10-K 1 active10k.htm May 31, 2003 Form 10-K

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

     

 

FORM 10-K

   

X           ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF

  

THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended May 31, 2003

    

OR

                TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

  

Commission File Number 1-7102

    

  

NATIONAL RURAL UTILITIES COOPERATIVE

FINANCE CORPORATION

   

(Exact name of registrant as specified in its charter)

    

DISTRICT OF COLUMBIA

(State or other jurisdiction of incorporation or organization)

52-0891669

(I.R.S. Employer Identification Number)

 

2201 COOPERATIVE WAY, HERNDON, VA 20171

(Address of principal executive offices)

(Registrant's telecommunications number, including area code, is 703-709-6700)

  

Securities registered pursuant to Section 12(b) of the Act:

   


Name of each

Name of each

exchange on

exchange on

Title of each class

which listed

Title of each class

which listed

5.30% Collateral Trust Bonds, due 2003

NYSE

5.70% Collateral Trust Bonds, due 2010

NYSE

6.00% Collateral Trust Bonds, due 2004

NYSE

7.20% Collateral Trust Bonds, due 2015

NYSE

6.375% Collateral Trust Bonds, due 2004

NYSE

6.55% Collateral Trust Bonds, due 2018

NYSE

5.50% Collateral Trust Bonds, due 2005

NYSE

7.35% Collateral Trust Bonds, due 2026

NYSE

6.125% Collateral Trust Bonds, due 2005

NYSE

6.75% Subordinated Notes, due 2043

NYSE

6.65% Collateral Trust Bonds, due 2005

NYSE

7.375% Quarterly Income Capital Securities, due 2047

NYSE

7.30% Collateral Trust Bonds, due 2006

NYSE

7.625% Quarterly Income Capital Securities, due 2050

NYSE

6.20% Collateral Trust Bonds, due 2008

NYSE

7.40% Quarterly Income Capital Securities, due 2050

NYSE

5.75% Collateral Trust Bonds, due 2008

NYSE

   

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No .

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained to the best of the registrant's knowledge in definitive proxy or information statements incorporated by reference in Part IV of this Form 10-K or any amendment to this Form 10-K. [ X ]

  

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes No X .

  

The Registrant has no stock.


      

TABLE OF CONTENTS

Part No.

Item No.

 

Page

I.

 

1.

 

Business

1

 
   

 

   

General

1

 
   

 

   

Members

2

 
   

 

   

Distribution Systems

3

 
   

 

   

Power Supply Systems

3

 
   

 

   

Service Organizations and Associate Member Systems

3

 
   

 

   

Telecommunications Systems

3

 
   

 

 

Loan Programs

4

 
   

 

   

Interest Rates on Loans

5

 
   

 

   

Electric Loan Programs

5

 
   

 

   

Telecommunications Loan Programs

6

 
   

 

   

RUS Guaranteed Loans for Rural Electric Systems

7

 
   

 

   

Conversion of Loans

7

 
   

 

   

Prepayment of Loans

7

 
   

 

 

Guarantee Programs

7

 
   

 

   

Guarantees of Long-Term Tax-Exempt Bonds

7

 
   

 

   

Guarantees of Lease Transactions

8

 
   

 

   

Guarantees of Tax Benefit Transfers

8

 
   

 

   

Letters of Credit

8

 
   

 

   

Other Guarantees

8

 
   

 

 

Disaster Recovery

9

 
   

 

 

Tax Status

9

 
   

 

 

Investment Policy

9

 
   

 

 

Employees

9

 
   

 

 

CFC Lending Competition

10

 
   

 

 

Member Regulation and Competition

10

 
   

 

 

The RUS Program

13

 
   

 

 

Member Financial Data

13

 
   

2.

 

Properties

21

 
   

3.

 

Legal Proceedings

21

 
   

4.

 

Submission of Matters to a Vote of Security Holders

21

 

II.

 

5.

 

Market for the Registrant's Common Equity and Related Stockholder Matters

22

 
   

6.

 

Selected Financial Data

22

 
   

7.

 

Management's Discussion and Analysis of Financial Condition and Results of Operations

23

 
   

 

   

Overview

24

 
   

 

   

Change of Auditors in Fiscal Year 2002

25

 
   

 

   

Critical Accounting Policies

26

 
   

 

   

New Accounting Pronouncements

29

 
   

 

   

Non-GAAP Financial Measures

30

 
   

 

   

Restatement

34

 
   

 

   

Margin Analysis

35

 
   

 

   

Liquidity and Capital Resources

39

 
   

 

   

Asset/Liability Management

49

 
   

 

   

Financial and Industry Outlook

55

 
   

7A.

 

Quantitative and Qualitative Disclosures About Market Risk

58

 
   

8.

 

Financial Statements and Supplementary Data

58

 
   

9.

 

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

58

 
   

9A.

 

Controls and Procedures

58

 

III.

 

10.

 

Directors and Executive Officers of the Registrant

59

 
   

11.

 

Executive Compensation

64

 
   

12.

 

Security Ownership of Certain Beneficial Owners and Management

66

 
   

13.

 

Certain Relationships and Related Transactions

66

 

IV.

 

14.

 

Exhibits, Financial Statement Schedules, and Reports on Form 8-K

67

 
       

Signatures

69

 



    


 
 

Part I

Item 1.

Business.

      

General

National Rural Utilities Cooperative Finance Corporation ("CFC") was incorporated as a private, not-for-profit cooperative association under the laws of the District of Columbia in April 1969. The principal purpose of CFC is to provide its members with a dependable source of low cost capital and financial products and services. CFC provides its members with a source of financing to supplement the loan programs of the Rural Utilities Service ("RUS") of the United States Department of Agriculture. CFC will also consider lending up to 100% of the loan requirements for those members electing not to borrow from RUS consistent with CFC's credit limitation policies. CFC is owned by and makes loans primarily to its rural utility system members ("utility members") to enable them to acquire, construct and operate electric distribution, generation, transmission and related facilities. CFC also provides guarantees to its members for tax-exempt financings of pollution control facilities and other properties constructed or acquired by its members, debt in connection with certain leases and various other transactions. CFC is exempt from federal income taxes under the provisions of Internal Revenue Code section 501(c)(4). CFC's internet address is  www.nrucfc.org, where under "Investors," you can find copies of this annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, all of which CFC makes available as soon as reasonably practicable after the report is filed with the Securities and Exchange Commission. Other than as set forth herein, information posted on CFC's website is not incorporated by reference into this Form 10-K.

