NELNET INC 10-Q

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK (All dollars are in thousands, except share amounts, unless otherwise noted) Interest Rate Risk The Company’s primary market risk exposure arises from fluctuations in its borrowing and lending rates, the spread between which could impact the Company due to shifts in market interest rates. The following table sets forth the Company’s loan assets and debt instruments by rate characteristics: As of September 30, 2020 As of December 31, 2019 Dollars Percent Dollars Percent Fixed-rate loan assets $ 8,632,613 44.2 % $ 3,647,365 17.5 % Variable-rate loan assets 10,886,953 55.8 17,151,354 82.5 Total $ 19,519,566 100.0 % $ 20,798,719 100.0 % Fixed-rate debt instruments $ 979,109 5.0 % $ 562,203 2.7 % Variable-rate debt instruments 18,483,288 95.0 20,240,977 97.3 Total $ 19,462,397 100.0 % $ 20,803,180 100.0 % FFELP loans originated prior to April 1, 2006 generally earn interest at the higher of the borrower rate, which is fixed over a period of time, or a floating rate based on the special allowance payment ("SAP") formula set by the Department. The SAP rate is based on an applicable index plus a fixed spread that depends on loan type, origination date, and repayment status. The Company generally finances its student loan portfolio with variable rate debt. In low and/or declining interest rate environments, when the fixed borrower rate is higher than the SAP rate, the Company’s student loans earn at a fixed rate while the interest on the variable rate debt typically continues to reflect the low and/or declining interest rates. In these interest rate environments, the Company may earn additional spread income that it refers to as floor income. Depending on the type of loan and when it was originated, the borrower rate is either fixed to term or is reset to an annual rate each July 1. As a result, for loans where the borrower rate is fixed to term, the Company may earn floor income for an extended period of time, which the Company refers to as fixed rate floor income, and for those loans where the borrower rate is reset annually on July 1, the Company may earn floor income to the next reset date, which the Company refers to as variable rate floor income. All FFELP loans first originated on or after April 1, 2006 effectively earn at the SAP rate, since lenders are required to rebate fixed rate floor income and variable rate floor income for those loans to the Department. As a result of the significant drop in interest rates in March 2020 and the first half of the second quarter of 2020, the Company earned $4.8 million of variable-rate floor income on approximately $1.4 billion of FFELP loans during the six months ended June 30, 2020. Since the borrower rate reset on July 1, 2020, the Company no longer earns such variable-rate floor income on these loans, reflecting the lower interest rate environment. No variable-rate floor income was earned by the Company in 2019. A summary of fixed rate floor income earned by the Company follows. Three months ended September 30, Nine months ended September 30, 2020 2019 2020 2019 Fixed rate floor income, gross $ 36,633 12,685 87,258 33,950 Derivative settlements (a) (3,588) 7,064 (2,772) 35,931 Fixed rate floor income, net $ 33,045 19,749 84,486 69,881 (a) Derivative settlements consist of settlements (paid) received related to the Company's derivatives used to hedge student loans earning fixed rate floor income. Gross fixed rate floor income increased for the three and nine months ended September 30, 2020 as compared to the same periods in 2019 due to lower interest rates in 2020 as compared to 2019. Absent the use of derivative instruments, a rise in interest rates will reduce the amount of floor income received and has an impact on earnings due to interest margin compression caused by increasing financing costs, until such time as the federally insured loans earn interest at a variable rate in accordance with their SAP formulas. In higher interest rate environments, where the interest rate rises above the borrower rate and fixed rate loans effectively become variable rate loans, the impact of the rate fluctuations is reduced. 