UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

Form 10-K

 

 

Commission file numbers 001-13251

 

 

 

 

SLM Corporation

(Exact Name of Registrant as Specified in Its Charter)

 

 

(703) 810-3000
(Registrant’s Telephone Number, Including Area Code)

 

Securities registered pursuant to Section 12(b) of the Act
Common Stock, par value $.20 per share.
Name of Exchange on which Listed:
New York Stock Exchange
6.97% Cumulative Redeemable Preferred Stock, Series A, par value $.20 per share
Floating Rate Non-Cumulative Preferred Stock, Series B, par value $.20 per share
Name of Exchange on which Listed:
New York Stock Exchange
Medium Term Notes, Series A, CPI-Linked Notes due 2017
Medium Term Notes, Series A, CPI-Linked Notes due 2018
6% Senior Notes due December 15, 2043
Name of Exchange on which Listed:
New York Stock Exchange

 

Securities registered pursuant to Section 12(g) of the Act:
None.

 

 

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     No o

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.  Yes o     No þ

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 þ     No o

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.  þ

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

                              (Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

The aggregate market value of voting stock held by non-affiliates of the registrant as of June 30, 2007 was $23.6 billion (based on closing sale price of $57.58 per share as reported for the New York Stock Exchange — Composite Transactions).

As of January 31, 2008, there were 466,570,624 shares of voting common stock outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement relating to the registrant’s Annual Meeting of Shareholders scheduled to be held May 8, 2008 are incorporated by reference into Part III of this Report.

 

 

FORWARD-LOOKING AND CAUTIONARY STATEMENTS

 

This report contains forward-looking statements and information that are based on management’s current expectations as of the date of this document. Statements that are not historical facts, including statements about our beliefs or expectations and statements that assume or are dependent upon future events are forward-looking statements, and are contained throughout this Annual Report on Form 10-K, including under the sections entitled “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” 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 occurrence of any event, change or other circumstances that could give rise to our ability to cost-effectively refinance the aggregate interim $30 billion asset-backed commercial paper conduit facilities (collectively, the “Interim ABCP Facility”) extended to SLM Corporation, more commonly known as Sallie Mae, and its subsidiaries (collectively, “the Company”) by Bank of America, N.A. and JPMorgan Chase, N.A. in connection with the Merger Agreement (defined in the Glossary below), including any potential foreclosure on the student loans under those facilities following their termination, increased financing costs and more limited liquidity; any adverse outcomes in any significant litigation to which we are a party; our derivative counterparties may terminate their positions with the Company if its credit ratings fall to certain levels and the Company could incur substantial additional costs to replace any terminated positions; changes in the terms of student loans and the educational credit marketplace arising from the implementation of applicable laws and regulations and from changes in these laws and regulations, which, among other things, may reduce the volume, average term and yields on student loans under the Federal Family Education Loan Program (“FFELP”) 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. In addition, a larger than expected increase in third-party consolidations of our FFELP loans could materially adversely affect our results of operations. 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; incorrect estimates or assumptions by management in connection with the preparation of our consolidated financial statements; changes in the composition of our Managed FFELP and Private Education Loan portfolios; 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; changes in projections of losses from loan defaults; changes in general economic conditions; changes in prepayment rates and credit spreads; and changes in the demand for debt management services and new laws or changes in existing laws that govern debt management services. All forward-looking statements contained in this report are qualified by these cautionary statements and are made only as of the date this Annual Report on Form 10-K is filed. The Company does not undertake any obligation to update or revise these forward-looking statements to conform the statement to actual results or changes in the Company’s expectations.

 

GLOSSARY

 

Listed below are definitions of key terms that are used throughout this document. See also APPENDIX A, “FEDERAL FAMILY EDUCATION LOAN PROGRAM,” for a further discussion of the FFELP and The College Cost Reduction and Access Act of 2007.

 

CCRAA — The College Cost Reduction and Access Act of 2007.

 

Consolidation Loan Rebate Fee — All holders of FFELP Consolidation Loans are required to pay to the U.S. Department of Education (“ED”) an annual 105 basis point Consolidation Loan Rebate Fee on all outstanding principal and accrued interest balances of FFELP Consolidation Loans purchased or originated after October 1, 1993, except for loans for which consolidation applications were received between October 1, 1998 and January 31, 1999, where the Consolidation Loan Rebate Fee is 62 basis points.

 

Constant Prepayment Rate (“CPR”) — A variable in life of loan estimates that measures the rate at which loans in the portfolio pay before their stated maturity. The CPR is directly correlated to the average life of the portfolio. CPR equals the percentage of loans that prepay annually as a percentage of the beginning of period balance.

 

“Core Earnings” — In accordance with the Rules and Regulations of the Securities and Exchange Commission (“SEC”), we prepare financial statements in accordance with generally accepted accounting principles in the United States of America (“GAAP”). In addition to evaluating the Company’s GAAP-based financial information, management evaluates the Company’s business segments on a basis that, as allowed under the Financial Accounting Standards Board’s (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 131, “Disclosures about Segments of an Enterprise and Related Information,” differs from GAAP. We refer to management’s basis of evaluating our segment results as “Core Earnings” presentations for each business segment and we refer to these performance measures in our presentations with credit rating agencies and lenders. While “Core Earnings” results are not a substitute for reported results under GAAP, we rely on “Core Earnings” performance measures in operating each business segment because we believe these measures provide additional information regarding the operational and performance indicators that are most closely assessed by management.

 

Our “Core Earnings” performance measures are the primary financial performance measures used by management to evaluate performance and to allocate resources. Accordingly, financial information is reported to management on a “Core Earnings” basis by reportable segment, as these are the measures used regularly by our chief operating decision makers. Our “Core Earnings” performance measures are used in developing our financial plans and tracking results, and also in establishing corporate performance targets and determining incentive compensation. Management believes this information provides additional insight into the financial performance of the Company’s core business activities. Our “Core Earnings” performance measures are not defined terms within GAAP and may not be comparable to similarly titled measures reported by other companies. “Core Earnings” net income reflects only current period adjustments to GAAP net income. Accordingly, the Company’s “Core Earnings” presentation does not represent another comprehensive basis of accounting.

 

See Note 20 to the consolidated financial statements,“Segment Reporting,” and “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — BUSINESS SEGMENTS — Limitations of ‘Core Earnings’” for further discussion of the differences between “Core Earnings” and GAAP, as well as reconciliations between “Core Earnings” and GAAP.

 

In prior filings with the SEC of SLM Corporation’s Annual Report on Form 10-K and quarterly report on Form 10-Q, “Core Earnings” has been labeled as “‘Core’ net income” or “Managed net income” in certain instances.

 

Direct Loans — Student loans originated directly by ED under the FDLP.

 

ED — The U.S. Department of Education.

Embedded Fixed Rate/Variable Rate Floor Income — Embedded Floor Income is Floor Income (see definition below) that is earned on off-balance sheet student loans that are in securitization trusts sponsored by us. At the time of the securitization, the value of Embedded Fixed Rate Floor Income is included in the initial valuation of the Residual Interest (see definition below) and the gain or loss on sale of the student loans. Embedded Floor Income is also included in the quarterly fair value adjustments of the Residual Interest.

 

Exceptional Performer (“EP”) Designation — The EP designation is determined by ED in recognition of a servicer meeting certain performance standards set by ED in servicing FFELP Loans. Upon receiving the EP designation, the EP servicer receives reimbursement on default claims higher than the legislated Risk Sharing (see definition below) levels on federally guaranteed student loans for all loans serviced for a period of at least 270 days before the date of default. The EP servicer is entitled to receive this benefit as long as it remains in compliance with the required servicing standards, which are assessed on an annual and quarterly basis through compliance audits and other criteria. The annual assessment is in part based upon subjective factors which alone may form the basis for an ED determination to withdraw the designation. If the designation is withdrawn, Risk Sharing may be applied retroactively to the date of the occurrence that resulted in noncompliance. The College Cost Reduction Act of 2007 eliminated the EP designation effective October 1, 2007. See also Appendix A, “FEDERAL FAMILY EDUCATION LOAN PROGRAM.”

 

FDLP — The William D. Ford Federal Direct Student Loan Program.

 

FFELP — The Federal Family Education Loan Program, formerly the Guaranteed Student Loan Program.

 

FFELP Consolidation Loans — Under the Federal Family Education Loan Program (“FFELP”), borrowers with multiple eligible student loans may consolidate them into a single student loan with one lender at a fixed rate for the life of the loan. The new note is considered a FFELP Consolidation Loan. Typically a borrower may consolidate his student loans only once unless the borrower has another eligible loan to consolidate with the existing FFELP Consolidation Loan. The borrower rate on a FFELP Consolidation Loan is fixed for the term of the loan and is set by the weighted average interest rate of the loans being consolidated, rounded up to the nearest 1/8th of a percent, not to exceed 8.25 percent. In low interest rate environments, FFELP Consolidation Loans provide an attractive refinancing opportunity to certain borrowers because they allow borrowers to consolidate variable rate loans into a long-term fixed rate loan. Holders of FFELP Consolidation Loans are eligible to earn interest under the Special Allowance Payment (“SAP”) formula (see definition below).

 

FFELP Stafford and Other Student Loans — Education loans to students or parents of students that are guaranteed or reinsured under the FFELP. The loans are primarily Stafford loans but also include PLUS and HEAL loans.

 

Fixed Rate Floor Income — We refer to Floor Income (see definition below) associated with student loans whose borrower rate is fixed to term (primarily FFELP Consolidation Loans and Stafford Loans originated on or after July 1, 2006) as Fixed Rate Floor Income.

 

Floor Income — FFELP student loans generally earn interest at the higher of a floating rate based on the Special Allowance Payment or SAP formula (see definition below) set by ED and the borrower rate, which is fixed over a period of time. We generally finance our student loan portfolio with floating rate debt over all interest rate levels. In low and/or declining interest rate environments, when the fixed borrower rate is higher than the rate produced by the SAP formula, our student loans earn at a fixed rate while the interest on our floating rate debt continues to decline. In these interest rate environments, we earn additional spread income that we refer to as Floor Income. Depending on the type of the student loan and when it was originated, the borrower rate is either fixed to term or is reset to a market rate each July 1. As a result, for loans where the borrower rate is fixed to term, we may earn Floor Income for an extended period of time, and for those loans where the borrower interest rate is reset annually on July 1, we may earn Floor Income to the next reset date.

In accordance with new legislation enacted in 2006, lenders are required to rebate Floor Income to ED for all new FFELP loans disbursed on or after April 1, 2006.

 

The following example shows the mechanics of Floor Income for a typical fixed rate FFELP Consolidation Loan (with a commercial paper-based SAP spread of 2.64 percent):

 

 

 

 

Based on this example, if the quarterly average commercial paper rate is over 4.61 percent, the holder of the student loan will earn at a floating rate based on the SAP formula, which in this example is a fixed spread to commercial paper of 2.64 percent. On the other hand, if the quarterly average commercial paper rate is below 4.61 percent, the SAP formula will produce a rate below the fixed borrower rate of 7.25 percent and the loan holder earns at the borrower rate of 7.25 percent. The difference between the fixed borrower rate and the lender’s expected yield based on the SAP formula is referred to as Floor Income. Our student loan assets are generally funded with floating rate debt, so when student loans are earning at the fixed borrower rate, decreases in interest rates may increase Floor Income.

 

Graphic Depiction of Floor Income:

 

 

Floor Income Contracts — We enter into contracts with counterparties under which, in exchange for an upfront fee representing the present value of the Floor Income that we expect to earn on a notional amount of underlying student loans being economically hedged, we will pay the counterparties the Floor Income earned on that notional amount over the life of the Floor Income Contract. Specifically, we agree to pay the counterparty the difference, if positive, between the fixed borrower rate less the SAP (see definition below) spread and the average of the applicable interest rate index on that notional amount, regardless of the actual balance of underlying student loans, over the life of the contract. The contracts generally do not extend over the life of the underlying student loans. This contract effectively locks in the amount of Floor Income we will earn over the period of the contract. Floor Income Contracts are not considered effective hedges under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and each quarter we must record the change in fair value of these contracts through income.

Front-End Borrower Benefits — Financial incentives offered to borrowers at origination. Front-End Borrower Benefits primarily represent our payment on behalf of borrowers for required FFELP fees, including the federal origination fee and federal default fee. We account for these Front-End Borrower Benefits as loan premiums amortized over the estimated life of the loans as an adjustment to the loan’s yield.

 

Gross Floor Income — Floor Income earned before payments on Floor Income Contracts.

 

GSE — The Student Loan Marketing Association was a federally chartered government-sponsored enterprise and wholly owned subsidiary of SLM Corporation that was dissolved under the terms of the Privatization Act (see definition below) on December 29, 2004.

 

Guarantors — State agencies or non-profit companies that guarantee (or insure) FFELP student loans made by eligible lenders under the HEA.

 

HEA — The Higher Education Act of 1965, as amended.

 

Interim ABCP Facility — An aggregate of $30 billion asset-backed commercial paper conduit facilities that we entered into on April 30, 2007 in connection with the Merger (defined below under “Merger Agreement”).

 

Lender Partners — Lender Partners are lenders who originate loans under forward purchase commitments to Sallie Mae where we own the loans from inception or, in most cases, acquire the loans soon after origination.

 

Managed Basis — We generally analyze the performance of our student loan portfolio on a Managed Basis, under which we view both on-balance sheet student loans and off-balance sheet student loans owned by the securitization trusts as a single portfolio, and the related on-balance sheet financings are combined with off-balance sheet debt. When the term Managed is capitalized in this document, it is referring to Managed Basis.

 

Merger Agreement — On April 16, 2007, the Company announced that a buyer group (“Buyer Group”) led by J.C. Flowers & Co. (“J.C. Flowers”), Bank of America, N.A. and JPMorgan Chase, N.A. (the “Merger”) signed a definitive agreement (“Merger Agreement”) to acquire the Company for approximately $25.3 billion or $60.00 per share of common stock. (See also “Merger Agreement” filed with the SEC on the Company’s Current Report on Form 8-K, dated April 18, 2007.) On January 25, 2008, the Company, Mustang Holding Company Inc. (“Mustang Holding”), Mustang Merger Sub, Inc. (“Mustang Sub”), J.C. Flowers, Bank of America, N.A. and JPMorgan Chase Bank, N.A. entered into a Settlement, Termination and Release Agreement (the “Agreement”). Under the Agreement, a lawsuit filed by the Company related to the Merger, as well as all counterclaims, was dismissed.

 

Preferred Lender List — Most higher education institutions select a small number of lenders to recommend to their students and parents. This recommended list is referred to as the Preferred Lender List.

 

Preferred Channel Originations — Preferred Channel Originations are comprised of: 1) loans that are originated by internally marketed Sallie Mae brands, and 2) student loans that are originated by lenders with forward purchase commitment agreements with Sallie Mae and are committed for sale to Sallie Mae, such that we either own them from inception or, in most cases, acquire them soon after origination.

 

Private Education Consolidation Loans — Borrowers with multiple Private Education Loans (defined below) may consolidate them into a single loan with Sallie Mae (Private Consolidation Loans^®). The interest rate on the new loan is variable rate with the spread set at the lower of the average weighted spread of the underlying loans (available only to Sallie Mae customers) or a new spread as a result of favorable underwriting criteria.

Private Education Loans — Education loans to students or parents of students that are not guaranteed or reinsured under the FFELP or any other federal or private student loan program. Private Education Loans include loans for higher education (undergraduate and graduate degrees) and for alternative education, such as career training, private kindergarten through secondary education schools and tutorial schools. Higher education loans have repayment terms similar to FFELP loans, whereby repayments begin after the borrower leaves school. Our higher education Private Education Loans to students attending Title IV Schools are not dischargeable in bankruptcy, except in certain limited circumstances. Repayment for alternative education generally begins immediately.

