| NELNET INC ITEM 1A RISK FACTORS If any of the following risks actually occurs, the Company’s business, financial condition, results of operations, and cash flows could be materially and adversely affected |
| The Company cannot predict with certainty the outcome of the OIG audit |
| A portion of the Company’s FFEL Program loan portfolio is comprised of loans currently financed or financed prior to September 30, 2004 with proceeds of tax-exempt obligations originally issued prior to October 1, 1993 |
| Based upon provisions of the Higher Education Act and regulations and guidance of the Department and related interpretations, the Company is entitled to receive special allowance payments on these loans equal to a 9dtta5prca minimum rate of return (the “9dtta5prca Floor”) |
| As of December 31, 2005, the Company had dlra3dtta5 billion of FFELP loans that were receiving special allowance payments based upon the 9dtta5prca Floor |
| In May 2003, the Company sought confirmation from the Department regarding whether it was allowed to receive the special allowance payments based on the 9dtta5prca Floor on loans being acquired with funds obtained from the proceeds of tax-exempt obligations originally issued prior to October 1, 1993 and then subsequently refinanced with proceeds of taxable obligations without retiring the tax-exempt obligations |
| Pending satisfactory resolution of this issue, the Company deferred recognition of that portion of the 9dtta5prca Floor income generated by these loans which exceeded statutorily defined special allowance rates under a taxable financing |
| In June 2004, after consideration of certain clarifying information received in connection with the guidance it had sought and based on written and verbal communications with the Department, management concluded that the earnings process had been completed and recognized the previously deferred income of dlra124dtta3 million on this portfolio |
| The Company is currently recognizing the 9dtta5prca Floor income on these loans as it is earned |
| In October 2004, Congress passed and President Bush signed into law the Taxpayer-Teacher Protection Act of 2004 (the “October 2004 Act”), which prospectively suspended eligibility for the 9dtta5prca Floor on any loans refinanced with proceeds of taxable obligations between September 30, 2004 and January 1, 2006 |
| The loans in the Company’s student loan portfolio that have been refinanced with 11 ______________________________________________________________________ proceeds of taxable obligations and are receiving special allowance payments under the 9dtta5prca Floor were all refinanced with proceeds of taxable obligations before September 30, 2004 |
| In April 2004, the Company ceased adding to its portfolio of loans receiving special allowance payments subject to the 9dtta5prca Floor, and thus the provisions of the October 2004 Act do not have an effect upon the eligibility of such loans to receive the 9dtta5prca Floor |
| On May 24, 2005, the Office of Inspector General of the Department (“OIG”) publicly released a Final Audit Report on Special Allowance Payments to New Mexico Educational Assistance Foundation for Loans Funded by Tax-Exempt Obligations (the “NMEAF Audit Report”) |
| In the NMEAF Audit Report, the OIG indicated it had determined that the New Mexico Educational Assistance Foundation (“NMEAF”), an entity unrelated to the Company, received what the OIG deemed to be improper special allowance payments under the 9dtta5prca Floor calculation for loans that were transferred as security for new debt obligations (“refunded bonds”) after the prior tax-exempt obligation was retired |
| The OIG recommended that the Chief Operating Officer for Federal Student Aid of the Department calculate and require repayment by NMEAF of the special allowance payments described in the NMEAF Audit Report |
| However, as discussed below, the Department subsequently determined that NMEAF complied with applicable laws, regulations, and Department guidance with respect to such special allowance payments |
| In June 2005, the OIG commenced an audit of the portion of the Company’s student loan portfolio receiving 9dtta5prca Floor special allowance payments |
| The Company is fully cooperating with the OIG in connection with this audit |
| The Company also understands that the Department, as part of a nationwide project, is separately conducting a review of lenders related to student loans financed with the proceeds of tax-exempt bonds that are eligible for the 9dtta5prca Floor |
| On June 30, 2005, the Company provided information to the Department that it requested as part of this project |
| On July 8, 2005, the Secretary of the Department announced that the Department had completed its review of the NMEAF Audit Report and determined that NMEAF complied with applicable laws, regulations, and Department guidance with respect to NMEAF’s receipt of 9dtta5prca Floor special allowance payments discussed in the NMEAF Audit Report and effectively indicated it disagreed with the OIG’s conclusions |
| Although retroactive changes to the Higher Education Act are extremely uncommon, if Congress were to enact legislation that applied retroactively to remove 9dtta5prca Floor eligibility for FFELP loans that have been refinanced with proceeds of taxable obligations from eligibility for the 9dtta5prca Floor, and if such legislation were to withstand legal challenge, it could have a material adverse effect upon the Company’s financial condition and results of operations |
| Of the dlra3dtta5 billion in loans held by the Company as of December 31, 2005 that are receiving 9dtta5prca Floor payments, approximately dlra2dtta9 billion in loans were financed prior to September 30, 2004 with proceeds of tax-exempt obligations originally issued prior to October 1, 1993 and then subsequently refinanced with the proceeds of taxable obligations, without retiring the tax-exempt obligations |
| The guidance issued by the Department has indicated that receipt of the 9dtta5prca Floor income on loans such as those held by the Company is permissible under current law and previous interpretations thereof |
| However, the Company cannot predict whether the Department will maintain its position in the future on the permissibility of the 9dtta5prca Floor |
| Likewise, although management believes that it has complied in all material respects with the rules and regulations with respect to the proper categorization of these loans as being eligible for the 9dtta5prca Floor special allowance payments, the Company cannot predict the outcome of the OIG audit |
| Costs, if any, associated with an adverse outcome of the OIG audit or resolution of findings or recommendations arising out of the OIG audit, a potential Department review of its position on the permissibility of the 9dtta5prca Floor, or legislation which would retroactively remove eligibility for the 9dtta5prca Floor could adversely affect the Company’s financial condition and results of operations |
