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 March 31, 2021 As of December 31, 2020 Dollars Percent Dollars Percent Fixed-rate loan assets $ 8,470,975 44.3 % $ 8,737,346 44.6 % Variable-rate loan assets 10,638,479 55.7 10,839,305 55.4 Total $ 19,109,454 100.0 % $ 19,576,651 100.0 % Fixed-rate debt instruments $ 951,143 5.0 % $ 960,327 4.9 % Variable-rate debt instruments 18,032,040 95.0 18,598,522 95.1 Total $ 18,983,183 100.0 % $ 19,558,849 100.0 % 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 FFELP 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 FFELP 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, the Company earned $0.9 million of variable-rate floor income on $1.4 billion of FFELP loans during the three months ended March 31, 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. A summary of fixed rate floor income earned by the Company follows. Three months ended March 31, 2021 2020 Fixed rate floor income, gross $ 35,539 18,758 Derivative settlements (a) (4,285) 2,125 Fixed rate floor income, net $ 31,254 20,883 (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 months ended March 31, 2021 as compared to the same period in 2020 due to lower interest rates in 2021 as compared to 2020. 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. The change from being in a net positive settlement position on such derivatives during the first quarter of 2020 to being in a net negative settlement position during the first quarter of 2021 was due to a decrease in interest rates. 54 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 March 31, 2021. Fixed interest rate range Borrower/lender weighted average yield Estimated variable conversion rate (a) Loan balance < 3.0% 2.88% 0.24% $ 1,148,014 3.0 - 3.49% 3.19% 0.55% 1,457,170 3.5 - 3.99% 3.65% 1.01% 1,399,853 4.0 - 4.49% 4.20% 1.56% 1,048,179 4.5 - 4.99% 4.71% 2.07% 652,729 5.0 - 5.49% 5.22% 2.58% 435,515 5.5 - 5.99% 5.67% 3.03% 292,332 6.0 - 6.49% 6.19% 3.55% 335,607 6.5 - 6.99% 6.70% 4.06% 328,879 7.0 - 7.49% 7.17% 4.53% 121,487 7.5 - 7.99% 7.71% 5.07% 221,019 8.0 - 8.99% 8.18% 5.54% 525,096 > 9.0% 9.05% 6.41% 198,084 $ 8,163,964 (a) The estimated variable conversion rate is the estimated short-term interest rate at which loans would convert to a variable rate. As of March 31, 2021, the weighted average estimated variable conversion rate was 1.94% and the short-term interest rate was 12 basis points. 55 The following table summarizes the outstanding derivative instruments as of March 31, 2021 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) 2021 $ 600,000 2.15 % 2022 (b) 500,000 0.94 2023 900,000 0.62 2024 (c) 2,500,000 0.35 2025 500,000 0.35 $ 5,000,000 0.67 % (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) $500.0 million of these derivatives have forward effective start dates in June 2021. 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 March 31, 2021. Index Frequency of variable resets Assets Funding of student loan assets 1 month LIBOR (a) Daily $ 17,313,992 — 3 month H15 financial commercial paper Daily 710,549 — 3 month Treasury bill Daily 580,842 — 1 month LIBOR Monthly — 10,446,455 3 month LIBOR (a) Quarterly — 6,269,914 Fixed rate — — 915,947 Auction-rate (b) Varies — 747,075 Asset-backed commercial paper (c) Varies — 247,018 Other (d) — 1,332,125 1,311,099 $ 19,937,508 19,937,508 (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 March 31, 2021. 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 March 31, 2021 was one-month LIBOR plus 9.1 basis points. (b) As of March 31, 2021, the Company was sponsor for $747.1 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. LIBOR is in the process of being discontinued as a benchmark rate, 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 "Interest Rate Risk - Replacement of LIBOR as a Benchmark Rate" under Item 2 above and Item 1A, "Risk Factors - Loan Portfolio - Interest rate risk - replacement of LIBOR as a benchmark rate" in the Company's 2020 Annual Report for additional information. 56 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 March 31, 2021 Effect on earnings: Decrease in pre-tax net income before impact of derivative settlements $ (14,282) (9.1) % $ (26,218) (16.6) % $ (1,605) (1.0) % $ (4,814) (3.1) % Impact of derivative settlements 9,130 5.8 27,390 17.3 1,516 1.0 4,549 2.9 Increase (decrease) in net income before taxes $ (5,152) (3.3) % $ 1,172 0.7 % $ (89) — % $ (265) (0.2) % Increase (decrease) in basic and diluted earnings per share $ (0.10) $ 0.02 $ — $ (0.01) Three months ended March 31, 2020 Effect on earnings: Decrease in pre-tax net income before impact of derivative settlements $ (9,915) (19.9) % $ (16,552) (33.2) % $ (1,974) (4.0) % $ (5,924) (11.9) % Impact of derivative settlements 4,351 8.7 13,053 26.2 1,591 3.2 4,774 9.6 Increase (decrease) in net income before taxes $ (5,564) (11.2) % $ (3,499) (7.0) % $ (383) (0.8) % $ (1,150) (2.3) % Increase (decrease) in basic and diluted earnings per share $ (0.11) $ (0.07) $ (0.01) $ (0.02) Financial Statement Impact – Derivatives For a table summarizing the effect of derivative instruments in the consolidated statements of operations, including the components of "derivative market value adjustments and derivative settlements, net" included in the consolidated statements of operations, see note 4 of the notes to consolidated financial statements included under Part I, Item 1 of this report.