UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 For the fiscal year ended December 31, 2004
or
| | TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 For the transition period from to .
COMMISSION FILE NUMBER 001-31924
NELNET, INC.
(Exact name of Registrant as specified in its charter)
NEBRASKA 84-0748903
(State of Incorporation) (I.R.S. Employer Identification No.)
121 SOUTH 13TH STREET, SUITE 201 68508
LINCOLN, NEBRASKA (Zip Code)
(Address of Principal Executive Offices)
Registrant's telephone number, including area code: (402) 458-2370
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
TITLE OF EACH CLASS
Class A Common Stock, Par Value $0.01 per Share
NAME OF EACH EXCHANGE ON WHICH REGISTERED:
New York Stock Exchange
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
None
Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Indicate by check mark whether the Registrant is an accelerated filer.
Yes [X] No [ ]
The aggregate market value of the Registrant's voting common stock held by
non-affiliates of the Registrant on June 30, 2004 (the last business day of the
Registrant's most recently completed second fiscal quarter), based upon the
closing sale price of the Registrant's Class A Common Stock on that date of
$17.75, was $360,899,745. For purposes of this calculation, the Registrant's
directors, executive officers, and greater than 10 percent shareholders are
deemed to be affiliates.
As of February 15, 2005, there were 39,687,037 and 13,983,454 shares of Class
A Common Stock and Class B Common Stock, par value $0.01 per share, outstanding,
respectively.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement to be filed for its
2005 Annual Meeting of Shareholders scheduled to be held May 26, 2005 are
incorporated by reference into Part III of this Form 10-K.
This report contains forward-looking statements and information that are
based on management's current expectations as of the date of this document. When
used in this report, the words "anticipate," "believe," "estimate," "intend,"
and "expect," and similar expressions are intended to identify forward-looking
statements. These forward-looking statements are subject to risks,
uncertainties, assumptions, and other factors that may cause the actual results
to be materially different from those reflected in such forward-looking
statements. These factors include, among others, the risks and uncertainties set
forth in "Risk Factors" and elsewhere in this Form 10-K and changes in the terms
of student loans and the educational credit marketplace arising from the
implementation of or changes in applicable laws and regulations, which may
reduce the volume, average term, and costs of yields on student loans under the
Federal Family Education Loan Program (the "FFEL Program" or "FFELP") of the
U.S. Department of Education (the "Department") or result in loans being
originated or refinanced under non-FFELP programs or may affect the terms upon
which banks and others agree to sell FFELP loans to the Company. The Company
could also be affected by changes in the demand for educational financing or in
financing preferences of lenders, educational institutions, students, and their
families; changes in the general interest rate environment and in the
securitization markets for education loans, which may increase the costs or
limit the availability of financings necessary to initiate, purchase, or carry
education loans; losses from loan defaults; and changes in prepayment rates and
credit spreads. References to "the Company" refer to Nelnet, Inc. and its
subsidiaries.
PART I.
ITEM 1. BUSINESS
OVERVIEW
The Company is one of the leading education finance companies in the United
States and is focused on providing quality student loan products and services to
students and schools nationwide. The Company ranks among the nation's leaders in
terms of total net student loan assets with $13.5 billion as of December 31,
2004. Headquartered in Lincoln, Nebraska, the Company originates, consolidates,
securitizes, holds, and services student loans, principally loans originated
under the FFEL Program. A detailed description of the FFEL Program appears in
Appendix A to this annual report on Form 10-K (the "Report").
The Company offers a broad range of financial services and technology-based
products. The Company's products are designed to simplify the student loan
process by automating financial aid delivery, loan processing, and funds
disbursement. The Company's infrastructure, technological expertise, and breadth
of product and service offerings connect the key constituents of the student
loan process, including lenders, financial aid officers, guaranty agencies,
governmental agencies, student and parent borrowers, servicers, and the capital
markets, thereby streamlining the education finance process.
The Company's business is comprised of three primary product and service
offerings:
o ASSET MANAGEMENT, INCLUDING STUDENT LOAN ORIGINATIONS AND ACQUISITIONS.
The Company provides student loan marketing, originations, acquisition,
and portfolio management. The Company owns a large portfolio of student
loan assets through a series of education lending subsidiaries. The
education lending subsidiaries primarily invest in student loans, through
an eligible lender trustee, made under Title IV of the Higher Education
Act of 1965, as amended (the "Higher Education Act"). Certain subsidiaries
also invest in non-federally insured student loans. The Company
obtains loans through direct origination or through acquisition of loans.
The Company also provides marketing, sales, managerial, and administrative
support related to its asset generation activities.
o STUDENT LOAN AND GUARANTEE SERVICING. The Company services its student
loan portfolio and the portfolios of third parties. Servicing activities
include loan origination activities, application processing, borrower
updates, payment processing, due diligence procedures, and claim
processing. In December 2004, the Company purchased EDULINX Canada
Corporation ("EDULINX"). EDULINX is a Canadian corporation that engages in
servicing Canadian student loans. As of December 31, 2004, the Company
serviced or provided complete outsourcing of servicing activities as
follows:
Company % Third party % Total
--------- ------ ----------- ------ ---------
(dollars in millions)
FFELP and private loans $ 11,888 56% $ 9,188 44% $ 21,076
Canadian loans -- -- 7,213 100% 7,213
--------- ------ ---------- ------ ----------
Total $ 11,888 42% $ 16,401 58% $ 28,289
========= ====== ========== ====== ==========
The Company also provides servicing support to guaranty agencies, which
includes system software, hardware and telecommunication support, borrower
and loan updates, default aversion tracking services, claim processing
services, and post-default collection services. As of December 31, 2004,
the Company provided servicing support to agencies that guarantee more
than $19 billion of FFELP loans.
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o Servicing Software. The Company uses internally developed student loan
servicing software and also provides this software to third-party student
loan holders and servicers. As of December 31, 2004, the Company's
software was used to service more than $50 billion in student loans, which
included $29 billion serviced by third parties using the Company's
software.
The Company's primary product and service offerings constitute reportable
segments under Statement of Financial Accounting Standards ("SFAS") No. 131,
Disclosures about Segments of an Enterprise and Related Information ("SFAS No.
131"). In 2004, the Asset Management, Student Loan and Guarantee Servicing, and
Servicing Software segments generated 76.5%, 21.8%, and 1.7%, respectively, of
the Company's total segment revenues (excluding intersegment revenue) and 81.1%,
19.7%, and (0.8)%, respectively, of its segment net income (loss) before taxes.
As of December 31, 2004, the percent of assets applicable to the Asset
Management, Student Loan and Guarantee Servicing, and Servicing Software
segments (excluding intersegment and certain operating activity assets) was
97.7%, 2.2%, and 0.1%, respectively. For additional information on the Company's
segment reporting, see note 19 of the notes to the consolidated financial
statements, which are included in this Report.
The Company's earnings and earnings growth are directly affected by the size
of its portfolio of student loans, the interest rate characteristics of its
portfolio, the costs associated with financing and managing its portfolio, and
the costs associated with origination and acquisition of the student loans in
the portfolio. The Company generates the majority of its earnings from the
spread, referred to as its student loan spread, between the yield it receives on
its student loan portfolio and the cost of funding these loans. While the spread
may vary due to fluctuations in interest rates, special allowance payments from
the federal government ensure that the Company receives a minimum yield on its
student loans, so long as certain requirements are met. In addition, the Company
maintains an overall interest rate risk management strategy that incorporates
the use of derivative instruments to minimize the economic effect of interest
rate volatility. The Company also earns fees from student loan and guarantee
servicing and licensing and maintenance fees from its servicing software.
Earnings growth is primarily driven by the growth in the student loan portfolio
and growth in the Company's fee-based product and service offerings, coupled
with cost-effective financing and expense management.
As of December 31, 2004, over 99% of the student loans in the Company's
portfolio were federally insured loans, as opposed to the less than 1% of loans
in its portfolio that did not carry federal guarantees. At least 98% of the
principal and accrued interest of FFELP loans is guaranteed by the federal
government, provided that the Company meets certain procedures and standards
specified in the Higher Education Act. The Company believes it is in material
compliance with the procedures and standards as required in the Higher Education
Act. FFELP loans originated prior to October 1, 1993 carry a 100% guarantee on
the principal amount and accrued interest, and FFELP loans originated after that
date are guaranteed for 98% of the principal amount and accrued interest, unless
serviced by a servicer who has been designated as an Exceptional Performer by
the Department, allowing these student loans to carry a 100% guarantee.
Effective June 1, 2004, the Company was designated as an Exceptional Performer.
As of December 31, 2004, service providers designated as an Exceptional
Performer serviced more than 99% of the Company's federally insured loans. Of
this 99%, third parties serviced approximately 9%. For further information, see
Part II, Item 7, "Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Overview -- Provision for Loan Losses."
HISTORY
The Company has a 27-year history dating back to the formation of UNIPAC
Service Corporation in 1978. UNIPAC was formed to service loans for Union Bank &
Trust Company, or Union Bank, of Lincoln, Nebraska and Packers Service
Corporation of Omaha, Nebraska. The Company grew its third-party student loan
servicing business to approximately $9.7 billion in loans in 2000, when it was
merged with Nelnet. The Company's immediate predecessor was formed in 1996 as a
student loan acquisition company, and, prior to the merger, it had built its
student loan portfolio through a series of spot portfolio acquisitions and later
through student loan company acquisitions.
In 2000, the Company created a vertically integrated platform that would be
able to compete in each sector of the student loan industry. Over the past five
years, the Company has acquired several education finance services and asset
management companies to complement its service offerings. For information about
the Company's recent acquisitions, see Part II, Item 7, "Management's Discussion
and Analysis of Financial Condition and Results of Operations -- Overview --
Acquisitions."
PRODUCT AND SERVICE OFFERINGS
ASSET MANAGEMENT, INCLUDING STUDENT LOAN ORIGINATIONS AND ACQUISITIONS
The Company's asset management business, including student loan originations
and acquisitions, is its largest product and service offering and drives the
majority of its earnings. When the Company originates FFELP loans on its own
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behalf or when the Company acquires FFELP loans from others, it engages one or
more "eligible lenders," as defined in the Higher Education Act, to act as its
trustees to hold title to all such originated and acquired FFELP loans. These
eligible lender trustees hold the legal title to the FFELP loans, and the
Company holds 100% of the beneficial interests in those loans. The Company
originated or acquired, through student loan channels, $4.1 billion in student
loans in 2004. In addition, the Company acquired $136.1 million of student loans
through a business combination in April 2004. The Company often originates loans
using the Nelnet brand name but, in many cases, it uses well-known,
geographically strategic brand names of its branding partners, such as SunTrust
Bank, Education Solutions, and Union Bank. This strategy gives the Company the
flexibility to market the brand with the best recognition in a given region or
at a given college or university. The Company originates and acquires loans
through its direct channel, branding partner channel, forward flow channel, and
through spot purchases.
Through the direct channel, the Company originates student loans in one of
its brand names directly to students and parent borrowers. In 2004, 50.5% of the
Company's student loan channel additions were attributable to this channel,
including loans originated through consolidation. Student loans that the
Company originates through its direct channel are the most profitable student
loans because these loans typically cost less than loans acquired through the
other channels, and they remain in the Company's portfolio for a longer period
of time. Once a student's loans have entered the grace or repayment period, they
are eligible to be consolidated if they meet certain requirements. Loan
consolidation allows borrowers to make one payment per month and extend the loan
repayment period. In addition to these attributes, in recent years, historically
low interest rates have contributed to demand for consolidation loans. To meet
this demand, the Company has developed an extensive loan consolidation
department to serve borrowers with loans in the Company's portfolio as well as
borrowers whose loans are held by other lenders.
Through the branding partner channel, the Company acquires student loans from
lenders to whom it provides marketing and origination services established
through various contracts with FFELP lenders. In 2004, 24.3% of the Company's
student loan channel additions were attributable to this channel. The Company
frequently acts as an exclusive marketing agent for some branding partners in
specified geographic areas. The Company ordinarily purchases loans originated by
those branding partners pursuant to a commitment to purchase loans at a premium
above par, shortly following full disbursement of the loans. The Company
ordinarily retains rights to acquire loans subsequently made to the same
borrowers, or serial loans. Some branding partners, however, retain rights to
portions of their loan originations. Origination and servicing of loans made by
branding partners is primarily performed by the Company during the lives of loan
origination and servicing agreements so that loans do not need to be changed to
a different servicer upon purchase by the Company. The marketing agreements and
commitments to purchase loans are ordinarily for the same term, which are
commonly three to five years in duration. These agreements ordinarily contain
provisions for automatic renewal for successive terms, subject to termination by
notice at the end of a term or early termination for breach. The Company is
generally obligated to purchase all of the loans originated by the branding
partners under these commitments, although the branding partners are not
obligated to provide the Company with a minimum amount of loans.
In addition to the branding partner channel, the Company has established a
forward flow channel for acquiring FFELP loans from lenders to whom it provides
origination services, but provides no marketing services, or who agree to sell
loans to the Company under forward sale commitments. In 2004, 19.1% of the
Company's student loan channel additions were attributable to this channel.
These forward flow commitments frequently obligate the lender to sell all loans
made by the applicable lender, but in other instances are limited to sales of
loans originated in certain specific geographic regions or exclude loans that
are otherwise committed for sale to third parties. The Company is generally
obligated to purchase loans subject to forward flow commitments shortly
following full disbursement, although the forward flow lenders are not obligated
to provide the Company with a minimum amount of loans. The Company also
typically retains rights to purchase serial loans. The loans subject to purchase
are generally subject to a servicing agreement with the Company for the life of
each such loan. Such forward flow commitments ordinarily are for terms of three
to five years in duration.
The Company also acquires student loans through spot purchases, which
accounted for 6.1% of the Company's student loan channel additions in 2004.
4
The following table summarizes the composition of the Company's student loan
portfolio, exclusive of the unamortized costs of origination and acquisition, as
of December 31, 2004.
As of
December 31, 2004
(loan balances in
thousands)
Loans outstanding............................. $13,299,094
Federally insured loans:
Stafford ................................ $ 5,047,487
PLUS/SLS (a)............................. $ 252,910
Consolidation ........................... $ 7,908,292
Non-federally insured loans................... $ 90,405
Number of borrowers........................... 938,825
Average outstanding principal balance per
borrower...................................... $ 14,166
Number of loans............................... 2,345,597
Average outstanding principal balance per loan $ 5,670
Weighted average annual borrower interest rate 4.21%
Weighted average remaining term (months)...... 194
- ----------
(a) Supplemental loans for students, or SLS, are the predecessor to
unsubsidized Stafford loans.
The Company's Capital Markets and Portfolio Administration departments
provide financing options to fund the Company's student loan portfolio. As of
December 31, 2004, the Company had a student loan warehousing capacity of $4.3
billion through 364-day commercial paper conduit programs (of which $2.5 billion
was outstanding as of December 31, 2004). These transactions provide short-term
asset financing for the Company's loan originations as well as purchases of
student loan portfolios. The financings are constructed to offer short-term
capital and are annually renewable.
Short-term student loan warehousing allows the Company to buy and manage
student loans prior to transferring them into more permanent financing
arrangements. The large student loan warehousing capacity allows the Company to
pool student loans in order to maximize loan portfolio characteristics for
efficient financing and to properly time market conditions. Generally, loans
that best fit long-term financing vehicles are selected to be transferred into
long-term securitizations. The Company holds loans in short-term warehousing for
a period of time ranging from approximately one month to as many as 18 months,
at which point these loans are transferred into long-term securitizations.
Because transferring those loans to a long-term securitization includes certain
fixed administrative costs, the Company maximizes its economies of scale by
executing large transactions that routinely price in line with SLM Corporation,
its largest competitor.
The Company had $11.8 billion in asset-backed securities issued and
outstanding as of December 31, 2004. These asset-backed securities allow the
Company to finance student loan assets over multiple years. In 2004, the Company
completed four asset-backed securitizations totaling $5.4 billion, which made
the Company the second largest issuer of student loan asset-backed securities
for the year.
The Company relies upon secured financing vehicles as its most significant
source of funding for student loans on a long-term basis. The net cash flow the
Company receives from the securitized student loans generally represents the
excess amounts, if any, generated by the underlying student loans over the
amounts required to be paid to the bondholders, after deducting servicing fees
and any other expenses relating to the securitizations. The Company's rights to
cash flow from securitized student loans are subordinate to bondholder interests
and may fail to generate any cash flow beyond what is due to pay bondholders.
The Company's original securitization transactions began in 1996, utilizing a
master trust structure, and were privately placed auction-rate note
securitizations. As the size and volume of the Company's securitizations
increased, the Company began publicly offering asset-backed securities under
shelf registration statements, using special purpose entities. When the Company
deemed long-term interest rates attractive, it issued fixed-rate debt backed by
cash flows from FFELP loans with fixed-rate floors, which effectively match the
funding of its assets and liabilities. In 2002, the Company began accessing the
term asset-backed securities market by issuing amortizing multi-tranche
LIBOR-indexed variable-rate debt securities. The Company has utilized financial
guarantees from monoline insurers and senior/subordinate structures to assist in
obtaining "AAA" ratings on its senior securitized debt in addition to cash
reserves and excess spread to assist in obtaining "A" and "AA" ratings on its
subordinated debt. The Company intends to continue to issue auction-rate notes,
variable-rate and fixed-rate term asset-backed securities, and debt securities
through other asset funding vehicles in order to minimize its cost of funds and
give it the most flexibility to optimize the return on its student loan assets.
5
The Company's subsidiary, Nelnet Capital LLC ("Nelnet Capital"), is a broker
dealer. Nelnet Capital sells certain tranches of the Company's auction-rate
securities in co-broker-dealer arrangements with certain third-party
broker-dealers. Nelnet Capital's fees received in conjunction with sales of the
Company's securities reduce the overall costs of issuance with respect to the
auction-rate securities.
STUDENT LOAN AND GUARANTEE SERVICING
The Company specializes in the servicing of FFEL Program loans, non-federally
insured student loans, and loans under the Canadian government-sponsored student
loan program. The Company's servicing division offers lenders across the U.S.
and Canada a complete line of education loan services, including recovery of
non-guaranteed loans, application processing, disbursement of funds, customer
service, account maintenance, federal reporting and billing collections, payment
processing, default aversion, and claim filing. The Company's student loan
division uses proprietary systems to manage the servicing process. These systems
provide for automated compliance with most Higher Education Act regulations as
well as regulations of the Canadian government-sponsored student loan program.
Effective June 1, 2004, the Company was designated as an Exceptional
Performer by the Department in recognition of its exceptional level of
performance in servicing FFEL Program loans. As a result of this designation,
the Company and its FFELP third-party servicing customers receive 100%
reimbursement on all eligible FFEL Program default claims submitted for
reimbursement during the 12-month period following the effective date of its
designation. The Company and its third-party servicing customers are not subject
to the 2% risk-sharing loss for eligible claims submitted during this 12-month
period. The Company is entitled to receive this benefit as long as it continues
to meet the required servicing standards published by the Department. Compliance
with such standard is assessed on a quarterly basis.
As the Company expands its student loan origination and acquisition
activities, it may face increased competition with some of its servicing
customers. In the past, servicing customers have terminated their servicing
relationships with the Company, and the Company could in the future lose more
servicing customers as a result. However, due to the life-of-loan servicing
agreements, the Company does not expect the potential loss of customers to have
a material adverse effect on its results of operations for the foreseeable
future.
The Canadian student loan servicing business of EDULINX is highly
concentrated among a handful of servicing customers. In the event EDULINX does
not secure a renewal of its contract to service under the Canadian Student Loan
Program, this could result in a negative impact on EDULINX's business.
The Company also provides servicing support for guaranty agencies, which are
the organizations that serve as the intermediary between the U.S. federal
government and the lender of FFELP loans and who are responsible for paying the
claims made on defaulted loans. The Company's guarantee servicing division uses
a proprietary system to manage the servicing support process and to provide for
automated compliance with most Higher Education Act regulations.
SERVICING SOFTWARE
The Company's servicing software is focused on providing technology
solutions to education finance issues. The Company's subsidiaries, Idaho
Financial Associates, Inc. and Charter Account Systems, Inc., provide student
loan software and support for entities involved in the asset management aspects
of the student loan arena.
OTHER SERVICES
In addition to the Company's three primary product and service offerings, the
Company provides additional services through its 50% owned companies. These
services include customized software solutions for the administration and
management of the student loan process, collection services for educational
debt, and customer-focused electronic transaction processing and account and
bill presentment.
SOFTWARE PRODUCTS
The Company offers a suite of software products and services to provide a
total systems solution to its customers. This total systems solution is designed
to assist the Company's customers, hundreds of colleges, universities, and
lenders, in the origination, delivery, and management of the education finance
process, while simplifying the financial aid process. The Company also licenses
its servicing software products to third-party student loan holders and
servicers.
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The Company also offers a variety of borrower services to assist students and
parents in navigating the financial aid process. These services include the
Company's unique @theU higher education resource, which provides free
information on college planning and financial aid, paired with a loyalty program
to allow members to earn credit toward reducing the balance of a student loan
regardless of lender or servicer. Another product, Nelnet Notes, provides online
assistance to help borrowers better understand the financial aid process, as
well as broader money management issues.
The Company's software products, including Web site content and
functionality, have been primarily developed and maintained using internal
business and technical resources. External software consultants are utilized on
selected occasions when circumstances require specific technical knowledge or
experience. The Company capitalizes software costs under the provisions of
Statement of Position 98-1, Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use. Material software developments or
enhancements that are considered to have useful lives of greater than one year
are capitalized and amortized over their useful lives. In addition, purchased
software is capitalized and amortized over the estimated useful life. Costs
related to maintaining the Company's existing software, including the costs of
programming, are expensed as incurred.
Costs associated with research and development related to the development of
computer software to be sold are expensed when incurred in accordance with SFAS
No. 86, Accounting for the Cost of Computer Software to be Sold, Leased, or
Otherwise Marketed.
INTEREST RATE RISK MANAGEMENT
Because the Company generates the majority of its earnings from its student
loan spread, the interest sensitivity of the balance sheet is a key
profitability driver. The majority of the student loans have variable-rate
characteristics in certain interest rate environments. Some of the student loans
include fixed-rate components depending upon the rate reset provisions, or, in
the case of consolidation loans, are fixed at the weighted average interest rate
of the underlying loans at the time of consolidation.
Historically, the Company has followed a policy of funding the majority of
its student loan portfolio with variable-rate debt. In a low interest rate
environment, the FFELP loan portfolio yields excess income primarily due to the
reduction in interest rates on the variable-rate liabilities that fund student
loans at a fixed borrower rate and also due to consolidation loans earning
interest at a fixed rate to the borrower. Therefore, absent utilizing derivative
instruments, in a low interest rate environment, a rise in interest rates will
have an adverse effect on earnings. In higher interest rate environments, where
the interest rate rises above the borrower rate and the fixed-rate loans become
variable-rate and are effectively matched with variable-rate debt, the impact of
rate fluctuations is substantially reduced.
The Company attempts to match the interest rate characteristics of pools of
loan assets with debt instruments of substantially similar characteristics,
particularly in rising interest rate markets. Due to the variability in duration
of the Company's assets and varying market conditions, the Company does not
attempt to perfectly match the interest rate characteristics of the entire loan
portfolio with the underlying debt instruments. The Company has adopted a policy
of periodically reviewing the mismatch related to the interest rate
characteristics of its assets and liabilities and the Company's outlook as to
current and future market conditions. Based on those factors, the Company will
periodically use derivative instruments as part of its overall risk management
strategy to manage risk arising from its fixed-rate and variable-rate financial
instruments. For further information, see Part II, Item 7A, "Quantitative and
Qualitative Disclosures about Market Risk -- Interest Rate Risk."
INTELLECTUAL PROPERTY
The Company owns numerous trademarks and service marks ("Marks") to identify
its various products and services. As of December 31, 2004, the Company had 10
pending and 42 registered Marks. The Company actively asserts its rights to
these Marks when it believes potential infringement may exist. The Company
believes its Marks have developed and continue to develop strong brand-name
recognition in the industry and the consumer marketplace. Each of the Marks has,
upon registration, an indefinite duration so long as the Company continues to
use the Mark on or in connection with such goods or services as the Mark
identifies. In order to protect the indefinite duration, the Company makes
filings to continue registration of the Marks. The Company owns one patent
application that has been published, but has not yet been issued, with respect
to a customer-loyalty program and has also actively asserted its rights
thereunder in situations where the Company believes its claims may be infringed
upon. The Company owns many copyright-protected works, including its various
computer system codes and displays, Web sites, publications, and marketing
collateral. The Company also has trade secret rights to many of its processes
and strategies and its software product designs. The Company's software products
are protected by both registered and common law copyrights, as well as strict
confidentiality and ownership provisions placed in license agreements which
restrict the ability to copy, distribute, or disclose the software products. The
Company also has adopted internal procedures designed to protect the Company's
intellectual property.
7
The Company seeks federal and/or state protection of intellectual property
when deemed appropriate, including patent, trademark/service mark, and
copyright. The decision whether to seek such protection may depend on the
perceived value of the intellectual property, the likelihood of securing
protection, the cost of securing and maintaining that protection, and the
potential for infringement. The Company's employees are trained in the
fundamentals of intellectual property, intellectual property protection, and
infringement issues. The Company's employees are also required to sign
agreements requiring, among other things, confidentiality of trade secrets,
assignment of inventions, and non-solicitation of other employees
post-termination. Consultants, suppliers, and other business partners are also
required to sign nondisclosure agreements to protect the Company's proprietary
rights.
SEASONALITY
Origination of student loans is generally subject to seasonal trends, which
correspond to the beginning of each semester of the school year. Stafford and
PLUS loans are disbursed as directed by the school and are usually divided into
two or three equal disbursements released at specified times during the school
year. The two periods of August through October and December through March
account for approximately 80% of the Company's total annual Stafford and PLUS
disbursements. While applications and disbursements are seasonal, the Company's
earnings are generally not tied to this cycle. Due to the Company's portfolio
size and the volume of its acquisitions through its branding and forward flow
channels, new disbursements or run-off for any given month will not materially
change the net interest earnings of the portfolio.
CUSTOMERS
As of December 31, 2004, the Company provided student loan servicing either
directly or through its proprietary software to more than 2.8 million borrowers
and currently has direct and indirect relationships with hundreds of colleges
and universities. As of December 31, 2004, the Company had
servicing agreements with more than 300 customers and software license
agreements with more than 35 licensees. Notwithstanding the depth of its
customer base, the Company's business is subject to some vulnerability arising
from concentrations of loan origination volume with borrowers attending certain
schools, loan origination volume generated by certain branding partners, loan
and guarantee servicing volume generated by certain loan servicing customers and
guaranty agencies, and software licensing volume generated by certain licensees.
The Company's ability to maintain strong relationships with significant schools,
branding partners, servicing customers, guaranty agencies, and software
licensees is subject to a variety of risks. Termination of such a strong
relationship could result in a material adverse effect on the Company's
business. The Company cannot assure that its forward flow channel lenders or
branding partners will continue their relationships with the Company, which
could result in an adverse effect on the Company's volume derived from one of
its loan acquisition channels.
The business of servicing Canadian student loans by EDULINX is limited to a
small group of servicing customers and the agreement with the largest of such
customers is currently scheduled to expire in February 2006. EDULINX cannot
guarantee that it will obtain a renewal of this largest servicing agreement or
that it will maintain its other servicing agreements, and the termination of any
such servicing agreements could result in an adverse effect on its business.
COMPETITION
The Company faces competition from many lenders in the highly competitive
student loan industry. Using its size, the Company has leveraged economies of
scale to gain market share and compete by offering a full array of FFELP and
non-federally insured loan products and services. In addition, the Company
differentiates itself from other lenders through its vertical integration,
technology, and strong relationships with colleges and universities.
The Company views SLM Corporation, the parent company of Sallie Mae, as its
largest competitor in loan origination and holding and servicing student loans.
Large national and regional banks are also strong competition, although many are
involved only in origination. In different geographic locations across the
country, the Company faces strong competition from the local tax-exempt student
loan secondary markets. The Federal Direct Lending ("FDL") Program has also
reduced the origination volume available for FFEL Program participants. In 2003
(according to the most recent Department information available), the FDL Program
accounted for approximately 25% of total student loan volume, although this
portion of total volume has decreased from approximately 33% in 1998. In
addition, in the last few years, low interest rates have attracted many new
competitors to the student loan consolidation business.
EMPLOYEES
As of December 31, 2004, the Company had approximately 2,700 employees.
Approximately 900 of these employees hold professional and management positions
while approximately 1,800 are in support and operational positions. None of the
Company's employees are covered by collective bargaining agreements. The Company
is not involved in any material disputes with any of its employees, and the
Company believes that relations with its employees are good.
AVAILABLE INFORMATION
Copies of the Company's annual reports on Form 10-K, quarterly reports on
Form 10-Q, current reports on Form 8-K, proxy statement, and amendments to such
8
reports are available on the Company's Web site free of charge as soon as
reasonably practicable after such reports are filed with or furnished to the
United States Securities and Exchange Commission (the "SEC"). Investors and
other interested parties can access these reports at HTTP://WWW.NELNET.NET. The
SEC maintains an Internet site (HTTP://WWW.SEC.GOV) that contains periodic and
other reports such as annual, quarterly, and current reports on Forms 10-K,
10-Q, and 8-K, respectively, as well as proxy and information statements
regarding the Company and other companies that file electronically with the SEC.
The Company has adopted a Code of Business Conduct and Ethics (the "Code of
Conduct") that applies to directors, officers, and employees, including the
Company's principal executive officers and its principal financial and
accounting officer, and has posted such Code of Conduct on its Web site.
Amendments to and waivers granted with respect to the Company's Code of Conduct
relating to its executive officers and directors required to be disclosed
pursuant to the applicable securities law and stock exchange rules and
regulations will also be posted on its Web site. The Company's Corporate
Governance Guidelines, Audit Committee Charter, Compensation Committee Charter,
and Nominating and Corporate Governance Committee Charter are also posted on its
Web site and, along with its Code of Conduct, are available in print without
charge to any shareholder who requests them. Please direct all requests as
follows:
Nelnet, Inc.
121 South 13th Street, Suite 201
Lincoln, Nebraska 68508
Attention: Secretary
RISK FACTORS
If any of the following risks actually occurs, the Company's business,
financial condition, and results of operations could be materially and adversely
affected.
FAILURE TO COMPLY WITH GOVERNMENTAL REGULATIONS OR GUARANTY AGENCY RULES COULD
HARM THE COMPANY'S BUSINESS.
The Company's principal business is comprised of originating, acquiring,
holding, and servicing student loans made and guaranteed pursuant to the FFEL
Program, which was created by the Higher Education Act. The Higher Education Act
governs most significant aspects of the Company's lines of business. The Company
is also subject to rules and regulations of the agencies that act as guarantors
of the student loans, known as guaranty agencies. In addition, the Company is
subject to certain federal and state banking laws, regulations, and
examinations, as well as federal and state consumer protection laws and
regulations, including, specifically with respect to the Company's non-federally
insured loan portfolio, certain state usury laws and related regulations and the
Federal Truth in Lending Act. Also, Canadian laws and regulations govern the
Company's Canadian loan servicing operations. These laws and regulations impose
substantial requirements upon lenders and servicers involved in consumer
finance. Failure to comply with these laws and regulations could result in
liability to borrowers, the imposition of civil penalties, and potential class
action suits.
The Company's failure to comply with regulatory regimes described above may
arise from:
o breaches of the Company's internal control systems, such as a failure to
adjust manual or automated servicing functions following a change in
regulatory requirements;
o technological defects, such as a malfunction in or destruction of the
Company's computer systems; or
o fraud by the Company's employees or other persons in activities such as
borrower payment processing.
Such failure to comply, irrespective of the reason, could subject the Company
to loss of the federal guarantee on federally insured loans, costs of curing
servicing deficiencies or remedial servicing, suspension or termination of the
Company's right to participate in the FFEL Program or to participate as a
servicer, negative publicity, and potential legal claims or actions brought by
the Company's servicing customers and borrowers.
THE COMPANY MUST SATISFY CERTAIN REQUIREMENTS NECESSARY TO MAINTAIN THE FEDERAL
GUARANTEES OF ITS FEDERALLY INSURED LOANS, AND THE COMPANY MAY INCUR PENALTIES
OR LOSE ITS GUARANTEES IF IT FAILS TO MEET THESE REQUIREMENTS.
The Company must meet various requirements in order to maintain the federal
guarantee on its federally insured loans. These requirements establish servicing
requirements and procedural guidelines and specify school and borrower
eligibility criteria. The federal guarantee on the Company's federally insured
loans is conditioned on compliance with origination, servicing, and collection
standards set by the Department and guaranty agencies. Federally insured loans
that are not originated, disbursed, or serviced in accordance with the
Department's regulations risk partial or complete loss of the guarantee thereof.
If the Company experiences a high rate of servicing deficiencies or costs
associated with remedial servicing, and if the Company is unsuccessful in curing
such deficiencies, the eventual losses on the loans that are not cured could be
material.
9
A guaranty agency may reject a loan for claim payment due to a violation of
the FFEL Program due diligence servicing requirements. In addition, a guaranty
agency may reject claims under other circumstances, including, for example, if a
claim is not timely filed or adequate documentation is not maintained. Once a
loan ceases to be guaranteed, it is ineligible for federal interest subsidies
and special allowance payments. If a loan is rejected for claim payment by a
guaranty agency, the Company continues to pursue the borrower for payment and/or
institutes a process to reinstate the guarantee.
Rejections of claims as to portions of interest may be made by guaranty
agencies for certain violations of the due diligence collection and servicing
requirements, even though the remainder of a claim may be paid. Examples of
errors that cause claim rejections include isolated missed collection calls or
failures to send collection letters as required.
The Department has implemented school eligibility requirements, which include
default rate limits. In order to maintain eligibility in the FFEL Program,
schools must maintain default rates below specified levels, and both guaranty
agencies and lenders are required to ensure that loans are made only to or on
behalf of students attending schools that do not exceed the default rate limits.
If the Company fails to comply with any of the above requirements, it could
incur penalties or lose the federal guarantee on some or all of its federally
insured loans. If the Company's actual loss experience on denied guarantees were
to increase substantially in future periods the impact could be material to the
Company's operations.
FAILURE TO COMPLY WITH RESTRICTIONS ON INDUCEMENTS UNDER THE HIGHER EDUCATION
ACT COULD HARM THE COMPANY'S BUSINESS.
The Higher Education Act generally prohibits a lender from providing certain
inducements to educational institutions or individuals in order to secure
applicants for FFELP loans. The Company has entered into arrangements with
various schools pursuant to which the schools become lenders of FFELP loans to
graduate students, and the Company provides funding, loan origination, and
servicing to the schools with respect to such loans. The Department challenged a
similar "school-as-lender" arrangement that SLM Corporation previously had in
place, but a federal court decision determined the arrangement fell within the
parameters of regulatory guidelines established by the Department. SLM
Corporation also has come under scrutiny as a result of recent claims that it
makes non-federally insured loans available to students of a school only if the
school, in return, promises to leave the FDL Program and market SLM
Corporation's FFELP loans to its students. The Department has stated that
non-federally insured loans are legal and permissible if offered simply as a
benefit to schools. The Company offers non-federally insured loans to student
borrowers on a regular basis but does so without requiring anything in return
from the schools that these borrowers attend. In addition, because guidance from
the Department permits de minimus gifts in connection with marketing of FFELP
loans, from time to time the Company entertains school financial aid officers at
student loan industry conferences and functions and sponsors promotional events
such as lunches and golf outings. If the Department were to change its position
on any of these matters, the Company may have to change the way it markets
non-federally insured and FFELP loans and a new marketing strategy may not be as
effective. If the Company fails to respond to the Departments change in
position, the Department could potentially impose sanctions upon the Company
that could negatively impact its business.
The Company has also entered into various agreements to acquire marketing
lists of prospective FFELP loan borrowers from sources such as college alumni
associations. The Company pays to acquire these lists and for the completed
applications for loans resulting there from. The Company believes that such
arrangements are permissible and do not violate restrictions on inducements, as
they fit within a regulatory exception recognized by the Department for
generalized marketing and advertising activities. The Department has provided
informal guidance to the Company that such arrangements are not improper
inducements, since such arrangements fall within the generalized marketing
exception. If the Department were to change its position, this could harm the
Company's reputation and marketing efforts, and, if the Company fails to adjust
its practices to such change, could potentially result in the Department
imposing sanctions on the Company. Such sanctions could negatively impact the
Company's business.
POSSIBLE CHANGES IN LEGISLATION AND REGULATIONS COULD HAVE A NEGATIVE IMPACT
UPON THE COMPANY'S BUSINESS.
Pursuant to the terms of the Higher Education Act, the FFEL Program is
periodically amended, and the Higher Education Act must be reauthorized by
Congress every five to six years in order to prevent sunset of that Act. Changes
in the Higher Education Act made in the two most recent reauthorizations have
included reductions in student loan yields paid to lenders, increased fees paid
by lenders, and a decreased level of federal guarantee. Future changes could
result in further negative impacts on the Company's business. Moreover, there
can be no assurance that the provisions of the Higher Education Act, which is
scheduled to expire on September 30, 2005, will be reauthorized. While Congress
has consistently extended the effective date of the Higher Education Act, it may
elect not to reauthorize the Department's ability to provide interest subsidies,
special allowance payments, and federal guarantees for student loans. A failure
to reauthorize such provisions of the Higher Education Act would reduce the
number of federally guaranteed student loans available for the Company to
originate or acquire in the future. With respect to EDULINX, changes in the
Canada Student Loans Program, or the CSLP, which governs the majority of the
loans serviced by EDULINX, could result in a similar negative impact on EDULINX'
business.
10
Some of the highlights of specific proposed legislation and President Bush's
fiscal year 2006 budget proposals that, if enacted, could have a material effect
on the Company's operations, in no particular order, include:
o allowing for increased borrower loan limits, which may provide
opportunities for increasing the average size of the Company's future
loan originations;
o allowing refinancing of consolidation loans, which would open
approximately 59% of the Company's portfolio to such refinancing;
o increasing origination fees paid by lenders in connection with making or
holding loans;
o allowing for variable-rate consolidation loans and extended repayment
terms of Stafford loans, which would lead to fewer loans lost through
consolidation of the Company's portfolio, but would also decrease
consolidation opportunities;
o allowing for the continuation of variable interest rates on Stafford and
PLUS loans beyond the scheduled change to fixed interest rates on July
1, 2006;
o changes to the FFEL Program guarantee rates and terms, including
proposals for a decrease in insurance on portfolios receiving the
benefit of the Exceptional Performance designation from 100% to 97% of
principal and accrued interest, and a decrease in insurance on
portfolios not subject to the Exceptional Performance designation from
98% to 95% of principal and accrued interest;
o eliminating variable-rate floor income, including prospectively and
permanently eliminating the 9.5% floor interest rate on loans refinanced
with funds from pre-1993 tax-exempt financings (the "9.5% Floor") and
eliminating rebate of excess earnings on loans where the borrower rate
is in excess of the lender rate;
o limiting and/or preventing a FFEL Program lender from making a
consolidation loan consisting of only FDL loans; and
o initiatives aimed at promoting the FDL Program to the detriment of the
FFEL Program.
In addition, Edward M. Kennedy of Massachusetts and others have been
proponents of legislation which could act to retroactively remove eligibility
for the 9.5% Floor from FFELP loans that have, prior to September 30, 2004, been
refinanced with proceeds of taxable obligations. The Company cannot predict
whether such legislation will be advanced in the future. If such retroactive
legislation were to be enacted and withstand legal challenge, it would have a
material adverse effect upon the Company's financial condition and results of
operations. Senator Kennedy called for such retroactive legislation during
congressional debate in October 2004. However, the Department has indicated that
receipt of the 9.5% Floor income is permissible under current law and previous
interpretations thereof. The Company cannot predict whether the Department will
maintain its position in the future on the permissibility of the 9.5% Floor.
The Company cannot predict whether the above legislative or budget proposals
will be enacted into law, but they may form some of the framework utilized by
Congress in negotiating the fiscal year 2006 budget resolution and
reauthorization of the Higher Education Act. In addition, the Department
oversees and implements the Higher Education Act and periodically issues
regulations and interpretations of that Act. Changes in such regulations and
interpretations could negatively impact the Company's business.
VARIATION IN THE MATURITIES, TIMING OF RATE RESET, AND VARIATION OF INDICES
OF THE COMPANY'S ASSETS AND LIABILITIES MAY POSE RISKS TO THE COMPANY.
Because the Company generates the majority of its earnings from the spread
between the yield received on its portfolio of student loans and the cost of
financing these loans, the interest rate sensitivity of the balance sheet could
have a material effect on the Company's results of operations. The majority of
the Company's student loans have variable-rate characteristics in interest rate
environments where the special allowance payment formula exceeds the borrower
rate. Some of the Company's student loans, primarily consolidation loans,
include fixed-rate components depending upon loan terms and the rate reset
provisions set by the Department. The Company has financed the majority of its
student loan portfolio with variable-rate debt. Absent utilization of derivative
instruments to match the interest rate characteristics and duration of the
assets and liabilities, fluctuations in the interest rate environment will
affect the Company's results of operations. Such fluctuations may be adverse and
may be material.
In the current low interest rate environment, the Company's federally insured
loan portfolio is yielding excess income due to variable-rate liabilities
financing student loans at a fixed borrower rate. Absent the use of derivative
instruments, a rise in interest rates will have an adverse effect on earnings
and fair values due to interest margin compression caused by increasing
financing costs, until such time as that the federally insured loans earn
interest at a variable rate in accordance with the special allowance payment
formula. In higher interest rate environments, where the interest rate rises
11
above the borrower rate and fixed-rate loans become variable, the impact of the
rate fluctuations is reduced. Loans that reset annually on each July 1st can
generate excess spread income as compared to the rate based on the special
allowance payment formula in declining interest rate environments where the
borrower rate establishes a floor on the Company's variable-rate assets. The
Company refers to this additional income as variable-rate floor income, and it
is included in loan interest income. Historically, the Company has earned
variable-rate floor income in declining interest rate environments. Since the
rates are reset annually, the Company views these earnings as temporary and not
necessarily sustainable. The Company's ability to earn variable-rate floor
income in future periods is dependent upon the interest rate environment
following the annual reset of borrower rates, and the Company cannot assure that
such environment will exist in the future.
Due to the variability in duration of the Company's assets and varying market
conditions, the Company does not attempt to perfectly match the interest rate
characteristics of its entire loan portfolio with the underlying debt
instruments. This mismatch in duration and interest rate characteristics could
have a negative impact on the Company's results of operations. The Company has
employed various derivative instruments to somewhat offset this mismatch.
Changes in interest rates and the composition of the Company's student loan
portfolio and derivative instruments will impact the effect of interest rates on
the Company's earnings, and the Company cannot predict any such impact with any
level of certainty.
MARKET RISKS TO WHICH THE COMPANY IS SUBJECT MAY HAVE AN ADVERSE IMPACT UPON ITS
BUSINESS AND OPERATIONS.
The Company's primary market risk exposure arises from fluctuations in its
borrowing and lending rates, the spread between which could be impacted by
shifts in market interest rates. The borrower rates on federally insured loans
are generally reset by the Department each July 1st based on a formula
determined by the date of the origination of the loan, with the exception of
rates on consolidation loans which are fixed to term. The interest rate the
Company actually receives on federally insured loans is the greater of the
borrower rate and a rate determined by a formula based on a spread to either the
91-day Treasury Bill index or the 90-day commercial paper index, depending on
when the loans were originated and the current repayment status of the loans.