| However, it is the opinion of the Company’s management, based on information currently known, that any adverse outcome or resolution of findings or recommendations arising out of the OIG audit, a potential Department review of the permissibility of the 9dtta5prca Floor, or legislation which would retroactively remove eligibility for the 9dtta5prca Floor would not have a material adverse effect on the Company’s ongoing operations |
| Failure to comply with governmental regulations or guaranty agency rules could harm the Company’s business |
| The Company’s principal business is comprised of originating, acquiring, holding, and servicing student loans made and guaranteed pursuant to the FFEL Program, which was created by the Higher Education Act |
| The Higher Education Act governs most significant aspects of the Company’s operations |
| The Company is also subject to rules of the agencies that act as guarantors of the student loans, known as guaranty agencies |
| In addition, the Company is subject to certain federal and state banking laws, regulations, and examinations, as well as federal and state consumer protection laws and regulations, including, without limitation, laws and regulations governing borrower privacy protection, information security, restrictions on access to student information, and specifically with respect to the Company’s non-federally insured loan portfolio, certain state usury laws and related regulations and the Federal Truth in Lending Act |
| Also, Canadian laws and regulations govern the Company’s Canadian loan servicing operations |
| All or most of these laws and regulations impose substantial requirements upon lenders and servicers involved in consumer finance |
| Failure to comply with these laws and regulations could result in liability to borrowers, the imposition of civil penalties, and potential class action suits |
| 12 ______________________________________________________________________ The Company’s failure to comply with regulatory regimes described above may arise from: • breaches of the Company’s internal control systems, such as a failure to adjust manual or automated servicing functions following a change in regulatory requirements; • technological defects, such as a malfunction in or destruction of the Company’s computer systems; or • fraud by the Company’s employees or other persons in activities such as borrower payment processing |
| Such failure to comply, irrespective of the reason, could subject the Company to loss of the federal guarantee on federally insured loans, costs of curing servicing deficiencies or remedial servicing, suspension or termination of the Company’s right to participate in the FFEL Program or to participate as a servicer, negative publicity, and potential legal claims or actions brought by the Company’s servicing customers and borrowers |
| The Company has the ability to cure servicing deficiencies and the Company’s historical losses in this area have been minimal |
| However, the Company’s loan servicing and guarantee servicing activities are highly dependent on its information systems, and the Company faces the risk of business disruption should there be extended failures of its systems |
| The Company has well-developed and tested business recovery plans to mitigate this risk |
| The Company also manages operational risk through its risk management and internal control processes covering its product and service offerings |
| These internal control processes are documented and tested regularly |
| The Company must satisfy certain requirements necessary to maintain the federal guarantees of its federally insured loans, and the Company may incur penalties or lose its guarantees if it fails to meet these requirements |
| The Company must meet various requirements in order to maintain the federal guarantee on its federally insured loans |
| These requirements establish servicing requirements and procedural guidelines and specify school and borrower eligibility criteria |
| The federal guarantee on the Company’s federally insured loans is conditioned on compliance with origination, servicing, and collection standards set by the Department and guaranty agencies |
| Federally insured loans that are not originated, disbursed, or serviced in accordance with the Department’s regulations risk partial or complete loss of the guarantee thereof |
| If the Company experiences a high rate of servicing deficiencies or costs associated with remedial servicing, and if the Company is unsuccessful in curing such deficiencies, the eventual losses on the loans that are not cured could be material |
| A guaranty agency may reject a loan for claim payment due to a violation of the FFEL Program due diligence servicing requirements |
| In addition, a guaranty agency may reject claims under other circumstances, including, for example, if a claim is not timely filed or adequate documentation is not maintained |
| If a loan is rejected for claim payment by a guaranty agency, the Company continues to pursue the borrower for payment and/or institutes a process to reinstate the guarantee |
| Rejections of claims as to portions of interest may be made by guaranty agencies for certain violations of the due diligence collection and servicing requirements, even though the remainder of a claim may be paid |
| Examples of errors that cause claim rejections include isolated missed collection calls or failures to send collection letters as required |
| The Department has implemented school eligibility requirements, which include default rate limits |
| In order to maintain eligibility in the FFEL Program, schools must maintain default rates below these specified limits, and both guaranty agencies and lenders are required to ensure that loans are made only to or on behalf of students attending schools that do not exceed the default rate limits |
| If the Company fails to comply with any of the above requirements, it could incur penalties or lose the federal guarantee on some or all of its federally insured loans |
| If the Company’s actual loss on denied guarantees were to increase substantially in future periods the impact could be material to the Company’s operations |
| Failure to comply with restrictions on inducements under the Higher Education Act could harm the Company’s business |
| The Higher Education Act generally prohibits a lender from providing certain inducements to educational institutions or individuals in order to secure applicants for FFELP loans |
| The Company has entered into arrangements with various schools pursuant to which the schools become lenders of FFELP loans to their graduate students, and the Company provides financing, loan origination, and servicing to the schools with respect to such loans |
| The Department has stated that non-federally insured loans are legal and permissible if offered simply as a benefit to schools |
| The Company offers non-federally insured loans to student borrowers on a regular basis but does so without requiring anything in return from the schools that these borrowers attend |
| In addition, because guidance from the Department permits de minimus gifts in connection with marketing of FFELP loans, from time to time the 13 ______________________________________________________________________ Company provides de minimus promotional events such as lunches and golf outings |
