**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

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**FORM 10-Q**

** **

**(MARKONE)**

| **ý** | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                                       |
| ** ** |       | **For  The Quarterly Period Ended September 30, 2005**                                                                                                                                                                |
| ** ** | ** ** | ** **                                                                                                                                                                                                                 |
| ** ** | ** ** | **OR**                                                                                                                                                                                                                     |
| ** ** | ** ** | ** **                                                                                                                                                                                                                 |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                    |
|       |       |                                                                                                                                                                                                                       |
| ** ** |       | **For  the transition period  from               to               ** |

 

**CommissionFile Number 001-31825**

 

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**The First Marblehead Corporation**

(Exact Name of Registrantas Specified in Its Charter)

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

 

Registrant’stelephone number, including area code: **(617) 638-2000**

 

Indicate by check markwhether the registrant: (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 markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act).

Yes ý No o

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

Yes o No ý

 

As of October 21,2005, the registrant had 64,942,044 shares of Common Stock, $0.01 par value pershare, outstanding.

 

 

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**THEFIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

** **

**Tableof Contents**

 
| ** **                         | **Page**                                                                                                                      |
|------------------------------------|-------------------------------------------------------------------------------------------------------------------------------|
| Part I. Financial Information |                                                                                                                          |
| Item 1—                       | Financial Statements                                                                                                          |   |
|                               | Condensed Consolidated  Balance Sheets as of September 30, 2005 and June 30, 2005                                   | 3 |
|                               | Condensed Consolidated  Statements of Operations for the three months ended September 30, 2005  and 2004                 | 4 |
|                               | Condensed Consolidated  Statement of Changes in Stockholders’ Equity for the three months ended  September 30, 2005 | 5 |
|                               | Condensed Consolidated  Statements of Cash Flows for the three months ended September 30, 2005  and 2004                 | 6 |
|                               | Notes to Unaudited Condensed  Consolidated Financial Statements                                                               | 7 |
| Item 2—                       | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                                   | 15 |
| Item 3—                       | Quantitative  and Qualitative Disclosures About Market Risk                                                                   | 38 |
| Item 4—                       | Controls and  Procedures                                                                                                      | 38 |
| Part II. Other  Information   |                                                                                                                          |
| Item 2—                       | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                  | 39 |
| Item 5—                       | Other Information                                                                                                             | 39 |
| Item 6—                       | Exhibits                                                                                                                      | 40 |
| SIGNATURES                         | 41                                                                                                                            |
| EXHIBIT INDEX                 | 42                                                                                                                            |

 

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,  2005** | ** ** | **June 30,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                                                                                                                                           |       |                         |       |                    |       |
| Cash and cash  equivalents                                                                                                                                                                                                                                                                                                                           |       | $                            | 156,086    |                    | $          | 193,796 |   |
| Service  receivables:                                                                                                                                                                                                                                                                                                                                |       |                         |       |                    |       |
| Structural  advisory fees                                                                                                                                                                                                                                                                                                                            |       | 53,570                       |       | 53,371                  |       |
| Residuals                                                                                                                                                                                                                                                                                                                                            |       | 254,757                      |       | 247,275                 |       |
| Processing fees  from The Education Resources Institute (TERI)                                                                                                                                                                                                                                                                                       |       | 9,133                        |       | 8,944                   |       |
|                                                                                                                                                                                                                                                                                                                                                 |       | 317,460                      |       | 309,590                 |       |
| Property and  equipment                                                                                                                                                                                                                                                                                                                              |       | 51,985                       |       | 49,269                  |       |
| Less accumulated  depreciation and amortization                                                                                                                                                                                                                                                                                                      |       | (12,751                      | )          | (10,174                 | )          |
| Property and  equipment, net                                                                                                                                                                                                                                                                                                                         |       | 39,234                       |       | 39,095                  |       |
| Goodwill                                                                                                                                                                                                                                                                                                                                             |       | 3,176                        |       | 3,176                   |       |
| Intangible  assets, net                                                                                                                                                                                                                                                                                                                              |       | 2,453                        |       | 2,620                   |       |
| Prepaid income  taxes                                                                                                                                                                                                                                                                                                                                |       | 7,271                        |       | 2,594                   |       |
| Other prepaid expenses                                                                                                                                                                                                                                                                                                                               |       | 6,859                        |       | 4,163                   |       |
| Other assets                                                                                                                                                                                                                                                                                                                                         |       | 4,302                        |       | 3,159                   |       |
| Total assets                                                                                                                                                                                                                                                                                                                                         |       | $                            | 536,841    |                    | $          | 558,193 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                                                       |       |                         |       |                    |       |
| Liabilities:                                                                                                                                                                                                                                                                                                                                         |       |                         |       |                    |       |
| Accounts payable  and accrued expenses                                                                                                                                                                                                                                                                                                               |       | $                            | 28,279     |                    | $          | 33,318 |   |
| Net deferred  income tax liability                                                                                                                                                                                                                                                                                                                   |       | 81,230                       |       | 84,208                  |       |
| Capital lease  obligations                                                                                                                                                                                                                                                                                                                           |       | 10,932                       |       | 12,118                  |       |
| Notes payable to  TERI                                                                                                                                                                                                                                                                                                                               |       | 5,107                        |       | 5,292                   |       |
| Other  liabilities                                                                                                                                                                                                                                                                                                                                   |       | 2,112                        |       | 1,691                   |       |
| Total  liabilities                                                                                                                                                                                                                                                                                                                                   |       | 127,660                      |       | 136,627                 |       |
| Commitments and  contingencies                                                                                                                                                                                                                                                                                                                       |       |                         |       |                    |       |
|                                                                                                                                                                                                                                                                                                                                                 |       |                         |       |                    |       |
| Stockholders’  equity:                                                                                                                                                                                                                                                                                                                          |       |                         |       |                    |       |
| Preferred stock,  par value $0.01 per share; 20,000,000 shares authorized; no shares  issued or outstanding                                                                                                                                                                                                                                     |       | —                       |       | —                  |       |
| Common stock,  par value $0.01 per share; 150,000,000 shares authorized at  September 30, 2005 and June 30, 2005; 66,419,644 and 66,368,824  shares issued at September 30, 2005 and June 30, 2005,  respectively; 64,919,644 and 64,899,824 shares outstanding at  September 30, 2005 and June 30, 2005, respectively |       | 664                          |       | 664                     |       |
| Additional  paid-in capital                                                                                                                                                                                                                                                                                                                          |       | 205,123                      |       | 206,452                 |       |
| Retained  earnings                                                                                                                                                                                                                                                                                                                                   |       | 260,357                      |       | 273,589                 |       |
| Deferred  compensation                                                                                                                                                                                                                                                                                                                               |       | —                       |       | (3,131                  | )          |
| Treasury stock,  1,500,000 and 1,469,000 shares held at September 30, 2005 and  June 30, 2005, respectively, at cost                                                                                                                                                                                                                       |       | (56,620                      | )          | (55,665                 | )          |
| Accumulated  other comprehensive loss                                                                                                                                                                                                                                                                                                                |       | (343                         | )          | (343                    | )          |
| Total  stockholders’ equity                                                                                                                                                                                                                                                                                                                     |       | 409,181                      |       | 421,566                 |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                                                                                                                                                                     |       | $                            | 536,841    |                    | $          | 558,193 |   |

 

See accompanyingnotes to unaudited condensed consolidated financial statements.

 

3

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**THEFIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

** **

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(unaudited)**

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

 
| ** **                                    | ** ** | **Three months ended  September 30,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
|                                          |       |                                       |       |   |   |
| Service revenue:                              |       |                                       |       |   |   |
| Up-front structural advisory fees             |       | $                                          | —     |   | $ | — |   |
|                                          |       |                                       |       |   |   |
| Additional structural advisory fees:          |       |                                       |       |   |   |
| From new securitizations                      |       | —                                     |       | — |   |
| Trust updates                                 |       | 199                                        |       | 619 |   |
| Total additional  structural advisory fees    |       | 199                                        |       | 619 |   |
|                                          |       |                                       |       |   |   |
| Residuals:                                    |       |                                       |       |   |   |
| From new  securitizations                     |       | —                                     |       | — |   |
| Trust updates                                 |       | 7,482                                      |       | 3,460 |   |
| Total residual  revenue                       |       | 7,482                                      |       | 3,460 |   |
|                                          |       |                                       |       |   |   |
| Processing fees  from TERI                    |       | 25,928                                     |       | 17,357 |   |
|                                          |       |                                       |       |   |   |
| Administrative  and other fees                |       | 1,462                                      |       | 968 |   |
| Total service  revenue                        |       | 35,071                                     |       | 22,404 |   |
| Operating expenses:                           |       |                                       |       |   |   |
| Compensation and  benefits                    |       | 19,742                                     |       | 14,880 |   |
| General and  administrative expenses          |       | 25,925                                     |       | 16,959 |   |
| Total operating  expenses                     |       | 45,667                                     |       | 31,839 |   |
| Loss from operations                          |       | (10,596                                    | )          | (9,435 | ) |
| Other income (expense):                       |       |                                       |       |   |   |
| Interest expense                              |       | (230                                       | )          | (119 | ) |
| Interest income                               |       | 1,459                                      |       | 482 |   |
| Net other income                              |       | 1,229                                      |       | 363 |   |
| Loss before  income tax benefit               |       | (9,367                                     | )          | (9,072 | ) |
| Income tax benefit                            |       | (3,925                                     | )          | (3,720 | ) |
| Net loss                                      |       | $                                          | (5,442     | ) | $ | (5,352 | ) |
|                                          |       |                                       |       |   |   |
| Net loss per  share, basic                    |       | $                                          | (0.08      | ) | $ | (0.08 | ) |
| Net loss per  share, diluted                  |       | (0.08                                      | )          | (0.08 | ) |
| Weighted average  shares outstanding, basic   |       | 64,916                                     |       | 64,321 |   |
| Weighted average  shares outstanding, diluted |       | 64,916                                     |       | 64,321 |   |

 

See accompanyingnotes to unaudited condensed consolidated financial statements.

 

4

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**THEFIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

** **

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

**(unaudited)**

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

 
| ** **                                           | ** ** | **Common stock** | ** ** | **Additional  Paid-in  capital** | ** ** | **Retained  earnings** | ** ** | **Deferred  compensation** | ** ** | **Accumulated  other  comprehensive  loss, net of tax** | ** ** | **Total  stockholders’  equity** | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|----------------------------------|------------|------------------------|------------|----------------------------|------------|------------------------------------------------------------------------|------------|---------------------------------------|------------|
| **Issued**                                           | ** ** | **In treasury**  |
| **Shares**                                           | ** ** | **Amount**            | ** ** | **Shares**                       | ** ** | **Amount**             |
| **Balance at June 30, 2005**                    |       | 66,368                |       | $                                | 664        |                   | (1,469     | )                          | $          | (55,665                                                                | )          | $                                     | 206,452    |   | $ | 273,589 |   | $ | (3,131 | ) | $ | (343 | ) | $ | 421,566 |   |
| Adoption of FAS 123 (R)                              |       | —                |       | —                           |       | —                 |       | —                     |       | (3,131                                                                 | )          | —                                |       | 3,131 |   | — |   | — |   |
| Net loss                                             |       | —                |       | —                           |       | —                 |       | —                     |       | —                                                                 |       | (5,442                                | )          | — |   | — |   | (5,442 | ) |
| Options exercised                                    |       | 41                    |       | —                           |       | —                 |       | —                     |       | 76                                                                     |       | —                                |       | — |   | — |   | 76 |   |
| Stock purchases through employee stock purchase plan |       | 11                    |       | —                           |       |                   |       | —                     |       | 340                                                                    |       | —                                |       | — |   | — |   | 340 |   |
| Repurchase of common stock                           |       | —                |       | —                           |       | (31                    | )          | (955                       | )          | —                                                                 |       | —                                |       | — |   | — |   | (955 | ) |
| Recognition of stock-based compensation              |       | —                |       | —                           |       | —                 |       | —                     |       | 845                                                                    |       | —                                |       | — |   | — |   | 845 |   |
| Cash dividend ($0.12 per share)                      |       | —                |       | —                           |       | —                 |       | —                     |       | —                                                                 |       | (7,790                                | )          | — |   | — |   | (7,790 | ) |
| Tax benefit from employee stock options              |       | —                |       | —                           |       | —                 |       | —                     |       | 541                                                                    |       | —                                |       | — |   | — |   | 541 |   |
| **Balance at September 30, 2005**               |       | 66,420                |       | $                                | 664        |                   | (1,500     | )                          | $          | (56,620                                                                | )          | $                                     | 205,123    |   | $ | 260,357 |   | $ | — |   | $ | (343 | ) | $ | 409,181 |   |

 

See accompanyingnotes to unaudited condensed consolidated financial statements.

 

5

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**THEFIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

** **

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(unaudited)**

**(inthousands)**

** **
| ** **                                                                   | ** ** | **Three months ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| Cash flows from operating  activities:                                       |       |                                       |       |   |   |
| Net loss                                                                     |       | $                                          | (5,442     | ) | $ | (5,352 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                                       |       |   |   |
| Depreciation and amortization                                                |       | 2,930                                      |       | 1,232 |   |
| Deferred income tax (benefit) expense                                        |       | (2,978                                     | )          | 1,418 |   |
| Tax benefit from employee stock options                                      |       | —                                     |       | 49 |   |
| Stock-based compensation                                                     |       | 845                                        |       | — |   |
| Change in assets/liabilities:                                                |       |                                       |       |   |   |
| (Increase) decrease in structural advisory fees                              |       | (199                                       | )          | 9,631 |   |
| (Increase) in residuals                                                      |       | (7,482                                     | )          | (3,460 | ) |
| (Increase) in processing fees from TERI                                      |       | (189                                       | )          | (375 | ) |
| (Increase) in prepaid income taxes                                           |       | (4,677                                     | )          | (5,181 | ) |
| (Increase) decrease in other prepaid expenses                                |       | (2,696                                     | )          | 869 |   |
| (Increase) in other assets                                                   |       | (1,143                                     | )          | (1,595 | ) |
| (Decrease) in accounts payable, accrued expenses,  and other liabilities     |       | (12,408                                    | )          | (11,846 | ) |
| Net cash used in operating activities                                        |       | (33,439                                    | )          | (14,610 | ) |
|                                                                         |       |                                       |       |   |   |
| Cash flows from  investing activities:                                       |       |                                       |       |   |   |
| Purchases of property and equipment                                          |       | (2,716                                     | )          | (1,283 | ) |
| Payments to TERI for loan database updates                                   |       | (186                                       | )          | (187 | ) |
| Net cash used in investing activities                                        |       | (2,902                                     | )          | (1,470 | ) |
|                                                                         |       |                                       |       |   |   |
| Cash flows from  financing activities:                                       |       |                                       |       |   |   |
| Repayment of notes payable and capital lease  obligations                    |       | (1,186                                     | )          | (7,414 | ) |
| Repayment of notes payable due to TERI                                       |       | (185                                       | )          | (174 | ) |
| Tax benefit from employee stock options                                      |       | 541                                        |       | — |   |
| Issuances of common stock                                                    |       | 416                                        |       | 1,035 |   |
| Repurchases of common stock                                                  |       | (955                                       | )          | — |   |
| Net cash used in financing activities                                        |       | (1,369                                     | )          | (6,553 | ) |
| Net decrease in cash  and cash equivalents                                   |       | (37,710                                    | )          | (22,633 | ) |
| Cash and cash  equivalents, beginning of period                              |       | 193,796                                    |       | 168,712 |   |
| Cash and cash  equivalents, end of period                                    |       | $                                          | 156,086    |   | $ | 146,079 |   |
|                                                                         |       |                                       |       |   |   |
| Supplemental  disclosures of cash flow information:                          |       |                                       |       |   |   |
| Interest paid                                                                |       | $                                          | 230        |   | $ | 369 |   |
| Income taxes paid                                                            |       | $                                          | 3,153      |   | $ | — |   |
| Supplemental disclosure  of non-cash activities:                             |       |                                       |       |   |   |
| Declaration of cash dividend                                                 |       | $                                          | 7,790      |   | $ | — |   |

 

See accompanyingnotes to unaudited condensed consolidated financial statements.

 

6

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**THEFIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

** **

**NOTESTO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(dollarsin thousands, except share and per share amounts)**

** **

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

** **

***Nature of Business***

*** ***

The First MarbleheadCorporation (FMC, and together with its subsidiaries, the Company), which wasincorporated under the laws of the State of Delaware on August 13, 1994,provides outsourcing services for private education lending in the UnitedStates. The Company helps meet the growing demand for private education loansby providing national and regional financial institutions and educationalinstitutions, as well as businesses and other enterprises, with an integratedsuite of services for designing and implementing student loan programs fortheir respective customers, students, employees and members. The Companyfocuses primarily on private student loan programs for undergraduate, graduateand professional education, and, to a lesser degree, on continuing educationprograms, the primary and secondary school market, career training and studyabroad programs. The Company is entitled to receive structural advisory feesand residuals for its services in connection with securitizations of loansgenerated by the loan programs that it facilitates. The Company also receivesreimbursement from The Education Resources Institute, Inc. (TERI) foroutsourced services the Company performs on TERI’s behalf and receives fees foradministrative services that the Company provides to the discrete trustvehicles that the Company forms for securitizations it facilitates.

