NELNET INC 10-Q

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK (All dollars are in thousands, except share amounts, unless otherwise noted) LIBOR Transition On June 30, 2023, the LIBOR administrator ceased publication (on a representative basis) of all USD LIBOR rates. When possible, the Company relied on fallback provisions or negotiated with counterparties to transition financial contracts from LIBOR to SOFR. Due to certain noteholder consent requirements, it was not practicable to modify certain of the Company's 70 asset-backed securities transactions. The SAP formula for the Company's FFELP loans, the majority of which were indexed to one-month LIBOR, were not able to be modified without legislative action. On March 15, 2022, the Adjustable Interest Rate (LIBOR) Act (the LIBOR Act) was signed into law. The LIBOR Act provides that for contracts that contain no fallback provision or contain fallback provisions that do not identify a specific USD LIBOR benchmark replacement (including the SAP formula for FFELP loans), a benchmark replacement based on SOFR will automatically replace the USD LIBOR benchmark in the contract after June 30, 2023. Following the enactment and implementation of the LIBOR Act, all of the Company's financial instruments which were indexed to USD LIBOR transitioned to SOFR after June 30, 2023. Specifically, after June 30, 2023, the SAP formula for FFELP loans transitioned to 30-day Average SOFR and the Company's LIBOR-indexed FFELP asset-backed securities also transitioned to a short-term SOFR index. The Company does not expect the transition from LIBOR to SOFR to significantly impact its asset-backed securitization cash flow forecast as discussed under Part I, Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Liquidity Needs and Sources of Liquidity Available to Satisfy Debt Obligations Secured by Loan Assets and Related Collateral - Bonds and Notes Issued in Asset-backed Securitizations." The Company's LIBOR-indexed derivatives transitioned to the fallback rate (SOFR) as defined in the individual agreements and/or published industry guidelines, as applicable. The market transition away from the previous LIBOR framework could result in significant changes to the interest rate characteristics of the Company's prior LIBOR-indexed assets and funding for those assets. The Company is still uncertain as to the long-term relationship between overnight SOFR and Term SOFR as they are new indices, and the Company's assumptions with respect to this relationship may evolve over time. To the extent that the spread between these indices were to widen, it could adversely impact future interest income earned on the Company's FFELP student loan portfolio. For a discussion of the risks related to the LIBOR transition, see Item 1A, "Risk Factors - Loan Portfolio - Interest rate risk - replacement of LIBOR as a benchmark rate" in the Company's 2022 Annual Report for additional information. 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, 2023 As of December 31, 2022 Dollars Percent Dollars Percent Fixed-rate loan assets $ 601,169 4.7 % $ 1,339,900 9.5 % Variable-rate loan assets 12,134,452 95.3 12,829,871 90.5 Total $ 12,735,621 100.0 % $ 14,169,771 100.0 % Fixed-rate debt instruments $ 514,023 4.2 % $ 617,083 4.5 % Variable-rate debt instruments 11,688,063 95.8 13,199,327 95.5 Total $ 12,202,086 100.0 % $ 13,816,410 100.0 % 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 2023 or 2022. 71 A summary of fixed rate floor income earned by the AGM operating segment follows. Three months ended September 30, Nine months ended September 30, 2023 2022 2023 2022 Fixed rate floor income, gross $ 450 7,585 2,016 54,870 Derivative settlements (a) 235 11,356 22,760 11,843 Fixed rate floor income, net $ 685 18,941 24,776 66,713 (a) Derivative settlements consist of settlements received 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, 2023 compared with the same periods in 2022 due to higher interest rates in 2023 compared with 2022. The Company had a significant portfolio of derivative instruments in which the Company paid a fixed rate and received a floating rate to economically hedge loans earning fixed rate floor income. On March 15, 2023, to minimize the Company's exposure to market volatility, the Company terminated its entire derivative portfolio hedging loans earning fixed rate floor income ($2.8 billion in notional amount of derivatives). Through March 15, 2023, the Company had received cash or had a receivable from its clearinghouse related to variation margin equal to the fair value of the $2.8 billion notional amount of fixed rate floor derivatives as of March 15, 2023 of $183.2 million, which included $19.1 million related to current period settlements. The decrease in net derivative settlements received by the Company during the three months ended September 30, 2023, compared with the same period in 2022, was due to the termination of the fixed rate floor derivatives in March 2023. The increase in net derivative settlements received by the Company during the nine months ended September 30, 2023, compared with the same period in 2022, was due to an increase in settlements on the Company's derivatives outstanding during