**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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**FORM 10-Q**

**(MARK ONE)**
| **x**                                                                                                                           | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|
| **For The Quarterly Period Ended September 30,  2006**                                                                          |
| **OR**                                                                                                                          |
| **o**                                                                                                                           | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
| **For the transition period  from               to** |

 

**CommissionFile Number 001-31825**

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**The First Marblehead Corporation**

(Exact Name of Registrantas Specified in Its Charter)

| **Delaware**                                  | ** ** | **04-3295311**       |
|-----------------------------------------------|------------|----------------------|
| (State or Other  Jurisdiction of              |       | (I.R.S. Employer     |
| Incorporation or  Organization)               |       | Identification  No.) |
| **The Prudential Tower**                      | ** ** | ** **           |
| **800  Boylston Street, 34****th Floor** | ** ** | ** **           |
| **Boston,  Massachusetts**                    | ** ** | **02199-8157**       |
| (Address of  Principal Executive Offices)     |       | (Zip Code)           |

 

Registrant’s telephonenumber, including area code: **(617) 638-2000**

Indicate by check mark whether the registrant: (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days. Yes x No o

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Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act (Check one):

| Large accelerated filer x | Accelerated filer  o | Non-accelerated  filer o |
|---------------------------|----------------------|--------------------------|

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

Asof October 20, 2006, the registrant had 62,936,285 shares of Common Stock,$0.01 par value per share, outstanding.

 

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**THE FIRSTMARBLEHEAD CORPORATION AND SUBSIDIARIES**

**Tableof Contents**

| Part I. Financial Information |   |                                                                                                                         |
|------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------------|
| Item  1—                      |   | Financial  Statements                                                                                                        |   |   |
|                               |   | Condensed Consolidated Balance Sheets as of  September 30, 2006 and June 30, 2006                                  |   | 3 |
|                               |   | Condensed Consolidated Statements of Operations for  the three months ended September 30, 2006 and 2005                 |   | 4 |
|                               |   | Condensed Consolidated Statement of Changes in  Stockholders’ Equity for the three months ended September 30, 2006 |   | 5 |
|                               |   | Condensed Consolidated Statements of Cash Flows for  the three months ended September 30, 2006 and 2005                 |   | 6 |
|                               |   | Notes to Unaudited Condensed Consolidated Financial  Statements                                                              |   | 7 |
| Item 2—                       |   | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                                  |   | 16 |
| Item 3—                       |   | Quantitative and Qualitative Disclosures About Market  Risk                                                                  |   | 36 |
| Item  4—                      |   | Controls  and Procedures                                                                                                     |   | 36 |
| Part II.  Other Information   |   |                                                                                                                         |
| Item  1A—                     |   | Risk Factors                                                                                                                 |   | 38 |
| Item 2—                       |   | Unregistered Sales of Equity Securities and Use of  Proceeds                                                                 |   | 53 |
| Item  5—                      |   | Other Information                                                                                                            |   | 53 |
| Item 6—                       |   | Exhibits                                                                                                                     |   | 53 |
| SIGNATURES                         |   | 54                                                                                                                           |
| EXHIBIT INDEX                      |   | 55                                                                                                                           |

 

2

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**Part I.   FinancialInformation**

**Item1—Financial Statements**

**THE FIRST MARBLEHEADCORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEETS(unaudited)(in thousands, except per share amounts)**

| ** **                                                                                                                                                                                                                                                                                                                      | ** ** | **September 30,  2006** | ** ** | **June 30,  2006** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                                                                                                                      |       |                         |       |                    |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                                                                                                                                       |       |                         | $          | 209,526                 |       |   | $ | 75,711 |   |
| Short-term investments                                                                                                                                                                                                                                                                                                          |       |                         | 55,500     |                    |       | 67,250 |   |
| Service receivables:                                                                                                                                                                                                                                                                                                            |       |                         |       |                    |       |   |   |
| Structural advisory fees                                                                                                                                                                                                                                                                                                        |       |                         | 106,848    |                    |       | 88,297 |   |
| Residuals                                                                                                                                                                                                                                                                                                                       |       |                         | 521,486    |                    |       | 452,823 |   |
| Processing fees from The Education Resources  Institute (TERI)                                                                                                                                                                                                                                                                  |       |                         | 12,331     |                    |       | 10,447 |   |
| Total service receivables                                                                                                                                                                                                                                                                                                       |       |                         | 640,665    |                    |       | 551,567 |   |
| Property and equipment                                                                                                                                                                                                                                                                                                          |       |                         | 63,389     |                    |       | 60,358 |   |
| Less accumulated depreciation and amortization                                                                                                                                                                                                                                                                                  |       |                         | (27,305    | )                       |       | (23,615 | ) |
| Property and equipment, net                                                                                                                                                                                                                                                                                                     |       |                         | 36,084     |                    |       | 36,743 |   |
| Goodwill                                                                                                                                                                                                                                                                                                                        |       |                         | 3,176      |                    |       | 3,176 |   |
| Intangible assets, net                                                                                                                                                                                                                                                                                                          |       |                         | 1,772      |                    |       | 1,897 |   |
| Prepaid income taxes                                                                                                                                                                                                                                                                                                            |       |                         | —     |                    |       | 11,649 |   |
| Other prepaid  expenses                                                                                                                                                                                                                                                                                                         |       |                         | 16,511     |                    |       | 17,272 |   |
| Other assets                                                                                                                                                                                                                                                                                                                    |       |                         | 4,396      |                    |       | 5,081 |   |
| Total assets                                                                                                                                                                                                                                                                                                                    |       |                         | $          | 967,630                 |       |   | $ | 770,346 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                                  |       |                         |       |                    |       |   |   |
| Liabilities:                                                                                                                                                                                                                                                                                                                    |       |                         |       |                    |       |   |   |
| Accounts payable and other accrued expenses                                                                                                                                                                                                                                                                                     |       |                         | $          | 29,306                  |       |   | $ | 34,430 |   |
| Income taxes payable                                                                                                                                                                                                                                                                                                            |       |                         | 63,679     |                    |       | — |   |
| Net deferred income tax liability                                                                                                                                                                                                                                                                                               |       |                         | 161,548    |                    |       | 144,240 |   |
| Capital lease obligations                                                                                                                                                                                                                                                                                                       |       |                         | 7,834      |                    |       | 8,789 |   |
| Notes payable to TERI                                                                                                                                                                                                                                                                                                           |       |                         | 4,341      |                    |       | 4,537 |   |
| Other liabilities                                                                                                                                                                                                                                                                                                               |       |                         | 2,178      |                    |       | 2,181 |   |
| Total liabilities                                                                                                                                                                                                                                                                                                               |       |                         | 268,886    |                    |       | 194,177 |   |
| Commitments and  contingencies                                                                                                                                                                                                                                                                                                  |       |                         |       |                    |       |   |   |
| Stockholders’  equity:                                                                                                                                                                                                                                                                                                     |       |                         |       |                    |       |   |   |
| Preferred stock, par value $0.01 per share; 20,000  shares authorized; no shares issued or outstanding                                                                                                                                                                                                                     |       |                         | —     |                    |       | — |   |
| Common stock, par value $0.01 per share; 150,000  shares authorized at September 30, 2006 and June 30, 2006; 67,074  and 66,889 shares issued at September 30, 2006 and June 30, 2006,  respectively; 62,936 and 63,042 shares outstanding at September 30, 2006  and June 30, 2006, respectively |       |                         | 671        |                    |       | 669 |   |
| Additional paid-in capital                                                                                                                                                                                                                                                                                                      |       |                         | 222,880    |                    |       | 217,955 |   |
| Retained earnings                                                                                                                                                                                                                                                                                                               |       |                         | 610,664    |                    |       | 479,090 |   |
| Treasury stock, 4,138 and 3,847 shares held at  September 30, 2006 and June 30, 2006, respectively, at cost                                                                                                                                                                                                           |       |                         | (135,471   | )                       |       | (121,545 | ) |
| Total stockholders’ equity                                                                                                                                                                                                                                                                                                 |       |                         | 698,744    |                    |       | 576,169 |   |
| Total liabilities  and stockholders’ equity                                                                                                                                                                                                                                                                                |       |                         | $          | 967,630                 |       |   | $ | 770,346 |   |

 

See accompanying notes to unaudited condensed consolidated financial statements.

3

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**THE FIRSTMARBLEHEAD CORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS(unaudited)(in thousands, except per share amounts)**

| ** **                                         | ** ** | **Three months ended  September 30,** | ** ** |
|----------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Service revenues:                                  |       |                                                 |       |   |   |
| Up-front  structural advisory fees                 |       | $                                                    | 173,310    |   | $ | — |   |
| Additional  structural advisory fees:              |       |                                                 |       |   |   |
| From new securitizations                           |       | 16,586                                               |       | — |   |
| Trust updates                                      |       | 1,965                                                |       | 199 |   |
| Total additional structural advisory fees          |       | 18,551                                               |       | 199 |   |
| Residuals:                                         |       |                                                 |       |   |   |
| From new securitizations                           |       | 56,755                                               |       | — |   |
| Trust updates                                      |       | 11,908                                               |       | 7,482 |   |
| Total residual revenues                            |       | 68,663                                               |       | 7,482 |   |
| Processing fees from TERI                          |       | 37,071                                               |       | 25,928 |   |
| Administrative and other fees                      |       | 4,226                                                |       | 1,462 |   |
| Total service revenues                             |       | 301,821                                              |       | 35,071 |   |
| Operating expenses:                                |       |                                                 |       |   |   |
| Compensation and benefits                          |       | 31,608                                               |       | 19,742 |   |
| General and administrative expenses                |       | 33,991                                               |       | 25,925 |   |
| Total operating expenses                           |       | 65,599                                               |       | 45,667 |   |
| Income (loss) from operations                      |       | 236,222                                              |       | (10,596 | ) |
| Interest income, net                               |       | 1,124                                                |       | 1,229 |   |
| Income (loss)  before income tax expense (benefit) |       | 237,346                                              |       | (9,367 | ) |
| Income tax expense (benefit)                       |       | 96,338                                               |       | (3,925 | ) |
| Net income (loss)                                  |       | $                                                    | 141,008    |   | $ | (5,442 | ) |
| Net income (loss) per share, basic                 |       | $                                                    | 2.24       |   | $ | (0.08 | ) |
| Net income (loss) per share, diluted               |       | 2.23                                                 |       | (0.08 | ) |
| Cash dividends declared per share                  |       | 0.15                                                 |       | 0.12 |   |
| Weighted average shares outstanding, basic         |       | 62,860                                               |       | 64,916 |   |
| Weighted average  shares outstanding, diluted      |       | 63,300                                               |       | 64,916 |   |

 

See accompanying notes to unaudited condensed consolidated financial statements.

4

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**THE FIRSTMARBLEHEAD CORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY(unaudited)(in thousands, except per share amounts)**

| ** **                                              | ** ** | **Common stock** | ** ** | **Additional**       | ** ** | ** **  | ** ** | **Total**    | ** ** |
|---------------------------------------------------------|------------|-----------------------|------------|----------------------|------------|-------------|------------|--------------|------------|
| ** **                                              | ** ** | **Issued**            | ** ** | **In treasury** | ** ** | **paid-in** | ** ** | **Retained** | ** ** | **stockholders’** | ** ** |
| ** **                                              | ** ** | **Shares**            | ** ** | **Amount**           | ** ** | **Shares**  | ** ** | **Amount**   | ** ** | **capital** | ** ** | **earnings** | ** ** | **equity** | ** ** |
| **Balance  at June 30, 2006**                      |       |                  | 66,889     |                 |       |        | $          | 669          |       |   |   | (3,847 | ) |   | $ | (121,545 | ) |   | $ | 217,955 |   |   |   | $ | 479,090 |   |   |   | $ | 576,169 |   |   |
| Net income                                              |       |                  | —     |                 |       |        | —     |         |       |   | — |   |   | — |   |   | — |   |   |   | 141,008 |   |   |   | 141,008 |   |   |
| Options exercised                                       |       |                  | 140        |                 |       |        | 2          |         |       |   | — |   |   | — |   |   | 481 |   |   |   | — |   |   |   | 483 |   |   |
| Stock issuances through employee stock purchase plan    |       |                  | 14         |                 |       |        | —     |         |       |   |   |   |   | — |   |   | 401 |   |   |   | — |   |   |   | 401 |   |   |
| Stock issuances from vesting of restricted stock  units |       |                  | 31         |                 |       |        | —     |         |       |   | — |   |   | — |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Repurchase of common stock                              |       |                  | —     |                 |       |        | —     |         |       |   | (291 | ) |   | (13,926 | ) |   | — |   |   |   | — |   |   |   | (13,926 | ) |   |
| Stock-based compensation                                |       |                  | —     |                 |       |        | —     |         |       |   | — |   |   | — |   |   | 1,542 |   |   |   | — |   |   |   | 1,542 |   |   |
| Cash dividend ($0.15 per share)                         |       |                  | —     |                 |       |        | —     |         |       |   | — |   |   | — |   |   | — |   |   |   | (9,434 | ) |   |   | (9,434 | ) |   |
| Tax benefit from stock-based compensation               |       |                  | —     |                 |       |        | —     |         |       |   | — |   |   | — |   |   | 2,501 |   |   |   | — |   |   |   | 2,501 |   |   |
| **Balance  at September 30, 2006**                 |       |                  | 67,074     |                 |       |        | $          | 671          |       |   |   | (4,138 | ) |   | $ | (135,471 | ) |   | $ | 222,880 |   |   |   | $ | 610,664 |   |   |   | $ | 698,744 |   |   |

 

See accompanying notes to unaudited condensed consolidated financial statements.

5

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**THE FIRSTMARBLEHEAD CORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS(unaudited)(in thousands)**

| ** **                                                                                           | ** ** | **Three months ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                           | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Cash flows from  operating activities:                                                               |       |                                                 |       |   |   |
| Net income (loss)                                                                                    |       | $                                                    | 141,008    |   | $ | (5,442 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                                                 |       |   |   |
| Depreciation and amortization                                                                        |       | 3,877                                                |       | 2,930 |   |
| Deferred income tax expense (benefit)                                                                |       | 17,308                                               |       | (2,978 | ) |
| Stock-based compensation                                                                             |       | 1,542                                                |       | 845 |   |
| Change in assets/liabilities:                                                                        |       |                                                 |       |   |   |
| (Increase) in structural advisory fees                                                               |       | (18,551                                              | )          | (199 | ) |
| (Increase) in residuals                                                                              |       | (68,663                                              | )          | (7,482 | ) |
| (Increase) in processing fees from TERI                                                              |       | (1,884                                               | )          | (189 | ) |
| (Increase) decrease in prepaid income taxes                                                          |       | 11,649                                               |       | (4,677 | ) |
| (Increase) decrease in other prepaid expenses                                                        |       | 761                                                  |       | (2,696 | ) |
| (Increase) in other assets                                                                           |       | 685                                                  |       | (1,143 | ) |
| (Decrease) in accounts payable, accrued expenses,  and other liabilities                             |       | (5,127                                               | )          | (12,408 | ) |
| Increase in income taxes payable                                                                     |       | 63,679                                               |       | — |   |
| Net cash provided by (used in) operating activities                                                  |       | 146,284                                              |       | (33,439 | ) |
| Cash flows from investing activities:                                                                |       |                                                 |       |   |   |
| Dispositions of short-term investments                                                               |       | 56,750                                               |       | — |   |
| Purchases of short-term investments                                                                  |       | (45,000                                              | )          | — |   |
| Purchases of property and equipment                                                                  |       | (3,031                                               | )          | (2,716 | ) |
| Payments to TERI for loan database updates                                                           |       | (62                                                  | )          | (186 | ) |
| Net cash provided by (used in) investing activities                                                  |       | 8,657                                                |       | (2,902 | ) |
| Cash flows from financing activities:                                                                |       |                                                 |       |   |   |
| Repayment of capital lease obligations                                                               |       | (955                                                 | )          | (1,186 | ) |
| Repayment of notes payable due to TERI                                                               |       | (196                                                 | )          | (185 | ) |
| Tax benefit from stock-based compensation                                                            |       | 2,501                                                |       | 541 |   |
| Issuances of common stock                                                                            |       | 884                                                  |       | 416 |   |
| Repurchases of common stock                                                                          |       | (13,926                                              | )          | (955 | ) |
| Cash dividends on common stock                                                                       |       | (9,434                                               | )          | — |   |
| Net cash used in financing activities                                                                |       | (21,126                                              | )          | (1,369 | ) |
| Net increase  (decrease) in cash and cash equivalents                                                |       | 133,815                                              |       | (37,710 | ) |
| Cash and cash  equivalents, beginning of period                                                      |       | 75,711                                               |       | 193,796 |   |
| Cash and cash  equivalents, end of period                                                            |       | $                                                    | 209,526    |   | $ | 156,086 |   |
| Supplemental disclosures of cash flow information:                                                   |       |                                                 |       |   |   |
| Interest paid                                                                                        |       | $                                                    | 193        |   | $ | 230 |   |
| Income taxes paid                                                                                    |       | $                                                    | 999        |   | $ | 3,153 |   |
| Supplemental disclosure of non-cash activities:                                                      |       |                                                 |       |   |   |
| Declaration of  cash dividend                                                                        |       | $                                                    | —     |   | $ | 7,790 |   |

 

See accompanying notes to unaudited condensed consolidated financial statements.

6

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**THE FIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(dollars and shares in thousands, except per share amounts)**

**(1)   Natureof Business and Summary of Significant Accounting Policies**

***Nature of Business***

The First MarbleheadCorporation (FMC, and together with its subsidiaries, the Company) providesoutsourcing services for private education lending in the United States. TheCompany helps meet the growing demand for private education loans by providingnational and regional financial institutions, educational institutions,businesses, and other enterprises with an integrated suite of services fordesigning and implementing student loan programs for their respectivecustomers, students, employees and members. The Company focuses primarily onprivate student loan programs for undergraduate, graduate and professionaleducation, and, to a lesser degree, on continuing education programs, theprimary and secondary school market, career training and study abroad programs.The Company is entitled to receive structural advisory fees and residuals forits services in connection with securitizations of loans generated by the loan programsthat it facilitates. From time to time, the Company also receives fees for itsservices in securitizing private student loan portfolios purchased fromthird-parties. The Company also receives reimbursement from The EducationResources Institute, Inc. (TERI) for outsourced services the Companyperforms on TERI’s behalf, reimbursement for marketing coordination services itprovides to certain clients and fees for administrative services that theCompany provides to the discrete trust vehicles that the Company forms forsecuritizations it facilitates.

***Basis of Presentation***

The Company’s accompanyingunaudited condensed consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesof America (GAAP) for interim financial information. Accordingly, they do notinclude all of the information and footnotes required by GAAP for completeconsolidated financial statements. In the opinion of management, alladjustments (consisting of only normal recurring accruals) considered necessaryfor a fair statement of the results for the interim periods have been included.The preparation of financial statements in conformity with GAAP requiresmanagement to make estimates and assumptions, including the determination ofthe fair value of expected future cash flows, that affect the amounts reportedin the condensed consolidated financial statements and accompanying notes.Interim results are not necessarily indicative of results to be expected forthe entire fiscal year. All significant intercompany balances and transactionshave been eliminated in consolidation. These unaudited financial statementsshould be read in conjunction with the audited consolidated financialstatements and related notes for the year ended June 30, 2006 included inthe Company’s Annual Report on Form 10-K filed with the Securitiesand Exchange Commission on September 12, 2006.

***Student Loan Market Seasonality and Revenue Related toSecuritization Transactions***

Origination of student loans is generally subject toseasonal trends, with the volume of loan applications increasing with theapproach of tuition payment dates. In general, the Company processes thegreatest application volume during the summer months, as students and their familiesseek to borrow money in order to pay tuition costs for the fall semester or theentire school year. The Company also tends to process an increased volume ofloan applications during November and December, as students and theirfamilies seek to borrow money to pay tuition costs for the spring semester.This seasonality of loan 

7

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**THE FIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(dollars and shares in thousands, except per share amounts)**

originations impacts theamount of processing fees from TERI that the Company earns in a particularquarter.

The Company closed asecuritization transaction in the first quarter of fiscal 2007. The Company didnot conduct a securitization transaction during the first quarter of fiscal2006. Therefore, during the first quarter of fiscal 2006, the Company did notgenerate any structural advisory fees or residuals from new securitizationtransactions. Variations in the size of securitization transactions the Companyfacilitates will also contribute to variability in our operating results on aquarterly basis.

