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Brazos Higher Education Authority, Inc Years Ended June 30, 2009

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					FINANCIAL STATEMENTS

Brazos Higher Education Authority, Inc.
Years Ended June 30, 2009 and 2008
With Report of Independent Auditors
                                    Brazos Higher Education Authority, Inc.

                                                     Financial Statements

                                            Years Ended June 30, 2009 and 2008




                                                               Contents

Management’s Discussion and Analysis ..........................................................................................i

Report of Independent Auditors ......................................................................................................1

Audited Financial Statements

Balance Sheets.................................................................................................................................2
Statements of Changes in Fund Balance .........................................................................................3
Statements of Cash Flows ...............................................................................................................4
Notes to Financial Statements .........................................................................................................6
BRAZOS HIGHER EDUCATION AUTHORITY, INC.
Management’s Discussion and Analysis
For the Years ended June 30, 2009 and June 30, 2008
(Dollars in Thousands)




This discussion and analysis of the financial performance of Brazos Higher Education
Authority, Inc. (BHEA) is required supplementary information. It introduces the basic
financial statements and provides an analytical overview of our financial activities. Please
read it in conjunction with the financial statements that follow this discussion.

BHEA is a non-profit corporation created to support the City of Waco, Texas. Our mission is to
make education a reality by supporting programs and initiatives to finance educational
opportunities through all available means while delivering premier services to all our
constituents. BHEA finances the purchase of student loans by issuing taxable and tax-exempt
debt. This combined debt structure enables BHEA to purchase loans both within Texas and
nationwide.

BHEA operates under the Federal Family Education Loan Program (FFELP). FFELP is the
federal program that allows undergraduate or graduate students at eligible postsecondary schools
to obtain low-cost loans.

Description of the Federal Family Education Loan Program

FFELP was originally enacted under the Higher Education Act of 1965. The Higher Education
Act has been amended and reauthorized several times. There can be no assurance that the Higher
Education Act, or other relevant federal or state laws, rules and regulations, will not be changed
in the future in a manner that will adversely impact the programs described below and the
student loans made there under.

Currently, there are five types of FFELP loans:

       Subsidized Stafford – the federal government pays the interest on these loans while the
        student is in school, during the grace period and during deferments.
       Unsubsidized Stafford – the student is responsible for all interest.
       Parent Loan for Undergraduate Students (PLUS) – supplemental loans to parents.
       Parent Loan for Graduate Students (GradPLUS) – supplemental loans to parents.
       Consolidation – loans that allow borrowers to combine Stafford and certain other
        education-related loans, fix the rate of interest and extend the repayment period.




                                                                                                 i
BRAZOS HIGHER EDUCATION AUTHORITY, INC.
Management’s Discussion and Analysis (continued)
For the Years ended June 30, 2009 and June 30, 2008
(Dollars in Thousands)




The interest rate charged to the borrower varies based upon the type of loan and regulations in
effect at the time that the loan was originated.

The U.S. Department of Education (DOE) guarantees FFELP loans. Their major function as a
guarantor is to guarantee principal and interest repayment to lenders if the borrower fails to pay
the loan. Under federal regulations, the Federal Fund (used to pay claims on defaulted loans) is
managed so that there is enough money to pay lenders when their normal collection efforts fail.
The federal government reinsures the Federal Fund, and reinsurance rates vary based upon
default rates of the portfolio of guaranteed loans and based upon the date the loan was disbursed
as follows:

       Disbursed before October 1, 1993 – 80% to 100%
       Disbursed between October 1, 1993 and September 30, 1998 – 78% to 98%
       Disbursed on or after October 1, 1998 – 75% to 98%
       Disbursed on or after July 1, 2006 - 75% to 97%

The Federal Fund is primarily used to pay claims on defaulted loans.

FFELP student loans originated prior to July 1, 2006 earn interest at the higher of a floating rate
based on the Special Allowance Payment or SAP formula set by ED and the borrower rate, which
is fixed over a period of time. We generally finance our student loan portfolio with floating rate
debt. In low and/or declining interest rate environments, when the fixed borrower rate is higher
than the rate produced by the SAP formula, our student loans earn at a fixed rate while the
interest on our floating rate debt continues to decline. In these interest rate environments, we
earn additional spread income. Depending on the type of the student loan and when it was
originated, the borrower rate is either fixed to term or is reset to a market rate each July 1. As a
result, for loans where the borrower rate is fixed to term, we may receive special allowance
payments for an extended period of time, and for those loans where the borrower interest rate is
reset annually on July 1, we may receive special allowance payments to the next reset date.

Forward-looking Statements

This financial report contains statements relating to future results that are considered “forward-
looking statements.” These statements relate to, among other things, risk-sharing losses,
servicing losses, simulation of changes in interest rates, litigation results, changes in law and
regulations and the adoption of new accounting standards. These forward-looking statements are


                                                                                                  ii
BRAZOS HIGHER EDUCATION AUTHORITY, INC.
Management’s Discussion and Analysis (continued)
For the Years ended June 30, 2009 and June 30, 2008
(Dollars in Thousands)




based on assumptions that involve risks and uncertainties and that are subject to change based on
various important factors (some of which are beyond our control). Actual results may differ
materially from those expressed or implied as a result of these risks and uncertainties. These
include, but are not limited to, interest rate fluctuations, changes in political and economic
conditions, competitive product and pricing pressures within our markets, market fluctuations,
the effects of adopting new accounting standards, inflation, technological change, changes in
policies and laws, success in gaining regulatory approvals when required, and success in the
timely development of new products and services. Such forward-looking statements speak only
as of the date on which such statements are made. BHEA undertakes no obligation to update any
forward-looking statement to reflect events or circumstances after the date on which such
statement is made or to reflect the occurrence of unanticipated events.

Description of the Basic Financial Statements

The statement of changes in fund balance reports all of our revenues and expenses. The
statement measures the results of our operations.

The balance sheet includes all assets and liabilities of BHEA. Assets consist of cash, receivables
and other tangible assets that we own or control. Liabilities are short- and long-term obligations
of BHEA. Fund balance is excess assets over liabilities.

The statement of cash flows supplements these statements providing relevant information about
cash receipts and payments.

The notes to the financial statements are an integral part of the financial statements and contain
important information necessary to get a complete view of our finances.




                                                                                               iii
BRAZOS HIGHER EDUCATION AUTHORITY, INC.
Management’s Discussion and Analysis (continued)
For the Years ended June 30, 2009 and June 30, 2008
(Dollars in Thousands)




Condensed Financial Information

 Balance Sheet                                    June 30,                  June 30,                  June 30,
                                                   2009                      2008                      2007

 Assets:
  Cash and cash equivalents                   $      177,448          $        230,268            $    509,330
  Student loan notes receivable, net               8,248,768                 8,902,092               9,343,738
  Interest receivable                                131,657                   179,984                 207,928
  Other                                               23,937                    25,775                  26,074
 Total assets                                 $    8,581,810          $      9,338,119            $ 10,087,070
 Liabilities and Fund Balance
   Notes and bonds payable, net               $    8,484,798          $      9,206,201            $    9,890,327
   Accrued interest payable                            4,428                    11,124                    16,062
   Excess interest payable                               -                         958                     1,624
   Other                                              31,903                    16,061                    12,663
 Total liabilities                                 8,521,129                 9,234,344                 9,920,676
 Fund balance:
   Restricted for debt service                        59,365                   102,547                 165,223
   Unrestricted                                        1,316                     1,228                   1,171
 Total fund balance                                   60,681                   103,775                 166,394
 Total liabilities and fund balance           $    8,581,810          $      9,338,119            $ 10,087,070


 Statement of Changes in Fund Balance                            June 30,              June 30,             June 30,
 For the Period ended:                                            2009                  2008                 2007

 Student loan interest income                                $      262,368      $        458,720       $      512,938
 Investment interest income                                           4,392                17,737               35,794
 Interest expense on notes and bonds payable                       (255,490)             (472,053)            (512,170)
 Arbitrage and excess interest fees                                   1,350                 1,106                 (344)
 Net interest income before provision for loan losses                12,620                 5,510               36,218
 Provision for loan losses                                           (1,986)               (1,866)              (3,344)
 Net interest income after provision for loan losses                 10,634                 3,644               32,874
 Noninterest income                                                   1,621                 8,572                4,677
 Operating income                                                    12,255                12,216               37,551
 Operating expenses                                                 (55,349)              (70,695)             (59,582)
 Revenue over expenses, before unrealized
  derivative gain (loss)                                     $      (43,094)     $        (58,479)      $        (22,031)




                                                                                                                            iv
BRAZOS HIGHER EDUCATION AUTHORITY, INC.
Management’s Discussion and Analysis (continued)
For the Years ended June 30, 2009 and June 30, 2008
(Dollars in Thousands)




Revenue over (under) expenses, before unrealized derivative gain (loss), for the period ended
June 30, 2009 was ($43,094) an increase of 26% from ($22,031) in 2008. Non-interest expense
decreased $15,346 from $70,695 in 2007 to $55,349 in 2008. This is due primarily to the
following:

       The Authority incurred a reduction in maintenance and operating fees of $12,846 due to
        indenture compliance reductions.
The following tables provide additional explanations.

Net Interest Income




                                                                                            v
BRAZOS HIGHER EDUCATION AUTHORITY, INC.
Management’s Discussion and Analysis (continued)
For the Years ended June 30, 2009 and June 30, 2008
(Dollars in Thousands)




Net interest income is created largely from our portfolio of student loans although we have
investments that are not related to student loans. For the period ended June 30, 2009, net interest
income before provision for loan losses was $12,620, an increase of $7,110 from $5,510 in 2008.

The following table explains the increases/decreases in the components that make up net interest
income before provision for loan losses:

                                                                              June 30,           June 30,
                                                              Variance          2009               2008
        Interest income:
           Student loan notes receivable, net                 $ (196,352)         262,368          458,720
           Investments                                           (13,345)           4,392           17,737
        Interest expense - Notes and bonds payable               216,807         (254,140)        (470,947)
           Net increase in net interest income before
            provision for loan losses                         $   7,110           12,620             5,510


          Net interest income on student loan notes receivable decreased $615,450, primarily due
           to the decrease in the net student loan holdings from $8,609,432 in 2008 to $7,993,982 in
           2009 and a substantial decrease in interest rates on student loan holdings during the 2009
           fiscal year. The following table shows the changes in components of net interest income.

