**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 September 30, 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 by check mark whether theregistrant: (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor 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 October 31, 2004, the registranthad 64,628,579 shares of Common Stock, $0.01 par value per share, outstanding.

 

 

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**THEFIRST MARBLEHEAD CORPORATION**

 

**Tableof Contents**

 
| Part I. Financial Information | Page                                                                                                                         |
|-------------------------------|------------------------------------------------------------------------------------------------------------------------------|
| Item 1—                  | Financial Statements                                                                                                         |   |
|                          | Condensed Consolidated Balance Sheets as of  September 30, 2004 and June 30, 2004                                  | 3 |
|                          | Condensed Consolidated Statements of  Operations for the three months ended September 30, 2004 and 2003                 | 4 |
|                          | Condensed Consolidated Statement of Changes  in Stockholders’ Equity for the three months ended September 30, 2004 | 5 |
|                          | Condensed Consolidated Statements of Cash  Flows for the three months ended September 30, 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                                                                  | 42 |
| Item 4—                  | Controls and Procedures                                                                                                      | 42 |
| Part II. Other Information    |                                                                                                                         |
| Item 2—                  | Unregistered Sales of Equity Securities and  Use of Proceeds                                                                 | 43 |
| Item 5—                  | Other Information                                                                                                            | 43 |
| Item  6—                 | Exhibits                                                                                                                     | 44 |
| SIGNATURES                    | 45                                                                                                                           |
| EXHIBIT INDEX                 | 46                                                                                                                           |

 

2

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**Part I. Financial Information**

 

**Item1—Financial Statements**

 

**THEFIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(unaudited)**

**(inthousands, except share and per share amounts)**

 
| ** **                                                                                                                                                                                         | ** ** | **September 30,  2004** | ** ** | **June 30,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-------------------------|------------|
| ** **                                                                                                                                                                                         | ** ** | ** **                   | ** ** | ** **              | ** ** |
| **ASSETS**                                                                                                                                                                                         |       |                         |       |                    |       |
| Cash and  other short-term investments                                                                                                                                                             |       | $                            | 146,079    |                    | $          | 168,712 |   |
|                                                                                                                                                                                               |       |                         |       |                    |       |
| Service  receivables:                                                                                                                                                                              |       |                         |       |                    |       |
| Structural  advisory fees                                                                                                                                                                          |       | 24,703                       |       | 34,334                  |       |
| Residuals                                                                                                                                                                                          |       | 111,955                      |       | 108,495                 |       |
| Processing  fees from The Education Resources Institute (TERI)                                                                                                                                     |       | 6,427                        |       | 6,052                   |       |
|                                                                                                                                                                                               |       | 143,085                      |       | 148,881                 |       |
|                                                                                                                                                                                               |       |                         |       |                    |       |
| Other  receivables                                                                                                                                                                                 |       | 2,033                        |       | 438                     |       |
|                                                                                                                                                                                               |       |                         |       |                    |       |
| Property and  equipment                                                                                                                                                                            |       | 16,429                       |       | 15,146                  |       |
| Less  accumulated depreciation and amortization                                                                                                                                                    |       | (5,238                       | )          | (4,315                  | )          |
| Property and  equipment, net                                                                                                                                                                       |       | 11,191                       |       | 10,831                  |       |
|                                                                                                                                                                                               |       |                         |       |                    |       |
| Goodwill                                                                                                                                                                                           |       | 3,176                        |       | 3,176                   |       |
| Intangible  assets, net                                                                                                                                                                            |       | 3,058                        |       | 3,180                   |       |
| Prepaid and  other current assets                                                                                                                                                                  |       | 27,343                       |       | 23,030                  |       |
| Other assets                                                                                                                                                                                       |       | 1,808                        |       | 1,808                   |       |
|                                                                                                                                                                                               |       |                         |       |                    |       |
| Total assets                                                                                                                                                                                       |       | $                            | 337,773    |                    | $          | 360,056 |   |
|                                                                                                                                                                                               |       |                         |       |                    |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                     |       |                         |       |                    |       |
| Liabilities:                                                                                                                                                                                       |       |                         |       |                    |       |
| Accounts  payable and accrued expenses                                                                                                                                                             |       | $                            | 14,431     |                    | $          | 26,285 |   |
| Net deferred  tax liability                                                                                                                                                                        |       | 41,556                       |       | 40,138                  |       |
| Notes  payable and capital lease obligations                                                                                                                                                       |       | 1,765                        |       | 9,179                   |       |
| Notes  payable to TERI                                                                                                                                                                             |       | 5,830                        |       | 6,004                   |       |
| Other  liabilities                                                                                                                                                                                 |       | 323                          |       | 314                     |       |
| Total  liabilities                                                                                                                                                                                 |       | 63,905                       |       | 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; 100,000,000 shares authorized; 64,446,739  and 63,975,000 shares issued and outstanding at September 30, 2004 and June 30,  2004, respectively |       | 644                          |       | 640                     |       |
| Additional  paid-in capital                                                                                                                                                                        |       | 164,652                      |       | 163,572                 |       |
| Retained  earnings                                                                                                                                                                                 |       | 108,572                      |       | 113,924                 |       |
| Total  stockholders’ equity                                                                                                                                                                   |       | 273,868                      |       | 278,136                 |       |
|                                                                                                                                                                                               |       |                         |       |                    |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                   |       | $                            | 337,773    |                    | $          | 360,056 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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**THEFIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(unaudited)**

**(inthousands, except per share amounts)**

 
| ** **                                    | ** ** | **Three months ended  September 30,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                    | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
|                                          |       |                                       |       |   |   |
| Service  revenue:                             |       |                                       |       |   |   |
| Structural  advisory fees                     |       | $                                          | 619        |   | $ | (278 | ) |
| Residuals                                     |       | 3,460                                      |       | 1,594 |   |
| Administrative  and other fees                |       | 968                                        |       | 313 |   |
| Processing  fees from TERI                    |       | 17,357                                     |       | 7,840 |   |
| Total  service revenue                        |       | 22,404                                     |       | 9,469 |   |
|                                          |       |                                       |       |   |   |
| Operating  expenses:                          |       |                                       |       |   |   |
| Compensation  and benefits                    |       | 14,880                                     |       | 8,872 |   |
| General and  administrative expenses          |       | 16,959                                     |       | 6,339 |   |
| Total  operating expenses                     |       | 31,839                                     |       | 15,211 |   |
| Loss from  operations                         |       | (9,435                                     | )          | (5,742 | ) |
| Other  (income) expense:                      |       |                                       |       |   |   |
| Interest  expense                             |       | 119                                        |       | 120 |   |
| Interest  income                              |       | (482                                       | )          | (21 | ) |
| Total other  (income) expense, net            |       | (363                                       | )          | 99 |   |
| Loss before  income tax benefit               |       | (9,072                                     | )          | (5,841 | ) |
| Income tax  benefit                           |       | (3,720                                     | )          | (2,764 | ) |
| Net loss                                      |       | $                                          | (5,352     | ) | $ | (3,077 | ) |
|                                          |       |                                       |       |   |   |
| Net loss per  share, basic                    |       | $                                          | (0.08      | ) | $ | (0.06 | ) |
| Net loss per  share, diluted                  |       | (0.08                                      | )          | (0.06 | ) |
| Weighted  average shares outstanding, basic   |       | 64,321                                     |       | 53,326 |   |
| Weighted  average shares outstanding, diluted |       | 64,321                                     |       | 53,326 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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**THEFIRST MARBLEHEAD CORPORATION**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY**

**(unaudited)**

**(inthousands)**

 
| ** **                                            | ** ** | **Common  Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Retained  Earnings** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|-------------------------------------------------------|------------|-------------------|------------|----------------------------------|------------|------------------------|------------|---------------------------------------|------------|
|                                                  |       |              |       |                             |       |                   |       |                                  |       |
| Balance at June 30,  2004                        |       | $                 | 640        |                             | $          | 163,572                |       | $                                     | 113,924    |   | $ | 278,136 |   |
|                                                  |       |              |       |                             |       |                   |       |                                  |       |
| Options  exercised                                    |       | 4                 |       | 481                              |       | —                 |       | 485                                   |       |
| Stock  purchases through employee stock purchase plan |       | —            |       | 550                              |       | —                 |       | 550                                   |       |
| Tax benefit  from employee stock options              |       | —            |       | 49                               |       | —                 |       | 49                                    |       |
| Net loss                                              |       | —            |       | —                           |       | (5,352                 | )          | (5,352                                | )          |
| Balance at September 30,  2004                   |       | $                 | 644        |                             | $          | 164,652                |       | $                                     | 108,572    |   | $ | 273,868 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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**THEFIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(unaudited)**

**(inthousands)**

 
| ** **                                                                   | ** ** | **Three months ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                   | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
|                                                                         |       |                                       |       |   |   |
| Cash flows  from operating activities:                                       |       |                                       |       |   |   |
| Net loss                                                                     |       | $                                          | (5,352     | ) | $ | (3,077 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities: |       |                                       |       |   |   |
| Depreciation                                                                 |       | 923                                        |       | 396 |   |
| Amortization                                                                 |       | 309                                        |       | 280 |   |
| Tax benefit  from employee stock options                                     |       | 49                                         |       | — |   |
| Non-cash  compensation                                                       |       | —                                     |       | 1,642 |   |
| Change in  assets/liabilities:                                               |       |                                       |       |   |   |
| (Increase)  decrease in processing fees from TERI and other receivables      |       | (1,969                                     | )          | 462 |   |
| Decrease in  structural advisory fees                                        |       | 9,631                                      |       | 278 |   |
| (Increase)  in residuals                                                     |       | (3,460                                     | )          | (1,594 | ) |
| (Increase)  in prepaid and other current assets                              |       | (4,313                                     | )          | (1,092 | ) |
| Increase  (decrease) in net deferred tax liability                           |       | 1,418                                      |       | (502 | ) |
| (Decrease)  in accounts payable, accrued expenses and other liabilities      |       | (11,846                                    | )          | (3,063 | ) |
| Net cash  used in operating activities                                       |       | (14,610                                    | )          | (6,270 | ) |
| Cash flows  from investing activities:                                       |       |                                       |       |   |   |
| Purchases of  property and equipment                                         |       | (1,283                                     | )          | (1,142 | ) |
| Payments to  TERI for loan database updates                                  |       | (187                                       | )          | (187 | ) |
| Net cash  used in investing activities                                       |       | (1,470                                     | )          | (1,329 | ) |
| Cash flows  from financing activities:                                       |       |                                       |       |   |   |
| Repayment of  notes payable due to TERI                                      |       | (174                                       | )          | (164 | ) |
| Repayment of  notes payable and capital lease obligations                    |       | (7,414                                     | )          | (40 | ) |
| Proceeds  from capital lease obligations                                     |       | —                                     |       | 148 |   |
| Stock  options exercised                                                     |       | 1,035                                      |       | 277 |   |
| Net cash  provided by (used in) financing activities                         |       | (6,553                                     | )          | 221 |   |
| Net decrease  in cash and other short-term investments                       |       | (22,633                                    | )          | (7,378 | ) |
| Cash and  other short-term investments, beginning of period                  |       | 168,712                                    |       | 18,327 |   |
| Cash and  other short-term investments, end of period                        |       | $                                          | 146,079    |   | $ | 10,949 |   |
|                                                                         |       |                                       |       |   |   |
| Supplemental  disclosures of cash flow information:                          |       |                                       |       |   |   |
| Interest  paid                                                               |       | $                                          | 369        |   | $ | 120 |   |
|                                                                         |       |                                       |       |   |   |
| Income taxes  paid                                                           |       | $                                          | —     |   | $ | 6,435 |   |
|                                                                         |       |                                       |       |   |   |
| Supplemental  disclosure of non-cash activities:                             |       |                                       |       |   |   |
| Structural  advisory fees and residuals                                      |       | $                                          | 4,079      |   | $ | 1,316 |   |
|                                                                         |       |                                       |       |   |   |
| Non-cash  compensation                                                       |       | $                                          | —     |   | $ | 1,642 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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**THEFIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

 

**NOTESTO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL 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 trust vehicles that the Company forms forsecuritizations 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 reportedin the consolidated financial statements and accompanying notes. Interimresults are not necessarily indicative of results to be expected for the entirefiscal year. 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 current period 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.Therefore, during the first quarters of fiscal 2005 and fiscal 2004, theCompany did not generate any structural advisory fees or residuals from newsecuritization transactions. The Company closed a securitization transaction inOctober 2004 and expects to close securitization transactions in the third andfourth quarters of fiscal 2005.

 

***Concentrations***

 

**TERI**

 

The Education Resources Institute, Inc.(TERI) is a private, not-for-profit Massachusetts corporation as described undersection 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 September 30, 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

 

7

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increase.

 

**PHEAA**

 

As of September 30, 2004, there wereeight TERI-approved loan servicers, all of which were utilized by the Company.As of September 30, 2004, Pennsylvania Higher Education Assistance Agency(PHEAA) serviced a majority of the loans for which the Company facilitatedorigination. The Company’s use of third-party loan servicers allows the Companyto increase the volume of loans in its clients’ loan programs without incurringthe overhead investment in servicing operations. As with any external serviceprovider, there are risks associated with inadequate or untimely services. Inaddition, if the Company’s relationship with PHEAA terminates, the Companywould either need to expand or develop a relationship with anotherTERI-approved loan servicer, which could be time-consuming and costly.

 

***Significant Customers***

 

During the three month periods ended September 30,2004 and 2003, processing fees from TERI represented approximately 77% and 83%,respectively, of total service revenue. The Company did not recognize more than10% of total service revenue from any other customer.

 

***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:

 

•     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

 

•     theimpact of the estimates and assumptions on the Company’s financial condition oroperating performance is material.

 

The Company believes that its accounting policies involving therecognition and valuation of the Company’s service revenue related to thesecuritizations that it structures for its clients, as well as the valuation ofgoodwill and intangible assets, fit the definition of critical accountingestimates. The Company also considers its policy with respect to thedetermination of whether or not to consolidate the securitization trusts thatit facilitates to be a critical accounting policy. See “Management’s Discussionand Analysis of Financial Condition and Results of Operations—Application ofCritical 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 lossand net loss per share for the three month periods ended September 30,2004 and 2003, had the Company elected to recognize compensation expense forthe granting of options under SFAS No. 123 using the Black-Scholes optionpricing model, are as follows:

 

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| ** **                                                                                                                      | ** ** | **Three months ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                      | ** ** | **(in thousands, except per share  data)** | ** ** |
| ** **                                                                                                                      | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
|                                                                                                                            |       |                                       |       |   |   |
| Net loss—as  reported                                                                                                      |       | $                                          | (5,352     | ) | $ | (3,077 | ) |
| Less: Total  stock-based employee compensation expense determined under the fair value  based method for all awards, net of tax |       | (738                                       | )          | (243 | ) |
|                                                                                                                            |       |                                       |       |   |   |
| Net loss—pro  forma                                                                                                        |       | $                                          | (6,090     | ) | $ | (3,320 | ) |
|                                                                                                                            |       |                                       |       |   |   |
| Net loss per  share—basic—as reported                                                                                 |       | $                                          | (0.08      | ) | $ | (0.06 | ) |
| Net loss per  share—basic—pro forma                                                                                   |       | $                                          | (0.09      | ) | $ | (0.06 | ) |
| Net loss per  share—diluted—as reported                                                                               |       | $                                          | (0.08      | ) | $ | (0.06 | ) |
| Net loss per  share—diluted—pro forma                                                                                 |       | $                                          | (0.09      | ) | $ | (0.06 | ) |

 

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

# ** **

As of September 30,2004, there were options to purchase 3,179,450 shares of the Company’s commonstock outstanding.  As of September 30, 2003, there were options topurchase 6,070,240 shares of the Company’s common stock outstanding. TheCompany has not included these options in the computation of diluted net incomeper share for the three months ended September 30, 2004 or 2003, as theireffects would have been antidilutive.

