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| FMD > SEC Filings for FMD > Form 10-Q on 6-Nov-2009 | All Recent SEC Filings |
6-Nov-2009
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.
We use the terms "First Marblehead," "we," "us" and "our" in this quarterly report to refer to the business of The First Marblehead Corporation, or "FMC," and its subsidiaries on a consolidated basis.
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. For this purpose, any statements contained herein regarding our strategy, future operations and products, financial performance, future funding transactions, projected costs, future market position, prospects, plans and outlook 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 guaranty 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 "-Executive Summary-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 6, 2009.
Executive Summary
Overview
We offer outsourcing services to national and regional financial institutions and educational institutions for designing and implementing private education loan programs. These private education loan programs are designed to be marketed to prospective student borrowers and their families directly or through educational institutions and to generate portfolios intended to be held by the originating lender or financed in the capital markets. In addition, we provide administrative and other services to securitization trusts that we have facilitated, asset servicing to the third-party owner of certain securitization trusts and portfolio management services to a limited number of clients.
We offer prospective clients the opportunity to outsource key components of their private education loan programs to us by providing a fully integrated suite of services, including our new Monogram product offering. In addition, we offer the following services on a stand alone, fee-for-service basis:
º •
º Loan origination-We can provide loan processing services to schools
and lenders, from application intake through loan disbursement. We are
able to customize our services to meet the specific branding, pricing
and underwriting requirements of our clients.
º •
º Portfolio management-We manage private education loan portfolios on
behalf of their owners by employing risk analytics to monitor and
manage the performance of the portfolio over time.
As part of this service offering, we monitor portfolio performance metrics, work with our clients to manage the performance of third-party vendors and interface with rating agencies. Our infrastructure provides us with data that enables robust analytics, and we are able to customize collections strategies as needed to optimize loan performance.
º •
º Trust administration-As administrator for securitization trusts that
we facilitated, we monitor the performance of the loan servicers and
third-party collection agencies, including ensuring compliance with
servicing guidelines and review of default prevention and collections
activities. In this capacity, we are responsible for reconciliation of
funds among the third parties and the trusts. We also provide regular
reporting to investors in the asset-backed securities, or ABS, issued
by the trusts and other parties related to the trusts.
º •
º Asset Servicing-Our experience enables us to offer asset servicing
such as residual analysis and valuation optimization services and
strategies relating to asset funding.
We also provide banking services such as residential and commercial mortgage loans, retail savings products, time deposit products and money market accounts through our subsidiary Union Federal Savings Bank, or Union Federal, which is a federally chartered thrift regulated by the Office of Thrift Supervision, or OTS. In the past, Union Federal has also offered private education loans directly to consumers. Substantially all of our financial results have been derived from these activities, which are considered to be in a single industry segment for financial reporting purposes.
Our new Monogram product offering encompasses some or all of our service offerings and enables a lender to customize its loan program to meet its risk control and return objectives without a third-party guaranty. Specifically, the lender can customize the range of loan terms offered to its qualified applicants, such as repayment options, loan limits and borrower pricing. The Monogram product is based on our proprietary origination risk score model, which uses borrower and cosigner attributes, as well as distribution channel variables, to assign a specific level of credit risk to the application at the time of initial credit decisioning. A score is assigned to each application and governs the loan terms offered to applicants who have been conditionally approved for a loan. For example, higher risk applicants may not be eligible to defer principal and interest while in school. Our on-line application also provides a qualified applicant with some ability to configure loan terms, showing the financial effects of the choices using a real-time repayment calculator. The product can be structured to offer lenders either a "make and hold" or "make and sell" loan program. In "make and hold" loan programs, lenders finance the loans on their balance sheet and generally intend to continue to hold the loans through the scheduled repayment, prepayment or default. In "make and sell" loan programs, lenders intend to hold the loans on their balance sheet for some limited period of time before disposing of the loans in a capital markets transaction. We believe that the loans generated through the Monogram loan product will generally have shorter repayment terms, higher cosigner participation rates, and an increased percentage of borrowers making payments while in school compared to our past loan products. The success of the new product will be the key driver of our future financial results and will be critical to growing and diversifying our revenues and client base. In light of regulatory constraints, Union Federal is not expected to participate as a program lender during fiscal 2010.
Historically, the driver of our results of operations and financial condition has been the volume of private education loans for which we provided outsourcing services from loan origination through securitization. In addition, asset-backed securitizations were our sole source of permanent financing for our clients' private education loan programs, and substantially all of our income was derived from such securitizations. Securitization refers to the technique of pooling loans and selling them to a special purpose, bankruptcy remote entity, typically a trust, which issues bonds backed by those loans to investors. 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. Although we provided those various services without charging a separate fee, or at "cost" in the case of loan processing services, we generally
entered into agreements with the lender clients giving us the exclusive right to securitize the private education loans that they did not intend to hold. For our past securitization services, we are entitled to receive from the trusts additional structural advisory fees over time and, in the case of certain trusts, residual cash flows.
