**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

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**FORM 10-Q**

**(MARK ONE)**

 
| **ý** | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**                                                                                                             |
|------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                                |
|       |       | **For The Quarterly Period Ended December 31, 2004**                                                                                                                                                           |
| ** ** | ** ** | ** **                                                                                                                                                                                                          |
| ** ** | ** ** | **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 Registrant asSpecified in Its Charter)

 

| **Delaware**                                                                      | ** ** | **04-3295311**                         |
|-----------------------------------------------------------------------------------|------------|----------------------------------------|
| (State or  Other Jurisdiction of  Incorporation or Organization)                  |       | (I.R.S.  Employer  Identification No.) |
|                                                                              |       |                                   |
| **The Prudential Tower   800 Boylston Street, 34th Floor  Boston, Massachusetts** | ** ** | **02199-8157**                         |
| (Address of  Principal Executive Offices)                                         |       | (Zip Code)                             |
|                                                                              |       |                                   |
| Registrant’s  telephone number, including area code: **(617) 638-2000** |

 

Indicate bycheck mark whether the registrant: (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.

 

Yes ý No o

 

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Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

 

Yes o No ý

 

As of January 31, 2005, the registranthad 65,729,769 shares of Common Stock, $0.01 par value per share, outstanding.

 

 

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**THEFIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

 

**Tableof Contents**

 
| Part I. Financial Information |                                                                                                                      |
|-------------------------------|---------------------------------------------------------------------------------------------------------------------------|
| Item 1—                  | Financial Statements                                                                                                      |   |
|                          | Condensed Consolidated Balance Sheets as of  December 31, 2004 and June 30, 2004                                | 3 |
|                          | Condensed Consolidated Statements of  Operations for the three and six months ended December  31, 2004 and 2003      | 4 |
|                          | Condensed Consolidated Statement of Changes  in Stockholders’ Equity for the six months ended December 31, 2004 | 5 |
|                          | Condensed Consolidated Statements of Cash  Flows for the six months ended December 31, 2004 and 2003                 | 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                                                               | 46 |
| Item 4—                  | Controls and Procedures                                                                                                   | 46 |
| Part II. Other Information    |                                                                                                                      |
| Item 2—                  | Unregistered Sales of Equity Securities and  Use of Proceeds                                                              | 47 |
| Item 4—                  | Submission of Matters to a Vote of Security  Holders                                                                      | 47 |
| Item  6—                 | Exhibits                                                                                                                  | 47 |
| SIGNATURES                    | 48                                                                                                                        |
| EXHIBIT  INDEX                | 49                                                                                                                        |

 

2

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**Part I. Financial Information**

 

**Item 1—Financial Statements**

 

**THE FIRST MARBLEHEAD CORPORATION ANDSUBSIDIARIES**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(unaudited)**

**(in thousands, except share and per shareamounts)**

 
| ** **                                                                                                                                                                                                                                                             | ** ** | **December 31,  2004** | ** ** | **June 30,   2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| ** **                                                                                                                                                                                                                                                             | ** ** | ** **                  | ** ** | ** **               | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                             |       |                        |       |                     |       |
| Cash and other short-term investments                                                                                                                                                                                                                                  |       | $                           | 199,084    |                     | $          | 168,712 |   |
|                                                                                                                                                                                                                                                                   |       |                        |       |                     |       |
| Service receivables:                                                                                                                                                                                                                                                   |       |                        |       |                     |       |
| Structural advisory fees                                                                                                                                                                                                                                               |       | 34,825                      |       | 34,334                   |       |
| Residuals                                                                                                                                                                                                                                                              |       | 175,178                     |       | 108,495                  |       |
| Processing fees from The Education  Resources Institute (TERI)                                                                                                                                                                                                         |       | 6,478                       |       | 6,052                    |       |
|                                                                                                                                                                                                                                                                   |       | 216,481                     |       | 148,881                  |       |
|                                                                                                                                                                                                                                                                   |       |                        |       |                     |       |
| Other receivables                                                                                                                                                                                                                                                      |       | 1,858                       |       | 438                      |       |
|                                                                                                                                                                                                                                                                   |       |                        |       |                     |       |
| Property and equipment                                                                                                                                                                                                                                                 |       | 22,501                      |       | 15,146                   |       |
| Less accumulated depreciation and  amortization                                                                                                                                                                                                                        |       | (6,248                      | )          | (4,315                   | )          |
| Property and equipment, net                                                                                                                                                                                                                                            |       | 16,253                      |       | 10,831                   |       |
|                                                                                                                                                                                                                                                                   |       |                        |       |                     |       |
| Goodwill                                                                                                                                                                                                                                                               |       | 3,176                       |       | 3,176                    |       |
| Intangible assets, net                                                                                                                                                                                                                                                 |       | 2,922                       |       | 3,180                    |       |
| Prepaid and other current assets                                                                                                                                                                                                                                       |       | 6,836                       |       | 23,030                   |       |
| Other assets                                                                                                                                                                                                                                                           |       | 2,008                       |       | 1,808                    |       |
|                                                                                                                                                                                                                                                                   |       |                        |       |                     |       |
| Total assets                                                                                                                                                                                                                                                           |       | $                           | 448,618    |                     | $          | 360,056 |   |
|                                                                                                                                                                                                                                                                   |       |                        |       |                     |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                         |       |                        |       |                     |       |
| Liabilities:                                                                                                                                                                                                                                                           |       |                        |       |                     |       |
| Accounts payable and accrued expenses                                                                                                                                                                                                                                  |       | $                           | 21,822     |                     | $          | 26,285 |   |
| Net deferred tax liability                                                                                                                                                                                                                                             |       | 67,478                      |       | 40,138                   |       |
| Notes payable and capital lease obligations                                                                                                                                                                                                                            |       | 1,651                       |       | 9,179                    |       |
| Notes payable to TERI                                                                                                                                                                                                                                                  |       | 5,653                       |       | 6,004                    |       |
| Other liabilities                                                                                                                                                                                                                                                      |       | 331                         |       | 314                      |       |
| Total liabilities                                                                                                                                                                                                                                                      |       | 96,935                      |       | 81,920                   |       |
| Commitments and contingencies                                                                                                                                                                                                                                          |       |                        |       |                     |       |
| Stockholders’ equity:                                                                                                                                                                                                                                             |       |                        |       |                     |       |
| Preferred stock, par value $0.01 per share;  20,000,000 shares authorized; no shares issued or outstanding                                                                                                                                                             |       | —                      |       | —                   |       |
| Common stock, par value $0.01 per share;  150,000,000 and 100,000,000 shares authorized at December 31, 2004 and June  30, 2004, respectively; 64,690,139 and 63,975,000 shares issued and  outstanding at December 31, 2004 and June 30, 2004, respectively |       | 647                         |       | 640                      |       |
| Additional paid-in capital                                                                                                                                                                                                                                             |       | 171,205                     |       | 163,572                  |       |
| Retained earnings                                                                                                                                                                                                                                                      |       | 183,102                     |       | 113,924                  |       |
| Deferred compensation                                                                                                                                                                                                                                                  |       | (3,271                      | )          | —                   |       |
| Total stockholders’ equity                                                                                                                                                                                                                                        |       | 351,683                     |       | 278,136                  |       |
|                                                                                                                                                                                                                                                                   |       |                        |       |                     |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                                        |       | $                           | 448,618    |                     | $          | 360,056 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

3

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**THE FIRST MARBLEHEAD CORPORATION ANDSUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

**(unaudited)**

**(in thousands, except per share amounts)**

 
| ** **                                    | ** ** | **Three months ended  December 31,** | ** ** | **Six months ended  December 31,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------|------------|------------------------------------|------------|
| ** **                                    | ** ** | **2004**                                  | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                          |       |                                      |       |                               |       |   |   |   |   |
| Service revenue:                              |       |                                      |       |                               |       |   |   |   |   |
| Structural advisory fees                      |       | $                                         | 75,172     |                               | $          | 38,977 |   | $ | 75,791 |   | $ | 38,699 |   |
| Residuals                                     |       | 63,223                                    |       | 30,944                             |       | 66,683 |   | 32,538 |   |
| Administrative and other fees                 |       | 863                                       |       | 458                                |       | 1,831 |   | 771 |   |
| Processing fees from TERI                     |       | 16,579                                    |       | 7,144                              |       | 33,936 |   | 14,983 |   |
| Total service revenue                         |       | 155,837                                   |       | 77,523                             |       | 178,241 |   | 86,991 |   |
|                                          |       |                                      |       |                               |       |   |   |   |   |
| Operating expenses:                           |       |                                      |       |                               |       |   |   |   |   |
| Compensation and benefits                     |       | 15,318                                    |       | 7,798                              |       | 30,198 |   | 16,666 |   |
| General and administrative expenses           |       | 14,355                                    |       | 7,668                              |       | 31,314 |   | 14,010 |   |
| Total operating expenses                      |       | 29,673                                    |       | 15,466                             |       | 61,512 |   | 30,676 |   |
| Income from operations                        |       | 126,164                                   |       | 62,057                             |       | 116,729 |   | 56,315 |   |
| Other (income) expense:                       |       |                                      |       |                               |       |   |   |   |   |
| Interest expense                              |       | 115                                       |       | 131                                |       | 234 |   | 251 |   |
| Interest income                               |       | (873                                      | )          | (173                               | )          | (1,355 | ) | (194 | ) |
| Total other (income) expense, net             |       | (758                                      | )          | (42                                | )          | (1,121 | ) | 57 |   |
| Income before income tax expense              |       | 126,922                                   |       | 62,099                             |       | 117,850 |   | 56,258 |   |
| Income tax expense                            |       | 52,392                                    |       | 25,460                             |       | 48,672 |   | 22,697 |   |
| Net income                                    |       | $                                         | 74,530     |                               | $          | 36,639 |   | $ | 69,178 |   | $ | 33,561 |   |
|                                          |       |                                      |       |                               |       |   |   |   |   |
| Net income per share, basic                   |       | $                                         | 1.15       |                               | $          | 0.62 |   | $ | 1.07 |   | $ | 0.60 |   |
| Net income per share, diluted                 |       | 1.12                                      |       | 0.58                               |       | 1.04 |   | 0.55 |   |
| Weighted average shares outstanding, basic    |       | 64,624                                    |       | 59,084                             |       | 64,473 |   | 56,205 |   |
| Weighted average shares outstanding,  diluted |       | 66,821                                    |       | 63,402                             |       | 66,803 |   | 60,592 |   |
|                                               |            |                                           |            |                                    |            |  |  |  |  |  |  |  |  |  |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

4

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**THE FIRST MARBLEHEAD CORPORATION ANDSUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF CHANGESIN STOCKHOLDERS’ EQUITY**

**(unaudited)**

**(in thousands)**

 
| ** **                                            | ** ** | **Common   Stock** | ** ** | **Additional  Paid-in   Capital** | ** ** | **Retained   Earnings** | ** ** | **Deferred   Compensation** | ** ** |
|-------------------------------------------------------|------------|--------------------|------------|-----------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                                                  |       |               |       |                              |       |                    |       |                        |       |
| Balance at June 30, 2004                         |       | $                  | 640        |                              | $          | 163,572                 |       | $                           | 113,924    |   | $ | — |   |
|                                                  |       |               |       |                              |       |                    |       |                        |       |
| Options exercised                                     |       | 7                  |       | 972                               |       | —                  |       | —                      |       |
| Stock purchases through employee stock  purchase plan |       | —             |       | 550                               |       | —                  |       | —                      |       |
| Tax benefit from employee stock options               |       | —             |       | 2,705                             |       | —                  |       | —                      |       |
| Grant of restricted stock units                       |       | —             |       | 3,406                             |       | —                  |       | (3,406                      | )          |
| Amortization of deferred compensation                 |       |               |       |                              |       |                    |       | 135                         |       |
| Net income                                            |       | —             |       | —                            |       | 69,178                  |       | —                      |       |
| Balance at December 31, 2004                     |       | $                  | 647        |                              | $          | 171,205                 |       | $                           | 183,102    |   | $ | (3,271 | ) |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

5

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**THE FIRST MARBLEHEAD CORPORATION ANDSUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF CASHFLOWS**

**(unaudited)**

**(in thousands)**

 
| ** **                                                                         | ** ** | **Six months ended  December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                                | ** ** | **2003** | ** ** |
|                                                                               |       |                                    |       |   |   |
| Cash flows from operating activities:                                              |       |                                    |       |   |   |
| Net income                                                                         |       | $                                       | 69,178     |   | $ | 33,561 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                                    |       |   |   |
| Depreciation                                                                       |       | 1,933                                   |       | 862 |   |
| Amortization                                                                       |       | 631                                     |       | 564 |   |
| Tax benefit from employee stock options                                            |       | 2,705                                   |       | — |   |
| Non-cash compensation                                                              |       | 135                                     |       | 1,642 |   |
| Change in assets/liabilities:                                                      |       |                                    |       |   |   |
| (Increase) in processing fees from TERI and  other receivables                     |       | (1,846                                  | )          | (656 | ) |
| (Increase) in structural advisory fees                                             |       | (491                                    | )          | (14,199 | ) |
| (Increase) in residuals                                                            |       | (66,683                                 | )          | (32,537 | ) |
| Decrease (increase) in prepaid and other  current assets                           |       | 16,194                                  |       | (947 | ) |
| (Increase) in deposits                                                             |       | (200                                    | )          | — |   |
| Increase in net deferred tax liability                                             |       | 27,340                                  |       | 15,582 |   |
| (Decrease) increase in accounts payable, accrued  expenses and other liabilities   |       | (4,446                                  | )          | 953 |   |
| Net cash provided by operating activities                                          |       | 44,450                                  |       | 4,825 |   |
| Cash flows from investing activities:                                              |       |                                    |       |   |   |
| Purchases of property and equipment                                                |       | (7,355                                  | )          | (3,244 | ) |
| Payments to TERI for loan database updates                                         |       | (373                                    | )          | (374 | ) |
| Net cash used in investing activities                                              |       | (7,728                                  | )          | (3,618 | ) |
| Cash flows from financing activities:                                              |       |                                    |       |   |   |
| Repayment of notes payable due to TERI                                             |       | (351                                    | )          | (330 | ) |
| Repayment of notes payable and capital  lease obligations                          |       | (7,528                                  | )          | — |   |
| Proceeds from notes payable                                                        |       | —                                  |       | 7,000 |   |
| Net proceeds from initial public offering                                          |       | —                                  |       | 115,107 |   |
| Stock options exercised                                                            |       | 1,529                                   |       | 644 |   |
| Net cash (used in) provided by financing  activities                               |       | (6,350                                  | )          | 122,421 |   |
| Net increase in cash and other short-term  investments                             |       | 30,372                                  |       | 123,628 |   |
| Cash and other short-term investments,  beginning of period                        |       | 168,712                                 |       | 18,327 |   |
| Cash and other short-term investments, end  of period                              |       | $                                       | 199,084    |   | $ | 141,955 |   |
|                                                                               |       |                                    |       |   |   |
| Supplemental disclosures of cash flow  information:                                |       |                                    |       |   |   |
| Interest paid                                                                      |       | $                                       | 484        |   | $ | 178 |   |
|                                                                               |       |                                    |       |   |   |
| Income taxes paid                                                                  |       | $                                       | —     |   | $ | 8,635 |   |
|                                                                               |       |                                    |       |   |   |
| Debt issuance costs                                                                |       | $                                       | —     |   | $ | 250 |   |
|                                                                               |       |                                    |       |   |   |
| Supplemental disclosure of non-cash  activities:                                   |       |                                    |       |   |   |
| Structural advisory fees and residuals  recognized                                 |       | $                                       | 77,424     |   | $ | 38,237 |   |
|                                                                               |       |                                    |       |   |   |
| Non-cash compensation                                                              |       | $                                       | 135        |   | $ | 1,642 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

6

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** **

**THE FIRST MARBLEHEAD CORPORATION ANDSUBSIDIARIES**

 

**NOTES TO UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

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

 

***Natureof Business***

 

The First Marblehead Corporation (FMC, andtogether with its subsidiaries, the Company), which was incorporated under thelaws of the State of Delaware on August 13, 1994, provides outsourcingservices for private education lending in the United States. The Company helpsmeet the growing demand for private education loans by providing national andregional financial institutions and educational institutions, as well asbusinesses 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 onloan programs for undergraduate, graduate and professional education, and, to alesser degree, on the primary and secondary school market. The Company isentitled to receive structural advisory fees and residuals for its services inconnection with securitizations of loans generated by the loan programs that itfacilitates. The Company also receives fees for administrative services that itprovides to the discrete bankruptcy remote, special purpose trusts that theCompany forms for securitizations it facilitates.

 

***Basisof Presentation***

 

The accompanying unaudited condensedconsolidated financial statements of the Company 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 that affect the amounts reported inthe consolidated financial statements and accompanying notes. Interim resultsare not necessarily indicative of results to be expected for the entire fiscalyear. All significant intercompany balances and transactions have beeneliminated in consolidation. These unaudited condensed consolidated financialstatements should be read in conjunction with the audited consolidatedfinancial statements and related notes for the year ended June 30, 2004included in the Company’s Annual Report on Form 10-K filed with the Securitiesand Exchange Commission on September 15, 2004. Certain prior periodamounts have been reclassified to conform with currentperiod presentation.

 

***StudentLoan Market Seasonality and Revenue Related to Securitization Transactions***

 

Origination of student loans is generallysubject to seasonal trends, with the volume of loan applications increasingwith the approach of tuition payment dates. In general, the Company processesthe greatest application volume during the summer months, as students and theirfamilies seek to borrow money in order to pay tuition costs for the fallsemester or the entire school year. The Company also tends to process increasedvolume of loan applications during December and January, as students and theirfamilies seek to borrow money to pay tuition costs for the spring semester.This seasonality of loan originations impacts the amount of processing feesfrom TERI that the Company earns in a particular quarter.

 

The Company did not conduct a securitizationtransaction during the first quarter of either fiscal 2005 or fiscal 2004. TheCompany closed one securitization transaction in the second quarter, and twosecuritization transactions in the fourth quarter, of fiscal 2004. The Companyclosed one securitization transaction during the second quarter of fiscal 2005and expects to close additional securitization transactions in the third andfourth quarters of the current fiscal year.

 

***Concentrations***

 

**TERI**

 

The Education Resources Institute, Inc.(TERI) is a private, not-for-profit Massachusetts corporation as describedunder section 501(c)(3) of the Internal Revenue Code of 1986, as amended.Incorporated in 1985, TERI is the oldest and largest guarantor of alternative,or private, student loans. In its role as guarantor in the private educationlending market, TERI agrees to reimburse lenders for unpaid principal andinterest on defaulted loans. TERI is the exclusive third-party provider ofborrower default guarantees for the Company’s clients’ private student loans.As of December 31, 2004, 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, FMC’s clients may not wish to enter into guarantee arrangements withTERI. In addition, FMC may receive lower structural advisory fees because thecosts of obtaining financial guarantee insurance or structuring other creditenhancements for structuring the asset-backed securitizations could increase.

 

7

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**PHEAA**

 

As of December 31, 2004, there were nineTERI-approved loan servicers to service new loan facilitation volume. As of December 31,2004, Pennsylvania Higher Education Assistance Agency (PHEAA) serviced amajority of the loans for which the Company facilitated origination. TheCompany’s use of third-party loan servicers allows the Company to increase thevolume of loans in its clients’ loan programs without incurring the overheadinvestment in servicing operations. As with any external service provider,there are risks associated with inadequate or untimely services. In addition,if the Company’s relationship with PHEAA terminates, the Company would eitherneed to expand or develop a relationship with another TERI-approved loanservicer, which could be time-consuming and costly.

 

***Significant Customers***

 

During the three and six month periods ended December 31,2004, processing fees from TERI represented approximately 11% and 19%, respectively,of total service revenue. Securitization-related fees from the NationalCollegiate Student Loan Trust 2004-2 (NCSLT 2004-2) represented approximately75% of total service revenue for the first six months of fiscal 2005.NCSLT 2004-2 purchased private student loans from several lendersincluding Bank One N.A., Bank of America N.A. and Charter One Bank N.A. TheCompany did not recognize more than 10% of total service revenue from any othercustomer.

 

***CriticalAccounting Policies and Estimates***

 

The preparation of the Company’s financialstatements requires the Company to make estimates, assumptions and judgmentsthat affect the reported amounts of assets and liabilities and the reportedamounts of income and expenses during the reporting periods. The Company basesits estimates and judgments on historical experience and on various otherfactors, and actual results may differ from these estimates under varyingassumptions or conditions.

 

On an ongoing basis, the Company evaluates itsestimates and judgments, particularly as they relate to accounting policiesthat the Company believes are most important to the portrayal of the Company’sfinancial condition and results of operations. The Company regards anaccounting estimate or assumption underlying its financial statements to be acritical accounting estimate where:

 

•                                          the nature of the estimate or assumptionis material due to the level of subjectivity and judgment necessary to accountfor highly uncertain matters or the susceptibility of such matters to change;and

 

•                                          the impact of the estimates and assumptionson the Company’s financial condition or operating performance is material.

 

The Company believes that its accounting policies involving therecognition and valuation of the Company’s securitization-related servicerevenue, as well as the valuation of goodwill and intangible assets, fit thedefinition of critical accounting estimates. The Company also considers itspolicy with respect to the determination of whether or not to consolidate thesecuritization trusts that it facilitates to be a critical accounting policy.See “Management’s Discussion and Analysis of Financial Condition and Results ofOperations—Application of Critical Accounting Policies and Estimates”.

 

**(2)****                                 StockOptions**

 

The Company uses the intrinsic value methodto account for stock options and provides pro forma net earnings disclosures asif the fair-value-based method had been applied.