 

In the context of our Private Education Loan business, we use the term “non-traditional loans” to describe education loans made to certain borrowers that have or are expected to have a high default rate as a result of a number of factors, including having a lower tier credit rating, low program completion and graduation rates or, where the borrower is expected to graduate, a low expected income relative to the borrower’s cost of attendance.

 

Privatization Act — The Student Loan Marketing Association Reorganization Act of 1996.

 

Reconciliation Legislation — The Higher Education Reconciliation Act of 2005, which reauthorized the student loan programs of the HEA and generally became effective as of July 1, 2006.

 

Repayment Borrower Benefits — Financial incentives offered to borrowers based on pre-determined qualifying factors, which are generally tied directly to making on-time monthly payments. The impact of Repayment Borrower Benefits is dependent on the estimate of the number of borrowers who will eventually qualify for these benefits and the amount of the financial benefit offered to the borrower. We occasionally change Repayment Borrower Benefits programs in both amount and qualification factors. These programmatic changes must be reflected in the estimate of the Repayment Borrower Benefits discount when made.

 

Residual Interest — When we securitize student loans, we retain the right to receive cash flows from the student loans sold to trusts we sponsor in excess of amounts needed to pay servicing, derivative costs (if any), other fees, and the principal and interest on the bonds backed by the student loans. The Residual Interest, which may also include reserve and other cash accounts, is the present value of these future expected cash flows, which includes the present value of Embedded Fixed Rate Floor Income described above. We value the Residual Interest at the time of sale of the student loans to the trust and at the end of each subsequent quarter.

 

Retained Interest — The Retained Interest includes the Residual Interest (defined above) and servicing rights (as the Company retains the servicing responsibilities).

 

Risk Sharing — When a FFELP loan defaults, the federal government guarantees 97 percent of the principal balance plus accrued interest (98 percent on loans disbursed before July 1, 2006) and the holder of the loan is at risk for the remaining amount not guaranteed as a Risk Sharing loss on the loan. FFELP student loans originated after October 1, 1993 are subject to Risk Sharing on loan default claim payments unless the default results from the borrower’s death, disability or bankruptcy. FFELP loans serviced by a servicer that has EP designation (see definition above) from ED are subject to one-percent Risk Sharing for claims filed on or after July 1, 2006 and before October 1, 2007.

 

Special Allowance Payment (“SAP”) — FFELP student loans originated prior to April 1, 2006 (with the exception of certain PLUS and SLS loans discussed below) generally earn interest at the greater of the borrower rate or a floating rate determined by reference to the average of the applicable floating rates (91-day Treasury bill rate or commercial paper) in a calendar quarter, plus a fixed spread that is dependent upon when the loan was originated and the loan’s repayment status. If the resulting floating rate exceeds the borrower rate, ED pays the difference directly to us. This payment is referred to as the Special Allowance Payment or SAP and the formula used to determine the floating rate is the SAP formula. We refer to the fixed spread to the underlying index as the SAP spread. For loans disbursed after April 1, 2006, FFELP loans effectively only

earn at the SAP rate, as the excess interest earned when the borrower rate exceeds the SAP rate (Floor Income) must be refunded to ED.

 

Variable rate PLUS Loans and SLS Loans earn SAP only if the variable rate, which is reset annually, exceeds the applicable maximum borrower rate. For PLUS loans disbursed on or after January 1, 2000, this limitation on SAP was repealed effective April 1, 2006.

 

Title IV Programs and Title IV Loans — Student loan programs created under Title IV of the HEA, including the FFELP and the FDLP, and student loans originated under those programs, respectively.

 

Variable Rate Floor Income — For FFELP Stafford student loans whose borrower interest rate resets annually on July 1, we may earn Floor Income or Embedded Floor Income (see definitions above) based on a calculation of the difference between the borrower rate and the then current interest rate. We refer to this as Variable Rate Floor Income because Floor Income is earned only through the next reset date.

 

Wholesale Consolidation Loans — During 2006, we implemented a loan acquisition strategy under which we began purchasing a significant amount of FFELP Consolidation Loans, primarily via the spot market, which augments our in-house FFELP Consolidation Loan origination process. Wholesale Consolidation Loans are considered incremental volume to our core acquisition channels, which are focused on the retail marketplace with an emphasis on our brand strategy.

 

PART I.

 

 

INTRODUCTION TO SLM CORPORATION

 

SLM Corporation, more commonly known as Sallie Mae, is the market leader in education finance. SLM Corporation is a holding company that operates through a number of subsidiaries. (References in this Annual Report to the “Company” refer to SLM Corporation and its subsidiaries).

 

Our primary business is to originate and hold student loans. We provide funding, delivery and servicing support for education loans in the United States through our participation in the Federal Family Education Loan Program (“FFELP”) and through our own non-federally guaranteed Private Education Loan programs. We primarily market our FFELP Stafford loans and Private Education Loans through on-campus financial aid offices. We have also expanded into direct-to-consumer marketing, primarily for Private Education Loans, to reach those students and families that choose not to consult with the financial aid office.

 

We have used both internal growth and strategic acquisitions to attain our leadership position in the education finance marketplace. Our sales force, which delivers our products on campuses across the country, is the largest in the student loan industry. The core of our marketing strategy is to promote our on-campus brands, which generate student loan originations through our Preferred Channel. Loans generated through our Preferred Channel are more profitable than loans acquired through other acquisition channels because we own them earlier in the student loan’s life and generally incur lower costs to acquire such loans. We have built brand leadership through the Sallie Mae name, the brands of our subsidiaries and those of our lender partners. These sales and marketing efforts are supported by the largest and most diversified servicing capabilities in the industry.

 

We have expanded into a number of fee-based businesses, most notably, our Asset Performance Group (“APG”) business (formerly, Debt Management Operations (“DMO”)). We also earn fees for a number of services including student loan and guarantee servicing, 529 college-savings plan administration services, and for providing processing capabilities and information technology to educational institutions. We also operate an affinity marketing program through Upromise, Inc. (“Upromise”). References in this Annual Report to “Upromise” refer to Upromise and its subsidiaries.

 

At December 31, 2007, we had approximately 11,000 employees.

 

CURRENT BUSINESS STRATEGY

 

On September 27, 2007, the College Cost Reduction and Access Act of 2007 (“CCRAA”) was signed into law by the President, resulting in, among other things, a reduction in the yield received by the Company on FFELP loans originated on or after October 1, 2007. In the summer of 2007, the global capital markets began to experience a severe dislocation that has persisted to present. This dislocation, along with a reduction in the Company’s unsecured debt ratings caused by the proposed Merger, resulted in more limited access to the capital markets than the Company has enjoyed in the past and a substantial increase in its cost of newly obtained funding.

 

Our management team is evaluating certain aspects of our business in light of the impact of the CCRAA and the current challenges in the capital markets. The CCRAA has a number of important implications for the profitability of our FFELP loan business, including a reduction in Special Allowance Payments, the elimination of the Exceptional Performer designation and the corresponding reduction in default payments to 97 percent through 2012 and 95 percent thereafter, an increase in the lender paid origination fees for certain loan types and a reduction in default collection retention fees and account maintenance fees related to guaranty agency activities. As a result, we expect that the CCRAA will significantly reduce and, combined with higher financing costs, could possibly eliminate the profitability of new FFELP loan originations, while also increasing our Risk Sharing in connection with our FFELP loan portfolio.

We plan to curtail less profitable student loan origination and acquisition activities that have less strategic value, including originations of Private Education Loans for high default rate and lower-tier credit borrowers, as well as spot purchases and Wholesale Consolidation Loan purchases, all of which will also reduce our funding needs. We expect to minimize incremental FFELP Consolidation Loan volume as a result of significant margin erosion for FFELP Consolidation Loans created by the combined effect of the CCRAA and elevated funding costs. However, we will continue our efforts to protect select FFELP assets existing in our portfolio. We expect to continue to aggressively pursue other FFELP-related fee income opportunities such as FFELP loan servicing, guarantor servicing and collections. In addition, we plan to reduce and, over time, to no longer offer certain borrower benefits in connection with both our FFELP loans and our Private Education Loans.

 

We expect to continue to focus on generally higher-margin Private Education Loans, originated both through our school channel and our direct-to-consumer channel, with particular attention to upholding our more stringent underwriting standards. In January 2008, we notified some of our school customers whose students have non-traditional loans that we were curtailing certain high default rate lending programs and reviewing the pricing of others. Actual credit performance at these programs was materially below our original expectations. Charge-offs at these non-traditional schools are largely driven by low program completion and graduation rates. The non-traditional portfolio is also particularly impacted by the weakening U.S. economy. We also expect to adjust our Private Education Loan pricing at all schools to reflect the current financing and market conditions.

 

We expect to see lenders exit the student loan industry in response to the CCRAA and current conditions in the credit markets and, as a result, expect to partially offset declining loan volumes caused by our more selective lending policies with increased market share assumed from participants exiting the industry.

 

The impacts of the CCRAA as well as the challenges we are facing in the capital markets are also requiring us to rationalize our business operations and reduce our costs. We are undertaking a thorough review of all of our business units with a goal of achieving appropriate risk-adjusted returns across all of our business segments and providing cost-effective services. As a result, we aim to reduce our operating expenses by up to 20 percent as compared to 2007 operating expenses by year-end 2009, before adjusting for growth and other investments. Since year-end 2007, we have reduced our work force by approximately three percent.

 

BUSINESS SEGMENTS

 

We provide an array of credit products and related services to the higher education and consumer credit communities and others through two primary business segments: our Lending business segment and our APG business segment. These defined business segments operate in distinct business environments and have unique characteristics and face different opportunities and challenges. They are considered reportable segments under the Financial Accounting Standards Board’s (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 131, “Disclosures about Segments of an Enterprise and Related Information,” based on quantitative thresholds applied to the Company’s financial statements. In addition, within our Corporate and Other business segment, we provide a number of complementary products and services to guarantors and lender partners that are managed within smaller operating segments, the most prominent being our Guarantor Servicing and Loan Servicing businesses. Our Corporate and Other business segment also includes the activities of our Upromise subsidiary. In accordance with SFAS No. 131, we include in Note 20 to our consolidated financial statements, “Segment Reporting,” separate financial information about our operating segments.

 

Management, including the Company’s chief operating decision makers, evaluates the performance of the Company’s operating segments based on their profitability as measured by “Core Earnings.” Accordingly, we provide information regarding the Company’s reportable segments in this report based on “Core Earnings.” “Core Earnings” are the primary financial performance measures used by management to develop the Company’s financial plans, track results, and establish corporate performance targets and incentive compensation. While “Core Earnings” are not a substitute for reported results under generally accepted accounting principles in the United States (“GAAP”), the Company relies on “Core Earnings” in operating its business because “Core Earnings” permit management to make meaningful period-to-period comparisons of the

operational and performance indicators that are most closely assessed by management. Management believes this information provides additional insight into the financial performance of the core business activities of our operating segments. (See “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — BUSINESS SEGMENTS” for a detailed discussion of our “Core Earnings,” including a table that summarizes the pre-tax differences between “Core Earnings” and GAAP by business segment and the limitations to this presentation. )

 

We generate most of our “Core Earnings” earnings in our Lending business from the spread between the yield we receive on our Managed portfolio of student loans and the cost of funding these loans less the provisions for loan losses. We incur servicing, selling and administrative expenses in providing these products and services, and provide for loan losses. On our consolidated statement of income, prepared in accordance with GAAP, this spread income is reported as “net interest income” for on-balance sheet loans, and as “gains on student loan securitizations” and “servicing and securitization revenue” for off-balance sheet loans for which we have a Retained Interest. Total “Core Earnings” revenues for this segment were $1.4 billion in 2007.

 

In our APG business segment, we provide a wide range of accounts receivable and collections services including student loan default aversion services, defaulted student loan portfolio management services, contingency collections services for student loans and other asset classes, and accounts receivable management and collection for purchased portfolios of receivables that are delinquent or have been charged off by their original creditors as well as sub-performing and non-performing mortgage loans. In the purchased receivables business, we focus on a variety of consumer debt types with emphasis on charged-off credit card receivables and distressed mortgage receivables. We purchase these portfolios at a discount to their face value, and then use both our internal collection operations coupled with third-party collection agencies to maximize the recovery on these receivables.

 

LENDING BUSINESS SEGMENT

 

In our Lending business segment, we originate and acquire both federally guaranteed student loans (FFELP loans), which are administered by the U.S. Department of Education (“ED”), and Private Education Loans, which are not federally guaranteed. Borrowers use Private Education Loans primarily to supplement federally guaranteed loans in meeting the cost of education. We manage the largest portfolio of FFELP and Private Education Loans in the student loan industry, serving over 10 million student and parent customers through our ownership and management of $163.6 billion in Managed student loans as of December 31, 2007, of which $135.2 billion or 83 percent are federally insured. We serve a diverse range of clients that includes over 6,000 educational and financial institutions and state agencies. We are the largest servicer of student loans, servicing a portfolio of $127.4 billion of FFELP loans and $32.6 billion of Private Education Loans as of December 31, 2007. We also market student loans, both federal and private, directly to the consumer. In addition to education lending, we originate mortgage and consumer loans. In 2007 we originated $848 million in mortgage and consumer loans. Our mortgage and consumer loan portfolio totaled $545 million at December 31, 2007, of which $19 million are mortgages in the held-for-sale portfolio.

Student Lending Marketplace

 

The following chart shows estimated sources of funding for attending two-year and four-year colleges for the academic year (“AY”) ending June 30, 2008 (AY 2007-2008). Approximately 36 percent of the funding comes from federally guaranteed student loans and Private Education Loans. Parent/student contributions consist of savings/investments, current period earnings and other loans obtained through the normal financial aid process.

 

Sources of Funding for College Attendance — AY 2007-2008⁽¹⁾

 

Total Projected Cost — $258 Billion

(dollars in billions)

 

 

 

 

  Federally Guaranteed Student Lending Programs

 

There are two competing programs that provide student loans where the ultimate credit risk lies with the federal government: the FFELP and the Federal Direct Lending Program (“FDLP”). FFELP loans are provided by private sector institutions and are ultimately guaranteed by ED except for the Risk Sharing loss. FDLP loans are funded by taxpayers and provided to borrowers directly by ED on terms similar to student loans in the FFELP. In addition to these government guaranteed programs, financial institutions also make Private Education Loans, where the lender or holder assumes the credit risk of the borrower.

 

For the federal fiscal year (“FFY”) ended September 30, 2007 (FFY 2007), ED estimated that the FFELP’s market share in federally guaranteed student loans was 80 percent, up from 79 percent in FFY 2006. (See “LENDING BUSINESS SEGMENT — Competition.”) Total FFELP and FDLP volume for FFY 2007 grew by 7 percent, with the FFELP portion growing 8 percent.

 

The Higher Education Act (the “HEA”) includes regulations that cover every aspect of the servicing of a federally guaranteed student loan, including communications with borrowers, loan originations and default aversion. Failure to service a student loan properly could jeopardize the guarantee on federal student loans. This guarantee generally covers 98 and 97 percent (95 percent after 2012) of the student loan’s principal and accrued interest for loans disbursed before and after July 1, 2006, respectively. In the case of death, disability or bankruptcy of the borrower, the guarantee covers 100 percent of the student loan’s principal and accrued interest.