 

**(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 and recovery estimates. The fees are paid to the Companyfrom the various separate securitization trusts established by The NationalCollegiate Trust (NCT trusts), from The National Collegiate Master Student LoanTrust I (NCMSLT) and The National Collegiate Student Loan Trust 2003-1 (NCSLT2003) and from The National Collegiate Student Loan Trust 2004-1 (NCSLT2004-1). Processing fees receivable from TERI represents amounts due from TERIfor expenses incurred by First Marblehead Education Resources, Inc. (FMER), awholly owned subsidiary of FMC, on TERI’s behalf.

 

The Company did not conduct anysecuritization transactions in the first quarter of either fiscal 2005 or fiscal2004. The Company does, on a quarterly basis, update its estimate of thepresent value of its structural advisory fees and residuals receivables toreflect the passage of time, any change in discount rates used to estimatetheir present value, and any changes to the trust performance metrics that theCompany considers in its present value estimates, such as default, recovery,prepayment and forward London Interbank Offered Rate (LIBOR) rates.

 

For the NCT trusts, NCMSLT, NCSLT 2003 andNCSLT 2004-1 the Company made no changes in its assumptions regarding defaultrates, prepayment rates and recovery rates in the first quarter of eitherfiscal 2005 or 2004.

 

The Company uses an implied forward LIBORcurve to estimate trust cash flows. During the three month period ended September 30,2004, the implied forward LIBOR curve decreased and flattened. This decreaseresulted in a decrease in the interest to be capitalized on the underlyingstudent loan assets during their respective deferment periods, which decreasesthe balance on which the Company expects to charge its 15 basis points per yearof additional structural advisory fees over the life of the trust, and thereforedecreases the fair market value of the structural advisory fees receivable.However, the flattening of the curve improved the net excess spread between thetrust assets and liabilities, resulting in an increase in the fair market valueof residuals receivable during the period. The impact of changing LIBOR ratesduring the three month period ended September 30, 2003 did not have amaterial impact on the fair market value of these receivables during thatperiod.

 

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 September 30, 2004, this rate decreased by 46 basis points from 

 

9

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6.58% to 6.12%. From July 1, 2003 to September 30, 2003, thisrate increased by 62 basis points from 5.33% to 5.95%. A decrease in the 10-yearU.S. Treasury rate has the effect of increasing the fair market value of theCompany’s structural advisory fees receivable, while an increase in the ratehas the opposite effect on the Company’s estimate of their fair market value.In determining an appropriate discount rate for valuing residuals, we reviewthe rates used by student loan securitizers, as well as rates used in the muchbroader commercial mortgage-backed securities (CMBS) market. We believe thatthe 12% discount rate we use is appropriate given the expected 24-year life ofthe trust assets and residuals.

 

The following table summarizes the changes inthe structural advisory fees receivable for the three month periods ended September 30,2004 and 2003:

 
| ** **                                      | ** ** | **Three months ended  September 30,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                      | ** ** | **(in thousands)**                         | ** ** |
| ** **                                      | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
|                                            |       |                                       |       |   |   |
| Fair value  at beginning of period              |       | $                                          | 24,084     |   | $ | 10,785 |   |
| Additions  from structuring new securitizations |       | —                                     |       | — |   |
| Fair market  value adjustments                  |       | 619                                        |       | (278 | ) |
| Fair value  at end of period                    |       | $                                          | 24,703     |   | $ | 10,507 |   |

 

The following table summarizes the changes in the residuals receivablefor the three month periods ended September 30, 2004 and 2003:

 
| ** **                                      | ** ** | **Three months ended  September 30,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                      | ** ** | **(in thousands)**                         | ** ** |
| ** **                                      | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
|                                            |       |                                       |       |   |   |
| Fair value  at beginning of period              |       | $                                          | 108,495    |   | $ | 43,600 |   |
| Additions  from structuring new securitizations |       | —                                     |       | — |   |
| Fair market  value adjustments                  |       | 3,460                                      |       | 1,594 |   |
| Fair value  at end of period                    |       | $                                          | 111,955    |   | $ | 45,194 |   |

 

The principal balance of loans facilitatedand available to the Company for later securitization at September 30,2004 and June 30, 2004 totaled $1.15 billion and $276.1 million,respectively.

 

The effect on the fair market 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 September 30, 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:

 

**(dollarsin thousands)**

 
| **Structural  advisory fees receivables, September 30, 2004** |   | $      | 24,703 |                                                     |   |   |   |   |
|--------------------------------------------------------------------|--------|--------|--------|----------------------------------------------------------|--------|--------|--------|--------|
|                                                               |   |   |   |                                                     |   |   |   |
| Default rate                                                       |   |   |   | Default rate                                             |   |   |   |
| +10%                                                               |   | $      | (184   | )                                                        | -10%   |   | $      | 186    |   |
| +20%                                                               |   | (376   | )      | -20%                                                     |   | 369    |   |
| Default  recovery rate                                             |   |   |   | Default recovery rate                                    |   |   |   |
| +10%                                                               |   | — |   | -10%                                                     |   | (185   | )      |
| +20%                                                               |   | 201    |   | -20%                                                     |   | (185   | )      |
| Prepayment  rate                                                   |   |   |   | Prepayment rate                                          |   |   |   |
| +10%                                                               |   | (631   | )      | -10%                                                     |   | 663    |   |
| +20%                                                               |   | (1,230 | )      | -20%                                                     |   | 1,357  |   |
| Discount  rate                                                     |   |   |   | Discount rate                                            |   |   |   |
| +10%                                                               |   | (978   | )      | -10%                                                     |   | 1,037  |   |
| +20%                                                               |   | (1,917 | )      | -20%                                                     |   | 2,129  |   |
| Forward  LIBOR rates                                               |   |   |   | Forward LIBOR rates                                      |   |   |   |
| +1%                                                                |   | 722    |   | -1%                                                      |   | (891   | )      |
| +2%                                                                |   | 1,653  |   | -2%                                                      |   | (1,252 | )      |
| Change in  assumed spread between LIBOR and auction rate           |   |   |   | Change in  assumed spread between LIBOR and auction rate |   |   |   |
| +.05%                                                              |   | — |   | -.05%                                                    |   | — |   |
| +.10%                                                              |   | 3      |   | -.10%                                                    |   | (1     | )      |
|                                                                    |        |        |        |                                                          |        |        |        |        |  |

 

10

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**(dollarsin thousands)**

 
| **Residuals  receivables, September 30, 2004**      |   | $       | 111,955 |                                                     |   |   |   |   |
|----------------------------------------------------------|--------|---------|---------|----------------------------------------------------------|--------|--------|--------|--------|
|                                                     |   |    |    |                                                     |   |   |   |
| Default rate                                             |   |    |    | Default rate                                             |   |   |   |
| +10%                                                     |   | $       | (2,615  | )                                                        | - 10%  |   | $      | 834    |   |
| +20%                                                     |   | (6,622  | )       | - 20%                                                    |   | 1,616  |   |
| Default  recovery rate                                   |   |    |    | Default recovery rate                                    |   |   |   |
| +10%                                                     |   | 630     |    | - 10%                                                    |   | (747   | )      |
| +20%                                                     |   | 830     |    | - 20%                                                    |   | (1,753 | )      |
| Prepayment  rate                                         |   |    |    | Prepayment rate                                          |   |   |   |
| +10%                                                     |   | (5,305  | )       | - 10%                                                    |   | 5,563  |   |
| +20%                                                     |   | (10,361 | )       | - 20%                                                    |   | 11,405 |   |
| Discount  rate                                           |   |    |    | Discount rate                                            |   |   |   |
| +10%                                                     |   | (10,686 | )       | - 10%                                                    |   | 11,983 |   |
| +20%                                                     |   | (20,096 | )       | - 20%                                                    |   | 25,520 |   |
| Forward  LIBOR rates                                     |   |    |    | Forward LIBOR rates                                      |   |   |   |
| +1%                                                      |   | 4,123   |    | - 1%                                                     |   | $      | (4,237 | )      |
| +2%                                                      |   | 8,050   |    | - 2%                                                     |   | (5,673 | )      |
| Change in  assumed spread between LIBOR and auction rate |   |    |    | Change in  assumed spread between LIBOR and auction rate |   |   |   |
| +.05%                                                    |   | (2,012  | )       | -.05%                                                    |   | 2,012  |   |
| +.10%                                                    |   | (4,021  | )       | -.10%                                                    |   | 4,027  |   |

 

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

 

At September 30, 2004 and June 30,2004, Milestone Capital Management (MCM), an institutional money managementfirm, was managing approximately $133.9 million and $145.2 million,respectively, of cash and other short-term investments for the Company andcharging its standard fees for its services. One of the Company’s directors isa director of MCM. Members of the director’s immediate family own approximately40% 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 greaterof 6% or 1% above the highest published *WallStreet Journal*prime rate. The terms of the line of credit requiredthat: the Company maintain accurate books and records; the assets be free ofall liens, encumbrances and financing not approved by the lender; and whenthere was a balance outstanding under the line, no dividends or payments ofprincipal and interest on any loans held by any guarantor, officer, director orstockholder could be made. A member of the board of directors of the Company isalso a director and significant stockholder of a company that owns the bank.The Company believes that the line of credit was on substantially the sameterms as those prevailing at the same time for comparable transactions withthird parties. The Company did not renew this credit facility upon expiration.The Company had no amounts outstanding under 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

 

11

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note payable agreement with TERI on June 20, 2001, amounting to$3.9 million, $2.0 million of which related to the acquisition ofTERI’s software and network assets and $1.9 million of which related tothe Company’s acquisition of a workforce-in-place. Principal and interest at anannual rate of 6% are payable in 120 monthly installments of $43,298commencing on July 20, 2001 and ending on June 20, 2011. The notepayable is secured by the software and network assets and workforce-in-placeintangible assets. The outstanding balance of this note payable at September 30,2004 and June 30, 2004 amounted to $2.9 million 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 andinterest at an annual rate of 6% are payable in 120 monthly installmentsof $44,408 commencing on July 20, 2001 and ending on June 20, 2011.The note payable is secured by the loan database. The outstanding balance ofthis note payable was approximately $3.0 million at September 30, 2004 andJune 30, 2004.

 

**(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 September 30, 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 revolving credit facility. This letterof credit reduces the amount the Company may borrow under this revolving creditfacility.

 

***(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.  The Company agreed to repay this note withthe first $7.25 million of the $10.25 million up-front structural advisory feethat it received in July 2004 in connection with the December 2003securitization.  This note was furthercollateralized 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:

 

•                  7,906,250 sharessold by the Company; and

 

•                  6,468,750 sharessold 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 the fiscal year ended June 30, 2004.

 

12

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***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 $900,000through June 30, 2003. The executive officer earned additional non-cashcompensation of approximately $1.6 million during the first quarter of fiscal2004. On September 30, 2003, the agreement was terminated in exchange forvested options issued by these 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 Company’s Board ofDirectors approved a resolution to increase the number of authorized shares ofcommon stock from 100,000,000 to 150,000,000. This resolution is subject tostockholder approval. 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 September 30, 2004, options topurchase 64,000 shares of common stock have been issued under this plan.

 

***2003Stock Incentive Plan***

 

In September 2003, the Board of Directorsand stockholders approved the 2003 Stock Incentive Plan and reserved 1,200,000shares of common stock for issuance under this plan. As of September 30,2004, no options had been issued under this plan.

 

***StockSplits***

 

In August 2003, the stockholders approveda 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 to be effected as a stockdividend immediately prior to the effectiveness of the initial public offering.On October 29, 2003, the stockholders became entitled to payment of suchstock dividend. All prior period share data have been retroactively adjusted toreflect 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, 40,499shares were issued under the Stock Purchase Plan.

 

***(9)  Pension Plan***

*** ***

FMER has anon-contributory defined benefit pension plan that covers substantially allFMER employees. The following table sets forth the amounts recognized relatedto FMER’s defined benefit pension plan in the Company’s consolidated financialstatements for the three month periods ended September 30, 2004 and 2003:

 

13

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| ** **                                    | ** ** | **Three months ended  September 30,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                    | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
| **Components  of net periodic pension cost:** |       |                                       |       |   |   |
| Service cost                                  |       | $                                          | 157,538    |   | 148,989 |   |
| Interest on  projected benefit obligations    |       | 62,030                                     |       | 52,574 |   |
| Loss  recognized                              |       | 8,980                                      |       | 17,466 |   |
| Expected  return on plan assets               |       | (42,248                                    | )          | (34,439 | ) |
| Net periodic  pension cost                    |       | $                                          | 186,300    |   | $ | 184,590 |   |
|                                               |            |                                            |            |  |  |  |  |

 

**Employer Contributions**

 

During thethree months ended September 30, 2004, the Company made contributions of$300,000 to FMER’s defined benefit pension plan. The Company expects to makeadditional aggregate contributions of approximately $300,000 during theremainder of fiscal year 2005.

 

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

 

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 issuedFASB Interpretation (FIN) No. 46 (revised December 2003), “Consolidationof Variable Interest Entities” (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 September 30, 2004, thesecuritization trusts created after January 31, 2003 have either met thecriteria to be a qualified special-purpose entity (QSPE), as defined in paragraph 35of SFAS No. 140, “Accounting for the Transfers and Servicing of FinancialAssets and Extinguishments of Liabilities,” or the Company has determined thatit is not the primary beneficiary of the securitization trusts, as defined byFIN No. 46R. Accordingly, the Company did not consolidate these existingsecuritization trusts in these financial statements. In addition, thesecuritization trusts created prior to January 31, 2003 have been amendedin order for them to be considered QSPEs. The adoption of FIN No. 46R,which the Company began to apply in December 2003, did not have a materialimpact on the Company’s consolidated financial condition, results ofoperations, 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 first 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**

 

*Leases*

 

In October 2004, the Company enteredinto two non-cancelable operating leases, each for approximately 26,000 squarefeet of office space at different locations in Boston, MA. The first leaseexpires in March 2014. The space from the first lease will be used toexpand the Company’s corporate offices. The second lease expires in April 2014.The space from the second lease will be used to expand the Company’s loanprocessing facilities and information technology infrastructure. The futureminimum lease payments required under these new leases for each of the fivefiscal years subsequent to June 30, 2004 and thereafter are approximatelyas follows:

 
| ** ** | ** ** | **(in thousands)** | ** ** |
|------------|------------|--------------------|------------|
| ** ** | ** ** | ** **         | ** ** |
| 2005       |       | $                  | 559        |   |
| 2006       |       | 1,759              |       |
| 2007       |       | 1,759              |       |
| 2008       |       | 1,759              |       |
| 2009       |       | 1,780              |       |
| Thereafter |       | 9,696              |       |
|       |       | $                  | 17,312     |   |

 

14

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*Restricted Stock Units*

 

On October 26, 2004, the Company’s boardof directors granted an aggregate of 70,000 restricted stock units (Units)under the Company’s 2003 Stock Incentive Plan to certain executive officers andmembers of the Company’s management. Each Unit represents the right to receivein the future one share of the common stock of the Company, subject to certainterms and conditions. The Units will vest as to one-third of the originalnumber of Units granted on each of the third, fourth and fifth anniversaries ofthe recipient’s first date of employment.

