20050623 guide to student loan auction rate securities

See Disclosure Appendix A1 for the Analyst Certification and Other Disclosures.

U N I T E D S T A T E S JUNE 23, 2005

F I X E D I N C O M E

R E S E A R C H

Asset-Backeds and Mortgage Credit UNITED STATES

Mary E. Kane (212) 816-8409 [email protected] New York

Ritvik Singh (212) 816-0503 [email protected]

New York

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A Guide to Student Loan Auction Rate Securities

➤ Auction rate securities (ARS) classes accounted for 18% ($12 billion) of student loan ABS issuance in 2004.

➤ In a master trust structure, the ARS classes are subordinate in cash flow to the term LIBOR classes. In a discrete trust, the ARS classes are frequently the longer classes in a sequential pay structure.

➤ The sector attracts shorter term investors because the coupon resets frequently and liquidity is good. ARS spreads are attractive compared to term LIBOR classes.

➤ Major accounting firms have ruled that investors must account for auction rate securities as investments, rather than cash equivalents.

➤ The auction rate securities market survived its biggest test ever in early 2005. The newly reinvented ARS market has emerged even stronger than before.

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JUNE 23, 2005

A Guide to Student Loan Auction Rate Securities

June 23, 2005 A Guide to Student Loan Auction Rate Securities

Citigroup Global Markets 4

Contents

Executive Summary ......................................................................................................................... 5

Overview of Auction Rate Student Loan ABSs 6 What You Need to Know About Auction Rate Classes of Student Loan ABS .................................... 6 ➤ Introduction............................................................................................................................... 6 ➤ ARS Supply .............................................................................................................................. 7 ➤ Top Issuers................................................................................................................................ 8 ➤ The Basics................................................................................................................................. 8 ➤ Trust Structures ......................................................................................................................... 9 ➤ Dutch Auction Mechanism ........................................................................................................ 10 ➤ Available Funds Cap Risk.......................................................................................................... 13 ➤ Recent Accounting Change........................................................................................................ 13 Who’s Who in the Auction Rate Securities Market............................................................................ 14 ➤ Largest FFELP Holders and Originators..................................................................................... 14 ➤ Highlights of Selected Auction Rate Participants........................................................................ 15 ➤ Credit Enhancements for Selected Issuers .................................................................................. 16 Summary Background for Selected Auction Rate Participants ........................................................... 17 ➤ SLM Corporation (Sallie Mae)................................................................................................... 17 ➤ Pennsylvania Higher Education Assistance Agency (PHEAA).................................................... 18 ➤ Nelnet ....................................................................................................................................... 19 ➤ Collegiate Funding Services (CFS-Suntech Servicing LLC) ....................................................... 19 ➤ Brazos Group ............................................................................................................................ 20 ➤ College Loan Corporation.......................................................................................................... 21 ➤ Kentucky Higher Education....................................................................................................... 21 ➤ Education Lending Group (CIT) ................................................................................................ 21 ➤ Edfinancial Services (Ed Funding of the South).......................................................................... 22 ➤ Access Group ............................................................................................................................ 22 ➤ NorthStar................................................................................................................................... 22 ➤ GCO Education ......................................................................................................................... 23 ➤ Great Lakes (Third-Party Servicer) ............................................................................................ 23 ➤ First Marblehead (National Collegiate Funding)......................................................................... 23 “Adversity Forges Virtue” — The Market Renaissance..................................................................... 24 ➤ Historical ARS Spreads ............................................................................................................. 25

The authors would like to thank Elizabeth Escobar for her tireless and capable assistance in formatting this report. As well, our esteemed colleagues in the editorial group Norma Lana, Chris Saunders, Judith Antelman, and Cecilia Sarmas, who always provide helpful guidance and offer good ideas.



Auction rate securities collateralized by student loans are an

attractive alternative for term LIBOR investors.

What Are Student Loan Auction Rate Securities?

Student loan ABSs (SLABS) have carved out a niche in the $250 billion auction rate securities (ARS) market. Auction rate securities accounted for 18% ($12 billion) of student loan ABS issuance in 2004. Auction rate securities are long-term, adjustable rate bonds benchmarked to short-term interest rates. Counting the auction rate classes in term student loan supply, the total student loan sector exceeded the supply of credit card issuance in 2004 by some 25% ($65 billion compared with $52 billion in card supply).

Who Are the Major Players?

The ARS market includes a diverse range of players, from large, investment-grade companies to nonprofit issuers and state agency guarantors. Sallie Mae possesses the largest managed student loan portfolio. Other major players include Pennsylvania Higher Education (PHEAA), with $33 billion in managed assets, Collegiate Funding Services (CFS), with $11.5 billion in managed assets, Brazos Group, with $8.7 billion in managed assets, Northstar ($2.6 billion in managed balances), and Access Group ($3.8 billion in managed balances).

Typical Trust Structures

Discrete trusts and master trusts can issue auction rate securities (they can be senior and/or subordinate classes). In a master trust structure, the ARS classes are subordinate in cash flow to the term LIBOR classes. In a discrete trust, the ARS classes are frequently the longer classes in a sequential pay structure.

The required credit enhancement for FFELP loans generally ranges from 3% to 5% subordination, 0.25% to 0.75% up-front cash reserve account and excess spread. The subordinate class becomes pro rata once the LIBOR classes are retired and the collateral percentages attain defined levels.

Market Epiphany and Renaissance

Three events instigated ARS market dislocation during early 2005:

1 Typical first-quarter spread widening coinciding with quarter end and corporate tax payment due dates;

2 An ongoing SEC investigation into broker dealers, causing some investors to remain on the sidelines until there is clarity;

3 A change in accounting rules, requiring some investors to switch how they had been accounting for ARS, from near cash to investments.

The combination of these ARS market events during the first quarter of 2005 widened spreads to extraordinarily attractive levels. The unusually wide spreads drew numerous nontraditional ARS investors into the sector. Since early April, ARS spreads steadily compressed to more typical levels. Ironically, this market crisis served to fortify and expand the investor base and improve market liquidity. ARS spreads are attractive relative to the term LIBOR market.



Overview of Auction Rate Student Loan ABSs

What You Need to Know About Auction Rate Classes of Student Loan ABS

Introduction

Student loan ABSs (SLABS) have carved out a niche in the $250 billion auction rate securities (ARS) market. ARS transactions collateralized by student loans accounted for approximately 6% of ARS issuance in 2004. Auction rate securities are long-term, adjustable rate bonds benchmarked to short-term interest rates. Public finance issuers account for the majority of issuance in ARS market. However, some student loan issuers have incorporated this interest rate determination method into their SLABS transactions.

The ARS market uses short-term benchmarks for pricing investments. The interest rate on an ARS typically resets every seven, 28, or 35 days. The interest rate is determined via a Dutch auction (similar to the method used in the Treasury market). While the benchmark is short term, the investor does not have a put back to the issuer. In the event of a failed auction, the existing holder of the securities continues to own the securities at the maximum rate stipulated in the trust documents. Failed auctions are rare. The maximum interest rate pertaining to a failed auction is a penalty rate much higher than typical ARS market rates. (We discuss ARS mechanics later in this report.)

The ARS market encompasses several types of securities, including taxable and tax-exempt debt, taxable preferred, par value preferred, and municipal preferred securities. The issuer and investor bases for these sectors are quite diverse (see Figure 1).

The investor does not have a put back to the

issuer in a failed auction.



Figure 1. Auction Rate Securities Market Sectors at December 31, 2004 Muni Preferred Tax-Exempt Debt Par Value Preferred Taxable Preferred Taxable Debt Market Size $30 billion $109 billion $9 billion $32 billion $76 billion

Maturity Perpetual maturity. Dividend adjusts via auction/remarketing.

Stated final maturity. Coupon adjusted via auction.

Perpetual maturity. Dividend adjusted via auction.

Perpetual maturity. Dividend adjusted via auction.

