impairment and (b) rising interest rates during the second quarter of 2004 which decreased the value of the Floor Income component of our Retained Interest resulting in $33 million of impairment.
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 Education Loans, the Prime rate.
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 September 30, 2004 and is not necessarily reflective of positions that existed throughout the period.
68
Weighted Average Life
The following table reflects the weighted average life for our Managed earning assets and liabilities at September 30, 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 1.2 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
The following table summarizes our common share repurchase and equity forward activity for the three and nine months ended September 30, 2004 and 2003.
69
acceleration of these equity forward contracts, we entered into new equity forward contracts with the same counterparties covering 46.7 million shares of our common stock. The purchase prices related to these new equity forward contracts were the current market prices of our stock when such contracts were entered into. The net reduction of equity forward contracts outstanding from this transaction of 6.7 million shares is shown net in the "exercises" row of the table.
At September 30, 2004, the total common shares that could potentially be acquired over the next five years under outstanding equity forward contracts was 48.1 million shares at an average price of $43.46 per share. We have remaining authority to enter into additional share repurchases and equity forward contracts for 8.4 million shares. In October 2004, the Board of Directors voted to authorize the repurchase of up to an additional 30 million shares of the Company's common stock, in addition to the remaining authority at September 30, 2004.
STUDENT LOAN MARKETING ASSOCIATION
Privatization Act—GSE Wind-Down
On June 30, 2004, the Company purchased FFELP student loans through non-GSE affiliates and as a result the GSE was required by statute to terminate all such activity. As a result, the GSE is no longer a source of liquidity for the Company's purchase of student loans and the Company's GSE-related financing activities will primarily consist of refinancing the remainder of its assets through non-GSE sources. All GSE debt that remains outstanding upon completion of these Wind-Down activities will 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 provide for the interest and principal obligations of the defeased debt. Through September 30, 2004, the Company repurchased approximately $1.7 billion of GSE debt through a tender offer and recorded a loss of $103 million. Based on current interest rates on October 13, 2004, the Company estimates that additional losses related to future debt repurchases and the eventual defeasance of the debt will be between $117 million and $127 million.
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
70
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 September 30, 2004, the GSE's statutory capital adequacy ratio was 36.64 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 September 30, 2004, the GSE's capital ratio under this measurement formula was 150 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 and the GSE has not issued any long-term debt since July 2003. The GSE will no longer issue short-term floating rate notes, but will continue to issue other short-term debt as necessary, until all current GSE assets are refinanced. 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 have securitized, sold, and transferred the majority of the GSE's assets such that at September 30, 2004, the GSE had $4.7 billion in assets remaining of which none were student loans. This represents four percent of total Managed assets. At September 30, 2004, the GSE's assets primarily consisted of investments, cash and cash equivalents.
Given the GSE's current exemption from state income taxes, management is continually evaluating the impact upon the Company's overall state tax position resulting from planned sales and transfers of GSE assets. It is currently projected that for 2005, the Company's state tax rate will increase by 0.5 percent to 1 percent above current levels as a result of the GSE asset transfers.
71
The following table summarizes the GSE's asset sales and transfers for the three and nine months ended September 30, 2004 and 2003 (carrying value includes accrued interest).
72
All intercompany transactions between the GSE and the Company and its non-GSE subsidiaries have been eliminated in the Company's consolidated financial statements.
The following table shows the percentage of certain assets and income held by the GSE versus non-GSE as of and for the nine months ended September 30, 2004.
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 and nine months ended September 30, 2004 and 2003.
73
RECENT DEVELOPMENTS
Acquisitions
During the third quarter of 2004, we completed one acquisition and announced two additional acquisitions. We will account for these transactions under the purchase method of accounting as defined in SFAS No. 141, "Business Combinations," and allocate the purchase price to the fair market value of the assets acquired, including identifiable intangible assets and goodwill.
On September 15, 2004, we acquired 64 percent of Arrow Financial Services, a full-service, accounts receivable management company that purchases charged-off debt, conducts contingency collection work and performs third-party receivables servicing across a number of consumer asset classes, for a purchase price of approximately $165 million. Under the terms of the agreement, Sallie Mae has the option to purchase the remaining interest in Arrow Financial Services over a three-year period. The acquisition will be accounted for under the purchase accounting method and the purchase price will be allocated to tangible and intangible assets based on their fair market values when the independent appraisal is complete.
On October 15, 2004, we completed our purchase of the outstanding stock of Southwest Student Services Corporation ("Southwest") from the Helios Education Foundation. The transaction includes Southwest's $4.8 billion student loan portfolio, its Phoenix-based loan origination and servicing center and its sales and marketing operations. In addition to the student loan portfolio, the purchase will expand our loan origination capability and broaden our market reach.