The Company issues asset-backed securities, both fixed- and variable-rate, to
fund its student loan assets. The variable-rate debt is generally indexed to
90-day LIBOR or set by auction. The income generated by the Company's student
loan assets is generally driven by different short-term indices than the
Company's liabilities, which creates interest rate risk. The Company has
historically borne this risk internally through the net spread on its portfolio
while continuing to monitor this interest rate risk.
The Company purchased EDULINX in December 2004. EDULINX is a Canadian
corporation that engages in servicing Canadian student loans. As a result of
this acquisition, the Company is also exposed to market risk related to
fluctuations in foreign currency exchange rates between the U.S. and Canadian
dollars. The Company has not entered into any foreign currency derivative
instruments to hedge this risk. Fluctuations in foreign currency exchange rates
may have an adverse effect on the financial position, results of operations, and
cash flows of the Company.
THE COMPANY'S DERIVATIVE INSTRUMENTS MAY NOT BE SUCCESSFUL IN MANAGING ITS
INTEREST RATE RISKS.
When the Company utilizes derivative instruments, it utilizes them to manage
interest rate sensitivity. Although the Company does not use derivative
instruments for speculative purposes, the majority of its derivative instruments
do not qualify for hedge accounting under SFAS No. 133, Accounting for
Derivatives Instruments and Hedging Activities ("SFAS No. 133"); consequently,
the change in fair value of these derivative instruments is included in the
Company's operating results. Changes or shifts in the forward yield curve can
significantly impact the valuation of the Company's derivatives. Accordingly,
changes or shifts to the forward yield curve will impact the financial position,
results of operations, and cash flows of the Company. The derivative instruments
used by the Company are typically in the form of interest rate swaps, basis
swaps, and interest rate caps. Interest rate swaps effectively convert
variable-rate debt obligations to a fixed-rate or fixed-rate debt obligations to
a variable-rate. Basis swaps effectively convert variable-rate debt obligations
to a variable-rate based on a different index. Interest rate caps effectively
limit the maximum interest on variable-rate debt obligations.
Developing an effective strategy for dealing with movements in interest rates
is complex, and no strategy can completely insulate the Company from risks
associated with such fluctuations. In addition, a counterparty to a derivative
instrument could default on its obligation, thereby exposing the Company to
credit risk. Further, the Company may have to repay certain costs, such as
transaction fees or brokerage costs, if the Company terminates a derivative
instrument. Finally, the Company's interest rate risk management activities
could expose the Company to substantial losses if interest rates move materially
differently from management's expectations. As a result, the Company cannot
assure that its economic hedging activities will effectively manage its interest
rate sensitivity or have the desired beneficial impact on its results of
operations or financial condition.
When the fair value of a derivative instrument is negative, the Company owes
the counterparty and, therefore, has no credit risk. However, if the value of
derivatives with a counterparty exceeds a specified threshold, the Company may
12
have to pay a collateral deposit to the counterparty. If interest rates move
materially differently from management's expectations, the Company could be
required to deposit a significant amount of collateral with its derivative
instrument counterparties. The collateral deposits, if significant, could
negatively impact the Company's capital resources. The Company manages market
risks associated with interest rates by establishing and monitoring limits as to
the types and degree of risk that may be undertaken.
THE COMPANY FACES LIQUIDITY RISKS DUE TO THE FACT THAT ITS OPERATING AND
WAREHOUSE FINANCING NEEDS ARE SUBSTANTIALLY PROVIDED BY THIRD-PARTY SOURCES.
The Company's primary funding needs are those required to finance its student
loan portfolio and satisfy its cash requirements for new student loan
originations and acquisitions, operating expenses, and technological
development. The Company's operating and warehouse financings are substantially
provided by third parties, over which it has no control. Unavailability of such
financing sources may subject the Company to the risk that it may be unable to
meet its financial commitments to creditors, branding partners, forward flow
lenders, or borrowers when due unless it finds alternative funding mechanisms.
The Company relies upon conduit warehouse loan financing vehicles to support
its funding needs on a short-term basis. There can be no assurance that the
Company will be able to maintain such warehouse financing in the future. As of
December 31, 2004, the Company had a student loan warehousing capacity of $4.3
billion, of which $2.5 billion was outstanding, through 364-day commercial paper
conduit programs. These conduit programs mature in 2005 through 2009; however,
they must be renewed annually by underlying liquidity providers and may be
terminated at any time for cause. There can be no assurance the Company will be
able to maintain such conduit facilities, find alternative funding, or increase
the commitment level of such facilities, if necessary. While the Company's
conduit facilities have historically been renewed for successive terms, there
can be no assurance that this will continue in the future. The Company's has two
general operating lines of credit that are for terms of less than one year each,
are renewable at the option of the lenders, and may be terminated at any time
for cause. In addition, the Company has a credit facility agreement with a
Canadian financial institution that is cancelable by either party upon demand.
CHARACTERISTICS UNIQUE TO ASSET-BACKED SECURITIZATION POSE RISKS TO THE
COMPANY'S CONTINUED LIQUIDITY.
The Company has historically relied upon, and expects to continue to rely
upon, asset-backed securitizations as its most significant source of funding for
student loans on a long-term basis. As of December 31, 2004 and 2003, $11.8
billion and $9.3 billion, respectively, of the Company's student loans were
funded by long-term asset-backed securitizations. The net cash flow the Company
receives from the securitized student loans generally represents the excess
amounts, if any, generated by the underlying student loans over the amounts
required to be paid to the bondholders, after deducting servicing fees and any
other expenses relating to the securitizations. In addition, some of the
residual interests in these securitizations have been pledged to secure
additional bond obligations. The Company's rights to cash flow from securitized
student loans are subordinate to bondholder interests, and these loans may fail
to generate any cash flow beyond what is due to pay bondholders.
The interest rates on certain of the Company's asset-backed securities are
set and periodically reset via a "dutch auction" utilizing remarketing agents
for varying intervals ranging from seven to 91 days. Investors and potential
investors submit orders through a broker-dealer as to the principal amount of
notes they wish to buy, hold, or sell at various interest rates. The
broker-dealers submit their clients' orders to the auction agent or remarketing
agent, who determines the interest rate for the upcoming period. If there are
insufficient potential bid orders to purchase all of the notes offered for sale
or being repriced, the Company could be subject to interest costs substantially
above the anticipated and historical rates paid on these types of securities. A
failed auction or remarketing could also reduce the investor base of the
Company's other financing and debt instruments.
In addition, rising interest rates existing at the time the Company's
asset-backed securities are remarketed may cause other competing investments to
become more attractive to investors than the Company's securities, which may
decrease the Company's liquidity.
FUTURE LOSSES DUE TO DEFAULTS ON LOANS HELD BY THE COMPANY PRESENT CREDIT RISK
WHICH COULD ADVERSELY AFFECT THE COMPANY'S EARNINGS.
As of December 31, 2004, more than 99% of the Company's student loan
portfolio was comprised of federally insured loans. These loans benefit from a
federal guarantee of between 98% and 100% of their principal balance and accrued
interest.
13
In June 2004, the Company was designated as an Exceptional Performer by the
Department in recognition of its exceptional level of performance in servicing
FFEL Program loans. As a result of this designation, the Company is not subject
to the 2% risk sharing loss for eligible claims submitted during a 12-month
period. The Company is entitled to receive this benefit as long as it and/or its
other service providers designated as Exceptional Performers continue to meet
the required servicing standards published by the Department. Compliance with
such standards is assessed on a quarterly basis. The Company bears full risk of
losses experienced with respect to the unguaranteed portion of its federally
insured loans (those loans not serviced by a service provider designated as an
Exceptional Performer). If the Company or a third party service provider were to
lose its Exceptional Performance designation, either by the Department
discontinuing the program or the Company or third party not meeting the required
servicing standards, loans serviced by the Company or third-party would become
subject to the 2% risk sharing loss for all claims submitted after any loss of
the Exceptional Performance designation. If the Department discontinued the
program, the Company would have to establish a provision for loan losses related
to the 2% risk sharing. Based on the balance of federally insured loans
outstanding as of December 31, 2004, this provision would be approximately $9.0
million. In addition, President Bush's fiscal year 2006 budget proposals provide
for a decrease in insurance (i) under the Exceptional Performer designation from
100% to 97% and (ii) on portfolios not subject to the Exceptional Performer
designation from 98% to 95% of principal and accrued interest. The Company
cannot predict whether the budget proposals will be enacted into law, but they
may form some of the framework for Congress as it negotiates the fiscal year
2006 budget resolution.
Losses on the Company's non-federally insured loans are borne by the Company,
with the exception of certain privately insured loans. Privately insured loans
constitute a minority of the Company's non-federally insured loan portfolio. The
loan loss pattern on the Company's non-federally insured loan portfolio is not
as developed as that on its federally insured loan portfolio. As of December 31,
2004, the aggregate principal balance of non-federally insured loans comprised
less than 1% of the Company's entire student loan portfolio; however, it is
expected to increase to between 3% and 5% over the next three to five years.
There can be no assurance that this percentage will not further increase over
the long term. The performance of student loans in the portfolio is affected by
the economy, and a prolonged economic downturn may have an adverse effect on the
credit performance of these loans.
While the Company has provided allowances estimated to cover losses that may
be experienced in both its federally insured and non-federally insured loan
portfolios, there can be no assurance that such allowances will be sufficient to
cover actual losses in the future.
THE COMPANY COULD EXPERIENCE CASH FLOW PROBLEMS IF A GUARANTY AGENCY DEFAULTS ON
ITS GUARANTEE OBLIGATION.
A deterioration in the financial status of a guaranty agency and its ability
to honor guarantee claims on defaulted student loans could result in a failure
of that guaranty agency to make its guarantee payments in a timely manner, if at
all. The financial condition of a guaranty agency can be adversely affected if
it submits a large number of reimbursement claims to the Department, which
results in a reduction of the amount of reimbursement that the Department is
obligated to pay the guaranty agency. The Department may also require a guaranty
agency to return its reserve funds to the Department upon a finding that the
reserves are unnecessary for the guaranty agency to pay its FFEL Program
expenses or to serve the best interests of the FFEL Program.
If the Department has determined that a guaranty agency is unable to meet its
guarantee obligations, the loan holder may submit claims directly to the
Department, and the Department is required to pay the full guarantee claim.
However, the Department's obligation to pay guarantee claims directly in this
fashion is contingent upon the Department making the determination that a
guaranty agency is unable to meet its guarantee obligations. The Department may
not ever make this determination with respect to a guaranty agency and, even if
the Department does make this determination, payment of the guarantee claims may
not be made in a timely manner, which could result in the Company experiencing
cash shortfalls.
FAILURE OF COUNTERPARTIES TO PERFORM UNDER CREDIT ENHANCEMENT AGREEMENTS COULD
HARM THE COMPANY'S BUSINESS.
In connection with the Company's securitizations, the Company periodically
utilizes credit enhancements or other support agreements such as letters of
credit, bond insurance, and interest rate swap agreements. The Company utilizes
these credit enhancement agreements in order to improve the marketability of
certain of its asset-backed securities when such enhancements will lower the
overall costs with respect to these securities. The Company cannot assure
performance of the counterparties to these various agreements, and failure of
such counterparties to perform their obligations under these agreements could
impair the viability of the underlying debt or securitization structures, which
in turn could adversely impact the Company's results of operations and financial
condition.
COMPETITION CREATED BY THE FDL PROGRAM AND FROM OTHER LENDERS AND SERVICERS MAY
ADVERSELY IMPACT THE COMPANY'S BUSINESS.
14
Under the FDL Program, the Department makes loans directly to student
borrowers through the educational institutions they attend. The volume of
student loans made under the FFEL Program and available for the Company to
originate or acquire may be reduced to the extent loans are made to students
under the FDL Program. In addition, if the FDL Program expands, to the extent
the volume of loans serviced by the Company is reduced, the Company may
experience reduced economies of scale, which could adversely affect earnings.
Loan volume reductions could further reduce amounts received by the guaranty
agencies available to pay claims on defaulted student loans.
In the FFEL Program market, the Company faces significant competition from
SLM Corporation, the parent company of Sallie Mae. SLM Corporation services
nearly half of all outstanding federally insured loans and is the largest holder
of student loans. The Company also faces intense competition from other existing
lenders and servicers. As the Company expands its student loan origination and
acquisition activities, that expansion may result in increased competition with
some of its servicing customers. This has in the past resulted in servicing
customers terminating their contractual relationships with the Company, and the
Company could in the future lose more servicing customers as a result. As the
Company seeks to further expand its business, the Company will face numerous
other competitors, many of which will be well established in the markets the
Company seeks to penetrate. Some of the Company's competitors are much larger
than the Company, have better name recognition, and have greater financial and
other resources. In addition, several competitors have large market
capitalizations or cash reserves and are better positioned to acquire companies
or portfolios in order to gain market share. Furthermore, many of the
institutions with which the Company competes have significantly more equity
relative to their asset bases. Consequently, such competitors may have more
flexibility to address the risks inherent in the student loan business. Finally,
some of the Company's competitors are tax-exempt organizations that do not pay
federal or state income taxes and which generally receive floor income on
certain tax-exempt obligations on a greater percentage of their student loan
portfolio because they have financed a greater percentage of their student loans
with tax-exempt obligations issued prior to October 1, 1993. These factors could
give the Company's competitors a strategic advantage.
HIGHER RATES OF PREPAYMENTS OF STUDENT LOANS COULD REDUCE THE COMPANY'S PROFITS.
Pursuant to the Higher Education Act, borrowers may prepay loans made under
the FFEL Program at any time. Prepayments may result from consolidating student
loans, which tends to occur more frequently in low interest rate environments,
from borrower defaults, which will result in the receipt of a guarantee payment,
and from voluntary full or partial prepayments, among other things. High
prepayment rates will have the most impact on the Company's asset-backed
securitization transactions priced in relation to LIBOR. As of December 31,
2004, the Company had six transactions outstanding totaling approximately $5.8
billion that had experienced cumulative prepayment rates ranging from 19.3% to
22.7% as compared to four transactions outstanding totaling approximately $3.2
billion that had experienced cumulative prepayment rates ranging from 19.4% to
22.4% as of December 31, 2003. The rate of prepayments of student loans may be
influenced by a variety of economic, social, and other factors affecting
borrowers, including interest rates and the availability of alternative
financing. The Company's profits could be adversely affected by higher
prepayments, which would reduce the amount of interest the Company received and
expose the Company to reinvestment risk.
INCREASES IN CONSOLIDATION LOAN ACTIVITY BY THE COMPANY AND ITS COMPETITORS
PRESENT A RISK TO THE COMPANY'S LOAN PORTFOLIO AND PROFITABILITY.
The Company's portfolio of federally insured loans is subject to refinancing
through the use of consolidation loans, which are expressly permitted by the
Higher Education Act. Consolidation loan activity may result in three
detrimental effects. First, when the Company consolidates loans in its
portfolio, the new consolidation loans have a lower yield than the loans being
refinanced due to the statutorily mandated consolidation loan rebate fee of
1.05% per year. Although consolidation loans generally feature higher average
balances, longer average lives, and slightly higher special allowance payments,
such attributes may not be sufficient to counterbalance the cost of the rebate
fees. Second, and more significantly, the Company may lose student loans in its
portfolio that are consolidated away by competing lenders. Increased
consolidations of student loans by the Company's competitors may result in a
negative return on loans, when considering the origination costs or acquisition
premiums paid with respect to these loans. Additionally, consolidation of loans
away by competing lenders can result in a decrease of the Company's servicing
portfolio, thereby decreasing fee-based servicing income. Third, increased
consolidations of the Company's own student loans create cash flow risk because
the Company incurs upfront consolidation costs, which are in addition to the
origination or acquisition costs incurred in connection with the underlying
student loans, while extending the repayment schedule of the consolidated loans.
The Company's student loan origination and lending activities could be
significantly impacted by the reauthorization of the Higher Education Act
relative to the single holder rule. For example, if the single holder rule,
which generally restricts a competitor from consolidating loans away from a
holder that owns all of a student's loans, were abolished, a substantial portion
of the Company's non-consolidated portfolio would be at risk of being
consolidated away by a competitor. On the other hand, abolition of the rule
would also open up a portion of the rest of the market and provide the Company
with the potential to gain market share. Other potential changes to the Higher
Education Act relating to consolidation loans that could adversely impact the
Company include allowing refinancing of consolidation loans, which would open
approximately 59% of the Company's portfolio to such refinancing, and increasing
origination fees paid by lenders in connection with making consolidation loans.
15
THE VOLUME OF AVAILABLE STUDENT LOANS MAY DECREASE IN THE FUTURE AND MAY
ADVERSELY AFFECT THE COMPANY'S INCOME.
The Company's student loan originations generally are limited to students
attending eligible educational institutions in the United States. Volumes of
originations are greater at some schools than others, and the Company's ability
to remain an active lender at a particular school with concentrated volumes is
subject to a variety of risks, including the fact that each school has the
option to remove the Company from its "preferred lender" list or to add other
lenders to its "preferred lender" list, the risk that a school may enter the FDL
Program, or the risk that a school may begin making student loans itself. The
Company acquires student loans through forward flow commitments with other
student loan lenders, but each of these commitments has a finite term. There can
be no assurance that these lenders will renew or extend their existing forward
flow commitments on terms that are favorable to the Company, if at all,
following their expiration.
In addition, as of December 31, 2004, third parties owned approximately 58%
of the loans the Company serviced. To the extent that third-party servicing
clients reduce the volume of student loans that the Company processes on their
behalf, the Company's income would be reduced, and, to the extent the related
costs could not be reduced correspondingly, net income could be materially
adversely affected. Such volume reductions occur for a variety of reasons,
including if third-party servicing clients commence or increase internal
servicing activities, shift volume to another service provider, perhaps because
such other service provider does not compete with the client in student loan
originations and acquisitions, or exit the FFEL Program completely.
SPECIAL ALLOWANCE PAYMENTS ON STUDENT LOANS ORIGINATED OR ACQUIRED WITH THE
PROCEEDS OF CERTAIN TAX-EXEMPT OBLIGATIONS MAY LIMIT THE INTEREST RATE ON
CERTAIN STUDENT LOANS TO THE COMPANY'S DETRIMENT.
Student loans originated or acquired with the proceeds of tax-exempt
obligations issued prior to October 1, 1993, as well as student loans acquired
with the sale proceeds of those student loans, receive only a portion of the
special allowance payment which they would otherwise be entitled to receive, but
those made prior to October 30, 2004 are guaranteed a minimum rate of return of
9.5% per year, less the applicable interest rate for the student loan.
As of December 31, 2004, approximately $3.0 billion of the Company's student
loan portfolio was comprised of loans that were previously financed with the
proceeds of tax-exempt obligations issued prior to October 1, 1993. Based upon
provisions of the Higher Education Act and related interpretations by the
Department, the Company believes that, for each of these student loans, the
Company will receive partial special allowance payments, subject to the 9.5%
Floor. However, the Department may change its regulations or its interpretations
of existing regulations, or the Higher Education Act may be amended, to
eliminate this special allowance payment treatment. In this event, the Company
would receive regular special allowance payments, but with no minimum rate of
return.
In the current low interest rate environment, the Company generally receives
partial special allowance payments and the 9.5% Floor with respect to its
eligible student loans originated or acquired with qualifying tax-exempt
proceeds. In a higher interest rate environment, however, the regular special
allowance payments on loans not originated or acquired with qualifying
tax-exempt proceeds may exceed the total subsidy to holders of eligible loans
originated or acquired with qualifying tax-exempt proceeds. Thus, in a higher
interest rate environment, these loans could have an adverse effect upon the
Company's earnings.
FAILURES IN THE COMPANY'S INFORMATION TECHNOLOGY SYSTEM COULD MATERIALLY DISRUPT
ITS BUSINESS.
The Company's servicing and operating processes are highly dependent upon its
information technology system infrastructure, and the Company faces the risk of
business disruption if failures in its information systems occur, which could
have a material impact upon its business and operations. The Company depends
heavily on its own computer-based data processing systems in servicing both its
own student loans and those of third-party servicing customers. If servicing
errors do occur, they may result in a loss of the federal guarantee on the
federally insured loans serviced or in a failure to collect amounts due on the
student loans that the Company serviced. In addition, although the Company
regularly backs up its data and maintains detailed disaster recovery plans, the
Company does not maintain fully redundant information systems. A major physical
disaster or other calamity that causes significant damage to information systems
could adversely affect the Company's business. Additionally, loss of information
systems for a sustained period of time could have a negative impact on the
Company's performance and ultimately on cash flow in the event the Company were
unable to process borrower payments.
TRANSACTIONS WITH AFFILIATES AND POTENTIAL CONFLICTS OF INTEREST OF CERTAIN OF
THE COMPANY'S OFFICERS AND DIRECTORS, INCLUDING ONE OF ITS CO-CHIEF EXECUTIVE
OFFICERS, POSE RISKS TO THE COMPANY'S SHAREHOLDERS.
16
The Company has entered into certain contractual arrangements with entities
controlled by Michael S. Dunlap, the Company's Chairman and Co-Chief Executive
Officer and a principal shareholder, and members of his family and, to a lesser
extent, with entities in which other directors and members of management hold
equity interests or board or management positions. Such arrangements constitute
a significant portion of the Company's business and include, among other things:
o performance of servicing duties;
o sales of student loans by such affiliates to the Company; and
o sales of student loan origination rights by such affiliates to the
Company.
These arrangements may present potential conflicts of interest.
Many of these arrangements are with Union Bank, in which Michael S. Dunlap
owns an indirect interest and of which he serves as non-executive chairman.
Union Bank is a significant source of student loans to the Company and a
significant servicing customer.
In 2004 and 2003, approximately 9.5% and 10.4%, respectively, of the
principal amount of the Company's student loan channel acquisitions were
acquired from Union Bank, a portion of which loans were originated by Union Bank
and a portion of which were originated by third parties. The Company believes
that the acquisitions were made on terms similar to those made from unrelated
entities. The Company intends to maintain its relationship with Union Bank,
which provides substantial benefits to the Company, although there can be no
assurance that all transactions engaged with Union Bank are, or in the future
will be, on terms that are no less favorable than what could be obtained from an
unrelated third party.
MATERIAL PROBLEMS AFFECTING UNION BANK COULD HAVE A MATERIAL ADVERSE EFFECT ON
THE COMPANY.
The ability of Union Bank to continue to do business with the Company will
depend on the development of Union Bank's own business, financial condition, and
results of operations, which will be affected by competitive and other factors
beyond the Company's control or knowledge. Because Union Bank is a privately
held company, an investor in the Company's securities might have little advance
warning of problems affecting Union Bank, even though these problems could have
a material adverse effect on the Company.
IMPOSITION OF PERSONAL HOLDING COMPANY TAX WOULD DECREASE THE COMPANY'S NET
income.
A corporation is considered to be a "personal holding company" under the U.S.
Internal Revenue Code of 1986, as amended (the "Code"), if (1) at least 60% of
its adjusted ordinary gross income is "personal holding company income"
(generally, passive income) and (2) at any time during the last half of the
taxable year more than half, by value, of its stock is owned by five or fewer
individuals, as determined under attribution rules of the Code. If both of these
tests are met, a personal holding company is subject to an additional tax on its
undistributed personal holding company income, currently at a 15% rate. Five or
fewer individuals hold more than half the value of the Company's stock. In June
2003, the Company submitted a request for a private letter ruling from the
Internal Revenue Service seeking a determination that its federally guaranteed
student loans qualify as assets of a "lending or finance business," as defined
in the Code. Such a determination would have enabled the Company to establish
that a company holding such loans does not constitute a personal holding
company. Based on its historical practice of not issuing private letter rulings
concerning matters that it considers to be primarily factual, the Internal
Revenue Service has indicated that it will not issue the requested ruling,
taking no position on the merits of the legal issue. So long as more than half
of the Company's value continues to be held by five or fewer individuals, if it
were to be determined that some portion of its federally guaranteed student
loans does not qualify as assets of a "lending or finance business," as defined
in the Code, the Company could become subject to personal holding company tax on
its undistributed personal holding company income. The Company continues to
believe that neither Nelnet, Inc. nor any of its subsidiaries is a personal
holding company. However, even if Nelnet, Inc. or one of its subsidiaries was
determined to be a personal holding company, the Company believes that by
utilizing intercompany distributions, it can eliminate or substantially
eliminate its exposure to personal holding company taxes, although it cannot
assure that this will be the case.
"DO NOT CALL" REGISTRIES LIMIT THE COMPANY'S ABILITY TO MARKET ITS PRODUCTS AND
SERVICES.
The Company's direct marketing operations are or may become subject to
various federal and state "do not call" laws and requirements. In January 2003,
the Federal Trade Commission amended its rules to provide for a national "do not
call" registry. Under these new federal regulations, which are currently being
challenged in court, consumers may have their phone numbers added to the
national "do not call" registry. Generally, the Company is prohibited from
calling anyone on that registry. In September 2003, telemarketers first obtained
access to the registry and since that time have been required to compare their
call lists against the national "do not call" registry at least once every 90
days. The Company is also required to pay a fee to access the registry on a
quarterly basis. Enforcement of the Federal "do not call" provisions began in
the fall of 2003, and the rule provides for fines of up to $11,000 per violation
and other possible penalties. This and similar state laws may restrict the
Company's ability to effectively market its products and services to new
customers. Furthermore, compliance with this rule may prove difficult, and the
Company may incur penalties for improperly conducting its marketing activities.
17
THE COMPANY'S INABILITY TO MAINTAIN ITS RELATIONSHIPS WITH SIGNIFICANT BRANDING
PARTNERS AND/OR CUSTOMERS COULD HAVE AN ADVERSE IMPACT ON ITS BUSINESS.
The Company's inability to maintain strong relationships with significant
schools, branding partners, servicing customers, guaranty agencies, and software
licensees could result in loss of:
o loan origination volume with borrowers attending certain schools;
o loan origination volume generated by some of the Company's branding
partners;
o loan and guarantee servicing volume generated by some of the Company's
loan servicing customers and guaranty agencies; and
o software licensing volume generated by some of the Company's licensees.
The Company cannot assure that its forward flow channel lenders or its
branding partners will continue their relationships with the Company. Loss of a
strong relationship, like that with a significant branding partner such as Union
Bank, or with schools from which a significant volume of student loans is
directly or indirectly acquired, could result in an adverse effect on the
Company's business.
The business of servicing Canadian student loans by EDULINX is limited to a
small group of servicing customers and the agreement with the largest of such
customers is currently scheduled to expire in February 2006. EDULINX cannot
guarantee that it will obtain a renewal of this largest servicing agreement or
that it will maintain its other servicing agreements, and the termination of any
such servicing agreements could result in an adverse effect on its business.
THE COMPANY CANNOT PREDICT WITH CERTAINTY THE OUTCOME OF THE SEC INFORMAL
INVESTIGATION.
Following the Company's disclosures related to recognition of 9.5% Floor
income, Senator Edward M. Kennedy, by letter to the Secretary of Education dated
August 26, 2004, requested information as to whether the Department had approved
of the Company's receipt of the 9.5% Floor income and, if not, why the
Department had not sought to recover claimed subsidies under the 9.5% Floor. By
letter dated September 10, 2004, the Company furnished to the Department certain
background information concerning the growth of the 9.5% Floor loans in its
portfolio, which information had been requested by the Department. Senator
Kennedy, in a second letter to the SEC dated September 21, 2004, requested that
the SEC investigate the Company's activities related to the 9.5% Floor. More
specifically, Senator Kennedy raised concerns about the Company's disclosures in
connection with its decision to recognize the previously deferred income, and
trading of Company securities by Company executives following such disclosures.
On September 27, 2004, the Company voluntarily contacted the SEC to request a
meeting with the SEC Staff. The Company's request was granted, and
representatives of the Company met with representatives of the SEC Staff on
October 12, 2004. Company representatives offered to provide to the SEC
information that the SEC Staff wished to have relating to the issues raised in
Senator Kennedy's letter. By letter dated October 14, 2004, the SEC Staff
requested that, in connection with an informal investigation, the Company
provide certain identified information. The Company has furnished to the SEC
Staff the information it has requested and is fully cooperating with the SEC
Staff in its informal investigation. The Company continues to believe that the
concerns expressed to the SEC by Senator Kennedy are entirely unfounded, but it
is not appropriate or feasible to determine or predict the ultimate outcome of
the SEC's informal investigation. The Company's costs related to the SEC's
informal investigation are being expensed as incurred. Additional costs, if any,
associated with an adverse outcome or resolution of that matter, in a manner
that is currently indeterminate and inherently unpredictable, could adversely
affect the Company's financial condition and results of operations. Although it
is possible that an adverse outcome in certain circumstances could have a
material adverse effect, based on information currently known by the Company's
management, in its opinion, the outcome of such pending informal investigation
is not likely to have such an effect.
ITEM 2. PROPERTIES
The following table lists the principal facilities leased by the Company. The
Company does not own any of its principal facilities.
Approximate Lease
square expiration
Location Primary Function or Segment feet date
-------- --------------------------- ---- ----
Jacksonville, FL.. Student Loan and Guarantee Servicing, Loan 135,000 October 2013
Generation, Technology
Denver, CO........ Student Loan Servicing, Loan Generation, Technology 124,000 February 2008
Mississauga, Ontario Student Loan Servicing 114,000 August 2009
Lincoln, NE....... Corporate Headquarters, Student Loan Servicing, 95,000 December 2010
Loan Generation
Indianapolis, IN.. Student Loan Servicing, Loan Generation 59,000 February 2008
The Company leases other facilities located throughout the United States.
These properties are leased on terms and for durations that are reflective of
commercial standards in the communities where these properties are located. The
Company believes that its respective properties are generally adequate to meet
its long-term business goals. The Company's principal office is located at 121
South 13th Street, Suite 201, Lincoln, Nebraska 68508.
ITEM 3. LEGAL PROCEEDINGS
The Company is subject to various claims, lawsuits, and proceedings that
arise in the normal course of business. These matters principally consist of
claims by borrowers disputing the manner in which their loans have been
processed. On the basis of present information, anticipated insurance coverage,
and advice received from counsel, it is the opinion of the Company's management
that the disposition or ultimate determination of these claims, lawsuits, and
proceedings will not have a material adverse effect on the Company's business,
financial position, or results of operations.
In addition to such legal proceedings that arise in the ordinary course of
business, the Company has furnished to the SEC Staff information the SEC
requested pursuant to an informal investigation and the Company is fully
cooperating with the SEC on such informal investigation. For further
information, see Part II, Item 7, "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Overview -- Recent
Developments."
18
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth
quarter of fiscal 2004.
PART II.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED SHAREHOLDER MATTERS,
AND ISSUER PURCHASES OF EQUITY SECURITIES
The Company's Class A Common Stock is listed and traded on the New York Stock
Exchange under the symbol "NNI," while its Class B Common Stock is not publicly
traded. The number of holders of record of the Company's Class A Common Stock
and Class B Common Stock as of February 15, 2005 was approximately 206 and
seven, respectively. Because many shares of the Company's Class A Common stock
are held by brokers and other institutions on behalf of shareholders, the
Company is unable to estimate the total number of beneficial owners represented
by these record holders.
The following table sets forth the high and low sales prices for the
Company's Class A Common Stock for each full quarterly period in 2004 and for
the partial quarter from December 11, 2003 (the initial public offering date of
the Company's Class A Common Stock) until December 31, 2003. The price paid per
share by the initial purchasers in the Company's initial public offering on
December 11, 2003 was $21.00.
2003 2004
------------ -------------------------------------------------
4th Quarter (a) 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
------------ ----------- ----------- ----------- ----------
High $ 22.40 $ 25.68 $ 25.83 $ 24.70 $ 27.00
Low 20.86 22.00 16.80 16.76 19.20
----------
(a) Stock prices are for the partial quarter from December 11, 2003 (the
initial public offering date of the Company's Class A Common Stock)
through December 31, 2003
The Company did not pay cash dividends on either class of its Common Stock
for the two most recent fiscal years and does not intend to pay dividends in the
foreseeable future. The Company intends to retain its earnings to finance
operations and future growth, and any decision to pay cash dividends will be
made by the Company's board of directors based on factors such as the Company's
results of operations and working capital requirements. The credit agreement
with the Company's general credit providers restricts payment of dividends or
other distributions to shareholders in the event the Company is in default under
the credit agreement or if payment of such a dividend or distribution would
result in such a default. In addition, trust indentures governing debt issued by
the education lending subsidiaries generally limit the amounts of funds that can
be transferred to the Company by its subsidiaries through cash dividends.
For information regarding the Company's equity compensation plans, see Part
III, Item 12 of this Report.
19
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected financial and other operating
information of the Company. The selected financial data in the table is derived
from the consolidated financial statements of the Company. The data should be
read in conjunction with the consolidated financial statements, the related
notes, and "Management's Discussion and Analysis of Financial Condition and
Results of Operations" included in this Report.
Year ended December 31,
-------------------------------------------------------------
2004 2003 2002 2001 2000
----------- ----------- ----------- ----------- ----------
(dollars in thousands, except share data)
Income Statement Data:
Net interest income.......... $ 398,166 $ 171,722 $ 185,029 $ 115,120 $ 64,853
Less provision (recovery) for
loan losses.................. (529) 11,475 5,587 3,925 1,370
----------- ---------- ---------- ---------- ----------
Net interest income after
provision (recovery)
for loan losses............ 398,695 160,247 179,442 111,195 63,483
Loan servicing and other fee
income..................... 98,661 102,959 105,160 93,172 66,015
Software services and other
income..................... 25,868 19,017 22,781 7,713 8,431
Derivative market value
adjustment and
net settlements............ (46,058) (2,784) (579) (3,517) --
Operating expenses........... (242,751) (233,150) (230,963) (195,438) (131,196)
----------- ----------- ----------- ----------- -----------
Income before income taxes
and minority interest...... 234,415 46,289 75,841 13,125 6,733
Net income................... 149,179 27,103 48,538 7,147 4,520
Earnings per share, basic
and diluted................ $ 2.78 $ 0.60 $ 1.08 $ 0.16 $ 0.11
Weighted average shares
outstanding................ 53,648,605 45,501,583 44,971,290 44,331,490 41,187,230
Other Data:
Origination and acquisition
volume (a)................. $ 4,079,491 $ 3,093,014 $ 1,983,403 $ 1,448,607 $ 1,027,498
Average student loans........ $11,809,663 $ 9,316,354 $ 8,171,898 $ 5,135,227 $ 3,388,156
Student loans serviced (at
end of period)............. $28,288,622 $18,773,899 $17,863,210 $16,585,295 $11,971,095
Ratios:
Core student loan spread..... 1.66% 1.78% 1.65% 1.66% 2.26%
Return on average total
assets..................... 1.11% 0.25% 0.52% 0.12% 0.12%
Return on average equity..... 39.7% 19.4% 49.2% 11.7% 8.2%
Net loan charge-offs as a
percentage of average
student loans.............. 0.070% 0.080% 0.047% 0.042% 0.055%
As of December 31,
-------------------------------------------------------------
2004 2003 2002 2001 2000
-------- --------- --------- -------- ---------
(dollars in thousands)
Balance Sheet Data:
Cash and cash equivalents.... $ 39,989 $ 198,423 $ 40,155 $ 36,440 $ 23,263
Student loans receivables, net 13,461,814 10,455,442 8,559,420 7,423,872 3,585,943
Total assets................. 15,160,005 11,932,186 9,766,583 8,134,560 4,021,948
Bonds and notes payable...... 14,300,606 11,366,458 9,447,682 7,926,362 3,934,130
Shareholders' equity......... 456,175 305,489 109,122 63,186 54,161
- ------------
(a) Initial loans originated or acquired through various channels, including
originations through the direct channel and acquisitions through the
branding partner channel, the forward flow channel, and the secondary market
(spot purchases).
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
The Company is one of the leading education finance companies in the United
States and is focused on providing quality student loan products and services to
students and schools nationwide. The Company ranks among the nation's leaders in
terms of total net student loan assets with $13.5 billion as of December 31,
2004.
The Company's business is comprised of three primary product and service
offerings:
o ASSET MANAGEMENT, INCLUDING STUDENT LOAN ORIGINATIONS AND ACQUISITIONS.
The Company provides student loan marketing, originations, acquisition,
and portfolio management. The Company owns a large portfolio of student
loan assets through a series of education lending subsidiaries. The
Company obtains loans through direct origination or through acquisition of
loans. The Company also provides marketing, sales, managerial, and
administrative support related to its asset generation activities.
o STUDENT LOAN AND GUARANTEE SERVICING. The Company services its student
loan portfolio and the portfolios of third parties. Servicing activities
include loan origination activities, application processing, borrower
updates, payment processing, due diligence procedures, and claim
processing. The Company also provides servicing support to guaranty
agencies, which includes system software, hardware and telecommunication
support, borrower and loan updates, default aversion tracking services,
claim processing services, and post-default collection services.
20
o SERVICING SOFTWARE. The Company uses internally developed student loan
servicing software and also provides this software to third-party student
loan holders and servicers.
The Company's education lending subsidiaries under the Asset Management
service offering are engaged in the securitization of education finance assets.
These education lending subsidiaries hold beneficial interests in eligible
loans, subject to creditors with specific interests. The liabilities of the
Company's education lending subsidiaries are not the obligations of the Company
or any of its other subsidiaries and cannot be consolidated in the event of
bankruptcy. The transfers of student loans to the eligible lender trusts do not
qualify for sales under the provisions of SFAS No. 140, Accounting for Transfers
and Servicing of Financial Assets and Extinguishments of Liabilities, as the
trusts continue to be under the effective control of the Company. Accordingly,
all the financial activities and related assets and liabilities, including debt,
of the securitizations are reflected in the Company's consolidated financial
statements.
The Company's primary product and service offerings constitute reportable
segments per the provisions of SFAS No. 131. The following table shows the
percent of total segment revenue (excluding intersegment revenue) and net income
(loss) before taxes for each of the Company's segments:
Years ended December 31,
---------------------------------------------------------------
2004 2003
------------------------------ -------------------------------
Student Student
loan and loan and
Asset guarantee Servicing Asset guarantee Servicing
management servicing software management servicing software
---------- --------- --------- ---------- ---------- --------
Segment revenue.............. 76.5% 21.8% 1.7% 60.8% 36.2% 3.0%
Segment net income (loss)
before taxes................. 81.1% 19.7% ( 0.8)% 62.2% 41.9% (4.1)%
The Company's derivative market value adjustment and net settlements are
included in the Asset Management segment. Because the majority of the Company's
derivatives do not qualify for hedge accounting under SFAS No. 133, the
derivative market value adjustment can cause the percent of revenue and net
income (loss) before taxes to fluctuate from period to period between segments.
The Company's student loan portfolio has grown significantly through
originations and acquisitions. The Company originated or acquired $4.1 billion
of student loans in 2004 through student loan channel acquisitions, including:
o the direct channel, in which the Company originates student loans in one
of its brand names directly to student and parent borrowers, which
accounted for 50.5% of the student loans added to the Company's loan
portfolio through a student loan channel in 2004;
o the branding partner channel, in which the Company acquires student loans
from lenders to whom it provides marketing and origination services, which
accounted for 24.3% of the student loans added to the Company's loan
portfolio through a student loan channel in 2004; and
o the forward flow channel, in which the Company acquires student loans from
lenders to whom it provides origination services, but provides no
marketing services, or who have agreed to sell loans to the Company under
forward sale commitments, which accounted for 19.1% of the student loans
added to the Company's loan portfolio through a student loan channel in
2004.
In addition, the Company also acquires student loans through spot purchases,
which accounted for 6.1% of student loans added to the Company's loan portfolio
through a student loan channel in 2004.
Not included in the previous student loan channel acquisition data is the
addition of $136.1 million of student loans acquired through a business
combination in April 2004.
21
SIGNIFICANT DRIVERS AND TRENDS
The Company's earnings and earnings growth are directly affected by the size
of its portfolio of student loans, the interest rate characteristics of its
portfolio, the costs associated with financing and managing its portfolio, and
the costs associated with the origination and acquisition of the student loans
in the portfolio. See "-- Student Loan Portfolio." In addition to the impact of
growth of the Company's student loan portfolio, the Company's results of
operations and financial condition may be materially affected by, among other
things, changes in:
o applicable laws and regulations that may affect the volume, terms,
effective yields, or refinancing options of education loans;
o demand for education financing and competition within the student loan
industry;
o the interest rate environment, funding spreads on the Company's financing
programs, and access to capital markets; and
o prepayment rates on student loans, including prepayments relating to loan
consolidations.
The Company's net interest income, or net interest earned on its student loan
portfolio, is the primary source of income and is primarily impacted by the size
of the portfolio and the net yield of the assets in the portfolio. If the
Company's student loan portfolio continues to grow and its net interest margin
remains relatively stable, the Company expects its net interest income to
increase. The Company's portfolio of FFELP loans generally earns interest at the
higher of a variable rate based on the special allowance payment, or SAP,
formula set by the Department and the borrower rate, which is fixed over a
period of time. The SAP formula is based on an applicable index plus a fixed
spread that is dependent upon when the loan was originated, the loan's repayment
status, and funding sources for the loan. Based upon provisions of the Higher
Education Act and related interpretations by the Department, loans financed
prior to September 30, 2004 with tax-exempt obligations issued prior to October
1, 1993 are entitled to receive special allowance payments equal to a 9.5%
minimum rate of return. In May 2003, the Company sought confirmation from the
Department regarding the treatment and recognition of special allowance payments
on a portion of its portfolio that had been previously financed with tax-exempt
obligations. While pending satisfactory resolution of this issue with the
Department, the Company deferred recognition of the interest income that was
generated by these loans in excess of income based upon the standard special
allowance rate. In June 2004, after consideration of certain clarifying
information received in connection with the guidance it had sought, including
written and verbal communications with the Department, the Company concluded
that the earnings process had been completed related to the special allowance
payments on these loans and recognized $124.3 million of interest income. As of
December 31, 2003, the amount of deferred excess interest income on these loans
was $42.9 million. The Company currently recognizes the income from the special
allowance payments, referred to as the special allowance yield adjustment, on
these loans as it is earned and would expect its net interest income to increase
over historical periods accordingly; however, since the portfolio subject to the
9.5% floor is not expected to increase, amounts recognized will decrease as
compared to the current period. In addition, if interest rates rise, the normal
yield on the portfolio of loans earning this special allowance will increase,
thereby reducing the special allowance yield adjustment. The Company entered
into $3.7 billion in notional amount of interest rate swaps in July 2004 to
reduce the risk of rising interest rates on this portfolio.
Net interest income increased by $226.4 million, or 131.9%, in 2004 as
compared to 2003. Net interest income, excluding the effects of variable-rate
floor income and the special allowance yield adjustment, increased approximately
$35.4 million, or 22.3%, in 2004 as compared to 2003, due primarily to portfolio
growth. Net student loans receivable increased by $3.0 billion, or 28.8%, to
$13.5 billion as of December 31, 2004 as compared to $10.5 billion as of
December 31, 2003.
Interest income is also dependent upon the relative level of interest rates.
The Company maintains an overall interest rate risk management strategy that
incorporates the use of interest rate derivative instruments to reduce the
economic effect of interest rate volatility. The Company's management has
structured all of its derivative instruments with the intent that each is
economically effective. However, most of the Company's derivative instruments do
not qualify for hedge accounting under SFAS No. 133 and thus may adversely
impact earnings. In addition, the mark-to-market adjustment recorded through
earnings in the Company's consolidated statements of income may fluctuate from
period to period. See Item 7A, "Quantitative and Qualitative Disclosures about
Market Risk -- Interest Rate Risk."