                                                                                     June 30,         June 30,
                                                                   Variance           2009              2008
        Interest income, student loan notes receivable, net
           Student loan interest income                            $ (223,265)         369,480          592,745
           Premium amortization                                        23,104          (38,821)         (61,925)
           DOE rebate fees                                              3,809          (68,291)         (72,100)


           Total                                                   $ (196,352)         262,368          458,720




                                                                                                                   vi
BRAZOS HIGHER EDUCATION AUTHORITY, INC.
Management’s Discussion and Analysis (continued)
For the Years ended June 30, 2009 and June 30, 2008
(Dollars in Thousands)




              o Interest income on student loan notes receivable decreased $223,268 primarily
                due to the decrease in the net student loan holdings from $8,609,432 in 2008 to
                $7,993,982 in 2009 and a substantial decrease in interest rates on student loan
                holdings during the 2009 fiscal year.

              o Premium amortization decreased $23,104 primarily due to a decrease in student
                loan consolidation payoffs as compared to the previous year.

       Interest income on investments decreased $13,345 primarily due to the decrease in
        interest rates on investments and a reduction of investment balances during the 2009
        fiscal year. During the 2009 fiscal year, interest rate contract fell to the point that the
        Authority was earning less than 10 bps on some guaranteed investment contracts.
       Interest expense decreased $216,807 primarily due to a decrease in bonds payable, net
        from $9,206,201 in 2008 to $8,484,798 in 2009 and a substantial decrease in interest rates
        during the 2009 fiscal year. The following table shows the average rates earned on
        interest earning assets and the average rates paid on interest bearing liabilities.

                                             June 30, 2009            June 30, 2008          June 30, 2007
   For the periods ended:                  Balances     Rate        Balances      Rate     Balances     Rate
   Average interest earning assets
   Student loan notes receivable, net     $ 8,576,444   3.04%   $    9,192,419    5.00%   $ 8,451,310   5.61%
   Investments                                259,224   1.69%          386,773    4.70%       614,432   5.23%
   Average interest earning assets        $ 8,835,668   3.00%   $    9,579,192    4.99%   $ 9,065,742   5.58%

   Average interest bearing liabilities
   Notes and bonds payable                $ 8,887,913   2.86%   $    9,614,056    4.91%   $ 9,038,444   5.23%

   Net interest spread                                  0.14%                     0.08%                 0.35%


The net interest spread on student loans increased slightly from the period ended June 30, 2008
to the period ended June 30, 2009.




                                                                                                                vii
BRAZOS HIGHER EDUCATION AUTHORITY, INC.
Management’s Discussion and Analysis (continued)
For the Years ended June 30, 2009 and June 30, 2008
(Dollars in Thousands)




The following table shows the net interest spread on student loans.

                                                        June 30,     June 30,         June 30,
For the periods ended:                                    2009         2008             2007
Student loan yields                                        3.04%           5.00%           5.61%
Cost of funds                                              2.86%           4.91%           5.23%

Net interest spread on student loans                       0.18%           0.09%           0.38%


Net interest spread on student loans increased primarily due to a decrease in interest rates on
interest bearing liabilities and the failed auctions on auction rate securities. Failed auctions
caused bond interest rates to be set at a higher rate. However, the net loan rate limited the interest
rate paid on these securities. See interest rate environment section for a discussion of failed
actions.

Provision for Loan Losses

Under FFELP, 98% of principal and interest on student loans is guaranteed. The provision for
loan losses represents our estimate of the costs related to the 2% risk sharing on FFELP loans we
own. For loans disbursed after July 1, 2006, the guaranteed amount will be reduced to 97% of
principal and interest on student loans.

In making our estimates, we consider the trend in default rates in our portfolio and changes in
economic conditions. We believe the provision for loan losses is adequate to cover inherent
losses in the student loan portfolio at June 30, 2009. A roll-forward of our allowance for loan
losses is presented in the following table.

                                                        June 30,         June 30,          June 30,
         For the periods ended:                           2009             2008             2007
         Balance at beginning of period             $       7,531    $       8,135     $       6,334
         Provision for losses                               1,986            1,866             3,344
         Charge-offs, net of recoveries                    (2,864)          (2,470)           (1,543)
         Balance at end of period                   $       6,653    $       7,531     $       8,135

         Allowance as a percentage of ending
          balance of student loans                         0.08%            0.09%              0.09%




                                                                                                        viii
BRAZOS HIGHER EDUCATION AUTHORITY, INC.
Management’s Discussion and Analysis (continued)
For the Years ended June 30, 2009 and June 30, 2008
(Dollars in Thousands)




Operating Expenses




For the period ended June 30, 2009, operating expenses were $55,349, a decrease of $15,346
from $70,695 in 2008. The primary reason for the increase is as follows:

       The Authority incurred a reduction in maintenance and operating fees of $12,846 due to
        indenture compliance reductions.




                                                                                            ix
BRAZOS HIGHER EDUCATION AUTHORITY, INC.
Management’s Discussion and Analysis (continued)
For the Years ended June 30, 2009 and June 30, 2008
(Dollars in Thousands)




Financial Position and Liquidity

A substantial portion of the Authority’s fund balance is restricted for debt service. This restricted
fund balance represents assets available for the payment of debt obligations that are not available
for general-purpose expenditures. Restricted fund balance amounted to $59,365 and unrestricted
fund balance was $1,316 at June 30, 2009.

Description of Debt Activity

The Authority’s principal funding need is securing capital to fund student loan purchases. The
primary source to raise this capital is access to bond markets.

The Authority issues both tax-exempt and taxable debt instruments. The ability to issue tax-
exempt bonds allows the Authority to achieve a reduced cost of debt.

At June 30, 2009, the Authority’s outstanding debt amounted to just over $8.4 billion. The
following table shows our debt activity for the last three fiscal years.

                                                  June 30,       June 30,     June 30,
 For the periods ended:                            2009           2008         2007

 Capital market activity
 Proceeds from issuing taxable student loan
  revenue bonds                               $         -    $     180,200   $ 2,478,400
 Proceeds from issuing tax-exempt student
  loan revenue bonds                                    -              -          71,600



RISKS

Overview

Managing risk is an essential part of managing BHEA’s operations. BHEA’s most prominent risk
exposures are operational, market and interest rate, credit, political and regulatory, and
consolidation loan risk.




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BRAZOS HIGHER EDUCATION AUTHORITY, INC.
Management’s Discussion and Analysis (continued)
For the Years ended June 30, 2009 and June 30, 2008
(Dollars in Thousands)




Operational Risk

Operational risk can result from regulatory compliance errors, servicing errors, technology
failures, breaches of the internal control system, and the risk of fraud or unauthorized
transactions by employees or persons outside the Authority. This risk of loss also includes the
potential legal actions that could arise as a result of an operational deficiency or as a result of
noncompliance with applicable regulatory standards and contractual commitments, adverse
business decisions or their implementation, and customer attrition due to potential negative
publicity.

BHEA mediates servicing risk by contracting with multiple qualified and financially sound third-
party servicers. These servicers are responsible for complying with the standards set by the DOE
and guarantor agencies. BHEA monitors these servicers for contract performance and
compliance with federal regulations.

Our operating processes are highly dependent on our information system infrastructure. BHEA
faces the risk of business disruption should there be extended failures of our information
systems. BHEA has implemented a number of back up and recovery plans in the event of
systems failures. These plans are tested regularly and monitored constantly. We manage
operational risk through our risk management and internal control processes. Each manager
maintains a system of controls with the objective of providing proper transaction authorization
and execution, proper system operations, safeguarding of assets from misuse or theft, and
ensuring the reliability of financial and other data. While we believe that we have designed
effective methods to minimize operational risks, our operations remain vulnerable to natural
disasters, human error, technology and communication system breakdowns and fraud.

Market and Interest Rate Risk

Market risk is the risk of loss from adverse changes in market prices and/or interest rates of our
financial instruments. Our primary market risk is from changes in interest rates and interest
spreads. We have an active interest rate risk management program that is designed to reduce our
exposure to changes in interest rates and maintain consistent earning spreads in all interest rate
environments. We use derivative instruments to hedge our interest rate exposure. Even the use of
hedging activities cannot eliminate all potential interest rate exposures. There is also the risk that
the hedges will not perform as designed.




                                                                                                   xi
BRAZOS HIGHER EDUCATION AUTHORITY, INC.
Management’s Discussion and Analysis (continued)
For the Years ended June 30, 2009 and June 30, 2008
(Dollars in Thousands)




Credit Risk

The Authority’s credit risk is inherent principally in its student loan notes receivable. A downturn
in the economy resulting in substantial unemployment either regionally or nationwide may result
in an increase in defaults by borrowers, thus, causing increased default claims to be paid by the
loan guarantor. It is impossible to predict the status of the economy or unemployment levels or at
which point a downturn in the economy would significantly increase the Authority’s credit risk
exposure. The credit risk of the Authority is substantially decreased by the guaranteed nature of
the majority of its investments in student loan notes receivable.

Political/Regulatory Risk

Because we operate in a federally sponsored loan program, we are subject to political and
regulatory risk. As part of the Higher Education Act (HEA), the student loan program is
periodically amended and must be ‘‘reauthorized’’ every six years. There can be no assurances
that any reauthorization will not result in changes that may have a materially adverse impact to
the Authority.

Consolidation Loan Risk

Consolidation loans can have two detrimental effects. First, we may lose student loans in our
portfolio that are consolidated with other lenders. This, along with consolidating our own loans,
could also accelerate premium amortization on purchased loans. Second, consolidation loans
have lower current yields than the FFELP Stafford loans they replace. This is somewhat offset by
the longer average lives of consolidation loans and that current regulations do not generally
allow these loans to be reconsolidated.

Interest Rate Risk Management

BHEA enters into interest rate contracts in order to manage interest rate exposure. Interest rate
contracts involve the risk of dealing with counterparties and their ability to meet contractual
terms.

These counterparties must receive appropriate credit approval before the Authority enters into
such interest rate contracts. At June 30, 2008, BHEA has interest rate swap agreements that
effectively modify BHEA’s exposure to interest rate risk by converting a portion of BHEA’s
variable rate bonds notes to a fixed rate. These contracts are designated as cash flow hedges.



                                                                                                 xii
BRAZOS HIGHER EDUCATION AUTHORITY, INC.
Management’s Discussion and Analysis (continued)
For the Years ended June 30, 2009 and June 30, 2008
(Dollars in Thousands)




These agreements involve the receipt of floating rate amounts in exchange for fixed-rate interest
payments over the life of the agreements without an exchange of the underlying notional amount.

Description of Currently Known Facts, Decisions or Conditions Expected to have a
Significant Effect on Results of Operations

Interest Rate Environment

The Federal Reserve lowered the interest rate by 175 basis points from July, 2008 through
December, 2008. These cuts were in response to the economic turmoil in the credit markets
caused by the sub-prime mortgage problem. The mortgage problem triggered a general and deep
tightening of credit and liquidity policy in the capital markets. The liquidity crisis caused banks
and investors to generally withdraw from the asset-backed bond markets, as investors fled the
Asset Backed Security (ABS) market. Decreased investor demand for these securities has created
pressure on banks and brokers of Auction Rate Securities (ARS) and the brokers absorbed these
bonds onto their own balance sheets. The lack of liquidity in the ARS market generally caused
interest rate spreads to widen, reducing net interest income for the Authority during this period.
Because much of the ARS paper was funded by investors who issued commercial paper, the
demand for ARS notes fell sharply across all risk ratings. Investment banks that typically provide
demand for the ARS continued to provide support for this market during the first two quarters of
the current fiscal year, allowing investors to leave the ARS market as opposed to suffering failed
auctions. The price for providing this continued demand for ARS in the current market showed
up in higher auction rates.