 

***Basis of Presentation***

*** ***

The Company’s accompanyingunaudited condensed consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesof America (GAAP) for interim financial information. Accordingly, they do notinclude all of the information and footnotes required by GAAP for completeconsolidated financial statements. In the opinion of management, alladjustments (consisting of normal recurring accruals) considered necessary fora fair statement of the results for the interim periods have been included. Thepreparation of financial statements in conformity with GAAP requires managementto make estimates and assumptions that affect the amounts reported in theconsolidated financial statements and accompanying notes. Interim results arenot necessarily indicative of results to be expected for the entire fiscalyear. All significant intercompany balances and transactions have beeneliminated in consolidation. These unaudited financial statements should beread in conjunction with the audited consolidated financial statements andrelated notes for the year ended June 30, 2005 included in the Company’s AnnualReport on Form 10-K filed with the Securities and Exchange Commission on September 7,2005. Certain prior period amounts have been reclassified to conform to currentperiod presentation in the condensed consolidated statement of cash flows.

 

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

*** ***

Origination of studentloans is generally subject to seasonal trends, with the volume of loanapplications increasing with the approach of tuition payment dates. In general,the Company processes the greatest application volume during the summer months,as students and their families seek to borrow money in order to pay tuitioncosts for the fall semester or the entire school year. The Company also tendsto process an increased volume of loan applications during November andDecember, as students and their families seek to borrow money to pay tuitioncosts for the spring semester. This seasonality of loan originations impactsthe amount of processing fees from TERI that the Company earns in a particularquarter. 

 

The Company did notconduct a securitization transaction during the first quarter of either fiscal2006 or fiscal 2005. Therefore, during the first quarters of fiscal 2006 andfiscal 2005, the Company did not generate any structural advisory fees orresiduals from new securitization transactions. The Company expects to closesecuritization transactions in the second, third and fourth quarters of fiscal2006.

 

7

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**THEFIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

** **

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS (continued)**

**(dollarsin thousands, except share and per share amounts)**

 

***Concentrations***

*** ***

**TERI**

** **

TERIis a private, not-for-profit Massachusetts organization as described under section 501(c)(3) ofthe Internal Revenue Code. Incorporated in 1985, TERI is the oldest and largestguarantor of alternative, or private, student loans. In its role as guarantorin the private education lending market, TERI agrees to reimburse lenders orthe securitization trusts for unpaid principal and interest on defaulted loans.TERI is the exclusive third-party provider of borrower default guarantees forthe Company’s clients’ private student loans. As of September 30, 2005,TERI has a Baa3 counterparty rating from Moody’s Investors Service, which isthe lowest investment grade rating, and an insurer financial strength rating ofA+ from Fitch Ratings. If these ratings are lowered, FMC’s clients may not wishto enter into guarantee arrangements with TERI. In addition, FMC may receivelower structural advisory fees because the costs of obtaining financialguarantee insurance for the asset-backed securitizations that FMC structurescould increase.

 

OnFebruary 2, 2001, FMC and TERI entered into a two-year Master LoanGuaranty Agreement which granted TERI a right of first refusal to guaranteeexisting and future FMC private label loan programs, as well as new, jointlycreated loan programs during the term of the Agreement. In June 2001, as aresult of the closing of the Company’s acquisition of TERI’s loan processingoperations, the Master Loan Guaranty Agreement was automatically extended for afive-year term from the date of the acquisition closing. The loans guaranteedpursuant to the Master Loan Guaranty Agreement comprise only a portion of TERI’sguarantee business, and the Master Loan Guaranty Agreement does not precludeTERI from continuing to provide its guarantees to loan originators notassociated with FMC. Under the terms of the Master Loan Guaranty Agreement, FMCalso agreed to provide a beneficial interest for TERI of 25% of the residualvalue of TERI-guaranteed loans owned by the securitization trusts that purchasethe loans, and a right of first refusal to guarantee FMC’s private labelclients’ existing and future loan programs. 

 

In October 2004, FMCrenewed its Master Loan Guaranty Agreement and certain additional agreementswith TERI, in each case for an additional term through June 2011. Underthe terms of the original Master Loan Guaranty Agreement, TERI is required toplace into a segregated reserve the majority of the guarantee fees it receivesfor loans that are originated. The segregated reserve amounts are then pledgedto each trust that purchases loans at the time of securitization. TERI isallowed to retain as an administrative fee a portion of the guarantee fee equalto 150 basis points multiplied by the principal balance of loans originated andsecuritized.  In October 2004, FMCentered into a fourth supplement to the Master Loan Guaranty Agreement, underwhich FMC granted to TERI a right to elect once each fiscal year to increasethe amount of its administration fees by 25 basis points, with acorresponding reduction from 25% to 20% in TERI’s ownership of the residual valueof the TERI-guaranteed loans purchased during that year by the securitizationtrusts and a resulting increase from 75% to 80% in FMC’s residual ownership.TERI made such an election for fiscal 2005. In October 2005, FMC entered into a fifth supplement to the MasterLoan Guaranty Agreement. Under the terms of this fifth supplement, TERI’s administrativefee will increase, and the amount deposited in the segregated reserve willdecrease, by 65 basis points. In addition, TERI’s residual interest in the trustscreated at the time of securitization will be reduced by the present value ofthis 65 basis point reduction in the amount placed in the segregated reserve,using a residual discount factor of 12%.  Under the fifth supplement, TERI continues tohave a right to elect once each fiscal year to increase the amount ofits administrative fees, and reduce the amount placed in the segregatedreserve, by 25 basis points. If TERI makes such an election, however, TERI’sownership of the residual value of the TERI-guaranteed loans purchased duringthat year by the securitization trusts will be reduced by the presentvalue of the 25 basis point reduction in the amount placed in the segregatedreserve, using a discount factor of 12%. For the fiscal year ending June 30,2006, TERI has made such an election.

** **

Undera Master Servicing Agreement with a term through June 2011, FirstMarblehead Educational Resources, Inc. (FMER), a wholly owned subsidiaryof FMC, provides to TERI underwriting, documentation and other originationservices, as well as technical support, disbursements, customer service,collections, accounting services and guarantee claims management andadministrative services, in support of TERI’s loan guarantee function. FMCguarantees the full and timely performance by FMER of its obligations pursuantto this Master Servicing Agreement. FMC also benefits from use of the acquiredTERI assets, including historical loan data, to support the design andimplementation of future FMC loan programs and new jointly created loanprograms. In addition, TERI has the right to designate one of threerepresentatives to serve on the board of directors of FMER.

 

**PHEAA**

** **

Asof September 30, 2005, there were nine TERI-approved loan servicers.Servicers provide administrative services relating to loans, includingprocessing deferment and forbearance requests, sending out account statementsand accrual notices, responding to borrower inquiries, and collecting andcrediting payments received from borrowers. The Company currently utilizes fiveof these

 

8

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**THEFIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

** **

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS (continued)**

**(dollarsin thousands, except share and per share amounts)**

 

servicers. As of September 30,2005, Pennsylvania Higher Education Assistance Agency (PHEAA) services amajority of the loans for which the Company facilitates origination. Thisarrangement allows the Company to increase the volume of loans in the Company’sclients’ loan programs without incurring the overhead investment of servicingoperations. As with any external service provider, there are risks associatedwith inadequate or untimely services. In addition, if the Company’srelationship with PHEAA terminates, the Company would either need to expand ordevelop a relationship with another TERI-approved loan servicer, which could betime-consuming and costly.

 

**Significant Customers**

** **

Duringthe first quarter of fiscal 2006 and fiscal 2005, processing fees from TERIrepresented approximately 74% and 77%, respectively, of total service revenue.The Company did not recognize more than 10% of total service revenue from anyother customer. 

 

***Significant Accounting Policies and Estimates***

* *

The preparation of the Company’sconsolidated financial statements requires the Company 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. The Company bases its estimates and judgments on historicalexperience and on various other factors, and actual results may differ fromthese estimates under varying assumptions or conditions. On an ongoing basis,the Company evaluates its estimates and judgments, particularly as they relateto accounting policies that the Company believes are most important to theportrayal of the Company’s financial condition and results of operations, suchas its accounting policies involving the recognition and valuation of the Company’ssecuritization-related service revenue, and with respect to the determinationof whether or not to consolidate the securitization trusts that itfacilitates.  See “Management’sDiscussion and Analysis of Financial Condition and Results of Operations—Applicationof Critical Accounting Policies and Estimates”.

 

***Cashand cash equivalents***

*** ***

Cash and cash equivalentsat September 30, 2005 include $136,552 held in a money market fund thatinvests in short-term obligations of the U.S. Treasury and repurchaseagreements fully collateralized by obligations of the U.S. Treasury. Includedin cash and other short-term investments are compensating balances supportingvarious financing arrangements of $13,695 and $23,309 at September 30,2005 and June 30, 2005, respectively.

 

***Incometaxes***

*** ***

In determining aquarterly provision for income taxes, the Company uses an estimated annualeffective tax rate which is based on its expected annual income, statutory taxrates and tax planning opportunities available to it in the variousjurisdictions in which it operates. The Company’s estimated annual effectivetax rate also includes its best estimate of the ultimate outcome of tax audits.The Company has a net deferred income tax liability because, under GAAP, itrecognizes residuals in financial statement income earlier than they arerecognized for income tax purposes.

 

**(2)****           Stock Options**

** **

At September 30,2005, the Company had four stock-based compensation plans, which are describedmore fully in Note 9 and Note 13 of the Company’s audited consolidatedfinancial statements and related notes for the year ended June 30, 2005which are included in the Company’s Annual Report on Form 10-K filed withthe Securities and Exchange Commission on September 7, 2005. Prior to July 1,2005, the Company accounted for those plans under the recognition andmeasurement provisions of APB Opinion No. 25, *Accountingfor Stock Issued to Employees*(Opinion 25), and relatedInterpretations, as permitted by FASB Statement No. 123, *Accounting for Stock-Based Compensation*(Statement 123). Nostock-based compensation cost was recognized in the Statement of Operations forthe years ended on or prior to June 30, 2005, as options granted underthose plans had an exercise price equal to or greater than the market value ofthe underlying common stock on the date of grant. Effective July 1, 2005,the Company adopted the fair value recognition provisions of FASB Statement No. 123(R),*Share-Based Payment*(Statement 123(R)),using the modified-prospective transition method. Under this transition method,compensation cost recognized in the first quarter of fiscal 2006 includes: (a) compensationcost for all share-based payments granted prior to, but not yet vested, as of July 1,2005, based on the grant date fair value estimated in accordance with theoriginal provisions of Statement 123, and (b) compensation cost for allshare-based payments granted on or subsequent to July 1, 2005, based onthe grant-date fair value estimated in accordance with the provisions of Statement123(R). Results

 

9

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**THEFIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

** **

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS (continued)**

**(dollarsin thousands, except share and per share amounts)**

 

for prior periods havenot been restated.

 

As a result of adoptingStatement 123(R) on July 1, 2005, the Company’s loss before income taxes forthe first quarter of fiscal 2006 is approximately $332 lower and net loss forthe first quarter of fiscal 2006 is approximately $194 lower than if it hadcontinued to account for share-based compensation under Opinion 25. The Company’sbasic and diluted earnings per share for the first quarter of fiscal 2006 wouldhave remained $.08 if it had continued to account for share-based compensationunder Opinion 25. 

 

As required, prior to theadoption of Statement 123(R), the Company presented all tax benefits ofdeductions resulting from the exercise of stock options as operating cash flowsin the Statement of Cash Flows. Statement 123(R) requires the cash flowsresulting from the tax benefits from tax deductions in excess of thecompensation cost recognized for those options (excess tax benefits) to beclassified as financing cash flows. The $541 excess tax benefits classified asa financing cash inflow during the first quarter of fiscal 2006 would have beenclassified as an operating cash inflow if the Company had not adopted Statement123(R).

 

For purposes of pro formadisclosures for periods prior to July 1, 2005, the estimated fair value ofthe stock options is amortized to expense over the vesting period of theoptions. The Company’s consolidated pro forma net loss and net loss per sharefor the three month period ended September 30, 2004, had the Companyelected to recognize compensation expense for the granting of options underSFAS No. 123 using the Black-Scholes option pricing model, is as follows: 

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

 

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

# ** **

As of September 30, 2005, there were options topurchase 1,732,815 shares of the Company’s common stock (Common Stock)outstanding and 327,914 restricted stock units outstanding.  Eachrestricted stock unit represents the right to receive one share of Common Stockupon vesting. As of September 30, 2004, there were options to purchase 3,179,450shares of Common Stock outstanding.  TheCompany has not included these options and restricted stock units in thecomputation of diluted net loss per share for the three months ended September 30,2005 or 2004, as their effects would have been antidilutive.

 

**(4)****           Service Receivables**

** **

Structural advisory feesand residuals receivables represent the present value of additional structuraladvisory fees and residuals expected to be collected over the life of the studentloans, net of prepayment, default and recovery estimates. The fees are paid tothe Company from the various separate securitization trusts that have purchasedstudent loans facilitated by the Company. Processing fees receivable from TERIrepresents amounts due from TERI for expenses incurred by FMER on TERI’sbehalf. 

 

The Company did notconduct any securitization transactions in the first quarter of either fiscal2006 or fiscal 2005. The Company does, on a quarterly basis, update itsestimate of the present value of its structural advisory fees and residualsreceivables to reflect the passage of time, any change in discount rates usedto estimate their present value, and any changes to the trust performance

 

10

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**THEFIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

** **

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS (continued)**

**(dollarsin thousands, except share and per share amounts)**

 

metrics that the Companyconsiders in its present value estimates, such as default, recovery, prepaymentand forward London Interbank Offered Rate, or LIBOR, rates. 

 

For the NCT trusts andthe private label loan trusts, the Company made no changes in its assumptionsregarding default, recovery or prepayment rates in the first quarter of eitherfiscal 2006 or 2005.   

 

The Company uses animplied forward LIBOR curve to estimate trust cash flows. During the firstquarter of fiscal 2006, rates along the implied forward LIBOR curve generallyincreased and flattened. The increase resulted in an increase in the interestto be capitalized on the underlying student loan assets during their respectivedeferment periods, which increases the balance on which the Company expects tocharge its 15 to 30 basis points per year of additional structural advisoryfees over the life of the trust, and therefore increases the estimated present valueof the structural advisory fees receivable. The flattening of the forward LIBORcurve improved the net excess spread between the trust assets and liabilities,resulting in an increase in the estimated present value of the residualsreceivable during the period.  During thefirst quarter of fiscal 2005, the rates along the implied forward LIBOR curve generallydecreased and flattened. This decrease resulted in a decrease in the interestto be capitalized on the underlying student loan assets during their respectivedeferment periods, which decreases the balance on which the Company expects tocharge its 15 to 30 basis points per year of additional structural advisoryfees over the life of the trust, and therefore decreases the estimated present valueof the structural advisory fees receivable. However, the flattening of therates along the implied forward LIBOR curve improved the net excess spreadbetween the trust assets and liabilities, resulting in an increase in the estimatedpresent value of the residuals receivable during the period that more thanoffset the effect of the decrease in LIBOR rates during the period.

 

The Company bases thediscount rate that it uses to calculate the present value of its additionalstructural advisory fees on the 10-year U.S. Treasury rate plus 200 basispoints. From July 1, 2005 to September 30, 2005, this rate increased37 basis points from 5.96% to 6.33%. From July 1, 2004 to September 30,2004, this rate decreased by 46 basis points from 6.58% to 6.12%. A decrease inthe 10-year U.S. Treasury rate has the effect of increasing the estimatedpresent value of the Company’s structural advisory fees receivable, while anincrease in the rate has the opposite effect on the Company’s estimate of theirpresent value. In determining an appropriate discount rate for valuingresiduals, we review the rates used by student loan securitizers, as well asrates used in the much broader commercial mortgage-backed securities (CMBS)market. We believe that the 12% discount rate we use is appropriate given themaximum 24-year life of the trust assets and residuals. 

 

The following tablesummarizes the changes in the structural advisory fees receivable for the firstquarter of fiscal 2006 and fiscal 2005: 

 
| ** **                                                                | ** ** | **Three months ended  September 30,** | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
|                                                                      |       |                                       |       |   |   |
| Fair value of additional structural advisory fees at  beginning of period |       | $                                          | 53,371     |   | $ | 24,084 |   |
| Fair value adjustments                                                    |       | 199                                        |       | 619 |   |
| Total structural advisory fees receivable at end of  period               |       | $                                          | 53,570     |   | $ | 24,703 |   |

 

The following tablesummarizes the changes in the residuals receivable for the first quarter offiscal 2006 and fiscal 2005: 

 
| ** **                        | ** ** | **Three months ended  September 30,** | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|
| ** **                        | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
|                              |       |                                       |       |   |   |
| Fair value at beginning of period |       | $                                          | 247,275    |   | $ | 108,495 |   |
| Fair value adjustments            |       | 7,482                                      |       | 3,460 |   |
| Fair value at end of period       |       | $                                          | 254,757    |   | $ | 111,955 |   |

 

11

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**THEFIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

** **

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS (continued)**

**(dollarsin thousands, except share and per share amounts)**

 

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

 

**(5)****           Related Party Transactions**

** **

AtSeptember 30, 2005, the Company had invested approximately $136,552 ofcash and cash equivalents in a money market fund. The investment advisor forthis fund is Milestone Capital Management, LLC (MCM), an institutional moneymanagement firm. Members of the immediate family of one of the Company’sdirectors indirectly own approximately 65% of MCM’s outstanding equity.