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, accelerated during the third quarter of fiscal 2008 and, to a lesser extent, persist as of November 6, 2009. In addition, our lender clients previously had the opportunity to mitigate their credit risk through a loan repayment guaranty by The Education Resources Institute, Inc., or TERI, and we historically received reimbursement from TERI for outsourced loan processing services we performed on TERI's behalf. In April 2008, TERI filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code, or Bankruptcy Code. We refer in this quarterly report to TERI's bankruptcy proceedings as the TERI Reorganization. The TERI Reorganization, together with capital markets dislocations, has had, and will likely continue to have, a material negative effect on securitization trusts' ability to realize guaranty obligations of TERI, our client relationships, our facilitated loan volumes, the value of our service receivables and our ability to realize fully the cost reimbursement obligations of TERI.
As a result, we took several measures in fiscal 2009 to adjust our business model. Our new Monogram product offering has been designed to reduce our dependence on the securitization market in order to generate revenue, as well as our dependence on credit enhancement. We have changed our fee structure with respect to our services and developed additional services that would provide us with fee-based income as our services are provided. In addition, in August 2009, we received $132.7 million in gross proceeds from an equity financing, and we greatly reduced our annual cash expenditure requirements through reductions in headcount, consolidation of office space and other cost saving initiatives that began in fiscal 2008. Finally, as of March 31, 2009, we sold the trust certificate of NC Residuals Owners Trust, which represented our residual interests in trusts holding substantially all of the TERI-guaranteed private education loans that we previously securitized. We refer to this trust certificate in this quarterly report as the Trust Certificate, and to these trusts as the NCSLT Trusts. We remain focused on preserving capital and maximizing liquidity in these challenging market conditions.
Recent Developments
We have summarized below certain recent developments affecting our business since the beginning of the first quarter of fiscal 2010:
º •
º On July 2, 2009, we entered into a supervisory agreement with the OTS
that requires us, among other things, to maintain Union Federal's
regulatory capital ratios at specified levels. We refer to the
agreement in this quarterly report as the Supervisory Agreement. Union
Federal entered into a stipulation in July 2009 consenting to the
issuance by the OTS of an order to cease and desist, which we refer to
in this quarterly report as the Order. See "Risks Relating to
Regulatory Matters" in Part II, Item 1A of this quarterly report for
additional details. We have taken steps to address the matters
identified by the OTS in the Supervisory Agreement and the Order and
the requirements imposed on Union Federal and us by the OTS.
º •
º In August 2009, we completed the development of our new Monogram
product offering. As of November 6, 2009, we had not fully deployed
the product to any clients, although we are engaged in discussions
with national and regional lenders regarding the product offering.
º •
º On October 1, 2009, we received $176.6 million from the Internal
Revenue Service as a refund for federal income taxes previously paid
by us on prior taxable income. The refund resulted from our loss from
operations and the sale of residual interests in the NCSLT Trusts.
º •
º We favorably resolved certain securities litigation, including state
and federal shareholder derivative lawsuits. On October 1, 2009, the
Massachusetts Superior Court entered an order for dismissal without
prejudice of a state derivative action filed in June 2008 against
certain of our current and former officers and directors and nominally
against us. On October 6, 2009, the United States District Court for
the District of Massachusetts entered an order for dismissal with
prejudice of a consolidated federal derivative action filed against
certain of our current and former officers and directors and nominally
against us. In addition, the period during which plaintiffs could
appeal the dismissal of the consolidated class action lawsuit filed in
November 2008 has expired. No compensation in any form passed directly
or indirectly from any defendant to any plaintiffs or plaintiffs'
attorneys in any of these actions. See Note 14, "Subsequent
Events-Resolution of Securities Litigation," in the notes to our
unaudited condensed consolidated financial statements included under
Part I, Item 1 of this quarterly report for additional details.
º •
º On October 16, 2009, following receipt of approval from the OTS, Union
Federal sold a portfolio of private education loans with an aggregate
outstanding principal and accrued interest balance of approximately
$233.8 million. The portfolio represented approximately 88% of the
private education loans held by Union Federal as of September 30,
2009, measured by principal balance, and the sale resulted in gross
proceeds to Union Federal of approximately $121.5 million. As a result
of the sale, Union Federal achieved the reduction required by the
Order in the level of private education loans held by Union Federal.
