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| SLM > SEC Filings for SLM > Form 10-K on 2-Mar-2009 | All Recent SEC Filings |
2-Mar-2009
Annual Report
FORWARD-LOOKING AND CAUTIONARY STATEMENTS
Some of the statements contained in this Annual Report discuss future expectations and business strategies or include other "forward-looking" information. Those statements are subject to known and unknown risks, uncertainties and other factors that could cause the actual results to differ materially from those contemplated by the statements. The forward-looking information is based on various factors and was derived using numerous assumptions.
OVERVIEW
This section provides an overview of the Company's 2008 business results from a financial perspective. Certain financial impacts of funding and liquidity, loan losses, asset growth, fee income, the distressed debt purchased paper business, operating expenses, and capital adequacy are summarized below. The income statement amounts discussed in this Overview section are on a "Core Earnings" basis.
As discussed in the Business section, legislative changes to the FFELP, the credit markets and the economic downturn impacted the Company's financial results for 2008. The Company reported $526 million in "Core Earnings" net income, a decrease from $560 million in 2007. ("Core Earnings" are defined in "BUSINESS SEGMENTS - Limitations of 'Core Earnings' - Pre-tax Differences between 'Core Earnings' and GAAP by Business Segment.")
Funding and Liquidity
The Company's results were affected by higher funding costs than in prior periods. The higher costs were, in part, related to the 2008 Asset-Backed Financing Facility; the after-tax fees for this Facility were $225 million for the year. This Facility was reduced from $34 billion at the beginning of the year to $28 billion by year end and was extended by 60 days to mature on April 28, 2009.
Our funding costs were also affected by higher than average interest rate index divergence. Most of our FFELP loans earn interest based on market CP rates; our funding costs are primarily based on LIBOR. Due to government intervention in the CP marketplace and other market dislocations, the spread widened as much as 200 basis points on certain days during the fourth quarter of 2008, compared to an average spread of 8 basis points in the third quarter of 2008. ED established an alternative interest rate calculation for a portion of the fourth quarter to address the issue, which resulted in a 21 basis point spread for the Company for the fourth quarter.
In the fourth quarter, we secured access to stable and profitable funding sources for new FFELP and Private Education Loan originations. ECASLA provides FFELP lenders with access to unlimited funding to meet student demand through AY 2009-2010. Our Private Education Loan originations are being funded by term deposits issued by Sallie Mae Bank.
The Company's primary funding challenge is to replace our short-term funding sources, principally the 2008 Asset-Backed Financing Facility, with longer-term, lower-cost funding. Two federally-sponsored programs, the ED Conduit Program and the Federal Reserve Bank of New York's Term Asset-Backed Liquidity Facility, which are discussed in the "LIQUIDITY AND CAPITAL RESOURCES" section, are under development and offer significant potential. At year end, approximately $30 billion in student loans assets were eligible for these programs, which are expected to be operational in the first quarter of 2009.
In 2008, we issued approximately $26 billion in term funding, including $18.5 billion in term FFELP ABS funding, which carried an average spread of 125 basis points over LIBOR. In early January 2009, we
announced a $1.5 billion, 12.5 year asset-backed securities facility. The cost of this facility is expected to average LIBOR plus 5.75 percent and is expected to fund our Private Education Loans. Though significantly more expensive than historical transactions, this facility demonstrates term funding capability and availability for our Private Education Loan portfolio.
At year end, 70 percent of our Managed student loans were funded for the life of the loans and another 12 percent were funded for an average life of 4.3 years.
At year end, we held approximately $11 billion in primary liquidity, consisting of cash and short-term investments and committed lines of credit. We have $5.2 billion in standby liquidity in the form of unencumbered FFELP loans.
Loan Losses
On a "Core Earnings" basis, the loan loss provision for the year was $1 billion, of which $127 million was for FFELP loans. The provision for Private Education Loans in the fourth quarter was $348 million, approximately double the average of the first three quarters of the year. We began significantly increasing the Private Education Loan allowance for loan loss in the fourth quarter of 2007 and throughout 2008 primarily related to the continued weakening of the U.S. economy, which in particular impacts our non-traditional loans which are now moving into repayment status. At year end, our Private Education Loan allowance for loan loss covered approximately two years of expected losses for Private Education Loans.