 

**(6)****           Notes Payable to TERI**

 

Inconnection with the acquisition of TERI’s loan processing operations, theCompany entered into a Note Payable Agreement with TERI on June 20, 2001,amounting to $3,900, $2,000 of which relates to the acquisition of TERI’ssoftware and network assets and $1,900 of which relates to theworkforce-in-place. Principal and interest at an annual rate of 6% are payablein 120 monthly installments of $43 commencing on July 20, 2001 andending on June 20, 2011. The note payable is secured by the software andnetwork assets. The outstanding balance of this note payable at September 30,2005 was $2,521.

 

TheCompany also entered into a second note payable with TERI amounting to $4,000 onJune 20, 2001 to fund the acquisition of TERI’s loan database. Principaland interest at an annual rate of 6% are payable in 120 monthlyinstallments of $44 commencing on July 20, 2001 and ending on June 20,2011. The note payable is secured by the loan database. The outstanding balanceof this note payable at September 30, 2005 was $2,586.

 

**(7)****           Other Borrowings**

** **

***(a)   Revolving Line ofCredit***

** **

On August 28, 2003,the Company entered into an agreement with Fleet National Bank to establish arevolving line of credit in the amount of $10,000, which included a sub-limitfor letters of credit. Fleet National Bank was acquired by Bank of America, andthe Company’s agreement related to this facility was assigned to Bank ofAmerica. The revolving credit facility, which matured on August 28, 2005,contained certain financial covenants and restrictions, including a restrictionon the Company’s ability to pay cash dividends in the event it was in default.No amounts were outstanding under this revolving line of credit at June 30,2005. 

 

***(b) EquipmentLine of Credit***

*** ***

InJanuary 2005, the Company entered into an equipment financing leaseagreement which it will use to finance purchases of furniture and equipment.The agreement allows the Company to finance up to $20,000 worth of furnitureand equipment purchased before December 30, 2005. The Company expects torepay amounts drawn down on the lease at terms ranging from three to fiveyears. As of September 30, 2005, we had drawn $10,513 under this line ofcredit.

 

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

** **

***2002Director Stock Plan***

 

In September 2002,the Board of Directors approved, and in August 2003, the Company’s stockholdersapproved, the 2002 Director Stock Plan and reserved 200,000 shares of Common Stockfor issuance to the Company’s non-employee directors.  As of September 30, 2005, options topurchase 88,000 shares of Common Stock have been issued under this plan.

 

***2003 Stock Incentive Plan***

*** ***

In September 2003,the Board of Directors and stockholders approved the 2003 Stock Incentive Planand reserved 1,200,000 shares of Common Stock for issuance under this plan.  On August 9, 2005, the Board ofDirectors authorized, subject to stockholder approval, an amendment increasingthe number of shares of Common Stock reserved for issuance under the 2003 StockIncentive Plan from 1,200,000 to 2,700,000. On October 27, 2005, theCompany’s stockholders approved this amendment. As of September 30, 2005,

 

12

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**THEFIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

** **

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS (continued)**

**(dollarsin thousands, except share and per share amounts)**

 

there were options topurchase 800,000 shares of Common Stock outstanding and 327,914 restrictedstock units outstanding under this plan.

 

***2003 Employee Stock Purchase Plan***

*** ***

InOctober 2003, the Board of Directors and stockholders approved the 2003Employee Stock Purchase Plan (Stock Purchase Plan). A total of 400,000 sharesof Common Stock are authorized for issuance under this plan. The Stock PurchasePlan permits eligible employees to purchase shares of Common Stock at the lowerof 85% of the fair market value of the Common Stock at the beginning or at theend of each offering period. Employees who own 5% or more of the Company’s CommonStock are not eligible to participate in the Stock Purchase Plan. Participationis voluntary. Under the Stock Purchase Plan, 11,420 and 40,499 shares of CommonStock were issued in July 2005 and July 2004, respectively.

 

***ShareRepurchase Program***

 

In the fourth quarter offiscal 2005, the Board of Directors approved the repurchase of 1,500,000 sharesof Common Stock from time to time on the open market or in privately negotiatedtransactions. On September 29, 2005, the Board of Directors approved therepurchase of an additional 5,000,000 shares of Common Stock. As of September 30,2005, the Company had repurchased in aggregate 1,500,000 shares of its CommonStock.

 

***CashDividend***

 

On September 15,2005, the Board of Directors declared a cash dividend of $0.12 per share on theCommon Stock. The dividend was paid on October 5, 2005 to stockholders ofrecord at the close of business on September 26, 2005.

 

***(9) Pension Plan***

*** ***

FMER has anon-contributory defined benefit pension plan that covers substantially allFMER employees employed on or before December 31, 2004.  During the second quarter of fiscal 2005, thebenefits under the plan were frozen. The following table sets forth the amountsrecognized related to FMER’s defined benefit pension plan in the Company’sconsolidated financial statements for the three-month periods ended September 30,2005 and 2004:

 

| ** **                                    | ** ** | **Three months ended  September 30,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| **Components  of net periodic pension cost:** |       |                                       |       |   |   |
| Service cost                                  |       | $                                          | —     |   | $ | 157 |   |
| Interest on  projected benefit obligations    |       | 44                                         |       | 62 |   |
| Loss recognized                               |       | 5                                          |       | 9 |   |
| Expected return  on plan assets               |       | (47                                        | )          | (42 | ) |
| Net periodic  pension cost                    |       | $                                          | 2          |   | $ | 186 |   |

 

***EmployerContributions***

*** ***

Duringthe three months ended September 30, 2005, the Company made contributionsof $50 to FMER’s defined benefit pension plan. The Company expects to makeadditional contributions of approximately $200 during the remaining threequarters of fiscal year 2006. 

 

13

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**THEFIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES**

** **

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS (continued)**

**(dollarsin thousands, except share and per share amounts)**

 

**(10)****         New Accounting Pronouncements**

** **

The FASB has issuedexposure drafts that would amend FASB Statement No. 140, “Accounting forthe Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities.”  The proposed amendmentswould, among other things, change the requirements that an entity must meet tobe considered a qualified special-purpose entity (QSPE).  The FASB has announced that it expects toissue final guidance in the first calendar quarter of 2006.  The Company is monitoring the status of theexposure drafts to assess their impact, if any, on its financial statements. 

 

14

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**Item 2.Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

** **

*Youshould read the following discussion and analysis of our financial conditionand results of operations together with our unaudited condensed consolidated financialstatements and accompanying notes included elsewhere in this filing. Inaddition to the historical 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 application of our critical accounting policies and thefactors including, but not limited to, those set forth under “Factors That May AffectFuture Results” below.*

 

**ExecutiveSummary**

** **

***Overview***

*** ***

Weprovide outsourcing services for private education lending in the United States.We provide services in connection with each of the five typical phases of thestudent loan lifecycle, offering our clients a single point of interface for:

 

**•**       programdesign and marketing;

 

**•**       borrowerinquiry and application;

 

**•**       loanorigination and disbursement;

 

**•**       loansecuritization; and

 

**•**       loanservicing.

 

Wereceive fees for the services we provide in connection with both processing ourclients’ 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.

 

Wedo not take a direct ownership interest in the loans our clients generate, nordo we serve as a lender or guarantor with respect to any loan programs that wefacilitate. We assist the lenders in our loan programs in selecting theunderwriting criteria used in deciding whether a student loan will be made toan applicant. However, each lender has ultimate control over the selection ofthese criteria, and in providing our services, we are obligated by contract toobserve them. Lenders that wish to have their loans guaranteed by The EducationResources Institute, or TERI, are required to meet TERI’s underwritingcriteria. Although we oversee loan servicing as a component of ouradministrative duties, we do not act as a loan servicer.

 

Wecurrently focus on facilitating private student loans for undergraduate,graduate and professional education, although we also provide service offeringsfor continuing education programs, primary and secondary schools, careertraining and study abroad programs. During the first quarter of fiscal 2006, we processed over 370,000 loanapplications and facilitated approximately $1.3 billion in loans at approximately4,700 schools.  During all of fiscal2005, we processed over 876,000 loan applications and facilitated approximately$2.7 billion in loans at over 5,300 schools. We have provided structural,advisory and other services for 28 securitization transactions since ourformation in 1991.

 

Weoffer services in connection with two primary loan products:

 

**•**       *Private label* programs that:

 

**•**        are marketeddirectly to prospective student borrowers and their families (direct toconsumer) by:

 

**•**       lenders;

 

**•**       thirdparties who are not themselves lenders; loans under these programs are made byreferral lenders; and

 

**•**       businesses,unions, affinity groups and other organizations.

 

**•**        are marketeddirectly to educational institutions (school channel) by:

 

**•**       lenders; and

 

**•**       thirdparties who are not themselves lenders; loans under these programs are made byreferral lenders.

 

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

 

15

----

 

Duringfiscal 2005, we securitized both private label loans and GATE loans. Ourprivate label programs, including processing fees from TERI, contributed $405.1million or 97% of our total service revenue in fiscal 2005, while our GATEprograms contributed $12.8 million or 3% of our total service revenue in fiscal2005. 

 

In June 2001, wesignificantly enhanced our risk management and loan processing capabilitiesthrough a strategic relationship with TERI, the nation’s oldest and largestguarantor of private student loans. We acquired TERI’s loan processingoperations, including its historical database, but not its investment assets orguarantee liabilities. In connection with this acquisition, 161 members of TERI’sstaff became our employees. In addition, we entered into a master servicingagreement pursuant to which TERI engages us to provide loan origination andprocessing services with respect to the loans generated through the privatelabel programs we facilitate, as well as other TERI-guaranteed loans. TERIreimburses us for the expenses we incur in providing these services. Under theterms of a master loan guaranty agreement that we entered into with TERI in2001, we also agreed to provide a beneficial interest for TERI of 25% of theresidual value of TERI-guaranteed loans owned by the securitization trusts thatpurchase the loans, and a right of first refusal to guarantee our private labelclients’ existing and future loan programs. 

 

In October 2004, werenewed our master loan guaranty agreement and certain additional agreementswith TERI, in each case for an additional term through June 2011. Underthe terms of the original master loan guaranty agreement, TERI is required toplace into a segregated reserve the majority of the guarantee fees it receivesfor loans that are originated. The segregated reserve amounts are then pledgedto each trust that purchases loans at the time of securitization. TERI isallowed to retain as an administrative fee a portion of the guarantee fee equalto 150 basis points multiplied by the principal balance of loans originated andsecuritized. In October 2004, we entered into a fourth supplement to themaster loan guaranty agreement, under which we granted to TERI a right to electonce each fiscal year to increase the amount of its administration fees by 25basis points, with a corresponding reduction from 25% to 20% in TERI’sownership of the residual value of the TERI-guaranteed loans purchased duringthat year by the securitization trusts and a resulting increase from 75% to 80%in our residual ownership. TERI made such an election for the fiscal year endedJune 30, 2005.  In October 2005,we entered into a fifth supplement to the master loan guaranty agreement.  Under the terms of this fifth supplement,TERI’s administrative fee, and the amount deposited in the segregated reserve,will decrease by 65 basis points. In addition, TERI’s residual interest in thetrusts created at the time of securitization will be reduced by the presentvalue of this 65 basis point reduction in the amount placed in the segregatedreserve, using a residual discount factor of 12%.  Under the fifth supplement, TERI continues tohave a right to elect once each fiscal year to increase the amount ofits administrative fees, and reduce the amount placed in the segregatedreserve, by 25 basis points. If TERI makes such an election, however, TERI’sownership of the residual value of the TERI-guaranteed loans purchased during thatyear by the securitization trusts will be reduced by the present value ofthe 25 basis point reduction in the amount placed in the segregated reserve,using a discount factor of 12%. For the fiscal year ending June 30, 2006,TERI has made such an election.

** **

Theprimary driver of our results of operations and financial condition is thevolume of loans for which we provide outsourcing services from loan originationthrough securitization. The following table shows the volume of loansfacilitated during the first quarters of fiscal 2006 and fiscal 2005:

 
| ** **                                                                                          | ** ** | **Quarter ended September 30,** | ** **   |
|-----------------------------------------------------------------------------------------------------|------------|------------------------------------------------|--------------|
| ** **                                                                                          | ** ** | **2005**                                       | ** **   | **2004** | ** ** |
| Approximate  number of loans facilitated that were also available to us for securitization          |       | 107,000                                        |         | 88,000 |   |
| Approximate  number of loans facilitated                                                            |       | 126,000                                        |         | 108,000 |   |
| Aggregate  principal amount of loans facilitated that were also available to us for  securitization |       | $                                              | 1.10 billion |   | $ | 868 million |   |
| Aggregate  principal amount of loans facilitated                                                    |       | $                                              | 1.25 billion |   | $ | 1.03 billion |   |

 

Thedollar volume of loans that we facilitated that were available to us forsecuritization increased 27% in the first quarter of fiscal 2006 as compared tothe first quarter of fiscal 2005. The total dollar volume of loans that wefacilitated in the first quarter of fiscal 2006 increased 21% as compared to thefirst quarter of fiscal 2005. 

 

Althoughwe offer our clients a fully integrated suite of outsourcing services, we donot charge separate fees for many of these services. Moreover, although wereceive fees for providing loan processing services to TERI in connection withTERI-guaranteed loans, these fees represent reimbursement of the directexpenses we incur. Accordingly, we do not earn a profit on these fees. Althoughwe provide these various services without charging a separate fee, or at “cost”in the case of TERI-guaranteed loans, we generally enter into agreements withthe private label lenders, and Bank of America in the case of GATE programs,giving us the exclusive right to securitize the loans that they do not intendto hold, and we receive structural advisory fees and residuals for facilitatingsecuritizations of these loans. Our level of profitability depends on thesestructural advisory fees and residuals. We discuss the manner in which werecognize them as revenue in greater detail below. We may in the future enterinto arrangements with private label lenders under which we provide outsourcingservices, but do not have the exclusive right to securitize the loans that theyoriginate.

 

16

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Changesin any of the following factors can materially affect our financial results:

 

•       the demandfor private education financing;

 

•       thecompetition for providing private education financing;

 

•       theeducation financing preferences of students and their families;

 

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

 

•       the 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;

 

•       borrowerdefault rates and our ability to recover principal and interest from suchborrowers; and

 

•       prepaymentrates on private student loans, including prepayments through loanconsolidation.

 

***Securitizations and Related Revenue***

*** ***

Westructure and facilitate securitization transactions for our clients through aseries of bankruptcy remote, qualified special purpose statutory trusts. Thetrusts purchase private student loans from the originating lenders, whichrelinquish to the trust their ownership interest in the loans. The debtinstruments that the trusts issue to finance the purchase of these studentloans are obligations of the trusts, rather than our obligations or those oforiginating lenders. As of September 30, 2005, we have utilized sixspecial purpose entities for the securitization of TERI-guaranteed privatelabel loans. We refer to these trusts as private label loan trusts. Inaddition, National**Collegiate Trust, or NCT, was formed in fiscal 1993 andhas established separate securitization trusts, which we refer to as the NCT trusts,which have purchased primarily GATE loans and a limited number ofTERI-guaranteed and other loans. In the future, we may securitize private labelor GATE loans using new trust vehicles.

 

Underthe terms of some of our contracts with key lender clients, we have an obligationto securitize periodically, typically twice per year, the private student loansthat these clients originate, and we may agree with other lenders to securitizemore frequently in the future. If we do not honor our obligations to theselenders, we may be required to pay liquidated damages, generally not exceedingan amount equal to 1% of the face amount of the loans available forsecuritization.