 

For purposes of pro forma disclosures, theestimated fair value of the stock options is amortized to expense over thevesting period of the options. The Company’s consolidated pro forma net incomeand net income per share for the three and six month periods ended December 31,2004 and 2003, had the Company elected to recognize compensation expense for thegranting of options under SFAS No. 123 using the Black-Scholes option pricingmodel, are as follows:

 

8

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| ** **                                                                                                                      | ** ** | **Three months ended   December 31,**   | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                                                      | ** ** | **(in thousands, except per share amounts)** | ** ** |
| ** **                                                                                                                      | ** ** | **2004**                                     | ** ** | **2003** | ** ** |
|                                                                                                                            |       |                                         |       |   |   |
| Net income—as reported                                                                                                     |       | $                                            | 74,530     |   | $ | 36,639 |   |
| Less: Total stock-based employee  compensation expense determined under the fair-value-based method for all  awards, net of tax |       | (102                                         | )          | (146 | ) |
|                                                                                                                            |       |                                         |       |   |   |
| Net income—pro forma                                                                                                       |       | $                                            | 74,428     |   | $ | 36,493 |   |
|                                                                                                                            |       |                                         |       |   |   |
| Net income per share—basic—as reported                                                                                |       | $                                            | 1.15       |   | $ | 0.62 |   |
| Net income per share—basic—pro forma                                                                                  |       | $                                            | 1.15       |   | $ | 0.62 |   |
| Net income per share—diluted—as reported                                                                              |       | $                                            | 1.12       |   | $ | 0.58 |   |
| Net income per share—diluted—pro forma                                                                                |       | $                                            | 1.11       |   | $ | 0.58 |   |

 
| ** **                                                                                                                      | ** ** | **Six months ended   December 31,**     | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                                                      | ** ** | **(in thousands, except per share amounts)** | ** ** |
| ** **                                                                                                                      | ** ** | **2004**                                     | ** ** | **2003** | ** ** |
|                                                                                                                            |       |                                         |       |   |   |
| Net income—as reported                                                                                                     |       | $                                            | 69,178     |   | $ | 33,561 |   |
| Less: Total stock-based employee  compensation expense determined under the fair-value-based method for all  awards, net of tax |       | (773                                         | )          | (377 | ) |
|                                                                                                                            |       |                                         |       |   |   |
| Net income—pro forma                                                                                                       |       | $                                            | 68,405     |   | $ | 33,184 |   |
|                                                                                                                            |       |                                         |       |   |   |
| Net income per share—basic—as reported                                                                                |       | $                                            | 1.07       |   | $ | 0.60 |   |
| Net income per share—basic—pro forma                                                                                  |       | $                                            | 1.06       |   | $ | 0.59 |   |
| Net income per share—diluted—as reported                                                                              |       | $                                            | 1.04       |   | $ | 0.55 |   |
| Net income per share—diluted—pro forma                                                                                |       | $                                            | 1.02       |   | $ | 0.55 |   |

 

# **(3)**                                 Net Income per Share

# ** **

The following table setsforth our computation of basic and diluted net income per share of the Company’sstock:

 
| ** **                                                           | ** ** | **Three months ended   December 31,**        | ** ** | **Six months ended   December 31,** | ** ** |
|----------------------------------------------------------------------|------------|----------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                           | ** ** | **(in thousands, except per share amounts)** | ** ** |
| ** **                                                           | ** ** | **2004**                                     | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                 |       |                                         |       |                                |       |   |   |   |   |
| Net income                                                           |       | $                                            | 74,530     |                                | $          | 36,639 |   | $ | 69,178 |   | $ | 33,561 |   |
|                                                                 |       |                                         |       |                                |       |   |   |   |   |
| Shares used in computing net income per  common share –basic    |       | 64,624                                       |       | 59,084                              |       | 64,473 |   | 56,205 |   |
| Effect of dilutive securities:                                       |       |                                         |       |                                |       |   |   |   |   |
| Stock options                                                        |       | 2,193                                        |       | 4,318                               |       | 2,330 |   | 4,387 |   |
| Restricted stock units                                               |       | 4                                            |       | —                              |       | — |   | — |   |
|                                                                 |       |                                         |       |                                |       |   |   |   |   |
| Dilutive potential common shares                                     |       | 2,197                                        |       | 4,318                               |       | 2,330 |   | 4,387 |   |
|                                                                 |       |                                         |       |                                |       |   |   |   |   |
| Shares used in computing net income per  common share – diluted |       | 66,821                                       |       | 63,402                              |       | 66,803 |   | 60,592 |   |
|                                                                 |       |                                         |       |                                |       |   |   |   |   |
| Net income per common share:                                         |       |                                         |       |                                |       |   |   |   |   |
| Basic                                                                |       | $                                            | 1.15       |                                | $          | .62 |   | $ | 1.07 |   | $ | .60 |   |
|                                                                 |       |                                         |       |                                |       |   |   |   |   |
| Diluted                                                              |       | $                                            | 1.12       |                                | $          | .58 |   | $ | 1.04 |   | $ | .55 |   |

 

9

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**(4)****                                 ServiceReceivables**

 

Structural advisory fees and residualsreceivables represent the present value of additional structural advisory feesand residuals expected to be collected over the life of the student loans, netof prepayment, default, recovery and cost of funding estimates. The fees arepaid to the Company from the various separate securitization trusts establishedby The National Collegiate Trust (NCT trusts), and from The National CollegiateMaster Student Loan Trust I (NCMSLT), The National Collegiate Student LoanTrust 2003-1 (NCSLT 2003), The National Collegiate Student Loan Trust 2004-1(NCSLT 2004-1) and NCSLT 2004-2. Processing fees receivable from TERIrepresents amounts due from TERI for expenses incurred by First MarbleheadEducation Resources, Inc. (FMER), a wholly owned subsidiary of FMC, on TERI’sbehalf.

 

The Company conducted securitizationtransactions in the second quarter of fiscal 2005 and 2004. The Company, on aquarterly basis, updates its estimate of the present value of its structuraladvisory fees and residuals receivables to reflect the passage of time, anychange in discount rates used to estimate their present value, and any changesto the trust performance metrics that the Company considers in its presentvalue estimates, such as default, recovery, prepayment and forward LondonInterbank Offered Rate (LIBOR) rates.

 

The Company made no changes in itsassumptions regarding default rates, prepayment rates and recovery rates duringthe first six months of either fiscal 2005 or 2004 for the NCT trusts, NCMSLT,NCSLT 2003, NCSLT 2004-1 or NCSLT 2004-2.

 

The Company uses an implied forward LIBORcurve to estimate trust cash flows. During the six months ended December 31,2004, the implied forward LIBOR curve flattened. This flattening of the LIBORcurve did not have a material effect on the estimated fair value of thestructural advisory fees receivable during the six months ended December 31,2004. The flattening of the curve improved the net excess spread between thetrust assets and liabilities, resulting in an increase in the estimated fairvalue of residuals receivable during the period. During the six months endedDecember 31, 2003, the rates along the implied forward LIBOR curve increased.These increases in rates resulted in an increase in the average life of theunderlying trust assets, thereby having the effect of increasing the estimated fairvalue of the structural advisory fees and residuals receivables during the period.

 

The Company bases the discount rate that ituses to calculate the present value of its additional structural advisory feeson the 10-year U.S. Treasury rate plus 200 basis points. From July 1, 2004to December 31, 2004, this rate decreased by 36 basis points from 6.58% to6.22%. From July 1, 2003 to December 31, 2003, this rate increased by92 basis points from 5.33% to 6.25%. A decrease in the 10-year U.S. Treasuryrate has the effect of increasing the estimated fair value of the Company’sstructural advisory fees receivable, while an increase in the rate has theopposite effect on the Company’s estimate of their fair value. In determiningan appropriate discount rate for valuing residuals, we review the rates used bystudent loan securitizers, as well as rates used in the much broader asset-backedsecurities (ABS) market. We believe that the 12% discount rate we use isappropriate given the expected 24-year life of the trust assets and residuals.

 

The following table summarizes the changes inthe structural advisory fees receivable for the six month periods ended December 31,2004 and 2003:

 
| ** **                                                     | ** ** | **Six months ended   December 31,** | ** ** |
|----------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                     | ** ** | **(in thousands)**                       | ** ** |
| ** **                                                     | ** ** | **2004**                                 | ** ** | **2003** | ** ** |
|                                                           |       |                                     |       |   |   |
| Fair value of structural advisory fees at  beginning of period |       | $                                        | 24,084     | (1) | $ | 10,785 |   |
| Additions from structuring new  securitizations                |       | 9,931                                    |       | 5,925 |   |
| Fair value adjustments                                         |       | 810                                      |       | (226 | ) |
| Fair value of structural advisory fees at  end of period       |       | $                                        | 34,825     |   | 16,484 | (1) |
|                                                                |            |                                          |            |  |  |  |  |

 

----

(1) Excludes additional up-front structural advisory fees received inJuly 2004 related to the December 2003 securitization transaction. See Note 7(b)for additional information.

 

The following table summarizes the changes in the residuals receivablefor the six month periods ended December 31, 2004 and 2003:

 
| ** **                                      | ** ** | **Six months ended  December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                      | ** ** | **(in thousands)**                      | ** ** |
| ** **                                      | ** ** | **2004**                                | ** ** | **2003** | ** ** |
|                                            |       |                                    |       |   |   |
| Fair value of residuals at beginning of  period |       | $                                       | 108,495    |   | $ | 43,600 |   |
| Additions from structuring new  securitizations |       | 57,057                                  |       | 29,730 |   |
| Fair value adjustments                          |       | 9,626                                   |       | 2,808 |   |
| Fair value of residuals at end of period        |       | $                                       | 175,178    |   | $ | 76,138 |   |

 

10

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The effect on the fair value of thestructural advisory fees and residuals receivables based on variations of 10%or 20%, except for the forward LIBOR rates, which are based on variations of 1%and 2% from the forward LIBOR rates at December 31, 2004, and changes inthe assumed spread between one month LIBOR rates and the auction rates whichare based on .05% and .10% changes, from the assumed levels for each keyassumption are as follows:

 

**(dollars in thousands)**

 
| **Structural  advisory fees receivables, December 31, 2004** | ** ** | $      | 34,825  |                                                     | ** ** |   |   |   |
|-------------------------------------------------------------------|------------|--------|---------|----------------------------------------------------------|------------|--------|--------|--------|
|                                                              |       |   |    |                                                     |       |   |   |
| Default rate                                                      |       |   |    | Default rate                                             |       |   |   |
| +10%                                                              |       | $      | (186    | )                                                        | -10%       |   | $      | 194    |   |
| +20%                                                              |       | (377   | )       | -20%                                                     |       | 378    |   |
| Default  recovery rate                                            |       |   |    | Default recovery rate                                    |       |   |   |
| +10%                                                              |       | — |    | -10%                                                     |       | (130   | )      |
| +20%                                                              |       | 142    |    | -20%                                                     |       | (130   | )      |
| Prepayment  rate                                                  |       |   |    | Prepayment rate                                          |       |   |   |
| +10%                                                              |       | (887   | )       | -10%                                                     |       | 936    |   |
| +20%                                                              |       | (1,728 | )       | -20%                                                     |       | 1,922  |   |
| Discount  rate                                                    |       |   |    | Discount rate                                            |       |   |   |
| +10%                                                              |       | (1,282 | )       | -10%                                                     |       | 1,346  |   |
| +20%                                                              |       | (2,507 | )       | -20%                                                     |       | 2,785  |   |
| Forward  LIBOR rates                                              |       |   |    | Forward LIBOR rates                                      |       |   |   |
| +1%                                                               |       | 1,092  |    | -1%                                                      |       | (1,202 | )      |
| +2%                                                               |       | 2,332  |    | -2%                                                      |       | (2,321 | )      |
| Change in  assumed spread between LIBOR and auction rate          |       |   |    | Change in assumed spread between LIBOR and  auction rate |       |   |   |
| +.05%                                                             |       | (1     | )  | -.05%                                                    |       | 1      |   |
| +.10%                                                             |       | (1     | )       | -.10%                                                    |       | 2      |   |
|                                                                   |            |        |         |                                                          |            |        |        |        |  |

 

**(dollars in thousands)**

 
| **Residuals  receivables, December 31, 2004**       | ** ** | $       | 175,178      |                                                     | ** ** |    |   |   |
|----------------------------------------------------------|------------|---------|--------------|----------------------------------------------------------|------------|---------|--------|--------|
|                                                     |       |    |         |                                                     |       |    |   |
| Default rate                                             |       |    |         | Default rate                                             |       |    |   |
| +10%                                                     |       | $       |  (1,528 | )                                                        | - 10%      |    | $      | 1,016  |   |
| +20%                                                     |       | (4,854  | )            | - 20%                                                    |       | 1,865   |   |
| Default  recovery rate                                   |       |    |         | Default recovery rate                                    |       |    |   |
| +10%                                                     |       | 421     |         | - 10%                                                    |       | (505    | )      |
| +20%                                                     |       | 485     |         | - 20%                                                    |       | (1,186  | )      |
| Prepayment  rate                                         |       |    |         | Prepayment rate                                          |       |    |   |
| +10%                                                     |       | (7,710  | )            | - 10%                                                    |       | 8,083   |   |
| +20%                                                     |       | (15,069 | )            | - 20%                                                    |       | 16,572  |   |
| Discount  rate                                           |       |    |         | Discount rate                                            |       |    |   |
| +10%                                                     |       | (15,867 | )            | - 10%                                                    |       | 17,779  |   |
| +20%                                                     |       | (29,971 | )            | - 20%                                                    |       | 37,797  |   |
| Forward  LIBOR rates                                     |       |    |         | Forward LIBOR rates                                      |       |    |   |
| +1%                                                      |       | 7,821   |         | - 1%                                                     |       |    | (7,842 | )      |
| +2%                                                      |       | 15,557  |         | - 2%                                                     |       | (15,607 | )      |
| Change in  assumed spread between LIBOR and auction rate |       |    |         | Change in  assumed spread between LIBOR and auction rate |       |    |   |
| +.05%                                                    |       | (1,922  | )            | -.05%                                                    |       | 1,923   |   |
| +.10%                                                    |       | (3,840  | )            | -.10%                                                    |       | 3,847   |   |

 

11

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**(5)****                                 RelatedParty Transaction**

 

At December 31, 2004 and June 30,2004, Milestone Capital Management (MCM), an institutional money managementfirm, was managing approximately $181.8 million and $145.2 million,respectively, of cash and other short-term investments for the Company andcharging its standard fees for its services.  Members of the immediate family of one of theCompany’s directors own approximately 20% of MCM’s outstanding equity.

 

**(6)****                                 Borrowingsfrom Related Parties**

 

***(a)  Line of Credit***

 

The Company entered into a $975,000 revolvingline of credit with a bank effective April 24, 2002. The line of creditmatured on April 24, 2003 and was renewed through December 31, 2003subject to the same terms and conditions, with interest payable at the greater of 6% or 1% above the highest published *Wall Street Journal*prime rate. The termsof the line of credit required that: the Company maintain accurate books andrecords; the assets be free of all liens, encumbrances and financing notapproved by the lender; and when there was a balance outstanding under theline, no dividends or payments of principal and interest on any loans held byany guarantor, officer, director or stockholder could be made. A member of theboard of directors of the Company is also a director and significantstockholder of a company that owns the bank. The Company believes that the lineof credit was on substantially the same terms as those prevailing at the sametime for comparable transactions with third parties. The Company did not renewthis credit facility upon expiration. The Company had no amounts outstandingunder this line of credit at June 30, 2003 or any time thereafter.

 

***(b)  Notes Payable to TERI***

 

In connection with the Company’s acquisitionof TERI’s loan processing operations in June 2001, the Company enteredinto a note payable agreement with TERI on June 20, 2001, amounting to$3.9 million, $2.0 million of which related to the acquisition of TERI’ssoftware and network assets and $1.9 million of which related to theCompany’s acquisition of a workforce-in-place. Principal andinterest at an annual rate of 6% are payable in 120 monthly installmentsof $43,298 commencing on July 20, 2001 and ending on June 20, 2011.The note payable is secured by the software and network assets andworkforce-in-place intangible assets. The outstanding balance of this notepayable at December 31, 2004 and June 30, 2004 amounted to $2.8million and $3.0 million, respectively.

 

The Company also entered into a second notepayable with TERI on June 20, 2001, amounting to $4.0 million, to fund theCompany’s acquisition of TERI’s loan database in June 2001. Principal and interest at an annual rate of 6% are payable in120 monthly installments of $44,408 commencing on July 20, 2001 andending on June 20, 2011. The note payable is secured by the loandatabase. The outstanding balance of this note payable was approximately $2.9and $3.0 million at December 31, 2004 and June 30, 2004, respectively.

 

**(7)****                                 OtherBorrowings**

 

***(a)   Revolving Line of Credit***

 

On August 28, 2003, the Company enteredinto an agreement with Fleet National Bank to establish a revolving line ofcredit in the amount of $10 million, which includes a sub-limit forletters of credit. Fleet National Bank was recently acquired by Bank ofAmerica, and our agreement has been assigned to Bank of America. The revolvingcredit facility matures on August 28, 2005, with interest currentlypayable, at the Company’s option, at the bank’s prime rate or LIBOR plus 2%.The revolving credit line contains financial covenants, including minimumtrailing 12-month up-front structural advisory fees, minimum tangible networth, maximum liabilities to net worth ratios and minimum cash flow to debtservice ratios, as well as certain financial reporting covenants. Thisagreement restricts the Company’s ability to pay cash dividends in the event itis in default. No amounts were outstanding under this revolving line of creditat December 31, 2004 or June 30, 2004. The proceeds, if any, will beused for working capital and general corporate purposes. Bank of America hasalso issued on the Company’s behalf a letter of credit in the amount of $0.5million in lieu of security deposits for the lease of office space. Third partybeneficiaries have not drawn upon this letter of credit, which reduces theamount the Company may borrow under the revolving credit facility.

 

***(b)   Note Payable Related to December 2003Securitization***

 

In December 2003, the Company received$7.0 million upon the issuance of a $7.25 million note to the lead underwriterof the Company’s December 2003 securitization transaction.  The Company agreed to repay this note withthe first $7.25 million of the up-front structural advisory fee that itreceived in July 2004 in connection with the December 2003securitization. This July 2004 up-front

 

12

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structuraladvisory fee payment was in addition to the $24.5 million up-front structuraladvisory fee payment received at the time of the December 2003 securitizationtransaction and, at December 31, 2003, was estimated to be $8.5 million.Because the performance of the trust created by the December 2003securitization transaction during its first six months was better thananticipated at December 31, 2003, the Company received an additional $1.75million in July 2004 resulting in a total second up-front structural advisoryfee payment of $10.25 million. The note was further collateralized by the first$6.3 million of residual cash flow from the December 2003securitization as well as $700,000 of restricted cash. The note was paid infull in July 2004.

 

**(8)****                                 Stockholders’Equity**

 

***InitialPublic Offering***

 

In November 2003, an aggregate of14,375,000 shares of the Company’s common stock were sold in an initial publicoffering at a price of $16.00 per share, including:

 

•                  7,906,250shares sold by the Company; and

 

•                  6,468,750shares sold by the Company’s selling stockholders.

 

Net proceeds of the initial public offeringto the Company, after underwriting discounts and offering expenses, wereapproximately $115.1 million. The Company did not receive any of the proceedsfrom the selling stockholders.

 

***Follow-on Offering***

 

In June 2004, an aggregate of 7,406,312shares of the Company’s common stock were sold in a follow-on public offeringat a price of $36.50 per share. The Company did not sell any shares in thisoffering and therefore did not receive any proceeds from the sale of stock.Immediately prior to the follow-on offering, employees participating in theoffering exercised options to purchase 2,044,390 shares of common stock whichwere then sold in the offering. The Company received approximately $3.0 millionin the aggregate in payment of the exercise prices for these options. TheCompany incurred approximately $1.0 million in offering costs related to thisoffering, which were recorded as general and administrative expenses during thefourth quarter of fiscal 2004.

 

***EquityTransactions***

 

An executive officer of the Company had anagreement with two principal stockholders of the Company relating to shares ofcommon stock of the Company owned by these stockholders. Pursuant to thisagreement, the executive officer earned non-cash compensation of approximately$1.6 million during the first quarter of fiscal 2004. On September 30,2003, the agreement was terminated in exchange for vested options issued bythese two principal stockholders.

 

***AuthorizedShares***

 

In July 2003, the Board of Directorsapproved, and in August 2003 the stockholders approved, an increase in thetotal number of authorized shares of common stock from 14,280,440 to25,000,000. In October 2003, the Board of Directors and stockholdersapproved an increase in the total number of authorized shares of common stockfrom 25,000,000 to 100,000,000. On August 10, 2004, the Board of Directorsapproved, and on November 18, 2004 the Company’s stockholders’ approved,an increase in the total number of authorized shares of common stock from100,000,000 to 150,000,000. Also, see “Stock Splits” below.

 

***2002 Director Stock Plan***

 

In September 2002, the Board ofDirectors approved, and in August 2003, the Company’s stockholdersapproved, the 2002 Director Stock Plan and reserved 200,000 shares of commonstock for issuance to the Company’s non-employee directors.  As of December 31, 2004, options topurchase 64,000 shares of common stock have been issued under this plan.

 

***2003Stock Incentive Plan***

 

In September 2003, the Board ofDirectors and stockholders approved the 2003 Stock Incentive Plan and reserved1,200,000 shares of common stock for issuance under this plan. As of December 31,2004, 70,000 restricted stock units have been issued under this plan.

 

13

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***StockSplits***

 

In August 2003, the stockholdersapproved a 10-for-1 stock split which became effective on August 25, 2003.In October 2003, the Board of Directors approved a 4-for-1 stock split tobe effected as a stock dividend immediately prior to the Company’s initialpublic offering. On October 29, 2003, the stockholders became entitled topayment of such stock dividend. All prior period share data have beenretroactively adjusted to reflect these stock splits.

 

***2003Employee Stock Purchase Plan***

 

In October 2003, the Board of Directorsand stockholders approved the 2003 Employee Stock Purchase Plan (Stock PurchasePlan). A total of 400,000 shares of common stock are authorized for issuanceunder this plan. The Stock Purchase Plan permits eligible employees to purchaseshares of common stock at the lower of 85% of the fair market value of thecommon stock at the beginning or at the end of each offering period. Employeeswho own 5% or more of the Company’s common stock are not eligible toparticipate in the Stock Purchase Plan. Participation is voluntary. Prior to June 30,2004, no shares had been issued under this plan. During July 2004 andJanuary 2005, a total of 40,499 and 10,050 shares, respectively, were issuedunder the Stock Purchase Plan.

