TMCnet News
FIRST MARBLEHEAD CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion and analysis of our financial condition and results of operations together with our unaudited consolidated financial statements and accompanying notes included in Part I of this quarterly report and in conjunction with our audited consolidated financial statements included in our annual report on Form 10-K for fiscal 2012 filed with the Securities and Exchange Commission, or SEC, on September 12, 2012, which we refer to as our Annual Report. Unless otherwise indicated, or unless the context of the discussion requires otherwise, we use the terms "we," "us," "our" and similar references to refer to The First Marblehead Corporation and its subsidiaries, on a consolidated basis. We use the terms "First Marblehead" or "FMD" to refer to The First Marblehead Corporation on a stand-alone basis. We use the term "education loans" to refer to private education loans, which are not guaranteed by the federal government. Our fiscal year ends on June 30, and we identify our fiscal years by the calendar years in which they end. For example, we refer to the fiscal year ending June 30, 2013 as "fiscal 2013." Factors That May Affect Future Results In addition to historical information, this quarterly report includes forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act, and Section 27A of the Securities Act of 1933, as amended. For this purpose, any statements contained herein regarding our strategy, future operations and products, financial performance and liquidity, future funding transactions, projected costs, projected loan portfolio performance, future market position, prospects, plans and outlook of management, other than statements of historical facts, are forward-looking statements. The words "anticipates," "believes," "estimates," "expects," "intends," "may," "observe," "plans," "projects," "will," "would," and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We cannot guaranty that we actually will achieve the results, plans, intentions or expectations expressed or implied in our forward-looking statements, which involve risks, assumptions and uncertainties. There are a number of important factors that could cause actual results, timing of events, levels of activity or performance to differ materially from those expressed or implied in the forward-looking statements we make. These important factors include our "critical accounting estimates" set forth below under "-Critical Accounting Policies and Estimates" and factors including, but not limited to, those set forth under the caption "Risk Factors" in Item 1A of Part II of this quarterly report. Although we may elect to update forward-looking statements in the future, we specifically disclaim any obligation to do so, even if our estimates change, and readers should not rely on those forward-looking statements as representing our views as of any date subsequent to November 8, 2012. Executive Summary Overview We are a specialty finance company focused on the education financing marketplace. We provide loan programs for K-12, undergraduate and graduate students, as well as tuition planning, tuition billing, refund management and payment technology services in the United States. We offer a fully integrated suite of services through our Monogram® loan product service platform, which we refer to as the Monogram platform, as well as certain services on a stand-alone, fee-for-service basis. We partner with lenders to design and administer education loan programs through our Monogram platform, which are school-certified and designed to be marketed through educational institutions or to prospective student borrowers and their families directly and designed to generate portfolios intended to be held by the originating lender or financed in the capital markets. We also offer a number of ancillary services in support of our clients, including loan origination, retail banking, portfolio management and securitization services. These offerings are part of a change in our revenue model that we have been implementing since fiscal 2009 to focus on fee-based revenues. Our long-term success depends on the continued development of our four principal revenue lines: • Partnered lending-We provide customized Monogram-based education loan programs for lenders who wish to hold originated portfolios to maturity. We are paid for our origination and marketing services at the time approved education loans are disbursed and receive monthly payments for portfolio management services, credit enhancement and administrative services throughout the life of the loan. We may provide credit enhancements by funding participation interest accounts, which we refer to as participation accounts, or, in the case of our subsidiary Union Federal Savings Bank, which we refer to as Union Federal®, deposit accounts, to serve as a first loss reserve for defaulted program loans. In consideration for funding participation accounts, we are entitled to receive a share of the interest generated on the loans. • Banking services-Union Federal offers traditional retail banking products on a stand-alone basis. In addition, Union Federal generates additional revenues by originating Monogram-based education loan portfolios, subject to regulatory conditions, with the intent of holding them to maturity. • Capital markets-Our capital markets experience coupled with our loan performance database and risk analytics expertise provide specialized insight into funding options available to our clients. We have a right of first refusal should one of our partner lenders wish to sell some or all of its education loan portfolio prior to maturity. In addition to traditional asset-backed securitizations, funding options may also include whole loan sales or other financing alternatives. We can also earn fees for analytical and structuring work, on-going fees for portfolio management services and net interest income by retaining a portion of the equity in any of these transactions. • Fee-for-service-Loan origination, portfolio management, tuition billing and payment processing, and refund management services are each available on a stand-alone, fee-for-service basis. We offer outsourced tuition planning, tuition billing and payment technology services for universities, colleges and secondary schools through our subsidiary Tuition Management Systems LLC, which we refer to as TMS. 23 -------------------------------------------------------------------------------- Table of Contents Business Trends, Uncertainties and Outlook The following discussion of business trends, uncertainties and outlook focuses on certain developments affecting our business since the beginning of fiscal 2013. Loan Origination We began originating education loans based on our Monogram platform in the beginning of fiscal 2011 and providing services for two lender clients related to school-certified education loan programs funded by these lender clients based on our Monogram platform. During fiscal 2012, we began performing services for Union Federal related to school-certified education loan programs based on our Monogram platform, including a K-12 loan program. In June 2012, we launched a Monogram-based loan program with a new lender client and in August 2012, we launched a Monogram-based loan consolidation program with an existing client. Our Monogram platform continues to provide us with an opportunity to originate, administer, manage and finance education loans, and our lender clients' Monogram-based loan programs are a significant step in our return to the education financing marketplace. The following table presents our loan origination metrics with respect to our Monogram-based programs for the three months ended September 30, 2012 and 2011. We refer to loans that we have approved following receipt of all applicant data, including the signed credit agreement, required certifications from the school or applicant and any required income or employment verification as booked loans. We refer to loans for which we have disbursed loan funds on behalf of the lender as disbursed loans. For three months ended September 30, 2012 For three months ended September 30, 2011 Partnered Lending Union Federal Total Partnered Lending Union Federal Total (dollars in thousands) Booked Loans $ 63,089 $ 21,378 $ 84,467 $ 14,798 $ 16,481 $ 31,279 Disbursed Loans 33,077 12,925 46,002 7,256 7,479 14,735 Historically, we have processed the greatest loan application volume during the summer and early fall months, as students and their families seek to borrow money in order to pay tuition costs for the fall semester or the entire academic year. Since we began originating the education loans at Union Federal in fiscal 2012, we have disbursed loans with weighted average FICO scores in the range of 750-760 and 84%-87% of these loans had co-signers. These credit qualities demonstrate that our strong loan growth has been accomplished while also focusing on providing loans to high credit quality borrowers. Portfolio Performance Credit performance of consumer-related loans generally has been adversely affected by general economic conditions in the United States over the past four years. These conditions have included higher unemployment rates and deteriorating credit performance, including higher levels of education loan defaults and lower recoveries on such defaulted loans. Although these conditions have lessened to a certain extent recently, they may have a material adverse effect on consumer loan portfolio performance in the future. Our Monogram-based education loan portfolios have yet to experience significant adverse portfolio performance as a