 

Wereceive several types of fees in connection with our securitization services:

 

•       *Structural advisory fees*. We charge structural advisoryfees that are paid in two portions:

 

•        *Up-front*. We receive a portion of thestructural advisory fees at the time the securitization trust purchases theloans, or soon thereafter. In exchange for these fees, we structure the securitiessold in the securitization, coordinate the attorneys, accountants, trustees,loan servicers, loan originators and other transaction participants and preparethe cash flow modeling for rating agencies and financial guarantee insurers, asneeded. In securitizations we facilitated in fiscal 2005, these fees rangedfrom 1.6% to 8.5% of the principal and capitalized interest of the loanssecuritized; and

 

•        *Additional*. We receive a portion of thestructural advisory fees over time, based on the amount of loans outstanding inthe trust from time to time over the life of the trust. This portionaccumulates monthly from the date of a securitization transaction at a rate of15 to 30 basis points per year. We begin to receive this additionalportion, plus interest, once the ratio of trust assets to trust liabilities,which we refer to as the “parity ratio,” reaches a stipulated level, whichranges from 103.0% to 105.0%. The level applicable to a particular trust isdetermined at the time of securitization. We currently expect to receive theadditional fees beginning five to seven years after the date of a particularsecuritization transaction*.*

 

•       *Residual.* We also have the right to receivea portion of the residual interests that these trusts create. This interest isjunior in priority to the rights of the holders of the debt sold in thesecuritizations and entitles us to receive:

 

•        inconnection with the securitizations of exclusively private label loans, 75% to80% of the residual cash flows once a parity ratio of 103.0% to 103.5%,depending on the particular trust, is reached and maintained;

 

•        inconnection with securitizations in the NCT trusts, our share of residual cashflows once all of the debt-holders of the securitization trust have beenrepaid, plus, in the case of GATE loans securitized in fiscal years prior tofiscal 2005, an additional 10% of the residual cash flows. We are entitled toreceive 100% of the residual cash flows for GATE loans securitized subsequentto fiscal 2004.

 

17

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Our residual interestderives almost exclusively from the services we perform in connection with eachsecuritization rather than from a direct cash contribution to thesecuritization trust. In the case of securitizations of exclusively privatelabel loans, we currently expect to receive the residuals beginningapproximately five to six years after the date of a particular securitization.In the case of securitizations in the NCT trusts that occurred prior to fiscal2005, we expect to receive the residuals beginning 12 to 15 years after thedate of each securitization. In the case of securitizations in the NCT truststhat occurred in fiscal 2005, we currently expect to receive residualsbeginning five to six years after the date of securitization.

 

•       *Administrative and other fees*.  Our administrative and other fees representprimarily the administrative fees we receive from the trusts for their dailymanagement and services we provide in obtaining information from the loanservicers and reporting this and other information to the parties related tothe securitization. We receive fees ranging from five to 20 basis pointsper year of the student loan balance in the trust. In addition, in connectionwith some securitizations, we receive other fees from originating lenders whentheir loans are purchased by the securitization trust, although these fees havenot been material and we do not expect them to be material in the future. Wealso record as administrative and other fees the reimbursement we receive forcertain call center costs.

 

***Processing Fees from TERI***

 

Weprovide outsourcing services to TERI, including loan origination, customerservice, default prevention, default processing and administrative servicesunder a master servicing agreement between TERI and us. We recognize as revenuethe monthly reimbursement that TERI provides us for the expenses we incur inproviding these services.

 

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

*** ***

Werecognize up-front structural advisory fees as revenue at the time thesecuritization trust purchases the loans. In order for the securitization trustto purchase the loans, all of the applicable services must be performed, ratingagencies must deliver their ratings letters, transaction counsel must deliverthe required legal opinions and the underwriters must receive the debtsecurities issued by the securitization trust. These events indicate that thesecuritization transaction has been properly structured and loans have beenproperly sold to the securitization trust.

 

Asrequired under accounting principles generally accepted in the United States,or GAAP, we also recognize additional structural advisory fees and residuals asrevenue at that time, as they are deemed to be earned at the time of thesecuritization but before we actually receive payment. These amounts are deemedearned because evidence of an arrangement exists, we have provided theservices, the fee is fixed and determinable based upon a discounted cash flowanalysis, there are no future contingencies or obligations and collection isreasonably assured.

 

UnderGAAP, we are required to estimate the present value of the additional structuraladvisory fees and residuals as if they are 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 the value in earnings that period.

 

Becausethere are no quoted market prices for our additional structural advisory feesand residuals receivables, we use certain key assumptions to estimate theirvalues. See “—Application of Critical Accounting Policies and Estimates—ServiceRevenue.”

 

Werecognize administrative and other fees, as well as processing fees from TERI,as revenue at the time that we perform the underlying services.

 

18

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***Quarterly Fluctuations***

*** ***

Ourquarterly revenue, operating results and profitability have varied and are expectedto continue to vary on a quarterly basis primarily because of the timing of thesecuritizations that we structure. We did not facilitate a securitization inthe first quarter of either fiscal 2006 or fiscal 2005.  In fiscal 2005, we facilitated onesecuritization in the second quarter, one securitization in the third quarterand three securitizations in the fourth quarter. We plan to facilitate one securitizationin each of the second and third quarters of fiscal 2006 and two securitizationsin the fourth quarter of fiscal 2006. The following tables set forth ourquarterly service revenue and net income (loss) for the first quarter of fiscal2006 and for each of the quarters of fiscal 2005:

 
| ** **        | ** ** | **Fiscal 2006**          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------|------------|--------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **        | ** ** | **First Quarter**        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service revenue   |       | $                        | 35,071     |       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss          |       | (5,442                   | )          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **        | ** ** | ** **               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **        | ** ** | **2005 Fiscal Quarters** | ** ** |
| ** **        | ** ** | **First**                | ** ** | **Second** | ** ** | **Third**  | ** ** | **Fourth** | ** ** |
| Service revenue   |       | $                        | 22,404     |       | $          | 155,837    |       | $          | 119,534    |   | $ | 120,201 | ** ** |
| Net income (loss) |       | (5,352                   | )          | 74,530     |       | 47,438     |       | 43,048     | ** ** |
|                   |            |                          |            |            |            |            |            |            |            |  |  |  |  |

 

***Application of Critical Accounting Policies and Estimates***

*** ***

Ourcondensed consolidated financial statements have been prepared in accordancewith GAAP. The preparation of these financial statements requires us to makeestimates, assumptions and judgments that affect the reported amounts of assetsand liabilities 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.

 

Oursignificant accounting policies are more fully described in Note 2 of the notesto the audited consolidated financial statements for the fiscal year ended June 30,2005, which are included in our Annual Report on Form 10-K filed with theSecurities and Exchange Commission on September 7, 2005. On an ongoingbasis, we evaluate our estimates and judgments, particularly as they relate toaccounting policies that we believe are most important to the portrayal of ourfinancial condition and results of operations. We regard an accounting estimateor assumption underlying our financial statements to be a “critical accountingestimate” where:

 

•       the natureof the estimate 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 impactof the estimates and assumptions on our financial condition or operatingperformance is material.

 

Wehave discussed our accounting policies with the audit committee of our board ofdirectors, and we believe that our estimates relating to the recognition andvaluation of our securitization-related revenue, as described below, fit thedefinition of critical accounting estimates. We also consider our policy withrespect to the determination of whether or not to consolidate thesecuritization trusts that we facilitate to be a critical accounting policy.

 

***ServiceRevenue***

*** ***

Fora discussion of our revenue recognition policies, see “—Recognition andValuation of Service Revenue.”

 

Becausethere are no quoted market prices for our additional structural advisory feesand residuals receivables, we use the following key assumptions to estimatetheir 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, including the forward LIBOR andthe spread between LIBOR and auction rates; and

 

•       expecteddefaults, net of recoveries.

 

Webase these estimates on our proprietary historical data, third-party data andour industry experience, adjusting for specific program and borrowercharacteristics such as loan type and borrower creditworthiness. We analyzecreditworthiness in several tiers, and select appropriate loan performanceassumptions based on these tiers. We also monitor trends in loan performanceover time and make adjustments we believe are necessary to value properly ourreceivables balances. We recognize the revenue associated with our processingfees from TERI and our administrative and other fees as we perform theseservices.

 

19

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Thefollowing table shows the approximate weighted average loan performanceassumptions for the remaining life of the securitization trusts at September 30,2005:

 
| ** **                | ** ** | ** **         | ** ** | **Percentage rate** | ** ** | **Percentage discount rate** | ** ** |
|---------------------------|------------|--------------------|------------|--------------------------|------------|----------------------------------------|------------|
| **Trust**                 | ** ** | **Loan type** | ** ** | **Default**              | ** ** | **Recovery**                           | ** ** | **CPR** | ** ** | **Structural  advisory fees** | ** ** | **Residuals** | ** ** |
| Private label loan trusts |       | Private label      |       | 8.78                     | %          | 40                                     | %          | 7 | % | 6.33 | % | 12 | % |
| NCT trusts                |       | Private label      |       | 7.11                     |       | 46                                     |       | 7 |   | 6.33 |   | 12 |   |
| NCT trusts                |       | GATE               |       | 21.00                    |       | 47                                     |       | 4 |   | 6.33 |   | 12 |   |

 

Ourprivate label loan programs, under which approximately 80% of the borrowershave creditworthy co-borrowers, typically a family member, have an extensivecredit underwriting process. GATE programs had a borrower approval rate ofapproximately 89% in fiscal 2005 as a result of the credit support provided bythe participating schools. Accordingly, we believe that borrowers in ourprivate label programs will prepay at a higher rate and default at a lower ratethan borrowers in our GATE programs.

 

AtSeptember 30, 2005, we used a 6.33% discount rate for valuing additionalstructural advisory fees, as compared to a 6.12% discount rate at September 30,2004. Based on the priority payment status of additional structural advisoryfees in the flow of funds out of the securitization trust, we believe thesefees are comparable to 10 year spreads on triple-B rated structured finance andcorporate debt securities. Based on market quotes for such securities, webelieve a spread over comparable maturity U.S. Treasury Notes of 200basis points is an appropriate discount rate in valuing these projectedcash flows.

 

Toour knowledge, there have been no market transactions involving residualsgenerated by a pool of securitized student loans. In determining an appropriatediscount rate for valuing our residuals, we review the rates used by studentloan securitizers as well as rates used in the much broader asset-backedsecurities, or ABS, market. We believe that the 12% discount rate we use isappropriate given the maximum 24-year life of the trust assets and residuals.

 

Twoprivate label loan trusts have issued senior auction rate notes to finance thepurchase of student loans. Interest rates for the auction rate notes aredetermined from time to time at auction. At September 30, 2005, we used a10 basis point spread over LIBOR to project the future cost of funding of thesenior auction rate notes in the trusts. Since inception of the first trust,the average spread over LIBOR for the senior auction rate notes of that trusthas been 7.9 basis points. Since the inception of the second trust, theaverage spread over LIBOR for the senior auction rate notes of that trust hasbeen 9.3 basis points.

 

Otherthan the change in the discount rate to be applied to additional structuraladvisory fees, we did not change any loan performance assumptions regardingdefault rates, recovery rates, CPR rates or discount rates in valuing theseprojected cash flows during the first quarter of fiscal 2006 or fiscal 2005.

 

*Sensitivityanalysis*

* *

Increasesin our estimates of defaults, prepayments and discount rates, increases in thespread between LIBOR and auction rates, as well as decreases in defaultrecovery rates and the multi-year forward estimates of LIBOR would have anegative effect on the value of our additional structural advisory fees andresiduals. Student loan prepayments include either full or partial payments bya borrower in advance of the maturity schedule specified in the note,including payments as a result of loan consolidation activity. Becauseessentially all credit defaults are reimbursable by third parties, increases indefaults generally have the same effect as increases in prepayments. Ifdefaults increase beyond the level of expected third party reimbursement, thenthese changes will have an additional negative effect on the value of ouradditional structural advisory fees and residuals. For purposes of thissensitivity analysis, we have assumed no amounts in excess of the pledge fundestablished at the time of each securitization of private label loans areavailable to reimburse the trust for defaults. Also, in the case ofsecuritizations of GATE loans in which we have invested a portion of ourup-front structural advisory fees, increases in estimates of defaults wouldreduce the value of our residual interests because amounts that we wouldotherwise receive as residual interests would be applied to the defaults. LIBORis the reference rate for the loan assets and, we believe, a reasonable indexfor borrowings of the trusts. Because the trusts’ student loan assets earninterest based on LIBOR and some trusts have outstanding securities that payinterest based on the results of auction rates, changes in the spread betweenLIBOR and the auction rate can affect the performance of the trust.

 

The following tables showthe estimated change in our structural advisory fees and residuals receivablesbalance at September 30, 2005 based on changes in these loan performanceassumptions:

 

20

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| ** **                             | ** ** | **Percentage change in  assumptions** | ** ** | **Receivables** | ** ** | **Percentage change in  assumptions** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|-----------------|------------|---------------------------------------|------------|
| **Structural advisory fees**           | ** ** | **Down 20%**                          | ** ** | **Down 10%**    | ** ** | **balance**                           | ** ** | **Up 10%** | ** ** | **Up 20%** | ** ** |
| ** **                             | ** ** | **(dollars in thousands)**            | ** ** |
| Default rate:                          |       |                                  |       |            |       |                                  |       |   |   |   |   |
| Private label loan trusts              |       | $                                     | 47,521     |            | $          | 47,357                                |       | $ | 47,192 |   | $ | 47,028 |   | $ | 46,864 |   |
| GATE loan trusts(1)                    |       | 6,587                                 |       | 6,482           |       | 6,378                                 |       | 6,274 |   | 6,169 |   |
| Total                                  |       | $                                     | 54,108     |            | $          | 53,839                                |       | $ | 53,570 |   | $ | 53,302 |   | $ | 53,033 |   |
| Change in receivables balance:         |       | 1.00                                  | %          | 0.50            | %          |                                  |       | (0.50 | )% | (1.00 | )% |
| Default recovery rate:                 |       |                                  |       |            |       |                                  |       |   |   |   |   |
| Private label loan trusts              |       | $                                     | 47,192     |            | $          | 47,192                                |       | $ | 47,192 |   | $ | 47,192 |   | $ | 47,192 |   |
| GATE loan trusts(1)                    |       | 6,213                                 |       | 6,213           |       | 6,378                                 |       | 6,378 |   | 6,198 |   |
| Total                                  |       | $                                     | 53,405     |            | $          | 53,405                                |       | $ | 53,570 |   | $ | 53,570 |   | $ | 53,390 |   |
| Change in receivables balance:         |       | (0.31                                 | )%         | (0.31           | )%         |                                  |       | 0.00 | % | (0.34 | )% |
| Annual constant prepayment rate (CPR): |       |                                  |       |            |       |                                  |       |   |   |   |   |
| Private label loan trusts              |       | $                                     | 49,792     |            | $          | 48,457                                |       | $ | 47,192 |   | $ | 45,994 |   | $ | 44,859 |   |
| GATE loan trusts(1)                    |       | 6,644                                 |       | 6,510           |       | 6,378                                 |       | 6,249 |   | 6,125 |   |
| Total                                  |       | $                                     | 56,436     |            | $          | 54,967                                |       | $ | 53,570 |   | $ | 52,243 |   | $ | 50,984 |   |
| Change in receivables balance:         |       | 5.35                                  | %          | 2.61            | %          |                                  |       | (2.48 | )% | (4.83 | )% |
| Discount rate:                         |       |                                  |       |            |       |                                  |       |   |   |   |   |
| Private label loan trusts              |       | $                                     | 50,798     |            | $          | 48,950                                |       | $ | 47,192 |   | $ | 45,519 |   | $ | 43,925 |   |
| GATE loan trusts(1)                    |       | 6,872                                 |       | 6,618           |       | 6,378                                 |       | 6,147 |   | 5,922 |   |
| Total                                  |       | $                                     | 57,670     |            | $          | 55,568                                |       | $ | 53,570 |   | $ | 51,666 |   | $ | 49,847 |   |
| Change in receivables balance:         |       | 7.65                                  | %          | 3.73            | %          |                                  |       | (3.55 | )% | (6.95 | )% |

 
| ** **                     | ** ** | **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      |       | $                          | 44,110     |                       | $          | 45,663                   |       | $ | 47,192 |   | $ | 48,670 |   | $ | 50,218 |   |
| GATE loan trusts(1)            |       | 5,965                      |       | 6,125                      |       | 6,378                    |       | 6,470 |   | 6,736 |   |
| Total                          |       | $                          | 50,075     |                       | $          | 51,788                   |       | $ | 53,570 |   | $ | 55,140 |   | $ | 56,954 |   |
| Change in receivables balance: |       | (6.52                      | )%         | (3.33                      | )%         |                     |       | 2.93 | % | 6.32 | % |

 

----

(1)           GATEloan trusts include approximately $357 million of GATE loans and $38 million ofTERI-guaranteed loans.