 

***(9) Pension Plan***

*** ***

FMER has a non-contributory defined benefitpension plan that covers substantially all FMER employees. During the secondquarter of fiscal 2005, the Company recorded a net curtailment gain of $655,000as the benefits under the plan were frozen. The following table sets forth theamounts recognized related to FMER’s defined benefit pension plan in theCompany’s condensed consolidated financial statements for the three and six monthperiods ended December 31, 2004 and 2003:

 
| ** **                                    | ** ** | **Three months ended  December 31,  (in thousands)** | ** ** | **Six months ended  December 31,  (in thousands)** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                    | ** ** | **2004**                                                  | ** ** | **2003**                                                | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Components of net periodic pension cost:**  |       |                                                      |       |                                                    |       |   |   |   |   |
| Service cost                                  |       | $                                                         | 157        |                                                    | $          | 149 |   | $ | 315 |   | $ | 298 |   |
| Interest on projected benefit obligations     |       | 62                                                        |       | 53                                                      |       | 124 |   | 106 |   |
| Loss recognized                               |       | 9                                                         |       | 17                                                      |       | 18 |   | 34 |   |
| Expected return on plan assets                |       | (42                                                       | )          | (34                                                     | )          | (84 | ) | (68 | ) |
| Net periodic pension cost before  curtailment |       | 186                                                       |       | 185                                                     |       | 373 |   | 370 |   |
| Curtailment gain                              |       | (655                                                      | )          | —                                                  |       | (655 | ) | — |   |
| Net periodic pension (gain) cost              |       | $                                                         | (469       | )                                                       | $          | 185 |   | $ | (282 | ) | $ | 370 |   |

 

***Employer Contributions***

 

During thesix months ended December 31, 2004, the Company made contributions of $312,000to FMER’s defined benefit pension plan. The Company expects to make additionalaggregate contributions of approximately $300,000 during the remainder offiscal 2005.

 

**(10)****                          NewAccounting Pronouncements**

 

On December 16, 2004, the FinancialAccounting Standards Board (FASB) issued FASB Statement No. 123 (revised 2004),“Share-Based Payment” (Statement 123R), which is a revision of FASB StatementNo. 123, “Accounting for Stock-Based Compensation.” Statement 123R supersedesAPB Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends FASBStatement No. 95, “Statement of Cash Flows.” Statement 123R requires a publiccompany to measure the cost of employee services received in exchange for anaward of equity instruments, including stock options, based on the grant-datefair value of the award, with limited exceptions. That cost will be recognizedover the period during which the employee is required to provide service inexchange for the award, which is typically the vesting period. Statement 123Reliminates the alternative to use Opinion 25’s intrinsic value method ofaccounting that was provided in Statement 123 as originally issued.

 

The Company expects to adopt Statement 123Ron July 1, 2005. Statement 123R permits public companies to adopt itsrequirements using one of two methods:

 

1.                                     A“modified prospective” method in which compensation cost is recognizedbeginning with the effective date (a) based on the requirements of Statement 123Rfor all share-based payments granted after the effective date and (b) based onthe requirements of Statement 123 for all awards granted to employees prior tothe effective date of Statement 123R that remain unvested on the effectivedate.

 

14

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2.                                       A“modified retrospective” method which includes the requirements of the modifiedprospective method described above, but also permits entities to restate itspreviously issued financial statements to include in its income statement amountspreviously recognized under Statement 123 for purposes of pro forma disclosuresfor either (a) all prior periods presented or (b) prior interim periods of theyear of adoption.

 

The Company plans to adopt Statement 123R using themodified-prospective method.

 

As permittedby Statement 123, the Company currently accounts for share-based payments toemployees using Opinion 25’s intrinsic value method and, as such, generallyrecognizes no compensation cost for employee stock options. The adoption ofStatement 123R’s fair-value method will impact the Company’s results ofoperations, although the impact of adoption of Statement 123R cannot bepredicted at this time because it will depend on levels of share-based paymentsgranted in the future. However, had the Company adopted Statement 123R in priorperiods, the impact of that standard would have approximately the impact ofStatement 123 as described in the disclosure of pro forma net income and earningsper share in Note 2 to the Company’s condensed consolidated financialstatements. Statement 123R also requires the benefits of tax deductions in excessof recognized compensation cost to be reported as a financing cash flow, ratherthan as an operating cash flow as required under current literature. Thisrequirement will reduce net operating cash flows and increase net financingcash flows in periods after adoption. While the Company cannot estimate what theimpact on the cash flow statement will be in the future (because they dependon, among other things, when employees exercise stock options), the amount ofoperating cash flows recognized in prior periods for such excess tax deductionswere $2.7 million during the six months ended December 31, 2004 and $29.9million during the year ended June 30, 2004.

 

Beginning July 1, 2003, and forsecuritization trusts created after January 31, 2003, the Company appliedFASB Interpretation (FIN) No. 46, “Consolidation of Variable InterestEntities, an interpretation of ARB No. 51,” in assessing consolidation.FIN No. 46 provided a new framework for identifying variable interestentities and determining when a company should include the assets, liabilities,non-controlling interests and results of activities of a variable interestentity in its consolidated financial statements.

 

On December 24, 2003, the FASB issued FINNo. 46 (revised December 2003), “Consolidation of Variable InterestEntities” (FIN No. 46R), which addressed how a business enterprise shouldevaluate whether it has a controlling interest in an entity through means otherthan voting rights and accordingly should consolidate the entity.  FIN No. 46R has replaced FIN No. 46.  At December 31, 2004, the securitizationtrusts created after January 31, 2003 have either met the criteria to be aqualified special-purpose entity (QSPE), as defined in paragraph 35 ofFASB Statement No. 140, “Accounting for the Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities,” or the Company hasdetermined that it is not the primary beneficiary of the securitization trusts,as defined by FIN No. 46R. Accordingly, the Company did not consolidatethese existing securitization trusts in these financial statements. Inaddition, the securitization trusts created prior to January 31, 2003 havebeen amended in order for them to be considered QSPEs. The adoption of FINNo. 46R, which the Company began to apply in December 2003, did nothave a material impact on the Company’s consolidated financial condition,results of operations, earnings per share or cash flows.

 

The FASB issued an Exposure Draft, “QualifyingSpecial-Purpose Entities and Isolation of Transferred Assets—an amendment ofFASB Statement No. 140.” This proposal would, among other things, changethe requirements that an entity must meet to be considered a QSPE. The FASB hasannounced that it expects to issue in the third calendar quarter of 2005 arevised exposure draft that would include all of the proposed amendments toFASB Statement No. 140.  The Company ismonitoring the status of this exposure draft to assess its impact on itsconsolidated financial statements.

 

**(11) Subsequent Events**

 

***Equipment Financing Lease***

 

InJanuary 2005, the Company entered into an equipment financing lease agreementwhich will be used to finance the purchases of furniture and equipment. The agreementallows the Company to finance up to $20 million of furniture and equipmentpurchased before December 30, 2005.

*** ***

***Follow-on Offering***

 

In January 2005, an aggregate of3,933,605 shares of the Company’s common stock were sold in a follow-on publicoffering at a price of $57.40 per share. The Company did not sell any shares inthis offering and therefore did not receive any proceeds from the sale ofstock. Immediately prior to the follow-on offering, an employee participatingin the offering exercised an option to purchase 1,012,980 shares of commonstock which were then sold in the offering. The Company received approximately$1.9 million in payment of the exercise price for this option. The Company has recordedas general and administrative expenses approximately $0.4 million in offeringcosts related to this offering, most of which was recorded during the secondquarter of fiscal 2005.

 

15

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**Item 2-Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

*You should read thefollowing discussion and analysis of our financial condition and results ofoperations together with our condensed consolidated financial statements andaccompanying notes included elsewhere in this filing. In addition to thehistorical information, the discussion contains certain forward-lookingstatements that involve risks and uncertainties. Our actual results coulddiffer materially from those expressed or implied by the forward-lookingstatements due to our critical accounting policies and factors including, butnot limited to, those set forth under “Factors That May Affect Future Results”below.*

 

**Executive Summary**

 

***Overview***

 

We provide outsourcing services for privateeducation lending in the United States. We provide services in connection witheach of the five typical phases of the student loan lifecycle, offering ourclients a single point of interface for:

 

**•**                  program design and marketing;

 

**•**                  borrower inquiry and application;

 

**•**                  loan origination and disbursement;

 

**•**                  loan securitization; and

 

**•**                  loanservicing.

 

We receive fees for the services we provide in connection with bothprocessing our clients’ private student loans and structuring and administeringsecuritizations of those loans. Securitization refers to the technique ofpooling loans and selling them to a special purpose, bankruptcy remote entity,typically a trust, which issues securities to investors backed by those loans.

 

We do not take a direct ownership interest inthe loans 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, we are obligated by contract to observe them. Lenderswho wish to have their loans guaranteed by TERI are required to meet TERI’sunderwriting criteria. Although we oversee loan servicing as a component of ouradministrative duties, we do not act as a loan servicer.

 

We currently focus on facilitating privatestudent loans for undergraduate, graduate and professional education, althoughwe also provide service offerings for continuing education programs, primaryand secondary schools, career training and study abroad programs. During thefirst six months of fiscal 2005, we processed approximately 533,000 loanapplications and facilitated $1.6 billion in loans at over 4,800 schools.During fiscal 2004, we processed over 560,000 loan applications and facilitated$1.8 billion in loans at over 4,800 schools. We have provided structural,advisory and other services for 23 securitization transactions since ourformation in 1991.

 

We offer services in connection with loanprograms targeted at two primary marketing channels:

 

*Private label* programs that:

 

**•**                  lenders market directly to prospective student borrowers andtheir families;

 

**•**                  lenders market directly to educational institutions;

 

**•**                  third parties who are not themselves lenders design andmarket directly to prospective student borrowers and their families; loansunder these programs are made by referral lenders;

 

**•**                  third parties who are not themselves lenders design andmarket directly to educational institutions; loans under these

 

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programs are madeby referral lenders; and

 

**•**                  businesses, unions, affinity groups and other organizationsoffer to their employees or members.

 

*Guaranteed Access toEducation*, or *GATE*,programs that educational institutions offer directly to their students.

 

During fiscal 2004, we securitized bothprivate label loans and GATE loans. During the first six months of fiscal 2005,we facilitated one securitization of only private label loans. We expect we willsecuritize GATE loans, including those we have facilitated during the first sixmonths of our current fiscal year, in the fourth fiscal quarter. During fiscal2004, our private label programs contributed $191.1 million, or 96%, ofour total service revenue, while our GATE programs contributed$8.2 million, or 4%, of our total service revenue.

 

In June 2001, we significantly enhanced our riskmanagement and loan processing capabilities through a strategic relationshipwith The Education Resources Institute, Inc., or TERI, the nation’s oldestand largest guarantor of private student loans. We acquired TERI’s loanprocessing operations, including its historical database, but not itsinvestment assets or guarantee liabilities. In connection with this acquisition,161 members of TERI’s staff became our employees. In addition, we entered intoa master servicing agreement pursuant to which TERI engages us to provide loanorigination and processing services with respect to the loans generated throughthe private label programs we facilitate, as well as other TERI-guaranteedloans. TERI reimburses us for the expenses we incur in providing theseservices. Under the terms of a master loan guaranty agreement that we enteredinto with TERI in 2001, we also agreed to provide a beneficial interest forTERI of 25% of the residual value of TERI-guaranteed loans owned by thesecuritization trusts that purchase the loans, and a right of first refusal toguarantee our private label clients’ existing and future loan programs. In October 2004,we renewed our master servicing agreement, master loan guaranty agreement andcertain additional agreements with TERI, in each case for an additional termthrough June 2011.  In addition, weentered into a supplement to the master loan guaranty agreement, under which wegranted to TERI a right to elect once each fiscal year to increase the amountof its administration fees by 25 basis points, with a corresponding reductionfrom 25 percent to 20 percent in TERI’s ownership of the residual value of theTERI-guaranteed loans purchased during that year by the securitization trustand a resulting increase from 75 percent to 80 percent in our residualownership.  TERI has made such anelection for the fiscal year ending June 30, 2005.

 

The primary driver of our results ofoperations and financial condition is the volume of loans for which we provideoutsourcing services from loan origination through securitization. Wefacilitated the securitization of $1.25 billion of student loans duringfiscal 2004, up from $560 million during fiscal 2003.

 

During the first six months of fiscal 2005,we facilitated approximately 176,000 loans in an aggregate principal amount ofapproximately $1.6 billion. Approximately $1.3 billion of this amount wasavailable to us for securitization. During the first six months of fiscal 2004,we facilitated approximately 112,000 loans in an aggregate principal amount ofapproximately $981 million. Approximately $747 million of this amount wasavailable to us for securitization. During fiscal 2004, we facilitatedapproximately 200,000 loans in an aggregate principal amount of approximately$1.8 billion. Approximately $1.38 billion of this amount was available tous for securitization.

 

The dollar volume of the loans that wefacilitated in the first six months of fiscal 2005 increased 62% as compared tothe first six months of fiscal 2004. The loans that we facilitated that areavailable to us for securitization increased 76% in the first six months offiscal 2005 as compared to the first six months of fiscal 2004.

 

Although we offer our clients a fullyintegrated suite of outsourcing services, we do not charge separate fees formany of these services. Moreover, although we receive fees for providing loanprocessing services to TERI in connection with TERI-guaranteed loans, thesefees represent reimbursement of the direct expenses we incur. Accordingly, wedo not earn a profit on these fees. Although we provide these various serviceswithout charging a separate fee, or at “cost” in the case of TERI-guaranteedloans, we generally enter into agreements with the private label lenders, andBank of America, N.A. in the case of GATE programs, giving us the exclusiveright to securitize the loans that they do not intend to hold, and we receivestructural advisory fees and residuals for facilitating securitizations ofthese loans. Our level of profitability depends on these structural advisoryfees and residuals. We discuss the manner in which we recognize them as revenuein greater detail below. We may in the future enter into arrangements withprivate label lenders under which we provide outsourcing services, but do nothave the exclusive right to securitize the loans that they originate.

 

Changes in any of the following factors canmaterially affect our financial results:

 

**•**                  the demand for private education financing;

 

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**•**                  the competition for providing private education financing;

 

**•**                  the education financing preferences of students and theirfamilies;

 

•                  applicablelaws and regulations, which may affect the terms upon which our clients agreeto make private student loans and the cost and complexity of our loanfacilitation operations;

 

**•**                  the private student loan securitization market, including thecosts or availability of financing;

 

**•**                  the general interest rate environment, including its effecton our discount rates;

 

**•**                  our critical accounting policies and estimates;

 

**•**                  borrower default rates; and

 

**•**                  prepayment rates on private student loans, includingprepayments through loan consolidation.

 

***Securitizations andRelated Revenue***

 

We structure and facilitate securitizationtransactions for our clients through a series of bankruptcy remote, qualifiedspecial purpose statutory trusts. The trusts purchase private student loansfrom the originating lenders, which relinquish to the trust their ownershipinterest in the loans. The debt instruments that the trusts issue to financethe purchase of these student loans are obligations of the trusts, rather thanour obligations or those of originating lenders. As of December 31, 2004, wehave utilized the following special purpose entities for the securitizations wehave structured:

 

**•**                  *The National Collegiate Student Loan Trust 2004-2*,or *NCSLT 2004-2*, was formed in October 2004to purchase exclusively TERI-guaranteed private label loans.

 

**•**                  *The National Collegiate Student Loan Trust 2004-1*,or *NCSLT 2004-1*, was formed inMay 2004 to purchase exclusively TERI-guaranteed private label loans.

 

**•**                  *The National Collegiate Student Loan Trust 2003-1*,or *NCSLT 2003*, was formed in December 2003to purchase exclusively TERI-guaranteed private label loans.

 

**•**                  *The National Collegiate Master Student Loan Trust I*,or *NCMSLT*, was formed in fiscal2002 to purchase exclusively TERI-guaranteed private label loans.

 

**•**                  *The National Collegiate Trust*, or *NCT*, was formed in fiscal 1993 and hasestablished separate securitization trusts, which we refer to as the NCTtrusts, that have purchased primarily GATE loans and a limited number of TERI-guaranteedand other loans.

 

In the future, we may securitize privatelabel or GATE loans using new trust vehicles.

 

Under the terms of some of our contracts withkey lender clients, we have an obligation to securitize periodically, typicallytwice per year, the private student loans that these clients originate, and wemay agree with other lenders to securitize more frequently in the future. If wedo not honor our obligations to these lenders, we may be required to payliquidated damages, generally not exceeding an amount equal to 1% of the faceamount of the loans available for securitization.

 

We receive several types of fees inconnection with our securitization services:

 

*Structural advisory fees*.  We charge structural advisory fees that arepaid in two portions:

 

**•**                  *Up-front*. We receive a portion of the structural advisory fees at the time thesecuritization trust purchases the loans, or soon thereafter. For these fees,we structure the securities sold in the securitization, coordinate theattorneys, accountants, trustees, loan servicers, loan originators and othertransaction participants and prepare the cash flow modeling for rating agenciesand financial guarantee insurers, as needed. In securitizations we facilitatedin fiscal

 

18

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2005 and 2004, these fees have ranged from4.7% to 8.1% of the principal and accrued interest of the loans securitized;and

 

**•**                  *Additional*.  We receive a portion of the structuraladvisory fees over time, based on the amount of loans outstanding in the trustfrom time to time over the life of the trust. This portion accumulates monthlyfrom the date of a securitization transaction at a rate of 15 basis points peryear. We begin to receive this additional portion, plus interest, once theratio of trust assets to trust liabilities, which we refer to as the “parityratio,” reaches a stipulated

level, whichranges from 103.0% to 105.0%. The level applicable to a particular trust isdetermined at securitization. We currently expect to receive the additionalfees beginning five to seven years after the date of a particular securitizationtransaction.

 

*Residuals*.  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 entitles us to receive:

 

**•**                  inconnection with the securitizations in NCSLT 2004-2, 80% of the residual cashflows once a parity ratio of 103.0% is reached and maintained;

 

**•**                  inconnection with the securitizations in NCSLT 2004-1 and NCSLT 2003, 75% of theresidual cash flows once a parity ratio of 103.0% is reached and maintained;

 

**•**                  inconnection with securitizations in NCMSLT, 75% of the residual cash flows oncea parity ratio of 103.5% is reached and maintained; and

 

**•**                  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 securitized GATE loans, an additional 10% of the residualcash flows.

 

Our residual interest derives almostexclusively from the services we perform in connection with each securitizationrather than from a direct cash contribution to the securitization trust. Wecontributed no capital to NCSLT 2004-2, NCSLT 2004-1, NCSLT 2003 or NCMSLT, thetrusts that have securitized solely TERI-guaranteed private label loans. Inconnection with the three most recent securitizations of GATE loans in the NCTtrusts, in order to accommodate a limited number of schools, we invested in theaggregate approximately one-third of our GATE-related up-front structuraladvisory fees to eliminate the risk exposure of those schools. Theseinvestments, which reduced our up-front structural advisory fees that wouldhave been recognized in these periods, totaled $1.3 million,$2.0 million and $1.8 million in fiscal 2004, 2003 and 2002,respectively. In fiscal 2004, our investment comprised 1.5% of our totalup-front structural advisory fees. In exchange for these investments, wereceived the rights to the residual interest that these schools would otherwisehold in the trust and accounted for these rights as residuals, consistent withthe manner in which we account for our other residuals. The value of these residualinterests is primarily affected by the loan performance at each school. In thecase of securitizations in NCSLT 2004-2, NCSLT 2004-1, NCSLT 2003 and NCMSLT,we currently expect to receive the residuals beginning approximately five tosix years after the date of a particular securitization. In the case ofsecuritizations in the NCT trusts, we currently expect to receive the residualsbeginning 12 to 15 years after the date of a particular securitization.

 

*Administrative andother fees*. Our administrative and other fees represent primarily the administrativefees we receive from the trusts for their daily management and for the serviceswe provide in obtaining information from the loan servicers and reporting thisand other information to the parties related to the securitization. We receivefees ranging from 5 to 20 basis points per year of the student loan balance inthe trust. In addition, in connection with some securitizations, we receiveother fees from originating lenders when their loans are purchased by thesecuritization trust, although these fees have not been material and we do notexpect them to be material in the future. We also record as administrative andother fees the reimbursement we receive for certain call center costs. Thesefees were approximately $0.4 million and $0.2 million for the first six monthsof fiscal 2005 and fiscal 2004, respectively. The increase in these fees isprimarily due to the increase in loan facilitations.

 

***Processing Fees fromTERI***

 

We provide outsourcing services to TERI,including loan origination, customer service, default prevention, defaultprocessing and administrative services under a master servicing agreementbetween TERI and us. We recognize as revenue the monthly reimbursement thatTERI provides us for the expenses we incur in providing these services.

 

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***Recognition andValuation of Service Revenue***

 

We recognize up-front structural advisoryfees as revenue at the time the securitization trust purchases the loans. Inorder for the securitization trust to purchase the loans, all of the applicableservices must be performed, rating agencies must deliver their ratings letters,transaction counsel must deliver the required legal opinions and theunderwriters must receive the debt securities created 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 accounting principlesgenerally accepted in the United States, 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 and 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. We estimatethe present value of the additional structural advisory fees and residualsbased on certain assumptions we make about the timing and amount of payment.

 

We are required to measure the additionalstructural advisory fees and residuals like investments in debt securitiesclassified as available-for-sale or trading, similar to retained interests insecuritizations. Accordingly, we record additional structural advisory fees andresiduals receivables on our balance sheet at fair value using a discountedcash flow model. We estimate the fair value both initially and at eachsubsequent quarter and reflect the change in value in earnings for that period.

 

Because there are no quoted market prices forour additional structural advisory fees and residuals receivables, we usecertain key assumptions to estimate their values. See “Application of CriticalAccounting Policies and Estimates—Service Revenue.”