Stated final maturity. Coupon adjusted via auction.

Auction Frequency 7 and 28 days 7, 28, and 35 days 49 and 90 days 7 and 28 days 7, 28 and 35 days

Tax Features Fully tax-exempt Fully tax-exempt DRD eligible a Fully taxable Fully taxable

Issuers Closed-end municipal bond funds

Municipalities Asset-backed Nonprofit issuers State authorities and agencies

Corporations Closed-end funds

Closed-end funds Monoline insurers

Asset-backed Nonprofit issuers State authorities and agencies CDOs Closed-end funds

Investors Individuals Corporations Asset Managers Trust Departments

Individuals Corporations Asset managers Trust department LLCs GSEs

Corporations Asset managers

Individuals Corporations Asset managers Trust departments Nonprofit orgs. Pension funds

GSEs Corporations Asset managers Trust departments Nonprofit orgs. Pension funds LLCs Municipal agencies

a The IRS allows Dividend Received Deductions to corporate investors. Subject to certain conditions, corporate investors can deduct 70% of their dividend income from their taxable income. The conditions include a holding period of at least 46 days and dividends paid from earnings and profits. Sources: SDC and Citigroup.

ARS Supply

In 2004, taxable auction rate classes of SLABS accounted for $11.6 billion (18%) of total student loan issuance. Counting the auction rate classes in term student loan supply, the total student loan sector exceeded the supply of credit card issuance in 2004 by some 25% ($65 billion compared with $52 billion in card supply). Year-to-date, we estimate that new student loan ARS supply (taxable and tax-exempt) is off by approximately 4% ($2.3 billion compared to $2.4 billion). More issuers are tapping the term LIBOR market as investors have become more receptive to longer- term floater classes. Term LIBOR issuance is up 5.5% year over year ($24 billion).

In Figure 2, we show student loan issuance by sector in 2004. Term LIBOR classes account for the vast majority of issuance in the student loan ABS sector, comprising 75% of issuance in 2004 ($48 billion). Nonetheless, taxable and tax-exempt auction rate debt classes account for a meaningful proportion of sector issuance.

Figure 2. Student Loan Issuance By Sector 2004 — Full Year (Dollars in Millions) Sector Amount ($MM) Percent of TotalAuction rate tax exempt 4,546 27.7Auction rate taxable 11,624 70.7Variable Rate (VRDN) tax exempt 170 1.0Variable (VRDN) taxable 0 0.0Fixed-rate tax exempt 46 0.3Fixed-rate taxable 0 0.0T-bill FRN (taxable) 0 0.0LIBOR FRN 48 0.3CP FRN 0 0.0

Total $64,704 100.0

Source: SDC Database.

ARS supply accounted for 18% of SLABS issuance in 2004.



Top Issuers

The auction rate securities market has a long and prominent history, and has been in use for approximately 20 years. The ARS market developed as an alternative to variable rate demand notes (VRDN). Unlike VRDN notes, auction rate securities do not have a put to the issuer and do not require a letter of credit, which makes the cost of issuing an ARS more favorable than a VRDN. Not-for-profit entities have been the most active issuers of ARS classes in SLABS transactions. Sallie Mae is not among the top ten ARS issuers, although it accounted for about 50% of all 2004 SLABS issuance. Sallie Mae’s investor base is deep, and it has been able to issue longer-term LIBOR rate classes. Increasingly, off-the-run issuers have been able to issue long-term LIBOR term classes as well. We show the most active auction rate taxable SLAB issuers in 2004 (see Figure 3). (We examine numerous issuers in more depth in later in the “Who’s Who” section of the report.)

Figure 3. Top Student Loan Issuers With Auction Rate Taxable SLAB Classes, 2004 (Dollars in Millions) Top Issuers ARS Amount ($MM)Brazos Higher Education Authority 1,290.6Higher Education Funding 1,000.0Brazos Student Finance Corporation 920.0Education Loans Incorporated 893.5Connecticut Student Loan Foundation 629.0Northstar Education Finance 595.5Iowa Student Loan Liquidity Corporation 582.4Missouri Higher Education Loan Authority 575.0Arizona Education Loan Marketing Corporation 470.0Access Group 443.9

Sources: SDC and Citigroup.

The Basics

A student loan ABS auction rate security is simply a standard student loan ABS that uses the ARS market as its pricing mechanism. Federal Family Education Loan Program (FFELP) loans collateralize the transaction. The required credit enhancement is the customary amount (3%–5% subordination, a 0.25%–0.75% cash reserve account, plus excess spread for triple-A classes), which applies to any student loan ABS transaction (see Figure 4).

Figure 4. Typical Credit Enhancement For Triple-A Classes of FFELP SLABS Transactions Credit Enhancement Range Subordination 3%–5% Cash reserve account 0.25%–1.00% up front, changing to defined amount of balance Excess spread 0.65%–1.00% Reinsurance 98% to 100% US Department of Education

Source: Citigroup.

The US Department of Education reinsures the student loans (FFELP loans) that collateralize these transactions. These FFELP student loans may include Stafford, PLUS, and/or consolidation loans.

The US Department of Education (DOE) reinsures the FFELP loans from 98% to 100% (under current DOE regulations). This reinsurance is a full faith and credit obligation of the US government. The ABS investor’s risk lies in rejected, uncured

Consolidation loans collateralize the majority

of student loan ARS.



claims (which are usually minimal). The required credit enhancement takes into account potential losses to the security from the uncured, rejected claims.

Trust Structures

Student loan ABS trusts may price one or more classes of their structure in the auction rate market. Some trusts issue SLABS exclusively in the ARS market, while others may combine LIBOR and auction rate classes (and, on rare occasions, fixed-rate classes) in the same transaction. SLABS auction rate securities can be senior and/or subordinate classes.

Discrete Trust or Master Trust

The ARS structure may take the form of a discrete trust or a master trust. A discrete trust consists of one pool of receivables that amortizes after the pool cutoff, as the students repay their loans. Sallie Mae uses discrete trusts only. However, Sallie Mae structured one discrete trust (a privately placed transaction, SLMA 2003-10), which partially revolves.

A master trust structure allows repeated new issuances out of the same trust. All issuances share the same collateral group. The master trust collateral consists of a revolving pool of student loans to which the seller sells additional loans during its lifetime to support additional issuances. Examples of issuers that have utilized a master trust structure are Brazos, Nelnet, Access Group, and College Loan Corp. Issuers using the discrete trust structure with ARS classes are Sallie Mae, Education Lending (now CIT Financial), and Collegiate Funding Services. We contrast the trust structural alternatives for discrete and master trusts in Figure 5.

Figure 5. Structural Contrasts Between Discrete and Master Trusts Discrete Trust Master Trust Origin Genesis at cutoff Numerous issuances Collateral Collateral specific pool Shared collateral pool Amortization Amortizes as students repay loans Revolving Pricing benchmark LIBOR and/or ARS LIBOR and/or ARS Structure Sequential Sequential, PAC, TAC

Source Citigroup.

A master trust structure facilitates the creation of a PAC (planned amortization class) or a TAC (targeted amortization class) within the structure. PAC and TAC structures have defined payment windows, and may be bullet securities or have tight payment windows. Classes with defined payment windows are senior in the waterfall to the auction-rate investors. This is because the term investors have a specified targeted maturity and cash flow window, while the ARS investor rolls over every 28 days. The ARS class finances the longer-term trust maturities and absorbs the prepayment variability. The cash flow variability does not matter to the ARS investors because their coupon reprices frequently, and it is a liquid market.

Brazos Higher Education Authority, Inc. priced a SLABS transaction in March 2005, which is a typical TAC structure, incorporating both LIBOR and ARS classes. Brazos’s trust is a master trust, and its 2005-1 deal is its second $1 billion transaction from that trust. The 2005-1 transaction possesses eight classes: four term LIBOR classes with targeted principal balance schedules, and four ARS classes, one of which is the subordinate Class B. The Class B is rated A2/A and represents 5% of the total

A master trust structure facilitates the creation of

a PAC or a TAC class.



note balance. Total credit enhancement for the triple-A classes consists of a reserve fund (0.75% up front), approximately 85bp excess spread, and 5% subordination.