More recently, adverse conditions in the securitization markets have reduced access to and
increased the cost of borrowing in the market for student loan asset-backed securities. Although
the Authority expects ABS financing to remain the primary source of funding, we have seen, and
continue to expect to see, pricing less favorable than prior to the credit market dislocation that
began in the summer of 2007.

In February 2008, an imbalance of supply and demand in the auction rate securities market as a
whole led to failures of the auctions pursuant to which certain of the Authority’s auction rate
securities’ interest rates are set. This imbalance continued through the first quarter of the current
(2010) fiscal year. As a result, all of the Authority’s auction rate securities as of June 30, 2009,
bear interest at the maximum rate allowable under their terms.




                                                                                                 xiii
BRAZOS HIGHER EDUCATION AUTHORITY, INC.
Management’s Discussion and Analysis (continued)
For the Years ended June 30, 2009 and June 30, 2008
(Dollars in Thousands)




The Maximum Rate for taxable ARS in the Authority is set at 30-day LIBOR plus 150 basis
points for Senior debt and 30-day LIBOR plus 250 basis points for Subordinate debt. During the
third quarter of the current fiscal year, rating agencies lowered the ratings of certain Senior and
Subordinate debt triggering an increase in the maximum rate for such debt to 30-day LIBOR plus
350 basis points. This effectively increased the interest expense incurred by the Authority.
However, each of these issues was limited by the net loan rate discussed below. Therefore, the
overall impact to the cash flows was not adversely impacted. During the third quarter, twenty-
one senior issues with outstanding principal balance of $1,283,500 and twelve subordinate issues
with outstanding principal balance of $358,700 were downgraded.

The Maximum Rate for tax-exempt ARS is set at the greater of 1.0 minus the statutory corporate
tax rate (currently 35%), or 65% of 30-day AA rated financial Commercial Paper (CP), or 175%
of the Security Industry and Financial Markets Association (SIFMA) rate, not to exceed 14% or
15% depending on the individual trust indenture. The SIFMA index is set weekly. During the
period ended June 30, 2009, the SIFMA rate experienced an unprecedented increase, causing tax-
exempt ARS to be set at higher than normal rates. On September 17, 2008, the SIFMA increased
to 5.15%, causing tax-exempt ARS rates that re-set during that week to be set at 9.01%. On
September 24, 2008, SIFMA again increased, to 7.96%, causing tax-exempt ARS rates that reset
during that week to be set at 13.93%. The SIFMA index has since dropped back to historical
levels and was set at 0.54% at June 30, 2009.

Each of the individual trusts within the Authority has provisions for calculation of a net loan rate
for taxable ARS notes. This rate is intended to protect each trust from incurring cash outflows
that the cash inflows cannot sustain. The Authority largely missed the market disruption with
respect to its LIBOR-based Floating Rate Notes (FRNs) because the Authority’s FRNs reset
quarterly. The FRNs are fixed for three months; therefore, spreads on student loans financed with
FRNs are generally not affected to the extent of those financed with ARS notes.

In general, the amount, type and cost of our funding from the capital markets and borrowings
from financial institutions, have a direct impact on the Authority’s operating expenses and
financial results and can limit the Authority’s ability to grow assets. A number of factors could
make such securitization more difficult, more expensive or unavailable on any terms, including,
but not limited to, financial results and losses, changes within our organization, specific events
that have an adverse impact on the Authority’s reputation, changes in the activities of our
business partners, disruptions in the capital markets, specific events that have an adverse impact
on the financial services industry, changes affecting assets, corporate and regulatory structure,
interest rate fluctuations, ratings agencies’ actions, general economic conditions and the legal,



                                                                                                xiv
BRAZOS HIGHER EDUCATION AUTHORITY, INC.
Management’s Discussion and Analysis (continued)
For the Years ended June 30, 2009 and June 30, 2008
(Dollars in Thousands)




regulatory, and accounting environments governing the Authority’s funding transactions. In
addition, the ability to raise funds is strongly affected by the general state of the U.S. and world
economies, and may become increasingly difficult due to economic and other factors. Finally, the
Authority competes for funding with other industry participants, some of which are publicly
traded. Competition from these institutions may increase the Authority’s cost of funds.

If the term asset-backed securities market were to experience a prolonged disruption, if asset
quality were to deteriorate, or if debt ratings were to be downgraded, the Authority may be
unable to securitize student loans or to do so on favorable pricing and terms. If the Authority
were unable to find cost-effective and stable funding alternatives, funding capabilities and
liquidity would be negatively impacted and cost of funds could increase, adversely affecting
results of operations and ability to originate student loans. There can be no assurance the
Authority will be able to cost-effectively finance these facilities.

HR 3221

In September 2009, HR 3221 passed the House and moved to the Senate for review. HR 3221
includes a provision to eliminate the Federal Family Education Loan Program. The passage of
this bill would eliminate BHEA’s ability to fund new student loans. BHEA would continue to
administer the current indenture trusts until all debt has been repaid, which is anticipated to
continue for several years. Should this bill pass the Senate, it is highly probable that it will be
signed by President Obama due to his strong desire to eliminate the Federal Family Education
Loan Program, the only competition of the Federal Government’s Direct Loan Program.




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                              Report of Independent Auditors

Board of Directors
Brazos Higher Education Authority, Inc.
We have audited the accompanying balance sheets of Brazos Higher Education Authority, Inc.
(the Authority) as of June 30, 2009 and 2008, and the related statements of changes in fund
balance and cash flows for the years then ended. These financial statements are the responsibility
of the Authority’s management. Our responsibility is to express an opinion on these financial
statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United
States and the standards for financial audits contained in Government Auditing Standards, issued
by the Comptroller General of the United States. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial statements are free
of material misstatement. We were not engaged to perform an audit of the Authority’s internal
control over financial reporting. Our audits included consideration of internal control over
financial reporting as a basis for designing audit procedures that are appropriate in the
circumstances, but not for the purpose of expressing an opinion on the effectiveness of the
Authority’s internal control over financial reporting. Accordingly, we express no such opinion.
An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and significant estimates made
by management, and evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects,
the financial position of the Authority as of June 30, 2009 and 2008, and the results of its
operations and its cash flows for the years then ended, in conformity with accounting principles
generally accepted in the United States.

In accordance with Government Auditing Standards, we have also issued our report dated
October 27, 2009, on our consideration of the Authority’s internal control over financial
reporting and on our tests of its compliance with certain provisions of laws, regulations,
contracts, grant agreements and other matters. The purpose of that report is to describe the scope
of our testing of internal control over financial reporting and compliance and the results of that
testing, and not to provide an opinion on the internal control over financial reporting or on
compliance. That report is an integral part of an audit performed in accordance with Government
Auditing Standards and should be considered in assessing the results of our audit.




October 27, 2009



                                                                                                  1
                         Brazos Higher Education Authority, Inc.

                                       Balance Sheets


                                                                    June 30
                                                             2009           2008
                                                                (In Thousands)
Assets
Cash and short-term investments                          $    177,448    $    230,268
Interest receivable:
  Student loan notes receivable, net                           131,617         179,530
  Investments                                                       40             454
Student loan notes receivable, net                           8,248,768       8,902,092
Other receivables                                                    –             107
Deferred debt issue costs                                       23,766          25,007
Other assets                                                       171             661
Total assets                                             $   8,581,810   $   9,338,119

Liabilities and fund balance
Liabilities:
  Notes and bonds payable, net                           $   8,484,798   $   9,206,201
  Accrued interest payable                                       4,428          11,124
  Rebatable arbitrage payable                                      282             673
  Excess interest payable                                            –             958
  DOE fees payable                                               5,551           5,855
  Other payable                                                    119              28
  Administrative and loan servicing fees payable                 2,538           2,487
  Derivative liability                                          23,413           7,018
                                                             8,521,129       9,234,344

Commitments and contingencies

Fund balance:
 Restricted                                                     59,365         102,547
 Unrestricted                                                    1,316           1,228
                                                                60,681         103,775
Total liabilities and fund balance                       $   8,581,810   $   9,338,119

See accompanying notes.




                                                                                         2
                         Brazos Higher Education Authority, Inc.

                          Statements of Changes in Fund Balance


                                                                Years Ended June 30
                                                                2009           2008
                                                                   (In Thousands)
Interest income:
  Student loan notes receivable, net                        $   262,368    $   458,720
  Investments                                                     4,392         17,737
                                                                266,760        476,457
Interest expense:
  Notes and bonds payable                                       255,490        472,053
  Arbitrage and excess interest                                  (1,350)        (1,106)
                                                                254,140        470,947

Net interest income before provision for loan losses             12,620          5,510
Provision for loan losses                                        (1,986)        (1,866)
Net interest income after provision for loan losses              10,634          3,644

Non-interest income:
 Other                                                            1,621          8,572

Non-interest expense:
 Administrative and loan servicing fees                          35,208         50,186
 Auction agent and broker-dealer fees                               243          4,865
 Amortization of debt issue costs                                 1,119          1,136
 Loss on early extinguishment of debt                               243              –
 Derivative fair value adjustment                                16,395          5,698
 Other                                                            2,141          8,810
                                                                 55,349         70,695

Revenue under expenses, before amortization of unrealized
 derivative gain                                                (43,094)       (58,479)
Amortization of previously unrealized derivative gain                 –         (4,140)
Fund balance, beginning of year                                 103,775        166,394
Fund balance, end of year                                   $    60,681    $   103,775

See accompanying notes.