On September 23, 2004, we announced our intent to purchase the secondary market and related businesses of Education Assistance Foundation ("EAF") and its affiliate, Student Loan Finance Association ("SLFA"). SLFA is a Northwest regional leader in education loan funding and acquisition. The transaction includes SLFA's $1.6 billion student loan portfolio and an origination franchise that generates $50 million of student loan volume annually. In addition, as a part of this transaction, we will enter into a full service guarantor servicing contract with EAF's affiliate, Northwest Education Association ("NELA"), a guarantee agency for FFELP student loans that serves the Pacific Northwest. In a related transaction, NELA will become an affiliate of USAF, the Company's largest guarantor servicing client. We expect to close the transaction in two steps. The first step, which will include NELA and a portion of the SLFA assets, is expected to close by the end of 2004. The balance of the transactions is expected to close in 2005.
74
Exceptional Performer Designation
On October 5, 2004, the DOE formally notified us that the Company's loan servicing division, Sallie Mae Servicing, received the Department's "Exceptional Performer" designation, a classification awarded to qualified lenders and loan servicers for meeting certain government standards in administering loans under the FFELP.
To qualify as an Exceptional Performer, lenders and servicers must achieve an overall compliance performance rating of 97 percent or higher for servicing requirements set by the DOE on federally guaranteed loans.
As a result of the designation, during a one-year period that commenced on October 19, 2004, the Company will receive 100 percent reimbursement on default claims on federally guaranteed student loans that were serviced by Sallie Mae Servicing for a period of at least 270 days prior to the date of default. This one-year period may be extended on an annual basis so long as the Company maintains a satisfactory overall compliance rating. The initial one-year period and any extensions are subject to quarterly compliance audits that can result in the revocation of the designation.
Bank One/JPMorgan Chase Merger
On July 30, 2004, following the merger of JPMorgan Chase and Bank One, the Company and Bank One entered into a comprehensive agreement under which (i) certain agreements between the parties were terminated in consideration for Bank One agreeing to pay termination fees of $23 million, including a $14 million fee to terminate a marketing services agreement and a $9 million fee to terminate a loan purchase agreement, and (ii) the ExportSS agreement between the parties was extended by more than three years. The separate joint venture agreement with JPMorgan Chase was not affected by the merger. Under its terms, by year end 2004, we will offer JPMorgan Chase new loan purchase and servicing terms for a five-year period beginning September 2007. If the Company and JPMorgan Chase are unable to mutually agree upon such terms by May 31, 2005, then either party may trigger a "Dutch auction" process. Under that process, the electing party offers to purchase the other party's 50 percent interest or sell its 50 percent interest in the joint venture at a specified price. The non-electing party then has the right to either sell its interest in the joint venture or purchase the electing party's interest, in either case at the originally offered price. If we are the successful purchaser in a Dutch auction, then for a two-year period following the closing:
During the academic year 2004-2005, we expect to originate $5.4 billion of loans through the Bank One/JPMorgan Chase brand names.
75
Legislative Update
American Jobs Creation Act of 2004
On October 22, 2004 President Bush signed into law the American Jobs Creation Act of 2004 (the "October 22 Act"), which amends the Internal Revenue Code of 1986. Among other things, the October 22 Act permits the Secretary of the Treasury to contract with private entities to perform tax-collection services similar to the services the Company's Pioneer Credit Recovery subsidiary currently performs for the U.S. Department of Education. The Company believes that it is well qualified to bid for any work outsourced under the October 22 Act.
Taxpayer-Teacher Protection Act of 2004
On October 30, 2004 President Bush signed the Taxpayer-Teacher Protection Act of 2004 (the "October 30 Act"), a new law that amends the Higher Education Act of 1965, as amended ("HEA"). The October 30 Act restricts the situations in which lenders are entitled to a minimum yield of 9.5 percent in connection with loans made from the proceeds of certain tax-exempt bonds. Specifically, the DOE will no longer guarantee a minimum yield of 9.5 percent for a loan financed with qualifying tax-exempt bonds if (1) the underlying bond matures, is retired, is defeased or is refunded or (2) if the loan is refinanced with funds obtained from certain bonds or is sold or transferred to another holder. The Act, which is effective for a 15-month period, is expected to be permanently extended as part of the reauthorization of the HEA. Management expects that the October 30 Act will have no impact on the Company's earnings or operations.
OTHER RELATED EVENTS AND INFORMATION
Congress reauthorizes HEA every five years. The HEA was originally scheduled to expire on September 30, 2003. In October 2004, Congress passed legislation extending the HEA until September 30, 2005. We now expect final Congressional action on the next full reauthorization to occur in 2005.
As with past HEA 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:
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 or introduced by Members of Congress, including proposals to create a program that may 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
76
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 adopted, a student loan auction proposal, depending on its structure, 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. We expect that some of these proposals will be discussed in the context of the full HEA reauthorization.