Asset Growth
In 2008, the Company originated $17.9 billion in FFELP loans, a four percent increase over 2007. We refocused our FFELP originations on our internal lending brands, which grew 48 percent over 2007. We expect FFELP volume to exceed $20 billion in AY 2008-2009.
Private Education Loan originations for 2008 were $6.3 billion, a 20 percent decline from 2007. In 2008, the Company increased its underwriting standards and as a result, average FICO scores and loans with cosigner have increased. The Company expects to continue to increase its underwriting standards, shorten the term of Private Education Loans, and require interest payments while students are attending school. The impact of these product changes and the overall economy may impact future Private Education Loan asset growth.
Fee Income
Fee income from our contingency business was relatively stable, increasing $4 million from $336 million in 2007 to $340 million in 2008.
Fee income from our guarantor servicing business was $121 million for the year, a $35 million decrease from last year. The decrease was primarily due to legislative changes that reduce by 40 percent the account maintenance fee paid to guarantee agencies, and a one-time non-recurring increase to 2007 revenue of $15 million related to a contingency resolution.
A possible source of additional fee income for 2009 is an increase in third-party servicing. We originated $0.5 billion of FFELP loans for third parties in the fourth quarter, a 14 percent increase from the year-ago quarter. The Company will seek to be a loan servicer for ED under the Loan Purchase Program.
Purchased Paper Business
We have decided to exit the debt purchased paper business (see "ASSET PERFORMANCE GROUP BUSINESS SEGMENT"). This line of business reported a $203 million after-tax loss for the year, primarily due to a $368 million pre-tax impairment charge. The economy and changes in real estate values will continue to impact this line of business.
Operating Expenses
Excluding restructuring expenses, fourth quarter 2008 operating expenses on a "Core Earnings" basis were $270 million, a 26 percent decrease from the year-ago period, exceeding the Company's 20 percent cost reduction target. For 2008, operating expenses on a "Core Earnings" basis were $1.3 billion, compared to $1.4 billion in 2007.
Capital Adequacy
At year end, the Company's tangible capital ratio was 1.8 percent of Managed assets, compared to 2 percent at 2007 year end. With 81 percent of our Managed loans carrying an explicit federal government guarantee and with 70 percent of our Managed loans funded for the life of the loan, we currently believe that our capital levels are appropriate. In the current economic environment, we cannot predict the availability nor cost of additional capital, should the Company determine that additional capital is necessary.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management's Discussion and Analysis of Financial Condition and Results of Operations addresses our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States of America ("GAAP"). Note 2 to the consolidated financial statements, "Significant Accounting Policies," includes a summary of the significant accounting policies and methods used in the preparation of our consolidated financial statements. 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. Actual results may differ from these estimates under varying assumptions or conditions. On a quarterly basis, management evaluates its estimates, particularly those that include the most difficult, subjective or complex judgments and are often about matters that are inherently uncertain. The most significant estimates and assumptions relate to the following critical accounting policies that are discussed in more detail below.
Allowance for Loan Losses
We maintain an allowance for loan losses at an amount sufficient to absorb losses incurred in our FFELP loan and Private Education Loan portfolios at the reporting date based on a projection of estimated probable net credit losses incurred in the portfolio. We analyze those portfolios to determine the effects that the various stages of delinquency have on borrower default behavior and ultimate net charge-off. We estimate the allowance for loan losses for our loan portfolio using a migration analysis of delinquent and current accounts. A migration analysis is a technique used to estimate the likelihood that a loan receivable may progress through the various delinquency stages and ultimately charge off, net of recoveries, and is a widely used reserving methodology in the consumer finance industry. We also use the migration analysis to estimate the amount of uncollectible accrued interest on Private Education Loans and write-off that amount against current period interest income. The evaluation of the allowance for loan losses is inherently subjective, as it requires material estimates that may be susceptible to significant changes. Our default estimates are based on a loss confirmation period of generally two years (i.e., our allowance for loan loss covers the next two years of expected losses). The two-year estimate of the allowance for loan losses is subject to a number of assumptions. If actual future performance in delinquency, charge-offs and recoveries are significantly different than estimated, this could materially affect our estimate of the allowance for loan losses and the related provision for loan losses on our income statement. We believe that the Private Education Loan and FFELP allowance for loan losses are appropriate to cover probable losses incurred in the student loan portfolio.