FFELP student loans are guaranteed by state agencies or non-profit companies called guarantors, with ED providing reinsurance to the guarantor. Guarantors are responsible for performing certain functions necessary to ensure the program’s soundness and accountability. These functions include reviewing loan application data to detect and prevent fraud and abuse and to assist lenders in preventing default by providing counseling to borrowers. Generally, the guarantor is responsible for ensuring that loans are being serviced in compliance with the requirements of the HEA. When a borrower defaults on a FFELP loan, we submit a claim to the guarantor who reimburses us for principal and accrued interest subject to the Risk Sharing (See APPENDIX A, “FEDERAL FAMILY EDUCATION LOAN PROGRAM,” to this document for a more complete description of the role of guarantors.)

 

  Private Education Loan Products

 

In addition to federal loan programs, which have statutory limits on annual and total borrowing, we sponsor a variety of Private Education Loan programs and purchase loans made under such programs to bridge the gap between the cost of education and a student’s resources. The majority of our higher education Private Education Loans are made in conjunction with a FFELP Stafford loan, and are marketed to schools through the same marketing channels — and by the same sales force — as FFELP loans. In 2004, we expanded our direct-to-consumer loan marketing channel with our Tuition Answer^sm loan program under which we originate and purchase loans outside of the traditional financial aid process. We also originate and purchase Private Education Loans marketed by our SLM Financial subsidiary to career training, technical and trade schools, tutorial and learning centers, and private kindergarten through secondary education schools. These loans are primarily made at schools not eligible for Title IV loans. Private Education Loans are discussed in more detail below.

 

  Drivers of Growth in the Student Loan Industry

 

The growth in our Managed student loan portfolio is driven by the growth in the overall student loan marketplace, as well as by our own market share gains. Rising enrollment and college costs have resulted in the size of the federally insured student loan market more than doubling over the last 10 years. Federally insured student loan originations grew from $29.0 billion in FFY 1997 to $64.3 billion in FFY 2007.

 

According to the College Board, tuition and fees at four-year public institutions and four-year private institutions have increased 54 percent and 33 percent, respectively, in constant, inflation-adjusted dollars, since AY 1997-1998. Under the FFELP, there are limits to the amount students can borrow each academic year. The first loan limit increases since 1992 were implemented July 1, 2007 when freshman and sophomore limits were increased to $3,500 and $4,500 from $2,625 and $3,500, respectively. The fact that guaranteed student loan limits have not kept pace with tuition increases has driven more students and parents to Private Education Loans to meet an increasing portion of their education financing needs. Loans — both federal and private — as a percentage of total student aid were 53 percent of total student aid in AY 1996-1997 and 52 percent in AY 2006-2007. Private Education Loans accounted for 24 percent of total student loans — both federally guaranteed and Private Education Loans — in AY 2006-2007, compared to 7 percent in AY 1997-1998.

 

The National Center for Education Statistics predicts that the college-age population will increase approximately 14 percent from 2007 to 2016. Demand for education credit will also increase due to the rise in students not attending college directly from high school and adult education.

The following charts show the historical and projected enrollment and average tuition and fee growth for four-year public and private colleges and universities.

 

Historical and Projected Enrollment

(in millions)

 

 

Source: National Center for Education Statistics

 

Note: Total enrollment in all degree-granting institutions; middle alternative projections for 2006 onward.

 

Cost of Attendance⁽¹⁾
Cumulative % Increase from AY 1997-1998

 

 

Source: The College Board

 

 

Sallie Mae’s Lending Business

 

Our primary marketing point-of-contact is the school’s financial aid office where we focus on delivering flexible and cost-effective products to the school and its students. Our sales force is the largest in the industry and currently markets the following internal lender brands: Academic Management Services (“AMS”), Nellie Mae, Sallie Mae Education Trust, SLM Financial, Student Loan Funding Resources (“SLFR”), Southwest Student Services (“Southwest”) and Student Loan Finance Association (“SLFA”). We also actively market the loan guarantee of United Student Aid Funds, Inc. (“USA Funds”) and its affiliate, Northwest Education Loan Association (“NELA”), through a separate sales force.

 

We acquire student loans from two principal sources: our Preferred Channel and strategic acquisitions.

 

In 2007, we originated $25.5 billion in student loans through our Preferred Channel, of which a total of $16.6 billion or 65 percent was originated through our internal lending brands. The mix of Preferred Channel Originations marks a significant shift from the past, when our internal lending brands were the smallest component of our Preferred Channel Originations. Internal lending brand growth is a key factor to our long-

term market penetration. This positions us to control our future volume as well as the costs to originate new assets. Our internal lending brand loans are our most valuable loans because we do not pay a premium other than to ED to originate them. The adverse impact of the CCRAA on FFELP loan profitability has further increased the importance of our internal lending brands as a vehicle for achieving appropriate risk-adjusted returns.

 

Preferred Channel Originations growth has been fueled by new business from schools leaving the FDLP or other FFELP lending relationships, same school sales growth, and growth in the for-profit sector. Since 1999, we have partnered with over 300 schools that have chosen to return to the FFELP from the FDLP. Our FFELP loan originations at these schools totaled over $2.4 billion in 2007. In addition to working with new schools, we have also forged broader relationships with many of our existing school clients. Our FFELP and private originations at for-profit schools have grown faster than at not-for-profit schools due to enrollment trends as well as our increased market share of lending to these institutions. We expect that in 2008 and in subsequent years this trend will be reversed. Many of our for-profit school customers have programs for which we offer non-traditional loans. As we cut back on Private Education Loan programs to this non-traditional segment of our customer base, we expect to lose FFELP loan volume originated through these schools as well. Similarly, as we reduce premiums for lender partner and school-as-lender purchases, we expect to lose FFELP volume. Accordingly, we expect volume in both FFELP loan and Private Education Loan originations to decline in 2008 relative to 2007.

 

Consolidation Loans

 

Between 2003 and 2006, we experienced a surge in consolidation activity as a result of aggressive marketing and historically low interest rates. This growth has contributed to the changing composition of our student loan portfolio. FFELP Consolidation Loans earn a lower yield than FFELP Stafford Loans due primarily to the Consolidation Loan Rebate Fee. The Consolidation Loan margin was 75 basis points lower than a FFELP Stafford loan in repayment as a result of this fee. This negative impact is somewhat mitigated by the longer average life of FFELP Consolidation Loans. FFELP Consolidation Loans now represent 67 percent of both our on-balance sheet federally guaranteed student loan portfolio and Managed federally guaranteed portfolio, respectively.

 

We expect the percentage of our portfolio consisting of Consolidation Loans will decline steadily over time. The CCRAA dramatically reduced the margin on new FFELP Consolidation Loans and, as a result these loans are only marginally profitable for high balance loans and are not profitable for lower loan balances. Legislation passed in 2006 provided for all FFELP loans to bear a fixed rate to the borrower, thereby eliminating the potential for the borrower to lock in a more beneficial interest rate on post-July 1, 2006 loans in a low interest rate environment. This had a significant adverse impact on the Consolidation Loan industry that developed as a result of the low interest rate environment that existed between 2000 and 2004. Accordingly, we are no longer buying Wholesale Consolidation Loans or actively marketing Consolidation Loans to our customer base. Finally, under the HEA, borrowers with loan balances exceeding $30,000 can extend their repayment term without consolidating their loans. As a result of all of these factors, we believe that FFELP loans will have a much lower propensity to consolidate in the future. We intend to accommodate those borrowers who have high loan balances and who wish to consolidate their loans. We will also direct borrowers wishing to extend their loan’s term to the FFELP extended repayment product, which we believe will be an attractive alternative to a Consolidation Loan for borrowers seeking a lower monthly payment.

 

GradPLUS

 

The Deficit Reduction Act of 2005 expanded the existing Federal PLUS loan program to include graduate and professional students (“GradPLUS Loans”). Previously, PLUS loans were restricted to parents of dependent, undergraduate students.

 

GradPLUS Loans generally have a lower rate of interest than our Private Education Loans and they allow graduate and professional students to borrow up to the full cost of their education (tuition, room and board),

less other financial aid received. In 2007, we originated $606 million of GradPLUS loans which represented two percent of our Preferred Channel Originations.

 

Private Education Loans

 

The rising cost of education has led students and their parents to seek additional private sources to finance their education. Private Education Loans are often packaged as supplemental or companion products to FFELP loans. Over the last several years, the growth of Private Education Loans has continued due to tuition increasing faster than the rate of inflation coupled with stagnant FFELP lending limits. This growth combined with the relatively higher spreads has led to Private Education Loans contributing a higher percentage of our net interest margin in recent years. We expect this trend to continue in the foreseeable future in part due to margin erosion for FFELP student loans. In 2007, Private Education Loans contributed 36 percent of our overall “Core Earnings” net interest income before provisions for loan losses plus other income, up from 29 percent in 2006.

 

The Higher Education Reconciliation Act of 2005 increased FFELP loan limits on July 1, 2007 for freshman and sophomores. This, along with the introduction of GradPLUS Loans discussed above, will somewhat offset the rate of growth in Private Education Loans in the future. We believe this loss of future Private Education Loan volume for graduate students will be replaced by an increase in federally insured loans.

 

Since we bear the full credit risk for Private Education Loans, they are underwritten and priced according to credit risk based upon customized consumer credit scoring criteria. We mitigate some of this credit risk by providing price and eligibility incentives for students to obtain a credit-worthy cosigner, and 52 percent of our Managed Private Education Loans have a cosigner. Due to their higher risk profile, Private Education Loans earn higher spreads than their FFELP loan counterparts. In 2007, Private Education Loans earned an average “Core Earnings” spread (before provisions for loan losses and the Interim ABCP Facility Fees) of 5.15 percent versus an average “Core Earnings” spread of 1.04 percent for FFELP loans (before provisions for loan losses and the Interim ABCP Facility Fees).

 

Our largest Private Education Loan program is the Signature Student Loan^®, which is offered to undergraduates and graduates through the financial aid offices of colleges and universities to supplement traditional FFELP loans. We also offer specialized loan products to graduate and professional students primarily through our MBA Loans^®, LAWLOANS^® and, Sallie Mae Medical School Loans^® and Sallie Mae DENTALoans^® programs. Generally, these loans do not require borrowers to begin repaying their loans until after graduation and allow a grace period from six to nine months.

 

In 2004 we began to offer Tuition Answer^® loans directly to the consumer through targeted direct mail campaigns and Web-based initiatives. Under the Tuition Answer loan program, creditworthy parents, sponsors and students may borrow between $1,500 and $40,000 per year to cover any qualified higher education expense, but now capped at the full cost of tuition and board at the school they attend. No school certification is required, although a borrower must provide enrollment documentation. At December 31, 2007, we had $3.3 billion of Tuition Answer loans outstanding in our Managed student loan portfolio.

 

We also offer alternative Private Education Loans for information technology, cosmetology, mechanics, medical/dental/lab, culinary and broadcasting education programs. On average, these career training programs typically last fewer than 12 months. These loans require the borrower to begin repaying the loan immediately; however, students can opt to make relatively small payments while enrolled. At December 31, 2007, we had $2.4 billion of career training loans outstanding.

 

Acquisitions

 

We have acquired several companies in the student loan industry that have increased our sales and marketing capabilities, added significant new brands and greatly enhanced our product offerings. The following

table provides a timeline of strategic acquisitions that have played a major role in the growth of our Lending business.

 

Lending Segment Timeline

 

 

Financing

 

Prior to the announcement of the Merger, the Company funded its loan originations primarily with a combination of term asset-backed securitizations and unsecured debt. Upon the announcement of the Merger on April 17, 2007, credit spreads on our unsecured debt widened considerably, significantly increasing our cost of accessing the unsecured debt markets. As a result, in the near term, we expect to fund our operations primarily through the issuance of student loan asset-backed securities and borrowings under secured student loan financing facilities, as further described below. We historically have been a regular issuer of term asset-backed securities in the domestic and international capital markets. (See also “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — LIQUIDITY AND CAPITAL RESOURCES.”) For the reasons described above, securitization is currently and is likely to continue to be our principal source of cost-effective financing. We expect approximately 90 percent or more of our funding needs in 2008 will be satisfied through asset-backed securitizations.

 

The Company has engaged J.P. Morgan Securities, Inc. (“JPMorgan”) and Banc of America Securities, LLC (“BAS”) as Lead Arrangers and Joint Bookrunners along with Barclays Capital, The Royal Bank of Scotland, plc and Deutsche Bank Securities, Inc. as Co-Lead Arrangers and Credit Suisse, New York Branch, as Arranger to underwrite and arrange up to $28.0 billion of secured FFELP loan facilities and a $7.0 billion secured private credit student loans facility (together, the “Facilities”).

 

As of February 28, 2008, we anticipate closing on $23.4 billion of FFELP student loan ABCP conduit facilities and $5.9 billion of Private Education Loan ABCP conduit facilities on February 29, 2008, or as soon as practical thereafter. Also on that date, we anticipate closing on an additional $2.0 billion secured FFELP loan facility. In addition, we anticipate closing on an additional $2.5 billion of student loan ABCP conduit facilities by mid March 2008. The new $33.8 billion of financing facilities we expect to close on, which may ultimately be increased to up to $35 billion in aggregate, will replace our $30 billion Interim ABCP Facility and $6 billion ABCP facility. The initial term of each of the new facilities will be 364 days. These new facilities will provide funding for certain of our FFELP loans and Private Education Loans until such time as these loans are refinanced in the term ABS markets. In the event amounts outstanding under the Interim ABCP Facility are not repaid by the Company in full, the Interim ABCP Facility will terminate on April 24, 2008.

 

In connection with our financing programs, we undertake regular investor development efforts intended to continually expand and diversify our pool of investors.

 

One of our major objectives when financing our business is to minimize interest rate risk by matching the interest rate and term characteristics of our Managed assets with our Managed liabilities, generally on a pooled

basis, to the extent practical. To achieve this objective, we use derivative financial instruments extensively to reduce our interest rate and foreign currency exposure. Match funding and interest rate risk management also help stabilize our student loan spread in various interest rate environments.

 

On February 4, 2008, Standard & Poor’s Ratings Services announced that it lowered our credit ratings to “BBB-/A-3” from “BBB+/A-2.” Standard & Poor’s also announced that our rating remains on CreditWatch with negative implications, pending the closing of the new asset-backed commercial paper conduit discussed above. Notwithstanding the lowering of our credit rating, we believe that we have taken several steps in the last several months to further strengthen the company and position it for ratings improvement in the future. These steps include raising more than $3.0 billion in equity capital, securing commitments for $33.8 billion in financing from some of the world’s largest financial institutions, eliminating our equity forward positions and curtailing certain private education lending programs to students attending schools where loan performance is materially below our original expectations. We intend to continue to work with Standard & Poor’s and the other rating agencies to demonstrate our financial strength and stability.

 

Sallie Mae Bank

 

On November 3, 2005, we announced that the Utah Department of Financial Institutions approved our application for an industrial bank charter. Beginning in February and August 2006, Sallie Mae Bank (the “Bank”) began funding and originating Private Education Loans and FFELP Consolidation Loans, respectively, made by Sallie Mae to students and families nationwide. This allows us to capture the full economics of these loans from origination. In addition, the industrial bank charter allows us to expand the products and services we can offer to students and families. Funds received in connection with our tuition payment plan product are deposited and held in escrow with the Bank. In addition, cash rebates that Upromise members earn from qualifying purchases from Upromise’s participating companies are held by the Bank. These deposits are used by the Bank for a low cost source of funding.