 

We recognize administrative and other fees,as well as processing fees from TERI, as revenue at the time that we performthe underlying services.

 

***QuarterlyFluctuations***

 

Our quarterly revenue, operating results andprofitability have varied and are expected to continue to vary on a quarterlybasis primarily because of the timing of the securitizations that we structure.During fiscal 2005 and fiscal 2004, we facilitated securitizations in thesecond fiscal quarter. During fiscal 2004, we also facilitated twosecuritization transactions in the fourth fiscal quarter. We expect to closeadditional securitization transactions in the third and fourth quarters offiscal 2005. The following tables set forth our quarterly service revenue and netincome (loss) for each of the first and second quarters of fiscal 2005 and foreach of the quarters of fiscal 2004:

 
| ** **        | ** ** | **2005 fiscal quarter** | ** ** |
|-------------------|------------|-------------------------|------------|
| ** **        | ** ** | **First**               | ** ** | **Second** | ** ** |
| ** **        | ** ** | **(in thousands)**      | ** ** |
| Service revenue   |       | $                       | 22,404     |   | 155,837 |   |
| Net (loss) income |       | (5,352                  | )          | 74,530 |   |
|                   |            |                         |            |  |  |  |

 
| ** **        | ** ** | **2004 fiscal quarter** | ** ** |
|-------------------|------------|-------------------------|------------|
| ** **        | ** ** | **First**               | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** |
| ** **        | ** ** | ** **              | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| Service revenue   |       | $                       | 9,469      |   | $ | 77,523 |   | $ | 11,127 |   | $ | 101,141 |   |
| Net (loss) income |       | (3,077                  | )          | 36,639 |   | (3,566 | ) | 45,276 |   |
|                   |            |                         |            |  |  |  |  |  |  |  |  |  |  |

 

***Application ofCritical Accounting Policies and Estimates***

 

Our consolidated financial statements havebeen prepared in accordance with accounting principles generally accepted inthe United States. The preparation of these financial statements requires us tomake estimates, assumptions and judgments that affect the reported amounts ofassets and liabilities and the reported amounts of income and expenses duringthe reporting periods. We base our estimates, assumptions and judgments onhistorical experience and on various other factors that we believe arereasonable under the circumstances. Actual results may differ from theseestimates under varying assumptions or conditions.

 

Our significant accounting policies are morefully described in Note 2 of the notes to the audited consolidatedfinancial statements for the year ended June 30, 2004, which are includedin our annual report on Form 10-K filed with the Securities and ExchangeCommission on September 15, 2004. On an ongoing basis, we evaluate ourestimates and judgments, particularly as they relate to accounting policiesthat we believe are most important to the portrayal of our financial conditionand results of operations.

 

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We regard an accountingestimate or assumption underlying our financial statements to be a “criticalaccounting estimate” where:

 

**•**                  thenature of the estimate or assumption is material due to the level ofsubjectivity and judgment necessary to account for highly uncertain matters orthe susceptibility of such matters to change; and

 

**•**                  the impact of the estimates and assumptions on our financialcondition or operating performance is material.

 

We have discussed our accounting policieswith the audit committee of our Board of Directors, and we believe that ourestimates relating to the recognition and valuation of our securitzation-relatedservice revenue, as well as the valuation of goodwill and intangible assets,fit the definition of critical accounting estimates. We also consider ourpolicy with respect to the determination of whether or not to consolidate thesecuritization trusts that we facilitate to be a critical accounting policy.

 

***Service Revenue***

 

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

 

Because there are no quoted market prices forour additional structural advisory fees and residuals receivables, we use thefollowing key assumptions to estimate their values:

 

**•**                  the discount rate, which we use to calculate the presentvalue of our additional structural advisory fees and residuals;

 

**•**                  the annual compound rate of student loan prepayments, whichwe refer to as the constant prepayment rate, or CPR;

 

**•**                  thetrend of interest rates over the life of the loan pool, including the forwardLondon Interbank Offered Rate, or LIBOR, and the spread between LIBOR andauction rates; and

 

**•**                  expecteddefaults, net of recoveries.

 

We base these estimates on our proprietaryhistorical data, third-party data and our industry experience, adjusting forspecific program and borrower characteristics such as loan type and borrowercreditworthiness. We also monitor trends in loan performance over time, andmake adjustments we believe are necessary to value properly our receivablesbalance. We recognize the revenue associated with our processing fees from TERIand our administrative and other fees as we perform these services.

 

The following table shows the loan performanceassumptions for the life of each trust at December 31, 2004:

 
| ** **   | ** ** | ** **     | ** ** | **Percentage rate** | ** ** | **Discount rate** | ** ** |
|--------------|------------|----------------|------------|---------------------|------------|-------------------|------------|
| **Trust**    | ** ** | **Loan type**  | ** ** | **Default**         | ** ** | **Recovery**      | ** ** | **CPR** | ** ** | **Structural  advisory fees** | ** ** | **Residuals** | ** ** |
| NCSLT 2004-2 |       | Private  label |       | 9.12                | %          | 40                | %          | 7 | % | 6.22 | % | 12 | % |
| NCSLT 2004-1 |       | Private  label |       | 8.76                |       | 40                |       | 7 |   | 6.22 |   | 12 |   |
| NCSLT 2003   |       | Private  label |       | 9.06                |       | 40                |       | 7 |   | 6.22 |   | 12 |   |
| NCMSLT       |       | Private  label |       | 8.08                |       | 40                |       | 7 |   | 6.22 |   | 12 |   |
| NCT trusts   |       | Private  label |       | 7.11                |       | 46                |       | 7 |   | 6.22 |   | 12 |   |
| NCT trusts   |       | GATE           |       | 23.23               |       | 47                |       | 4 |   | 6.22 |   | 12 |   |

 

In selecting loan performance assumptions, weconsider the underlying creditworthiness of the student loan borrowers as wellas the type of loans being securitized. We analyze creditworthiness in severaltiers, and select appropriate loan performance assumptions based on thesetiers. For example, approximately five percent of the loans securitized inNCSLT 2004-2, three percent of the loans securitized in NCSLT 2004-1 and fourpercent of the loans securitized in NCSLT 2003 represent a new product lineoffered beginning in fiscal 2003 by some of our private label clients. This newproduct line includes co-signed loans for which the co-signer has a Fair, Isaacand Company, or FICO, credit score between 625 and 644, which is lower than ourother tiered products, which require a FICO score of 645 or above. We worked,in consultation with TERI and our bank clients, to structure and price thisloan product to reflect its increased default risk. Accordingly, the interestrate being charged on these loans and the segregated reserves that TERIprovided to NCSLT 2004-2, NCSLT 2004-1 and NCSLT 2003 to cover projecteddefault exposure on these loans are greater than those provided for our clients’other loan products. Although the inclusion of these new loans contributed toestimated overall default rates for NCSLT 2004-2, NCSLT 2004-1 and NCSLT 2003that are 104 basis points, 68 basis points and 98 basis points higher,respectively, than what we estimated for NCMSLT, the average FICO score forloans in each of the trusts remained above 700.

 

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Our private label loan programs, under whichapproximately 80% of the borrowers have creditworthy co-borrowers, typicallyhave an extensive credit underwriting process. GATE programs had a borrowerapproval rate of approximately 95% in fiscal 2004 as a result of the creditsupport provided by the participating schools. Accordingly, we believe thatborrowers in our private label programs will prepay at a higher rate and defaultat a lower rate than borrowers in our GATE programs.

 

We do not believe we can accurately determinethe market price of residuals generated by a pool of securitized student loans.To our knowledge, there have been no market transactions in this type of asset.In determining an appropriate discount rate for valuing residuals, we reviewedthe rates used by student loan securitizers as well as rates used in the muchbroader asset-backed securities, or ABS, market. We believe that the 12%discount rate we use is appropriate given the maximum 24-year life of the trustassets and residuals.

 

At December 31, 2004, we used a 6.22%discount rate for valuing structural advisory fees, as compared to a 6.58%discount rate at June 30, 2004. Based on the priority payment status ofstructural advisory fees in the flow of funds out of the securitization trust,we believe these fees are comparable to 10 year spreads on triple-B ratedstructured finance and corporate debt securities. Based on market quotes onsuch securities, we believe a spread over comparable maturity U.S. TreasuryNotes of 200 basis points is an appropriate discount rate in valuing theseprojected cash flows. At December 31, 2004, we used a 10 basis pointspread over LIBOR to project the cost of funding the senior auction rate notesin the trusts. This compares with an average spread for senior auction ratenotes of 10.3 basis points and 7.3 basis points for the twelve months ended December 31,2004 and June 30, 2004, respectively.

 

Other than changes in the discount rate to beapplied to structural advisory fees, we did not change any other loanperformance assumptions regarding default rates, recovery rates, CPR rates ordiscount rates in valuing these projected cash flows during the first sixmonths of fiscal 2005.

 

*Sensitivity analysis*

 

Increases in our estimates of defaults,prepayments and discount rates, increases in the spread between LIBOR andauction rates, as well as decreases in default recovery rates and themulti-year forward estimates of LIBOR would have a negative effect on the valueof our additional structural advisory fees and residuals. Student loanprepayments include either full or partial payments by a borrower in advance ofthe maturity schedule specified in the note, including payments as aresult of loan consolidation activity. Because essentially all credit defaultsare reimbursable by third parties, increases in defaults generally have thesame effect as increases in prepayments. If defaults increase beyond the levelof expected third party reimbursement, then these changes will have anadditional negative effect on the value of our additional structural advisoryfees and residuals. Also, in the case of securitizations of GATE loans in whichwe have invested a portion of our up-front structural advisory fees, increasesin estimates of defaults would reduce the value of our residual interestsbecause amounts that we would otherwise receive as residual interests would beapplied to the defaults. LIBOR is the reference rate for the loan assets and,we believe, a reasonable index for borrowings of the trusts. Because the trusts’student loan assets earn interest based on LIBOR and some trusts haveoutstanding securities that pay interest based on the results of auction rates,changes in the spread between LIBOR and the auction rate can affect theperformance of the trust.

 

The following tables show the estimatedchange in our structural advisory fees and residuals receivables balance at December 31,2004 based on changes in these loan performance assumptions:

 
| ** **                             | ** ** | **Percentage change in  assumptions** | ** ** | **Receivables  balance** | ** ** | **Percentage change in  assumptions** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|--------------------------|------------|---------------------------------------|------------|
| **Structural advisory fees**           | ** ** | **Down 20%**                          | ** ** | **Down 10%**             | ** ** | ** **                            | **Up 10%** | ** ** | **Up 20%** | ** ** |
| ** **                             | ** ** | **(dollars in thousands)**            | ** ** |
| Default rate:                          |       |                                  |       |                     |       |                                  |       |   |   |   |   |
| Private label loan trusts              |       | $                                     | 30,032     |                     | $          | 29,931                                |       | $ | 29,818 |   | $ | 29,713 |   | $ | 29,605 |   |
| GATE loan trusts(1)                    |       | 5,171                                 |       | 5,088                    |       | 5,007                                 |       | 4,926 |   | 4,843 |   |
| Total                                  |       | $                                     | 35,203     |                     | $          | 35,019                                |       | $ | 34,825 |   | $ | 34,639 |   | $ | 34,448 |   |
| Change in receivables balance:         |       | 1.09                                  | %          | 0.56                     | %          |                                  |       | (0.54 | )% | (1.08 | )% |
| Default recovery rate:                 |       |                                  |       |                     |       |                                  |       |   |   |   |   |
| Private label loan trusts              |       | $                                     | 29,818     |                     | $          | 29,818                                |       | $ | 29,818 |   | $ | 29,818 |   | $ | 29,818 |   |
| GATE loan trusts(1)                    |       | 4,877                                 |       | 4,877                    |       | 5,007                                 |       | 5,007 |   | 5,149 |   |
| Total                                  |       | $                                     | 34,695     |                     | $          | 34,695                                |       | $ | 34,825 |   | $ | 34,825 |   | $ | 34,967 |   |
| Change in receivables balance:         |       | (0.37                                 | )%         | (0.37                    | )%         |                                  |       | 0.00 | % | 0.41 | % |
| Annual constant prepayment rate (CPR): |       |                                  |       |                     |       |                                  |       |   |   |   |   |
| Private label loan trusts              |       | $                                     | 31,531     |                     | $          | 30,650                                |       | $ | 29,818 |   | $ | 29,032 |   | $ | 28,288 |   |
| GATE loan trusts(1)                    |       | 5,216                                 |       | 5,111                    |       | 5,007                                 |       | 4,906 |   | 4,809 |   |
| Total                                  |       | $                                     | 36,747     |                     | $          | 35,761                                |       | $ | 34,825 |   | $ | 33,938 |   | $ | 33,097 |   |
| Change in receivables balance:         |       | 5.52                                  | %          | 2.69                     | %          |                                  |       | (2.55 | )% | (4.96 | )% |
| Discount rate:                         |       |                                  |       |                     |       |                                  |       |   |   |   |   |
| Private label loan trusts              |       | $                                     | 32,215     |                     | $          | 30,975                                |       | $ | 29,818 |   | $ | 28,717 |   | $ | 27,669 |   |
| GATE loan trusts(1)                    |       | 5,395                                 |       | 5,196                    |       | 5,007                                 |       | 4,826 |   | 4,649 |   |
| Total                                  |       | $                                     | 37,610     |                     | $          | 36,171                                |       | $ | 34,825 |   | $ | 33,543 |   | $ | 32,318 |   |
| Change in receivables balance:         |       | 8.00                                  | %          | 3.86                     | %          |                                  |       | (3.68 | )% | (7.20 | )% |
|                                        |            |                                       |            |                          |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

22

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| ** **                                                 | ** ** | **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:                                       |       |                         |       |                        |       |                     |       |   |   |   |   |
| Private label loan trusts                                  |       | $                            | 27,821     |                        | $          | 28,814                   |       | $ | 29,818 |   | $ | 30,838 |   | $ | 31,869 |   |
| GATE loan trusts(1)                                        |       | 4,683                        |       | 4,809                       |       | 5,007                    |       | 5,079 |   | 5,288 |   |
| Total                                                      |       | $                            | 32,504     |                        | $          | 33,623                   |       | $ | 34,825 |   | $ | 35,917 |   | $ | 37,157 |   |
| Change in receivables balance:                             |       | (6.66                        | )%         | (3.45                       | )%         |                     |       | 3.14 | % | 6.70 | % |
|                                                       |       |                         |       |                        |       |                     |       |   |   |   |   |
| ** **                                                 | ** ** | **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 rates: |       |                         |       |                        |       |                     |       |   |   |   |   |
| Private label loan trusts                                  |       | $                            | 29,820     |                        | $          | 29,819                   |       | $ | 29,818 |   | $ | 29,817 |   | $ | 29,817 |   |
| GATE loan trusts(1)                                        |       | 5,007                        |       | 5,007                       |       | 5,007                    |       | 5,007 |   | 5,007 |   |
| Total                                                      |       | $                            | 34,827     |                        | $          | 34,826                   |       | $ | 34,825 |   | $ | 34,824 |   | $ | 34,824 |   |
| Change in receivables balance:                             |       | 0.01                         | %          | 0.00                        | %          |                     |       | (0.00 | )% | (0.00 | )% |
|                                                            |            |                              |            |                             |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)                                  GATEloan trusts include approximately $373.0 million of GATE loans and $42.2million of TERI-guaranteed loans.

 
| ** **                             | ** ** | **Percentage change in  assumptions** | ** ** | **Receivables  balance**   | ** ** | **Percentage change in  assumptions** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|----------------------------|------------|---------------------------------------|------------|
| **Residuals**                          | ** ** | **Down 20%**                          | ** ** | **Down 10%**               | ** ** | ** **                            | **Up 10%** | ** ** | **Up 20%** | ** ** |
| ** **                             | ** ** | ** **                            | ** ** | **(dollars in thousands)** | ** ** | ** **                            | ** ** |
| Default rate:                          |       |                                  |       |                       |       |                                  |       |   |   |   |   |
| Private label loan trusts              |       | $                                     | 172,697    |                       | $          | 171,657                               |       | $ | 170,461 |   | $ | 168,754 |   | $ | 165,509 |   |
| GATE loan trusts(1)                    |       | 4,346                                 |       | 4,537                      |       | 4,717                                 |       | 4,896 |   | 4,815 |   |
| Total                                  |       | $                                     | 177,043    |                       | $          | 176,194                               |       | $ | 175,178 |   | $ | 173,650 |   | $ | 170,324 |   |
| Change in receivables balance:         |       | 1.06                                  | %          | 0.58                       | %          |                                  |       | (0.87 | )% | (2.77 | )% |
| Default recovery rate:                 |       |                                  |       |                       |       |                                  |       |   |   |   |   |
| Private label loan trusts              |       | $                                     | 169,986    |                       | $          | 170,320                               |       | $ | 170,461 |   | $ | 170,515 |   | $ | 170,526 |   |
| GATE loan trusts(1)                    |       | 4,006                                 |       | 4,353                      |       | 4,717                                 |       | 5,084 |   | 5,137 |   |
| Total                                  |       | $                                     | 173,992    |                       | $          | 174,673                               |       | $ | 175,178 |   | $ | 175,599 |   | $ | 175,663 |   |
| Change in receivables balance:         |       | (0.68                                 | )%         | (0.29                      | )%         |                                  |       | 0.24 | % | 0.28 | % |
| Annual constant prepayment rate (CPR): |       |                                  |       |                       |       |                                  |       |   |   |   |   |
| Private label loan trusts              |       | $                                     | 186,832    |                       | $          | 178,445                               |       | $ | 170,461 |   | $ | 162,850 |   | $ | 155,587 |   |
| GATE loan trusts(1)                    |       | 4,918                                 |       | 4,816                      |       | 4,717                                 |       | 4,618 |   | 4,522 |   |
| Total                                  |       | $                                     | 191,750    |                       | $          | 183,261                               |       | $ | 175,178 |   | $ | 167,468 |   | $ | 160,109 |   |
| Change in receivables balance:         |       | 9.46                                  | %          | 4.61                       | %          |                                  |       | (4.40 | )% | (8.60 | )% |
| Discount rate:                         |       |                                  |       |                       |       |                                  |       |   |   |   |   |
| Private label loan trusts              |       | $                                     | 206,636    |                       | $          | 187,492                               |       | $ | 170,461 |   | $ | 155,271 |   | $ | 141,684 |   |
| GATE loan trusts(1)                    |       | 6,339                                 |       | 5,465                      |       | 4,717                                 |       | 4,040 |   | 3,523 |   |
| Total                                  |       | $                                     | 212,975    |                       | $          | 192,957                               |       | $ | 175,178 |   | $ | 159,311 |   | $ | 145,207 |   |
| Change in receivables balance:         |       | 21.58                                 | %          | 10.15                      | %          |                                  |       | (9.06 | )% | (17.11 | )% |
|                                        |            |                                       |            |                            |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

23

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| ** **                                                 | ** ** | **Change i-n 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:                                       |       |                         |       |                        |       |                     |       |   |   |   |   |
| Private label loan trusts                                  |       | $                            | 155,279    |                        | $          | 162,865                  |       | $ | 170,461 |   | $ | 178,060 |   | $ | 185,654 |   |
| GATE loan trusts(1)                                        |       | 4,292                        |       | 4,471                       |       | 4,717                    |       | 4,939 |   | 5,081 |   |
| Total                                                      |       | $                            | 159,571    |                        | $          | 167,336                  |       | $ | 175,178 |   | $ | 182,999 |   | $ | 190,735 |   |
| Change in receivables balance:                             |       | (8.91                        | )%         | (4.48                       | )%         |                     |       | 4.46 | % | 8.88 | % |
|                                                       |       |                         |       |                        |       |                     |       |   |   |   |   |
| ** **                                                 | ** ** | **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 rates: |       |                         |       |                        |       |                     |       |   |   |   |   |
| Private label loan trusts                                  |       | $                            | 174,308    |                        | $          | 172,384                  |       | $ | 170,461 |   | $ | 168,539 |   | $ | 166,621 |   |
| GATE loan trusts(1)                                        |       | 4,717                        |       | 4,717                       |       | 4,717                    |       | 4,717 |   | 4,717 |   |
| Total                                                      |       | $                            | 179,025    |                        | $          | 177,101                  |       | $ | 175,178 |   | $ | 173,256 |   | $ | 171,338 |   |
| Change in receivables balance:                             |       | 2.20                         | %          | 1.10                        | %          |                     |       | (1.10 | )% | (2.19 | )% |
|                                                            |            |                              |            |                             |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)                                  GATEloan trusts include approximately $373.0 million of GATE loans and $42.2million of TERI-guaranteed loans.

 

Thesesensitivities are hypothetical and should be used with caution. The effect ofeach change in assumption must be calculated independently, holding all otherassumptions constant. Because the key assumptions may not in fact beindependent, the net effect of simultaneous adverse changes in key assumptionsmay differ from the sum of the individual effects above.

 

***Valuation of Goodwill and Intangible Assets***

 

We haverecorded goodwill, representing the fair value of the workforce-in-place aswell as certain direct acquisition costs, as the excess of the purchase pricewe paid for TERI’s loan processing operations over the estimated fair value ofthe net assets of the business we acquired. In addition, we recorded as anintangible asset the fair value of the proprietary loan database that weacquired. The database currently contains eight years of monthly loan paymenthistory, including among other things, how much interest and principal eachborrower paid each month, whether the borrower paid on time, was delinquent ordefaulted on their obligation to pay, if they requested a deferment of paymentsfor a period of time, when the borrower made their final payment and theircredit information which resulted in our client’s decision to make the loan.The database also includes this information for defaulted loans, as well ascredit characteristics on certain TERI-guaranteed loans, for eleven additionalyears. We use the information in the database to construct portfolio defaultand delinquency trends and to assist our clients in loan pricing. Under theterms of our database sale and supplementation agreement with TERI, we pay TERIa monthly fee, which is recorded as an intangible asset, in consideration forthe right to receive updates to the loan database we acquired in 2001. Ouragreement with TERI had an initial term ending in June 2006. In October 2004,we exercised our right to renew this agreement for an additional five-yearterm, through June 2011. Beginning in July 2007, the monthly fee wepay to TERI pursuant to our agreement will be reduced from approximately$62,000 per month to approximately $21,000 per month.