When calculating the allowance for loan losses on Private Education Loans, we divide the portfolio into categories of similar risk characteristics based on loan program type, loan status (in-school, grace, forbearance, repayment, and delinquency), underwriting criteria (FICO scores), and existence or absence of a cosigner. As noted above, we use historical experience of borrower default behavior and charge-offs to estimate the probable credit losses incurred in the loan portfolio at the reporting date. Also, we use historical borrower payment behavior to estimate the timing and amount of future recoveries on charged off loans. We then apply the default and collection rate projections to each category of loans. Once the quantitative calculation is
performed, management reviews the adequacy of the allowance for loan losses and determines if qualitative adjustments need to be considered. One technique for making this determination is through projection modeling, which is used to determine if the allowance for loan losses is sufficient to absorb net credit losses anticipated during the loss confirmation period. Projection modeling is an independent forward-looking projection of net charge-offs. Assumptions that are utilized in the projection modeling include (but are not limited to) historical experience, recent changes in collection policies and procedures, collection performance, and macroeconomic indicators. Additionally, management considers changes in laws and regulations that could potentially impact the allowance for loan losses.
The majority of our Private Education Loan programs do not require that borrowers begin repayment until six months after they have graduated or otherwise left school. Consequently, our loss estimates for these programs are generally low while the borrower is in school. At December 31, 2008, 38 percent of the principal balance in the higher education Managed Private Education Loan portfolio is related to borrowers who are in in-school or grace status and not required to make payments. As the current portfolio ages, an increasing percentage of the borrowers will leave school and be required to begin payments on their loans. The allowance for losses will change accordingly.
Similar to the rules governing FFELP payment requirements, our collection policies allow for periods of nonpayment for borrowers requesting additional payment grace periods upon leaving school or experiencing temporary difficulty meeting payment obligations. This is referred to as forbearance status and is considered separately in our allowance for loan losses. The loss confirmation period is in alignment with our typical collection cycle and takes into account these periods of nonpayment.
In general, Private Education Loan principal is charged off against the allowance when the loan exceeds 212 days delinquency. As further discussed in "LENDING BUSINESS SEGMENT - Private Education Loan Losses - Activity in the Allowance for Private Education Loan Losses," this period we corrected our charge-off methodology.
In the fourth quarter of 2007, we recorded provision expense of $667 million related to the Managed Private Education Loan portfolio. This significant increase in provision primarily related to the non-traditional portion of our loan portfolio (education loans made to certain borrowers that have or are expected to have a high default rate) which we had been expanding over the past few years. We have taken actions in 2008 to terminate these non-traditional loan programs because the performance of these loans is materially different from our original expectations and from the rest of our Private Education Loan programs. However, there can be no assurance that our non-traditional loans outstanding will not require additional significant loan provisions or have any further adverse effect on the overall credit quality of our Managed Private Education Loan portfolio.
Also, we have seen higher delinquencies and continued deterioration of the overall portfolio in 2008 due primarily to the weakening U.S. economy, which has resulted in increased provisioning for expected losses. If the economy continues to weaken beyond our expectations, the expected losses resulting from our default and collection estimates embedded in the allowance for loan losses could continue to increase.
FFELP loans are guaranteed as to their principal and accrued interest in the event of default subject to a Risk Sharing level set based on the date of loan disbursement. For loans disbursed after October 1, 1993, and before July 1, 2006, we receive 98 percent reimbursement on all qualifying default claims. For loans disbursed on or after July 1, 2006, we receive 97 percent reimbursement. The CCRAA reduces the Risk Sharing level for loans disbursed on or after October 1, 2012 to 95 percent reimbursement, which will impact the allowance for loan losses in the future.