| If the Department were to change its position on any of these matters, the Company may have to change the way it markets non-federally insured and FFELP loans and a new marketing strategy may not be as effective |
| If the Company fails to respond to the Department’s change in position, the Department could potentially impose sanctions upon the Company that could negatively impact its business |
| The Company has also entered into various agreements to acquire marketing lists of prospective FFELP loan borrowers from sources such as college alumni associations |
| The Company pays to acquire these lists and for the completed applications for loans resulting therefrom |
| The Company believes that such arrangements are permissible and do not violate restrictions on inducements, as they fit within a regulatory exception recognized by the Department for generalized marketing and advertising activities |
| The Department has provided informal guidance to the Company that such arrangements are not improper inducements, since such arrangements fall within the generalized marketing exception |
| If the Department were to change its position, this could harm the Company’s reputation and marketing efforts, and, if the Company fails to adjust its practices to such change, could potentially result in the Department imposing sanctions on the Company |
| Such sanctions could negatively impact the Company’s business |
| Changes in legislation and regulations could have a negative impact upon the Company’s business |
| HERA was enacted into law on February 8, 2006 and effectively reauthorized the Title IV provisions of the FFEL Program through 2012 |
| HERA did not reauthorize the entire Higher Education Act, which is set to expire on March 31, 2006 |
| Therefore, further action will be required by Congress to either extend or reauthorize the remaining titles of the Higher Education Act |
| The Company does not anticipate a negative impact from the reauthorization of the remaining titles of the Higher Education Act |
| However, it cannot predict the outcome of this or any other legislation impacting the FFEL Program, and recognizes that a level of political and legislative risk always exists within the industry |
| This could include changes in legislation further impacting lender margins, fees paid to the Department, new policies affecting the competition between the FDL Program and FFEL Programs, or additional lender risk sharing |
| Variation in the maturities, timing of rate reset, and variation of indices of the Company’s assets and liabilities may pose risks to the Company |
| Because the Company generates the majority of its earnings from the spread between the yield received on its portfolio of student loans and the cost of financing these loans, the interest rate sensitivity of the balance sheet could have a material effect on the Company’s results of operations |
| The majority of the Company’s student loans have variable-rate characteristics in interest rate environments where the result of the special allowance payment formula exceeds the borrower rate |
| Some of the Company’s student loans, primarily consolidation loans, include fixed-rate components depending upon loan terms and the rate reset provisions set by the Department |
| The Company has financed the majority of its student loan portfolio with variable-rate debt |
| Absent utilization of derivative instruments to match the interest rate characteristics and duration of the assets and liabilities, fluctuations in the interest rate environment will affect the Company’s results of operations |
| Such fluctuations may be adverse and may be material |
| In the current low interest rate environment, the Company’s federally insured loan portfolio is yielding excess income due to variable-rate liabilities financing student loans which have a fixed borrower rate |
| Absent the use of derivative instruments, a rise in interest rates will have an adverse effect on earnings and fair values due to interest margin compression caused by increasing financing costs, until such time as the federally insured loans earn interest at a variable rate in accordance with the special allowance payment formula |
| In higher interest rate environments, where the interest rate rises above the borrower rate and fixed-rate loans become variable, the impact of the rate fluctuations is reduced |
| Due to the variability in duration of the Company’s assets and varying market conditions, the Company does not attempt to perfectly match the interest rate characteristics of its entire loan portfolio with the underlying debt instruments |
| This mismatch in duration and interest rate characteristics could have a negative impact on the Company’s results of operations |
| The Company has employed various derivative instruments to somewhat offset this mismatch |
| Changes in interest rates and the composition of the Company’s student loan portfolio and derivative instruments will impact the effect of interest rates on the Company’s earnings, and the Company cannot predict any such impact with any level of certainty |
| Market risks to which the Company is subject may have an adverse impact upon its business and operations |
| The Company’s primary market risk exposure arises from fluctuations in its borrowing and lending rates, the spread between which could be impacted by shifts in market interest rates |
| The borrower rates on federally insured loans are generally reset by the Department each July 1st based on a formula determined by the date of the origination of the loan, with the exception of rates on consolidation loans, which are fixed to term |
| The interest rate the Company actually receives on federally insured loans is the greater of the borrower rate and a rate determined by a formula based on a spread to either the 91-day Treasury Bill index or the 90-day commercial paper index, depending on when the loans were originated and the current repayment status of the loans |
| 14 ______________________________________________________________________ The Company issues asset-backed securities, both fixed- and variable-rate, to fund its student loan assets |
| The variable-rate debt is generally indexed to 90-day LIBOR or set by auction |
| The income generated by the Company’s student loan assets is generally driven by different short-term indices than the Company’s liabilities, which creates interest rate risk |
| The Company has historically borne this risk internally through the net spread on its portfolio while continuing to monitor this interest rate risk |
| The Company purchased EDULINX in December 2004 |
| EDULINX is a Canadian corporation that engages in servicing Canadian student loans |
| As a result of this acquisition, the Company is also exposed to market risk related to fluctuations in foreign currency exchange rates between the US and Canadian dollars |
| The Company has not entered into any foreign currency derivative instruments to hedge this risk |
