Sallie Mae 2006 Annual Report Download - page 21

Item 1A. Risk Factors
LENDING BUSINESS SEGMENT — FFELP STUDENT LOANS
A larger than expected increase in third party consolidation activity may reduce our FFELP student loan
spread, 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 FFELP 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 FFELP student loan spread may be adversely affected because third party consolidators generally target
our highest yielding FFELP Consolidation Loans. 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 relates principally 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 Consolidation Loans over the life of the
Floor Income Contract. If third party consolidation activity that involves refinancing an existing FFELP
Consolidation Loan with a new FFELP Consolidation 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 Consolidation 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 BUSI-
NESS 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 DISCUS-
SION 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 the premiums and the 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 Borrower Benefits. In arriving at the
expected yield, we must make a number of estimates that when changed must be reflected as a cumulative
student loan 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.
In addition, the impact of our 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.
The incentives are offered to attract new borrowers and to improve our borrowers’ payment behavior. 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
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