 
| ** **                             | ** ** | **Percentage change in  assumptions** | ** ** | **Receivables** | ** ** | **Percentage change in  assumptions** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|-----------------|------------|---------------------------------------|------------|
| **Residuals**                          | ** ** | **Down 20%**                          | ** ** | **Down 10%**    | ** ** | **balance**                           | ** ** | **Up 10%** | ** ** | **Up 20%** | ** ** |
| ** **                             | ** ** | **(dollars in thousands)**            | ** ** |
| Default rate:                          |       |                                  |       |            |       |                                  |       |   |   |   |   |
| Private label loan trusts              |       | $                                     | 248,416    |            | $          | 246,811                               |       | $ | 244,897 |   | $ | 242,062 |   | $ | 238,005 |   |
| GATE loan trusts(1)                    |       | 9,084                                 |       | 9,482           |       | 9,860                                 |       | 10,235 |   | 10,065 |   |
| Total                                  |       | $                                     | 257,500    |            | $          | 256,293                               |       | $ | 254,757 |   | $ | 252,297 |   | $ | 248,070 |   |
| Change in receivables balance:         |       | 1.08                                  | %          | 0.60            | %          |                                  |       | (0.97 | )% | (2.62 | )% |
| Default recovery rate:                 |       |                                  |       |            |       |                                  |       |   |   |   |   |
| Private label loan trusts              |       | $                                     | 243,964    |            | $          | 244,495                               |       | $ | 244,897 |   | $ | 245,065 |   | $ | 245,185 |   |
| GATE loan trusts(1)                    |       | 8,373                                 |       | 9,100           |       | 9,860                                 |       | 10,628 |   | 10,738 |   |
| Total                                  |       | $                                     | 252,337    |            | $          | 253,595                               |       | $ | 254,757 |   | $ | 255,693 |   | $ | 255,923 |   |
| Change in receivables balance:         |       | (0.95                                 | )%         | (0.46           | )%         |                                  |       | 0.37 | % | 0.46 | % |
| Annual constant prepayment rate (CPR): |       |                                  |       |            |       |                                  |       |   |   |   |   |
| Private label loan trusts              |       | $                                     | 269,383    |            | $          | 256,851                               |       | $ | 244,897 |   | $ | 233,489 |   | $ | 222,595 |   |
| GATE loan trusts(1)                    |       | 10,281                                |       | 10,068          |       | 9,860                                 |       | 9,652 |   | 9,453 |   |
| Total                                  |       | $                                     | 279,664    |            | $          | 266,919                               |       | $ | 254,757 |   | $ | 243,141 |   | $ | 232,048 |   |
| Change in receivables balance:         |       | 9.78                                  | %          | 4.77            | %          |                                  |       | (4.56 | )% | (8.91 | )% |
| Discount rate:                         |       |                                  |       |            |       |                                  |       |   |   |   |   |
| Private label loan trusts              |       | $                                     | 294,257    |            | $          | 268,200                               |       | $ | 244,897 |   | $ | 224,006 |   | $ | 205,237 |   |
| GATE loan trusts(1)                    |       | 13,250                                |       | 11,424          |       | 9,860                                 |       | 8,444 |   | 7,364 |   |
| Total                                  |       | $                                     | 307,507    |            | $          | 279,624                               |       | $ | 254,757 |   | $ | 232,450 |   | $ | 212,601 |   |
| Change in receivables balance:         |       | 20.71                                 | %          | 9.76            | %          |                                  |       | (8.76 | )% | (16.55 | )% |

 

21

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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     |       | $                          | 235,239    |                       | $          | 240,648                  |       | $ | 244,897 |   | $ | 247,675 |   | $ | 249,704 |   |
| GATE loan trusts(1)            |       | 8,972                      |       | 9,346                      |       | 9,860                    |       | 10,324 |   | 10,620 |   |
| Total                          |       | $                          | 244,211    |                       | $          | 249,994                  |       | $ | 254,757 |   | $ | 257,999 |   | $ | 260,324 |   |
| Change in receivables balance: |       | (4.14                      | )%         | (1.87                      | )%         |                     |       | 1.27 | % | 2.19 | % |

 
| ** **                                                        | ** ** | **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  rate indices: |       |                         |       |                        |       |                     |       |   |   |   |   |
| Private label loan trusts                                         |       | $                            | 248,889    |                        | $          | 246,893                  |       | $ | 244,897 |   | $ | 242,903 |   | $ | 240,910 |   |
| GATE loan trusts(1)                                               |       | 9,860                        |       | 9,860                       |       | 9,860                    |       | 9,860 |   | 9,860 |   |
| Total                                                             |       | $                            | 258,749    |                        | $          | 256,753                  |       | $ | 254,757 |   | $ | 252,763 |   | $ | 250,770 |   |
| Change in receivables balance:                                    |       | 1.57                         | %          | 0.78                        | %          |                     |       | (0.78 | )% | (1.56 | )% |

 

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(1)           GATEloan trusts include approximately $357 million of GATE loans and $38 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.

 

***Consolidation***

*** ***

Ourconsolidated financial statements include the accounts of First Marblehead andits subsidiaries, after eliminating inter-company accounts and transactions. Wehave not consolidated the securitization trusts. Prior to July 1, 2003,this accounting treatment was in accordance with various Emerging Issues TaskForce issues and related interpretations. We considered, among other things,the following factors in assessing consolidation of the securitization trusts:

 

•       we did nothave unilateral decision-making abilities related to significant mattersaffecting the securitization trusts, such as asset acquisition, prepayment ofdebt, placement of debt obligations and modification of trust documents;

 

•       we did nothave substantially all the risks and rewards of ownership, as TERI and therespective colleges provide substantially all of the student loan guarantees;

 

•       we were afacilitator of securitization transactions, for which we receive market-basedfees, and we were not the transferor of assets to the securitization trusts;and

 

•       ourcontinuing involvement in the trusts is limited to a passive residual interestand our role as an administrator for the trust for which we receive market-basedfees.

 

BeginningJuly 1, 2003, and for securitization trusts created after January 31,2003, we applied Financial Accounting Standards Board, or FASB, InterpretationFIN No. 46, “Consolidation of Variable Interest Entities, aninterpretation of ARB No. 51,” or FIN 46, in assessing consolidation. FIN No. 46provided a new framework for identifying variable interest entities anddetermining when a company should include the assets, liabilities,non-controlling interests and results of activities of a variable interestentity in its consolidated financial statements.

 

OnDecember 24, 2003, the FASB issued FIN No. 46 (revised December 2003),“Consolidation of Variable Interest Entities,” or FIN No. 46R, which addressedhow a business enterprise should evaluate whether it has a controlling interestin an entity through means other than voting rights and accordingly shouldconsolidate the entity. FIN No. 46R has replaced FIN No. 46. At September 30,2005, the securitization trusts created after January 31, 2003 have eithermet the criteria to be a qualified special-purpose entity, or

 

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QSPE,as defined in paragraph 35 of FASB Statement No. 140, “Accounting forthe Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities,” or the Company has determined that it is not the primarybeneficiary of the securitization trusts, as defined by FIN No. 46R.Accordingly, the Company did not consolidate these existing securitizationtrusts in these financial statements. In addition, the securitization trustscreated prior to January 31, 2003 have been amended in order for them tobe considered QSPEs. The adoption of FIN No. 46R, which the Company beganto apply in December 2003, did not have a material impact on the Company’sconsolidated financial condition, results of operations, earnings per share orcash flows.

 

The FASB has issuedexposure drafts that would amend FASB Statement No. 140. The proposedamendments would, among other things, change the requirements that an entitymust meet to be considered a QSPE. The FASB has announced that it expects toissue final guidance in the first calendar quarter of 2006. We are monitoringthe status of the exposure drafts to assess their impact, if any, on ourfinancial statements.

 

**Resultsof Operations**

 

***Three months ended September 30, 2005 and 2004***

 

***Revenue Related to Securitization Transactions***

 

We did not conduct asecuritization transaction during the first quarter of either fiscal 2006 orfiscal 2005. Therefore, during these quarters we did not generate any up-frontstructural advisory fees, additional structural advisory fees or residual feerevenues from new securitization transactions.

 

The principal balance ofloans facilitated and available to us for later securitization at September 30,2005 and June 30, 2005 totaled $1.48 billion and $385.8 million,respectively.

 

*Structuraladvisory fees*

 

During the first quarterof fiscal 2006, the fair value adjustments of our additional structuraladvisory fees resulted in an increase of approximately $0.2 million.  This increase was due to the accretion of thediscounting inherent in these present value estimates and the impact of the increasein the implied forward LIBOR curve during the period, offset by an increase inthe discount rate.  During the firstquarter of fiscal 2005, the fair value adjustments of our additional structuraladvisory fees resulted in an increase of approximately $0.6 million. Thisincrease was due to the accretion of the discounting inherent in these presentvalue estimates and a decrease in the discount rate, offset by a decrease inthe implied forward LIBOR curve during the period.

 

On a quarterly basis, weupdate our estimate of the fair value of our additional structural advisoryfees, which have an estimated average life of approximately six to eight years.In doing so, we give effect to the passage of time, which results in theaccretion of the discounting inherent in these present value estimates, and wealso adjust for any changes in the discount rate that we use in estimating thepresent value of these receivables. For a discussion of the assumptions we makein estimating our additional structural advisory fees, see “—Executive Summary—Applicationof Critical Accounting Policies—Service Revenue.”

 

We base the discount ratethat we use to calculate the present value of our additional structuraladvisory fees on the 10-year U.S. Treasury rate plus 200 basis points. Thediscount rate was 6.33% at September 30, 2005, 5.96% at June 30,2005, 6.12% at September 30, 2004, and 6.58% at June 30, 2004. Adecrease in the 10-year U.S. Treasury rate has the effect of increasing thefair value of our structural advisory fees receivable, while an increase in therate has the opposite effect on our estimate of their fair value.

 

On an ongoing basis, wemonitor the performance of trust assets, including default, recovery, prepaymentand forward LIBOR rate experience, which we also consider in our estimates. Weuse an implied forward LIBOR curve to estimate trust cash flows. During thefirst quarter of 2006, the rates along the implied forward LIBOR curveincreased.  This increase resulted in anincrease in the interest to be capitalized on the underlying student loanassets during their respective deferment periods, which increases the balanceon which we expect to charge our 15 to 30 basis points per year of additionalstructural advisory fees over the life of the trust, and therefore increasesthe estimated present value of the structural advisory fees receivable. During thefirst quarter of fiscal 2005, the rates along the implied forward LIBOR curve decreased.This decrease 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 to 30 basis pointsper year of additional structural advisory fees over the life of the trust, andtherefore decreases the estimated present value of the structural advisory feesreceivable.  For a discussion of theassumptions we make in estimating our additional structural advisory feesreceivable, see “—Executive Summary—Application of Critical Accounting Policiesand Estimates—Service Revenue.”

 

23

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We made no changes in ourassumptions regarding default rates, prepayment rates and recovery rates forthe private label loan trusts or NCT trusts during either the first quarter offiscal 2006 or fiscal 2005.

 

*Residuals*

 

The fair valueadjustments of our residuals receivable resulted in an increase ofapproximately $7.5 million during the first quarter of fiscal 2006 and $3.5 millionduring the first quarter of fiscal 2005. These increases were primarily due tothe passage of time and the impact of movement in the implied forward LIBORcurve. The amount of this fair value adjustment also increased between periodsas the underlying receivables balance increased. We expect that adjustments forthe passage of time will continue to increase as we conduct more securitizationtransactions and thereby add to the residual revenues that we discount topresent value.

 

As we do with ouradditional structural advisory fees, on a quarterly basis, we update ourestimate of the fair value of our residuals. In doing so, we give effect forthe passage of time, which results in the accretion of the discounting inherentin these present value estimates, and we also adjust for any change in thediscount rate that we use in estimating the present value of these receivables.We used a 12% discount factor during the first quarter of fiscal 2006 and fiscal2005. We also monitor the performance of trust assets, including default,recovery, prepayment and forward LIBOR rates experience, which we also considerin our estimates. We use an implied forward LIBOR curve to estimate trust cashflows. During the first quarter of fiscal 2006 and the first of quarter offiscal 2005, the rates along the implied forward LIBOR curve flattened.  This flattening of the curve improved the netexcess spread between the trust assets and liabilities, resulting in anincrease in the fair value of the residuals receivable during each period. Fora discussion of the assumptions we make in estimating our residuals, see “—ExecutiveSummary—Application of Critical Accounting Policies and Estimates—ServiceRevenue.”

 

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

 

For a discussion of theassumptions we make in estimating our residuals, see “—Executive Summary—Applicationof Critical Accounting Policies and Estimates—Service Revenue.”

 

*Processing fees from TERI*

 

Processing fees from TERIincreased to $25.9 million for the first quarter of fiscal 2006 from $17.4 millionfor the first quarter of fiscal 2005. The increase reflects the additionalreimbursed expenses required to process the volume of private label loans thatwe facilitated during the fiscal 2006 period, which increased to $1.21 billion forthe first quarter of fiscal 2006 from $1.01 billion for the first quarter offiscal 2005. We expect that our processing fees from TERI will continue toincrease as we devote additional personnel and other resources to facilitateexpected increases in private label loan volumes. The increase was also due tothe expansion of our loan processing facilities which was partially reimbursedby TERI.

 

*Administrativeand other fees*

 

Administrative and otherfees increased to $1.5 million for the first quarter of fiscal 2006 from $1.0 millionfor the first quarter of fiscal 2005. The increase was due primarily toincreasing student loan balances in the securitization trusts during the fiscal2006 period compared to the fiscal 2005 period. We expect that ouradministrative and other fees will continue to increase as the student loanbalances in the securitization trusts continue to increase.

 

***Operating Expenses***

 

Total operating expensesincreased to $45.7 million for the first quarter of fiscal 2006 from $31.8 millionfor the first quarter of fiscal 2005. Compensation and benefits increased to $19.7million for the first quarter of fiscal 2006 from $14.9 million for thefirst quarter of fiscal 2005. General and administrative expenses increased to $25.9million for the first quarter of fiscal 2006 from $17.0 million for thefirst quarter of fiscal 2005.

 

Compensation and benefitsand general and administrative expenses increased primarily as a result of anincrease in personnel. We hired additional personnel to meet the operatingrequirements from our growing loan processing and securitization activities.

 

General andadministrative expenses increased as a result of increases in several subcategoriesof expenses, offset in part by a decrease in consulting fees. Marketingcoordination expenses increased from $0.7 million for the first quarter offiscal 2005 to $2.8

 

24

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million for the firstquarter of fiscal 2006. The increase in marketing coordination expense wasprimarily due to our additional efforts to increase loan facilitation volumesfor our clients. Depreciation and amortization expense increased from $1.2million for the first quarter of fiscal 2005 to $2.9 million for the firstquarter of fiscal 2006. Occupancy costs increased from $2.1 million for thefirst quarter of fiscal 2005 to $3.6 million for the first quarter of fiscal2006. The increase in depreciation and occupancy expense is due to theexpansion of our loan processing operations and corporate headquarters whichresulted in increased office space under lease and additional purchases offixed assets. Equipment expenses increased from $1.2 million for the firstquarter of fiscal 2005 to $2.9 million for the first quarter of fiscal 2006.The increase in equipment expenses was primarily due to an increase in softwaremaintenance costs and leased equipment costs. Temporary employment expensesincreased from $0.6 million for the first quarter of fiscal 2005 to $2.2million for the first quarter of fiscal 2006. External call center costsincreased from $2.5 million for the first quarter of fiscal 2005 to $3.8million for the first quarter of fiscal 2006. The increases in temporaryemployment services expense and external call center costs were primarily dueto increases in the volume of loans facilitated during the fiscal 2006 period.Travel and entertainment expenses increased from $0.8 million for the firstquarter of fiscal 2005 to $1.1 million for the first quarter of fiscal 2006.The increase in travel and entertainment expenses was primarily due to anincrease in air travel expenses for business development and investor relationsefforts. Consulting fees decreased from $4.3 million for the first quarter offiscal 2005 to $2.4 million for the first quarter of fiscal 2006. This decreasewas primarily due to a decrease in consulting costs related to our efforts toredesign our loan origination systems.

 

We expect that ouroperating expenses will continue to increase as we devote additional resourcesto the expected increasing loan volumes facilitated for our existing and newclients.

 

The following tablesummarizes the components of operating expenses, both those reimbursed and notreimbursed 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)**              | ** ** |
|                     |       |                            |       |                                      |       |                              |   |   |   |   |   |   |   |   |   |
| 2006                     |       | $                               | 12,852     |                                      | $          | 12,945                            |   | $ | 25,797 |   | $ | 6,890 |   | $ | 12,980 |   | $ | 19,870 |   | $ | 45,667 |   |
| 2005                     |       | 8,376                           |       | 8,951                                     |       | 17,327                            |   | 6,504 |   | 8,008 |   | 14,512 |   | 31,839 |   |
|                          |            |                                 |            |                                           |            |                                   |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Other Income (Expense)***

 

*Interest income (expense), net*

 

Net interest income was $1.2 millionfor the first quarter of fiscal 2006 as compared to net interest income of $0.4million for the first quarter of fiscal 2005. Interest expense was $0.2 millionfor the first quarter of fiscal 2006 and $0.1 million for the first quarter offiscal 2005. Interest income was $1.5 million for the first quarter offiscal 2006 and $0.5 million for the first quarter of fiscal 2005. The increasein interest income was due to greater cash available for investment in thecurrent year period as well as an increase in average yields on investments.  Interest expense for both periods is dueprimarily to our capital lease obligations and our notes issued to TERI in 2001to finance our purchase of TERI’s loan processing operations.

 

***Income Tax Benefit***

 

Income tax benefit increasedto $3.9 million for the first quarter of fiscal 2006 from approximately $3.7 millionfor the first quarter of fiscal 2005. The increase in income tax benefit wasprimarily the result of an increase in the amount of loss before income tax benefitbetween periods.