Similar to the Private Education allowance for loan losses, the FFELP allowance for loan losses uses historical experience of borrower default behavior and a two year loss confirmation period to estimate the credit losses incurred in the loan portfolio at the reporting date. We divide the portfolio into categories of similar risk characteristics based on loan program type, school type and loan status. We then apply the default rate projections, net of applicable Risk Sharing, to each category for the current period to perform our
quantitative calculation. Once the quantitative calculation is performed, management reviews the adequacy of the allowance for loan losses and determines if qualitative adjustments need to be considered.
The 2007 FFELP provision included one-time adjustments for the repeal of the Exceptional Performer program (and the resulting increase in our Risk Sharing percentage) due to the passage of the CCRAA, which was effective October 1, 2007, as well as increased provision related to the increase in our default expectations due to an increase in recent delinquencies and claim filings. The provision in 2008 increased due to an increase in delinquencies and claim filings from the weakening of the U.S. economy, as well as the portfolio transitioning to FFELP loans, which are subject to more Risk Sharing. Since we are impacted by changes in the laws and regulations of the FFELP, any changes made to the Risk Sharing levels could have a material impact on our FFELP allowance for loan losses. Also, if the economy continues to weaken beyond our expectations, the losses embedded in the FFELP allowance for loan losses could continue to increase.
Premium and Discount Amortization
For both federally insured and Private Education Loans, we account for premiums paid, discounts received, and capitalized direct origination costs incurred on the origination of student loans in accordance with the Financial Accounting Standards Board's ("FASB") Statement of Financial Accounting Standard ("SFAS") No. 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases." The unamortized portion of the premiums and the discounts is included in the carrying value of the student loans on the consolidated balance sheet. We recognize income on our student loan portfolio based on the expected yield over the estimated life of the student loan after giving effect to the amortization of purchase premiums and accretion of student loan discounts. In arriving at the expected yield, we make a number of estimates that when changed are reflected as a cumulative adjustment to interest income in the current period. The most critical estimates for premium and discount amortization are incorporated in the Constant Prepayment Rate ("CPR"), which measures the rate at which loans in the portfolio pay down principal compared to their stated terms. The CPR estimate is based on historical prepayments due to consolidation activity, defaults, and term extensions from the utilization of forbearance, as well as, management's qualitative expectation of future prepayments and term extensions.
In the development of the CPR estimates, the effect of consolidation activity can be a significant assumption. Between 2003 and 2006, we experienced a surge in FFELP Stafford loan consolidation activity as a result of aggressive marketing and historically low interest rates. This, in turn, has had a significant effect on premium and discount amortization in our financial statements. More recently, as a result of the CCRAA and the current U.S. economic and credit environment, we, as well as many other industry competitors, have suspended our FFELP consolidation program. In lieu of consolidation, we may offer a term extension option for FFELP loans based on the borrower's total indebtedness.
Based upon these market factors, we have updated our CPR assumptions that are affected by consolidation activity, and we have updated the estimates used in developing the cash flows and effective yield calculations as they relate to the amortization of student loan premium and discount amortization.
Consolidation activity affects estimates differently depending on whether the original loans being consolidated were on-balance sheet or off-balance sheet and whether the resulting consolidation is retained by us or consolidated with a third party. When we consolidate a loan that was in our portfolio, the term of that loan is generally extended and the term of the amortization of associated student loan premiums and discounts is likewise extended to match the new term of the loan. In that process, the unamortized premium balance must be adjusted to reflect the new expected term of the consolidated loan as if it had been in place from inception.
At the beginning of 2008, when we evaluated our estimates by taking into consideration the suspension of our FFELP consolidation program, there was an expectation of increased external consolidations to third parties, but an overall decrease in total consolidation activity (when taking into account both internal consolidations and consolidations to third parties) due to a lack of financial incentive for lenders to continue offering a consolidation product. External consolidations did not significantly increase as expected; therefore,
the consolidation assumptions implemented in the first quarter of 2008 were reduced during the third quarter of 2008, as we made the decision to lower the consolidation rate as additional information became available.