| Fluctuations in foreign currency exchange rates may have an adverse effect on the financial position, results of operations, and cash flows of the Company |
| The Company’s derivative instruments may not be successful in managing its interest rate risks |
| When the Company utilizes derivative instruments, it utilizes them to manage interest rate sensitivity |
| Although the Company does not use derivative instruments for speculative purposes, its derivative instruments do not qualify for hedge accounting under SFAS Nodtta 133; consequently, the change in fair value of these derivative instruments is included in the Company’s operating results |
| Changes or shifts in the forward yield curve can significantly impact the valuation of the Company’s derivatives |
| Accordingly, changes or shifts to the forward yield curve will impact the financial position, results of operations, and cash flows of the Company |
| The derivative instruments used by the Company are typically in the form of interest rate swaps and basis swaps |
| Interest rate swaps effectively convert variable-rate debt obligations to a fixed-rate or fixed-rate debt obligations to a variable-rate |
| Basis swaps effectively convert the index upon which debt obligations are based |
| Developing an effective strategy for dealing with movements in interest rates is complex, and no strategy can completely insulate the Company from risks associated with such fluctuations |
| In addition, a counterparty to a derivative instrument could default on its obligation, thereby exposing the Company to credit risk |
| Further, the Company may have to repay certain costs, such as transaction fees or brokerage costs, if the Company terminates a derivative instrument |
| Finally, the Company’s interest rate risk management activities could expose the Company to substantial losses if interest rates move materially differently from management’s expectations |
| As a result, the Company cannot assure that its economic hedging activities will effectively manage its interest rate sensitivity or have the desired beneficial impact on its results of operations or financial condition |
| When the fair value of a derivative instrument is negative, the Company owes the counterparty and, therefore, has no credit risk |
| However, if the value of derivatives with a counterparty exceeds a specified threshold, the Company may have to pay a collateral deposit to the counterparty |
| If interest rates move materially differently from management’s expectations, the Company could be required to deposit a significant amount of collateral with its derivative instrument counterparties |
| The collateral deposits, if significant, could negatively impact the Company’s capital resources |
| The Company faces liquidity risks due to the fact that its operating and warehouse financing needs are substantially provided by third-party sources |
| The Company’s primary funding needs are those required to finance its student loan portfolio and satisfy its cash requirements for new student loan originations and acquisitions, operating expenses, and technological development |
| The Company’s operating and warehouse financings are substantially provided by third parties, over which it has no control |
| Unavailability of such financing sources may subject the Company to the risk that it may be unable to meet its financial commitments to creditors, branding partners, forward flow lenders, or borrowers when due unless it finds alternative funding mechanisms |
| The Company relies upon conduit warehouse loan financing vehicles to support its funding needs on a short-term basis |
| There can be no assurance that the Company will be able to maintain such warehouse financing in the future |
| As of December 31, 2005, the Company had a student loan warehousing capacity of dlra6dtta6 billion, of which dlra4dtta8 billion was outstanding and dlra1dtta8 billion was available for future use, through 364-day commercial paper conduit programs |
| These conduit programs mature in 2006 through 2009; however, they must be renewed annually by underlying liquidity providers and may be terminated at any time for cause |
| There can be no assurance the Company will be able to maintain such conduit facilities, find alternative funding, or increase the commitment level of such facilities, if necessary |
| While the Company’s conduit facilities have historically been renewed for successive terms, there can be no assurance that this will continue in the future |
| In August 2005, the Company entered into a credit agreement for a dlra500dtta0 million unsecured line of credit |
| Concurrently with entry into this agreement, the Company terminated its existing dlra35dtta0 million operating line of credit and dlra50dtta0 million commercial paper operating line of credit |
| At December 31, 2005, there was dlra90dtta0 million outstanding on this line and dlra410dtta0 was available for future uses |
| 15 ______________________________________________________________________ Characteristics unique to asset-backed securitization pose risks to the Company’s continued liquidity |
| The Company has historically relied upon, and expects to continue to rely upon, asset-backed securitizations as its most significant source of funding for student loans on a long-term basis |
| As of December 31, 2005 and 2004, dlra16dtta5 billion and dlra11dtta8 billion, respectively, of the Company’s student loans were funded by long-term asset-backed securitizations |
| The net cash flow the Company receives from the securitized student loans generally represents the excess amounts, if any, generated by the underlying student loans over the amounts required to be paid to the bondholders, after deducting servicing fees and any other expenses relating to the securitizations |
| In addition, some of the residual interests in these securitizations have been pledged to secure additional bond obligations |
| The Company’s rights to cash flow from securitized student loans are subordinate to bondholder interests, and these loans may fail to generate any cash flow beyond what is due to bondholders |
| The interest rates on certain of the Company’s asset-backed securities are set and periodically reset via a “dutch auction” utilizing remarketing agents for varying intervals ranging from seven to 91 days |
| Investors and potential investors submit orders through a broker-dealer as to the principal amount of notes they wish to buy, hold, or sell at various interest rates |
| The broker-dealers submit their clients’ orders to the auction agent or remarketing agent, who determines the interest rate for the upcoming period |
| If there are insufficient potential bid orders to purchase all of the notes offered for sale or being repriced, the Company could be subject to interest costs substantially above the anticipated and historical rates paid on these types of securities |
| A failed auction or remarketing could also reduce the investor base of the Company’s other financing and debt instruments |
| In addition, rising interest rates existing at the time the Company’s asset-backed securities are remarketed may cause other competing investments to become more attractive to investors than the Company’s securities, which may decrease the Company’s liquidity |
