Sallie Mae 2005 Annual Report Download - page 62

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income throughout the life of the contract. The change in the value of Floor Income Contracts is
primarily caused by changing interest rates that cause the amount of Floor Income earned on the
underlying student loans and paid to the counterparties to vary. This is economically offset by the
change in value of the student loan portfolio, including our Retained Interests, earning Floor Income
but that offsetting change in value is not recognized under SFAS No. 133. We believe the Floor
Income Contracts are economic hedges because they effectively fix the amount of Floor Income
earned over the contract period, thus eliminating the timing and uncertainty that changes in interest
rates can have on Floor Income for that period. Prior to SFAS No. 133, we accounted for Floor
Income Contracts as hedges and amortized the upfront cash compensation ratably over the lives of the
contracts.
Basis swaps are used to convert floating rate debt from one interest rate index to another to better
match the interest rate characteristics of the assets financed by that debt. We primarily use basis swaps
to change the index of our fixed rate and LIBOR-based debt to better match the cash flows of our
student loan assets that are primarily indexed to a commercial paper, Prime or Treasury bill index.
SFAS No. 133 requires that when using basis swaps, the change in the cash flows of the hedge
effectively offset both the change in the cash flows of the asset and the change in the cash flows of the
liability. Our basis swaps hedge variable interest rate risk, however they do not meet this effectiveness
test because our FFELP student loans can earn at either a variable or a fixed interest rate depending
on market interest rates. We also have basis swaps that do not meet the SFAS No. 133 effectiveness
test that economically hedge off-balance sheet instruments. As a result, under GAAP these swaps are
recorded at fair value with changes in fair value reflected in the income statement.
Generally, a decrease in current interest rates and the respective forward interest rate curves results in
an unrealized loss related to our written Floor Income Contracts which is offset by an increase in the
value of the economically hedged student loans. This increase is not recognized in income. We will
experience unrealized gains/losses related to our basis swaps if the two underlying indices (and related
forward curve) do not move in parallel.
Under SFAS No. 150, equity forward contracts that allow a net settlement option either in cash or the
Company’s stock are required to be accounted for as derivatives in accordance with SFAS No. 133. As
a result, we account for our equity forward contracts as derivatives in accordance with SFAS No. 133
and mark them to market through earnings. They do not qualify as effective SFAS No. 133 hedges, as
a requirement to achieve hedge accounting is the hedged item must impact net income and the
settlement of these contracts through the purchase of our own stock does not impact net income.
The table below quantifies the adjustments for derivative accounting under SFAS No. 133 on our net
income for the years ended December 31, 2005, 2004 and 2003, when compared with the accounting
principles employed in all years prior to the SFAS No. 133 implementation.
Years ended December 31,
2005 2004 2003
“Core earnings” derivative adjustments:
Gains (losses) on derivative and hedging activities, net,
included in other income(1) ........................... $ 247 $ 849 $(238 )
Less: Realized losses on derivative and hedging activities,
net(1) .............................................. 387 713 739
Unrealized gains (losses) on derivative and hedging
activities, net....................................... 634 1,562 501
Other pre-SFAS No. 133 accounting adjustments ......... 3 (9) 1
Total net impact of SFAS No. 133 derivative accounting . . . $637 $1,553 $502
(1) See “Reclassification of Realized Gains (Losses) on Derivative and Hedging Activities” below for a
detailed breakdown of the components of realized losses on derivative and hedging activities.