 

Competition

 

Our primary competitor for federally guaranteed student loans is the FDLP, which in its first four years of existence (FFYs 1994-1997) grew its market share of the total federally sponsored student loan market from four percent in FFY 1994 to a peak of 34 percent in FFY 1997. The FDLP’s market share has steadily declined since then to 20 percent in FFY 2007. Historically, we have also faced competition for both federally guaranteed and non-guaranteed student loans from a variety of financial institutions including banks, thrifts and state-supported secondary markets. However, as a result of the CCRAA and the dislocation in the capital markets, the student loan industry is undergoing a significant transition. A number of student lenders have ceased operations altogether or curtailed activity. The environment of aggressive price competition between lenders has also decreased dramatically. Many of the lenders that remain in the business have been rationalizing pricing by reducing borrower benefits. As a result of these factors, we believe that as the largest student lender, we are well positioned to increase market share in the coming years. Our FFY 2007 FFELP Preferred Channel Originations totaled $17 billion, representing a 27 percent market share.

 

ASSET PERFORMANCE GROUP BUSINESS SEGMENT

 

In our APG segment, we provide a wide range of accounts receivable and collections services including student loan default aversion services, defaulted student loan portfolio management services, and contingency collections services for student loans and other asset classes. We also provide accounts receivable management and collections services on consumer and mortgage receivable portfolios that we purchase. The table below presents a timeline of key acquisitions that have fueled the growth of our APG business, including: General Revenue Corporation (“GRC”) and Pioneer Credit Recovery (“PCR”), concentrated in the student loan industry; AFS Holdings, LLC, the parent company of Arrow Financial Services, LLC (collectively, “AFS”), a debt management company that purchases and services distressed debt in several industries including and outside of education receivables; and GRP/AG Holdings, LLC (“GRP”), a debt management company that acquires and manages portfolios of sub-performing and non-performing mortgage loans.

In recent years we have diversified our APG contingency revenue stream into the purchase of distressed and defaulted receivables to complement our student loan business. We now have the expertise to acquire and manage portfolios of sub-performing and non-performing mortgage loans, substantially all of which are secured by one-to-four family residential real estate. We also have a servicing platform and a disciplined portfolio pricing approach to several consumer debt asset classes.

 

APG Segment Timeline

 

 

In 2007, our APG business segment had revenues totaling $605 million and net income of $116 million. Our largest customer, USA Funds, accounted for 28 percent of our revenue in 2007.

 

Products and Services

 

Student Loan Default Aversion Services

 

We provide default aversion services for five guarantors, including the nation’s largest, USA Funds. These services are designed to prevent a default once a borrower’s loan has been placed in delinquency status.

 

Defaulted Student Loan Portfolio Management Services

 

Our APG business segment manages the defaulted student loan portfolios for six guarantors under long-term contracts. APG’s largest customer, USA Funds, represents approximately 17 percent of defaulted student loan portfolios in the market. Our portfolio management services include selecting collection agencies and determining account placements to those agencies, processing loan consolidations and loan rehabilitations, and managing federal and state offset programs.

 

Contingency Collection Services

 

Our APG business segment is also engaged in the collection of defaulted student loans and other debt on behalf of various clients including guarantors, federal agencies, schools, credit card issuers, utilities, and other retail clients. We earn fees that are contingent on the amounts collected. We provide collection services for ED and now have approximately 11 percent of the total market for such services. We have relationships with more than 900 colleges and universities to provide collection services for delinquent student loans and other receivables from various campus-based programs.

 

Collection of Purchased Receivables

 

In our APG business, we also purchase delinquent and defaulted receivables from credit originators and other holders of receivables at a significant discount from the face value of the debt instruments. In addition, we purchase sub-performing and non-performing mortgage receivables at a discount usually calculated as a percentage of the underlying collateral. We use a combination of internal collectors and outside collection agencies to collect on these portfolios, seeking to attain the highest cost/benefit for our overall collection strategy. We recognize revenue primarily using the effective yield method, though we use the cost recovery

method when appropriate, in certain circumstances. A major success factor in the purchased receivables business is the ability to effectively price the portfolios. We conduct both quantitative and qualitative analysis to appropriately price each portfolio to yield a return consistent with our APG financial targets.

 

Competition

 

The private sector collections industry is highly fragmented with few large companies and a large number of small scale companies. The APG businesses that provide third-party collections services for ED, FFELP guarantors and other federal holders of defaulted debt are highly competitive. In addition to competing with other collection enterprises, we also compete with credit grantors who each have unique mixes of internal collections, outsourced collections, and debt sales. Although the scale, diversification, and performance of our APG business has been a competitive advantage, the trend in the collections industry is for credit grantors to sell portfolios rather than to manage contingency collections.

 

In the purchased paper business, the marketplace is trending more toward open market competitive bidding rather than solicitation by sellers to a select group of potential buyers. Price inflation and the availability of capital in the sector contribute to this trend. Unlike many of our competitors, our APG business does not rely solely on purchased portfolio revenue. This enables us to maintain pricing discipline and purchase only those portfolios that are expected to meet our profitability and strategic goals. Portfolios are purchased individually on a spot basis or through contractual relationships with sellers to periodically purchase portfolios at set prices. We compete primarily on price, and additionally on the basis of our reputation and industry experience.

 

CORPORATE AND OTHER BUSINESS SEGMENT

 

The Company’s Corporate and Other business segment includes the aggregate activity of its smaller operating segments, primarily its Guarantor Servicing, Loan Servicing, and Upromise operating segments. Corporate and Other also includes several smaller products and services, including comprehensive financing and loan delivery solutions to college financial aid offices and students to streamline the financial aid process.

 

Guarantor Services

 

We earn fees for providing a full complement of administrative services to FFELP guarantors. FFELP student loans are guaranteed by these agencies, with ED providing reinsurance to the guarantor. The guarantors are non-profit institutions or state agencies that, in addition to providing the primary guarantee on FFELP loans, are responsible for other activities, including:

 

 

Currently, we provide a variety of these services to nine guarantors and, in AY 2006-2007, we processed $17.9 billion in new FFELP loan guarantees, of which $14.2 billion was for USA Funds, the nation’s largest guarantor. We processed guarantees for approximately 32 percent of the FFELP loan market in AY 2006-2007.

 

Guarantor servicing fee revenue, which includes guarantee issuance and account maintenance fees, was $156 million for the year ended December 31, 2007, 86 percent of which we earned from services performed on behalf of USA Funds. Under some of our guarantee services agreements, including our agreement with USA Funds, we receive certain scheduled fees for the services that we provide under such agreements. The

payment for these services includes a contractually agreed upon set percentage of the account maintenance fees that the guarantors receive from ED.

 

The Company’s guarantee services agreement with USA Funds has a five-year term that will be automatically increased by an additional year on October 1 of each year unless a prior notice is given by either party.

 

Our primary non-profit competitors in guarantor servicing are state and non-profit guarantee agencies that provide third-party outsourcing to other guarantors.

 

(See APPENDIX A, “FEDERAL FAMILY EDUCATION LOAN PROGRAM — Guarantor Funding” for details of the fees paid to guarantors.)

 

Upromise

 

Upromise has a number of programs that encourage consumers to save for the cost of college education. Upromise has established an affinity marketing program which is designed to increase consumer purchases of merchant goods and services and to promote saving for college by consumers who are members of this program. Merchant partners generally pay Upromise transaction fees based on member purchase volume, either online or in stores depending on the contractual arrangement with the merchant partner. A percentage of the consumer members’ purchases is set aside in an account maintained by Upromise on the members’ behalf.

 

Upromise, through its wholly owned subsidiaries, Upromise Investments, Inc. (“UII”), a registered broker-dealer, and Upromise Investment Advisors, LLC (“UIA”), provides transfer and servicing agent services and program management associated with various 529 college-savings plans. Upromise manages $19 billion in 529 college-savings plans.

 

REGULATION

 

Like other participants in the FFELP, the Company is subject to the HEA and, from time to time, to review of its student loan operations by ED and guarantee agencies. ED is authorized under its regulations to limit, suspend or terminate lenders from participating in the FFELP, as well as impose civil penalties if lenders violate program regulations. The laws relating to the FFELP are subject to revision. In addition, Sallie Mae, Inc., as a servicer of federal student loans, is subject to certain ED regulations regarding financial responsibility and administrative capability that govern all third-party servicers of insured student loans. Failure to satisfy such standards may result in the loss of the government guarantee of the payment of principal and accrued interest on defaulted FFELP loans. Also, in connection with our guarantor servicing operations, the Company must comply with, on behalf of its guarantor servicing customers, certain ED regulations that govern guarantor activities as well as agreements for reimbursement between the Secretary of Education and the Company’s guarantor servicing customers. Failure to comply with these regulations or the provisions of these agreements may result in the termination of the Secretary of Education’s reimbursement obligation.

 

The Company’s originating or servicing of federal and private student loans also subjects it to federal and state consumer protection, privacy and related laws and regulations. Some of the more significant federal laws and regulations that are applicable to our student loan business include:

 

 

APG’s debt collection and receivables management activities are subject to federal and state consumer protection, privacy and related laws and regulations. Some of the more significant federal laws and regulations that are applicable to our APG business include:

 

 

In addition, our APG business is subject to state laws and regulations similar to the federal laws and regulations listed above. Finally, certain APG subsidiaries are subject to regulation under the HEA and under the various laws and regulations that govern government contractors.

 

Sallie Mae Bank is subject to Utah banking regulations as well as regulations issued by the Federal Deposit Insurance Corporation, and undergoes periodic regulatory examinations.

 

Finally, Upromise’s affiliates, which administer 529 college-savings plans, are subject to regulation by the Municipal Securities Rulemaking Board, the National Association of Securities Dealers, Inc. and the Securities and Exchange Commission (“SEC”) through the Investment Advisers Act of 1940.

 

AVAILABLE INFORMATION

 

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 SLM Corporation and other companies that file electronically with the SEC. Copies of our annual reports on Form 10-K and our quarterly reports on Form 10-Q are available on our website as soon as reasonably practicable after we electronically file such reports with the SEC. Investors and other interested parties can also access these reports at www. salliemae.com/about/investors.

 

Our Code of Business Conduct, which applies to Board members and all employees, including our Chief Executive Officer and Chief Financial Officer, is also available, free of charge, on our website at www.salliemae.com/about/business_code. htm. We intend to disclose any amendments to or waivers from our Code of Business Conduct (to the extent applicable to our Chief Executive Officer or Chief Financial Officer) by posting such information on our website.

 

In 2007, the Company submitted the annual certification of its Chief Executive Officer regarding the Company’s compliance with the NYSE’s corporate governance listing standards, pursuant to Section 303A.12(a) of the NYSE Listed Company Manual.

 

In addition, we filed as exhibits to the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 and to this Annual Report on Form 10-K, the certifications required under Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

LENDING BUSINESS SEGMENT — FFELP STUDENT LOANS

 

Because of the new FFELP economics resulting from the College Cost Reduction and Access Act of 2007 and the increased funding spreads in the current capital markets, we have made significant changes to our business strategy, but there can be no assurance that such changes will be effective in meeting these challenges.

 

On September 27, 2007, the College Cost Reduction and Access Act of 2007 (“CCRAA”) was signed into law by the President. The CCRAA substantially reduced the profitability of our FFELP business, including a reduction in Special Allowance Payments, the elimination of the Exceptional Performer designation and the corresponding reduction in default payments to 97 percent through 2012 and 95 percent thereafter, an increase in the lender paid origination fees for certain loan types, and reduction in default collections retention fees and account maintenance fees related to guaranty agency activities. As a result, assuming no reductions to borrower benefits or to our operating and servicing costs, we expect that the CCRAA will reduce substantially our pre-tax yield on FFELP loans. This reduction combined with higher financing costs resulting from the severe dislocations in the global capital markets, could possibly eliminate the profitability of new FFELP loan originations, while increasing our Risk Sharing in connection with our FFELP loan portfolio. We also expect that low-balance FFELP Consolidation Loans will no longer be profitable.

 

As a result of these developments, management has revised its business strategy to:

 

 

 

 

In addition, we have reduced the premium that we pay for FFELP loan volume at certain school-as-lender clients. We also anticipate reducing the premium that we pay for FFELP loan volume with certain of our lender partners. These actions are likely to effectively end our school-as-lender relationships and to result in certain of our lender partners either exiting the FFELP business or seeking others with whom to partner. These actions could also adversely affect the growth in our guarantee and APG collection businesses.

 

We also will undertake a comprehensive review of all of our business units with a goal of achieving appropriate risk-adjusted returns across all of our business segments and providing cost-effective services. In addition, we aim to reduce our operating expenses by up to 20 percent as compared to 2007 operating expenses by year-end 2009, before adjusting for growth and other investments. Since year-end 2007, as part of this expense reduction effort, we have reduced our work force by approximately three percent. Accordingly, we could lose management that are key to managing operational risk.

 

There can be no assurance that changes we are making or may make in the future to address these developments will be successful in meeting the significant challenges of the new FFELP economics and the increased funding spreads in the current capital markets.

 

A larger than expected increase in third-party consolidation activity may reduce our loan spreads, materially impair our Retained Interest, reduce our interest earning assets and otherwise materially adversely affect our results of operations.

 

If third-party consolidation activity increases beyond management’s expectations, our student loan spread may be adversely affected; our Retained Interest may be materially impaired; our future earnings may be reduced from the loss of interest earning assets; and our results of operations may be adversely affected. Our student loan spread may be adversely affected because third-party consolidators generally target our highest yielding FFELP Loans and an increased run-off of Private Education Loans, which generally have higher

yields than our FFELP loans, would change the overall mix within our portfolio resulting in a reduction to our weighted-average loan spread. Our Retained Interest may be materially impaired if consolidation activity reaches levels not anticipated by management. We may also incur impairment charges if we increase our expected future Constant Prepayment Rate (“CPR”) assumptions used to value the Residual Interest as a result of such unanticipated levels of consolidation. The potentially material adverse affect on our operating results related to FFELP loans also relates to our hedging activities in connection with Floor Income. We enter into certain Floor Income Contracts under which we receive an upfront fee in exchange for our payment of the Floor Income earned on a notional amount of underlying FFELP Loans over the life of the Floor Income Contract. If third-party consolidation activity that involves refinancing a Sallie Mae managed existing FFELP Loan with a new third-party owned FFELP Loan increases substantially, then the Floor Income that we are obligated to pay under such Floor Income Contracts may exceed the Floor Income actually generated from the underlying FFELP loans, possibly to a material extent. In such a scenario, we would either close out the related Floor Income Contracts or purchase an offsetting hedge. In either case, the adverse impact on both our GAAP and “Core Earnings” could be material. (See “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — LENDING BUSINESS SEGMENT — Floor Income — Managed Basis.”)

 

Incorrect estimates and assumptions by management in connection with the preparation of our consolidated financial statements could adversely affect the reported amounts of assets and liabilities and the reported amounts of income and expenses.

 

The preparation of our consolidated financial statements requires management to make certain critical accounting estimates and assumptions that could affect the reported amounts of assets and liabilities and the reported amounts of income and expense during the reporting periods. (See “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — CRITICAL ACCOUNTING POLICIES AND ESTIMATES.”) For example, for both our federally insured and Private Education Loans, the unamortized portion of premiums and discounts is included in the carrying value of the student loan on the consolidated balance sheet. We recognize income on our student loan portfolio based on the expected yield of the student loan after giving effect to the amortization of purchase premiums and accretion of student loan income discounts, as well as the impact of Repayment Borrower Benefits. In arriving at the expected yield, we make a number of estimates that when changed are reflected as a cumulative catch-up from the inception of the student loan. The most sensitive estimate for premium and discount amortization is the estimate of the CPR, which measures the rate at which loans in the portfolio pay before their stated maturity. The CPR is used in calculating the average life of the portfolio. A number of factors can affect the CPR estimate such as the rate of consolidation activity and default rates. If we make an incorrect CPR estimate, the previously recognized income on our student loan portfolio based on the expected yield of the student loan will need to be adjusted in the current period.