| Future losses due to defaults on loans held by the Company present credit risk which could adversely affect the Company’s earnings |
| As of December 31, 2005, 99prca of the Company’s student loan portfolio was comprised of federally insured loans |
| These loans currently benefit from a federal guarantee of their principal balance and accrued interest |
| As a result of the Company’s Exceptional Performer designation, the Company receives 100prca reimbursement on all eligible FFELP default claims submitted for reimbursement during a 12-month period (June 1, 2005 through May 31, 2006) |
| The Company is not subject to the 2prca risk sharing on eligible claims submitted during this 12-month period |
| Only FFELP loans that are serviced by the Company, as well as loans owned by the Company and serviced by other service providers designated as Exceptional Performers by the Department, are eligible for the 100prca reimbursement |
| As of December 31, 2005, more than 95prca of the Company’s federally insured loans were serviced by providers designated as Exceptional Performers |
| The Company is entitled to receive this benefit as long as it and/or its service providers continue to meet the required servicing standards published by the Department |
| Compliance with such standards is assessed on a quarterly basis |
| In addition, service providers must apply for redesignation as an Exceptional Performer with the Department on an annual basis |
| The Company bears full risk of losses experienced with respect to the unguaranteed portion, the 2prca risk sharing portion, of its federally insured loans (those loans not serviced by a service provider designated as an Exceptional Performer) |
| If the Company or a third party service provider were to lose its Exceptional Performer designation, either by the Department or Congress discontinuing the program or the Company or third party not meeting the required servicing standards, loans serviced by the Company or third-party would become subject to the 2prca risk sharing loss for all claims submitted after any loss of the Exceptional Performer designation |
| If the Department discontinued the program or Congress eliminated the program, the Company would have to establish a provision for loan losses related to the 2prca risk sharing |
| One of the changes to the Higher Education Act as a result of HERA’s enactment, was to lower the guarantee rates on FFELP loans, including a decrease in insurance and reinsurance on portfolios receiving the benefit of Exceptional Performance designation by 1prca, from 100prca to 99prca of principal and accrued interest (effective July 1, 2006), and a decrease in insurance and reinsurance on portfolios not subject to the Exceptional Performance designation by 1prca, from 98prca to 97prca of principal and accrued interest (effective for all loans first disbursed on and after July 1, 2006) |
| Based on its current loan portfolio, the Company estimates it will recognize a one-time provision during 2006 of approximately dlra5-7 million based upon the increased risk sharing of 1prca |
| In addition, this change in legislation will have an ongoing impact on the Company’s provision for loan losses in future periods |
| Losses on the Company’s non-federally insured loans are borne by the Company |
| The loan loss pattern on the Company’s non-federally insured loan portfolio is not as developed as that on its federally insured loan portfolio |
| As of December 31, 2005, the aggregate principal balance of non-federally insured loans comprised 1prca of the Company’s entire student loan portfolio |
| This portfolio is expected to increase to no more than 3prca - 5prca of the Company’s student loan portfolio over the next three to five years |
| There can be no assurance that this percentage will not increase further over the long term |
| The performance of student loans in the portfolio is affected by the economy, and a prolonged economic downturn may have an adverse effect on the credit performance of these loans |
| 16 ______________________________________________________________________ While the Company has provided allowances estimated to cover losses that may be experienced in both its federally insured and non-federally insured loan portfolios, there can be no assurance that such allowances will be sufficient to cover actual losses in the future |
| The Company could experience cash flow problems if a guaranty agency defaults on its guarantee obligation |
| A deterioration in the financial status of a guaranty agency and its ability to honor guarantee claims on defaulted student loans could result in a failure of that guaranty agency to make its guarantee payments in a timely manner, if at all |
| The financial condition of a guaranty agency can be adversely affected if it submits a large number of reimbursement claims to the Department, which results in a reduction of the amount of reimbursement that the Department is obligated to pay the guaranty agency |
| The Department may also require a guaranty agency to return its reserve funds to the Department upon a finding that the reserves are unnecessary for the guaranty agency to pay its FFEL Program expenses or to serve the best interests of the FFEL Program |
| If the Department has determined that a guaranty agency is unable to meet its guarantee obligations, the loan holder may submit claims directly to the Department, and the Department is required to pay the full guarantee claim |
| However, the Department’s obligation to pay guarantee claims directly in this fashion is contingent upon the Department making the determination that a guaranty agency is unable to meet its guarantee obligations |
| The Department may not ever make this determination with respect to a guaranty agency and, even if the Department does make this determination, payment of the guarantee claims may not be made in a timely manner, which could result in the Company experiencing cash shortfalls |
| As of December 31, 2005, Nebraska Student Loan Program, Inc, Colorado Student Loan Program, United Student Aid Funds, Inc, California Student Aid Commission, and Tennessee Student Assistance Corporation were the primary guarantors of the student loans beneficially owned by the Company’s education lending subsidiaries |
| Management periodically reviews the financial condition of its guarantors and does not believe the level of concentration creates an unusual or unanticipated credit risk |
| In addition, management believes that based on amendments to the Higher Education Act, the security for and payment of any of the education lending subsidiaries’ obligations would not be materially adversely affected as a result of legislative action or other failure to perform on its obligations on the part of any guaranty agency |
| The Company, however, cannot provide absolute assurances to that effect |
| Competition created by the FDL Program and from other lenders and servicers may adversely impact the Company’s business |
| Under the FDL Program, the Department makes loans directly to student borrowers through the educational institutions they attend |