The classes A1 through A4 are LIBOR classes with TAC schedules. The base case consolidation loan ramp (100% CLR) begins at 0% CPR and increases to 8% CPR at month 120, then remains at a constant periodic 8% CPR for the remaining life of the security. The TAC classes can withstand cash flow variability from 50% CLR to 150% CLR. The ARS classes absorb the prepayment variability, and receive principal payments according to the defined flow of funds in the trust documents (see Figure 6).

Figure 6. TAC Structure Example — BRHEA 2005-1 WindowClass WAL Rating (Mdy/S&P) Coupon (100% CLR) Legal Final TAC Band A1 3.06 AAA/Aaa 3M LIBOR + 3bp 3/06-12/09 9/26/16 50% CLR-150% CLR A2 7.02 AAA/Aaa 3M LIBOR + 8bp 3/10-3/14 12/26/18 50% CLR-150% CLR A3 10.65 AAA/Aaa 3M LIBOR + 11bp 6/14-12/16 9/26/22 50% CLR-150% CLR A4 13.91 AAA/Aaa 3M LIBOR + 15bp 3/17-9/21 3/26/29 50% CLR-150% CLR A5 NA AAA/Aaa 28-day ARS NA 6/25/41 Payments according to Flow of Funds A6 NA AAA/Aaa 28-day ARS NA 6/25/41 Payments according to Flow of Funds A7 NA AAA/Aaa 28-day ARS NA 6/25/41 Payments according to Flow of Funds B-1 NA A2/A 28-day ARS NA 6/25/41 Payments according to Flow of Funds

Source: Citigroup.

Dutch Auction Mechanism

Auction rate securities allow trusts to finance their longer-term cash flows with a short-term variable rate. Interest rates typically reset every seven, 28, or 35 days. The ARS trade at par and are callable at par on any interest payment date at the option of the issuer. Interest is paid at each reset date in arrears. The frequent reset dates on the notes provide significant liquidity for this asset class.

Parties

There are three groups of participants in the auction rate process:

Existing and potential owners. Participants in each auction include existing owners (including a broker-dealer) and potential owners who may be interested in acquiring the notes;

Auction rate agent. Acts as an agent for the issuer in connection with the auctions. The auction rate agent tallies up the bids, determines which bids are accepted or rejected, and confirms purchases and sales from the auction.

Broker-dealers. The auction agent enters into a broker-dealer agreement. Existing and potential owners participate in auctions only by submitting orders through a broker-dealer.

Auction Procedures

Auction orders fall into one of the following three categories:

Bid/hold orders. The existing owner specifies the minimum interest rate that he is willing to accept to continue to hold the securities for the upcoming auction period. No order submitted is deemed to be a hold order.

The TAC band is effective from 50% CLR to 150% CLR.

Frequent reset dates provide significant liquidity.

Existing and potential owners submit orders to

broker-dealers.



Sell orders. Orders to sell by an existing owner without regard to the upcoming interest rate.

Potential bid orders. A current or potential investor specifies the minimum interest rate he will accept to purchase auction rate notes in the upcoming interest period for a specified principal amount.

Broker-Dealer Role

A broker dealer may submit orders in auctions for its own account. Any broker-dealer submitting an order for its own account in any auction will have an advantage over other bidders in that it would have knowledge of other orders placed through it in that auction (but it would not have knowledge of orders submitted by other broker dealers, if any). As a result of the broker-dealer bidding, the auction-clearing rate may be higher or lower than the rate that would have prevailed if the broker-dealer had not bid. A broker dealer may also bid in order to prevent what would otherwise be a failed auction, an “all hold” auction (if the broker dealer owns securities in its own account), or an auction clearing at a rate that the broker-dealer believes does not reflect the market for such securities at the time of the auction. Broker-dealers may, but are not obligated to, advise holders of the auction rate securities that the rate that will apply in an “all hold” auction is often a lower rate than would apply if holders submit bids. Such advice, if given, may facilitate the submission of bids by existing holders that would avoid the occurrence of an “all hold” auction. A broker dealer may, but is not obligated to, encourage additional or revised investor bidding in order to prevent an “all-hold” auction.

Auction Interest Rates

The recent Brazos 2005-1 transaction is typical of classic ARS transactions. The auction establishes the interest rate on the auction rate notes, subject to the least of the following rates:

1 The rate determined in the auction;

2 The maximum auction rate, defined as the lesser of the:

3 LIBOR rate for a comparable period plus a spread, ranging from 1.50% (if rated triple-A) to 3.50% (if rated below single-A); or

4 The maximum rate permitted by law; and

5 The net loan rate, defined as the weighted averaged interest rate on the student loans (net of the fee payable to the DOE, transaction expenses, and credit losses) limited by the available funds cap, prevents an increase in ARS spreads from adversely affecting other bondholders in the trust. (If the auction rate exceeds the net loan rate, the trust can carry over the shortfall at a rate of one-month LIBOR.)

Auction Example

The following example illustrates how the auction procedures determine the interest rate on the auction notes:

Assumptions

➤ Denominations (units) = $50,000;

➤ Auction period = 28 days;

➤ Principal amount outstanding = $25 million (500 units).

ARS classes are subject to an available funds cap, but term classes are not.



We summarize all the orders received for the auction in Figure 7.

Figure 7. Example of Orders Received in Auction Bid/hold Orders Sell Orders Potential Bid Orders 10 units at 2.90% 50 units sell 20 units at 2.95% 30 units at 3.02% 50 units sell 30 units at 3.00% 60 units at 3.05% 100 units sell 50 units at 3.05% 100 units at 3.10% Total: 200 units 50 units at 3.10% 100 units at 3.12% 50 units at 3.11% Total: 300 units 50 units at 3.14% 100 units at 3.15% Total: 350 units

Source: Brazos Higher Education Authority, Inc., 2005-1 Prospectus.

The total units under the existing bid/hold orders and sell orders must always equal the issue size at a minimum (in this case, 500 units) in order to have a successful auction. The auction agent would organize the orders in their ascending order (see Figure 8).

Figure 8. Auction Orders Arranged in Ascending Order Order Number Number of Units Cumulative Units %1 10 (W)a 10 2.902 20 (W) 30 2.953 30 (W) 60 3.004 30 (W) 90 3.025 50 (W) 140 3.056 60 (W) 200 3.057 100 (W) 300 3.108 50 (W) 350 3.109 50 (W) 400 3.1110 100 (W) 500 3.1211 50 (L) NA 3.1412 100 (L) NA 3.15a (W) Winning order. (L) Losing order. Source: Brazos Higher Education Authority, Inc., 2005-1 Prospectus.

The lowest bid rate where all available notes can sell at par is the clearing rate for the auction. All winning orders will price at that rate. In Figure 8, order No. 10 is the order that clears the market of all available units. In this case, 3.12% is the interest rate for the next interest accrual period for order Nos. 1 through 10. Multiple orders at the winning rate are allocated units on a pro rata basis. The interest rate will never exceed the maximum rate or the net loan rate.

Failed or Unsuccessful Auction

If there are insufficient bids to purchase all the notes offered for sale, there is no clearing bid — a failed auction. In a failed auction, the existing holders must hold the notes, and earn the maximum rate specified in the offering document. In Brazos Higher Education Authority, Inc. 2005-1, the maximum applicable interest rate ranges from LIBOR + 1.50% to 3.50%, depending on the rating. If a payment default occurs, the rate is equal to LIBOR + 1.50%. In a failed auction, the existing holder must continue to hold its positions until a successful auction with a clearing bid takes place. In a worst-case scenario (inability to auction the notes), the assets in the trust self-liquidate, and repay the ARS investors over time.