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 and nine months ended September 30, 2004 and 2003 and the effect on fair values at September 30, 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.
77
78
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—On-Balance Sheet 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 and nine months ended September 30, 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 the fixed rate nature of student loans to variable rate, and to fix the relative spread between the student loan asset rate and the variable rate liability.
In the above table under the scenario where interest rates increase 100 basis points, the increase in pre-tax net income before the unrealized derivative market value adjustment for 2004 is primarily due to the impact of (i) our off-balance sheet Consolidation Loan securitizations and the related Embedded Floor Income recognized as part of the gain on sale, which results in no change in the Embedded Floor Income as a result of the increase in rates and (ii) our unhedged on-balance sheet loans not currently having significant Floor Income due to the recent increase in interest rates, which results in these loans being more variable rate in nature. The decrease in pre-tax net income in 2003 before the unrealized derivative market value adjustment 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 the unrealized derivative market value adjustment 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.
79
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.
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's") 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.
80
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
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 two million borrowers. In addition, the plaintiffs alleged that the Company charged excessive interest by capitalizing interest quarterly in violation of the promissory note. On February 28, 2003, the trial court granted the Company's motion to dismiss the complaint in its entirety. The Court of Appeals affirmed the Superior Court's decision granting our motion to dismiss the complaint, but granted plaintiffs leave to re-plead the first count, which alleged violations of the D.C. Consumer Protection Procedures Act. The Court of Appeals affirmed the dismissal of the remaining two counts with prejudice. On October 15, 2004, the plaintiffs filed an amended class action complaint. On September 15, 2004, the Company filed a motion to dismiss the amended complaint for failure to state a claim and non-compliance with the Court of Appeals' ruling.
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.
81
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. In addition, the collections subsidiaries in our debt management operation group are occasionally named in lawsuits in which the plaintiffs allege that we have violated a federal or state law in the process of collecting their account. It is not unusual for these subsidiaries to be named in a class action lawsuit relating to these allegations. 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.
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 third 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 has authorized the purchase of up to 227.5 million shares as of September 30, 2004. In October 2004, the Board of Directors voted to authorize the repurchase of up to an additional 30 million shares of the Company's common stock, in addition to the remaining authority at September 30, 2004.
Item 3. Defaults Upon Senior Securities
Nothing to report.
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
82
Item 6. Exhibits and Reports on Form 8-K
The Company furnished or filed one Current Report on Form 8-K with the Commission during the quarter ended September 30, 2004 or thereafter. On October 21, 2004, the Company furnished a Current Report in connection with the Company's press release announcing its earnings for the quarter ended September 30, 2004 and its supplemental financial information for the same period.
83
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: November 9, 2004
84
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 ASSOCIATIONCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDER'S EQUITY(Dollars in thousands)(Unaudited)
A-4
A-5
STUDENT LOAN MARKETING ASSOCIATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) (Unaudited)
A-6
STUDENT LOAN MARKETING ASSOCIATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Information at September 30, 2004 and for the three and nine months ended September 30, 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 and nine months ended September 30, 2004 may not necessarily be indicative of the results for the year ending December 31, 2004. The GSE is a wholly owned subsidiary of SLM Corporation ("the Company"). 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.
Going Concern—GSE Wind-Down
The financial statements have been prepared using the going concern basis of accounting, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company continues to use going concern accounting as substantially all assets and operations of the GSE will be transferred to its parent, SLM Corporation. As of September 2004, the Company had substantially completed the Wind-Down of the GSE and, on November 1, 2004, the Company sent notices to the Secretary of Education and the Secretary of the Treasury that it intends to wind-down and dissolve the GSE on December 31, 2004 or as soon as practicable thereafter. Accordingly, SLMA will not continue as a going concern and its assets will be realized and liabilities satisfied through the Wind-Down process. On October 28, 2004, as part of the Wind-Down process, the GSE paid a cash dividend of $900 million to the Company.
On June 30, 2004, the Company purchased FFELP student loans through non-GSE affiliates and as a result the GSE was required by statute to terminate all such activity. As a result, the GSE is no longer a source of liquidity for SLM Corporation's purchase of student loans and SLM Corporation's GSE related financing activities will primarily consist of refinancing the remainder of the GSE's assets through non-GSE sources. All GSE debt that remains outstanding upon completion of these Wind-Down activities will be defeased through the 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. Through September 30, 2004, SLM Corporation repurchased approximately $1.7 billion of GSE debt through a tender offer and recorded a loss of $103 million. Also in connection with the Wind-Down, the GSE will no longer issue short-term floating rate notes, but will continue to issue other short-term debt, as necessary, until all current GSE assets are refinanced. At September 30, 2004, the GSE had $4.7 billion in assets remaining primarily consisting of cash and cash equivalents and investments. The GSE no longer holds student loans.