                                                                                          3
                         Brazos Higher Education Authority, Inc.

                                 Statements of Cash Flows


                                                                 Years Ended June 30
                                                                 2009           2008
                                                                    (In Thousands)
Cash flows from operating activities
Revenue under expenses, before amortization of unrealized
  derivative gain                                            $    (43,094) $     (58,479)
Adjustments to reconcile revenue under expenses, before
  unrealized derivative loss to net cash from operating
  activities:
     Student loan interest capitalized                           (125,607)     (131,823)
     Amortization of loan purchase premiums                        38,820        61,925
     Amortization of bond discount                                  1,586         1,619
     Amortization of debt issue costs                               1,119         1,136
     Provision for loan losses                                      1,986         1,866
     Derivative market value adjustment                            16,395         5,698
     Bonds payable market value adjustment                          1,275         2,293
     Loss on early extinguishment of debt                             243             –
     Amortization of previously unrealized derivative gain              –        (4,140)
     Changes in assets and liabilities:
       Decrease (increase) in assets:
           Interest receivable                                    48,327         27,944
           Other receivables                                         107           (107)
           Other assets                                              490            (29)
       Increase (decrease) in liabilities:
           Accrued interest payable                                (6,696)       (4,938)
           Rebatable arbitrage payable                               (391)       (2,118)
           Excess interest payable                                   (958)         (666)
           Administrative and loan servicing fees payable              51           642
           Other payable                                               91          (440)
           DOE fees payable                                          (304)         (384)
Net cash from operating activities                                (66,560)     (100,001)

Cash flows from investing activities
Principal collected on student loan notes receivable             749,128       1,127,141
Proceeds from sale of student loan notes receivable                1,116          26,632
Purchase of student loan notes receivable                        (12,119)       (644,095)
Net cash flows from investing activities                         738,125         509,678




                                                                                            4
                        Brazos Higher Education Authority, Inc.

                          Statements of Cash Flows (continued)


                                                             Years Ended June 30
                                                             2009           2008
                                                                (In Thousands)
Cash flows from financing activities
Proceeds from the issuance of bonds payable              $          – $      179,803
Repayment of bonds payable                                   (724,385)      (867,841)
Payment of deferred debt issue costs                                –           (701)
Net cash flows from financing activities                     (724,385)      (688,739)

Net change in cash and short term investments                 (52,820)      (279,062)
Cash and short-term investments, beginning of year            230,268        509,330
Cash and short-term investments, end of year             $    177,448 $      230,268

Supplemental disclosure of cash and noncash items
Cash paid during the year for interest                   $    259,324   $   477,220

See accompanying notes.




                                                                                      5
                         Brazos Higher Education Authority, Inc.

                               Notes to Financial Statements

                                     June 30, 2009 and 2008
                                     (Dollars in Thousands)


1. Organization

Brazos Higher Education Authority, Inc. (the Authority) is a Texas not-for-profit public benefit
corporation, which was incorporated in May 1975 for the purpose of providing funds for the
acquisition and servicing of student loans that are insured by the U.S. Department of Education
(DOE) and guaranteed by various national guarantors under the Federal Family Education Loan
Program (FFELP) as provided for in the Higher Education Act of 1965, as amended. To maintain
such insurance and guarantee of student loans, the Authority must comply with the servicing,
collecting, accounting, and reporting requirements of the FFELP. The Authority has contracted
with Brazos Higher Education Service Corporation, Inc. (BHESC) to serve as master servicer.
BHESC has contracted with various subservicers for loan servicing duties. Funding for the
Authority has been provided by financial institutions, the issuance of asset-backed bonds and,
periodically, by advances from affiliates.

The Authority’s primary source of revenue is interest on student loans and investment income.
The Authority obtains financing through notes payable, and issuance of student loan revenue
bonds to fund its student loan purchase program. All borrowings on the notes payable and bonds
are expected to be repaid solely from funds derived from student loan principal repayments,
interest, special allowance payments, interest subsidy payments, guarantee payments on
defaulted notes, proceeds from sales of student loan notes, proceeds from bonds or notes secured
by student loans, and investment income.

Interest Rate Environment

During the period from August 2007 through March 2009, the Federal Reserve lowered the
interest rate by 500 basis points. These cuts were in response to the general deterioration in the
United States economy. In addition, various economic factors caused banks and investors to
generally withdraw from the asset-backed bond markets, as investors fled the Asset-Backed
Security (ABS) market. Decreased investor demand for these securities has created pressure on
banks and brokers of Auction Rate Securities (ARS), a significant source of the Authority’s
financing, and the brokers absorbed these ARS onto their own balance sheets. The lack of
liquidity in the ARS market generally caused interest rate spreads to widen, reducing net interest
income for the Authority during this period. Because much of the ARS market was funded by
investors who issued commercial paper, the demand for ARS fell sharply across all risk ratings.




                                                                                                6
                         Brazos Higher Education Authority, Inc.

                      Notes to the Financial Statements (continued)




1. Organization (continued)

In February 2008, an imbalance of supply and demand in the ARS market as a whole led to
failures of the auctions pursuant to which certain of the Authority’s ARS interest rates are set.
The failed auctions have continued through 2009.

Each of the individual ARS trust estates within the Authority has provisions which stipulate the
determination of ARS interest rates in an event of auction failures. The Authority’s Taxable ARS
also have provisions which, during a period of auction failure, limit the interest rate on the ARS
to the lesser of the Maximum Rate or the Net Loan Rate. The Authority’s Maximum Rate
applied to taxable ARS is defined as the lesser of the 30-day LIBOR plus 150 basis points for
Senior debt and 30-day LIBOR plus 250 basis points for Subordinate debt. Each of the individual
trust estates within the Authority has provisions for calculation of a Net Loan Rate for taxable
ARS. The Net Loan Rate is intended to protect each trust estate from incurring cash outflows
that the cash inflows cannot sustain. The Net Loan Rates of the Authority’s respective trust
estates currently range from 2.30% to 2.82%. During 2009, the Net Loan Rate was invoked for
most taxable bond issues.

During the third quarter, twenty-one Senior issues with outstanding principal balance of
$1,283,500 and twelve Subordinate issues with outstanding principal balance of $358,700 were
downgraded by national rating agencies. This downgrade triggered an increase in the maximum
rate for affected Subordinate and Senior debt to 30-day LIBOR plus 350 basis points. This
effectively increased the interest expense incurred by the Authority. However, each of these
issues was limited by the Net Loan Rate discussed above. Therefore, the overall cash flows of
the trust estates which hold these respective issues were not adversely impacted.

The Maximum Rate for tax-exempt ARS is set at the greater of 1.0 minus the statutory corporate
tax rate (currently 35%), or 65% of 30-day AA rated financial Commercial Paper (CP), or 175%
of the Security Industry and Financial Markets Association (SIFMA) rate, not to exceed 14% or
15%, depending on the individual trust indenture. The SIFMA index is set weekly. During the
period ended June 30, 2009, the SIFMA rate experienced an unprecedented increase, causing
tax-exempt ARS to be set at higher than normal rates. On September 17, 2008, the SIFMA
increased to 5.15%, causing tax-exempt ARS rates that reset during that week to be set at 9.01%.
On September 24, 2008, SIFMA again increased, to 7.96%, causing tax-exempt ARS rates that
reset during that week to be set at 13.93%. The SIFMA index has since dropped back to
historical levels and was set at 0.54% at June 30, 2009. This significant increase in interest rates
did not have a material impact upon the respective trust estates cash flows due to the net loan
rate.



                                                                                                  7
                          Brazos Higher Education Authority, Inc.

                      Notes to the Financial Statements (continued)




1. Organization (continued)

Another significant source of the Authority’s financing is in the form of LIBOR-based Floating
Rate Notes (FRNs). The market disruption experienced in the ARS market, and discussed above,
did not have a significant impact upon the Authority’s FRNs, primarily because the Authority’s
FRNs reset quarterly. The FRNs are fixed for three months; therefore, spreads on student loans
financed with FRNs are generally not affected to the extent of those financed with ARS notes.

2. Significant Accounting Policies

Basis of Presentation

The accounts of the Authority are maintained in accordance with the principles of fund
accounting in accordance with the debt instruments. This is a system under which resources are
classified for accounting purposes into funds established for specific purposes. The Authority
aggregates its funds into general groups by the source of funding. The fund balance related to
specific financings is restricted by the bond agreements, and as such, is shown as restricted on
the balance sheets. The nondebt-related fund balance, if any, is shown as unrestricted on the
balance sheets.

Affiliated Entities

The Authority is affiliated with the following entities:

      Brazos Student Finance Corporation (BSFC)
      Bosque Higher Education Authority, Inc. (Bosque)
      Trinity Higher Education Authority, Inc. (THEA)
      Federated Student Finance Corporation (FSFC)
      Academic Finance Corporation (AFC)
      Acapita Education Finance Corporation (AEFC)
      Affordian, Inc. (AFF)
      EdInvest Company (EDI)
      Brazos Higher Education Service Corporation, Inc. (BHESC)
      Educational Funding Services, Inc. (EFCA)




                                                                                              8
                         Brazos Higher Education Authority, Inc.

                      Notes to the Financial Statements (continued)




2. Significant Accounting Policies (continued)

All of the entities operate in the student loan higher education industry and are controlled by
common officers and directors with the ability to influence the business performed by each
entity. BHESC provides headquarter facilities and administrative support and performs
marketing, accounting, servicing, and collection duties on a contractual basis at an agreed-upon
rate.

Recently Issued Accounting Pronouncements

On May 28, 2009, the Financial Accounting Standards Board (FASB) issued FASB Statement
No. 165, Subsequent Events, to provide accounting literature for subsequent events and to
modify the definition to refer to events or transactions that occur after the balance sheet date, but
before the financial statements are available to be issued. The standard now requires the date
through which the Authority has evaluated subsequent events and the basis for that date be
disclosed. This statement was effective for annual financial periods ending after June 15, 2009.

Pending Accounting Pronouncements

On June 30, 2009, the FASB issued FASB Statement No. 168, The FASB Accounting Standards
Codification™ and the Hierarchy of Generally Accepted Accounting Principles, a replacement
of FASB Statement No. 162. The FASB Accounting Standards Codification (Codification) will
become the source of authoritative US generally accepted accounting principles (GAAP)
recognized by the FASB to be applied by nongovernmental entities. On the effective date, the
Codification will supersede all then existing non-SEC accounting and reporting standards. This
statement is effective for financial statements issued for interim and annual periods ending after
September 15, 2009. The effects of this statement will not have an impact on our financial
statements, but will have a change on the way we disclose certain accounting principles and
application of those principles.

Debt Issue Costs and Bond Discount

The Authority capitalizes debt issue costs incurred when issuing debt. Debt issue costs include
costs related directly to the issuance of notes and bonds payable and consist primarily of filing
fees, trustee fees and expenses, document reproduction costs, legal fees, costs of credit ratings,
underwriter’s fees, and other costs. The Authority also issues bonds at a discount and records the
discount as an adjustment to bonds payable, net, on the balance sheet. Debt issue costs and bond




                                                                                                   9
                         Brazos Higher Education Authority, Inc.

                      Notes to the Financial Statements (continued)




2. Significant Accounting Policies (continued)

discounts are amortized over the terms of the bonds using a method that approximates the
effective interest method. The amortization of the bond discount is included within interest
expense on bonds payable in the statements of changes in fund balance.

Interest Receivable

Interest receivable on student loan notes receivable includes special allowance payments
receivable from the DOE, government subsidy interest, and borrower interest on all student loans
outstanding.