 

*Renewal of TERI Agreement*

 

On October 26, 2004, the board ofdirectors of the Company authorized the renewal, for an additional term throughJune 2011, of the Database Sale and Supplementation Agreement with TERI.The Company currently pays a monthly purchase fee of $62,294 as considerationfor the right to receive updates and queries to a loan database acquired fromTERI in June 2001. These payments commenced in July 2001 and will bepaid through June 2007 under the original terms of the agreement. Underthe terms of the renewal, beginning in July 2007 and through June 2011,the Company’s monthly purchase fee will be reduced to $20,627.

 

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 the factors including, but not limited to, those set forthunder “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 designand marketing;

 

•                  borrower inquiryand application;

 

•                  loan originationand disbursement;

 

•                  loansecuritization; and

 

•                  loan servicing.

 

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, weare obligated by contract to observe them. Although we oversee loan servicingas a component of our administrative 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 quarter of fiscal 2005, we processed approximately 375,000 loan applicationsand facilitated $1.03 billion in loans at over 4,400 schools. During all of fiscal2004, 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 marketdirectly to prospective student borrowers and their families;

 

•                  lenders marketdirectly to educational institutions;

 

•     third parties who are notthemselves lenders design and market directly to prospective student borrowersand their families; loans under these programs are made by referral lenders;

 

•                  third partieswho are not themselves lenders design and market directly to educationalinstitutions; loans under these programs are made by referral lenders; and

 

•                  businesses,unions, affinity groups and other organizations offer to their employees or members.

 

16

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

 

During fiscal 2004, we securitized bothprivate label loans and GATE loans. During fiscal 2004, our private labelprograms contributed $191.1 million, or 96%, of our total service revenue,while our GATE programs contributed $8.2 million, or 4%, of our totalservice 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 thisacquisition, 161 members of TERI’s staff became our employees. In addition, weentered into a master servicing agreement pursuant to which TERI engages us toprovide loan origination and processing services with respect to the loansgenerated through the private label programs we facilitate, as well as otherTERI-guaranteed loans. TERI reimburses us for the expenses we incur inproviding these services. Under the terms of a master loan guaranty agreementthat we entered into with TERI in 2001, we also agreed to provide a beneficialinterest for TERI of 25% of the residual value of TERI-guaranteed loans ownedby the securitization trusts that purchase the loans, and a right of firstrefusal to guarantee our private label clients’ existing and future loanprograms. In October 2004, we renewed our master servicing agreement,master loan guaranty agreement and certain additional agreements with TERI, ineach case for an additional term through June 2011.  In addition, we entered into a supplement tothe master loan guaranty agreement, providing TERI with an option to adjustonce per fiscal year the amount of its guaranty fee that is held in acollateral reserve for guaranty claims, with a corresponding reduction from 25percent to 20 percent in TERI’s ownership of the residual value of theTERI-guaranteed loans purchased during that year by the securitizationtrust.  TERI has made such an electionfor 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 quarter of fiscal 2005, wefacilitated approximately 108,000 loans in an aggregate principal amount ofapproximately $1.03 billion. Approximately $868 million of this amount wasavailable to us for securitization. During the first quarter of fiscal 2004, wefacilitated approximately 68,000 loans in an aggregate principal amount ofapproximately $621 million. Approximately $477 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 quarter of fiscal 2005 increased 66% as compared tothe first quarter of fiscal 2004. The loans that we facilitated that areavailable to us for securitization increased 82% in the first quarter of fiscal2005 as compared to the first quarter 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 in ourrevenue in greater detail below. We may in the future enter into arrangementswith private label lenders under which we provide outsourcing services, but donot have the exclusive right to securitize the loans that they originate.

 

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

 

•                  the demand forprivate education financing;

 

•                  the competitionfor providing private education financing;

 

•                  the educationfinancing preferences of students and their families;

 

•                  applicable lawsand regulations, which may affect the terms upon which our clients agree tomake private student loans and the cost and complexity of our loan facilitationoperations;

 

17

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•                  the privatestudent loan securitization market, including the costs or availability offinancing;

 

•                  the generalinterest rate environment, including its effect on our discount rates;

 

•                  our criticalaccounting policies and estimates;

 

•                  borrower defaultrates; and

 

•                  prepayment rateson private student loans, including prepayments 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. In October 2004, weclosed a securitization transaction.  Therevenue from this securitization transaction will be included in our financialresults for the second quarter of fiscal 2005.  As of November 1, 2004, we have utilizedthe following special purpose entities for the securitizations we havestructured:

 

•                  *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 ofTERI-guaranteed and 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 years 2004 and 2003, these fees have ranged from 4.7% to 7.0% of the principaland 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 loan. 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 

 

18

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level, which ranges from 103.0% to 105.0%.The level applicable to a particular trust is determined at securitization. Wecurrently expect to receive the additional fees beginning five to seven yearsafter the date of a particular securitization transaction.

 

*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:

 

•                  in connectionwith the securitizations in NCSLT 2004-2, 80% of the residual cash flows once aparity ratio of 103.0% is reached and maintained;

 

•                  in connectionwith the securitizations in NCSLT 2004-1 and NCSLT 2003, 75% of the residualcash flows once a parity ratio of 103.0% is reached and maintained;

 

•                  in connectionwith securitizations in NCMSLT, 75% of the residual cash flows once a parityratio of 103.5% is reached and maintained; and

 

•                  in connectionwith securitizations in the NCT trusts, our share of residual cash flows onceall of the debtholders of the securitization trust have been repaid, plus, inthe case of securitized GATE loans, 10% of the residual cash 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 of securitizationsin the NCT trusts, we currently expect to receive the residuals beginning 12 to15 years after the date of a particular securitization.

 

*Administrative and other fees*.  Our administrative and other fees representprimarily the administrative fees we receive from the trusts for their dailymanagement and for the services we provide in obtaining information from theloan servicers and reporting this and other information to the parties relatedto the securitization. We receive fees ranging from 5 to 20 basis points peryear of the student loan balance in the trust. In addition, in connection withsome securitizations, we receive other fees from originating lenders when theirloans are purchased by the securitization trust although these fees have notbeen material and we do not expect them to be material in the future. We alsorecord as administrative and other fees the reimbursement we receive forcertain call center costs. These fees were approximately $0.3 million for thefirst quarter of fiscal 2005. These fees were not material during the prioryear period. The increase in these fees is primarily due to the increase inloan 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.

 

***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.

 

19

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As required under U.S. generally acceptedaccounting principles, we also recognize additional structural advisory feesand residuals as revenue at that time, as they are deemed to be earned at thetime of the securitization and before we actually receive payment. Theseamounts are deemed earned because evidence of an arrangement exists, we haveprovided the services, the fee is fixed and determinable based upon adiscounted cash flow analysis, there are no future contingencies or obligationsand collection is reasonably assured. We estimate the present value of theadditional structural advisory fees and residuals based on certain assumptionswe 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.

 

***Quarterly Fluctuations***

 

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 2004 and fiscal 2003, we facilitated securitizations in thesecond and fourth fiscal quarters. We closed a securitization transaction in October 2004and expect to close additional securitization transactions in the third andfourth quarters of fiscal 2005. The following table sets forth our quarterlyservice revenue and net income (loss) for the first quarter of fiscal 2005 andfor each of the quarters of fiscal 2004:

 
|             |   | **First quarter  fiscal 2005** |   |   |   |   |   |   |   |   |   |   |
|------------------|--------|--------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
|             |   | **(in thousands)**             |   |   |   |   |   |   |   |   |   |   |
| Service  revenue |   | $                              | 22,404 |   |   |   |   |   |   |   |   |   |   |
| Net loss         |   |                           | (5,352 | )      |   |   |   |   |   |   |   |   |   |

 
| ** **         | ** ** | **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 U.S. generally accepted accounting principles.The preparation of these financial statements requires us to make estimates,assumptions and judgments that affect the reported amounts of assets andliabilities and the reported amounts of income and expenses during thereporting 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. We regard an accounting estimate or assumptionunderlying our financial statements to be a “critical accounting estimate”where:

 

•                  the nature of theestimate or assumption is material due to the level of subjectivity andjudgment necessary to account for highly uncertain matters or thesusceptibility of such matters to change; and

 

•                  the impact ofthe estimates and assumptions on our financial condition or operatingperformance is material.

 

20

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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 service revenuerelated to the securitizations that we structure for our clients, as well asthe valuation of goodwill and intangible assets, fit the definition of criticalaccounting estimates. We also consider our policy with respect to thedetermination of whether or not to consolidate the securitization trusts thatwe 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 discountrate, which we use to calculate the present value of our additional structuraladvisory fees and residuals;

 

•                  the annualcompound rate of student loan prepayments, which we refer to as the constantprepayment rate, or CPR;

 

•                  the trend ofinterest rates over the life of the loan pool; 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 recognize the revenue associated with our processing feesfrom TERI and our administrative and other fees as we perform these services.

 

The following table shows the loanperformance assumptions for the life of each trust at September 30, 2004,except for NCSLT 2004-2 which includes loan performance assumptions for thelife of the trust as of October 28, 2004, the date of the securitizationtransaction for this trust:

 
| ** **   | ** ** | ** **    | ** ** | **Percentage rate** | ** ** | **Discount rate** | ** ** |
|--------------|------------|---------------|------------|---------------------|------------|-------------------|------------|
| **Trust**    | ** ** | **Loan type** | ** ** | **Default**         | ** ** | **Recovery**      | ** ** | **CPR** | ** ** | **Structural  advisory fees** | ** ** | **Residuals** | ** ** |
| NCSLT 2004-2 |       | Private label |       | 9.12                | %          | 40                | %          | 7 | % | 6.00 | % | 12 | % |
| NCSLT 2004-1 |       | Private label |       | 8.76                |       | 40                |       | 7 |   | 6.12 |   | 12 |   |
| NCSLT 2003   |       | Private label |       | 9.06                |       | 40                |       | 7 |   | 6.12 |   | 12 |   |
| NCMSLT       |       | Private label |       | 8.08                |       | 40                |       | 7 |   | 6.12 |   | 12 |   |
| NCT trusts   |       | Private label |       | 7.11                |       | 46                |       | 7 |   | 6.12 |   | 12 |   |
| NCT trusts   |       | GATE          |       | 23.23               |       | 47                |       | 4 |   | 6.12 |   | 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 lower Fair,Isaac and Company, or FICO, credit score, between 625 and 644, than our othertiered products, which require a FICO score of 645 or above. We worked, inconsultation with TERI and our bank clients, to structure and price this loanproduct to reflect its increased default risk. Accordingly, the interest ratebeing charged on these loans and the segregated reserves that TERI provided toNCSLT 2004-2, NCSLT 2004-1 and NCSLT 2003 to cover projected default exposureon these loans are greater than those provided for our clients’ other loanproducts. Although the inclusion of these new loans contributed to estimatedoverall default rates for NCSLT 2004-2, NCSLT 2004-1 and NCSLT 2003 that are 104basis points, 68 basis points and 98 basis points higher, respectively, thanwhat we estimated for NCMSLT, the average FICO score for loans in each of thetrusts remained above 700.

 

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 anddefault at a lower rate than borrowers in our GATE programs. We also monitortrends in loan performance over time, and make adjustments we believe arenecessary to value properly our receivables balance.

 

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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 and rates used in the much broadercommercial mortgage-backed securities, or CMBS, market, where actual tradeshave occurred. We believe that the 12% discount rate we use is appropriategiven the maximum 24-year life of the trust assets and residuals.

 

At September 30, 2004, we used a 6.12%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 September 30, 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 during the twelve monthsended September 30, 2004 of 11.5 basis points and an average spread duringthe twelve months ended June 30, 2004 of 7.3 basis points.

 

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 quarter offiscal 2005.

 

We used a 4% prepayment rate to value the2004 GATE loan securitizations.

* *

*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 September 30,2004 based on changes in these loan performance assumptions:

 
| ** **                              | ** ** | **Percentage change in  assumptions** | ** ** | ** **   | ** ** | **Percentage change in  assumptions** | ** ** |
|-----------------------------------------|------------|---------------------------------------|------------|--------------|------------|---------------------------------------|------------|
| **Structural advisory fees**            | ** ** | **Down 20%**                          | ** ** | **Down 10%** | ** ** | **Receivables  balance**              | ** ** | **Up 10%** | ** ** | **Up 20%** | ** ** |
| ** **                              | ** ** | **(dollars in thousands)**            | ** ** |
| Default  rate:                          |       |                                  |       |         |       |                                  |       |   |   |   |   |
| Private  label loan trusts              |       | $                                     | 19,954     |         | $          | 19,852                                |       | $ | 19,747 |   | $ | 19,644 |   | $ | 19,533 |   |
| GATE loan  trusts(1)                    |       | 5,118                                 |       | 5,037        |       | 4,956                                 |       | 4,875 |   | 4,794 |   |
| Total                                   |       | $                                     | 25,072     |         | $          | 24,889                                |       | $ | 24,703 |   | $ | 24,519 |   | $ | 24,327 |   |
| Change in  receivables balance:         |       | 1.50                                  | %          | 0.75         | %          |                                  |       | (0.74 | )% | (1.52 | )% |
| Default  recovery rate:                 |       |                                  |       |         |       |                                  |       |   |   |   |   |
| Private  label loan trusts              |       | $                                     | 19,691     |         | $          | 19,691                                |       | $ | 19,747 |   | $ | 19,747 |   | $ | 19,808 |   |
| GATE loan  trusts(1)                    |       | 4,827                                 |       | 4,827        |       | 4,956                                 |       | 4,956 |   | 5,096 |   |
| Total                                   |       | $                                     | 24,518     |         | $          | 24,518                                |       | $ | 24,703 |   | $ | 24,703 |   | $ | 24,904 |   |
| Change in  receivables balance:         |       | (0.75                                 | )%         | (0.75        | )%         |                                  |       | 0.00 | % | 0.81 | % |
| Annual  constant prepayment rate (CPR): |       |                                  |       |         |       |                                  |       |   |   |   |   |
| Private  label loan trusts              |       | $                                     | 20,898     |         | $          | 20,307                                |       | $ | 19,747 |   | $ | 19,216 |   | $ | 18,713 |   |
| GATE loan  trusts(1)                    |       | 5,162                                 |       | 5,059        |       | 4,956                                 |       | 4,856 |   | 4,760 |   |
| Total                                   |       | $                                     | 26,060     |         | $          | 25,366                                |       | $ | 24,703 |   | $ | 24,072 |   | $ | 23,473 |   |
| Change in  receivables balance:         |       | 5.49                                  | %          | 2.68         | %          |                                  |       | (2.55 | )% | (4.98 | )% |
| Discount  rate:                         |       |                                  |       |         |       |                                  |       |   |   |   |   |
| Private  label loan trusts              |       | $                                     | 21,492     |         | $          | 20,597                                |       | $ | 19,747 |   | $ | 18,948 |   | $ | 18,184 |   |
| GATE loan  trusts(1)                    |       | 5,340                                 |       | 5,143        |       | 4,956                                 |       | 4,777 |   | 4,602 |   |
| Total                                   |       | $                                     | 26,832     |         | $          | 25,740                                |       | $ | 24,703 |   | $ | 23,725 |   | $ | 22,786 |   |
| Change in  receivables balance:         |       | 8.62                                  | %          | 4.20         | %          |                                  |       | (3.96 | )% | (7.76 | )% |