majority of these portfolios has yet to experience more than 12-months of seasoning. Consequently, in evaluating loan portfolio performance, we review projected gross default rates and projected post-default recovery rates. Further, we evaluate the loan portfolio performance of the securitization trusts that we previously facilitated and, accordingly, the estimated fair value of our service revenue receivables from those trusts. The service revenue receivables that remain on our consolidated balance sheet at September 30, 2012 and June 30, 2012 have not been significantly impacted by defaults or recoveries since the trusts possess guarantees that help partially negate the overall impact of any default activity. These securitization trusts are also cash flowing, seasoned portfolios that, for the most part, have relatively short weighted-average lives. Capital Markets We believe that conditions in the capital markets generally improved in fiscal 2012 compared to recent years. In particular, investors in asset-backed securities, or ABS, demonstrated increased interest in ABS backed by private education loans that exhibited a strong credit profile. Additionally, in fiscal 2012 investors demonstrated increasing interest in longer duration ABS in the sector. We believe that, as a result of the recent market trends, there has been a tightening in credit spreads for the private education loan securitization marketplace during fiscal 2012 and the first quarter of fiscal 2013. The structure and economics of any financing transaction may be materially different from prior transactions that we have sponsored. Such differences may include lower revenues as a result of wider credit spreads and higher initial cash requirements on our part. 24 -------------------------------------------------------------------------------- Table of Contents Uncertainties Our near-term financial performance and future growth depends in large part on our ability to successfully and efficiently market our Monogram platform and TMS services and originate education loans through Union Federal so that we may grow and diversify our client base and revenues. Facilitated loan volume is a key element of our financial results and business strategy, and we believe that the results from the current peak origination season through the first quarter of fiscal 2013 demonstrate market demand for Monogram-based education loans. We have invested in our distribution capabilities over the course of the past two years, including our school channel sales force and TMS, but we face challenges in increasing loan volumes after our prolonged absence from the marketplace. For example, competitors with larger customer bases, greater name or brand recognition, or more established customer relationships than those of our clients, have an advantage in attracting loan applicants at a lower acquisition cost than us and making education loans on a recurring, or "serialized," basis. These disadvantages for us are particularly acute in the current peak origination season because we have only been operating Monogram-based loan programs since fiscal 2011. Outlook Our long-term success depends on our ability to attract additional lender clients, or otherwise obtain additional sources of interim or permanent financing. This is particularly true because of the regulatory conditions and approvals relating to the Union Federal Private Student Loan Program. To date, we have entered into education loan program agreements based on our Monogram platform with four lender clients, including our subsidiary Union Federal. We are uncertain as to the degree of market acceptance that our Monogram platform will achieve, particularly in the current economic environment where lenders continue to evaluate their education lending business models. We believe, however, that the credit quality characteristics of the loan portfolios originated in the 2011-2012 and the 2012-2013 academic years will be attractive to additional potential lender clients, as well as capital markets participants. We also believe that the ability to permanently finance private education loan portfolios through the capital markets would make our products and services more attractive to lenders and would accelerate improvement in our long-term financial results. On October 19, 2012, FMD's subsidiary First Marblehead Education Loan Services LLC currently d/b/a Cology LLC, which we refer to as Cology, completed its acquisition of a substantial portion of the assets of Cology, Inc. and certain of its affiliates, which we refer to as Cology, Inc., for $4.7 million in cash and the assumption of certain liabilities. Cology, Inc. provided processing, disbursement and life-of-loan servicing to over 250 credit unions and lending institutions in the United States and processed over $450 million in private education loans during the twelve month period ended June 30, 2012. We expect to loan processing services to the former customers of Cology, Inc. similar to the services provided to them by Cology, Inc. prior to the asset acquisition. In addition, we expect to provide various Monogram products and services to these customers to assist them in education loan product design, pricing, marketing, reporting and analysis, as well as education loan portfolio management services. We are uncertain of the volume of education loans to be generated by the Monogram-based loan programs of our four lender clients, one of which is our subsidiary Union Federal, or any additional lender clients, including clients acquired through our asset acquisition of Cology, Inc., during fiscal 2013. It is our view that returning to profitability will be dependent on a number of factors, including our loan capacity and related volumes, expense management and growth at TMS and Union Federal, and the availability of financing alternatives, including our ability to successfully re-enter the securitization market. In particular, we need to generate loan volumes substantially greater than those that we have generated to date, as well as to develop funding capacity for Monogram-based loan programs at loan volume levels greater than those of our four lender clients with lower credit enhancement levels and higher capital markets advance rates than those available today. We must also continue to achieve efficiencies in attracting applicants, through loan serialization or otherwise, in order to reduce our overall cost of acquisition. Changes in any of the following factors could materially affect our financial results: • Demand for education financing, which may be affected by changes in limitations established by the federal government on the amount of federal loans that a student can receive, the terms and eligibility criteria for loans and grants under federal or state government programs and legislation recently passed or currently under consideration; • The extent to which our services and products, including our Monogram platform, Cology offerings and TMS offerings, gain market share and remain competitive at pricing favorable to us; • The amount of education loan volume disbursed under our lender clients' Monogram-based loan programs; • Our ability to sell Monogram products and services to customers acquired in our asset acquisition of Cology, Inc.; • An adverse outcome relating to the federal income tax treatment of our sale of the trust certificate of NC Residuals Owners Trust, which we refer to as the Trust Certificate, in fiscal 2009 or our asset services agreement with the purchaser of the Trust Certificate, including any challenge related to federal tax refunds previously received in the amount of $176.6 million as a result of the audit currently being conducted by the Internal Revenue Service, or IRS; • Regulatory requirements applicable to Union Federal, TMS and us, including conditions and approvals relating to the Union Federal Private Student Loan Program, which limit Union Federal's ability to fund education loans; 25 -------------------------------------------------------------------------------- Table of Contents • Conditions in the education loan financing market, including the costs or availability of financing, rating agency assumptions or actions, and market receptivity to private education loan asset-backed securitizations; • The underlying loan performance of the Monogram-based loan programs, including the net default rates, unemployment rates, and the timing and amounts of excess credit enhancements that may be material to us; • The resolution of any appeal of the order of the Massachusetts Appellate Tax Board, or ATB, in the cases pertaining to our Massachusetts state income tax returns; • Application of critical accounting policies and estimates, which impact the carrying value of assets and liabilities, as well as our determinations to consolidate or deconsolidate a VIE; • Application of The Dodd-Frank Wall Street Reform and Consumer Protection Act, or Dodd-Frank Act, enacted in July 2010, through the supervisory authority of the Consumer Financial Protection Bureau, or CFPB, which has the authority to regulate consumer financial products such as education loans, and to take enforcement actions against institutions marketing and selling consumer financial products under its supervision, such as Union Federal, and institutions that act as service providers to originators of education loans, such as our subsidiary First Marblehead Education Resources, or FMER; • Applicable laws and regulations, which may affect the terms upon which lenders agree to make education loans, the terms of future portfolio funding transactions, including disclosure and risk retention requirements, recovery rates on