Cash and Short-Term Investments

Cash and short-term investments consist of demand deposits in banks, money market funds,
guaranteed investment contracts, and repurchase agreements with original maturities of 90 days
or less. Cash and short-term investments are held in trust with either Wells Fargo Bank, N.A. or
U.S. Bank, N.A. (collectively, the Trustees) under various trust indentures, subject to certain
limitations (see Note 2 – Trustees), and are pledged to secure related notes and bonds payable.
Guaranteed investment contracts are stated at fair value and represent unsecured investments.
Repurchase agreements are stated at fair value and are fully collateralized by underlying
securities. Any realized or unrealized changes in fair value are recorded through the statement of
changes in fund balance. Interest income from these investments is recorded on an accrual basis.

Cash and short-term investments are comprised of the following:

                                                                             June 30
                                                                      2009             2008

   Cash – demand deposits                                         $     1,579    $       1,302
   Repurchase agreements                                               16,051           56,181
   Guaranteed investment contracts                                    113,240          136,346
   Money market funds                                                  46,578           36,439
   Total cash and short-term investments                          $   177,448    $     230,268

As of June 30, 2009 and 2008, the Authority had $74,435 and $81,579, respectively, in cash and
short-term investment reserves in compliance with the bond indenture requirements.




                                                                                                 10
                         Brazos Higher Education Authority, Inc.

                      Notes to the Financial Statements (continued)




2. Significant Accounting Policies (continued)

Student Loan Notes Receivable, Net

Student loans are stated at the principal amount outstanding, plus unamortized purchase
premiums, transfer fees, and contingent borrower benefits, net of the allowance for loan losses.
All student loan notes receivable are pledged to secure related bonds payable.

Premiums on Loans Purchased

The Authority defers premiums paid on student loan notes purchased and amortizes such
premiums over the estimated life of the student loan notes as an adjustment to the yield of the
related loans, utilizing a method which approximates the effective interest rate method.
Amortization of the premiums is included within the statements of changes in fund balance in
interest on student loan notes receivable, net, and was $33,902 and $56,344 for the years ended
June 30, 2009 and 2008, respectively. Included on the balance sheets within the student loan
notes receivable, net balance is $238,713 and $272,547 at June 30, 2009 and 2008, respectively,
of unamortized loan purchase premiums.

Federal Income Taxes

The Authority is a not-for-profit public benefit corporation, which is exempt from federal income
taxes under the provisions of Section 501(c)(3) of the Internal Revenue Code. As such, no
provision for federal income taxes has been provided in the accompanying financial statements.

In July 2006, FASB Interpretation 48 (FIN 48), Accounting for Uncertainty in Income Taxes—an
interpretation of FASB Statement No. 109, was issued. FIN 48 creates a single model to address
uncertainty in tax positions and clarifies the accounting for income taxes by prescribing the
minimum recognition threshold a tax position is required to meet before being recognized in the
financial statements. Under the requirements of FIN 48, tax-exempt organizations could now be
required to record an obligation as the result of a tax position they have historically taken on
various tax exposure items. Prior to FIN 48, the determination of when to record a liability for a
tax exposure was based on whether a liability was considered probable and reasonably estimable
in accordance with FASB Statement No. 5, Accounting for Contingencies. On July 1, 2007, the
Authority adopted FIN 48. There was no impact on the financial statements as of June 30, 2009,
from the adoption of FIN 48.




                                                                                               11
                         Brazos Higher Education Authority, Inc.

                      Notes to the Financial Statements (continued)




2. Significant Accounting Policies (continued)

Trustees

The Authority contracts certain services to trustees. Trustees hold the pledged student loan notes
receivable and other invested assets in the Authority’s name and invest and disburse funds as
directed by the Authority pursuant to the requirements of the indenture agreements. The trustees
also monitor the invested assets of the Authority and the related cash flows of the loans and other
assets pledged under the trust to secure the related debt.

Concentration Risk

The Authority’s credit risk is inherent principally in its student loan notes receivable. A
downturn in the economy resulting in substantial unemployment has resulted in an increase in
defaults by borrowers in paying student loans, thus causing increased default claims to be paid
by the loan guarantor for federally guaranteed loans. It is impossible to predict the status of the
economy or unemployment levels or at which point the economy would improve, thereby
significantly decreasing the Authority’s credit risk exposure. However, the credit risk of the
Authority is substantially decreased by the guaranteed nature of its investments in student loan
notes receivable.

The Authority’s loan portfolio is also concentrated in FFELP loans. At June 30, 2009, 100% of
the portfolio is FFELP loans and approximately 79% of the portfolio is consolidation loans. Any
changes in legislation related to the FFELP and/or consolidation loans could have a significant
impact on the Authority.

Student Loan Income

The Authority recognizes interest income on student loans as earned, net of amortization of
premiums and amortized DOE lender fees and DOE rebate fees paid. Additionally, income is
recognized based upon the principal amount outstanding in accordance with the terms of the
applicable loan agreement until the outstanding balance is paid off, after giving effect to
estimates for borrower utilization of borrower benefit incentives for making timely loan
payments.




                                                                                                12
                         Brazos Higher Education Authority, Inc.

                      Notes to the Financial Statements (continued)




2. Significant Accounting Policies (continued)

Interest Expense

Interest expense is based upon contractual interest rates (variable) adjusted for the amortization
of bond discount costs.

Derivative Financial Instruments

The Authority may enter into derivative contracts for the purpose of managing exposure to
interest rate risk. For derivatives designated as hedging the exposure to changes in the fair value
of an asset or liability (fair value hedge), the gain or loss is recognized in earnings in the period
of change together with the offsetting loss or gain to the hedged item attributable to the risk
being hedged. Earnings will be affected to the extent to which the hedge is not effective in
achieving offsetting changes in fair value.

In applying hedge accounting for derivatives, the Authority established a method for assessing
the effectiveness of the hedging derivative and a measurement approach for determining the
ineffective aspect of the hedge upon the inception of the hedge. This method is consistent with
the Authority’s approach to managing risk.

Derivatives that are not designated as hedging as defined in Statement of Financial Accounting
Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, are recorded
at fair value with a corresponding increase or decrease to the statement of changes in fund
balance.

Department of Education Fees

DOE fees consist of rebate fees due to the DOE. Rebate fees are monthly fees assessed by the
DOE on the outstanding consolidation loan balance at the end of the month. Rebate fees are
accounted for as an adjustment to the yield on student loan notes receivable, included within the
statements of changes in fund balance in interest on student loan notes receivable, net, and were
$68,291 and $72,100 for the years ended June 30, 2009 and 2008, respectively.




                                                                                                  13
                         Brazos Higher Education Authority, Inc.

                      Notes to the Financial Statements (continued)




2. Significant Accounting Policies (continued)

Estimates in Financial Statements

The preparation of financial statements in conformity with accounting principles generally
accepted in the United States requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results may differ from those estimates. Key
accounting policies that include significant judgments and estimates include use of the effective
interest rate method to amortize premiums on loans purchased, accounting for contingent
borrower benefits, provision for loan losses, and derivative accounting.

Reclassifications

Certain reclassifications have been made to prior year financial statements in order to conform to
the current year presentation.

3. Interest Receivable on Student Loan Notes Receivable

FFELP loans obligate the borrower to either pay interest at a stated fixed rate or an annually reset
variable rate that has a cap depending on when the loan was originated. The Authority earns
interest at the greater of the aforementioned borrower’s rate or a floating rate set by the DOE. If
the floating rate exceeds the borrower’s rate, the DOE makes a payment directly to the Authority
based upon the Special Allowance Payment (SAP) formula. SAP is generally paid whenever the
average of all of the applicable floating rates (91-day Treasury bill, commercial paper, and
52-week Treasury bill) in a calendar quarter, plus a spread of between 1.74% and 3.50%,
depending on the loan status and origination date, exceeds the rate of interest that the borrower is
obligated to pay. These rates are then applied to the quarterly average daily balance for loans
eligible to receive SAP. Actual cash receipts from the DOE may vary based on changes in actual
average daily balance and actual average of all of the applicable floating rates.

If the floating rate determined by the SAP formula is less than the rate the borrower is obligated
to pay, the Authority earns interest at the borrower rate for loans first disbursed prior to April 1,
2006. For these loans, the rate a borrower is obligated to pay sets a minimum rate for
determining the yield that the Authority earns on the loan.




                                                                                                  14
                         Brazos Higher Education Authority, Inc.

                      Notes to the Financial Statements (continued)




3. Interest Receivable on Student Loan Notes Receivable (continued)

For loans first disbursed on or after April 1, 2006, the Authority earns interest at the SAP rate. If
the SAP rate is less than the stated borrower rate, the Authority “rebates” the difference between
the borrower rate and the lower SAP rate to the DOE. If the SAP rate is greater than the stated
borrower rate, the DOE makes SAP payments to the Authority for the difference between the
two rates.

Prior to October 30, 2004, the DOE guaranteed a minimum yield of 9.5% (9.5% SAP Floor) in
connection with loans made from proceeds of certain tax-exempt bonds. On October 30, 2004,
President Bush signed the Taxpayer-Teacher Protection Act of 2004 (the October 30 Act), a new
law that amends the Higher Education Act (HEA). The October 30 Act restricts the situations in
which lenders are entitled to the 9.5% SAP Floor in connection with loans made from the
proceeds of certain tax-exempt bonds. Specifically, the DOE will no longer guarantee payment
of the 9.5% SAP Floor for a loan financed with qualifying tax-exempt bonds if (1) the
underlying bond matures, is retired, is defeased or is refunded or (2) if the loan is refinanced with
funds obtained from certain bonds or is sold or transferred to another holder. The October 30 Act
was extended as part of the reauthorization of the HEA.

On January 24, 2007, the DOE issued a letter that provides its interpretation of the Higher
Education Act of 1965, as amended, and the DOE’s regulations that control eligibility for SAP at
the 9.5% SAP Floor; in effect, defining those loans that it believes are eligible for SAP at the
9.5% SAP Floor.

The DOE suspended payment of claims for SAP at the 9.5% SAP Floor rate beginning the
quarter ended September 30, 2006. Since the issuance of the DOE’s interpretation, the Authority
has not claimed amounts previously considered eligible for the 9.5% SAP Floor.

At June 30, 2009, student loans held by the Authority had stated interest rates determined
annually by the DOE ranging from 3.61% to 8.25% and are generally payable by the borrower
following a specified grace period. Effective July 1, 2009, the DOE reset these rates to range
from 1.88% to 8.50%.

For FFELP loans, the U.S. Government pays the Authority the interest on subsidized student
loans from the date of acquisition until the end of the grace period as defined in the regulations.




                                                                                                  15
                         Brazos Higher Education Authority, Inc.

                      Notes to the Financial Statements (continued)




3. Interest Receivable on Student Loan Notes Receivable (continued)

Under certain conditions, the Authority may capitalize accrued interest receivable and add it to
the borrower’s outstanding principal. For unsubsidized FFELP student loans, the borrower has
the option of either paying the interest or having accrued interest capitalized from the date of the
loan origination until the end of the grace period and during periods of deferment. Borrowers of
both subsidized and unsubsidized FFELP student loans have the option of having accrued
interest capitalized during periods of forbearance. Subsequent interest accrues on the new total
principal balance that includes any capitalized interest.