 

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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      |       | $                          | 18,816     |                       | $          | 19,052                   |       | $ | 19,747 |   | $ | 20,398 |   | $ | 21,122 |   |
| GATE loan  trusts(1)            |       | 4,635                      |       | 4,760                      |       | 4,956                    |       | 5,027 |   | 5,234 |   |
| Total                           |       | $                          | 23,451     |                       | $          | 23,812                   |       | $ | 24,703 |   | $ | 25,425 |   | $ | 26,356 |   |
| Change in  receivables balance: |       | (5.07                      | )%         | (3.61                      | )%         |                     |       | 2.92 | % | 6.69 | % |
|                                 |            |                            |            |                            |            |                          |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                                 | ** ** | **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                                 |       | $                            | 19,746     |                        | $          | 19,747                   |       | $ | 19,747 |   | $ | 19,747 |   | $ | 19,750 |   |
| GATE loan  trusts(1)                                       |       | 4,956                        |       | 4,956                       |       | 4,956                    |       | 4,956 |   | 4,956 |   |
| Total                                                      |       | $                            | 24,702     |                        | $          | 24,703                   |       | $ | 24,703 |   | $ | 24,703 |   | $ | 24,706 |   |
| Change in  receivables balance:                            |       | 0.00                         | %          | 0.00                        | %          |                     |       | 0.00 | % | 0.01 | % |
|                                                            |            |                              |            |                             |            |                          |            |  |  |  |  |  |  |  |  |  |  |

 

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(1)                                  GATEloan trusts include approximately $377 million of GATE loans and $44 million ofTERI-guaranteed loans.

 
| ** **                              | ** ** | **Percentage change in  assumptions** | ** ** | ** **   | ** ** | **Percentage change in  assumptions** | ** ** |
|-----------------------------------------|------------|---------------------------------------|------------|--------------|------------|---------------------------------------|------------|
| **Residuals**                           | ** ** | **Down 20%**                          | ** ** | **Down 10%** | ** ** | **Receivables  balance**              | ** ** | **Up 10%** | ** ** | **Up 20%** | ** ** |
| ** **                              | ** ** | **(dollars in thousands)**            | ** ** |
| Default  rate:                          |       |                                  |       |         |       |                                  |       |   |   |   |   |
| Private  label loan trusts              |       | $                                     | 109,352    |         | $          | 108,384                               |       | $ | 107,375 |   | $ | 104,586 |   | $ | 100,658 |   |
| GATE loan  trusts(1)                    |       | 4,219                                 |       | 4,405        |       | 4,580                                 |       | 4,754 |   | 4,675 |   |
| Total                                   |       | $                                     | 113,571    |         | $          | 112,789                               |       | $ | 111,955 |   | $ | 109,340 |   | $ | 105,333 |   |
| Change in  receivables balance:         |       | 1.44                                  | %          | 0.74         | %          |                                  |       | (2.34 | )% | (5.91 | )% |
| Default  recovery rate:                 |       |                                  |       |         |       |                                  |       |   |   |   |   |
| Private  label loan trusts              |       | $                                     | 106,313    |         | $          | 106,981                               |       | $ | 107,375 |   | $ | 107,648 |   | $ | 107,797 |   |
| GATE loan  trusts(1)                    |       | 3,889                                 |       | 4,227        |       | 4,580                                 |       | 4,937 |   | 4,988 |   |
| Total                                   |       | $                                     | 110,202    |         | $          | 111,208                               |       | $ | 111,955 |   | $ | 112,585 |   | $ | 112,785 |   |
| Change in  receivables balance:         |       | (1.57                                 | )%         | (0.67        | )%         |                                  |       | 0.56 | % | 0.74 | % |
| Annual  constant prepayment rate (CPR): |       |                                  |       |         |       |                                  |       |   |   |   |   |
| Private  label loan trusts              |       | $                                     | 118,584    |         | $          | 112,841                               |       | $ | 107,375 |   | $ | 102,167 |   | $ | 97,203 |   |
| GATE loan  trusts(1)                    |       | 4,776                                 |       | 4,677        |       | 4,580                                 |       | 4,483 |   | 4,391 |   |
| Total                                   |       | $                                     | 123,360    |         | $          | 117,518                               |       | $ | 111,955 |   | $ | 106,650 |   | $ | 101,594 |   |
| Change in  receivables balance:         |       | 10.19                                 | %          | 4.97         | %          |                                  |       | (4.74 | )% | (9.25 | )% |
| Discount  rate:                         |       |                                  |       |         |       |                                  |       |   |   |   |   |
| Private  label loan trusts              |       | $                                     | 131,321    |         | $          | 118,632                               |       | $ | 107,375 |   | $ | 97,347 |   | $ | 88,438 |   |
| GATE loan  trusts(1)                    |       | 6,154                                 |       | 5,306        |       | 4,580                                 |       | 3,922 |   | 3,421 |   |
| Total                                   |       | $                                     | 137,475    |         | $          | 123,938                               |       | $ | 111,955 |   | $ | 101,269 |   | $ | 91,859 |   |
| Change in  receivables balance:         |       | 22.79                                 | %          | 10.70        | %          |                                  |       | (9.54 | )% | (17.95 | )% |
|                                         |            |                                       |            |              |            |                                       |            |  |  |  |  |  |  |  |  |  |  |

 

23

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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      |       | $                          | 102,115    |                       | $          | 103,377                  |       | $ | 107,375 |   | $ | 111,282 |   | $ | 115,072 |   |
| GATE loan  trusts(1)            |       | 4,167                      |       | 4,341                      |       | 4,580                    |       | 4,796 |   | 4,933 |   |
| Total                           |       | $                          | 106,282    |                       | $          | 107,718                  |       | $ | 111,955 |   | $ | 116,078 |   | $ | 120,005 |   |
| Change in  receivables balance: |       | (5.07                      | )%         | (3.78                      | )%         |                     |       | 3.68 | % | 7.19 | % |

 
| ** **                                                 | ** ** | **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                                 |       | $                            | 111,402    |                        | $          | 109,387                  |       | $ | 107,375 |   | $ | 105,363 |   | $ | 103,354 |   |
| GATE loan  trusts(1)                                       |       | 4,580                        |       | 4,580                       |       | 4,580                    |       | 4,580 |   | 4,580 |   |
| Total                                                      |       | $                            | 115,982    |                        | $          | 113,967                  |       | $ | 111,955 |   | $ | 109,943 |   | $ | 107,934 |   |
| Change in  receivables balance:                            |       | 3.60                         | %          | 1.80                        | %          |                     |       | (1.80 | )% | (3.59 | )% |

 

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(1)                                  GATE loan trustsinclude approximately $377 million of GATE loans and $44 million ofTERI-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 each borrowerpaid each month, whether the borrower paid on time, was delinquent or defaultedon their obligation to pay, if they requested a deferment of payments for aperiod of time, when the borrower made their final payment and their creditinformation which resulted in our client’s decision to make the loan. Thedatabase also includes this information for defaulted loans, as well as creditcharacteristics on certain TERI-guaranteed loans, for eleven additional years.We use the information in the database to construct portfolio default anddelinquency trends and to assist our clients in loan pricing. Under the termsof our database sale and supplementation agreement with TERI, we pay TERI amonthly fee, which is recorded as an intangible asset, in consideration for theright 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 numberof private label clients, and revenue and profitability related to privatelabel loans. Impairment, if any, would be determined based upon a discountedcash flow analysis, using a discount rate commensurate with the risks 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 September 30,2004, goodwill totaled $3.2 million and net intangible assets totaled$3.1 million.

 

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***Consolidation***

 

Our consolidated financial statements include the accounts of FirstMarblehead and its subsidiaries, after eliminating intercompany accounts andtransactions. We have not consolidated the securitization trusts. Prior toJuly 1, 2003, this accounting treatment was in accordance with variousEmerging Issues Task Force issues and related interpretations. We considered,among other things, the following factors in assessing consolidation of thesecuritization 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 afacilitator of securitization transactions, for which we receive market-basedfees, and we are not the transferor of assets to the securitization trusts; and

 

•                  our continuinginvolvement in the trusts is limited to a passive residual interest and ourrole as an administrator for the trust for which we receive market-based fees.

 

From July 1, 2003, and for securitization trusts created afterJanuary 31, 2003, we applied FASB Interpretation, or FIN, No. 46, “Consolidationof Variable Interest Entities, an interpretation of ARB No. 51,” inassessing consolidation. FIN No. 46 provided a new framework foridentifying variable interest entities and determining when a company shouldinclude the assets, liabilities, non-controlling interests and results ofactivities of a variable interest entity in its consolidated financialstatements.

 

On December 24, 2003, the FASB issued FIN No. 46 (revised December 2003),“Consolidation of Variable Interest Entities” (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 September 30, 2004, the securitization trusts createdafter January 31, 2003 have either met the criteria to be a qualifiedspecial purpose entity, or 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 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 FIN No. 46R, which we began to apply in December 2003,did not have a material impact on our consolidated financial condition, resultsof operations, earnings per share or cash flows.

 

The FASB has issued an Exposure Draft, “Qualifying Special-PurposeEntities and Isolation of Transferred Assets, an amendment of FASB StatementNo. 140.” This proposal would, among other things, change the requirementsthat an entity must meet to be considered a QSPE. The FASB has announced thatit expects to issue in the first calendar quarter of 2005 a revised exposuredraft that would include all of the proposed amendments to FASB StatementNo. 140. We are monitoring the status of the exposure draft to assess itsimpact on our financial statements.

 

**Results of Operations**

 

***Three months endedSeptember 30, 2004 and 2003***

 

***Revenue Related toSecuritization Transactions***

 

We did not conduct a securitization transaction during the firstquarter of either fiscal 2005 or fiscal 2004. Therefore, during these quarterswe did not generate any up-front structural advisory fees, additionalstructural advisory fees or residual fee revenues from new securitizationtransactions.

 

*Structural advisory fees*

 

During the first quarter of fiscal 2005, the fair market valueadjustments of our additional structural advisory fees resulted in an increaseof approximately $0.6 million. This increase was due to the accretion ofthe discounting inherent in these present value estimates and a decrease in thediscount rate offset by the impact of the movement in the implied forward LIBORcurve during the period. During the first quarter of fiscal 2004, the fairmarket value adjustments of our additional structural advisory fees resulted ina decrease of approximately $0.3 million, as the increase in the discountrate more than offset the accretion of the

 

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discountinginherent in these present value estimates and the movement in the impliedforward LIBOR curve during the period.

 

On a quarterly basis, we update our estimate of the present value ofour additional structural advisory fees, which have an estimated average lifeof approximately six to eight years. In doing so, we give effect to the passageof time, which results in the accretion of the discounting inherent in thesepresent value estimates, and we also adjust for any change in the discount ratethat we use in estimating the present value of these receivables. For adiscussion of the assumptions we make in estimating our additional structuraladvisory fees, see “—Application of Critical Accounting Policies—ServiceRevenue.”

 

We base the discount rate that we use to calculate the present value ofour additional structural advisory fees on the 10-year U.S. Treasury rate plus200 basis points. The discount rate used equaled 6.12% at September 30, 2004,6.58% at June 30, 2004, 5.95% at September 30, 2003, and 5.33% atJune 30, 2003. A decrease in the 10-year U.S. Treasury rate has the effectof increasing the fair market value of our structural advisory fees receivable,while an increase in the rate has the opposite effect on our estimate of theirfair market value.

 

On an ongoing basis, we monitor the performance of trust assets,including default, recovery, prepayment and forward LIBOR rates experience,which we also consider in our estimates. We use an implied forward LIBOR curveto estimate trust cash flows. During the first quarter of fiscal 2005, theimplied forward LIBOR curve decreased. Thisdecrease resulted in a decrease in the interest to be capitalized on theunderlying student loan assets during their respective deferment periods, whichdecreases the balance on which we expect to charge our 15 basis points per yearof additional structural advisory fees over the life of the trust, andtherefore decreases the fair market value of the structural advisory fees.  The impact of changing LIBOR rates during thefirst quarter of fiscal 2004 did not have a material impact on the fair marketvalue of additional structural advisory fees receivable during that period. Fora discussion of the assumptions we make in estimating our additional structuraladvisory fees receivable, see “ —Application of Critical Accounting Policiesand Estimates—Service Revenue.”

 

We made no changes in our assumptions regarding default rates,prepayment rates and recovery rates for the NCSLT 2004-1, NCSLT 2003, NCMSLT orNCT trusts during either the first quarter of fiscal 2005 or fiscal 2004.

 

*Residuals*

 

During the first quarter of fiscal 2005 and the first quarter of fiscal2004, the fair market value adjustments of our residuals receivable resulted inan increase of approximately $3.5 million and $1.6 million, respectively,due to the passage of time and the impact of movement in the implied forwardLIBOR curve. The amount of this fair market value adjustment also increasedbetween periods as the underlying receivables balance increased. We expect thatadjustments for the passage of time will continue to increase as we conductmore securitization transactions and thereby add to the residual revenues thatwe discount to present value.

 

As we do with our additional structural advisory fees, on a quarterlybasis, we update our estimate of the present value of our residuals. In doingso, we give effect for the passage of time, which results in the accretion ofthe discounting inherent in these present value estimates, and we also adjustfor any change in the discount rate that we use in estimating the present valueof these receivables. We used a 12% discount factor during the first quarter offiscal 2005 and fiscal 2004. We also monitor the performance of trust assets,including default, recovery, prepayment and forward LIBOR rates experience,which we also consider in our estimates. We use an implied forward LIBOR curveto estimate trust cash flows. During the first quarter of fiscal 2005, theimplied forward LIBOR curve flattened. Theflattening of the curve improved the net excess spread between the trust assetsand liabilities, resulting in an increase in the fair market value of residualsreceivable during the period. For a discussion of the assumptions wemake in estimating our residuals, see “—Application of Critical AccountingPolicies and Estimates—Service Revenue.”

 

In determining an appropriate discount rate for valuing residuals, wereview the rates used by student loan securitizers, as well as rates used inthe much broader CMBS market. We believe that the 12% discount rate we use isappropriate given the maximum 24-year life of the trust assets and residuals.

 

For a discussion of the assumptions we make in estimating ourresiduals, see “—Application of Critical Accounting Policies andEstimates—Service Revenue.”

 

*Administrativeand other fees*

 

Administrative and other fees increased to $1.0 million for the firstquarter of fiscal 2005 from $0.3 million for the first quarter 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 to increaseas the

 

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student loanbalances in the securitization trusts continue to increase.

