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| FMD > SEC Filings for FMD > Form 10-Q on 10-Nov-2008 | All Recent SEC Filings |
10-Nov-2008
Quarterly Report
You should read the following discussion and analysis of our financial condition and results of operations together with our unaudited condensed consolidated financial statements and accompanying notes included in this quarterly report.
Factors That May Affect Future Results
In addition to historical information, this quarterly report includes forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act, and Section 27A of the Securities Act of 1933, as amended, or the Securities Act. For this purpose, any statements contained herein regarding our strategy, future operations, financial position, future revenues and funding transactions, projected costs, prospects, plans and objectives of management, other than statements of historical facts, are forward-looking statements. The words "anticipates," "believes," "estimates," "expects," "intends," "may," "observe," "plans," "projects," "will," "would," and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We cannot guarantee that we actually will achieve the plans, intentions or expectations expressed or implied in our forward-looking statements, which involve risks, assumptions and uncertainties. There are a number of important factors that could cause actual results, levels of activity, performance or events to differ materially from those expressed or implied in the forward-looking statements we make. These important factors include our "critical accounting estimates" set forth below under "-Application of Critical Accounting Policies and Estimates" and factors including, but not limited to, those set forth below under the caption "Risk Factors" in Item 1A of Part II of this quarterly report. Although we may elect to update forward-looking statements in the future, we specifically disclaim any obligation to do so, even if our estimates change, and readers should not rely on those forward-looking statements as representing our views as of any date subsequent to November 10, 2008.
Executive Summary
Recent Developments
Our inability to access the securitization markets as a result of market disruptions continued during the first quarter of fiscal 2009. That inability, together with the reorganization in bankruptcy of The Education Resources Institute, Inc., or TERI, has strained our client relationships, resulted in the termination of several material client agreements, reduced our facilitated loan volume and created uncertainty about our business prospects. We have made significant changes in our senior leadership, and have made significant expense reductions in the attempt to overcome the challenges currently facing us. We have summarized below recent developments affecting our business:
º •
º The conditions of the debt capital markets generally, and the
asset-backed securities, or ABS, market specifically, rapidly
deteriorated during the second quarter of fiscal 2008 and the capital
market dislocations persist as of the date of this quarterly report.
Our business has been and continues to be materially adversely
impacted by the current market dynamics, including an inability to
access the securitization market and interim financing facilities on
attractive terms. These challenges are further discussed below under
the caption "-Business Trends, Uncertainties and Outlook."
º •
º On August 18, 2008, we sold to affiliates of GS Capital Partners, or
GSCP, an aggregate of 132,701 shares of our series B non-voting
convertible preferred stock, which we refer to as series B preferred
stock, at a purchase price of $1,000 per share. We received gross
proceeds of $132.7 million from the sale of the series B preferred
stock, which provided us with critical short-term liquidity and
capital resources. The shares of series B preferred stock are
convertible at an initial conversion price of $15.00 per share into
8,846,733 shares of our common stock. See
º •
º On April 7, 2008, TERI filed a voluntary petition for relief, which we
refer to herein as the TERI Reorganization, under Chapter 11 of the
United States Bankruptcy Code, or the Bankruptcy Code, in the United
States Bankruptcy Court for the District of Massachusetts, or the
Bankruptcy Court. The TERI Reorganization has had, and will likely
continue to have, a material negative effect on our client
relationships, facilitated loan volume, loans available for
securitization, ability to fully realize TERI's cost reimbursement and
guaranty obligations, and the value of our service receivables.
º •
º We experienced significant changes in senior management during the
first quarter of fiscal 2009. On August 18, 2008, we announced that
Daniel Meyers would return to the company as Chief Executive Officer
and President, and as a director, effective September 1, 2008.