  

Rural Telephone Finance Cooperative ("RTFC") was incorporated as a private cooperative association in the state of South Dakota in September 1987 and was created for the purpose of providing and/or arranging financing for its rural telecommunications members and affiliates. CFC is the sole source of funding for RTFC and manages the affairs of RTFC through a long-term management agreement. RTFC is a class E member of CFC. RTFC's results of operations and financial condition have been combined with those of CFC in the accompanying financial statements (see Note 1(b) to the combined financial statements). RTFC is headquartered with CFC in Herndon, VA. RTFC is a taxable entity and takes tax deductions for allocations of net margins as allowed by law under Subchapter T of the Internal Revenue Code.

  

Except as indicated, financial information presented herein includes the consolidated results of CFC and certain entities created and controlled by CFC to hold foreclosed assets, presented with RTFC on a combined basis. CFC established limited liability corporations and partnerships to hold foreclosed assets. CFC has full ownership and control of all such companies and thus consolidates their financial results.

     

National Cooperative Services Corporation ("NCSC") was incorporated in 1981 in the District of Columbia as a private cooperative association. NCSC provides lease financing related to its members and general financing to for-profit or non-profit entities that are owned, operated or controlled by or provide substantial benefit to members of CFC. NCSC also markets, through its sponsoring cooperative members, a consumer loan program for home improvements and an affinity credit card program. Both programs are currently funded by third parties. CFC is the sole source of funding for NCSC either through direct loans or through guarantees of NCSC debt. NCSC's membership consists of CFC and electric systems that are members of CFC or are eligible for such membership. NCSC is a class C member of CFC. As of May 31, 2003, NCSC had 332 members in 43 states and the District of Columbia. NCSC operates under a management agreement with CFC. It is headquartered with CFC in Herndon, VA and is a taxable corporation. As of June 1, 2003, CFC intends to consolidate financial results with NCSC. See Note 1(r) to the combined financial statements for further explanation.

    

There are two primary segments of CFC's business, rural electric lending and rural telecommunications lending. Lending to electric cooperatives is done through CFC and lending to telecommunications organizations is done through RTFC. In many cases, the consumer and commercial customers of the electric cooperatives are also the customers of the telecommunications organizations, as the service territories of the electric and telecommunications members overlap in many of the rural areas of the United States.

 

Members

CFC had 1,042 electric members as of May 31, 2003, including 898 utility members, most of which are consumer-owned cooperatives, 71 service members and 73 associate members. The utility members included 826 distribution systems and 72 generation and transmission ("power supply") systems operating in 49 states, the District of Columbia and one U.S. territory.

 

CFC currently has five classes of electric members:

*

Class A - cooperative or not-for-profit distribution systems;

*

Class B - cooperative or not-for-profit power supply systems;

*

Class C - statewide and regional associations which are wholly-owned or controlled by Class A or Class B members;

 
   
 

   
*

Class D - national associations of cooperatives; and

*

Class E - associate members - not-for-profit groups or entities organized on a cooperative basis which are owned, controlled or operated by Class A, B or C members and which provide non-electric services primarily for the benefit of ultimate consumers. Associate members are not entitled to vote at any meeting of the members and are not eligible to be represented on CFC's board of directors.

    

RTFC had 513 telecommunications members as of May 31, 2003. Membership in RTFC is limited to commercial (for-profit) or cooperative (not-for-profit) telecommunications systems eligible to receive loans or other assistance from RUS, which are engaged (or plan to be engaged) in providing telecommunication services to ultimate users and affiliates of such corporations.

 

Set forth below is a table showing by state or U.S. territory the total number of CFC and RTFC members, the percentage of total loans and the percentage of total loans and guarantees outstanding at May 31, 2003.

      

Number

Loan and

Number

Loan and

of

Loan

Guarantee

of

Loan

Guarantee

Members

%

%

Members

%

%

Alabama

30

1.51%

1.48%

Missouri

64

3.17%

3.48%

 

Alaska

29

1.60%

1.47%

Montana

39

1.12%

1.02%

 

American Samoa

1

0.01%

0.01%

Nebraska

40

0.07%

0.06%

 

Arizona

23

0.77%

0.92%

Nevada

6

0.47%

0.42%

 

Arkansas

29

2.67%

2.57%

New Hampshire

6

1.05%

1.10%

California

11

0.12%

0.11%

New Jersey

1

0.10%

0.09%

Colorado

40

4.91%

4.75%

New Mexico

25

0.21%

0.19%

 

Connecticut

2

1.03%

0.94%

New York

13

0.08%

0.08%

Delaware

2

0.08%

0.07%

North Carolina

45

4.76%

4.81%

 

District of Columbia

5

1.53%

4.16%

North Dakota

35

0.39%

0.35%

 

Florida

20

2.44%

2.82%

Ohio

42

1.95%

1.78%

 

Georgia

69

7.90%

7.20%

Oklahoma

51

2.45%

2.31%

Guam

1

0.00%

0.00%

Oregon

40

1.46%

1.45%

Hawaii

1

0.00%

0.00%

Pennsylvania

26

0.94%

0.97%

Idaho

17

0.87%

0.79%

South Carolina

38

2.75%

2.51%

 

Illinois

52

3.15%

2.90%

South Dakota

48

0.80%

0.73%

 

Indiana

52

1.68%

2.04%

Tennessee

29

0.54%

0.49%

 

Iowa

121

5.73%

5.28%

Texas

112

17.76%

16.88%

 

Kansas

50

1.56%

1.57%

Utah

11

2.93%

3.01%

 

Kentucky

33

1.48%

2.02%

Vermont

8

0.33%

0.30%

 