Union Federal plans to sell the balance of its private education loan
portfolio to an affiliate by December 31, 2009, subject to OTS
approval.
Business Trends and Uncertainties
Beginning in late 2007 and continuing through the date of this quarterly report, general economic conditions in the United States have deteriorated. Our business has been and continues to be materially adversely impacted by these conditions, and our inability to access the securitization markets as a result of market disruptions continued during the first quarter of fiscal 2010. In addition, credit performance of consumer-related loans generally, and the private education loans held by us and the various securitization trusts we have facilitated, continued to be adversely affected by general economic conditions, including increasing unemployment rates. The interest rate, economic and credit environments may continue to have a material negative effect on the estimated value of our service receivables and loans held for sale.
During the first quarter of fiscal 2010, we increased the weighted-average gross default rate assumptions used to estimate the fair value of our additional structural advisory fees, asset servicing fees and residuals receivables by 111 basis points to 20.11%. Since June 30, 2006, we have increased the projected weighted-average gross default rates for the NCSLT Trusts by 1,089 basis points. The portfolio of private education loans held by us has also experienced a higher level of defaults than we originally projected. During the first quarter of fiscal 2010, prepayment rates, however, remained at a rate that is extremely low by historical standards. During the first quarter of fiscal 2010, we recorded an unrealized loss of $123.9 million in connection with write-downs of our loans held for sale to their estimated fair value. We recorded aggregate losses during fiscal 2009 of $138.2 million in connection with similar write-downs. We may record a realized or unrealized loss in the future in connection with the remaining portfolio of private education loans held for sale.
Changes in any of the following factors could materially affect our financial results:
º •
º market acceptance of our Monogram product offering and our fee for
service offerings;
º •
º demand for private education financing, which may be affected by
changes in 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 loan programs and legislation recently passed or under consideration as of November 6, 2009;
º •
º competition for providing private education financing and reluctance
by lenders to participate in the private education loan market;
º •
º private education loan securitization market, including the costs or
availability of financing, the impact of government efforts such as
the Term Asset-Backed Securities Loan Facility, or TALF, and market
receptivity to private education loan asset-backed securitizations;
º •
º regulatory requirements applicable to Union Federal and us, including
the Supervisory Agreement and the Order;
º •
º valuation adjustments relating to the portfolio of private education
loans held for sale by UFSB Private Loan SPV, LLC;
º •
º general interest rate and consumer credit environments, including
their effect on our assumed discount, net default and prepayment rates
and the trusts' ability to recover principal and interest from
borrowers;
º •
º our critical accounting policies and estimates;
º •
º challenges relating to the federal income tax treatment of the sale of
the Trust Certificate or our asset servicing agreement with the
purchasers of the Trust Certificate, including proceedings relating to
any tax refund previously received;
º •
º changes in generally accepted accounting principles, which could
impact the carrying value of assets and liabilities, as well as
require the consolidation of certain off-balance sheet entities;
º •
º applicable laws and regulations, which may affect the terms upon which
lenders agree to make private education loans, recovery rates on
defaulted education loans and the cost and complexity of our loan
facilitation operations;
º •
º developments in connection with the TERI Reorganization, including
approval of the plan of reorganization proposed by TERI and the
official committee of unsecured creditors, or Creditors Committee, on
September 22, 2009; and
º •
º actions taken by rating agencies, including changes to transaction
assumptions, ratings actions on outstanding securitization
transactions and/or modifications of credit enhancement levels.
In addition, rating agencies have expressed concerns that direct to consumer loans will experience higher levels of defaults than school channel loans. A significant portion of the loans that we have facilitated for clients in the past, and all of our private education loans held for sale at September 30, 2009, are direct to consumer loans. We believe, however, that conditions in capital markets began to improve during the first quarter of fiscal 2010, including additional issuances of private education loan ABS pursuant to the TALF program. If we are able to facilitate the securitization of private education loans in the future, we expect the structure and economics of such a transaction to be substantially different from our past transactions. We expect lower revenues and additional cash requirements on our part and limited, if any, demand for subordinate tranches of ABS.
In July 2009, Union Federal agreed pursuant to the Order to submit to the OTS a new business plan for Union Federal covering fiscal years 2010, 2011 and 2012. We are uncertain whether the OTS will approve the new business plan that we proposed for Union Federal, including the extent to which Union Federal will be permitted to originate private education loans. See Note 13, "Union Federal Regulatory Matters-Supervisory Agreement and Order to Cease and Desist."