Competition for the supply channel of education financing in the student loan
industry has caused the cost of acquisition (or premiums) related to the
Company's student loan assets to increase. In addition, the Company has seen
significant increases in consolidation loan activity and consolidation loan
volume within the industry. The increase in competition for consolidation loans
has caused the Company to be aggressive in its measures to protect and secure
the Company's existing portfolio through consolidation efforts. The Company will
amortize its premiums paid from the purchase of student loans over the average
22
useful life of the assets. When the Company's loans are consolidated, the
Company may accelerate recognition of unamortized premiums if the consolidated
loan is considered a new loan. The increase in premiums paid on student loans
due to the increase in entrants and competition within the industry, coupled
with the Company's asset retention practices through consolidation efforts, have
caused the Company's yields to be reduced in recent periods due to the
amortization of premiums, consolidation rebate fees, and the lower yields on
consolidation loans. If the percent of consolidation loans continues to increase
as a percent of the Company's overall loan portfolio, the Company will continue
to experience reduced yields. If these trends continue, the Company could
continue to see an increase in consolidation rebate fees and amortization costs
and a reduction in yield. See "-- Student Loan Portfolio -- Student Loan Spread
Analysis." Although the Company's short-term yields may be reduced if this trend
continues, the Company will have been successful in protecting its assets and
stabilizing its balance sheet for long-term growth. Conversely, a reduction in
consolidation of the Company's own loans or the loans of third parties could
positively impact the effect of amortization on the Company's student loan yield
from period to period. Also, as the Company's portfolio of consolidation loans
grows both in nominal dollars and as a percent of the total portfolio, the
impact of premium amortization as a percent of student loan yield should
decrease unless the cost of acquisition of consolidation loans or underlying
loans increases substantially in the future.
Net interest income includes $70.4 million, or 60 basis points, in yield
reduction due to the amortization of premiums and deferred origination costs in
2004 as compared to $69.3 million, or 74 basis points, in 2003. The Company's
unamortized premiums and deferred origination costs, as a percent of student
loans, decreased from 1.5% as of December 31, 2003 to 1.3% as of December 31,
2004. Net interest income also includes $68.1 million, or 58 basis points, in
yield reduction due to consolidation rebate fees in 2004, as compared to $40.9
million, or 44 basis points, in 2003. The increase in the consolidation loan
rebate fee, combined with the lower lender yield of the consolidation loans the
Company is originating, has resulted in student loan interest spread
compression, excluding the effects of variable-rate floor income and the special
allowance yield adjustment, net of settlements on derivatives, from 1.78% in
2003 to 1.66% in 2004.
RECENT DEVELOPMENTS
As previously discussed, based on provisions of the Higher Education Act and
related interpretations, education lenders may receive special allowance
payments providing the 9.5% Floor on loans currently or financed prior to
September 30, 2004 with proceeds of tax-exempt obligations issued prior to
October 1, 1993. The Company holds FFELP loans, which are receiving special
allowance payments based upon the 9.5% Floor, and were previously financed prior
to September 30, 2004 with proceeds of tax-exempt obligations issued prior to
October 1, 1993, of approximately $3.0 billion as of December 31, 2004. The
Company sought confirmation regarding whether it was allowed to receive the
special allowance income based on the 9.5% Floor on such loans following
refinancing with proceeds of taxable obligations. For periods through March 31,
2004, the Company had deferred recognition of a portion of the income from the
9.5% Floor which exceeded ordinary special allowance payment rates generated by
these loans, pending satisfactory resolution of this issue. As previously
disclosed, after consideration of certain clarifying information received in
connection with the guidance it had sought and based on written and verbal
communications with the Department, the Company concluded that the earnings
process had been completed and determined to recognize the related income.
Following the Company's disclosures related to recognition of such income,
Senator Edward M. Kennedy, by letter to the Secretary of Education dated August
26, 2004, requested information as to whether the Department had approved of the
Company's receipt of the 9.5% Floor income and, if not, why the Department had
not sought to recover claimed subsidies under the 9.5% Floor. By letter dated
September 10, 2004, the Company furnished to the Department certain background
information concerning the growth of the 9.5% Floor loans in its portfolio,
which information had been requested by the Department. Senator Kennedy, in a
second letter to the SEC dated September 21, 2004, requested that the SEC
investigate the Company's activities related to the 9.5% Floor. More
specifically, Senator Kennedy raised concerns about the Company's disclosures in
connection with its decision to recognize the previously deferred income, and
trading of Company securities by Company executives following such disclosures.
On September 27, 2004, the Company voluntarily contacted the SEC to request a
meeting with the SEC Staff. The Company's request was granted, and
representatives of the Company met with representatives of the SEC Staff on
October 12, 2004. Company representatives offered to provide to the SEC
information that the SEC Staff wished to have relating to the issues raised in
Senator Kennedy's letter. By letter dated October 14, 2004, the SEC Staff
requested that, in connection with an informal investigation, the Company
provide certain identified information. The Company has furnished to the SEC
Staff the information it has requested and is fully cooperating with the SEC
Staff in its informal investigation.
The Company continues to believe that the concerns expressed to the SEC by
Senator Kennedy are entirely unfounded, but it is not appropriate or feasible to
determine or predict the ultimate outcome of the SEC's informal investigation.
The Company's costs related to the SEC's informal investigation are being
expensed as incurred. Additional costs, if any, associated with an adverse
outcome or resolution of that matter, in a manner that is currently
indeterminate and inherently unpredictable, could adversely affect the Company's
financial condition and results of operations. Although it is possible that an
adverse outcome in certain circumstances could have a material adverse effect,
based on information currently known by the Company's management, in its
opinion, the outcome of such pending informal investigation is not likely to
have such an effect.
23
In October 2004, Congress passed and President Bush signed into law the
Taxpayer-Teacher Protection Act of 2004 (the "October Act"), which prospectively
suspended eligibility for the 9.5% Floor on any loans refinanced with proceeds
of taxable obligations between September 30, 2004 and January 1, 2006. The
Company's FFELP loans, which have been refinanced with proceeds of taxable
obligations and are receiving special allowance payments under the 9.5% Floor,
were all refinanced with proceeds of taxable obligations well before September
30, 2004. The Company had ceased adding to its portfolio of loans receiving
special allowance payments subject to the 9.5% Floor in May 2004, and thus the
language in the October Act is not expected to have an effect upon the
eligibility of such loans for the 9.5% Floor, nor is it expected to have a
material effect upon the Company's financial condition or results of operation.
President Bush has made several proposals in connection with the FFEL
Program in his fiscal year 2006 budget as proposed to Congress. Some of the
highlights of the President's budget proposals, in no particular order, include:
o prospectively ending eligibility for the 9.5% Floor (making the
provision of the October Act permanent);
o reducing the federal guarantee on FFEL Program loans from 98% to 95%;
o reducing the guarantee for loans serviced by servicers designated as
exceptional performers from 100% to 97%;
o providing for variable interest rates on consolidation loans, and
maintaining variable interest rates on all other loan types, effectively
repealing the planned change to fixed interest rates that was to occur
on July 1, 2006;
o granting extended repayment terms and increasing the limits on the
amount that borrowers may borrow for FFELP loans;
o increasing the origination fee charged to lenders from 50 basis points
to 100 basis points;
o imposing a new annual 25 basis point origination fee on consolidation
loans; and
o permitting the reconsolidation (or refinancing) of existing
consolidation loans on multiple occasions and require borrowers to pay a
100 basis point origination fee for each such refinancing.
The Company cannot predict whether the President's budget proposals will be
enacted into law, but they may form some of the framework for the Congress as it
negotiates the fiscal year 2006 budget resolution.
ACQUISITIONS
The Company has positioned itself for growth by building a strong foundation
through acquisitions. Although the Company's assets, loan portfolios, and
fee-based revenues increase through such transactions, a key aspect of each
transaction is its impact on the Company's prospective organic growth and the
development of its integrated platform of services. As a result of these
acquisitions and the Company's rapid organic growth, the period-to-period
comparability of the Company's results of operations may be difficult. A summary
of the Company's 2004 acquisitions follows:
In January 2004, the Company acquired 50% of the membership interests in
Premiere Credit of North America, LLC ("Premiere"), a collection services
company that specializes in collection of educational debt. This investment is
being accounted for under the equity method of accounting.
In March 2004, the Company acquired rights, title, and interest in certain
assets of the Rhode Island Student Loan Authority ("RISLA"), including the right
to originate student loans in RISLA's name without competition from RISLA for a
period of ten years. The Company further agreed to provide administrative
services in connection with certain of the indentures governing debt securities
of RISLA for a 10-year period.
In April 2004, the Company purchased SLAAA Acquisition Corp. ("SLAAA"), a
student loan secondary market.
Also in April 2004, the Company purchased 50% of the stock of infiNET
Integrated Solutions, Inc. ("infiNET"), an ecommerce services provider for
colleges, universities, and healthcare organizations. InfiNET provides
customer-focused electronic transactions, information sharing, and account and
bill presentment. This investment is being accounted for under the equity method
of accounting.
In December 2004, the Company purchased 100% of the stock of EDULINX. EDULINX
is a Canadian corporation that engages in servicing of Canadian student loans.
NET INTEREST INCOME
The Company generates the majority of its earnings from its student loan
spread. This spread income is reported on the Company's income statement as net
interest income. The amortization and write-offs of premiums or discounts,
including capitalized costs of origination, the consolidation loan rebate fee,
and yield adjustments from borrower benefit programs, are netted against loan
interest income on the Company's income statement. The amortization and
write-offs of debt issuance costs are included in interest expense on the
Company's income statement.
The Company's portfolio of FFELP loans generally earns interest at the higher
of a variable rate based on the special allowance payment, or SAP, formula set
by the Department and the borrower rate, which is fixed over a period of time.
The SAP formula is based on an applicable index plus a fixed spread that is
dependent upon when the loan was originated, the loan's repayment status, and
funding sources for the loan. Depending on the type of student loan and when the
loan was originated, the borrower rate is either fixed to term or is reset to a
market rate each July 1. The larger the reduction in rates subsequent to the
July 1 annual borrower interest rate reset date, the greater the Company's
opportunity to earn variable-rate floor income. In declining interest rate
environments, the Company can earn significant amounts of such income.
Conversely, as the decline in rates abates, or in environments where interest
rates are rising, the Company's opportunity to earn variable-rate floor income
can be reduced, in some cases substantially. Since the borrower rates are reset
annually, the Company views earnings on variable-rate floor income as temporary
and not necessarily sustainable. The Company's ability to earn variable-rate
floor income in future periods is dependent upon the interest rate environment
following the annual reset of borrower rates, and the Company cannot assure the
nature of such environment in the future. The Company recorded approximately
$348,000 of variable-rate floor income in 2004 as compared to approximately
$12.8 million in 2003.
On those FFELP loans with fixed-term borrower rates, primarily consolidation
loans, the Company earns interest at the greater of the borrower rate or a
variable rate based on the SAP formula. Since the Company finances the majority
of its student loan portfolio with variable-rate debt, the Company may earn
excess spread on these loans for an extended period of time.
24
On most consolidation loans, the Company must pay a 1.05% per year rebate fee
to the Department. Those consolidation loans that have variable interest rates
based on the SAP formula earn an annual yield less than that of a Stafford loan.
Those consolidation loans that have fixed interest rates less than the sum of
1.05% and the variable rate based on the SAP formula also earn an annual yield
less than that of a Stafford loan. As a result, as consolidation loans matching
these criteria become a larger portion of the Company's loan portfolio, there
will be a lower yield on the Company's loan portfolio in the short term.
However, due to the extended terms of consolidation loans, the Company expects
to earn the yield on these loans for a longer duration, making them beneficial
to the Company in the long term.
Because the Company generates the majority of its earnings from its student
loan spread, the interest rate sensitivity of the Company's balance sheet is
very important to its operations. The current and future interest rate
environment can and will affect the Company's interest earnings, net interest
income, and net income. The effects of changing interest rate environments are
further outlined in Item 7A, "Quantitative and Qualitative Disclosures about
Market Risk -- Interest Rate Risk."
Investment interest income includes income from unrestricted interest-earning
deposits and funds in the Company's special purpose entities for its
asset-backed securitizations.
PROVISION FOR LOAN LOSSES
The allowance for loan losses is estimated and established through a
provision charged to expense. Losses are charged against the allowance when
management believes the collectibility of the loan principal is unlikely.
Recovery of amounts previously charged off is credited to the allowance for loan
losses. The Company maintains an allowance for loan losses associated with its
student loan portfolio at a level that is based on the performance
characteristics of the underlying loans. The Company analyzes the allowance
separately for its federally insured loans and its non-federally insured loans.
The allowance for the federally insured loan portfolio is based on periodic
evaluations of the Company's loan portfolios considering past experience, trends
in student loan claims rejected for payment by guarantors, changes to federal
student loan programs, current economic conditions, and other relevant factors.
The federal government guarantees 98% of principal and interest of federally
insured student loans, which limits the Company's loss exposure to 2% of the
outstanding balance of the Company's federally insured portfolio.
Effective June 1, 2004, the Company was designated as an Exceptional
Performer by the Department in recognition of its exceptional level of
performance in servicing FFEL Program loans. As a result of this designation,
the Company receives 100% reimbursement on all eligible FFEL Program default
claims submitted for reimbursement during the 12-month period following the
effective date of its designation. The Company is not subject to the 2% risk
sharing loss for eligible claims submitted during this 12-month period. Only
FFEL Program loans that are serviced by the Company, as well as loans owned by
the Company and serviced by other service providers designated as Exceptional
Performers by the Department, are subject to the 100% reimbursement. In 2004,
the Company's allowance and the provision for loan losses were each reduced by
$9.4 million to account for the estimated effects of the Exceptional Performance
designations.
As of December 31, 2004, service providers designated as an Exceptional
Performer serviced more than 99% of the Company's federally insured loans. Of
this 99%, third parties serviced approximately 9%. The Company is entitled to
receive this benefit as long as it and/or its other service providers continue
to meet the required servicing standards published by the Department. Compliance
with such standards is assessed on a quarterly basis.
In determining the adequacy of the allowance for loan losses on the
non-federally insured loans, the Company considers several factors including:
loans in repayment versus those in a nonpaying status, months in repayment,
delinquency status, type of program, and trends in defaults in the portfolio
based on Company and industry data. The Company charges off these uninsured
loans when the collection of principal and interest is 120 days past due.
The evaluation of the allowance for loan losses is inherently subjective, as
it requires material estimates that may be subject to significant changes. The
provision for loan losses reflects the activity for the applicable period and
provides an allowance at a level that management believes is adequate to cover
probable losses inherent in the loan portfolio.
OTHER INCOME
The Company also earns fees and generates income from other sources,
including principally loan servicing, guarantee servicing, and licensing fees on
its software products. Loan servicing fees are determined according to
individual agreements with customers and are calculated based on the dollar
25
value or number of loans serviced for each customer. Guarantee servicing fees
are calculated based on the number of loans serviced or amounts collected.
Software services income includes software license and maintenance fees
associated with student loan software products. Other income also includes the
derivative market value adjustment and net settlements as further discussed in
Item 7A, "Quantitative and Qualitative Disclosures about Market Risk -- Interest
Rate Risk." The Company's other income included net settlements incurred on
derivatives of $34.1 million in 2004 as compared to $1.6 million in 2003. The
Company's other income also included mark-to-market losses on derivative
instruments of $11.9 million in 2004 as compared to $1.2 million in 2003. This
increase, in addition to the changes in interest rates and fluctuations in the
forward yield curve, is the result of the Company entering into $3.7 billion in
notional amount of derivatives in July 2004.
OPERATING EXPENSES
Operating expenses include costs incurred to manage and administer the
Company's student loan portfolio and its financing transactions, costs incurred
to generate and acquire student loans, and general and administrative expenses.
Operating expenses also include amortization of intangible assets related to
acquisitions, which in 2004 was $8.8 million as compared to $12.8 million in
2003.
The Company does not believe inflation has a significant effect on its
operations.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 2004 COMPARED TO YEAR ENDED DECEMBER 31, 2003
Change
---------------------
2004 2003 Dollars Percent
----------- ----------- ---------- ---------
(dollars in thousands)
Interest income:
Loan interest, excluding variable-rate floor income........ $ 705,036 $ 413,301 $ 291,735 70.6 %
Variable-rate floor income................................. 348 12,830 (12,482) (97.3)
Amortization of loan premiums and deferred origination costs (70,370) (69,316) (1,054) (1.5)
Investment interest........................................ 17,762 15,203 2,559 16.8
----------- ----------- ---------- ---------
Total interest income.................................. 652,776 372,018 280,758 75.5
Interest expense:
Interest on bonds and notes payable........................ 254,610 200,296 54,314 27.1
------------ ------------ ----------- ----------
Net interest income.................................... 398,166 171,722 226,444 131.9
Less provision (recovery) for loan losses...................... (529) 11,475 (12,004) (104.6)
----------- ----------- ---------- ---------
Net interest income after provision (recovery) for
loan losses.......................................... 398,695 160,247 238,448 148.8
----------- ----------- ---------- ---------
Other income:
Loan servicing and other fee income........................ 98,661 102,959 (4,298) (4.2)
Software services and other income......................... 25,868 19,017 6,851 36.0
Derivatives settlements, net............................... (34,140) (1,601) (32,539) (2,032.4)
Derivative market value adjustment......................... (11,918) (1,183) (10,735) (907.4)
----------- ----------- ---------- ---------
Total other income..................................... 78,471 119,192 (40,721) (34.2)
----------- ----------- ---------- ---------
Operating expenses:
Salaries and benefits...................................... 133,667 124,273 9,394 7.6
Other operating expenses:
Depreciation and amortization, excluding amortization
of intangible assets................................... 10,631 10,358 273 2.6
Amortization of intangible assets........................ 8,768 12,766 (3,998) (31.3)
Trustee and other debt related fees...................... 10,291 14,138 (3,847) (27.2)
Occupancy and communications............................. 12,817 12,101 716 5.9
Advertising and marketing................................ 11,470 10,182 1,288 12.6
Professional services.................................... 15,067 9,437 5,630 59.7
Consulting fees and support services to related parties.. -- 3,519 (3,519) (100.0)
Postage and distribution................................. 13,235 13,241 (6) (0.0)
Other.................................................... 26,805 23,135 3,670 15.9
----------- ----------- ---------- ---------
Total other operating expenses......................... 109,084 108,877 207 0.2
----------- ----------- ---------- ---------
Total operating expenses............................... 242,751 233,150 9,601 4.1
----------- ----------- ---------- ---------
Income before income taxes and minority interest....... 234,415 46,289 188,126 406.4
Income tax expense......................................... 85,236 19,295 65,941 341.8
----------- ----------- ---------- ---------
Income before minority interest........................ 149,179 26,994 122,185 452.6
Minority interest in subsidiary loss....................... -- 109 (109) (100.0)
----------- ----------- ---------- ---------
Net income............................................. $ 149,179 $ 27,103 $ 122,076 450.4 %
=========== =========== ========== =========
Net interest income. Total loan interest, including amortization of loan
premiums and deferred origination costs, increased as a result of an increase in
26
the size of the student loan portfolio and the special allowance yield
adjustment, offset by changes in the interest rate environment and in the
pricing characteristics of the Company's student loan assets. The special
allowance yield adjustment of $203.5 million, offset by lower average interest
rates on loans, caused an increase in the student loan net yield on the
Company's student loan portfolio to 5.37% from 3.83% (when excluding the special
allowance yield adjustment, the student loan yield in 2004 was 3.65%).
Variable-rate floor income decreased due to the relative change in interest
rates during the periods subsequent to the annual borrower interest rate reset
date on July 1 of each year. Consequently, the Company realized approximately
$348,000 of variable-rate floor income in 2004 as compared to $12.8 million in
2003. The weighted average interest rate on the student loan portfolio increased
due to the special allowance yield adjustment, offset by lower interest rates on
loans, and the increase in the number of lower yielding consolidation loans,
resulting in an increase in loan interest income of approximately $156.0
million. Consolidation loan activity also increased the amortization and
write-off of premiums and deferred origination costs and increased the amount
incurred on consolidation rebate fees, reducing loan interest income
approximately $29.2 million. The increase in loan interest income was also a
result of an increase in the Company's portfolio of student loans. The average
student loan portfolio increased $2.5 billion, or 26.8%, which increased loan
interest income by approximately $163.3 million.
Interest expense on bonds and notes payable increased as average total debt
increased approximately $2.2 billion, or 21.2%. Average variable-rate debt
increased $2.4 billion, which increased interest expense by approximately $41.3
million. The Company reduced average fixed-rate debt by $191.6 million, which
decreased the Company's overall interest expense by approximately $11.4 million.
The increase in interest rates, specifically LIBOR and auction rates, increased
the Company's average cost of funds (excluding derivative settlement costs) to
1.99% from 1.89%, which increased interest expense approximately $27.2 million.
Interest expense in 2003 also includes $2.6 million due to the write off of debt
issuance costs incurred as a result of refinancing certain debt transactions.
Net interest income, excluding the effects of variable-rate floor income and
the special allowance yield adjustment, increased approximately $35.4 million,
or 22.3%, to approximately $194.3 million from approximately $158.9 million.
This increase is consistent with the increase in the average student loan
portfolio of 26.8%.
Provision for loan losses. The provision for loan losses for federally
insured student loans decreased approximately $11.4 million from an expense of
$3.8 million to a recovery of $7.6 million because of the Company and other
servicer's Exceptional Performer designation in 2004. The provision for loan
losses for non-federally insured loans decreased approximately $530,000 from
$7.6 million in 2003 to $7.1 million in 2004 because of the decrease in the
non-federally insured loans and expected performance of the non-federally
insured loan portfolio.
Other income. Loan servicing and other fee income decreased due to the
reduction in the number and dollar amount of loans serviced for third parties in
our U.S. servicing operations from $9.6 billion as of December 31, 2003 to $9.2
billion as of December 31, 2004. Total average U.S. third-party loan servicing
volume decreased $892.2 million, or 8.8%, which resulted in a decrease in loan
servicing income of $6.4 million. The decrease in servicing volume is due to
loan pay downs being greater than loan additions within the third-party customer
portfolios. This decrease was offset by an increase in servicing fees on the
Canadian servicing operations of $4.6 million due to the acquisition of EDULINX
in December 2004. The Company had no Canadian servicing operations in 2003. In
addition, guarantee servicing income decreased $2.5 million due to a customer
that did not renew its servicing contract in March 2004.
The software services and other income increased $1.8 million as the Company
began providing administrative services to RISLA in March 2004. In addition,
other income increased $1.8 million as a result of the acquisition of Nelnet
Capital in August 2003. Also, a one-time gain of $3.0 million was recorded on
the sale of a fixed asset in 2004.
The Company utilizes derivative instruments to provide economic hedges to
protect against the impact of adverse changes in interest rates. In 2004, the
derivative market value adjustment losses were $11.9 million and net settlements
representing realized costs were $34.1 million as compared to $1.2 million and
$1.6 million, respectively, in 2003. This increase, in addition to the changes
in interest rates and fluctuations in the forward yield curve, is the result of
the Company entering into $3.7 billion in notional amount of derivatives in July
2004. See Item 7A, "Quantitative and Qualitative Disclosures about Market Risk
- -- Interest Rate Risk."
Operating expenses. The Company's 2004 compensation plans included various
bonus and incentive programs for its employee base and covered the majority of
employees, including senior executive management. The incentive compensation
plans are tied to various performance targets and measures including loan
volume, customer satisfaction, and profitability. A significant portion of the
incentive is based on exceeding certain profitability targets and effectively
"earning through" the target to fund the incentive pool. The Company's incentive
and bonus compensation for 2004 was approximately 10% of net income before
taxes. The amount incurred by the Company in 2004 for its bonus and incentive
plans was approximately $6.2 million more than the amount incurred in 2003.
In addition to a net increase in the bonus and incentive compensation
expenses, salaries and benefits increased due to the acquisition of EDULINX in
December 2004 and our increased personnel resulting from our agreement to
provide administrative services to RISLA in March 2004 and the continued
expansion of our marketing efforts. This increase was reduced by a non-cash
stock compensation charge of $5.2 million recognized in 2003 equal to the
difference between the product of the estimated initial public offering price
and the number of shares issued in March 2003 and the total price paid by the
employees.
27
The decrease in the amortization of intangible assets is due to certain
intangible assets becoming fully amortized in 2003. The decrease in trustee and
other debt related fees relates to the reduced broker dealer fees from the
acquisition of Nelnet Capital as previously discussed. Advertising and marketing
expenses increased due to the expansion of the Company's marketing efforts,
especially in the consolidations area. Professional services increased due to
additional costs related to operations as a public company. No costs were
incurred in 2004 relating to consulting fees and support services to related
parties due to the termination of these agreements in July 2003. Other expenses
increased as the Company redeemed a portion of its student loan interest margin
notes in July 2004 and expensed the call-premium of $1.9 million on that
redemption. In addition, charitable contributions incurred by the Company in
2004 were approximately $4.0 million greater than what was incurred in 2003.
Income tax expense. Income tax expense increased due to the increase in
income before income taxes. The Company's effective tax rate was 36.4% and 41.7%
in 2004 and 2003, respectively. The decrease in the effective tax rate in 2004
was principally a result of the non-cash compensation expense recognized in 2003
for financial statement purposes that was not deductible for tax purposes.
YEAR ENDED DECEMBER 31, 2003 COMPARED YEAR ENDED DECEMBER 31, 2002
Change
--------------------
2003 2002 Dollars Percent
--------- ---------- --------- ---------
(dollars in thousands)
Interest income:
Loan interest, excluding variable-rate floor income.. $ 413,301 $ 408,281 $ 5,020 1.2 %
Variable-rate floor income........................... 12,830 49,800 (36,970) (74.2)
Amortization of loan premiums and deferred
origination costs.................................. (69,316) (55,065) (14,251) (25.9)
Investment interest.................................. 15,203 20,759 (5,556) (26.8)
--------- ---------- --------- ---------
Total interest income............................ 372,018 423,775 (51,757) (12.2)
Interest expense:
Interest on bonds and notes payable.................. 200,296 238,746 (38,450) (16.1)
--------- ---------- --------- ---------
Net interest income.............................. 171,722 185,029 (13,307) (7.2)
Less provision for loan losses........................... 11,475 5,587 5,888 105.4
--------- ---------- --------- ---------
Net interest income after provision for
loan losses.................................... 160,247 179,442 (19,195) (10.7)
--------- ---------- --------- ---------
Other income:
Loan servicing and other fee income.................. 102,959 105,160 (2,201) (2.1)
Software services and other income................... 19,017 22,781 (3,764) (16.5)
Derivatives settlements, net......................... (1,601) (3,541) 1,940 54.8
Derivative market value adjustment................... (1,183) 2,962 (4,145) 139.9
--------- ---------- --------- ---------
Total other income............................... 119,192 127,362 (8,170) (6.4)
--------- ---------- --------- ---------
Operating expenses:
Salaries and benefits................................ 124,273 106,874 17,399 16.3
Other operating expenses:
Depreciation and amortization, excluding
amortization of intangible assets................ 10,358 10,235 123 1.2
Amortization of intangible assets.................. 12,766 22,214 (9,448) (42.5)
Trustee and other debt related fees................ 14,138.. 12,879 1,259 9.8
Occupancy and communications....................... 12,101 11,424 677 5.9
Advertising and marketing.......................... 10,182 11,512 (1,330) (11.6)
Professional services.............................. 9,437 9,237 200 2.2
Consulting fees and support services to
related parties.................................. 3,519 12,800 (9,281) (72.5)
Postage and distribution........................... 13,241 11,095 2,146 19.3
Other.............................................. 23,135 22,693 442 1.9
--------- ---------- --------- ---------
Total other operating expenses................... 108,877 124,089 (15,212) (12.3)
--------- ---------- --------- ---------
Total operating expenses......................... 233,150 230,963 2,187 0.9
--------- ---------- --------- ---------
Income before income taxes and minority interest. 46,289 75,841 (29,552) (39.0)
Income tax expense................................... 19,295 27,679 (8,384) (30.3)
--------- ---------- --------- ---------
Income before minority interest.................. 26,994 48,162 (21,168) (44.0)
Minority interest in subsidiary loss................. 109 376 (267) (71.0)
--------- ---------- --------- ---------
Net income....................................... $ 27,103 $ 48,538 $ 21,435) (44.2)%
========= ========== ========= =========
Net interest income. Total loan interest, including variable-rate floor
income and amortization of loan premiums and deferred origination costs,
decreased as a result of changes in the interest rate environment and in the
pricing characteristics of the Company's student loan assets, offset by an
increase in the size of the student loan portfolio. The lower average interest
rates on loans caused a decrease in the student loan net yield on the Company's
student loan portfolio to 3.83% from 4.93%. Variable-rate floor income decreased
due to the relative change in interest rates during the periods subsequent to
the annual borrower interest rate reset date on July 1 of each year.
Consequently, the Company realized approximately $12.8 million of variable-rate
floor income in 2003 as compared to $49.8 million in 2002. The weighted average
interest rate on the student loan portfolio decreased due to the lower interest
rates and the increase in the number of lower yielding consolidation loans,
resulting in a decrease in loan interest income of approximately $36.6 million.
Consolidation loan activity also increased the amortization and write-off of
premiums and deferred origination costs and increased the amount incurred on
consolidation rebate fees, reducing loan interest income approximately $29.8
million. The decrease in loan interest income was partially offset by an
increase in the Company's portfolio of student loans. The average student loan
portfolio increased $1.1 billion, or 14.0%, which increased loan interest income
by approximately $57.3 million.
28
Investment interest income decreased due to the termination of a joint
venture with a large financial institution in the second quarter of 2003.
Interest expense on bonds and notes payable decreased despite an increase in
average total debt of approximately $1.6 billion. Average variable-rate debt
increased $1.8 billion, which increased interest expense by approximately $22.0
million. The Company reduced average fixed-rate debt by $212.0 million, which
decreased the Company's overall interest expense by approximately $12.5 million.
The reduction in interest rates, specifically LIBOR and auction rates, decreased
interest expense approximately $43.0 million and resulted in the decrease in the
Company's average cost of funds (excluding derivative settlement costs) to 1.89%
from 2.63%. Interest expense in 2003 also includes $2.6 million due to the write
off of debt issuance costs incurred as a result of refinancing certain debt
transactions as compared to $5.3 million in 2002.
Net interest income, excluding the effects of variable-rate floor income,
increased approximately $23.7 million, or 17.5%, to approximately $158.9 million
from approximately $135.2 million. This increase is consistent with the increase
in the average student loan portfolio of 14.0%.
Provision for loan losses. The provision for loan losses for federally
insured student loans increased approximately $878,000 from $3.0 million in 2002
to $3.8 million in 2003 due to the increase in the size of the Company's
federally insured student loan portfolio. The provision for loan losses on
non-federally insured loans increased $5.0 million from $2.6 million in 2002 to
$7.6 million in 2003. This increase was due to a provision of $4.3 million for
an identified pool of non-federally insured loans based on aging, delinquency,
and performance of such identified pool. This pool of non-federally insured
loans was limited to borrowers attending a single school, and, in early 2002,
the Company ceased making non-federally insured loans to borrowers attending
that school. The remaining increase was due to the increase in the size of the
Company's non-federally insured loan portfolio.
Other income. Loan servicing and other fee income decreased primarily due to
the reduction in the number and dollar amount of loans the Company serviced for
third parties from $10.7 billion as of December 31, 2002 to $9.6 billion as of
December 31, 2003. This decrease resulted in a decrease in loan servicing income
of $6.9 million. The decrease in servicing volume is due to loan pay downs being
greater than loan additions within the third-party customer portfolios. This
decrease was offset by an increase in guarantee servicing income of $4.7 million
due to higher guarantee volumes.
The software services and other income decreased $5.7 million due to
additional income earned in 2002 on marketing contracts that were terminated in
the fourth quarter of 2002. The decrease was offset by an increase of $3.4
million due to the acquisitions of Charter Accounts Systems, Inc. in May 2002
and Idaho Financial Associates, Inc. in January 2002 and an increase of $1.3
million due to the broker dealer fee income generated from the acquisition of
Nelnet Capital in August 2003. In 2002, the Company recognized marketing income
of $2.3 million as a broker on a loan sale as compared to $150,000 in 2003.
The Company utilizes derivative instruments to provide economic hedges to
protect against the impact of adverse changes in interest rates. In 2003, the
derivative market value adjustment losses were $1.2 million and net settlements
representing realized interest costs were $1.6 million as compared to $3.0
million of derivative market value adjustment gains and $3.5 million of net
settlements incurred in 2002. See Item 7A, "Quantitative and Qualitative
Disclosures about Market Risk -- Interest Rate Risk."
Operating expenses. Salaries and benefits increased as a non-cash stock
compensation expense of $5.2 million was recognized in 2003 equal to the
difference between the product of the estimated initial public offering price
and the number of shares issued in March 2003 and the total price paid by the
employees. In addition, salary expense increased $5.1 million in 2003 associated
with the termination of consulting and employment agreements. The remaining
increase of $7.1 million is due to the increased personnel from the acquisitions
previously described and expansion of the Company's marketing efforts.
The decrease in the amortization of intangible assets is due to certain
intangible assets becoming fully amortized in 2002. The increase in trustee and
other debt related fees relates to the $1.6 billion increase in average debt
outstanding. Advertising and marketing expenses decreased due a $2.4 million
expense incurred on a large marketing contract that was terminated in December
2002. This decrease was offset by an increase in marketing activities related to
consolidation activities in 2003. Consulting fees and support services to
related parties decreased due to conversion-related fees paid in 2002 and the
termination of a large consulting agreement in December 2002. Postage and
distribution expenses increased due to an increase in mass mailings to promote
origination of Stafford and consolidation loans.
Income tax expense. Income tax expense decreased due to the decrease in
income before income taxes. The Company's effective tax rate was 41.7% and 36.5%
in 2003 and 2002, respectively. The increase in the effective tax rate was
principally a result of the non-cash compensation expense recognized in 2003 for
financial statement purposes that was not deductible for tax purposes.
29
FINANCIAL CONDITION
AS OF DECEMBER 31, 2004 COMPARED TO DECEMBER 31, 2003
Change
---------------------
2004 2003 Dollars Percent
------------- ------------ ----------- --------
(dollars in thousands)
Assets:
Student loans receivable, net.................. $13,461,814 $10,455,442 $ 3,006,372 28.8 %
Cash, cash equivalents, and investments........ 1,302,954 1,155,215 147,739 12.8
Other assets................................... 395,237 321,529 73,708 22.9
------------ ------------ ------------ --------
Total assets.............................. $15,160,005 $11,932,186 $ 3,227,819 27.1 %
============ ============ ============ ========
Liabilities:
Bonds and notes payable........................ $14,300,606 $11,366,458 $ 2,934,148 25.8 %
Fair value of derivative instruments, net...... 11,895 677 11,218 1,657.0
Other liabilities.............................. 391,329 259,562 131,767 50.8
------------ ------------ ------------ --------
Total liabilities......................... 14,703,830 11,626,697 3,077,133 26.5
Shareholders' equity........................... 456,175 305,489 150,686 49.3
------------ ------------ ------------ --------
Total liabilities and shareholders' equity $15,160,005 $11,932,186 $ 3,227,819 27.1 %
============ ============ ============ ========
Total assets increased primarily because of an increase in student loans
receivable. The Company originated or acquired $4.1 billion of student loans in
2004, offset by repayments of approximately $1.2 billion. Cash, cash
equivalents, and investments increased primarily because of a $107.2 million
increase in restricted cash due to loan program customers, which reflects timing
of disbursements on loans and increased lockbox volume. Total liabilities
increased primarily because of an increase in bonds and notes payable, resulting
from additional borrowings to fund growth in student loans. The fair value of
derivatives instruments increased due to the larger notional amounts and change
in market conditions on the Company's derivative instruments. Other liabilities
include restricted cash due to loan program customers that increased $107.2
million as a result of timing of disbursements on loans and increased lockbox
volume. Shareholders' equity increased primarily as a result of net income of
$149.2 million in 2004.
LIQUIDITY AND CAPITAL RESOURCES
The Company utilizes operating cash flows, operating lines of credit, and
secured financing transactions to fund operations and student loan originations
and acquisitions. In addition, in December 2003, the Company consummated an
initial public offering of its Class A Common Stock that yielded the Company net
proceeds of $163.7 million. Operating activities provided net cash of $241.1
million in 2004, an increase of $88.1 million from the net cash provided by
operating activities of $153.0 million in 2003. Operating cash flows are driven
by net income adjusted for various non-cash items such as the provision
(recovery) for loan losses, depreciation and amortization, deferred income
taxes, the derivative market value adjustment, non-cash compensation expense,
income from equity method investments, and the gain on the sale of a fixed
asset. These non-cash items resulted in an increase in cash provided by
operating activities of $1.4 million in 2004 as compared to 2003. In addition,
the special allowance yield adjustment received in 2004, reduced by the change
in settlement costs on derivative instruments and related operating expenses and
taxes, increased cash provided by operating activities in 2004 over 2003.
As of December 31, 2004, the Company had a $35.0 million operating line of
credit and a $50.0 million commercial paper commitment under two separate
facilities that expire in September 2005. In addition, EDULINX has a credit
facility agreement with a Canadian financial institution for approximately $12.5
million ($15 million in Canadian dollars) that is cancelable by either party
upon demand. The Company uses these facilities primarily for general operating
purposes and had no borrowings under these facilities as of December 31, 2004.
The Company believes these facilities, the growth in the cash flow from
operating activities, and the initial public stock offering indicate a favorable
trend in its available capital resources.
The Company's secured financing instruments include commercial paper lines,
short-term student loan warehouse programs, variable-rate tax-exempt bonds,
fixed-rate bonds, fixed-rate tax-exempt bonds, and various asset-backed
securities. Of the $14.3 billion of debt outstanding as of December 31, 2004,
$11.8 billion was issued under securitization transactions. In 2004, the Company
completed four asset-backed securities transactions totaling $5.4 billion. The
proceeds from the September 2004 asset-backed securities issuance of $2.0
billion were used to redeem $1.7 billion of outstanding student loan
asset-backed auction rate notes. In addition, in February 2005, the Company
completed a $1.3 billion asset-backed securities transaction. Depending on
market conditions, the Company anticipates continuing to access the asset-backed
securities market in 2005 and subsequent years. Securities issued in the
securitization transactions are generally priced off a spread to LIBOR or set
under an auction procedure. The student loans financed are generally priced on a
spread to commercial paper or U.S. Treasury Bills.
30
The Company's warehouse facilities allow for expansion of liquidity and
capacity for student loan growth and should provide adequate liquidity to fund
the Company's student loan operations for the foreseeable future. As of December
31, 2004, the Company had a student loan warehousing capacity of $4.3 billion,
of which $2.5 billion was outstanding, through 364-day commercial paper conduit
programs. These conduit programs mature in 2005 through 2009; however, they must
be renewed annually by underlying liquidity providers. Historically, the Company
has been able to renew its commercial paper conduit programs, including the
underlying liquidity agreements, and therefore does not believe the renewal of
these contracts present a significant risk to its liquidity. Because the Company
continues to grow its student loan portfolio, the Company increased its student
loan warehousing capacity to $4.4 billion in February 2005.
The Company is limited in the amounts of funds that can be transferred from
its subsidiaries through intercompany loans, advances, or cash dividends. These
limitations result from the restrictions contained in trust indentures under
debt financing arrangements to which the Company's education lending
subsidiaries are parties. The Company does not believe these limitations will
affect its operating cash needs. The amounts of cash and investments restricted
in the respective reserve accounts of the education lending subsidiaries are
shown on the balance sheets as restricted cash and investments.
The following table summarizes the Company's bonds and notes outstanding as
of December 31, 2004:
Interest rate
range on
Carrying Percent of carrying
amount total amount Final maturity
----------- ---------- -------------- --------------
(dollars in thousands)
Variable-rate bonds and notes (a):
Bond and notes based on indices.......... $ 7,449,652 52.1 % 1.84% - 3.25% 11/25/09 - 01/25/41
Bond and notes based on auction.......... 3,590,920 25.1 1.70% - 2.55% 11/01/09 - 07/01/43
------------- ----------
Total variable-rate bonds and notes.... 11,040,572 77.2
Commerical paper and other................... 2,532,393 17.7 2.24% - 2.37% 05/13/05 - 09/02/09
Fixed-rate bonds and notes (a)............... 712,641 5.0 5.20% - 6.68% 05/01/05 - 05/01/29
Other borrowings............................. 15,000 0.1 6.00% 11/01/05
------------- ----------
Total.................................... $ 14,300,606 100.0 %
============= ==========
- --------------------------------
(a) Issued in securitization transactions.
Total unused commitments under various commercial paper, warehouse, and
operating line of credit agreements totaled $1.9 billion as of December 31,
2004.
The Company is committed under noncancelable operating leases for certain
office and warehouse space and equipment. The Company's contractual obligations
as of December 31, 2004 were as follows:
Less than More
Total 1 year 1 to 3 years 3 to 5 years than 5 years
------------ ---------- ------------- ------------ ------------
(dollars in thousands)
Bonds and notes payable....... $14,300,606 $2,292,443 $209,152 $799,888 $10,999,123
Operating lease obligations... 18,956 5,879 9,060 3,344 673
------------ ---------- ---------- ----------- ------------
Total...................... $14,319,562 $2,298,322 $218,212 $803,232 $10,999,796
============ ========== ========== =========== ============
The Company has commitments with its branding partners and forward flow
lenders which obligate the Company to purchase loans originated under specific
criteria, although the branding partners and forward flow lenders are not
obligated to provide the Company with a minimum amount of loans. Branding
partners are from whom the Company acquires student loans and to whom the
Company provides marketing and origination services. Forward flow lenders are
from whom the Company acquires student loans and to whom the Company provides
origination services. These commitments generally run for periods ranging from
one to five years and are generally renewable. The Company was committed to
extend credit or was obligated to purchase $265.5 million of student loans at
current market rates at the respective sellers' requests under various
agreements.
On December 1, 2004, the Company purchased EDULINX in a business combination
for $7.0 million. An additional payment of approximately $6.3 million is to be
paid by the Company if EDULINX obtains an extension or renewal of a significant
customer servicing contract that currently expires in February 2006. This
contingency payment is due following the date on which such extension or renewal
period of the servicing contract commences.
31
STUDENT LOAN PORTFOLIO
The table below describes the components of the Company's loan portfolio:
As of December 31, 2004 As of December 31, 2003
--------------------------- --------------------------
Dollars Percent Dollars Percent
-------------- ------------ -------------- -----------
(dollars in thousands)
Federally insured:
Stafford................................... $ 5,047,487 37.5 % $ 4,900,249 46.9 %
PLUS/SLS (a)............................... 252,910 1.9 249,217 2.4
Consolidation.............................. 7,908,292 58.7 5,073,081 48.5
Non-federally insured.......................... 90,405 0.7 92,327 0.9
------------- ----------- -------------- ----------
Total.................................. 13,299,094 98.8 10,314,874 98.7
Unamortized premiums and deferred origination
costs........................................ 169,992 1.3 156,594 1.5
Allowance for loan losses:
Allowance - federally insured.............. (117) (0.0) (9,755) (0.1)
Allowance - non-federally insured.......... (7,155) (0.1) (6,271) (0.1)
------------- ----------- -------------- ----------
Net.................................... $ 13,461,814 100.0 % $10,455,442 100.0 %
============= =========== ============== ==========
----------
(a) Supplemental loans for students, or SLS, are the predecessor to
unsubsidized Stafford loans.