Louisiana

18

1.46%

1.33%

Virgin Islands

1

3.20%

2.91%

 

Maine

6

0.21%

0.19%

Virginia

28

1.24%

1.15%

 

Maryland

2

0.53%

0.48%

Washington

18

0.45%

0.41%

 

Massachusetts

2

0.00%

0.00%

West Virginia

5

0.02%

0.02%

 

Michigan

26

1.42%

1.30%

Wisconsin

63

1.56%

1.43%

 

Minnesota

78

4.38%

4.47%

Wyoming

15

0.73%

0.72%

Mississippi

26

2.43%

2.46%

Total

1,555

100.00%

100.00%

   

Distribution Systems

Distribution systems are utilities engaged in retail sales of electricity to consumers in their service areas. Most distribution systems have all-requirements power purchase contracts with their power supply systems, which are owned and controlled by the member distribution systems. The wholesale power contracts between the distribution systems and the power supply systems provide for rate adjustments to cover the costs of supplying power, although in certain cases such adjustments must be approved by regulatory agencies. Wholesale power for resale also comes from other sources, including power supply system contracts with government agencies, investor-owned utilities and other entities, and in rare cases, the distribution system's own generating facilities.

   

Wholesale power supply contracts ordinarily guarantee neither an uninterrupted supply nor a constant cost of power. Contracts with RUS-financed power supply systems (which generally require the distribution system to purchase all its power requirements from the power supply system) provide for rate increases to pass along increases in sellers' costs. The wholesale power contracts permit the power supply system, subject to approval by RUS and, in certain circumstances, regulatory agencies, to establish rates to its members so as to produce revenues sufficient, with revenues from all other sources, to meet the costs of operation and maintenance (including replacements, insurance, taxes and administrative and general overhead expenses) of all generating, transmission and related facilities, to pay the cost of any power and energy purchased for resale, to pay the costs of generation and transmission, to make all payments on account of all indebtedness and lease obligations of the

 

2


  
 
power supply system and to provide for the establishment and maintenance of reasonable reserves. The board of directors of the power supply system may review the rates under the wholesale power contracts at least annually.
 

Power contracts with investor-owned utilities and power supply systems which do not borrow from RUS generally have rates subject to regulation by the Federal Energy Regulatory Commission ("FERC"). Contracts with federal agencies generally permit rate changes by the selling agency (subject, in some cases, to federal regulatory approval).

   

Power Supply Systems

Power supply systems are utilities that purchase or generate electric power and provide it on a wholesale basis to distribution systems for delivery to the ultimate retail consumer. Of the 60 operating power supply systems financed in whole or in part by RUS or CFC at December 31, 2001 (the most recent year for which data is available), 59 were cooperatives owned directly or indirectly by groups of distribution systems and one was government owned. Of this number, 34 had generating capacity of at least 100 megawatts, and 10 had no generating capacity. The systems with no generating capacity generally operated transmission lines to supply certain distribution systems. Certain other power supply systems have been formed but do not yet own generating or transmission facilities.

  

At December 31, 2001, the 54 power supply systems that provide reports to CFC owned interests in 141 generating plants representing generating capacity of approximately 32,036 megawatts, or approximately 5.28% of the nation's estimated electric generating capacity, and served 570 RUS distribution system borrowers. Certain of the power supply systems which lease generating plants from others operate these facilities to produce their power requirements. Of the power supply systems' total generating capacity in place as of December 31, 2001, steam plants accounted for 83.6% (including nuclear capacity representing approximately 1.5% of such total generating capacity), internal combustion plants accounted for 13.7% and hydroelectric plants accounted for 1.3%.

  

Service Organizations and Associate Member Systems

Service organizations include the National Rural Electric Cooperative Association ("NRECA"), statewide and regional cooperative associations, and NCSC. NRECA represents cooperatives nationally. The statewide cooperative associations represent the cooperatives within a state.

  

Associate members include organizations that are owned, controlled or operated by, or provide significant benefit to, Class A, B or C members and that provide non-electric services primarily for the benefit of ultimate consumers.

  

Telecommunications Systems

Telecommunications systems include not-for-profit cooperative organizations and for-profit commercial organizations that primarily provide local exchange and access telecommunications services to rural areas.

   

Independent rural telecommunications companies provide service throughout America's rural areas. These companies, which number approximately 1,300, are called independent because they are not affiliated with the regional bell operating companies ("RBOCs"). Included in the total are approximately 250 not-for-profit cooperative telecommunications companies. The majority of these independent rural telecommunications companies are family-owned or privately-held commercial companies. However, approximately 20 of these commercial companies are publicly traded or issue bonds in the marketplace.

 

Rural telecommunications companies (including all local exchange carriers ("LECs") other than RBOCs and Sprint) comprise a relatively small sector of a local exchange telecommunications industry that provide service to nearly 175 million access lines. These rural companies range in size from fewer than 100 customers to more than 1,000,000. Rural telecommunications companies' annual operating revenues range from less than $100,000 to over $2 billion. In addition to basic local exchange and access telecommunications service, most independents offer other communications services including wireless telephone, cable television and internet access. Most rural telecommunications companies' networks incorporate digital switching, fiber optics and other advanced technologies.

3

 

  

Loan Programs

Set forth below is a table showing loans outstanding to borrowers at May 31, 2003, 2002 and 2001 and the weighted average interest rates thereon and loans committed but unadvanced to borrowers at May 31, 2003.