 

We do notamortize goodwill. We evaluate goodwill for impairment on at least an annualbasis. We consider the following factors in assessing goodwill for impairment:increases in private label loan volume facilitated and securitized,the number of private label clients, and revenue and profitability related toprivate label loans. Impairment, if any, would be determined based upon adiscounted cash flow analysis, using a discount rate commensurate with therisks involved.

 

We amortizethe acquisition cost of the proprietary loan database over its estimated usefullife of five years, using the straight-line method. Capitalized costs paid toTERI for monthly database updates are amortized over five years from the dateof capitalization. We review this acquisition cost for impairment wheneverevents or changes in circumstances indicate that the carrying amount of theasset may not be recoverable.

 

Any changes inthe estimates that we use to determine the carrying value of our goodwill andintangible assets or which adversely affect their value or estimated life couldadversely affect our results of operations and financial condition. At December 31,2004, goodwill totaled $3.2 million and net intangible assets totaled $2.9 million.

 

24

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***Consolidation***

 

Our consolidated financial statements includethe accounts of First Marblehead and its subsidiaries, after eliminating intercompany accounts and transactions. We have notconsolidated the securitization trusts. Prior to July 1, 2003, this accountingtreatment was in accordance with various Emerging Issues Task Force issues andrelated interpretations. We considered, among other things, the followingfactors in assessing consolidation of the securitization trusts:

 

•                  we do not havedecision-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 do not havesubstantially all the risks and rewards of ownership, as TERI and therespective colleges provide substantially all of the student loan guarantees;

 

•                  we are a facilitator of securitization transactions, forwhich we receive market-based fees, and we are not the transferor of assets tothe securitization trusts; and

 

•                  our continuing involvement in the trusts is limited to apassive residual interest and our role as an administrator for the trust forwhich we receive market-based fees.

 

From July 1, 2003, and forsecuritization trusts created after January 31, 2003, we applied FASBInterpretation, or FIN, No. 46, “Consolidation of Variable InterestEntities, an interpretation of ARB No. 51,” in assessing consolidation.FIN No. 46 provided a new framework for identifying variable interestentities and determining when a company should include the assets, liabilities,non-controlling interests and results of activities of a variable interestentity in its consolidated financial statements.

 

On December 24, 2003, the FinancialAccounting Standards Board, or FASB, issued FIN No. 46 (revised December 2003),“Consolidation of Variable Interest Entities,” or FIN No. 46R, whichaddressed how a business enterprise should evaluate whether it has acontrolling interest in an entity through means other than voting rights andaccordingly should consolidate the entity. FIN No. 46R has replaced FINNo. 46. At December 31, 2004, the securitization trusts created afterJanuary 31, 2003 have either met the criteria to be a qualified specialpurpose entity, or QSPE, as defined in paragraph 35 of FASB StatementNo. 140, “Accounting for the Transfers and Servicing of Financial Assetsand Extinguishments of Liabilities,” or we have determined that we are not theprimary beneficiary of the securitization trusts, as defined by FINNo. 46R. Accordingly, we have not consolidated the existing securitizationtrusts in our financial statements. In addition, the securitization trustscreated prior to January 31, 2003 have been amended in order for them tobe considered QSPEs. The adoption of FINNo. 46R, which we began to apply in December 2003, did not have amaterial impact on our consolidated financial condition, results of operations,earnings per share or cash flows.

 

The FASB has issued an Exposure Draft, “QualifyingSpecial-Purpose Entities and Isolation of Transferred Assets, an amendment ofFASB Statement No. 140.” This proposal would, among other things, changethe requirements that an entity must meet to be considered a QSPE. The FASB hasannounced that it expects to issue in the third calendar quarter of 2005 arevised exposure draft that would include all of the proposed amendments toFASB Statement No. 140. We are monitoring the status of the exposure draftto assess its impact on our financial statements.

 

**Results of Operations**

 

***Three and six monthsended December 31, 2004 and 2003***

 

***Revenue Related toSecuritization Transactions***

 

The followingtable sets forth for the first six months of fiscal year 2005 and 2004 (bydollar amount and as a percentage of the total volume of loans securitized):

 

•                                          thetotal volume of loans securitized by loan type and the securitization-relatedservice revenue components, other than administrative and other fees; and

•                                          updates to reflect any fair value adjustment to additionalstructural advisory fees and residuals for prior trusts.

 

25

----

 
| **First six months of fiscal  year:** | ** ** | **Total volume of  loans  securitized(1)** | ** ** | **Up-front structural  advisory fees** | ** ** | **Additional structural  advisory fees** | ** ** | **Total  structural  advisory fees** | ** ** | **Residuals** | ** ** |
|---------------------------------------|------------|--------------------------------------------|------------|----------------------------------------|------------|------------------------------------------|------------|--------------------------------------|------------|---------------|------------|
| ** **                            | ** ** | **(dollars in thousands)**                 | ** ** |
| 2005                                  |       |                                       |       |                                   |       |                                     |       |                                 |       |          |       |   |   |   |   |   |   |
| Private  label loans                  |       | $                                          | 806,779    |                                   | $          | 65,050                                   |       | 8.1                                  | %          | $             | 9,931      |   | 1.2 | % | $ | 74,981 |   | $ | 57,057 |   | 7.1 | % |
| Trust  updates (2)                    |       | —                                     |       | —                                 |       |                                     |       | 810                                  |       |          |       | 810 |   | 9,626 |   |   |   |
| Total                                 |       | $                                          | 806,779    |                                   | $          | 65,050                                   |       |                                 |       | $             | 10,741     |   |   |   | $ | 75,791 |   | $ | 66,683 |   |   |   |
|                                  |       |                                       |       |                                   |       |                                     |       |                                 |       |          |       |   |   |   |   |   |   |   |   |   |   |   |
| 2004                                  |       |                                       |       |                                   |       |                                     |       |                                 |       |          |       |   |   |   |   |   |   |
| Private  label loans                  |       | $                                          | 532,336    |                                   | $          | 33,000                                   |       | 6.2                                  | %          | $             | 5,925      |   | 1.1 | % | $ | 38,925 |   | $ | 29,730 |   | 5.6 | % |
| Trust  updates (2)                    |       | —                                     |       | —                                 |       |                                     |       | (226                                 | )          |          |       | (226 | ) | 2,808 |   |   |   |
| Total                                 |       | $                                          | 532,336    |                                   | $          | 33,000                                   |       |                                 |       | $             | 5,699      |   |   |   | $ | 38,699 |   | $ | 32,538 |   |   |   |

 

----

(1)                                  Representstotal principal and accrued interest.

 

(2)                                  Trustupdates reflect changes resulting from the passage of time, which results inaccretion of the discounting inherent in the present value estimates ofadditional structural advisory fees and residuals, as well as changes in theassumptions underlying our estimates of the fair value of these service revenuecomponents.

 

The principal balance of loans facilitatedand available to us for later securitization at December 31, 2004 and June 30,2004 totaled $796.0 million and $276.1 million, respectively.

 

*Structural advisory fees*

 

Structural advisory fees increased to $75.8million for the first six months of fiscal 2005 from $38.7 million for thefirst six months of fiscal 2004. The increase in structural advisory fees wasprimarily a result of an increase in the securitization volume, as well as anincrease in the advisory fee rates as a percentage of the loan volume securitized.

 

*Up-frontstructural advisory fees*

 

*The up-front component of structural advisory feesincreased to $65 million for the first six months of  fiscal 2005 from $33.0 millionfor the first six months of fiscal 2004. The increase in up-front structuraladvisory fees was primarily a result of an increase in securitization volume.An increase in the up-front structural advisory fee rate as a percentage of theloan volume securitized also resulted in an increase in our revenue in thefirst six months of fiscal 2005.  Webelieve that this increase in rate is due in part to more efficientsecuritization transactions as the balance of student loans securitizedincreased and new securitizations structures were introduced.  We do not currently expect further significantimprovement in the fee rates we are able to earn on future securitizationtransactions.*

 

The following table reflects the increases in up-front structuraladvisory fees attributable to the increases in securitization volume andchanges in the fee rates and loan mix: 

 
| ** **                                                                            | ** ** | **Up-front structural advisory  fees** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                            | ** ** | **Total volume of  loans securitized** | ** ** | **Change  attributable to  increased  securitization  volume** | ** ** | **Change attributable to  change in fee rate and  loan mix** | ** ** | **Total  increase** | ** ** |
| ** **                                                                            | ** ** | **(in thousands)**                     | ** ** |
| Six months ended  December 31, 2004 vs.  six months ended December 31, 2003 |       | $                                      | 806,779    |   | $ | 17,015 |   | $ | 15,035 |   | $ | 32,050 |   |
|                                                                                       |            |                                        |            |  |  |  |  |  |  |  |  |  |  |

 

*Additional structural advisory fees*

 

The additional component of structural advisory fees increased to$10.7 million for the first six months of fiscal 2005 from$5.7 million for the first six months of fiscal 2004. The increase inadditional structural advisory fees was primarily a result of an increase insecuritization volume, but was also the result of fair value adjustments duringthe fiscal 2005 period.

 

The following tables summarize the changes in the fair value of thestructural advisory fees receivable for the three and six months ended December 31,2004 and 2003: 

 

26

----

 
| ** **                                            | ** ** | **Three months ended  December 31,** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                            | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| ** **                                            | ** ** | **(in thousands)**                        | ** ** |
|                                                  |       |                                      |       |   |   |
| Fair value  at beginning of period                    |       | $                                         | 24,703     |   | $ | 10,506 |   |
| Revenue  recognized during period                     |       |                                      |       |   |   |
| Additions  from structuring new securitizations       |       | 9,931                                     |       | 5,925 |   |
| Fair value  adjustments                               |       | 191                                       |       | 53 |   |
| Total  additional structural advisory fees recognized |       | 10,122                                    |       | 5,978 |   |
| Fair value  at end of period                          |       | $                                         | 34,825     |   | $ | 16,484 | (1) |

 
| ** **                                            | ** ** | **Six months ended  December 31,** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                            | ** ** | **2004**                                | ** ** | **2003** | ** ** |
| ** **                                            | ** ** | **(in thousands)**                      | ** ** |
|                                                  |       |                                    |       |   |   |
| Fair value  at beginning of period                    |       | $                                       | 24,084     | (1) | $ | 10,785 |   |
| Revenue  recognized during period                     |       |                                    |       |   |   |
| Additions  from structuring new securitizations       |       | 9,931                                   |       | 5,925 |   |
| Fair value  adjustments                               |       | 810                                     |       | (226 | ) |
| Total  additional structural advisory fees recognized |       | 10,741                                  |       | 5,699 |   |
| Fair value  at end of period                          |       | $                                       | 34,825     |   | $ | 16,484 | (1) |

 

----

(1) Excludes the structural advisory fee receivable from the December 2003securitization that we collected in July 2004, which was estimated to be$8.5 million at December 31, 2003 and $10.25 million at June 30,2004.

 

During the first six months of fiscal 2005, the fair value adjustmentsof our additional structural advisory fees resulted in an increase ofapproximately $0.8 million. This increase was primarily due to theaccretion of the discounting inherent in these present value estimates and thedecrease in the discount rate during the period. During the first six months offiscal 2004, the fair value adjustments of our additional structural advisoryfees resulted in a decrease of approximately $0.2 million, as the accretionof the discounting inherent in these present value estimates and the impact ofupward movement in the implied forward one-month LIBOR curve were more thanoffset by the effect of the increase in the discount rate during the period.

 

On a quarterly basis, we update our estimateof the present value of our additional structural advisory fees, which have anestimated average life of approximately six to eight years. In doing so, wegive effect to the passage of time, which results in the accretion of the discountinginherent in these present value estimates, and we also adjust for any change inthe discount rate that we use in estimating the present value of thesereceivables. For a discussion of the assumptions we make in estimating ouradditional structural advisory fees, see “—Application of Critical AccountingPolicies—Service Revenue.”

 

We base the discount rate that we use tocalculate the present value of our additional structural advisory fees on the10-year U.S. Treasury rate plus 200 basis points. We applied a discount rate of6.22% at December 31, 2004, 6.12% at September 30, 2004, 6.58% at June 30,2004, 6.25% at December 31, 2003, 5.95% at September 30, 2003, and5.33% at June 30, 2003. A decrease in the 10-year U.S. Treasury rate hasthe effect of increasing the estimated fair value of our structural advisoryfees receivable, while an increase in the rate has the opposite effect on ourestimate of their fair value.

 

On an ongoing basis, we monitor theperformance of trust assets, including default, recovery, prepayment andforward LIBOR rates experience, which we also consider in our estimates. We usean implied forward LIBOR curve to estimate trust cash flows. During the firstsix months of fiscal 2005, the implied forward LIBOR curve flattened. This flattening  did nothave a material impact on the estimated fair value of additional structuraladvisory fees receivable during the period. During the first six months of fiscal 2004, the rates along the impliedforward LIBOR curve increased.  Theseincreases in rates resulted in an increase in the average life of theunderlying trust assets, thereby increasing the estimated fair value of the structuraladvisory fees receivable during the period.  For a discussion of the assumptions we make inestimating our additional structural advisory fees receivable, see “ —Application of Critical Accounting Policies andEstimates—Service Revenue.”

 

We made no changes in our assumptionsregarding default rates, prepayment rates and recovery rates for the NCSLT2004-2, NCSLT 2004-1, NCSLT 2003, NCMSLT or NCT trusts during either the firstsix months of fiscal 2005 or 2004.

 

27

----

 

*Residuals*

 

Residuals increased to $66.7 million for the first six months offiscal 2005 from $32.5 million for the first six months of fiscal 2004.The increase in residuals was primarily a result of an increase insecuritization volume. We used a discount rate of 12% throughout the first sixmonths of fiscal 2005 and all of fiscal 2004.

 

The following table reflects the increases in residuals attributable tothe increase in securitization volume and the change attributable to updates toprior trusts: 
| ** **                                                                            | ** ** | ** **                              | ** ** | **Residuals**                                                                           | ** ** |
|---------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **Total volume  of loans  securitized** | ** ** | **Change  attributable to  increased  securitization  volume and  change in loan  mix** | ** ** | **Change  attributable to  trust updates(1)** | ** ** | **Total increase** | ** ** |
| ** **                                                                            | ** ** | **(in thousands)**                      | ** ** |
| Six months  ended December 31, 2004 vs.  six months ended December 31, 2003 |       | $                                       | 806,779    |                                                                                    | $          | 27,327 |   | $ | 6,818 |   | $ | 34,145 |   |
|                                                                                       |            |                                         |            |                                                                                         |            |  |  |  |  |  |  |  |  |

 

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(1)          The change attributableto trust updates in fiscal 2005 and 2004 was primarily the result of thepassage of time and the resulting accretion of the discounting inherent inthese present value estimates of residuals, rather than changes in ourassumptions.

 

The following tables summarize the changes in the fair value of theresiduals receivable for the three and six months ended December 31, 2004and 2003: 
| ** **                                      | ** ** | **Three months ended  December 31,** | ** ** |
|-------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                      | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| ** **                                      | ** ** | **(in thousands)**                        | ** ** |
|                                            |       |                                      |       |   |   |
| Fair value  at beginning of period              |       | $                                         | 111,955    |   | $ | 45,195 |   |
| Revenue  recognized during period               |       |                                      |       |   |   |
| Additions  from structuring new securitizations |       | 57,057                                    |       | 29,730 |   |
| Fair value  adjustments                         |       | 6,166                                     |       | 1,213 |   |
| Total  residuals fees recognized                |       | 63,223                                    |       | 30,943 |   |
| Fair value  at end of period                    |       | $                                         | 175,178    |   | $ | 76,138 |   |
|                                                 |            |                                           |            |  |  |  |  |  |

 
| ** **                                      | ** ** | **Six months ended  December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                      | ** ** | **2004**                                | ** ** | **2003** | ** ** |
| ** **                                      | ** ** | **(in thousands)**                      | ** ** |
|                                            |       |                                    |       |   |   |
| Fair value  at beginning of period              |       | $                                       | 108,495    |   | $ | 43,600 |   |
| Revenue  recognized during period               |       |                                    |       |   |   |
| Additions  from structuring new securitizations |       | 57,057                                  |       | 29,730 |   |
| Fair value  adjustments                         |       | 9,626                                   |       | 2,808 |   |
| Total  residuals fees recognized                |       | 66,683                                  |       | 32,538 |   |
| Fair value  at end of period                    |       | $                                       | 175,178    |   | $ | 76,138 |   |
|                                                 |            |                                         |            |  |  |  |  |  |  |

 

During the first six months of fiscal 2005and the first six months of fiscal 2004, the fair value adjustments of ourresiduals receivable resulted in an increase of approximately $9.6 millionand $2.8 million, respectively, due to the passage of time and the impact ofmovement in the implied forward LIBOR curve. The amount of this fair valueadjustment also increased between periods as the underlying receivables balanceincreased. We expect that adjustments for the passage of time will continue toincrease as we conduct more securitization transactions and thereby add to theresidual revenues that we discount to present value.

 

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As we do with our additional structuraladvisory fees, on a quarterly basis, we update our estimate of the presentvalue of our residuals. In doing so, we give effect for the passage of time,which results in the accretion of the discounting inherent in these presentvalue estimates, and we also adjust for any change in the discount rate that weuse in estimating the present value of these receivables. We used a 12%discount factor during the first six months of fiscal 2005 and fiscal 2004. Wealso monitor the performance of trust assets, including default, recovery,prepayment and forward LIBOR rates experience, which we also consider in ourestimates. We use an implied forward LIBOR curve to estimate trust cash flows.During the first six months of fiscal 2005, the implied forward LIBOR curveflattened. The flattening of the curve improved the net excess spread betweenthe trust assets and liabilities, resulting in an increase in the estimated fairvalue of residuals receivable during the period. During the first six months offiscal 2004, the rates along the implied forward LIBOR curve increased.  These increases in rates resulted in anincrease in the average life of the underlying trust assets, thereby increasingthe estimated fair value of the residuals receivable during the period.  For a discussion of the assumptions we makein estimating our residuals, see “—Application of Critical Accounting Policiesand Estimates—Service Revenue.”

 

In determining an appropriate discount ratefor valuing residuals, we review the rates used by student loan securitizers, as well as rates used in the much broader ABSmarket. We believe that the 12% discount rate we use is appropriate given themaximum 24-year life of the trust assets and residuals.

 

For a discussion of the assumptions we makein estimating our residuals, see “—Application of Critical Accounting Policiesand Estimates—Service Revenue.”

 

*Administrative and other fees*

 

Administrative and other fees increased to$0.9 million in the second quarter of fiscal 2005 from $0.5 million in thesecond quarter of fiscal 2004, and increased to $1.8 million for the first sixmonths of fiscal 2005 from $0.8 million for the first six months of fiscal 2004.The increase was due primarily to increasing student loan balances in thesecuritization trusts during the fiscal 2005 period compared to the fiscal 2004period. We expect that our administrative and other fees will continue toincrease as the student loan balances in the securitization trusts continue toincrease.

 

*Processing fees from TERI*

 

Processing fees from TERI increased to $16.6million for the second quarter of fiscal 2005 from $7.1 million for the secondquarter of fiscal 2004, and increased to $33.9 million for the first six monthsof fiscal 2005 from $15.0 million for the first six months of fiscal 2004.The increase was due to increased reimbursed expenses required to process thevolume of private label loans that we facilitated during the fiscal 2005period, which increased to $1.5 billion for the first six months of fiscal 2005from $931 million for the first six months of fiscal 2004. We expect that ourprocessing fees from TERI will continue to increase as we devote additionalpersonnel and other resources to facilitate expected increases in private labelloan volumes.

 

***Operating Expenses***

 

Total operating expenses increased to $29.7million in the second quarter of fiscal 2005 from $15.5 million in the secondquarter of fiscal 2004. Total operating expenses increased to $61.5 million forthe first six months of fiscal 2005 from $30.7 million for the first sixmonths of fiscal 2004. Compensation and benefits increased to $15.3 million inthe second quarter of fiscal 2005 from $7.8 million in the second quarter offiscal 2004, and increased to $30.2 million for the first six months of fiscal2005 from $16.7 million for the first six months of fiscal 2004. Generaland administrative expenses increased to $14.4 million in the second quarter offiscal 2005 from $7.7 million in the second quarter of fiscal 2004, andincreased to $31.3 million for the first six months of fiscal 2005 from$14.0 million for the first six months of fiscal 2004.

 

Compensation and benefits and general andadministrative expenses increased primarily as a result of an increase inpersonnel. We hired additional personnel to meet the operating requirementsfrom our growing loan processing and securitization activities. As ourfinancial performance improves, we anticipate awarding higher performance-basedcash compensation to our employees.

 

General and administrative expenses alsoincreased as a result of an increase in consulting fees, an increase inprofessional fees, an increase in external call centercosts and an increase in occupancy costs. Consulting fees increased to $3.0million for the second quarter of fiscal 2005 from $0.9 million for the secondquarter of fiscal 2004, and increased to $7.4 million in the first six monthsof fiscal 2005 from $1.6 million in the first six months of fiscal 2004,primarily as a result of the hiring of experts to assist us in our redesignefforts for our loan origination systems. Professional fees increased to $2.5million for the second quarter of fiscal 2005 from $1.8 million for the secondquarter of fiscal 2004, and increased to $4.9 million in the first six monthsof fiscal 2005 from $2.7 million in the first six months of fiscal 2004. Theseexpenses increased primarily as a result of increased legal, audit and investorrelations expenses as a result of being a public company. In addition, weincurred greater recruiting and placement fees as we hired additionalemployees. External call center costs increased to $1.7 million for the secondquarter of fiscal 2005 from $0.7 million for the second quarter of fiscal 2004,and increased to $4.5 million for the first six months of fiscal 2005 from $1.9million in the first six months of fiscal 2004. The increase in external callcenter costs was primarily due to the increase in

 

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the volume ofloans facilitated during the current year period. Occupancy expenses increasedto $2.2 million for the second quarter of fiscal 2005 from $0.9 million for thesecond quarter of fiscal 2004, and increased to $4.4 million in the first sixmonths of fiscal 2005 from $1.6 million in the first six months of fiscal 2004as we moved and expanded our corporate headquarters and expanded our loanprocessing operations throughout fiscal 2004 and the first six months of fiscal2005.