this period as a result of an increase in interest rates. The following table shows AGM’s federally insured student loan assets that were earning fixed rate floor income as of September 30, 2023. Fixed interest rate range Borrower/lender weighted average yield Estimated variable conversion rate (a) Loan balance 8.0 - 8.99% 8.24% 5.60% $ 209,696 > 9.0% 9.05% 6.41% 127,221 $ 336,917 (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, 2023, the weighted average estimated variable conversion rate was 5.91% and the short-term interest rate was 541 basis points. In June 2023, the Company entered into a derivative with a notional amount of $50.0 million and a maturity date in 2030 to hedge a portion of loans remaining that earn fixed rate floor income. Based on the terms of this derivative, the Company pays a weighted average fixed rate of 3.44% and receives payments based on SOFR that resets quarterly. 72 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, 2023. Index Frequency of variable resets Assets Funding of student loan assets 30 day Average SOFR (a) (b) Daily $ 11,513,858 — 3 month H15 financial commercial paper Daily 396,323 — 3 month Treasury bill Daily 388,803 — 30 day Average SOFR / 1 month CME Term SOFR (a) Monthly — 6,932,106 90 day Average SOFR / 3 month CME Term SOFR (a) (b) Quarterly — 3,096,170 Asset-backed commercial paper (c) Varies — 1,466,178 Fixed rate — — 497,397 Auction-rate (d) Varies — 89,910 Other (e) — 1,197,776 1,414,999 $ 13,496,760 13,496,760 (a) Transitioned from LIBOR to SOFR after June 30, 2023. See "LIBOR Transition" above. (b) The Company has certain basis swaps outstanding in which the Company received three-month LIBOR set discretely in advance and paid one-month LIBOR plus or minus a spread as defined in the agreements (the "1:3 Basis Swaps"). Subsequent to the discontinuation of LIBOR on June 30, 2023, the Company now receives and pays the term adjusted SOFR plus the tenor spread adjustment relating to LIBOR. 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, 2023. Maturity Notional amount (i) 2024 $ 1,750,000 2026 1,150,000 2027 250,000 $ 3,150,000 (i) The weighted average rate paid by the Company on the 1:3 Basis Swaps as of September 30, 2023 was the term adjusted SOFR plus the tenor spread adjustment relating to LIBOR plus 10.1 basis points. (c) The interest rate on the Company's FFELP warehouse facilities is indexed to asset-backed commercial paper rates. (d) As of September 30, 2023, the Company was sponsor for $89.9 million of outstanding asset-backed securities that were set and provide for interest rates to be periodically reset via a "dutch auction" (the “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 SOFR or Treasury Securities, or the Net Loan Rate as defined in the financing documents. (e) Assets include accrued interest receivable and restricted cash. Funding represents overcollateralization (equity) and other liabilities included in FFELP loan asset-backed securitizations and warehouse facility. 73 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 and decreases 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. Interest rates Change from increase of 100 basis points Change from increase of 300 basis points Change from decrease of 100 basis points Change from decrease of 300 basis points Dollars Percent Dollars Percent Dollars Percent Dollars Percent Three months ended September 30, 2023 Effect on earnings: Increase (decrease) in pre-tax net income before impact of derivative settlements $ 522 1.0 % $ 2,093 4.0 % $ 2,166 4.1 % $ 9,199 17.4 % Impact of derivative settlements (a) 126 0.2 378 0.7 (126) (0.2) (378) (0.7) Increase (decrease) in net income before taxes $ 648 1.2 % $ 2,471 4.7 % $ 2,040 3.9 % $ 8,821 16.7 % Increase (decrease) in basic and diluted earnings per share $ 0.01 $ 0.05 $ 0.04 $ 0.18 Three months ended September 30, 2022 Effect on earnings: Increase (decrease) in pre-tax net income before impact of derivative settlements $ (2,396) (1.9) % $ (3,702) (2.9) % Impact of derivative settlements 6,553 5.2 19,660 15.5 Increase (decrease) in net income before taxes $ 4,157 3.3 % $ 15,958 12.6 % Increase (decrease) in basic and diluted earnings per share $ 0.08 $ 0.32 Nine months ended September 30, 2023 Effect on earnings: Increase (decrease) in pre-tax net income before impact of derivative settlements $ 2,006 1.8 % $ 9,525 8.4 % $ 2,556 2.2 % $ 16,611 14.6 % Impact of derivative settlements (a) 159 0.1 477 0.4 (159) (0.1) (477) (0.4) Increase (decrease) in net income before taxes $ 2,165 1.9 % $ 10,002 8.8 % $ 2,397 2.1 % $ 16,134 14.2 % Increase (decrease) in basic and diluted earnings per share $ 0.04 $ 0.20 $ 0.05 $ 0.33 Nine months ended September 30, 2022 Effect on earnings: Increase (decrease) in pre-tax net income before impact of derivative settlements $ (18,464) (3.9) % $ (31,854) (6.7) % Impact of derivative settlements 25,008 5.3 75,025 15.8 Increase (decrease) in net income before taxes $ 6,544 1.4 % $ 43,171 9.1 % Increase (decrease) in basic and diluted earnings per share $ 0.13 $ 0.87 (a) On March 15, 2023, the Company terminated its existing derivative portfolio hedging loans earning fixed rate floor income. The table above excludes the impact of these derivatives for the entire period. 