defaulted education loans and the cost and complexity of our loan facilitation operations; and • Departures or long-term unavailability of key personnel. Critical Accounting Policies and Estimates Our consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles, or GAAP. The preparation of our consolidated financial statements requires management to make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities, at the date of our financial statements, as well as the reported amounts of revenues and expenses during the reporting period. We base our estimates, assumptions and judgments on our historical experience, economic conditions and on various other factors that we believe are reasonable under the circumstances. Actual results may differ from these estimates under varying assumptions or conditions. Our significant accounting policies are described more fully in Note 2, "Summary of Significant Accounting Policies," in the notes to our unaudited consolidated financial statements included in Part I of this quarterly report. On an ongoing basis, we evaluate our estimates, assumptions and judgments, particularly as they relate to accounting policies that we believe are most important to the portrayal of our financial condition and results of operations. We regard an accounting estimate or assumption underlying our consolidated financial statements to be a "critical accounting estimate" where: • The nature of the estimate or assumption is material due to the level of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change; and • The impact of the estimates and assumptions on our financial condition or operating performance is material. We have discussed our accounting policies with the Audit Committee of the FMD Board of Directors. We consider the following to be our critical accounting policies: • Whether or not to consolidate the financial results of a variable interest entity, or VIE; • The determination of goodwill and intangible asset impairment; and • Income taxes relating to uncertain tax positions accrued for under Financial Accounting Standards Board Interpretation, or FASB, No. 48, Accounting for Uncertainty in Income Taxes (now incorporated into Accounting Standards Codification, or ASC, 740, Income Taxes). During the three months ended September 30, 2012, there were no significant changes in our critical accounting policies from those disclosed in Item 7 of Part II of our Annual Report under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources-Application of Critical Accounting Policies and Estimates." Results of Operations-Three Months Ended September 30, 2012 and 2011 Financial Results Summary The financial results of operations include FMD and its subsidiaries for the fiscal years then ended. These results are reported through our continuing operations. Previously consolidated securitization trusts and the results of our subsidiary First Marblehead Data Services, Inc., or FMDS, are included in discontinued operations as discussed below for each of the fiscal years then ended. 26 -------------------------------------------------------------------------------- Table of Contents Discontinued Operations Upon our adoption of Accounting Standards Update, or ASU, 2009-16, Transfers and Servicing (Topic 860)-Accounting for Transfers of Financial Assets, or ASU 2009-16, and ASU 2009-17, Consolidation (Topic 810)-Improvements to Financial Reporting by Enterprises Involved With Variable Interest Entities, or ASU 2009-17, effective July 1, 2010, we consolidated 14 securitization trusts that we facilitated during fiscal 2004 through fiscal 2008. The education loans purchased by certain of the securitization trusts, which we refer to as the Trusts, were initially subject to a default repayment guaranty by The Education Resources Institute, Inc., or TERI, while the education loans purchased by other securitization trusts, which we refer to as the NCT Trusts, were, with limited exceptions, not TERI-guaranteed. Of the 14 securitization trusts consolidated on July 1, 2010, 11 were Trusts and 3 were NCT Trusts. We refer to the consolidated Trusts as the NCSLT Trusts and the consolidated NCT Trusts as the GATE Trusts. Consistent with our goal of refining our business model and focusing on our Monogram platform and tuition billing and payment processing services, we disposed of certain components of our business in fiscal 2012. In particular, we sold our variable interests in the Trusts, we sold our trust administrator, FMDS, and we resigned as the special servicer of the Trusts, including the NCSLT Trusts. In addition, the new third party owner of FMDS terminated the agreement, effective September 30, 2012, with our subsidiary FMER for the special servicing of the NCT Trusts, including the GATE Trusts. During the fourth quarter of fiscal 2012, we determined that we no longer had any significant continuing involvement in the operations relating to the NCSLT Trusts and the GATE Trusts once FMER ceased to provide special servicing to these trusts. Further, we concluded that this would occur within an appropriate assessment period for both the NCSLT Trusts and the GATE Trusts. As such, we reported the operations and activities relating to the NCSLT Trusts, the GATE Trusts and FMDS within discontinued operations for all prior periods presented. For additional information, see Note 3, "Discontinued Operations," in the notes to our unaudited consolidated financial statements included in Part I of this quarterly report and Note 3, "Discontinued Operations," in the notes to our consolidated financial statements included in Item 8 of Part II of our Annual Report. Overall Results The following table summarizes the results of our consolidated operations: Three months ended Change between September 30, periods 2012 2011 2012 - 2011 (dollars in thousands) Revenues: Net interest income: Interest income $ 1,193 $ 554 $ 639 Interest expense (273 ) (239 ) (34 ) Net interest income 920 315 605 Provision for loan losses 74 172 (98 ) Net interest income after provision for loan losses 994 487 507 Non-interest revenues: Tuition payment processing fees 7,424 7,279 145 Administrative and other fees 3,415 2,389 1,026 Fair value changes to service revenue receivables 838 948 (110 ) Total non-interest revenues 11,677 10,616 1,061 Total revenues 12,671 11,103 1,568 Total non-interest expenses 26,208 30,681 (4,473 ) Loss from operations (13,537 ) (19,578 ) 6,041 Other income - 1,124 (1,124 ) Loss from continuing operations, before income taxes (13,537 ) (18,454 ) 4,917 Income tax expense from continuing operations 395 339 56 Loss from continuing operations (13,932 ) (18,793 ) 4,861 Discontinued operations, net of taxes - (69,165 ) 69,165 Net loss $ (13,932 ) $ (87,958 ) $ 74,026 The net loss on a consolidated basis improved $74.0 million from a net loss of $88.0 million for the three months ended September 30, 2011 to a net loss of $13.9 million for the three months ended September 30, 2012. The net loss from continuing operations improved 27-------------------------------------------------------------------------------- Table of Contents by $4.9 million to a net loss of $13.9 million, or $(0.14) per share on a fully diluted basis, for the three months ended September 30, 2012 from a net loss from continuing operations of $18.8 million, or $(0.19) per share on a fully diluted basis, for the three months ended September 30, 2011. The improvement in the net loss from continuing operations was largely driven by a decrease in non-interest expenses of $4.5 million coupled with an increase of $1.1 million in non-interest revenues partially offset by a decrease in $1.1 million in other income. The net loss from discontinued operations, net of taxes totaled $69.2 million, or $(0.68) per share on a fully diluted basis, for the three months ended September 30, 2011. The revenues and expenses of discontinued operations for the three months ended September 30, 2011 were as follows: For the three months ended September 30, 2011 (dollars in thousands) Total revenues $ (65,931 ) Total expenses 9,652 Other income 6,881 Net loss from discontinued operations, before income taxes (68,702 ) Income tax expense 463 Discontinued operations, net of taxes $ (69,165 ) Net Interest Income after Provision for Loan Losses Net interest income after provision for loan losses for the three months ended September 30, 2012 increased by $507 thousand, compared to the three months ended September 30, 2011. The increase resulted from an improved net interest margin primarily as a result of increased investments in our higher-yielding education loans and investment securities. Non-Interest Revenues Non-interest revenues include tuition payment processing fees earned by TMS, fee-for-service revenues for loan origination and program support and fees related to our Monogram platform, as well as fees for portfolio management. Non-interest revenues for the three months ended September 30, 2012 were $11.7 million, up $1.1 million from the three months ended September 30, 2011. The increase was principally the result of increased loan processing and market support fees received in conjunction with our Monogram platform as a result of significantly higher partnered lending loan disbursements. Fair value changes to service revenue receivables We record our service revenue receivables at fair value on our consolidated balance sheet. At September 30, 2012, our service revenue receivables consisted of additional structural advisory fee and residual receivables and represent the estimated fair value of the service revenue receivables expected to be collected over the life of the various separate securitization trusts that