Activity in the Allowance for Loan Losses
The provision for loan losses represents the periodic expense of maintaining
an allowance sufficient to absorb losses, net of recoveries, inherent in the
portfolio of student loans. An analysis of the Company's allowance for loan
losses is presented in the following table:
Year ended December 31,
-----------------------------------------------
2004 2003 2002
--------------- -------------- --------------
(dollars in thousands)
Balance at beginning of year.......................................... $ 16,026 $ 12,000 $ 10,242
Provision (recovery) for loan losses:
Federally insured loans.......................................... (7,639) 3,835 2,957
Non-federally insured loans...................................... 7,110 7,640 2,630
-------------- -------------- --------------
Total provision (recovery) for loan losses.................... (529) 11,475 5,587
Charge-offs:
Federally insured loans.......................................... (1,999) (3,450) (2,570)
Non-federally insured loans...................................... (6,674) (4,132) (1,333)
-------------- -------------- --------------
Total charge-offs............................................ (8,673) (7,582) (3,903)
Recoveries, non-federally insured loans.............................. 448 133 74
-------------- -------------- --------------
Net charge-offs...................................................... (8,225) (7,449) (3,829)
-------------- -------------- --------------
Balance at end of year............................................... $ 7,272 $ 16,026 $ 12,000
============== ============== ==============
Allocation of the allowance for loan losses:
Federally insured loans........................................ $ 117 $ 9,755 $ 9,370
Non-federally insured loans.................................... 7,155 6,271 2,630
-------------- -------------- --------------
Total allowance for loan losses............................. $ 7,272 $ 16,026 $ 12,000
============== ============== ==============
Net loan charge-offs as a percentage of average student loans....... 0.070 % 0.080 % 0.047 %
Total allowance as a percentage of average student loans............ 0.062 % 0.172 % 0.147 %
Total allowance as a percentage of ending balance of student loans.. 0.055 % 0.155 % 0.143 %
Non-federally insured allowance as a percentage of the ending
balance of non-federally insured loans......................... 7.914 % 6.792 % 3.495 %
Average student loans............................................... $11,809,663 $ 9,316,354 $8,171,898
Ending balance of student loans..................................... $13,299,094 $10,314,874 $8,404,388
Ending balance of non-federally insured loans....................... $ 90,405 $ 92,327 $ 75,260
In 2004, the Company's allowance and the provision for loan losses were each
reduced by $9.4 million to account for the estimated effects of the Company's
(and other service providers servicing the Company's student loans) Exceptional
Performance designations.
32
Delinquencies have the potential to adversely impact the Company's earnings
through increased servicing and collection costs and account charge-offs. The
table below shows the Company's student loan delinquency amounts:
As of December 31, 2004 As of December 31, 2003
-------------------------- ------------------------
Dollars Percent Dollars Percent
-------------- --------- -------------- --------
(dollars in thousands)
Federally Insured Loans:
Loans in-school/grace/deferment(1)......... $ 3,584,260 $ 2,941,228
Loans in forebearance(2)................... 1,654,158 1,362,335
Loans in repayment status:
Loans current........................... 7,142,808 89.6 % 5,244,281 88.6 %
Loans delinquent 31-60 days(3).......... 338,434 4.3 279,435 4.7
Loans delinquent 61-90 days(3).......... 154,477 1.9 130,339 2.2
Loans delinquent 91 days or greater(4).. 334,552 4.2 264,929 4.5
-------------- --------- -------------- --------
Total loans in repayment.............. 7,970,271 100.0 % 5,918,984 100.0 %
-------------- ========= -------------- ========
Total federally insured loans......... $ 13,208,689 $ 10,222,547
============== ==============
Non-Federally Insured Loans:
Loans in-school/grace/deferment(1)......... $ 23,106 $ 25,537
Loans in forebearance(2)................... 2,110 14,776
Loans in repayment status:
Loans current........................... 58,606 89.9 % 45,554 87.5 %
Loans delinquent 31-60 days(3).......... 2,559 3.9 2,531 4.9
Loans delinquent 61-90 days(3).......... 1,495 2.3 1,556 3.0
Loans delinquent 91 days or greater(4).. 2,529 3.9 2,373 4.6
-------------- --------- -------------- --------
Total loans in repayment.............. 65,189 100.0 % 52,014 100.0 %
-------------- ========= -------------- ========
Total non-federally insured loans..... $ 90,405 $ 92,327
============== ==============
- ----------
(1) Loans for borrowers who still may be attending school or engaging in other
permitted educational activities and are not yet required to make payments
on the loans, e.g., residency periods for medical students or a grace period
for bar exam preparation for law students.
(2) Loans for borrowers who have temporarily ceased making full payments due to
hardship or other factors, according to a schedule approved by the servicer
consistent with the established loan program servicing procedures and
policies.
(3) The period of delinquency is based on the number of days scheduled payments
are contractually past due and relate to repayment loans, that is,
receivables not charged off, and not in school, grace, deferment, or
forbearance.
(4) Loans delinquent 91 days or greater include loans in claim status, which are
loans which have gone into default and have been submitted to the guaranty
agency for FFELP loans, or the insurer for non-federally insured loans, to
process the claim for payment.
During 2004, the Company reclassified FFELP loans and the related allowance
that have been rejected for reimbursement by the guarantor to the non-federally
insured loan portfolio, because these loans are effectively uninsured. In the
above tables, the reclassification is reflected for all periods presented.
Origination and Acquisition
The Company's student loan portfolio increases through various channels,
including originations through the direct channel and acquisitions through the
branding partner channel, the forward flow channel, and spot purchases. The
Company's portfolio also increases with the addition of portfolios acquired
through business acquisitions.
One of the Company's primary objectives is to focus on originations through
the direct channel and acquisitions through the branding partner channel. The
Company has extensive and growing relationships with many large financial and
educational institutions that are active in the education finance industry. The
Company's branding relationships and forward flow relationships include Union
Bank, an entity under common control with the Company, as well as many schools
and national and regional financial institutions. Loss of a strong relationship,
like that with a significant branding partner such as Union Bank, or with
schools from which the Company directly or indirectly acquires a significant
volume of student loans, could result in an adverse effect on the volume derived
from the branding partner channel.
33
The table below sets forth the activity of loans originated or acquired through
each of the Company's channels:
Year ended December 31,
-------------------------------------
2004 2003 2002
------------ ------------ -----------
(dollars in thousands)
Beginning balance................................... $10,314,874 $ 8,404,388 $7,267,055
Direct channel:
Consolidation loan originations................. 3,060,427 2,266,499 859,120
Less consolidation of existing portfolio........ (1,282,100) (1,160,000) (682,383)
------------- ------------- ---------
Net consolidation loan originations.......... 1,778,327 1,106,499 176,737
Stafford/PLUS loan originations................. 279,885 236,855 224,827
Branding partner channel............................ 989,867 808,843 521,023
Forward flow channel................................ 780,803 602,777 577,603
Other channels...................................... 250,609 338,040 483,213
------------- ------------- ---------
Total channel acquisitions...................... 4,079,491 3,093,014 1,983,403
Loans acquired in business acquisition.............. 136,138 -- --
Repayments, claims, capitalized interest, and other. (1,231,409) (1,182,528) (846,070)
------------- ------------- ---------
Ending balance...................................... $13,299,094 $10,314,874 $8,404,388
============ ============= =========
Student Loan Spread Analysis
Maintenance of the spread on assets is a key factor in maintaining and
growing the Company's income. The following table analyzes the student loan
spread on the Company's portfolio of student loans and represents the spread on
assets earned in conjunction with the liabilities and derivative instruments
used to fund the assets:
Year ended December 31,
--------------------------------------------
2004 2003 2002
------------- -------------- -----------
Student loan yield................................... 6.55 % 5.01 % 5.91 %
Consolidation rebate fees............................ (0.58) (0.44) (0.31)
Premium and deferred origination costs amortization.. (0.60) (0.74) (0.67)
------------- -------------- -----------
Student loan net yield............................... 5.37 3.83 4.93
Student loan cost of funds (a)....................... (2.25) (1.91) (2.67)
------------- -------------- -----------
Student loan spread.................................. 3.12 1.92 2.26
Variable-rate floor income........................... -- (0.14) (0.61)
Special allowance yield adjustment, net of
settlements on derivatives (b).................... (1.46) -- --
------------- -------------- -----------
Core student loan spread............................. 1.66 % 1.78 % 1.65 %
============= ============== ===========
Average balance of student loans (in thousands)......$11,809,663 $ 9,316,354 $ 8,171,898
Average balance of debt outstanding (in thousands)... 12,822,524 10,578,088 9,071,936
----------
(a) The student loan cost of funds includes the effects of the net
settlement costs on the Company's derivative instruments of $34.1
million, $1.6 million, and $3.5 million in 2004, 2003, and 2002,
respectively.
(b) The special allowance yield adjustment in 2004, which was approximately
$203.5 million, represents the impact on net spread had loans earned at
statutorily defined rates under a taxable financing. This special
allowance yield adjustment has been reduced by the net settlements on
derivative instruments that were used to hedge this loan portfolio
earning the excess yield, which was $31.2 million in 2004.
The increase in lower yielding consolidation loans coupled with a slightly
higher interest rate environment has caused some compression in the Company's
student loan spread when excluding the special allowance yield adjustment, net
of settlements on derivatives.
CRITICAL ACCOUNTING POLICIES
This Management's Discussion and Analysis of Financial Condition and Results
of Operations discusses the Company's consolidated financial statements, which
have been prepared in accordance with U.S. generally accepted accounting
principles, or GAAP. The preparation of these financial statements requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and the reported amounts of income and expenses during
the reporting periods. The Company bases its estimates and judgments on
historical experience and on various other factors that the Company believes are
reasonable under the circumstances. Actual results may differ from these
estimates under varying assumptions or conditions. Note 2 of the consolidated
financial statements, which are included in this Report, includes a summary of
the significant accounting policies and methods used in the preparation of the
consolidated financial statements.
34
On an on-going basis, management evaluates its estimates and judgments,
particularly as they relate to accounting policies that management believes are
most "critical" -- that is, they are most important to the portrayal of the
Company's financial condition and results of operations and they require
management's most difficult, subjective, or complex judgments, often as a result
of the need to make estimates about the effect of matters that are inherently
uncertain. Management has determined the only critical accounting policy is
determining the level of the allowance for loan losses.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses represents management's estimate of probable
losses on student loans. This evaluation process is subject to numerous
estimates and judgments. The Company evaluates the adequacy of the allowance for
loan losses on its federally insured loan portfolio separately from its
non-federally insured loan portfolio.
The allowance for the federally insured loan portfolio is based on periodic
evaluations of the Company's loan portfolios considering past experience, trends
in student loan claims rejected for payment by guarantors, changes to federal
student loan programs, current economic conditions, and other relevant factors.
The federal government guarantees 98% of principal and interest of federally
insured student loans, which limits the Company's loss exposure to 2% of the
outstanding balance of the Company's federally insured portfolio.
Effective June 1, 2004, the Company was designated as an Exceptional
Performer by the Department in recognition of its exceptional level of
performance in servicing FFEL Program loans. As a result of this designation,
the Company receives 100% reimbursement on all eligible FFEL Program default
claims submitted for reimbursement during the 12-month period following the
effective date of its designation. The Company is not subject to the 2% risk
sharing loss for eligible claims submitted during this 12-month period. Only
FFEL Program loans that are serviced by the Company, as well as loans owned by
the Company and serviced by other service providers designated as Exceptional
Performers by the Department, are subject to the 100% reimbursement. As of
December 31, 2004, service providers designated as an Exceptional Performer
serviced more than 99% of the Company's federally insured loans. Of this 99%,
third parties serviced approximately 9%. The Company is entitled to receive this
benefit as long as it and/or its other service providers continue to meet the
required servicing standards published by the Department. Compliance with such
standards is assessed on a quarterly basis.
In determining the adequacy of the allowance for loan losses on the
non-federally insured loans, the Company considers several factors including:
loans in repayment versus those in a nonpaying status, months in repayment,
delinquency status, type of program, and trends in defaults in the portfolio
based on Company and industry data. The Company charges off these uninsured
loans when the collection of principal and interest is 120 days past due.
The allowance for federally insured and non-federally insured loans is
maintained at a level management believes is adequate to provide for estimated
probable credit losses inherent in the loan portfolio. This evaluation is
inherently subjective because it requires estimates that may be susceptible to
significant changes.
RECENT ACCOUNTING PRONOUNCEMENTS
In December 2004, the Financial Accounting Standards Board ("FASB")
issued SFAS No. 153, Exchanges of Nonmonetary Assets ("SFAS No. 153"). This
Statement amends the guidance in Accounting Principles Board Opinion ("APB") No.
29, Accounting for Nonmonetary Transactions ("APB No. 29"). APB No. 29 provides
an exception to the basic measurement principle (fair value) for exchanges of
similar assets, requiring that some nonmonetary exchanges be recorded on a
carryover basis. SFAS No. 153 eliminates the exception to fair value for
exchanges of similar productive assets and replaces it with a general exception
for exchange transactions that do not have commercial substance, that is,
transactions that are not expected to result in significant changes in the cash
flows of the reporting entity. The provisions of SFAS No. 153 are effective for
exchanges of nonmonetary assets occurring in fiscal periods beginning after June
15, 2005. As of December 31, 2004, management believes that SFAS No. 153 will
not have a significant effect on the financial position, results of operations,
and cash flows of the Company.
In December 2004, the FASB revised SFAS No. 123 (revised 2004), Share-Based
Payments ("SFAS No. 123R"). SFAS No. 123R eliminates the alternative to use the
intrinsic value method of accounting under the provisions of APB No. 25,
Accounting for Stock Issued to Employees ("APB No. 25") (generally resulting in
recognition of no compensation expense) and instead requires a company to
recognize in its financial statements the cost of employee services received in
exchange for valuable equity instruments issued, and liabilities incurred, to
employees in share-based payment transactions. The cost will be based on the
grant-date fair value of the award and will be recognized over the period for
which an employee is required to provide service in exchange for the award. For
public entities that do not file as small business issuers, the provisions of
the revised statement are to be applied prospectively for awards that are
granted, modified, or settled in the first interim or annual period beginning
after June 15, 2005. Because the Company does not issue share-based payments to
employees that are accounted for under APB No. 25's intrinsic value method of
accounting, management believes that SFAS No. 123R will not have an effect on
the financial position, results of operations, and cash flows of the Company.
35
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management is responsible for establishing and maintaining adequate internal
control over financial reporting for the Company. The Company's internal control
system was designed to provide reasonable assurance to the Company's management
and board of directors regarding the preparation and fair presentation of
published financial statements.
Management has assessed the effectiveness of the Company's internal control
over financial reporting as of December 31, 2004, based on the criteria for
effective internal control described in Internal Control--Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission.
Based on its assessment, management concluded that the Company's internal
control over financial reporting was effective as of December 31, 2004.
Management has engaged KPMG LLP ("KPMG"), the independent registered public
accounting firm that audited the consolidated financial statements included in
this Annual Report on Form 10-K, to attest to and report on management's
evaluation of the Company's internal control over financial reporting. KPMG's
report is included herein.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders
Nelnet, Inc.:
We have audited management's assessment, included in the accompanying
Management's Report on Internal Control over Financial Reporting, that Nelnet,
Inc. maintained effective internal control over financial reporting as of
December 31, 2004, based on the criteria established in Internal
Control--Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO). Nelnet, Inc.'s management is
responsible for maintaining effective internal control over financial reporting
and for its assessment of the effectiveness of internal control over financial
reporting. Our responsibility is to express an opinion on management's
assessment and an opinion on the effectiveness of the Company's internal control
over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating management's assessment, testing
and evaluating the design and operating effectiveness of internal control, and
performing such other procedures as we considered necessary in the
circumstances. We believe that our audit provides a reasonable basis for our
opinion.
A company's internal control over financial reporting is a process
designed to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles. A company's internal
control over financial reporting includes those policies and procedures that (1)
pertain to the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the company;
(2) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
36
Because of its inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the
degree of compliance with the policies or procedures may deteriorate.
In our opinion, management's assessment that Nelnet, Inc. maintained
effective internal control over financial reporting as of December 31, 2004, is
fairly stated, in all material respects, based on criteria established in
Internal Control--Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO). Also, in our opinion, Nelnet,
Inc. maintained, in all material respects, effective internal control over
financial reporting as of December 31, 2004, based on criteria established in
Internal Control--Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the consolidated balance
sheets of Nelnet, Inc. and subsidiaries as of December 31, 2004 and December 31,
2003, and the related consolidated statements of income, shareholders' equity
and comprehensive income, and cash flows for each of the years in the three-year
period ended December 31, 2004, and our report dated February 28, 2005 expressed
an unqualified opinion on those consolidated financial statements.
/s/ KPMG LLP
Lincoln, Nebraska
February 28, 2005
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISK
The Company's primary market risk exposure arises from fluctuations in its
borrowing and lending rates, the spread between which could impact the Company
due to shifts in market interest rates. Because the Company generates the
majority of its earnings from its student loan spread, the interest sensitivity
of the balance sheet is a key profitability driver. The majority of student
loans have variable-rate characteristics in certain interest rate environments.
Some of the student loans include fixed-rate components depending upon the rate
reset provisions, or, in the case of consolidation loans, are fixed at the
weighted average interest rate of the underlying loans at the time of
consolidation. The following table sets forth the Company's loan assets and debt
instruments by rate characteristics:
As of December 31, 2004 As of December 31, 2003
----------------------- -----------------------
Dollars Percent Dollars Percent
------------ --------- ------------- ---------
(dollars in thousands)
Fixed-rate loan assets.................$ 5,559,748 41.8 % $ 5,532,497 53.6 %
Variable-rate loan assets............... 7,739,346 58.2 4,782,377 46.4
------------ --------- ------------- ---------
Total...............................$13,299,094 100.0 % $ 10,314,874 100.0 %
============ ========= ============= =========
Fixed-rate debt instruments............$ 712,641 5.0 % $ 927,694 8.2 %
Variable-rate debt instruments..........13,587,965 95.0 10,438,764 91.8
------------ --------- ------------- ---------
Total.............................. $14,300,606 100.0 % $ 11,366,458 100.0 %
============ ========= ============= =========
The following table shows the Company's student loan assets currently earning
at a fixed-rate as of December 31, 2004:
Borrower/ Estimated
lender variable Current
Fixed interest weighted conversion balance of
rate range average yield rate (a) fixed rate assets
-------------- -------------- ------------ ------------------
(dollars in thousands)
5.0 - 5.5% 5.13% 2.49% $ 89,727
5.5 - 6.0 5.69 3.05 148,983
6.0 - 6.5 6.21 3.57 293,269
6.5 - 7.0 6.71 4.07 356,572
7.0 - 8.0 7.52 4.88 311,288
> 8.0 8.56 5.92 995,187
9.5 floor yield 9.50 6.86 3,364,722
----------------
$ 5,559,748
=================
- ---------------------
(a) The estimated variable conversion rate is the estimated short-term
interest rate at which loans would convert to variable rate.
Historically, the Company has followed a policy of funding the majority of
its student loan portfolio with variable-rate debt. In a low interest rate
environment, the FFELP loan portfolio yields excess income primarily due to the
reduction in interest rates on the variable-rate liabilities that fund student
loans at a fixed borrower rate and also due to consolidation loans earning
interest at a fixed rate to the borrower. Therefore, absent utilizing derivative
instruments, in a low interest rate environment, a rise in interest rates will
have an adverse effect on earnings. In higher interest rate environments, where
the interest rate rises above the borrower rate and the fixed-rate loans become
variable rate and are effectively matched with variable-rate debt, the impact of
rate fluctuations is substantially reduced.
The Company attempts to match the interest rate characteristics of pools of
loan assets with debt instruments of substantially similar characteristics,
particularly in rising interest rate environments. Due to the variability in
duration of the Company's assets and varying market conditions, the Company does
not attempt to perfectly match the interest rate characteristics of the entire
loan portfolio with the underlying debt instruments. The Company has adopted a
policy of periodically reviewing the mismatch related to the interest rate
characteristics of its assets and liabilities and the Company's outlook as to
current and future market conditions. Based on those factors, the Company will
periodically use derivative instruments as part of its overall risk management
strategy to manage risk arising from its fixed-rate and variable-rate financial
instruments.
37
The following table summarizes the notional values and fair values of the
Company's outstanding derivative instruments as of December 31, 2004:
Notional amounts by product type
----------------------------------------------------------
Weighted average
Fixed/ Floating/ fixed rate on
floating Basis fixed fixed/floating
Maturity swaps (a) swaps (b) swaps (c) Total swaps
- -------------------------------- ---------- ---------- ----------- -------- ----------------
(dollars in millions)
2005............................ $1,187 1,000 210 2,397 2.20%
2006............................ 613 500 -- 1,113 2.99
2007............................ 512 -- -- 512 3.42
2008............................ 463 -- -- 463 3.76
2009............................ 312 -- -- 312 4.01
2010............................ 1,138 -- -- 1,138 4.25
-------- -------- --------- --------- --------
Total.........................$ 4,225 1,500 210 5,935 3.32%
======== ======== ========= ========= ========
Fair value (d) (in thousands)...$(7,763) (2,769) (1,363) (11,895)
======== ======== ========= =========
- ----------
(a) A fixed/floating swap is an interest rate swap in which the Company agrees
to pay a fixed rate in exchange for a floating rate. The interest rate swap
converts a portion of the Company's variable-rate debt (equal to the
notional amount of the swap) to a fixed rate for a period of time, fixing
the relative spread between a portion of the Company's student loan assets
and the converted fixed-rate liability.
(b) A basis swap is an interest rate swap agreement in which the Company agrees
to pay a floating rate in exchange for another floating rate, based upon
different market indices. The Company has employed basis swaps to limit its
sensitivity to dramatic fluctuations in the underlying indices used to price
a portion of its variable-rate assets and variable-rate debt.
(c) A floating/fixed swap is an interest rate swap in which the Company agrees
to pay a floating rate in exchange for a fixed rate. The interest rate swap
converts a portion of the Company's fixed-rate debt (equal to the notional
amount of the swap) to a floating rate for a period of time.
(d) Fair value is determined from market quotes from independent security
brokers. Fair value indicates an estimated amount the Company would receive
(pay) if the contracts were cancelled or transferred to other parties.
Derivative instruments that are currently used as part of the Company's
interest rate risk management strategy include interest rate swaps and basis
swaps. The Company accounts for its derivative instruments in accordance with
SFAS No. 133. SFAS No. 133 requires that changes in the fair value of derivative
instruments be recognized currently in earnings unless specific hedge accounting
criteria as specified by SFAS No. 133 are met. Management has structured all of
the Company's derivative transactions with the intent that each is economically
effective. However, the majority of the Company's derivative instruments do not
qualify for hedge accounting under SFAS No. 133; consequently, the change in
fair value of these derivative instruments is included in the Company's
operating results. As of December 31, 2004, the Company accounted for one
interest rate swap with a notional amount of $150 million as a cash flow hedge
in accordance with SFAS No. 133. Gains and losses on the effective portion of
this qualifying hedge are accumulated in other comprehensive income and
reclassified to current period earnings over the period in which the stated
hedged transactions impact earnings. Ineffectiveness is recorded to earnings
through interest expense.
38
The following is a summary of the amounts included in derivative market value
adjustment and net settlements on the consolidated income statements related to
those derivative instruments that do not qualify for hedge accounting:
Year ended December 31,
------------------------------
2004 2003 2002
--------- --------- ---------
(dollars in thousands)
Change in fair value of derivative instruments..$(11,918) $(1,183) $ 2,962
Settlements, net................................ (34,140) (1,601) (3,541)
--------- --------- ---------
Derivative market value adjustment and net
settlements $(46,058) $(2,784) $ (579)
========= ========= =========
The increase in the derivative market value adjustment and net settlements in
2004, in addition to the changes in interest rates and fluctuations in the
forward yield curve, is the result of the Company entering into $3.7 billion in
notional amount of derivatives in July 2004.
The following tables summarize the effect on the Company's earnings, based
upon a sensitivity analysis performed by the Company assuming a hypothetical
increase and decrease in interest rates of 100 basis points and an increase in
interest rates of 200 basis points while funding spreads remain constant. The
effect on earnings was performed on the Company's variable-rate assets and
liabilities. The analysis includes the effects of the derivative instruments in
existence during these periods.
As a result of the Company's interest rate management activities, primarily
initiated in 2004, the Company expects the change in pre-tax net income
resulting from 100 basis point and 200 basis point increases in interest rates
will not result in a proportional decrease in net income.
Year ended December 31, 2004
------------------------------------------------------------------
Change from decrease Change from increase Change from increase
of 100 basis points of 100 basis points of 200 basis points
------------------ ------------------- -------------------
Dollar Percent Dollar Percent Dollar Percent
-------- -------- --------- -------- --------- --------
Effect on earnings: (dollars in thousands, except share data)
Increase (decrease) in pre-tax
net income before
impact of derivative settlements...$ 69,617 29.7 % $ (36,312) (15.5)% $ (66,882) (28.5)%
Impact of derivative settlements..... (60,177) (25.7) 60,177 25.7 120,355 51.3
-------- -------- --------- -------- --------- --------
Increase in net income before taxes..$ 9,440 4.0% $ 23,865 10.2% $ 53,473 22.8%
======== ======== ========= ======== ========= ========
Increase in basic and diluted
earning per share..................$ 0.11 $0.28 $ 0.63
======== ========= =========
Year ended December 31, 2003
------------------------------------------------------------------
Change from decrease Change from increase Change from increase
of 100 basis points of 100 basis points of 200 basis points
------------------ ------------------- -------------------
Dollar Percent Dollar Percent Dollar Percent
-------- -------- --------- -------- --------- --------
Effect on earnings: (dollars in thousands, except share data)
Increase (decrease) in pre-tax net
income before impact of derivative
settlements.........................$ 34,719 75.0.% $ (18,256) (39.4)% $ (30,356) (65.6)%
Impact of derivative settlements...... (8,382) (18.1) 6,007 13.0 13,202 28.5
-------- -------- --------- -------- --------- --------
Increase (decrease) in net income
before taxes........................$ 26,337 56.9 % $ (12,249) (26.4)% $ (17,154) (37.1)%
======== ======== ========= ======== ========= ========
Increase (decrease) in basic and
diluted earning per share...........$ 0.37 (0.17) (0.24)
======== ========= =========
Year ended December 31, 2002
------------------------------------------------------------------
Change from decrease Change from increase Change from increase
of 100 basis points of 100 basis points of 200 basis points
------------------ ------------------- -------------------
Dollar Percent Dollar Percent Dollar Percent
-------- -------- --------- -------- --------- --------
Effect on earnings: (dollars in thousands, except share data)
Increase (decrease) in pre-tax net
income before impact of derivative
settlements.........................$ 15,119 18.6 % $ (11,553) (14.2)% $(20,236) (24.9) %
Impact of derivative settlements...... -- -- -- -- -- --
-------- -------- --------- -------- --------- --------
Increase (decrease) in net income
before taxes....................... $ 15,119 18.6 % $ (11,553) (14.2)% $(20,236) (24.9) %
======== ======== ========= ======== ========= ========
Increase (decrease) in basic and
diluted earning per share...........$ 0.22. $ (0.16) (0.29)
======== ========= =========
39
The Company has historically provided information concerning the difference
between volumes of assets and volumes of liabilities maturing or repricing
during specific future time intervals (interest rate gap analysis). Management
believes the table above provides a better perspective of the Company's interest
rate risk.
FOREIGN CURRENCY EXCHANGE RISK
The Company purchased EDULINX in December 2004. EDULINX is a Canadian
corporation that engages in servicing Canadian student loans. As a result of
this acquisition, the Company is exposed to market risk related to fluctuations
in foreign currency exchange rates between the U.S. and Canadian dollars. The
Company has not entered into any foreign currency derivative instruments to
hedge this risk. However, the Company does not believe fluctuations in foreign
currency exchange rates will have a significant effect on the financial
position, results of operations, or cash flows of the Company.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Reference is made to the consolidated financial statements listed under the
heading "(a) 1. Consolidated Financial Statements" of Item 15 of this Report,
which consolidated financial statements are incorporated into this Report by
reference in response to this Item 8.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
DISCLOSURE CONTROLS AND PROCEDURES
Under supervision and with the participation of certain members of the
Company's management, including the co-chief executive officers and the chief
financial officer, the Company completed an evaluation of the effectiveness of
the design and operation of its disclosure controls and procedures (as defined
in Rules 13a-15(e) and 15d-15(e) to the Securities Act). Based on this
evaluation, the Company's co-chief executive officers and the chief financial
officer believe that the disclosure controls and procedures were effective as of
the end of the period covered by this Report with respect to timely
communication to them and other members of management responsible for preparing
periodic reports and material information required to be disclosed in this
Report as it relates to the Company and its consolidated subsidiaries.
The effectiveness of the Company's or any system of disclosure controls and
procedures is subject to certain limitations, including the exercise of judgment
in designing, implementing, and evaluating the controls and procedures, the
assumptions used in identifying the likelihood of future events, and the
inability to eliminate misconduct completely. As a result, there can be no
assurance that the Company's disclosure controls and procedures will prevent all
errors or fraud or ensure that all material information will be made known to
appropriate management in a timely fashion. By their nature, the Company's or
any system of disclosure controls and procedures can provide only reasonable
assurance regarding management's control objectives.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
There was no change in the Company's internal control over financial
reporting during the Company's last quarter that has materially affected, or is
reasonably likely to materially affect, the Company's internal control over
financial reporting.
ITEM 9B. OTHER INFORMATION
During the fourth quarter of 2004, no information was required to be
disclosed in a report on Form 8-K, but not reported.
PART III.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information as to the directors and executive officers of the Company set
forth under the captions "PROPOSAL 1--ELECTION OF DIRECTORS--Nominees" and
"Executive Officers" in the Proxy Statement to be filed on Schedule 14A, no
later than 120 days after the end of the Company's fiscal year with the SEC,
relating to the Company's Annual Meeting of Shareholders scheduled to be held on
May 26, 2005 (the "Proxy Statement") is incorporated into this Report by
reference.
ITEM 11. EXECUTIVE COMPENSATION
The information set forth under the caption "EXECUTIVE COMPENSATION" in the
Proxy Statement is incorporated into this Report by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information set forth under the caption "SECURITY OWNERSHIP OF DIRECTORS,
EXECUTIVE OFFICERS, AND PRINCIPAL SHAREHOLDERS--Stock Ownership" in the Proxy
Statement is incorporated into this Report by reference. There are no
arrangements known to the Company, the operation of which may at a subsequent
date result in a change in the control of the Company.
40
The following table summarizes, as of December 31, 2004, information about
compensation plans under which equity securities are authorized for issuance.
Equity Compensation Plan Information
Number of shares Weighted-average Number of shares
to be issued upon exercise price of remaining available
exercise of outstanding for future issuance
outstanding options, warrants, under equity
options, and rights compensation plans
warrants, and (excluding
rights securities reflected
in column (a))
Plan category (a) (b) (c)
----------------------- ------------------- -------------------- ---------------------
Equity compensation
plans approved by
shareholders 0 $0 2,054,797
Equity compensation
plans not approved by
shareholders 0 $0 0
------------------- -------------------- ---------------------
Total 0 $0 2,054,797
=================== ==================== =====================
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information set forth under the caption "CERTAIN RELATIONSHIPS AND
RELATED TRANSACTIONS" in the Proxy Statement is incorporated into this Report by
reference.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information set forth under the caption "PROPOSAL 2--APPOINTMENT OF
INDEPENDENT AUDITOR--Independent Accounting Fees and Services" in the Proxy
Statement is incorporated into this Report by reference.
PART IV.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) 1. Consolidated Financial Statements
The following consolidated financial statements of Nelnet, Inc. and its
subsidiaries and the Report of Independent Registered Public Accounting Firm
thereon are included in Item 8 above:
Page
Report of Independent Registered Public Accounting Firm.............F-2
Consolidated Financial Statements for the years
ended December 31, 2004, 2003, and 2002:
Consolidated Balance Sheets as of December 31, 2004 and 2003.......F-3
Consolidated Statements of Income for the years ended
December 31, 2004, 2003, and 2002................................F-4
Consolidated Statements of Shareholders' Equity and Comprehensive
Income for the years ended December 31, 2004, 2003, and 2002.....F-5
Consolidated Statements of Cash Flows for the years ended
December 31, 2004, 2003, and 2002................................F-6
Notes to the Consolidated Financial Statements.....................F-7
2. Financial Statement Schedules
All schedules are omitted because they are not applicable or the
required information is shown in the consolidated financial statements or
notes thereto.
3. Exhibits
The exhibits listed in the accompanying index to exhibits are filed or
incorporated by reference as part of this Report.
4. Appendix
Appendix A - Federal Family Education Loan Program
41
(b) Exhibits
EXHIBIT INDEX
Exhibit
No. Description
----------- ----------------------------------------
2.1 Plan of Reorganization, Plan of Merger and Merger Agreement,
dated as of October 14, 1999, by and between Union Financial
Services, Inc. and National Education Loan Network, Inc.
Incorporated by reference to Exhibit 2.1 to the registrant's
Registration Statement on Form S-1 (File No. 333-108070) (the
"Form S-1 Registration Statement").
2.2 Articles of Merger certified by Union Financial Services, Inc.,
dated October 15, 1999. Incorporated by reference to Exhibit 2.2
to the registrant's Form S-1 Registration Statement.
2.3 Agreement and Plan of Reorganization, dated as of March 1, 2000,
by and among UNIPAC Service Corporation, NelNet, Inc.
(subsequently renamed National Education Loan Network, Inc.) and
National Education Loan Network, Inc. Incorporated by reference
to Exhibit 2.3 to the registrant's Form S-1 Registration
Statement.
2.4 Plan of Merger, dated as of March 1, 2000, by and among NelNet,
Inc. (subsequently renamed National Education Loan Network,
Inc.), National Education Loan Network, Inc. and UNIPAC Service
Corporation. Incorporated by reference to Exhibit 2.4 to the
registrant's Form S-1 Registration Statement.
2.5 Articles of Merger certified by NelNet, Inc., dated March 1,
2000. Incorporated by reference to Exhibit 2.5 to the
registrant's Form S-1 Registration Statement.
2.6 Letter Agreement relating to the purchase of the stock of
InTuition Holdings, Inc., dated as of June 15, 2000, between
NELnet, Inc. (subsequently renamed National Education Loan
Network, Inc.) and Farmers & Merchants Investment Inc.
Incorporated by reference to Exhibit 2.6 to the registrant's
Form S-1 Registration Statement.
2.7 Transfer Agreement with Irrevocable Power of Attorney, dated as
of June 28, 2001, by and between InTuition Development Holdings,
LLC and InTuition Guarantee Services II, Inc. (which
subsequently became Nelnet Guarantee Services Inc.) relating to
the membership interests in InTuition Guarantee Services, LLC
(which subsequently became GuaranTec LLP). Incorporated by
reference to Exhibit 2.7 to the registrant's Form S-1
Registration Statement.
2.8 Master Stock Purchase Agreement, dated as of December 12, 2001,
by and between EFS, Inc. and NELnet, Inc. (subsequently renamed
National Education Loan Network, Inc.). Incorporated by
reference to Exhibit 2.8 to the registrant's Form S-1
Registration Statement.
2.9 Stock Purchase Agreement, dated as of January 24, 2002, by and
among NELnet, Inc. (subsequently renamed National Education Loan
Network, Inc.) and Hilario Arguinchona. Incorporated by
reference to Exhibit 2.9 to the registrant's Form S-1
Registration Statement.
2.10 Purchase Agreement, dated as of February 14, 2002, by and
between InTuition Guarantee Services, LLC and NELnet, Inc.
(subsequently renamed National Education Loan Network, Inc.).
Incorporated by reference to Exhibit 2.10 to the registrant's
Form S-1 Registration Statement.
2.11 Stock Purchase Agreement, dated May 1, 2002, by and among Nelnet
Loan Services, Inc. (subsequently renamed Nelnet, Inc.) and
Nelnet, Inc. (subsequently renamed National Education Loan
Network, Inc.). Incorporated by reference to Exhibit 2.11 to the
registrant's Form S-1 Registration Statement.
2.12 Stock Purchase Agreement, dated as of May 1, 2002, by and
between Farmers & Merchants Investment Inc. and Nelnet Loan
Services, Inc. (subsequently renamed Nelnet, Inc.). Incorporated
by reference to Exhibit 2.12 to the registrant's Form S-1
Registration Statement.
2.13 Stock Purchase Agreement, dated May 2, 2002, by and among
Packers Service Group, Inc. and Infovisa, Inc. Incorporated by
reference to Exhibit 2.13 to the registrant's Form S-1
Registration Statement.
2.14 Stock Purchase Agreement, dated as of May 9, 2002, among Thomas
Morrill, James Callier, Michael Cruskie, Dominic Rotondi, and
Nelnet, Inc. (subsequently renamed National Education Loan
Network, Inc.) concerning Charter Account Systems, Inc.
Incorporated by reference to Exhibit 2.14 to the registrant's
Form S-1 Registration Statement.
2.15 Senior Stock Purchase (Call) Option Agreement by and between
NELnet, Inc. (subsequently renamed National Education Loan
Network, Inc.) and Maine Educational Loan Marketing Corporation
dated as of June 30, 2000. Incorporated by reference to Exhibit
2.15 to the registrant's Form S-1 Registration Statement.
2.16 Purchase Agreement, dated as of July 3, 2003, by and between
Nelnet Loan Services, Inc. (subsequently renamed Nelnet, Inc.),
Union Financial Services, Inc. and Packers Service Group, Inc.
Incorporated by reference to Exhibit 2.16 to the registrant's
Form S-1 Registration Statement.
2.17 Agreement for Purchase of LLC Membership Interest among David A.
Hoeft, Todd J. Wolfe, Tina D. Mercer, Premiere Credit of North
America, LLC and Nelnet, Inc., dated as of January 28, 2004.
Incorporated by reference to Exhibit 2.17 to the registrant's
annual report for the year ended 2003, filed on Form 10-K.
3.1 Second Amended and Restated Articles of Incorporation of Nelnet,
Inc. Incorporated by reference to Exhibit 3.1 to the
registrant's Form S-1 Registration Statement.
3.2 Second Amended and Restated Bylaws of Nelnet, Inc. Incorporated
by reference to Exhibit 3.2 to the registrant's Form S-1
Registration Statement.
3.3 Third Amended and Restated Bylaws of Nelnet, Inc. Incorporated
by reference to Exhibit 3.1 to the registrant's current report
on Form 8-K filed on November 18, 2004.
42
4.1 Form of Class A Common Stock Certificate of Nelnet, Inc.
Incorporated by reference to Exhibit 4.1 to the registrant's
Form S-1 Registration Statement.
4.2 Indenture of Trust by and between NELNET Student Loan
Corporation-2 and Zions First National Bank, as Trustee, dated
as of June 1, 2000. Incorporated by reference to Exhibit 4.2 to
the registrant's Form S-1 Registration Statement.
4.3 Series 2000 Supplemental Indenture of Trust by and between
NELNET Student Loan Corporation-2 and Zions First National Bank,
as Trustee, authorizing the issuance of $1,000,000,000 NELNET
Student Loan Corporation-2 Taxable Student Loan Asset-Backed
Notes Series 2000, dated as of June 1, 2000. Incorporated by
reference to Exhibit 4.3 to the registrant's Form S-1
Registration Statement.
4.4 Indenture of Trust by and between Nelnet Student Loan Trust
2002-1 and Zions First National Bank, as Trustee, dated as of
May 1, 2002. Incorporated by reference to Exhibit 4.4 to the
registrant's Form S-1 Registration Statement.
4.5 Indenture of Trust by and between Nelnet Student Loan Trust
2002-2 and Zions First National Bank, as Trustee, dated as of
September 1, 2002. Incorporated by reference to Exhibit 4.5 to
the registrant's Form S-1 Registration Statement.
4.6 Indenture of Trust between Nelnet Student Loan Trust 2003-1 and
Zions First National Bank, as Trustee, dated as of January 1,
2003. Incorporated by reference to Exhibit 4.6 to the
registrant's Form S-1 Registration Statement.
4.7 Indenture of Trust by and among Nelnet Education Loan Funding,
Inc., Wells Fargo Bank Minnesota, National Association, as
Indenture Trustee, and Wells Fargo Bank Minnesota, National
Association, as Eligible Lender Trustee, dated as of June 1,
2003. Incorporated by reference to Exhibit 4.7 to the
registrant's Form S-1 Registration Statement.
4.8 Series 2003-1 Supplemental Indenture of Trust by and between
Nelnet Education Loan Funding, Inc. and Wells Fargo Bank
Minnesota, National Association, as Indenture Trustee,
authorizing the issuance of $1,030,000,000 Nelnet Education Loan
Funding, Inc. Student Loan Asset-Backed Notes Series 2003-1,
dated as of June 1, 2003. Incorporated by reference to Exhibit
4.8 to the registrant's Form S-1 Registration Statement.
4.9 Option Agreement, dated as of January 24, 2002, by and between
NELnet, Inc. (subsequently renamed National Education Loan
Network, Inc.) and Hilario Arguinchona. Incorporated by
reference to Exhibit 4.10 to the registrant's Form S-1
Registration Statement.
4.10 Registration Rights Agreement, dated as of December 16, 2003, by
and among Nelnet, Inc. and the shareholders of Nelnet, Inc.
signatory thereto. Incorporated by reference to Exhibit 4.11 to
the registrant's Form S-1 Registration Statement.
4.11 Indenture of Trust among Nelnet Education Loan Funding, Inc. and
Wells Fargo Bank Minnesota, National Association, as Indenture
Trustee and Eligible Lender Trustee, dated as of January 1,
2004. Incorporated by reference to Exhibit 4.11 to the
registrant's annual report for the year ended 2003, filed on
Form 10-K.
4.12 Trust Agreement, dated as of April 1, 2001, among NELNET Student
Loan Corporation-1, as Depositor, MELMAC LLC, as Depositor,
NELnet, Inc. (subsequently renamed National Education Loan
Network, Inc.), as Administrator, The Chase Manhattan Bank, as
Collateral Agent, Note Registrar and Note Paying Agent, and
Wilmington Trust Company, as Trustee, Certificate Registrar and
Certificate Paying Agent. Incorporated by reference to Exhibit
10.59 to the registrant's Form S-1 Registration Statement.
4.13 Trust Agreement, dated as of December 1, 2001, among EMT Corp.,
as Depositor, NELnet, Inc. (subsequently renamed National
Education Loan Network, Inc.), as Administrator, JPMorgan Chase
Bank, as Collateral Agent, Note Registrar and Note Paying Agent,
and Wilmington Trust Company, as Trustee, Certificate Registrar
and Certificate Paying Agent. Incorporated by reference to
Exhibit 10.60 to the registrant's Form S-1 Registration
Statement.
4.14 Indenture of Trust among Nelnet Education Loan Funding, Inc. and
Wells Fargo Bank, National Association, as Indenture Trustee and
Eligible Lender Trustee, dated as of April 1, 2004. Incorporated
by reference to Exhibit 4.14 to the registrant's quarterly
report for the period ended March 31, 2004, filed on Form 10-Q.
4.15 Indenture of Trust, dated as of July 1, 2004, between Nelnet
Student Loan Trust 2004-3 and Zions First National Bank, as
eligible lender trustee and as indenture trustee. Incorporated
by reference to Exhibit 4.15 to the registrant's quarterly
report for the period ended June 30, 2004, filed on Form 10-Q.
4.16 Indenture of Trust, dated as of September 1, 2004, between
Nelnet Student Loan Trust 2004-4 and Zions First National Bank,
as eligible lender trustee and as indenture trustee.
Incorporated by reference to Exhibit 4.16 to the registrant's
quarterly report for the period ended September 30, 2004, filed
on Form 10-Q.
4.17* Indenture of Trust, dated as of February 1, 2005, by and
between Nelnet Student Loan Trust 2005-1 and Zions First
National Bank, as Trustee and Eligible Lender Trustee.