The lowest rate where all notes sell at par is the

clearing rate.



Available Funds Cap Risk

The rate on the ARS is capped by the net loan rate. If the auction rate exceeds the net loan rate, the auction note interest rate for that period will be the net loan rate and the trust will determine the carryover amount, if any, for that interest period. The carryover amount will bear interest at a rate of one-month LIBOR until the carryover amount is paid.

The ARS are subject to an available funds cap, whereas the LIBOR floaters are not. This is because the ARS, generally indexed to one-month LIBOR, bear more basis risk than the term LIBOR floaters, indexed to three-months LIBOR. The underlying student loan collateral is indexed to a floating rate. The special allowance payment (SAP) from the US Department of Education is indexed to a designated spread over commercial paper rates1, which correlates closely to three-months LIBOR, and there is little basis risk between those two benchmarks. The basis risk between the SAP benchmark and the one-month LIBOR-indexed ARS notes is also low, and the rating agencies require a cap on the ARS notes. Overall, we deem the available funds cap risk as low.

Recent Accounting Change

Major accounting firms have ruled that investors must account for auction rate securities as investments, rather than cash equivalents. This accounting treatment is appropriate, given the possibility that the investment term could potentially lengthen beyond the interest rate setting period. The accounting treatment reflects the risk that there is no put back to the issuer in a failed auction. Existing investors may have to hold the securities in position for an indefinite period of time if an auction were to fail. The underlying trust assets are long term, whereas the rate reset mechanism is short term. We note that failed auctions are rare, the market has good liquidity, and the underlying assets are very high quality.

We expect that this accounting pronouncement may affect some investors. However, we note that the ARS pricing mechanism accounts for only a minority of supply in the SLABS market. Moreover, the investor base is large and diversified.

1 See “Student Loan ABS Primer,” Citigroup, September 24, 2002.

The available funds cap risk is low because the

assets are floating.

The underlying assets are very high quality.



Who’s Who in the Auction Rate Securities Market

Largest FFELP Holders and Originators

We next examine major issuers of taxable student loan auction rate securities (ARS). Our survey includes 13 entities: Sallie Mae, Pennsylvania Higher Education (PHEAA), Nelnet, Collegiate Funding Services (CFS Suntech), Brazos Group, College Loan Corp., Kentucky Higher Ed, Ed Lending (CIT), Edfinancial Services, Access Group, Northstar, GCO, and First Marblehead.

To put issuers of student loan ARS in perspective, we show the largest holders of FFELP student loans reported by the US Board of Education for the academic year 2004 (see Figure 9). The market is concentrated, albeit fragmented. Sallie Mae possesses 37% of the student loans held by the top 60 holders ($85 billion). In addition, Sallie Mae holds almost four times as much as the second largest student loan holder ($22 billion). The top five holders account for 59% of the loans held by the top 60 holders (see Figure 9).

Figure 9. Top 60 FFELP Student Loan Holders 2004 (Dollars in Millions) FFELP Holder $Millions FFELP Holder $Millions FFELP Holder $Millions1. SLM Corporation 85,095 21. SunTrust Bank 2,013 41. Mississippi Higher Ed 8312. Student Loan Corp (Citibank) 21,548 22. SC Student Loan Corp. 2,004 42. Regions Bank 7533. Nelnet 12,308 23. College Foundation Inc. 1,823 43. GMAC 7404. First Union NTL BK 10,071 24. US Bank 1,707 44. All Student Loan Corp 7235. Wells Fargo Education Fin. 8,567 25. Student Loan Finance Assoc 1,654 45. Education Loan Trust 7076. Brazos Group 7,533 26. Education Loans Inc. 1,533 46. Oklahoma Student Loan 6927. College Loan Corp 6,314 27. Bank One 1,463 47. MT Higher Ed Stud Asst 6598. PA Higher Ed Asst Auth (PHEAA) 5,448 28. Citizens Bank 1,335 48. Fleet Bank 6389. AELMAC/Southwest Stu Srvcs 4,713 29. Utah State Board of Regents 1,318 49. RISLA/Rhode Island 61210. Goal Financial 4,042 30. Pittsburgh National Corp (PNC) 1,299 50. Union Bank & Trust 57511. Collegiate Funding Services 4,037 31. Iowa Student Loan Liquidity 1,279 51. Bank of North Dakota 53112. Education Lending Group 4,024 32. VSAC Education Loan Finance 1,241 52. New Mexico Educ Asst 52313. Missouri Higher Education 3,544 33. Michigan Higher Education Stud 1,213 53. Connecticut Student Loan 45614. Access Group 2,993 34. Kentucky Higher Ed Student 1,070 54. Indiana Secondary Market 45115. Bank of America 2,926 35. Panhandle Plains Hea 1,054 55. HSBC Bank USA 43316. EdAmerica 2,922 36. New Hampshire Higher Ed Loan 926 56. Louisiana Public Facilities 34717. Illinois Student Assistance 2,322 37. North Texas HEA 889 57. South Texas Higher Ed 34418. US Bank ELT Northstar 2,295 38. Lonestar Funding Group Inc. 863 58. Commerce Bank N A 33919. CA Higher Ed (CHELA) 2,274 39. CollegeInvest 859 59. Arkansas Student Loan 31920. Key Corp 2,210 40. JPMorgan Chase Bank 857 60. Wyoming Student Loan 307

Source: US Department of Education.

There is an active secondary student loan market, and numerous student loan originators do not hold the originated assets. Some originators sell their loans in the whole-loan market to third parties. For example, JP Morgan Chase has a contractual arrangement to sell its student loan production to Sallie Mae. (The former Bank One had a similar arrangement.) Sallie Mae renewed its contract with Bank One and JP Morgan in the first quarter of 2005, extending it through August 31, 2010. Many regional banks and state municipal education agencies engage in similar portfolio sales practices.

We show the 60 largest FFELP student loan originators for the academic year 2004 (see Figure 10). The US Department of Education reports consolidation loan originations and conventional FFELP originations separately. We combined the two classifications, and also combined Bank One and JP Morgan Chase’s originations with those of Sallie Mae.

The student loan market is fragmented.

Originators are not necessarily holders.



Figure 10. Top 60 Originators of FFELP Loans, 2004 (Dollars in Millions) FFELP Originator $MM FFELP Originator $MM FFELP Originator $MM1. SLM Corporation 21,404 21. S C Student Loan Corp 652 41. Mississippi Higher Ed 2612. Student Loan Corp (CITIBANK) 6,150 22. Fleet Bank 646 42. Comerica Bank 2553. Nelnet 3,350 23. Citizens Bank 604 43. Regions Bank 2464. Wells Fargo 2,914 24. Illinois Student 591 44. Provincial Bank 2245. College Loan Corp 2,752 25. Key Corp 577 45. HSBC Bank USA 2076. First Union Ntl Bk 2,596 26. Missouri Higher Ed 504 46. Iowa Student 2007. Bank of America 2,455 27. Next Student 499 47. CollegeInvest 1848. Collegiate Funding 2,269 28. Union Bank & Trust 480 48. Utah State Board 1839. Brazos Group 2,169 29. National City Bank 475 49. Mfg. and Traders 18010. AELMAC/Southwest 1,851 30. VSAC Education 426 50. All Student Loan 17711. Education Lending Group 1,841 31. Kentucky Higher Ed 417 51. Academic Loan Group 17212. Goal Financial 1,690 32. Nova Southeastern University 375 52. Twin City Federal 17013. SunTrust Bank 1,480 33. College Board 341 53. First National Bank 16414. Access Group 1,454 34. Amsouth Bancorp 320 54. Fifth Third Bank 16015. Penna Higher Ed 1,207 35. RISLA/Rhode Island 318 55. Zions First 15116. EdAmerica 1,189 36. CA Higher Ed (CHELA) 303 56. Student Loan Finance 15017. US Bank 1,182 37. New Hampshire Higher 286 57. Connecticut Student 13218. Northstar 1,116 38. Commerce Bank 283 58. New Mexico Educ Asst 13119. Pittsburgh National 1,024 39. Washington Mutual 267 59. Bancorp South Bank 12620 College Foundation 690 40. Stillwater Natl Bk 263 60. Panhandle Plains Hea 126

Note: Dollar amount of new guarantees includes Stafford, PLUS loans, and consolidation loans. Sources: US Department of Education and Citigroup.