    

Loans outstanding and weighted average interest rates

Unadvanced

(Dollar amounts in thousands)

thereon at May 31,

Commitments at

Long-term fixed rate secured loans (C):

2003 (A)

2002

2001

May 31, 2003 (B)

Electric systems

$

9,484,490

5.64%

$

7,848,861

6.32%

$

6,088,076

6.85%

$

-

Telecommunication systems

2,735,220

7.77%

2,694,945

7.90%

2,453,158

8.17%

-

Total long-term fixed rate secured loans

12,219,710

6.12%

10,543,806

6.72%

8,541,234

7.23%

-

Long-term variable rate secured loans (D):

Electric systems

3,211,434

3.36%

4,127,019

4.21%

5,096,467

7.05%

5,650,836

Telecommunication systems

1,965,390

5.30%

2,138,174

5.71%

2,481,257

7.69%

291,724

Total long-term variable rate secured loans

5,176,824

4.09%

6,265,193

4.72%

7,577,724

7.26%

5,942,560

Loans guaranteed by RUS:

Electric systems

266,857

4.71%

242,574

4.75%

182,134

6.31%

30,388

Intermediate-term secured loans:

Electric systems

14,525

3.63%

31,133

5.48%

55,325

7.08%

28,522

Intermediate-term unsecured loans:

Electric systems

50,843

3.65%

177,154

5.19%

276,785

7.24%

72,559

Telecommunication systems

18,642

5.45%

7,298

5.75%

13,836

7.50%

4,827

Total intermediate-term unsecured loans

69,485

4.13%

184,452

5.21%

290,621

7.25%

77,386

Line of credit loans (E):

Electric systems

884,146

3.57%

1,002,459

4.57%

1,193,795

7.35%

5,233,146

Telecommunication systems

223,388

5.60%

226,113

6.32%

377,148

8.12%

377,409

Total line of credit loans

1,107,534

3.98%

1,228,572

4.89%

1,570,943

7.53%

5,610,555

Nonperforming loans:

Electric systems

-

-

1,002,782

-

812

-

-

Telecommunication systems

-

-

8,546

-

-

-

-

Total nonperforming loans

-

-

1,011,328

-

812

-

-

Restructured loans (F):

Electric systems

629,406

-

540,051

6.92%

1,465,157

2.63%

-

Total loans

19,484,341

5.23%

20,047,109

5.61%

19,683,950

6.91%

11,689,411

Less: Allowance for loan losses (G):

(565,058

)

(506,742

)

(331,997

)

-

Net loans

$

18,919,283

$

19,540,367

$

19,351,953

$

11,689,411

Total by member class:

Distribution

$

11,410,592

$

11,866,442

$

11,444,999

$

8,527,266

Power supply

2,701,094

2,624,039

2,308,384

2,321,125

Statewide and associate

430,015

481,552

605,168

167,059

Telecommunication systems

4,942,640

5,075,076

5,325,399

673,961

Total

$

19,484,341

$

20,047,109

$

19,683,950

$

11,689,411

 

 ________________________________________

(A)

The interest rates in effect at August 1, 2003 on loans to electric members were 5.35% for long-term loans with a seven-year fixed rate term, 2.80% on variable rate long-term loans and 3.05% on intermediate-term loans and lines of credit. The rates in effect at August 1, 2003 on loans to telecommunication systems were 6.20% for long-term loans with a seven-year fixed rate term, 4.65% on long-term variable rate loans, 4.90% on intermediate-term loans and lines of credit.

(B)

Unadvanced commitments include loans approved by CFC for which loan contracts have been approved and executed, but funds have not been advanced. Since commitments may expire without being fully drawn upon, the total amounts reported as commitments do not necessarily represent future cash requirements. Collateral and security requirements for advances on commitments are identical to those on initial loan approval. As the interest rate on unadvanced commitments is not set, long-term unadvanced commitments have been classified in this chart as variable rate unadvanced commitments. However, once the loan contracts are executed and funds are advanced, the commitments could be at either a fixed or a variable rate.

(C)

Generally, under the terms of long-term fixed rate loans, members may select a fixed rate for periods that range from one to 35 years. Upon expiration of the interest rate term, the borrower may select another fixed rate term of one to 35 years (but not beyond maturity of the loan) or a variable rate. The borrower may also repay to CFC the principal then outstanding together with interest due thereon and other sums, if required. Includes $522 million and $395 million of unsecured loans at May 31, 2003 and 2002, respectively.

(D)

Includes $328 million and $266 million of unsecured loans and $396 million and $498 million of unsecured unadvanced commitments at May 31, 2003 and 2002, respectively.

(E)

Includes $331 million and $387 million of secured loans and $306 million and $251 million of secured unadvanced commitments at May 31, 2003 and 2002, respectively.

(F)

The rate on restructured loans represents the rate at which CFC was accruing interest on loans classified as restructured at May 31, 2003, 2002 and 2001.

(G)

CFC includes its guarantee exposures and loan exposures in the calculations of the loan loss allowance. Under the terms of the guarantee agreements, if CFC is required to advance funds, such amount becomes a loan receivable from the member whose obligation CFC guaranteed.

 

   

4



 

   
Total loans outstanding, by state or U.S. territory, are summarized below:
   

 

(Dollar amounts in thousands)