10.1 Agreement to Terminate Stockholders Agreement, dated as of
August 4, 2003, by and among Nelnet Loan Services, Inc. (f/k/a
UNIPAC Service Corporation) (subsequently renamed Nelnet,
Inc.) and those stockholders party to the Stockholders
Agreement dated as of March 2, 2000. Incorporated by reference
to Exhibit 10.2 to the registrant's Form S-1 Registration
Statement.
43
10.2 Warehouse Note Purchase and Security Agreement among
NHELP-III, Inc., as the Issuer, Norwest Bank Minnesota,
National Association, as the Trustee, Delaware Funding
Corporation, as a Note Purchaser, Three Rivers Funding
Corporation, as a Note Purchaser, Morgan Guaranty Trust
Company of New York, as DFC Agent and Administrative Agent,
and Mellon Bank, N.A., as TRFC Agent, dated as of September 1,
1999. Incorporated by reference to Exhibit 10.10 to the
registrant's Form S-1 Registration Statement.
10.3 First Amendment to Warehouse Note Purchase and Security
Agreement among NHELP-III, Inc., as the Issuer, Wells Fargo
Bank Minnesota, National Association, as the successor
Trustee, Delaware Funding Corporation, as a Note Purchaser,
Three Rivers Funding Corporation, as a Note Purchaser, Morgan
Guaranty Trust Company of New York, as DFC Agent and
Administrative Agent, and Mellon Bank, N.A., as TRFC Agent,
dated as of September 1, 2000. Incorporated by reference to
Exhibit 10.11 to the registrant's Form S-1 Registration
Statement.
10.4 Second Amendment to Warehouse Note Purchase and Security
Agreement among NHELP-III, Inc., as the Issuer, Wells Fargo
Bank Minnesota, National Association, as the successor
Trustee, Delaware Funding Corporation, as a Note Purchaser,
Three Rivers Funding Corporation, as a Note Purchaser,
JPMorgan Chase Bank, as DFC Agent and Administrative Agent,
and Mellon Bank, N.A., as TRFC Agent, dated as of September
12, 2002. Incorporated by reference to Exhibit 10.12 to the
registrant's Form S-1 Registration Statement.
10.5 Amendment to Warehouse Note Purchase and Security Agreement,
dated as of June 1, 2003, by and among NHELP-III, Inc., as the
Issuer, Delaware Funding Corporation, as Note Purchaser, Three
Rivers Funding Corporation, as Note Purchaser, JPMorgan Chase
Bank (successor to Morgan Guaranty and Trust Company of New
York), as DFC Agent and Administrative Agent, and Mellon Bank,
N.A., as TRFC Agent. Incorporated by reference to Exhibit
10.13 to the registrant's Form S-1 Registration Statement.
10.6 Warehouse Loan and Security Agreement among NELnet Student
Loan Warehouse Corporation-1, as Borrower, Zions First
National Bank, as Trustee, Thunder Bay Funding Inc., as
Lender, and Royal Bank of Canada, as Facility Agent and
Alternate Lender, dated as of February 1, 2002. Incorporated
by reference to Exhibit 10.14 to the registrant's Form S-1
Registration Statement.
10.7 Amended and Restated Warehouse Loan and Security Agreement
among Nelnet Education Loan Funding, Inc., as Borrower, Wells
Fargo Bank Minnesota, National Association, as Eligible Lender
Trustee, Zions First National Bank, as Trustee, Thunder Bay
Funding, Inc., as Lender, and Royal Bank of Canada, as
Facility Agent and Alternate Lender, dated as of April 28,
2003. Incorporated by reference to Exhibit 10.15 to the
registrant's Form S-1 Registration Statement.
10.8 Warehouse Note Purchase and Security Agreement among Nelnet
Education Loan Funding, as Borrower, Wells Fargo Bank
Minnesota, National Association, as Trustee, Wells Fargo Bank
Minnesota, National Association, as Eligible Lender Trustee,
Quincy Capital Corporation, as Bank of America Conduit Lender,
Bank of America, N.A., as Bank of America Alternate Lender,
Bank of America, N.A., as Bank of America Facility Agent,
Gemini Securitization Corp., as Deutsche Bank Conduit Lender,
Deutsche Bank AG, New York Branch, as Deutsche Bank Alternate
Lender, Deutsche Bank AG, New York Branch, as Deutsche Bank
Facility Agent, Barton Capital Corporation, as Societe
Generale Conduit Lender, Societe Generale, as Societe Generale
Alternate Lender, Societe Generale, as Societe Generale
Facility Agent, and Bank of America, N.A., as Administrative
Agent, dated as of May 1, 2003. Incorporated by reference to
Exhibit 10.16 to the registrant's Form S-1 Registration
Statement.
10.9 Irrevocable Letter of Credit in the amount of $50,000,000,
dated as of May 23, 2003, by and between Nelnet, Inc.
(subsequently renamed National Education Loan Network, Inc.)
and Bank of America, N.A. Incorporated by reference to Exhibit
10.23 to the registrant's Form S-1 Registration Statement.
10.10 Continuing Guaranty, dated as of May 23, 2003, by and between
Nelnet Loan Services, Inc. (subsequently renamed Nelnet, Inc.)
and Bank of America, N.A. Incorporated by reference to Exhibit
10.24 to the registrant's Form S-1 Registration Statement.
10.11 Agreement Between 5280 Solutions and Nelnet/Unipac, dated as
of April 12, 2001. Incorporated by reference to Exhibit 10.25
to the registrant's Form S-1 Registration Statement.
10.12+ Employment Contract, dated as of May 1, 2001, by and between
NHELP, Inc. and Richard H. Pierce. Incorporated by reference to
Exhibit 10.26 to the registrant's Form S-1 Registration
Statement.
10.13 Marketing Expense Reimbursement Agreement, dated as of January
1, 1999, by and between Union Bank and Trust Company and
National Education Loan Network, Inc. Incorporated by
reference to Exhibit 10.27 to the registrant's Form S-1
Registration Statement.
10.14 First Amendment of Marketing Expense Reimbursement Agreement,
dated as of April 1, 2001, by and between Union Bank and Trust
Company and NELnet, Inc. (f/k/a National Education Loan
Network, Inc.) (subsequently renamed National Education Loan
Network, Inc.). Incorporated by reference to Exhibit 10.28 to
the registrant's Form S-1 Registration Statement.
10.15 Second Amendment of Marketing Expense Reimbursement Agreement,
dated as of December 21, 2001, by and between Union Bank and
Trust Company and NELnet, Inc. (f/k/a National Education Loan
Network, Inc.) (subsequently renamed National Education Loan
Network, Inc.). Incorporated by reference to Exhibit 10.29 to
the registrant's Form S-1 Registration Statement.
10.16 Amended and Restated Participation Agreement, dated as of June
1, 2001, by and between NELnet, Inc. (subsequently renamed
National Education Loan Network, Inc.) and Union Bank and Trust
Company. Incorporated by reference to Exhibit 10.30 to the
registrant's Form S-1 Registration Statement.
44
10.17 First Amendment of Amended and Restated Participation
Agreement, dated as of December 19, 2001, by and between Union
Bank and Trust Company and NELnet, Inc. (subsequently renamed
National Education Loan Network, Inc.). Incorporated by
reference to Exhibit 10.31 to the registrant's Form S-1
Registration Statement.
10.18 Second Amendment of Amended and Restated Participation
Agreement, dated as of December 1, 2002, by and between Union
Bank and Trust Company and Nelnet, Inc. (f/k/a NELnet, Inc.)
(subsequently renamed National Education Loan Network, Inc.).
Incorporated by reference to Exhibit 10.32 to the registrant's
Form S-1 Registration Statement.
10.19 Alternative Loan Participation Agreement, dated as of June 29,
2001, by and between NELnet, Inc. (subsequently renamed National
Education Loan Network, Inc.) and Union Bank and Trust Company.
Incorporated by reference to Exhibit 10.33 to the registrant's
Form S-1 Registration Statement.
10.20 Amended and Restated Agreement, dated as of January 1, 1999,
by and between Union Bank and Trust Company and National
Education Loan Network, Inc. Incorporated by reference to
Exhibit 10.34 to the registrant's Form S-1 Registration
Statement.
10.21 Guaranteed Purchase Agreement, dated as of March 19, 2001, by
and between NELnet, Inc. (subsequently renamed National
Education Loan Network, Inc.) and Union Bank and Trust Company.
Incorporated by reference to Exhibit 10.36 to the registrant's
Form S-1 Registration Statement.
10.22 First Amendment of Guaranteed Purchase Agreement, dated as of
February 1, 2002, by and between NELnet, Inc. (subsequently
renamed National Education Loan Network, Inc.) and Union Bank
and Trust Company. Incorporated by reference to Exhibit 10.37 to
the registrant's Form S-1 Registration Statement.
10.23 Second Amendment of Guaranteed Purchase Agreement, dated as of
December 1, 2002, by and between Nelnet, Inc. (f/k/a/ NELnet,
Inc.) (subsequently renamed National Education Loan Network,
Inc.) and Union Bank and Trust Company. Incorporated by
reference to Exhibit 10.38 to the registrant's Form S-1
Registration Statement.
10.24 Agreement For Use of Revolving Purchase Facility, dated as of
January 1, 1999, by and between Union Bank and Trust Company
and National Education Loan Network, Inc. Incorporated by
reference to Exhibit 10.78 to the registrant's Form S-1
Registration Statement.
10.25+ Nelnet, Inc. Executive Officers' Bonus Plan. Incorporated by
reference to Exhibit 10.79 to the registrant's Form S-1
Registration Statement.
10.26+ Share Retention Policy. Incorporated by reference to Exhibit
10.83 to the registrant's Form S-1 Registration Statement.
10.27+ Nelnet, Inc. Restricted Stock Plan. Incorporated by reference to
Exhibit 4.12 to the registrant's Form S-1 Registration
Statement.
10.28+ Nelnet, Inc. Directors Stock Compensation Plan. Incorporated by
reference to Exhibit 4.13 to the registrant's Form S-1
Registration Statement.
10.29+ Nelnet, Inc. Employee Share Purchase Plan. Incorporated by
reference to Exhibit 4.14 to the registrant's Form S-1
Registration Statement.
10.30 Operating Agreement of FirstMark Services, LLC, dated as of
March 31, 2002. Incorporated by reference to Exhibit 10.84 to
the registrant's Form S-1 Registration Statement.
10.31 Credit Agreement by and among Nelnet, Inc., National Education
Loan Network, Inc., M&I Marshall Ilsley Bank, SunTrust Bank,
First National Bank of Omaha, and Fifth Third Bank, Indiana,
dated as of September 25, 2003. Incorporated by reference to
Exhibit 10.85 to the registrant's Form S-1 Registration
Statement.
10.32 Guaranty Agreement, by and among Charter Account Systems, Inc.,
ClassCredit, Inc., EFS, Inc., EFS Services, Inc., GuaranTec LLP,
Idaho Financial Associates, Inc., InTuition, Inc., National
Higher Educational Loan Program, Inc., Nelnet Canada, Inc.,
Nelnet Corporation (subsequently renamed Nelnet Corporate
Services, Inc.), Nelnet Guarantee Services, Inc., Nelnet
Marketing Solutions, Inc., Student Partner Services, Inc., UFS
Securities, LLC and Shockley Financial Corp., dated as of
September 25, 2003. Incorporated by reference to Exhibit 10.86
to the registrant's Form S-1 Registration Statement.
10.33 Security Agreement, dated as of September 25, 2003, by and
between Nelnet, Inc. and M&I Marshall & Ilsley Bank, as Agent.
Incorporated by reference to Exhibit 10.87 to the registrant's
Form S-1 Registration Statement.
10.34 Security Agreement, dated as of September 25, 2003, by and
between National Education Loan Network, Inc. and M&I Marshall &
Ilsley Bank, as Agent. Incorporated by reference to Exhibit
10.88 to the registrant's Form S-1 Registration Statement.
10.35 Intercreditor Agreement, dated as of September 25, 2003, by
and among M&I Marshall & Ilsley Bank, SunTrust Bank, First
National Bank of Omaha, Fifth Third Bank, Indiana and Bank of
America, N.A. Incorporated by reference to Exhibit 10.89 to
the registrant's Form S-1 Registration Statement.
10.36 Letter Agreement by and between Nelnet Education Loan Funding,
Inc. and Bank of America, N.A., dated as of June 25, 2003,
relating to the increase of the Warehouse Note Purchase and
Security Agreement dated as of May 1, 2003. Incorporated by
reference to Exhibit 10.90 to the registrant's Form S-1
Registration Statement.
10.37 Letter Agreement by and between Nelnet Education Loan Funding,
Inc. and Deutsche Bank AG, New York Branch, dated as of June
25, 2003, relating to the increase of the Warehouse Note
Purchase and Security Agreement dated as of May 1, 2003.
Incorporated by reference to Exhibit 10.91 to the registrant's
Form S-1 Registration Statement.
10.38 Letter Agreement by and between Nelnet Education Loan Funding,
Inc. and Societe Generale, dated as of June 25, 2003, relating
to the increase of the Warehouse Note Purchase and Security
Agreement dated as of May 1, 2003. Incorporated by reference
to Exhibit 10.92 to the registrant's Form S-1 Registration
Statement.
45
10.39 Amendment to Application and Agreement for Standby Letter of
Credit, Loan Purchase Agreements, and Standby Student Loan
Purchase Agreements, dated effective October 21, 2003, by and
among National Education Loan Network, Inc., Nelnet, Inc.,
Nelnet Education Loan Funding, Inc., Union Bank and Trust
Company, and Bank of America, N.A. Incorporated by reference
to Exhibit 10.94 to the registrant's Form S-1 Registration
Statement.
10.40 Letter Agreement between Nelnet Education Loan Funding, Inc.
and Deutsche Bank AG, dated as of February 20, 2004.
Incorporated by reference to Exhibit 10.56 to the registrant's
annual report for the year ended 2003, filed on Form 10-K.
10.41 Letter Agreement between Nelnet Education Loan Funding, Inc.
and Bank of America, N.A., dated as of February 20, 2004.
Incorporated by reference to Exhibit 10.57 to the registrant's
annual report for the year ended 2003, filed on Form 10-K.
10.42 Letter Agreement between Nelnet Education Loan Funding, Inc. and
Societe Generale, dated as of February 20, 2004. Incorporated by
reference to Exhibit 10.58 to the registrant's annual report for
the year ended 2003, filed on Form 10-K.
10.43 Lease Assignment and Assumption Agreement between MES - Maine
Education Services as assignor and Nelnet Corporate Services,
Inc. as assignee, dated as of February 1, 2004. Incorporated
by reference to Exhibit 10.59 to the registrant's annual
report for the year ended 2003, filed on Form 10-K.
10.44 Operating Agreement for Premiere Credit of North America, LLC
among Nelnet, Inc., Todd J. Wolfe, David A. Hoeft, and Tina D.
Mercer, dated as of January 28, 2004. Incorporated by
reference to Exhibit 10.60 to the registrant's annual report
for the year ended 2003, filed on Form 10-K.
10.45 Third Amendment to Amended and Restated Participation
Agreement between National Education Loan Network, Inc. and
Union Bank and Trust Company, dated as of February 5, 2004.
Incorporated by reference to Exhibit 10.61 to the registrant's
annual report for the year ended 2003, filed on Form 10-K.
10.46 February 2004 Amendment to Application and Agreement for
Standby Letter of Credit, Loan Purchase Agreements and Standby
Student Loan Purchase Agreements, dated as of February 20,
2004, among National Education Loan Network, Inc., Nelnet,
Inc., Nelnet Education Loan Funding, Inc., Union Bank and
Trust Company, and Bank of America, N.A. Incorporated by
reference to Exhibit 10.62 to the registrant's annual report
for the year ended 2003, filed on Form 10-K.
10.47 Amendment to Application and Agreement for Standby Letter of
Credit, Loan Purchase Agreements, and Standby Student Loan
Purchase Agreements, dated effective November 20, 2003, by and
among National Education Loan Network, Inc., Nelnet, Inc.,
Nelnet Education Loan Funding, Inc., Union Bank and Trust
Company, and Bank of America, N.A. Incorporated by reference
to Exhibit 10.63 to the registrant's annual report for the
year ended 2003, filed on Form 10-K.
10.48 Amendment to Application and Agreement for Standby Letter of
Credit, Loan Purchase Agreements, and Standby Student Loan
Purchase Agreements, dated effective December 19, 2003, by and
among National Education Loan Network, Inc., Nelnet, Inc.,
Nelnet Education Loan Funding, Inc., Union Bank and Trust
Company, and Bank of America, N.A. Incorporated by reference
to Exhibit 10.64 to the registrant's annual report for the
year ended 2003, filed on Form 10-K.
10.49 Agreement of Lease Renewal among Marianne B. Jardine, Trustee
of National Education Loan of New England as assignee, dated
as of June 1, 2002. Incorporated by reference to Exhibit 10.65
to the registrant's annual report for the year ended 2003,
filed on Form 10-K.
10.50 Amended and Restated Warehouse Note Purchase and Security
Agreement, dated as of March 1, 2004, among NHELP-III, Inc.,
Wells Fargo Bank, National Association as Trustee, Delaware
Funding Company LLC, Park Avenue Receivables Company LLC,
Three Rivers Funding Corporation, JPMorgan Chase Bank, and
Mellon Bank, N.A. Incorporated by reference to Exhibit 10.66
to the registrant's quarterly report for the period ended
March 31, 2004, filed on Form 10-Q.
10.51 April 2004 Amendment to Application and Agreement for Standby
Letter of Credit, Loan Purchase Agreements, and Standby
Purchase Agreements, dated effective April 15, 2004, among
Bank of America, N.A., Nelnet Education Loan Funding, Inc.,
National Education Loan Network, Inc, Nelnet, Inc., and Union
Bank and Trust Company. Incorporated by reference to Exhibit
10.67 to the registrant's quarterly report for the period
ended March 31, 2004, filed on Form 10-Q.
10.52 Loan Sale and Commitment Agreement among Union Bank and Trust
Company and Student Loan Acquisition Authority of Arizona,
dated as of April 1, 2002, relating to student loan sale
terms. Incorporated by reference to Exhibit 10.68 to the
registrant's quarterly report for the period ended March 31,
2004, filed on Form 10-Q.
10.53 Letter Agreement among National Education Loan Network, Inc.,
Student Loan Acquisition Authority of Arizona, LLC, and Union
Bank and Trust Company, dated as of April 19, 2004, relating
to student loan sale terms. Incorporated by reference to
Exhibit 10.69 to the registrant's quarterly report for the
period ended March 31, 2004, filed on Form 10-Q.
10.54 Marketing Agreement dated as of May 1, 2004, between Nelnet,
Inc. and infiNET Integrated Solutions, Inc. Incorporated by
reference to Exhibit 10.70 to the registrant's quarterly
report for the period ended March 31, 2004, filed on Form
10-Q.
10.55 Agreement to Extend Termination Date for the Warehouse Note
Purchase and Security Agreement, dated as of May 1, 2004,
among Nelnet Education Loan Funding, Inc., Bank of America,
N.A., Deutsche Bank AG, New York Branch, and Societe Generale.
Incorporated by reference to Exhibit 10.71 to the registrant's
quarterly report for the period ended March 31, 2004, filed on
Form 10-Q.
46
10.56 Stock Purchase Agreement, dated as of April 5, 2004, between
National Education Loan Network, Inc. and infiNET Integrated
Solutions, Inc. Incorporated by reference to Exhibit 10.72 to
the registrant's quarterly report for the period ended March
31, 2004, filed on Form 10-Q.
10.57 Industrial Space Lease dated as of March 26, 2002, between CGA
Investment Company LLC and infiNET Integrated Solutions, Inc.
Incorporated by reference to Exhibit 10.73 to the registrant's
quarterly report for the period ended March 31, 2004, filed on
Form 10-Q.
10.58 First Amendment to Lease dated as of February 18, 2003,
between CGA Investment Company LLC and infiNET Integrated
Solutions, Inc. Incorporated by reference to Exhibit 10.74 to
the registrant's quarterly report for the period ended March
31, 2004, filed on Form 10-Q.
10.59 Second Amendment to Lease dated as of April 13, 2004, between
CGA Investment Company LLC and infiNET Integrated Solutions,
Inc. Incorporated by reference to Exhibit 10.75 to the
registrant's quarterly report for the period ended March 31,
2004, filed on Form 10-Q.
10.60 Line of Credit Agreement dated as of June 15, 2004, between
National Education Loan Network, Inc. and Premiere Credit of
North America, LLC. Incorporated by reference to Exhibit 10.76
to the registrant's quarterly report for the period ended June
30, 2004, filed on Form 10-Q.
10.61 Promissory Note dated as of June 15, 2004, and executed by
Premiere Credit of North America, LLC, in favor of National
Education Loan Network, Inc. Incorporated by reference to
Exhibit 10.77 to the registrant's quarterly report for the
period ended June 30, 2004, filed on Form 10-Q.
10.62 Security Agreement dated as of June 15, 2004, between National
Education Loan Network, Inc. and Premiere Credit of North
America, LLC. Incorporated by reference to Exhibit 10.78 to
the registrant's quarterly report for the period ended June
30, 2004, filed on Form 10-Q.
10.63 Real Estate Mortgage dated as of June 15, 2004, and executed
by Premiere Credit of North America, LLC, in favor of National
Education Loan Network, Inc. Incorporated by reference to
Exhibit 10.79 to the registrant's quarterly report for the
period ended June 30, 2004, filed on Form 10-Q.
10.64 First Amendment to Amended and Restated Warehouse Note
Purchase and Security Agreement dated as of June 29, 2004, by
and among NHELP-III, Inc., Delaware Funding Company, LLC, Park
Avenue Receivables Corporation, Three Rivers Funding
Corporation, JPMorgan Chase Bank, and Mellon Bank, N.A.
Incorporated by reference to Exhibit 10.80 to the registrant's
quarterly report for the period ended June 30, 2004, filed on
Form 10-Q.
10.65 Amendment of Agreements dated as of February 4, 2005, by and
between National Education Loan Network, Inc. and Union Bank
and Trust Company. Incorporated by reference to Exhibit 10.1
to the registrant's current report on Form 8-K on filed
February 10, 2005.
10.66* Agreement to Purchase and Sell Partial Interest in Aircraft,
dated as of September 27, 2004, among Nelnet Corporate Services,
Inc., Crete Carrier Corporation, and Nebco Intermodal, Inc.
10.67* Aircraft Management Agreement, dated as of September 30, 2004,
by and among Nelnet Corporate Services, Inc., Duncan Aviation,
Inc., and Union Financial Services, Inc.
10.68* Aircraft Joint Ownership Agreement, dated as of September 30,
2004, by and between Nelnet Corporate Services, Inc. and Union
Financial Services, Inc.
10.69* Aircraft Sales Agreement, dated as of October 1, 2004, by and
among Nelnet Corporate Services, Inc., Union Financial Services,
Inc., and Mobek Investments, LLC.
10.70* Amendment No. 1 to Credit Agreement dated September 24, 2004, by
and among Nelnet, Inc., National Education Loan Network, Inc.,
M&I Marshall Ilsley Bank, SunTrust Bank, First National Bank of
Omaha, and Fifth Third Bank.
14.1* Nelnet, Inc. Code of Ethics.
14.2* Nelnet Education Loan Funding, Inc. Code of Ethics.
21.1* Subsidiaries of Nelnet, Inc.
23.1* Consent of KPMG LLP, Independent Registered Public Accounting
Firm.
31.1* Certification Pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002 of Co-Chief Executive Officer Michael S. Dunlap.
31.2* Certification Pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002 of Co-Chief Executive Officer Stephen F. Butterfield.
31.3* Certification Pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002 of Chief Financial Officer Terry J. Heimes.
32.** Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
- ----------
* Filed herewith
** Furnished herewith
+ Indicates a compensatory plan or arrangement contemplated by Item 15(a)
(3) of Form 10-K
47
SIGNATURES
Pursuant to the requirements of the Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
Dated: March 16, 2005
NELNET, INC.
By: /s/ MICHAEL S. DUNLAP
-------------------------------------------------
Name: Michael S. Dunlap
Title: Chairman and Co-Chief Executive Officer
(Co-Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities indicated on the dates indicated.
Signature Title Date
/s/ MICHAEL S. DUNLAP Chairman and March 16, 2005
- -------------------------------- Co-Chief Executive Officer
Michael S. Dunlap (Co-Principal Executive
Officer)
/s/ STEPHEN F. BUTTERFIELD Vice Chairman and March 16, 2005
- -------------------------------- Co-Chief Executive Officer
Stephen F. Butterfield (Co-Principal Executive
Officer)
/s/ TERRY J. HEIMES Chief Financial Officer March 16, 2005
- -------------------------------- (Principal Financial Officer
Terry J. Heimes and
Principal Accounting Officer)
/s/ DON R. BOUC Director March 16, 2005
- --------------------------------
Don R. Bouc
/s/ JAMES P. ABEL Director March 16, 2005
- --------------------------------
James P. Abel
/s/ THOMAS E. HENNING Director March 16, 2005
- --------------------------------
Thomas E. Henning
/s/ ARTURO MORENO Director March 16, 2005
- --------------------------------
Arturo Moreno
/s/ BRIAN J. O'CONNOR Director March 16, 2005
- --------------------------------
Brian J. O'Connor
/s/ MICHAEL REARDON Director March 16, 2005
- --------------------------------
Michael Reardon
/s/ JAMES H. VANHORN Director March 16, 2005
- --------------------------------
James H. VanHorn
48
NELNET, INC. AND SUBSIDIARIES
Index to Consolidated Financial Statements
Page
Report of Independent Registered Public Accounting Firm F-2
Consolidated Balance Sheets as of December 31, 2004 and 2003 F-3
Consolidated Statements of Income for the years ended December 31, 2004,
2003, and 2002 F-4
Consolidated Statements of Shareholders' Equity and Comprehensive Income
for the years ended December 31, 2004, 2003, and 2002 F-5
Consolidated Statements of Cash Flows for the years ended December 31,
2004, 2003, and 2002 F-6
Notes to Consolidated Financial Statements F-7
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders
Nelnet, Inc.:
We have audited the accompanying consolidated balance sheets of Nelnet, Inc. and
subsidiaries as of December 31, 2004 and 2003, and the related consolidated
statements of income, shareholders' equity and comprehensive income, and cash
flows for each of the years in the three-year period ended December 31, 2004.
These consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Nelnet, Inc. and
subsidiaries as of December 31, 2004 and 2003, and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 2004 in conformity with U.S. generally accepted accounting
principles.
We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of Nelnet, Inc.'s
internal control over financial reporting as of December 31, 2004 based on
criteria established in Internal Control--Integrated Framework, issued by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our
report dated February 28, 2005 expressed an unqualified opinion on management's
assessment of, and the effective operation of, internal control over financial
reporting.
/s/ KPMG LLP
Lincoln, Nebraska
February 28, 2005
F-2
NELNET, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
December 31, 2004 and 2003
2004 2003
-------------- -------------
(Dollars in thousands, except share data)
Assets:
Student loans receivable (net of allowance for
loan losses of $7,272 in 2004 and $16,026 in 2003) $ 13,461,814 10,455,442
Cash and cash equivalents:
Cash and cash equivalents - not held at a related party 4,854 188,272
Cash and cash equivalents - held at a related party 35,135 10,151
-------------- -------------
Total cash and cash equivalents 39,989 198,423
Restricted cash 732,066 634,263
Restricted investments 281,829 180,688
Restricted cash - due to loan program customers 249,070 141,841
Accrued interest receivable 251,104 196,633
Accounts receivable, net 27,156 17,289
Goodwill 8,522 2,551
Intangible assets, net 11,987 9,079
Furniture, equipment, and leasehold improvements, net 29,870 19,138
Other assets 66,598 76,839
-------------- -------------
Total assets $ 15,160,005 11,932,186
============== =============
Liabilities:
Bonds and notes payable $ 14,300,606 11,366,458
Accrued interest payable 48,578 17,179
Fair value of derivative instruments, net 11,895 677
Other liabilities 93,681 100,542
Due to loan program customers 249,070 141,841
-------------- -------------
Total liabilities 14,703,830 11,626,697
-------------- -------------
Shareholders' equity:
Preferred stock, $0.01 par value.
Authorized 50,000,000 shares; no shares issued or outstanding -- --
Common stock:
Class A, $0.01 par value.
Authorized 600,000,000 shares; issued and outstanding
39,687,037 shares in 2004 and 39,601,834 shares in 2003 397 396
Class B, convertible, $0.01 par value.
Authorized 15,000,000 shares; issued and outstanding
13,983,454 shares in 2004 and 14,023,454 shares in 2003 140 140
Additional paid-in capital 207,915 206,831
Retained earnings 247,064 97,885
Unearned compensation (77) --
Accumulated other comprehensive income, net of taxes 736 237
-------------- -------------
Total shareholders' equity 456,175 305,489
Commitments and contingencies
-------------- -------------
Total liabilities and shareholders' equity $ 15,160,005 11,932,186
============== =============
See accompanying notes to consolidated financial statements.
F-3
NELNET, INC. AND SUBSIDIARIES
Consolidated Statements of Income
Years ended December 31, 2004, 2003, and 2002
2004 2003 2002
------------ ------------ ------------
(Dollars in thousands, except share data)
Interest income:
Loan interest $ 635,014 356,815 403,016
Investment interest 17,762 15,203 20,759
------------ ------------ ------------
Total interest income 652,776 372,018 423,775
Interest expense:
Interest on bonds and notes payable 254,610 200,296 238,746
------------ ------------ ------------
Net interest income 398,166 171,722 185,029
Less provision (recovery) for loan losses (529) 11,475 5,587
------------ ------------ ------------
Net interest income after provision (recovery)
for loan losses 398,695 160,247 179,442
------------ ------------ ------------
Other income:
Loan servicing and other fee income 98,661 102,959 105,160
Software services and other income 25,868 19,017 22,781
Derivative market value adjustment and net settlements (46,058) (2,784) (579)
------------ ------------ ------------
Total other income 78,471 119,192 127,362
------------ ------------ ------------
Operating expenses:
Salaries and benefits 133,667 124,273 106,874
Other operating expenses:
Depreciation and amortization 19,399 23,124 32,449
Trustee and other debt related fees 10,291 14,138 12,879
Occupancy and communications 12,817 12,101 11,424
Advertising and marketing 11,470 10,182 11,512
Professional services 15,067 9,437 9,237
Consulting fees and support services to related parties -- 3,519 12,800
Postage and distribution 13,235 13,241 11,095
Other 26,805 23,135 22,693
------------ ------------ ------------
Total other operating expenses 109,084 108,877 124,089
------------ ------------ ------------
Total operating expenses 242,751 233,150 230,963
------------ ------------ ------------
Income before income taxes and minority interest 234,415 46,289 75,841
Income tax expense 85,236 19,295 27,679
------------ ------------ ------------
Income before minority interest 149,179 26,994 48,162
Minority interest in subsidiary loss -- 109 376
------------ ------------ ------------
Net income $ 149,179 27,103 48,538
============ ============ ============
Earnings per share, basic and diluted $ 2.78 0.60 1.08
============ ============ ============
See accompanying notes to consolidated financial statements.
F-4
NELNET, INC. AND SUBSIDIARIES
Consolidated Statements of Shareholders'
Equity and Comprehensive
Income Years ended December 31, 2004, 2003, and 2002
Accumulated Total
Preferred Common stock shares Class A Class B Additional other share-
stock ------------------- Preferred common common paid-in Retained Unearned comprehensive holders'
shares Class A Class B stock stock stock capital earnings compensation income equity
-------- --------- --------- ------- ------- ------- ---------- -------- ------------ ------------ --------
(Dollars in thousands, except share data)
Balance as
of
December 31, 2001 -- 30,947,834 14,023,454 $ -- 309 140 37,499 25,238 -- -- 63,186
Net income -- -- -- -- -- -- -- 48,538 -- -- 48,538
Dividend
distribution -- -- -- -- -- -- -- (2,994) -- -- (2,994)
Recapture of
minority
interest
loss in
excess of
minority
interest
capital -- -- -- -- -- -- 392 -- -- -- 392
-------- ---------- ----------- ------- ------- ------- ---------- -------- ---------- ---------- --------
Balance as of
December 31, 2002 -- 30,947,834 14,023,454 -- 309 140 37,891 70,782 -- -- 109,122
Comprehensive
income:
Net income -- -- -- -- -- -- -- 27,103 -- -- 27,103
Other
comprehensive
income,
net of tax,
related to
cash
flow hedge -- -- -- -- -- -- -- -- -- 237 237
--------
Total
comprehensive
income 27,340
Non-cash
compensation
expense -- -- -- -- -- -- 5,166 -- -- -- 5,166
Issuance of
common stock -- 331,800 -- -- 3 -- 803 -- -- -- 806
Issuance
of common stock
in initial
public offering,
net of direct
offering
expenses of
$16,600 -- 8,586,800 -- -- 86 -- 163,612 -- -- -- 163,698
Redemption of
common stock -- (264,600) -- -- (2) -- (641) -- -- -- (643)
-------- ----------- ---------- ------- ------- ------- ---------- -------- ---------- ----------- --------
Balance as of
December 31, 2003 -- 39,601,834 14,023,454 -- 396 140 206,831 97,885 -- 237 305,489
Comprehensive
income:
Net income -- -- -- -- -- -- -- 149,179 -- -- 149,179
Other
comprehensive
income,
net of tax,
related to
cash
flow hedge -- -- -- -- -- -- -- -- -- 499 499
--------
Total
comprehensive
income 149,678
Issuance of
common stock,
net of
forfeitures -- 45,203 -- -- 1 -- 1,084 -- (77) -- 1,008
Conversion of
common stock -- 40,000 (40,000) -- -- -- -- -- -- -- --
-------- ----------- ----------- ------- ------- ------- ---------- -------- ---------- ---------- --------
Balance
as of
December 31, 2004 -- 39,687,037 13,983,454 $ -- 397 140 207,915 247,064 (77) 736 456,175
======== =========== =========== ======= ======= ======= ========== ======== ========== ========== ========
See accompanying notes to consolidated financial statements.
F-5
NELNET, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Years ended December 31, 2004, 2003, and 2002
2004 2003 2002
----------- ----------- ------------
(Dollars in thousands)
Net income $ 149,179 27,103 48,538
Adjustments to reconcile net income to net
cash provided by operating activities,
net of business acquisitions:
Depreciation and amortization, including
loan premiums and deferred origination costs 96,725 101,375 93,864
Derivative market value adjustment 11,918 1,183 (2,962)
Ineffectiveness of cash flow hedge 89 (118) --
Non-cash compensation expense 696 5,166 --
Gain on sale of fixed asset (3,037) -- --
Income from equity method investments (958) (778) (279)
Minority interest in subsidiary loss -- (109) (376)
Deferred income tax expense (benefit) 11,781 (3,197) (8,475)
Provision (recovery) for loan losses (529) 11,475 5,587
Decrease (increase) in accrued interest receivable (50,392) (19,618) 3,619
Decrease (increase) in accounts receivable 1,332 (2,451) 918
Decrease (increase) in other assets 20,127 (6,973) (7,329)
Increase (decrease) in accrued interest payable 28,488 (3,072) (894)
Increase (decrease) in other liabilities (24,337) 43,013 1,999
----------- ----------- ------------
Net cash provided by operating activities 241,082 152,999 134,210
----------- ----------- ------------
Cash flows from investing activities:
Originations, purchases, and consolidations
of student loans, including loan premiums
and deferred origination costs (3,485,907) (3,566,803) (2,534,693)
Purchases of student loans, including loan premiums,
from a related party (671,396) (735,540) (384,166)
Net proceeds from student loan principal
payments and loan consolidations 1,223,184 2,325,531 1,724,077
Proceeds from sale of fixed asset 3,573 -- --
Purchases of furniture, equipment, and leasehold improvements (16,456) (16,361) (13,408)
Decrease (increase) in restricted cash 61 (63,560) (357,045)
Purchases of restricted investments (954,489) (449,959) (318,822)
Proceeds from maturities of restricted investments 853,348 442,610 267,089
Purchase of equity method investments (10,110) -- --
Distributions from equity method investments 970 -- --
Purchase of loan origination rights (7,899) -- --
Business acquisitions, net of cash acquired (17,876) (1,760) (20,809)
----------- ----------- ------------
Net cash used in investing activities (3,082,997) (2,065,842) (1,637,777)
----------- ----------- ------------
Cash flows from financing activities:
Payments on bonds and notes payable (3,536,093) (2,350,860) (2,259,769)
Proceeds from issuance of bonds and notes payable 6,234,813 4,269,849 3,781,474
Payment of debt issuance costs (15,375) (11,739) (11,429)
Dividend distribution -- -- (2,994)
Redemption of common stock -- (643) --
Net proceeds from issuance of common stock 312 164,504 --
----------- ----------- ------------
Net cash provided by financing activities 2,683,657 2,071,111 1,507,282
----------- ----------- ------------
Effect of exchange rate fluctuations on cash (176) -- --
Net (decrease) increase in cash and cash equivalents (158,434) 158,268 3,715
Cash and cash equivalents, beginning of year 198,423 40,155 36,440
----------- ----------- ------------
Cash and cash equivalents, end of year $ 39,989 198,423 40,155
=========== =========== ============
Supplemental disclosures of cash flow information:
Interest paid $ 216,275 190,615 222,528
=========== =========== ============
Income taxes paid, net of refunds $ 60,117 21,635 40,098
=========== =========== ============
Supplemental disclosures of noncash operating, investing, and financing
activities regarding acquisitions and the Company's cash flow hedge are
contained in notes 4 and 14, respectively.
See accompanying notes to consolidated financial statements.
F-6
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2004, 2003, and 2002
1. DESCRIPTION OF BUSINESS
Nelnet, Inc. and its subsidiaries ("Nelnet" or the "Company") is one of the
leading education finance companies in the United States and is focused on
providing quality student loan products and services to students and schools
nationwide. The Company ranks among the nation's leaders in terms of total
student loan assets.
The Company's business is comprised of three primary product and service
offerings:
o ASSET MANAGEMENT, INCLUDING STUDENT LOAN ORIGINATIONS AND ACQUISITIONS. The
Company provides student loan marketing, originations, acquisition, and
portfolio management. The Company owns a large portfolio of student loan
assets through a series of education lending subsidiaries. The education
lending subsidiaries primarily invest in student loans, through an eligible
lender trustee, made under Title IV of the Higher Education Act of 1965, as
amended (the "Higher Education Act"). Certain subsidiaries also invest in
non-federally insured student loans. The Company obtains loans through
direct origination or through acquisition of loans. The Company also
provides marketing, sales, managerial, and administrative support related to
its asset generation activities.
Student loans beneficially owned by the education lending subsidiaries
include those originated under the Federal Family Education Loan Program
("FFELP" or "FFEL Program"), including the Stafford Loan Program, the Parent
Loan for Undergraduate Students ("PLUS") program, the Supplemental Loans for
Students ("SLS") program, and loans that consolidate certain borrower
obligations ("Consolidation"). Title to the student loans is held by
eligible lender trustees under the Higher Education Act for the benefit of
the education lending subsidiaries. The financed eligible loan borrowers are
geographically located throughout the United States. The bonds and notes
outstanding are payable primarily from interest and principal payments on
the student loans, as specified in the resolutions authorizing the sale of
the bonds and notes.
o STUDENT LOAN AND GUARANTEE SERVICING. The Company services its student loan
portfolio and the portfolios of third parties. Servicing activities include
loan origination activities, application processing, borrower updates,
payment processing, due diligence procedures, and claim processing. These
activities are performed internally for the Company's own portfolio, in
addition to generating fee revenue when performed for third-party clients.
As of December 31, 2004, the Company's U.S. operations serviced or provided
complete outsourcing of servicing activities for $21.1 billion in student
loans, including $11.9 billion of loans in its portfolio. In December 2004,
the Company purchased EDULINX Canada Corporation ("EDULINX") and its wholly
owned subsidiary, Tricura Canada, Inc. ("Tricura"). EDULINX is a Canadian
corporation that engages in servicing Canadian student loans. As of December
31, 2004, EDULINX serviced $7.2 billion ($8.7 billion in Canadian dollars)
in student loans.
The Company also provides servicing support to guaranty agencies, which
includes system software, hardware and telecommunication support, borrower
and loan updates, default aversion tracking services, claim processing
services, and post-default collection services. As of December 31, 2004, the
Company provided servicing support to agencies that guarantee more than $19
billion of FFELP loans.
o SERVICING SOFTWARE. The Company uses internally developed student loan
servicing software and also provides this software to third-party student
loan holders and servicers. As of December 31, 2004, the Company's software
was used to service more than $50 billion in student loans, which included
$29 billion serviced by third parties using the Company's software.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND PRACTICES
CONSOLIDATION
The consolidated financial statements include the accounts of the Company and
its subsidiaries. All significant intercompany balances and transactions have
been eliminated in consolidation.
The Company owns the stock of various corporations that are engaged in the
securitization of education finance assets. The Company's education lending
subsidiaries are separate entities holding beneficial interests in eligible
loans, subject to creditors with specific interests. The liabilities of the
Company's education lending subsidiaries are not the obligations of the Company
or any of its other subsidiaries and cannot be consolidated in the event of
bankruptcy. The transfers of student loans to the eligible lender trusts do not
qualify as sales under the provisions of Statement of Financial Accounting
Standards ("SFAS") No. 140, Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities, as the trusts continue to be under
the effective control of the Company. All the financial activities and related
assets and liabilities, including debt, of the securitizations are reflected in
the Company's consolidated financial statements.
F-7
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
The entities accounted for under the equity method and the Company's ownership
percentages as of December 31, 2004 and 2003 are summarized below:
As of December 31,
----------------
2004 2003
------ -------
5280 Solutions, Inc. 50 % 50 %
FirstMark Services LLC 50 50
Nelnet Mentor LLC 50 50
Premiere Credit of North America, LLC 50 --
infiNET Integrated Solutions, Inc. 50 --
As of December 31, 2004 and 2003, other assets in the accompanying consolidated
balance sheets includes $11.7 million and $1.6 million, respectively, of
investment in the entities accounted for under the equity method. Included in
these balances is $8.0 million of excess cost that is not being amortized as of
December 31, 2004. The Company would recognize a loss on this excess cost if
there was a loss in value of any equity method investment that is other than a
temporary decline. For the years ended December 31, 2004, 2003, and 2002, income
from the equity method investments of approximately $958,000, $778,000, and
$279,000, respectively, is included in software services and other income in the
accompanying consolidated statements of income.
USE OF ESTIMATES
The preparation of the consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make a number of estimates and assumptions that affect
the reported amounts of assets and liabilities, reported amounts of revenues and
expenses, and other disclosures. Actual results could differ from those
estimates.
STUDENT LOANS RECEIVABLE
Investments in student loans, including unamortized premiums and deferred
origination costs, are recorded at cost, net of the allowance for loan losses.
Student loans consist of federally insured student loans, non-federally insured
student loans, and student loan participations.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses represents management's estimate of probable
losses on student loans. This evaluation process is subject to numerous
estimates and judgments. The Company evaluates the adequacy of the allowance for
loan losses on its federally insured loan portfolio separately from its
non-federally insured loan portfolio.
The allowance for the federally insured loan portfolio is based on periodic
evaluations of the Company's loan portfolios considering past experience, trends
in student loan claims rejected for payment by guarantors, changes to federal
student loan programs, current economic conditions, and other relevant factors.
The federal government guarantees 98% of principal and interest of federally
insured student loans, which limits the Company's loss exposure to 2% of the
outstanding balance of the Company's federally insured portfolio.
