Sallie Mae 2005 Annual Report Download - page 165

SLM CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share amounts, unless otherwise stated)
F-43
10. Derivative Financial Instruments (Continued)
value of the cross-currency interest rate swaps executed to hedge these instruments. Management believes
certain derivative transactions entered into as hedges, primarily Floor Income Contracts, equity forward
contracts, and certain basis swaps and Eurodollar futures contracts, are economically effective; however,
those transactions generally do not qualify for hedge accounting under SFAS No. 133 (as discussed below)
and thus may adversely impact earnings.
By using derivative instruments, the Company is exposed to both market and credit risk. Market risk is
the chance of financial loss resulting from changes in interest rates, foreign exchange rates and/or stock
prices. Credit risk is the risk that a counterparty will not perform its obligations under a contract and it is
limited to the loss of the fair value gain in a derivative that the counterparty owes the Company. When the
fair value of a derivative contract is negative, the Company owes the counterparty and, therefore, has no
credit risk. The Company minimizes the credit risk in derivative instruments by entering into transactions
with highly rated counterparties that are reviewed periodically by the Company’s credit department. The
Company also maintains a policy of requiring that all derivative contracts be governed by an International
Swaps and Derivative Association Master Agreement. Depending on the nature of the derivative
transaction, bilateral collateral arrangements may be required as well. When the Company has more than
one outstanding derivative transaction with a counterparty, and there exists legally enforceable netting
provisions with the counterparty (i.e. a legal right to offset receivable and payable derivative contracts), the
“net” mark-to-market exposure represents the netting of the positive and negative exposures with the same
counterparty. When there is a net negative exposure, the Company considers its exposure to the
counterparty to be zero. At December 31, 2005 and 2004, the Company had a net positive exposure
(derivative gain positions to the Company less collateral which has been posted by counterparties to the
Company) related to corporate derivatives of $12 million and $67 million, respectively.
The Company’s on-balance sheet securitization trusts have $9.8 billion of Euro and British Pound
Sterling denominated bonds outstanding as of December 31, 2005. To convert these non-U.S. dollar
denominated bonds into U.S. dollar liabilities, the trusts have entered into foreign-currency swaps with
highly-rated counterparties. As of December 31, 2005, the net positive exposure on these swaps is $307
million. As previously discussed, the Company’s corporate derivatives contain provisions which require
collateral to be posted on a regular basis for changes in market values. With few exceptions, these trusts’
derivatives are structured such that the swap counterparties are not required to post collateral to the
respective trust for changes in market value, unless their credit rating has been withdrawn or is below a
certain level. If the swap counterparty does not post the required collateral or is downgraded further, the
counterparty must find a suitable replacement counterparty or provide the trust with a letter of credit or a
guaranty from an entity that has the required credit ratings. As of December 31, 2005, counterparties have
posted $28 million of collateral due to their credit rating being below the threshold in the collateral
agreement. Ultimately, the Company’s exposure related to a swap counterparty failing to make its required
payments is limited to the trust assets (primarily student loans and cash) which collateralize the
outstanding bonds in the trust. Because the bonds outstanding generally are at parity with the assets that
collateralize the bonds, management believes that even in periods of great stress in the foreign currency
markets, the likelihood of a material loss is remote.