***Concentrations***

**TERI**

TERI is a private, not-for-profit Massachusettsorganization as described under section 501(c)(3) of the InternalRevenue Code. Incorporated in 1985, TERI is the oldest and largest guarantor ofalternative, or private, student loans. In its role as guarantor in the privateeducation lending market, TERI agrees to reimburse lenders or securitizationtrusts for unpaid principal and interest on defaulted loans. TERI is theexclusive third-party provider of borrower default guarantees for the Company’sclients’ private student loans. As of September 30, 2006, TERI had a Baa3counterparty rating from Moody’s Investors Service, which is the lowestinvestment grade rating, and an insurer financial strength rating of A+ fromFitch Ratings. If these ratings are lowered, FMC’s clients may not wish toenter into guarantee arrangements with TERI. In addition, FMC may receive lowerstructural advisory fees because the costs of obtaining financial guaranteeinsurance for the asset-backed securitizations that FMC structures couldincrease.

In February 2001, FMC and TERI entered into atwo-year Master Loan Guaranty Agreement, which granted TERI a right of firstrefusal to guarantee loans under existing and future private label loanprograms facilitated by FMC, as well as new loan programs jointly created byFMC and TERI. In June 2001, as a result of the closing of the Company’sacquisition of TERI’s loan processing operations, the Master Loan GuarantyAgreement was automatically extended for a five-year term from the date of theacquisition closing. The loans guaranteed pursuant to the Master Loan GuarantyAgreement comprise only a portion of TERI’s guarantee business, and the MasterLoan Guaranty Agreement does not preclude TERI from continuing to provide itsguarantees to loan originators not associated with FMC. In October 2004,the Company renewed the Master Loan Guaranty Agreement and certain additionalagreements with TERI, in each case for an additional term through June 2011.

The Master Loan Guarantee Agreement generally providesthat the guarantee fees earned by TERI upon the disbursement of student loansare placed in a segregated reserve account which is held as collateral tosecure TERI’s obligation to purchase defaulted student loans. This account isheld by a third-party financial institution for the benefit of the programlender until the student loans are securitized, at which point the account ispledged to the securitization trust that purchases the loans. The Master LoanGuarantee Agreement, as implemented through guaranty agreements with individuallenders, entitles TERI to retain a portion of its guaranty fees as an administrativefee rather than place them in the pledged account.

In October 2005, the Company entered into asupplement to the Master Loan Guarantee Agreement. Under the terms of the 2005supplement, for securitizations of TERI-guaranteed loans during fiscal 2006,TERI’s administrative fee of 150 basis points increased, and the amountdeposited by TERI into the pledged account decreased, by 90 basis points. Inaddition, TERI’s residual interest in the trusts created at 

8

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**THE FIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(dollars and shares in thousands, except per share amounts)**

the time of thesecuritizations was correspondingly reduced to account for the 90 basis pointreduction in the pledged account. As a result, the administrative fee forsecuritizations of TERI-guaranteed loans in fiscal 2006 was 240 basis pointsmultiplied by the principal balance of the loans originated and securitized.For securitizations completed during fiscal 2006, TERI’s ownership of theresidual value of the TERI-guaranteed loans securitized ranged between 12 and15 percent.

In August 2006,the Company entered into a supplement to the Master Loan Guarantee Agreementthat provides as follows:

·       Foreach securitization closing between August 1, 2006 and June 30, 2007,TERI will be entitled to elect to adjust the amount of its administrative fee,and adjust the amount deposited into the pledged account, within specifiedparameters. As a result, the amount of the administrative fee applicable tosecuritizations closing between August 1, 2006 and June 30, 2007 mayrange from 150 basis points to 240 basis points, at TERI’s election. TheCompany has agreed to attempt in good faith to structure its securitizationtransactions to accommodate TERI’s election.

·       Foreach securitization for which TERI elects to adjust the administrative fee, theCompany will make a corresponding adjustment to the relative ownershippercentages of the residual interests in the applicable securitization trust.To the extent TERI elects to increase the amount of its administrative feeabove 150 basis points, such an adjustment would result in an increase in theCompany’s ownership percentage, and a decrease in the ownership interest ofTERI, by a percentage that will result in an equivalent dollar reduction in thefair value of TERI’s residual ownership interest at the time of thesecuritization.

TERI elected to receive an administrative fee of 175basis points for the securitization transaction the Company completed in thefirst quarter of fiscal 2007. TERI has elected to receive an administrative feeof 240 basis points for the securitization transaction the Company plans to completein the second quarter of fiscal 2007.

Under a Master ServicingAgreement with a term through June 2011, First Marblehead EducationResources, Inc. (FMER), a wholly owned subsidiary of FMC, provides to TERIunderwriting, documentation and other origination services, as well astechnical support, disbursements, customer service, collections, defaultprevention, default processing, accounting services and guarantee claimsmanagement and administrative services, in support of TERI’s loan guaranteefunction. FMC guarantees the full and timely performance by FMER of itsobligations pursuant to this Master Servicing Agreement. FMC uses the acquiredTERI assets, including historical loan data, to support the design andimplementation of loan programs facilitated by FMC and loan programs jointlycreated by FMC and TERI. In addition, TERI has the right to designate one ofthree representatives to serve on the board of directors of FMER. During thefirst quarter of fiscal 2007 and fiscal 2006, processing fees from TERIrepresented approximately 12% and 74%, respectively, of the Company’s totalservice revenue.

**PHEAA**

As of September 30,2006, there were eight TERI-approved loan servicers. Servicers provideadministrative services relating to loans, including processing deferment andforbearance requests, sending out account statements and accrual notices,responding to borrower inquiries, and collecting and crediting paymentsreceived from borrowers. As of September 30, 2006, the Company utilizedsix of these servicers. As of September 30, 2006, Pennsylvania HigherEducation Assistance Agency (PHEAA) serviced a 

9

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**THE FIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(dollars and shares in thousands, except per share amounts)**

majorityof the loans for which the Company facilitates origination. PHEAA also operatesunder the name American Education Services (AES). These arrangements allow theCompany to increase the volume of loans in the Company’s clients’ loan programswithout incurring the overhead investment of servicing operations. As with anyexternal service provider, there are risks associated with inadequate oruntimely services. In addition, if the Company’s relationship with PHEAAterminates, the Company would either need to expand or develop a relationshipwith another TERI-approved loan servicer, which could be time-consuming andcostly.

**SignificantCustomers**

Securitization-relatedfees from the private label loan trust used to securitize loans in the firstquarter of fiscal 2007 represented approximately 82% of total service revenuefor the first quarter of fiscal 2007. This securitization trust purchasedprivate student loans from several lenders including JP Morgan Chase Bank,N.A., Bank of America, N.A., and Charter One Bank, N.A. Charter One Bank, N.A.serves as program lender for several education loan marketers. The Company didnot recognize more than 10% of total service revenue from any other customer.

***Significant Accounting Policies and Estimates***

The preparation of theCompany’s consolidated financial statements requires the Company to makeestimates, assumptions and judgments that affect the reported amounts of assetsand liabilities and the reported amounts of income and expenses during thereporting periods. The Company bases its estimates and judgments on historicalexperience and on various other factors, and actual results may differ fromthese estimates under varying assumptions or conditions. On an ongoing basis,the Company evaluates its estimates and judgments, particularly as they relateto accounting policies that the Company believes are most important to theportrayal of the Company’s financial condition and results of operations, suchas its accounting policies involving the recognition and valuation of theCompany’s securitization-related service revenue, and with respect to thedetermination of whether or not to consolidate the securitization trusts thatit facilitates. See “Management’s Discussion and Analysis of FinancialCondition and Results of Operations—Application of Critical Accounting Policiesand Estimates”.

***Cash and Cash Equivalents***

Cash and cash equivalentsat September 30, 2006 included $209,526 held in money market funds.Included in cash and cash equivalents are compensating balances supportingvarious financing arrangements of $10,239 and $10,158 at September 30,2006 and June 30, 2006, respectively.

***Income Taxes***

In determining a quarterlyprovision for income taxes, the Company uses an estimated annual effective taxrate which is based on its expected annual income, statutory tax rates and taxplanning opportunities available to it in the various jurisdictions in which itoperates. The Company’s estimated annual effective tax rate also includes itsbest estimate of the ultimate outcome of tax audits. The Company has a netdeferred income tax liability primarily because, under GAAP, it recognizesresiduals in financial statement income earlier than they are recognized forincome tax purposes.

10

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**THE FIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(dollars and shares in thousands, except per share amounts)**

**(2)**   ServiceReceivables

Structural advisory fees and residuals receivablesrepresent the estimated fair value of additional structural advisory fees andresiduals expected to be collected over the life of the securitization trusts.The fees are expected to be paid to the Company from the various separatesecuritization trusts that have purchased student loans facilitated by theCompany. Private label loans guaranteed by TERI have generally been purchasedby several private label loan trusts. GATE loans, and a limited number ofTERI-guaranteed and other loans, have been purchased by separate securitizationtrusts (NCT trusts) established by the National Collegiate Trust. Processingfees receivable from TERI represents amounts due from TERI for expensesincurred by FMER for services performed on TERI’s behalf.

The Company conducted a securitization transaction inthe first quarter of fiscal 2007 but did not conduct a securitizationtransaction in the first quarter of fiscal 2006. On a quarterly basis, theCompany updates its estimates of the fair value of its structural advisory feesand residuals receivables to reflect the passage of time, any change indiscount rates used to estimate their fair value, any changes in the estimatedoperational expenses for the separate securitization trusts and any changes tothe trust performance metrics that the Company considers in its fair valueestimates, such as default, recovery, prepayment and forward London InterbankOffered Rate, or LIBOR, rates.

The Company made no changes in its assumptionsregarding default, recovery or prepayment rates in the first quarter of eitherfiscal 2007 or 2006, for either the NCT trusts or the private label loantrusts.

Thefollowing table summarizes changes in the estimated fair value of the Company’sstructural advisory fees receivable during the first quarters of fiscal 2007and fiscal 2006:

| ** **                             | ** ** | **Three months ended  September 30,** | ** ** |
|----------------------------------------|------------|------------------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Fair value at  beginning of period     |       | $                                                    | 88,297     |   | $ | 53,371 |   |
| Additions from new securitizations     |       | 16,586                                               |       | — |   |
| Trust updates                          |       |                                                 |       |   |   |
| Passage of time (fair value accretion) |       | 1,590                                                |       | 795 |   |
| Other factors                          |       | 375                                                  |       | (596 | ) |
| Total fair value adjustments           |       | 1,965                                                |       | 199 |   |
| Fair value at end of  period           |       | $                                                    | 106,848    |   | $ | 53,570 |   |

 

11

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**THE FIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(dollars and shares in thousands, except per share amounts)**

Thefollowing table summarizes the changes in the estimated fair value of theCompany’s residuals receivable during the first quarters of fiscal 2007 andfiscal 2006:

| ** **                             | ** ** | **Three months ended  September 30,** | ** ** |
|----------------------------------------|------------|------------------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Fair value at  beginning of period     |       | $                                                    | 452,823    |   | $ | 247,275 |   |
| Additions from new securitizations     |       | 56,755                                               |       | — |   |
| Trust updates                          |       |                                                 |       |   |   |
| Passage of time (fair value accretion) |       | 13,709                                               |       | 7,418 |   |
| Other factors                          |       | (1,801                                               | )          | 64 |   |
| Total fair value adjustments           |       | 11,908                                               |       | 7,482 |   |
| Fair value at end of period            |       | $                                                    | 521,486    |   | $ | 254,757 |   |

 

For a discussion of thesensitivity of the additional structural fees and residuals to variations inour assumptions and estimates, see “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Executive Summary—Application ofCritical Accounting Policies and Estimates—Service Revenue—Sensitivity Analysis”.

**(3)**   RelatedParty Transaction

At September 30,2006, the Company had invested approximately $196,533 of cash equivalents in amoney market fund. The investment adviser for this fund is Milestone CapitalManagement, LLC (MCM), an institutional money management firm. In addition,approximately $55,859 of cash equivalents and short-term investments wereinvested by MCM on behalf of the Company under an investment managementagreement. MCM receives a fee for services it performs under this agreement.MCM is a wholly owned subsidiary of Milestone Group Partners. Members of theimmediate family of one of the Company’s directors own approximately 65% ofMilestone Group Partners.

**(4)**   NotesPayable to TERI

The Company entered into a Note Payable Agreement withTERI on June 20, 2001, in the principal amount of $3,900, to fund theCompany’s acquisition of TERI’s loan processing operations. Of the principalamount, $2,000 related to the acquisition of TERI’s software and network assetsand $1,900 related to the acquired workforce-in-place. Under the terms of thenote payable, principal and interest at an annual rate of 6% are payable in120 monthly installments of $43 commencing on July 20, 2001 andending on June 20, 2011. The note payable is secured by the software andnetwork assets. The outstanding balance of this note payable at September 30,2006 was $2,143.

The Company also enteredinto a second note payable with TERI on June 20, 2001, in the principalamount of $4,000, to fund the acquisition of TERI’s loan database. Principaland interest at an annual rate of 6% are payable in 120 monthlyinstallments of $44 commencing on July 20, 2001 and ending on June 20,2011. The note payable is secured by the loan database. The outstanding balanceof this note payable at September 30, 2006 was $2,198.

12

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**THE FIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(dollars and shares in thousands, except per share amounts)**

**(5)**   Equipment Line of Credit

In January 2005, theCompany entered into an equipment financing lease agreement which it used tofinance purchases of furniture and equipment. The agreement, which expired on December 30,2005, allowed the Company to finance up to $20,000 worth of furniture andequipment purchased before December 30, 2005. The Company expects to repayamounts drawn down on the line of credit at terms ranging from three to fiveyears. At September 30, 2006, the outstanding principal balance on amountsborrowed under this line of credit was $7,056.

**(6)**   Stockholders’Equity

***2003 Stock Incentive Plan***

In September 2003,the Board of Directors and stockholders approved the 2003 Stock Incentive Planand reserved 1,200 shares of Common Stock for issuance under this plan. On August 9,2005, the Board of Directors authorized, subject to stockholder approval, anamendment increasing the number of shares of Common Stock reserved for issuanceunder the 2003 Stock Incentive Plan from 1,200 to 2,700. On October 27,2005, the Company’s stockholders approved this amendment. During the firstquarter of fiscal 2007, the Company granted 231 restricted stock units. As of September 30,2006, there were 589 restricted stock units outstanding and 2,080 sharesavailable for future grant under this plan.

***2003 Employee Stock Purchase Plan***

In October 2003, theBoard of Directors and stockholders approved the 2003 Employee Stock PurchasePlan (Stock Purchase Plan). A total of 400 shares of Common Stock areauthorized for issuance under this plan. The Stock Purchase Plan permits eligibleemployees to purchase shares of Common Stock at the lower of 85% of the fairmarket value of the Common Stock at the beginning or at the end of eachoffering period. Participation is voluntary. Under the Stock Purchase Plan, 14and 11 shares of Common Stock were issued in July 2006 and July 2005,respectively.

***Share Repurchase Program***

On September 29,2005, the Board of Directors approved the repurchase of up to 5,000 shares ofCommon Stock from time to time on the open market or in privately negotiatedtransactions. Through September 30, 2006, the Company had repurchased anaggregate of 2,638 shares of its Common Stock under this program. As of September 30,2006, 2,362 shares of the Company’s Common Stock may be purchased under thisprogram, which does not have a fixed expiration date.

***Cash Dividend***

On September 7, 2006,the Board of Directors declared a cash dividend of $0.15 per share on theCommon Stock. The dividend was paid on September 25, 2006 to stockholdersof record at the close of business on September 18, 2006.

13

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**THE FIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(dollars and shares in thousands, except per share amounts)**

**(7)**   NetIncome (Loss) per Share

Thefollowing table sets forth the computation of basic and diluted net income(loss) per share of Common Stock:

| ** **                                                                | ** ** | **Three months ended   September 30,** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                                                                | ** ** | **2006**                                                   | ** ** | **2005** | ** ** |
| Net income (loss)                                                         |       | $                                                          | 141,008    |   | $ | (5,442 | ) |
| Shares used in computing  net income (loss) per common share—basic   |       | 62,860                                                     |       | 64,916 |   |
| Effect of dilutive  securities:                                           |       |                                                       |       |   |   |
| Stock options                                                             |       | 304                                                        |       | — |   |
| Restricted stock units                                                    |       | 136                                                        |       | — |   |
| Dilutive potential  common shares                                         |       | 440                                                        |       | — |   |
| Shares used in computing  net income (loss) per common share—diluted |       | 63,300                                                     |       | 64,916 |   |
| Net income (loss) per  common share:                                      |       |                                                       |       |   |   |
| Basic                                                                     |       | $                                                          | 2.24       |   | $ | (0.08 | ) |
| Diluted                                                                   |       | $                                                          | 2.23       |   | $ | (0.08 | ) |

 

The Company did notinclude options and restricted stock units in the computation of diluted netloss per share for the first quarter of fiscal 2006 as their effects would havebeen antidilutive.

**(8)**   NewAccounting Pronouncements

In September 2006,the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin(SAB) No. 108, which provides interpretive guidance on the effects ofcarryover or reversal of prior year misstatements in quantifying a current yearmisstatement. The SEC staff believes that errors should be quantified usingboth a balance sheet and income statement approach and evaluated as to whethereither approach results in quantifying a misstatement that, when all relevantquantitative and qualitative factors are considered, is material. The SEC staffhas stated that it will not object if there is a one-time cumulative effectadjustment recorded to correct errors existing in prior years that previouslyhad been considered immaterial, quantitatively and qualitatively, based onappropriate use of the registrant’s previous approach. SAB No. 108describes the circumstances in which a one-time adjustment would be appropriateas well as the required disclosures. SAB No. 108, which becomes effectivefor fiscal years ending after November 15, 2006, will be applied to theCompany beginning with its annual financial statements for the fiscal yearending June 30, 2007. The adoption of SAB No. 108 is not expected tohave any material impact on the Company’s consolidated financial condition orresults of operations.

In September 2006,the Financial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards (SFAS) No. 158, *Employers’ Accounting forDefined Benefit Pension and Other Postretirement Plans, an amendment of FASBStatements No. 87, 88, 106 and 132(R).*SFAS No. 158requires an entity to recognize in its statement of financial position an assetfor a defined benefit postretirement plan’s overfunded status or a liabilityfor a plan’s underfunded status, measure a defined benefit postretirement plan’sassets and obligations that determine its funded status as of the end of theemployer’s fiscal year, and recognize changes in the funded status of a definedbenefit postretirement plan in comprehensive income in the year in which thechanges occur. The adoption of SFAS No. 158 is not expected to have anymaterial impact on the Company’s consolidated financial condition or results ofoperations.

14

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**THE FIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**(dollars and shares in thousands, except per share amounts)**

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements*, whichprovides guidance for using fair value to measure assets and liabilities. Thestandard also provides for expanded information about the extent to whichcompanies measure assets and liabilities at fair value, the information used tomeasure fair value, and the effect of fair value measurements on earnings. SFASNo. 157 applies whenever other standards require (or permit) assets orliabilities to be measured at fair value. The standard does not expand the useof fair value in any new circumstances. Under SFAS No. 157, fair valuerefers to the price that would be received to sell an asset or paid to transfera liability in an orderly transaction between market participants in the marketin which the reporting entity transacts. SFAS No. 157 clarifies theprinciple that fair value should be based on the assumptions marketparticipants would use when pricing the asset or liability and establishes afair value hierarchy that prioritizes the information used to develop thoseassumptions. The fair value hierarchy gives the highest priority to quotedprices in active markets and the lowest priority to unobservable data, such as,the reporting entity’s own data. Fair value measurements would be separatelydisclosed by level within the fair value hierarchy. SFAS No. 157 iseffective for financial statements issued for fiscal years beginning after November 15,2007, and interim periods within those fiscal years. The Company does notexpect the adoption of SFAS No. 157 to have any material impact on itsresults of operations or financial position.