have purchased education loans facilitated by us, with no further service obligations on our part. Changes in the estimated fair value of the service revenue receivables due, less any cash distributions received, were recorded in our consolidated statement of operations within the fair value changes to service revenue receivables. Prior to the sale of our variable interests in the Trusts on November 14, 2011, we recorded asset servicing fees and additional structural advisory fees related to the NCSLT Trusts. As compensation for our services related to asset servicing, we were entitled to a monthly asset servicing fee based on the aggregate outstanding principal balance of the education loans owned by the Trusts. In the absence of market-based transactions, we use cash flow modeling techniques to derive a Level 3 estimate of fair value for financial reporting purposes. Significant observable and unobservable inputs used to develop our fair value estimates include, but are not limited to, recovery, default and prepayment rates, discount rates and the forward London Interbank Offered Rate, or LIBOR, curve. See "-Financial Condition-Loans-Service Revenue Receivables" below for a more detailed description of the estimation process at September 30, 2012. The following table summarizes the estimated increases in the fair value changes in our service revenue receivables: Three months ended September 30, 2012 2011 (dollars in thousands) Additional structural advisory fees $ 69 $ 479 Residuals 769 413 Asset servicing fees - 56 Total fair value changes to service revenue receivables $ 838 $ 948 28 -------------------------------------------------------------------------------- Table of Contents Non-Interest Expenses The following table reflects the composition of non-interest expenses: Three months ended Change between September 30, periods 2012 2011 2012 - 2011 (dollars in thousands) Compensation and benefits $ 8,813 $ 10,901 $ (2,088 ) General and administrative: Third-party services 5,993 6,864 (871 ) Depreciation and amortization 1,006 1,234 (228 ) Marketing 3,164 4,501 (1,337 ) Occupancy and equipment 3,095 3,186 (91 ) Servicer fees 168 169 (1 ) Other 3,969 3,826 143 Total general and administrative 17,395 19,780 (2,385 ) Total non-interest expenses $ 26,208 $ 30,681 $ (4,473 ) Total number of employees at fiscal quarter-end 296 341 (45 ) Compensation and Benefits Compensation and benefits expenses for the three months ended September 30, 2012 was $8.8 million. The decrease of $2.1 million for the three months ended September 30, 2012 as compared to the three months ended September 30, 2011 was principally the result of lower headcount due to expense reduction efforts during the three months ended September 30, 2012 and certain severance costs incurred during the three months ended September 30, 2011. General and Administrative General and administrative expenses for the three months ended September 30, 2012 decreased by $2.4 million compared to the three months ended September 30, 2011. The decrease in the three months comparison was largely driven by a decrease in marketing costs of $1.3 million related to our loan acquisition efforts and third party services of $871 thousand as a result of lower costs relating to special servicing and decreased professional fees. Other Income We recorded other income of $1.1 million for the three months ended September 30, 2011 due to resolution of certain matters related to the TERI reorganization. This income represented cash distributions from the liquidating trust under TERI's confirmed plan of reorganization. Income Taxes We are subject to federal income tax, as well as income tax in multiple U.S. state and local jurisdictions. Our effective income tax rate is calculated on a consolidated basis. The IRS has begun an audit of our tax returns for fiscal years 2007 through 2010. In addition, we are involved in several matters before the ATB relating to the Massachusetts tax treatment of GATE Holdings, Inc., which we refer to as GATE, a former subsidiary of FMD. See Note 10, "Commitments and Contingencies-Income Tax Matters," in the notes to our unaudited consolidated financial statements included in Part I of this quarterly report for additional information regarding these matters. Our state income tax returns in jurisdictions other than Massachusetts remain subject to examination for various fiscal years ended between June 30, 2008 and June 30, 2012. Income tax expense from continuing operations for the three months ended September 30, 2012 and 2011 was $395 thousand and $339 thousand, respectively. Beginning in fiscal 2011, we no longer had any taxable income in prior periods to offset current period net operating losses. As a result, we recorded a net operating loss carryforward asset as of September 30, 2012 and June 30, 2012, totaling $32.7 million and $28.0 million, respectively, for which we recorded a full valuation allowance. Under current law, we do not have remaining taxes paid within available net operating loss carryback periods, and it is more likely than not that our deferred tax assets will not be realized through future reversals of existing temporary differences or available tax planning strategies. Accordingly, we have determined that a valuation allowance is necessary for all of our deferred tax assets not scheduled to reverse against existing deferred tax liabilities as of September 30, 2012 and June 30, 2012. We will continue to review the recognition of deferred tax assets on a quarterly basis. Financial Condition Total assets increased by $22.6 million since June 30, 2012. Total loans held-to-maturity increased by $13.6 million, or 33%, during the first three months of fiscal 2013, with increases of $12.3 million in education loans and $1.3 million in mortgage loans. Restricted 29-------------------------------------------------------------------------------- Table of Contents cash increased by $18.1 million, offset by a decrease in restricted funds due to clients of $18.7 million. Investments available-for-sale increased by $5.5 million due to a purchase of a mortgage-backed security of $8.1 million partially offset by principal repayments and deposits in participation accounts increased by $4.9 million. Our financial position at September 30, 2012 and June 30, 2012 reflects our efforts to diversify and grow our fee-for-services platforms. Cash, Cash Equivalents and Short-term Investments We had combined cash, cash equivalents and short-term investments of $186.9 million and $208.5 million at September 30, 2012 and June 30, 2012, respectively. Of this total, FMD and its non-bank subsidiaries held $155.0 million in interest-bearing and non-interest-bearing deposits, money market funds and certificates of deposit with highly-rated financial institutions at September 30, 2012. Union Federal held a total of $31.9 million in interest-bearing and non-interest-bearing deposits and money market funds at September 30, 2012. Union Federal is subject to restrictions on the payment of dividends without prior approval from the Office of the Comptroller of the Currency, or the OCC. The decrease of $21.6 million resulted primarily from $10.8 million to fund operations, $4.9 million to fund deposits in participation accounts on behalf of certain of our partnered lenders as a result of higher loan origination activity, and the continued investment in higher yielding assets, including education loans. Restricted Cash At September 30, 2012, restricted cash on our consolidated balance sheet included cash held by TMS of $79.2 million, net of $40.0 million held at Union Federal, and restricted cash held by FMD of $4.3 million and its other non-bank subsidiaries. Restricted cash held by TMS represents tuition payments collected from students or their families on behalf of educational institutions. These cash balances are held in escrow under a trust agreement for the benefit of TMS' educational institution clients and are generally subject to cyclicality, tending to peak in August of each school year, early in the enrollment cycle, and to decrease through May, the end of the school year. During fiscal 2012, TMS' restricted cash balances ranged from a high of $346.8 million during August 2011 to a low of $55.3 million during May 2012. In December 2011, we transferred $40.0 million of TMS deposits from a third party institution to Union Federal. The deposit remains subject to a trust agreement between TMS and a third party trustee. Subject to the capital requirements and other laws, regulations, and restrictions applicable to Union Federal, the cash that is deposited with Union Federal in connection with the tuition payment plans is not restricted at Union Federal and, accordingly, is not included in restricted cash and investments in our consolidated financial statements. This treatment is consistent with how third party institutions handle cash deposits by TMS. Restricted cash held by our other subsidiaries relates to recoveries on defaulted education loans collected on behalf of clients as well as undistributed loan origination proceeds. We record a liability on our consolidated balance sheet representing tuition payments due to our TMS clients, recoveries on defaults due to securitization trusts and education loan proceeds due to schools. Investments Available-for-Sale Investments classified as available-for-sale are reported at fair value on our balance sheet date. Our investment portfolio provides a source of short-term liquidity and acts as a counterbalance to our loan and deposit flows. Investments available-for-sale principally consisted of mortgage-backed federal agency securities held by Union Federal at