 

The amount of loan loss reserves also depends on estimates. We maintain an allowance for loan losses at an amount believed to be sufficient to absorb losses incurred in our FFELP loan and Private Education Loan portfolios based on estimated probable net credit losses as of the reporting date. We analyze those portfolios to determine the effects that the various stages of delinquency have on borrower default behavior and ultimate charge-off. 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, repayment, forbearance, delinquency), underwriting criteria, existence or absence of a cosigner, and aging. We use historical experience coupled with qualitative factors regarding changes in portfolio mix, macroeconomic indicators, policies, procedures, laws, regulations, underwriting, and other factors to estimate default and collection rate projections. We then apply these default and collection rate projections to each category of loan to estimate the necessary allowance balance. Because the process relies on historical experience, if current or future loan loss experience varies significantly from the past, our allowance could be deemed inadequate to cover incurred losses in the portfolio. Additionally, since the allowance estimate is also reliant on other qualitative factors, management’s ability to determine which qualitative factors are relevant to the allowance and our ability to accurately incorporate these factors into our estimates can have a material impact on the allowance.

In addition, the impact of our Repayment Borrower Benefits programs, which provide incentives to borrowers to make timely payments on their loans by allowing for reductions in future interest rates as well as rebates on outstanding balances, is dependent on the number of borrowers who will eventually qualify for these benefits. For example, we offer borrowers an incentive program that reduces their interest rate by a specified percentage per year or reduces their loan balance after they have made a specified initial number of scheduled payments on time and for so long as they continue to make subsequent scheduled payments on time. We regularly estimate the qualification rates for Repayment Borrower Benefits programs and book a level yield adjustment based upon that estimate. If our estimate of the qualification rates is lower than the actual rates, both the yield on our student loan portfolio and our net interest income will be lower than estimated and a cumulative adjustment will be made to reduce income, possibly to a material extent. Such an underestimation may also adversely affect the value of our Retained Interest because one of the assumptions made in assessing its value is the amount of Repayment Borrower Benefits expected to be earned by borrowers. Finally, we continue to look at new ways to improve borrower payment behavior. These efforts as well as the actions of competing lenders may lead to the addition or modification of Repayment Borrower Benefits programs.

 

LENDING BUSINESS SEGMENT — PRIVATE EDUCATION LOANS

 

Changes in the composition of our Managed student loan portfolio will increase the risk profile of our asset base and our capital requirements.

 

As of December 31, 2007, 17 percent of our Managed student loans were Private Education Loans. Private Education Loans are unsecured and are not guaranteed or reinsured under the FFELP or any other federal student loan program and are not insured by any private insurance program. Accordingly, we bear the full risk of loss on these loans if the borrower and cosigner, if applicable, default. Events beyond our control such as a prolonged economic downturn could make it difficult for Private Education Loan borrowers to meet their payment obligations for a variety of reasons, including job loss and unemployment, which could lead to higher levels of delinquencies and defaults. Private Education Loans now account for 36 percent of our “Core Earnings” net interest income before provisions for loan losses plus other income. We expect that Private Education Loans will become an increasingly higher percentage of both our margin and our Managed student loan portfolio, which will increase the risk profile of our asset base and raise our capital requirements because Private Education Loans have significantly higher capital requirements than FFELP loans. This may adversely affect the availability of capital for other purposes. In addition, the comparatively larger spreads on Private Education Loans, which historically have compensated for the narrowing FFELP spreads, may narrow as competition increases.

 

As a component of our Private Education Loan program, we made available to numerous schools various tailored loan programs that were designed to help finance the education of students who were academically qualified but did not meet our standard credit criteria. Management has recently taken specific steps to terminate these lending programs because the performance of these loans is materially different from originally expected, and from the rest of the Company’s Private Education Loan programs. In the fourth quarter of 2007, the Company recorded provision expense of $667 million related to its Managed Private Education Loan portfolio. This significant increase in provision primarily related to the non-traditional lending programs described above which are particularly impacted by the weakening U.S. economy. However, there can be no assurance that the Company’s non-traditional loans outstanding will not require additional significant loan provisions or have any further adverse effect on the overall credit quality of the Company’s Managed Private Education Loan portfolio.

 

Past charge-off rates on our Private Education Loans may not be indicative of future charge-off rates because, among other things, we use forbearance policies and our failure to adequately predict and reserve for charge-offs may adversely impact our results of operations.

 

We have established forbearance policies for our Private Education Loans under which we provide to the borrower temporary relief from payment of principal and/or interest in exchange for a processing fee paid by the borrower, which is waived under certain circumstances. At the end of each forbearance period, generally

granted in six-month increments, interest that the borrower otherwise would have paid is typically capitalized. At December 31, 2007, approximately 14 percent of our Managed Private Education Loans in repayment and forbearance were in forbearance. Forbearance is used most heavily when the borrower’s loan enters repayment; however, borrowers may apply for forbearance multiple times and a significant number of Private Education Loan borrowers have taken advantage of this option. When a borrower ends forbearance and enters repayment, the account is considered current. Accordingly, a borrower who may have been delinquent in his payments or may not have made any recent payments on his account will be accounted for as a borrower in a current repayment status when the borrower exits the forbearance period. In addition, past charge-off rates on our Private Education Loans may not be indicative of future charge-off rates because of, among other things, the use of forbearance and the effect of future changes to the forbearance policies. If our forbearance policies prove over time to be less effective on cash collections than we expect or if we limit the circumstances under which forbearance may be granted under our forbearance policies, the amount of future charge-offs could be materially adversely affected which could materially impact the ultimate default rate used to calculate loan loss reserves which could have a material adverse effect on our results of operations. (See “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — LENDING BUSINESS SEGMENT — Total Loan Net Charge-offs.”)

 

In addition, our loss estimates include losses to be incurred generally over a two-year loss emergence period. The two-year estimate of the allowance for loan losses is subject to a number of assumptions about future borrower behavior that may prove incorrect. For example, we use a migration analysis of historical charge-off experience and combine that with qualitative measures to project future trends. However, future charge-off rates can be higher than anticipated due to a variety of factors such as downturns in the economy, regulatory or operational changes in asset performance management effectiveness, and other unforeseeable future trends. If actual future performance in charge-offs and delinquency is worse 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.

 

If a school with which we have a business arrangement with respect to student loans closes or otherwise does not provide the borrower the promised education, the borrower could raise the same claims and defenses against us as the lender as it could against the school. As a result, our ability to collect loan amounts could be materially impaired.

 

The FTC Holder Rule provides that borrowers, under certain circumstances, may assert the same claims and defenses against repayment of a student loan used to finance an education at a school as that borrower may have against the school itself. Specifically, if a school with whom we have a business arrangement with respect to student loans closes or otherwise does not provide the borrower the promised education, the borrower could raise the same claims and defenses that the borrower has against the school against repayment of a student loan used to finance an education at that school. With the current dislocations in the capital markets, certain for-profit schools may be unable to secure lending for its students, which could lead to serious financial difficulties and, possibly, to the school closing before its students complete their education. In such cases, borrowers could assert claims and defenses against repayment of their loans from us up to the total amount of the loan depending upon how far along they were in their program of study. In addition, school closings result in an increase in defaults for the borrowers still in attendance at those schools at the time they closed and a significant increase in school closings could materially increase our allowance for loan losses.

ASSET PERFORMANCE GROUP BUSINESS SEGMENT

 

Our APG business segment may not be able to purchase defaulted consumer receivables at prices that management believes to be appropriate, and a decrease in our ability to purchase portfolios of receivables could adversely affect our net income.

 

If our APG business segment is not able to purchase defaulted consumer receivables at planned levels and at prices that management believes to be appropriate, we could experience short-term and long-term decreases in income.

 

The availability of receivables portfolios at prices which generate an appropriate return on our investment depends on a number of factors both within and outside of our control, including the following:

 

 

Because of the length of time involved in collecting defaulted consumer receivables on acquired portfolios and the volatility in the timing of our collections, we may not be able to identify trends and make changes in our purchasing strategies in a timely manner.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Future sales or issuances of our common stock may dilute the ownership interest of existing shareholders and depress the trading price of our common stock.

 

Future sales or issuances of our common stock may dilute the ownership interests of our existing shareholders. In addition, future sales or issuances of substantial amounts of our common stock may be at prices below current market prices and may adversely impact the market price of our common stock. Our mandatory convertible preferred stock, Series C has dividend and liquidation preference over our common stock.

 

The 7.25 percent mandatory convertible preferred stock, Series C may adversely affect the market price of our common stock.

 

The market price of our common stock is likely to be influenced by the 7.25 percent mandatory convertible preferred stock, Series C. For example, the market price of our common stock could become more volatile and could be depressed by:

 

 

We do not currently pay regular dividends on our common stock.

 

We have not paid dividends on our common stock since the execution of the Merger Agreement with the Buyer Group in April 2007. While the restriction on the payment of dividends under the Merger Agreement has been terminated, we expect to continue not paying dividends in the near term in order to focus on balance sheet improvement and expect to re-examine our dividend policy in the second half of 2008. Subject to

Delaware law, our board of directors will determine the payment of future dividends on our common stock, if any, and the amount of any dividends in light of any applicable contractual restrictions limiting our ability to pay dividends, our earnings and cash flows, our capital requirements, our financial condition, regulatory requirements and other factors our board of directors deems relevant.

 

There can be no assurance the commitments we announced that we secured on January 28, 2008, for $31.3 billion of 364-day financing from a consortium of banks will ultimately be funded, or if they are not funded our credit rating will not be further downgraded.

 

On January 28, 2008, we announced that we secured $31.3 billion of 364-day financing from a consortium of banks led by Bank of America, JPMorgan Chase, Barclays Capital, Deutsche Bank, Credit Suisse and The Royal Bank of Scotland, and from UBS. The commitments are intended to replace the $30.0 billion asset-backed commercial paper conduit facilities that we entered into with Bank of America and JPMorgan Chase in connection with the now terminated Merger as well as the $6.0 billion asset-backed commercial paper conduit facility. Funding under the commitments is subject to various conditions and there can be no assurance that all such conditions will be satisfied. In its February 4, 2008 announcement that our counterparty credit rating was lowered to BBB-, Standard & Poor’s Ratings Services noted that the decision to leave us on CreditWatch Negative reflects that the funding of the commitments is still subject to various conditions and that if the commitments do not close our ratings could be reduced further.

 

We are exposed to interest rate risk in the form of basis risk and repricing risk because the interest rate characteristics of our earning assets do not always match exactly the interest rate characteristics of the funding.

 

Depending on economic and other factors, we may fund our assets with debt that has a different index and/or reset frequency than the asset, but generally only where we believe there is a high degree of correlation between the interest rate movement of the two indices. For example, we use daily reset 3-month LIBOR to fund a large portion of our daily reset 3-month commercial paper indexed assets. We also use different index types and index reset frequencies to fund various other assets. In using different index types and different index reset frequencies to fund our assets, we are exposed to interest rate risk in the form of basis risk and repricing risk, which is the risk that the different indices may reset at different frequencies, or will not move in the same direction or with the same magnitude. While these indices are short-term with rate movements that are highly correlated over a long period of time, there can be no assurance that this high correlation will not be disrupted by capital market dislocations or other factors not within our control. In such circumstances, our earnings could be adversely affected, possibly to a material extent. During the second half of 2007, the spread between 3-month commercial paper and 3-month LIBOR became very volatile and widened significantly due to the deterioration of the broad credit markets, which increased our cost of funds. This level of volatility had not been seen previously. We still believe there is a high level of correlation between 3-month commercial paper and 3-month LIBOR over the long term. In addition, we fund a limited amount of daily reset 3-month commercial paper, T-bill indexed and Prime indexed assets with auction rate securities and asset-backed commercial paper borrowings. Auction rate securities and asset-backed commercial paper borrowings do not reset to an explicit underlying index.

 

At December 31, 2007, we had $3.3 billion of taxable and $1.7 billion of tax-exempt auction rate securities outstanding on a Managed Basis. In February 2008, an imbalance of supply and demand in the auction rate securities market as a whole led to failures of the auctions pursuant to which certain of our auction rate securities’ interest rates are set. As a result, certain of our auction rate securities bear interest at the maximum rate allowable under their terms. The maximum allowable interest rate on our $3.3 billion of taxable auction rate securities is generally LIBOR plus 1.50 percent. The maximum allowable interest rate on many of our $1.7 billion of tax-exempt auction rate securities was recently amended to LIBOR plus 2.00 percent through May 31, 2008. After May 31, 2008, the maximum allowable rate on these securities will revert to a formula driven rate, which, if in effect as of February 28, 2008, would have produced various maximum rates ranging up to 5.26 percent.

In the past, we employed reset rate note structures in conjunction with the issuance of certain tranches of our term asset-backed securities. Reset rate notes are subject to periodic remarketing, at which time the interest rates on the reset rate notes are reset. In the event a reset rate note cannot be remarketed on its remarketing date, the interest rate generally steps up to and remains LIBOR plus 0.75 percent, until such time as the bonds are successfully remarketed. The Company also has the option to repurchase the reset rate note upon a failed remarketing and hold it as an investment until such time it can be remarketed. The Company’s repurchase of a reset rate note requires additional funding, the availability and pricing of which may be less favorable to the Company than it was at the time the reset rate note was originally issued. As of December 31, 2007, on a Managed Basis, the Company had $2.6 billion, $2.1 billion and $2.5 billion of reset rate notes due to be remarketed in 2008, 2009 and 2010, and an additional $8.5 billion to be remarketed thereafter.

 

We may face limited availability of financing, variation in our funding costs and uncertainty in our securitization financing.

 

In general, the amount, type and cost of our funding, including securitization and unsecured financing from the capital markets and borrowings from financial institutions, have a direct impact on our operating expenses and financial results and can limit our ability to grow our assets.

 

A number of factors could make such securitization and unsecured financing more difficult, more expensive or unavailable on any terms both domestically and internationally (where funding transactions may be on terms more or less favorable than in the United States), including, but not limited to, financial results and losses, changes within our organization, specific events that have an adverse impact on our reputation, changes in the activities of our business partners, disruptions in the capital markets, specific events that have an adverse impact on the financial services industry, counterparty availability, changes affecting our assets, our corporate and regulatory structure, interest rate fluctuations, ratings agencies’ actions, general economic conditions and the legal, regulatory, accounting and tax environments governing our funding transactions. In addition, our ability to raise funds is strongly affected by the general state of the U.S. and world economies, and may become increasingly difficult due to economic and other factors. Finally, we compete for funding with other industry participants, some of which are publicly traded. Competition from these institutions may increase our cost of funds.

 

We are dependent on term asset-backed securities market for the long-term financing of student loans. We expect securitizations to provide approximately 90 percent or more of our funding needs in 2008. If the term asset-backed securities market were to experience a prolonged disruption, if our asset quality were to deteriorate or if our debt ratings were to be downgraded, we may be unable to securitize our student loans or to do so on favorable pricing and terms. If we were unable to continue to securitize our student loans at current pricing levels or on favorable terms, we would need to use alternative funding sources to fund new student loan originations and meet our other liquidity needs. If we were unable to find cost-effective and stable funding alternatives, our funding capabilities and liquidity would be negatively impacted and our cost of funds could increase, adversely affecting our results of operations and ability to originate student loans.