Interest on student loans receivable consisted of the following:

                                                                              June 30
                                                                       2009              2008

 Student loan interest receivable                                  $   136,583      $     151,314
 Interest subsidy receivable                                             9,573             13,029
 Special allowance (payable) receivable                                (14,539)            15,187
 Interest receivable on student loan notes receivable              $   131,617      $     179,530

4. Student Loan Notes Receivable

Student loan notes are purchased by the Authority primarily from affiliates. The Authority’s
student loan portfolio consists solely of loans originated under the FFELP federally sponsored
student loan program.

Student loan notes receivable consist of the following:

                                                                          June 30
                                                                   2009                 2008

 FFELP student loan notes receivable                          $ 7,993,982         $ 8,609,432
 Deferred loan premiums and transfer fees, net of
  accumulated amortization                                           261,028          299,780
 Contingent borrower benefits                                            411              411
                                                                   8,255,421        8,909,623
 Allowance for student loan losses                                    (6,653)          (7,531)




                                                                                                    16
                       Brazos Higher Education Authority, Inc.

                    Notes to the Financial Statements (continued)




Student loan notes receivable, net                  $ 8,248,768     $ 8,902,092




                                                                                  17
                         Brazos Higher Education Authority, Inc.

                      Notes to the Financial Statements (continued)




4. Student Loan Notes Receivable (continued)

Loan Programs

The FFELP includes the Federal Stafford Loan (Stafford) Program, the Federal Supplemental
Loans for Students (SLS) Program, the Federal Parent Loan for Undergraduate Students (PLUS)
Program, the Federal Parent Loan for Graduate Students (GradPLUS) Program, and the Federal
Consolidation Loan Program. These loan programs are available to students or parents of
students who, when the loans were originated, were enrolled in postsecondary institutions.

Stafford, SLS, GradPLUS, and PLUS loans have repayment periods ranging from between 5 and
10 years. Federal consolidation loans have repayment periods of 12 to 30 years. Repayment on
these loans commences subsequent to a grace period following the student’s graduation.

All FFELP loans held by the Authority have been either insured or guaranteed by the U.S.
Government, Texas Guaranteed Student Loan Corporation, or other national guarantors,
provided applicable program requirements have been met by the original lender, prior servicer,
and the current servicing agent with respect to such loans. The original lenders have warranted to
the Authority that the student loans have met these requirements and are valid obligations of the
borrowers. Student loan notes that do not conform to the terms of the purchase agreement
between the individual entities and the original lender may be returned to the original lending
institution for reimbursement of principal, interest, and costs incurred while held by the
individual entities.

In the event of default on a student loan due to borrower default, death, disability, or bankruptcy,
the Authority files a claim with the insurer or guarantor of the loan. The Authority will receive
the unpaid principal balance and accrued interest on the loan less any risk sharing, if applicable,
provided the loan has been properly originated and serviced.

Student Loan Servicing

BHESC provides the Authority with the necessary student loan servicing to maintain compliance
with the requirements of the FFELP loan program by holding subservicing agreements for loan
servicing duties with various student loan servicing agents. BHESC holds subservicing
agreements for loan servicing duties with Affiliated Computer Services, American Education




                                                                                                 18
                          Brazos Higher Education Authority, Inc.

                       Notes to the Financial Statements (continued)




4. Student Loan Notes Receivable (continued)

Services, Suntech Inc., Great Lakes Educational Loan Services, Inc., Student Assistance
Foundation of Montana, and Sallie Mae Servicing Corporation. Under the terms of these
subservicing agreements, the subservicer indemnifies the Authority for any loss of principal and
interest resulting from deficiencies in the loan servicing performed by the subservicer. At
June 30, 2009, 100% of the loan portfolio is serviced by subservicers.

Transfer Fees

The Authority defers transfer fees paid to BHESC for the performance of various general and
administrative transfer services, estimated brokerage-related equivalent fees for BHESC
employee services provided in the student loan origination process, and the performance of legal
services related to the transfer of student loans. These transfer fees approximate 0.30% to 0.60%
of the principal amount of the loans transferred. The Authority amortizes such fees over the
estimated life of the student loan notes as an adjustment to the yield of the related loans, utilizing
a method which approximates the effective interest rate method. Amortization of the fees is
included in the statements of changes in fund balance as a reduction of interest on student loan
notes receivable, net. For the years ended June 30, 2009 and 2008, $4,918 and $5,582,
respectively, is included as amortization of purchase premiums. Included in unamortized
purchase premiums is $22,315 and $27,233 at June 30, 2009 and 2008, respectively, of
unamortized transfer fees. In addition, for the years ended June 30, 2009 and 2008, the Authority
capitalized $-0- and $83, respectively, in transfer fees paid to BHESC. Beginning in fiscal year
2008, BHESC discontinued the transfer fees. This resulted in the Authority no longer recording
transfer fees. The transfer fees currently capitalized will continue to be amortized over the life of
the loans.

Allowance for Student Loan Losses

The Budget Reconciliation Act of 1993 (the Act) lowered the federal guarantee for FFELP
student loans made on or after October 1, 1993, to 98%. The Deficit Reduction Act of 2006
lowered the federal guarantee for FFELP student loans made on or after July 1, 2006, to 97%.
The Authority provides an allowance for estimated loss of guaranteed student loan principal and
interest related to the 98% guarantee limitation and unrecoverable amounts due to servicing
deficiencies on student loan notes receivable. The Act’s lowering of federal reinsurance has not
historically had a material impact on the Authority. The Authority determines the allowance for




                                                                                                   19
                          Brazos Higher Education Authority, Inc.

                      Notes to the Financial Statements (continued)




4. Student Loan Notes Receivable (continued)

loan losses based on loss factors applied to the portion of student loan balances without
government guarantee by individual loan type and status. Because the Authority’s portfolio
consists of guarantees ranging from 97% to 99%, and because there is a relatively small
percentage of loans at the 97% guarantee, management has considered that 98% of principal and
interest is guaranteed and there is only 2% of principal with credit risk.

Activity in the allowance for loan losses is summarized as follows:

                                                                                  June 30
                                                                        2009                 2008

  Balance, beginning of year                                        $        7,531       $     8,135
  Provision for loan losses                                                  1,986             1,866
  Charge-offs, net of recoveries                                            (2,864)           (2,470)
  Balance, end of year                                              $        6,653       $     7,531

5. Notes and Bonds Payable, Net

Notes and bonds payable consist of the following:

                                                                                              Final
                                                        June 30,             June 30,        Maturity
                                                         2009                 2008            Date

   Student Loan Revenue and Refunding Bonds
     Series 1994 A1-A2 & B1                         $       3,500       $       18,100       June 2014

                                                                                         December 2008
   Student Loan Revenue and Refunding Bonds                                                 through
     Series 1997 A1-A3                                     35,000               38,000   December 2031

                                                                                         December 2006
   Student Loan Revenue and Refunding Bonds                                                 through
     Series 1998 A1-A4                                     35,000               45,000   February 2038




                                                                                                         20
                          Brazos Higher Education Authority, Inc.

                      Notes to the Financial Statements (continued)




5. Notes and Bonds Payable, Net (continued)

                                                                                    Final
                                                     June 30,        June 30,      Maturity
                                                      2009             2008         Date

                                                                                 December 2005
                                                                                    through
  Student Loan Revenue Bonds Series 1999 A1-A6   $     253,350   $     322,600   December 2033

                                                                                  March 2006
  Student Loan Revenue Bonds Series 1999                                            through
    A7-A12 & B1                                        174,900         236,300   December 2034

  Student Loan Revenue Bonds Series 2000
    A1-A4 & B1                                          11,000          11,000     May 2030

  Student Loan Asset-Backed Bonds Series 2000
    A5-A11 & C1                                         26,000          26,000   October 2030

                                                                                 December 2005
  Student Loan Revenue and Refunding Bonds                                          through
    Series 2001 A1 & B1                                 35,000          35,000   February 2036

                                                                                 December 2005
  Student Loan Revenue and Refunding Bonds                                          through
    Series 2001 A2-A6 & B2                             111,400         118,800     July 2036

                                                                                  March 2006
  Student Loan Revenue and Refunding Bonds                                          through
    Series 2001 A7-A10 & C1                             24,800          31,900   November 2036

  Student Loan Revenue and Refunding Bonds
    Series 2002 A1-A3                                   43,300          76,900   December 2036

                                                                                 December 2005
  Student Loan Revenue and Refunding Bonds                                          through
    Series 2002 A4-A7 & C1                              22,200          29,900   December 2037

  Student Loan Revenue Bonds Series 2002
    A8-A12 & C2                                        193,100         271,900   December 2037




                                                                                                 21
                           Brazos Higher Education Authority, Inc.

                       Notes to the Financial Statements (continued)




5. Notes and Bonds Payable, Net (continued)

                                                                                      Final
                                                       June 30,        June 30,      Maturity
                                                        2009             2008         Date

                                                                                     May 2009
                                                                                      through
  Student Loan Revenue Bonds Series 2003 A1-A2     $      35,000   $      39,900   December 2037

                                                                                     June 2023
                                                                                      through
  Student Loan Revenue Bonds Series 2003 A3-A5            72,400          98,900     June 2038

  Student Loan Revenue Bonds Series 2003
    A6-A10 & B1                                           78,000          78,000     July 2039

  Student Loan Revenue Bonds Series 2003
    A11-A15 & B2                                         108,100         108,100   December 2039

  Student Loan Revenue Bonds Series 2004
    A1-A5 & B1                                            63,000          63,000   December 2039

                                                                                    March 2006
  Student Loan Revenue Bonds Series 2004                                              through
    A6-A11 & C1                                          210,000         211,000   December 2038

  Student Loan Revenue Bonds Series 2004 A12-A17         171,700         171,700   December 2039

  Student Loan Revenue Bonds Series 2004:
                                                                                   September 2013
                                                                                       through
     Series I-A-1 thru I-A-2                             399,807         475,552     June 2022

     Series I-A-3 thru I-A-5 & I-B-1                      70,000          70,000   December 2039

  Student Loan Revenue Bonds Series 2005 A1               78,500          78,500   December 2039

  Student Loan Revenue Bonds Series 2005:
                                                                                   September 2016
                                                                                       through
     Series I-A-1 thru I-A-4                             687,700         735,700     March 2029




                                                                                                    22
                           Brazos Higher Education Authority, Inc.

                       Notes to the Financial Statements (continued)




5. Notes and Bonds Payable, Net (continued)

                                                                                     Final
                                                    June 30,         June 30,       Maturity
                                                     2009              2008          Date

     Series I-A-5 thru I-A-7 & I-B-1            $      33,000    $      33,000      June 2041