 

*Processing feesfrom TERI*

 

Processing fees from TERI increased to $17.4 million for the firstquarter of fiscal 2005 from $7.8 million for the first quarter of fiscal2004. The increase reflects the additional reimbursed expenses required toprocess the volume of private label loans that we facilitated during the fiscal2005 period, which increased to $1.01 billion for the first quarter of fiscal2005 from $595 million for the first quarter 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 $31.8 million for the firstquarter of fiscal 2005 from $15.2 million for the first quarter of fiscal2004. Compensation and benefits increased to $14.9 million for the first quarterof fiscal 2005 from $8.9 million for the first quarter of fiscal 2004.General and administrative expenses increased to $17.0 million for the firstquarter of fiscal 2005 from $6.3 million for the first quarter of fiscal2004.

 

Compensation and benefits and general and administrative expensesincreased primarily as a result of an increase in personnel. We hiredadditional personnel to meet the operating requirements from our growing loanprocessing and securitization activities. As our financial performance improves,we anticipate awarding higher performance-based cash compensation to ouremployees.

 

General and administrative expenses also increased as a result of anincrease in consulting fees, an increase in professional fees, an increase inexternal call center costs, as well as an increase in occupancy and advertisingcosts. Consulting fees increased to $4.9 million in the first quarter of fiscal2005 from $1.2 million in the first quarter of fiscal 2004, primarily as aresult of the hiring of experts to assist us in our redesign efforts for ourloan origination systems. Professional fees increased to $1.8 million in thefirst quarter of fiscal 2005 from $0.4 million in the first quarter of fiscal2004. These expenses increased primarily as a result of increased legal, auditand investor relations expenses as a result of being a public company. Externalcall center costs increased to $2.1 million for the first quarter of fiscal2005 from $0.9 million in the first quarter of fiscal 2004. The increase inexternal call center costs is primarily due to the increase in the volume ofloans facilitated during current year period. Occupancy expenses increased to$2.2 million in the first quarter of fiscal 2005 from $0.7 million in the firstquarter of fiscal 2004 as we moved and expanded our corporate headquarters andexpanded our loan processing operations throughout fiscal 2004 and the firstquarter of fiscal 2005.  Our advertisingexpenses for the first quarter of fiscal 2005 increased approximately $0.6 millionas compared to the prior year end as we increased our efforts to make potentialborrowers aware of our loan products.

 

We expect that our operating expenses will continue to increase as we leaseadditional space to extend our operations and devote additional resources tothe expected increasing loan volumes facilitated for our existing and newclients.

 

The following table summarizes the components of operating expenses,both those reimbursed and not reimbursed by TERI:

 
| ** **                | ** ** | **Operating  expenses**          | ** ** |
|---------------------------|------------|----------------------------------|------------|
| ** **                | ** ** | **Expenses  reimbursed by TERI** | ** ** | **Expenses  not reimbursed by TERI** | ** ** |
| **First  fiscal quarter** | ** ** | **Compensation  and benefits**   | ** ** | **General  and  administrative  expenses** | ** ** | **Subtotal  operating  expenses** | ** ** | **Compensation  and benefits** | ** ** | **General  and  administrative  expenses** | ** ** | **Subtotal  operating  expenses** | ** ** | **Total  operating  expenses** | ** ** |
| ** **                | ** ** | **(in thousands)**               | ** ** |
|                      |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| 2005                      |       | $                                | 8,376      |   | $ | 8,951 |   | $ | 17,327 |   | $ | 6,504 |   | $ | 8,008 |   | $ | 14,512 |   | $ | 31,839 |   |
| 2004                      |       | 3,889                            |       | 3,943 |   | 7,832 |   | 4,983 |   | 2,396 |   | 7,379 |   | 15,211 |   |
|                           |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

A portion of interest expense was reimbursed by TERI during the periodspresented above. During the three months ended September 30, 2004 and 2003,TERI reimbursed interest expense of approximately $30,052 and $7,668,respectively.

 

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***Other (Income)Expense***

 

*Interest(income)expense, net*

 

Net interest income was $0.4 million for the first quarter offiscal 2005 as compared to net interest expense of $0.1 million for the firstquarter of fiscal 2004. Interest expense was $0.1 million in each of thefirst quarters of fiscal 2005 and fiscal 2004. Interest income was$0.5 million for the first quarter of fiscal 2005 and $21,000 for thefirst quarter of fiscal 2004. The increase in interest income resulted from anincrease in cash and other short-term investment balances as a result ofreceipt of net proceeds from our initial public offering in November 2003.Interest expense is primarily attributable to $7.9 million of notes issuedin June 2001 to TERI as a part of the purchase price for TERI’s loanprocessing operations as described below in “—Financial Condition, Liquidityand Capital Resources.”

 

***Income Tax Expense /Benefit***

 

Income tax benefit increased to $3.7 million for the first quarterof fiscal 2005 from approximately $2.8 million for the first quarter offiscal 2004. The increase in income tax benefit was primarily the result of anincrease in the amount of loss before income tax expense between periods.

 

**Financial Condition, Liquidity and CapitalResources**

 

Our liquidity requirements have historically consisted, and we expectthat they will continue to consist, of capital expenditures, working capital,business development expenses, general corporate expenses and potentialacquisitions.

 

On November 5, 2003, we completed an initial public offering ofour common stock at a price to the public of $16.00 per share, in which we sold7,906,250 shares and selling shareholders sold 6,468,750 shares. Net proceedsof the initial public offering to us were approximately $115.1 million. Wedid not receive any of the proceeds of the sale of the shares sold by theselling stockholders. In June 2004, selling stockholders sold an aggregateof 7,406,312 shares of our common stock in a follow-on public offering at aprice of $36.50 per share. We did not sell any shares in this offering andtherefore did not receive any proceeds from the sale of stock.

 

***Short-term FundingRequirements***

 

We expect to fund our short-term liquidity requirements through cashflow from operations and the proceeds of our initial public offering. Webelieve, based on our current operating plan and the proceeds of our initialpublic offering, that our current cash and other short-term investments will besufficient to fund our operations through at least fiscal 2005.

 

***Long-term FundingRequirements***

 

We expect to fund the growth of our business through cash flow fromoperations and through issuances of common stock, promissory notes or othersecurities. We expect to assess our financing alternatives periodically andaccess the capital markets opportunistically. If our existing resources areinsufficient to satisfy our liquidity requirements, or if we enter into anacquisition or strategic arrangement with another company, we may need to 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 raised approximately $143.5 millionfrom the sale of common stock and promissory notes, including approximately$115.1 million in net proceeds from our initial public offering.

 

Our actual liquidity and capital funding requirements may depend onnumerous factors, including:

 

•                  our facilitiesexpansion needs;

 

•                  the extent towhich our services gain increased market acceptance and remain competitive;

 

•                  the timing, sizeand composition of the loan pools of the securitization transactions that westructure; and

 

•                  the costs andtiming of acquisitions of complementary businesses.

 

If we are not able to obtain adequate funding when needed, we may haveto delay further expansion of our business.

 

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***Cash and othershort-term investments***

 

At September 30, 2004, we had $146.1 million in cash and othershort-term investments, and at June 30, 2004, we had $168.7 millionin cash and other short-term investments. Cash and other short-term investmentsinclude balances in money market funds.

 

***Structural AdvisoryFees and Residuals Receivables***

 

Our structural advisory fees and residuals receivables decreased to$136.7 million at September 30, 2004 from $142.8 million at June 30,2004, primarily as a result of the receipt of $10.25 million in structuraladvisory fees in July 2004. In the December 2003 securitization, wecollected $24.5 million of the up-front structural advisory fee inDecember 2003, at the time the securitization transaction closed, and wereceived a second payment of $10.25 million in July 2004 from this December2003 securitization 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 $2.0 million at September 30, 2004 from$0.4 million at June 30, 2004. The increase is primarily due to prepaid feesthat will be reimbursed to us by trusts used in future securitizationtransactions including NCSLT 2004-2 upon the closing of the October 2004securitization transaction.

 

***Property andEquipment, net***

 

During the first quarter of fiscal 2005, our property and equipment,net increased by $0.4 million, as we spent $1.3 million on the expansionof our processing facilities and corporate headquarters, offset by$0.9 million of depreciation expense recorded during the period.

 

***Prepaid and othercurrent assets***

 

We had prepaid and other current assets of $27.3 million at September30, 2004 up from $23.0 million at June 30, 2004. Included in prepaid andother current assets at September 30, 2004 and June 30, 2004 is prepaid incometaxes of approximately $25.4 million and $20.3 million, respectively. Thisbalance was primarily derived from a tax benefit of $29.9 million from employeestock option exercises, primarily in connection with stock option exercises atthe time of our follow-on offering in June 2004. This benefit, after offsettingaccrued income taxes resulted in the net prepaid income taxes balance at eachperiod end.

 

***Other Assets***

 

In connection with our facilitation of the securitization of GATE loansin June 2004, six schools participating in our GATE program faced limitson the amount of surety coverage that the GATE program’s current surety providerwas willing to provide to the NCT trust on their behalf. We provided the NCTtrust with an additional cash surety deposit of approximately $1.8 millionon behalf of these six schools. The surety coverage and our cash depositprovides the NCT trust bondholders with assurance that the pledge commitmentthat these school clients make to reimburse the NCT trusts for defaults bytheir student borrowers will be fulfilled.

 

Our cash deposit with the NCT trust on behalf of these schools willearn interest at the prevailing short-term interest rates. We will also earn asurety fee equal to 150 basis points of the initial notional amount of thepledge commitment which our cash deposit supports. As schools reimburse the NCTtrusts for student defaults, the amount of their pledge commitment is reduced.We are entitled to withdraw amounts in the surety reserve account, includingearned interest and surety fees, to the extent the balance in the suretyreserve account exceeds the pledge commitment. Once the NCT trust bondholdershave been paid in full, we will receive the entire amount remaining in thesurety reserve account.

 

***Accounts Payable andAccrued Expenses***

 

We had accounts payable and accrued expenses of $14.4 million atSeptember 30, 2004 and $26.3 million at June 30, 2004. At June 30,2004, we had approximately $8.2 million of withholding taxes that we hadcollected from employees related to their exercise of non-qualified stockoptions in our follow-on equity offering, which taxes we paid in July 2004.Our accrued bonuses were approximately $2.2 million lower at September 30,2004 as compared to June 30, 2004, as we paid during the first quarter offiscal 2005 the performance-based compensation earned during fiscal 2004. Ouraccounts payable were $1.0 million lower at September 30, 2004 as comparedto June 30, 2004, primarily due to the timing of the receipt of invoices.

 

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***Net Deferred TaxLiability***

 

We have a net deferred tax liability because, under accountingprinciples generally accepted in the United States of America, we recognizeresiduals in book income earlier than they are recognized for tax purposes. Ourdeferred tax liability increased primarily as a result of the increase inresidual revenue recognized during the first quarter of fiscal 2005.

 

***Notes Payable***

 

We had notes payable and capital lease obligations of $1.8 million atSeptember 30, 2004 and $9.2 million at June 30, 2004. During thesecond quarter of fiscal 2004, we received $7.0 million upon the issuanceof 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 $5.8 million at September 30, 2004 and $6.0 million at June 30, 2004.This balance relates to two acquisition notes we issued to acquire TERI’s loanprocessing operations in 2001.

 

***ContractualObligations***

 

As ofSeptember 30, 2004, our contractual obligations had not changed materially fromthose described under the caption “Item 7. Management’s Discussion and Analysisof Financial Condition and Results of Operations-Contractual Obligations” inour annual report on Form 10-K for the fiscal year ended June30, 2004. During the second fiscal quarter of 2005:

 

•                  Weentered into a lease for approximately 26,000 square feet of office space inBoston, Massachusetts which was described in the annual report on Form 10-K, onthe terms disclosed in the annual report on Form 10-K;

 

•                  Weexercised our right to renew our database sale and supplementation agreement,as well as several other agreements with TERI, for additional five-year termsthrough June 2011. Beginning in July 2007, monthly payments pursuant to thedatabase sale and supplementation agreement will be reduced to approximately$21,000; and

 

•                  Weentered into a lease for approximately 26,000 additional square feet of officespace for our loan processing operations in Boston, Massachusetts for basicannual rent between $745,000 and $872,000 through 2014.

*** ***

***Cash Flows***

 

Our net cash used in operating activities increased to $14.6 millionfor first quarter of fiscal 2005, compared to $6.3 million for the first quarterof fiscal 2004. Cash used in operations resulted primarily from our net loss, adecrease in accounts payable, accrued expenses and other liabilities, andincreases in residuals and prepaids and other current assets, offset by adecrease in our structural advisory fees.

 

We used $1.5 million of net cash in investing activities during thefirst quarter of fiscal 2005. The principal use of net cash was capitalexpenditures related to the expansion of our loan processing facilities andcorporate headquarters and, to a lesser extent, payments for loan databaseupdates from TERI.

 

We used net cash of $6.6 million in financing activities during thefirst quarter of fiscal 2005. The use of cash for financing activities wasprimarily due to the repayment of the $7.25 million note that we issued to thelead underwriter of the Company’s December 2003 securitization.

 

We expect that our capital expenditure requirements for fiscal 2005will be approximately $25.4 million. 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 $2.1 million.

 

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***Borrowings***

 

In June 2001, we issued two acquisition notes to TERI totaling$7.9 million to acquire TERI’s loan processing operations as well as itsworkforce-in-place. Principal and interest at an annual rate of 6% is payableon these notes in 120 monthly payments of $87,706 commencing onJuly 20, 2001 and ending on June 20, 2011. At September 30,2004, outstanding principal on these notes totaled $5.8 million as compared to$6.0 million at June 30, 2004.

 

In April 2002, we entered into a $975,000 revolving line of creditwith a bank. The line of credit was extended to December 31, 2003, withinterest payable annually at the greater of 6% or 1% above the highestpublished *Wall Street Journal*prime rate. Our lead director is a director and majority stockholder of thecompany that owns the bank that provided this line of credit. We believe thatthe terms of the line of credit were substantially the same as those prevailingat the time we entered into this credit arrangement as we would have receivedfrom other banks for a comparable transaction. We did not renew this revolvingline of credit when it expired. There were no amounts outstanding at June 30,2003 or any time thereafter.

 

In August 2003, we entered into a $10 million revolvingcredit facility with Fleet National Bank. Fleet National Bank was recentlyacquired by Bank of America, and our agreement related to this facility hasbeen assigned to Bank of America subsequent to the acquisition. The revolving creditfacility matures on August 28, 2005, with interest currently payable, atour option, at the bank’s prime rate, or LIBOR plus 2%. The revolving creditline contains financial covenants, including:

 

•                  minimum trailing12-month up-front structural advisory fees of not less than $25 to$30 million;

 

•                  minimum tangiblenet worth of not less than $40 million through June 30, 2004 and thesum of 100% of consolidated tangible net worth plus 85% of consolidated netincome, thereafter;

 

•                  a maximumliabilities to net worth ratio of not greater than 1.15 to 1.00; and

 

•                  a minimum cashflow to debt service ratio of not less than 1.50 to 1.00,

 

as well as certain financial reporting covenants. We expect to be ableto meet these financial and reporting requirements during the term of therevolving credit facility and are in compliance with these covenants as of thedate of this report. This agreement restricts our ability to pay cash dividendsin the event we are in default. As of September 30, 2004, we had no balanceoutstanding under the revolving credit facility. The maximum annual commitmentfee is $25,000.