May 31,

May 31,

State/Territory

2003

2002

2001

State/Territory

2003

2002

2001

Alabama

$

293,524

$

263,670

$

364,974 Montana

$

218,378

$

218,497

$

220,234

Alaska

312,080

295,386

293,070 Nebraska

13,421

12,363

12,785

American Samoa

2,850

-

- Nevada

90,817

93,399

94,958

Arizona

149,310

133,465

101,770 New Hampshire

204,835

229,569

243,973

Arkansas

520,305

517,218

531,224 New Jersey

19,415

9,293

8,724

California

23,497

18,042

86,783 New Mexico

40,061

38,519

38,063

Colorado

957,814

793,398

599,602 New York

16,640

16,885

19,808

Connecticut

200,000

201,896

44,421 North Carolina

927,217

963,335

972,887

Delaware

14,812

20,881

46,599 North Dakota

75,435

52,640

63,693

District of Columbia

298,272

335,410

432,122 Ohio

380,468

387,433

379,991

Florida

475,802

473,582

465,348 Oklahoma

476,736

521,388

460,758

Georgia

1,538,946

1,683,474

1,646,326 Oregon

285,024

279,818

262,721

Hawaii

-

233

812 Pennsylvania

182,996

159,157

150,203

Idaho

168,971

157,721

135,287 South Carolina

536,437

537,722

526,647

Illinois

613,838

683,718

607,305 South Dakota

156,218

162,881

165,015

Indiana

326,827

270,907

224,272 Tennessee

104,722

108,150

105,773

Iowa

1,117,138

1,167,938

1,201,570 Texas

3,461,097

4,081,770

3,859,623

Kansas

303,378

289,806

300,987 Utah

571,703

583,888

616,372

Kentucky

289,375

226,679

223,338 Vermont

63,604

40,851

42,019

Louisiana

283,669

261,570

247,395 Virgin Islands

623,037

615,599

587,849

Maine

40,047

43,780

43,568 Virginia

241,157

264,272

269,579

Maryland

102,886

130,094

132,746 Washington

87,893

87,190

91,436

Massachussetts

-

-

50 West Virginia

3,959

2,160

1,699

Michigan

277,150

298,981

306,469 Wisconsin

303,562

300,464

304,913

Minnesota

853,159

856,013

1,099,548 Wyoming

142,981

154,959

147,124

Mississippi

474,288

373,537

283,406 Total

$

19,484,341

$

20,047,109

$

19,683,950

Missouri

618,590

627,508

618,111

   

CFC's loan portfolio is widely dispersed throughout the United States and its territories, including 48 states, the District of Columbia, American Samoa and the U.S. Virgin Islands. At May 31, 2003, 2002 and 2001, no state or territory had over 18%, 21% and 20%, respectively, of total loans outstanding.

  

Interest Rates on Loans

CFC's goal as a not-for-profit cooperatively-owned finance company is to set rates at levels that will provide its members with the lowest cost financing while maintaining sound financial results as required to obtain high credit ratings on its debt instruments. CFC sets its interest rates based on the cost of funding plus provisions for general and administrative expenses, the loan loss allowance and a reasonable net margin. Various discounts, which reduce the stated interest rates, are available to borrowers meeting certain criteria related to performance, volume and whether they borrow exclusively from CFC. See Note 2 to the combined financial statements for the weighted average interest rates earned on all loans outstanding during the fiscal years ended May 31, 2003, 2002 and 2001.

  

Electric Loan Programs

Long-Term Loans

Long-term loans are generally for terms of up to 35 years. A borrower can select a fixed interest rate for periods of one to 35 years or a variable rate. Upon the expiration of the selected fixed interest rate term, the borrower must select the variable rate or select another fixed rate term for a period that does not exceed the remaining loan maturity. CFC sets long-term fixed rates daily and the long-term variable rate is set on the first business day of each month. The fixed rate on a loan is determined on the day the loan is advanced based on the rate term selected. A borrower may divide its loan into various tranches. The borrower then has the option of selecting a fixed or variable interest rate for each tranche.

        

To be eligible for long-term loan advances, distribution systems must maintain an average modified debt service coverage ratio ("MDSC"), as defined in the loan agreement, of 1.35 or greater. The distribution systems must also be in good standing with CFC and their states of incorporation, supply evidence of proper corporate authority and deliver to CFC annual audited financial statements and an annual compliance certificate. Generally, the minimum eligibility requirements for power supply systems are an average times interest earned ratio ("TIER") and MDSC, as described in the loan agreement, of 1.0 or greater. CFC has in the past and may in the future make long-term loans to distribution and power supply systems that do not meet the minimum lending

            

5

 


  

criteria. During the five years ended May 31, 2003, 3.89% of the dollar amount of long-term loans approved was to borrowers that did not meet the minimum lending criteria.

   

Line of Credit Loans

Line of credit loans may be advanced only at a variable interest rate. The line of credit variable interest rate is set on the first business day of each month. The principal amount of line of credit loans with maturities of greater than one year generally must be paid down to a zero outstanding balance for five consecutive days during each year.

  

To be eligible for a line of credit loan, distribution and power supply borrowers must be in good standing with CFC and demonstrate their ability to repay the loan.

  

Telecommunications Loan Programs

The following table summarizes CFC's telecommunications loan portfolio as of May 31, 2003, 2002 and 2001:

 

(Dollar amounts in thousands)

2003

2002

2001

Rural local exchange carriers

$

3,825,877

77%

$

3,811,897

75%

$

3,846,625

72%

Wireless providers

334,638

7%

357,292

7%

478,664

9%

Long distance carriers

324,066

7%

373,809

8%

422,247

8%

Fiber optic network providers

190,768

4%

211,245

4%

216,734

4%

Cable television providers

184,824

4%

194,806

4%

212,348

4%

Competitive local exchange carriers

64,492

1%

105,307

2%

105,310

2%

Other

17,975

-

20,720

-

43,471

1%

Total

$

4,942,640

100%

$

5,075,076

100%

$

5,325,399

100%

         

CFC's telecommunications loan portfolio is heavily concentrated in the rural local exchange carrier ("RLEC") segment of the telecommunications market. The two barriers to entry for potential competitors are the low population density of the RLEC service territories and the high quality of service the customers receive from the incumbent RLECs. These services are generally delivered over networks that include fiber optic cable and digital switching.

  

The businesses to which the remaining telecommunications loans have been made are generally supporting the operations of the RLECs and are owned, operated or controlled by RLECs. Many such loans are supported by payment guarantees from the sponsoring RLECs, particularly loans to personal communications service providers and competitive LECs.

   

Long-Term Loans

CFC makes long-term loans to rural telecommunications companies and their affiliates for the acquisition of and the construction or upgrade of wireline telecommunications systems, wireless telecommunications systems, fiber optic networks, cable television systems and other corporate purposes. Long-term loans are generally for periods of up to 15 years. Loans may be advanced at a fixed or variable interest rate. Fixed rates are generally available for periods from one year to 15 years. Upon the expiration of the selected fixed interest rate term, the borrower must select another fixed rate term for a period that does not exceed the remaining loan maturity or select the variable rate. CFC sets long-term fixed rates for telecommunications loans daily and the long-term variable rate is set on the first business day of each month. The fixed rate on a loan is determined on the day the loan is advanced or converted to a fixed rate based on the term selected. A borrower may divide its loan into various tranches. The borrower then has the option of selecting a fixed or variable interest rate for each tranche.