both September 30, 2012 and June 30, 2012. The investments available-for-sale increased by $5.5 million from $68.6 million as of June 30, 2012 to $74.1 million as of September 30, 2012 as a result of Union Federal's purchase of $8.1 million in mortgage-backed securities during the first three months of fiscal 2013. The portfolio had generated net unrealized gains of $1.1 million and $610 thousand at September 30, 2012 and June 30, 2012, respectively, which was recognized in accumulated other comprehensive income, a component of stockholders' equity. The following table provides a summary of investments available-for-sale by major category: Amortized cost Unrealized gains Unrealized losses Fair value (dollars in thousands) At September 30, 2012: Government-sponsored enterprises (GSE) mortgage-backed securities $ 57,516 $ 1,071 $ - $ 58,587 Mortgage-backed securities issued by U.S. government agencies 15,505 202 (164 ) 15,543 Total $ 73,021 $ 1,273 $ (164 ) $ 74,130 At June 30, 2012: GSE mortgage-backed securities $ 51,972 $ 369 $ (56 ) $ 52,285 Mortgage-backed securities issued by U.S. government agencies 16,016 299 (2 ) 16,313 Total $ 67,988 $ 668 $ (58 ) $ 68,598 30 -------------------------------------------------------------------------------- Table of Contents At September 30, 2012 and June 30, 2012, two and three investment securities totaling $9.0 million and $16.0 million, respectively, had unrealized losses of $164 thousand and $58 thousand, respectively, and had been in an unrealized loss position for less than one year. Management evaluates impairments in values, whether caused by adverse interest rates or credit movements, to determine if they are other-than-temporary. Additionally, management evaluates whether it intends to sell, or will be required to sell, the debt securities before the anticipated recovery of their remaining amortized cost. Management concluded the unrealized losses at September 30, 2012 and June 30, 2012 were temporary in nature. Loans At September 30, 2012 and June 30, 2012, we classified all education loans and substantially all mortgage loans as held-to-maturity. The net carrying value of loans consisted of the following, as of the dates indicated: September 30, 2012 June 30, 2012 (dollars in thousands) Education loans held-to-maturity, net $ 45,374 $ 33,095 Mortgage loans held-to-maturity, net 9,163 7,811 Education Loans Held-to-Maturity We began originating Monogram-based loans through Union Federal in fiscal 2012. At September 30, 2012 and June 30, 2012, education loans outstanding primarily consisted of education loans held by Union Federal, totaling $45.6 million and $33.3 million, respectively. Other education loans consisted of loans totaling $1.1 million at both September 30, 2012 and June 30, 2012 that were transferred by Union Federal to FMD in 2009 prior to the launch of our Monogram platform. These loans were fully reserved for at September 30, 2012 and June 30, 2012. The increase of $12.3 million in education loans at September 30, 2012 from June 30, 2012 was related to disbursed education loans through our Monogram platform at Union Federal. The following table summarizes the composition of the net carrying value of our education loans held-to-maturity as of the dates indicated: September 30, 2012 June 30, 2012 (dollars in thousands) Gross loan principal outstanding $ 46,734 $ 34,404 Allowance for loan losses (1,360 ) (1,309 ) Education loans held-to-maturity, net of allowance $ 45,374 $ 33,095 Allowance for Loan Losses The following is a roll forward of the net carrying value of education loans held-to-maturity during the first quarter of fiscal 2013 and fiscal 2012: Three months ended September 30, 2012 2011 Allowance Allowance Gross loans for loan Net carrying Gross loans for loan Net carrying outstanding losses value outstanding losses value (dollars in thousands) Balance, beginning of period $ 34,404 $ (1,309 ) $ 33,095 $ 1,336 $ (1,336 ) $ - Disbursements of principal to borrowers 12,925 - 12,925 7,479 - 7,479 Principal receipts from borrowers (794 ) - (794 ) (213 ) - (213 ) Interest capitalized on loans in deferment and forbearance 17 - 17 5 (5 ) - Interest capitalized on defaulted loans 15 (15 ) - - - - Provision for loan losses - 131 131 - 181 181 Net charge-offs (recoveries): Charge-offs (18 ) 18 - (104 ) 104 - Recoveries on defaulted loans 185 (185 ) - 201 (201 ) - Net charge-offs 167 (167 ) - 97 (97 ) - Balance, end of period $ 46,734 $ (1,360 ) $ 45,374 $ 8,704 $ (1,257 ) $ 7,447 31 -------------------------------------------------------------------------------- Table of Contents To estimate the allowance for loan losses on our newly originated Monogram-based loan portfolio, we utilized specific default and recovery rates projected for the Monogram-based loan portfolio over the 12-month loss confirmation period. We may also apply qualitative adjustments in determining the allowance for loan losses. Our default experience with this loan portfolio is limited by the seasoning of the portfolio; however, we have utilized our historical database and experience in projecting the level of defaults and recoveries of the Monogram-based loan portfolio relying in part on historical results from our securitization trusts that we previously facilitated for loans that have similar credit characteristics to those in our Monogram-based loan portfolio. At September 30, 2012 and June 30, 2012, there were $36 thousand and $54 thousand, respectively, of educations loans that were on non-accrual status and no education loans that had specific reserves. These loans consisted of loans that were transferred by Union Federal to FMD in 2009, prior to the launch of our Monogram platform. Our policy is to have a specific allowance for loans greater than 180 days past due, but not yet charged-off. Due to the nature and extent of the Monogram-based education loans issued through Union Federal, none of these loans were greater than 120 days past due at September 30, 2012 and June 30, 2012. Overall Education Loan Credit Quality Management monitors the credit quality of an education loan based on loan status, as outlined below. The impact of changes in loan status, such as delinquency and time in repayment, is incorporated into the quarterly allowance for loan loss calculation through our projection of defaults. The following table represents our loan origination metrics with respect to our Monogram-based programs held at Union Federal at September 30, 2012 and June 30, 2012: September 30, June 30, 2012 2012 Weighted-average FICO score 752 753 Co-signers 84.2 % 84.8 % Delinquent loans 0.19 % 0.03 % The following table provides additional information on the status of education loans outstanding: As a percentage As a percentage September 30, 2012 of total June 30, 2012 of total (dollars in thousands) Principal of loans outstanding: In basic forbearance $ 197 0.4 % $ 171 0.5 % In school and in deferment 19,459 41.6 14,781 43.0 In repayment, classified as: Current: £30 days past due 26,823 57.4 19,289 56.0 Delinquent: >30 days past due, but £120 days past due 219 0.5 109 0.3 Delinquent: >120 days past due, but £180 days past due 36 0.1 54 0.2 In default: >180 days past due, but not yet charged-off - - - - Total gross loan principal outstanding $ 46,734 100.0 % $ 34,404 100.0 % Non-accrual loan principal (>120 days past due) $ 36 0.1 % $ 54 0.2 % Past due loan principal (>90 days, but £120 days past due still accruing interest) 8 0.0 11 0.0 We use the following terms to describe borrowers' payment status: In School and In Deferment Pursuant to the terms of the education loans, a borrower is eligible to defer principal and interest payments while carrying a specified academic course load and may be eligible to defer payments for an additional six months after graduation during a grace period. At the end of the deferment period, any remaining accrued but unpaid interest is capitalized and added to principal outstanding. At September 30, 2012, approximately 42% of education loans were in school and in deferment. In Repayment We determine the repayment status of a borrower, including a borrower making payments pursuant to alternative payment plans, by contractual due dates. A borrower making reduced payments for a limited period of time pursuant to an alternative payment plan will be considered current if such reduced payments are timely made. Under our Monogram platform, borrowers may be in repayment while in school. Payment options while in school include full principal and interest, partial interest and interest only. 32-------------------------------------------------------------------------------- Table of Contents Forbearance Pursuant to the terms of the education loans, a borrower may apply for forbearance, which is a temporary reprieve from making full contractual payments. Forbearance can take many forms, at the option of the creditor. The most common forms of forbearance include the following: • Basic forbearance-Cessation of all contractual payments for a maximum allowable forbearance period of one year, granted in three-month increments. • Alternative payment plans-Pursuant to an alternative payment plan, a borrower can make a reduced payment for a limited period of time. The amount of the payment varies depending on the program and may be set at a fixed dollar amount, a percentage of contractual required payments or interest-only payments. Generally, approval for alternative payment plans is granted for a maximum of six to 24 months, depending on the program. Although these plans are available as part of our Monogram-based programs, they have not been substantially utilized due to the seasoning of our Monogram-based