Additionally, in previous years, the increased activity in FFELP Consolidation Loans had led to demand for the consolidation of Private Education Loans. Private Education Consolidation Loans provide an attractive refinancing opportunity to certain borrowers because they allow borrowers to lower their monthly payments by extending the life of the loan and/or lowering their interest rate. The private loan consolidation assumption was established in 2007 and was changed to explicitly consider private loan consolidation in the same manner as for FFELP. Because of limited historical data on private loan consolidation, the assumption primarily relies on near term plan data and timing assumptions. In the second quarter of 2008, we suspended making private consolidation loans due to funding limitations which impacted this assumption.
The consolidation, default, term extension and other prepayment factors affecting our CPR estimates are impacted by changes in our business strategy, FFELP legislative changes, and changes to the current economic and credit environment. If our accounting estimates, especially CPRs, are different as a result of changes to our business environment or actual consolidation or default activity, the previously recognized interest income on our student loan portfolio based on the expected yield of the student loan would potentially result in a material adjustment in the current period.
Fair Value Measurement
On January 1, 2008, we adopted SFAS No. 157, "Fair Value Measurements." This statement defines fair value, establishes a framework for measuring fair value within GAAP, and expands disclosures about fair value measurements. Accordingly, this statement does not change which types of instruments are carried at fair value, but rather establishes the framework for measuring fair value.
On February 12, 2008, the FASB issued FASB Staff Position ("FSP") SFAS No. 157-2, "Effective Date of SFAS No. 157," which deferred the effective date of SFAS No. 157 for nonfinancial assets and liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis. This FSP delayed the implementation of SFAS No. 157 for our accounting of goodwill, acquired intangibles, and other nonfinancial assets and liabilities that are measured at the lower of cost or market until January 1, 2009.
As such, SFAS No. 157 applies to the recurring fair value measurements of our investment portfolio accounted for under SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities;" our derivative portfolio and designated hedged assets or liabilities accounted for under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities;" and our Residual Interest in off-balance sheet securitization trusts accounted for under SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115." In general, changes in the fair value of items measured at fair value on a recurring basis will affect the consolidated statement of income and capital each period. In addition, SFAS No. 157 applies to FFELP student loans accounted for as held-for-sale loans under Statement of Position 01-6, "Accounting by Certain Entities (Including Entities with Trade Receivables) That Lend to or Finance the Activities of Others." These loans are accounted for at the lower of cost or fair value and as such affect the consolidated statements of income and capital on a non-recurring basis. Lastly, the valuation principles set forth in SFAS No. 157 apply to all financial instruments disclosed at fair value under SFAS No. 107, "Disclosures about Fair Value of Financial Instruments" in Note 16, "Fair Values of Financial Instruments," to the consolidated financial statements.
Liquidity is impacted to the extent that a decrease in fair value would result in less cash being received upon a sale of an investment. Liquidity is also impacted to the extent that changes in capital and net income affect compliance with principal financial covenants in our unsecured revolving credit facilities. Noncompliance with these covenants also impacts our ability to use our 2008 ABCP Facilities (see "LIQUIDITY AND CAPITAL RESOURCES - Additional Funding Sources for General Corporate Purposes"). Additionally, liquidity is impacted to the extent that changes in the fair value of derivative instruments result in the movement of collateral between us and our counterparties. Collateral agreements are bilateral and are based on the derivative fair values used to determine the net exposure between us and individual counterparties. For a
general description of valuation techniques and models used for the above items, see Note 16, "Fair Values of Financial Instruments," to the consolidated financial statements. For a discussion of the sensitivity of fair value estimates, see "Item 7A. Quantitative and Qualitative Disclosures about Market Risk."
In light of the recent economic turmoil occurring in the U.S., the FASB released FSP No. 157-3, "Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active," on October 10, 2008. This FSP clarified, among other things, that quotes and other market inputs need not be solely used to determine fair value if they do not relate to an active market. The FSP points out that when relevant observable market information is not available, an approach that incorporates management's judgments about the assumptions that . . .
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