 

In December 2003, we issued a $7.25 million note to the leadunderwriter of our December 2003 securitization to monetize a substantialportion of the second up-front structural advisory fee payment which we receivedin July 2004. We repaid the note in full with the first $7.25 million of thatpayment.

 

**Off-Balance Sheet Transactions**

 

We offer outsourcing services in connection with the lifecycle of aprivate student loan, from program design and marketing through loanadministration and, ultimately, to the sale and securitization of the loans. Wealso structure and facilitate the securitization of loans for our clientsthrough a series of bankruptcy remote, qualified special purpose trusts.

 

We do not utilize these trusts as a means to transfer assets orliabilities from our balance sheet to those of the trusts because we are notthe originator of the securitized student loans or the issuer of the relateddebt. We do not serve as lender, guarantor or loan servicer. Specifically,these trusts purchase such student loans from third-party financialinstitutions, the financing of which is provided through the issuance of asset-backedsecurities.

 

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 Accounting Policies andEstimates—Consolidation” for a discussion of our determination to notconsolidate these securitization trusts.

 

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**Recent Accounting Pronouncements**

 

Beginning July 1, 2003, and for securitization trusts createdafter January 31, 2003, we applied FIN No. 46, “Consolidation ofVariable Interest Entities, an interpretation of ARB No. 51,” in assessingconsolidation. FIN No. 46 provided a new framework for identifyingvariable interest entities and determining when a company should include theassets, liabilities, non-controlling interests and results of activities of avariable interest entity in its consolidated financial statements.

 

On December 24, 2003, the FASB issued FIN No. 46 (revisedDecember 2003), “Consolidation of Variable Interest Entities” (FINNo. 46R), which addressed how a business enterprise should evaluatewhether it has a controlling interest in an entity through means other than votingrights and accordingly should consolidate the entity. FIN No. 46R hasreplaced FIN No. 46. At September 30, 2004, the securitization trustscreated after January 31, 2003 have either met the criteria to be a QSPE,as defined in paragraph 35 of SFAS No. 140, “Accounting for theTransfers and Servicing of Financial Assets and Extinguishments of Liabilities,”or we have determined that we are not the primary beneficiary of thesecuritization trusts, as defined by FIN No. 46R. Accordingly, we did notconsolidate these existing securitization trusts in these financial statements.In addition, the securitization trusts created prior to January 31, 2003have been amended in order for them to be 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, “Qualifying Special-Purpose Entitiesand Isolation of Transferred Assets—an amendment of FASB StatementNo. 140.” This proposal would, among other things, change the requirementsthat an entity must meet to be considered a QSPE. The FASB has announced thatit expects to issue in the first calendar quarter of 2005 a revised exposuredraft that would include all of the proposed amendments to FASB StatementNo. 140. We are monitoring the status of this Exposure Draft to assess itsimpact on our consolidated financial statements.

 

**Inflation**

 

Inflation was not a material factor in either revenue or operatingexpenses during the periods presented.

 

**Factors That May Affect Future Results**

 

This quarterly report on Form 10-Q includes forward-lookingstatements within the meaning of Section 21E of the Securities ExchangeAct of 1934, as amended. For this purpose, any statements contained hereinregarding our strategy, future operations, financial position, future revenues,projected costs, prospects, plans and objectives of management, other thanstatements of historical facts, are forward-looking statements. The words “anticipates,”“believes,” “estimates,” “expects,” “intends,” “may,” “plans,” “projects,” “will,”“would” and similar expressions are intended to identify forward-lookingstatements, although not all forward-looking statements contain theseidentifying words. We cannot guarantee that we actually will achieve the plans,intentions or expectations expressed or implied in our forward-lookingstatements. There are a number of important factors that could cause actualresults, levels of activity, performance or events to differ materially fromthose expressed or implied in the forward-looking statements we make. Theseimportant factors include our “critical accounting estimates” and the riskfactors set forth below. Although we may elect to update forward-lookingstatements in the future, we specifically disclaim any obligation to do so,even if our estimates change, and readers should not rely on those forward-lookingstatements as representing our views as of any date subsequent to the date ofthis quarterly report.

 

**Risk Factors**

 

**We derive a significant portion of ourrevenue and substantially all of our income from structuring securitizationtransactions; our financial results and future growth would be adverselyaffected if we are unable to structure securitizations.**

 

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 have provided structural advisory and other services for 23 loansecuritizations since our formation in 1991, and we receive fees for theseservices. In connection with securitizations, we receive compensation in theform of structural advisory fees, residuals and administrative fees formanagement of the trusts. The amount and timing of the fees we recognize areaffected, in part, by the size and composition of loan pools to be securitized,the return expectations of investors and assumptions we make regarding loanportfolio performance, including defaults, recoveries, prepayments and the costof funding. Revenue from new securitizations constituted 78% of our totalservice revenue for fiscal 2004, 73% of our total service revenue for fiscal2003, and 64% of our total service revenue in fiscal 2002. Substantially all ofour net income in those fiscal periods was attributable to securitization-relatedrevenue.

 

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**The timing of our securitization activitieswill greatly affect our quarterly financial results.**

 

Our quarterly revenue, operating results and profitability have variedand are expected to continue to vary significantly on a quarterly basis. Infiscal 2004, we recognized 5%, 39%, 6% and 51% of our total service revenue inthe respective fiscal quarters of 2004. In fiscal 2003, we recognized 7%, 36%,17% and 40% of our total service revenue in the respective fiscal quarters of2003. Our quarterly revenue varies primarily because of the timing of thesecuritizations that we structure. We facilitated no securitizations in thefirst quarter of fiscal 2005, no securitizations in the first or third quartersof fiscal 2004, one securitization in the second quarter of fiscal 2004, andtwo securitizations in the fourth quarter of fiscal 2004. The timing of oursecuritization activities is affected to some degree by the seasonality ofstudent loan applications and loan originations. Origination of student loansis generally subject to seasonal trends, with the volume of loan applicationsincreasing with the approach of tuition payment dates. In fiscal 2004, weprocessed 34% of our total loan facilitation volume in the first quarter ended September 30,2004, and 20%, 27% and 19% of our total loan facilitation volume in therespective successive quarters.

 

**A number of factors, some of which are beyondour control, may adversely affect our securitization activities and therebyadversely affect our results of operations.**

 

Our financial performance and future growth depend in part on ourcontinued success in structuring securitizations. Several factors may affectboth our ability to structure securitizations and the revenue we generate forproviding our structural advisory and other services, including the following:

 

•                  degradation ofthe credit quality and performance in the loan portfolios of the trusts westructure could reduce or eliminate investor demand for securitizations that wefacilitate in the future;

 

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

 

•                  unwillingness offinancial guarantee providers to continue to provide credit insurance in thesecuritizations that we structure or in student loan-backed securitizationsgenerally;

 

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

 

•                  any materialdowngrading or withdrawal of ratings given to securities previously issued insecuritizations that we structured could reduce demand for additionalsecuritizations that we structure.

 

A portion of the securities issued since 1998 in securitizationtransactions that we structured were sold to asset backed commercial paperconduits. If these or similar asset backed conduits cease to purchasesecurities in the securitizations that we structure, we may experience a delayin the timing of our securitizations as we seek to find alternate channels ofdistribution.

 

Under the terms of some of our contracts with key lender clients, wehave an obligation to securitize loans originated by those lendersperiodically, typically twice per year. We may agree with other lenders tosecuritize more frequently in the future. If we do not honor these obligations,we may be required to pay liquidated or other damages, which could adverselyaffect our results of operations.

 

**In connection with our recognition of revenuefrom securitization transactions, if the estimates and judgments we make, andthe assumptions on which we rely, in preparing our financial statements proveinaccurate, our actual results may vary from those reflected in our financialstatements.**

 

Our financial statements have been prepared in accordance withaccounting principles generally accepted in the United States of America. Thepreparation of these financial statements requires us to make estimates,assumptions 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 our services in connection withsecuritization transactions. We receive an up-front portion of these structuraladvisory fees when the securitization trust purchases the loans, or soonthereafter. We receive an additional portion of these structural advisory feesover time, based on the amount of loans outstanding in the trust from time totime over the life of the loans. We also have the right to receive a portion ofthe residual interests that the trust creates. As required under accountingprinciples generally accepted in the United States of America, we recognize asrevenue the present value of the additional portion of

 

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the structuraladvisory fees and residuals at the time the securitization trust purchases theloans because they are deemed to be earned before they are actually paid to us.We record additional structural advisory fees and residuals as receivables onour balance sheet at fair value. Accounting rules require that thesereceivables be marked-to-market. We estimate the fair value both initially andat each subsequent quarter and reflect the change in value in earnings for thatperiod. Our key assumptions to estimate the value include prepayment anddiscount rates, interest rate trends, the expected credit losses from theunderlying securitized loan portfolio, net of recoveries and the expectedtiming of cash flows from the trusts’ underlying student loan assets. If ourassumptions are wrong, the additional structural advisory fees and residualsthat we receive from the trusts could be significantly less than reflected inour current financial statements, and we may incur a material negativeadjustment to our earnings in the period in which our assumptions change. For adiscussion of the sensitivity of the additional structural advisory fees andresiduals to variations in our assumptions and estimates, see “Management’sDiscussion and Analysis of Financial Condition and Results ofOperations—Application of Critical Accounting Policies and Estimates—ServiceRevenue-Sensitivity Analysis.”

 

Our residuals in each securitization we have facilitated aresubordinate to securities issued to investors in such securitizations and mayfail to generate any revenue for us if the securitized assets only generateenough revenue to pay the investors.

 

**Our financial results could be adverselyaffected if we were required to consolidate the financial results of theentities that we use for securitizations that we facilitate.**

 

We provide structural advisory and other services for loan securitizationsundertaken through Delaware statutory trusts. We do not consolidate thefinancial results of the trusts with our own financial results. For adiscussion of our decision not to consolidate, see “Management’s Discussion andAnalysis of Financial Condition and Results of Operations—ExecutiveSummary—Application of Critical Accounting Policies andEstimates—Consolidation.” Some of the relevant accounting rules are in theprocess of being amended. If as a result of these amendments or changes inaccounting rules we were required to consolidate the financial results of oneor more trusts with our own financial results, our financial results could beadversely affected, particularly in the early years of a trust when the trusttypically experiences losses.

 

**In structuring and facilitatingsecuritizations of our clients’ loans and as holders of rights to receiveresidual cash flows in those trusts, we may incur liabilities to investors inthe asset-backed securities those trusts issue.**

 

We have facilitated and structured a number of different specialpurpose trusts that have been used in securitizations to finance student loansthat our clients originate. Under applicable state and federal securities laws,if investors incur losses as a result of purchasing asset backed securitiesthat those trusts issue, we could be deemed responsible and could be liable tothose investors for damages. If we failed to cause the trusts to disclosecorrectly all material information regarding an investment in the asset-backedsecurities or if the trust made statements that were misleading in any materialrespect in information delivered to investors, it is possible that we could beheld responsible for that information or omission. In addition, under variousagreements entered into with underwriters or financial guarantee insurers ofthose asset-backed securities, we are contractually bound to indemnify thosepersons if investors are successful in seeking to recover losses from thoseparties and the trusts are found to have made materially misleading statementsor to have omitted material information.

 

We do not maintain reserves against this potential liability. If we areliable for losses investors incur in any of the securitizations that wefacilitate or structure, our profitability or financial position could bematerially adversely affected.

 

**If our relationships with key clientsterminate, our revenue and results of operations would be adversely affected.**

 

We structure and support private student loan programs for commercialbanks, including Bank One N.A. and Bank of America N.A. We also structure andsupport private student loan programs for marketing partners that refer theirborrowers to a particular lending source, such as Charter One Bank, N.A. Werefer to these lenders as referral lenders. Structural advisory fees andresiduals from securitization of Bank One private label loans representedapproximately 43% of our total service revenue for fiscal 2004, approximately59% of our total service revenue for fiscal 2003 and 50% of our total servicerevenue for fiscal 2002. Bank of America is the exclusive lender for our GATEprogram clients. Our GATE programs contributed 4% of our total service revenuein fiscal 2004. Structural advisory fees and residuals from securitization of CharterOne-funded private label loans represented approximately 17% of our totalservice revenue in fiscal 2004 and 2% of our total service revenue in fiscal2003.

 

Our current agreement with Bank One is scheduled to terminate in 2007,and our private label agreements with Bank of America and Charter One mayterminate as early as June 2005 and May 2005, respectively. However,each client has the right to terminate our agreement on short notice, generally30 days or less, if we materially breach our agreement, including ourfailure to perform at service levels specified in those contracts. In addition,under the terms of our lender clients’ guaranty agreements with TERI, both thelender and TERI may propose modifications to loan program guidelines during thefirst calendar quarter of each year. If the parties are unable to agree on aproposed modification, such as an adjustment of the guaranty fees, the partyproposing the

 

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modificationhas the option of terminating the guaranty agreement, effective as ofMay 1 of that calendar year. Under its master loan guaranty agreement withus, TERI may not propose a change to program guidelines without our consent.Similarly, under our agreements with lenders that have multi-year terms, thelender cannot change the program guidelines without our consent, which wecannot unreasonably withhold.

 

A significant decline in services to Bank One, Bank of America orCharter One, or the termination of guaranty agreements between those lendersand TERI, could reduce the overall volume of loans we facilitate, which couldbe difficult to replace through arrangements with other lenders. Our revenue,business and financial results could suffer as a result. In addition, there hasbeen significant consolidation within the banking industry. For example,Charter One Financial, Inc., the publicly traded parent company of Charter OneBank, N.A., was recently acquired by Citizens Financial Group, Inc. andBank One recently merged with JP Morgan Chase & Co. Further consolidationcould result in a loss of business if one or more of our clients were acquiredby a lender that is not our client.

 

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

 

In June 2001, we purchased the loan processing operations of TERIand entered into a series of agreements to govern future securitizations ofTERI-guaranteed loans. TERI continues to provide private student loanguarantee, education information and counseling services for students, and isthe exclusive third party provider of borrower default guarantees for ourclients’ private label loans. We have entered into an agreement to providevarious services to TERI and received fees from TERI for services performed of$17.4 million, or 77% of total service revenue, for the first quarter of fiscal2005, $7.8 million, or 83% of total service revenue, for the first quarter offiscal 2004 and $35.1 million, or 18% of total service revenue, for fiscal2004. In addition, we have agreed to undertake on a best-efforts basis toarrange or facilitate securitizations for a limited category of TERI-guaranteedloans and have the right to receive structural advisory and other fees inconnection with these securitizations. We also have entered into an agreementto receive from TERI updated information about the performance of the studentloans it has guaranteed to allow us to supplement our database. Each of theseagreements with TERI had an initial term through June 2006. In October 2004, weexercised our option to renew each agreement for an additional five-year term,through June 2011. If our agreements with TERI terminate for any reason, or ifTERI fails to comply with its obligations, our business would be adverselyaffected and the value of our intangible assets could be impaired for thefollowing reasons:

 

•                  we may not beable to offer our clients guarantee services from another guarantor and,accordingly, our access to loans and our opportunities to structuresecuritization transactions may diminish significantly;

 

•                  we may not besuccessful in establishing an arrangement with a third party to provide thewarranties that TERI currently provides to lenders related to originationservices. In such case, we may be required to provide such warranties; and

 

•                  if TERI isunable to provide guarantee services, the financial guarantee insurancecoverage we obtain in securitization transactions could be more costly, if itis available at all.