In July 2006, the FASB issued FASB InterpretationNo. 48, *Accounting for Uncertainty inIncome Taxes*—*an interpretation ofFASB Statement No. 109*(FIN No. 48). FIN No. 48clarifies the accounting for uncertainty in income taxes recognized in anentity’s financial statements in accordance with SFAS No. 109, *Accounting for Income Taxes*. It prescribesa recognition threshold and measurement attribute for financial statementdisclosure of tax positions taken or expected to be taken on a tax return. Thisinterpretation is effective for fiscal years beginning after December 15,2006. Consistent with its requirements, the Company will adopt FIN No. 48on July 1, 2007. The Company is currently evaluating the provisions of FINNo. 48 and has not yet determined the impact, if any, on its consolidatedfinancial statements.

In March 2006, the FASB issued SFAS No. 156,*Accounting For Servicing of Financial Assets, anAmendment of FASB Statement No. 140, Accounting for Transfers andServicing of Financial Assets and Extinguishments of Liabilities*(SFAS 156), which requires that all separately recognized servicing assets andliabilities be initially measured at fair value, if practicable, and requiresentities to elect either fair value measurement with changes in fair valuereflected in earnings or the amortization and impairment requirements of FASBStatement No. 140 for subsequent measurement. SFAS No. 156 will beeffective for the Company beginning in the first quarter of fiscal 2008. Theadoption of SFAS No. 156 is not expected to have any material impact onthe Company’s consolidated financial condition or results of operations.

In February 2006, the FASB issued SFAS No. 155,*Accounting for Certain Hybrid FinancialInstruments, an amendment of FASB Statements No. 133 and 140*.SFAS No. 155 will be effective for the Company beginning in the firstquarter of fiscal 2007. The statement permits interests in hybrid financialinstruments that contain an embedded derivative that would otherwise requirebifurcation, to be accounted for as a single financial instrument at fairvalue, with changes in fair value recognized in earnings. This election ispermitted on an instrument-by-instrument basis for all hybrid financialinstruments held, obtained, or issued as of the adoption date. The adoption ofSFAS No. 155 is not expected to have any material impact on the Company’sconsolidated financial condition or results of operations.

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**Item 2.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

*You should read the following discussion and analysisof our financial condition and results of operations together with ourunaudited condensed consolidated financial statements and accompanying notesincluded in this quarterly report. In addition to the historical information,the discussion contains certain forward-looking statements that involve risksand uncertainties. Our actual results could differ materially from thoseexpressed or implied by the forward-looking statements due to applications ofour critical accounting policies and factors including, but not limited to,those set forth under the caption “Risk Factors” in Item 1A of Part II ofthis quarterly report.*

**Executive Summary**

***Overview***

We offer ourclients, national and regional financial institutions, as well as businessesand other organizations, a suite of outsourcing services for private educationlending in the United States. We currently focus on facilitating privatestudent loans for undergraduate, graduate and professional education, althoughwe also provide service offerings for continuing education programs, theprimary and secondary school market, career training and study abroad programs.We provide services in connection with each of the five typical phases of thestudent loan lifecycle, offering our clients a single point of interface for:

·       program design andmarketing;

·       borrower inquiry andapplication;

·       loan origination anddisbursement;

·       loan securitization; and

·       loan servicing.

We receive fees for the services we provide inconnection with our clients’ private student loans, including processing, andstructuring and administering securitizations, of those loans. Securitizationrefers to the technique of pooling loans and selling them to a special purpose,bankruptcy remote entity, typically a trust, which issues securities to investorsbacked by those loans. We have provided structural, advisory and other servicesfor 32 securitization transactions since our formation in 1991, including onesecuritization transaction closing in the first quarter of fiscal 2007.

We offer services in connection with two primary loanprograms:

·       *Private label* programs that are:

·        “direct to consumer,” ormarketed directly to prospective student borrowers and their families by:

·       lenders;

·       businesses, affinity groupsand other organizations;

·       third parties that are notthemselves lenders which market loans on behalf of the lenders that fund theloans. We refer to these third parties as loan marketers, and we refer to thelenders that fund these loans as program lenders; and

·        “school channel,” ormarketed directly to educational institutions by:

·       lenders; and

·       education loan marketers onbehalf of program lenders.

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·       *Guaranteed Access to Education*, or *GATE*, programs that educationalinstitutions offer directly to their students.

During the first quarter of fiscal 2007, wesecuritized only private label loans. We did not conduct a securitizationtransaction in the first quarter of fiscal 2006.

We do not take a direct ownership interest in theloans our clients generate, nor do we serve as a lender or guarantor withrespect to any loan programs that we facilitate. We assist the lenders in ourloan programs in selecting the underwriting criteria used in deciding whether astudent loan will be made to an applicant. However, each lender has ultimatecontrol over the selection of these criteria, and in providing our services, weare obligated by contract to observe them. Our lender clients have theopportunity to mitigate their credit risk through a loan repayment guarantee byThe Education Resources Institute, Inc., or TERI, pursuant to which TERIguarantees repayment of the borrower’s loan principal, together withcapitalized or accrued interest, on defaulted loans. Lenders that wish to havetheir loans guaranteed by TERI are required to meet TERI’s underwritingcriteria. Although we oversee loan servicing as a component of ouradministrative duties, we do not act as a loan servicer.

The primary driver of our results of operations andfinancial condition is the volume of loans for which we provide outsourcing servicesfrom loan origination through securitization. The following table presentscertain financial and operating information for the first quarter of fiscal2007 and fiscal 2006.

| ** **                                                                                                | ** ** | **Three months ended  September 30,** | ** ** | **%  Increase** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------|------------|
| ** **                                                                                                | ** ** | **2006**                                             | ** ** | **2005**        | ** ** | **(decrease)** | ** ** |
| ** **                                                                                                | ** ** | **(dollars in thousands)**                 | ** ** | ** **      | ** ** |
| Approximate loan  applications processed                                                                  |       | 472,000                                              |       | 370,000         |       |   | 28 | % |   |
| Approximate  number of loans facilitated                                                                  |       | 159,000                                              |       | 126,000         |       |   | 26 | % |   |
| Approximate  number of loans facilitated that were also available to us for  securitization          |       | 138,000                                              |       | 107,000         |       |   | 29 | % |   |
| Principal amount  of loans facilitated                                                                    |       | $                                                    | 1,676,162  |            | $          | 1,253,682 |   |   | 34 | % |   |
| Principal amount  of loans facilitated that were also available to us for securitization                  |       | $                                                    | 1,522,231  |            | $          | 1,101,514 |   |   | 38 | % |   |
| Principal and  accrued interest balance of loans  securitized                                             |       | $                                                    | 1,386,132  |            | —     |   |   | — |   |   |
| Principal balance of  loans facilitated and available to us at quarter end for later  securitization |       | $                                                    | 826,668    |            | $          | 1,482,646 |   |   | (44 | )% |   |

 

The principal balance of loans facilitated andavailable to us for later securitization fluctuates as a result of severalfactors including (a) the timing of securitizations (b) the cut offdate for loan purchases as securitizations take place, (c) the loanpurchase eligibility criteria included in the different note purchaseagreements that govern the purchase of loans for securitization and (d) thedaily volume of loans facilitated prior to quarter end.

In June 2001, we significantly enhanced our riskmanagement and loan processing capabilities through a strategic relationshipwith TERI, the nation’s oldest and largest guarantor of private student loans.We acquired TERI’s loan processing operations, including its historicaldatabase, but not its investment assets or guarantee liabilities. In connectionwith this acquisition, 161 members of TERI’s staff became our employees. Inaddition, we entered into a master servicing agreement pursuant to which TERIengages us to provide loan origination and processing services with respect tothe loans generated through the private label programs we facilitate, as wellas other TERI-guaranteed loans. TERI reimburses us for the expenses we incur inproviding these services. Under the terms of a master loan guaranty agreementthat we have entered into with TERI, we have also agreed to provide abeneficial interest for TERI of a portion of the residual value ofTERI-guaranteed loans owned by the securitization trusts that purchase theloans, and 

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granted to TERI a right offirst refusal to provide a third-party guarantee of our private label clients’existing and future loan programs. In October 2004, we renewed our masterservicing agreement, master loan guaranty agreement and certain additionalagreements with TERI, in each case for an additional term through June 2011.

Although we offer our clients a fully integrated suiteof outsourcing services, we do not charge separate fees for many of theseservices. Moreover, although we receive fees for providing loan processingservices to TERI in connection with TERI-guaranteed loans, and fees fromcertain of our clients for marketing coordination services, these feesrepresent reimbursement of the direct expenses we incur. Accordingly, we do notearn a profit on these fees. Although we provide these various services withoutcharging a separate fee, or at “cost” in the case of processing services forTERI-guaranteed loans and marketing coordination services, we generally enterinto agreements with the private label lenders giving us the exclusive right tosecuritize the loans that they do not intend to hold. We receive structuraladvisory fees and residuals for facilitating securitizations of these loans.Our level of profitability depends on our ability to earn these structuraladvisory fees and residuals. We discuss the manner in which we recognize themas revenue in greater detail below. We may in the future enter intoarrangements with private label lenders under which we would provideoutsourcing services, but would not have the exclusive right to securitize theloans that they originate.

Changes in any ofthe following factors can materially affect our financial results:

·       the demand for privateeducation financing;

·       the competition forproviding private education financing;

·       the education financingpreferences of students and their families;

·       applicable laws andregulations, which may affect the terms upon which our clients agree to makeprivate student loans and the cost and complexity of our loan facilitationoperations;

·       the private student loansecuritization market, including the costs or availability of financing;

·       the general interest rateenvironment, including its effect on our discount rates;

·       our critical accountingpolicies and estimates;

·       borrower default rates andour ability to recover principal and interest from such borrowers;

·       prepayment rates, includingprepayments through loan consolidation of private student loans held by ourtrusts; and

·       theavailability of student loans through federal programs.

We announced in July 2006 that we had submittedan application to the Office of Thrift Supervision, or OTS, for approval toacquire Union Federal Savings Bank, or Union Federal. Union Federal is acommunity bank with approximately $40 million in assets with a single branchlocated in North Providence, Rhode Island. We believe that the acquisition ofUnion Federal would enhance our ability to research, develop and bring newproducts to market on behalf of our clients more quickly and effectively,consistent with our overall strategy of providing financial solutions tostudents. Completion of this acquisition is subject to customary closingconditions, including obtaining the approval of the OTS.

***Securitizations and Related Revenue***

We structure and facilitate securitizationtransactions for our clients through a series of bankruptcy remote, qualifiedspecial purpose statutory trusts. The trusts obtain through the securitizationprocess private student loans from the originating lenders or their assignees,which relinquish to the trust their 

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ownership interest in theloans. The debt instruments that the trusts issue to finance the purchase ofthese student loans are obligations of the trusts, rather than our obligationsor those of originating lenders or their assignees. We utilize special purposeentities for the securitization of TERI-guaranteed private label loans. Werefer to these trusts as private label loan trusts. In addition, the National**CollegiateTrust, or NCT, wasformed in fiscal 1993 and has established separate securitization trusts, whichwe refer to as the NCT trusts, which have purchased primarily GATE loans and alimited number of TERI-guaranteed and other loans. In the future, we maysecuritize private label or GATE loans using NCT trusts, private label loantrusts or new trust vehicles.

Under the terms of some of our contracts with keylender clients, we have an obligation to securitize periodically the privatestudent loans that these clients originate. If we do not honor our obligationsto these lenders, we may be required to pay liquidated damages, generally notexceeding an amount equal to 1% of the face amount of the loans available forsecuritization.

We receive several types of fees in connection withour securitization services:

·                    *Structural advisory fees*. We chargestructural advisory fees that are paid in two portions:

·                     *Up-front*. We receive a portion ofthe structural advisory fees at the time the securitization trust purchases theloans, or shortly thereafter. In exchange for these fees, we structure the debtsecurities sold in the securitization, coordinate the attorneys, accountants,trustees, loan servicers, loan originators and other transaction participantsand prepare the cash flow modeling for rating agencies as needed. In thesecuritization that we facilitated during the first quarter of fiscal 2007,these fees were 12.5% of the aggregate principal and capitalized interest ofthe loans securitized. In the securitizations that we facilitated in fiscal2006, these fees ranged from 7.5% to 8.4% of the aggregate principal andcapitalized interest of loans securitized; and

·                     *Additional*. We receive a portion ofthe structural advisory fees over time, based on the amount of loansoutstanding in the trust from time to time over the life of the trust. Thisportion accumulates monthly from the date of a securitization transaction at arate of 15 to 30 basis points per year. We begin to receive thisadditional portion, plus interest, once the ratio of trust assets to trustliabilities, which we refer to as the “parity ratio,” reaches a stipulatedlevel, which ranges from 103.0% to 105.0%. The level applicable to a particulartrust is determined at the time of securitization. We currently expect toreceive the additional fees beginning five to seven years after the date of aparticular securitization transaction*.*

·                    *Residual.* We also have the right to receive a portionof the residual interests that these trusts create. This interest is junior inpriority to the rights of the holders of the debt sold in the securitizationsand the additional structural advisory fees mentioned above and entitles us toreceive:

·                     inconnection with the securitizations of exclusively private label loans, 66% to88% of the net cash flows of the particular securitization trust once a parityratio of 103.0% to 103.5%, depending on the particular trust, is reached andmaintained;

·                     inconnection with securitizations in the NCT trusts, our share of residual cashflows once all of the debtholders of the securitization trust have been repaid,plus, in the case of GATE loans securitized in fiscal years prior to fiscal2005, an additional 10% of the residual cash flows. We are entitled to receive100% of the cash flows for GATE loans securitized in fiscal 2005 and for GATEloans and a portfolio of loans formerly held by Chela Funding II, LLCsecuritized in fiscal 2006.

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Our residual interest derives almost exclusively fromthe services we perform in connection with each securitization rather than froma direct cash contribution to the securitization trust. In the case ofsecuritizations of exclusively private label loans, we currently expect toreceive the residuals beginning approximately five to seven years after thedate of a particular securitization. In the case of securitizations in the NCTtrusts that occurred prior to fiscal 2005, we expect to receive the residualsbeginning 12 to 15 years after the date of a particular securitization. In thecase of the securitization in the NCT trusts that occurred in fiscal 2005 andfiscal 2006, we currently expect to receive residuals beginning five to sixyears after the date of securitization.

·                    *Administrative and other fees*. Our administrativeand other fees represent primarily the reimbursement of out of pocket costs wereceive related to marketing coordination services performed for some of ourclients. Our administrative and other fees also include the administrative feeswe receive from the trusts for their daily management and services we providein obtaining information from the loan servicers and reporting this and otherinformation to the parties related to the securitization. Our fees forperforming these services range from 5 to 20 basis points per year basedon the student loan balance in the trust.

***Processing Fees from TERI***

We provide outsourcingservices for TERI, including loan origination, customer service, defaultprocessing, default prevention and administrative services under a masterservicing agreement between TERI and us. We recognize as revenue the monthlyreimbursement that TERI provides us for the expenses we incur in providingthese services.

***Recognition and Valuation of Service Revenue***

We recognize up-front structural advisory fees asrevenue at the time the securitization trust purchases the loans. In order forthe securitization trust to purchase the loans, all of the applicable servicesmust be performed, rating agencies must deliver their ratings letters,transaction counsel must deliver the required legal opinions and theunderwriters must receive the debt securities issued by the securitizationtrust. These events indicate that the securitization transaction has beenproperly structured and loans have been properly sold to the securitizationtrust.

As required under GAAP, we also recognize additionalstructural advisory fees and residuals as revenue at that time, as they aredeemed to be earned at the time of the securitization but before we actuallyreceive payment. These amounts are deemed earned because evidence of anarrangement exists, we have provided the services, the fee is fixed anddeterminable based upon a discounted cash flow analysis, there are no futurecontingencies or obligations and collection is reasonably assured.

Under GAAP, we are required to estimate the fair valueof the additional structural advisory fees and residuals as if they areinvestments in debt securities classified as available-for-sale or trading,similar to retained interests in securitizations. Accordingly, we recordadditional structural advisory fees and residuals receivable on our balancesheet at estimated fair value using a discounted cash flow model. Because thereare no quoted market prices for our additional structural advisory fees andresiduals receivable, we use certain key assumptions to estimate their values.See “—Application of Critical Accounting Policies and Estimates—Service Revenueand Receivables.” We estimate the fair value both initially and at each subsequentquarter and reflect the change in the value in earnings for that period.

We generally recognizeadministrative and other fees, as well as processing fees from TERI, as revenueat the time that we perform the underlying services. We recognize marketingfees, which are a component of administrative and other fees, at the time thesecuritization trust purchases the loans derived from the related marketingcoordination services.

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***Quarterly Fluctuations***

Ourquarterly revenue, operating results and profitability have varied and maycontinue to vary on a quarterly basis primarily because of the timing and sizeof the securitizations that we structure. In fiscal 2006, we facilitated onesecuritization in the second quarter, one securitization in the third quarterand two securitizations in the fourth quarter. Unlike in previous years, wefacilitated a securitization transaction in the first quarter of fiscal 2007.We expect to facilitate securitizations in each remaining quarter of fiscal2007. However, variations in the size of each securitization transaction willcontinue to result in variability of our operating results on a quarterlybasis. The following tables set forth our quarterly service revenue and netincome (loss) for the first quarter of fiscal 2007 and each quarter of fiscal2006:
|                         | ** ** | **First quarter  fiscal 2007** | ** ** |
|-------------------------|------------|------------------------------------------|------------|
| ** **              | ** ** | **(in thousands)**                  | ** ** |
| Total service  revenues |       |                                     | $          | 301,821 |   |   |
| Net income              |       |                                     | 141,008    |   |   |

 

 
|                         | ** ** | **2006 fiscal quarters** | ** ** |
|-------------------------|------------|------------------------------------|------------|
| ** **              | ** ** | **First**                          | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** |
| ** **              | ** ** | **(in thousands)**            | ** ** |
| Total service  revenues |       | $                                  | 35,071     |   | $ | 230,495 |   | $ | 149,174 |   | $ | 148,832 |   |
| Net income (loss)       |       | (5,442                             | )          | 111,361 |   | 59,222 |   | 70,819 |   |
|                         |            |                                    |            |  |  |  |  |  |  |  |  |  |  |

 

 

***Application of Critical Accounting Policies andEstimates***

Our consolidated financial statements have been preparedin accordance with GAAP. The preparation of these financial statements requiresus to make estimates, assumptions and judgments that affect the reportedamounts of assets and liabilities and the reported amounts of income andexpenses during the reporting periods. We base our estimates, assumptions andjudgments on historical experience and on various other factors that we believeare reasonable under the circumstances. Actual results may differ from theseestimates under varying assumptions or conditions.

Our significantaccounting policies are more fully described in Note 2 of the notes to theaudited consolidated financial statements for the fiscal year ended June 30,2006, which are included in our Annual Report on Form 10-K filedwith the Securities and Exchange Commission on September 12, 2006. On anongoing basis, we evaluate our estimates and judgments, particularly as theyrelate to accounting policies that we believe are most important to theportrayal of our financial condition and results of operations. We regard anaccounting estimate or assumption underlying our financial statements to be a “criticalaccounting estimate” where:

·       the nature of the estimateor assumption is material due to the level of subjectivity and judgmentnecessary to account for highly uncertain matters or the susceptibility of suchmatters to change; and

·       the impact of the estimatesand assumptions on our financial condition or operating performance ismaterial.

We have discussed ouraccounting policies with the audit committee of our board of directors, and webelieve that our estimates relating to the recognition and valuation of oursecuritization-related revenue and receivables, as described below, fit thedefinition of critical accounting estimates. We also consider our policy withrespect to the determination of whether or not to consolidate the financialresults of the securitization trusts that we facilitate to be a criticalaccounting policy.

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*Service Revenue andReceivables*

For a discussion of our revenue recognition policies,see “—Recognition and Valuation of Service Revenue.”

Because there areno quoted market prices for our additional structural advisory fees orresiduals receivable, we use discounted cash flow modeling techniques and thefollowing key assumptions to estimate their values:

·       the discount rate, which weuse to calculate the fair value of our additional structural advisory fees andresiduals;

·       the annual rate of studentloan prepayments;

·       the trend of interest ratesover the life of the loan pool, including the forward LIBOR curve, and thespread between LIBOR and auction rates; and

·       expected loan defaults, netof recoveries.

We base these estimates on our proprietary historicaldata, third-party data and our industry experience, adjusting for specificprogram and borrower characteristics such as loan type and borrowercreditworthiness. We also monitor trends in loan performance over time and makeadjustments we believe are necessary to value properly our receivables balancesat each balance sheet date.