Mr. Meyers is a co-founder of the company and served as our Chief
Executive Officer and Chairman of the Board from our incorporation in
1994 to September 2005 and as our President from November 2004 to
September 2005. Mr. Meyers succeeded Jack L. Kopnisky, who had served
as our Chief Executive Officer, Chief Operating Officer and President
since September 2005.
º •
º In September 2008, we announced that John A. Hupalo, Senior Executive
Vice President, Chief Financial Officer and Group Head, Capital
Markets, Anne P. Bowen, Executive Vice President and Chief
Administrative Officer, Greg D. Johnson, Executive Vice President and
Chief Marketing Officer, and Richard E. Ross, Executive Vice President
and Chief Information Officer, would be leaving our company as of
September 30, 2008. Mr. Hupalo was succeeded by Kenneth S. Klipper as
Chief Financial Officer. Mr. Klipper has served as our Treasurer and
Chief Accounting Officer since November 2006 and as Senior Vice
President, Finance since March 2005.
º •
º During the first quarter of fiscal 2009, we adjusted components of the
package of key accounting assumptions used to estimate the fair value
of our service receivables, which resulted in a $98.0 million pre-tax
decrease in the value of our additional structural advisory fees and
residuals receivables. In addition, we reduced the carrying value of
our private student loans held for sale by $21.2 million. In general,
our adjustments during the quarter were necessary as a result of
conditions in the capital markets and trust performance trends. For a
discussion of these changes and the sensitivity of the additional
structural advisory fees and residuals to variations in our
assumptions and estimates, see "-Application of Critical Accounting
Policies and Estimates-Service Revenue and Receivables."
º •
º On September 24, 2008, Fitch Ratings, or Fitch, downgraded 25 classes,
upgraded 2 classes, and affirmed 45 classes, of ABS in 12
securitizations that we facilitated. In addition, Fitch placed 22
classes on 'Rating Watch Negative' and 15 classes remain on 'Rating
Watch Negative'. With respect to the affirmations and upgrades, Fitch
indicated that underlying private student loan pools were seasoned and
performing within expectations. With respect to the downgrades, Fitch
cited a combination of factors, including worse than expected default
rates, operational uncertainty relating to the TERI bankruptcy
proceedings, and concerns about loan recoveries in a post-TERI
environment.
º •
º On October 30, 2008, Moody's Investors Service, or Moody's,
downgraded, and maintained on review for possible downgrade, the
ratings assigned to 62 classes of ABS issued in 12 securitizations
that we facilitated, including ratings assigned to certain auction
rate notes. Moody's cited worse than expected collateral performance
and concerns regarding potential disruptions in collections activities
relating to trust-owned loans as a result of the TERI Reorganization.
We expect the impact of the downgrades on the future cost of funding
auction rate notes to decrease the estimated value of our service
receivables by approximately
º •
º On November 5, 2008, Moody's downgraded the insurance financial
strength rating of Ambac Assurance Corp., or Ambac, to Baa1 from Aa3.
Ambac has provided credit enhancement for certain ABS issued in
securitizations that we have facilitated, including with respect to
certain auction rate notes. The downgrading of Ambac's ratings
increases the likelihood that the ratings assigned to certain our ABS
may be further downgraded, which could increase the cost of funding
auction rate notes. This risk is further discussed below under
"-Application of Critical Accounting Policies and Estimates-Service
Revenue and Receivables-Auction Rate Note Interest Rates" and Item 1A
of Part II, "Risk Factors-Risks Related to Our Financial Reporting and
Liquidity."
Overview
We offer outsourcing services for private education lending in the United States. We offer services to national and regional financial institutions and educational institutions for designing and implementing private student loan programs, primarily for undergraduate, graduate and professional education. In addition, our wholly owned subsidiary Union Federal Savings Bank, or Union Federal, is a federally chartered thrift, regulated by the Office of Thrift Supervision, or OTS, that has offered private student loans directly to consumers and currently offers residential retail mortgages, retail savings products, time deposit products and demand deposit accounts.