 

In addition, the occurrence of certain events such as consolidations and reconsolidations may cause certain of our securitization transactions to amortize earlier than scheduled, which could accelerate the need for additional funding to the extent that we effected the refinancing.

 

The rating agencies could downgrade the ratings on our senior unsecured debt, which could increase our cost of funds.

 

Securitizations are the primary source of our long-term financing and liquidity. Our ability to access the securitization market and the ratings on our asset-backed securities are not directly or fully dependent upon the Company’s general corporate credit ratings. The Company also utilizes senior unsecured long-term and short-term debt, which is dependent upon rating agency scoring. As of February 28, 2008, our senior unsecured long-term debt was rated Baa1, BBB−, and BBB and senior unsecured short-term debt was rated P-2, A-3 and F-3 by Moody’s Investors Service, Inc., Standard and Poor’s Ratings Services, a division of The McGraw-Hill Companies, Inc., and Fitch Ratings, respectively, and all three rating agencies ratings were under review for possible downgrade. If any or all of these ratings were downgraded for any reason, our overall cost of issuing senior unsecured debt could increase.

Our derivative counterparties may terminate their positions with the Company if its credit ratings fall to certain levels and the Company could incur substantial additional costs to replace any terminated positions.

 

The majority of our ISDA Master Agreements provide that the counterparty may declare a “Termination Event” and terminate its positions if a “Designated Event” occurs and the Company’s unsecured and unsubordinated long-term debt rating fall to either of the pre-determined levels, which are typically “Baa3” for Moody’s and “BBB-” from S&P. For purposes of these ISDA Master Agreements, the execution of the Merger Agreement constituted a “Designated Event.” On February 4, 2008, Standard & Poor’s Ratings Services announced that it lowered our long-term debt rating to “BBB-/A-3” from “BBB+/A-2.” Standard & Poor’s also announced that our rating remains on CreditWatch with negative implications. As of February 28, 2008, 92 percent of the counterparties (on a notional basis) have agreed in writing to waive their rights (or do not have the rights) to declare a “Termination Event” arising from the Company executing the Merger Agreement and the resulting ratings downgrade. The remainder of the counterparties have agreed verbally to waive their rights at this time. Depending upon interest rates and exchange rates, the Company could be liable for substantial payments to terminate these positions if the counterparties exercise their right to terminate at any point in the future. It would be the Company’s intent to replace any terminated positions with derivatives executed with other counterparties, however, the Company may not be able to readily replace any terminated positions or may incur substantial additional costs to do so. Our liquidity could be adversely affected by these additional payments and costs. In addition, prior to the recent ratings downgrade, we had the use of cash collateral posted by these counterparties. As a result of our recent ratings downgrade, our ability to use that cash collateral may become restricted. We are currently in negotiations with our counterparties to waive these restrictions so that use of such cash collateral once again becomes unrestricted. If not waived, these cash collateral balances will appear in the “Restricted cash and investments” line of our consolidated balance sheet.

 

If our securitization trusts experience shortfalls on the assets which would result in the noteholders not receiving expected interest or principal payments, we may step in and make an advance to the trust to enable the trust to make these expected payments.

 

The investors in our securitization trusts have no recourse to the Company’s other assets should there be a failure of the trusts to pay when due and as a result we have no obligation related to these securitization trusts to fund any type of shortfall to the bondholders. To date, there have not been any noteholder payment shortfalls and we currently do not expect any payment shortfalls. In addition, we currently do not have any intent to fund shortfalls that might arise. We may decide, however, that it is in the best interest of the Company to fund any such shortfall. For example, by funding any shortfalls it may make it more cost effective to issue new securitizations in the future. Funding any shortfalls would reduce the amount of cash and liquidity we have on balance sheet and could result in a loss and reduction of equity as well. In addition, if we funded a shortfall related to an off-balance sheet trust, we would re-examine our accounting treatment to determine whether the trust would still be considered a “Qualified Special Purpose Entity” under SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities — a Replacement of SFAS No. 125.” As a result, we may determine that we are required to consolidate that trust on our balance sheet as of the date we funded any shortfall. We might also conclude that such actions could result in consolidation of all our off-balance sheet trusts onto our balance sheet.

 

GENERAL

 

Our business is subject to a number of risks, uncertainties and conditions, some of which are not within our control, including general economic conditions, increased competition, adverse changes in the laws and regulations that govern our businesses and failure to successfully identify, consummate and integrate strategic acquisitions.

 

Our business is subject to a number of risks, uncertainties and conditions, some of which we cannot control. For example, if the U.S. economy were to sustain a prolonged economic downturn, a number of our businesses — including our fastest growing businesses, Private Education Loan business and Asset Performance Group — could be adversely affected. We bear the full risk of loss on our portfolio of Private Education Loans. A prolonged economic downturn could make it difficult for borrowers to meet their payment

obligations for a variety of reasons, including job loss and underemployment. In addition, a prolonged economic downturn could extend the amortization period on APG’s purchased receivables.

 

Our principal business is comprised of acquiring, originating, holding and servicing education loans made and guaranteed under the FFELP. Most significant aspects of our principal business are governed by the HEA. We must also meet various requirements of the guaranty agencies, which are private not-for-profit organizations or state agencies that have entered into federal reinsurance contracts with ED, to maintain the federal guarantee on our FFELP loans. These requirements establish origination and servicing requirements, procedural guidelines and school and borrower eligibility criteria. The federal guarantee of FFELP loans is conditioned on loans being originated, disbursed or serviced in accordance with ED regulations.

 

If we fail to comply with any of the above requirements, we could incur penalties or lose the federal guarantee on some or all of our FFELP loans. In addition, our marketing practices are subject to the HEA’s prohibited inducement provision and our failure to comply with such regulation could subject us to a limitation, suspension or termination of our eligible lender status. Even if we comply with the above requirements, a failure to comply by third parties with whom we conduct business could result in us incurring penalties or losing the federal guarantee on some or all of our FFELP loans. If we experience a high rate of servicing deficiencies, we could incur costs associated with remedial servicing, and, if we are unsuccessful in curing such deficiencies, the eventual losses on the loans that are not cured could be material. Failure to comply with these laws and regulations could result in our liability to borrowers and potential class action suits, all of which could adversely affect our future growth rates.

 

Because of the risks, uncertainties and conditions described above, there can be no assurance that we can maintain our future growth rates at rates consistent with our historic growth rates.

 

Our GAAP earnings are highly susceptible to changes in interest rates because most of our derivatives do not qualify for hedge accounting treatment under SFAS No. 133.

 

Changes in interest rates can cause volatility in our GAAP earnings as a result of changes in the market value of our derivatives that do not qualify for hedge accounting treatment under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” Under SFAS No. 133, changes in derivative market values are recognized immediately in earnings. If a derivative instrument does not qualify for hedge accounting treatment under SFAS No. 133, there is no corresponding change in the fair value of the hedged item recognized in earnings. As a result, gain or loss recognized on a derivative will not be offset by a corresponding gain or loss on the underlying hedged item. Because most of our derivatives do not qualify for hedge accounting treatment, when interest rates change significantly, our GAAP earnings may fluctuate significantly.

 

For a discussion of operational, market and interest rate, and liquidity risks, see “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — RISKS.”

 

 

None.

 

The following table lists the principal facilities owned by the Company:

 

 

 

 

The following table lists the principal facilities leased by the Company as of December 31, 2007:

 

 

 

 

None of the Company’s facilities is encumbered by a mortgage. The Company believes that its headquarters, loan servicing centers data center, back-up facility and data management and collections centers are generally adequate to meet its long-term student loan and business goals. The Company’s principal office is currently in owned space at 12061 Bluemont Way, Reston, Virginia, 20190.

 

 

On April 6, 2007, the Company was served with a putative class action suit by several borrowers in federal court in the Central District of California (Anne Chae et. al., v. SLM Corporation et. al.). The complaint, which was amended on April 12, 2007, alleges violations of California Business & Professions Code 17200, breach of contract, breach of covenant of good faith and fair dealing, violation of consumer legal remedies act and unjust enrichment. The complaint challenges the Company’s FFELP billing practices as they relate to use of the simple daily interest method for calculating interest. On June 19, 2007, the Company filed the Company’s Motion to Dismiss the amended complaint. On September 14, 2007, the court entered an order denying Sallie Mae’s Motion to Dismiss. The court did not comment on the merits of the allegations or the plaintiffs’ case but instead merely determined that the allegations stated a claim sufficient under the Federal Rules of Civil Procedure. The Company filed an answer on September 28, 2007 and on November 26, 2007 filed a motion for judgment on the pleadings. On January 4, 2008, the court entered an order denying the Company’s motion without ruling on the merits of plaintiffs’ claims. On September 17, 2007, the court entered a scheduling order that set July 8, 2008, as the start date for the trial. Discovery has commenced and is scheduled to continue through May 30, 2008. The Company believes these allegations lack merit and will continue to vigorously defend itself in this case, and notes that ED and the applicable guarantor of plaintiffs’ loans have confirmed that simple daily interest is the proper method for calculating interest under the FFELP.

 

On September 11, 2007, the Office of the Inspector General (“OIG”), of ED, confirmed that they planned to conduct an audit to determine if the Company billed for special allowance payments, under the 9.5 percent floor calculation, in compliance with the Higher Education Act, regulations and guidance issued by ED. The audit covers the period from 2003 through 2006, and is currently confined to the Company’s Nellie Mae subsidiaries. We ceased billing under the 9.5 percent floor calculation at the end of 2006. We believe that our billing practices were consistent with longstanding ED guidance, but there can be no assurance that the OIG will not advocate an interpretation that differs from the ED’s previous guidance. The OIG has audited other industry participants who billed for 9.5 percent SAP and in certain cases ED has disagreed with the OIG’s recommendation.

 

In August 2005, Rhonda Salmeron (the “Plaintiff”) filed a qui tam whistleblower case under the False Claims Act against collection company Enterprise Recovery Systems, Inc., or ERS. In the fall of 2006, Plaintiff amended her complaint and added USA Funds, as a defendant. On September 17, 2007, Plaintiff filed a second amended complaint adding USA Group Guarantee Services Inc., USA Servicing Corp., Sallie Mae Servicing L.P. and Scott J. Nicholson, an officer and employee of ERS as defendants. On February 5, 2008, Plaintiff filed a Third Amended Complaint. Plaintiff alleges that the various defendants submitted false claims and/or created false records to support claims in connection with collection activity on federally guaranteed student loans. The allegations against USA Funds and Sallie Mae are that they allowed the creation of false records and the submission of false claims by failing to take adequate measures in connection with audits of ERS. At this time, we intend to vigorously defend the case. Plaintiff claims that the U.S. government has been damaged in an amount greater than $12 million. The False Claims Act provides for the award of treble damages and $5,500 to $11,000 per false claim in successful qui tam lawsuits. We intend to vigorously defend this action.

 

On December 17, 2007, Sasha Rodriguez and Cathelyn Gregoire filed a putative class action claim on behalf of themselves and persons similarly situated against us in the United States District Court for the District of Connecticut, alleging an intentional violation of civil rights laws (42 U.S.C. § 1981, 1982), the Equal Credit Opportunity Act and the Truth in Lending Act. Plaintiffs allege that we engaged in underwriting practices on private loans which resulted, among other things, in certain applicants being directed into substandard and more expensive student loans on the basis of race. No amount in controversy is stated in the complaint. We intend to vigorously defend this action.

On January 31, 2008, a putative securities class action lawsuit was filed against the Company and three senior officers in federal court in the Southern District of New York (Burch v. SLM Corporation, Albert L. Lord, C.E. Andrews, and Robert S. Autor). The case has been assigned to the Honorable William H. Pauley, III. The case purports to be brought on behalf of all persons who purchased or otherwise acquired the Common stock of the Company between January 18, 2007 and January 3, 2008. The complaint alleges that the Company and the named officers violated federal securities laws by issuing a series of materially false and misleading statements to the market throughout the Class Period, which statements allegedly had the effect of artificially inflating the market price of the Company’s securities. The complaint alleges that defendants caused the Company’s results for year-end 2006 and for the first three quarters of 2007 to be materially misstated because the Company failed to adequately accrue its loan loss provisions, which overstated the Company’s net income, and that the Company failed to adequately disclose allegedly known trends and uncertainties with respect to its non-traditional loan portfolio. The complaint alleges violations of the Securities Exchange Act of 1934 § 10(b) and § 20(a) and Rule 10b-5. The Company was served on February 5, 2008 and the case is pending. A class has not yet been certified in the above action. The Company is aware of press reports that other similar actions may be filed, but has not been served with any other complaints. We intend to vigorously assert our defenses.

 

On February 11, 2008, the Company received a subpoena from the Attorney General of the State of New York that seeks documents and information relating to our direct-to-consumer Tuition Answer product. We intend to cooperate with the Attorney General’s office.

 

 

Nothing to report.

 

PART II.

 

 

The Company’s common stock is listed and traded on the New York Stock Exchange under the symbol SLM. The number of holders of record of the Company’s common stock as of January 31, 2008 was 714. The following table sets forth the high and low sales prices for the Company’s common stock for each full quarterly period within the two most recent fiscal years.

 

Common Stock Prices

 

 

The Company paid quarterly cash dividends of $.22 for the first quarter of 2006, $.25 for the last three quarters of 2006 and $.25 for the first quarter of 2007.

 

Issuer Purchases of Equity Securities

 

The following table summarizes the Company’s common share repurchases during 2007 pursuant to the stock repurchase program (see Note 12 to the consolidated financial statements, “Stockholders’ Equity”) first authorized in September 1997 by the Board of Directors. Since the inception of the program, which has no expiration date, the Board of Directors has authorized the purchase of up to 342.5 million shares as of December 31, 2007. Included in this total are 25 million additional shares authorized for repurchase by the Board in November 2007.

 

 

     ­ ­

 

Stock Performance

 

The following graph compares the yearly percentage change in the Company’s cumulative total shareholder return on its common stock to that of Standard & Poor’s 500 Stock Index and Standard & Poor’s Financials Index. The graph assumes a base investment of $100 at December 31, 2002 and reinvestment of dividends through December 31, 2007.

 

Five Year Cumulative Total Shareholder Return

 

 

 

 

Source: Bloomberg Total Return Analysis

 

 

Selected Financial Data 2003-2007
(Dollars in millions, except per share amounts)

 

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, related notes, and “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS” included in this Form 10-K.

 

 

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Years ended December 31, 2005-2007
(Dollars in millions, except per share amounts, unless otherwise stated)

 

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

 

We are the largest source of funding, delivery and servicing support for education loans in the United States. Our primary business is to originate, acquire and hold both federally guaranteed student loans and Private Education Loans, which are not federally guaranteed or privately insured. The primary source of our earnings is from net interest income earned on those student loans as well as gains on the sales of such loans in securitization transactions. We also earn fees for pre-default and post-default receivables management services on student loans, such that we are engaged in every phase of the student loan life cycle — from originating and servicing student loans to default prevention and ultimately the collection on defaulted student loans. Through recent acquisitions, we have expanded our receivables management services to a number of different asset classes outside of student loans. We also provide a wide range of other financial services, processing capabilities and information technology to meet the needs of educational institutions, lenders, students and their families, and guarantee agencies. SLM Corporation, more commonly known as Sallie Mae, is a holding company that operates through a number of subsidiaries. References in this report to the “Company” refer to SLM Corporation and its subsidiaries.