Thefollowing table shows the approximate weighted average loan performanceassumptions for the remaining life of the securitization trusts at September 30,2006:

| ** **                 | ** ** | ** **    | ** ** | **Percentage rate** | ** ** | **Percentage discount rate** | ** ** |
|----------------------------|------------|---------------|------------|--------------------------|------------|----------------------------------------|------------|
| **Trust**                  | ** ** | ** **    | ** ** | **Loan type**       | ** ** | **Default**                            | ** ** | **Recovery** | ** ** | **Prepayments** | ** ** | **Structural  advisory fees** | ** ** | **Residuals** | ** ** |
| Private label  loan trusts |       | Private label |       |                     | 9.16       | %                                      |       |   | 40 | % |   |   | 7 | % |   |   | 6.63 | % |   |   | 12 | % |   |
| NCT trusts                 |       | GATE/Other    |       |                     | 17.87      |                                   |       |   | 48 |   |   |   | 5 |   |   |   | 6.63 |   |   |   | 12 |   |   |
|                            |            |               |            |                          |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

To our knowledge, there have been no public markettransactions involving the sale of residuals generated by a pool of securitizedstudent loans. In determining an appropriate discount rate for valuing ourresiduals, we review the rates used by student loan securitizers as well asrates used in the much broader asset-backed securities, or ABS, market. Webelieve that the 12% discount rate we use for securitization trusts facilitatedprior to fiscal 2007 is appropriate given the expected timing of cash flows andthe maximum 24-year life of the trust assets and residuals. Thesecuritization trust we facilitated in the first quarter of fiscal 2007 issued BBBrated securities, the first such issuance by one of our securitization trusts.The issuance of BBB rated securities created an additional class of debtholderswith an interest senior to our residual interest in the trust. As a result, weexpect cash flows derived from our residual interest in this trust to takelonger, and be subject to greater risk, compared to cash flows derived from ourresidual interests in earlier securitization trusts. As a result, we believethat a 13% discount rate is appropriate for this securitization trust.

In selecting loan performance assumptions, we considerthe underlying creditworthiness of the student loan borrowers as well as thetype of loans being securitized. We analyze creditworthiness in several tiers,and select what we believe to be appropriate loan performance assumptions basedon those tiers. We recently began facilitating loans under a program forborrowers who have Fair, Isaac and Company, or FICO, scores within our currentprogram parameters, but have information on their credit reports which indicatea higher risk of delinquency and default. We analyzed the default and recoveryhistory of loans originated with similar characteristics and credit criteria tothis program and developed what we believe are appropriate loan performanceassumptions based on this history. We worked, in consultation with TERI and ourbank clients, to structure and price loan products for this category of 

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borrowers. Loans underthis program are guaranteed by TERI, and borrowers are charged higher interestrates and fees to cover our projected performance assumptions. We expect theinclusion of these loans in future securitizations will result in slightlyhigher overall default rate assumptions for the trusts used to securitize theseloans.

Our private label loan programs, under whichapproximately 80% of the borrowers have creditworthy co-borrowers, typically afamily member, have an extensive credit underwriting process. GATE programs hada borrower approval rate of approximately 83% in fiscal 2006 as a result of thecredit support provided by the participating schools. Accordingly, we believethat borrowers in our private label programs will prepay at a higher rate anddefault at a lower rate than borrowers in our GATE programs.

At September 30, 2006, we used a 6.63% discountrate for valuing additional structural advisory fees, as compared to a 7.16%discount rate at June 30, 2006, a 6.33% discount rate at September 30,2005 and a 5.96% discount rate at June 30, 2005. Based on the prioritypayment status of additional structural advisory fees in the flow of funds outof the securitization trust, we believe these fees are comparable to 10-yearspreads on BBB rated structured finance and corporate debt securities. Based onmarket quotes for such securities, we believe a spread over comparable maturityU.S. Treasury Notes of 200 basis points is an appropriate discount rate invaluing these projected cash flows.

Two private label loan trusts have issuedpredominately senior auction rate notes to finance the purchase of studentloans. Interest rates for the auction rate notes are determined from time totime at auction. At September 30, 2006, we used a 10 basis point spreadover LIBOR to project the future cost of funding of the senior auction ratenotes in the trusts. Since inception of the first trust, the average spreadover LIBOR for the senior auction rate notes of that trust has been 5.6basis points. Since the inception of the second trust, the average spreadover LIBOR for the senior auction rate notes of that trust has been 6.9 basispoints.

Except for the change to the discount rate applied toadditional structural advisory fees to account for the change in the marketrate of 10-year U.S. Treasury Notes, we did not materially change anyloan performance assumptions regarding default rates, recovery rates ordiscount rates in valuing projected trust cash flows during the first quarterof fiscal 2007 or fiscal 2006. During the fourth quarter of fiscal 2006 and thefirst quarter of fiscal 2007, loans in the securitization trusts experiencedhigher prepayment rates than we had estimated would occur during these periodsof time, which partially offset the positive net accretion that comes fromupdating the carrying value of our structural advisory fees and residualsreceivables for the passage of time. We do not believe it is necessary at thistime to alter our assumptions regarding future prepayments that we use toestimate the fair value of these receivables. We continue to monitor theperformance of trust assets against our expectations, and will make suchadjustments to our estimates as we believe are necessary to value properly ourreceivables balances at each balance sheet date.

 

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*SensitivityAnalysis*

Increases in our estimates of defaults, prepaymentsand discount rates, increases in the spread between LIBOR and auction ratesindices, as well as decreases in default recovery rates and the multi-yearforward estimates of LIBOR would have a negative effect on the value of ouradditional structural advisory fees and residuals. Student loan prepaymentsinclude either full or partial payments by a borrower in advance of thematurity schedule specified in the note, including payments as a result of loanconsolidation activity. Because most credit defaults are reimbursable by thirdparties, increases in defaults generally have the same effect as increases inprepayments. If defaults increase beyond the level of expected third-partyreimbursement, then these changes will have an additional negative effect onthe value of our additional structural advisory fees and residuals. Forpurposes of this sensitivity analysis, we have assumed no amounts in excess ofthe pledged fund established at the time of each securitization of privatelabel loans are available to reimburse the trust for defaults. LIBOR is thereference rate for a substantial majority of the loan assets and, we believe, areasonable index for borrowings of the trusts. Because the trusts’ student loanassets earn interest based on LIBOR and some trusts have outstanding securitiesthat pay interest based on the results of auction rates, changes in the spreadbetween LIBOR and the auction rate can affect the performance of the trusts whichhave issued auction rate notes.

Thefollowing table shows the estimated change in our structured advisory fees andresiduals receivable balances at September 30, 2006 based on changes inour loan performance assumptions. The effect on the fair value of thestructural advisory fees and residuals receivables are based on variations of10% or 20%, except for the forward LIBOR rates, which are based on variationsof 1% and 2% from the forward LIBOR rates at September 30, 2006, andchanges in the assumed spread between 1-month LIBOR rates and auctionrates, which are based on .05% and .10% changes from the assumed levels foreach key assumption:
| ** **                             | ** ** | **Percentage change in**   | ** ** | ** **        | ** ** | **Percentage change in** | ** **     |
|----------------------------------------|------------|--------------------------------------|------------|-------------------|------------|------------------------------------|----------------|
| ** **                             | ** ** | **assumptions**                      | ** ** | **Receivables**   | ** ** | **assumptions**                    | ** **     |
| **Structural advisory fees** | ** ** | ** **                           | ** ** | **Down 20%** | ** ** | **Down 10%**                  | ** **     | **balance** | ** ** | **Up 10%** | ** ** | **Up 20%** | ** ** |
| ** **                             | ** ** | **(dollars in thousands)** | ** ** |
| Default rate:                          |       |                                 |       |              |       |                               |           |   |   |   |   |   |   |
| Total structural advisory fees         |       | $ 107,842                       |       | $ 107,345    |       |                               | $ 106,848 |   |   | $ 106,351 |   | $ 105,851 |   |
| Change in receivables balance          |       | 0.93                                 | %          | 0.47              | %          |                               |           |   |   | (0.47 | )% | (0.93 | )% |
| Default recovery rate:                 |       |                                 |       |              |       |                               |           |   |   |   |   |   |   |
| Total structural advisory fees         |       | $ 106,673                       |       | $ 106,760    |       |                               | $ 106,848 |   |   | $ 106,943 |   | $ 107,038 |   |
| Change in receivables balance          |       | (0.16                                | )%         | (0.08             | )%         |                               |           |   |   | 0.09 | % | 0.18 | % |
| Annual prepayment rate:                |       |                                 |       |              |       |                               |           |   |   |   |   |   |   |
| Total structural advisory fees         |       | $ 111,946                       |       | $ 109,334    |       |                               | $ 106,848 |   |   | $ 104,477 |   | $ 102,216 |   |
| Change in receivables balance          |       | 4.77                                 | %          | 2.33              | %          |                               |           |   |   | (2.22 | )% | (4.34 | )% |
| Discount rate:                         |       |                                 |       |              |       |                               |           |   |   |   |   |   |   |
| Total structural advisory fees         |       | $ 115,248                       |       | $ 110,905    |       |                               | $ 106,848 |   |   | $ 102,852 |   | $ 99,109 |   |
| Change in  receivables balance         |       | 7.86                                 | %          | 3.80              | %          |                               |           |   |   | (3.74 | )% | (7.24 | )% |
|                                        |            |                                      |            |                   |            |                                    |                |  |  |  |  |  |  |  |  |

 
| ** **                     | ** ** | **Change in assumption**   | ** **    | ** **            | ** ** | **Change in assumption** | ** **     |
|--------------------------------|------------|--------------------------------------|---------------|-----------------------|------------|------------------------------------|----------------|
| ** **                     | ** ** | **Down 200**                    | ** **    | **Down 100**     | ** ** | **Receivables**                    | ** **     | **Up 100** | ** ** | **Up 200** | ** ** |
| ** **                     | ** ** | **basis points**                | ** **    | **basis points** | ** ** | **balance**                        | ** **     | **basis points** | ** ** | **basis points** | ** ** |
| ** **                     | ** ** | **(dollars in thousands)** | ** **    |
| Forward LIBOR rates:           |       |                                 |          |                  |       |                               |           |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total structural advisory fees |       |                                 | $ 99,733 |                  |       |                               | $ 103,159 |   |   |   | $ 106,848 |   |   |   | $ 110,333 |   |   |   | $ 114,111 |   |   |
| Change in  receivables balance |       |                                 | (6.66         | )%                    |       |                               | (3.45          | )% |   |   |   |   |   |   | 3.26 | % |   |   | 6.80 | % |   |

 

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| ** **                     | ** ** | **Percentage change in**   | ** ** | ** **        | ** ** | **Percentage change in** | ** **     |
|--------------------------------|------------|--------------------------------------|------------|-------------------|------------|------------------------------------|----------------|
| ** **                     | ** ** | **assumptions**                      | ** ** | **Receivables**   | ** ** | **assumptions**                    | ** **     |
| **Residuals**                  | ** ** | ** **                           | ** ** | **Down 20%** | ** ** | **Down 10%**                  | ** **     | **balance** | ** ** | **Up 10%** | ** ** | **Up 20%** | ** ** |
| ** **                     | ** ** | **(dollars in thousands**) | ** ** |
| Default rate:                  |       |                                 |       |              |       |                               |           |   |   |   |   |   |   |
| Total residual fees            |       | $ 531,362                       |       | $ 526,407    |       |                               | $ 521,486 |   |   | $ 516,569 |   | $ 511,609 |   |
| Change in receivables balance  |       | 1.89                                 | %          | 0.94              | %          |                               |           |   |   | (0.94 | )% | (1.89 | )% |
| Default recovery  rate:        |       |                                 |       |              |       |                               |           |   |   |   |   |   |   |
| Total residual fees            |       | $ 519,837                       |       | $ 520,645    |       |                               | $ 521,486 |   |   | $ 522,332 |   | $ 523,177 |   |
| Change in receivables balance  |       | (0.32                                | )%         | (0.16             | )%         |                               |           |   |   | 0.16 | % | 0.32 | % |
| Annual prepayment  rate:       |       |                                 |       |              |       |                               |           |   |   |   |   |   |   |
| Total residual fees            |       | $ 570,714                       |       | 545,536           |       |                               | $ 521,486 |   |   | $ 498,523 |   | $ 476,580 |   |
| Change in receivables balance  |       | 9.44                                 | %          | 4.61              | %          |                               |           |   |   | (4.40 | )% | (8.61 | )% |
| Discount rate:                 |       |                                 |       |              |       |                               |           |   |   |   |   |   |   |
| Total residual fees            |       | $ 629,003                       |       | $ 572,190    |       |                               | $ 521,486 |   |   | $ 476,049 |   | $ 435,446 |   |
| Change in  receivables balance |       | 20.62                                | %          | 9.72              | %          |                               |           |   |   | (8.71 | )% | (16.50 | )% |
|                                |            |                                      |            |                   |            |                                    |                |  |  |  |  |  |  |  |  |

 
| ** **                    | ** ** | **Change in assumption**         | ** **     | ** **                                 | ** ** | **Change in assumption** | ** **     |
|-------------------------------|------------|--------------------------------------------|----------------|--------------------------------------------|------------|------------------------------------|----------------|
| ** **                    | ** ** | **Down 200   basis points** | ** **     | **Down 100   basis points** | ** ** | **Receivables  balance**           | ** **     | **Up 100   basis points** | ** ** | **Up 200   basis points** | ** ** |
| ** **                    | ** ** | **(dollars in thousands)**       | ** **     |
| Forward LIBOR  rates:         |       |                                       |           |                                       |       |                               |           |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total residual fees           |       |                                       | $ 501,751 |                                       |       |                               | $ 511,835 |   |   |   | $ 521,486 |   |   |   | $ 528,410 |   |   |   | $ 533,333 |   |   |
| Change in receivables balance |       |                                       | (3.78          | )%                                         |       |                               | (1.85          | )% |   |   |   |   |   |   | 1.33 | % |   |   | 2.27 | % |   |

 
| ** **                                                        | ** ** | **Change in assumption**     | ** **     | ** **                            | ** ** | **Change in assumption** | ** **     |
|-------------------------------------------------------------------|------------|----------------------------------------|----------------|---------------------------------------|------------|------------------------------------|----------------|
| ** **                                                        | ** ** | **Tighten 10  basis points** | ** **     | **Tighten 5  basis points** | ** ** | **Receivables  balance**           | ** **     | **Widen 5  basis points** | ** ** | **Widen 10  basis points** | ** ** |
| ** **                                                        | ** ** | **(dollars in thousands)**   | ** **     |
| Change in assumed  spread between LIBOR and auction rate indices: |       |                                   |           |                                  |       |                               |           |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total residual fees                                               |       |                                   | $ 525,179 |                                  |       |                               | $ 523,333 |   |   |   | $ 521,486 |   |   |   | $ 519,640 |   |   |   | $ 517,796 |   |   |
| Change in receivables balance                                     |       |                                   | 0.71           | %                                     |       |                               | 0.35           | % |   |   |   |   |   |   | (0.35 | )% |   |   | (0.71 | )% |   |

 

These sensitivities arehypothetical and should be used with caution. The effect of each change inassumption must be calculated independently, holding all other assumptionsconstant. Because the key assumptions may not in fact be independent, thenet effect of simultaneous adverse changes in key assumptions may differmaterially from the sum of the individual effects calculated above.

***Consolidation***

Our consolidatedfinancial statements include the accounts of The First Marblehead Corporationand its subsidiaries, after eliminating inter-company accounts andtransactions. We have not consolidated the financial results of thesecuritization trusts purchasing loans that we have facilitated. Prior to July 1,2003, this accounting treatment was in accordance with various Emerging IssuesTask Force issues and related interpretations. We considered, among otherthings, the following factors in assessing consolidation of the securitizationtrusts:

·       we did not have unilateraldecision-making abilities related to significant matters affecting thesecuritization trusts, such as asset acquisition, prepayment of debt, placementof debt obligations and modification of trust documents;

·       we did not havesubstantially all the risks and rewards of ownership, as TERI and therespective colleges provide substantially all of the student loan guarantees;

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·       we were a facilitator ofsecuritization transactions, for which we receive market-based fees, and wewere not the transferor of assets to the securitization trusts; and

·       our continuing involvementin the trusts is limited to a passive residual interest and our role as anadministrator for the trust for which we receive market-based fees.

Beginning July 1, 2003, and for securitizationtrusts created after January 31, 2003, we applied Financial AccountingStandards Board, or FASB, Interpretation No. 46, “Consolidation ofVariable Interest Entities, an interpretation of ARB No. 51,” or FIN No. 46,in assessing consolidation. FIN No. 46 provided a new framework foridentifying variable interest entities and determining when a company shouldinclude the assets, liabilities, non-controlling interests and results ofactivities of a variable interest entity in its consolidated financialstatements.

On December 24, 2003, the FASB issued FIN No. 46(revised December 2003), “Consolidation of Variable Interest Entities,” orFIN No. 46R, which addressed how a business enterprise should evaluatewhether it has a controlling interest in an entity through means other thanvoting rights and accordingly should consolidate the entity. FIN No. 46R hasreplaced FIN No. 46. At September 30, 2006, each securitization trustcreated after January 31, 2003 has met the criteria to be a qualifiedspecial-purpose entity, or QSPE, as defined in paragraph 35 of FASBStatement No. 140, “Accounting for the Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities.” Accordingly, we did notconsolidate these existing securitization trusts in our financial statements.In addition, the securitization trusts created prior to January 31, 2003in which we hold a variable interest that could result in us being consideredthe primary beneficiary of such trust, have been amended in order for them tobe considered QSPEs. The adoption of FIN No. 46R, which we began to applyin December 2003, did not have a material impact on our consolidatedfinancial condition, results of operations, earnings per share or cash flows.

The FASB has issued an exposuredraft that would amend FASB Statement No. 140. The proposed amendmentwould, among other things, change the requirements that an entity must meet tobe considered a QSPE. The FASB has announced that it expects to issue finalguidance in 2007. We are monitoring the status of the exposure draft to assess itsimpact, if any, on our financial statements.

**Results ofOperations**

***Three months ended September 30, 2006 and 2005***

***Revenue Related to Securitization Transactions***

The following tablesets forth for the first quarter of fiscal 2007:

·       the total principal andaccrued interest balance of private label loans securitized;

·       the securitization-relatedservice revenue components, other than administrative and other fees, by dollaramount and as a percentage of the total principal and accrued interest balanceof loans securitized; and

·       updates to reflect any fairvalue adjustment to additional structural advisory fees and residuals for priortrusts.

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We didnot facilitate a securitization transaction in the first quarter of fiscal2006.
| **First quarter of fiscal 2007:** | ** ** | ** ** | ** **       | **Total  volume  of loans  securitized(1)** | ** ** | **Up-front  structural  advisory fees** | ** ** | **Additional  structural  advisory fees** | ** ** | **Residuals** |
|-------------------------------------------------------|------------|------------|------------------|--------------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------------|------------|---------------|
| Private label  loans                                  |       |       | $ 1,386,132 |                                             |       | $ 173,308                               |       | 12.5                                           | %          | $ 16,586 |   | 1.2 | % |   | $ 56,755 |   |   | 4.1 | % |
| Trust updates(2)                                      |       |       | —           |                                             |       | —                                       |       |                                           |       | 1,965         |   |   |   |   | 11,908 |   |   |   |   |
| Other(3)                                              |       |       | —           |                                             |       | 2                                            |       |                                           |       | —        |   |   |   |   | — |   |   |   |   |
| Total                                                 |       |       | $ 1,386,132 |                                             |       | $ 173,310                               |       |                                           |       | $ 18,551 |   |   |   |   | $ 68,663 |   |   |   |   |

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(1)          Represents totalprincipal and accrued interest.

(2)          Trust updates reflectchanges resulting from the passage of time, which results in accretion of thediscounting inherent in the fair value estimates of additional structuraladvisory fees and residuals, as well as changes in the assumptions, if any,underlying our estimates of the fair value of these service revenue components.

(3)          Represents the receiptof funds from various trusts’ cost of issuance accounts once it was determinedthat the trust no longer needed such cost of issuance funds.