 

In such events, demand for our services, including opportunities tostructure and facilitate securitization transactions, could decline, whichwould adversely affect our business. In addition, the value of the loan poolsin the securitization transactions we facilitate could decline and the value ofour residuals could be reduced.

 

**Our business could be adversely affected ifTERI’s ratings are downgraded, if TERI fails to maintain its not-for-profitstatus or if TERI’s not-for-profit status ceased to be a competitive advantage.**

 

In its role as guarantor in the private education lending market, TERIagrees to reimburse lenders for unpaid principal and interest on defaultedloans. TERI is the exclusive provider of borrower default guarantees for ourclients’ private student loans. As of September 30, 2004, TERI had a Baa3counterparty rating from Moody’s Investors Service, which is the lowestinvestment grade rating, and an insurer financial strength rating of A+ fromFitch Ratings. If these ratings are lowered, our clients may not wish to enterinto guarantee arrangements with TERI. In addition, we may receive lowerstructural advisory fees because the costs of obtaining financial guaranteeinsurance for the asset-backed securitizations that we structure couldincrease. In such case, our business would be adversely affected.

 

TERI is a not-for-profit organization and, as a result, borrowers havebeen deemed unable to discharge in bankruptcy proceedings loans that TERIguarantees. If TERI loses its not-for-profit status, and TERI-guaranteedstudent loans become dischargeable in bankruptcy, recovery rates on these loanscould decline. In such event, our business could be adversely affected for thefollowing reasons:

 

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•                  our residuals inthe securitization trusts could decline because of increased default rates andcollection costs; and

 

•                  thesecuritization transactions that we structure could be on less favorable termsbecause investors and financial guarantee insurers could become more concernedwith default and recovery rates.

 

Assuming that TERI retains its not-for-profit status, TERI’s positionas the leading provider of private education loan guarantees could be adverselyaffected if the U.S. federal bankruptcy laws are amended to make student loansgenerally non-dischargeable in bankruptcy, as provided in legislation currentlybefore the U.S. Congress. If such an amendment were enacted:

 

•                  lenders whowould currently seek a guarantee from a not-for-profit entity such as TERI inorder for their private student loans to become non-dischargeable in bankruptcymay cease to do so; and

 

•                  TERI would ceaseto have this competitive advantage over potential for-profit providers of theservices that TERI provides.

 

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

 

**Our business could be adversely affected ifPHEAA fails to provide adequate or timely services or if our relationship withPHEAA terminates.**

 

As of September 30, 2004, Pennsylvania Higher Education AssistanceAgency, or PHEAA, serviced a majority of loans whose origination we facilitate.This arrangement allows us to increase the volume of loans in our clients’ loanprograms without incurring the overhead investment in servicing operations. Aswith any external service provider, there are risks associated with inadequateor untimely services. We regularly monitor the servicing portfolio reports,including delinquencies and defaults. A substantial increase in the delinquencyrate could adversely affect our ability to access profitably the securitizationmarkets for our clients’ loans. In addition, if our relationship with PHEAAterminates, we would need to develop a relationship with another TERI-approvedloan servicer, which could be time consuming and costly. In such event, ourbusiness could be adversely affected. Although we periodically review the costsassociated with establishing servicing operations to service loans, we have noplans to establish and perform servicing operations at this time.

 

**Surety limits that some of our GATE schoolclients face may lead us to make deposits in the securitization trustsestablished by The National Collegiate Trust on behalf of such schools.**

 

We have utilized several special purpose entities for thesecuritizations we have structured. One of these special purpose entities, TheNational Collegiate Trust, has established separate securitization trusts,which we refer to as the NCT trusts, that have purchased primarily GATE loans.Some of the school clients participating in our GATE program face limits on theamount of surety coverage which our current insurance vendor is willing toprovide on their behalf. This surety coverage provides NCT trust bondholderswith assurance that the pledge commitment these school clients make toreimburse the NCT trusts for defaults by their student borrowers will befulfilled. We can provide no assurance that in NCT trusts established in thefuture, our current insurance vendor will provide adequate surety coverage forall schools participating in the GATE program.

 

As these surety coverage limits are reached, we consider variousoptions for providing NCT trust bondholders in NCT trusts with additionalcredit enhancement so that school clients may continue to participate in theGATE program. For example, in our June 2004 securitization, we made a cashdeposit with the NCT trust on behalf of six schools, in an amount adequate tocover the additional surety amount required beyond what the GATE program’scurrent surety provider was willing to provide on the schools’ behalf. Ouraggregate cash surety deposit on behalf of these schools was $1.8 million.We could lose some or all of this deposit and future deposits we may make onbehalf of schools should such schools breach their commitments to reimburse theNCT trusts for defaults by their student borrowers.

 

**The outsourcing services market for educationlending is highly competitive, and if we are not able to compete effectively,our revenue and results of operations may be adversely affected.**

 

We assist national and regional financial institutions and educationalinstitutions, as well as businesses and other enterprises, in structuring andsupporting their private education loan programs. In providing our services, wereceive fees for services we provide primarily in connection with thesecuritization of our clients’ loans. The outsourcing services market in whichwe operate includes a large number of service providers, some of which havegreater financial, technical and marketing resources, larger customer bases,greater name recognition and more established relationships with their clientsthan we have. Larger competitors with greater financial resources may be betterable to respond to the need for technological changes, compete for skilledprofessionals, build upon

 

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efficienciesbased on a larger volume of loan transactions, fund internal growth and competefor market share generally. We may face competition from our clients if theychoose to provide directly the services that we currently provide, and fromthird parties who decide to expand their services to include the suite ofservices that we provide. We are aware of two competitors, SLM Corporation, orSallie Mae, and Servus Financial Corporation, an affiliate of Wells FargoCompany, that offer a similar range of services to lenders. Our business couldalso be adversely affected if Sallie Mae’s recently announced program to marketprivate student loans directly to consumers becomes successful or if Sallie Maeseeks to market more aggressively to third parties the full range of servicesfor private loan programs that we provide. If we are not able to competeeffectively, our revenue and results of operations may be adversely affected.In addition, if third parties choose to provide the range of services that weprovide, pricing for our services may become more competitive, which couldlower our profitability.

 

Historically, lenders in the education loan market have focused theirlending activities on federal loans because of the relative size of the federalloan market and because the federal government guarantees repayment of theseloans, thereby significantly limiting the lenders’ credit risk. The demand forour services could decline if lenders place additional emphasis on the privateeducation loan market and offer the services we provide.

 

**The growth of our business could be adverselyaffected if annual and aggregate limitations under federal student loanprograms increase.**

 

We focus our business exclusively on the market for private educationloans, and more than 90% of our business is concentrated in loan programs forpost-secondary education. The availability of loans that the federal governmentoriginates or guarantees affects the demand for private student loans becausestudents and their families often rely on private loans to bridge the gapbetween available funds, including family savings, grants and federal and stateloans, and the costs of post-secondary education. The federal governmentcurrently places both annual and aggregate limitations on the amount of federalloans that any student can receive, and these limitations are adjusted inconnection with funding authorizations from the United States Congress forprograms under the Higher Education Act. The limitations on federal studentloans have not been adjusted since 1992, and Congress is currently consideringproposals that could increase the limitations in the future. If Congressmaterially increases either the annual or aggregate loan limitations, orotherwise increases the funding available under federal student loan programs,demand for private student loans could weaken, which could adversely affect thevolume of private loans and the securitization transactions that we facilitateand structure and, as a result, the growth of our business.

 

**Access to alternative means of financing thecosts of education may reduce demand for private student loans.**

 

The demand for private student loans could weaken if student borrowersuse other vehicles to bridge the gap between available funds and costs ofpost-secondary education. These vehicles include, among others:

 

•                  home equityloans, under which families borrow money based on the value of their realestate;

 

•                  pre-paid tuitionplans, which allow students to pay tuition at today’s rates to cover tuitioncosts in the future;

 

•                  529 plans, whichare state sponsored investment plans that allow a family to save funds foreducation expenses; and

 

•                  education IRAs,now known as Coverdell Education Savings Accounts, under which a holder canmake annual contributions for education savings.

 

If demand for private student loans weakens, we would experiencereduced demand for our services, which would seriously harm our financialresults.

 

**If competitors acquire or develop a studentloan database or advanced loan information processing systems, our businesscould be adversely affected.**

 

We own a proprietary database of historical information on privatestudent loan performance that we use to help us establish the pricingprovisions of new loan programs, determine the terms of securitizationtransactions and establish the present value of the structural advisory feesand residuals that we recognize as revenue. We also have developed aproprietary loan information processing system to enhance our applicationprocessing and loan origination capabilities. Our student loan database andloan information processing system provide us with a competitive advantage inoffering our services. Third parties could create or acquire databases andsystems such as ours. For example, as lenders and other organizations in thestudent loan market originate or service loans, they compile over time informationfor their own student loan performance database. If a third party creates oracquires a student loan

 

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database ordevelops a loan information processing system, our competitive positioning,ability to attract new clients and business could be adversely affected.

 

**If our clients do not successfully market andsell student loans, our business will be adversely affected.**

 

We provide outsourcing services to lenders, marketing partners andeducational institutions, as well as businesses and other organizations instructuring and supporting their private education loan programs. We rely onour clients to market and sell education loans to student borrowers. If they donot devote sufficient time and resources to their marketing efforts, or if theyare otherwise not successful in these efforts, then we may experience areduction in the volume of loans that we process and securitize, and ourbusiness will be adversely affected.

 

**Changes in interest rates could affect thevalue of our additional structural advisory fees and residuals receivables, aswell as demand for private student loans and our services.**

 

Student loans typically carry floating interest rates. Higher interestrates would increase the cost of the loan to the borrower, which in turn, couldlessen demand for our services and cause an increase in prepayment and defaultrates for outstanding student loans. If this occurs, we may experience adecline in the value of our additional structural advisory fees and residualsreceivables in connection with the securitizations that we facilitate. Inaddition, most of the student loans that our clients originate carry floatingrates of interest tied to prevailing short-term interest rates. An increase ininterest rates could reduce borrowing for education generally, which, in turn,could cause the overall demand for our services to decline.

 

**If we are unable to protect theconfidentiality of our proprietary database and information systems andprocesses, the value of our services and technology will be adversely affected.**

 

We rely on trade secret laws and restrictions on disclosure to protectour proprietary database and information systems and processes. We have enteredinto confidentiality agreements with third parties and with some of ouremployees to maintain the confidentiality of our trade secrets and proprietaryinformation. These methods may neither effectively prevent disclosure of ourconfidential information nor provide meaningful protection for our confidentialinformation if there is unauthorized use or disclosure.

 

We own no patents and have filed no patent applications with respect toour proprietary database or loan information processing systems. Accordingly,our technology is not covered by patents that would preclude or inhibitcompetitors from entering our market. Monitoring unauthorized use of thesystems and processes that we developed is difficult, and we cannot be certainthat the steps that we have taken will prevent unauthorized use of our technology.Furthermore, others may independently develop substantially equivalentproprietary information and techniques or otherwise gain access to ourproprietary information. If we are unable to protect the confidentiality of ourproprietary information and know-how, the value of our technology and serviceswill be adversely affected.

 

**An interruption in or breach of ourinformation systems may result in lost business.**

 

We rely heavily upon communications and information systems to conductour business. As we implement our growth strategy and increase our volume ofbusiness, that reliance will increase. Any failure or interruption, or breachin security, of our information systems or the third party information systemson which we rely could cause underwriting or other delays and could result infewer loan applications being received, slower processing of applications andreduced efficiency in loan processing. A failure, interruption or breach insecurity could also result in an obligation to notify clients in states such asCalifornia that require such notification, with possible civil liabilityresulting from such failure, interruption or breach. We cannot assure you thatsuch failures, interruptions or breaches will not occur, or if they do occurthat we or the third parties on which we rely will adequately address them. Wehave implemented precautionary measures to avoid systems outages and tominimize the effects of any data or telephone systems interruptions, but wehave not instituted fully redundant systems. The occurrence of any failure,interruption or breach could significantly harm our business.

 

**The loan origination process is becomingincreasingly dependent upon technological advancement, and we could loseclients and market share if we are not able to keep pace with rapid changes intechnology.**

 

Our ability to handle an increasing volume of transactions is based inlarge part on the advanced systems and processes we have implemented anddeveloped. The loan origination process is becoming increasingly dependent upontechnological advancement such as the ability to process loans over theInternet, accept electronic signatures and provide process updates instantly.Our future success depends in part on our ability to develop and implementtechnology solutions that anticipate and keep pace with these and othercontinuing changes in technology, industry standards and client preferences. Wemay not be successful in anticipating or responding to these developments on atimely basis. If competitors introduce products, services, systems andprocesses that are better

 

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than ours orthat gain greater market acceptance, those that we offer or use may becomeobsolete or noncompetitive. Any one of these circumstances could have amaterial adverse effect on our ability to obtain and retain key clients.

 

We may be required to expend significant funds to develop or acquirenew technologies. If we cannot offer new technologies as quickly as ourcompetitors, we could lose clients and market share. We also could lose marketshare if our competitors develop more cost effective technologies than those weoffer or develop.

 

**We have expanded our operations rapidly inrecent years, and if we fail to manage effectively our growth, our financialresults could be adversely affected.**

 

The number of our employees increased to 539 regular employees and 134seasonal and part time employees as of September 30, 2004 from 232 regularemployees and 26 seasonal employees as of September 30, 2003. Many of theseemployees have very limited experience with us and a limited understanding ofour systems and controls. From our inception to September 30, 2004, our assetshave grown to $337.8 million. Our revenue increased to $199.3 million in fiscal2004 from $91.4 million for fiscal 2003 and $41.3 million for fiscal2002. Our growth may place a strain on our management systems and resources. Wemust continue to refine and expand our business development capabilities, oursystems and processes and our access to financing sources. As we grow, we mustcontinue to hire, train, supervise and manage new employees. We cannot assureyou that we will be able to:

 

•                  expand oursystems effectively;

 

•                  allocate ourhuman resources optimally;

 

•                  identify andhire qualified employees; or

 

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

 

If we areunable to manage our growth, our operations and our financial results could beadversely affected.

 

**If we become subject to the licensing orregistration laws of any jurisdiction or any additional government regulation,our compliance costs could increase significantly.**

 

Although we are subject to certain state and federal consumerprotection laws, which are subject to change, we believe our operationscurrently do not require us to be licensed with any regulatory body and onlyrequire us to be registered with one regulatory body. The MassachusettsDivision of Banks ruled that our business with TERI is not subject to licensurebecause, as a provider of loan origination outsourcing services, we do notconduct lending business with consumers in our own name and our processingcenters are not generally open to the public.

 

The Massachusetts Small Loan Act requires any person that is engaged,for compensation, in the business of making small loans, or in aiding orassisting the borrower or the lender in procuring or making such loans, toobtain a license. Under the statute, the business of making small loans includesthe making of loans of $6,000 or less with interest rates and expenses of morethan 12% per year. We could become subject to the Small Loan Act in the futureif, for example, interest rates exceed 12% or the Massachusetts Division ofBanks revokes its previous determination that our operations are exempt.