74 Asset and funding index mismatches Increase of 10 basis points Increase of 30 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, 2023 Three months ended September 30, 2022 Effect on earnings: Increase (decrease) in pre-tax net income before impact of derivative settlements $ (1,167) (2.2) % $ (3,501) (6.6) % $ (1,148) (0.9) % $ (3,445) (2.7) % Impact of derivative settlements 794 1.5 2,382 4.5 1,235 1.0 3,705 2.9 Increase (decrease) in net income before taxes $ (373) (0.7) % $ (1,119) (2.1) % $ 87 0.1 % $ 260 0.2 % Increase (decrease) in basic and diluted earnings per share $ (0.01) $ (0.02) $ 0.00 $ 0.01 Nine months ended September 30, 2023 Nine months ended September 30, 2022 Effect on earnings: Increase (decrease) in pre-tax net income before impact of derivative settlements $ (3,462) (3.0) % $ (10,387) (9.1) % $ (3,609) (0.8) % $ (10,828) (2.3) % Impact of derivative settlements 2,356 2.1 7,068 6.2 3,912 0.8 11,733 2.5 Increase (decrease) in net income before taxes $ (1,106) (0.9) % $ (3,319) (2.9) % $ 303 — % $ 905 0.2 % Increase (decrease) in basic and diluted earnings per share $ (0.02) $ (0.07) $ 0.01 $ 0.02 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 and the use of derivative instruments. The following table presents Nelnet Bank's loan assets, asset-backed security investments, and deposits by rate characteristics: As of September 30, 2023 As of December 31, 2022 Dollars Percent Dollars Percent Fixed-rate loan assets $ 400,639 $ 341,776 Fixed-rate investments 135,552 123,809 Total fixed-rate assets 536,191 50.5 % 465,585 52.2 % Variable-rate loan assets 68,174 78,019 Variable-rate investments 457,587 347,559 Total variable rate assets 525,761 49.5 425,578 47.8 Total assets $ 1,061,952 100.0 % $ 891,163 100.0 % Fixed-rate deposits $ 282,547 29.8 % $ 336,040 42.6 % Variable-rate deposits (a) 664,832 70.2 453,604 57.4 Total deposits $ 947,379 100.0 % $ 789,644 100.0 % (a) Nelnet Bank uses derivative instruments to hedge exposure to variability in cash flows of variable rate deposits to minimize the exposure to volatility in cash flows from future changes in interest rates. The derivatives are not reflected in the above table. See note 4 of the notes to the consolidated financial statements included under Part I, Item 1 of this report for a summary of Nelnet Bank's derivatives outstanding as of September 30, 2023. 75 Interest Rate and Market Risk - Investments The following table presents the rates earned on the Company’s available-for-sale debt securities (investments) and debt facilities used to fund a portion of such investments. The table below excludes securities (investments) held by Nelnet Bank. Average balance Interest income/ expense Average yields/ rates Average balance Interest income/ expense Average yields/ rates Nine months ended September 30, 2023 2022 Investments: Asset-backed securities available-for-sale (a) (b) $ 1,018,489 50,182 6.59 % $ 1,219,013 18,373 2.02 % Debt funding asset-backed securities available-for-sale: Participation agreement - variable rate (c) $ 154,295 6,206 5.38 % $ 336,109 5,088 2.02 % Repurchase agreements - variable rate (d) 421,266 18,653 5.92 452,813 5,247 1.55 $ 575,561 24,859 5.77 $ 788,922 10,335 1.75 (a) The Company has repurchased certain of its own asset-backed securities (bonds and notes payable) in the secondary market. For accounting purposes, these notes are eliminated in consolidation and are not included in the Company's consolidated financial statements. However, these securities remain legally outstanding at the trust level and the Company could sell these notes to third parties or redeem the notes at par as cash is generated by the trust estate. Upon a sale of these notes to third parties, the Company would obtain cash proceeds equal to the market value of the notes on the date of such sale. The table above includes these repurchased bonds. (b) The majority of the Company’s asset-backed securities earn floating rates with expected returns of approximately SOFR + 100 to 350 basis points to maturity. As of September 30, 2023, $257.5 million (par value) of the Company’s asset-backed securities earn a weighted average fixed rate of 3.52%. (c) Interest incurred by the Company on amounts borrowed under the participation agreement is at a variable rate of SOFR + 62.5 basis points. (d) Interest incurred by the Company on amounts borrowed under the repurchase agreements is at a variable rate of SOFR + 75 to 140 basis points. The Company’s portfolio of asset-backed investment securities has limited liquidity, and the Company could incur a significant loss if the investments were sold prior to maturity at an amount less than the original purchase price. As of September 30, 2023, the gross unrealized loss on the Company’s available-for-sale debt securities was $44.6 million, and the aggregate fair value of available-for-sale debt securities with unrealized losses was $717.1 million. The Company currently has the intent and ability to retain these investments, and none of the unrealized losses were due to credit losses. See note 5 of the notes to consolidated financial statements included under Part I, Item 1 of this report for additional information.