Ourprivate label loan products are marketed through two marketing channels: (a) directto consumer, which generally refers to programs that lenders, education loanmarketers, businesses, affinity groups or other organizations market directlyto prospective borrowers, and, (b) school channel, which refers toprograms that lenders or third parties market indirectly through educationalinstitutions. Private label loans do not include GATE loans. Our estimates ofthe allocation by marketing channel of our securitization revenues for thefirst quarter of fiscal 2007, expressed as a percentage of the total principaland accrued interest of private label loans securitized in each channel, are asfollows:
| ** **                                                      | ** ** | ** **             | ** ** | ** **                                 | ** ** | **Percentage yield**                         | ** ** |
|-----------------------------------------------------------------|------------|------------------------|------------|--------------------------------------------|------------|----------------------------------------------|------------|
| **Month and year  of  private label  securitization** | ** ** | **Marketing  channel** | ** ** | **Volume of loans  securitized** | ** ** | **Up-front  structural  advisory fees** | ** ** | **Additional  structural  advisory fees** | ** ** | **Residuals** | ** ** | **Total(2)** | ** ** |
| ** **                                                      | ** ** | ** **             | ** ** | **(dollars  in millions)**            | ** ** | ** **                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Fiscal  2007**                                                | ** ** | ** **             | ** ** | ** **                                 | ** ** | ** **                                   | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| September 2006                                                  |       | Direct  to consumer    |       | $  973                           |       | 70                                           | %          |   | 14.7 | % |   |   | 1.2 | % |   |   | 5.1 | % |   |   | 21.0 | % |   |
|                                                            |       | School  channel        |       | 413                                        |       | 30                                           |       |   | 7.3 |   |   |   | 1.2 |   |   |   | 1.7 |   |   |   | 10.2 |   |   |
|                                                            |       | Total                  |       | $ 1,386                               |       |                                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                            |       | Blended yield(1)       |       |                                       |       |                                         |       |   | 12.5 |   |   |   | 1.2 |   |   |   | 4.1 |   |   |   | 17.8 |   |   |

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(1)          Blended yield representssecuritization revenues as a percentage of the total principal and accruedinterest balance of the loans securitized from all marketing channels at thedate of securitization.

(2)          Due to rounding and thecomplex nature of these calculations, which involve allocating the totalrevenue for a securitization across the different marketing channels based onthe profitability of each marketing channel, the total yield by marketingchannel and securitization may not represent the sum of the individual yieldsby revenue source.

Theseyields by marketing channel represent an approximate allocation of revenues andcosts based on various estimates and assumptions regarding the relativeprofitability of these loans, and should be read with caution. Furthermore,these yields are dependent on a number of factors, including the mix of loansbetween marketing channels that are included in a particular securitization,the average life of loans, which can be impacted by prepayments, the time ofyear that the loans are securitized and the relative mix of loans from studentswith various expected terms to graduation, the structure of, and prevailingmarket 

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conditions at the time of, a securitization, themarketing fees which our clients earn on loans we securitize for them, alongwith a number of other factors. Therefore, readers are cautioned that theapproximated blended yields and yields by marketing channel above may not beindicative of yields that we may be able to achieve in future securitizations.

*Up-front structuraladvisory fees*

The up-front component ofstructural advisory fees was $173.3 million for the first quarter of fiscal2007. The up-front structural advisory fees as a percentage of the privatelabel loan volume securitized, or up-front structural advisory fee yield,increased in the first quarter of fiscal 2007 as compared to the last threequarters of fiscal 2006. The securitization trust we facilitated in the firstquarter of fiscal 2007 issued BBB rated securities, the first such issuance byone of our securitization trusts. The issuance of BBB rated securities enabledus to increase the up-front structural advisory fee yield, with a decrease inthe amount of residuals we expect to receive, from this securitizationtransaction. We expect our up-front structural advisory fee yield for futuresecuritizations to fluctuate as a result of market conditions at the time ofsecuritization and the transaction structure in light of the loan assets beingsecuritized.

*Additionalstructural advisory fees*

Thefollowing table summarizes the changes in our estimate of the fair value of thestructural advisory fees receivable for the first quarters of fiscal 2007 and fiscal2006:
| ** **                             | ** ** | **Three months ended  September 30,** | ** ** |
|----------------------------------------|------------|------------------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| ** **                             | ** ** | **(in thousands)**                              | ** ** |
| Fair value at  beginning of period     |       | $ 88,297                                        |       | $ 53,371 |   |
| Additions from new securitizations     |       | 16,586                                               |       | — |   |
| Trust updates                          |       |                                                 |       |   |   |
| Passage of time (fair value accretion) |       | 1,590                                                |       | 795 |   |
| Other factors                          |       | 375                                                  |       | (596 | ) |
| Total fair value adjustments           |       | 1,965                                                |       | 199 |   |
| Fair value at end of  period           |       | $ 106,848                                       |       | $ 53,570 |   |

 

During the first quarter of fiscal 2007, our estimatesof the fair value of our additional structural advisory fees resulted in anincrease in their carrying value of approximately $2.0 million. During the firstquarter of fiscal 2006, our estimates of the fair value of our additionalstructural advisory fees resulted in an increase in their carrying value ofapproximately $0.2 million. This increase was primarily due to the accretion ofthe discounting inherent in the fair value estimates and a decrease in thediscount rate we use in making our fair value estimates.

On a quarterly basis, we update our estimate of thefair value of our additional structural advisory fees, which we expect to beginto receive approximately five to seven years after the date of a particularsecuritization transaction. In doing so, we give effect to the passage of time,which results in the accretion of the discounting inherent in the fair valueestimates, and we also adjust for any change in the discount rate and otherassumptions that we use in estimating the fair value of these receivables. Wemonitor the performance of trust assets, including default, recovery,prepayment and forward LIBOR rate experience, which we also consider in ourestimates. We use an implied forward LIBOR curve to estimate trust cash flows.For a discussion of the assumptions we make in estimating our additionalstructural advisory fees, see “—Executive Summary—Application of CriticalAccounting Policies and Estimates—Service Revenue and Receivables.”

 

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We base the discount rate that we use to calculate thefair value of our additional structural advisory fees on the 10-year U.S.Treasury note rate plus 200 basis points. During the first quarters of fiscal2007 and fiscal 2006, the 10-year U.S. Treasury note rate decreased 53basis point and increased 37 basis points, respectively. We applied a discountrate of 6.63% at September 30, 2006, 7.16% at June 30, 2006, 6.33% atSeptember 30, 2005 and 5.96% at June 30, 2005. A decrease in the 10-yearU.S. Treasury note rate has the effect of increasing the estimated fair valueof our structural advisory fees receivable, while an increase in the rate hasthe opposite effect on our estimate of their fair value.

We made no changes in ourassumptions regarding default rates or recovery rates for the private labelloan trusts or NCT trusts during either the first quarter of fiscal 2007 or thefirst quarter of fiscal 2006.

*Residuals*

Service revenues from residuals increased to $68.7million during the first quarter of fiscal 2007 from $7.5 million during thefirst quarter of fiscal 2006. We did not conduct a securitization transactionin the first quarter of fiscal 2006. As a result, we did not earn any residualsfrom new securitizations in the prior year period.

Thefollowing table summarizes the changes in our estimate of the fair value of theresiduals receivable for the first quarters of fiscal 2007 and fiscal 2006:

| ** **                             | ** ** | **Three months ended  September 30,** | ** ** |
|----------------------------------------|------------|------------------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| ** **                             | ** ** | **(in thousands)**                              | ** ** |
| Fair value at  beginning of period     |       | $                                                    | 452,823    |   | $ | 247,275 |   |
| Additions from new securitizations     |       | 56,755                                               |       | — |   |
| Trust updates                          |       |                                                 |       |   |   |
| Passage of time (fair value accretion) |       | 13,709                                               |       | 7,418 |   |
| Other factors                          |       | (1,801                                               | )          | 64 |   |
| Total fair value adjustments           |       | 11,908                                               |       | 7,482 |   |
| Fair value at end of  period           |       | $                                                    | 521,486    |   | $ | 254,757 |   |

 

Our estimates of the fair value of our residualsreceivable resulted in an increase in their aggregate carrying value ofapproximately $11.9 million during the first quarter of fiscal 2007 and $7.5million during the first quarter of fiscal 2006 due primarily to the passage oftime. The amount of the fair value adjustments also increased between periodsas the underlying receivable balances increased. As we conduct moresecuritization transactions, we expect that adjustments for the passage of timewill continue to increase and thereby add to the residual revenues that wediscount to fair value.

As we do with our additional structural advisory fees,on a quarterly basis, we update our estimate of the fair value of ourresiduals. In doing so, we give effect to the passage of time, which results inthe accretion of the discounting inherent in these fair value estimates, and wealso adjust for any change in the discount rate that we use in estimating thefair value of these receivables. We used a 12% discount rate during the firstquarter of fiscal 2007 and throughout fiscal 2006 in valuing residuals forsecuritizations completed prior to fiscal 2007. We used a 13% discount rate invaluing residuals for the securitization completed in the first quarter offiscal 2007. We also monitor the performance of trust assets, includingdefault, recovery, prepayment and forward LIBOR rates experience, which we alsoconsider in our estimates. We use an implied forward LIBOR curve to estimatetrust cash flows. For a discussion of the assumptions we make in estimating ourresiduals, see “—Executive Summary—Application of Critical Accounting Policiesand Estimates—Service Revenue and Receivables.” Included in trust updates forthe first quarter of fiscal 2007 were the positive impact of expectedreductions in servicing related fees to be 

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paid by the securitizationtrusts as a result of the execution of a new contract with our largestservicer. This increase was partially offset by higher than expected prepaymentrates during the quarter. During the fourth quarter of fiscal 2006 and thefirst quarter of fiscal 2007, loans in the securitization trusts experiencedhigher prepayment rates than we had estimated would occur during these periodsof time, which partially offset the positive net accretion that comes fromupdating the carrying value of our structural advisory fees and residualsreceivables for the passage of time. We do not believe it is necessary at thistime to alter our assumptions regarding future prepayments what we use toestimate the fair value of these receivables. We continue to monitor theperformance of trust assets against our expectations, and will make suchadjustments to our estimates as we believe are necessary to value properly ourreceivables balance at each balance sheet date.

In determining anappropriate discount rate for valuing residuals, we review the rates used bystudent loan securitizers, as well as rates used in the much broader ABSmarket. We believe that the 12% discount rate we use for securitization trustscreated prior to fiscal 2007 is appropriate given the maximum 24-yearlife of the trust assets and residuals. The securitization trust we facilitatedin the first quarter of fiscal 2007 issued BBB rated securities, the first suchissuance by one of our securitization trusts. The issuance of BBB ratedsecurities created an additional class of debtholders with an interest seniorto our residual interest in the trust. As a result, we expect cash flows derivedfrom our residual interest in this trust to take longer, and be subject togreater risk, compared to cash flows derived from our residual interests inearlier securitization trusts. As a result, we believe that a  13%discount rate is appropriate for this securitization trust.

*Processing feesfrom TERI*

Processing fees from TERIincreased to $37.1 million for the first quarter of fiscal 2007 from $25.9 millionfor the first quarter of fiscal 2006. The increase was primarily due toincreased reimbursed expenses required to process the increased volume ofprivate label loans that we facilitated during the fiscal 2007 period. Thevolume of private label loans we facilitated increased to $1.6 billion for thefirst quarter of fiscal 2007 from $1.2 billion for the first quarter of fiscal2006.

*Administrative andother fees*

Administrative and otherfees increased to $4.2 million for the first quarter of fiscal 2007 from $1.5 millionfor the first quarter of fiscal 2006. The increases were primarily due toincreased reimbursed expenses that we generated between periods from marketingcoordination services provided to some of our clients. To a lesser extent, theincrease was due to increasing student loan balances in the securitizationtrusts during the first quarter of fiscal 2007 compared to the first quarter offiscal 2006. We generated approximately $2.9 million in reimbursable expensesfrom marketing coordination services during the first quarter of fiscal 2007.We did not generate any reimbursable expenses from marketing coordinationservices in the first quarter of fiscal 2006. We earned administrative fees forthe daily management of the securitization trusts of approximately $1.3 millionduring the first quarter of fiscal 2007 and $0.9 million during the firstquarter of fiscal 2006.

***Operating Expenses***

Total operating expenses increased to $65.6 millionfor the first quarter of fiscal 2007 from $45.7 million for the firstquarter of fiscal 2006. Compensation and benefits increased to $31.6 millionfor the first quarter of fiscal 2007 from $19.7 million for the first quarterof fiscal 2006. General and administrative expenses increased to $34.0 millionfor the first quarter of fiscal 2007 from $25.9 million for the first quarterof fiscal 2006.

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Compensation and benefits and general andadministrative expenses increased primarily as a result of an increase inpersonnel. Our average total number of employees was 5% higher during the firstquarter of fiscal 2007 than during the corresponding prior year period. We hiredadditional personnel to meet the operating and information systems requirementsfrom our growing loan processing and securitization activities. The increase incompensation and benefits expense is also due to an increase in accrualsrelated to our employee incentive compensation plans, primarily as a result ofour positive financial results during the first quarter of fiscal 2007.

General and administrative expenses increased duringthe first quarter of fiscal 2007 as compared to the first quarter of fiscal2006 as a result of increases in several categories of expense. Marketingcoordination expenses increased to $6.3 million for the first quarter of fiscal2007 from $2.8 million for the first quarter of fiscal 2006. The increase inmarketing coordination expense was primarily due to the recognition of deferredmarketing coordination expenses as a result of the securitization that tookplace during the first quarter of fiscal 2007. We did not conduct asecuritization during the first quarter of fiscal 2006. As a result, nodeferred marketing coordination expenses were recognized during that period.Depreciation and amortization expense increased to $3.9 million for the firstquarter of fiscal 2007 from $2.9 million for the first quarter of fiscal 2006.The increase in depreciation is primarily due to additional purchases of fixedassets. External call center costs increased to $6.9 million for the firstquarter of fiscal 2007 from $3.1 million for the first quarter of fiscal 2006,primarily due to an increase in the number of customer service personnelnecessary to process the increased volume of loans facilitated during the firstquarter of fiscal 2007 as well as the outsourcing of certain customer servicefunctions.

We expect that our operating expenses will continue toincrease as we devote additional resources to the expected increasing loanvolumes facilitated for our existing and new clients.

Thefollowing table summarizes the components of operating expenses, both thosereimbursed and not reimbursed by TERI under our master servicing agreement.

| ** **                         | ** ** | **Operating expenses**                    | ** ** |
|------------------------------------|------------|------------------------------------------------|------------|
| ** **                         | ** ** | **Expenses reimbursed by TERI** | ** ** | **Expenses not reimbursed by TERI** | ** ** | ** ** | ** ** |
| **First fiscal quarter** | ** ** | ** **                                     | ** ** | **Compensation  and benefits** | ** ** | **General and  administrative  expenses** | ** ** | **Subtotal  operating  expenses** | ** ** | **Compensation  and benefits** | ** ** | **General and  administrative  expenses** | ** ** | **Subtotal  operating  expenses** | ** ** | **Total  operating  expenses** | ** ** |
| ** **                         | ** ** | **(in thousands)**                        | ** ** |
| 2007                               |       |                                           | $          | 17,002 |   |   |   | $ | 19,971 |   |   |   | $ | 36,973 |   |   |   | $ | 14,606 |   |   |   | $ | 14,020 |   |   |   | $ | 28,626 |   |   |   | $ | 65,599 |   |   |
| 2006                               |       |                                           | 12,852     |   |   |   | 12,945 |   |   |   | 25,797 |   |   |   | 6,890 |   |   |   | 12,980 |   |   |   | 19,870 |   |   |   | 45,667 |   |   |
|                                    |            |                                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Interest Income, Net***

Net interest income of$1.1 million for the first quarter of fiscal 2007 and $1.2 million for thefirst quarter of fiscal 2006 remained relatively unchanged between the periods.A higher interest rate environment in the first quarter of fiscal 2007 offsetthe impact of our strategy of increasing our investments in tax exemptinstruments which normally carry lower average yields.

***Income Tax Expense (Benefit)***

Income tax expenseincreased to $96.3 million for the first quarter of fiscal 2007 as compared toan income tax benefit of $3.9 million for the first quarter of fiscal 2006. Theincrease in income tax expense was primarily the result of an increase in theamount of income before income tax expense between periods. During the firstquarter of fiscal 2007 our effective tax rate, or the income tax expense as apercentage of income before tax expense, increased to approximately 40.6% froman effective tax rate of 38.5% for all of fiscal 2006. The increase in oureffective tax rate was primarily due to the change in the relative sources oftotal service revenues as our up-front structural advisory fees increased andour residual revenues decreased during the first quarter of fiscal 2007 as comparedto all of fiscal 2006. Our effective 

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tax rateapplicable to up-front structural advisory fees is greater than our effectivetax rate applicable to residual revenues.

**Financial Condition, Liquidity and Capital Resources**

Our liquidity requirementshave historically consisted, and we expect that they will continue to consistof, capital expenditures, working capital, business development expenses,general corporate expenses, repurchases of our common stock, quarterly cashdividends and potential acquisitions.

***Short-term FundingRequirements***

We expect to fund ourshort-term liquidity requirements through cash flow from operations. Webelieve, based on our current operating plan, that our current cash, cashequivalents and short-term investments will be sufficient to fund ouroperations through at least fiscal 2007.

***Long-term FundingRequirements***

We expect to fund thegrowth of our business through cash flow from operations and through issuancesof common stock, promissory notes or other securities. We expect to assess ourfinancing alternatives periodically and access the capital marketsopportunistically. If our existing resources are insufficient to satisfy ourliquidity requirements, or if we enter into an acquisition or strategicarrangement with another company, we may need to sell additional equity or debtsecurities. Any sale of additional equity or convertible debt securities mayresult in additional dilution to our stockholders, and we cannot be certainthat additional public or private financing will be available in amounts or onterms acceptable to us, if at all. If we are unable to obtain this additionalfinancing, we may be required to delay, reduce the scope of, or eliminate oneor more aspects of our business development activities, which could harm thegrowth of our business, or we may be required to reduce or eliminate ourquarterly cash dividends to our stockholders.

Our actual liquidity andcapital funding requirements may depend on a number of factors, including:

·       thetiming, size and composition of the loan pools of the securitizationtransactions that we structure;

·       theamount and timing of receipt of additional structural advisory fees andresiduals;

·       ourfacilities expansion needs;

·       theextent to which our services gain increased market acceptance and remaincompetitive;

·       theextent to which we repurchase shares of our common stock or pay cash dividendsto our stockholders;

·       thetiming and magnitude of income tax payments; and

·       thecosts and timing of acquisitions of complementary businesses.

***Treasury Stock***

We had treasury stock of$135.5 million at September 30, 2006 and $121.5 million at June 30,2006. Our treasury stock balance was derived from repurchases of our commonstock in open market transactions. Our board of directors approved therepurchase of 1,500,000 shares of our common stock in the fourth quarter offiscal 2005 and approved the repurchase of an additional 5,000,000 shares ofour common stock in the first quarter of fiscal 2006. As of September 30,2006, we had repurchased an aggregate of 4,137,800 shares at an average price,excluding commissions, of $32.71 per share. During July 2006, we repurchased 291,000 shares of common stock atan average purchase price per share, excluding commissions, of $47.83.

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***Cash, CashEquivalents and Short-term Investments***

At September 30,2006, we had $265.0 million in cash, cash equivalents and short-terminvestments. At June 30, 2006, we had $143.0 million in cash, cashequivalents and short-term investments. The increase in cash, cash equivalentsand short-term investments is primarily due to cash generated from our September 2006securitization transaction offset by cash used to fund repurchases of ourcommon stock and the payment of cash dividends during the first quarter offiscal 2007. Cash, cash equivalents and short-term investments at September 30,2006 primarily include investments in variable rate demand notes and fundsdeposited in a money market fund that invests in short-term obligations of theU.S. Treasury and repurchase agreements fully collateralized by obligations ofthe U.S. Treasury.

***Service Receivables***

Our service receivablesincreased to $640.7 million at September 30, 2006 from $551.6 millionat June 30, 2006, primarily as a result of the structural advisory feesand residuals generated from the September 2006 securitizationtransaction. The increase in service receivables was also due to an increase inour estimate of the fair value of our residuals receivable of $11.9 millionduring the first quarter of fiscal 2007 primarily as a result of the accretionof the discounting inherent in the fair value estimates due to the passage oftime.