 

We have used both internal growth and strategic acquisitions to attain our leadership position in the education finance marketplace. Our sales force, which delivers our products on campuses across the country, is the largest in the student loan industry. The core of our marketing strategy is to promote our on-campus brands, which generate student loan originations through our Preferred Channel. Loans generated through our Preferred Channel are more profitable than loans acquired through other acquisition channels because we own them earlier in the student loan’s life and generally incur lower costs to acquire such loans. We have built brand leadership through the Sallie Mae name, the brands of our subsidiaries and those of our lender partners. These sales and marketing efforts are supported by the largest and most diversified servicing capabilities in the industry. In recent years, borrowers have been consolidating their FFELP Stafford loans into FFELP Consolidation Loans in much greater numbers such that FFELP Consolidation Loans now constitute 55 percent of our Managed loan portfolio.

 

We have expanded into a number of fee-based businesses, most notably, our Asset Performance Group (“APG”), formerly known as Debt Management Operations (“DMO”) business. Our APG business provides a wide range of accounts receivable and collections services including student loan default aversion services, defaulted student loan portfolio management services, contingency collections services for student loans and other asset classes, and accounts receivable management and collection for purchased portfolios of receivables that are delinquent or have been charged off by their original creditors. We also purchase and manage portfolios of sub-performing and non-performing mortgage loans.

 

We also earn fees for a number of services including student loan and guarantee servicing, 529 college-savings plan administration services, and for providing processing capabilities and information technology to educational institutions. We also operate an affinity marketing program through Upromise, Inc. (“Upromise”).

We manage our business through two primary operating segments: the Lending operating segment and the APG operating segment. Accordingly, the results of operations of the Company’s Lending and APG operating segments are presented separately below under “BUSINESS SEGMENTS.” These operating segments are considered reportable segments under the Financial Accounting Standards Board’s (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 131, “Disclosures about Segments of an Enterprise and Related Information,” based on quantitative thresholds applied to the Company’s financial statements.

 

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”). 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. We base our estimates 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. 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.

 

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. These estimates relate to the following accounting policies that are discussed in more detail below: application of the effective interest method for loans (premiums, discounts and Repayment Borrower Benefits), securitization accounting and Retained Interests, allowance for loan losses, and derivative accounting. In recent years, we have frequently updated a number of estimates to account for the continued high level of FFELP Consolidation Loan activity. Also, a number of these estimates affect life-of-loan calculations. Since our student loans have long average lives, the cumulative effect of relatively small changes in estimates can be material.

 

Premiums, Discounts and Repayment Borrower Benefits

 

For both federally insured and Private Education Loans, we account for premiums paid, discounts received, capitalized direct origination costs incurred on the origination of student loans, and the impact of Repayment Borrower Benefits in accordance with SFAS No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases.” The unamortized portion of the premiums and 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 of the student loan after giving effect to the amortization of purchase premiums and accretion of student loan discounts, as well as the impact of Repayment Borrower Benefits. Premiums, capitalized direct origination costs and discounts received are amortized over the estimated life of the loan, which includes an estimate of prepayment speeds. Estimates for future prepayments are incorporated in an estimated Constant Prepayment Rate (“CPR”), which is primarily based upon the historical prepayments due to consolidation and defaults, extensions from the utilization of forbearance, as well as, management’s expectation of future prepayments and extensions. For Repayment Borrower Benefits, the estimates of their effect on student loan yield are based on analyses of historical payment behavior of borrowers who are eligible for the incentives, and the evaluation of the ultimate qualification rate for these incentives. We periodically evaluate the assumptions used to estimate the loan life and qualification rates, and in instances where there are modifications to the assumptions, amortization is adjusted on a cumulative basis to reflect the change.

 

The estimate of the CPR measures the rate at which loans in the portfolio pay before their stated maturity. A number of factors can affect the CPR estimate such as the rate of consolidation activity and default rates. Changes in CPR estimates are discussed in more detail below. The impact of Repayment Borrower Benefits is dependent on the estimate of the number of borrowers who will eventually qualify for these benefits. For competitive purposes, we occasionally change Repayment Borrower Benefits programs in both amount and qualification factors. These programmatic changes are reflected in the estimate of the Repayment Borrower Benefits discount when made.

Securitization Accounting and Retained Interests

 

We regularly engage in securitization transactions as part of our financing strategy (see also “LIQUIDITY AND CAPITAL RESOURCES — Securitization Activities”). In a securitization, we sell student loans to a trust that issues bonds backed by the student loans as part of the transaction. When our securitizations meet the sale criteria of SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities — a Replacement of SFAS No. 125,” we record a gain on the sale of the student loans, which is the difference between the allocated cost basis of the assets sold and the relative fair value of the assets received. The primary judgment in determining the fair value of the assets received is the valuation of the Residual Interest.

 

The Residual Interests in each of our securitizations are treated as either (1) available-for-sale securities in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and therefore must be marked-to-market with temporary unrealized gains and losses recognized, net of tax, in accumulated other comprehensive income in stockholders’ equity or (2) securities marked-to-market through earnings under SFAS No. 155 “Accounting for Certain Hybrid Financial Instruments.” Since there are no quoted market prices for our Residual Interests, we estimate their fair value both initially and each subsequent quarter using the key assumptions listed below:

 

 

We recognize interest income and periodically evaluate our Residual Interests for other than temporary impairment in accordance with the Emerging Issues Task Force (“EITF”) Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Residual Beneficial Interests in Securitized Financial Assets.” Under this standard, each quarter we estimate the remaining cash flows to be received from our Retained Interests and use these revised cash flows to prospectively calculate a yield for income recognition. In cases where our estimate of future cash flows results in a lower yield from that used to recognize interest income in the prior quarter, the Residual Interest is written down to fair value, first to the extent of any unrealized gain in accumulated other comprehensive income, then through earnings as an other than temporary impairment, and the yield used to recognize subsequent income from the trust is negatively impacted.

 

We also receive income for servicing the loans in our securitization trusts. We assess the amounts received as compensation for these activities at inception and on an ongoing basis to determine if the amounts received are adequate compensation as defined in SFAS No. 140. To the extent such compensation is determined to be no more or less than adequate compensation, no servicing asset or obligation is recorded.

 

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. We analyze those portfolios to determine the effects that the various stages of delinquency have on borrower default behavior and ultimate charge-off. We estimate the allowance for loan losses for our Managed 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, 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.

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, repayment, forbearance, delinquency), underwriting criteria, existence or absence of a cosigner, and aging. We use historical experience coupled with qualitative factors regarding changes in portfolio mix, macroeconomic indicators, policies, procedures, laws, regulations, underwriting, and other factors to estimate default and collection rate projections. We then apply default and collection rate projections to each category. The vast majority of our Private Education Loan programs do not require the borrowers to begin repayment until six months after they have graduated or otherwise have left school. Consequently, our loss estimates for these programs are generally low while the borrower is in school. At December 31, 2007, 43 percent of the principal balance in the higher education Managed Private Education Loan portfolio is related to borrowers who are still in-school or grace 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 with the percentage of borrowers in repayment.

 

Our loss estimates are based on a loss emergence period of generally two years. 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 majority of forbearance occurs early in the repayment term when borrowers are starting their careers (see “LENDING BUSINESS SEGMENT — Private Education Loans — Private Education Loan Delinquencies”). At December 31, 2007, 13.9 percent of the Managed Private Education Loan portfolio in repayment and forbearance was in forbearance status. The loss emergence 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. Recoveries on loans charged off are considered when calculating the allowance for loan losses, and actual cash recoveries are therefore recorded directly to the allowance.

 

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, the Company receives 98 percent reimbursement on all qualifying default claims. For loans disbursed on or after July 1, 2006, the Company receives 97 percent reimbursement. In October 2005, the Company’s loan servicing division, Sallie Mae Servicing, was designated as an Exceptional Performer (“EP”) by ED which enabled the Company to receive 100 percent reimbursement on default claims filed from the date of designation through June 30, 2006 for loans that were serviced by Sallie Mae Servicing for a period of at least 270 days before the date of default. Legislation passed in early 2006 decreased the rate of reimbursement under the EP program from 100 percent to 99 percent for claims filed on or after July 1, 2006. As a result of this amended reimbursement level, the Company established an allowance at December 31, 2005 for loans that were subject to the one-percent Risk Sharing. The College Cost Reduction and Access Act of 2007 (“CCRAA”) repealed the EP program and returned loans to their previous disbursement date-based guarantee rates of 98 percent or 97 percent. In reaction, the Company increased its provision for FFELP loans to cumulatively increase the allowance for loan losses to cover these higher Risk Sharing levels.

 

The evaluation of the provisions for loan losses is inherently subjective, as it requires material estimates that may be susceptible to significant changes. Management believes that the allowance for loan losses is appropriate to cover probable losses in the student loan portfolio.

 

Effects of Consolidation Activity on Estimates

 

Between 2003 and 2006, we experienced a surge in consolidation activity as a result of aggressive marketing and historically low interest rates. This, in turn, has had a significant effect on a number of accounting estimates in recent years. We updated our assumptions that are affected primarily by consolidation activity and updated the estimates used in developing the cash flows and effective yield calculations as they relate to the amortization of student loan premiums and discounts, Repayment Borrower Benefits, Residual Interest income and the valuation of the Residual Interest.

Consolidation activity affects each estimate 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.

 

The estimate of the CPR also affects the estimate of the average life of securitized trusts and therefore affects the valuation of the Residual Interest. Prepayments shorten the average life of the trust, and if all other factors remain equal, will reduce the value of the Residual Interest, the securitization gain on sale and the effective yield used to recognize interest income. Prepayments on student loans in our securitized trusts are significantly impacted by the rate at which securitized loans are consolidated. When a loan is consolidated from the trust either by us or a third party, the loan is treated as a prepayment. In cases where the loan is consolidated by us, it will be recorded as an on-balance sheet asset. We discuss the effects of changes in our CPR estimates in “LIQUIDITY AND CAPITAL RESOURCES — Securitization Activities and Liquidity Risk and Funding Long-Term.”

 

The increased activity in FFELP Consolidation Loans has 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. Consolidation of Private Education Loans from off-balance sheet Private Education Loan trusts will increase the CPR used to value the Residual Interest.

 

Effect of Consolidation Activity

 

The schedule below summarizes the impact of loan consolidation on each affected financial statement line item.

 

On-Balance Sheet Student Loans

 

 

 

 

Off-Balance Sheet Student Loans

 

 

Derivative Accounting

 

We use interest rate swaps, cross-currency interest rate swaps, interest rate futures contracts, Floor Income Contracts and interest rate cap contracts as an integral part of our overall risk management strategy to manage interest rate and foreign currency risk arising from our fixed rate and floating rate financial instruments. In addition, we use equity forward contracts (see Note 12, “Stockholders’ Equity,” to the financial statements for further discussion) to lock-in our future purchase price of the Company’s stock to better manage share repurchases. We account for these instruments in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” which requires that every derivative instrument, including certain derivative instruments embedded in other contracts, be recorded at fair value on the balance sheet as either an asset or liability. We determine the fair value for our derivative instruments primarily by using pricing models that consider current market conditions and the contractual terms of the derivative contracts. Market inputs into the model include interest rates, optionality, forward interest rate curves, volatility factors, forward foreign exchange rates, and the closing price of the Company’s stock (related to our equity forward contracts). The fair values of some derivatives are determined using counterparty valuations. Pricing models and their underlying assumptions impact the amount and timing of unrealized gains and losses recognized; the use of different pricing models or assumptions could produce different financial results. As a matter of policy, we compare the fair values of our derivatives that we calculate to those provided by our counterparties on a monthly basis. Any significant differences are identified and resolved appropriately.

 

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. We believe that all of our derivatives are effective economic hedges and are a critical element of our interest rate risk management strategy. However, under SFAS No. 133, some of our derivatives, primarily Floor Income Contracts, certain Eurodollar futures contracts, basis swaps and equity forwards, do not qualify for “hedge treatment” under SFAS No. 133. Therefore, changes in market value along with the periodic net settlements must be recorded through the “gains (losses) on derivative and hedging activities, net” line in the consolidated statement of income with no consideration for the corresponding change in fair value of the hedged item. The derivative market value adjustment is primarily caused by interest rate and foreign currency exchange rate volatility, changing credit spreads during the period, and changes in our stock price (related to equity forwards) as well as, the volume and term of derivatives not receiving hedge accounting treatment. See also “BUSINESS SEGMENTS — Limitations of ‘Core Earnings’ — Pre-tax Differences between ‘Core Earnings’ and GAAP by Business Segment — Derivative Accounting” for a detailed discussion of our accounting for derivatives.

SELECTED FINANCIAL DATA

 

  Condensed Statements of Income

 

Condensed Balance Sheets

 

 

RESULTS OF OPERATIONS

 

We present the results of operations first on a consolidated basis followed by a presentation of the net interest margin with accompanying analysis presented in accordance with GAAP. As discussed in detail above in the “OVERVIEW” section, we have two primary business segments, Lending and APG, plus a Corporate and Other business segment. Since these business segments operate in distinct business environments, the discussion following the results of our operations is primarily presented on a segment basis. See “BUSINESS SEGMENTS” for further discussion on the components of each segment. Securitization gains and the ongoing servicing and securitization income are included in “LIQUIDITY AND CAPITAL RESOURCES — Securitization Activities.” The discussion of derivative market value gains and losses is under “BUSINESS SEGMENTS — Limitations of ‘Core Earnings’ — Pre-tax Differences between ‘Core Earnings’ and GAAP by Business Segment — Derivative Accounting.” The discussion of goodwill and acquired intangible amortization and impairment is discussed under “BUSINESS SEGMENTS — Limitations of ‘Core Earnings’ — Pre-tax Differences between ‘Core Earnings’ and GAAP by Business Segment — Acquired intangibles.”

 

CONSOLIDATED EARNINGS SUMMARY

 

The main drivers of our net income are the growth in our Managed student loan portfolio, which drives net interest income and securitization transactions, the spread we earn on student loans, unrealized gains and losses on derivatives that do not receive hedge accounting treatment, the timing and size of securitization gains, growth in our fee-based business and expense control.

Year Ended December 31, 2007 Compared to Year Ended December 31, 2006

 

For the year ended December 31, 2007, our net loss was $896 million, or $2.26 diluted loss per share, compared to net income of $1.2 billion, or $2.63 diluted earnings per share, in the year-ago period. The effective tax rate in those periods was (86) percent and 42 percent, respectively. The movement in the effective tax rate was primarily driven by the permanent tax impact of excluding non-taxable gains and losses on equity forward contracts which are marked to market through earnings under the FASB’s SFAS No. 133. Pre-tax income decreased by $2.5 billion versus the year ended December 31, 2006 primarily due to a $1.0 billion increase in net losses on derivative and hedging activities, which was mostly comprised of losses on our equity forward contracts. Losses on derivative and hedging activities were $1.4 billion for the year ended December 31, 2007 compared to $339 million for the year ended December 31, 2006.

 

Pre-tax income for the year ended December 31, 2007 also decreased versus the year ended December 31, 2006 due to a $535 million decrease in gains on student loan securitizations. The securitization gain in 2007 was the result of one Private Education Loan securitization that had a pre-tax gain of $367 million or 18.4 percent of the amount securitized. In the year-ago period, there were three Private Education Loan securitizations that had total pre-tax gains of $830 million or 16.3 percent of the amount securitized. For the year ended December 31, 2007, servicing and securitization income was $437 million, a $116 million decrease from the year ended December 31, 2006. This decrease was primarily due to a $97 million increase in impairment losses which was mainly the result of FFELP Stafford Consolidation Loan activity exceeding expectations, increased Private Education Consolidation Loan activity, increased Private Education Loan expected default activity, and an increase in the discount rate used to value the Private Education Loan Residual Interests (see “LIQUIDITY AND CAPITAL RESOURCES — Residual Interest in Securitized Receivables”).