The major student loan holders also tend to be the largest student loan originators. The top 60 2004 originators range from Sallie Mae’s $21 billion to Panhandle Plains $126 million. Among the top 15 originators, nonprofit, state agency–mandated, and for-profit companies are well represented. The Brazos Group and Access Group are prominent nonprofit originators. Pennsylvania Higher Education Assistance Agency is a public corporation and government instrumentality created by the Pennsylvania General Assembly. PHEAA was the number-eight holder and number-15 originator in 2004.

Highlights of Selected Auction Rate Participants

In the next section, we provide some highlights for selected auction rate players. We show their managed student loan portfolios, total assets, net worth (or unrestricted reserves in the case of nonprofit companies), unsecured ratings, and other relevant facts (see Figure 11).

Market players include finance companies,

banks, nonprofits, and universities.



Figure 11. Highlights for Selected Student Loan Auction Rate Market Participants, as of 31 Mar 05 (Dollars in Millions)

Sallie Mae (SLMA)Penn. Higher Ed. (PHEAA) Nelnet

Student Loan Corp Great Lakes (GL) CFS Suntech Brazos Groupa

Managed Portfolio 111,699 33,000 29,321 27,578 26,000 11,500 8,652Total Assets 83,769 5,782 16,031 26,999 NA 5,586 5,170Tangible Equity (Reserves) 2,050 2 482 1,190 NA 200 136Market Capitalization 21,032 Na 4,180 4,180 NA 475 NADOE Exceptional Performer EP EP EP EP EP EP NAThird-Party Servicers NA NA NA NA NA NA ACS/GL/SLMA/CFS/PHEAAEquity Ticker SLM NA NNI STU NA CFSI NAPublic Debt Ratings A2/A NA Baa2/BBB+ Aa1/AA- NA NA NAWeb Site (www) Slm.com pheaa.org nelnet.com studentloancorp.com mygreatlakes.com cfsloans.com brazosgroup.com

College Kentucky Ed Lending Edfinancial Loan Corpb Higher Ed (KHE) (CIT) Services Access Group North Star First Marblehead GCO ELFc

Managed Portfolio 7,000 5,700 4,323 4,074 3,825 2,697 NA 363Total Assets 1,172 56,781 5,687 4,512 2,963 544 391Tangible Equity (Reserves) 100 5,412 44 150 14 425 8Market Capitalization NA 8,009 NA NA NA 3,803 NaDOE Exceptional Performer EP NA EP NA NA NA NaThird-Party Servicers ACS/GL NA GL/ACS/Self NA Self & KHE GL PHEAA ACS/GLEquity Ticker Privately held NA CIT NA NA NA FMD NAPublic Debt Ratings NA NA A2/A NA NA NA NA NAWeb Site (www) collegeloancorp.com kheaa.com edlending.com edfinancial.com accessgroup.com northstar.org firstmarblehead.com gcoelf.coma Brazos Higher Education Authority, Inc. as of November 30, 2004. b 2005 Fact Sheet. c As of December 31, 2004. EP Exceptional Performer. Source: Citigroup.

The market includes a diverse range of players, from large, investment-grade companies to nonprofit issuers, which may not have significant name recognition. Sallie Mae possesses by far the largest managed portfolio, with $111 billion of managed assets as of March 31, 2005. Major players also possessing significant managed portfolios range from Pennsylvania Higher Education (PHEAA) with $33 billion in managed assets to CFS Suntech (CFS), with $11.5 billion in managed assets. (Managed assets include all serviced assets, including for third parties.) Four of the companies have public debt ratings (Sallie Mae, Nelnet, CIT/Ed Lending and Student Loan Corp).

Third-party servicing is a frequent occurrence. Originators commonly select ACS, Great Lakes, and PHEAA for third-party servicing, among others. PHEAA acts as a third-party servicer in addition to originating and purchasing student loans for its own account. PHEAA is also a guarantor. Great Lakes is a prominent servicer and guarantor. It does not originate or hold any assets, but it is a top-five servicer. Affiliated Computer Services (ACS) is a publicly held, NYSE-listed company rated Baa1/BBB+. ACS acts purely as a servicer and does not originate or hold any student loans, but works with many smaller lenders. We discuss each entity later in the report.

Credit Enhancements for Selected Issuers

Trusts tend to standardize their credit structures.2 This standardization is helpful for investors getting familiar with different issuer’s programs. Most trusts do not mix collateral and stick exclusively with specified collateral types — consolidation loans, Stafford and PLUS loans, or private loans. However, sometimes trusts systematically combine diversified trust collateral. Such trusts may mix consolidation loan collateral

2 See “ABSs and Mortgage Credit — What You Need to Know About Auction Rate Classes of Student Loan ABS,” by Mary E. Kane

and Ritvik Singh, Bond Market Roundup: Strategy, Citigroup, April 1, 2005.

Sallie Mae has the largest managed

portfolio by far.

Trusts’ structures are typically consistent for programmatic issuers.



with Stafford and PLUS loans. A few trusts mix FFELP and private collateral. The trust offering documents should describe the relevant details for each offering.

In Figure 12, we show the typical credit enhancement and structures for selected issuers. The senior and subordinate parity percentages are the initial levels at cutoff, and do not reflect the required parity percentages that the trust must obtain in order to pay the sub classes pro rata. Trust parity percentages at cutoff are negotiated, and sometimes vary from transaction to transaction.

Figure 12. Credit Enhancement and Typical Structure for Selected Auction Rate Securities Transactions (In Percent) Subordination Cash Senior Sub Excess (%) Reserve (%) Parity (%) Parity (%) Spreada (%) Collateral Transaction Trust Type SLMA 3.0 0.25 104.20 101.10 1.42 100% Consolidation 2003-10 Discrete PHEAA 5.0 0.95 104.50 98.90 0.83 85% Consolidation 2005-1 MT Nelnet 3.0 0.25 101.40 98.40 0.88 43% consolidation 2003-1 Discrete Collegiate Funding 5.0 1.00 102.09 96.94 1.20 100% Consolidation 2003-A Discrete Brazos (BRHEA) 5.0 0.75 103.19 98.01 0.84 90% Consolidation BRHEA 2005-1 MT College Loan Corp 4.9 0.75 103.30 98.20 1.46 90% Consolidation COLLE 2004-1 MT Kentucky Higher Ed 9.7 1.61 111.77 100.98 NA 38% Consolidation 2002 Series A MT Ed Lending (CIT) 3.0 0.50 102.79 99.71 0.94 100% Consolidation 2005-1 Discrete Edfinancial Services (Ed Funding of the South) 2.9 2.50 107.24 103.03 NA 22% Consolidation Series 2003 MT (b) Access Group 2.9 NAPP 101.60 97.80 1.00 24% Consolidation 2003-1 MT North Star 4.0 0.75 102.00 97.90 0.88 29% Consolidation 2004-2 MT First Marblehead (National Collegiate Funding) 10.0 20.0 109.60 98.70c 2.56 100% private 2005-1 Discrete GCO ELF 5.0 1.00 103.27 97.77 1.08 100% Consolidation 2005-1 MT a Excess spreads are estimates. b Tax exempt and taxable. c Excludes IO proceeds. O/C Overcollateralization. MT Master Trust. NA Not Available. NAPP Not Applicable. Sources: Citigroup and prospectuses.