 

**FinancialCondition, Liquidity and Capital Resources**

 

Our liquidityrequirements have historically consisted, and we expect that they will continueto consist, of capital expenditures, working capital, business developmentexpenses, general corporate expenses, quarterly cash dividends and potentialacquisitions.

 

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***Short-term Funding Requirements***

 

We expect to fund ourshort-term liquidity requirements through cash flow from operations and theproceeds of our initial public offering. We believe, based on our current operatingplan and the proceeds of our initial public offering, that our current cash andother short-term investments will be sufficient to fund our operations throughat least fiscal 2006.

 

***Long-term Funding Requirements***

 

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

 

From our inception, wehave raised approximately $147.8 million from the sale of common stock andpromissory notes, including approximately $115.1 million in net proceedsfrom our initial public offering.

 

Our actual liquidity andcapital funding requirements may depend on numerous factors, including:

 

•       our facilities expansion needs;

 

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

 

•       the extent to which we repurchase shares of our commonstock or pay cash dividends to our stockholders;

 

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

 

•       the costs and timing of acquisitions of complementarybusinesses.

 

If we are not able toobtain adequate funding when needed, we may have to delay further expansion ofour business, our share repurchase activities or cash dividend payments.

 

***TreasuryStock***

 

We had treasury stock of$56.6 million at September 30, 2005 and $55.7 million at June 30,2005. Our treasury stock balance was derived from the repurchases of our commonstock in open market transactions. Our board of directors approved therepurchase of 1,500,000 shares of our common stock in the fourth quarter offiscal 2005 and approved the repurchase of an additional 5,000,000 shares ofour common stock in the first quarter of fiscal 2006. As of September 30,2005, we had repurchased 1,500,000 shares in aggregate.

 

***Cash and Cash Equivalents***

 

At September 30, 2005,we had $156.1 million in cash and cash equivalents and at June 30, 2005,we had $193.8 million in cash and cash equivalents. The decrease in cashand cash equivalents is primarily due to cash used to fund operations duringthe first quarter of fiscal 2006. Cash and cash equivalents include primarilyfunds deposited in a money market fund that invests in short-term obligationsof the U.S. Treasury and repurchase agreements fully collateralized byobligations of the U.S. Treasury.

 

***Service Receivables***

 

Our service receivablesincreased to $317.5 million at September 30, 2005 from $309.6 millionat June 30, 2005. The increase in service receivables is primarily due to achange in our estimate of the fair value of our residuals receivable of $7.5million during the first quarter of fiscal 2006.

 

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***Property and Equipment, net***

 

During the first quarterof fiscal 2006, our property and equipment, net increased by $0.1 million, aswe spent $2.7 million on the expansion and improvement of our loan processingfacilities and systems, offset by $2.6 million of depreciation expenserecorded during the period.

 

***Prepaid Income Taxes***

 

We had prepaid income taxes of $7.3 million at September 30,2005 and $2.6 million at June 30, 2005. The increase in prepaid income taxes during the first quarter of fiscal2006 was primarily due to estimated tax payments made during the first quarterof fiscal 2006 of approximately $3.2 million and the current tax benefitgenerated by our loss for the first quarter of fiscal 2006 of approximately$0.9 million. At June 30, 2005, this balance was primarily derived from atax benefit of $34.3 million from employee stock option exercises, principallyin connection with a stock option exercise at the time of our follow-onoffering in January 2005.

 

***Other Prepaid Expenses***

 

We had other prepaid expensesof $6.9 million at September 30, 2005 compared to $4.2 million at June 30,2005. The increase in other prepaid expenses was primarily due to an increase indeferred marketing coordination expenses of approximately $1.1 million andan increase in prepaid software license and maintenance fees of approximately$1.5 million.

 

***Other Assets***

 

We had other assets of $4.3 million at September 30,2005 and $3.2 million at June 30, 2005. The increase in other assets is primarily due to an increase of $0.9 million in reimbursableprepaid marketing costs.

 

***Accounts Payable and Accrued Expenses***

 

We had accounts payableand accrued expenses of $28.3 million at September 30, 2005 and $33.3 millionat June 30, 2005. Our accrued bonuses were approximately $9.4 million lowerat September 30, 2005 as compared to June 30, 2005, as we paid duringthe first quarter of fiscal 2006 the performance-based compensation earnedduring fiscal 2005. Our accounts payable were $0.8 million lower at September 30,2005 as compared to June 30, 2005, primarily due to the timing of thereceipt of invoices. These decreases were partly offset by dividends payable of$7.8 million at September 30, 2005.

 

***Net Deferred Income Tax Liability***

 

We have a net deferredtax liability because, under accounting principles generally accepted in theUnited States of America, we recognize residuals in financial statement incomeearlier than they are recognized for income tax purposes. Our net deferred taxliability decreased primarily as a result of the recognition of our share oftaxable income from the securitization trusts, which more than offset the increasein residual revenue recognized during the first quarter of fiscal 2006.

 

***CapitalLease Obligations***

 

We had capital leaseobligations of $10.9 million at September 30, 2005 and $12.1 million at June 30,2005. The decrease in capital lease obligations was due to scheduled principalpayments made during the first fiscal quarter of 2006.

 

***Notes Payable to TERI***

 

We had notes payable toTERI of $5.1 million at September 30, 2005 and $5.3 million at June 30,2005. The balance relates to two acquisition notes we issued to acquire TERI’sloan processing operations in 2001. The decrease in notes payable to TERI isdue to the scheduled principal payments made during the first fiscal quarter of2006.

 

***OtherLiabilities***

 

We had other liabilitiesof $2.1 million at September 30, 2005 and $1.7 million at June 30,2005. The balance at both period ends related primarily to deferred rentrelated to several operating leases for office space.

 

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***Contractual Obligations***

 

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

 

***Cash Flows***

 

Our net cash used inoperating activities increased to $33.4 million for the first quarter of fiscal2006, compared to $14.6 million for the first quarter of fiscal 2005. Cash usedin operations resulted primarily from our net loss, a decrease in accountspayable, accrued expenses and other liabilities, a decrease in deferred incometax expense and increases in residuals and prepaid income taxes, offset by depreciationand amortization.

 

We used $2.9 million ofnet cash in investing activities during the first quarter of fiscal 2006. Theprincipal use of net cash was capital expenditures related to the expansion andimprovement of our loan processing facilities and systems and, to a lesserextent, payments for loan database updates from TERI.

 

We used net cash of $1.4 millionin financing activities during the first quarter of fiscal 2006.

 

We expect that ourcapital expenditure requirements for the final three quarters of fiscal 2006will be approximately $21.5 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 $2.4 million.

 

***Borrowings***

 

In June 2001, weissued two acquisition notes to TERI totaling $7.9 million to acquire TERI’sloan processing operations as well as its workforce-in-place. Principal andinterest at an annual rate of 6% is payable on these notes in 120 monthlypayments of $87,706 commencing on July 20, 2001 and ending on June 20,2011. At September 30, 2005, outstanding principal on these notes totaled $5.1million as compared to $5.3 million at June 30, 2005.

 

InAugust 2003, we entered into a $10 million revolving credit facilitywith Fleet National Bank. Fleet National Bank was subsequently acquired by Bankof America, and our agreement related to this facility was assigned to Bank ofAmerica. The revolving credit facility matured on August 28, 2005, and wedid not extend it. The revolving credit line contained certain financialcovenants with which we complied throughout the terms of the facility.

 

**Off-BalanceSheet Transactions**

 

We offer outsourcingservices in connection with the lifecycle of a private student loan, fromprogram design and marketing through loan administration and, ultimately, tothe sale and securitization of the loans. We also structure and facilitate thesecuritization of loans for our clients through a series of bankruptcy remote,qualified special purpose trusts.

 

We do not utilize thesetrusts as a means to transfer assets or liabilities from our balance sheet tothose of the trusts because we are not the originator of the securitizedstudent loans or the issuer of the related debt. We do not serve as lender,guarantor or loan servicer. Specifically, these trusts purchase such studentloans from third-party financial institutions, the financing of which isprovided through the issuance of asset-backed securities.

 

The principal uses ofthese trusts are to:

 

•       generate sources of liquidity for our clients’ assetssold into such trusts and to reduce their credit risk;

 

•       make available more funds to students and colleges;and

 

•       leverage the capital markets to reduce borrowing coststo students.

 

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

 

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**Inflation**

 

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

 

**FactorsThat May Affect Future Results**

 

Thisquarterly report on Form 10-Q includes forward-looking statements withinthe meaning of Section 21E of the Securities Exchange Act of 1934, asamended, or the Exchange Act. 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 provide any assurance that we actually willachieve the plans, intentions or expectations expressed or implied in ourforward-looking statements. There are a number of important factors that couldcause actual results, levels of activity, performance or events to differmaterially from those expressed or implied in the forward-looking statements wemake. These important factors include our “critical accounting estimates” andthe risk factors set forth below. Although we may elect to updateforward-looking statements in the future, we specifically disclaim anyobligation to do so, even if our estimates change, and readers should not relyon those forward-looking statements as representing our views as of any datesubsequent to the date of this quarterly report.

 

**RiskFactors**

 

***Wederive a significant portion of our revenue and substantially all of our incomefrom structuring securitization transactions; our financial results and futuregrowth would be adversely affected if we are unable to structuresecuritizations.***

*** ***

Securitizationrefers to the technique of pooling loans and selling them to a special purpose,bankruptcy remote entity, typically a trust, which issues securities toinvestors backed by those loans. As of the date of this quarterly report, wehave provided structural advisory and other services for 28 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 76% of our totalservice revenue for fiscal 2005, 78% of our total service revenue for fiscal2004 and 73% of our total service revenue for fiscal 2003. Substantially all ofour net income in those fiscal periods was attributable tosecuritization-related revenue.

 

***Thetiming of our securitization activities will greatly affect our quarterlyfinancial results.***

*** ***

Ourquarterly revenue, operating results and profitability have varied and areexpected to continue to vary significantly on a quarterly basis. In fiscal2005, we recognized 5%, 37%, 29% and 29% of our total service revenue in therespective fiscal quarters of fiscal 2005. In fiscal 2004, we recognized 5%,39%, 5% and 51% of our total service revenue in the respective fiscal quartersof 2004. Our quarterly revenue varies primarily because of the timing of thesecuritizations that we structure. In fiscal 2004, we facilitated onesecuritization in the second quarter and two securitizations in the fourthquarter, but none in the first or third quarters. In fiscal 2005, wefacilitated one securitization in the second quarter, one securitization in thethird quarter, and three securitizations in the fourth quarter, but none in thefirst quarter. The timing of our securitization activities is affected to somedegree by the seasonality of student loan applications and loan originations.Origination of student loans is generally subject to seasonal trends, with thevolume of loan applications increasing with the approach of tuition paymentdates. In fiscal 2005, we processed 39% of our total loan facilitation volumein the first quarter ended September 30, 2004, and 21%, 24%, and 17% ofour total loan facilitation volume in the respective successive quarters. Infiscal 2004, we processed 34% of our total loan facilitation volume in thefirst quarter ended September 30, 2003, and 20%, 27% and 19% of our totalloan facilitation volume in the respective successive quarters.

 

***Anumber of factors, some of which are beyond our control, may adversely affectour securitization activities and thereby adversely affect our results ofoperations.***

*** ***

Ourfinancial performance and future growth depend in part on our continued successin structuring securitizations. Several factors may affect both our ability tostructure securitizations and the revenue we generate for providing ourstructural advisory and other services, including the following:

 

•   degradationof the 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;

 

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

 

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

 

•   anymaterial downgrading or withdrawal of ratings given to securities previouslyissued in securitizations that we structured could reduce demand for additionalsecuritizations that we structure.

 

Aportion of the securities issued since 1998 in securitization transactions thatwe structured were sold to asset-backed commercial paper conduits. If these orsimilar asset-backed conduits cease to purchase securities in thesecuritizations that we structure, we may experience a delay in the timing ofour securitizations as we seek to find alternate channels of distribution.

 

Underthe terms of some of our contracts with key lender clients, we have anobligation to securitize loans originated by those lenders periodically,typically twice per year. We may agree with other lenders to securitize morefrequently in the future. If we do not honor these obligations, we may berequired to pay liquidated or other damages, which could adversely affect ourresults of operations.

 

***Inconnection with our recognition of revenue from securitization transactions, ifthe estimates we make, and the assumptions on which we rely, in preparing ourfinancial statements prove inaccurate, our actual results may vary from thosereflected in our financial statements.***

*** ***

Wereceive 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 trust. We also have the right to receive a portion ofthe residual interests that the trust creates. As required under GAAP, werecognize as revenue the present value of the additional portion of thestructural advisory fees and residuals at the time the securitization trustpurchases the loans because they are deemed to be earned before they areactually paid to us. We record additional structural advisory fees andresiduals as receivables on our balance sheet at fair value. Accounting rules requirethat these receivables be marked-to-market. We estimate the fair value bothinitially and in each subsequent quarter and reflect the change in value inearnings for that period. Our key assumptions to estimate the value includeprepayment and discount rates, interest rate trends, the spread between LIBORand the auction rates on our senior auction rate notes, the expected creditlosses from the underlying securitized loan portfolio, net of recoveries, andthe expected timing of cash flows from the trusts’ underlying student loanassets. If our assumptions are wrong, the additional structural advisory feesand residuals that we receive from the trusts could be significantly less thanreflected in our current financial statements, and we may incur a materialnegative adjustment to our earnings in the period in which our assumptionschange. For a discussion of the sensitivity of the additional structuraladvisory fees and residuals to variations in our assumptions and estimates, see“Management’s Discussion and Analysis of Financial Condition and Results ofOperations—Executive Summary—Application of Critical Accounting Policies andEstimates—Service Revenue—Sensitivity Analysis.”

 

Ourresiduals in each securitization we have facilitated are subordinate to securitiesissued to investors in such securitizations and may fail to generate any cashflow for us if the securitized assets only generate enough cash flow to pay theinvestors.

 

***Ourfinancial results could be adversely affected if we were required to consolidatethe financial results of the entities that we use for securitizations that wefacilitate.***

*** ***

Weprovide structural advisory and other services for loan securitizationsundertaken through statutory trusts. We do not consolidate the financialresults of the trusts with our own financial results. For a discussion of ourdecision not to consolidate, see “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Executive Summary—Application ofCritical Accounting Policies and Estimates—Consolidation” included in this quarterlyreport. Some of the relevant accounting rules are in the process of beingamended. If we were required to consolidate the financial results of one ormore trusts with our own financial results as a result of amendments or changesin accounting rules, or if the SEC or other accounting authorities do not agreewith our current approach, our financial results could be adversely affected,particularly in the early years of a trust when the trust typically experienceslosses.

 

***Instructuring and facilitating securitizations of our clients’ loans and asholders of rights to receive residual cash flows in those trusts, we may incurliabilities to investors in the asset-backed securities those trusts issue.***

*** ***

Wehave facilitated and structured a number of different special purpose truststhat have been used in securitizations to finance student loans that ourclients originate. Under applicable state and federal securities laws, ifinvestors incur losses as a result of purchasing asset-backed securities thatthose trusts issue, we could be deemed responsible and could be liable to thoseinvestors for damages. If we failed to cause the trusts to disclose adequatelyall material information regarding an investment in the asset-backed securitiesor if the trust made statements that were misleading in any material respect ininformation delivered to investors, it is possible that we could be heldresponsible for that information or omission. In addition, under various agreementsentered into with underwriters or financial guarantee insurers of thoseasset-backed securities, we are contractually bound to indemnify those personsif

 

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investors are successfulin seeking to recover losses from those parties and the trusts are found tohave made materially misleading statements or to have omitted materialinformation.

 

Wedo not maintain reserves or insurance against this potential liability. If weare liable for losses investors incur in any of the securitizations that we facilitateor structure, our profitability or financial position could be materiallyadversely affected.

 

***Ifour relationships with key clients terminate, our revenue and results ofoperations would be adversely affected.***

*** ***

Westructure and support private student loan programs for commercial banks,including JPMorgan Chase Bank, N.A., successor by merger to Bank One, N.A., andBank of America, N.A. We also structure and support private student loanprograms for marketing partners that refer their borrowers to a particularlending source, such as Charter One Bank, N.A. We refer to these lenders asreferral lenders. Structural advisory fees and residuals from securitization ofJPMorgan Chase Bank private label loans represented approximately 30% of ourtotal service revenue for fiscal 2005 and approximately 44% of our totalservice revenue for fiscal 2004. Structural advisory fees and residuals fromsecuritization of Bank of America private label loans represented approximately15% of total service revenue for fiscal 2005 and approximately 8% of totalservice revenue for fiscal 2004. In addition, Bank of America is the exclusivelender for our GATE program clients. Our GATE programs contributed 3% of ourtotal service revenue in fiscal 2005 and 4% of our total service revenue infiscal 2004. Structural advisory fees and residuals from securitization ofprivate label loans funded by Charter One Bank represented approximately 22% ofour total service revenue for fiscal 2005 and approximately 16% of our totalservice revenue in fiscal 2004.