education loan portfolio. The use of forbearance is contemplated at the origination of an education loan and is included in the credit agreement with the borrower. Under both basic forbearance and alternative payment plans, the education loan continues to accrue interest. When forbearance ceases, unpaid interest is capitalized and added to principal outstanding, and the borrower's required payments are recalculated at a higher amount to pay off the loan, plus the additional accrued and capitalized interest, at the original stated interest rate by the original maturity date. There is no forgiveness of principal or interest, reduction in the interest rate or extension of the maturity date. Forbearance programs result in a delay in the timing of payments received from borrowers, but at the same time, assuming the collection of the forborne amounts, provide for an increase in the gross volume of cash receipts over the term of the education loan due to the additional accrued interest capitalized while in forbearance. Forbearance programs may have the effect of delaying default emergence, and alternative payment plans may reduce the utilization of basic forbearance. Mortgage Loans Held-to-Maturity Through Union Federal we carry a held-to-maturity portfolio of mortgage loans. We maintain an allowance for loan losses for our mortgage loan portfolio held-to-maturity on a specific-identification basis when the loan becomes 30 days past due or the borrower makes modified payments. We set the allowance for loan losses at an amount believed to be adequate so that the net carrying value of the mortgage loan does not exceed the net realizable value of the collateral. In addition, we establish a general allowance for loan losses for mortgage loans less than 30 days past due based upon characteristics attributable to the loans in the portfolio and the related collateral. A mortgage loan for which we have foreclosed on the property is reclassified to other real estate owned, a component of other assets, and is carried at estimated net realizable value after any initial write-downs through the allowance for loan losses. We do not have any mortgage loans greater than 90 days past due that are accruing interest. Service Revenue Receivables We record our service revenue receivables at fair value on our consolidated balance sheet. At September 30, 2012 and June 30, 2012, our service revenue receivables consisted of additional structural advisory fees and residual receivables and represented the estimated fair value of the service revenue receivables expected to be collected over the life of the various separate securitization trusts that have purchased education loans facilitated by us, with no further service obligations on our part related to the GATE Trusts and other securitization trusts we previously facilitated. Changes in the estimated fair value of the service revenue receivables due, less any cash distributions received, are recorded in our consolidated statement of operations within the fair value changes to service revenue receivables. In the absence of market-based transactions, we use cash flow modeling techniques to derive a Level 3 estimate of fair value for financial reporting purposes. Such estimates include, but are not limited to, recovery, default and prepayment rates, discount rates and the forward LIBOR curve. The following table summarizes the fair value of our service revenue receivables on our consolidated balance sheet as of the dates indicated: September 30, June 30, 2012 2012 (dollars in thousands) Additional structural advisory fees $ 2,716 $ 3,170 Residuals 13,351 13,171 Total fair value of service revenue receivables $ 16,067 $ 16,341 33 -------------------------------------------------------------------------------- Table of Contents Sensitivity to Changes in Assumptions As noted above, the service revenue receivables recorded at June 30, 2012 were related to the GATE Trusts and other securitization trusts we previously facilitated. Unlike the NCSLT Trusts, these trusts are very well seasoned and are not as sensitive to default rates or recovery rates because these trusts have guarantees from schools and, in some cases, from a third party bank. As such, these guarantees help to partially negate the overall impact of default activity. In addition, the recoveries are returned back to the schools or bank, as applicable, not the residual interest holder. Further, due to the seasoning of these education loans, they have relatively short weighted-average lives and, as such, are not significantly impacted by other assumptions, such as discount rates. At September 30, 2012, there were no significant changes to the recovery, default, prepayment and discount rate assumptions used. Goodwill & Intangible Assets Goodwill represents the excess of the cost of an acquisition over the fair value of the net tangible and other intangible assets acquired. Other intangible assets represent purchased assets that can be distinguished from goodwill because of contractual rights or because the asset can be exchanged on its own or in combination with a related contract, asset or liability. In connection with our acquisition of TMS, we recorded other intangible assets related to the TMS customer list and tradename, each of which we amortize on a straight-line basis over 15 years, and technology, which we amortize on a straight-line basis over six years. We record amortization expense in general and administrative expenses in our consolidated statement of operations. The customer list intangible asset is related to educational institutions with which TMS had existing tuition programs in place as of December 31, 2010. The trade name intangible asset relates to the name and reputation of TMS in the tuition payment industry. Intangible assets attributable to technology represented the replacement cost of software and systems acquired that are necessary to support operations, net of an obsolescence factor. Goodwill represents the value ascribed to the acquisition of TMS that cannot be separately ascribed to a tangible or intangible asset. In 2012, we evaluated our goodwill for impairment on May 31, which is our annual impairment testing date, and concluded that the fair market value of the TMS reporting unit was greater than 10% in excess of our recorded book value and, therefore, was not impaired as of that date. In determining whether impairment exists, we assess impairment at the level of the TMS reporting unit. There have been no indicators of impairment since that date. Various assumptions go into our assessment of whether there is any goodwill impairment to be recorded. The more meaningful assumptions that contribute to the cash flow model used to determine the fair value of the TMS reporting unit include the net retention rate of new and existing clients, the penetration rate achieved in the overall customer portfolio, adoption of refund management and Campus Advantage products and pricing, the level of interest income to be earned by TMS on funds received but not yet disbursed to client schools, including the forward LIBOR curve, the level of cash balances and the applicable hold periods, all of which impact net interest income, expense levels at TMS and the discount rate used to determine the present value of the cash flow streams. TMS' business would be adversely affected if any of the following were to occur: higher attrition rates than planned as a result of the competitive environment or our inability to provide products and services that are competitive in the marketplace, lower than planned adoption rates of refund management and Campus Advantage products, higher expense levels incurred to provide services to TMS' clients, a lower interest rate environment than depicted by the LIBOR curve, shorter hold periods or lower cash balances than contemplated, which would reduce our overall net interest income opportunity for cash that is held by us on behalf of our school clients, increases in equity returns required by investors and changes in our business model that may impact one or more of these variables. During the quarter ended September 30, 2012, we recorded amortization expenses on our intangible assets of $533 thousand, which reduced our balance of intangible assets from $20.9 million at June 30, 2012 to $20.4 million at September 30, 2012. Contractual Obligations Our consolidated contractual obligations consist of commitments under operating leases. At September 30, 2012, there were no material changes from the contractual obligations disclosed under Item 7 of Part II of our Annual Report under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations-Financial Condition-Contractual Obligations." Total Stockholders' Equity Total stockholders' equity decreased during the three months ended September 30, 2012 from June 30, 2012 as a result of our net loss of $13.9 million partially offset by an increase in additional paid in capital for stock compensation of $1.1 million and a $499 thousand increase in accumulated other comprehensive income for the net unrealized gains on the investments available-for-sale portfolio, net of tax. Off-Balance Sheet Arrangements We offer outsourcing services in connection with education loan programs, from program design through securitization of the education loans. We have historically structured and facilitated the securitization of education loans for our clients through a series of special purpose trusts. 