The trust structure may be a master trust or a discrete trust. Sallie Mae uses discrete trusts, as does Nelnet. The subordinate parity percentages at cutoff range from 103% to 97%. Sallie Mae, Collegiate Funding, CIT/Ed Lending, and GCO ELF sell transactions containing 100% consolidation loans, while other issuers included some mixed collateral. The combination of collateral mix, over- or undercollateralization and cash reserve determine the required credit enhancement amounts for particular transactions.

As Figure 12 shows, the required credit enhancement for FFELP loans generally ranges from 3% to 5% subordination, 0.25% to 0.75% up-front cash reserve account and excess spread. The credit enhancement requirements are greater for private loans (10% for First Marblehead), which do not carry US Department of Education reinsurance, but often carry third-party insurance.

Summary Background for Selected Auction Rate Participants

SLM Corporation (Sallie Mae)

SLM Corporation (Sallie Mae) is the largest provider of education finance loans in the United States. The US government established Sallie Mae in 1973, as a federally chartered government-sponsored enterprise (GSE), similar to Freddie Mac and Fannie Mae. Its purpose was to facilitate national access to higher education by acting as a secondary market for student loans. Sallie Mae dissolved its GSE status at the end of 2004 by defeasing the GSE’s debt and dissolving its federal charter. In

Trusts must frequently achieve a target

overcollateralization in order to pay the subs

pro rata.

Most structures are senior/sub, and can be

master trust or discrete trust structures.

Sallie Mae dissolved its GSE status in 2004.



doing so, Sallie Mae became a completely private company. SLM Corporation is a holding company that operates through a number of subsidiaries.

Sallie Mae originates, acquires, and holds education loans. It also provides funding, delivery, and servicing support for student loans. In recent years, Sallie Mae also diversified into default management and loan collection services. It operates its businesses through two primary business segments — lending and debt management. Through its corporate office, it provides complementary products such as guarantor servicing and loan servicing. Sallie Mae derives the majority of its assets and earnings from US government-reinsured FFELP loans. It also participates in the alternative (private) student loan market.

The majority of Sallie Mae’s on-balance-sheet assets are federally insured (89% as of March 31, 2005). Only 9% of its assets are private education loans, up somewhat from 8% at the end of 2004. We show Sallie Mae’s assets as of December 31, 2004, and March 31, 2005, in Figure 13.

Figure 13. Sallie Mae’s Asset Distribution, as of 31 Mar 05 and 31 Dec 04 (Dollars in Millions) Assets 31 Mar 05 % 31 Dec 04 %Federally insured student loans, net 63,379 89 60,561 90Private Education Loans, net 6,527 9 5,420 8Other loans, net 1,095 2 1,048 2Total loan assets 71,001 100 67,029 100

Source: 10-K report.

Sallie Mae is a publicly traded company, listed on the New York Stock Exchange, with more than $3 billion of equity, and had a market capitalization of $21 billion at the end of the first quarter of 2005 (ticker symbol SLM). The Department of Education conferred its exceptional performer designation to Sallie Mae, making it qualified for 100% reimbursement on FFELP claims.

Pennsylvania Higher Education Assistance Agency (PHEAA)

Pennsylvania Higher Education Assistance Agency (PHEAA) is a public corporation and a government instrumentality of the Commonwealth of Pennsylvania. PHEAA was founded in 1964 and is located in Harrisburg, Pennsylvania. In addition to servicing loans, PHEAA also guarantees FFELP loans, administers certain state scholarship and financial aid programs, and issues tax-exempt and taxable notes to finance its lending and secondary market purchases of student loan portfolios. PHEAA ranks number-three among student loan servicers in the United States. Its average serviced loans totaled $23.3 billion for the nine months ended March 31, 2005, compared to $18.4 billion in 2004. PHEAA is a US Department of Education (DOE)–designated recipient of the exceptional performer status. PHEAA ranked number eight among the top holders, and number 15 among the top originators in 2004.

PHEAA issues from a master trust, and consolidation loans comprised 85% of the collateral issued from its 2005-1 transaction.

The majority of SLM’s assets are federally

reinsured.

PHEAA is a guarantor and EP-status servicer.



Nelnet

Nelnet is one of the leading education finance companies in the United States and focuses on providing FFELP and private loans to students and schools nationwide. Nelnet’s headquarters are based in Lincoln, Nebraska. In fiscal year 2004, Nelnet was the third largest originator and holder of FFELP student loans in the nation. Nelnet is a publicly traded company, first listed on the NYSE in December 2003. Nelnet issued its first public unsecured debt in May 2005. Moody’s and S&P rate the firm Baa2 (stable)/BBB+.

Nelnet’s rejection rates for servicing error are low and the DOE conferred its exceptional-performer rating on it during 2004. Nelnet is a vertically integrated educational finance organization dedicated to providing products and services that facilitate education for students, schools, lenders, and guarantors. Nelnet is the third largest originator and holder of student loans. Nelnet also ranks number two among the top servicers in the United States (see Figure 14).

Figure 14. Student Loan Servicer League Table, not Including Federal Direct Loans (Dollars in Millions) Servicer Serviced Assets Percent of Sallie Mae Servicing $87.9 47.9Nelnet Corp. 18.8 10.2Pennsylvania Higher Ed 16.9 9.2Affiliated Computer Services (ACS) 15.7 8.6Great Lakes 15.6 8.5Student Loan Corp 14.2 7.7CFS-SunTech 7.8 4.2Wells Fargo 6.7 3.7

Source: 2004 Student Loan Servicing Association Volume Survey (www.slsa.net).

Nelnet issues from discrete trusts and combines Stafford, PLUS, and consolidation loan collateral in its trusts. Nelnet segregated its 9.5% floor collateral in several transactions. Under old DOE rules, some student loans qualify for a 9.5% minimum guaranteed rate of return.3 Congress largely eliminated that excess return for new originations in 2004, but grandfathered existing 9.5% floor holdings. The rating agencies do not count the incremental surplus excess spread as credit enhancement in ABS transactions.

The SEC is currently investigating Nelnet’s activities related to its 9.5% floor loans. The company has furnished the SEC with the information it has requested and is cooperating with the SEC staff in its informal investigation. The company believes that the concerns about these loans are unfounded, but it cannot predict the ultimate outcome of the SEC’s informal investigation. Nelnet is expensing the costs related to the SEC’s informal investigation as incurred.

Collegiate Funding Services (CFS-Suntech Servicing LLC)

Collegiate Funding Services is a publicly held, for-profit student loan lender based in Fredericksburg, Virginia. Its servicing arm, CFS-Suntech Servicing LLC, is the successor in interest to SunTech, Inc. SunTech, Inc. began servicing education loans in 1990. Prior to that time, the operation was part of the Mississippi secondary market

3 See “ABSs and Mortgage Credit — Student Loan ABS and the 9.5% Loan Controversy,” Bond Market Roundup: Strategy,

Citigroup, October 22, 2004.

Nelnet is the second largest FFELP servicer in

the United States.

Nelnet segregated its 9.5% loans in

specific transactions.

http://www.slsa.net/



and had serviced loans since 1984. As of December 31, 2004, CFS Suntech serviced a portfolio of almost $10.9 billion in FFELP and private education loans, operating out of four offices.4 About 95% of its loans are consolidation loans. CFS ranked number 11 among the top holders and number eight among originators in 2004.

CFS Suntech carries Moody’s highest servicer quality rating: SQ-1. CFS lost the DOE’s exceptional performer (EP) designation, effective October 2004. CFS had experienced a systems print queue error and failed to provide some borrowers with final demand letters as required under DOE regulations. CFS discovered the error itself and reported the infraction to the DOE. CFS is challenging the DOE’s determination and is able to reapply for EP status in September 2005.

CFS first listed on the Nasdaq in July 2004 and has a current market capitalization of $463 million. Lightyear Capital still retains approximately a 50% interest in the firm. CFS has not issued any public debt, and does not have unsecured public debt ratings.