 

We expect that our operating expenses willcontinue to increase as we devote additional resources to the expectedincreasing loan volumes facilitated for our existing and new clients and as aresult of increased space under lease.

 

The following table summarizes the componentsof operating expenses, both those reimbursed and not reimbursed by TERI underour Master Servicing Agreement, for the three and six month periods ended December 31,2004 and 2003:

 
| ** **                                | ** ** | **Operating expenses**          | ** ** |
|-------------------------------------------|------------|---------------------------------|------------|
| ** **                                | ** ** | **Expenses reimbursed by TERI** | ** ** | **Expenses not reimbursed by TERI** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | **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)**              | ** ** |
| **Three  months ended December 31,** |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| 2004                                      |       | $                               | 8,581      |   | $ | 7,969 |   | $ | 16,550 |   | $ | 6,737 |   | $ | 6,386 |   | $ | 13,123 |   | $ | 29,673 |   |
| 2003                                      |       | 3,719                           |       | 3,419 |   | 7,138 |   | 4,079 |   | 4,249 |   | 8,328 |   | 15,466 |   |
|                                      |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Six months  ended December 31,**   |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| 2004                                      |       | $                               | 17,140     |   | $ | 16,737 |   | $ | 33,877 |   | $ | 13,058 |   | $ | 14,577 |   | $ | 27,635 |   | $ | 61,512 |   |
| 2003                                      |       | 7,628                           |       | 7,341 |   | 14,969 |   | 9,038 |   | 6,669 |   | 15,707 |   | 30,676 |   |

 

A portion of interest expense was reimbursed by TERI during the periodspresented above. During the three months ended December 31, 2004 and 2003,TERI reimbursed interest expense of approximately $28,805 and $6,057,respectively. During the six months ended December 31, 2004 and 2003, TERIreimbursed interest expense of approximately $58,858 and $13,822, respectively.

 

***Other (Income)Expense***

 

*Interest (income) expense, net*

 

We recorded net interest income during thesecond quarter of fiscal 2005 of $0.8 million compared to net interest incomeduring the same period in the prior year of $42,000. Net interest income was$1.1 million for the first six months of fiscal 2005 as compared to netinterest expense of $0.1 million for the first six months of fiscal 2004. Theincrease in interest income resulted from an increase in cash and othershort-term investment balances as a result of receipt of cash fromsecuritization transactions in June 2004 and October 2004. Interestexpense is primarily attributable to $7.9 million of notes issued in June 2001to TERI as a part of the purchase price for TERI’sloan processing operations as described below in “—Financial Condition,Liquidity and Capital Resources.”

 

***Income Tax Expense***

 

Income tax expense increased to $52.4 millionfor the second quarter of fiscal 2005 from $25.5 million for the second quarterof fiscal 2004, and increased to $48.7 million for the first six months offiscal 2005 from $22.7 million for the first six months of fiscal 2004.The increase in income tax expense was primarily the result of an increase in theamount of income before income tax expense between periods.

 

**Financial Condition, Liquidity and CapitalResources**

 

Our liquidity requirements have historicallyconsisted, and we expect that they will continue to consist, of capitalexpenditures, working capital, business development expenses, general corporateexpenses and potential acquisitions.

 

On November 5, 2003, we completed aninitial public offering of our common stock at a price to the public of $16.00per share, in which we sold 7,906,250 shares and selling shareholders sold6,468,750 shares. Net proceeds of the initial public offering to us wereapproximately $115.1 million. We did not receive any of the proceeds ofthe sale of the shares sold by the selling stockholders. In June 2004,selling stockholders sold an aggregate of 7,406,312 shares of our common stockin a follow-on public offering at a price of $36.50 per share. In January 2005,selling stockholders sold an aggregate of 3,933,605 shares of our common stockin a follow-on public offering at a price of $57.40 per share. We did not sellany shares in the June 2004 and January 2005

 

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offerings andtherefore did not receive any proceeds from the sale of stock. We did, however,receive approximately $3.0 million in connection with the June 2004offering, and approximately $1.9 million in connection with the January 2005offering, from certain selling stockholders who exercised options and then soldthe resulting shares in the offerings.

 

***Short-term FundingRequirements***

 

We expect to fund our short-term liquidityrequirements through cash flow from operations and the proceeds of our initialpublic offering. We believe, based on our current operating plan and theproceeds of our initial public offering, that our current cash and othershort-term investments will be sufficient to fund our operations through atleast fiscal 2006.

 

***Long-term FundingRequirements***

 

We expect to fund the growth of our businessthrough cash flow from operations and through issuances of common stock,promissory notes or other securities. We expect to assess our financingalternatives periodically and access the capital markets opportunistically. Ifour existing resources are insufficient to satisfy our liquidity requirements,or if we enter into an acquisition or strategic arrangement with anothercompany, or if we otherwise believe that raising additional capital would be inour best interests and the best interests of our stockholders, we may selladditional equity or debt securities. Any sale of additional equity or debtsecurities may result in additional dilution to our stockholders, and we cannotbe certain that additional public or private financing will be available inamounts or on terms acceptable to us, if at all. If we are unable to obtainthis additional financing, we may be required to delay, reduce the scope of, oreliminate one or more aspects of our business development activities, whichcould harm the growth of our business.

 

From our inception, we have raisedapproximately $143.9 million from the sale of common stock and promissorynotes, including approximately $115.1 million in net proceeds from ourinitial public offering.

 

Our actual liquidity and capital fundingrequirements may depend on numerous factors, including:

 

•                  our facilities expansion needs;

 

•                  the extent to which our services gain increased marketacceptance and remain competitive;

 

•                  the timing, size and composition of the loan pools of thesecuritization transactions that we structure; and

 

•                  the costs and timing of acquisitions of complementarybusinesses.

 

If we are not able to obtain adequate fundingwhen needed, we may have to delay further expansion of our business.

 

***Cash and OtherShort-term Investments***

 

At December 31, 2004, we had $199.1million in cash and other short-term investments, and at June 30, 2004, wehad $168.7 million in cash and other short-term investments. The increaseresulted primarily from our receipt of up-front structural advisory fees inconnection with our October 2004 securitization transaction. Cash andother short-term investments include balances in money market funds.

 

***Structural AdvisoryFees and Residuals Receivables***

 

Our structural advisory fees and residualsreceivables increased to $210.0 million at December 31, 2004 from$142.8 million at June 30, 2004, primarily as a result of thestructural advisory fees and residuals generated from the October 2004securitization transaction. This increase in structural advisory fees andresiduals receivables was partially offset by the receipt of $10.25 million instructural advisory fees in July 2004. In the December 2003securitization, we collected $24.5 million of the up-front structuraladvisory fee in December 2003, at the time the securitization transaction closed,and we received a second payment of $10.25 million in July 2004 from this December 2003securitization transaction (of which $7.25 million was used to repay anoutstanding note payable). The $10.25 million second payment was recordedas a structural advisory fee receivable at June 30, 2004.

 

***Other Receivables***

 

Other receivables increased to $1.9 millionat December 31, 2004 from $0.4 million at June 30, 2004. The increaseis primarily due to prepaid marketing fees that will be reimbursed to us by trustsused in future securitization transactions.

 

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***Property andEquipment, Net***

 

During the first six months of fiscal 2005,our property and equipment, net increased by $5.4 million, as we spent$7.4 million on the expansion of our processing facilities and corporateheadquarters, which was offset by $1.9 million of depreciation expenserecorded during the period. Included in capital additions for the first sixmonths of fiscal 2005 are capitalized software development costs of $3.5million which are primarily related to the improvement of our loan processingsystems.

 

***Prepaid and OtherCurrent Assets***

 

We had prepaid and other current assets of$6.8 million at December 31, 2004 down from $23.0 million at June 30,2004. Prepaid and other current assets at June 30, 2004 included prepaidincome taxes of approximately $20.3 million. This balance was primarily derivedfrom a tax benefit of $29.9 million from employee stock option exercises,primarily in connection with stock option exercises at the time of ourfollow-on offering in June 2004. This benefit, after offsetting fiscalyear 2004 accrued income taxes, resulted in the net prepaid income taxesbalance at June 30, 2004. Taxes owed as a result of income earned duringthe first six months of fiscal 2005 more than offset the June 30, 2004prepaid income tax balance. During the first six months of fiscal 2005, we madeshort-term deposits of approximately $4.1 million related to the build out ofour new loan processing facility.

 

***Other Assets***

 

In connection with our facilitation of thesecuritization of GATE loans in June 2004, six schools participating inour GATE program faced limits on the amount of surety coverage that the GATEprogram’s current surety provider was willing to provide to the NCT trust ontheir behalf. We provided the NCT trust with an additional cash surety depositof approximately $1.8 million on behalf of these six schools. The suretycoverage and our cash deposit provides the NCT trust bondholders with assurancethat the pledge commitment that these school clients make to reimburse the NCTtrusts for defaults by their student borrowers will be fulfilled.

 

Our cash deposit with the NCT trust on behalfof these schools will earn interest at the prevailing short-term interestrates. We will also earn a surety fee equal to 150 basis points of the initialnotional amount of the pledge commitment which our cash deposit supports. Asschools reimburse the NCT trusts for student defaults, the amount of theirpledge commitment is reduced. We are entitled to withdraw amounts in the suretyreserve account, including earned interest and surety fees,to the extent the balance in the surety reserve account exceeds the pledgecommitment. Once the NCT trust bondholders have been paid in full, we willreceive the entire amount remaining in the surety reserve account.

 

***Accounts Payable andAccrued Expenses***

 

We had accounts payable and accrued expensesof $21.8 million at December 31, 2004 and $26.3 million at June 30,2004. In July 2004, we paid approximately $8.2 million of withholdingtaxes that we had collected from employees related to their exercise ofnon-qualified stock options in our follow-on offering in June 2004. Thisdecrease in accrued expenses was partially offset by accrued bonuses that wereapproximately $1.3 million higher at December 31, 2004 as compared to June 30,2004, primarily due to an increase in the number of our employees and theadoption of our executive incentive compensation plan by our stockholders in November 2004.At December 31, 2004, we had accrued income taxes of $3.4 million,compared to no accrued income taxes at June 30, 2004 due to the taxbenefit derived from stock option exercises. Our accounts payable were $0.6million lower at December 31, 2004 as compared to June 30, 2004,primarily due to the timing of the receipt and payment of invoices.

 

***Net Deferred TaxLiability***

 

We have a net deferred tax liability because,under accounting principles generally accepted in the United States of America,we recognize residuals in book income earlier than they are recognized for taxpurposes. Our deferred tax liability increased primarily as a result of theincrease in residual revenue recognized during the first quarter of fiscal2005.

 

***Notes Payable***

 

We had notes payable and capital leaseobligations of $1.7 million at December 31, 2004 and $9.2 million at June 30,2004. During the second quarter of fiscal 2004, we received $7.0 millionupon the issuance of a $7.25 million note to the lead underwriter of our December 2003securitization. We repaid this note with the first $7.25 million of thesecond up-front structural advisory fee that we received in July 2004 inconnection with the December 2003 securitization. We had notes payable toTERI of $5.7 million at December 31, 2004 and $6.0 million at June 30,2004. This balance relates to two acquisition notes we issued to acquire TERI’s loan processing operations in 2001.

 

32

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***Deferred Compensation***

 

We recorded deferred compensation during thesecond quarter of fiscal 2005 as we granted 70,000 restricted stock units tocertain senior managers and executive officers.

 

***ContractualObligations***

 

As of December 31, 2004, our contractualobligations had not changed materially from those described under the caption “Item7. Management’s Discussion and Analysis of Financial Condition and Results ofOperations-Contractual Obligations” in our annual report on Form 10-K forthe fiscal year ended June 30, 2004. During the first six monthsof fiscal 2005:

 

•                  We entered into a lease forapproximately 26,000 square feet of office space in Boston, Massachusetts whichwas described in the annual report on Form 10-K, on the terms disclosed in theannual report on Form 10-K;

 

•                  We exercised our right to renew ourdatabase sale and supplementation agreement, as well as several otheragreements with TERI, for additional five-year terms through June 2011.Beginning in July 2007, monthly payments pursuant to the database sale andsupplementation agreement will be reduced to approximately $21,000;

 

•                  We entered into a lease forapproximately 136,000 additional square feet of office space for our loanprocessing operations in Boston, Massachusetts for basic annual rent between$745,000 and $872,000 through 2014;

 

•                  We entered into a lease for the useof a corporate aircraft for basic annual rent of approximately $1.4 millionthrough 2009, which was structured to be treated as a capital asset for taxpurposes; and

 

•                  We entered into an equipmentfinancing lease agreement which we will use to finance the purchases offurniture and equipment. The agreement allows us to finance up to $20 millionworth of furniture and equipment purchased before December 30, 2005. Weexpect to repay amounts drawn down on the lease in terms ranging from three tofive years. We made draws of approximately $2.5 million and $1.6 million followingexecution of the agreement. These initial draws were used to reimburse us fordeposits we made during the quarter.

 

***Cash Flows***

 

Our net cash provided by operating activitiesincreased to $44.5 million for the first six months of fiscal 2005, compared to$4.8 million for the first six months of fiscal 2004. Cash provided byoperations resulted primarily from an increase in net income, an increase inour deferred tax liability and a decrease in prepaid and other current assets,partially offset by an increase in residuals and a decrease in accountspayable, accrued expenses and other liabilities.

 

We used $7.7 million of net cash in investingactivities during the first six months of fiscal 2005. The principal use of netcash was capital expenditures related to the expansion of our loan processingfacilities and corporate headquarters and, to a lesser extent, payments forloan database updates from TERI.

 

We used net cash of $6.4 million in financingactivities during the first six months of fiscal 2005. Cash used in financingactivities primarily related to the repayment of the $7.25 million note that weissued to the lead underwriter of the Company’s December 2003securitization, offset in part by the receipt of exercise prices for employeestock options.

 

We expect that our capital expenditurerequirements for the remainder of fiscal 2005 will be approximately $31.2million. We plan to utilize our recently executed equipment line of credit tofinance a portion of these costs. We expect to use these funds primarily forthe expansion of our loan processing operations, purchase of computer andoffice equipment, and leasehold improvements to our corporate headquarters. Wecurrently have capital expenditure commitments over the next 12 months ofapproximately $9.3 million.

 

***Borrowings***

 

In June 2001, we issued two acquisitionnotes to TERI totaling $7.9 million to acquire TERI’sloan processing operations. Principal and interest at an annual rate of 6% ispayable on these notes in 120 monthly payments of an aggregate of $87,706commencing on July 20, 2001 and ending on June 20, 2011. At December 31,2004, outstanding principal on these notes totaled $5.7 million as compared to$6.0 million at June 30, 2004.

 

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In April 2002, we entered into a$975,000 revolving line of credit with a bank. The line of credit was extendedto December 31, 2003, with interest payable annually at the greater of 6% or 1% above the highest published *Wall Street Journal* prime rate. Our leaddirector is a director and majority stockholder of the company that owns thebank that provided this line of credit. We believe that the terms of the lineof credit were substantially the same as those prevailing at the time weentered into this credit arrangement as we would have received from other banksfor a comparable transaction. We did not renew this revolving line of creditwhen it expired. There were no amounts outstanding at June 30, 2003 or anytime thereafter.

 

In August 2003, we entered into a$10 million revolving credit facility with Fleet National Bank. FleetNational Bank was recently acquired by Bank of America, and our agreementrelated to this facility has been assigned to Bank of America. The revolvingcredit facility matures on August 28, 2005, with interest currentlypayable, at our option, at the bank’s prime rate, or LIBOR plus 2%. Therevolving credit line contains financial covenants, including:

 

•                  minimum trailing 12-month up-front structural advisory feesof not less than $25 to $30 million;

 

•                  minimum tangiblenet worth of not less than the sum of 100% of consolidated tangible net worthplus 85% of consolidated net income;

 

•                  a maximum liabilities to net worth ratio of not greater than1.15 to 1.00; and

 

•                  a minimum cash flow to debt service ratio of not less than1.50 to 1.00,

 

as well ascertain financial reporting covenants. We expect to be able to meet thesefinancial and reporting requirements during the term of the revolving creditfacility and are in compliance with these covenants as of the date of thisreport. This agreement restricts our ability to pay cash dividends in the eventwe are in default. As of December 31, 2004, we had no balance outstandingunder the revolving credit facility. The maximum annual commitment fee is$25,000. Bank of America has issued on our behalf a letter of credit in theamount of $0.5 million in lieu of security deposits for the lease of officespace. Third party beneficiaries have not drawn upon this letter of credit,which reduces the amount that we may borrow under the revolving creditfacility.

 

In December 2003, we issued a$7.25 million note to the lead underwriter of our December 2003securitization to monetize a substantial portion of the second up-frontstructural advisory fee payment which we received in July 2004. We repaidthe note in full with the first $7.25 million of that payment.

 

**Off-Balance Sheet Transactions**

 

We structure and facilitate thesecuritization of loans for our clients through a series of bankruptcy remote,qualified special purpose trusts. We do not utilize these trusts as a means totransfer assets or liabilities from our balance sheet to those of the trustsbecause we are not the originator of the securitized student loans or theissuer of the related debt. We do not serve as lender, guarantor or loan servicer. Specifically, these trusts purchase such studentloans from third-party financial institutions, the financing of which isprovided through the issuance of asset-backed securities.

 

The principal uses of these trusts are to:

 

•                  generate sourcesof liquidity for our clients’ assets sold into such trusts and to reduce theircredit risk;

 

•                  make availablemore funds to students and colleges; and

 

•                  leverage thecapital markets to reduce borrowing costs to students.

 

See “Application of Critical AccountingPolicies and Estimates—Consolidation” for a discussion of our determination tonot consolidate these securitization trusts.

 

**Recent Accounting Pronouncements**

 

On December 16, 2004, the FASB issuedFASB Statement No. 123 (revised 2004), “Share-Based Payment” (Statement 123R),which is a revision of FASB Statement No. 123, “Accounting for Stock-BasedCompensation.” Statement 123R supersedes APB Opinion No. 25, “Accounting forStock Issued to Employees,” and amends FASB Statement No. 95, “Statement ofCash Flows.” Statement 123R requires a public company to measure the cost of employeeservices received in exchange for an award of equity

 

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instruments,including stock options, based on the grant-date fair value of the award, withlimited exceptions. That cost will be recognized over the period during whichthe employee is required to provide service in exchange for the award, which istypically the vesting period. Statement 123R eliminates the alternative to useOpinion 25’s intrinsic value method of accounting that was provided inStatement 123 as originally issued.

 

We expect to adopt Statement 123R on July 1,2005. Statement 123R permits public companies to adopt its requirements usingone of two methods:

 

1.                                       A“modified prospective” method in which compensation cost is recognizedbeginning with the effective date (a) based on the requirements of Statement123R for all share-based payments granted after the effective date and (b)based on the requirements of Statement 123 for all awards granted to employeesprior to the effective date of Statement 123R that remain unvested on theeffective date.

2.                                       A“modified retrospective” method which includes the requirements of the modifiedprospective method described above, but also permits entities to restate itspreviously issued financial statements to include in its income statementamounts previously recognized under Statement 123 for purposes of pro formadisclosures for either (a) all prior periods presented or (b) prior interimperiods of the year of adoption.

 

We plan to adopt Statement 123R using the modified-prospective method.

 

As permitted by Statement 123, we currentlyaccount for share-based payments to employees using Opinion 25’s intrinsicvalue method and, as such, generally recognize no compensation cost foremployee stock options.  The adoption ofStatement 123R’s fair-value method will impact our results of operations,although the impact of adoption of Statement 123R cannot be predicted at thistime because it will depend on levels of share-based payments granted in the future.However, had we adopted Statement 123R in prior periods, the impact of thatstandard would have approximately the impact of Statement 123 as described inthe disclosure of pro forma net income and earnings per share in Note 2 to ourcondensed consolidated financial statements. Statement 123R also requires thebenefits of tax deductions in excess of recognized compensation cost to bereported as a financing cash flow, rather than as an operating cash flow asrequired under current literature. This requirement will reduce net operatingcash flows and increase net financing cash flows in periods after adoption.While we cannot estimate what the impact on the cash flow statement will be inthe future (because they depend on, among other things, when employees exercisestock options), the amount of operating cash flows recognized in prior periodsfor such excess tax deductions were $2.7 million during the six months ended December 31,2004 and $29.9 million during the year ended June 30, 2004.

 

Beginning July 1, 2003, and forsecuritization trusts created after January 31, 2003, we applied FINNo. 46, “Consolidation of Variable Interest Entities, an interpretation ofARB No. 51,” in assessing consolidation. FIN No. 46 provided a newframework for identifying variable interest entities and determining when acompany should include the assets, liabilities, non-controlling interests andresults of activities of a variable interest entity in its consolidatedfinancial statements.

 

On December 24, 2003, the FASB issuedFIN No. 46 (revised December 2003), “Consolidation of VariableInterest Entities,” or FIN No. 46R, which addressed how a businessenterprise should evaluate whether it has a controlling interest in an entitythrough means other than voting rights and accordingly should consolidate theentity. FIN No. 46R has replaced FIN No. 46. At December 31,2004, the securitization trusts created after January 31, 2003 have eithermet the criteria to be a QSPE, as defined in paragraph 35 of SFASNo. 140, “Accounting for the Transfers and Servicing of Financial Assetsand Extinguishments of Liabilities,” or we have determined that we are not theprimary beneficiary of the securitization trusts, as defined by FINNo. 46R. Accordingly, we did not consolidate these existing securitizationtrusts in these financial statements. In addition, the securitization trustscreated prior to January 31, 2003 have been amended in order for them tobe considered QSPEs. The adoption of FINNo. 46R, which we began to apply in December 2003, did not have amaterial impact on our consolidated financial condition, results of operations,earnings per share or cash flows. For additional information regarding ouradoption of FIN No. 46, see “ —Consolidation.”