34-------------------------------------------------------------------------------- Table of Contents The principal uses of the securitization trusts we facilitated have been to generate sources of liquidity for our clients' and Union Federal's assets sold into such trusts and make available more funds to students and colleges. See Note 2, "Summary of Significant Accounting Policies-Consolidation" in the notes to our unaudited consolidated financial statements included in Part I of this quarterly report for a discussion of our determination to not consolidate these securitization trusts. Consolidated Average Balance Sheet The following table reflects our consolidated average balance sheet, net interest income and yields earned and paid on interest-earning assets and interest-bearing liabilities from continuing operations: Three months ended September 30, 2012 2011 Average Average Average Average Balance Interest Yield Balance Interest Yield (dollars in thousands) Assets: Interest-bearing cash and cash equivalents $ 128,380 $ 53 0.16 % $ 211,652 $ 84 0.16 % Short-term investments 69,239 102 0.59 50,000 57 0.45 Interest-bearing restricted cash 21,372 22 0.40 129,676 242 0.74 Investments available-for-sale 69,823 348 1.98 10,787 70 2.57 Education loans held-to-maturity 37,610 590 6.22 1,445 22 5.94 Mortgage loans held-to-maturity 8,720 78 3.56 6,824 79 4.63 Total interest-earning assets 335,144 1,193 1.41 410,384 554 0.54 Non-interest-bearing cash 1,054 2,230 Allowance for loan losses and lower of cost or fair value adjustments (1,947 ) (2,225 ) Other assets 173,211 130,280 Total assets $ 507,462 $ 540,669 Liabilities:Time and savings account deposits $ 48,891 $ 125 1.02 % $ 41,830 $ 98 0.93 % Money market account deposits 40,046 108 1.07 21,747 60 1.09 Other interest-bearing liabilities 2,607 40 6.10 5,456 81 5.95 Total interest-bearing liabilities 91,544 273 1.18 69,033 239 1.38 Non-interest-bearing deposits - 5 All other liabilities 195,838 224,463 Total liabilities 287,382 293,501 Stockholders' equity 220,080 247,168 Total liabilities and stockholders' equity $ 507,462 $ 540,669 Total interest-earning assets $ 335,144 $ 410,384 Net interest income $ 920 $ 315 Net interest margin 1.09 % 0.30 % 35 -------------------------------------------------------------------------------- Table of Contents Analysis of changes in net interest income Change between periods for three months ended September 30, 2012 - 2011 Due to change in Volume Rate Net change (dollars in thousands) Interest-bearing cash and cash equivalents $ (34 ) $ 3 $ (31 ) Short-term investments 28 17 45 Interest-bearing restricted cash (108 ) (112 ) (220 ) Investments available-for-sale 294 (16 ) 278 Education loans held-to-maturity 567 1 568 Mortgage loans held-to-maturity 17 (18 ) (1 ) Total interest income 639 Time and savings account deposits 18 9 27 Money market account deposits 49 (1 ) 48 Other interest-bearing liabilities (43 ) 2 (41 ) Total interest expense 34 Net increase in net interest income $ 605 Liquidity and Capital Resources Sources and Uses of Cash The following is a discussion of sources and uses of cash on a GAAP basis as presented in our consolidated statements of cash flows included in our unaudited consolidated financial statements included in Part I of this quarterly report. We also use a non-GAAP financial metric, "net operating cash usage," when evaluating our cash and liquidity position, discussed in detail under "-Non-GAAP Measure: Net Operating Cash Usage" below. Net cash used in operating activities of continuing operations for the three months ended September 30, 2012 was $19.9 million, compared with net cash used in operating activities of continuing operations of $9.8 million for the three months ended September 30, 2011. The increase in cash used was principally the result of the change in net funding of participation accounts of $9.0 million as the September 30, 2011 period included a $4.0 million return of cash. We anticipate continuing to receive fees related to loan origination and portfolio management services and fees related to Monogram-based loan programs. We believe that our significant cash, cash equivalents and investments, coupled with management of our expenses and these fees, will be adequate to fund our operating losses in the short term as we seek to expand our client and revenue base over the short- and long-term. We are uncertain, however, as to whether we will be successful in selling our Monogram platform to additional lenders or how much loan volume may be originated by current or any additional lenders in the future. Net cash provided by investing activities of continuing operations for the three months ended September 30, 2012 was $6.1 million, compared with net cash used in investing activities of continuing operations of $17.6 million for the three months ended September 30, 2011. The improvement of $23.7 million was primarily due to maturities of short-term investments of $25.0 million, and a reduction in $4.8 million in net purchases of investments available-for-sale partially offset by an increase in education loans held-to-maturity of $4.9 million. Net cash provided by financing activities of continuing operations was $17.1 million for the three months ended September 30, 2012, primarily reflecting an increase in deposits. Net cash provided by financing activities of continuing operations was $5.8 million for the three months ended September 30, 2011, primarily reflecting an increase in deposits. The OCC regulates all capital distributions by Union Federal directly or indirectly to us, including dividend payments. Union Federal is required to file a notice with the OCC at least 30 days before the proposed declaration of a dividend or approval of a proposed capital distribution by Union Federal's board of directors. Union Federal must file an application to receive the approval of the OCC for a proposed capital distribution when, among other circumstances, the total amount of all capital distributions (including the proposed capital distribution) for the applicable calendar year exceeds net income for that year to date plus the retained net income for the preceding two years. A notice or application to make a capital distribution by Union Federal may be disapproved or denied by the OCC if it determines that, after making the capital distribution, Union Federal would fail to meet minimum required capital levels or if the capital distribution raises safety or soundness concerns or is otherwise restricted by statute, regulation or agreement between Union Federal and the OCC or a condition imposed by an OCC agreement. Under the Federal Deposit Insurance Corporation Improvement Act, or FDICIA, an Federal Deposit Insurance Corporation, or FDIC, insured depository institution such as Union Federal is prohibited from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would become "undercapitalized" (as such term is used in the FDICIA). 36-------------------------------------------------------------------------------- Table of Contents Sources and Uses of Liquidity We expect to fund our short-term liquidity requirements primarily through cash and cash equivalents and revenues from operations, and we expect to fund our long-term liquidity requirements through revenues from operations and various financing vehicles available to us in the ABS markets and may utilize issuances of common stock, promissory notes or other securities. We expect to assess our financing alternatives periodically and access the capital markets opportunistically. If our existing resources are insufficient to satisfy our liquidity requirements, or if we were to enter into a strategic arrangement with another company, we may need to sell additional equity or debt securities. Any sale of additional equity or convertible debt securities may result in additional dilution to our stockholders, and we cannot be certain that additional public or private financing will be available in amounts or on terms acceptable to us, if at all. If we are unable to obtain this additional financing, we may be required to further delay, reduce the scope of, or eliminate one or more aspects of our operational activities, which could harm our business. Our liquidity and capital funding requirements may depend on a number of factors, including: • Cash necessary to fund our operations, including the operations of Union Federal and TMS, and capital expenditures; • The extent to which our services and products, including Monogram-based loan programs and TMS offerings, gain market share and remain competitive at pricing levels favorable to us; • The results of the audit conducted by the IRS of our tax returns for fiscal 2007 through fiscal 2010, which could result in challenges to tax refunds previously received in the amount of $176.6 million in connection with our sale of the Trust Certificate; • The profitability of our Monogram platform, which is dependent on, among other things, the amount of loan volume our lender clients are able to generate and costs incurred to acquire such volume; • The extent to which we fund credit enhancement arrangements or contribute to credit facility providers in connection with our Monogram platform; • The ability to access wholesale financing opportunities within Union Federal to help meet the liquidity needs generated by Monogram-based loans; • The regulatory capital requirements applicable to Union Federal (see "-Support of Subsidiary Bank" below for additional information) as well as any capital contributions FMD may make to Union Federal; • The resolution of any appeal of the order issued by the Massachusetts Appellate Tax Board on November 9, 2011, which we refer to as the ATB Order, in the cases pertaining to our Massachusetts state income tax returns for fiscal 2004 through fiscal 2006, which could also affect our state tax liabilities in subsequent tax years through fiscal 2009; and • The timing, size, structure and terms of any securitization or other funding transactions that we structure, as well as the composition of the loan pool being securitized; Liquidity is required for capital expenditures, working capital, business development expenses, business acquisitions, income tax payments, costs associated with alternative financing transactions, general corporate expenses, capital provided in connection with Monogram-based loan program credit enhancement arrangements or capital markets transactions and maintaining the regulatory capital of Union Federal. In order to preserve capital and maximize liquidity in challenging market conditions, we have in past periods taken certain broad measures to reduce the risk related to education loans and residual receivables on our consolidated balance sheet, to change our fee structure and to add new products and reduce our overhead expenses. See Item 7 of Part II of our Annual Report under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations-Executive Summary-Overview," for an expanded description of actions taken by us since fiscal 2009 in response to the economic challenges facing us. In addition, the FMD Board of Directors has eliminated regular quarterly cash dividends for the foreseeable future. 