Brazos Group

The Brazos Group of companies is one of the oldest nonprofit entities operating in the student loan finance sector. Brazos celebrated its 30th anniversary in May 2005. Founded in Waco, Texas, in 1975, the Brazos Group is the sixth largest holder and a top-nine originator of FFELP student loans in the United States. Brazos is the number-one nonprofit student loan holder and originator in the nation. As of November 30, 2004, Brazos held more than $8.8 billion in student loans. Brazos’s originations are national in scope and it also purchases loans in the secondary market (about one-third of its 2004 volume).

Brazos’s corporate structure consists of 18 affiliated companies. Each company may originate and purchase student loans. Each company serves different market niches and several of these companies have issued auction rate securities. We show the Brazos corporate structure in Figure 15. The entities that have issued ARS are shown in boldface type.

Figure 15. The Brazos Group Corporate Structure The Brazos Group of Companies

1st Student Financial Brazos Student Finance Corporation Academic Finance Corporation Ed-Invest Company Affordian, Inc. Educational Funding Services, Inc. Amerifund Education Corporation EFSI Bosque Higher Education Authority, Inc. Federated Student Finance Corporation Brazos Educational Assistance, Inc. Global Education Finance Corporation Brazos Higher Education Authority, Inc. — Sole issuer tax exempt Pecos Student Finance Corporation Brazos Higher Education Service Corporation, Inc. (Mgt Company) Trinity Higher Education Authority, Inc. Brazos Education Finance Corporation

Source: Citigroup.

Brazos acts as master servicer for the trusts it manages and contracts the subservicing function to third parties. Its principal subservicers are ACS Education Services, CFS Suntech, Great Lakes, Pennsylvania Higher Ed (PHEAA), and Sallie Mae Servicing. Brazos also services some receivables itself, but these are not included in the term

4 See “ABSs and Mortgage Credit — Collegiate Funding Services Achieves High Grades,” Bond Market Roundup: Strategy,

Citigroup, November 12, 2004.

Brazos is the largest nonprofit student loan

originator and holder in the nation.



LIBOR pools. Brazos does service loans for some of the auction rate securities transactions, but it is not the custodian on those loans. Brazos’s servicing responsibilities are currently limited to in-school servicing, and some repayment servicing for its own portfolio.

Brazos principal business focus is on federally reinsured loans. Private loans represent 8.4% of its portfolio as of November 30, 2004. In the taxable ABS market, Brazos is a programmatic issuer, and has issued out of two entities:

➤ Brazos Higher Education Authority, Inc. (ticker BRHEA — FFELP collateral only);

➤ Brazos Student Loan Finance Corp. (ticker BRAZO — combines FFELP and alternative loans).

Both BRHEA and BRAZO issue out of master trust structures. BRHEA includes FFELP collateral only, while BRAZO includes FFELP and also permits a capped level of alternative loans.

College Loan Corporation

College Loan Corporation (CLC) is a privately held California S-corporation founded in September 1999. It has provided loans to more than 450,000 borrowers, obtaining more than $11 billion in higher education funding. It has nationwide school representation, and its team has over 200 years of combined experience.

CLC is one of the fastest growing student loan lenders. It numbers among the nation’s largest FFELP holders, holding the number-seven position, with $6.3 billion in holdings. It was number five among the top originators in 2004, with $2.8 billion in FFELP originations. CLC outsources its servicing to ACS and Great Lakes, both recipients of the DOE exceptional performer status. CLC issues out of a master trust. Some 90% of the loans in its 2004-1 transaction were consolidation loans.

Kentucky Higher Education

The Kentucky Higher Education Assistance Authority (KHEAA) is a public corporation and governmental agency and instrumentality of the Commonwealth of Kentucky. The state established the authority in 1966 to improve students’ access to higher education. KHEAA administers several financial aid programs and disseminates information about higher education opportunities.

KHEAA is a guarantor, servicer, originator, and holder of student loans. It services for its own account and for third parties. One of its notable third-party accounts is Access Group. KHEAA ranked 31 among originators and 34 among holders. Kentucky Higher Education has issued in the tax-exempt ARS market.

Education Lending Group (CIT)

CIT acquired Education Lending Group in 2005, and operates it as a wholly owned subsidiary. Ed Lending originates and/or purchases federally guaranteed (Stafford, PLUS, Consolidation) and private credit student loans. Education Lending Group operates through four student loan origination channels: preferred lender list (it is on more than 730 lender lists), direct marketing, strategic alliances, and secondary market acquisitions. The multichanneled origination strategy limits the reliance on any one source, permits greater penetration of the student loan market, and reduces seasonality.

College Loan Corp. is privately held and

outsources servicing to ACS and Great Lakes.

CIT acquired Ed Lending in early 2005.



The company’s management team is seasoned, with an average of over 16 years of industry experience. Annual originations have grown strongly, increasing from $45 million in 2001 to $1.6 billion in 2004. Ed Lending began to service its receivables during 2004, and currently services a portion of its own portfolio. The company would like to increase the amount it services over time. Great Lakes, carrying the DOE exceptional servicer designation, currently services the majority of Ed Lending’s receivables (70%). The total portfolio balance has grown from $44 million at year-end 2001 to $4.4 billion as of March 31, 2005.

Edfinancial Services (Ed Funding of the South)

The company known as EdAmerica is the student loan lending unit of the nonprofit entity Edfinancial Services. It provides student loan funding by purchasing loans from originators. The company is based in Knoxville, Tennessee, and has two servicing satellite centers in Jacksonville, Florida, and Little Rock, Arkansas. “It began business as a secondary market maker, buying loans across the state of Tennessee only. It is also affiliated with Educational Funding of the South (formerly known as the Volunteer State Student Funding Corp., a nonprofit public-benefit corporation organized under the laws of Tennessee, established in 1985).

Edfinancial is also a major student loan servicer in the United States, and a recipient of the DOE’s exceptional performer designation. EdSouth received its nonprofit 501(c) (3) designation and operates as a 150(d) corporation under the IRS code in both Florida and Tennessee. In addition, EdSouth has received a mandate from the Governor of Florida to serve as a secondary market provider for student loans in Florida. EdSouth has no employees and its day-to-day operations are performed by Education Services of America, Inc.

Access Group

Access is a nonstock 501 (c) (3) nonprofit Delaware corporation. Access is a membership organization — members include state-operated and nonprofit American Bar Association–approved law schools located in the United States. Its mission originally took shape as the “Law Assured Access Program.” Under the direction of the Law School Admission Council (LSAC), this program initially provided financial access to American Bar Association (ABA)-approved law schools.

Access has a seasoned track record in the student loan market. Its involvement spans some 20-plus years, since 1983. The traditional FFELP student loan sector accounts for 60% of its volume and the private loan sector accounts for the remaining 40% of its business. In the private loan business, Access Group primarily focuses on students pursuing graduate education, principally law schools, but also medical schools and other graduate school programs. The vast majority (99%) of the private loan business is dedicated to graduate and professional education.

NorthStar

NorthStar is a nonprofit entity located in St. Paul, Minnesota. It specializes in loans to graduate and professional students. Northstar has significant lending relationships with approximately 100 select low-default schools. About 90% of its borrowers are graduate students. In its 2004-2 transaction, loans to medical students account for 63% of the pool. North Star’s customers include nearly 500,000 students located in all 50 states. Since 1991, NorthStar has processed more than $1 billion in medical

Edfinancial is a recipient of the exceptional performer status.

Access Group has a 20-year track record.

Medical students account for 63% of NorthStar’s loans. Graduate students

comprise 90%.



student loans and more than $1.3 billion in graduate student loans. NorthStar has been in the graduate and alternative loan market since 1991.

NorthStar issues from a master trust, and its 2004-2 transaction (ticker NEF) issued TAC classes and an auction rate subordinate class. Great Lakes, a DOE exceptional performer, services 100% of its collateral.