66 The decrease in net derivative settlements (paid) received from the floor income interest rate swaps for the three and nine months ended September 30, 2020 as compared to the same periods in 2019 was due to a decrease in the notional amount of derivatives outstanding and a decrease in interest rates. The following graph depicts fixed rate floor income for a borrower with a fixed rate of 6.75% and a SAP rate of 2.64%: The following table shows the Company’s federally insured student loan assets that were earning fixed rate floor income as of September 30, 2020. Fixed interest rate range Borrower/lender weighted average yield Estimated variable conversion rate (a) Loan balance < 3.0% 2.88 % 0.24 % $ 1,187,724 3.0 - 3.49% 3.19 % 0.55 % 1,492,759 3.5 - 3.99% 3.65 % 1.01 % 1,448,423 4.0 - 4.49% 4.20 % 1.56 % 1,079,025 4.5 - 4.99% 4.71 % 2.07 % 675,545 5.0 - 5.49% 5.22 % 2.58 % 445,530 5.5 - 5.99% 5.67 % 3.03 % 298,883 6.0 - 6.49% 6.19 % 3.55 % 345,881 6.5 - 6.99% 6.70 % 4.06 % 340,012 7.0 - 7.49% 7.17 % 4.53 % 122,688 7.5 - 7.99% 7.71 % 5.07 % 222,253 8.0 - 8.99% 8.18 % 5.54 % 523,747 > 9.0% 9.05 % 6.41 % 202,584 $ 8,385,054 (a) The estimated variable conversion rate is the estimated short-term interest rate at which loans would convert to a variable rate. As of September 30, 2020, the weighted average estimated variable conversion rate was 1.93% and the short-term interest rate was 17 basis points. 67 The following table summarizes the outstanding derivative instruments as of September 30, 2020 used by the Company to economically hedge loans earning fixed rate floor income. Maturity Notional amount Weighted average fixed rate paid by the Company (a)(c) 2021 $ 600,000 2.15 % 2022 (b) 500,000 0.94 2023 400,000 1.00 2024 250,000 0.28 $ 1,750,000 1.28 % (a) For all interest rate derivatives, the Company receives discrete three-month LIBOR. (b) $250.0 million of these derivatives have forward effective start dates in June 2021. (c) Excluding the derivatives with forward effective start dates, the weighted average fixed rate paid by the Company as of September 30, 2020 on its $1.5 billion floor income derivative portfolio was 1.21%. The Company is also exposed to interest rate risk in the form of basis risk and repricing risk because the interest rate characteristics of the Company’s assets do not match the interest rate characteristics of the funding for those assets. The following table presents the Company’s FFELP student loan assets and related funding for those assets arranged by underlying indices as of September 30, 2020. Index Frequency of variable resets Assets Funding of student loan assets 1 month LIBOR (a) Daily $ 17,778,799 — 3 month H15 financial commercial paper Daily 760,997 — 3 month Treasury bill Daily 605,783 — 1 month LIBOR Monthly — 10,580,507 3 month LIBOR (a) Quarterly — 6,684,928 Fixed rate — — 939,132 Auction-rate (b) Varies — 751,675 Asset-backed commercial paper (c) Varies — 145,149 Other (d) — 1,247,145 1,291,333 $ 20,392,724 20,392,724 (a) The Company has certain basis swaps outstanding in which the Company receives three-month LIBOR and pays one-month LIBOR plus or minus a spread as defined in the agreements (the "1:3 Basis Swaps"). The Company entered into these derivative instruments to better match the interest rate characteristics on its student loan assets and the debt funding such assets. The following table summarizes the 1:3 Basis Swaps outstanding as of September 30, 2020. Maturity Notional amount (i) 2021 $ 250,000 2022 2,000,000 2023 750,000 2024 1,750,000 2026 1,150,000 2027 250,000 $ 6,150,000 (i) The weighted average rate paid by the Company on the 1:3 Basis Swaps as of September 30, 2020 was one-month LIBOR plus 9.1 basis points. (b) As of September 30, 2020, the Company was sponsor for $751.7 million of outstanding asset-backed securities that were set and provide for interest rates to be periodically reset via a "dutch auction" (“Auction Rate Securities”). Since the auction feature has essentially been inoperable for substantially all auction rate securities since 2008, the Auction Rate Securities generally pay interest to the holder at a maximum rate as defined by the indenture. While these rates will vary, they will generally be based on a spread to