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 - AGM Operating Segment AGM’s primary market risk exposure arises from fluctuations in its borrowing and lending rates, the spread between which could impact AGM due to shifts in market interest rates. The following table sets forth AGM’s loan assets and debt instruments by rate characteristics: As of September 30, 2022 As of December 31, 2021 Dollars Percent Dollars Percent Fixed-rate loan assets $ 2,015,443 13.6 % $ 7,434,068 42.6 % Variable-rate loan assets 12,778,572 86.4 10,007,722 57.4 Total $ 14,794,015 100.0 % $ 17,441,790 100.0 % Fixed-rate debt instruments $ 671,012 4.7 % $ 801,548 4.7 % Variable-rate debt instruments 13,622,627 95.3 16,279,722 95.3 Total $ 14,293,639 100.0 % $ 17,081,270 100.0 % 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. No variable-rate floor income was earned by the Company in 2022 or 2021. A summary of fixed rate floor income earned by the AGM operating segment follows. Three months ended September 30, Nine months ended September 30, 2022 2021 2022 2021 Fixed rate floor income, gross $ 7,585 35,850 54,870 108,029 Derivative settlements (a) 11,356 (5,209) 11,843 (14,648) Fixed rate floor income, net $ 18,941 30,641 66,713 93,381 (a) Derivative settlements consist of settlements received (paid) related to the Company's derivatives used to hedge student loans earning fixed rate floor income. Gross fixed rate floor income decreased for the three and nine months ended September 30, 2022 as compared to the same periods in 2021 due to higher interest rates in 2022 as compared to 2021. 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 Company enters into derivative instruments to hedge student loans earning fixed rate floor income. The increase in net derivative settlements received by the Company during the three and nine months ended September 30, 2022, as compared to net derivative settlements paid during the same periods in 2021, was due to an increase in interest rates, partially offset by a decrease in the notional amount of derivatives outstanding. 62 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 AGM’s federally insured student loan assets that were earning fixed rate floor income as of September 30, 2022. Fixed interest rate range Borrower/lender weighted average yield Estimated variable conversion rate (a) Loan balance 5.0 - 5.49% 5.35% 2.71% $ 177,056 5.5 - 5.99% 5.68% 3.04% 199,123 6.0 - 6.49% 6.19% 3.55% 245,508 6.5 - 6.99% 6.70% 4.06% 238,899 7.0 - 7.49% 7.17% 4.53% 87,432 7.5 - 7.99% 7.72% 5.08% 167,776 8.0 - 8.99% 8.18% 5.54% 390,549 > 9.0% 9.05% 6.41% 150,258 $ 1,656,601 (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, 2022, the weighted average estimated variable conversion rate was 4.41% and the short-term interest rate was 251 basis points. The following table summarizes the outstanding derivative instruments as of September 30, 2022 used by AGM to economically hedge loans earning fixed rate floor income. Maturity Notional amount Weighted average fixed rate paid by the Company (a) 2024 $ 2,000,000 0.35 % 2026 500,000 1.02 2031 100,000 1.53 $ 2,600,000 0.52 % (a) For all interest rate derivatives, the Company receives discrete three-month LIBOR. 63 AGM is also exposed to interest rate risk in the form of basis risk and repricing risk because the interest rate characteristics of AGM’s assets do not match the interest rate characteristics of the funding for those assets. The following table presents AGM’s FFELP student loan assets and related funding for those assets arranged by underlying indices as of September 30, 2022. Index Frequency of variable resets Assets Funding of student loan assets 1 month LIBOR (a) Daily $ 13,345,170 — 3 month H15 financial commercial paper Daily 509,155 — 3 month Treasury bill Daily 446,066 — 1 month LIBOR Monthly — 8,933,130 3 month LIBOR (a) Quarterly — 4,122,979 Fixed rate — — 646,956 Asset-backed commercial paper (b) Varies — 249,543 Auction-rate (c) Varies — 208,660 Other (d) — 1,493,406 1,632,529 $ 15,793,797 15,793,797 (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, 2022. Maturity Notional amount (i) 2022 $ 1,000,000 2023 750,000 2024 1,750,000 2026 1,150,000 2027 250,000 $ 4,900,000 (i) The weighted average rate paid by the Company on the 1:3 Basis Swaps as of September 30, 2022 was one-month LIBOR plus 9.4 basis points. (b) The interest rate on the Company's FFELP warehouse facility is indexed to asset-backed commercial paper rates. (c) As of September 30, 2022, the Company was sponsor for $208.7 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. (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 the 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 - Repayment 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 2021 Annual Report for additional information. 64 Sensitivity Analysis The following tables summarize the effect on the Company’s consolidated earnings, based upon a sensitivity analysis performed on AGM's assets and liabilities 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 AGM’s variable rate assets (including loans earning fixed rate floor income) and liabilities. The analysis includes the effects of AGM’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, 2022 Effect on earnings: Decrease in pre-tax net income before impact of derivative settlements $ (2,396) (1.9) % $ (3,702) (2.9) % $ (1,148) (0.9) % $ (3,445) (2.7) % Impact of derivative settlements 6,553 5.2 19,660 15.5 1,235 1.0 3,705 2.9 Increase (decrease) in net income before taxes $ 4,157 3.3 % $ 15,958 12.6 % $ 87 0.1 % $ 260 0.2 % Increase (decrease) in basic and diluted earnings per share $ 0.08 $ 0.32 $ 0.00 $ 0.01 Three months ended September 30, 2021 Effect on earnings: Decrease in pre-tax net income before impact of derivative settlements $ (14,394) (21.5) % $ (27,280) (40.8) % $ (1,484) (2.2) % $ (4,453) (6.7) % Impact of derivative settlements 12,252 18.3 36,756 55.0 1,487 2.2 4,461 6.7 Increase (decrease) in net income before taxes $ (2,142) (3.2) % $ 9,476 14.2 % $ 3 0.0 % $ 8 0.0 % Increase (decrease) in basic and diluted earnings per share $ (0.04) $ 0.19 $ 0.00 $ 0.00 Nine months ended September 30, 2022 Effect on earnings: Decrease in pre-tax net income before impact of derivative settlements $ (18,464) (3.9) % $ (31,854) (6.7) % $ (3,609) (0.8) % $ (10,828) (2.3) % Impact of derivative settlements 25,008 5.3 75,025 15.8 3,912 0.8 11,733 2.5 Increase (decrease) in net income before taxes $ 6,544 1.4 % $ 43,171 9.1 % $ 303 0.0 % $ 905 0.2 % Increase (decrease) in basic and diluted earnings per share $ 0.13 $ 0.87 $ 0.00 $ 0.02 Nine months ended September 30, 2021 Effect on earnings: Decrease in pre-tax net income before impact of derivative settlements $ (42,749) (12.8) % $ (79,285) (23.7) % $ (4,659) (1.4) % $ (13,980) (4.2) % Impact of derivative settlements 30,944 9.3 92,831 27.8 4,474 1.3 13,423 4.0 Increase (decrease) in net income before taxes $ (11,805) (3.5) % $ 13,546 4.1 % $ (185) (0.1) % $ (557) (0.2) % Increase (decrease) in basic and diluted earnings per share $ (0.23) $ 0.27 $ 0.00 $ (0.01) 65 Interest Rate Risk - Nelnet Bank To manage Nelnet Bank's risk from fluctuations in market interest rates, the Company actively monitors interest rates and other interest sensitive components to minimize the impact that changes in interest rates have on the fair value of assets, net income, and cash flow. To achieve this objective, the Company manages and mitigates Nelnet Bank's exposure to fluctuations in market interest rates through several techniques, including managing the maturity, repricing, and mix of fixed and variable rate assets and liabilities. The following table presents Nelnet Bank's loan assets and deposits by rate characteristics: As of September 30, 2022 As of December 31, 2021 Dollars Percent Dollars Percent Fixed-rate loan assets $ 343,653 80.0 % $ 191,410 74.2 % Variable-rate loan assets 85,823 20.0 66,491 25.8 Total $ 429,476 100.0 % $ 257,901 100.0 % Fixed-rate deposits $ 372,015 49.5 % $ 344,315 80.9 % Variable-rate deposits 379,355 50.5 81,085 19.1 Total $ 751,370 100.0 % $ 425,400 100.0 %