***Property andEquipment, net***

During the first quarterof fiscal 2007, our property and equipment, net decreased by $0.7 million, as$3.7 million of depreciation expense recorded during the period was offset inpart by $3.0 million we spent on the expansion and improvement of our loanprocessing facilities and systems.

***Prepaid IncomeTaxes***

We had no prepaid incometaxes at September 30, 2006 as compared to $11.6 million at June 30,2006. At June 30, 2006, this balance was primarily derived from the incometax benefit of employee stock option exercises and tax allocation strategiesimplemented in the fourth quarter of fiscal 2006.

***Other PrepaidExpenses***

We had other prepaidexpenses of $16.5 million at September 30, 2006 compared to $17.3 millionat June 30, 2006. The decrease in other prepaid expenses was primarily dueto a decrease in prepaid marketing expenses of approximately $2.0 million,which was partially offset by an increase in prepaid maintenance expensesrelated to software licenses of $1.7 million.

***Other Assets***

We had other assets of$4.4 million at September 30, 2006 and $5.1 million at June 30, 2006.The decrease in other assets is primarily due to the refund or amortization ofmiscellaneous prepaid fees and insurance during the first quarter of fiscal2007.

***Accounts Payableand Accrued Expenses***

We had accounts payableand accrued expenses of $29.3 million at September 30, 2006 and$34.4 million at June 30, 2006. Our accrued bonuses wereapproximately $3.6 million lower at September 30, 2006 as compared toJune 30, 2006, as a result of our payment of 2006 bonuses in the firstquarter of fiscal 2007. Our accrued marketing expenses were approximately $1.8million lower at September 30, 2006, as compared to June 30, 2006primarily due to the timing of the receipt and processing of invoices.

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***Income TaxesPayable***

We had income taxespayable of $63.7 million at September 30, 2006 as compared to no incometaxes payable at June 30, 2006. Our income taxes payable increased becauseof the earnings generated in the first quarter of fiscal 2007.

***Net Deferred IncomeTax Liability***

We have a net deferredincome tax liability primarily because, under GAAP, we recognize residuals infinancial statement income earlier than they are recognized for income taxpurposes. Our net deferred income tax liability increased primarily as a resultof the increase in residual revenue recognized during the first quarter offiscal 2007, which more than offset the recognition of our share of taxableincome from the securitization trusts.

***Capital LeaseObligations***

We had capital leaseobligations of $7.8 million at September 30, 2006 and $8.8 million atJune 30, 2006. The decrease in capital lease obligations was due toscheduled principal payments made during the first quarter of fiscal 2007.

***Notes Payable toTERI***

We had notes payable toTERI of $4.3 million at September 30, 2006 and $4.5 million atJune 30, 2006. The balance relates to two acquisition notes we issued toacquire TERI’s loan processing operations in 2001. The decrease in notespayable to TERI is due to scheduled principal payments made during the firstquarter of fiscal 2007.

***Other Liabilities***

We had other liabilitiesof $2.2 million at September 30, 2006 and June 30, 2006. The balanceat both period ends related primarily to deferred rent related to severaloperating leases for office space.

***ContractualObligations***

As of September 30,2006, our contractual obligations had not changed materially from thosedescribed under the caption “Item 7. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations-Financial Condition, Liquidityand Capital Resources-Contractual Obligations” in our annual report onForm 10-K for the fiscal year ended June 30, 2006.

***Cash Flows***

Our net cash provided byoperating activities increased to $146.3 million for the first quarter offiscal 2007, compared to cash used in operating activities of $33.4 million forthe first quarter of 2006. The increase in cash provided by operations resultedprimarily from increases in net income and income taxes payable, and a decreasein prepaid income taxes, offset in part by increases in residual receivablesand structural advisory fee receivables.

Our cash provided byinvesting activities was $8.7 million during the first quarter of fiscal 2007compared to $2.9 million used in investing activities during the first quarterof fiscal 2006. Net cash provided by investing activities increased during thefirst quarter of fiscal 2007 primarily as a result of proceeds from thedisposition of short-term investments, partially offset by uses of net cashduring the first quarter of fiscal 2007 for purchases of short-terminvestments, capital expenditures related to the expansion and improvement ofour loan processing facilities and systems and, to a lesser extent, paymentsfor loan database updates from TERI.

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We used net cash of $21.1 million in financingactivities during the first quarter of fiscal 2007 compared to $1.4 millionduring the first quarter of fiscal 2006. We used cash in financing activitiesduring the first quarter of fiscal 2007 primarily for our repurchases of commonstock and cash dividends paid to common stockholders. We used cash in financingactivities during the first quarter of fiscal 2006 primarily for the repaymentof capital lease obligations and repurchases of common stock.

We expect that our capitalexpenditure requirements for the final three quarters of fiscal 2007 will beapproximately $19.3 million. We expect to use these funds primarily for theexpansion of our loan processing operations and the purchase of computer andoffice equipment.

***Borrowings***

In June 2001, weissued two acquisition notes to TERI totaling $7.9 million to acquire TERI’sloan processing operations as well as its workforce-in-place. Principal andinterest at an annual rate of 6% is payable on these notes in 120 monthlypayments of $87,706 commencing on July 20, 2001 and ending on June 20,2011. At September 30, 2006, outstanding principal on these notes totaled$4.3 million as compared to $4.5 million at June 30, 2006.

**Off-Balance SheetTransactions**

We offer outsourcing services in connection with thelifecycle of a private student loan, from program design and marketing throughloan administration and, ultimately, to the sale and securitization of theloans. We also structure and facilitate the securitization of loans for ourclients through a series of bankruptcy remote, qualified special purposetrusts.

We do not utilize these trusts as a means to transferassets or liabilities from our balance sheet to those of the trusts because weare not the originator of the securitized student loans or the issuer of therelated debt. We do not serve as lender, guarantor or loan servicer.Specifically, these trusts purchase such student loans from third-partyfinancial institutions, the financing of which is provided through the issuanceof asset-backed securities.

The principal uses of these trusts are to:

·       generate sources ofliquidity for our clients’ assets sold into such trusts and to reduce theircredit risk;

·       make available more fundsto students and colleges; and

·       leverage the capitalmarkets to reduce borrowing costs to students.

See “—Executive Summary—Applicationof Critical Accounting Policies and Estimates—Consolidation” for a discussionof our determination to not consolidate these securitization trusts.

**Inflation**

Inflation was not amaterial factor in either revenue or operating expenses during the periodspresented.

**Factors That May AffectFuture Results**

This quarterly reportincludes forward-looking statements within the meaning of Section 21E ofthe Securities Exchange Act of 1934, as amended, or the Exchange Act, and Section 27Aof the Securities Act of 1933, as amended. For this purpose, any statementscontained herein regarding our strategy, future operations, financial position,future revenues, projected costs, prospects, plans and objectives ofmanagement, other than statements of historical facts, are forward-lookingstatements. The words 

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“anticipates,”“believes,” “estimates,” “expects,” “intends,” “may,” “plans,” “projects,” “will,”“would” and similar expressions are intended to identify forward-lookingstatements, although not all forward-looking statements contain theseidentifying words. We cannot guarantee that we actually will achieve the plans,intentions or expectations expressed or implied in our forward-lookingstatements. There are a number of important factors that could cause actualresults, levels of activity, performance or events to differ materially fromthose expressed or implied in the forward-looking statements we make. Theseimportant factors include our “critical accounting estimates” set forth aboveunder “—Application of Critical Accounting Policies and Estimates” and the riskfactors set forth below under Item 1A of Part II. Although we may elect toupdate forward-looking statements in the future, we specifically disclaim anyobligation to do so, even if our estimates change, and readers should not relyon those forward-looking statements as representing our views as of any datesubsequent to November 8, 2006.

**Item 3—Quantitativeand Qualitative Disclosures about Market Risk**

***General***

Market risk is the risk ofchange in fair value of a financial instrument due to changes in interestrates, equity prices, creditworthiness, foreign exchange rates or otherfactors. Our primary market risk exposure relates to changes in interest ratesapplicable to our cash, cash equivalents and short-term investments. We manageour market risk through a conservative investment policy, the primary objectiveof which is preservation of capital. At September 30, 2006, cash, cashequivalents and short-term investments consisted primarily of investments invariable rate demand notes and money market funds, all of which were due ondemand. As a result, we do not believe a change in interest rate would have a materialimpact on the fair value of cash, cash equivalents and short-term investments.

***Risk Related to Structural Advisory Fees and Residuals***

Because there are noquoted market prices for our additional structural advisory fees and residualsreceivables, we use discounted cash flow modeling techniques and variousassumptions to estimate their values. We base these estimates on ourproprietary historical data, third-party data and our industry experience,adjusting for specific program and borrower characteristics such as loan typeand borrower creditworthiness. Increases in our estimates of defaults,prepayments and discount rates, increases in the spread between LIBOR andauction rate indices, as well as decreases in default recovery rates and themulti-year forward estimates of the LIBOR rate, which is the reference rate fornearly all of the loan assets and all of the borrowings of the securitizationtrusts, would have a negative effect on the value of our additional structuraladvisory fees and residuals. For an analysis of the estimated change in ourstructural advisory fees and residuals receivables balance at September 30,2006 based on changes in these loan performance assumptions, see “Management’sDiscussion and Analysis of Financial Conditions and Results of Operations—ExecutiveSummary—Application of Critical Accounting Policies and Estimates—SensitivityAnalysis.”

**Item 4—Controls andProcedures**

Our management, with the participation of our chiefexecutive officer and chief financial officer, evaluated the effectiveness ofour disclosure controls and procedures as of September 30, 2006. The term “disclosurecontrols and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) underthe Exchange Act, means controls and other procedures of a company that aredesigned to ensure that information required to be disclosed by us in thereports that we file or submit under the Exchange Act is recorded, processed,summarized and reported, within the time periods specified in the SEC’s rules andforms. Disclosure controls and procedures include, without limitation, controlsand procedures designed to ensure that information required to be disclosed bya company in the reports that it files or submits under the Exchange Act isaccumulated and communicated to the company’s management, including itsprincipal 

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executive and principalfinancial officers, as appropriate to allow timely decisions regarding requireddisclosure. Management recognizes that any controls and procedures, no matterhow well designed and operated, can provide only reasonable assurance ofachieving their objectives and management necessarily applies its judgment inevaluating the cost-benefit relationship of possible controls and procedures.Based on the evaluation of our disclosure controls and procedures as of September 30,2006, our chief executive officer and chief financial officer concluded that,as of such date, our disclosure controls and procedures were effective at thereasonable assurance level.

No change in our internal control over financialreporting, as defined in Rules 13a-15(f) and 15d-15(f) underthe Exchange Act, occurred during the fiscal quarter ended September 30,2006 that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

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**Part II.   OtherInformation**

**Item 1A.**   RiskFactors

Investing in our common stock involves a high degreeof risk. You should carefully consider the risks and uncertainties describedbelow in addition to the other information included in this quarterly report.If any of the following risks actually occurs, our business, financialcondition or results of operations would likely suffer. In that case, thetrading price of our common stock could fall.

We have not made anymaterial changes to the risk factors previously disclosed in our annual reporton Form 10-K for the fiscal year ended June 30, 2006.

***We derive asignificant portion of our revenue and substantially all of our income fromstructuring securitization transactions; our financial results and future growthwould be adversely affected if we are unable to structure securitizations.***

Securitization refers tothe technique of pooling loans and selling them to a special purpose,bankruptcy remote entity, typically a trust, which issues securities toinvestors backed by those loans. As of the date of this quarterly report, wehave provided structural advisory and other services for 32 loansecuritizations since our formation in 1991. In connection withsecuritizations, we receive compensation in the form of structuraladvisory fees, residuals and administrative fees for management of the trusts.The amount and timing of the fees we recognize are affected, in part, by thesize and composition of loan pools to be securitized, the return expectationsof investors and assumptions we make regarding loan portfolio performance,including defaults, recoveries, prepayments and the cost of funding. Revenuefrom new securitizations constituted 82% of our total service revenue for thefirst quarter of fiscal 2007, 74% of our total service revenue for fiscal 2006,76% of our total service revenue for fiscal 2005 and 78% of our total servicerevenue for fiscal 2004. Substantially all of our net income in those fiscalperiods was attributable to securitization-related revenue.

***A number offactors, some of which are beyond our control, may adversely affect oursecuritization activities and thereby adversely affect our results ofoperations.***

Our financialperformance and future growth depend in part on our continued success instructuring securitizations. Several factors may affect both our abilityto structure securitizations and the revenue we generate for providing ourstructural advisory and other services, including the following:

·       degradation of the creditquality or performance of the loan portfolios of the trusts we structure, whichcould reduce or eliminate investor demand for future securitizations that wefacilitate;

·       prolongedvolatility in the capital markets generally or in the student loan sectorspecifically, which could restrict or delay our access to the capital markets;

·       unwillingnessof financial guarantee providers to offer credit insurance in thesecuritizations that we structure or in student loan-backed securitizationsgenerally;

·       adverseperformance of, or other problems with, student loan-backed securitizationsthat other parties facilitate could impact pricing or demand for oursecuritizations;

·       challengesto the enforceability of student loans based on violations of federal or stateconsumer protection laws and related regulations, or imposition of penalties orliability on assignees of student loans for violation of such laws andregulations; and

·       anymaterial downgrading or withdrawal of ratings given to securities previouslyissued in securitizations that we structured, or any occurrence of an event ofdefault with respect to such securities, which could reduce demand foradditional securitizations that we structure.

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A portion of the securities issued since 1998 insecuritization transactions that we structured were sold to asset-backedcommercial paper conduits. If these or similar asset-backed conduits cease topurchase securities in the securitizations that we structure, wemay experience a delay in the timing of our securitizations as we seek tofind alternate channels of distribution.

Under the terms of some ofour contracts with key lender clients, we have an obligation to securitizeloans originated by those lenders periodically. We may agree with otherlenders to securitize more frequently in the future. If we do not honor theseobligations, we may be required to pay liquidated or other damages, whichcould adversely affect our results of operations.

***In connection withour recognition of revenue from securitization transactions, if the estimateswe make, and the assumptions on which we rely, in preparing our financialstatements prove inaccurate, our actual results may vary materially fromthose reflected in our financial statements.***

We receive structural advisory fees for our servicesin connection with securitization transactions. We receive an up-front portionof these structural advisory fees when the securitization trust purchases theloans or soon thereafter. We receive an additional portion of these structuraladvisory fees over time, based on the amount of loans outstanding in the trustfrom time to time over the life of the trust. We also have the right to receivea portion of any residual interests that the trust creates. As required underaccounting principles generally accepted in the United States of America, orGAAP, we recognize as revenue an estimate of the fair value of the additionalportion of the structural advisory fees and residuals at the time thesecuritization trust purchases the loans because these revenues are deemed tobe earned before they are actually paid to us. We record additional structuraladvisory fees and residuals as receivables on our balance sheet at our estimateof their fair value. Accounting rules require that these receivables berecorded at fair value. We estimate the fair value both initially and in eachsubsequent quarter and reflect the change in our estimate of fair value inearnings for that period. Our key assumptions to estimate the fair valueinclude prepayment and discount rates, interest rate trends, the spread betweenLIBOR and the auction rates on our senior auction rate notes, the expectedcredit losses from the underlying securitized loan portfolio, net ofrecoveries, and the expected timing of cash flows from the trusts’ underlyingstudent loan assets. If the actual performance of some or all of thesecuritization trusts varies from the key assumptions we use, the actualadditional structural advisory fees and residuals that we receive from thetrusts could be significantly less than reflected in our current financialstatements, and we may incur a material negative adjustment to ourearnings in the period in which our assumptions change. For a discussion of thesensitivity of the additional structural advisory fees and residuals tovariations in our assumptions and estimates, see “Management’s Discussion andAnalysis of Financial Condition and Results of Operations—Executive Summary—Applicationof Critical Accounting Policies and Estimates—Service Revenue and Receivables—SensitivityAnalysis.”  In particular, economic,regulatory, competitive and other factors affecting prepayment, default andrecovery rates on the underlying securitized loan portfolio, including full orpartial prepayments and prepayments as a result of loan consolidation activity,could cause or contribute to differences between the actual performance of thesecuritization trusts and our key assumptions.

Our residuals andadditional structural advisory fees in each securitization we have facilitatedare subordinate to securities issued to investors in such securitizations andmay fail to generate any cash flow for us if the securitized assets onlygenerate enough cash flow to pay the debt holders.

***Our financialresults could be adversely affected if we were required to consolidate thefinancial results of the entities that we use for securitizations that wefacilitate.***

We provide structuraladvisory and other services for loan securitizations undertaken throughstatutory trusts. We do not consolidate the financial results of the trustswith our own financial results. For a discussion of our decision not toconsolidate, see “Management’s Discussion and Analysis of Financial 

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Conditionand Results of Operations—Executive Summary—Application of Critical AccountingPolicies and Estimates—Consolidation” included in this quarterly report. Someof the accounting rules relevant to this issue are in the process of beingamended. If we were required to consolidate the financial results of one ormore trusts with our own financial results as a result of amendments or changesin accounting rules, or if the SEC or other accounting authorities do not agreewith our current approach, our financial results could be adversely affected,particularly in the early years of a trust when the trust typically experienceslosses.

***If ourrelationships with key clients terminate, our revenue and results of operationswould be adversely affected.***

We structure and support private student loan programsfor commercial banks, including JPMorgan Chase Bank and Bank of America.Structural advisory fees and residuals from securitization of JPMorgan ChaseBank loans represented approximately 26% of our total service revenue forfiscal 2006 and approximately 30% of our total service revenue for fiscal 2005.Structural advisory fees and residuals from securitization of Bank of Americaloans represented approximately 16% of total service revenue for fiscal 2006and approximately 18% of total service revenue for fiscal 2005. We alsostructure and support private student loan programs for companies that assistlenders such as Charter One Bank, N.A. in marketing their programs tocustomers. Structural advisory fees and residuals from securitization of loansmarketed by Collegiate Funding Services, or CFS, represented approximately 10%of our total service revenue for fiscal 2006 and approximately 17% of our totalservice revenue for fiscal 2005. JPMorgan Chase Bank acquired CFS in March 2006,and we entered into an agreement with JPMorgan Chase Bank in May 2006 thatterminated our previous agreement with CFS. Under our new agreement, JPMorganChase Bank agreed to increase its marketing expenditures in connection with itsEducation One loan program in an amount equal to CFS’s marketing commitmentunder its previous agreement with us, although we cannot assure you that theresulting loan volume will offset the loss of the loan volume derived from CFS.

We have agreements with lenders that govern thepurchase of loans for securitization. Our agreement with JPMorgan Chase Bank isscheduled to terminate in March 2010. Our agreements pursuant to whichCharter One Bank serves as a program lender are generally scheduled toterminate in May 2007. Our agreement with Bank of America governing thepurchase of direct-to-consumer loans expires on May 31, 2008, providedthat either party may terminate this agreement on or after June 1,2007, upon 90 days notice. Our agreement with Bank of America governing thepurchase of school channel loans can be terminated at any time upon 180 daysnotice. Our two agreements with Bank of America that govern the purchase ofGATE loans expire on November 30, 2007, but can be terminated by eitherparty with 90 days notice. In the absence of termination, both agreements willautomatically renew for successive one-year terms. Each client above has theright to terminate its agreement on short notice, generally 30 days orless, if we materially breach our agreement, including our failure toperform at service levels specified in those contracts. In addition, underthe terms of our lender clients’ guaranty agreements with TERI, both the lenderand TERI may propose modifications to loan program guidelines during thefirst calendar quarter of each year. If the parties are unable to agree on aproposed modification, such as an adjustment of the guarantee fees, the partyproposing the modification has the option of terminating the guarantyagreement, effective as of May 1 of that calendar year. Under its masterloan guaranty agreement with us, TERI may not propose a change to programguidelines without our consent. Similarly, under our agreements with lendersthat have multi-year terms, the lender cannot change the program guidelineswithout our consent, which we cannot unreasonably withhold.

A significant decline inservices to JPMorgan Chase Bank, Bank of America, or Charter One Bank, or thetermination of guaranty agreements between those lenders and TERI, could reducethe overall volume of loans we facilitate, which could be difficult to replacethrough arrangements with other lenders. Our revenue, business and financialresults could suffer as a result.