Effective June 1, 2004, the Company was designated as an Exceptional Performer
by the U.S. Department of Education (the "Department") in recognition of its
exceptional level of performance in servicing FFELP loans. As a result of this
designation, the Company receives 100% reimbursement on all eligible FFELP
default claims submitted for reimbursement during the 12-month period following
the effective date of its designation. The Company is not subject to the 2% risk
sharing loss for eligible claims submitted during this 12-month period. Only
FFELP loans that are serviced by the Company, as well as loans owned by the
Company and serviced by other service providers designated as Exceptional
Performers by the Department, are subject to the 100% reimbursement. In 2004,
the Company's allowance and the provision for loan losses were each reduced by
$9.4 million to account for the estimated effects of the Exceptional Performance
designations.
As of December 31, 2004, service providers designated as an Exceptional
Performer serviced more than 99% of the Company's federally insured loans. Of
this 99%, third parties serviced approximately 9%. The Company is entitled to
receive this benefit as long as it and/or its other service providers continue
to meet the required servicing standards published by the Department. Compliance
with such standards is assessed on a quarterly basis. If the Company or a third
party servicer were to lose its Exceptional Performance designation, either by
the Department discontinuing the program or the Company or third party servicer
not meeting the required servicing standards, loans serviced by the Company or
third party would become subject to the 2% risk sharing loss for all claims
submitted after any loss of the designation.
F-8
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
In determining the adequacy of the allowance for loan losses on the
non-federally insured loans, the Company considers several factors including:
loans in repayment versus those in a nonpaying status, months in repayment,
delinquency status, type of program, and trends in defaults in the portfolio
based on Company and industry data. The Company places a non-federally insured
loan on nonaccrual status and charges off these uninsured loans when the
collection of principal and interest is 120 days past due.
The evaluation of the allowance for loan losses is inherently subjective, as it
requires material estimates that may be subject to significant changes. The
provision for loan losses reflects the activity for the applicable period and
provides an allowance at a level that the Company's management believes is
adequate to cover probable losses inherent in the loan portfolio.
CASH AND CASH EQUIVALENTS
For purposes of the consolidated statements of cash flows, the Company considers
all investments with maturities when purchased of three months or less to be
cash equivalents.
RESTRICTED CASH AND RESTRICTED INVESTMENTS
The Company's restricted cash and restricted investments are held by the
trustees in various accounts, subject to use restrictions imposed by the trust
indenture. The Company recognizes all restricted cash and restricted investments
held by trustees on the consolidated balance sheets.
RESTRICTED CASH - DUE TO LOAN PROGRAM CUSTOMERS/DUE TO LOAN PROGRAM CUSTOMERS
As a servicer of student loans, the Company collects student loan remittances
and subsequently disburses these remittances to the appropriate lending
entities. In addition, the Company requests funding from lenders and
subsequently disburses loan funds to borrowers and schools on behalf of
borrowers. Cash collected for customers and the related liability are included
in the accompanying consolidated balance sheets. Interest income earned, net of
service charges, by the Company on this cash for the years ended December 31,
2004, 2003, and 2002 was approximately $1,017,000, $213,000, and $930,000,
respectively.
EDULINX has several bank accounts used for the purpose of disbursing and
collecting student loan funds on behalf of its customers. These funds are not
the property of EDULINX, but rather are held in trust for the various
stakeholders. Accordingly, they are not reflected on the accompanying
consolidated balance sheets. As of December 31, 2004, the cumulative cash
balance held in trust at EDULINX was $18.4 million.
GOODWILL AND INTANGIBLE ASSETS
Goodwill consists of the difference between the purchase price incurred in
acquisitions using the purchase method of accounting and the fair value of the
net assets acquired. In accordance with SFAS No. 142, Goodwill and Other
Intangible Assets, goodwill is not amortized, but instead is assessed for
impairment at least annually. During this assessment, management relies on a
number of factors, including operating results, business plans, and anticipated
future cash flows.
Intangible assets, consisting of lender relationships, loan origination rights,
servicing system software, and other intellectual property, are being amortized
on a straight-line basis over the expected periods to be benefited, ranging from
36 to 120 months.
FURNITURE, EQUIPMENT, AND LEASEHOLD IMPROVEMENTS
Furniture and equipment are carried at cost, net of accumulated depreciation.
Maintenance and repairs are charged to expense as incurred, and major
improvements, including leasehold improvements, are capitalized. Gains and
losses from retirement of furniture, equipment, and leasehold improvements are
included in determining net income. The Company uses accelerated and
straight-line methods for recording depreciation and amortization. Accelerated
methods are used for certain equipment and software when this method is believed
to provide a better matching of income and expenses.
IMPAIRMENT OF LONG-LIVED ASSETS
Long-lived assets, such as furniture, equipment, leasehold improvements, and
purchased intangibles subject to amortization, are reviewed for impairment
whenever events or changes in circumstances indicate that the carrying amount of
an asset may not be recoverable. Recoverability of assets to be held and used is
measured by a comparison of the carrying amount of an asset to estimated
undiscounted future cash flows expected to be generated by the asset. If the
carrying amount of an asset exceeds its estimated future cash flows, an
impairment charge is recognized by the amount by which the carrying amount of
the asset exceeds the fair value of the asset.
F-9
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
Goodwill and intangible assets not subject to amortization are tested annually
for impairment. An impairment loss is recognized to the extent that the carrying
amount exceeds the asset's estimated fair value.
There were no impairments of long-lived assets, goodwill, or intangible assets
not subject to amortization in 2004, 2003, or 2002.
SOFTWARE DEVELOPED OR OBTAINED FOR INTERNAL-USE
Certain direct development costs associated with internal-use software are
capitalized, including external direct costs of services and payroll costs for
employees devoting time to the software projects. These costs are included in
furniture, equipment, and leasehold improvements and are amortized over a period
of three years beginning when the asset is placed into service. During the years
ended December 31, 2004 and 2003, the Company capitalized $4.3 million and $1.4
million, respectively, in costs related to internal-use software development. No
costs were capitalized in 2002. Amortization of internal-use software was $0.5
million during the year ended December 31, 2004. There was no amortization of
internal-use software in 2003 and 2002.
OTHER ASSETS
Other assets are recorded at cost or amortized cost and consist primarily of
prepaid bond insurance, debt issuance costs, deferred tax assets, income taxes
receivable, investments in entities accounted for under the equity method, and
deposits. Prepaid bond insurance and debt issuance costs are amortized using the
straight-line method and effective interest methods, respectively, over the
estimated lives of the bonds and notes payable.
REVENUE RECOGNITION
Student Loan Income - The Company recognizes student loan income using the
interest method, net of amortization of loan premiums and deferred origination
costs. Loan income is recognized based on the expected yield of the loan after
giving effect to borrower utilization of incentives for timely payment
("borrower benefits") and other yield adjustments. The effect of borrower
benefits on student loan yield is based on borrowers who are eligible for the
incentives. The interest is paid by the Department or the borrower, depending on
the status of the loan at the time of the accrual. In addition, the Department
makes quarterly interest subsidy payments on certain qualified FFELP loans until
the student is required under the provisions of the Higher Education Act to
begin repayment. Repayment of FFELP loans normally begins within six months
after completion of the loan holder's course of study, leaving school, or
ceasing to carry at least one-half the normal full-time academic load, as
determined by the educational institution. Repayment of PLUS and Consolidation
loans normally begins within 60 days from the date of loan disbursement, and
repayment of SLS loans begins within one month after completion of course study,
leaving school, or ceasing to carry at least the normal full-time academic load,
as determined by the educational institution. Repayment of non-federally insured
loans typically begins six months following a borrower's graduation from a
qualified institution and the interest is either paid by the borrower or
capitalized annually or at repayment.
The Department provides a special allowance to lenders participating in the FFEL
Program. The special allowance is accrued using the interest method based upon
the average rate established in the auction of 13-week Treasury Bills in the
previous quarter relative to the yield of the student loan. Under certain
circumstances, the special allowance is reduced by approximately one-half for
loans that were originated or purchased from funds obtained from issuance of
tax-exempt obligations, depending upon the issuance date of the obligation.
Loan premiums and deferred origination costs are amortized over the estimated
lives of the related loans in accordance with SFAS No. 91, Accounting for
Non-Refundable Fees and Costs Associated with Originating or Acquiring Loans and
Initial Direct Costs of Leases. The Company periodically evaluates the
assumptions used to estimate the life of the loans. The Company also pays the
Department an annual 105 basis point rebate fee on Consolidation loans. The
amortization of loan premiums and deferred origination costs and rebate fees
incurred are netted against student loan income.
Loan and Guarantee Servicing Income - Loan and guarantee servicing fees are
determined according to agreements with customers and are calculated based on
the dollar value or number of loans serviced or amounts collected for each
customer. Revenue is recognized when earned pursuant to applicable agreements,
and when ultimate collection is assured. As of December 31, 2004 and 2003, the
Company's U.S. operations serviced $21.1 billion and $18.7 billion,
respectively, of loans, including $11.9 billion and $9.2 billion of
Company-owned loans. As of December 31, 2004, the Company also serviced $7.2
billion ($8.7 billion in Canadian dollars) in student loans through its Canadian
operations.
F-10
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
Software Services - The Company accounts for software revenues in accordance
with the AICPA's Statement of Position 97-2, Software Revenue Recognition ("SOP
97-2"). SOP 97-2 provides guidance on when and in what amounts income should be
recognized for licensing, selling, leasing, or otherwise marketing computer
software. Income for contracts with customers that does not require significant
production, modification, or customization of software is recognized when all
the following criteria are met: persuasive evidence of an arrangement exists,
delivery has occurred, vendors fee is fixed and determinable, and collectibility
is probable. Income paid on maintenance and enhancement agreements for services
to be performed in subsequent periods is deferred and recognized in income over
the life of the agreements.
MINORITY INTEREST
In 2003 and 2002, minority interest reflected the proportionate share of
shareholders' equity and loss attributable to the minority shareholders of
Student Partner Services. In 2003, the Company purchased the remaining minority
interest of Student Partner Services.
The Company allocated its non-wholly owned subsidiary, Infovisa, Inc.'s
("Infovisa") income or loss proportionately between the Company's percentage
interest and the remaining percentage minority interest. When losses applicable
to the minority interest exceeded the minority interest in equity capital, such
excess was charged against the Company's interest as a charge to retained
earnings in the Company's shareholders' equity. When earnings were generated
applicable to the minority interest, the Company's interest was credited through
retained earnings to the extent of losses previously charged to retained
earnings. For purposes of reporting on the Company, these changes are reflected
in additional paid-in capital, as retained earnings are those of the Company.
During 2002, Infovisa was sold to a related party and the minority interest loss
was recaptured through additional paid-in capital at the date of sale.
DERIVATIVES AND HEDGING ACTIVITIES
The Company's derivatives and hedging activities are recorded in accordance with
SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as
amended by SFAS No. 138, Accounting for Certain Derivative Instruments and
Certain Hedging Activities, an Amendment of FASB Statement No. 133 ("SFAS No.
133"). These statements establish accounting and reporting standards for
derivative instruments and hedging activities, as defined, including certain
derivative instruments embedded in other contracts, and requires that an entity
recognize all derivatives as either assets or liabilities on the balance sheet
and measure them at fair value. The fair value of the Company's derivative
instruments is determined from market quotes from independent security brokers.
The Company has entered into certain derivative instruments such as interest
rate swaps, caps, and basis swaps as part of managing its interest rate risk.
Interest rate swaps are used to exchange fixed and floating rate interest
payment obligations, while caps are used to protect the Company's income
statement from unfavorable movements in interest rates while allowing benefit
from favorable movements. Basis swaps are used to convert variable-rate debt
from one interest rate index to another to match the interest rate
characteristics of the assets. The Company uses basis swaps to change the index
of the LIBOR-based debt to better match the cash flows of student loan assets.
All derivative instruments that qualify for hedge accounting pursuant to SFAS
No. 133 are recorded at fair value and classified either as a hedge of the fair
value of a recognized asset or liability ("fair value hedge") or as a hedge of
the variability of cash flows to be received or paid related to a recognized
asset or liability of a forecasted transaction ("cash flow hedge"). For all
hedging relationships, the Company formally documents the hedging relationship
and its risk-management objective and strategy for undertaking the hedge, the
hedging instrument, the items hedged, the nature of the risk being hedged, how
the hedging instrument's effectiveness in offsetting the hedged risk will be
assessed, and a description of the method of measuring effectiveness. This
process includes linking all derivatives that are designated as fair value or
cash flow hedges to specific assets and liabilities on the balance sheet or to
specific forecasted transactions. The Company also formally assesses, both at
the hedge's inception and on an ongoing basis, whether the derivatives that are
used in hedging transactions are highly effective in offsetting changes in fair
values or cash flows of hedged items.
F-11
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
Changes in the fair value of a derivative instrument that is highly effective
and is designated and qualifies as a fair value hedge and the offsetting changes
in the fair value of the hedged item are recorded in the income statement.
Changes in the fair value of a derivative instrument that is highly effective
and designated and qualifies as a cash flow hedge are recognized in other
comprehensive income to the extent that the derivative is effective as a hedge,
until earnings are affected by the variability in cash flows of the designated
hedged item. The Company performs an assessment, both at inception of the hedge
and on a quarterly basis thereafter, to determine whether these derivative
instruments are highly effective in offsetting changes in the value of the
hedged items. Any change in fair value resulting from hedge ineffectiveness is
immediately recorded in the income statement.
The Company discontinues hedge accounting prospectively when it is determined
that the derivative is no longer effective in offsetting changes in the fair
value or cash flows of the hedged item; the derivative expires or is sold,
terminated, or exercised; the derivative is dedesignated as a hedging
instrument, because it is unlikely that a forecasted transaction will occur; or
management determines that designation of the derivative as a hedging instrument
is no longer appropriate.
Changes in the fair value of derivative instruments that do not qualify for
hedge accounting are reported in current period earnings.
Net settlement income (expense) on derivatives that do not qualify as hedges
under SFAS No. 133 are included in the derivative market value adjustment on the
income statement. As a result, the derivative market value adjustment includes
both the unrealized changes in the fair value of the Company's derivatives, as
well as the net settlements on those derivatives that do not qualify as hedges
under SFAS No. 133.
TRANSLATION OF FOREIGN CURRENCY
The Company's foreign subsidiary, EDULINX, uses the Canadian dollar as its
functional currency. The assets and liabilities of EDULINX are translated to
U.S. dollars at the exchange rate in effect at the balance sheet date. Revenues
and expenses are translated at the average exchange rate during the period.
Translation gains or losses (net of tax) are reflected in the consolidated
financial statements as a component of accumulated other comprehensive income.
EDULINX was purchased in December 2004, thus, the translation gain was
insignificant for the year ended December 31, 2004.
INCOME TAXES
Income taxes are recorded in accordance with SFAS No. 109, Accounting for Income
Taxes ("SFAS No. 109"). The asset and liability approach underlying SFAS No. 109
requires the recognition of deferred tax liabilities and assets for the expected
future tax consequences of temporary differences between the carrying amounts
and tax basis of the Company's assets and liabilities. To the extent the tax
laws change, deferred tax assets and liabilities are adjusted in the period that
the tax change is enacted.
Income tax expense includes deferred tax expense, which represents the net
change in the deferred tax asset or liability balance during the year, plus any
change made in the valuation allowance, and current tax expense, which
represents the amount of tax currently payable to or receivable from a tax
authority plus amounts for expected tax deficiencies (including both tax and
interest).
In accordance with SFAS No. 5, Accounting for Contingencies, the Company records
a reserve for expected controversies with the Internal Revenue Service and
various state taxing authorities when it is deemed that deficiencies arising
from such controversies are probable and reasonably estimable. This reserve
includes both tax and interest on these deficiencies.
EARNINGS PER SHARE
The basic earnings per common share is computed by dividing net income by the
weighted average number of common shares outstanding for the periods presented.
The weighted average number of shares for the years ended December 31, 2004,
2003, and 2002 were 53,648,605, 45,501,583, and 44,971,290, respectively. Nelnet
had no common stock equivalents and no potentially dilutive common shares during
the years presented.
RECLASSIFICATION
Certain prior year amounts have been reclassified to conform to the 2004
consolidated financial statement presentation.
F-12
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
3. RECENT DEVELOPMENTS
A portion of the Company's FFELP loan portfolio is comprised of loans that are
currently or were financed prior to September 30, 2004 with tax-exempt
obligations issued prior to October 1, 1993. Based upon provisions of the Higher
Education Act and related interpretations by the Department, the Company is
entitled to receive special allowance payments on these loans providing the
Company with a 9.5% minimum rate of return (the "9.5% Floor"). In May 2003, the
Company sought confirmation from the Department regarding whether it was allowed
to receive these special allowance payments based on the 9.5% minimum rate of
return. While pending satisfactory resolution of this issue with the Department,
the Company deferred recognition of the interest income that was generated by
these loans in excess of income based upon the standard special allowance rate.
In June 2004, after consideration of certain clarifying information received in
connection with the guidance it had sought, and based on written and verbal
communications with the Department, the Company concluded that the earnings
process had been completed related to the special allowance payments on these
loans and recognized $124.3 million of deferred interest income in the second
quarter of 2004. As of December 31, 2003, the amount of deferred excess interest
income on these loans was $42.9 million and was included in other liabilities on
the Company's consolidated balance sheet.
Following the Company's disclosures related to recognition of such income,
Senator Edward M. Kennedy, by letter to the Secretary of Education dated August
26, 2004, requested information as to whether the Department had approved of the
Company's receipt of the 9.5% Floor income and, if not, why the Department had
not sought to recover claimed subsidies under the 9.5% Floor. By letter dated
September 10, 2004, the Company furnished to the Department certain background
information concerning the growth of the 9.5% Floor loans in its portfolio,
which information had been requested by the Department. Senator Kennedy, in a
second letter to the Securities and Exchange Commission ("SEC") dated September
21, 2004, requested that the SEC investigate the Company's activities related to
the 9.5% Floor. More specifically, Senator Kennedy raised concerns about the
Company's disclosures in connection with its decision to recognize the
previously deferred income, and trading of Company securities by Company
executives following such disclosures. On September 27, 2004, the Company
voluntarily contacted the SEC to request a meeting with the SEC Staff. The
Company's request was granted, and representatives of the Company met with
representatives of the SEC Staff on October 12, 2004. Company representatives
offered to provide to the SEC information that the SEC Staff wished to have
relating to the issues raised in Senator Kennedy's letter. By letter dated
October 14, 2004, the SEC Staff requested that, in connection with an informal
investigation, the Company provide certain identified information. The Company
has furnished to the SEC Staff the information it has requested and is fully
cooperating with the SEC Staff in its informal investigation.
The Company continues to believe that the concerns expressed to the SEC by
Senator Kennedy are entirely unfounded, but it is not appropriate or feasible to
determine or predict the ultimate outcome of the SEC's informal investigation.
The Company's costs related to the SEC's informal investigation are being
expensed as incurred. Additional costs, if any, associated with an adverse
outcome or resolution of that matter, in a manner that is currently
indeterminate and inherently unpredictable, could adversely affect the Company's
financial condition and results of operations. Although it is possible that an
adverse outcome in certain circumstances could have a material adverse effect,
based on information currently known by the Company's management, in its
opinion, the outcome of such pending informal investigation is not likely to
have such an effect.
4. ACQUISITIONS
The Company has positioned itself for growth by building a strong foundation
through acquisitions. Although the Company's assets, loan portfolios, and
fee-based revenues increase through such transactions, a key aspect of each
transaction is its impact on the Company's prospective organic growth and the
development of its integrated platform of services.
On June 30, 2001, the Company acquired 51% of the voting control of GuaranTec,
LLP ("GuaranTec") for $2.6 million. On January 1, 2002, the Company acquired the
remaining 49% of GuaranTec for $4.5 million from an entity under common control
with the Company. The excess purchase price over the acquiree's carrying value
was $3.0 million. As the 49% interest was acquired from an entity under common
control, the excess purchase price was recorded as a dividend distribution in
the consolidated statement of shareholders' equity in 2002.
On January 2, 2002, the Company acquired Idaho Financial Associates, Inc.
("IFA") for $17.0 million. The acquisition was accounted for under purchase
accounting. The assets and liabilities of IFA were recorded at fair value. An
intangible asset, representing servicing system software and other intellectual
property, of $14.2 million was recorded and is being amortized over its
estimated useful life of three years. The results of operations of IFA have been
included in the consolidated financial statements since the date of acquisition.
F-13
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
On May 9, 2002, the Company acquired Charter Account Systems, Inc. ("Charter")
for $6.8 million. The acquisition was accounted for under purchase accounting.
The assets and liabilities of Charter were recorded at fair value. An intangible
asset, representing servicing system software and other intellectual property,
of $6.8 million was recorded and is being amortized over its estimated useful
life of three years. The excess purchase price and acquisition costs over the
fair value of the net identifiable assets acquired was $2.6 million and has been
recognized as goodwill. The results of operations of Charter have been included
in the consolidated financial statements since the date of acquisition.
The Company acquired IFA and Charter to provide student loan servicing software
solutions to the student lending industry. The allocation of the purchase price
for the IFA and Charter acquisitions is shown below (dollars in thousands):
Cash and investments $ 2,972
Accounts receivable 1,390
Intangible assets 21,061
Excess cost over fair value of net assets acquired 2,551
Deferred revenue and other liabilities (4,193)
----------
Total purchase price $ 23,781
==========
On August 7, 2003, the Company acquired Nelnet Capital, LLC ("Nelnet Capital")
for $2.6 million from affiliated parties. The acquisition was accounted for
under purchase accounting. The results of operations of Nelnet Capital have been
included in the consolidated financial statements from the date of acquisition.
On January 28, 2004, the Company acquired 50% of the membership interests in
Premiere Credit of North America, LLC ("Premiere"). Premiere is a collection
services company that specializes in collection of educational debt. Total
consideration paid by the Company for Premiere was $5.3 million, $2.3 million of
which represents excess purchase price, which will not be amortized. Included in
the Premiere purchase agreement is a "call" option, which expires six years
after the purchase date, that allows the Company to purchase 100% ownership of
Premiere at a price as determined in the agreement. In addition, Premiere has a
"put" option, which expires five years after the purchase date, to require the
Company to purchase 100% ownership of Premiere at a price as determined in the
agreement. The Company is accounting for Premiere using the equity method of
accounting. The investment in Premiere is included in other assets on the
consolidated balance sheet.
On March 11, 2004, the Company acquired rights, title, and interest in certain
assets of the Rhode Island Student Loan Authority ("RISLA"), including the right
to originate student loans in RISLA's name without competition from RISLA for a
term of 10 years. Total consideration paid by the Company for the rights to
originate student loans was $7.9 million, which will be amortized over 10 years.
These origination rights are included in intangible assets on the consolidated
balance sheet. The Company also purchased certain assets, consisting primarily
of furniture and equipment from RISLA for $0.3 million and a portfolio of
federally insured loans with an aggregate outstanding balance of $175.1 million.
The Company further agreed to provide administrative services in connection with
certain of the indentures governing debt securities of RISLA for a 10-year
period.
On April 19, 2004, the Company purchased 100% of SLAAA Acquisition Corp.
("SLAAA") and its wholly owned subsidiaries, Student Loan Acquisition Authority
of Arizona LLC and SLAAA Management Company, for $11.1 million, including direct
acquisition costs. SLAAA is a student loan secondary market. The excess of the
purchase price and acquisition costs over the fair value of the net identifiable
assets acquired was $6.0 million and has been recognized as goodwill. This
acquisition was accounted for under purchase accounting and the results of
operations have been included in the consolidated financial statements from the
date of acquisition.
The allocation of the purchase price for SLAAA is shown below (dollars in
thousands):
Cash and cash equivalents $ 277
Restricted cash 97,864
Student loans and accrued interest 146,173
Other assets 133
Excess cost over fair value of net assets acquired 5,971
Bonds and notes payable and accrued interest (238,645)
Other liabilities (667)
----------
Total purchase price $ 11,106
==========
F-14
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
On April 20, 2004, the Company purchased 50% of the stock of infiNET Integrated
Solutions, Inc. ("infiNET"). InfiNET provides customer-focused electronic
transactions, information sharing, and account and bill presentment for
colleges, universities, and healthcare organizations. Total consideration paid
by the Company for infiNET was $4.9 million, which generated $5.7 million of
excess purchase price that will not be amortized. The Company is accounting for
infiNET using the equity method of accounting. The investment in infiNET is
included in other assets on the consolidated balance sheet.
On December 1, 2004, the Company purchased 100% of EDULINX and its wholly owned
subsidiary, Tricura, for $7.0 million. The purchase price is subject to change
based on certain post-closing adjustments, as defined in the purchase agreement.
In addition to the post-closing adjustments, an additional payment of
approximately $6.3 million is to be paid by the Company if EDULINX obtains an
extension or renewal of a significant customer servicing contract that currently
expires in February 2006. This contingency payment is due following the date on
which such extension or renewal period of the servicing contract commences. The
acquisition was accounted for under purchase accounting and the results of
operations have been included in the consolidated financial statements from the
date of acquisition.
The purchase price allocation for EDULINX has not yet been finalized due to the
acquisition occurring late in the fiscal year. The preliminary allocation of the
purchase price for EDULINX is shown below (dollars in thousands):
Accounts receivable $ 11,273
Intangible assets 3,820
Furniture, equipment, and leasehold improvements 5,464
Other assets 1,180
Other liabilities (14,690)
---------
Total purchase price $ 7,047
=========
The following unaudited pro forma information presents the combined results of
the Company as though the 2004 acquisitions of EDULINX and SLAAA occurred on
January 1, 2003. The pro forma financial information does not necessarily
reflect the results of operations if the acquisitions had been in effect at the
beginning of the period or that may be attained in the future.
Pro forma
year ended
December 31,
--------------------------
2004 2003
------------- ----------
(Dollars in thousands)
(Unaudited)
Net interest income $ 398,930 176,408
Other income 122,636 165,213
Net income 145,842 23,404
Weighted average shares outstanding, basic and diuted 53,648,605 45,501,583
Earnings per share, basic and diluted $ 2.72 0.52
The pro forma information presenting the combined operations of the Company as
though the 2003 and 2002 acquisitions occurred on January 1, 2003 and January 1,
2002, respectively, is not significantly different than actual 2003 or 2002
results.
5. RECAPITALIZATION
Effective August 14, 2003, the shareholders of the Company approved amended and
restated articles of incorporation. The amended and restated articles of
incorporation effected a recapitalization of the Company whereby each share of
Class A voting common stock and each share of Class B nonvoting common stock
held by two principal shareholders and a related entity (the "Principal
Shareholders") was converted into 210 shares of new Class B common stock, and
each share of Class B nonvoting common stock (other than those owned by the
Principal Shareholders) was converted into 210 shares of new Class A common
stock. Also, effective with the conversion of the Class B shares to Class A
F-15
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
shares, certain former Class B shareholders converted their new Class B shares
into new Class A shares. The new Class B common stock has ten votes per share,
and the new Class A common stock has one vote per share. Each Class B share is
convertible at any time at the holder's option into one Class A share. With the
exception of the voting rights and the conversion feature, the Class A and Class
B shares are identical in terms of other rights, including dividend and
liquidation rights. The Company's shareholders' equity has been restated to
reflect the new capital stock structure for all periods presented.
On December 11, 2003, the Company consummated an initial public offering. The
Company sold 8,000,000 shares of Class A common stock at a price of $21 per
share for net proceeds of $152.2 million. On December 22, 2003, the underwriters
exercised their over-allotment option and purchased an additional 586,800 shares
at $21 per share, which yielded net proceeds to the Company of $11.5 million.
In August 2004, a principal shareholder gifted 40,000 Class B shares of common
stock to certain charitable organizations. Per the Company's articles of
incorporation, these shares automatically converted to Class A shares upon
transfer.
6. RESTRICTED INVESTMENTS
The Company's restricted investments are held by a trustee in various accounts
subject to use restrictions and consist of guaranteed investment contracts,
commercial banking deposits, and repurchase agreements, which are classified as
held-to-maturity. Due to the characteristics of the investments, there is no
available or active market for these types of financial instruments. These
investments are guaranteed and are purchased and redeemed at par value, which
equals their cost as of December 31, 2004 and 2003. The carrying value of these
investments by contractual maturity is shown below:
As of December 31,
-----------------------
2004 2003
---------- ----------
(Dollars in thousands)
Over 1 year through 5 years $ 22,023 1,714
After 5 years through 10 years -- 30,038
After 10 years 259,806 148,936
---------- ----------
$ 281,829 180,688
========== ==========
7. STUDENT LOANS RECEIVABLE AND CONCENTRATION OF CREDIT RISK
Student loans receivable as of December 31, 2004 and 2003 consisted of the
following:
As of December 31,
-----------------------
2004 2003
----------- ----------
(Dollars in thousands)
Federally insured loans $ 13,208,689 10,222,547
Non-federally insured loans 90,405 92,327
----------- ----------
13,299,094 10,314,874
Unamortized premiums and deferred origination costs 169,992 156,594
Less allowance for loan losses - federally insured loans 117 9,755
Less allowance for loan losses - non-federally insured loans 7,155 6,271
----------- ----------
$ 13,461,814 10,455,442
=========== ==========
Federally insured allowance as a percentage
of ending balance of federally insured loans 0.00% 0.10%
Non-federally insured allowance as a percentage
of ending balance of non-federally insured loans 7.91% 6.79%
Total allowance as a percentage of ending balance of total loans 0.05% 0.16%
Federally insured loans may be made under the FFEL Program by certain lenders as
defined by the Higher Education Act. These loans, including related accrued
interest, are guaranteed at their maximum level permitted under the Higher
Education Act by an authorized guaranty agency, which has a contract of
reinsurance with the Department. The terms of the loans, which vary on an
individual basis, generally provide for repayment in monthly installments of
principal and interest over a period of up to 20 years. Interest rates on loans
may be fixed or variable, dependent upon type, terms of loan agreements, and
date of origination. Interest rates on loans currently range from 2.6% to 12.0%
(the weighted average rate was 4.2% and 4.5% as of December 31, 2004 and 2003,
respectively). Interest rates on variable-rate loans varies based on the average
of the 91-day U.S. Treasury Bill rate.For FFELP loans, the education lending
subsidiaries have entered into trust agreements in which unrelated financial
institutions serve as the eligible lender trustees. As eligible lender trustees,
the financial institutions act as the eligible lender in acquiring certain
eligible student loans as an accommodation to the subsidiaries, which hold
beneficial interests in the student loan assets as the beneficiaries of such
trusts.
F-16
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
Substantially all FFELP loan principal and related accrued interest is
guaranteed as defined by the Higher Education Act. These guarantees are made
subject to the performance of certain loan servicing procedures stipulated by
applicable regulations. If these due diligence procedures are not met, affected
student loans may not be covered by the guarantees should the borrower default.
The Company and its education lending subsidiaries retain and enforce recourse
provisions against servicers and lenders under certain circumstances. Such
student loans are subject to "cure" procedures and reinstatement of the
guarantee under certain circumstances. Also, in accordance with the Student Loan
Reform Act of 1993, student loans disbursed prior to October 1, 1993 are fully
insured, and loans disbursed subsequent to October 1, 1993 are insured up to 98%
of their principal amount and accrued interest, unless serviced by a servicer
who has been designated as an Exceptional Performer by the Department, allowing
these student loans to carry a 100% guarantee.
Student loans receivable also includes non-federally insured loans. The
non-federally insured loan portfolio consists of privately insured and uninsured
loans. The terms of the non-federally insured loans, which vary on an individual
basis, generally provide for repayment in monthly installments of principal and
interest over a period of up to 20 years. Interest rates on the loans will vary
based on the average of the 91-day U.S. Treasury Bill or the prime rate. The
uninsured loans are not covered by guarantees or collateral should the borrower
default. The privately insured loans are insured for 90% of their principal
amount and accrued interest.
During 2004, the Company reclassified FFELP loans, and the related allowance,
that have been rejected for reimbursement by the guarantor to the non-federally
insured loan portfolio, because these loans are effectively uninsured. In the
previous table, the reclassification is reflected for all periods presented.
The Company has provided for an allowance for loan losses related to the
non-federally insured loans and federally insured loans. Activity in the
allowance for loan losses for the years ended December 31, 2004, 2003, and 2002
is shown below:
2004 2003 2002
---------- ----------- ----------
(Dollars in thousands)
Beginning balance $ 16,026 12,000 10,242
Provision for loan losses (529) 11,475 5,587
Loans charged off, net of recoveries (8,225) (7,449) (3,829)
---------- ----------- ----------
Ending balance $ 7,272 16,026 12,000
========== =========== ==========
8. GUARANTY AND INSURANCE AGENCIES
As of December 31, 2004, Nebraska Student Loan Program, Inc., Colorado Student
Loan Program, United Student Aid Funds, Inc., California Student Aid Commission,
and Tennessee Student Assistance Corporation were the primary guarantors of the
student loans beneficially owned by the education lending subsidiaries.
Management periodically reviews the financial condition of its guarantors and
does not believe the level of concentration creates an unusual or unanticipated
credit risk. In addition, management believes that based on amendments to the
Higher Education Act, the security for and payment of any of the education
lending subsidiaries' obligations would not be materially adversely affected as
a result of legislative action or other failure to perform on its obligations on
the part of any guaranty agency. The education lending subsidiaries, however,
offer no absolute assurances to that effect.
An education lending subsidiary also has a student loan indemnification
agreement with a private insurer, under which a portion of the private loans are
insured. The agreement indemnifies the education lending subsidiary for 90% of
losses incurred resulting from borrower default. Upon default, all rights of
recovery are subrogated to a private insurer. As of December 31, 2004 and 2003,
a private insurer insured 31% and 33%, respectively, of the non-federally
insured loans owned by the Company.
F-17
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
9. INTANGIBLE ASSETS AND GOODWILL
Intangible assets as of December 31, 2004 and 2003 consist of the following:
As of December 31,
Useful ----------------------
life 2004 2003
------------ ----------- ----------
(Dollars in thousands)
Lender relationship and loan origination rights
(net of accumulated amortization of $4,376 and
$2,690, respectively) 36-120 months $ 7,505 1,292
Servicing systems software and other intellectual
property (net of accumulated amortization of
$20,294 and $13,273, respectively) 36 months 766 7,787
Intangible assets - EDULINX (net of accumulated
amortization of $61) 60 months 3,716 --
----------- ----------
$ 11,987 9,079
=========== ==========
As discussed in note 4, the purchase price allocation for EDULINX is
preliminary. The excess purchase price over net assets acquired is currently
allocated to existing customer service contracts.
The Company recorded amortization expense on its intangible assets of $8.8
million, $12.8 million, and $22.2 million during the years ended December 31,
2004, 2003, and 2002, respectively. The Company will continue to amortize
intangible assets over their remaining useful lives and estimates it will record
amortization expense as follows (dollars in thousands):
2005 $ 2,313
2006 1,546
2007 1,546
2008 1,546
2009 1,482
2010 and thereafter 3,554
------------
$ 11,987
============
The change in the carrying amount of goodwill for the years ended December 31,
2004 and 2003 was as follows:
2004 2003
---------- ----------
(Dollars in thousands)
Beginning balance $ 2,551 2,551
Goodwill acquired 5,971 --
---------- ----------
Ending balance $ 8,522 2,551
========== ==========
F-18
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
10. FURNITURE, EQUIPMENT, AND LEASEHOLD IMPROVEMENTS
Furniture, equipment, and leasehold improvements as of December 31, 2004 and
2003 consist of the following:
As of December 31,
Useful -----------------------
life 2004 2003
----------- ----------- ----------
(Dollars in thousands)
Computer equipment and software 2-7 years $ 43,873 39,418
Office furniture and equipment 3-10 years 13,730 11,794
Leasehold improvements 1-10 years 7,987 6,073
----------- ----------
65,590 57,285
Accumulated depreciation and amortization 35,720 38,147
----------- ----------
$ 29,870 19,138
=========== ==========
Depreciation and amortization expense for the years ended December 31, 2004,
2003, and 2002 related to furniture, equipment, and leasehold improvements was
$10.6 million, $10.1 million, and $10.1 million, respectively.
11. BONDS AND NOTES PAYABLE
The education lending subsidiaries periodically issue bonds, commercial paper,
short-term variable auction rate notes, taxable student loan asset-backed notes,
and other credit facilities to finance the acquisition of student loans or to
refinance existing debt. Most of the bonds and notes payable are primarily
secured by the student loans receivable, related accrued interest, and by the
amounts on deposit in the accounts established under the respective bond
resolutions or financing agreements. The student loan interest margin ("SLIMS")
notes are secured by the rights to residual cash flows from certain
variable-rate bonds and notes and fixed-rate notes. Certain variable-rate bonds
and notes and fixed-rate bonds of $1.0 billion and $1.2 billion as of December
31, 2004 and 2003, respectively, are secured by financial guaranty insurance
policies issued by Municipal Bond Investors Assurance Corporation and Ambac
Assurance Corporation.
The following table summarizes outstanding bonds and notes payable as of
December 31, 2004 and 2003 by type of instrument:
As of December 31, 2004
------------------------------------------------
Carrying Interest rate
amount range Final maturity
------------------------------------------------
(Dollars in thousands)
Variable-rate bonds and notes:
Bonds and notes based on indices $ 7,449,652 1.84% - 3.25% 11/25/09 - 01/25/41
Bonds and notes based on auction 3,590,920 1.70% - 2.55% 11/01/09 - 07/01/43
-----------
Total variable-rate bonds and notes 11,040,572
Commercial paper and other 2,532,393 2.24% - 2.37% 05/13/05 - 09/02/09
Fixed-rate bonds and notes 712,641 5.20% - 6.68% 05/01/05 - 05/01/29
Other borrowings 15,000 6.00% 11/01/05
-----------
$ 14,300,606
===========
F-19
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
As of December 31, 2003
------------------------------------------------
Carrying Interest rate
amount range Final maturity
------------------------------------------------
(Dollars in thousands)
Variable-rate bonds and notes:
Bonds and notes based on indices $ 3,133,859 1.17% - 1.87% 05/01/07 - 01/25/37
Bonds and notes based on auction 5,195,270 1.00% - 1.30% 11/01/09 - 07/01/43
-------------
Total variable-rate bonds and notes 8,329,129
Commercial paper and other 2,051,738 1.11% - 1.15% 05/14/04 - 06/01/05
Fixed-rate bonds and notes 927,694 5.50% - 6.68% 05/01/05 - 06/01/28
Other borrowings 57,897 1.30% - 6.00% 01/30/04 - 11/01/05
-------------
$ 11,366,458
=============
In January, April, July, and September 2004, the Company consummated debt
offerings of student loan asset-backed notes of $1.0 billion, $1.0 billion, $1.4
billion, and $2.0 billion, respectively, with final maturity dates ranging from
2009 through 2041. The majority of notes issued in these transactions have
variable interest rates based on a spread to LIBOR or reset under auction
procedures. Included in the January 2004 issuance was $210.0 million of notes
with a fixed interest rate that resets August 25, 2005. The Company entered into
a derivative financial instrument to convert this fixed interest rate to a
variable rate until the August 2005 reset date. The proceeds from the September
2004 debt offering were used to redeem $1.7 billion of the Company's student
loan asset-backed auction rate notes.
In July 2004, the Company redeemed a portion of its SLIMS for $47.4 million,
which included a call-premium. The call-premium of $1.9 million and write-off of
the unamortized debt issuance costs of $0.7 million were expensed during the
year ended December 31, 2004 and are included in other operating expenses and
interest on bonds and notes payable, respectively, in the consolidated statement
of income.
The Company has a $35 million operating line of credit and a $50 million
commercial paper commitment under two separate facilities that expire in
September 2005. As of December 31, 2004, there was no amount outstanding under
these facilities. As of December 31, 2003, there was $12.7 million outstanding
under these facilities, which bore interest at the current commercial paper rate
plus 0.25% (weighted average rate of 1.40% as of December 31, 2003).
EDULINX has an unsecured credit facility agreement with a Canadian financial
institution that is cancelable by either party upon demand. The agreement
includes a general security agreement over the assets of EDULINX and its
subsidiary and has a credit limit of approximately $12.5 million ($15.0 million
in Canadian dollars). There was no amount outstanding on this line as of
December 31, 2004.
In May and October 2002, the Company consummated debt offerings of student loan
asset-backed notes of $1.0 billion and $1.2 billion, respectively. In connection
with these debt offerings, the Company entered into agreements with certain
investment banks pursuant to which the Company will pay the investment banks a
fee equal in the aggregate to 0.01% and 0.0075% per annum of the principal
balance of the May and October 2002 notes, respectively. These fees are for
credit enhancements to the notes whereby the investment banks will provide
liquidity advances to the Company in the instance of disintermediation in the
spread between student loan interest rates and the notes' interest rates as
defined in the agreement. The total amount paid by the Company under these
agreements was approximately $115,000, $155,000, and $72,000 during the years
ended December 31, 2004, 2003, and 2002, respectively.
F-20
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
Bonds and notes outstanding as of December 31, 2004 are due in varying amounts
as shown below (dollars in thousands). The student loan warehouse lines are
renewable annually by underlying liquidity providers; therefore, they are
reflected as maturing in 2005.
2005 $ 2,292,443
2006 115,434
2007 93,718
2008 76,800
2009 723,088
2010 and thereafter 10,999,123
------------
$ 14,300,606
============
Generally, bonds bearing interest at variable rates can be redeemed on any
interest payment date at par plus accrued interest. Subject to certain
provisions, all bonds and notes are subject to redemption prior to maturity at
the option of certain education lending subsidiaries.
An education lending subsidiary has irrevocably escrowed funds to make the
remaining principal and interest payments on previously issued bonds and notes.
Accordingly, neither these obligations nor the escrowed funds are included on
the accompanying consolidated balance sheets. As of December 31, 2004 and 2003,
$23.9 million and $22.2 million, respectively, of defeased debt remained
outstanding.
As of December 31, 2004 and 2003, certain education lending subsidiaries had
various short-term borrowing agreements with a maximum aggregate stated amount
of $4.3 billion and $2.8 billion, respectively. The unused commitments under
these warehouse agreements were $1.8 billion and $708 million as of December 31,
2004 and 2003, respectively.
Certain bond resolutions contain, among other requirements, covenants relating
to restrictions on additional indebtedness, limits as to direct and indirect
administrative expenses, and maintaining certain financial ratios. Management
believes the Company is in compliance with all covenants of the bond indentures
and related credit agreements.