  Student Loan Revenue Bonds Series 2005:
                                                                                   June 2014
                                                                                    through
     Series I-A-8 thru I-A-12                        1,087,494        1,153,059    March 2023

     Series I-B-2                                      69,100           69,100      June 2042

  Student Loan Revenue Bonds Series 2005:
                                                                                  September 2020
                                                                                      through
     Series I-A-13 thru I-A-16                        739,109          823,960      March 2026

     Series I-B-3                                      50,000           50,000      June 2042

  Student Loan Revenue Bonds Series 2005:
      Series A-2 thru A-4                             170,100          170,100    December 2040

     Series A-5                                        83,786          130,900    December 2040

  Student Loan Revenue Bonds Series 2006:
      Series A-1                                       56,950           56,950    December 2040

     Series A-2                                       222,850          243,050    December 2040

  Student Loan Revenue Bonds Series 2006:
                                                                                   March 2022
                                                                                     through
     Series I-A-1 thru I-A-3                          541,485          573,575    December 2024

     Series I-A-4 thru I-A-8 & I-B-1                   50,000           50,000      June 2042

  Student Loan Revenue Bonds Series 2006:
      Series A-3 thru A-6 & B-1                       288,200          288,200      June 2042




                                                                                                   23
                          Brazos Higher Education Authority, Inc.

                      Notes to the Financial Statements (continued)




5. Notes and Bonds Payable, Net (continued)

                                                                                    Final
                                                   June 30,         June 30,       Maturity
                                                    2009             2008           Date

  Student Loan Revenue Bonds Series 2006:
      Series I-A-9 thru I-A-10                                                   December 2024
                                                                                    through
                                               $     552,238    $     552,238      June 2026

     Series I-A-11 thru I-A-15 & I-B-2               209,700          211,350      June 2042

  Student Loan Revenue Bonds Series 2006:
      Series A-7 thru A-10                           218,100          218,100    December 2042

  Student Loan Revenue Bonds Series 2006:
      Series A-11 thru A-15                          383,700          383,700    December 2042

  Student Loan Revenue Bonds Series 2007:
      Series A-1 thru A-4                            160,000          160,000      June 2043

  Student Loan Revenue Bonds Series 2007:
      Series I-A-1 thru I-A-5 & I-B-1                500,000          500,000      June 2043

  Student Loan Revenue Bonds Series 2007:
      Series A-5 thru A-6                             156,280          180,200     June 2039
                                                    8,514,849        9,239,234

  Less:
   Unamortized bond discount                           30,051           31,757
   Fair value adjustment                                    –            1,276
                                               $    8,484,798   $    9,206,201




                                                                                                 24
                          Brazos Higher Education Authority, Inc.

                       Notes to the Financial Statements (continued)




5. Notes and Bonds Payable, Net (continued)

Interest rates for the various bond series are based on fixed and variable rates. The interest rates
for each class of bonds are:

   Floating rate securities                  3-month LIBOR plus spread                0.64% – 0.77%
                                             varying from 0.3% – 0.16%
   Taxable auction rate securities                  Set at auction                    1.81% – 2.82%
   Tax-exempt auction rate securities               Set at auction                    0.60% – 1.30%
   Reset rate securities                                Fixed                         1.36% – 1.38%
   Variable rate demand notes                          Variable                               5.25%

The auction rates are determined every 7, 28, or 35 days depending on the auction procedures
described in the indenture agreement. The interest rates may be converted to variable or fixed
rate by the Authority within the guidelines established by the indenture agreements.

Pursuant to the individual indenture agreement for each debt instrument, the respective bond
issues are secured solely by those student loans and other invested assets held by each individual
bond issue’s trust estate.

Pursuant to the indenture and note agreements, the Authority is subject to certain financial and
nonfinancial covenants. Under the note agreements, the Authority has certain minimum
collateral coverage requirements. Under the indenture covenants, the Authority must make
timely principal and interest payments or the bonds will default. The Authority was in
compliance with financial and nonfinancial debt covenants at June 30, 2009.

The maturities of bonds payable as of June 30, 2009, by fiscal year, are as follows:

   2010                                                                           $   211,714
   2011                                                                               203,009
   2012                                                                               212,540
   2013                                                                               208,445
   2014                                                                               212,006
   Thereafter                                                                       7,467,135
                                                                                  $ 8,514,849

The actual maturities of notes and bonds payable may differ from the contractual maturities
noted above, as the Authority has the ability to prepay the debt outstanding.



                                                                                                 25
                         Brazos Higher Education Authority, Inc.

                      Notes to the Financial Statements (continued)




6. Derivative Financial Instruments and Hedging Activities

In prior years, the Authority entered into an interest rate contract in order to manage interest rate
exposure. This interest rate swap agreement effectively modifies the Authority’s exposure to
interest rate risk by converting a portion of the Authority’s variable rate LIBOR-based bonds
payable to variable rate commercial paper-based bonds payable. The Authority has elected not to
take hedge accounting allowed under FAS 133 to account for this contract. The notional amount
of this interest rate swap totals $250,000. The estimated fair value of this interest rate swap was
$28,228 liability and $11,460 liability at June 30, 2009 and 2008, respectively. There was
$16,768 and $23,405 negative effect on income related to the derivative market value adjustment
for the years ended June 30, 2009 and 2008, respectively. The interest rate swap matures in
December 2012.

In prior years, the Authority sold and terminated its position in an interest rate swap with a
notional amount of $400,000 for fair value and cash consideration of $10,351, which was
previously designated as a cash flow hedge. The unrealized gain of $10,351 related to this
interest rate swap included in fund balance was amortized and reclassified against interest
expense over the original remaining life of the terminated interest rate swap. The Authority also
sold and terminated its position in an interest rate swap with a notional amount of $500,000 for
fair value and cash consideration of $11,217, which was also designated as a cash flow hedge.
The previously unrealized gain of $11,217 related to this interest rate swap included in fund
balance was amortized and reclassified against interest expense over the original remaining life
of the terminated interest rate swap. The variable rate bonds that these swaps previously hedged
remain outstanding at June 30, 2008. The Authority amortized $-0- and $4,140 of the unrealized
gains discussed above for the years ended June 30, 2009 and 2008, respectively. There was no
unamortized balance of unrealized gains included in the fund balance as of June 30, 2009 or
2008. At June 30, 2009, there were no outstanding interest rate swaps designated as cash flow
hedges.

In prior years, the Authority entered into interest rate contracts that were initially accounted for
and designated as fair value hedges. During the first quarter of fiscal year 2007, these interest
rate contracts were determined to be ineffective at hedging the exposure to changes in fair value
of the hedged debt and the Authority ceased accounting for these interest rate contracts as fair
value hedges. The result of this change is that the bonds payable market value adjustment of
$5,479 that existed as of May 31, 2006 (the last date the interest rate swaps were deemed to be
effective) is being amortized to interest income over the remaining three-year term of the interest




                                                                                                  26
                         Brazos Higher Education Authority, Inc.

                      Notes to the Financial Statements (continued)




6. Derivative Financial Instruments and Hedging Activities (continued)

rate contracts. The Authority amortized $1,275 and $2,293 of this fair value adjustment into
interest income during the years ended June 30, 2009 and 2008, respectively. The unamortized
fair value adjustment included in notes and bonds payable, net, as of June 30, 2009 and 2008,
was $-0- and $1,275, respectively. The estimated fair value of these interest rate swaps at
June 30, 2009 and 2008, was $-0- asset and $4,442 asset, respectively. There was a $4,442
negative and $10,969 positive effect on income related to the change in fair value of the interest
rate swap for the years ended June 30, 2009 and 2008, respectively. One of these interest rate
contracts matured in December 2008. The remaining interest rate contract matured in
March 2009.

7. Fair Value of Financial Instruments

At June 30, 2009 and 2008, the estimated fair values of the Authority’s financial instruments are
as follows:

                                                  2009                              2008
                                       Carrying          Fair            Carrying          Fair
                                       Amount            Value           Amount            Value
   Financial assets:
     Cash and short term
       investments                 $     177,448     $    177,448    $     230,268     $    230,268
     Student loan notes
       receivable, net                 8,248,768         7,936,965       8,902,092         8,579,300

   Financial liabilities:
     Notes and bonds payable,
        net                            8,484,798         8,261,420       9,206,201         9,143,215
     Interest rate swaps                  23,413            23,413           7,018             7,018

The following methods and assumptions were used to estimate the fair value of each class of
financial instruments:

Cash and Short term investments

The fair values of cash and short term investments approximate the carrying amount due to the
short maturity of these instruments.



                                                                                                       27
                          Brazos Higher Education Authority, Inc.

                       Notes to the Financial Statements (continued)




7. Fair Value of Financial Instruments (continued)

Student Loan Notes Receivable, net

The fair value of student loan notes receivable has been determined using discounted cash flow
models.

Notes and Bonds Payable, net

The fair value of the bonds payable is based on the discounted value of the future cash flows
using current rates for similar bonds.

Interest Rate Swaps

The estimated fair value of interest rate swap agreements is based on quoted market prices,
dealer quotes, and prices obtained from independent pricing services.

8. Fair Value Measurements

Effective July 1, 2008, the Authority adopted the provisions of Statement of Financial
Accounting Standards (SFAS) No. 157, Fair Value Measurements (SFAS 157), for financial
assets and financial liabilities. In accordance with Financial Accounting Standards Board Staff
Position (FSP) No. 157-2, Effective Date of FASB Statement No. 157, the Authority will delay
application of SFAS 157 for nonfinancial assets and nonfinancial liabilities until July 1, 2009. As
of June 30, 2009, the Authority did not have nonfinancial assets and liabilities required to be
measured at fair value. SFAS 157 defines fair value, establishes a framework for measuring fair
value in generally accepted accounting principles, and expands disclosures about fair value
measurements.

SFAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer
a liability in an orderly transaction between market participants. A fair value measurement
assumes that the transaction to sell the asset or transfer the liability occurs in the principal market
for the asset or liability or, in the absence of a principal market, the most advantageous market
for the asset or liability. The price in the principal (or most advantageous) market used to
measure the fair value of the asset or liability shall not be adjusted for transaction costs. An
orderly transaction is a transaction that assumes exposure to the market for a period prior to the




                                                                                                    28
                         Brazos Higher Education Authority, Inc.

                      Notes to the Financial Statements (continued)




8. Fair Value Measurements (continued)

measurement date to allow for marketing activities that are usual and customary for transactions
involving such assets and liabilities; it is not a forced transaction. Market participants are buyers
and sellers in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to
transact, and (iv) willing to transact.