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***The outsourcingservices market for education lending is highly competitive and if we are notable to compete effectively, our revenue and results of operations may beadversely affected.***

We assist national and regional financial institutionsand educational institutions, as well as businesses, education loan marketersand other enterprises, in structuring and supporting their private educationloan programs. We receive fees for services we provide primarily in connectionwith the securitization of our clients’ loans. The outsourcing services marketin which we operate includes a large number of service providers, some of whichhave greater financial, technical and marketing resources, larger customerbases, greater name recognition and more established relationships with theirclients than we have. Larger competitors with greater financial resourcesmay be better able than us to respond to the need for technologicalchanges, compete for skilled professionals, build upon efficiencies based on alarger volume of loan transactions, fund internal growth and compete for marketshare generally. We may face competition from our clients if they choose,or acquire the ability, to provide directly the services that we provide. In March 2006,our client JPMorgan Chase Bank completed its acquisition of CFS, a marketer ofeducation loans we facilitate. This acquisition could result in the emergence ofa new competitor with the ability to offer outsourced services, includingsecuritization services, for private student loans. In addition, wemay face competition from third parties who decide to expand theirservices to include the suite of services that we provide. We are aware oftwo principal competitors, SLM Corporation, or Sallie Mae, and Servus FinancialCorporation, an affiliate of Wells Fargo Company, that offer a similar range ofservices to lenders. Our business could also be adversely affected if SallieMae’s program to market private student loans directly to consumers continuesto grow, if Sallie Mae seeks to market more aggressively to third parties thefull range of services for private loan programs that we provide or if SallieMae’s recently announced private loan consolidation product results inincreased consolidation of private student loans held by the securitizationtrusts we have facilitated. We are also aware of smaller privately held venturebacked companies that are developing systems and expertise with plans tocompete directly with us. If we are not able to compete effectively, ourrevenue and results of operations may be adversely affected. In addition, ifthird parties choose to provide the range of services that we provide, pricingfor our services may become more competitive, which could lower ourprofitability.

In addition, there has been significant consolidationwithin the banking industry. For example, in 2004 Charter One Financial, Inc.,the publicly-traded parent company of Charter One Bank was acquired by CitizensFinancial Group, Inc. and Bank One Corporation was acquired by JPMorganChase & Co. In addition, Sallie Mae acquired our client, SouthwestStudent Services Corporation, resulting in termination of our relationship withthat client. The acquisition by JPMorgan Chase Bank of CFS could result in areduction in our business with either or both of them. The merger may alsonegatively affect the volume of Charter One Bank loans that we process andsecuritize, because Charter One Bank no longer serves as a program lender forCFS loan programs that we facilitate. Further consolidation could result in aloss of business if one or more of our clients were acquired by a competitor ora lender that is not our client.

Historically, lenders inthe education loan market have focused their lending activities on federalloans because of the relative size of the federal loan market and because thefederal government guarantees repayment of these loans, thereby significantlylimiting the lenders’ credit risk. The demand for our services could decline iflenders place additional emphasis on the private education loan market andoffer the services we provide.

***If our clients donot successfully market and sell student loans, our business will be adverselyaffected.***

We provide outsourcingservices to lenders, loan marketers and educational institutions, as well asbusinesses and other organizations, in structuring and supporting their privateeducation loan programs. We rely on our clients to market and sell educationloans to student borrowers. If they do not devote sufficient time and resourcesto their marketing efforts, or if they are otherwise not successful in theseefforts, then we may experience a reduction in the volume of loans that weprocess and securitize, and our 

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businesswill be adversely affected. In addition, if the loans were marketed by ourclients in a manner that is unfair or deceptive, or if the marketing,origination or servicing violated any applicable law, state unfair anddeceptive practices acts could impose liability on a securitization trustholding the loan or create defenses to the enforceability of the loan.

***In structuring andfacilitating securitizations of our clients’ loans and as holders of rights toreceive residual cash flows in those trusts, we may incur liabilities toinvestors in the asset-backed securities those trusts issue.***

We have facilitated and structured a number ofdifferent special purpose trusts that have been used in securitizations to financestudent loans that our clients originate. Under applicable state and federalsecurities laws, if investors incur losses as a result of purchasingasset-backed securities that those trusts issue, we could be deemed responsibleand could be liable to those investors for damages. If we failed to cause thetrusts to disclose adequately all material information regarding an investmentin the asset-backed securities or if the trust made statements that weremisleading in any material respect in information delivered to investors, it ispossible that we could be held responsible for that information or omission. Inaddition, under various agreements entered into with underwriters or financialguarantee insurers of those asset-backed securities, we are contractually boundto indemnify those persons if investors are successful in seeking to recoverlosses from those parties and the trusts are found to have made materiallymisleading statements or to have omitted material information.

If we are liable forlosses investors incur in any of the securitizations that we facilitate orstructure and any insurance that we may have does not cover this liability orproves to be insufficient, our profitability or financial position could bematerially adversely affected.

***If our relationship with TERI terminates, our businesscould be adversely affected.***

In June 2001,we purchased the loan processing operations of TERI and entered into a seriesof agreements to govern future securitizations of TERI-guaranteed loans. TERIcontinues to provide private student loan guarantee, education information andcounseling services for students, and is the exclusive third-party provider ofborrower default guarantees for our clients’ private label loans. We haveentered into an agreement to provide various services for TERI and receivedfees from TERI for services performed of $37.1 million, or 12% of total servicerevenue, for the first quarter of fiscal 2007, and $25.9 million or 74% oftotal service revenue, for the first quarter of fiscal 2006. In addition, wehave agreed to undertake on a best-efforts basis to arrange or facilitatesecuritizations for a limited category of TERI-guaranteed loans and have theright to receive structural advisory and other fees in connection with thesesecuritizations. We also have entered into an agreement to receive from TERIupdated information about the performance of the student loans it hasguaranteed, to allow us to supplement our database. Each of these agreementswith TERI had an initial term through June 2006. In October 2004, weexercised our option to renew each agreement for an additional five-year term,through June 2011. If our agreements with TERI terminate for any reason,or if TERI fails to comply with its obligations, our business would be adverselyaffected and the value of our intangible assets could be impaired for thefollowing reasons:

·       we may not be able to offerour clients guarantee services from another guarantor and, accordingly, ouraccess to loans and our opportunities to structure securitization transactionsmay diminish significantly;

·       we may not be successful inestablishing an arrangement with a third-party to provide the warranties thatTERI currently provides to lenders related to origination services. In suchcase, we may be required to provide such warranties; and

·       if TERI is unable toprovide guarantee services for loans, any financial guarantee insurancecoverage we obtain in securitization transactions could be more costly, ifavailable at all.

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In such events, demand forour services, including opportunities to structure and facilitatesecuritization transactions, could decline, which would adversely affect ourbusiness. In addition, the value of the loans in the securitization transactionswe facilitate could decline and the value of our residuals could be reduced.

***Our business could be adversely affected if TERI’sratings are downgraded.***

In its role as guarantorin the private education lending market, TERI agrees to reimburse lenders forunpaid principal and interest on defaulted loans. TERI is the exclusiveprovider of borrower default guarantees for our clients’ private label loans.As of September 30, 2006, TERI had a Baa3 counterparty rating from Moody’sInvestors Service, which is the lowest investment grade rating, and an insurerfinancial strength rating of A+ from Fitch Ratings. If these ratings arelowered, our clients may not wish to enter into guarantee arrangements withTERI. In addition, we may receive lower structural advisory fees because thecosts of obtaining financial guarantee insurance for the asset-backedsecuritizations that we structure could increase. Finally, the inability ofTERI as student loan guarantor to meet its guaranty obligations could reducethe amount of principal or interest paid to the holders of asset-backedsecurities, which could adversely affect our residual interests insecuritization trusts or harm our ability to structure securitizations in thefuture. In each such case, our business would be adversely affected.

***Our business couldbe adversely affected if PHEAA fails to provide adequate or timely services orif our relationship with PHEAA terminates.***

As of September 30,2006, PHEAA serviced a majority of loans whose origination we support. Thisarrangement allows us to increase the volume of loans in our clients’ loanprograms without incurring the overhead investment in servicing operations. Ourreliance on an external service provider for loan servicing subjects us torisks associated with inadequate or untimely services, such as inadequatenotice of developments in prepayments, delinquencies and defaults. Asubstantial increase in these rates could adversely affect our ability toaccess profitably the securitization markets for our clients’ loans and thevalue of our additional structural advisory fees and residuals receivable. Inaddition, if our relationship with PHEAA terminates, we would either need toexpand or develop a relationship with another TERI-approved loan servicer,which could be time consuming and costly. In such event, our business could beadversely affected. Although we periodically review the costs associated withestablishing servicing operations to service loans, we have no plans toestablish and perform servicing operations at this time.

***The growth of ourbusiness could be adversely affected by changes in the annual or aggregate limitationsunder federal student loan programs or expansions in the population of studentseligible for loans under federal student loan programs.***

We focus our businessexclusively on the market for private education loans, and more than 90% of ourbusiness is concentrated in loan programs for post-secondary education. Theavailability of loans that the federal government originates or guaranteesaffects the demand for private student loans because students and theirfamilies often rely on private loans to bridge the gap between available funds,including family savings, grants and federal and state loans, and the costs ofpost-secondary education. The federal government currently places both annualand aggregate limitations on the amount of federal loans that any student canreceive and determines the criteria for student eligibility. These guidelinesare adjusted in connection with funding authorizations from the United StatesCongress for programs under the Higher Education Act. During February 2006,Congress passed, and the President signed, the Deficit Reduction Act of 2005.The Deficit Reduction Act of 2005 includes several changes to federal studentloan programs. Although aggregate borrowing limits do not change, the DeficitReduction Act of 2005 increases amounts that first and second year collegestudents may borrow and makes Parent Loans for Undergraduate Students, or PLUS,loans available to graduate and professional students. Loans to fund graduatelevel 

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educationrepresented approximately 11% during the first quarter of fiscal 2007, 15%during fiscal 2006 and 13% during fiscal 2005 of our total loan facilitationvolume. The loan limit increases take effect July 1, 2007 while most otherprovisions took effect July 1, 2006. This recent legislation, as well asfuture legislation, could weaken the demand for private student loans, whichcould adversely affect the volume of private loans and the securitizationtransactions that we facilitate and structure and, as a result, the growth ofour business.

***Access to alternative means of financing the costs ofeducation may reduce demand for private student loans.***

The demand for private student loans could weaken ifstudent borrowers use other vehicles to bridge the gap between available fundsand costs of post-secondary education. These vehicles include, among others:

·       home equity loans, underwhich families borrow money based on the value of their real estate;

·       pre-paid tuition plans,which allow students to pay tuition at today’s rates to cover tuition costs inthe future;

·       529 plans, which arestate-sponsored investment plans that allow a family to save funds foreducation expenses; and

·       education IRAs, now knownas Coverdell Education Savings Accounts, under which a holder can make annualcontributions for education savings.

If demand for privatestudent loans weakens, we would experience reduced demand for our services,which would seriously harm our financial results.

***The timing of oursecuritization activities and size of our securitization transactions willgreatly affect our quarterly financial results.***

Our quarterly revenue,operating results and profitability have varied and may continue to varysignificantly on a quarterly basis. In fiscal 2006, we recognized 6%, 41%, 26%and 27% of our total service revenue in the respective fiscal quarters offiscal 2006. Our quarterly revenue varied primarily because of the timing ofthe securitizations that we structured. In fiscal 2006, we facilitated onesecuritization in the second quarter, one securitization in the third quarter,and two securitizations in the fourth quarter, but none in the first quarter.Unlike in previous fiscal years, we facilitated one securitization in the firstquarter of fiscal 2007. Variations in the size of each securitization transactionwill continue to result in variability of our operating results on a quarterlybasis. The timing and size of our planned securitization activities may beaffected by the seasonality of student loan applications and loan originations,as well as the other factors that could adversely affect our securitizationactivities. Origination of student loans is generally subject to seasonaltrends, with the volume of loan applications increasing with the approach oftuition payment dates. In fiscal 2006, we processed 37% of our total loanfacilitation volume in the first quarter ended September 2005, and 19%,25% and 19% of our total loan facilitation volume in the respective successivequarters.

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***If competitorsacquire or develop a student loan database or advanced loan informationprocessing systems, our business could be adversely affected.***

We own a proprietarydatabase of historical information on private student loan performance that weuse to help us establish the pricing provisions of new loan programs on behalfof lenders, determine the terms of securitization transactions and establishthe fair value of the structural advisory fees and residuals that we recognizeas revenue. We also have developed a proprietary loan information processingsystem to enhance our application processing and loan origination capabilities.Our student loan database and loan information processing system provide uswith a competitive advantage in offering our services. Third parties couldcreate or acquire databases and systems such as ours. For example, as lendersand other organizations in the student loan market originate or service loans,they compile over time information for their own student loan performance database.If a third party creates or acquires a student loan database or develops a loaninformation processing system, our competitive positioning, ability to attractnew clients and business could be adversely affected.

***Changes in interestrates could affect the value of our additional structural advisory fees andresiduals receivable, as well as demand for private student loans and ourservices.***

Student loans typicallycarry floating interest rates. Higher interest rates would increase the cost ofthe loan to the borrower, which in turn, could cause an increase in defaultrates for outstanding student loans. In addition, higher interest rates, or theperception that interest rates could increase in the future, could cause anincrease in prepayments, including full or partial prepayments or prepaymentsas a result of loan consolidation activity. If the prepayment or default ratesincreased for the student loans held by the securitization trusts, we mayexperience a decline in the value of our additional structural advisory feesand residuals receivable, and future securitization transactions may be lessprofitable for us. In addition, most of the student loans that our clientsoriginate carry floating rates of interest tied to prevailing short-terminterest rates. An increase in interest rates could reduce borrowing foreducation generally, which, in turn, could cause the overall demand for ourservices to decline.

***If we are unable toprotect the confidentiality of our proprietary database and information systemsand processes, the value of our services and technology will be adverselyaffected.***

We rely on trade secret laws and restrictions ondisclosure to protect our proprietary database and information systems andprocesses. We have entered into confidentiality agreements with third partiesand with some of our employees to maintain the confidentiality of our tradesecrets and proprietary information. These methods may neither effectivelyprevent disclosure of our confidential information nor provide meaningfulprotection for our confidential information if there is unauthorized use ordisclosure.

We own no patents and havefiled no patent applications with respect to our proprietary database or loaninformation processing systems. Accordingly, our technology is not covered bypatents that would preclude or inhibit competitors from entering our market.Monitoring unauthorized use of the systems and processes that we developed isdifficult, and we cannot be certain that the steps that we have taken willprevent unauthorized use of our technology. Furthermore, others mayindependently develop substantially equivalent proprietary information andtechniques or otherwise gain access to our proprietary information. If we areunable to protect the confidentiality of our proprietary information andknow-how, the value of our technology and services will be adversely affected.

***An interruption inor breach of our information systems may result in lost business.***

We rely heavily uponcommunications and information systems to conduct our business. As we implementour growth strategy and increase our volume of business, that reliance willincrease. Our systems and operations are potentially vulnerable to damage orinterruption from network failure, 

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hardwarefailure, software failure, power or telecommunications failures, computerviruses and worms, penetration of our network by hackers or other unauthorizedusers and natural disasters. Any failure or interruption, or breach insecurity, of our information systems or the third-party information systems onwhich we rely could cause underwriting or other delays and could result infewer loan applications being received, slower processing of applications andreduced efficiency in loan processing. A failure, interruption or breach insecurity could also result in an obligation to notify clients in states such asCalifornia that require such notification, with possible civil liabilityresulting from such failure, interruption or breach. We cannot assure you thatsuch failures, interruptions or breaches will not occur, or if they do occurthat we or the third parties on whom we rely will adequately address them. Theprecautionary measures that we have implemented to avoid systems outages and tominimize the effects of any data or telephone systems interruptions may not beadequate, and we may not have anticipated or addressed all of the potentialevents that could threaten or undermine our information systems. In addition,we have not instituted redundancy for key systems. The occurrence of anyfailure, interruption or breach could significantly impair the reputation ofour brand, diminish the attractiveness of our services and harm our business.

***If we experience adata security breach and confidential customer information is disclosed, we maybe subject to penalties imposed by regulators, civil actions for damages andnegative publicity, which could affect our customer relationships and have amaterial adverse effect on our business. In addition, current state and federallegislative proposals, if enacted, may impose additional requirements on us tosafeguard confidential customer information, which may result in increasedcompliance costs.***

Recently, data securitybreaches suffered by well-known companies and institutions have attracted a substantialamount of media attention, prompting state and federal legislative proposalsaddressing data privacy and security. If some of the current proposals areadopted, we may be subject to more extensive requirements to protect theborrower information that we process in connection with the loans.Implementation of systems and procedures to address these requirements wouldincrease our compliance costs. If we were to experience a data security breach,or if we or the securitization trusts that we administer otherwise improperlydisclose confidential customer information, such breach or other disclosurecould generate negative publicity about us and could adversely affect ourrelationships with our clients, including the lenders and educational institutionswith which we do business. This could have a material adverse effect on ourbusiness. In addition, pending legislative proposals, if adopted, likely wouldresult in substantial penalties for unauthorized disclosure of confidentialconsumer information.

***The loanorigination process is becoming increasingly dependent upon technologicaladvancement, and we could lose clients and market share if we are not able tokeep pace with rapid changes in technology.***

Our ability to handle an increasing volume of transactionsis based in large part on the systems and processes we have implemented anddeveloped. The loan origination process is becoming increasingly dependent upontechnological advancement such as the ability to process loans over theInternet, accept electronic signatures and provide process updates instantly.Our future success depends in part on our ability to develop and implementtechnology solutions that anticipate and keep pace with these and othercontinuing changes in technology, industry standards and client preferences. Wemay not be successful in anticipating or responding to these developments on atimely basis. If competitors introduce products, services, systems andprocesses that are better than ours or that gain greater market acceptance, thosethat we offer or use may become obsolete or noncompetitive. Any one of thesecircumstances could have a material adverse effect on our ability to obtain andretain key clients.

We may be required toexpend significant funds to develop or acquire new technologies. If we cannotoffer new technologies as quickly as our competitors, we could lose clients andmarket share. We also 

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couldlose market share if our competitors develop more cost effective technologiesthan those we offer or develop.

***We have expandedour operations rapidly in recent years, and if we fail to manage effectivelyour growth, our financial results could be adversely affected.***

The number of ouremployees increased to 936 regular employees as of September 30, 2006 from873 regular employees and 13 seasonal employees as of September 30, 2005.Many of these employees have limited experience with us and a limitedunderstanding of our systems and controls. From our inception to September 30,2006, our assets have grown to $967.6 million. Our revenue increased to $301.8million for the first quarter of fiscal 2007 from $35.1 million for the firstquarter of fiscal 2006. Our growth may place a strain on our management,systems and resources. We must continue to refine and expand our business developmentcapabilities, our systems and processes and our access to financing sources. Aswe grow, we must continue to hire, train, supervise and manage new employees.

We have recently begun toco-source some borrower service functions, including some call centeroperations, in an effort to reduce costs and enhance our ability to process anincreasing volume of loans. We have limited experience with our co-sourcingvendor and rely on the vendor to provide a high level of customer service. Ourreliance on this external service provider subjects us to risks associated withinadequate or untimely services, and could result in a lower number of loansthan we would experience if we performed the service function in-house.

We have applied to theOffice of Thrift Supervision to acquire Union Federal Savings Bank, NorthProvidence, Rhode Island, and if the acquisition is approved, we may facechallenges in integrating our products, services and employees.

Wecannot assure you that we will be able to:

·       expandour systems effectively;

·       allocateour human resources optimally;

·       identifyand hire qualified employees or vendors; or

·       incorporateeffectively the components of any business that we may acquire in our effort toachieve growth.

If we are unable to manageour growth, our operations and our financial results could be adverselyaffected.

***We may be subject to state registration or licensingrequirements in jurisdictions where we are not currently registered orlicensed. If we determine that we are subject to the registration or licensingrequirements of any jurisdiction, our compliance costs could increasesignificantly and other adverse consequences may result.***

Basedon the advice of national counsel and, in some states, additional local counselopinions and informal advice from state regulators, we have been operating onthe basis that no registrations or licenses are required of us under lawsapplicable to loan brokers, small lenders and loan arrangers, and other similarlaws. We will continue to review state registration and licensing requirementsthat may become applicable to us in the future, in view of the expansion of thescope of the services we provide, our plans for future activities and the timethat has elapsed since our prior review. As a result of this continuing review,we may determine that registration or licensing is required in jurisdictionswhere we are not currently registered or licensed. Even if we are notphysically present in a state, its regulators may take the position that registrationor licensing is required because we provide services by mail, telephone, theInternet or other remote means. If we identify any states in which registrationor licensing is required, we will proceed with registration or licensing in theaffected state. If any state asserts jurisdiction over our business, we willconsider whether to challenge the assertion or proceed with registration orlicensing in the affected state. 