We offer services in connection with each of the five typical phases of the student loan lifecycle, enabling our clients to have a single point of interface for:
º •
º program design and marketing;
º •
º borrower inquiry and application;
º •
º loan origination and disbursement;
º •
º loan securitization, if available; and
º •
º loan servicing and portfolio management.
Historically, the primary driver of our results of operations and financial condition has been the volume of student loans for which we have provided outsourcing services from loan origination through securitization. Securitization refers to the technique of pooling loans and selling them to a special purpose, bankruptcy remote entity, typically a trust, which issues to investors securities backed by those loans. We have provided structural, advisory and other services for 38 securitization transactions since our formation in 1991, and student loan asset-backed securitizations have historically been our sole source of permanent financing for our clients' private student loan programs.
We have not taken a direct ownership interest in the student loans our clients have generated, nor have we served as a guarantor with respect to any student loan programs that we have facilitated. We have generally assisted the lenders in our loan programs in selecting their underwriting criteria used in deciding whether a student loan will be made to an applicant. However, each lender has had ultimate control over the selection of these criteria, and in providing our services we have been obligated by contract to comply with them. Union Federal has funded a portion of our proprietary loan programs in the past, although it is not doing so as of November 10, 2008. Union Federal held approximately $482.7 million of private student loans as of September 30, 2008, of which loans with a principal and interest receivable balance of $254.7 million were pledged as collateral under a warehouse facility
provided by a conduit lender. Our proprietary loan programs are Astrive Student Loans, Monticello Student Loans and Laurel Collegiate Loans.
Our lender clients have previously had the opportunity to mitigate their credit risk through a loan repayment guaranty by TERI, pursuant to which TERI guaranteed repayment of the borrower's loan principal, including capitalized interest together with accrued and unpaid interest, on defaulted loans. Lenders that wished to have TERI guaranty their loans were required to meet TERI's underwriting criteria.
In the past, we offered our clients a fully integrated suite of outsourcing services, but we did not charge separate fees for many of those services. Moreover, although we received fees for providing loan processing services to TERI in connection with TERI-guaranteed loans, and fees from certain of our clients for marketing coordination services, those fees represented reimbursement of the direct expenses we incurred. Accordingly, we did not earn a profit on those fees in the past. Although we provided those various services without charging a separate fee, or at "cost" in the case of processing services for TERI-guaranteed loans and marketing coordination services, we generally entered into agreements with the lender clients giving us the exclusive right to securitize the student loans that they did not intend to hold. We received structural advisory fees and residuals for facilitating securitizations of those loans.
We have been unable to access the securitization market since September 2007 as a result of market disruptions that began in the second quarter of fiscal 2008 and persist as of November 10, 2008. That inability, together with the TERI Reorganization, has impacted our client relationships, resulted in the termination of certain material client agreements, reduced our facilitated loan volume and challenged our business prospects. During the first quarter of fiscal 2008, we facilitated loans with an aggregate principal balance of $2.4 billion and received $46.2 million in processing fees from TERI. During the first quarter of fiscal 2009, we facilitated loans with an aggregate principal balance of $128.1 million and received $2.4 million in processing fees from TERI.
We have refined our products and services, and significantly reduced our operating expenses, in an attempt to overcome the challenges currently facing us. We have worked over the past several months to develop all facets of a new private label loan program that would not require a guaranty from a third party, as well as outsourced loan origination services and portfolio management services on a stand alone basis. As a result, we are able to offer both a fully integrated suite of services for private student loan programs, as well as certain services on a fee-for-service basis. We expect in the future to enter into arrangements with private label lenders under which we provide fee-based outsourcing services, but may not have the exclusive right to securitize the student loans that they fund. As in the past, however, we expect our level of profitability to continue to depend in the future on our ability to earn structural advisory fees and residuals for facilitating securitizations. We also generate fees as the administrator of the trusts that have purchased the private label loans, and in this capacity monitor the performance of the loan servicers.