| The volume of student loans made under the FFEL Program and available for the Company to originate or acquire may be reduced to the extent loans are made to students under the FDL Program |
| In addition, if the FDL Program expands, to the extent the volume of loans serviced by the Company is reduced, the Company may experience reduced economies of scale, which could adversely affect earnings |
| Loan volume reductions could further reduce amounts received by the guaranty agencies available to pay claims on defaulted student loans |
| In the FFEL Program market, the Company faces significant competition from SLM Corporation, the parent company of Sallie Mae |
| SLM Corporation services nearly half of all outstanding federally insured loans and is the largest holder of student loans |
| The Company also faces intense competition from other existing lenders and servicers |
| As the Company expands its student loan origination and acquisition activities, that expansion may result in increased competition with some of its servicing customers |
| This has in the past occasionally resulted in servicing customers terminating their contractual relationships with the Company, and the Company could in the future lose more servicing customers as a result |
| As the Company seeks to further expand its business, the Company will face numerous other competitors, many of which will be well established in the markets the Company seeks to penetrate |
| Some of the Company’s competitors are much larger than the Company, have better name recognition, and have greater financial and other resources |
| In addition, several competitors have large market capitalizations or cash reserves and are better positioned to acquire companies or portfolios in order to gain market share |
| Consequently, such competitors may have more flexibility to address the risks inherent in the student loan business |
| Finally, some of the Company’s competitors are tax-exempt organizations that do not pay federal or state income taxes and which generally receive floor income on certain tax-exempt obligations on a greater percentage of their student loan portfolio than the Company |
| These factors could give the Company’s competitors a strategic advantage |
| Higher rates of prepayments of student loans could reduce the Company’s profits |
| Pursuant to the Higher Education Act, borrowers may prepay loans made under the FFEL Program at any time without penalty |
| Prepayments may result from consolidating student loans, which tends to occur more frequently in low interest rate environments, from borrower defaults, which will result in the receipt of a guarantee payment, and from voluntary full or partial prepayments, among other things |
| High prepayment rates will have the most impact on the Company’s asset-backed securitization transactions priced in relation to LIBOR As of December 31, 2005, the Company had 10 transactions outstanding totaling approximately dlra10dtta1 billion that had experienced cumulative prepayment rates ranging from 13dtta0prca to 25dtta2prca as compared to six transactions outstanding totaling approximately dlra5dtta8 billion that had experienced cumulative prepayment rates ranging from 19dtta3prca to 22dtta7prca as of December 31, 2004 |
| 17 ______________________________________________________________________ The rate of prepayments of student loans may be influenced by a variety of economic, social, and other factors affecting borrowers, including interest rates and the availability of alternative financing |
| The Company’s profits could be adversely affected by higher prepayments, which would reduce the amount of interest the Company received and expose the Company to reinvestment risk |
| Increases in consolidation loan activity by the Company and its competitors present a risk to the Company’s loan portfolio and profitability |
| The Company’s portfolio of federally insured loans is subject to refinancing through the use of consolidation loans, which are expressly permitted by the Higher Education Act |
| Consolidation loan activity may result in three detrimental effects |
| First, when the Company consolidates loans in its portfolio, the new consolidation loans have a lower yield than the loans being refinanced due to the statutorily mandated consolidation loan rebate fee of 1dtta05prca per year |
| Although consolidation loans generally feature higher average balances, longer average lives, and slightly higher special allowance payments, such attributes may not be sufficient to counterbalance the cost of the rebate fees |
| Second, and more significantly, the Company may lose student loans in its portfolio that are consolidated away by competing lenders |
| Increased consolidations of student loans by the Company’s competitors may result in a negative return on loans, when considering the origination costs or acquisition premiums paid with respect to these loans |
| Additionally, consolidation of loans away by competing lenders can result in a decrease of the Company’s servicing portfolio, thereby decreasing fee-based servicing income |
| Third, increased consolidations of the Company’s own student loans create cash flow risk because the Company incurs upfront consolidation costs, which are in addition to the origination or acquisition costs incurred in connection with the underlying student loans, while extending the repayment schedule of the consolidated loans |
| The Company’s student loan origination and lending activities could be significantly impacted by legislation relative to the single holder rule |
| For example, if the single holder rule, which generally restricts a competitor from consolidating loans away from a holder that owns all of a student’s loans, were abolished, a substantial portion of the Company’s non-consolidated portfolio would be at risk of being consolidated away by a competitor |
| On the other hand, abolition of the rule would also open up a portion of the rest of the market and provide the Company with the potential to gain market share |
| Other potential changes to the Higher Education Act relating to consolidation loans that could adversely impact the Company include allowing refinancing of consolidation loans, which would open approximately 64prca of the Company’s portfolio to such refinancing, and increasing origination fees paid by lenders in connection with making consolidation loans |
| The volume of available student loans may decrease in the future and may adversely affect the Company’s income |
| The Company’s student loan originations generally are limited to students attending eligible educational institutions in the United States |
| Volumes of originations are greater at some schools than others, and the Company’s ability to remain an active lender at a particular school with concentrated volumes is subject to a variety of risks, including the fact that each school has the option to remove the Company from its “preferred lender” list or to add other lenders to its “preferred lender” list, the risk that a school may enter the FDL Program, or the risk that a school may begin making student loans itself |