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Compliance with such requirements could involveadditional costs, which could have a material adverse effect on our business.Our failure to comply with these laws could lead to, among other things:

·       curtailmentof our ability to continue to conduct business in the relevant jurisdiction,pending processing of registration or a license application;

·       administrativeenforcement actions;

·       classaction lawsuits;

·       theassertion of legal defenses delaying or otherwise affecting the enforcement ofloans; and

·       criminalas well as civil liability. This could have a material adverse effect on ourbusiness.

***If the regulatoryexemptions or rulings that allow us to conduct our business withoutregistration or licensing are modified or revoked, or the statutory andregulatory requirements change in the future, our compliance costs couldincrease substantially.***

The Massachusetts Division of Banks ruled that ourbusiness with TERI is not subject to licensing because, as a provider of loanorigination outsourcing services, we do not conduct a lending business withconsumers in our own name and our processing centers are not generally open tothe public. The Massachusetts Small Loan Act requires any person that is engaged,for compensation, in the business of making small loans, or in aiding orassisting the borrower or the lender in procuring or making such loans, toobtain a license. Under the statute, the business of making small loansincludes the making of loans of $6,000 or less with interest rates and expensesof more than 12% per year. The TERI-guaranteed loans that we facilitate, aswell as GATE loans we support, include amounts as small as $1,000, and a smallportion of those loans have combined interest rates and fees exceeding 12%. Wecould therefore become subject to the Small Loan Act with respect to theseloans if the Massachusetts Division of Banks revokes its previous determinationthat our operations are exempt or determines that our activities exceed thescope of the determination.

We could also becomesubject to registration or licensing requirements due to changes in existingfederal and state laws and regulations. The Massachusetts legislature could,for example, modify the statutory requirements under the Small Loan Act. If theMassachusetts legislature, or any other state or federal regulatory authority,changes existing laws and rules, or enacts new laws or rules, we could beforced to make changes in our relationships with lenders, educational institutions,guarantors, servicers or the trusts involved in the securitizations that wefacilitate. Specifically, changes in existing laws and rules could alsorequire us to implement additional or different programs and informationtechnology systems and could impose licensing, capital and reserve requirementsand additional costs, including administrative, compliance and third-partyservice costs.

***We may be exposedto liability for failures of third parties with which we do business to complywith the registration, licensing and other requirements that apply to them.***

Third parties with whichwe do business, including federal and state chartered financial institutions,non-bank loan marketers, as well as TERI, are subject to registration,licensing and extensive governmental regulations, including Truth-in-Lendinglaws and other consumer protection laws and regulations. For example, some ofthe third-party marketers with which we do business may be subject to stateregistration or licensing requirements and laws and regulations, includingthose relating to small loans, loan brokers and credit services organizations.As a result of the activities that we conduct for our clients, it may beasserted that we have some responsibility for compliance by third parties withwhich we do business with the laws and regulations applicable to them, whetheron contractual or other grounds. If it is determined that we have failed tocomply with our obligations with respect to these third parties, we could besubject to civil or criminal liability.

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***We could alsobecome subject to registration or licensing and other regulatory requirementsin Massachusetts and other states by expanding the scope or extent of ourservices.***

We are in the process ofexpanding the scope of the services we provide on behalf of lenders to includecertain advertising and marketing functions. As a result of this expansion ofour services, or if we expand our services in the future to include, amongothers, loan guarantees or direct solicitation of consumers, our currentexemption from the Massachusetts Small Loan Act could be invalidated, andconsequently, we may need to obtain a license from the Massachusetts Divisionof Banks. In addition, we may become subject to the laws and regulations ofother states governing such expanded services. We may also become subject tostate regulatory requirements if the extent of the activities that we conductin a particular state expands. Compliance with such requirements could involveadditional costs, which could have a material adverse effect on our business.

***Failure to complywith consumer protection laws could subject us to civil and criminal penaltiesand have a material adverse effect on our business.***

The federal government andstate governments regulate extensively the financial institutions and otherentities that originate loans in the student loan market. These regulationsinclude bankruptcy, tax, usury, disclosure, credit reporting, identity theft,privacy, fraud and abuse and other laws to protect borrowers. Changes inconsumer protection laws or related regulations, or in the prevailinginterpretations thereof, may expose us to litigation, adversely affect thecollection of balances due on the loan assets held by securitization trusts orotherwise adversely affect our business. Moreover, changes in the consumerprotection laws and related regulations, or in the prevailing interpretationsthereof, could invalidate or call into question the legality of certain of ourservices and business practices. Recent or future changes in federal and statebankruptcy and debtor relief laws may increase credit losses on the loans heldby securitization trusts and related administrative expenses. Violations of thelaws or regulations governing our operations, or the operations of TERI or ourother clients, could result in the imposition of civil or criminal penalties,the cancellation of our contracts to provide services or our exclusion fromparticipating in education loan programs. These penalties or exclusions, werethey to occur, would negatively impair our ability to operate our business. Inaddition, the loan assets held by securitization trusts that we have structuredcould be adversely impacted by violation of tax or consumer protection laws. Insuch event, the value of our residual interests could also be adverselyimpacted. In some cases, such violations may render the loan assetsunenforceable.

***Recent litigationhas sought to re-characterize “payday loan” marketers and other originators aslenders; if litigation on similar theories were successful against us or anythird-party marketer, the loans that we securitize would be subject toindividual state consumer protection laws.***

We provide financial and educational institutions, aswell as other organizations, with an integrated suite of services in support ofprivate student loan programs. All of the lenders with which we work arefederally-insured banks and credit unions and, therefore, are not subject tomany state consumer protection laws, including limitations on certain interestrates, fees and other charges. In providing our services, we do not act as alender, guarantor or loan servicer, and the terms of the loans that wesecuritize are regulated in accordance with the laws and regulations applicableto the lenders.

The association between loan marketers andout-of-state national banks has come under recent scrutiny, specifically in thecontext of high-interest “payday loans”. Recent litigation asserts that paydayloan marketers use out-of-state lenders in order to evade the usury andinterest rate caps, and other consumer protection laws, imposed by the stateswhere they do business. Such litigation has sought, successfully in someinstances, to re-characterize the loan marketer as the lender for purposes ofstate consumer protection law restrictions. Similar civil actions have beenbrought in the context of gift cards. 

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We believe that ouractivities, and the activities of third parties whose marketing on behalf oflenders is coordinated by us, are distinguishable from the activities involvedin these cases.

Although we do not make,guarantee or service the loans and our activities are done in the name of andunder the control and supervision of lenders, additional state consumerprotection laws would be applicable to the loans if we, or any third-party loanmarketer whose activities we coordinate, were re-characterized as alender, and the loans (or the provisions governing interest rates, fees andother charges) could be unenforceable. In addition, we could be subject toclaims by consumers, as well as enforcement actions by regulators. Even if wewere not required to cease doing business with residents of certain states orto change our business practices to comply with applicable laws andregulations, we could be required to register or obtain licenses or regulatoryapprovals that could impose a substantial cost on us. To date, there have beenno actions taken or threatened against us on the theory that we have engaged inunauthorized lending. However, such actions could have a material adverseeffect on our business.

***The price of our common stock may be volatile.***

The trading priceof our common stock may fluctuate substantially, depending on many factors,some of which are beyond our control and may not be related to our operatingperformance. These fluctuations could cause you to lose part or all of yourinvestment in our shares of common stock. Those factors that could causefluctuations include, but are not limited to, the following:

·       actual or anticipatedchanges in our earnings or fluctuations in our operating results or in theexpectations of securities analysts;

·       difficulties we mayencounter in the securitizations that we structure or the loss of opportunitiesto structure securitization transactions;

·       announcement by us, ourcompetitors or our potential competitors of acquisitions, new products orservices, significant contracts, commercial relationships or capitalcommitments;

·       price and volumefluctuations in the overall stock market from time to time;

·       significant volatility inthe market price and trading volume of financial services and processoutsourcing companies;

·       general economic conditionsand trends;

·       negative publicity aboutthe student loan market generally or us specifically;

·       major catastrophic events;

·       loss of a significantclient or clients;

·       purchases or sales of largeblocks of our stock; or

·       departures of keypersonnel.

In the past, followingperiods of volatility in the market price of a company’s securities, securitiesclass action litigation has often been brought against that company. Due to thepotential volatility of our stock price, we may therefore be the target ofsecurities litigation in the future. Securities litigation could result insubstantial costs and divert management’s attention and resources from ourbusiness.

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***If a substantialnumber of shares become available for sale and are sold in a short period oftime, the market price of our common stock could decline.***

Future sales of asubstantial number of shares of our common stock in the public market, or theperception that such sales may occur, could adversely affect thethen-prevailing market price of our common stock. As of October 20, 2006,we had 62,936,285 shares of common stock outstanding. Subject to limitationsunder federal securities laws, including in some cases the volume limitationsof Rule 144, these shares are eligible for sale in the public market. Themarket price of shares of our common stock may drop significantly if ourexisting stockholders sell a substantial number of shares. A decline in the priceof shares of our common stock might impede our ability to raise capital throughthe issuance of additional shares of our common stock or other equitysecurities.

***Insiders havesubstantial control over us and could limit your ability to influence the outcomeof key transactions, including a change of control.***

Our directors andexecutive officers, and entities affiliated with them, beneficially ownapproximately 35% of the outstanding shares of our common stock. As a result,these stockholders, if acting together, could substantially influence mattersrequiring approval by our stockholders, including the election of directors andthe approval of mergers or other extraordinary transactions. They may also haveinterests that differ from yours and may vote in a way with which you disagreeand which may be adverse to your interests. The concentration of ownership mayhave the effect of delaying, preventing or deterring a change of control of ourcompany, could deprive our stockholders of an opportunity to receive a premiumfor their common stock as part of a sale of our company and might ultimatelyaffect the market price of our common stock.

***We may not receive approval from the Office of ThriftSupervision to acquire Union Federal Savings Bank.***

In July 2006, we submittedan application to the OTS for approval to acquire Union Federal Savings Bank inNorth Providence, Rhode Island, from Union Bank, a Rhode Island bankingcorporation. We cannot assure you that we will receive OTS approval, which isbased on a number of factors, including an assessment of the financial andmanagerial resources and future prospects of First Marblehead and UnionFederal, and the impact of the acquisition on competition in the parties’respective markets. Moreover, as a condition to approving the acquisition, theOTS may impose restrictions on us and may require prior approval of any futurematerial changes to Union Federal’s business plans. Even if we do receiveapproval, it may not be in a timely manner. We have already spent significanttime and resources on this proposed acquisition and the OTS application, andthe OTS review process could further divert the attention of senior managementfrom our business operations. If the OTS does not approve our acquisition ofUnion Federal, our growth strategy and business prospects could be materiallyadversely affected.

***We do not have experience with being regulated as asavings and loan holding company.***

We are not currently regulated as a savings and loanholding company or bank holding company, and do not control any FDIC-insuredinstitution. If we receive OTS approval, upon acquiring control of Union Federal,we would become subject to regulation as a savings and loan holding company andwould be limited to activities that are financial in nature and certainreal-estate related activities. We would also be required to register with theOTS and file periodic reports, and would be subject to examination by the OTS.The OTS would also have certain types of enforcement powers over us, includingthe ability to issue cease-and-desist orders, force divestiture of UnionFederal and impose civil and monetary penalties for violations of federalbanking laws and regulations or for unsafe or unsound banking practices.

In addition, savings banks such as Union Federal aresubject to extensive regulation, supervision and examination by the OTS and theFederal Deposit Insurance Corporation. Such regulation covers all 

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banking business,including activities and investments, lending practices, safeguarding deposits,capitalization, risk management policies and procedures, relationships withaffiliated companies, recordkeeping and conduct and qualifications ofpersonnel. In particular, the failure of a savings bank to meet minimum capitalrequirements can initiate certain mandatory, and possibly additionaldiscretionary, actions by regulators that, if undertaken, could have a directmaterial adverse effect on a saving bank’s operations and financial statements.

There is a risk that wecould incur additional costs in complying with regulations applicable tosavings and loan holding companies and savings banks, or significant penaltiesif we fail to comply. Our ability to comply with all applicable laws and rules willdepend largely on our establishment and maintenance of a system to ensure suchcompliance, as well as our ability to attract and retain qualified compliancepersonnel. We could be subject to disciplinary or other actions due to claimednoncompliance in the future, which could have an adverse effect on our business,financial condition and operating results.

***Some provisions inour restated certificate of incorporation and amended and restated by-laws maydeter third-parties from acquiring us.***

Our restated certificate of incorporation and amendedand restated by-laws contain provisions that may make the acquisition of ourcompany more difficult without the approval of our board of directors,including the following:

·       only our board ofdirectors, the chairman of our board of directors or our president may call specialmeetings of our stockholders;

·       our stockholders may takeaction only at a meeting of our stockholders and not by written consent;

·       we have authorizedundesignated preferred stock, the terms of which may be established and sharesof which may be issued without stockholder approval;

·       our directors may beremoved only for cause by the affirmative vote of a majority of the directorspresent at a meeting duly held at which a quorum is present, or the holders of75% of the votes that all stockholders would be entitled to cast in theelection of directors; and

·       we impose advance noticerequirements for stockholder proposals.

These anti-takeoverdefenses could discourage, delay or prevent a transaction involving a change incontrol of our company. These provisions could also discourage proxy contestsand make it more difficult for you and other stockholders to elect directors ofyour choosing and cause us to take other corporate actions you desire.

***Section 203 ofthe Delaware General Corporation Law may delay, defer or prevent a change incontrol that our stockholders might consider to be in their best interests.***

We are subject to Section 203of the Delaware General Corporation Law which, subject to certain exceptions,prohibits “business combinations” between a Delaware corporation and an “interestedstockholder,” which is generally defined as a stockholder who becomes abeneficial owner of 15% or more of a Delaware corporation’s voting stock, for athree-year period following the date that such stockholder became an interestedstockholder. Section 203 could have the effect of delaying, deferring orpreventing a change in control that our stockholders might consider to be intheir best interests.

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**Item 2—Unregistered Sales of Equity Securities and Useof Proceeds**

***(a) RecentSales of Unregistered Securities***

None.

***(b) Use of Proceeds from Registered Securities***

In our initial publicoffering or IPO, we sold 7,906,250 shares of common stock, including an over-allotmentoption of 1,031,750 shares, pursuant to a registration statement on Form S-1 (File No. 333-108531)that was declared effective by the SEC on October 30, 2003. We received inaggregate net proceeds of approximately $115.1 million, after deductingunderwriting discounts and commissions of approximately $8.9 million andexpenses of the offering of approximately $2.5 million. From the effective dateof the registration statement through September 30, 2006, we have notspent any of the net proceeds from the IPO, which have been invested in cash,cash equivalents and short-term investments. Accordingly, none of the netproceeds of the IPO has been paid by us, directly or indirectly, to anydirector, officer, or general partner of us, or any of their associates, or toany person owing ten percent or more of any class of our equities securities orany of our affiliates.

***(c) IssuerPurchases of Equity Securities***
| **Period**                                         | ** ** | ** ** | ** ** | **Total number  of shares  purchased (1)** | ** ** | **Average price  paid per  share (2)** | ** ** | **Total number of  shares purchased  as part of  publicly  announced plans  or programs (1)** | ** ** | **Maximum number  of shares that may  yet be purchased  under the plans or  programs (1)** | ** ** |
|----------------------------------------------------|------------|------------|------------|-----------------------------------------------------------|------------|-------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|------------|
| July 1, 2006  to July 31, 2006           |       |       | 291,000    |                                                      |       |                                                  | $47.83     |                                                                                                                                  |       |                                                                                                                                         | 291,000    |   |   |   | 2,362,200 |   |   |
| August 1,  2006 to August 31, 2006       |       |       | —     |                                                      |       |                                                  | —     |                                                                                                                                  |       |                                                                                                                                         | —     |   |   |   | 2,362,200 |   |   |
| September 1,  2006 to September 30, 2006 |       |       | —     |                                                      |       |                                                  | —     |                                                                                                                                  |       |                                                                                                                                         | —     |   |   |   | 2,362,200 |   |   |
| Total                                              |       |       | 291,000    |                                                      |       |                                                  | $47.83     |                                                                                                                                  |       |                                                                                                                                         | 291,000    |   |   |   | 2,362,200 |   |   |

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(1)          On September 29,2005, we announced a repurchase program of up to 5,000,000 shares of our commonstock. This repurchase program does not have a fixed expiration date. Prior to October 1,2005, we repurchased an aggregate of 1,500,000 shares of our common stockpursuant to repurchase programs announced on April 29, 2005 and June 2,2005.

(2)          Averageprice paid per share excludes commissions that we paid to the brokers thateffected theserepurchases.

**Item 5—OtherInformation**

On October 2,2006, we entered into a Fifteenth Amendment to Program Agreements (the “Amendment”)with JPMorgan Chase Bank, N.A., successor by merger to Bank One, N.A. TheAmendment amended the minimum purchase price due to JPMorgan Chase Bank inconnection with future securitizations of its loan volume. The Amendment alsoincreased the minimum marketing expenditures by JPMorgan Chase Bank duringcalendar year 2007 with respect to its private loan programs. This summary isqualified by the Amendment, a copy of which is filed as exhibit 10.2 to thisquarterly report on Form 10-Q and incorporated herein by reference.

**Item 6—Exhibits**

See the Exhibit Indexon the page immediately preceding the exhibits for a list of exhibitsfiled as part of this quarterly report whichExhibit Index is incorporated herein by this reference.

 

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
|                             | **THE FIRST MARBLEHEAD CORPORATION** |
|-----------------------------|--------------------------------------|
| Date: November 8, 2006 | By:                                  | /s/ Jack L. Kopnisky |
|                        |                                 | Jack L. Kopnisky |
|                        | * *                             | *Chief Executive Officer, President & Chief  Operating Officer* |
|                        | * *                             | *(Duly authorized officer)* |
| Date: November 8, 2006      | By:                                  | /s/ John A. Hupalo |
|                        |                                 | John  A. Hupalo |
|                        | * *                             | *Senior Executive Vice President and Chief  Financial Officer* |
|                        | * *                             | *(Principal financial officer)* |
| Date: November 8, 2006      | By:                                  | /s/ Kenneth S. Klipper |
|                        | * *                             | Kenneth S. Klipper |
|                        | * *                             | *Senior Vice President, Treasurer  and Chief Accounting Officer* |
|                        | * *                             | *(Principal  accounting officer)* |

 

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**EXHIBITINDEX**

| Exhibit  Number | ** ** | **Description**                                                                                                                                                                                                                       |
|-----------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1            | †     | Amended and Restated  Private Student Loan Servicing Agreement, dated as of September 28,  2006, between the Pennsylvania Higher Education Assistance Agency and the  Registrant                                                 |
| 10.2            | †     | Fifteenth Amendment to Program Agreements, dated as  of October 2, 2006, between JPMorgan Chase Bank, N.A. and the Registrant                                                                                                    |
| 10.3            |       | Employment Agreement and Mutual General Release,  dated November 1, 2006, between Donald R. Peck and the Registrant                                                                                                              |
| 31.1            |       | Chief Executive Officer—Certification pursuant to  Rule 13a-14(a) of the Securities Exchange Act of 1934, as  adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                   |
| 31.2            |       | Chief Financial Officer—Certification pursuant to  Rule 13a-14(a) of the Securities Exchange Act of 1934, as  adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                   |
| 32.1            |       | Chief Executive Officer—Certification pursuant to  Rule 13a-14(b) of the Securities Exchange Act of 1934 and 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002  |
| 32.2            |       | Chief Financial Officer—Certification pursuant to  Rule 13a-14(b) of the Securities Exchange Act of 1934 and 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

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†                    Confidentialtreatment has been requested for certain provisions of thisExhibit pursuant to Rule 24b-2 promulgated under the SecuritiesExchange Act of 1934, as amended.

 

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