Changes in any of the following factors have materially affected and may continue to materially affect our financial results:
º •
º the private student loan securitization market, including the costs or
availability of financing and market receptivity to private student
loan asset backed notes and auction rate notes;
º •
º developments in connection with the TERI Reorganization;
º •
º regulatory capital requirements of Union Federal and valuation
adjustments relating to its portfolio of private student loans held
for sale;
º •
º our critical accounting policies and estimates, and federal and state
income taxes;
º •
º the demand for private education financing, which may be affected by
limitations established by the federal government on the amount of
federal loans that a student can receive, the terms and eligibility
criteria for loans under the federal government's Parent Loans for
Undergraduate Students, or PLUS, program and legislation recently
passed or under consideration as of the date of this quarterly report;
º •
º the competition for providing private education financing;
º •
º the education financing preferences of students and their families as
well as educational institutions;
º •
º applicable laws and regulations, which may affect the terms upon which
lenders agree to make private student loans and the cost and
complexity of our loan facilitation operations;
º •
º actions taken by the rating agencies, including changes to transaction
assumptions, ratings actions on outstanding securitization
transactions and/or modifications of credit enhancement levels;
º •
º borrower default rates and our ability to recover principal and
interest from such borrowers;
º •
º prepayment rates of private student loans held by our trusts; and
º •
º the availability of student loans or grants through government
programs.
Business Trends, Uncertainties and Outlook
Portfolio Funding. Dislocations in the debt capital markets persisted throughout the first quarter of fiscal 2009, and we did not complete a securitization during the quarter. We expect the TERI Reorganization to materially adversely affect our ability to facilitate the securitization of TERI-guaranteed loans. As a result, we do not expect to complete a securitization in the near-term and may not complete any securitizations during fiscal 2009.
In addition, we expect pricing terms in future securitizations, if any, to be substantially less favorable than in the past and investors to have limited or no demand for subordinate tranches of ABS in securitization transactions, if any, that we are able to facilitate. If we are able to facilitate the securitization of TERI-guaranteed loans in the future, our up-front structural advisory fee yields would likely decline and market conditions would likely dictate that we obtain additional credit enhancement for such securitizations, the cost of which would result in lower revenues and additional cash requirements.
Student loan asset-backed securitizations have historically been our sole source of permanent financing for our clients' private student loan programs. We have pursued alternative means to finance our clients' loans, but other sources of funding have not been available on acceptable terms, if available at all. Recent conditions in the capital markets have generally resulted in a substantial widening of credit spreads and significantly more restrictive covenants, which have adversely affected the pricing, terms and conditions of alternative funding mechanisms we have pursued. In addition, the TERI Reorganization and subsequent ratings downgrades resulted in events of termination under the indenture relating to an education loan warehouse facility to fund the purchase of education loans from Union Federal. As a result, the facility is no longer available to finance student loans originated by Union Federal on an interim basis. The facility terminated in July 2008.
TERI Reorganization. In June 2008, in the context of the TERI Reorganization, our "master" agreements with TERI were terminated, effective as of May 31, 2008. We entered into a transition services agreement with TERI pursuant to which we provided a reduced level of services, and received
a reduced level of fees. The term of the transition services agreement expired on September 29, 2008. In October 2008, we entered into a letter agreement with TERI, subject to subsequent approval by the Bankruptcy Court, to provide limited additional services to TERI, including continued occupancy through December 15, 2008 of certain office space subleased by TERI from us. TERI paid $0.2 million of rent in advance in consideration for the continued occupancy, and the sublease relating to the office space will terminate as of December 15, 2008.