12. INCOME TAXES
The provision (benefit) for income taxes for the years ended December 31, 2004,
2003, and 2002 consists of the following components:
2004 2003 2002
-------- --------- ---------
(Dollars in thousands)
Current:
Federal $ 67,616 20,742 33,204
State 5,106 1,750 2,950
-------- --------- ---------
72,722 22,492 36,154
-------- --------- ---------
Deferred:
Federal 11,455 (2,982) (7,717)
State 1,059 (215) (758)
-------- --------- ---------
12,514 (3,197) (8,475)
-------- --------- ---------
$ 85,236 19,295 27,679
======== ========= =========
F-21
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
The differences between the income tax provision computed at the statutory
federal corporate tax rate and the financial statement provision for income
taxes for the years ended December 31, 2004, 2003, and 2002 are shown below:
2004 2003 2002
---------- -------- --------
Tax expense at federal rate 35.0 % 35.0 35.0
Increase (decrease) resulting from:
State tax, net of federal income tax benefit 1.7 2.2 1.9
Non-cash compensation expense -- 3.9 --
Other, net (0.3) 0.6 (0.4)
---------- -------- --------
36.4 % 41.7 36.5
========== ======== ========
The Company's net deferred income tax liability or asset, which is included in
other liabilities and other assets as of December 31, 2004 and 2003,
respectively, consists of the following components:
As of December 31,
---------------------------
2004 2003
----------- -----------
(Dollars in thousands)
Deferred tax liabilities:
Loan origination services $ 14,398 5,819
Prepaid expenses 1,668 --
Certain equity method investments 1,182 161
Depreciation 2,237 599
Other 459 489
----------- ----------
Deferred tax liabilities 19,944 7,068
----------- ----------
Deferred tax assets:
Student loans 3,957 10,539
Accrued expenses 2,187 1,566
Basis in swap contracts 4,793 389
Amortization 6,015 3,185
Other 1,379 1,103
----------- ----------
Deferred tax assets 18,331 16,782
----------- ----------
Net deferred income tax
(liability) asset $ (1,613) 9,714
=========== ==========
No valuation allowance was considered necessary for the deferred tax assets as
of December 31, 2004 and 2003. In assessing the realizability of the Company's
deferred tax assets, management considers whether it is more likely than not
that some portion or all of the deferred tax assets will be realized. The
ultimate realization of deferred tax assets is dependent upon the generation of
future taxable income during the period in which those temporary differences
become deductible. Management considers the scheduled reversals of deferred tax
liabilities, projected taxable income, carryback opportunities, and tax planning
strategies in making the assessment of the amount of the valuation allowance.
As of December 31, 2004 and 2003, income taxes (payable) receivable of $(10.9)
million and $1.7 million, respectively, are included in other liabilities and
other assets on the consolidated balance sheets, respectively.
F-22
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
13. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table summarizes the fair values of the Company's financial
instruments as of December 31, 2004 and 2003:
As of December 31,
---------------------------------------------------------
2004 2003
---------------------------- ---------------------------
Fair value Carrying value Fair value Carrying value
------------ -------------- ------------ --------------
(Dollars in thousands)
Financial assets:
Student loans receivable $13,757,289 13,461,814 10,628,895 10,455,442
Cash and cash equivalents 39,989 39,989 198,423 198,423
Restricted cash 732,066 732,066 634,263 634,263
Restricted investments 281,829 281,829 180,668 180,688
Restricted cash - due to loan
program customers 249,070 249,070 141,841 141,841
Accrued interest receivable 251,104 251,104 196,633 196,633
Financial liabilities:
Bonds and notes payable 14,331,925 14,300,606 11,417,810 11,366,458
Accrued interest payable 48,578 48,578 17,179 17,179
Due to loan program customers 249,070 249,070 141,841 141,841
Derivative instruments 11,895 11,895 677 677
CASH AND CASH EQUIVALENTS, RESTRICTED CASH - DUE TO LOAN PROGRAM CUSTOMERS,
RESTRICTED CASH, ACCRUED INTEREST RECEIVABLE/PAYABLE, AND DUE TO LOAN PROGRAM
CUSTOMERS
The carrying amount approximates fair value due to the variable rate of interest
and/or the short maturities of these instruments.
STUDENT LOANS RECEIVABLE
The fair value of student loans receivable is estimated at amounts recently paid
by the Company to acquire a similar portfolio of loans in the market.
RESTRICTED INVESTMENTS
Due to the characteristics of the investments, there is no available or active
market for these types of financial instruments. These investments are
guaranteed and are purchased and redeemed at par value, which equals their cost.
BONDS AND NOTES PAYABLE
The fair value of the bonds and notes payable is based on market prices for
securities that possess similar credit risk and interest rate risk.
DERIVATIVE INSTRUMENTS
The fair value of the derivative instruments, obtained from market quotes from
independent security brokers, was the estimated net amount that would have been
paid or received to terminate the respective agreements.
LIMITATIONS
The fair value of a financial instrument is the current amount that would be
exchanged between willing parties, other than in a forced liquidation. Fair
value is best determined based upon quoted market prices. However, in many
instances, there are no quoted market prices for the Company's various financial
instruments. In cases where quoted market prices are not available, fair values
are based on estimates using present value or other valuation techniques. Those
techniques are significantly affected by the assumptions used, including the
discount rate and estimates of future cash flows. Accordingly, the fair value
estimates may not be realized in an immediate settlement of the instrument. SFAS
No. 107, Disclosures About Fair Value of Financial Instruments, excludes certain
financial instruments and all nonfinancial instruments from its disclosure
requirements.
F-23
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
14. DERIVATIVE FINANCIAL INSTRUMENTS
The Company maintains an overall interest rate risk management strategy that
incorporates the use of derivative instruments to minimize the economic effect
of interest rate volatility. The Company's goal is to manage interest rate
sensitivity by modifying the repricing or maturity characteristics of certain
balance sheet assets and liabilities so that the net interest margin is not, on
a material basis, adversely affected by movements in interest rates. The Company
views this strategy as a prudent management of interest rate sensitivity. The
Company accounts for derivative instruments under SFAS No. 133, which requires
that every derivative instrument be recorded on the balance sheet as either an
asset or liability measured at its fair value. Management has structured all of
the Company's derivative transactions with the intent that each is economically
effective; however, the majority do not qualify for hedge accounting under SFAS
No. 133.
By using derivative instruments, the Company is exposed to credit and market
risk. If the counterparty fails to perform, credit risk is equal to the extent
of the fair value gain in a derivative. When the fair value of a derivative
contract is positive, this generally indicates that the counterparty owes the
Company. When the fair value of a derivative contract is negative, the Company
owes the counterparty and, therefore, it has no credit risk. The Company
minimizes the credit (or repayment) risk in derivative instruments by entering
into transactions with high-quality counterparties that are reviewed
periodically by the Company's risk committee. The Company also maintains a
policy of requiring that all derivative contracts be governed by an
International Swaps and Derivative Association Master Agreement.
Market risk is the adverse effect that a change in interest rates, or implied
volatility rates, has on the value of a financial instrument. The Company
manages market risk associated with interest rates by establishing and
monitoring limits as to the types and degree of risk that may be undertaken.
The following table summarizes the notional values and fair values of the
Company's outstanding derivative instruments as of December 31, 2004:
Weighted average
Fixed/ Floating/ fixed rate on
floating Basis fixed fixed/floating
Maturity swaps (a) swaps (b) swaps (c) Total swaps
- ------------------------- --------- --------- --------- -------- -------------
(Dollars in millions)
2005 $ 1,187 1,000 210 2,397 2.20 %
2006 613 500 -- 1,113 2.99
2007 512 -- -- 512 3.42
2008 463 -- -- 463 3.76
2009 312 -- -- 312 4.01
2010 1,138 -- -- 1,138 4.25
-------- -------- -------- -------- ---------
Total $ 4,225 1,500 210 5,935 3.32 %
======== ======== ======== ======== =========
Fair value (d)
(dollars in thousands) $(7,763) (2,769) (1,363) (11,895)
======== ======== ======== ========
------------------------------------
(a) A fixed/floating swap is an interest rate swap in which the Company
agrees to pay a fixed rate in exchange for a floating rate. The interest
rate swap converts a portion of the Company's variable-rate debt (equal
to the notional amount of the swap) to a fixed rate for a period of time
fixing the relative spread between a portion of the Company's student
loan assets and the converted fixed-rate liability.
(b) A basis swap is an interest rate swap agreement in which the Company
agrees to pay a floating rate in exchange for another floating rate,
based upon different market indices. The Company has employed basis
swaps to limit its sensitivity to dramatic fluctuations in the
underlying indices used to price a portion of its variable-rate assets
and variable-rate debt.
(c) A floating/fixed swap is an interest rate swap in which the Company
agrees to pay a floating rate in exchange for a fixed rate. The interest
rate swap converts a portion of the Company's fixed-rate debt (equal to
the notional amount of the swap) to a floating rate for a period of
time.
(d) Fair value is determined from market quotes from independent security
brokers. Fair value indicates an estimated amount the Company would
receive (pay) if the contracts were cancelled or transferred to other
parties.
F-24
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
The Company accounts for derivative instruments under SFAS No. 133, which
requires that every derivative instrument be recorded on the balance sheet as
either an asset or liability measured at its fair value. Management has
structured all of the Company's derivative transactions with the intent that
each is economically effective. As more fully described below, if certain
criteria are met, derivative instruments are classified and accounted for by the
Company as either fair value or cash flow hedges. If these criteria are not met,
the derivative financial instruments are accounted for as trading.
FAIR VALUE HEDGES
As of December 31, 2004, there were no outstanding derivative instruments
accounted for as fair value hedges.
CASH FLOW HEDGES
Cash flow hedges are generally used by the Company to hedge the exposure of
variability in cash flows of a forecasted debt issuance. This strategy is used
primarily to minimize the exposure to volatility from future interest rate
changes. Gains and losses on the effective portion of a qualifying hedge are
accumulated in other comprehensive income (net of tax) and reclassified to
current period earnings over the period in which the stated hedged transactions
impact earnings. Ineffectiveness is recorded immediately to earnings.
The Company accounts for one interest rate swap with a notional amount of $150
million that matures in September 2005 as a cash flow hedge. As of December 31,
2004 and 2003, the fair market value for this derivative was $1.2 million and
$0.5 million, respectively. The following table shows the components of the
change in accumulated other comprehensive income, net of tax, related to this
interest rate swap for the years ended December 31, 2004 and 2003:
2004 2003
--------- ---------
(Dollars in thousands)
Beginning balance $ 237 --
Change in fair value of cash flow hedge 443 311
Hedge ineffectiveness reclassified to earnings 56 (74)
--------- ---------
Total change in unrealized gain on derivative 499 237
--------- ---------
Ending balance $ 736 237
========= =========
The deferred gains for this derivative accumulated in other comprehensive income
that are expected to be reclassed to earnings during the next 12 months are not
material to the consolidated financial statements.
TRADING ACTIVITIES
When instruments do not qualify as hedges under SFAS No. 133, they are accounted
for as trading. All outstanding derivative instruments, with the one exception
noted previously, are accounted for as trading. The change in fair value of
trading derivative instruments is recorded in the consolidated statements of
income at each reporting date. In addition, the net settlements on these
derivatives are included with the derivative market value adjustment on the
consolidated statements of income.
The following is a summary of the amounts included in derivative market value
adjustment and net settlements on the consolidated income statements for the
years ended December 31, 2004, 2003, and 2002:
2004 2003 2002
---------- -------- --------
(Dollars in thousands)
Change in fair value of derivative instruments $ (11,918) (1,183) 2,962
Settlements, net (34,140) (1,601) (3,541)
---------- -------- --------
Derivative market value adjustment and
net settlements $ (46,058) (2,784) (579)
========== ======== ========
F-25
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
15. EMPLOYEE BENEFIT PLANS
DEFINED CONTRIBUTION PLANS
The Company has a 401(k) savings plan that covers substantially all of its U.S.
employees. Employees may contribute up to 100% of their pre-tax salary, subject
to IRS limitations. The Company made contributions to the plan of $2.1 million,
$1.7 million, and $1.4 million during the years ended December 31, 2004, 2003,
and 2002, respectively. Union Bank & Trust Company ("UB&T"), an entity under
common control with the Company, serves as the trustee for the plan.
EFS, Inc., a wholly owned subsidiary of the Company, maintained two retirement
plans which covered substantially all its employees. The first was a 401(k)
savings plan and the second was a defined contribution pension plan, which is an
employee stock ownership plan ("ESOP"). Upon acquisition by the Company, the
ESOP sold its shares to the Company and distribution of the cash occurred in
2003. EFS, Inc. made contributions to the plan of approximately $208,000 for the
year ended December 31, 2002. Effective April 1, 2002, employees participating
in the EFS, Inc. 401(k) savings plan became eligible to participate in the
Company's 401(k) plan.
EDULINX has a deferred profit sharing plan under which employees are entitled to
benefits as a function of base salary, age, and years of service. Permanent
full-time and permanent part-time employees may join the plan after 12 months of
continuous service. For the period from December 1, 2004 to December 31, 2004,
EDULINX made contributions to the plan of approximately $89,000.
EMPLOYEE SHARE PURCHASE PLAN
The Company has an employee share purchase plan pursuant to which employees are
entitled to purchase common stock from payroll deductions at a 15% discount from
market value. The employee share purchase plan is intended to enhance the
Company's ability to attract and retain employees and to better enable such
persons to participate in the Company's long-term success and growth.
A total of 1,000,000 Class A common stock shares are reserved for issuance under
the employee share purchase plan, subject to equitable adjustment by the
compensation committee in the event of stock dividends, recapitalizations, and
other similar corporate events. All employees, other than those whose customary
employment is 20 hours or less per week, who have been employed for at least six
months, or another period determined by the Company's compensation committee not
in excess of two years, are eligible to purchase Class A common stock under the
plan. During the year ended December 31, 2004, the Company recognized
compensation expense of approximately $150,000 in connection with issuing 18,844
shares under this plan.
RESTRICTED STOCK PLAN
The Company has a restricted stock plan that is intended to provide incentives
to attract, retain, and motivate employees in order to achieve long-term growth
and profitability objectives. The restricted stock plan provides for the grant
to eligible employees of awards of restricted shares of Class A common stock. An
aggregate of 1,000,000 shares of Class A common stock have been reserved for
issuance under the restricted stock plan, subject to antidilution adjustments in
the event of certain changes in capital structure.
On September 10, 2004, the Company issued 4,300 shares of its Class A common
stock under the restricted stock plan. These shares vest at the end of two
years. In December 2004, 350 shares of this issuance were forfeited. The
unearned compensation of approximately $77,000 recorded in shareholders' equity
on the consolidated balance sheet as of December 31, 2004 will be recognized as
expense over the remaining vesting period. For the year ended December 31, 2004,
the Company recognized compensation expense of approximately $17,000 related to
shares issued under the restricted stock plan.
BOOK VALUE STOCK PLAN
In March 2003, the Company issued 331,800 shares of Class A common stock at a
formula price based on book value to employees of the Company. Each new
shareholder was required to sign a shareholder agreement that restricts the
sale, assignment, pledge, or otherwise transfer of any interest in any of the
shares of stock without obtaining the prior written consent of the holders of an
aggregate of more than 50% of the Class A shareholders. The Company has the
option to redeem the outstanding stock in the event of termination of
employment, divorce, or change in control at the formula price based on book
value at the redemption date.
The Company accounted for the stock issuance by applying the provisions of
Emerging Issues Task Force ("EITF") 88-6, Book Value Stock Plans in an Initial
Public Offering ("EITF 88-6"). Because the shareholder agreements did not
provide any mechanism that converted the book value stock to market value stock
upon completion of an initial public offering ("IPO"), the Company accounted for
the transaction as book value stock that remains book value stock. The book
value stock issued in March 2003 was presumed to have been issued in
contemplation of the IPO and, thus, was subject to variable-plan accounting for
actual changes in the book value of those shares from the date of issuance in
accordance with the provisions of EITF 88-6.
F-26
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
Upon the consummation of the IPO, the shareholder agreements were terminated in
accordance with an agreement entered into by all shareholders in August 2003. As
a result, in the third quarter of 2003, the Company recognized a compensation
charge of $5.2 million equal to the difference between the estimated IPO price
(estimated fair value) of that number of shares and the total price paid by the
employees.
DIRECTOR'S STOCK COMPENSATION PLAN
The Company has a share-based compensation plan for nonemployee directors
pursuant to which nonemployee directors can elect to receive their annual
retainer fees in the form of cash or Class A common stock. Up to 100,000 shares
may be issued under the plan, subject to antidilution adjustments in the event
of certain changes in capital structure. If a nonemployee director elects to
receive Class A common stock, the number of shares of Class A common stock that
will be awarded will be equal to the amount of the annual retainer fee otherwise
payable in cash divided by 85% of the fair market value of a share of Class A
common stock on the date the fee is payable. Nonemployee directors who choose to
receive Class A common stock may also elect to defer receipt of the Class A
common stock until termination of their service on the board of directors. Any
dividends paid in respect of deferred shares during the deferral period will
also be deferred in the form of additional shares and paid out at termination
from the board of directors. The plan may be amended or terminated by the board
of directors at any time, but no amendment or termination will adversely affect
a nonemployee director's rights with respect to previously deferred shares
without the consent of the nonemployee director.
On February 19, 2004, the Company issued 22,409 shares of its Class A common
stock under the plan. These shares were issued in consideration for the board
members' 2004 annual retainer fees. For the year ended December 31, 2004, the
Company recognized approximately $529,000 of expense related to these shares.
NON-PENSION POST-RETIREMENT BENEFIT PLANS
EDULINX has non-pension post-retirement plans that consist of health care and
life insurance plans. As of December 31, 2004, a liability related to these
plans of $1.1 million is included in other liabilities on the accompanying
consolidated balance sheets.
16. COMMITMENTS
The education lending subsidiaries acquire eligible loans on a regular basis
from lending institutions as part of their normal business operations. As of
December 31, 2004 and 2003, the education lending subsidiaries were committed to
extend credit or to purchase up to $265.5 million and $287.4 million,
respectively, in student loans at current market rates upon the sellers' request
under various agreements. Commitments to extend credit are agreements to lend to
a borrower as long as there is no violation of any condition established in the
commitment agreement. Commitments generally have fixed expiration dates or other
termination clauses.
The Company is committed under noncancelable operating leases for office and
warehouse space and equipment. Total rental expense incurred by the Company for
the years ended December 31, 2004, 2003, and 2002 was $7.2 million, $6.1
million, and $6.9 million, respectively. Minimum future rentals under
noncancelable operating leases are shown below (dollars in thousands):
2005 $ 5,879
2006 4,904
2007 4,156
2008 2,075
2009 1,269
2010 and thereafter 673
--------
$18,956
========
17. RELATED PARTIES
The Company serviced loans for UB&T, an entity under common control with the
Company, of $469 million and $544 million as of December 31, 2004 and 2003,
respectively. Income earned by the Company from servicing loans for UB&T for the
years ended December 31, 2004, 2003, and 2002 was $5.4 million, $5.4 million,
and $5.5 million, respectively. As of December 31, 2004 and 2003, accounts
receivable includes $0.6 million and $1.1 million, respectively, from UB&T for
loan servicing. The loan servicing terms with UB&T were similar to those terms
with unrelated entities.
F-27
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
The Company participates in the Short-Term Federal Investment Trust ("STFIT") of
the Student Loan Trust Division of UB&T, which is included in cash and cash
equivalents held at a related party and restricted cash - due to loan program
customers on the accompanying consolidated balance sheets. As of December 31,
2004 and 2003, the Company had approximately $245.9 million and $71.1 million,
respectively, invested in the STFIT or deposited at UB&T in operating accounts,
of which approximately $210.8 million and $60.9 million, respectively, is cash
collected for customers. The Company's participation in the STFIT had similar
terms and investment yields as those prevailing for other nonaffiliated
customers. Interest income earned by the Company on the amounts invested in the
STFIT for the years ended December 31, 2004, 2003, and 2002 was $1.6 million,
$1.0 million, and $1.7 million, respectively.
During the years ended December 31, 2004, 2003, and 2002, the education lending
subsidiaries purchased student loans of $657.8 million, $726.0 million, and
$377.8 million, respectively, from UB&T. Premiums paid on these loans totaled
$13.6 million, $9.5 million, and $6.4 million, respectively. The purchases from
UB&T were made on terms similar to those made with unrelated entities. During
the years ended December 31, 2004, 2003, and 2002, UB&T reimbursed the Company
$0.9 million, $1.0 million, and $0.5 million, respectively, for student loan
marketing services. The Company has sold to UB&T, as trustee, participation
interests with balances of approximately $272.8 million and $223.4 million as of
December 31, 2004 and 2003, respectively. During the years ended December 31,
2004 and 2003, UB&T reimbursed the Company $1.3 million and $0.5 million,
respectively, and during the year ended December 31, 2002, the Company
reimbursed UB&T $0.2 million for marketing services and fees related to the
Nebraska College Savings Plan.
During the years ended December 31, 2004 and 2002, UB&T paid the Company
marketing income of $0.5 million and $2.3 million, respectively, as a broker on
a loan sale, which is included in software services and other income in the
accompanying consolidated statements of income. No amount was paid during the
year ended December 31, 2003.
The Company incurred a consulting management fee for services provided by an
entity that is a minority stockholder of the Company. The Company incurred
management fee expenses of $1.7 million and $1.8 million for the years ended
December 31, 2003 and 2002, respectively. This agreement terminated in 2003.
In 2004, the Company recorded a one-time gain of $3.0 million related to the
sale of a fixed asset to an entity, of which a principal shareholder is a
director of the Company. The gain is included in software services and other
income in the accompanying consolidated statement of income.
As of December 31, 2004, $510,000 was receivable from Nelnet Mentor LLC, an
entity with 50% interest owned by the Company, and is included in other
liabilities in the accompanying consolidated balance sheet.
Premiere, an entity with 50% interest owned by the Company, provides the Company
with certain collection services. During the year ended December 31, 2004, the
Company incurred collection fee expenses of approximately $121,000 for these
services, which is included in other operating expenses in the accompanying
consolidated statement of income. The Company also provided a $1.0 million
operating line of credit to Premiere in June 2004 that is automatically
renewable for 1 year terms. As of December 31, 2004, Premiere owed the Company
approximately $879,000 under this line of credit, which is included in other
assets in the accompanying consolidated balance sheet.
The Company has an agreement with 5280 Solutions, Inc. ("5280"), an entity with
50% voting interest owned by the Company, to provide certain software
development and technology support services. During the years ended December 31,
2004, 2003, and 2002, the Company paid 5280 fees of $3.9 million, $3.2 million,
and $6.1 million, respectively, for these services, which is included in
salaries and benefits expense in the accompanying consolidated statements of
income. As of December 31, 2004 and 2003, approximately $360,000 and $496,000,
respectively, was payable to 5280 and is included in other liabilities in the
accompanying consolidated balance sheets.
The Company has an agreement with FirstMark Services LLC ("FirstMark"), an
entity with 50% voting interest owned by the Company, whereby FirstMark has
agreed to provide subcontracting servicing functions on the Company's behalf
with respect to private loan servicing. During the years ended December 31,
2004, 2003, and 2002, the Company paid FirstMark fees of $6.5 million, $5.5
million, and $4.6 million, respectively. The Company also provides a $2.5
million operating line of credit to FirstMark that is automatically renewable
for 1 year terms. As of December 31, 2004, no amounts were owed under this line
of credit. As of December 31, 2003, FirstMark owed the Company $565,000 under
this line of credit, which is included in other assets in the accompanying
consolidated balance sheet.
During the years ended December 31, 2003 and 2002, the Company paid Nelnet
Capital $1.4 million each for services related to financings. All payments were
made before the acquisition of Nelnet Capital. These payments have been recorded
as debt issuance costs and are included in other assets in the accompanying
consolidated balance sheets.
F-28
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
During the year ended December 31, 2002, the Company incurred consulting fees of
$1.7 million for services provided by a related party through common ownership
in connection with eligible loan purchases. This agreement terminated in 2003.
In addition, during the years ended December 31, 2003 and 2002, the Company
incurred consulting fees of $1.8 million and $2.4 million, respectively, for
services provided by a significant shareholder. This agreement terminated in
2003.
18. CONDENSED PARENT COMPANY FINANCIAL STATEMENTS
The following represents the condensed balance sheets as of December 31, 2004
and 2003 and condensed statements of income and cash flows for each of the years
in the three-year period ended December 31, 2004 for Nelnet, Inc.
The Company is limited in the amount of funds that can be transferred to it by
its subsidiaries through intercompany loans, advances, or cash dividends. These
limitations relate to the restrictions by trust indentures under the education
lending subsidiaries debt financing arrangements. The amounts of cash and
investments restricted in the respective reserve accounts of the education
lending subsidiaries are shown on the consolidated balance sheets as restricted
cash and investments.
BALANCE SHEETS
(Parent Company Only)
As of December 31,
------------------------
2004 2003
----------- ---------
(Dollars in thousands)
Assets:
Cash and cash equivalents $ 9,504 157,723
Restricted cash 10,018 --
Restricted cash - due to loan program customers 249,070 141,841
Investment in subsidiaries 413,136 135,035
Accounts receivable 20,920 20,714
Other assets 9,474 19,008
----------- ---------
Total assets $ 712,122 474,321
=========== =========
Liabilities:
Notes payable $ -- 12,662
Other liabilities 6,877 14,329
Due to loan program customers 249,070 141,841
----------- ---------
Total liabilities 255,947 168,832
----------- ---------
Shareholders' equity:
Common stock 537 536
Additional paid-in capital 207,915 206,831
Retained earnings 247,064 97,885
Unearned compensation (77) --
Accumulated other comprehensive income 736 237
----------- ---------
Total shareholders' equity 456,175 305,489
----------- ---------
Total liabilities and shareholders' equity $ 712,122 474,321
=========== =========
STATEMENTS OF INCOME
(Parent Company Only)
Year ended December 31,
------------------------------
2004 2003 2002
--------- -------- --------
(Dollars in thousands)
Operating revenues $ 161,988 146,952 118,189
Derivative market value adjustment and
net settlements (39,705) -- --
Operating expenses 116,257 118,815 109,853
-------- -------- --------
Net operating income 6,026 28,137 8,336
Net interest income 1,505 740 1,515
Equity in earnings of subsidiaries 147,909 12,076 42,137
Income tax expense 6,261 13,850 3,450
-------- -------- --------
Net income $ 149,179 27,103 48,538
======== ======== ========
F-29
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
STATEMENTS OF CASH FLOWS
(Parent Company Only)
Year ended December 31,
------------------------------------
2004 2003 2002
----------- ---------- ----------
(Dollars in thousands)
Cash flows from operating activities:
Net income $ 149,179 27,103 48,538
Adjustments to reconcile net income to net cash
provided by operating activities,
net of business acquisitions:
Depreciation and amortization 240 870 10,635
Derivative market value adjustment 5,679 -- --
Ineffectiveness of cash flow hedge 89 -- --
Noncash compensation expense 696 5,166 --
Equity in earnings of subsidiaries (147,909) (12,076) (42,137)
Income from equity method investment 22 -- --
Decrease in accounts receivable (206) (563) (6,564)
Decrease (increase) in other assets 14,697 10,277 (1,181)
Increase (decrease) in other liabilities (21,798) 1,617 (3,294)
----------- ---------- ----------
Net cash provided by operating activities 689 32,394 5,997
----------- ---------- ----------
Cash flows from investing activities:
Increase in restricted cash (10,018) -- --
Cash received on sale of subsidiary -- -- 6,051
Business acquisitions, net of cash acquired -- (1,760) (1,776)
Purchase of preferred stock of affiliate -- -- (10,000)
Purchase of equity method investment (5,250) -- --
Capital contributions to/from subsidiary, net (121,115) (50,571) --
----------- ---------- ----------
Net cash flows used in investing activities (136,383) (52,331) (5,725)
----------- ---------- ----------
Cash flows from financing activities:
Payments on note payable (12,662) --
Proceeds from issuance of note payable -- 12,662 --
Payment of debt issuance costs (175) -- --
Redemption of common stock -- (643) --
Net proceeds from issuance of common stock 312 164,504 --
----------- ---------- ----------
Net cash flows provided by (used in)
financing activities (12,525) 176,523 --
----------- ---------- ----------
Net increase (decrease) in cash and
cash equivalents (148,219) 156,586 272
Cash and cash equivalents, beginning of year 157,723 1,137 865
----------- ---------- ----------
Cash and cash equivalents, end of year $ 9,504 157,723 1,137
=========== ========== ==========
Supplemental cash flow information:
Income taxes paid, net of refunds $ 17,056 21,635 6,677
=========== ========== ==========
Interest paid $ 570 124 --
=========== ========== ==========
F-30
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
19. SEGMENT REPORTING
The Company is a vertically integrated education finance organization that has
three operating segments as defined in SFAS No. 131, Disclosures about Segments
of an Enterprise and Related Information ("SFAS No. 131"), as follows: Asset
Management, Student Loan and Guarantee Servicing, and Servicing Software. The
accounting policies of the reportable segments are the same as those described
in the summary of significant accounting policies. Costs excluded from segment
net income before taxes consist of unallocated corporate expenses, net of
miscellaneous revenues. Thus, net income before taxes of the segments includes
only the costs that are directly attributable to the operations of the
individual segment.
The Asset Management segment includes the acquisition, management, and ownership
of the student loan assets. Revenues are primarily generated from net interest
income on the student loan assets. The Company generates student loan assets
through direct origination or through acquisitions. The student loan assets are
held in a series of education lending subsidiaries designed specifically for
this purpose.
The Student Loan and Guarantee Servicing segment provides for the servicing of
the Company's student loan portfolios and the portfolios of third parties and
servicing provided to guaranty agencies. The student loan servicing activities
include application processing, borrower updates, payment processing, due
diligence procedures, and claim processing. These activities are performed
internally for the Company's own portfolio in addition to generating fee revenue
when performed for third-party clients. The guarantee servicing activities
include providing systems software, hardware and telecommunications support,
borrower and loan updates, default aversion tracking services, claim processing
services, and post-default collection services to guaranty agencies.
The Servicing Software segment provides software licenses and maintenance
associated with student loan software products.
Substantially all of the Company's revenues are earned from customers in the
United States and no single customer accounts for a significant amount of any
reportable segment's revenues. Intersegment revenues are charged by a segment to
another segment that provides the product or service. The amount of intersegment
revenue is based on comparable fees charged in the market.
Segment data is as follows:
Student loan
Asset and guarantee Servicing Total
management servicing software segments
---------- ----------- --------- --------
(Dollars in thousands)
Year ended December 31, 2004:
Net interest income $ 396,095 1,377 7 397,479
Other income (expense) (40,056) 99,899 8,051 67,894
Intersegment revenues -- 87,673 3,932 91,605
---------- ----------- ---------- ---------
Total revenue 356,039 188,949 11,990 556,978
Recovery for loan losses (529) -- -- (529)
Depreciation and amortization 1,333 280 7,070 8,683
Net income (loss) before taxes $ 223,139 54,178 (2,286) 275,031
========== =========== ========== =========
F-31
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
Student loan
Asset and guarantee Servicing Total
management servicing software segments
----------- ----------- ------------ -----------
(Dollars in thousands)
Year ended December 31, 2003:
Net interest income $ 176,471 740 10 177,221
Other income 568 104,876 8,753 114,197
Intersegment revenues -- 65,596 2,708 68,304
----------- ----------- ------------ -----------
Total revenue 177,039 171,212 11,471 359,722
Provision for loan losses 11,475 -- -- 11,475
Depreciation and amortization 3,473 872 7,131 11,476
Net income (loss) before taxes $ 51,611 34,775 (3,394) 82,992
=========== =========== ============ ===========
Student loan
Asset and guarantee Servicing Total
management servicing software segments
------------ ------------- ---------- -----------
(Dollars in thousands)
Year ended December 31, 2002:
Net interest income $ 184,796 1,427 42 186,265
Other income 3,278 102,888 5,387 111,553
Intersegment revenues -- 55,217 1,553 56,770
----------- ----------- ------------ ------------
Total revenue 188,074 159,532 6,982 354,588
Provision for loan losses 5,587 -- -- 5,587
Depreciation and amortization 3,473 12,428 6,358 22,259
Net income (loss) before taxes $ 86,991 13,344 (9,129) 91,206
=========== =========== ============ ============
2004 2003
------------ -----------
(Dollars in thousands)
Segment total assets:
Asset management $ 14,808,684 11,502,354
Student loan and guarantee
servicing 334,181 334,965
Servicing software 5,934 12,508
------------- ------------
Total segments $ 15,148,799 11,849,827
============= ============
Reconciliation of segment data to the consolidated financial statements is as
follows.
2004 2003 2002
----------- --------- ---------
(Dollars in thousands)
Total segment revenues $ 556,978 359,722 354,588
Elimination of intersegment revenues (91,605) (68,304) (56,770)
Corporate revenues (expenses), net 11,264 (504) 14,573
----------- --------- ---------
Total consolidated revenues $ 476,637 290,914 312,391
=========== ========= =========
Total net income before taxes of segments $ 275,031 82,992 91,206
Corporate expenses, net (40,616) (36,703) (15,365)
----------- --------- ---------
Total consolidated net
income before taxes $ 234,415 46,289 75,841
=========== ========= =========
F-32
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
2004 2003
------------ ------------
(Dollars in thousands)
Total segment assets $ 15,148,799 11,849,827
Elimination of intercompany assets (39,213) (30,140)
Assets of other operating activities 50,419 101,058
Income tax receivable and net
deferred tax asset -- 11,441
------------ ------------
Total consolidated assets $ 15,160,005 11,932,186
============ ============
Net corporate revenues included in the previous tables are from activities that
are not related to the three identified operating segments, such as investment
earnings and revenue for marketing services. The net corporate expenses include
expenses for marketing and other unallocated support services. The net
corporate revenues and expenses are not associated with an ongoing business
activity as defined by SFAS No. 131 and, therefore, have not been included
within the operating segments.
The assets held at the corporate level are not identified with any of the
operating segments. Accordingly, these assets are included in the reconciliation
of segment assets to total assets. These assets consist primarily of cash,
investments, furniture, equipment, leasehold improvements, and other assets.
20. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
2004
-------------------------------------------------
First Second Third Fourth
quarter quarter quarter quarter
----------- ----------- ----------- -----------
(Dollars in thousands)
Net interest income $ 43,335 175,228 89,405 90,198
Less provision (recovery) for loan losses 3,115 (6,421) 2,300 477
----------- ----------- ----------- -----------
Net interest income after provision
(recovery) for loan 40,220 181,649 87,105 89,721
Derivative market value adjustment and
net settlements (3,741) 1,357 (56,214) 12,540
Other income 31,287 27,541 32,558 33,143
Operating expenses (53,212) (76,196) (51,502) (61,841)
Income tax expense (5,433) (49,098) (4,310) (26,395)
----------- ----------- ----------- -----------
Net income $ 9,121 85,253 7,637 47,168
=========== =========== =========== ===========
Earnings per share, basic and diluted $ 0.17 1.59 0.14 0.88
=========== =========== =========== ===========
2003
-------------------------------------------------
First Second Third Fourth
quarter quarter quarter quarter
------------------------ ----------- ----------
(Dollars in thousands)
Net interest income $ 42,258 45,190 40,981 43,293
Less provision for loan losses 2,410 2,450 4,015 2,600
----------- ----------- ----------- ----------
Net interest income after provision for
loan losses 39,848 42,740 36,966 40,693
Derivative market value adjustment and
net settlements -- -- (5,655) 2,871
Other income 30,477 28,871 31,652 30,976
Operating expenses (55,234) (57,445) (62,269) (58,202)
Income tax expense (5,622) (5,840) (1,827) (6,006)
Minority interest in net loss of subsidiary 109 -- -- --
----------- ----------- ----------- ----------
Net income (loss) $ 9,578 8,326 (1,133) 10,332
=========== =========== =========== ==========
Earnings per share, basic and diluted $ 0.21 0.19 (0.03) 0.22
=========== =========== =========== ==========
F-33
NELNET, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
21. SUBSEQUENT EVENT
On February 4, 2005, the Company entered into an agreement to amend certain
existing contracts with UB&T, an entity under common control with the Company.
Under the agreement, UB&T agreed to sell to the Company, prior to March 1, 2005,
a portfolio of guaranteed student loans with an aggregate outstanding balance of
approximately $600 million. The Company agreed to pay the outstanding principal
and accrued interest with respect to the student loans to be purchased, together
with a one-time payment to UB&T in the amount of $20 million. UB&T also
committed to transfer to the Company substantially all of the remaining balance
of UB&T's origination rights in guaranteed student loans to be originated in the
future, except for student loans previously committed for sale to others. UB&T
will continue to originate student loans, and such guaranteed student loans not
previously committed for sale to others are to be sold by UB&T to the Company in
the future. UB&T also granted to the Company exclusive rights as marketing agent
for student loans on behalf of UB&T.
F-34
APPENDIX A
THE FEDERAL FAMILY EDUCATION LOAN PROGRAM
The Federal Family Education Loan Program
The Higher Education Act of 1965, as amended (the "Higher Education Act")
provides for a program of direct federal insurance for student loans as well as
reinsurance of student loans guaranteed or insured by state agencies or private
non-profit corporations.
The Higher Education Act currently authorizes certain student loans to be
covered under the Federal Family Education Loan Program ("FFELP" or "FFEL
Program") of the U.S. Department of Education (the "Department"). The 1998
Amendments to the Higher Education Act extended the authorization for the FFEL
Program through September 30, 2004. In October 2004, Congress passed a one-year
extension of the Higher Education Act through September 30, 2005. Congress has
extended similar authorization dates in prior versions of the Higher Education
Act. However, the current authorization dates may not again be extended and the
other provisions of the Higher Education Act may not be continued in their
present form.
Generally, a student is eligible for loans made under the FFEL Program only
if he or she:
o has been accepted for enrollment or is enrolled in good standing at an
eligible institution of higher education;
o is carrying or planning to carry at least one-half the normal full-time
workload, as determined by the institution, for the course of study the
student is pursuing;
o is not currently in default on any federal education loan; and
o meets other applicable requirements.
Eligible institutions include higher educational institutions and vocational
schools that comply with specific federal regulations. Each loan is to be
evidenced by an unsecured note.
The Higher Education Act also establishes maximum interest rates for each of
the various types of loans. These rates vary not only among loan types, but also
within loan types depending upon when the loan was made or when the borrower
first obtained a loan under the FFEL Program. The Higher Education Act allows
lesser rates of interest to be charged.
Regulations authorize the Department to limit, suspend or terminate lenders'
participation in the FFEL Program, as well as to impose civil penalties, if
lenders violate certain program regulations. The regulations also authorize the
Department to impose penalties on the servicer and/or limit, suspend or
terminate the servicer's eligibility to contract to service FFELP loans if the
servicer fails to meet standards of financial responsibility or administrative
capability included in the regulations or violates certain other FFELP
requirements. The Department conducts frequent on-site audits of the Company's
loan servicing activities. Guaranty agencies conduct similar audits on a regular
basis. In addition, the Company engages independent third parties to conduct
compliance reviews, as required by the Department, with respect to the Company's
own student loan portfolio and the portfolios of the Company's third-party
servicing clients.
Types of Loans
Four types of loans are currently available under the FFEL Program:
o Subsidized Stafford loans,
o Unsubsidized Stafford loans,
o PLUS loans, and
o Consolidation loans.
These loan types vary as to eligibility requirements, interest rates, repayment
periods, loan limits and eligibility for interest subsidies and special
allowance payments. Some of these loan types have had other names in the past.
References to these various loan types include, where appropriate, their
predecessors.
A-1
The primary loan under the FFEL Program is the subsidized Stafford loan.
Students who are not eligible for subsidized Stafford loans based on their
economic circumstances may be able to obtain unsubsidized Stafford loans.
Parents of students may be able to obtain PLUS loans on behalf of their
dependents. Consolidation loans are available to borrowers, with existing loans
made under the FFEL Program and other federal programs, to consolidate repayment
of the borrower's existing loans. Prior to July 1, 1994, the FFEL Program also
offered SLS loans to graduate and professional students and independent
undergraduate students and, under certain circumstances, dependent undergraduate
students, to supplement their Stafford loans.
Subsidized Stafford Loans
General. Subsidized Stafford loans are eligible for insurance and reinsurance
under the Higher Education Act if the eligible student to whom the loan is made
has been accepted or is enrolled in good standing at an eligible institution of
higher education or vocational school and is carrying at least one-half the
normal full-time workload at that institution. Subsidized Stafford loans have
limits as to the maximum amount which may be borrowed for an academic year and
in the aggregate for both undergraduate and graduate/professional study. Both
aggregate limitations exclude loans made under the SLS and PLUS programs. The
Secretary of Education has discretion to raise these limits to accommodate
students undertaking specialized training requiring exceptionally high costs of
education.
Subsidized Stafford loans are made only to student borrowers who meet the
needs tests provided in the Higher Education Act. Provisions addressing the
implementation of needs analysis and the relationship between unmet need for
financing and the availability of subsidized Stafford loan funding have been the
subjects of frequent and extensive amendment in recent years. Further amendment
to such provisions may materially affect the availability of subsidized Stafford
loan funding to borrowers or the availability of subsidized Stafford loans for
secondary market acquisition.
Interest rates for subsidized Stafford loans. For a Stafford loan made prior
to July 1, 1994, the applicable interest rate for a borrower who, on the date
the promissory note was signed, did not have an outstanding balance on a
previous FFELP loan:
(1) is 7% per annum for a loan covering a period of instruction beginning
before January 1, 1981;
(2) is 9% per annum for a loan covering a period of instruction beginning
on or after January 1, 1981, but before September 13, 1983;
(3) is 8% per annum for a loan covering a period of instruction beginning
on or after September 13, 1983, but before July 1, 1988;
(4) is 8% per annum for the period from the disbursement of the loan
through the date which is 48 months after the loan enters repayment, for a
loan made prior to October 1, 1992, covering a period of instruction
beginning on or after July 1, 1988, and beginning on the first day of the
49th month shall be adjusted annually, and for any 12-month period commencing
on a July 1 shall be equal to the bond equivalent rate of 91-day U.S.
Treasury bills auctioned at the final auction prior to the preceding June 1,
plus 3.25% per annum (but not to exceed 10% per annum); or
(5) for a loan made on or after October 1, 1992 shall be adjusted
annually, and for any 12-month period commencing on a July 1 shall be equal
to the bond equivalent rate of 91-day U.S. Treasury bills auctioned at the
final auction prior to the preceding June 1, plus 3.1% per annum (but not to
exceed 9% per annum).
For a Stafford loan made prior to July 1, 1994, the applicable interest rate
for a borrower who, on the date the promissory note evidencing the loan was
signed, had an outstanding balance on a previous loan made insured or guaranteed
under the FFEL Program:
(6) for a loan made prior to July 23, 1992 is the applicable interest rate
on the previous loan or, if the previous loan is not a Stafford loan, 8% per
annum; or
(7) for a loan made on or after July 23, 1992 shall be adjusted annually,
and for any twelve month period commencing on a July 1 shall be equal to the
bond equivalent rate of 91-day U.S. Treasury bills auctioned at the final
auction prior to the preceding June 1, plus 3.1% per annum but not to exceed:
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o 7% per annum in the case of a Stafford loan made to a borrower who has a
loan described in clause (1)above;
o 8% per annum in the case of:
-- a Stafford loan made to a borrower who has a loan described in clause
(3) above,
-- a Stafford loan which has not been in repayment for four years and
which was made to a borrower who has a loan described in clause (4)
above,
-- a Stafford loan for which the first disbursement was made prior to
December 20, 1993 to a borrower whose previous loans do not include a
Stafford loan or an unsubsidized Stafford loan;
o 9% per annum in the case of a Stafford loan made to a borrower who has a
loan described in clauses (2) or (5) above or a Stafford loan for which
the first disbursement was made on or after December 20, 1993 to a
borrower whose previous loans do not include a Stafford loan or an
unsubsidized Stafford loan; and
o 10% per annum in the case of a Stafford loan which has been in repayment
for four years or more and which was made to a borrower who has a loan
described in clause (4) above.
(8) The interest rate on all Stafford loans made on or after July 1, 1994,
regardless of whether the borrower is a new borrower or a repeat borrower, is a
variable rate. The interest rate on all Stafford loans made on or after July 1,
1994, but prior to July 1, 1995, shall be adjusted annually, and for any twelve
month period commencing on a July 1 shall be equal to the bond equivalent rate
of 91-day U.S. Treasury Bills auctioned at the final auction prior to the
preceding June 1, plus 3.1% per annum, except that the interest rate shall not
exceed 8.25% per annum.
