Sallie Mae 2006 Annual Report Download - page 165

10. Derivative Financial Instruments (Continued)
balance sheet assets and liabilities including the Residual Interests from off-balance sheet securitizations. In
addition, the Company uses equity forward contracts based on the Company’s stock. The Company accounts
for its derivatives under SFAS No. 133 which requires that every derivative instrument, including certain
derivative instruments embedded in other contracts, be recorded in the balance sheet as either an asset or
liability measured at its fair value. As more fully described below, if certain criteria are met, derivative
instruments are classified and accounted for by the Company as either fair value or cash flow hedges. If these
criteria are not met, the derivative financial instruments are accounted for as trading.
Fair Value Hedges
Fair value hedges are generally used by the Company to hedge the exposure to changes in fair value of a
recognized fixed rate asset or liability. The Company enters into interest rate swaps to convert fixed rate assets
into variable rate assets and fixed rate debt into variable rate debt. The Company also enters into cross-
currency interest rate swaps to convert foreign currency denominated fixed and floating debt to U.S. dollar
denominated variable debt. For fair value hedges, the Company generally considers all components of the
derivative’s gain and/or loss when assessing hedge effectiveness and generally hedges changes in fair value
due to interest rates or interest rates and foreign currency exchange rates or the total change in fair value.
Cash Flow Hedges
Cash flow hedges are used by the Company to hedge the exposure to variability in cash flows for a
forecasted debt issuance and for exposure to variability in cash flows of floating rate debt. This strategy is
used primarily to minimize the exposure to volatility from future changes in interest rates. Gains and losses on
the effective portion of a qualifying hedge are accumulated in other comprehensive income and ineffectiveness
is recorded immediately to earnings. In the case of a forecasted debt issuance, gains and losses are reclassified
to earnings over the period which the stated hedged transaction impacts earnings. If the stated transaction is
deemed probable not to occur, gains and losses are reclassified immediately to earnings. In assessing hedge
effectiveness, all components of each derivative’s gains or losses are included in the assessment. The Company
generally hedges exposure to changes in cash flows due to changes in interest rates or total changes in cash
flow.
Trading Activities
When instruments do not qualify as hedges under SFAS No. 133, they are accounted for as trading where
all changes in fair value of the derivatives are recorded through earnings. The Company sells interest rate
floors (Floor Income Contracts) to hedge the Embedded Floor Income options in student loan assets. The
Floor Income Contracts are written options which under SFAS No. 133 have a more stringent effectiveness
hurdle to meet. Therefore, these relationships do not satisfy hedging qualifications under SFAS No. 133, but
are considered economic hedges for risk management purposes. The Company uses this strategy to minimize
its exposure to changes in interest rates.
The Company also uses basis swaps to minimize earnings variability caused by having different reset
characteristics on the Company’s interest-earning assets and interest-bearing liabilities. These swaps usually
possess a term of up to 15 years with a pay rate indexed to 91-day Treasury bill, 3-month commercial paper,
52-week Treasury bill, LIBOR, Prime, or 1-year constant maturity Treasury rates. The specific terms and
notional amounts of the swaps are determined based on management’s review of its asset/liability structure, its
assessment of future interest rate relationships, and on other factors such as short-term strategic initiatives.
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. The
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SLM CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share amounts, unless otherwise stated)