 

Wehave agreements with these commercial banks that govern the purchase of loansfor securitization. Our agreement with JPMorgan Chase Bank is scheduled toterminate in April 2007. Our agreement with Charter One Bank is scheduledto terminate in May 2007, except with respect to loans marketed byCollegiate Funding Services, L.L.C. and funded by Charter One Bank, in whichcase our agreement has a term through July 2007. Our agreement with Bankof America governing the purchase of school channel loans can be terminated atany time upon 180 days notice. Of our two agreements with Bank of America thatgovern the purchase of GATE loans, one may terminate at any time upon 120 daysnotice and the other may terminate as early as May 2006. Our agreementwith Bank of America governing the purchase of direct-to-consumer loans extendsthrough May 2006. Each client above has the right to terminate theiragreement on short notice, generally 30 days or less, if we materiallybreach our agreement, including our failure to perform at service levelsspecified in those contracts. In addition, under the terms of our lenderclients’ guaranty agreements with TERI, both the lender and TERI may proposemodifications to loan program guidelines during the first calendar quarter ofeach year. If the parties are unable to agree on a proposed modification, suchas an adjustment of the guarantee fees, the party proposing the modificationhas the option of terminating the guaranty agreement, effective as of May 1of that calendar year. Under its master loan guaranty agreement with us, TERImay not propose a change to program guidelines without our consent. Similarly,under our agreements with lenders that have multi-year terms, the lender cannotchange the program guidelines without our consent, which we cannot unreasonablywithhold.

 

Asignificant decline in services to JP Morgan Chase, Bank of America or CharterOne Bank, or the termination of guaranty agreements between those lenders andTERI, could reduce the overall volume of loans we facilitate, which could bedifficult to replace through arrangements with other lenders. Our revenue,business and financial results could suffer as a result.

 

***Ifour relationship with TERI terminates, our business could be adversely affected.***

*** ***

InJune 2001, we purchased the loan processing operations of TERI and enteredinto a series of agreements to govern future securitizations of TERI-guaranteedloans. TERI continues to provide private student loan guarantee, educationinformation and counseling services for students, and is the exclusive thirdparty provider of borrower default guarantees for our clients’ private labelloans. We have entered into an agreement to provide various services for TERIand received fees from TERI for services performed of $25.9 million, or 74% oftotal service revenue, for the first quarter of fiscal 2006, and $17.4 millionor 77% of total service revenue for the first quarter of fiscal 2005. Inaddition, we have agreed to undertake on a best-efforts basis to arrange orfacilitate securitizations for a limited category of TERI-guaranteed loans andhave the right to receive structural advisory and other fees in connection withthese securitizations. We also have entered into an agreement to receive fromTERI updated information about the performance of the student loans it hasguaranteed to allow us to supplement our database. Each of these agreementswith TERI had an initial term through June 2006. In October 2004, weexercised our option to renew each agreement for an additional five-year term,through June 2011. If our agreements with TERI terminate for any reason,or if TERI fails to comply with its obligations, our business would beadversely affected and the value of our intangible assets could be impaired forthe following reasons:

 

•   wemay not be able to offer our clients guarantee services from another guarantorand, accordingly, our access to loans and our opportunities to structuresecuritization transactions may diminish significantly;

 

•   wemay not be successful in establishing an arrangement with a third party toprovide the warranties that TERI currently provides to lenders related toorigination services. In such case, we may be required to provide suchwarranties; and

 

•   ifTERI is unable to provide guarantee services, any financial guarantee insurancecoverage we obtain in securitization transactions could be more costly, if itis available at all.

 

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Insuch events, demand for our services, including opportunities to structure andfacilitate securitization transactions, could decline, which would adverselyaffect our business. In addition, the value of the loan pools in thesecuritization transactions we facilitate could decline and the value of ourresiduals could be reduced.

 

***Ourbusiness could be adversely affected if TERI’s ratings are downgraded.***

*** ***

Inits role as guarantor in the private education lending market, TERI agrees toreimburse lenders for unpaid principal and interest on defaulted loans. TERI isthe exclusive provider of borrower default guarantees for our clients’ privatelabel loans. As of September 30, 2005, TERI had a Baa3 counterparty ratingfrom Moody’s Investors Service, which is the lowest investment grade rating,and an insurer financial strength rating of A+ from Fitch Ratings. If theseratings are lowered, our clients may not wish to enter into guaranteearrangements with TERI. In addition, we may receive lower structural advisoryfees because the costs of obtaining financial guarantee insurance for theasset-backed securitizations that we structure could increase. In such case,our business would be adversely affected.

 

***Ourbusiness could be adversely affected if PHEAA fails to provide adequate ortimely services or if our relationship with PHEAA terminates.***

*** ***

Asof September 30, 2005, PHEAA serviced a majority of loans whoseorigination we facilitate. This arrangement allows us to increase the volume ofloans in our clients’ loan programs without incurring the overhead investmentin servicing operations. As with any external service provider, there are risksassociated with inadequate or untimely services. We regularly monitor theservicing portfolio reports, including delinquencies and defaults. Asubstantial increase in the delinquency rate could adversely affect our abilityto access profitably the securitization markets for our clients’ loans. Inaddition, if our relationship with PHEAA terminates, we would either need toexpand or develop a relationship with another TERI-approved loan servicer,which could be time consuming and costly. In such event, our business could beadversely affected. Although we periodically review the costs associated withestablishing servicing operations to service loans, we have no plans toestablish and perform servicing operations at this time.

 

***Theoutsourcing services market for education lending is highly competitive and ifwe are not able to compete effectively, our revenue and results of operationsmay be adversely affected.***

*** ***

Weassist 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 efficiencies based on a larger volume of loantransactions, fund internal growth and compete for market share generally. Wemay face competition from our clients if they choose to provide directly theservices that we currently provide, and from third parties who decide to expandtheir services to include the suite of services that we provide. We are awareof two principal competitors, SLM Corporation, or Sallie Mae, and ServusFinancial Corporation, an affiliate of Wells Fargo Company, that offer asimilar range of services to lenders. Our business could also be adverselyaffected if Sallie Mae’s program to market private student loans directly toconsumers continues to grow or if Sallie Mae seeks to market more aggressivelyto third parties the full range of services for private loan programs that weprovide. If we are not able to compete effectively, our revenue and results ofoperations may be adversely affected. In addition, if third parties choose toprovide the range of services that we provide, pricing for our services maybecome more competitive, which could lower our profitability.

 

Inaddition, there has been significant consolidation within the banking industry.For example, Charter One Financial, Inc., the publicly traded parentcompany of Charter One Bank was acquired by Citizens Financial Group, Inc.,and Bank One Corporation was acquired by J.P. Morgan Chase & Co. Inaddition, Sallie Mae acquired our client, Southwest Student ServicesCorporation, resulting in termination of our relationship with that client.Further consolidation could result in a loss of business if one or more of ourclients were acquired by a competitor or a lender that is not our client.

 

Historically,lenders in the education loan market have focused their lending activities onfederal loans because of the relative size of the federal loan market andbecause the federal government guarantees repayment of these loans, therebysignificantly limiting the lenders’ credit risk. The demand for our servicescould decline if lenders place additional emphasis on the private educationloan market and offer the services we provide.

 

***Thegrowth of our business could be adversely affected if annual and aggregatelimitations under federal student loan programs increase.***

*** ***

Wefocus our business exclusively on the market for private education loans, andmore 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 because studentsand their families often rely on private loans to bridge the gap betweenavailable funds, including family savings, grants and federal and state loans,and the costs of post-secondary education. The federal government

 

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currently places bothannual and aggregate limitations on the amount of federal loans that anystudent can receive, and these limitations are adjusted in connection withfunding authorizations from the United States Congress for programs under theHigher Education Act. The limitations on federal student loans have not beenadjusted since 1992, and Congress is currently considering proposals that couldincrease the limitations in the future. If Congress materially increases eitherthe annual or aggregate loan limitations, or otherwise increases the fundingavailable under federal student loan programs, demand for private student loanscould weaken, which could adversely affect the volume of private loans and thesecuritization transactions that we facilitate and structure and, as a result,the growth of our business.

 

***Accessto alternative means of financing the costs of education may reduce demand forprivate student loans.***

*** ***

Thedemand for private student loans could weaken if student borrowers use othervehicles to bridge the gap between available funds and costs of post-secondaryeducation. These vehicles include, among others:

 

•   homeequity loans, under which families borrow money based on the value of theirreal estate;

 

•   pre-paidtuition plans, which allow students to pay tuition at today’s rates to covertuition costs in the future;

 

•   529plans, which are state-sponsored investment plans that allow a family to savefunds for education expenses; and

 

•   educationIRAs, now known as Coverdell Education Savings Accounts, under which a holdercan make annual contributions for education savings.

 

Ifdemand for private student loans weakens, we would experience reduced demandfor our services, which would seriously harm our financial results.

 

***Ifcompetitors acquire or develop a student loan database or advanced loaninformation processing systems, our business could be adversely affected.***

*** ***

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

 

***Ifour clients do not successfully market and sell student loans, our businesswill be adversely affected.***

*** ***

Weprovide outsourcing services to lenders, marketing partners and educationalinstitutions, as well as businesses and other organizations, in structuring andsupporting their private education loan programs. We rely on our clients tomarket and sell education loans to student borrowers. If they do not devotesufficient time and resources to their marketing efforts, or if they areotherwise not successful in these efforts, then we may experience a reductionin the volume of loans that we process and securitize, and our business will beadversely affected.

 

***Changesin interest rates could affect the value of our additional structural advisoryfees and residuals receivables, as well as demand for private student loans andour services.***

*** ***

Studentloans typically carry floating interest rates. Higher interest rates wouldincrease the cost of the loan to the borrower, which in turn, could lessendemand for our services and cause an increase in prepayment and default ratesfor outstanding student loans. If this occurs, we may experience a decline inthe value of our additional structural advisory fees and residuals receivablesin connection with the securitizations that we facilitate. In addition, most ofthe student loans that our clients originate carry floating rates of interesttied to prevailing short-term interest rates. An increase in interest ratescould reduce borrowing for education generally, which, in turn, could cause theoverall demand for our services to decline.

 

***Ifwe are unable to protect the confidentiality of our proprietary database andinformation systems and processes, the value of our services and technologywill be adversely affected.***

*** ***

Werely on trade secret laws and restrictions on disclosure to protect ourproprietary 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.

 

Weown no patents and have filed no patent applications with respect to ourproprietary database or loan information processing systems. Accordingly, ourtechnology is not covered by patents that would preclude or inhibit competitorsfrom entering our market.

 

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Monitoring unauthorizeduse of the systems and processes that we developed is difficult, and we cannotbe certain that the steps that we have taken will prevent unauthorized use ofour technology. Furthermore, others may independently develop substantiallyequivalent proprietary information and techniques or otherwise gain access toour proprietary information. If we are unable to protect the confidentiality ofour proprietary information and know-how, the value of our technology andservices will be adversely affected.

 

***Aninterruption in or breach of our information systems may result in lostbusiness.***

*** ***

Werely heavily upon communications and information systems to conduct ourbusiness. 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 whom we rely will adequately address them. Wehave implemented precautionary measures to avoid systems outages and to minimizethe effects of any data or telephone systems interruptions, but we have notinstituted redundancy for key systems. The occurrence of any failure,interruption or breach could significantly harm our business.

 

***Ifwe experience a data security breach and confidential customer information isdisclosed, we may be subject to penalties imposed by regulators, civil actionsfor damages and negative publicity, which could affect our customerrelationships and have a material adverse effect on our business. In addition,current state and federal legislative proposals, if enacted, may imposeadditional requirements on us to safeguard confidential customer information,which may result in increased compliance costs.***

*** ***

Recently,data security breaches suffered by well-known companies and institutions haveattracted a substantial amount of media attention, prompting state and federallegislative proposals addressing data privacy and security. If some of thecurrent proposals are adopted, we may be subject to more extensive requirementsto protect the borrower information that we process in connection with theloans. Implementation of systems and procedures to address these requirementswould increase our compliance costs. If we were to experience a large-scaledata security breach, such breach could generate negative publicity about usand could adversely affect our relationships with our clients, including thelenders and educational institutions with which we do business. This could havea material adverse effect on our business. In addition, pending legislativeproposals, if adopted, likely would result in substantial penalties forunauthorized disclosure of confidential consumer information.

 

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

*** ***

Ourability to handle an increasing volume of transactions is based in large parton the advanced systems and processes we have implemented and developed. Theloan origination process is becoming increasingly dependent upon technologicaladvancement such as the ability to process loans over the Internet, acceptelectronic signatures and provide process updates instantly. Our future successdepends in part on our ability to develop and implement technology solutionsthat anticipate and keep pace with these and other continuing changes intechnology, industry standards and client preferences. We may not be successfulin anticipating or responding to these developments on a timely basis. Ifcompetitors introduce products, services, systems and processes that are betterthan ours or that gain greater market acceptance, those that we offer or usemay become obsolete or noncompetitive. Any one of these circumstances couldhave a material adverse effect on our ability to obtain and retain key clients.

 

Wemay be required to expend significant funds to develop or acquire newtechnologies. 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.

 

***Wehave expanded our operations rapidly in recent years, and if we fail to manageeffectively our growth, our financial results could be adversely affected.***

*** ***

Thenumber of our employees increased to 873 regular employees and 13 seasonalemployees as of September 30, 2005 from 539 regular employees and 134 seasonalemployees as of September 30, 2004. Many of these employees have verylimited experience with us and a limited understanding of our systems andcontrols. From our inception to September 30, 2005, our assets have grownto $536.8 million. Our revenue increased to $418.0 million for fiscal 2005 from$199.3 million in fiscal 2004 and $91.4 million in fiscal 2003. Our growthmay place a strain on our management, systems and resources. We must continueto refine and expand our business development capabilities, our systems and processesand our access to financing sources. As we grow, we must continue to hire,train, supervise and manage new employees.

 

Wecannot assure you that we will be able to:

 

•   expandour systems effectively;

 

•   allocateour human resources optimally;

 

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•   identifyand hire qualified employees; or

 

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

 

Ifwe are unable to manage our growth, our operations and our financial resultscould be adversely affected.

 

***Wemay be subject to state registration or licensing requirements in jurisdictionswhere we are not currently registered or licensed. If we determine that we aresubject to the registration or licensing requirements of any jurisdiction, ourcompliance costs could increase significantly and other adverse consequencesmay result.***

*** ***

Basedon the advice of counsel and, in some states, additional informal advice fromstate regulators, we have been operating on the basis that no registrations orlicenses for loan brokers and loan arrangers are required of us. Although webelieve that our prior consultations with national and local counsel identifiedall material registration, licensing and other regulatory requirements thenapplicable, we are conducting a nationwide review of state registration andlicensing requirements that may be applicable to us now, based on the expansionof the scope of the services we provide and the time that has elapsed since ourprior review. As a result of this current review, we may determine thatregistration or licensing is required in jurisdictions where we are notcurrently registered or licensed. Even if we are not physically present in astate, its regulators may take the position that registration or licensing isrequired because we provide services by mail, telephone, the Internet or otherremote means. If we identify any states in which registration or licensing isrequired, we will proceed with registration or licensing in the affected state.If any state asserts jurisdiction over our business, we will consider whetherto challenge the assertion or proceed with registration or licensing in theaffected state. Compliance with such requirements could involve additionalcosts, which could have a material adverse effect on our business. Our failureto comply with these laws could lead to, among other things: (a) curtailmentof our ability to continue to conduct business in the relevant jurisdiction,pending processing of registration or a license application, (b) administrativeenforcement actions, (c) class action lawsuits, (d) the assertion oflegal defenses delaying or otherwise affecting the enforcement of loans, and (e) criminalas well as civil liability. This could have a material adverse effect on ourbusiness.

 

***Ifthe regulatory exemptions or rulings that allow us to conduct our businesswithout registration or licensing are modified or revoked, or the statutory andregulatory requirements change in the future, our compliance costs couldincrease substantially.***

*** ***

TheMassachusetts Division of Banks ruled that our business with TERI is notsubject to licensing because, as a provider of loan origination outsourcingservices, we do not conduct a lending business with consumers in our own nameand our processing centers are not generally open to the public. TheMassachusetts Small Loan Act requires any person that is engaged, forcompensation, in the business of making small loans, or in aiding or assistingthe borrower or the lender in procuring or making such loans, to obtain alicense. Under the statute, the business of making small loans includes themaking of loans of $6,000 or less with interest rates and expenses of more than12% per year. The TERI-guaranteed loans that we facilitate include amounts assmall as $1,000, and a small portion of those loans have combined interestrates and fees exceeding 12%. We could therefore become subject to the SmallLoan Act with respect to these loans if the Massachusetts Division of Banksrevokes its previous determination that our operations are exempt or determinesthat our activities exceed the scope of the determination.

 

Wecould also become subject to registration or licensing requirements due tochanges in existing federal and state laws and regulations. The Massachusettslegislature could, for example, modify the statutory requirements under theSmall Loan Act. If the Massachusetts legislature, or any other state or federalregulatory authority, changes existing laws and rules, or enacts new laws orrules, we could be forced to make changes in our relationships with lenders,educational institutions, guarantors, servicers or the trusts involved in thesecuritizations that we facilitate. Specifically, changes in existing laws and rules couldalso require us to implement additional or different programs and informationtechnology systems and could impose licensing, capital and reserve requirementsand additional costs, including administrative, compliance and third-partyservice costs.