(9) For any Stafford loan made on or after July 1, 1995, but prior to July 1,
1998, the interest rate is further reduced prior to the time the loan enters
repayment and during any deferment periods. During deferment periods, the
formula described in clause (8) above is applied, except that 2.5% is
substituted for 3.1%, and the rate shall not exceed 8.25% per annum.
(10) For Stafford loans made on or after July 1, 1998 but before July 1,
2006, the applicable interest rate shall be adjusted annually, and for any
twelve month period commencing on a July 1 shall be equal to the bond equivalent
rate of 91-day U.S. Treasury bills auctioned at the final auction prior to the
proceeding June 1, plus 1.7% per annum prior to the time the loan enters
repayment and during any deferment periods, and 2.3% per annum during repayment,
but not to exceed 8.25% per annum.
For loans the first disbursement of which is made on or after July 1, 2006,
the applicable interest rate will be 6.8%. There can be no assurance that the
interest rate provisions for these loans will not be further amended.
UNSUBSIDIZED STAFFORD LOANS
General. Unsubsidized Stafford loans were created by Congress in 1992 for
students who do not qualify for subsidized Stafford loans due to parental and/or
student income and assets in excess of permitted amounts. These students are
entitled to borrow the difference between the Stafford loan maximum and their
subsidized Stafford eligibility. The general requirements for unsubsidized
Stafford loans are essentially the same as those for subsidized Stafford loans.
The interest rate, the annual loan limits and the special allowance payment
provisions of the unsubsidized Stafford loans are the same as the subsidized
Stafford loans. However, the terms of the unsubsidized Stafford loans differ
materially from subsidized Stafford loans in that the federal government will
not make interest subsidy payments and the loan limitations are determined
without respect to the expected family contribution. The borrower will be
required to either pay interest from the time the loan is disbursed or
capitalize the interest until repayment begins. Unsubsidized Stafford loans were
not available before October 1, 1992. A student meeting the general eligibility
requirements for a loan under the FFEL Program is eligible for an unsubsidized
Stafford loan without regard to need.
Interest rates for unsubsidized Stafford loans. Unsubsidized Stafford loans
are subject to the same interest rate provisions as subsidized Stafford loans.
PLUS Loans
General. PLUS loans are made only to borrowers who are parents and, under
certain circumstances, spouses of remarried parents, of dependent undergraduate
students. For PLUS loans made on or after July 1, 1993, the parent borrower must
not have an adverse credit history as determined pursuant to criteria
established by the Department. The basic provisions applicable to PLUS loans are
similar to those of Stafford loans with respect to the involvement of guaranty
agencies and the Secretary of Education in providing federal insurance and
reinsurance on the loans. However, PLUS loans differ significantly, particularly
from the subsidized Stafford loans, because federal interest subsidy payments
are not available under the PLUS loan program and special allowance payments are
more restricted.
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Interest rates for PLUS loans. The applicable interest rate depends upon the
date of issuance of the loan and the period of enrollment for which the loan is
to apply. The applicable interest rate on a PLUS loan:
o made on or after January 1, 1981, but before October 1, 1981, is 9% per
annum;
o made on or after October 1, 1981, but before November 1, 1982, is 14% per
annum;
o made on or after November 1, 1982, but before July 1, 1987, is 12% per
annum;
o made on or after July 1, 1987, but before October 1, 1992 shall be
adjusted annually, and for any 12-month period beginning on July 1 shall
be equal to the bond equivalent rate of 52-week U.S. Treasury bills
auctioned at the final auction prior to the preceding June 1, plus 3.25%
per annum (but not to exceed 12% per annum);
o made on or after October 1, 1992, but before July 1, 1994, shall be
adjusted annually, and for any 12-month period beginning on July 1 shall
be equal to the bond equivalent rate of 52-week U.S. Treasury bills
auctioned at the final auction prior to the preceding June 1, plus 3.1%
per annum (but not to exceed 10% per annum);
o made on or after July 1, 1994, but before July 1, 1998, is the same as
that for a loan made on or after October 1, 1992, but before July 1, 1994,
except that such rate shall not exceed 9% per annum;
o made on or after July 1, 1998, but before July 1, 2006, shall be adjusted
annually, and for any 12-month period beginning on July 1 shall be equal
to the bond equivalent rate of 91-day U.S. Treasury bills auctioned at the
final auction prior to the preceding June 1, plus 3.1% per annum (but not
to exceed 9% per annum); or
o the first disbursement of which is made on or after July 1, 2006 will be
7.9%.
For any 12-month period beginning on July 1, 2001 or any succeeding year, the
weekly average 1-year constant maturity Treasury yield, as published by the
Board of Governors of the Federal Reserve System, for the last calendar week
before such June 26, will be substituted for the 52-week Treasury bill as the
index for interest rate calculations.
SLS LOANS
General. SLS loans were limited to graduate or professional students,
independent undergraduate students, and dependent undergraduate students, if the
students' parents were unable to obtain a PLUS loan. Except for dependent
undergraduate students, eligibility for SLS loans was determined without regard
to need. SLS loans were similar to Stafford loans with respect to the
involvement of guaranty agencies and the Secretary of Education in providing
federal insurance and reinsurance on the loans. However, SLS loans differed
significantly, particularly from subsidized Stafford loans, because federal
interest subsidy payments were not available under the SLS loan program and
special allowance payments were more restricted.
Interest rates for SLS loans. The applicable interest rates on SLS loans made
prior to October 1, 1992 were identical to the applicable interest rates on PLUS
loans made at the same time. For SLS loans made on or after October 1, 1992, the
applicable interest rate was the same as the applicable interest rate on PLUS
loans, except that the ceiling was 11% per annum instead of 10% per annum.
CONSOLIDATION LOANS
GENERAL. The Higher Education Act authorizes a program under which certain
borrowers may consolidate their various federally insured education loans into a
single loan insured and reinsured on a basis similar to Stafford loans.
Consolidation loans may be obtained in an amount sufficient to pay outstanding
principal, unpaid interest and late charges on federally insured or reinsured
student loans incurred under the FFEL and Direct Loan Programs, including PLUS
loans made to the consolidating borrower as well as loans made pursuant to the
Perkins Loan Program (formally National Direct Student Loan Program), FISL,
Nursing Student Loan, Health Education Assistance Loan, and Health Professions
Student Loan Programs. To be eligible for a FFELP Consolidation loan, a borrower
must:
o have outstanding indebtedness on student loans made under the FFEL Program
and/or certain other federal student loan programs, and
o be in repayment status or in a grace period on loans that are to be
consolidated.
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Borrowers who are in default on loans that are to be consolidated must first
make satisfactory arrangements to repay the loans to the respective holder(s),
or must agree to repay the consolidating lender under an income-sensitive
repayment arrangement in order to include the defaulted loans in the
Consolidation loan. For applications received on or after January 1, 1993,
borrowers may add additional loans to a Consolidation loan during the 180-day
period following the origination of the Consolidation loan.
Consolidation loans for which the applications were received prior to January
1, 1993 required a minimum student loan indebtedness of $5,000. For
Consolidation loans disbursed prior to July 1, 1994, the required minimum
outstanding student loan indebtedness was $7,500. As of July 1, 1994,
Consolidation loans are no longer subject to a minimum loan amount.
A married couple that agrees to be jointly and severally liable on a
Consolidation loan, for which the application is received on or after January 1,
1993, may be treated as an individual for purposes of obtaining a Consolidation
loan. .
Interest rates for Consolidation loans. A Consolidation loan made prior to
July 1, 1994 bears interest at a rate equal to the weighted average of the
interest rates on the loans retired, rounded to the nearest whole percent, but
not less than 9% per annum. Except as described in the next sentence, a
Consolidation loan made on or after July 1, 1994 bears interest at a rate equal
to the weighted average of the interest rates on the loans retired, rounded
upward to the nearest whole percent, but with no minimum rate. For a
Consolidation loan for which the application is received by an eligible lender
on or after November 13, 1997 and before October 1, 1998, the interest rate
shall be adjusted annually, and for any twelve-month period commencing on a July
1 shall be equal to the bond equivalent rate of 91-day U.S. Treasury bills
auctioned at the final auction prior to the preceding June 1, plus 3.1% per
annum, but not to exceed 8.25% per annum. Notwithstanding these general interest
rates, the portion, if any, of a Consolidation loan that repaid a loan made
under title VII, Sections 700-721 of the Public Health Services Act, as amended,
has a different variable interest rate. Such portion is adjusted on July 1 of
each year, but is the sum of the average of the T-Bill Rates auctioned for the
quarter ending on the preceding June 30, plus 3.0%, without any cap on the
interest rate. Consolidation loans made on or after October 1, 1998 and before
July 1, 2006 will bear interest at a per annum rate equal to the lesser of 8.25%
or the weighted average of the interest rates on the loans being consolidated,
rounded to the nearest higher 1/8 of 1%. Consolidation loans for which the
application is received on or after July 1, 2006, will bear interest also at a
rate per annum equal to the lesser of 8.25% or the weighted average of the
interest rates on the loans being consolidated, rounded to the nearest higher
1/8 of 1%. For a discussion of required payments that reduce the return on
Consolidation loans, see "Fees -- Rebate Fees on Consolidation Loans" in this
Appendix.
MAXIMUM LOAN AMOUNTS
Each type of loan is subject to certain limits on the maximum principal
amount, with respect to a given academic year and/or in the aggregate.
Consolidation loans are currently limited only by the amount of eligible loans
to be consolidated. PLUS loans are limited to the difference between the cost of
attendance and the other aid available to the student. Stafford loans,
subsidized and unsubsidized, are subject to both annual and aggregate limits
according to the provisions of the Higher Education Act.
Loan limits for subsidized Stafford and unsubsidized Stafford loans.
Subsidized and unsubsidized Stafford loans are generally treated as one loan
type for loan limit purposes. A dependent student who has not successfully
completed the first year of a program of undergraduate education may borrow up
to $2,625 in an academic year. A dependent student who has successfully
completed the first year, but who has not successfully completed the second year
may borrow up to $3,500 in Stafford loans per academic year. A dependent
undergraduate student who has successfully completed the first and second year,
but who has not successfully completed the remainder of a program of
undergraduate education, may borrow up to $5,500 per academic year. Independent
undergraduate students are subject to the same limits as those applicable to
dependent students, but are also eligible for additional unsubsidized Stafford
loan amounts. Such amounts are increased by $4,000 for each of the first two
years, and by $5,000 for third-, fourth-, and fifth-year students. For students
enrolled in programs of less than an academic year in length, the limits are
generally reduced in proportion to the amount by which the programs are less
than one year in length.
A graduate or professional student may borrow up to $18,500 in an academic
year where no more than $8,500 is representative of subsidized Stafford loan
amounts. The maximum aggregate amount of Stafford loans, including that portion
of a Consolidation loan used to repay such loans, which an undergraduate student
may have outstanding is $46,000 where no more than $23,000 is representative of
subsidized Stafford loan amounts. The maximum aggregate amount for a graduate
and professional student, including loans for undergraduate education, is
$138,500 with subsidized Stafford loan amounts comprising no more than $65,500
of the aggregate total. In some instances, schools may certify loan amounts in
excess of the above limits, i.e., for certain health profession students.
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With the enactment of the Higher Education Amendments of 1992, an
undergraduate student who had not successfully completed the first and second
year of a program of undergraduate education could borrow Stafford loans in
amounts up to $2,625 in an academic year. An undergraduate student who had
successfully completed the first and second year, but who had not successfully
completed the remainder of a program of undergraduate education could borrow up
to $4,000 per academic year. The maximum for graduate and professional students
was $7,500 per academic year. The maximum aggregate amount of Stafford loans
which a borrower could have outstanding, including that portion of a
Consolidation loan used to repay such loans, was $17,250. The maximum aggregate
amount for a graduate or professional student, including loans for undergraduate
education, was $54,750.
Loan limits for PLUS loans. For PLUS loans made on or after July 1, 1993, the
amounts of PLUS loans are limited only by the student's unmet need. Prior to
that time PLUS loans were subject to limits similar to those of SLS loans
applied with respect to each student on behalf of whom the parent borrowed.
Loan limits for SLS loans. A student who had not successfully completed the
first and second year of a program of undergraduate education could borrow a SLS
loan in an amount of up to $4,000. A student who had successfully completed the
first and second year, but who had not successfully completed the remainder of a
program of undergraduate education could borrow up to $5,000 per year. Graduate
and professional students could borrow up to $10,000 per year. SLS loans were
subject to an aggregate maximum of $23,000 ($73,000 for graduate and
professional students). Prior to the 1992 changes, SLS loans were available in
amounts of $4,000 per academic year, up to a $20,000 aggregate maximum. Prior to
the 1986 changes, a graduate or professional student could borrow $3,000 of SLS
loans per academic year, up to a $15,000 maximum, and an independent
undergraduate student could borrow $2,500 of SLS loans per academic year minus
the amount of all other FFELP loans to such student for such academic year, up
to the maximum amount of all FFELP loans to that student of $12,500. In 1989,
the amount of SLS loans for students enrolled in programs of less than an
academic year in length were limited in a manner similar to the limits described
above under Stafford Loans.
DISBURSEMENT REQUIREMENTS
The Higher Education Act now requires that virtually all Stafford loans and
PLUS loans be disbursed by eligible lenders in at least two separate
installments. The proceeds of a loan made to any undergraduate first-year
student borrowing for the first time under the program must be delivered to the
student no earlier than thirty days after the enrollment period begins, with few
exceptions.
REPAYMENT
Repayment periods. Loans made under the FFEL Program, other than
consolidation loans, must provide for repayment of principal in periodic
installments over a period of not less than five nor more than ten years. After
the 1998 Amendments, lenders were required to offer extended repayment schedules
to new borrowers who accumulate outstanding FFELP loans of more than $30,000, in
which case the repayment period may extend up to 25 years subject to certain
minimum repayment amounts. A consolidation loan must be repaid during a period
agreed to by the borrower and lender, subject to maximum repayment periods which
vary depending upon the principal amount of the borrower's outstanding student
loans, but may not be longer than 30 years. For consolidation loans for which
the application was received prior to January 1, 1993, the repayment period
could not exceed 25 years.
Repayment of principal on a Stafford loan does not commence while a student
remains a qualified student, but generally begins upon expiration of the
applicable grace period. Grace periods may be waived by borrowers. For Stafford
loans for which the applicable rate of interest is 7% per annum, the repayment
period commences not more than twelve months after the borrower ceases to pursue
at least a half-time course of study. For other subsidized Stafford loans and
unsubsidized Stafford loans, the repayment period commences not more than six
months after the borrower ceases to pursue at least a half-time course of study.
In the case of SLS, PLUS and consolidation loans, the repayment period
commences on the date of final disbursement of the loan, except that the
borrower of a SLS loan who also has a Stafford loan may defer repayment of the
SLS loan to coincide with the commencement of repayment of the subsidized
Stafford or unsubsidized Stafford loan. During periods in which repayment of
principal is required, payments of principal and interest must in general be
made at a rate of not less than the greater of $600 per year or the interest
that accrues during the year, except that a borrower and lender may agree to a
lesser rate at any time before or during the repayment period. A borrower may
agree, with concurrence of the lender, to repay the loan in less than five years
with the right subsequently to extend his minimum repayment period to five
years. Borrowers may accelerate, without penalty, the repayment of all or any
part of the loan.
Income-sensitive repayment schedules. Since 1993, lenders of subsidized
Stafford, unsubsidized Stafford, SLS, and consolidation loans have been required
to offer borrowers the option of repaying in accordance with income-sensitive
repayment schedules. In 2000, lenders were required to offer income-sensitive
repayment schedules to PLUS borrowers as well. Use of income-sensitive repayment
schedules may extend the ten-year maximum term for up to five years if the
payment amount established from the borrower's income will not repay the loan
within the applicable maximum repayment period. In addition, if the repayment
schedule on a loan that has been converted to a variable interest rate does not
provide for adjustments to the amount of the monthly installment payments, the
ten-year maximum term may be extended for up to three years.
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Deferment periods. No principal repayments need be made during certain
periods of deferment prescribed by the Higher Education Act. For subsidized
Stafford, unsubsidized Stafford, and SLS loans to a borrower who first obtained
a loan which was disbursed before July 1, 1993, deferments are available:
o during a period not exceeding three years while the borrower is a member
of the Armed Forces, an officer in the Commissioned Corps of the Public
Health Service or, with respect to a borrower who first obtained a student
loan disbursed on or after July 1, 1987, or a student loan to cover the
cost of instruction for a period of enrollment beginning on or after July
1, 1987, an active duty member of the National Oceanic and Atmospheric
Administration Corps;
o during a period not in excess of three years while the borrower is a
volunteer under the Peace Corps Act;
o during a period not in excess of three years while the borrower is a
full-time paid volunteer under the Domestic Volunteer Act of 1973;
o during a period not exceeding three years while the borrower is a
full-time paid volunteer for an organization which is exempt from taxation
under Section 501(c)(3) of the Code;
o during a period not exceeding two years while the borrower is serving an
internship necessary to receive professional recognition required to begin
professional practice or service, or a qualified internship or residency
program;
o during a period not exceeding three years while the borrower is
temporarily totally disabled, as established by sworn affidavit of a
qualified physician, or while the borrower is unable to secure employment
by reason of the care required by a dependent who is so disabled;
o during a period not to exceed twenty-four months while the borrower is
seeking and unable to find full-time employment;
o during any period that the borrower is pursuing a full-time course of
study at an eligible institution (or, with respect to a borrower who first
obtained a student loan disbursed on or after July 1, 1987, or a student
loan to cover the cost of instruction for a period of enrollment beginning
on or after July 1, 1987, is pursuing at least a half-time course of
study), or is pursuing a course of study pursuant to a graduate fellowship
program or a rehabilitation training program for disabled individuals
approved by the Secretary of Education;
o during a period, not in excess of 6 months, while the borrower is on
parental leave; and
o only with respect to a borrower who first obtained a student loan
disbursed on or after July 1, 1987, or a student loan to cover the cost of
instruction for a period of enrollment beginning on or after July 1, 1987,
during a period not in excess of three years while the borrower is a
full-time teacher in a public or nonprofit private elementary or secondary
school in a "teacher shortage area" (as prescribed by the Secretary of
Education), and during a period not in excess of 12 months for mothers,
with preschool age children, who are entering or re-entering the work
force and who are compensated at a rate not exceeding $1 per hour in
excess of the federal minimum wage.
For loans to a borrower who first obtains a loan on or after July 1, 1993,
deferments are available:
o during any period that the borrower is pursuing at least a half-time
course of study at an eligible institution or a course of study pursuant
to a graduate fellowship program or rehabilitation training program
approved by the Secretary of Education;
o during a period not exceeding three years while the borrower is seeking
and unable to find full-time employment; and
o during a period not in excess of three years for any reason which the
lender determines, in accordance with regulations under the Higher
Education Act, has caused or will cause the borrower economic hardship.
Economic hardship includes working full time and earning an amount not in
excess of the greater of the minimum wage or the poverty line for a family
of two. Additional categories of economic hardship are based on the
relationship between a borrower's educational debt burden and his or her
income.
Prior to the 1992 changes, only certain of the deferment periods described
above were available to PLUS loan borrowers, and only certain deferment periods
were available to consolidation loan borrowers. Prior to the 1986 changes, PLUS
loan borrowers were not entitled to certain deferment periods. Deferment periods
extend the maximum repayment term.
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Forbearance period. The Higher Education Act also provides for periods of
forbearance during which the borrower, in case of temporary financial hardship,
may postpone any payments. A borrower is entitled to forbearance for a period
not to exceed three years while the borrower's debt burden under Title IV of the
Higher Education Act (which includes the FFEL Program) equals or exceeds 20% of
the borrower's gross income, and also is entitled to forbearance while he or she
is serving in a qualifying medical or dental internship program or in a
"national service position" under the National and Community Service Trust Act
of 1993. In addition, mandatory administrative forbearances are provided in
exceptional circumstances such as a local or national emergency or military
mobilization, or when the geographical area in which the borrower or endorser
resides has been designated a disaster area by the President of the United
States or Mexico, the Prime Minister of Canada, or by the governor of a state.
In other circumstances, forbearance is at the lender's option. Forbearance also
extends the maximum repayment term.
Interest payments during grace, deferment and forbearance periods. The
Secretary of Education makes interest payments on behalf of the borrower of
certain eligible loans while the borrower is in school and during grace and
deferment periods. Interest that accrues during forbearance periods and, if the
loan is not eligible for interest subsidy payments, while the borrower is in
school and during the grace and deferment periods, may be paid monthly or
quarterly or capitalized not more frequently than quarterly.
FEES
Guarantee fee. A guaranty agency is authorized to charge a premium, or
guarantee fee, of up to 1% of the principal amount of the loan, which must be
deducted proportionately from each disbursement of the proceeds of the loan to
the borrower. Guarantee fees may not currently be charged to borrowers of
consolidation loans. However, borrowers may be charged an insurance fee to cover
the costs of increased or extended liability with respect to consolidation
loans. For loans made prior to July 1, 1994, the maximum guarantee fee was 3% of
the principal amount of the loan, but no such guarantee fee was authorized to be
charged with respect to unsubsidized Stafford loans.
Origination fee. An eligible lender is authorized to charge the borrower of a
subsidized Stafford loan or unsubsidized Stafford loan an origination fee in an
amount not to exceed 3% of the principal amount of the loan, and is required to
charge the borrower of a PLUS loan an origination fee in the amount of 3% of the
principal amount of the loan. These fees must be deducted proportionately from
each disbursement of the loan proceeds to the borrower. These fees are not
retained by the lender, but must be passed on to the Secretary of Education.
Lender fee. The lender of any loan under the FFEL Program made on or after
October 1, 1993 is required to pay to the Secretary of Education a fee equal to
0.5% of the principal amount of such loan.
Rebate fee on Consolidation Loans. The holder of any consolidation loan made
on or after October 1, 1993 is required to pay to the Secretary of Education a
monthly fee equal to 0.0875% (1.05% per annum) of the principal amount of, and
accrued interest on the consolidation loan. For loans made pursuant to
applications received on or after October 1, 1998, and on or before January 31,
1999 the fee was reduced to 0.62%.
INTEREST SUBSIDY PAYMENTS
Interest subsidy payments are interest payments paid with respect to an
eligible loan before the time that the loan enters repayment and during
deferment periods. The Secretary of Education and the guaranty agencies enter
into interest subsidy agreements whereby the Secretary of Education agrees to
pay interest subsidy payments to the holders of eligible guaranteed loans for
the benefit of students meeting certain requirements, subject to the holders'
compliance with all requirements of the Higher Education Act. Subsidized
Stafford loans are eligible for interest subsidy payments. Consolidation loans
for which the application was received on or after January 1, 1993, are eligible
for interest subsidy payments; however, any portion of the consolidation loan
attributable to underlying Health Education Assistance Loans (HEAL) is not
subsidized. Consolidation loans made from applications received on or after
August 10, 1993 are eligible for interest subsidy payments only if all
underlying loans consolidated are subsidized Stafford loans. Consolidation loans
for which the application is received by an eligible lender on or after November
13, 1997, are eligible for interest subsidy payments on that portion of the
Consolidation loan that repays subsidized FFELP and Federal Direct Loan Program
loans. In addition, to be eligible for interest subsidy payments, guaranteed
loans must be made by an eligible lender under the applicable guaranty agency's
guarantee program, and must meet requirements prescribed by the rules and
regulations promulgated under the Higher Education Act.
The Secretary of Education makes interest subsidy payments quarterly on
behalf of the borrower to the holder of a guaranteed loan in a total amount
equal to the interest which accrues on the unpaid principal amount prior to the
commencement of the repayment period of the loan or during any deferment period.
A borrower may elect to forego interest subsidy payments, in which case the
borrower is required to make interest payments.
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SPECIAL ALLOWANCE PAYMENTS
The Higher Education Act provides for special allowance payments to be made
by the Secretary of Education to eligible lenders. The rates for special
allowance payments are based on formulas that differ according to the type of
loan, the date the loan was originally made or insured and the type of funds
used to finance the loan (taxable or tax-exempt).
Subsidized and unsubsidized Stafford loans. The effective formulas for
special allowance payment rates for Stafford and unsubsidized Stafford loans are
summarized in the following chart. The T-Bill Rate mentioned in the chart refers
to the average of the bond equivalent yield of the 91-day Treasury bills
auctioned during the preceding quarter.
Date of Loans Annualized SAP Rate
----------------------------- ----------------------------------
On or after October 1, 1981.. T-Bill Rate less Applicable Interest Rate + 3.5%
On or after November 16, 1986 T-Bill Rate less Applicable Interest Rate + 3.25%
On or after October 1, 1992.. T-Bill Rate less Applicable Interest Rate + 3.1%
On or after July 1, 1995..... T-Bill Rate less Applicable Interest Rate + 3.1%(1)
On or after July 1, 1998..... T-Bill Rate less Applicable Interest Rate + 2.8%(2)
On or after January 1, 2000
before July 1, 2003........ 3 Month Commercial Paper Rate less Applicable(3)
Interest Rate + 2.34%
- ----------
(1) Substitute 2.5% in this formula while loans are in-school, grace or
deferment status.
(2) Substitute 2.2% in this formula while such loans are in-school, grace or
deferment status.
(3) Substitute 1.74% in this formula while such loans are in-school, grace or
deferment status.
Federal PLUS, SLS and consolidation loans. The formula for special allowance
payments on PLUS, SLS and Consolidation loans are as follows:
Date of Loans Annualized SAP Rate
-------------------------- -------------------------------
On or after October 1, 1992 T-Bill Rate less Applicable Interest Rate + 3.1%
On or after January 1, 2000 3 Month Commercial Paper Rate less
Applicable Interest Rate + 2.64%
For PLUS and SLS loans made prior to July 1, 1994 and PLUS loans made on or
after July 1, 1998,which bear interest at rates adjusted annually, special
allowance payments are made only in years during which the interest rate ceiling
on such loans operates to reduce the rate that would otherwise apply based upon
the applicable formula. See "Interest rates for PLUS loans" and "Interest rates
for SLS loans" in this Appendix. Special allowance payments are paid with
respect to PLUS loans made on or after October 1, 1992 only if the rate that
would otherwise apply exceeds 10% per annum. For PLUS loans made after July 1,
1998 and before July 1, 2006, special allowance is paid only if the sum of the
91-day Treasury bill rate determined at an auction held on June 1 of each year
plus 3.1% exceeds 9.0%. For PLUS loans first disbursed on or after July 1, 2006,
special allowance is paid for such loans in any 12-month period beginning on
July 1 and ending on June 30 only if the sum of the average of the bond
equivalent rates of the quotes of the 3-month commercial paper rate for the last
calendar week ending on or before such July 1 plus 2.64% exceeds 9.0%. The
portion, if any, of a consolidation loan that repaid a loan made under Title
VII, Sections 700-721 of the Public Health Services Act, as amended, is
ineligible for special allowance payments.
Special allowance payments for loans financed by tax-exempt bonds. The
effective formulas for special allowance payment rates for Stafford Loans and
unsubsidized Stafford Loans differ depending on whether loans to borrowers were
acquired or originated with the proceeds of tax-exempt obligations. The formula
for special allowance payments for loans financed with the proceeds of
tax-exempt obligations originally issued prior to October 1, 1993 is:
T Bill Rate less Applicable Interest Rate + 3.5%
------------------------------------------------
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provided that the special allowance applicable to the loans may not be less than
9 1/2% less the Applicable Interest Rate. Loans acquired or originated with the
proceeds of tax-exempt obligations originally issued on or after October 1, 1993
receive special allowance payments made on other loans. Beginning on October 1,
2004 and ending on December 31, 2005, any new loans acquired or originated using
the proceeds of tax-exempt obligations originally issued prior to October
1,1993, if either the underlying bonds are refunded or loans are refinanced,
receive special allowance payments made on other loans.
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Adjustments to special allowance payments. Special allowance payments and
interest subsidy payments are reduced by the amount which the lender is
authorized or required to charge as an origination fee. The Higher Education Act
provides that if special allowance payments or interest subsidy payments have
not been made within 30 days after the Secretary of Education receives an
accurate, timely and complete request therefore, the special allowance payable
to such holder shall be increased by an amount equal to the daily interest
accruing on the special allowance and interest subsidy payments due the holder.
DESCRIPTION OF THE GUARANTY AGENCIES
The following discussion relates to guaranty agencies under the FFELP.
A guaranty agency guarantees loans made to students or parents of students by
lending institutions such as banks, credit unions, savings and loan
associations, certain schools, pension funds and insurance companies. A guaranty
agency generally purchases defaulted student loans which it has guaranteed with
its reserve fund. A lender may submit a default claim to the guaranty agency
after the student loan has been delinquent for at least 270 days. The default
claim package must include all information and documentation required under the
FFELP regulations and the guaranty agency's policies and procedures.
In general, a guaranty agency's reserve fund has been funded principally by
administrative cost allowances paid by the Secretary of Education, guarantee
fees paid by lenders, investment income on moneys in the reserve fund, and a
portion of the moneys collected from borrowers on guaranteed loans that have
been reimbursed by the Secretary of Education to cover the guaranty agency's
administrative expenses.
Various changes to the Higher Education Act have adversely affected the
receipt of revenues by the guaranty agencies and their ability to maintain their
reserve funds at previous levels, and may adversely affect their ability to meet
their guarantee obligations. These changes include:
o the reduction in reinsurance payments from the Secretary of Education
because of reduced reimbursement percentages;
o the reduction in maximum permitted guarantee fees from 3% to 1% for loans
made on or after July 1, 1994;
o the replacement of the administrative cost allowance with a student loan
processing and issuance fee equal to 65 basis points (40 basis points for
loans made on or after October 1, 1993) paid at the time a loan is
guaranteed, and an account maintenance fee of 12 basis points (10 basis
points for fiscal years 2001-2003) paid annually on outstanding guaranteed
student loans;
o the reduction in supplemental preclaims assistance payments from the
Secretary of Education; and
o the reduction in retention by a guaranty agency of collections on
defaulted loans from 27% to 24% (23% beginning on October 1, 2003).
Additionally, the adequacy of a guaranty agency's reserve fund to meet its
guarantee obligations with respect to existing student loans depends, in
significant part, on its ability to collect revenues generated by new loan
guarantees. The William D. Ford Federal Direct Loan Program ("FDL Program")
discussed below may adversely affect the volume of new loan guarantees. Future
legislation may make additional changes to the Higher Education Act that would
significantly affect the revenues received by guaranty agencies and the
structure of the guaranty agency program.
The Higher Education Act gives the Secretary of Education various oversight
powers over guaranty agencies. These include requiring a guaranty agency to
maintain its reserve fund at a certain required level and taking various actions
relating to a guaranty agency if its administrative and financial condition
jeopardizes its ability to meet its obligations. These actions include, among
others, providing advances to the guaranty agency, terminating the guaranty
agency's federal reimbursement contracts, assuming responsibility for all
functions of the guaranty agency, and transferring the guaranty agency's
guarantees to another guaranty agency or assuming such guarantees. The Higher
Education Act provides that a guaranty agency's reserve fund shall be considered
to be the property of the United States to be used in the operation of the FFEL
Program or the Direct Loan Program, and, under certain circumstances, the
Secretary of Education may demand payment of amounts in the reserve fund.
The 1998 Amendments mandate the recall of guaranty agency reserve funds by
the Secretary of Education amounting to $85 million in fiscal year 2002, $82.5
million in fiscal year 2006, and $82.5 million in fiscal year 2007. However,
certain minimum reserve levels are protected from recall, and under the 1998
Amendments, guaranty agency reserve funds were restructured to provide guaranty
agencies with additional flexibility in choosing how to spend certain funds they
receive. The new recall of reserves for guaranty agencies increases the risk
that resources available to guaranty agencies to meet their guarantee obligation
will be significantly reduced. Relevant federal laws, including the Higher
Education Act, may be further changed in a manner that may adversely affect the
ability of a guaranty agency to meet its guarantee obligations.
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Under the Higher Education Act, if the Department has determined that a
guaranty agency is unable to meet its insurance obligations, the holders of
loans guaranteed by such guaranty agency must submit claims directly to the
Department, and the Department is required to pay the full guarantee payment due
with respect thereto in accordance with guarantee claims processing standards no
more stringent than those applied by the guaranty agency.
There are no assurances as to the Secretary of Education's actions if a
guaranty agency encounters administrative or financial difficulties or that the
Secretary of Education will not demand that a guaranty agency transfer
additional portions or all of its reserve fund to the Secretary of Education.
Federal Agreements
General. A guaranty agency's right to receive federal reimbursements for
various guarantee claims paid by such guaranty agency is governed by the Higher
Education Act and various contracts entered into between guaranty agencies and
the Secretary of Education. Each guaranty agency and the Secretary of Education
have entered into federal reimbursement contracts pursuant to the Higher
Education Act, which provide for the guaranty agency to receive reimbursement of
a percentage of insurance payments that the guaranty agency makes to eligible
lenders with respect to loans guaranteed by the guaranty agency prior to the
termination of the federal reimbursement contracts or the expiration of the
authority of the Higher Education Act. The federal reimbursement contracts
provide for termination under certain circumstances and also provide for certain
actions short of termination by the Secretary of Education to protect the
federal interest.
In addition to guarantee benefits, qualified student loans acquired under the
FFEL Program benefit from certain federal subsidies. Each guaranty agency and
the Secretary of Education have entered into an Interest Subsidy Agreement under
the Higher Education Act which entitles the holders of eligible loans guaranteed
by the guaranty agency to receive interest subsidy payments from the Secretary
of Education on behalf of certain students while the student is in school,
during a six to twelve month grace period after the student leaves school, and
during certain deferment periods, subject to the holders' compliance with all
requirements of the Higher Education Act.
United States Courts of Appeals have held that the federal government,
through subsequent legislation, has the right unilaterally to amend the
contracts between the Secretary of Education and the guaranty agencies described
herein. Amendments to the Higher Education Act in 1986, 1987, 1992, 1993, and
1998, respectively:
o abrogated certain rights of guaranty agencies under contracts with the
Secretary of Education relating to the repayment of certain advances from
the Secretary of Education,
o authorized the Secretary of Education to withhold reimbursement payments
otherwise due to certain guaranty agencies until specified amounts of such
guaranty agencies' reserves had been eliminated,
o added new reserve level requirements for guaranty agencies and authorized
the Secretary of Education to terminate the Federal Reimbursement
Contracts under circumstances that did not previously warrant such
termination,
o expanded the Secretary of Education's authority to terminate such
contracts and to seize guaranty agencies' reserves, and
o mandated the additional recall of guaranty agency reserve funds.
FEDERAL INSURANCE AND REIMBURSEMENT OF GUARANTY AGENCIES
Effect of annual claims rate. With respect to loans made prior to October 1,
1993, the Secretary of Education currently agrees to reimburse the guaranty
agency for up to 100% of the amounts paid on claims made by lenders, as
discussed in the formula described below, so long as the eligible lender has
properly serviced such loan. The amount of reimbursement is lower for loans
originated after October 1, 1993, as described below. Depending on the claims
rate experience of a guaranty agency, such reimbursement may be reduced as
discussed in the formula described below. The Secretary of Education also agrees
to repay 100% of the unpaid principal plus applicable accrued interest expended
by a guaranty agency in discharging its guarantee obligation as a result of the
bankruptcy, death, or total and permanent disability of a borrower, or in the
case of a PLUS loan, the death of the student on behalf of whom the loan was
borrowed, or in certain circumstances, as a result of school closures, which
reimbursements are not to be included in the calculations of the guaranty
agency's claims rate experience for the purpose of federal reimbursement under
the Federal Reimbursement Contracts.
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The formula used for loans initially disbursed prior to October 1, 1993 is
summarized below:
Claims Rate Federal Payment
--------------- -------------------------
0% up to 5%.. 100%
5% up to 9%.. 100% of claims up to 5%; 90% of
claims 5% and over
9% and over.. 100% of claims up to 5%; 90% of
claims 5% and over, up to 9%; 80%
of claims 9% and over
The claims experience is not accumulated from year to year, but is determined
solely on the basis of claims in any one federal fiscal year compared with the
original principal amount of loans in repayment at the beginning of that year.
The 1993 Amendments reduce the reimbursement amounts described above,
effective for loans initially disbursed on or after October 1, 1993 as follows:
100% reimbursement is reduced to 98%, 90% reimbursement is reduced to 88%, and
80% reimbursement is reduced to 78%, subject to certain limited exceptions. The
1998 Amendments further reduce the federal reimbursement amounts from 98% to
95%, 88% to 85%, and 78% to 75% respectively, for student loans first disbursed
on or after October 1, 1998.
The reduced reinsurance for federal guaranty agencies increases the risk that
resources available to guaranty agencies to meet their guarantee obligation will
be significantly reduced.
Reimbursement. The original principal amount of loans guaranteed by a
guaranty agency which are in repayment for purposes of computing reimbursement
payments to a guaranty agency means the original principal amount of all loans
guaranteed by a guaranty agency less:
o the original principal amount of such loans that have been fully repaid,
and
o the original amount of such loans for which the first principal
installment payment has not become due.
Guaranty agencies with default rates below 5% are required to pay the Secretary
of Education annual fees equivalent to 0.51% of new loans guaranteed, while all
other such agencies must pay a 0.5% fee. The Secretary of Education may withhold
reimbursement payments if a guaranty agency makes a material misrepresentation
or fails to comply with the terms of its agreements with the Secretary of
Education or applicable federal law.
Under the guarantee agreements, if a payment on a FFELP loan guaranteed by a
guaranty agency is received after reimbursement by the Secretary of Education,
the guaranty agency is entitled to receive an equitable share of the payment.
Any originator of any student loan guaranteed by a guaranty agency is
required to discount from the proceeds of the loan at the time of disbursement,
and pay to the guaranty agency, an insurance premium which may not exceed that
permitted under the Higher Education Act.
Under present practice, after the Secretary of Education reimburses a
guaranty agency for a default claim paid on a guaranteed loan, the guaranty
agency continues to seek repayment from the borrower. The guaranty agency
returns to the Secretary of Education payments that it receives from a borrower
after deducting and retaining: a percentage amount equal to the complement of
the reimbursement percentage in effect at the time the loan was reimbursed, and
an amount equal to 24% of such payments for certain administrative costs. The
Secretary of Education may, however, require the assignment to the Secretary of
defaulted guaranteed loans, in which event no further collections activity need
be undertaken by the guaranty agency, and no amount of any recoveries shall be
paid to the guaranty agency.
A guaranty agency may enter into an addendum to its Interest Subsidy
Agreement that allows the guaranty agency to refer to the Secretary of Education
certain defaulted guaranteed loans. Such loans are then reported to the IRS to
"offset" any tax refunds which may be due any defaulted borrower. To the extent
that the guaranty agency has originally received less than 100% reimbursement
from the Secretary of Education with respect to such a referred loan, the
guaranty agency will not recover any amounts subsequently collected by the
federal government which are attributable to that portion of the defaulted loan
for which the guaranty agency has not been reimbursed.
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Rehabilitation of defaulted loans. Under the Higher Education Act, the
Secretary of Education is authorized to enter into an agreement with a guaranty
agency pursuant to which the guaranty agency shall sell defaulted loans that are
eligible for rehabilitation to an eligible lender. The guaranty agency shall
repay the Secretary of Education an amount equal to 81.5% of the then current
principal balance of such loan, multiplied by the reimbursement percentage in
effect at the time the loan was reimbursed. The amount of such repayment shall
be deducted from the amount of federal reimbursement payments for the fiscal
year in which such repayment occurs, for purposes of determining the
reimbursement rate for that fiscal year.
For a loan to be eligible for rehabilitation, the guaranty agency must have
received consecutive payments for 12 months of amounts owed on such loan. Upon
rehabilitation, a loan is eligible for all the benefits under the Higher
Education Act for which it would have been eligible had no default occurred
(except that a borrower's loan may only be rehabilitated once).
Eligibility for federal reimbursement. To be eligible for federal
reimbursement payments, guaranteed loans must be made by an eligible lender
under the applicable guaranty agency's guarantee program, which must meet
requirements prescribed by the rules and regulations promulgated under the
Higher Education Act, including the borrower eligibility, loan amount,
disbursement, interest rate, repayment period and guarantee fee provisions
described herein and the other requirements set forth in the Higher Education
Act.
Prior to the 1998 Amendments, a FFELP loan was considered to be in default
for purposes of the Higher Education Act when the borrower failed to make an
installment payment when due, or to comply with the other terms of the loan, and
if the failure persists for 180 days in the case of a loan repayable in monthly
installments or for 240 days in the case of a loan repayable in less frequent
installments. Under the 1998 Amendments, the delinquency period required for a
student loan to be declared in default is increased from 180 days to 270 days
for loans payable in monthly installments on which the first day of delinquency
occurs on or after the date of enactment of the 1998 Amendments and from 240
days to 330 days for a loan payable less frequently than monthly on which the
delinquency occurs after the date of enactment of the 1998 Amendments.
The guaranty agency must pay the lender for the defaulted loan prior to
submitting a claim to the Secretary of Education for reimbursement. The guaranty
agency must submit a reimbursement claim to the Secretary of Education within 45
days after it has paid the lender's default claim. As a prerequisite to
entitlement to payment on the guarantee by the guaranty agency, and in turn
payment of reimbursement by the Secretary of Education, the lender must have
exercised reasonable care and diligence in making, servicing and collecting the
guaranteed loan. Generally, these procedures require:
o that completed loan applications be processed;
o a determination of whether an applicant is an eligible borrower
attending an eligible institution under the Higher Education Act;
o the borrower's responsibilities under the loan be explained to him or her;
o the promissory note evidencing the loan be executed by the borrower; and
o that the loan proceeds be disbursed by the lender in a specified manner.
After the loan is made, the lender must establish repayment terms with the
borrower, properly administer deferments and forbearances and credit the
borrower for payments made. If a borrower becomes delinquent in repaying a loan,
a lender must perform certain collection procedures, primarily telephone calls,
demand letters, skip tracing procedures and requesting assistance from the
applicable guaranty agency, that vary depending upon the length of time a loan
is delinquent.
DIRECT LOANS
The Student Loan Reform Act of 1993 authorized a program of "direct loans,"
to be originated by schools with funds provided by the Secretary of Education.
Under the FDL Program, the Secretary of Education is directed to enter into
agreements with schools, or origination agents in lieu of schools, to disburse
loans with funds provided by the Secretary of Education. Participation in the
program by schools is voluntary. The goals set forth in the 1993 Amendments call
for the direct loan program to constitute 5% of the total volume of loans made
under the FFEL Program and the FDL Program for academic year 1994-1995, 40% for
academic year 1995-1996, 50% for academic years 1996-1997 and 1997-1998 and 60%
for academic year 1998-1999. No provision is made for the size of the FDL
Program thereafter. Based upon information released by the General Accounting
Office, participation by schools in the FDL Program has not been sufficient to
meet the goals for the 1995-1996 or 1996-1997 academic years. The 1998
Amendments removed references to the "phase-in" of the FDL Program, including
restrictions on annual limits for FDL Program volume and the Secretary's
authority to select additional institutions to achieve balanced school
representation.
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The loan terms are generally the same under the FDL Program as under the FFEL
Program, though more flexible repayment provisions are available under the FDL
Program. At the discretion of the Secretary of Education, students attending
schools that participate in the FDL Program (and their parents) may still be
eligible for participation in the FFEL Program, though no borrower could obtain
loans under both programs for the same period of enrollment.
It is difficult to predict the impact of the FDL Program. There is no way to
accurately predict the number of schools that will participate in future years,
or, if the Secretary authorizes students attending participating schools to
continue to be eligible for FFEL Program loans, how many students will seek
loans under the FDL Program instead of the FFEL Program. In addition, it is
impossible to predict whether future legislation will eliminate, limit or expand
the FDL Program or the FFEL Program.
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