SFAS 157 requires the use of valuation techniques that are consistent with the market approach,
the income approach, and/or the cost approach. The market approach uses prices and other
relevant information generated by market transactions involving identical or comparable assets
and liabilities. The income approach uses valuation techniques to convert future amounts, such
as cash flows or earnings, to a single present amount on a discounted basis. The cost approach is
based on the amount that currently would be required to replace the service capacity of an asset
(replacement cost). Valuation techniques should be consistently applied. Inputs to valuation
techniques refer to the assumptions that market participants would use in pricing the asset or
liability. Inputs to valuation techniques refer to the assumptions that market participants would
use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the
assumptions market participants would use in pricing the asset or liability developed based on
the best information available in the circumstances. In that regard, SFAS 157 establishes a fair
value hierarchy for valuation inputs that gives the highest priority to quoted prices in active
markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair
value hierarchy is as follows:

   • Level 1 Inputs – Unadjusted quoted prices in active markets for identical assets or
       liabilities that the reporting entity has the ability to access at the measurement date.

   • Level 2 Inputs – Inputs other than quoted prices included in Level 1 that are observable
       for the asset or liability, either directly or indirectly. These might include quoted prices
       for similar assets or liabilities in active markets, quoted prices for identical or similar
       assets or liabilities in markets that are not active, inputs other than quoted prices that are
       observable for the assets or liabilities (such as interest rates, volatilities, prepayment
       speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by
       market data by correlation or other means.

   • Level 3 Inputs – Unobservable inputs for determining the fair values of assets or
       liabilities that reflect an entity’s own assumptions that market participants would use in
       pricing the assets or liabilities.




                                                                                                  29
                            Brazos Higher Education Authority, Inc.

                          Notes to the Financial Statements (continued)




8. Fair Value Measurements (continued)

A description of the valuation methodologies used for instruments measured at fair value, as well
as the general classification of such instruments to the valuation hierarchy, is set forth below.
These valuation methodologies were applied to all of the Authority’s financial assets and
financial liabilities carried at fair value effective July 1, 2008.

In general, fair value is based upon quoted market prices, where available. If such quoted market
prices are not available, fair value is based upon internally developed models that primarily use,
as inputs, observable market-based parameters. Valuation adjustments may be made to ensure
that financial instruments are recorded at fair value. These adjustments may include amounts to
reflect counterparty credit quality and the Authority’s creditworthiness, among other things, as
well as unobservable parameters. Any such valuation adjustments are applied consistently over
time. The Authority’s valuation methodologies may produce a fair value calculation that may not
be indicative of net realizable value or reflective of future fair values. While management
believes the Authority’s valuation methodologies are appropriate and consistent with other
market participants, the use of different methodologies or assumptions to determine the fair value
of certain financial instruments could result in a different estimate of fair value at the reporting
date.

Derivatives

Derivatives are reported at fair value utilizing Level 2 inputs. The Authority uses third-party
financial institutions to run model valuations for each derivative. These third-party financial
institutions obtain dealer quotations for comparative purposes to assess the reasonableness of the
model valuations.

The following table summarizes financial assets and financial liabilities measured at fair value
on a recurring basis as of June 30, 2009, segregated by the level of the valuation inputs within
the fair value hierarchy utilized to measure fair value:

                                             Level 1           Level 2        Level 3       Total Fair
                                             Inputs            Inputs         Inputs          Value

 Derivative liabilities                  $             –   $     23,413   $             –   $ 23,413




                                                                                                       30
                         Brazos Higher Education Authority, Inc.

                      Notes to the Financial Statements (continued)




8. Fair Value Measurements (continued)

Effective July 1, 2008, the Authority adopted the provisions of SFAS No. 159, The Fair Value
Option for Financial Assets and Financial Liabilities—Including an amendment of FASB
Statement No. 115 (SFAS 159). SFAS 159 permits the Authority to choose to measure eligible
items at fair value at specified election dates. Unrealized gains and losses on items for which the
fair value measurement option has been elected are reported in earnings at each subsequent
reporting date. The fair value option (i) may be applied instrument by instrument, with certain
exceptions; thus the Authority may record identical financial assets and liabilities at fair value or
by another measurement basis permitted under generally accepted accounting principles, (ii) is
irrevocable (unless a new election date occurs), and (iii) is applied only to entire instruments and
not to portions of instruments. Adoption of SFAS 159 on July 1, 2008, did not have a significant
impact on the Authority’s financial statements.

9. Commitments and Contingencies

During the normal course of business, the Authority makes commitments with various banks and
other student loan originators to purchase student loan notes. At June 30, 2009, the Authority had
commitments outstanding to purchase $244,910 of FFELP student loan notes receivable from
commercial banks through November 2009. At June 30, 2009 and 2008, the Authority had no
material contingencies.

10. Related-Party Transactions

Included in administrative and loan servicing fees are administrative fees paid to BHESC and
servicing fees, which are comprised of servicing fees paid to BHESC and servicing fees paid to
third-party subservicers. During the years ended June 30, 2009 and 2008, the Authority recorded
$18,538 and $30,311, respectively, in administrative fees paid to BHESC for providing
administrative support, such as accounting and information technology infrastructure.

In addition, during the years ended June 30, 2009 and 2008, the Authority recorded $-0- and
$204, respectively, in servicing fees paid to BHESC for interim student loan servicing.

During the years ended June 30, 2009 and 2008, the Authority purchased $2,723 and $195,355,
respectively, in principal amounts of student loans from affiliated entities at market prices. The
premiums paid on the purchase of student loans are capitalized and included in student loan
notes receivable in the accompanying financial statements.




                                                                                                  31
                         Brazos Higher Education Authority, Inc.

                      Notes to the Financial Statements (continued)




10. Related-Party Transactions (continued)

During the years ended June 30, 2009 and 2008, affiliated entities purchased $304 and $19,279,
respectively, in principal amounts of student loans from the Authority at market prices.

11. Subsequent Events

Interest Rate Environment

Since June 30, 2009, the credit market continues to experience credit and liquidity volatility.
Current national and global economies have improved over the last year. However, the market
for funding student loans has continued to struggle. Current funding costs are still significantly
higher than previous costs, reducing spreads and preventing new fundings at sustainable margins.
Additionally, ARS continue to fail, causing debt rates to be set higher than historical trends. This
volatility continues to cause instability in the Authority’s spreads, thereby reducing earnings.
Additionally, this volatility has made it difficult to predict future earnings of the Authority.

Subsequent events have been evaluated through October 27, 2009, which is the date the financial
statement representation letter was signed by management.




                                                                                                 32
                             Management Discussion and Analysis


Introduction
The Management’s Discussion and Analysis (MD&A) of Brazos Higher Education Authority,
Inc.’s (the “Authority”) financial performance provides an overall review of the Authority’s
financial activities for the year ended June 30, 2009. The intent of this discussion and analysis is
to look at the Authority’s financial performance as a whole. Readers should also review the
notes to the financial statements and the financial statements to enhance their understanding of
the Authority’s financial performance.

Overview of the Financial Statements
This discussion and analysis serves as an introduction to the Authority’s basic financial
statements and notes to the financial statements. This report also includes supplementary
information in addition to the basic financial statements themselves.

The first statement, Balance Sheets provides information on all of the Authority’s assets,
liabilities, and fund balance. Over time, increases and decreases in net assets help determine
whether the Authority’s financial position is improving or deteriorating.

The second statement, Statements of Changes in Fund Balance provides information which
shows how the Authority’s fund balance changed as a result of the six-month period’s activities.
The statement uses the accrual basis of accounting and all revenues and expenses are reported
regardless of the timing of when cash is received or paid.

The third statement, Statement of Cash Flows, provides information which shows how the
Authority’s cash balance changed as a result of the six-month period’s activities.

Analysis of the Authority’s Financial Statements
Total assets of the Authority decreased from $9.3 billion to $8.6 billion during the period ended
June 30, 2009. This is due, in part, to market conditions which increased the cost of funds used
to finance student loans and legislative changes which halted new financing activity during this
period. Liabilities also decreased during the period from $9.2 billion to $8.5 billion as cash
collections were used to pay principal on the notes and bonds payable.

Expenses exceeded revenues by $43.1 million for the period ended June 30, 2009, resulting in an
ending fund balance of $60.7 million at June 30, 2009. Contributing factors to these results
include market conditions during which liquidity and credit policies tightened, resulting in higher
cost of funds for the Authority, as discussed further below. Also contributing to the excess of
expenses over revenues was the realization of losses related to fair value adjustments of certain
interest rate derivatives.

Cash decreased by $52.8 million during the period ended June 30, 2009. An increase in cost of
funds and no new financing activities led to this decrease in cash. At the same time, cash
collected during the period in excess of $750.2 million and $724.4 million was used to repay
principal on bonds outstanding. $12.1 million was used to purchase additional student loan notes
receivable.



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Market Conditions Contributing to the Authority’s Financial Results

The continued tightened credit and liquidity policy in the capital markets during the period ended
June 30, 2009, along with legislative changes, caused financing of new student loans to cease.
Although federally insured student loans are generally still considered to be performing assets
and maintain the financial backing of the Department of Education, the liquidity crisis caused
banks and investors to generally withdraw from the asset-backed bond markets, as investors fled
the ABS marked in favor of the more secure and liquid U.S. Treasuries market. Decreased
spread due to higher financing cost and lower yields due to legislation make financing FFELP
student loans difficult. Decreased investor demand for these securities has created pressure on
banks and brokers of Auction Rate Securities and the brokers absorbed these bonds onto their
own balance sheets. Interest rates due to failed ARS auctions reduced net interest income for the
Authority during this period.

On or around February 12, 2008, many banks and brokers ceased support of the ARS market,
triggering failed auctions not only for the Authority but for other issuers in the student loan
industry as well as other ABS markets. While not an event of default, failed auctions generally
result in the interest rates on the ARS bonds being reset at the Maximum Rate as defined for each
series of bond under the terms of their respective indentures. This continues to keep costs of
funds higher for the Authority through the date of this MD&A.

Legislative Developments in the Student Loan Industry
The President of the United States signed the College Cost Reduction and Access Act into law
on September 27, 2007. This Act institutes significant changes to the Federal Family Education
Loan Program. Lower lender yields and increased lender expenses established under the College
Cost Reduction and Access Act could adversely affect participants in the Federal Family
Education Loan Program, including the Authority. The full impact of this legislation on
participants in the Federal Family Education Loan Program, including the Authority, is difficult
to predict. These legislative changes to the Federal Family Education Loan Program and the
capital market disruption that began in the third quarter of 2007 continue to impact the
Authority’s operating results. The Authority cannot determine nor control the length and the
depth of the capital market disruption, and plans to be more selective in pursuing financing
activity. As a result of these events, the Authority will likely experience a decrease in financing
volume compared to historical periods.


Contacting the Authority
This financial report is designed to provide investors, creditors, banks, and other interested
parties with a general overview of the Authority’s finances. If you have any questions about this
report or need additional financial information, contact Ricky Turman, Executive Vice President
& Chief Financial Officer, 2600 Washington Avenue, Waco, Texas 76710 or by calling 254-753-
0915, 8:30 to 5:00 central standard time.




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