GCO Education

GCO Education Loan Funding Corp. (GCO ELF) commenced operations in September 2004 by acquiring the student loan assets and infrastructure from GMAC. GMAC’s involvement in the student loan business had been to facilitate student loan financing for its employees, and also to engage in open market portfolio purchases. Formed in the third quarter of 2004, GCO ELF supports higher education by providing liquidity for federally insured student loan assets through spot and forward purchase activities. GCO ELF is an affiliated company of Greystone & Co., Inc., headquartered in New York, New York.

Greystone & Co., Inc. is a private investment and real estate organization of companies with expertise in a range of loan products, servicing, trading, securitization, and transaction structuring. Greystone is: (1) a leading national lender that offers multifamily, senior housing, healthcare facility, small-balance commercial, and asset-based business loans; (2) a servicing company that services approximately $7 billion of multifamily, senior housing, healthcare, and commercial loans; (3) an investment-banking group trading in mortgages, federally guaranteed student loans, and other debt obligations; and (4) a real estate company active in development and redevelopment of residential rental and commercial properties.

GCO issues from a master trust. GCO’s last transaction, 2005-1 (ticker GCOE) issued two senior TAC classes and two auction rate classes (one senior and one subordinate). ACS Education Services (61%) and Great Lakes Educational Services (39%) service its portfolio.

Great Lakes (Third-Party Servicer)

Great Lakes Educational Loan Services, Inc. (Great Lakes) is a student loan guarantor and a top-five servicer. It has been in business since 1967. Great Lakes is not a student loan lender. As a guarantor, its primary mission is to manage the student loan portfolio on behalf of lenders. Its administrative responsibilities may include the initial processing of the student loan application and promissory note, issuing student loan disbursements, in-school tracking, and conversion to repayment. As a servicer, Great Lakes has achieved the DOE Exceptional Servicer designation, qualifying its FFELP loans for 100% DOE reinsurance. It offers Web-based products for borrowers, originators, schools, and financial aid professionals.

First Marblehead (National Collegiate Funding)

First Marblehead provides outsourcing services for private education lending in the United States. It facilitates financing for financial and educational institutions. It does not serve as a lender, guarantor, or loan servicer. Instead, it receives fees for processing and securitizing loans made by its clients under the underwriting guidelines it developed. First Marblehead owns the TERI database, a proprietary database with more than 18 years of historical information on private student loan

GCO was formerly with GMAC, but is now a part

of Greystone & Co.

Great Lakes provides third-party

servicing for numerous student loan lenders.

First Marblehead does not serve as lender,

guarantor, or servicer.



performance. This database helps it to facilitate the underwriting, structuring, and pricing of private loan programs. In addition, it helps to estimate default, recovery data, and reserve rates.

Private education loans are not guaranteed by the US government and are funded by private-sector lenders. In fiscal 2004, First Marblehead facilitated approximately $1.8 billion in loan disbursements for students at over 4,800 schools. It provided structural, advisory, and other services for 22 securitization transactions since its formation in 1991. It facilitated one securitization in fiscal 2001 and three securitizations in each of fiscal 2002, 2003, and 2004. It provides private label loan services to 15 of the 20 largest originators of federally guaranteed student loans, of which Bank One N.A., Bank of America N.A., and Charter One Bank N.A. are its three most significant clients.

Although its focus is not on federally reinsured loans, First Marblehead does procure third-party insurance for the private loans it facilitates. TERI, a Massachusetts-based student loan insurer, insures a significant amount of First Marblehead’s private loans. First Marblehead also self-insures some of the student loans. First Marblehead adds the insurance fee to the loan balance when a student begins to amortize his loan.

First Marblehead issues under the name of National Collegiate Funding (ticker NCSLT) from discrete trusts. It also used a master trust structure in earlier transactions (ticker NCMSL). Since First Marblehead uses private loan collateral only, its required subordination (10%) is greater than for FFELP issuers. Pennsylvania Higher Education Assistance Agency (PHEAA) services its portfolio.

“Adversity Forges Virtue”5 — The Market Renaissance The auction rate securities market faced a significant test in early 2005. The market passed that test (with flying colors) reinventing itself, and emerging stronger than ever. Three events were the catalysts:

➤ Typical first-quarter spread widening coinciding with quarter end and corporate tax payment due dates;

➤ An ongoing SEC investigation, causing some investors to remain on the sidelines until there is clarity;

➤ Change in accounting rules, requiring some investors to switch how they had been accounting for ARS, from near cash to investments

As a result of these combined forces, some traditional ARS investors dropped out of the sector, pressuring the market. Auction rate spreads typically back up at quarter ends, when corporate investors frequently draw on investments to meet tax liabilities and balance sheet needs. This technical factor generally causes some displacement and spread widening in the first quarter.

The combination of ARS market events during the first quarter of 2005, however, caused unusually wide spreads. The dramatic spread widening could not escape the notice of many nontraditional sector investors. These nontraditional investors include

5 “Of Adversity,” Bacon’s Essays, Francis Bacon, (1597–1625).

First Marblehead specializes exclusively in

private loans.



investors from the corporate, term LIBOR ABS, and short-term sectors. These new investors recognized the value and got involved. Ironically, this market crisis served to fortify and expand the investor base and improve the market liquidity.

Historical ARS Spreads

The yields on ARS classes have been historically attractive. The average spread during 2004 was one-month LIBOR + 6.4bp. Through June 20, 2005, the average spread has been LIBOR + 6.2bp. Those spreads compare favorably to term LIBOR SLABS transactions. Brazos recently priced term LIBOR classes in its 2005-2 transaction (BRHEA 2005-2) at LIBOR + 2bp and LIBOR + 10bp, for its three- and seven-year TAC classes, respectively. Sallie Mae priced its 2005-4 transaction at LIBOR + 1bp and LIBOR + 8bp for its three- and seven-year classes priced in May 2005. The ARS market is pricing the risk at somewhere between three and seven years.

Considering that the ARS classes have significant liquidity since they remarket so frequently, this spread is attractive. Spreads in the auction rate market display some seasonality, particularly around quarter ends and tax payment dates, when liquidity fluctuates. In March and April 2005, however, ARS spreads widened out considerably — to as wide as LIBOR + 45bp. These extraordinarily wide spreads were unprecedented in the ARS market.

Quarter-end pressures are typical in the ARS market. Corporate tax payment due dates at quarter end also typically affect liquidity. However, this year the new accounting change requiring corporations to account for ARS as an investment caused some market displacement. The accounting interpretation may have eliminated some investors, contributing to the spread widening. Nontraditional ARS investors took notice of the unusually wide spreads, however, and the market drew in crossover buyers from the term LIBOR market.

ARS spreads snapped back early in the second quarter of 2005. Since early April 2005, ARS spreads have steadily compressed. Current spreads range from LIBOR flat to LIBOR – 2bp. Numerous new investors have flocked to the sector, and the market is more liquid as a result of the March/April events (see Figure 16).

Figure 16. CGMI Taxable 28-Day ARS Student Loan Triple-A Average Versus LIBOR Jan 04–Jun 05

-0.2%

-0.1%

0.0%

0.1%

0.2%

0.3%

0.4%

0.5%

Jan 02 May 02 Oct 02 Feb 03 Jul 03 Dec 03 Apr 04 Sep 04 Feb 05 Jun 05

Spre

ad to

One

-Mon

th L

IBOR

(BP)

Spread to LIBOR

Source: Citigroup.

Triple-A ARS spreads averaged LIBOR + 6bp

during 2004.

Disclosure Appendix A1 ANALYST CERTIFICATION

We, Mary Kane, and Ritvik Singh, hereby certify that all of the views expressed in this report accurately reflect our personal views about any and all of the subject securities, issuers, currencies, commodities, futures, options, economies or strategies. We also certify that no part of our compensation was, is, or will be directly or indirectly related to the specific recommendation(s) or view(s) expressed in this report.

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