 

***Wemay be exposed to liability for failures of third parties with which we dobusiness to comply with the registration, licensing and other requirements thatapply to them.***

*** ***

Thirdparties with which we do business, including federal and state charteredfinancial institutions as well as TERI, are subject to registration, licensingand extensive governmental regulations, including Truth-in-Lending laws andother consumer protection laws and regulations. For example, some of the thirdparty marketers with which we do business may be subject to state registrationor licensing requirements and laws and regulations, including those relating tosmall loans, loan brokers and credit services organizations. As a result of theactivities that we conduct for our clients, it may be asserted that we havesome responsibility for compliance by third parties, with which we do business,with the laws and regulations applicable to them, whether on contractual orother grounds. If it is determined that we have failed to comply with ourobligations with respect to these third parties, we could be subject to civilor criminal liability.

 

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***Wecould also become subject to registration or licensing and other regulatoryrequirements in Massachusetts and other states by expanding the scope or extentof our services.***

*** ***

Weare in the process of expanding the scope of the services we provide on behalfof lenders to include certain advertising and marketing functions. As a resultof this expansion of our services, or if we expand our services in the futureto include, among others, loan guarantees, our current exemption from theMassachusetts Small Loan Act could be invalidated, and consequently, we mayneed to obtain a license from the Massachusetts Division of Banks. In addition,we may become subject to the laws and regulations of other states governingsuch expanded services. We may also become subject to state regulatoryrequirements if the extent of the activities that we conduct in a particularstate expands. Compliance with such requirements could involve additional costs,which could have a material adverse effect on our business.

 

***Failureto comply with consumer protection laws could subject us to civil and criminalpenalties and have a material adverse effect on our business.***

*** ***

Thefederal government and state governments regulate extensively the financialinstitutions and other entities that originate loans in the student loanmarket. These regulations include bankruptcy, tax, usury, disclosure, creditreporting, identity theft, privacy, fraud and abuse and other laws to protectborrowers. Changes in consumer protection laws or related regulations, or inthe prevailing interpretations thereof, may expose us to litigation, adverselyaffect the collection of balances due on the loan assets held by securitizationtrusts or otherwise adversely affect our business. Moreover, changes in theconsumer protection laws and related regulations, or in the prevailinginterpretations thereof, could invalidate or call into question the legality ofcertain of our services and business practices. Recent or future changes infederal and state bankruptcy and debtor relief laws may increase credit losseson the loans held by securitization trusts and related administrative expenses.Violations of the laws or regulations governing our operations, or theoperations of TERI or our other clients, could result in the imposition ofcivil or criminal penalties, the cancellation of our contracts to provideservices or our exclusion from participating in education loan programs. Thesepenalties or exclusions, were they to occur, would negatively impair ourability to operate our business. In addition, the loan assets held bysecuritization trusts that we have structured could be adversely impacted byviolation of tax or consumer protection laws. In such event, the value of ourresidual interests could also be adversely impacted. In some cases, suchviolations may render the loan assets unenforceable.

 

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

*** ***

Weprovide financial and educational institutions, as well as other organizations,with an integrated suite of services in support of private student loanprograms. The lenders with which we work are federally-insured banks and,therefore, are not subject to many state consumer protection laws, includinglimitations on interest rates, fees and other charges. In providing ourservices, we do not act as a lender, guarantor or loan servicer, and the termsof the loans that we securitize are regulated in accordance with the laws andregulations applicable to the lenders.

 

Theassociation between loan marketers and out-of-state national banks has comeunder recent scrutiny, specifically in the context of high-interest “paydayloans”. Recent litigation asserts that payday loan marketers use out-of-statelenders in order to evade the usury and interest rate caps, and other consumerprotection laws, imposed by the states where they do business. Such litigationhas sought, successfully in some instances, to re-characterize the loanmarketer as the lender for purposes of state consumer protection law restrictions.Similar civil actions have been brought in the context of gift cards. Webelieve that our activities, and the activities of third parties whosemarketing on behalf of lenders is coordinated by us, are distinguishable fromthe activities involved in these cases.

 

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

 

***Theprice of our common stock may be volatile.***

*** ***

Thetrading price of our common stock may fluctuate substantially, depending onmany factors, some of which are beyond our control and may not be related toour operating performance. These fluctuations could cause you to lose part orall of your investment in our shares of common stock. Those factors that couldcause fluctuations include, but are not limited to, the following:

 

•   difficultieswe may encounter in the securitizations that we structure or the loss ofopportunities to structure securitization transactions;

 

•   priceand volume fluctuations 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;

 

•   actualor anticipated changes in our earnings or fluctuations in our operating resultsor in the expectations of securities analysts;

 

•   generaleconomic conditions and trends;

 

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

 

•   majorcatastrophic events;

 

•   lossof a significant client or clients;

 

•   salesof large blocks of our stock; or

 

•   departuresof key personnel.

 

Inthe past, following periods of volatility in the market price of a company’ssecurities, securities class action litigation has often been brought againstthat company. Due to the potential volatility of our stock price, we maytherefore be the target of securities litigation in the future. Securitieslitigation could result in substantial costs and divert management’s attentionand resources from our business.

 

***Ifa substantial number of shares become available for sale and are sold in ashort period of time, the market price of our common stock could decline.***

*** ***

Wehave only been a public company since October 2003. For the twelve monthperiod ended September 30, 2005, the average daily trading volume of ourcommon stock on the New York Stock Exchange was approximately 774,000 shares.As a result, future sales of a substantial number of shares of our common stockin the public market, or the perception that such sales may occur, couldadversely affect the then-prevailing market price of our common stock.

 

Asof October 21, 2005, we had 64,942,044 shares of common stock outstanding.Subject to limitations under federal securities laws, including in some casesthe holding period requirements and volume limitations of Rule 144, theseshares are eligible for sale in the public market. The market price of sharesof our common stock may drop significantly if our existing stockholders sell asubstantial number of shares that had previously been subject to lock-upagreements. A decline in the price of shares of our common stock might impedeour ability to raise capital through the issuance of additional shares of ourcommon stock or other equity securities.

 

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

*** ***

Ourdirectors and executive officers, and entities affiliated with them,beneficially own approximately 41% of the outstanding shares of our commonstock. As a result, these stockholders, if acting together, would be able toinfluence or control matters requiring approval by our stockholders, includingthe election of directors and the approval of mergers or other extraordinarytransactions. They may also have interests that differ from yours and may votein a way with which you disagree and which may be adverse to your interests.The concentration of ownership may have the effect of delaying, preventing ordeterring a change of control of our company, could deprive our stockholders ofan opportunity to receive a premium for their common stock as part of a sale ofour company and might ultimately affect the market price of our common stock.

 

***Someprovisions in our certificate of incorporation and by-laws may deter thirdparties from acquiring us.***

*** ***

Ourcertificate of incorporation and by-laws contain provisions that may make theacquisition of our company more difficult without the approval of our board ofdirectors, including the following:

 

•   onlyour board of directors, the chairman of our board of directors or our presidentmay call special meetings of our stockholders;

 

•   ourstockholders may take action only at a meeting of our stockholders and not bywritten consent;

 

•   wehave authorized undesignated preferred stock, the terms of which may beestablished and shares of which may be issued without stockholder approval;

 

•   ourdirectors may be removed only for cause by the affirmative vote of a majorityof the directors present at a meeting duly held at which a quorum is present,or the holders of 75% of the votes that all stockholders would be entitled tocast in the election of directors; and

 

•   weimpose advance notice requirements for stockholder proposals.

 

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Theseanti-takeover defenses could discourage, delay or prevent a transactioninvolving a change in control of our company. These provisions could alsodiscourage proxy contests and make it more difficult for you and otherstockholders to elect directors of your choosing and cause us to take othercorporate actions you desire.

 

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

*** ***

Weare subject to Section 203 of the Delaware General Corporation Law which,subject to certain exceptions, prohibits “business combinations” between aDelaware corporation and an “interested stockholder,” which is generallydefined as a stockholder who becomes a beneficial owner of 15% or more of aDelaware corporation’s voting stock, for a three-year period following the datethat such stockholder became an interested stockholder. Section 203 couldhave the effect of delaying, deferring or preventing a change in control thatour stockholders might consider to be in their best interests.

 

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

 

***General***

 

Marketrisk is the risk of change in fair value of a financial instrument due tochanges in interest rates, equity prices, creditworthiness, foreign exchangerates or other factors. We manage our market risk through a conservativeinvestment policy, the primary objective of which is preservation of capital.At September 30, 2005, cash and cash equivalents consisted primarily ofbalances in money market funds. As a result, we do not believe a change ininterest rates would have a material impact on the fair value of cash and cashequivalents.

 

***Market Risks Related to Structural Advisory Fees andResiduals***

 

Becausethere are no quoted market prices for our additional structural advisory feesand residuals receivables, we use assumptions to estimate their values. We basethese estimates on our proprietary historical data, third party data and ourindustry experience, adjusting for specific program and borrowercharacteristics such as loan type and borrower creditworthiness. Increases inour estimates of defaults, prepayments and discount rates, increases in thespread between LIBOR and auction rate indices as well as decreases in defaultrecovery rates and the multi-year forward estimates of the LIBOR rate, which isthe reference rate for the loan assets and borrowings of the securitizationtrusts, would have a negative effect on the value of our additional structuraladvisory fees and residuals. For an analysis of the estimated change in ourstructural advisory fees and residuals receivables balance at September 30,2005 based on changes in these loan performance assumptions, see “Management’sDiscussion and Analysis of Financial Conditions and Results of Operations—ExecutiveSummary—Application of Critical Accounting Policies and Estimates—ServiceRevenue—Sensitivity Analysis.”

 

**Item4—Controls and Procedures**

 

Ourmanagement, with the participation of our chief executive officer and chieffinancial officer, evaluated the effectiveness of our disclosure controls andprocedures as of September 30, 2005. The term “disclosure controls andprocedures,” as defined in Rules 13a-15(e) and 15d-15(e) underthe Exchange Act, means controls and other procedures of a company that aredesigned to ensure that information required to be disclosed by us in thereports that we file or submit under the Exchange Act is recorded, processed,summarized and reported, within the time periods specified in the SEC’s rules andforms. Disclosure controls and procedures include, without limitation, controlsand procedures designed to ensure that information required to be disclosed bya company in the reports that it files or submits under the Exchange Act isaccumulated and communicated to the company’s management, including itsprincipal executive and principal financial officers, as appropriate to allowtimely decisions regarding required disclosure. Management recognizes that anycontrols and procedures, no matter how well designed and operated, can provideonly reasonable assurance of achieving their objectives and managementnecessarily applies its judgment in evaluating the cost-benefit relationship ofpossible controls and procedures. Based on the evaluation of our disclosurecontrols and procedures as of September 30, 2005, our chief executiveofficer and chief financial officer concluded that, as of such date, ourdisclosure controls and procedures were effective at the reasonable assurancelevel.

 

Nochange in our internal control over financial reporting occurred during thefiscal quarter ended September 30, 2005 that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

 

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**Part II.Other Information**

 

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

 

***(a) Recent Sales of Unregistered Securities***

 

None.

 

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

 

In our initial public offering,or IPO, we sold 7,906,250 shares of common stock, including an over-allotmentoption of 1,031,750 shares, pursuant to a registration statement on Form S-1(File No. 333-108531) that was declared effective by the SEC on October 30,2003.  We received in aggregate netproceeds of approximately $115.1 million, after deducting underwritingdiscounts and commissions of approximately $8.9 million and expenses of theoffering of approximately $2.5 million. From the effective date of the registration statement through September 30,2005, we have not spent any of the net proceeds from the IPO, which have beeninvested in cash and cash equivalents. Accordingly, none of the net proceeds of the IPO has been paid by us,directly or indirectly, to any director, officer, or general partner of us, orany of their associates, or to any person owing ten percent or more of anyclass of our equities securities or any of out affiliates.

 

In June 2004, wecompleted a follow-on public offering of 7,406,312 shares of our common stock,including an over-allotment option of 966,041 shares, pursuant to aregistration statement on Form S-1 (File No. 333-116142) that wasdeclared effective by the SEC on June 22, 2004.  All of these shares were offered by sellingstockholders, and we did not receive any of the proceeds from theoffering.  In January 2005, wecompleted a follow-on public offering of 3,933,605 shares of our common stock,including an over-allotment option of 513,078 shares, pursuant to aregistration statement on Form S-3 (File No. 333-120740 that wasdeclared effective on January 12, 2005. All of these shares were offeredby selling stockholders, and we did not receive any proceeds from the offering.

 

***(c) Issuer Purchases of Equity Securities***

 
| **Period**                                         | ** ** | **Total  number  of shares  purchased (1)** | ** ** | **Average  price  paid per share  (2)** | ** ** | **Total  number of  shares purchased  as part of  publicly  announced plans  or programs (1)** | ** ** | **Maximum  number  of shares that may  yet be purchased  under the plans or  programs** | ** ** |
|----------------------------------------------------|------------|---------------------------------------------|------------|-----------------------------------------|------------|------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|
| July 1,  2005 to July 31, 2005           |       | —                                      |       | —                                  |       | —                                                                                         |       | 31,000                                                                                  |       |
| August 1,  2005 to August 31, 2005       |       | 31,000                                      |       | $                                       | 30.78      |                                                                                           | 31,000     |                                                                                    | —     | (1) |
| September 1,  2005 to September 30, 2005 |       | —                                      |       | —                                  |       | —                                                                                         |       | 5,000,000                                                                               | (3)        |
| Total                                              |       | 31,000                                      |       | $                                       | 30.78      |                                                                                           | 31,000     |                                                                                    | 5,000,000  | (3) |

 

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(1)         On April 29, 2005, we announced a repurchase program of up to 1,000,000shares of our common stock. On June 2, 2005, we announced that our boardof directors had authorized the repurchase of up to an additional 500,000shares of our common stock. Following the repurchases completed in August 2005,we had repurchased an aggregate of 1,500,000 shares of our common stockpursuant to these repurchase programs, including 1,469,000 shares repurchasedduring the fourth quarter of fiscal 2005 and previously reported.

 

(2)         Average price paid per share excludes commissions that we paid to the brokersthat effected these repurchases.

 

(3)         On September 29, 2005, we announced a repurchase program of up to5,000,000 shares of our common stock. This repurchase program does not have afixed expiration date.

 

**Item5—Other Information**

 

In connection with the receipt of bonuses for fiscal2005, all executive officers who had not previously signed and delivered ourform Invention, Non-Disclosure, Non-Competition and Non-Solicitation Agreement,which we refer to as our non-competition agreement,

 

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were required tosign the non-competition agreement.  Thenon-competition agreement provides for (i) the confidentiality of ourproprietary information, (ii) the assignment to us of all inventions anddevelopments created during the course of employment with us and (iii) theprohibition on competition with our business or the solicitation of ouremployees while employed by us and for a period of one year after terminationof employment.  This summary is qualifiedin its entirety by the form of non-competition agreement attached hereto asexhibit 10.2.

 

On November 7, 2005, we entered into a letteragreement with John Hupalo, our Executive Vice President, Group Head CapitalMarkets, amending the letter agreement between Mr. Hupalo and us, dated February 24,2003, relating to the terms of Mr. Hupalo’s employment with us.  Under the terms of the amended agreement, if Mr. Hupalo’semployment is terminated by us without cause, he will be entitled to (a) apayment equal to his base salary for one year and (b) continuation ofbenefits for one year.  Mr. Hupaloentered into our form non-competition agreement in consideration for theseverance benefits provided for in the amended agreement.

 

**Item6—Exhibits**

 

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

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
| ** **                   | **THE  FIRST MARBLEHEAD CORPORATION** |
|------------------------------|---------------------------------------|
| ** **                   | ** **                            |
| Date: November 8,  2005 | By:                                   |   |
|                         |                                  |  /s/ Donald R. Peck |   |
|                         |                                  |  Donald R. Peck |
|                         |                                  | * Executive  Vice President,* |
|                         |                                  | * Chief  Financial Officer, Treasurer and Secretary* |
|                         |                                  |   |
|                         |                                  | *   (Duly  authorized officer and principal financial officer)* |

 

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**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                         |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                                    |
| 10.1†          |       | Fifth supplement, dated  October 6, 2005, to Master Loan Guaranty Agreement dated  February 2, 2001, as amended and extended, between the Registrant and  The Educational Resources Institute, Inc.                      |
| 10.2                |       | Form of Invention,  Non-Disclosure, Non-Competition and Non-Solicitation Agreement                                                                                                                                                 |
| 10.3                |       | Letter Agreement  between the Registrant and John Hupalo, dated November 7, 2005                                                                                                                                                   |
| 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. |
|                |       |                                                                                                                                                                                                                                    |
|                     |
| †              |       | Confidential treatment  has been requested for certain provisions of this Exhibit pursuant to  Rule 24b-2 promulgated under the Securities Exchange Act of 1934.                                                              |

 

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