Application of Critical Accounting Policies and Estimates
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP. The preparation of these financial statements requires us to make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities at the report date and the reported amounts of income and expenses during the reporting periods. We base our estimates, assumptions and judgments on historical experience and on various other factors that we believe are reasonable under the circumstances. Actual results may differ from these estimates under varying assumptions or conditions.
Our significant accounting policies are more fully described in Note 2, "Summary of Significant Accounting Policies," in the notes to our audited consolidated financial statements for the fiscal year ended June 30, 2009, which are included under Item 8 of our annual report on Form 10-K filed with the Securities and Exchange Commission, or SEC, on September 3, 2009. On an ongoing basis, we evaluate our estimates and judgments, particularly as they relate to accounting policies that we believe are most important to the portrayal of our financial condition and results of operations, such as those involving recognition of service revenues and the valuation of our service receivables and portfolio of private education loans held for sale. We regard an accounting estimate or assumption underlying our financial statements to be a "critical accounting estimate" where:
º •
º the nature of the estimate or assumption is material due to the level
of subjectivity and judgment necessary to account for highly uncertain
matters or the susceptibility of such matters to change; and
º •
º the impact of the estimates and assumptions on our financial condition
or operating performance is material.
We have discussed our accounting policies with the Audit Committee of our Board of Directors, and we believe that our estimates relating to the recognition and valuation of our securitization-related revenue and receivables and asset servicing revenue and receivables, as described below, fit the definition of critical accounting estimates. We also consider our policy with respect to the determination of whether or not to consolidate the financial results of the securitization trusts that we facilitate and the valuation of the portfolio of private education loans held for sale to be critical accounting policies.
We have historically structured and facilitated securitization transactions for our clients through a series of bankruptcy remote, special purpose statutory trusts. Through the securitization process, the trusts obtain private education loans from the originating lenders or their assignees, which relinquish to the trust their ownership interest in the loans. The debt instruments that the trusts issue to finance the purchase of these private education loans are obligations of the trusts, rather than our obligations or those of originating lenders or their assignees. We have received several types of fees in connection with our past securitization services:
º •
º Up-front structural advisory fees. We received a portion of the
structural advisory fees at the time the securitization trust
purchased the loans.
º •
º Additional structural advisory fees. We are entitled to receive a
portion of the structural advisory fees over time, based on the amount
of loans outstanding in the trust from time to time over the life of
the trust.
º •
º Asset servicing fees. For the NCLST Trusts for which we were
previously entitled to receive a portion of the residual interests, we
are now entitled to receive asset servicing fees for services we are
contractually obligated to perform on behalf of the new residual
interest owners. Receipt
of such fees is contingent upon distributions available to the owners of the residual interests of such trusts. See Note 4, "Service Receivables and Related Revenues," in the notes to our unaudited condensed consolidated financial statements included under Part I, Item 1 of this quarterly report for additional details.
º •
º Residuals. We also have the right to receive a portion of the residual
interests, if any, generated by various securitization trusts other
than the NCSLT Trusts. This right is junior in priority to the rights
of the holders of the debt sold in the securitizations and additional
structural advisory fees.
As required under GAAP, we recognize the fair value of additional structural advisory fees and residuals as revenue at the time the securitization trust purchases the private education loans, as they are deemed to be earned at the time of the securitization but before we actually receive payment. These amounts are deemed earned because evidence of an arrangement exists, we have provided the services, the fee is fixed and determinable based upon a discounted cash flow analysis, there are no future contingencies or obligations and collection is reasonably assured. We earn asset servicing fees as the services are performed; however, the receipt of the fees is contingent on distributions available to the owners of the residual interests of the trusts subject to these services. Under GAAP, we are required to estimate the fair value of the additional structural advisory fees, asset servicing fees and residuals receivables as if they are investments in securities classified as trading, similar to retained interests in securitizations. In subsequent periods, we reevaluate the estimated fair value of these receivables and recognize the change in fair value as servicing revenue in the period in which the change in estimate occurs.
Because there are no quoted market prices for our additional structural advisory fees, asset servicing fees or residuals receivables, we use discounted cash flow modeling techniques and the following key assumptions to estimate their values:
º •
º expected annual rate and timing of loan defaults, and TERI's
obligation to pay default claims, if applicable;
º •
º discount rate, which we use to calculate the present value of our
future cash flows;
º •
º expected amount and timing of recoveries of defaulted loans, including
use of recoveries to replenish trusts' segregated reserve accounts
pledged to the securitization trusts by TERI to secure its guaranty
obligations, which we refer to as Pledged Accounts;
º •
º trend of interest rates over the life of the loan pool, including the
forward London Interbank Offered Rate, or LIBOR, curve and the spread
. . .
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