 

Net interest income after provisions for loan losses decreased by $594 million versus the year ended December 31, 2006. The decrease was due to the year-over-year increase in the provisions for loan losses of $728 million, which offset the year-over-year $134 million increase in net interest income. The increase in net interest income was primarily due to an increase of $30.8 billion in the average balance of on-balance sheet interest earning assets offset by a decrease in the student loan spread, including the impact of Wholesale Consolidation Loans (see “Student Loan Spread — Student Loan Spread Analysis — On-Balance Sheet”). The increase in provisions for loan losses relates to higher provision amounts for Private Education Loans, FFELP loans, and mortgage loans primarily due to a weakening U.S. economy (see “LENDING BUSINESS SEGMENT — Activity in the Allowance for Private Education Loan Losses; and — Total Provisions for Loan Losses”).

 

Fee and other income and collections revenue increased $42 million from $1.11 billion for the year ended December 31, 2006 to $1.15 billion for the year ended December 31, 2007. Operating expenses increased by $206 million year-over-year. This increase in operating expenses was primarily due to $56 million in Merger-related expenses and $23 million in severance costs incurred in 2007. As part of the Company’s cost reduction efforts, these severance costs were related to the elimination of approximately 350 positions (representing three percent of the overall employee population) across all areas of the Company. Operating expenses in 2007 also included $93 million related to a full year of expenses for Upromise compared to $33 million incurred in 2006 subsequent to the August 2006 acquisition of this subsidiary.

 

Our Managed student loan portfolio grew by $21.5 billion (or 15 percent), from $142.1 billion at December 31, 2006 to $163.6 billion at December 31, 2007. In 2007 we acquired $40.3 billion of student loans, an 8 percent increase over the $37.4 billion acquired in the year-ago period. The 2007 acquisitions included $9.3 billion in Private Education Loans, an 11 percent increase over the $8.4 billion acquired in 2006. In the year ended December 31, 2007, we originated $25.5 billion of student loans through our Preferred Channel, an increase of 9 percent over the $23.4 billion originated in the year-ago period.

 

Year Ended December 31, 2006 Compared to Year Ended December 31, 2005

 

For the year ended December 31, 2006, net income was $1.2 billion ($2.63 diluted earnings per share), a 16 percent decrease from the $1.4 billion in net income ($3.05 diluted earnings per share) for the year ended

December 31, 2005. On a pre-tax basis, year-to-date 2006 net income of $2.0 billion was a 6 percent decrease from the $2.1 billion in pre-tax net income earned in the year ended December 31, 2005. The larger percentage decrease in year-over-year, after-tax net income versus pre-tax net income is driven by the tax accounting permanent impact of excluding $360 million in unrealized equity forward losses from 2006 taxable income and excluding $121 million of unrealized equity forward gains from 2005 taxable income. Fluctuations in the effective tax rate were primarily driven by the permanent tax impact of excluding non-taxable gains and losses on equity forward contracts as discussed above. The net effect from excluding non-taxable gains and losses on equity forward contracts from taxable income was an increase in the effective tax rate from 34 percent in the year ended December 31, 2005 to 42 percent in the year ended December 31, 2006.

 

Year-over-year net interest income is roughly unchanged as the $12 billion increase in average interest earning assets was offset by a 23 basis point decrease in the net interest margin. The year-over-year decrease in the net interest margin is due to higher average interest rates which reduced Floor Income by $155 million, and to the increase in the average balance of lower yielding cash and investments.

 

Securitization gains increased by $350 million in the year ended December 31, 2006 versus 2005. The securitization gains for 2006 were primarily driven by the three off-balance sheet Private Education Loan securitizations, which had total pre-tax gains of $830 million or 16 percent of the amount securitized, versus two off-balance sheet Private Education Loan securitizations in 2005, which had pre-tax gains of $453 million or 15 percent of the amount securitized.

 

For the year ended December 31, 2006, servicing and securitization revenue increased by $196 million to $553 million. The increase in servicing and securitization revenue can be attributed to $103 million in lower impairments on our Retained Interests and the growth in the average balance of off-balance sheet student loans. Impairments are primarily caused by the effect of FFELP Consolidation Loan activity on our FFELP Stafford securitization trusts. Pre-tax impairments on our Retained Interests in securitizations totaled $157 million for the year ended December 31, 2006 versus $260 million for the year ended December 31, 2005.

 

In 2006, net losses on derivative and hedging activities were $339 million, a decrease of $586 million from the net gains of $247 million in 2005. This decrease primarily relates to $230 million of unrealized losses in 2006, versus unrealized gains of $634 million in the prior year, which resulted in a year-over-year reduction in pre-tax income of $864 million. The effect of the unrealized losses was partially offset by a $278 million reduction in realized losses on derivatives and hedging activities on instruments that were not accounted for as hedges. The decrease in unrealized gains was primarily due to the impact of a lower SLM stock price on our equity forward contracts which resulted in a mark-to-market unrealized loss of $360 million in 2006 versus an unrealized gain of $121 million in the year-ago period, and to a decrease of $305 million in unrealized gains on Floor Income Contracts. The smaller unrealized gains on our Floor Income Contracts were primarily caused by the relationship between the Floor Income Contracts’ strike prices versus the estimated forward interest rates during 2006 versus 2005.

 

Fee and other income and collections revenue increased $192 million from $915 million for the year ended December 31, 2005 to $1.1 billion for the year ended December 31, 2006. Operating expenses increased by $208 million year-over-year. This increase in operating expenses can primarily be attributed to $63 million of stock option compensation expense, due to the implementation of SFAS No. 123(R) in the first quarter of 2006 and to $33 million related to expenses for Upromise, acquired in August 2006.

 

Our Managed student loan portfolio grew by $19.6 billion (or 16 percent), from $122.5 billion at December 31, 2005 to $142.1 billion at December 31, 2006. In 2006 we acquired $37.4 billion of student loans, a 24 percent increase over the $30.2 billion acquired in the year-ago period. The 2006 acquisitions included $8.4 billion in Private Education Loans, a 31 percent increase over the $6.4 billion acquired in 2005. In the year ended December 31, 2006, we originated $23.4 billion of student loans through our Preferred Channel, an increase of 9 percent over the $21.4 billion originated in the year-ago period.

  Average Balance Sheets

 

The following table reflects the rates earned on interest earning assets and paid on interest bearing liabilities for the years ended December 31, 2007, 2006 and 2005. This table reflects the net interest margin for the entire Company for our on-balance sheet assets. It is included in the Lending segment discussion because that segment includes substantially all interest earning assets and interest bearing liabilities.

 

 

Rate/Volume Analysis

 

The following rate/volume analysis shows the relative contribution of changes in interest rates and asset volumes.

 

The changes in net interest income are primarily due to fluctuations in the student loan spread discussed below, as well as the growth of our student loan portfolio and the level of cash and investments we may hold on our balance sheet for liquidity purposes. In connection with the Merger Agreement, we increased our liquidity portfolio to higher than historical levels. The liquidity portfolio has a negative net interest margin and, as a result, the increase in this portfolio reduced net interest income by $18 million for the year ended December 31, 2007.

 

Student Loans

 

For both federally insured and Private Education Loans, we account for premiums paid, discounts received and certain origination costs incurred on the origination and acquisition of student loans in accordance with SFAS No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases.” The unamortized portion of the premiums and discounts is included in the carrying value of the student loan on the consolidated balance sheet. We recognize income on our student loan portfolio based on the expected yield of the student loan after giving effect to the amortization of purchase premiums and the accretion of student loan discounts, as well as interest rate reductions and rebates expected to be earned through Repayment Borrower Benefits programs. Discounts on Private Education Loans are deferred and accreted to income over the lives of the student loans. In the table below, this accretion of discounts is netted with the amortization of the premiums.

 

Student Loan Spread

 

An important performance measure closely monitored by management is the student loan spread. The student loan spread is the difference between the income earned on the student loan assets and the interest paid on the debt funding those assets. A number of factors can affect the overall student loan spread, such as:

 

 

Student Loan Spread Analysis — On-Balance Sheet

 

The following table analyzes the reported earnings from on-balance sheet student loans. For an analysis of our student loan spread for the entire portfolio of Managed student loans on a similar basis to the on-balance sheet analysis, see “LENDING BUSINESS SEGMENT — Student Loan Spread Analysis — ‘Core Earnings’ Basis.”

 

 

The table above shows the various items that impact our student loan spread. Gross Floor Income (Floor Income earned before payments on Floor Income Contracts) is impacted by the level of interest rates and the percentage of the FFELP portfolio eligible to earn Floor Income. The spread impact from Consolidation Loan Rebate Fees fluctuates as a function of the percentage of FFELP Consolidation Loans on our balance sheet. Repayment Borrower Benefits are generally impacted by the amount of Repayment Borrower Benefits being offered as well as the payment behavior of the underlying loans. Premium and discount amortization is generally impacted by the prices we pay for loans and amounts capitalized related to such purchases or originations. Premium and discount amortization is also impacted by prepayment behavior of the underlying loans.

 

The decrease in our student loan spread, before Interim ABCP Facility Fees and the effect of Wholesale Consolidation Loans, for the year ended December 31, 2007 versus 2006 was primarily due to an increase in our cost of funds. Our cost of funds for on-balance sheet student loans excludes the impact of basis swaps that economically hedge the re-pricing and basis mismatch between our funding and student loan asset indices, but do not receive hedge accounting treatment under SFAS No. 133. We use basis swaps extensively to manage our basis risk associated with our interest rate sensitive assets and liabilities. These swaps generally do not qualify as accounting hedges, and as a result, are required to be accounted for in the “gains (losses) on derivatives and hedging activities, net” line in the consolidated statement of income, as opposed to being accounted for in interest expense. As a result, these basis swaps are not considered in the calculation of the cost of funds in the above table, and in times of volatile movements of interest rates like those experienced in the second half of 2007, the student loan spread in the above table can significantly change. See “LENDING BUSINESS SEGMENT — Student Loan Spread Analysis — ‘Core Earnings’ Basis,” which reflects these basis swaps in interest expense, and demonstrates the economic hedge effectiveness of these basis swaps. The

decrease in the student loan spread was also due to an increase in the estimate of uncollectible accrued interest related to our Private Education Loans (see “LENDING BUSINESS SEGMENT — Student Loan Spread Analysis — ‘Core Earnings’ Basis.”)

 

The decrease in the student loan spread before the effect of Wholesale Consolidation Loans in the year ended December 31, 2006 versus 2005 was primarily due to the reduction in Gross Floor Income earned. A primary driver of fluctuations in our on-balance sheet student loan spread when interest rates significantly change from period to period can be the level of Gross Floor Income earned in the period. Interest rates increased significantly between 2005 and 2006 which reduced Gross Floor Income earned. We believe that we have economically hedged most of the long-term Floor Income through the sale of Floor Income Contracts, under which we receive an upfront fee and agree to pay the counterparty the Floor Income earned on a notional amount of student loans. These contracts do not qualify for hedge accounting treatment and as a result the payments on the Floor Income Contracts are included in the consolidated statement of income with “gains (losses) on derivative and hedging activities, net” rather than in student loan interest income, where the offsetting Floor Income is recorded.

 

In the second half of 2006, we implemented a new loan acquisition strategy under which we began purchasing FFELP Consolidation Loans outside of our normal origination channels, primarily via the spot market. We refer to this volume as our Wholesale Consolidation Channel. FFELP Consolidation Loans acquired through this channel are considered incremental volume to our core acquisition channels, which are focused on the retail marketplace with an emphasis on our internal brand strategy. Wholesale Consolidation Loans generally command significantly higher premiums than our originated FFELP Consolidation Loans, and as a result, Wholesale Consolidation Loans have lower spreads. Since Wholesale Consolidation Loans are acquired outside of our core loan acquisition channels and have different yields and return expectations than the rest of our FFELP Consolidation Loan portfolio, we have excluded the impact of the Wholesale Consolidation Loan volume from the student loan spread analysis to provide more meaningful period-over-period comparisons on the performance of our student loan portfolio. We are no longer buying Wholesale Consolidation Loans.

 

FEDERAL AND STATE TAXES

 

The Company is subject to federal and state income taxes. Our effective tax rate for the years ended December 31, 2007, 2006 and 2005 was (86) percent, 42 percent and 34 percent, respectively. The effective tax rate reflects the permanent impact of the exclusion of gains and losses on equity forward contracts with respect to the Company’s stock for tax purposes. These permanent differences were a $1.6 billion loss in 2007, a $360 million loss in 2006, and a $121 million gain in 2005.

 

BUSINESS SEGMENTS

 

The results of operations of the Company’s Lending and APG operating segments are presented below. These defined business segments operate in distinct business environments and are considered reportable segments under SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” based on quantitative thresholds applied to the Company’s financial statements. In addition, we provide other complementary products and services through smaller operating segments that do not meet such thresholds and are aggregated in the Corporate and Other reportable segment for financial reporting purposes. These products and services include guarantor and loan servicing, 529 college-savings plan administration, and the operation of an affinity marketing program.

 

The management reporting process measures the performance of the Company’s operating segments based on the management structure of the Company as well as the methodology used by management to evaluate performance and allocate resources. In accordance with the Rules and Regulations of the Securities and Exchange Commission (“SEC”), we prepare financial statements in accordance with GAAP. In addition to evaluating the Company’s GAAP-based financial information, management, including the Company’s chief operation decision makers, evaluates the performance of the Company’s operating segments based on their profitability on a basis that, as allowed under SFAS No. 131, differs from GAAP. We refer to management’s basis of evaluating our segment results as “Core Earnings” presentations for each business segment and we

refer to these performance measures in our presentations with credit rating agencies and lenders. Accordingly, information regarding the Company’s reportable segments is provided herein based on “Core Earnings,” which are discussed in detail below.

 

Our “Core Earnings” are not defined terms within GAAP and may not be comparable to similarly titled measures reported by other companies. “Core Earnings” net income reflects only current period adjustments to GAAP net income as described below. Unlike financial accounting, there is no comprehensive, authoritative guidance for management reporting and as a result, our management reporting is not necessarily comparable with similar information for any other financial institution. Our operating segments are defined by the products and services they offer or the types of customers they serve, and they reflect the manner in which financial information is currently evaluated by management. Intersegment revenues and expenses are netted within the appropriate financial statement line items consistent with the income statement presentation provided to management. Changes in management structure or allocation methodologies and procedures may result in changes in reported segment financial information.

 

“Core Earnings” are the primary financial performance measures used by management to develop the Company’s financial plans, track results, and establish corporate performance targets and incentive compensation. While “Core Earnings” are not a substitute for reported results under GAAP, we rely on “Core Earnings” in operating our business because “Core Earnings” permit management to make meaningful period-to-period comparisons of the operational and performance indicators that are most closely assessed by management. Management believes this information provides additional insight into the financial performance of the core business activities of our operating segments. Accordingly, the tables presented below reflect “Core Earnings” which are reviewed and utilized by management to manage the business for each of our reportable segments. A further discussion regarding “Core Earnings” is included under “Limitations of ‘Core Earnings’ ” and “Pre-tax Differences between ‘Core Earnings’ and GAAP by Business Segment.”

The Lending operating segment includes all discussion of income and related expenses associated with the net interest margin, the student loan spread and its components, the provisions for loan losses, and other fees earned on our Managed portfolio of student loans. The APG operating segment reflects the fees earned and expenses incurred in providing accounts receivable management and collection services. Our Corporate and Other reportable segment includes our remaining fee businesses and other corporate expenses that do not pertain directly to the primary segments identified above.