A-7
In addition to unrealized gains and losses, 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 (collectively referred to as "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. The table below summarizes the reclassification of the realized derivative transactions for the three and nine months ended September 30, 2003.
2. Student Loans
As a result of the GSE Wind-Down, as of September 30, 2004, SLMA no longer holds student loans. (See Note 1, "Going Concern—GSE Wind-Down," and Note 6, "Related Parties"). Previously, SLMA purchased student loans from originating lenders. SLMA's portfolio consisted 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 purchased Private Education Loans.
A-8
The following table reflects the distribution of SLMA's student loan portfolio by program as of September 30, 2004 and 2003.
3. Allowance for Student Loan Losses
The provisions for student loan losses represent the periodic expense of maintaining an allowance sufficient to absorb losses, net of recoveries, inherent in the student loan portfolios. The evaluation of the provisions for student loan losses is inherently subjective as it requires material estimates that may be susceptible to significant changes. SLMA believes that the allowance for student loan losses is adequate to cover probable losses in the student loan portfolios.
A-9
The following table summarizes changes in the allowance for student loan losses for SLMA's Private Education and federally insured student loan portfolios for the three and nine months ended September 30, 2004 and 2003.
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, and in the second quarter of 2004, SLMA sold its Retained Interests in securitizations to SLM Corporation in a cash transaction.
A-10
The following table summarizes securitization activity for the three and nine months ended September 30, 2004 and 2003. Those securitizations listed as sales are off-balance sheet transactions and those listed as financings remain on-balance sheet.
A-11
Key economic assumptions used in estimating the fair value of the Retained Interests at the date of securitization for FFELP Stafford securitization transactions that qualified as sales during the three and nine months ended September 30, 2004 and 2003 were as follows:
A-12
The following tables summarize the fair values and notional amounts of all derivative instruments at September 30, 2004 and December 31, 2003, and their impact on other comprehensive income and earnings for the three and nine months ended September 30, 2004 and 2003. At September 30, 2004 and December 31, 2003, $0 million and $156 million (fair value), respectively, of available-for-sale investment securities were pledged as collateral against these derivative instruments.
A-13
A-14
6. 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 has securitized, sold and transferred the majority of SLMA's assets. The following table summarizes SLMA's asset sales and transfers for the three and nine months ended September 30, 2004 and 2003 (carrying value includes accrued interest).
A-15
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 September 30, 2004 and 2003 totaled $3 million and $23 million, respectively, and for the nine months ended September 30, 2004 and 2003 totaled $37 million and $70 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.
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 September 30, 2004 and 2003 totaled $0 million and $68 million, respectively, and for the nine months ended September 30, 2004 and 2003 totaled $63 million and $151 million, respectively.
At September 30, 2004 and December 31, 2003, SLMA had a net intercompany liability of $275 million and $530 million, respectively, with SLM Corporation and several of its non-GSE subsidiaries.
Through the second quarter of 2004, SLMA purchased insurance for its Private Education Loan portfolio from HICA. SLMA paid HICA insurance premiums in return for HICA's guarantee of payment of principal and interest on Private Education Loans. In connection with this arrangement, HICA invested its insurance reserves related to SLMA's HICA insured loans in a Master Promissory Note of SLMA to HICA. This note matured on July 1, 2004. At December 31, 2003, SLMA owed HICA $69 million under this note.
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, the jury returned a verdict in favor of SLMA on all counts. CLC subsequently filed an appeal. Oral argument, before the U.S. Court of Appeals for the Fourth Circuit, was held on June 4, 2004 and on September 26, 2004. The Court of Appeals has not yet issued a decision in the case.
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 two million
A-16
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 trial court granted SLMA's motion to dismiss the complaint in its entirety. The Court of Appeals affirmed the Superior Court's decision granting SLMA's motion to dismiss the complaint, but granted plaintiffs leave to re-plead the first count, which alleged violations of the D.C. Consumer Protection Procedures Act. The Court of Appeals affirmed the dismissal of the remaining two counts with prejudice. On September 15, 2004, the plaintiffs filed an amended class action complaint. On October 15, 2004, SLMA filed a motion to dismiss the amended complaint for failure to state a claim and non-compliance with the Court of Appeals' ruling.
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. On May 14, 2004, the court issued an order dismissing two of the three counts of the complaint. The case is currently in the discovery phase.
SLMA, 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. SLMA together with the other plaintiffs and the DOE have filed cross-motions for summary judgment. The Court has not ruled on these motions.
SLMA is also subject to various claims, lawsuits and other actions that arise in the normal course of business. 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.
A-17
QuickLinks