37 -------------------------------------------------------------------------------- Table of Contents Deposits Union Federal has liabilities for retail time, money market and savings deposits accounts. The following table summarizes Union Federal's time deposits greater than $100 thousand by maturity at September 30, 2012: (dollars in thousands) Within three months $ 222 Three to six months 2,460 Six months to twelve months 7,589 Greater than twelve months 9,041 Total time deposits >$100 thousand $ 19,312 The maturities of these deposits are not directly indicative of the future timing of cash needed for financing activities because they do not take into account the customers that may reinvest their funds into new time deposits or into other types of deposit accounts. Restricted Funds Due to Clients As part of our TMS operations, we collect tuition payments from students or their families on behalf of educational institutions. Included in restricted cash on our consolidated balance sheet are recoveries on defaulted education loans due to our portfolio management clients (primarily securitization trusts facilitated by us), undisbursed education loan proceeds for our loan origination clients and tuition payments in custody at other financial institutions. These cash balances are recorded as restricted cash on our consolidated balance sheet because they are deposited in segregated depository accounts. Included in restricted funds due to clients on our consolidated balance sheet were tuition payments due to our TMS clients, recoveries on defaults due to securitization trusts and education loan proceeds due to students or schools. Line of Credit At September 30, 2012, through Union Federal we had $70.3 million available for borrowing under an unused line of credit with the Federal Home Loan Bank of Boston. There were no borrowings outstanding under this line of credit at September 30, 2012 or June 30, 2012. Support of Subsidiary Bank Union Federal is a federally-chartered thrift that is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can result in initiation of certain mandatory and possible additional discretionary actions by the regulators that, if undertaken, could have a direct material effect on our liquidity. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, Union Federal must meet specific capital guidelines that involve quantitative measures of Union Federal's assets and liabilities as calculated under regulatory accounting practices. The capital amounts and classifications, however, are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Union Federal's equity capital was $19.1 million at September 30, 2012, up from $16.3 million at June 30, 2012, principally due to a $2.3 million capital contribution paid to Union Federal by FMD during the three months ended September 30, 2012. Quantitative measures established by regulation to ensure capital adequacy require Union Federal to maintain minimum amounts and ratios of total capital and Tier 1 capital to risk-weighted assets (each as defined in the regulations). As of September 30, 2012 and June 30, 2012, Union Federal was well capitalized under the regulatory framework for prompt corrective action. In March 2010, the FMD Board of Directors adopted resolutions required by the U.S. Office of Thrift Supervision, or OTS, undertaking to support the implementation by Union Federal of its business plan, so long as Union Federal is owned or controlled by FMD, and to notify the OTS in advance of any distribution to our stockholders in excess of $1.0 million per fiscal quarter and any incurrence or guarantee of debt in excess of $5.0 million. These resolutions continue to be applied by the Board of Governors of the Federal Reserve System, or the Federal Reserve. FMD is subject to regulation, supervision and examination by the Federal Reserve as a savings and loan holding company, and Union Federal is subject to regulation, supervision and examination by the OCC. Union Federal's regulatory capital ratios were as follows as of the dates below: Regulatory Guidelines Well September 30, June 30, Minimum Capitalized 2012 2012 Capital ratios: Tier 1 risk-based capital 4.0 % 6.0 % 28.0 % 31.3 % Total risk-based capital 8.0 10.0 28.3 31.7 Tier 1 (core) capital 4.0 5.0 11.1 11.0 38 -------------------------------------------------------------------------------- Table of Contents Non-GAAP Measure: Net Operating Cash Usage In addition to providing financial measurements based on GAAP, we present below an additional financial metric that we refer to as "net operating cash usage" that was not prepared in accordance with GAAP. We define "net operating cash usage" to approximate cash required to fund our operations. "Net operating cash usage" is not directly comparable to our consolidated statement of cash flows prepared in accordance with GAAP. Legislative and regulatory guidance discourage the use of, and emphasis on, non-GAAP financial metrics and require companies to explain why a non-GAAP financial metric is relevant to management and investors. Management and the FMD Board of Directors use this non-GAAP financial metric, in addition to GAAP financial measures, as a basis for measuring and forecasting our core operating performance and comparing such performance to that of prior periods. This non-GAAP financial measure is also used by us in our financial and operational decision-making. We believe that the inclusion of this non-GAAP financial metric helps investors to gain a better understanding of our results, including our non-interest expenses and liquidity position. In addition, our presentation of this non-GAAP financial measure is consistent with how we expect that analysts may calculate their estimates of our financial results in their research reports and with how clients, investors, analysts and financial news media may evaluate our financial results. There are limitations associated with reliance on any non-GAAP financial measure because any such measure is specific to our operations and financial performance, which makes comparisons with other companies' financial results more challenging. Nevertheless, by providing both GAAP and non-GAAP financial measures, we believe that investors are able to compare our GAAP results to those of other companies, while also gaining a better understanding of our operating performance, consistent with management's evaluation. "Net operating cash usage" should be considered in addition to, and not as a substitute for, or superior to, financial information prepared in accordance with GAAP. "Net operating cash usage" excludes the effects of income taxes, acquisitions or divestitures, participation account net fundings and changes in other assets and other liabilities that are solely related to short-term timing of cash payments or receipts. In accordance with the requirements of Regulation G promulgated by the SEC, the table below presents the most directly comparable GAAP financial measure, loss from continuing operations, before income taxes, for the three months ended September 30, 2012 and 2011 and reconciles the GAAP measure to the comparable non-GAAP financial metric: September 30, 2012 2011 (dollars in thousands) Loss from continuing operations, before income taxes $ (13,537 ) $ (18,454 ) Adjustments to net loss from continuing operations, before income taxes: Fair value changes to service revenue receivables (838 ) (948 ) Depreciation and amortization 1,006 1,234 Stock-based compensation 1,068 1,342 TMS deferred revenue 1,458 781 Cash receipts from trust distributions 1,112 28 Other, net of cash flows from FMDS in 2011 (1,107 ) 147 Non-GAAP net operating cash usage $ (10,838 ) $ (15,870 ) "Net operating cash usage" for the three months ended September 30, 2012 decreased by $5.0 million compared to the three months ended September 30, 2011. The decrease of $5.0 million for the three months ended September 30, 2012 as compared to the three months ended September 30, 2011 was largely the result of a decrease in non-interest expenses of $4.5 million driven principally by decreases of $2.1 million in compensation and benefits expenses, $1.3 million in marketing costs and $871 thousand in third party services and increased cash receipts from trust distributions of $1.1 million offset by $1.1 million of cash flows related to FMDS not received in the three months ended September 30, 2012. |