    

To borrow from CFC, a wireline telecommunications system generally must be able to demonstrate the ability to achieve and maintain an annual debt service coverage ratio ("DSC") and an annual TIER of 1.25 and 1.50, respectively. To borrow from CFC, a cable television system, fiber optic network or wireless telecommunications system generally must be able to demonstrate the ability to achieve and maintain an annual DSC of 1.25. Loans made to start-up ventures using emerging technologies are evaluated based on the quality of the business plan and the level and quality of credit support from established companies. Based on the business plan, specific covenants are developed for each transaction which require performance at levels deemed sufficient to repay the CFC obligations under the approved terms.

      

Intermediate-Term Loans and Line of Credit Loans

CFC provides intermediate-term equipment financing to telecommunications borrowers for periods up to five years. These loans are provided on an unsecured basis and are used to finance the purchase and installation of central office equipment, support assets and other communications equipment. Intermediate-term equipment financing loans are generally made to operating telecommunications companies with an equity level of at least 25% of total assets and which have achieved a DSC ratio for each of the previous two calendar years of at least 1.75.

              

6

 

 


 

CFC also provides line of credit loans to telecommunications systems for periods of up to five years. These line of credit loans are typically in the form of a revolving line of credit, which generally requires the borrower to pay off the balance for five consecutive business days at least once during each 12-month period. These line of credit loans may be provided on a secured or unsecured basis and are designed primarily to assist borrowers with liquidity and cash management.

       

Interim financing line of credit loans are also made available to CFC telecommunications members that have an RUS and/or Rural Telephone Bank ("RTB") loan application pending and have received approval from RUS to obtain interim financing. These loans are for terms up to 24 months and the borrower must repay the CFC loan with advances from the RUS/RTB long-term loans.

       

RUS Guaranteed Loans for Rural Electric Systems

The level of authority for RUS loan guarantees for the fiscal year ending September 30, 2003 is $2.7 billion. The expected level for fiscal year 2004 is $2.1 billion. CFC may participate as an eligible lender in the RUS loan guarantee program under the terms and conditions of a master loan guarantee and servicing agreement between RUS and CFC. Under this agreement, CFC may make long-term secured loans to eligible members for periods of up to 35 years, at fixed or variable rates established by CFC. RUS guarantees the principal and interest payments on the notes evidencing such loans. The guarantees are uncontestable except for fraud or misrepresentation which the holder had actual knowledge of at the time it became a holder. At May 31, 2003, CFC had $224 million of loans outstanding under this program. In addition, at May 31, 2003, CFC was holding certificates totaling $43 million representing interests in trusts holding RUS guaranteed loans.
   

Conversion of Loans

A borrower may convert a long-term loan from a variable interest rate to a fixed interest rate at any time without a fee. A borrower may convert a fixed rate to another fixed rate or a variable rate at any time, subject to a fee in most instances. Intermediate-term loans and line of credit loans do not offer conversion options. The fee on the conversion of a fixed interest rate to a variable interest rate ranges from 25 to 50 basis points of the outstanding loan amount plus a make whole premium, if applicable per current loan policies.

    

Prepayment of Loans

Borrowers may prepay long-term loans at any time, subject to the payment of a prepayment fee of 33 to 50 basis points and a make-whole premium, if applicable. Line of credit loans may be prepaid at any time without a premium.

  

Guarantee Programs

      

CFC uses the same credit policies and monitoring procedures in providing guarantees as it does for loans and commitments.

The following chart provides a breakout of guarantees outstanding by type.

   
   

May 31,

(Dollar amounts in thousands)

2003

2002

2001

Long-term tax-exempt bonds

$

899,420

$

940,990

$

979,725

Debt portions of leveraged lease transactions

34,105

41,064

103,794

Indemnifications of tax benefit transfers

184,605

208,637

232,930

Letters of credit

314,114

310,926

370,592

Other guarantees

471,312

554,768

530,517

Total

$

1,903,556

$

2,056,385

$

2,217,559

  

Guarantees of Long-Term Tax-Exempt Bonds

CFC has guaranteed debt issued in connection with the construction or acquisition by CFC members of pollution control, solid waste disposal, industrial development and electric distribution facilities. Governmental authorities issue such debt and the interest thereon is exempt from federal taxation. The proceeds of the offering are made available to the member system, which in turn is obligated to pay the governmental authority amounts sufficient to service the debt. The debt, which is guaranteed by CFC, may include short- and long-term obligations.

   

In the event of a default by a system for nonpayment of debt service, CFC is obligated to pay, after available debt service reserve funds have been exhausted, scheduled debt service under its guarantee. The bond issue may not be accelerated so long as CFC performs under its guarantee. The system is required to repay, on demand, any amount advanced by CFC pursuant to its guarantee. This repayment obligation is secured by a common mortgage with RUS on all the system's assets, but CFC may not exercise remedies thereunder for up to two years following default. However, if the debt is accelerated because of a determination that the interest thereon is not tax-exempt, the system's obligation to reimburse CFC for any guarantee payments

              

7

 


  

will be treated as a long-term loan. The system is required to pay to CFC initial and/or on-going guarantee fees in connection with these transactions.

 

Certain guaranteed long-term debt bears interest at variable rates which are adjusted at intervals of one to 270 days, weekly, each five weeks or semi-annually to a level expected to permit their resale or auction at par. At the option of the member on whose behalf it is issued, and provided funding sources are available, rates on such debt may be fixed until maturity. Holders have the right to tender the debt for purchase at par at the time rates are reset when the debt bears interest at a variable rate and CFC has committed to purchase debt so tendered if it cannot otherwise be remarketed. If CFC held the securities, the cooperative would pay interest to CFC at its intermediate-term loan rate. Since the inception of the program in the mid-1980s, all bonds have been successfully remarketed and thus, CFC has not been required to purchase any bonds.