LIBOR or Treasury Securities, or the Net Loan Rate as defined in the financing documents. (c) The interest rates on the Company's warehouse facilities are indexed to asset-backed commercial paper rates. (d) Assets include accrued interest receivable and restricted cash. Funding represents overcollateralization (equity) and other liabilities included in FFELP asset-backed securitizations and warehouse facilities. There is significant uncertainty regarding the availability of LIBOR as a benchmark rate after 2021, and any market transition away from the current LIBOR framework could result in significant changes to the interest rate characteristics of the Company's LIBOR-indexed assets and funding for those assets. See Item 1A, "Risk Factors - Loan Portfolio - Interest rate risk - replacement of LIBOR as a benchmark rate" in the Company's 2019 Annual Report. 68 Sensitivity Analysis The following tables summarize the effect on the Company’s earnings, based upon a sensitivity analysis performed by the Company assuming hypothetical increases in interest rates of 100 basis points and 300 basis points while funding spreads remain constant. In addition, a sensitivity analysis was performed assuming the funding index increases 10 basis points and 30 basis points while holding the asset index constant, if the funding index is different than the asset index. The sensitivity analysis was performed on the Company’s variable rate assets (including loans earning fixed rate floor income) and liabilities. The analysis includes the effects of the Company’s derivative instruments in existence during these periods. Interest rates Asset and funding index mismatches Change from increase of 100 basis points Change from increase of 300 basis points Increase of 10 basis points Increase of 30 basis points Dollars Percent Dollars Percent Dollars Percent Dollars Percent Three months ended September 30, 2020 Effect on earnings: Decrease in pre-tax net income before impact of derivative settlements $ (16,328) (18.1) % $ (31,947) (35.4) % $ (1,737) (1.9) % $ (5,212) (5.7) % Impact of derivative settlements 2,643 2.9 7,930 8.8 1,546 1.7 4,638 5.1 Increase (decrease) in net income before taxes $ (13,685) (15.2) % $ (24,017) (26.6) % $ (191) (0.2) % $ (574) (0.6) % Increase (decrease) in basic and diluted earnings per share $ (0.27) $ (0.47) $ — $ (0.01) Three months ended September 30, 2019 Effect on earnings: Decrease in pre-tax net income before impact of derivative settlements $ (6,119) (14.6) % $ (12,330) (29.4) % $ (2,343) (5.6) % $ (7,029) (16.7) % Impact of derivative settlements 6,932 16.5 20,795 49.6 1,613 3.8 4,839 11.5 Increase (decrease) in net income before taxes $ 813 1.9 % $ 8,465 20.2 % $ (730) (1.8) % $ (2,190) (5.2) % Increase (decrease) in basic and diluted earnings per share $ 0.02 $ 0.16 $ (0.01) $ (0.04) Nine months ended September 30, 2020 Effect on earnings: Decrease in pre-tax net income before impact of derivative settlements $ (42,577) (28.7) % $ (79,919) (53.9) % $ (5,491) (3.7) % $ (16,479) (11.1) % Impact of derivative settlements 8,859 6.0 26,577 17.9 4,566 3.1 13,698 9.2 Increase (decrease) in net income before taxes $ (33,718) (22.7) % $ (53,342) (36.0) % $ (925) (0.6) % $ (2,781) (1.9) % Increase (decrease) in basic and diluted earnings per share $ (0.65) $ (1.03) $ (0.02) $ (0.05) Nine months ended September 30, 2019 Effect on earnings: Decrease in pre-tax net income before impact of derivative settlements $ (15,042) (11.9) % $ (28,881) (22.9) % $ (7,343) (5.8) % $ (22,028) (17.5) % Impact of derivative settlements 23,122 18.4 69,366 55.1 5,167 4.1 15,501 12.3 Increase (decrease) in net income before taxes $ 8,080 6.5 % $ 40,485 32.2 % $ (2,176) (1.7) % $ (6,527) (5.2) % Increase (decrease) in basic and diluted earnings per share $ 0.15 $ 0.77 $ (0.04) $ (0.12) Financial Statement Impact – Derivatives For a table summarizing the effect of derivative instruments in the consolidated statements of income, including the components of "derivative market value adjustments and derivative settlements, net" included in the consolidated statements of income, see note 4 of the notes to consolidated financial statements included under Part I, Item 1 of this report. 69