 

The FASB issued an Exposure Draft, “QualifyingSpecial-Purpose Entities and Isolation of Transferred Assets—an amendment ofFASB Statement No. 140.” This proposal would, among other things, changethe requirements that an entity must meet to be considered a QSPE. The FASB hasannounced that it expects to issue in the third calendar quarter of 2005 arevised exposure draft that would include all of the proposed amendments toFASB Statement No. 140. We are monitoring the status of this ExposureDraft to assess its impact on our consolidated financial statements.

 

**Inflation**

 

Inflation was not a material factor in eitherrevenue or operating expenses during the periods presented.

 

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**Factors That May Affect Future Results**

 

This quarterly report on Form 10-Qincludes forward-looking statements within the meaning of Section 21E ofthe Securities Exchange Act of 1934, as amended. For this purpose, anystatements contained herein regarding our strategy, future operations,financial position, future revenues, projected costs, prospects, plans andobjectives of management, other than statements of historical facts, areforward-looking statements. The words “anticipates,” “believes,” “estimates,” “expects,”“intends,” “may,” “plans,” “projects,” “will,” “would” and similar expressionsare intended to identify forward-looking statements, although not allforward-looking statements contain these identifying words. We cannot guaranteethat we actually will achieve the plans, intentions or expectations expressedor implied in our forward-looking statements. There are a number of importantfactors that could cause actual results, levels of activity, performance orevents to differ materially from those expressed or implied in theforward-looking statements we make. These important factors include our “criticalaccounting estimates” and the risk factors set forth below. Although we mayelect to update forward-looking statements in the future, we specificallydisclaim any obligation to do so, even if our estimates change, and readersshould not rely on those forward-looking statements as representing our viewsas of any date subsequent to the date of this quarterly report.

 

**Risk Factors**

 

***We derive asignificant portion of our revenue and substantially all of our income fromstructuring securitization transactions; our financial results and futuregrowth would be adversely affected if we are unable to structuresecuritizations.***

 

Securitization refers to the technique ofpooling loans and selling them to a special purpose, bankruptcy remote entity,typically a trust, which issues securities to investors backed by those loans.As of the date of this Quarterly Report, we have provided structural advisoryand other services for 23 loan securitizations since our formation in 1991, andwe receive fees for these services. In connection with securitizations, wereceive compensation in the form of structural advisory fees, residuals andadministrative fees for management of the trusts. The amount and timing of thefees we recognize are affected, in part, by the size and composition of loanpools to be securitized, the return expectations of investors and assumptionswe make regarding loan portfolio performance, including defaults, recoveries,prepayments and the cost of funding. Revenue from new securitizationsconstituted 75% of our total service revenue for the first six months of fiscal2005, 78% of our total service revenue for fiscal 2004, 73% of our totalservice revenue for fiscal 2003 and 64% of our total service revenue in fiscal2002. Substantially all of our net income in those fiscal periods wasattributable to securitization-related revenue.

 

***The timing of oursecuritization activities will greatly affect our quarterly financial results.***

 

Our quarterly revenue, operating results andprofitability have varied and are expected to continue to vary significantly ona quarterly basis. In fiscal 2004, we recognized 5%, 39%, 5% and 51% of ourtotal service revenue in the respective fiscal quarters of 2004. In fiscal2003, we recognized 7%, 36%, 17% and 40% of our total service revenue in therespective fiscal quarters of 2003. Our quarterly revenue varies primarilybecause of the timing of the securitizations that we structure. In fiscal 2004,we facilitated one securitization in the second quarter and two securitizationsin the fourth quarter, but none in the first or third quarters. Thus far infiscal 2005, we facilitated one securitization in the second quarter. Thetiming of our securitization activities is affected to some degree by theseasonality of student loan applications and loan originations. Origination ofstudent loans is generally subject to seasonal trends, with the volume of loanapplications increasing with the approach of tuition payment dates. In fiscal 2004,we processed 34% of our total loan facilitation volume in the first quarterended September 30, 2003, and 20%, 27% and 19% of our total loanfacilitation volume in the respective successive quarters.

 

***A number of factors,some of which are beyond our control, may adversely affect our securitizationactivities and thereby adversely affect our results of operations.***

 

Our financial performance and future growthdepend in part on our continued success in structuring securitizations. Severalfactors may affect both our ability to structure securitizations and therevenue we generate for providing our structural advisory and other services,including the following:

 

•                  degradation of the credit quality and performance in the loanportfolios of the trusts we structure could reduce or eliminate investor demandfor securitizations that we facilitate in the future;

 

•                  prolonged volatility in the capital marketsgenerally or in the student loan sector specifically, which could restrict ordelay our access to the capital markets;

 

•                  unwillingness of financial guarantee providers to continue toprovide credit insurance in the securitizations that we structure or in studentloan-backed securitizations generally;

 

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•                  adverse performance of, or other problems with, studentloan-backed securitizations that other parties facilitate could impact pricingor demand for our securitizations; and

 

•                  any material downgrading or withdrawal of ratings givento securities previously issued in securitizations that we structured couldreduce demand for additional securitizations that we structure.

 

A portion of the securities issued since 1998in securitization 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, we may experiencea delay in the timing of our securitizations as we seek to find alternatechannels of distribution.

 

Under the terms of some of our contracts withkey lender clients, we have an obligation to securitize loans originated bythose lenders periodically, typically twice per year. 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, which couldadversely 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 from those reflectedin our financial statements.***

 

Our financial statements have been preparedin accordance with accounting principles generally accepted in the UnitedStates of America. The preparation of these financial statements requires us tomake estimates and judgments that affect the reported amounts of our assets,liabilities, revenue and expenses, the amount of fees we accrue and relateddisclosure of contingent assets and liabilities.

 

We receive structural advisory fees for ourservices in connection with securitization transactions. We receive an up-frontportion of these structural advisory fees when the securitization trustpurchases the loans or soon thereafter. We receive an additional portion ofthese structural advisory fees over time, based on the amount of loansoutstanding in the trust from time to time over the life of the trust. We alsohave the right to receive a portion of the residual interests that the trustcreates. As required under accounting principles generally accepted in theUnited States of America, we recognize as revenue the present value of theadditional portion of the structural advisory fees and residuals at the time thesecuritization trust purchases the loans because they are deemed to be earnedbefore they are actually paid to us. We record additional structural advisoryfees and residuals as receivables on our balance sheet at fair value.Accounting rules require that these receivables be marked-to-market. Weestimate the fair value both initially and in each subsequent quarter andreflect the change in value in earnings for that period. Our key assumptions toestimate the value include prepayment and discount rates, interest rate trends,the expected credit losses from the underlying securitized loan portfolio, netof recoveries, and the expected timing of cash flows from the trusts’underlying student loan assets. If our assumptions are wrong, the additionalstructural advisory fees and residuals that we receive from the trusts could besignificantly less than reflected in our current financial statements, and wemay incur a material negative adjustment to our earnings in the period in whichour assumptions change. For a discussion of the sensitivity of the additionalstructural advisory fees and residuals to variations in our assumptions andestimates, see “Management’s Discussion and Analysis of Financial Condition andResults of Operations—Executive Summary—Application of Critical AccountingPolicies and Estimates—Service Revenue-Sensitivity Analysis” included in thisQuarterly Report.

 

Our residuals in each securitization we havefacilitated are subordinate to securities issued to investors in suchsecuritizations and may fail to generate any revenue for us if the securitizedassets only generate enough revenue to pay the investors.

 

***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 structural advisory and otherservices for loan securitizations undertaken through Delaware statutory trusts.We do not consolidate the financial results of the trusts with our ownfinancial results. For a discussion of our decision not to consolidate, see “Management’sDiscussion and Analysis of Financial Condition and Results ofOperations—Executive Summary—Application of Critical Accounting Policies andEstimates—Consolidation” included in this Quarterly Report. Some of therelevant accounting rules are in the process of being amended. If we wererequired to consolidate the financial results of one or more trusts with ourown financial results as a result of amendments or changes in accounting rules,or if the SEC or other accounting authorities do not agree with our currentapproach, our financial results could be adversely affected, particularly inthe early years of a trust when the trust typically experiences losses.

 

***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 numberof different special purpose trusts that have been used in securitizations tofinance student loans that our clients originate. Under applicable state andfederal securities laws, if investors incur losses as a result of purchasing

 

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asset-backedsecurities that those trusts issue, we could be deemed responsible and could beliable to those investors for damages. If we failed to cause the trusts todisclose adequately all material information regarding an investment in theasset-backed securities or if the trust made statements that were misleading inany material respect in information delivered to investors, it is possible thatwe could be held responsible for that information or omission. In addition,under various agreements entered into with underwriters or financial guaranteeinsurers of those asset-backed securities, we are contractually bound toindemnify 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.

 

We do not maintain reserves or insuranceagainst this potential liability. If we are liable for losses investors incurin any of the securitizations that we facilitate or structure, ourprofitability or financial position could be materially adversely affected.

 

***If our relationshipswith key clients terminate, our revenue and results of operations would beadversely affected.***

 

We structure and support private student loanprograms for commercial banks, including Bank One and Bank of America. We alsostructure and support private student loan programs for marketing partners thatrefer their borrowers to a particular lending source, such as Charter One Bank.We refer to these lenders as referral lenders. Structural advisory fees andresiduals from securitization of Bank One private label loans representedapproximately 33% of our total service revenue for the first six months offiscal 2005 and approximately 43% of our total service revenue for fiscal 2004.Structural advisory fees and residuals from securitization of Bank of Americaprivate label loans represented approximately 11% of total service revenue forthe first six months of fiscal 2005 and approximately 9% of total servicerevenue for fiscal 2004. In addition, Bank of America is the exclusive lenderfor our GATE program clients. Our GATE programs contributed 4% of our totalservice revenue in fiscal 2004. Structural advisory fees and residualsfrom securitization of Charter One-funded private label loans representedapproximately 24% of our total service revenue for the first six months offiscal 2005 and approximately 17% of our total service revenue in fiscal 2004.

 

We have agreements with these commercial banksthat govern the purchase of loans for securitization. Our agreement with BankOne is scheduled to terminate in April 2007. Our agreement with CharterOne is scheduled to terminate in May 2006, except with respect to loansmarketed by Collegiate Funding Services, L.L.C. and funded by Charter One, inwhich case our agreement has a term through July, 2007. Our agreement with Bankof America governing the purchase of school channel loans can be terminated atany time upon 180 days notice. Of our two agreements with Bank of America thatgovern the purchase of GATE loans, one may terminate at any time upon 120 daysnotice and the other may terminate as early as May 2006. Our agreement withBank of America governing the purchase of direct-to-consumer loans mayterminate as early as May 2006. Each client above has the right to terminatetheir agreement on short notice, generally 30 days or less, if wematerially breach our agreement, including our failure to perform at servicelevels specified in those contracts. In addition, under the terms of our lenderclients’ guaranty agreements with TERI, both the lender and TERI may proposemodifications to loan program guidelines during the first calendar quarter ofeach year. If the parties are unable to agree on a proposed modification, suchas an adjustment of the guaranty fees, the party proposing the modification hasthe option of terminating the guaranty agreement, effective as of May 1 ofthat calendar year. Under its master loan guaranty agreement with us, TERI maynot propose a change to program guidelines without our consent. Similarly,under our agreements with lenders that have multi-year terms, the lender cannotchange the program guidelines without our consent, which we cannot unreasonablywithhold.

 

A significant decline in services to BankOne, Bank of America or Charter One, or the termination of guaranty agreementsbetween those lenders and TERI, could reduce the overall volume of loans wefacilitate, which could be difficult to replace through arrangements with otherlenders. Our revenue, business and financial results could suffer as a result.

 

***If our relationshipwith TERI terminates, our business could be adversely affected.***

 

In June 2001, we purchased the loanprocessing operations of TERI and entered into a series of agreements to governfuture securitizations of TERI-guaranteed loans. TERI continues to provideprivate student loan guarantee, education information and counseling servicesfor students, and is the exclusive third party provider of borrower defaultguarantees for our clients’ private label loans. We have entered into anagreement to provide various services to TERI and received fees from TERI forservices performed of $33.9 million, or 19% of total service revenue, forthe first six months of fiscal 2005, $15.0 million, or 17% of totalservice revenue, for the first six months of fiscal 2004 and$35.1 million, or 18% of total service revenue, for fiscal 2004. Inaddition, we have agreed to undertake on a best-efforts basis to arrange orfacilitate securitizations for a limited category of TERI-guaranteed loans andhave the right to receive structural advisory and other fees in connection withthese securitizations. We also have entered into an agreement to receive fromTERI updated information about the performance of the student loans it hasguaranteed to allow us to supplement our database. Each of these agreementswith TERI has 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 beadversely affected and the value of our intangible assets could be impaired forthe following reasons:

 

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•                  we may not be able to offer our clients guaranteeservices from another guarantor and, accordingly, our access to loans and ouropportunities to structure securitization transactions may diminishsignificantly;

 

•                  we may not be successful in establishing anarrangement with a third party to provide the warranties that TERI currentlyprovides to lenders related to origination services. In such case, we may berequired to provide such warranties; and

 

•                  if TERI is unable to provide guarantee services, thefinancial guarantee insurance coverage we obtain in securitization transactionscould be more costly, if it is available at all.

 

In such events, demand for our services,including opportunities to structure and facilitate securitizationtransactions, could decline, which would adversely affect our business. Inaddition, the value of the loan pools in the securitization transactions wefacilitate could decline and the value of our residuals could be reduced.

 

***Our business couldbe adversely affected if TERI’s ratings aredowngraded, if TERI fails to maintain its not-for-profit status or if TERI’s not-for-profit status ceased to be a competitiveadvantage.***

 

In its role as guarantor in the private educationlending market, TERI agrees to reimburse lenders for unpaid principal andinterest on defaulted loans. TERI is the exclusive provider of borrower defaultguarantees for our clients’ private student loans. As of December 31,2004, TERI had a Baa3 counterparty rating from Moody’s Investors Service, whichis the lowest investment grade rating, and an insurer financial strength ratingof A+ from Fitch Ratings. If these ratings are lowered, our clients may notwish to enter into guarantee arrangements with TERI. In addition, we mayreceive lower structural advisory fees because the costs of obtaining financialguarantee insurance for the asset-backed securitizations that we structurecould increase. In such case, our business would be adversely affected.

 

TERI is a not-for-profit organization and, asa result, borrowers have been deemed unable to discharge in bankruptcyproceedings loans that TERI guarantees. If TERI loses its not-for-profitstatus, and TERI-guaranteed student loans become dischargeable in bankruptcy,recovery rates on these loans could decline. In such event, our business couldbe adversely affected for the following reasons:

 

•                  our residuals in the securitization trusts coulddecline because of increased default rates and collection costs; and

 

•                  the securitization transactions that we structure couldbe on less favorable terms because investors and financial guarantee insurerscould become more concerned with default and recovery rates.

 

Assuming that TERI retains its not-for-profitstatus, TERI’s position as the leading provider ofprivate education loan guarantees could be adversely affected if the U.S.federal bankruptcy laws are amended to make student loans generallynon-dischargeable in bankruptcy, as provided in legislation currently beforethe U.S. Congress. If such an amendment were enacted:

 

•                  lenders who would currently seek a guarantee from anot-for-profit entity such as TERI in order for their private student loans tobecome non-dischargeable in bankruptcy may cease to do so; and

 

•                  TERI would cease to have this competitive advantageover potential for-profit providers of the services that TERI provides.

 

As a result, lenders might be less inclinedto utilize the TERI-guaranteed private label loan programs, which could, in turn,harm our business and results of operations.

 

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

 

As of December 31, 2004, PennsylvaniaHigher Education Assistance Agency, or PHEAA, serviced a majority of loanswhose origination we facilitate. This arrangement allows us to increase thevolume of loans in our clients’ loan programs without incurring the overheadinvestment in servicing operations. As with any external service provider,there are risks associated with inadequate or untimely services. We regularlymonitor the servicing portfolio reports, including delinquencies and defaults.A substantial increase in the delinquency rate could adversely affect our abilityto access profitably the securitization markets for our clients’ loans. 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 suchevent, our business could be adversely affected. Although we periodicallyreview the costs associated with establishing servicing operations to serviceloans, we have no plans to establish and perform servicing operations at this time.

 

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***Surety limits thatsome of our GATE school clients face may lead us to make deposits in thesecuritization trusts established by The National Collegiate Trust on behalf ofsuch schools.***

 

We have utilized several special purposeentities for the securitizations we have structured. One of these specialpurpose entities, The National Collegiate Trust, has established separatesecuritization trusts, which we refer to as the NCT trusts,that have purchased primarily GATE loans. Some of the school clientsparticipating in our GATE program face limits on the amount of surety coveragewhich our current insurance vendor is willing to provide on their behalf. Thissurety coverage provides NCT trust bondholders with assurance that the pledgecommitment these school clients make to reimburse the NCT trusts for defaultsby their student borrowers will be fulfilled. We can provide no assurance thatin NCT trusts established in the future, our current insurance vendor willprovide adequate surety coverage for all schools participating in the GATEprogram.

 

As these surety coverage limits are reached,we will consider various options for providing NCT trust bondholders in NCTtrusts with additional credit enhancement so that school clients may continueto participate in the GATE program. For example, in our June 2004securitization, we made a cash deposit with the NCT trust on behalf of sixschools, in an amount adequate to cover the additional surety amount requiredbeyond what the GATE program’s current surety provider was willing to provideon the schools’ behalf. Our aggregate cash surety deposit on behalf of theseschools was $1.8 million. We could lose some or all of this deposit andfuture deposits we make on behalf of schools should such schools breach theircommitments to reimburse the NCT trusts for defaults by their studentborrowers.

 

***The outsourcingservices market for education lending is highly competitive,and if we are not able to compete effectively, our revenue and results ofoperations may be adversely affected.***

 

We assist national and regional financialinstitutions and educational institutions, as well as businesses and otherenterprises, in structuring and supporting their private education loan programs.In providing our services, we receive fees for services we provide primarily inconnection with the securitization of our clients’ loans. The outsourcingservices market in which we operate includes a large number of serviceproviders, some of which have greater financial, technical and marketingresources, larger customer bases, greater name recognition and more establishedrelationships with their clients than we have. Larger competitors with greaterfinancial resources may be better able 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 toprovide directly the services that we currently provide, and from third partieswho decide to expand their services to include the suite of services that weprovide. We are aware of two competitors, SLM Corporation, or Sallie Mae, and Servus Financial Corporation, an affiliate of Wells FargoCompany, that offer a similar range of services tolenders. Our business could also be adversely affected if Sallie Mae’s recentlyannounced program to market private student loans directly to consumers becomessuccessful or if Sallie Mae seeks to market more aggressively to third partiesthe full range of services for private loan programs that we provide. If we arenot able to compete effectively, our revenue and results of operations may beadversely affected. In addition, if third parties choose to provide the rangeof services that we provide, pricing for our services may become morecompetitive, which could lower our profitability.

 

In addition, there has been significantconsolidation within the banking industry. For example, Charter One Financial,Inc., the publicly traded parent company of Charter One Bank, N.A., wasrecently acquired by Citizens Financial Group, Inc., and Bank One Corporationrecently merged with J.P. Morgan Chase & Co.  In addition, Sallie Mae recently acquired ourclient, Southwest Student Services Corporation, resulting in termination of ourrelationship with that client. Further consolidation could result in a loss ofbusiness if one or more of our clients were acquired by a competitor or alender that is not our client.

 

Historically, lenders in the education loanmarket have focused their lending activities on federal loans because of therelative size of the federal loan market and because the federal governmentguarantees repayment of these loans, thereby significantly limiting the lenders’credit risk. The demand for our services could decline if lenders placeadditional emphasis on the private education loan market and offer the serviceswe provide.

 

***The growth of ourbusiness could be adversely affected if annual and aggregate limitations underfederal student loan programs increase.***

 

We focus our business exclusively on themarket for private education loans, and more than 90% of our business isconcentrated in loan programs for post-secondary education. The availability ofloans that the federal government originates or guarantees affects the demandfor private student loans because students and their families often rely onprivate loans to bridge the gap between available funds, including familysavings, grants and federal and state loans, and the costs of post-secondaryeducation. The federal government currently places both annual and aggregatelimitations on the amount of federal loans that any student can receive, andthese limitations are adjusted in connection with funding authorizations fromthe United States Congress for programs under the Higher Education Act. Thelimitations on federal student loans have not been adjusted since 1992, andCongress is currently considering proposals that could

 

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increase thelimitations in the future. If Congress materially increases either the annualor aggregate loan limitations, or otherwise increases the funding availableunder federal student loan programs, demand for private student loans couldweaken, which could adversely affect the volume of private loans and thesecuritization transactions that we facilitate and structure and, as a result,the growth of our business.

 

***Access to alternativemeans of financing the costs of education may reduce demand for private studentloans.***

 

The demand for private student loans couldweaken if student borrowers use other vehicles to bridge the gap betweenavailable funds and costs of post-secondary education. These vehicles include,among others:

 

•                  home equity loans, under which families borrow moneybased on the value of their real estate;

 

•                  pre-paid tuition plans, which allow students to paytuition at today’s rates to cover tuition costs in the future;

 

•                  529 plans, which are state-sponsored investmentplans that allow a family to save funds for education expenses; and

 

•                  education IRAs, now known as Coverdell EducationSavings Accounts, under which a holder can make annual contributions for educationsavings.

 

If demand for private student loans weakens,we would experience reduced demand for our services, which would seriously harmour financial results.