 

Guarantees of Lease Transactions

CFC has a program of lending to or guaranteeing debt issued by NCSC in connection with leveraged lease transactions. In such transactions, NCSC lends money to an industrial or financial company (a "lessor") for the purchase of a power plant (or an undivided interest therein) or utility equipment which is then leased to a CFC member (the "lessee") under a lease requiring the lessee to pay amounts sufficient to permit the lessor to service the loan. The loans are made on a non-recourse basis to the lessor but are secured by the property leased and the owner's rights as lessor. NCSC borrows the funds it lends either directly from CFC or from another creditor with a CFC guarantee. NCSC is obligated to pay administrative and/or guarantee fees to CFC in connection with these transactions. The lessee in each transaction reimburses such fees to NCSC. CFC may also guarantee the rent obligation of its members to a third party.

 

Guarantees of Tax Benefit Transfers

CFC has also guaranteed members' obligations to indemnify against loss of tax benefits in certain tax benefit transfers that occurred in 1981 and 1982. A member's obligation to reimburse CFC for any guarantee payments would be treated as a long-term loan, secured on a pari passu basis with RUS by a first lien on substantially all the member's property to the extent of any cash received by the member at the outset of the transaction. The remainder would be treated as an intermediate-term loan secured by a subordinated mortgage on substantially all of the member's property. Due to changes in federal tax law, no guarantees of this nature have occurred since 1982.

    

Letters of Credit

CFC issues irrevocable letters of credit to support members' obligations to energy marketers, other third parties and to the Rural Business and Cooperative Development Service. Letters of credit are generally issued on an unsecured basis and with such issuance fees as may be determined from time to time. Each letter of credit issued by CFC is supported by a reimbursement agreement with the member on whose behalf the letter of credit was issued. In the event a beneficiary draws on a letter of credit, the agreement generally requires the member to reimburse CFC within one year from the date of the draw, with interest accruing from such date at CFC's line of credit variable rate of interest.

  

Other Guarantees

CFC may provide other guarantees as requested by its members. Such guarantees may be made on a secured or unsecured basis with guarantee fees set to cover CFC's general and administrative expenses, a provision for losses and a reasonable margin. Included in other guarantees at May 31, 2003, 2002 and 2001 was $284 million, $334 million and $318 million, respectively, of commercial paper issued by NCSC.

   

Members' interest expense for the year ended May 31, 2003 on debt obligations guaranteed by CFC was approximately $28 million.

  

The following chart summarizes guarantees outstanding by member class at May 31, 2003, 2002 and 2001.

 

Guarantees by Member Class

(Dollar amounts in thousands)

2003

2002

2001

Electric systems:

Distribution

$

77,725

4%

$

66,670

3%

$

153,982

7%

Power supply

1,220,795

64%

1,304,367

64%

1,377,755

62%

Statewide and associate

600,036

32%

680,011

33%

685,822

31%

Subtotal electric systems

1,898,556

100%

2,051,048

100%

2,217,559

100%

Telecommunication systems

5,000

-

5,337

-

-

-

Total

$

1,903,556

100%

$

2,056,385

100%

$

2,217,559

100%

                

8

   


 

Total guarantees outstanding by state and territory are summarized as follows:

   

 

May 31,

May 31,

(Dollar amounts in thousands)

2003

2002

2001

2003

2002

2001

Alabama

$

22,795

$

25,945

$

31,053

Missouri

$

126,198

$

138,755

$

150,372

Alaska

3,320

3,240

3,240

New Hampshire

31,500

27,500

31,200

Arizona

47,250

47,425

53,577

North Carolina

100,950

100,265

99,400

Arkansas

29,703

35,688

41,485

North Dakota

-

338

-

Colorado

57,273

58,007

58,716

Ohio

1,000

-

65,000

District of Columbia

590,941

674,435

681,873

Oklahoma

16,760

23,154

31,447

Florida

128,264

137,944

147,057

Oregon

25,810

24,628

14,580

Idaho

850

850

850

Pennsylvania

24,229

23,428

11,772

Illinois

7,093

7,719

15,049

Tennessee

295

300

-

Indiana

109,047

121,264

118,205

Texas

149,217

145,935

147,696

Iowa

12,572

14,290

9,942

Utah

71,749

78,315

114,404

Kansas

33,100

34,300

42,500

Virginia

4,215

4,207

3,950

Kentucky

142,785

149,405

155,240

Wisconsin

1,439

1,475

1,511

Michigan

196

691

585

Wyoming

10,005

10,195

10,380

Minnesota

103,696

111,863

119,745

Total

$

1,903,556

$

2,056,385

$

2,217,559

Mississippi

51,304

54,824

56,730

  

Disaster Recovery

 

CFC has had in place a disaster recovery and business continuity plan since May 2001. The plan includes a duplication of CFC's information systems at an off-site facility and a comprehensive business recovery plan. CFC's production data is replicated in real time to the recovery site. The plan also includes steps for each of CFC's operating groups to conduct business with a view to minimizing disruption for customers. Recovery exercises are conducted twice annually with different teams to expand recovery experience among the staff. CFC contracts with an external vendor for the facilities to house the backup systems as well as office space and related office equipment. CFC is currently studying the costs and benefits of creating its own facility to house the backup system versus contracting with a vendor.

 

Tax Status

   

In 1969, CFC obtained a ruling from the Internal Revenue Service recognizing CFC's exemption from the payment of federal income taxes under Section 501(c)(4) of the Internal Revenue Code. Such exempt status could be removed as a result of changes in legislation or in administrative policy or as a result of changes in CFC's business. CFC believes that its operations have not changed materially from those described to the Internal Revenue Service in its exemption filing. RTFC is taxable under Subchapter T of the Internal Revenue Code. As long as RTFC continues to qualify under Subchapter T of the Internal Revenue Code, it is allowed a deduction from taxable income for the amount of net margin allocated to its members.

 

Investment Policy

 

Surplus funds are invested pursuant to policies adopted by CFC's board of directors. Under present policy, surplus funds may be invested in direct obligations of or guaranteed by the United States or agencies thereof or other highly liquid investment grade paper. Current investments include high-rated securities such as commercial paper, obligations of foreign governments, Eurodollar deposits, bankers' acceptances, bank letters of credit, certificates of deposit or working capital acceptances. The policy also permits investments in certain types of repurchase agreements with highly rated financial institutions, whereby the assets consist of eligible securities of a type listed above set aside in a segregated account.