The official committee of TERI's unsecured creditors, which we refer to as the creditors committee, continues to have a right to challenge the validity, perfection, priority or enforceability of the securitization trusts' security interests in funds to be transferred after the filing of TERI's petition for reorganization, which we refer to as post-petition transfers, to the segregated reserve accounts pledged by TERI to such trusts, which we refer to as pledged accounts. The creditors committee may also challenge the trusts' security interests in any other collateral securing TERI's guaranty obligations, other than funds in the pledged accounts as of April 7, 2008. TERI may also continue to have a similar right to challenge the trusts' security interests, but such right is being challenged by the creditors committee as of November 10, 2008. We expect TERI or the creditors committee to raise potential objections with regard to the validity or perfection of the trusts' security interests in certain collateral, in particular, the trusts' security interests in cash recoveries on defaulted loans and proceeds expected by us to be deposited in the pledged accounts from sales by TERI of rehabilitated loans back to the trusts.
If the creditors committee or any other party were successful in challenging the trusts' security interests in the post-petition transfers to the pledged accounts or other collateral, including recoveries, the amount of pledged collateral available exclusively to a particular securitization trust to satisfy TERI's guaranty obligations to that trust would decrease materially. As a result, the trust's unsecured claims against TERI would increase proportionately. For example, recoveries from defaulted student loans, which have historically been used to replenish a particular trust's pledged account, would instead become an asset of TERI's bankruptcy estate and available to satisfy administrative claims of TERI's bankruptcy estate and other holders of claims in accordance with the priorities established by the Bankruptcy Code. In addition, TERI may seek to reject its guaranty obligations entirely in the context of the TERI Reorganization. Any of these developments would decrease materially our service receivables and could further harm our ability to structure securitizations in the future.
Beginning in June 2008, TERI resumed paying its obligations under the guaranty agreements with respect to defaulted loans from the trusts, but only using cash in the pledged account established for the benefit of the specific trust that owned the defaulted loan. As of November 10, 2008, TERI is not permitted to satisfy its guaranty obligations using funds from TERI's general reserves. Funds in the pledged accounts of certain trusts have been exhausted, or are expected to be exhausted in the near term, at which point such trust will have a general unsecured claim against TERI. TERI has not resumed paying guaranty obligations with respect to defaulted loans of lenders holding TERI-guaranteed loans that have not been securitized.
Certain of our agreements with clients provide for termination rights in the event of the filing by TERI of a voluntary petition under federal bankruptcy laws. As a result of the TERI Reorganization, certain clients, including JPMorgan Chase Bank, N.A., Bank of America, N.A. and RBS Citizens, N.A. have terminated some or all of their agreements with us. These terminations will result in a significant reduction in our facilitated loan volumes during fiscal 2009 compared to prior fiscal years. In addition, we expect that the guaranty agreements or loan origination agreements that a significant number of our clients have with TERI will be terminated in the context of the TERI Reorganization. Termination of a client's guaranty agreement or loan origination agreement with TERI would generally result in the termination of our agreements with the client. As a result, we expect to lose additional clients in the future as the TERI Reorganization evolves unless we can develop an alternative to a TERI-guaranteed private label loan program acceptable to former, current and prospective clients.
Write-down of Service Receivables and Loans Held for Sale. Our financial results for the first quarter of fiscal 2009 reflected our inability to access the securitization market, as well as:
º •
º a $98.0 million pre-tax write-down of our service receivables as a
result of certain changes to assumptions used to derive the estimated
fair values of these receivables, as further detailed below under the
caption "Application of Critical Accounting Policies and
Estimates-Service Revenue and Receivables."
º •
º a $21.2 million write-down of the carrying value of our portfolio of
private education loans held for sale, as further described below in
Item 3 under the caption "Quantitative and Qualitative Disclosures
about Market Risk."
In general, each of these adjustments was necessary as a result of conditions in the capital markets and performance trends. We believe that our portfolios of securitized and unsecuritized loans may continue to be adversely affected by a negative consumer credit cycle that is affecting many other classes of consumer loans.
Liquidity and Capital Resources. In August 2008, we received $132.7 million in gross proceeds from the sale of shares of series B preferred . . .
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