 

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

 

We own a proprietary database of historicalinformation on private student loan performance that we use to help usestablish the pricing provisions of new loan programs, determine the terms ofsecuritization transactions and establish the present value of the structuraladvisory fees and residuals that we recognize as revenue. We also havedeveloped a proprietary loan information processing system to enhance ourapplication processing and loan origination capabilities. Our student loandatabase and loan information processing system provide us with a competitiveadvantage in offering our services. Third parties could create or acquiredatabases and systems such as ours. For example, as lenders and otherorganizations in the student loan market originate or service loans, theycompile 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.

 

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

 

We provide outsourcing services to lenders,marketing partners and educational institutions, as well as businesses andother organizations, in structuring and supporting their private education loanprograms. We rely on our clients to market and sell education loans to studentborrowers. If they do not devote sufficient time and resources to theirmarketing efforts, or if they are otherwise not successful in these efforts,then we may experience a reduction in the volume of loans that we process andsecuritize, and our business will be adversely affected.

 

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

 

Student loans typically carry floatinginterest rates. Higher interest rates would increase the cost of the loan tothe borrower, which in turn, could lessen demand for our services and cause anincrease in prepayment and default rates for outstanding student loans. If thisoccurs, we may experience a decline in the value of our additional structuraladvisory fees and residuals receivables in connection with the securitizationsthat we facilitate. 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 restrictionson disclosure 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

 

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confidentialityof our trade secrets 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 have filed no patentapplications with respect to our proprietary database or loan informationprocessing systems. Accordingly, our technology is not covered by patents thatwould preclude or inhibit competitors from entering our market. Monitoringunauthorized use of the systems and processes that we developed is difficult,and we cannot be certain that the steps that we have taken will preventunauthorized use of our technology. Furthermore, others may independentlydevelop substantially equivalent proprietary information and techniques orotherwise gain access to our proprietary information. If we are unable toprotect the confidentiality of our proprietary information and know-how, thevalue 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 upon communications andinformation systems to conduct our business. As we implement our growthstrategy and increase our volume of business, that reliance will increase. Anyfailure or interruption, or breach in security, of our information systems orthe third party information systems on which we rely could cause underwritingor other delays and could result in fewer loan applications being received,slower processing of applications and reduced efficiency in loan processing. Afailure, interruption or breach in security could also result in an obligationto notify clients in states such as California that require such notification,with possible civil liability resulting from such failure, interruption orbreach. We cannot assure you that such failures, interruptions or breaches willnot occur, or if they do occur that we or the third parties on which we rely will adequately address them. We haveimplemented precautionary measures to avoid systems outages and to minimize theeffects of any data or telephone systems interruptions, but we have notinstituted fully redundant systems. The occurrence of any failure, interruptionor breach could significantly harm our business.

 

***The loan originationprocess is becoming increasingly dependent upon technological advancement, andwe could lose clients and market share if we are not able to keep pace withrapid changes in technology.***

 

Our ability to handle an increasing volume oftransactions is based in large part on the advanced systems and processes wehave implemented and developed. The loan origination process is becomingincreasingly dependent upon technological advancement such as the ability toprocess loans over the Internet, accept electronic signatures and provide processupdates instantly. Our future success depends in part on our ability to developand implement technology solutions that anticipate and keep pace with these andother continuing changes in technology, industry standards and clientpreferences. We may not be successful in anticipating or responding to thesedevelopments on a timely basis. If competitors introduce products, services,systems and processes that are better than ours or that gain greater marketacceptance, those that we offer or use may become obsolete or noncompetitive.Any one of these circumstances could have a material adverse effect on ourability to obtain and retain key clients.

 

We may be required to expend significantfunds to develop or acquire new technologies. If we cannot offer new technologiesas quickly as our competitors, we could lose clients and market share. We alsocould lose market share if our competitors develop more cost effectivetechnologies than those we offer or develop.

 

***We have expanded ouroperations rapidly in recent years, and if we fail to manage effectively ourgrowth, our financial results could be adversely affected.***

 

The number of our employees increased to 655regular employees and 107 seasonal and part time employees as of December 31,2004 from 310 regular employees and 47 seasonal employees as of December 31,2003. Many of these employees have very limited experience with us and alimited understanding of our systems and controls. From our inception to December 31,2004, our assets have grown to $448.6 million. Our revenue increased to$178.2 million for the first six months of fiscal 2005 from $87.0 million forthe first six months of fiscal 2004. Our revenue increased to$199.3 million in fiscal 2004 from $91.4 million for fiscal 2003 and$41.3 million for fiscal 2002. Our growth may place a strain on ourmanagement, systems and resources. We must continue to refine and expand ourbusiness development capabilities, our systems and processes and our access tofinancing sources. As we grow, we must continue to hire, train, supervise andmanage new employees. We cannot assure you that we will be able to:

 

•                  expand our systems effectively;

 

•                  allocate our human resources optimally;

 

•                  identify and hire qualified employees; or

 

•                  incorporate effectively the components of anybusiness that we may acquire in our effort to achieve growth.

 

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If we are unable to manage our growth, ouroperations and our financial results could be adversely affected.

 

***If we become subjectto the licensing or registration laws of any jurisdiction or any additionalgovernment regulation, our compliance costs could increase significantly.***

 

Although we are subject to certain state andfederal consumer protection laws, which are subject to change, we believe ouroperations currently do not require us to be licensed with any regulatory bodyand only require us to be registered with one regulatory body. TheMassachusetts Division of Banks ruled that our business with TERI is notsubject to licensure because, as a provider of loan origination outsourcingservices, we do not conduct lending business with consumers in our own name andour processing centers are not generally open to the public.

 

The Massachusetts Small Loan Act requires anyperson that is engaged, for compensation, in the business of making smallloans, or in aiding or assisting the borrower or the lender in procuring ormaking such loans, to obtain a license. Under the statute, the business ofmaking small loans includes the making of loans of $6,000 or less with interestrates and expenses of more than 12% per year. The TERI-guaranteed loansthat we facilitate include amounts as small as $1,000, and a small portion ofthose loans have combined interest rates and fees exceeding 12%.  We could therefore become subject to the SmallLoan Act with respect to these loans if the Massachusetts Division of Banksrevokes its previous determination that our operations are exempt.

 

We could also become subject to licensinglaws due to changes in existing federal and state regulations. TheMassachusetts legislature could, for example, modify the statutory requirementsunder the Small Loan Act. If the Massachusetts legislature, or any other stateor federal regulatory authority, changes existing laws and rules, or enacts newlaws or rules, we could be forced to make changes in our relationships withlenders, educational institutions, guarantors, servicersor the trusts involved in the securitizations that we facilitate. Specifically,changes in existing laws and rules could also require us to implementadditional or different programs and information technology systems and couldimpose licensing, capital and reserve requirements and additional costs,including administrative, compliance and third party service costs.

 

We could also become subject to regulatoryrequirements in Massachusetts and other states if we engage in certainregulated activities in the future, such as loan guarantees, or if ouroperations became sufficiently localized in other states to trigger licensingor registration requirements. We have consulted with national counsel regardingstate laws outside of Massachusetts governing the licensing and registration ofloan brokers and loan arrangers. As a result of that legal review, we haveconsulted with local counsel in relevant states. Based on the advice of localcounsel and, in some states, additional informal advice from state regulators,we have concluded that no such licenses or registrations are required, exceptin Pennsylvania, where local counsel has advised us that we need to register asa “loan broker” with the Pennsylvania Department of Banking. We are in theprocess of completing and filing that registration. While we have not receivedformal licensing or registration rulings from states other than Massachusetts,we do not believe that any other state would have jurisdiction over ouroperations because:

 

•                  all of our contracts with consumers are conducted inthe name of federal and state chartered financial institutions, which generallyare exempt from additional licensure of the business of lending, or in the nameof TERI, which has satisfied Massachusetts licensure requirements; and

 

•                  our contacts with borrowers outside of Massachusettsoccur exclusively in interstate commerce, through the mail, by phone andthrough the Internet.

 

If any state asserts jurisdiction over ourbusiness, we will proceed with licensing or registration in the affected state.Our activities in that state could be curtailed pending processing of a licensingapplication or registration, and we could be subject to civil or criminalpenalties.

 

We believe that our consultations withnational and local counsel have identified all material licensing, registrationand regulatory requirements that could apply to our business outside ofMassachusetts. The risk remains, however, that an unusual regulatory regimecould exist in a state that would permit such state, even if we were notphysically present, to assert successfully jurisdiction over our operations forservices we provide through the mail, by phone, through the Internet or byother remote means. Our failure to comply with such requirements could subjectus to civil or criminal penalties and could curtail our ability to continue toconduct business in that jurisdiction. In addition, compliance with suchrequirements could involve additional costs. Either of these consequences couldhave a material adverse effect on our business and results of operations.

 

In addition, other organizations with whichwe work, including TERI, are subject to licensing and extensive governmentalregulations, including truth-in-lending laws and other consumer protectionregulations. From time to time we have, and we may in the future, becomeresponsible for compliance with these regulations under contractualarrangements with our clients. If we fail to comply with these regulations, wecould be subject to civil or criminal penalties.

 

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***Failure to complywith consumer protection laws could subject us to civil and criminal penaltiesand affect the value of our assets. Compliance with recently enacted identitytheft laws and regulations will increase the cost and complexity of ouroperations and may reduce our ability to process growing loan volumes in atimely fashion.***

 

The federal government and state governmentsregulate extensively the financial institutions and other entities thatoriginate loans in the student loan market. These regulations include usury,disclosure, credit reporting, identity theft, privacy, fraud and abuse andother laws to protect borrowers. Violations of the laws or regulationsgoverning our operations or the operation of TERI or our other clients couldresult in the imposition of civil or criminal penalties, the cancellation ofour contracts to provide services or exclusion from participating in educationloan programs. These penalties or exclusions, were they to occur, wouldnegatively impair our ability to operate our business. In addition, the loanassets held by securitization trusts that we have structured could be adverselyimpacted by violation of consumer protection laws. In such event, the value ofour residual interests could also be adversely impacted. In some cases, suchviolations may render the loan assets unenforceable.

 

The Fair and Accurate Credit Transactions Actof 2003 imposes significant new federal law requirements on loan applicationprocessors, including requirements with respect to resolving addressinconsistencies, responding to “red flags” of potential identity theft andprocessing identity theft notices and other requirements that will require bothchanges to automated loan processing and the creation of manual exceptionsystems. These new requirements will strain systems and personnel that arealready undergoing rapid change due to loan volume growth. Failure to complywith these requirements will violate our obligations to the lenders we serveand could subject them to regulatory action and result in termination of ourprocessing contracts.

 

***Recent litigation has sought to recharacterize“payday loan” marketers as lenders; if similar litigation were successfulagainst education loan marketers, our ability tosecuritize loans by referral lenders could be adversely affected.***

 

Our private label clients include loanmarketers who are not themselves lenders. These clients design and brand loan programs that are marketed directlyto prospective student borrowers and their families, or directly to educationalinstitutions.  The loans under theseprograms, however, are made by referral lenders. Because referral lenders arefederally-insured, they are not subject to most state consumer protectionlimitations on fees and charges. Most of our referral lenders are nationalbanks who are exempt from virtually all state consumerprotection laws.

 

The association between loan marketers andout-of-state national banks has come under recent scrutiny, specifically in thecontext of high-interest “payday loans” and other predatory short-term creditpractices.  Recent litigation assertsthat payday loan marketers use out-of-state lenders in order to evade the usuryand interest rate caps, and other consumer protection laws, imposed by thestates where they do business.  Suchlitigation has sought, successfully in some instances, to recharacterizethe loan marketer as the lender for purposes of state consumer protection lawrestrictions.  Similar civil actions havebeen brought in the context of gift cards.

 

We believe the activities of our privatelabel clients are distinguishable from the activities involved in the pendingcases.  Nevertheless, we are monitoringthese legal trends, because the recharacterization ofprivate label loans marketed by nonlenders wouldmaterially adversely affect our ability to securitize such loans and negativelyaffect our revenues.

 

***The price of ourcommon stock may be volatile.***

 

The trading price of our common stock mayfluctuate substantially, depending on many factors, some of which are beyondour control and may not be related to our operating performance. Thesefluctuations could cause you to lose part or all of your investment in ourshares of common stock. Those factors that could cause fluctuations include,but are not limited to, the following:

 

•                  difficulties we may encounter in the securitizations that westructure or the loss of opportunities to structure securitizationtransactions;

 

•                  price and volume fluctuations in the overall stock marketfrom time to time;

 

•                  significant volatility in the market price and trading volumeof financial services and process outsourcing companies;

 

•                  actual or anticipated changes in our earnings orfluctuations in our operating results or in the expectations of securitiesanalysts;

 

•                  general economic conditions and trends;

 

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•                  negative publicity about the student loan marketgenerally or us specifically;

 

•                  major catastrophic events;

 

•                  loss of a significant client or clients;

 

•                  sales of large blocks of our stock; or

 

•                  departures of key personnel.

 

In the past, following periods of volatilityin the market price of a company’s securities, securities class actionlitigation has often been brought against that company. Due to the potentialvolatility of our stock price, we may therefore be the target of securitieslitigation in the future. Securities litigation could result in substantialcosts and divert management’s attention and resources from our business.

 

***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.***

 

We have only been a public company since October 2003.For the twelve month period ended December 31, 2004, the average dailytrading volume of our common stock on the New York Stock Exchange was less than275,000 shares. As a result, future sales of a substantial number of shares ofour common stock in the public market, or the perception that such sales mayoccur, could adversely affect the then-prevailing market price of our commonstock.

 

In connection with our follow-on offeringcompleted in January 2005, all selling stockholders and all parties to theregistration rights agreement dated November 3, 2004 entered into a lock-upagreement with the underwriters. As a result of these lock-up agreements,approximately 31,955,605 shares are subject to contractual restrictions onresale, through April 12, 2005.

 

The market price of shares of our commonstock may drop significantly if our stockholders subject to the lock-upagreement sell a substantial number of shares when the restrictions on resalelapse. A decline in the price of shares of our common stock might impede ourability to raise capital through the issuance of additional shares of ourcommon stock or other equity securities.

 

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

 

Our directors and executive officers, andentities affiliated with them, beneficially own approximately 52% of theoutstanding shares of our common stock. As a result, these stockholders, ifacting together, would be able to influence or control matters requiringapproval by our stockholders, including the election of directors and theapproval 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.

 

***Some provisions inour certificate of incorporation and by-laws may deter third parties fromacquiring us.***

 

Our certificate of incorporation and by-lawscontain provisions that may make the acquisition of our company more difficultwithout the approval of our board of directors, including the following:

 

•                  only our board of directors, the chairman of our boardof directors or our president may call special meetings of our stockholders;

 

•                  our stockholders may take action only at a meeting ofour stockholders and not by written consent;

 

•                  we have authorized undesignated preferred stock, theterms of which may be established and shares of which may be issued withoutstockholder approval;

 

•                  our directors may be removed only for cause by theaffirmative vote of a majority of the directors present at a meeting duly heldat which a quorum is present, or the holders of 75% of the votes that allstockholders would be entitled to cast in the election of directors; and

 

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•                  we impose advance notice requirements for stockholderproposals.

 

These anti-takeover defenses coulddiscourage, delay or prevent a transaction involving a change in control of ourcompany. These provisions could also discourage proxy contests and make it moredifficult for you and other stockholders to elect directors of your choosing and cause us to take other corporate actionsyou 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 203 of theDelaware 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.

 

**Item 3—Quantitative and Qualitative Disclosures****About****Market Risk**

 

***General***

 

Market risk is the risk of change in fairvalue of a financial instrument due to changes in interest rates, equityprices, creditworthiness, foreign exchange rates or other factors. Our primarymarket risk exposure is to changes in interest rates in our cash and othershort-term investments. Cash and other short-term investments include balancesin money market funds. The primary objective of our investment policy is thepreservation of capital. Accordingly, we manage our interest rate risk througha conservative investment policy and an active portfolio management strategythat involves the selection of investments with appropriate characteristics,such as duration, yield, currency and liquidity.

 

***Risks Related toStructural Advisory Fees and Residuals***

 

Because there are no quoted market prices forour additional structural advisory fees and residuals receivables, we useassumptions 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 rates, as well as decreases in default recovery rates and the multi-yearforward estimates of the LIBOR rate, which is the reference rate for the loanassets and borrowings of the securitization trusts, would have a negativeeffect on the value of our additional structural advisory fees and residuals.For an analysis of the estimated change in our structural advisory fees andresiduals receivables balances at December 31, 2004 based on changes inthese loan performance assumptions, see “—Application of Critical AccountingPolicies and Estimates—Service Revenue—Sensitivity Analysis.”

 

**Item 4—Controls and Procedures**

 

Our management, with the participation of ourchief executive officer and chief financial officer, evaluated theeffectiveness of our disclosure controls and procedures (as defined inRules 13a-15(e) and 15d-15(e) under the Exchange Act) as of December 31,2004. Based on this evaluation, our chief executive officer and chief financialofficer concluded that, as of December 31, 2004, our disclosure controlsand procedures were (1) designed to ensure that material informationrelating to us, including our consolidated subsidiaries, is made known to ourchief executive officer and chief financial officer by others within thoseentities, particularly during the period in which this report was beingprepared and (2) effective, in that they provide reasonable assurance thatinformation required to be disclosed by us in the reports that we file orsubmit under the Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and forms.

 

No change in our internal control overfinancial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under theExchange Act) occurred during the second quarter of the fiscal year ending June 30,2005 that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

 

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**Part II. Other Information**

 

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

 

***(b) Use of Proceeds from RegisteredSecurities***

 

In our initial public offering, we sold 7,906,250shares of common stock, including an over-allotment option of 1,031,750 shares,pursuant to a registration statement on Form S-1 (FileNo. 333-108531) that was declared effective by the Securities and ExchangeCommission on October 30, 2003. We received aggregate net proceeds ofapproximately $115.1 million, after deducting underwriting discounts andcommissions of approximately $8.9 million and expenses of the offering ofapproximately $2.5 million. From the effective date of the registrationstatement through December 31, 2004, we have not spent any of the netproceeds of the IPO, which have been invested in cash and other short-terminvestments. Accordingly, none of the net proceeds of the IPO has been paid byus, directly or indirectly, to any director, officer or general partner of us,or any of their associates, or to any person owning ten percent or more of anyclass of our equity securities, or any of our affiliates.

 

In June 2004, we completed a follow-on publicoffering of 7,406,312 shares of our common stock, including an over-allotmentoption of 966,041 shares, pursuant to a registration statement on Form S-1(File No. 333-116142) that was declared effective by the SEC on June 22,2004. All of these shares were offered by selling stockholders, and we did notreceive any proceeds from the offering.

 

In January 2005, we completed a follow-on publicoffering of 3,933,605 shares of our common stock, including an over-allotmentoption of 513,078 shares, pursuant to a registration statement on Form S-3(File No. 333-120740) that was declared effective by the SEC on January 12,2005. All of these shares were offered by selling stockholders, and we did notreceive any proceeds from the offering.

 

**Item 4—Submission of Matters to a Vote of Security Holders**

 

On November 18, 2004, the following proposals were voted on at our2004 annual meeting of stockholders:

 
| **Proposal**                                                                                                                                                                                                                                   | ** ** | **For**    | ** ** | **Against/Withheld** | ** ** | **Abstentions** | ** ** | **Broker  Non-Votes** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|----------------------|------------|-----------------|------------|-----------------------|------------|
|                                                                                                                                                                                                                                           |       |       |       |                 |       |            |       |                  |       |
| To elect the following eight persons to serve as directors until the  next annual meeting of stockholders and until their successors are duly  elected and qualified (subject to such director’s earlier death, resignation  or removal): |       |       |       |                 |       |            |       |                  |       |
|                                                                                                                                                                                                                                           |       |       |       |                 |       |            |       |                  |       |
| Daniel Maxwell Meyers                                                                                                                                                                                                                          |       | 61,001,684 |       | 716,223              |       | N/A             |       | N/A                   |       |
| Stephen E. Anbinder                                                                                                                                                                                                                            |       | 61,102,586 |       | 615,321              |       | N/A             |       | N/A                   |       |
| Leslie L. Alexander                                                                                                                                                                                                                            |       | 61,147,362 |       | 570,545              |       | N/A             |       | N/A                   |       |
| William R. Berkley                                                                                                                                                                                                                             |       | 61,046,321 |       | 671,586              |       | N/A             |       | N/A                   |       |
| Dort A. Cameron  III                                                                                                                                                                                                                           |       | 60,989,644 |       | 728,263              |       | N/A             |       | N/A                   |       |
| George G. Daly                                                                                                                                                                                                                                 |       | 61,025,928 |       | 691,979              |       | N/A             |       | N/A                   |       |
| Peter S. Drotch                                                                                                                                                                                                                                |       | 61,014,881 |       | 703,026              |       | N/A             |       | N/A                   |       |
| William D. Hansen                                                                                                                                                                                                                              |       | 61,016,793 |       | 701,114              |       | N/A             |       | N/A                   |       |
|                                                                                                                                                                                                                                           |       |       |       |                 |       |            |       |                  |       |
| To approve  an amendment to the Company’s Restated Certificate of Incorporation to  increase the authorized number of shares of capital stock                                                                                             |       | 61,168,438 |       | 530,347              |       | 19,122          |       | 0                     |       |
|                                                                                                                                                                                                                                           |       |       |       |                 |       |            |       |                  |       |
| To approve  the Company’s Executive Incentive Compensation Plan                                                                                                                                                                           |       | 54,543,774 |       | 584,430              |       | 37,013          |       | 6,552,690             |       |

 

**Item6—Exhibits**

 

See the Exhibit Index on the page immediatelypreceding the exhibits for a list of exhibits filed as part of this quarterlyreport, which Exhibit Index is incorporated herein by this reference.

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
| ** **                   | **THE FIRST MARBLEHEAD CORPORATION** |
|------------------------------|--------------------------------------|
| ** **                   | ** **                           |
| Date: February 11, 2005 | By:                                  | /s/ Donald  R. Peck |   |
|                         |                                 | Donald R. Peck |   |
|                         |                                 | *Executive Vice President,* |   |
| * *                     |                                 | *Chief Financial Officer, Treasurer and  Secretary* |   |

 

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**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                               |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | ** **                                                                                                                                                                                                                    |
| 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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