 

We could also become subject to licensing laws due to changes inexisting federal and state regulations. The Massachusetts legislature could,for example, modify the statutory requirements under the Small Loan Act. If theMassachusetts legislature, or any other state or federal regulatory authority,changes existing laws and rules, or enacts new laws or rules, we could beforced to make changes in our relationships with lenders, educationalinstitutions, guarantors, servicers or the trusts involved in thesecuritizations that we facilitate. Specifically, changes in existing laws andrules could also require us to implement additional or different programs andinformation technology systems and could impose licensing, capital and reserverequirements and additional costs, including administrative, compliance andthird party service costs.

 

We could also become subject to regulatory requirements inMassachusetts and other states if we engage in certain regulated activities inthe future, such as loan guarantees, or if our operations became sufficientlylocalized in other states to trigger licensing or registration requirements. Wehave consulted with national counsel regarding state laws outside of Massachusettsgoverning the licensing and registration of loan brokers and loan arrangers. Asa result of that legal review, we have consulted with local counsel in relevantstates. Based on the advice of local counsel and, in some states, additionalinformal advice from state regulators, we have concluded that no such licensesor registrations are required, except in Pennsylvania, where local counsel hasadvised us that we need to register as a “loan broker” with the PennsylvaniaDepartment of Banking. We are in the process of completing and filing that

 

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registration.While we have not received formal licensing or registration rulings from statesother than Massachusetts, we do not believe that any other state would havejurisdiction over our operations because:

 

•                  all of ourcontacts with consumers are conducted in the name of federal and statechartered financial institutions, which generally are exempt from additionallicensure of the business of lending, or in the name of TERI, which hassatisfied Massachusetts licensure requirements; and

 

•                  our contactswith borrowers outside of Massachusetts occur exclusively in interstatecommerce, through the mail, by phone and through the Internet.

 

If any state asserts jurisdiction over our business, we will proceedwith licensing or registration in the affected state. Our activities in thatstate could be curtailed pending processing of a licensing application orregistration, and we could be subject to civil or criminal penalties.

 

We believe that our consultations with national and local counsel haveidentified all material licensing, registration and regulatory requirementsthat could apply to our business outside of Massachusetts. The risk remains,however, that an unusual regulatory regime could exist in a state that wouldpermit such state, even if we were not physically present, to assertsuccessfully jurisdiction over our operations for services we provide throughthe mail, by phone, through the Internet or by other remote means. Our failureto comply with such requirements could subject us to civil or criminalpenalties and could curtail our ability to continue to conduct business in thatjurisdiction. In addition, compliance with such requirements could involve additionalcosts. Either of these consequences could have a material adverse effect on ourbusiness and results of operations.

 

In addition, other organizations with which we work, including TERI,are subject to licensing and extensive governmental regulations, includingtruth-in-lending laws and other consumer protection regulations. From time totime we have, and we may in the future, become responsible for compliance withthese regulations under contractual arrangements with our clients. If we failto comply with these regulations, we could be subject to civil or criminalpenalties.

 

**Failure to comply with consumer protectionlaws could subject us to civil and criminal penalties and affect the value ofour assets. Compliance with recently enacted identity theft laws andregulations will increase the cost and complexity of our operations and mayreduce our ability to process growing loan volumes in a timely fashion.**

 

The federal government and state governments regulate extensively thefinancial institutions and other entities that originate loans in the studentloan market. These regulations include usury, disclosure, credit reporting,identity theft, privacy, fraud and abuse and other laws to protect borrowers.Violations of the laws or regulations governing our operations or the operationof TERI or our other clients could result in the imposition of civil orcriminal penalties, the cancellation of our contracts to provide services orexclusion from participating in education loan programs. These penalties or exclusions,were they to occur, would negatively impair our ability to operate ourbusiness. In addition, the loan assets held by securitization trusts that wehave structured could be adversely impacted by violation of consumer protectionlaws. In such event, the value of our residual interests could also beadversely impacted. In some cases, such violations may render the loan assetsunenforceable.

 

The Fair and Accurate Credit Transactions Act of 2003 imposessignificant new federal law requirements on loan application processors,including requirements with respect to resolving address inconsistencies,responding to “red flags” of potential identity theft and processing identitytheft notices and other requirements that will require both changes to automatedloan processing and the creation of manual exception systems. These newrequirements will strain systems and personnel that are already undergoingrapid change due to loan volume growth. Failure to comply with theserequirements will violate our obligations to the lenders we serve and couldsubject them to regulatory action and result in termination of our processingcontracts.

 

**The price of our common stock may bevolatile.**

 

Prior to our initial public offering, which we closed onNovember 5, 2003, there was no public trading market for our common stock.The trading market for our common stock is therefore immature, and the tradingprice of our common stock may fluctuate substantially. These fluctuations couldcause you to lose part or all of your investment in our shares of common stock.Those factors that could cause fluctuations include, but are not limited to,the following:

 

•                  difficulties wemay encounter in the securitizations that we structure or the loss ofopportunities to structure securitization transactions;

 

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

 

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•                  significantvolatility in the market price and trading volume of financial services andprocess outsourcing companies;

 

•                  actual oranticipated changes in our earnings or fluctuations in our operating results orin the expectations of securities analysts;

 

•                  general economicconditions and trends;

 

•                  negativepublicity about the student loan market generally or us specifically;

 

•                  majorcatastrophic events;

 

•                  loss of asignificant client or clients;

 

•                  sales of largeblocks of our stock; or

 

•                  departures ofkey personnel.

 

In the past, following periods of volatility in the market price of acompany’s securities, securities class action litigation has often been broughtagainst that company. Due to the potential volatility of our stock price, wemay therefore be the target of securities litigation in the future. Securitieslitigation could result in substantial costs and divert management’s attentionand resources from our business.

 

**If a substantial number of shares becomeavailable for sale and are sold in a short period of time, the market price ofour common stock could decline.**

 

We have only been a public company since October 2003. For theeleven month period ended September 30, 2004, the average daily tradingvolume of our common stock on the New York Stock Exchange was less than 250,000shares. As a result, future sales of a substantial number of shares of ourcommon stock in the public market, or the perception that such sales may occur,could adversely affect the then-prevailing market price of our common stock.

 

As of September 30, 2004, we had 64,446,739 shares of common stockoutstanding. In connection with the follow-on public offering that we closed onJune 28, 2004, all selling stockholders entered into lock-up agreementswith the underwriters of the offering. As a result of these lock-up agreements,24,670,484 shares were subject to contractual restrictions on resale throughSeptember 20, 2004. Subject to limitations under federal securities laws,including in some cases the holding period requirements and volume limitationsof Rule 144 under the Securities Act of 1933, these shares became eligible forsale on September 21, 2004.

 

The market price of shares of our common stock may drop significantlyif our existing stockholders sell a substantial number of shares. A decline inthe price of shares of our common stock might impede our ability to raisecapital through the issuance of additional shares of our common stock or otherequity securities.

 

**Insiders have substantial control over us andcould limit your ability to influence the outcome of key transactions,including a change of control.**

 

As of September 30, 2004, our directors and executive officers, andentities affiliated with them, beneficially own approximately 59% 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 in our certificate ofincorporation and by-laws may deter third parties from acquiring us.**

 

Our certificate of incorporation and by-laws contain provisions thatmay make the acquisition of our company more difficult without the approval ofour board of directors, including the following:

 

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

 

•                  our stockholdersmay take action only at a meeting of our stockholders and not by writtenconsent;

 

•                  we haveauthorized undesignated preferred stock, the terms of which may be establishedand shares of which may be issued without stockholder approval;

 

•                  our directorsmay be removed only for cause by the affirmative vote of a majority of thedirectors present at a meeting duly held at which a quorum is present, or theholders of 75% of the votes that all stockholders would be entitled to cast inthe election of directors; and

 

•                  we imposeadvance notice requirements for stockholder proposals.

 

These anti-takeover defenses could discourage, delay or prevent atransaction involving a change in control of our company. These provisionscould also discourage proxy contests and make it more difficult for you andother stockholders to elect directors of your choosing and cause us to takeother corporate actions you desire.

 

**Section 203 of the Delaware GeneralCorporation Law may delay, defer or prevent a change in control that ourstockholders might consider to be in their best interests.**

 

We are subject to Section 203 of the Delaware General CorporationLaw which, subject to certain exceptions, prohibits “business combinations”between a Delaware corporation and an “interested stockholder,” which isgenerally defined as a stockholder who becomes a beneficial owner of 15% ormore of a Delaware corporation’s voting stock, for a three-year periodfollowing the date that such stockholder became an interested stockholder.Section 203 could have the effect of delaying, deferring or preventing achange in control that our stockholders might consider to be in their bestinterests.

 

**Item3—Quantitative and Qualitative Disclosures About Market Risk**

 

***General***

 

Market risk is the risk of change in fair value of a financialinstrument due to changes in interest rates, equity prices, creditworthiness,foreign exchange rates or other factors. Our primary market risk exposure is tochanges in interest rates in our cash and other short-term investments. Cashand other short-term investments include balances in money market funds. Theprimary objective of our investment policy is the preservation of capital.Accordingly, because of the conservative nature of our investment policy andthe relatively short duration of our investments, interest rate risk ismitigated. We expect to continue to manage our interest rate risk through anactive portfolio management strategy that involves the selection of investmentswith appropriate characteristics, such as duration, yield, currency andliquidity.

 

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

 

Because there are no quoted market prices for our additional structuraladvisory fees and residuals receivables, we use assumptions to estimate theirvalues. We base these estimates on our proprietary historical data, third partydata and our industry experience, adjusting for specific program and borrower characteristicssuch as loan type and borrower creditworthiness. Increases in our estimates ofdefaults, prepayments and discount rates, increases in the spread between LIBORand auction rates as well as decreases in default recovery rates and themulti-year forward estimates of the LIBOR rate, which is the reference rate forthe loan assets and borrowings of the securitization trusts, would have anegative effect on the value of our additional structural advisory fees andresiduals. For an analysis of the estimated change in our structural advisoryfees and residuals receivables balance at September 30, 2004 based onchanges in these loan performance assumptions, see “—Application of CriticalAccounting Policies and Estimates—Service Revenue—Sensitivity Analysis.”

 

**Item4—Controls and Procedures**

 

Our management, with the participation of our chief executive officerand chief financial officer, evaluated the effectiveness of our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Exchange Act) as of September 30, 2004. Based on this evaluation, ourchief executive officer and chief financial officer concluded that, as ofSeptember 30, 2004, our

 

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disclosurecontrols and procedures were (1) designed to ensure that materialinformation relating to us, including our consolidated subsidiaries, is madeknown to our chief executive officer and chief financial officer by otherswithin those entities, particularly during the period in which this report wasbeing prepared and (2) effective, in that they provide reasonableassurance that information required to be disclosed by us in the reports thatwe file or submit under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and forms.

 

No change in our internal control over financial reporting (as definedin Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred duringthe first quarter of the fiscal year ending June 30, 2005 that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

 

**Part II. Other Information**

 

**Item2—Unregistered Sales of Equity Securities and Use of Proceeds**

 

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

 

In ourinitial public offering, we sold 7,906,250 shares of common stock, including anover-allotment option of 1,031,750 shares, pursuant to a registration statementon Form S-1 (File No. 333-108531) that was declared effective by theSecurities and Exchange Commission on October 30, 2003. We receivedaggregate net proceeds of approximately $115.1 million, after deductingunderwriting discounts and commissions of approximately $8.9 million andexpenses of the offering of approximately $2.5 million. From the effectivedate of the registration statement through September 30, 2004, we have notspent any of the net proceeds of the IPO, which have been invested in cash andother short-term investments. Accordingly, none of the net proceeds of the IPOhas been paid by us, directly or indirectly, to any director, officer orgeneral partner of us, or any of their associates, or to any person owning tenpercent or more of any class of our equity securities, or any of ouraffiliates.

 

InJune 2004, we completed a follow-on public offering of 7,406,312 shares ofour common stock, including an over-allotment option of 966,041 shares,pursuant to a registration statement on Form S-1 (FileNo. 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.

 

**Item 5—Other Information**

 

OnOctober 15, 2004, The First Marblehead Corporation (the “Company”) entered intoa Second Amendment, dated as of September 30, 2004 (the “Amendment”), to theAmended and Restated Standard Form Commercial Lease (the “Lease”), dated as ofFebruary 18, 2004, by and between OMV Associates Limited Partnership (the “Landlord”)and the Company.  Pursuant to the Amendment,the Company will lease an additional 25,265 square feet of office space (the “AmendmentPremises”) located at 31 St. James Avenue, Boston, Massachusetts, increasingthe number of square feet at the location to be used by the Company for loanprocessing activities to approximately 124,000 (the “Premises”).

 

Underthe Amendment, the initial term of the lease for the Amendment Premises beganon October 1, 2004 (the “Commencement Date”) and will expire on April 30, 2014,which is the expiration date of the initial lease term applicable toapproximately 91,000 square feet of the Premises.  The Amendment also extends the initial leaseterm applicable to approximately 7,300 square feet of the Premises from April30, 2009 to April 30, 2014.  As a result,the initial term applicable to the entire Premises will now expire on April 30,2014.  The Company has the option,exercisable twice, to extend the initial term applicable to the entire Premisesfor an additional five years, subject to the basic rent for the extended termsbeing 95% of the fair market value as designated by the Landlord.

 

Theannual basic rent for the Amendment Premises from the Commencement Date throughApril 30, 2009 will be approximately $745,000. The annual basic rent for the Amendment Premises from May 1, 2009through April 30, 2014 will be approximately $872,000.  The Amendment did not otherwise change theannual basic rent under the Lease.

 

Underthe Amendment, the Company no longer has an expansion option for additionalspace under the Lease.  In addition, theCompany has an obligation to lease up to six suites located on the fifth floorof the building (the “Put Suites”) as any of the Put Suites becomes availablefor lease during the term of the Lease. The Company continues to have a right of first offer with respect tooffice space at the same location currently leased to another tenant.

 

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The foregoingsummary of the Amendment is subject to, and qualified in its entirety by, (i)the Amendment attached to this Form 10-Q as Exhibit 10.1 and incorporatedherein by reference and (ii) the Lease, filed as Exhibit 10.3 to the Company’sForm 10-Q filed on May 14, 2004 incorporated herein by reference.

 

**Item 6—Exhibits**

 

See the Exhibit Index on thepage immediately preceding the exhibits for a list of exhibits filed as part ofthis quarterly report which Exhibit Index is incorporated herein by thisreference.

 

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**SIGNATURES**

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 
| ** **              | **THE FIRST  MARBLEHEAD CORPORATION**         |
|-------------------------|-----------------------------------------------|
| ** **              | ** **                                    |
| Date: November 12, 2004 | By:                                           |
|                    | /s/ Donald R. Peck                            |   |
|                    | Donald  R. Peck                               |   |
|                    | *Executive  Vice President,*                  |   |
|                    | *Chief  Financial Officer and Treasurer* |   |
|                         |                                               |  |  |

 

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**EXHIBIT INDEX**

 
| **Exhibit Number** | ** ** | **Description**                                                                                                                                                                                                     |
|--------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|               |       |                                                                                                                                                                                                                |
| 10.1               |       | Second Amendment, dated as of September 30,  2004, to Amended and Restated Standard Form Commercial Lease between OMV  Associates Limited Partnership and the Company dated as of February 18, 2004.                |
| 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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