| The Company acquires student loans through forward flow commitments with other student loan lenders, but each of these commitments has a finite term |
| There can be no assurance that these lenders will renew or extend their existing forward flow commitments on terms that are favorable to the Company, if at all, following their expiration |
| In addition, as of December 31, 2005, third parties owned approximately 52prca of the loans the Company serviced |
| To the extent that third-party servicing clients reduce the volume of student loans that the Company processes on their behalf, the Company’s income would be reduced, and, to the extent the related costs could not be reduced correspondingly, net income could be adversely affected |
| Such volume reductions occur for a variety of reasons, including if third-party servicing clients commence or increase internal servicing activities, shift volume to another service provider, perhaps because such other service provider does not compete with the client in student loan originations and acquisitions, or exit the FFEL Program completely |
| Special allowance payments on student loans originated or acquired with the proceeds of certain tax-exempt obligations may limit the interest rate on certain student loans to the Company’s detriment |
| Student loans originated or acquired with the proceeds of tax-exempt obligations issued prior to October 1, 1993, as well as student loans acquired with the sale proceeds of those student loans, receive only a portion of the special allowance payment which they would otherwise be entitled to receive, but such loans made prior to September 30, 2004, are guaranteed a minimum rate of return of 9dtta5prca per year, less the applicable interest rate for the student loan |
| In the current interest rate environment, the Company generally receives partial special allowance payments and the 9dtta5prca Floor with respect to its eligible student loans originated or acquired with qualifying tax-exempt proceeds |
| In a higher interest rate environment, however, the regular special allowance payments on loans not originated or acquired with qualifying tax-exempt proceeds may exceed the total subsidy to holders of eligible loans originated or acquired with qualifying tax-exempt proceeds |
| Thus, in a higher interest rate environment, these loans could have an adverse effect upon the Company’s earnings |
| 18 ______________________________________________________________________ Included in the Company’s dlra3dtta5 billion student loan portfolio that is receiving 9dtta5prca Floor income, is dlra2dtta9 billion in loans that were refinanced prior to September 30, 2004 with proceeds of tax-exempt obligations originally issued prior to October 1, 1993 and then subsequently refinanced with proceeds of taxable obligations |
| This dlra2dtta9 billion loan portfolio is amortizing based on principal payments |
| As of December 31, 2005, the remaining dlra0dtta6 billion of the Company’s portfolio receiving the 9dtta5prca Floor was financed with tax-exempt obligations originally issued prior to October 1, 1993 |
| Historically, the Company was allowed to finance additional loans with these tax-exempt obligations as borrowers paid on their loans |
| The Company received 9dtta5prca Floor income on these “recycled” loans |
| HERA, enacted into law on February 8, 2006, eliminated the 9dtta5prca Floor income on new loans previously financed with pre-October 1, 1993 tax-exempt bonds and the recycling for loans made or purchased on or after February 8, 2006 |
| As such, this dlra0dtta6 billion loan portfolio receiving the 9dtta5prca Floor income will amortize, and not be replaced with new loans, as principal payments are made on these loans |
| Failures in the Company’s information technology system could materially disrupt its business |
| The Company’s servicing and operating processes are highly dependent upon its information technology system infrastructure, and the Company faces the risk of business disruption if failures in its information systems occur, which could have a material impact upon its business and operations |
| The Company depends heavily on its own computer-based data processing systems in servicing both its own student loans and those of third-party servicing customers |
| If servicing errors do occur, they may result in a loss of the federal guarantee on the federally insured loans serviced or in a failure to collect amounts due on the student loans that the Company services |
| In addition, although the Company regularly backs up its data and maintains detailed disaster recovery plans, the Company does not maintain fully redundant information systems |
| A major physical disaster or other calamity that causes significant damage to information systems could adversely affect the Company’s business |
| Additionally, loss of information systems for a sustained period of time could have a negative impact on the Company’s performance and ultimately on cash flow in the event the Company were unable to process borrower payments |
| Transactions with affiliates and potential conflicts of interest of certain of the Company’s officers and directors, including one of its Co-Chief Executive Officers, pose risks to the Company’s shareholders |
| The Company has entered into certain contractual arrangements with entities controlled by Michael S Dunlap, the Company’s Chairman and Co-Chief Executive Officer and a principal shareholder, and members of his family and, to a lesser extent, with entities in which other directors and members of management hold equity interests or board or management positions |
| Such arrangements constitute a significant portion of the Company’s business and include sales of student loans and student loan origination rights by such affiliates to the Company |
| These arrangements may present potential conflicts of interest |
| Many of these arrangements are with Union Bank, in which Michael S Dunlap owns an indirect interest and of which he serves as non-executive chairman |
| In February 2005, the Company entered into an agreement to amend certain existing contracts with Union Bank |
| Under the agreement, Union Bank committed to transfer to the Company substantially all of the remaining balance of Union Bank’s origination rights in guaranteed student loans to be originated in the future, except for student loans previously committed for sale to others |
| Union Bank will continue to originate student loans, and such guaranteed student loans not previously committed for sale to others are to be sold by Union Bank to the Company in the future |
| Union Bank also granted to the Company exclusive rights as marketing agent for student loans on behalf of Union Bank |
| As part of the agreement, Union Bank also agreed to sell the Company a portfolio of dlra630dtta8 million in guaranteed student loans |
| The Company agreed to pay the outstanding principal and accrued interest with respect to the student loans purchased, together with a one-time payment to Union Bank in the amount of dlra20dtta0 million |
| The Company believes that the acquisitions from Union Bank were made on terms similar to those made from unrelated entities |
| The Company intends to maintain its relationship with Union Bank, which provides substantial benefits to the Company, although there can be no assurance that all transactions engaged with Union Bank are, or in the future will be, on terms that are no less favorable than what could be obtained from an unrelated third party |
| Imposition of personal holding company tax would decrease the Company’s net income |
| A corporation is considered to be a “personal holding company” under the US Internal Revenue Code of 1986, as amended (the “Code”), if (1) at least 60prca of its adjusted ordinary gross income is “personal holding company income” (generally, passive income) and (2) at any time during the last half of the taxable year more than half, by value, of its stock is owned by five or fewer individuals, as determined under attribution rules of the Code |
| If both of these tests are met, a personal holding company is subject to an additional tax on its undistributed personal holding company income, currently at a 15prca rate |
| Five or fewer individuals hold more than half the value of the Company’s stock |
| In June 2003, the Company submitted a request for a private letter ruling from the Internal Revenue Service seeking a determination that its federally guaranteed student loans qualify as assets of a “lending or finance business,” as defined in the Code |
| Such a determination would have assured the Company that holding such loans does not make it a personal holding company |
| Based on its historical practice of not issuing private letter rulings concerning matters that it considers to be primarily factual, however, the Internal Revenue Service has indicated that it will not issue the requested ruling, taking no position on 19 ______________________________________________________________________ the merits of the legal issue |
| So long as more than half of the Company’s value continues to be held by five or fewer individuals, if it were to be determined that some portion of its federally guaranteed student loans does not qualify as assets of a “lending or finance business,” as defined in the Code, the Company could become subject to personal holding company tax on its undistributed personal holding company income |
| The Company continues to believe that neither Nelnet, Inc |
| nor any of its subsidiaries is a personal holding company |
| or one of its subsidiaries was determined to be a personal holding company, the Company believes that by utilizing intercompany distributions, it could eliminate or substantially eliminate its exposure to personal holding company taxes, although it cannot assure that this will be the case |
| “Do not call” registries limit the Company’s ability to market its products and services |
| The Company’s direct marketing operations are or may become subject to additional federal and state “do not call” laws and requirements |
| In January 2003, the Federal Trade Commission amended its rules to provide for a national “do not call” registry |
| Under these federal regulations, consumers may have their phone numbers added to the national “do not call” registry |
| Generally, the Company is prohibited from calling anyone on that registry with whom it does not have an existing relationship |
| In September 2003, telemarketers first obtained access to the registry and since that time have been required to compare their call lists against the national “do not call” registry at least once every 90 days |
| The Company is also required to pay a fee to access the registry on a quarterly basis |
| Enforcement of the Federal “do not call” provisions began in the fall of 2003, and the rule provides for fines of up to dlra11cmam000 per violation and other possible penalties |
| This and similar state laws may restrict the Company’s ability to effectively market its products and services to new customers |
| Furthermore, compliance with this rule may prove difficult, and the Company may incur penalties for improperly conducting its marketing activities |
| The Company’s inability to maintain its relationships with significant branding and forward flow partners and/or customers could have an adverse impact on its business |
| The Company’s inability to maintain strong relationships with significant schools, branding and forward flow partners, servicing customers, guaranty agencies, and software licensees could result in loss of: • loan origination volume with borrowers attending certain schools; • loan origination volume generated by some of the Company’s branding and forward flow partners; • loan and guarantee servicing volume generated by some of the Company’s loan servicing and guaranty agency customers; and • software licensing volume generated by some of the Company’s licensees |
| The Company cannot assure that its forward flow channel lenders or its branding partners will continue their relationships with the Company |
| Loss of a strong branding or forward flow partner or relationships with schools from which a significant volume of student loans is directly or indirectly acquired, could result in an adverse effect on the Company’s business |
| The business of servicing Canadian student loans by EDULINX is limited to a small group of servicing customers and the agreement with the largest of such customers is currently scheduled to expire in July 2007 |
| During 2005, the Company recognized dlra42dtta4 million, or 28prca of its loan and guarantee servicing income, from this customer |
| EDULINX cannot guarantee that it will obtain a renewal of this largest servicing agreement or that it will maintain its other servicing agreements and the termination of any such servicing agreements could result in a material adverse effect on the Company |
| The Company’s failure to successfully manage business and certain asset acquisitions could have a material adverse effect on the Company’s business, financial condition, and/or results of operations |
| The Company may acquire new products and services or enhance existing products and services through acquisitions of other companies, product lines, technologies, and personnel, or through investments in other companies |
| Any acquisition or investment is subject to a number of risks |
| Such risks may include diversion of management time and resources, disruption of the Company’s ongoing business, difficulties in integrating acquisitions, dilution to existing stockholders if the Company’s common stock is issued in consideration for an acquisition or investment, incurring or assuming indebtedness or other liabilities in connection with an acquisition, lack of familiarity with new markets, and difficulties in supporting new product lines |
| The Company’s failure to successfully manage acquisitions or investments, or successfully integrate acquisitions, could have a material adverse effect on the Company’s business, financial condition, and/or results of operations |
| Correspondingly, the Company’s expectations to the accretive nature of the acquisitions could be inaccurate |