   

Employees

 

At May 31, 2003, CFC had 222 employees, including engineering, financial and legal personnel, management specialists, credit analysts, accountants and support staff. CFC believes that its relations with its employees are good. At May 31, 2003, CFC was operating a telecommunications company it had received in a bankruptcy settlement. This company had a total of 177 additional employees consisting of senior management, marketing and sales support, engineers, technicians, IT support and customer service. The company is not unionized and it believes its relationship with its employees are good.

 

                

9

   

 


 

CFC Lending Competition

  

CFC competes with other lenders on price and the variety of options and additional services offered as well as its overall approach to and relationship with its member/owners.

  

According to annual financial data filed with CFC, the 808 reporting electric cooperative distribution and 51 reporting power supply systems had a total of $44 billion in long-term debt outstanding at December 31, 2002. RUS is the dominant lender to the electric cooperative industry with $25 billion or 62% of the total outstanding debt for the 859 systems reporting 2002 results to CFC. At December 31, 2002, CFC had a total of $14 billion of long-term exposure to its reporting distribution and power supply member systems, including $13 billion of long-term loans and $1 billion of guarantees. CFC's $14 billion long-term exposure represented 36% of the total long-term debt to these electric systems. The remaining $1 billion or 2% was borrowed from other sources. (Competition data is based on December 31, 2002 financial data filed with CFC by its members).

  

Under the insured loan program, RUS typically does not lend the full amount of debt requested by the cooperative, requiring the cooperative to seek supplemental lending from private capital sources. During fiscal year 2003, CFC was selected as the lender for 62% of the total supplemental lending requirement (not including amounts lent by FFB). The amount of funding proposed for RUS direct lending for fiscal year 2004 is $2.0 billion. The amount approved for the prior year was $1.3 billion. The amount proposed for RUS guaranteed loans for fiscal year 2004 is $2.1 billion. CFC and other lenders are not in competition with RUS, but rather compete for the supplemental lending requirement, as well as for the full lending requirement for those cooperatives that have decided not to borrow from RUS. CFC and other lenders also compete to fund projects in anticipation of long-term funding from RUS. Under the hardship program, RUS lends 100% of the amount. Under the guarantee program, RUS will guarantee the repayment of all principal and interest by the cooperative.

       

Legislation enacted in 1992 allows RUS electric borrowers to prepay their loans to RUS at a discount based on the government's cost of funds at the time of prepayment. If a borrower chooses to prepay its notes, it becomes ineligible for future RUS insured loans for a period of ten years, but remains eligible for RUS loan guarantees. During the year ended May 31, 2003, CFC was selected as lender for over 95% of the total lent to distribution systems for the repayment of their RUS debt. As of May 31, 2003, 233 borrowers had either fully prepaid or partially prepaid their RUS notes under these provisions. In total, CFC has lent $3.3 billion to distribution systems for the purpose of prepaying their RUS debt, representing 94% of the total note buyouts.

   

The competitive market for providing credit to the rural telecommunications industry is difficult to quantify, since many rural telecommunications companies are not RUS borrowers. At December 31, 2002, RUS had a total of $3.6 billion outstanding to telecommunications borrowers. The RTB, an instrumentality of the United States that provides supplemental financing to RUS borrowers and is managed by RUS, had a total of $818 million outstanding to telecommunications borrowers at December 31, 2002. CFC is not in direct competition with RUS or RTB, but rather competes with other lenders for additional supplemental lending and for the full lending requirement of the rural telecommunications companies that have decided not to borrow from RUS or RTB or for projects not eligible for RUS or RTB financing. CFC's competition includes regional banks, a government sponsored enterprise and insurance companies. At December 31, 2002, CFC had a total of $4.8 billion in long-term loans outstanding to telecommunications borrowers. At December 31, 2002, CFC is aware of only CoBank, ACB ("CoBank") (which at December 31, 2002 had a telecom portfolio of approximately $3.1 billion), as a lender with a telecommunications loan portfolio of similar size to CFC's and RUS/RTB's.

   

Member Regulation and Competition

   

Electric Systems

In 1992 Congress passed the Energy Policy Act effectively providing competition in the generation sector of the wholesale electric power industry. Subsequently in 1996, FERC issued orders 888 and 889. Order 888 provides for competitive wholesale power sales by requiring jurisdictional public utilities that own, control or operate transmission facilities to file non-discriminatory open access transmission tariffs that provide others with transmission service comparable to the service they provide themselves. The reciprocity provision associated with order 888 also provides comparable access to transmission facilities of non-jurisdictional utilities (including RUS borrowers and municipal and other publicly owned electric utilities) that use jurisdictional utilities' transmission systems. The order further provides for the recovery of stranded costs from departing wholesale customers with agreements dated prior to July 11, 1994. After that date, stranded costs must be agreed upon in the service agreement. Order 889 provides for a real-time electronic information system referred to as the Open Access Same-Time Information System. It also establishes standards of conduct to ensure that transmission owners and their affiliates do not have an unfair competitive advantage by using transmission to sell power.

                  

10

 


      

Section 211 of the Federal Power Act as amended by the Energy Policy Act of 1992 classifies any cooperative with significant transmission assets as a "transmitting utility" for purposes of this section. Under the provisions of this act, FERC has the authority to order such cooperatives to provide open access for unaffiliated entities. This provision also authorizes FERC to require investor-owned and other utilities to provide the same open access transmission for the benefit of cooperatives. Electric cooperatives have strongly supported section 211 for this reason. Under the Federal Power Act, a cooperative that pays off its RUS debt may be treated as a jurisdictional public utility subject to FERC regulation if it provides transmission service in interstate commerce, or provides sales for resale in interstate commerce.
  

The trend toward retail electric competition has appreciably slowed. At May 31, 2003, 17 states were active in the process of moving toward customer choice. In these states, customer choice was either currently available to all or some customers or will soon be available. Those states are Arizona, Connecticut, Delaware, Illinois, Maine, Maryland, Massachusetts, Michigan, New Hampshire, New Jersey, New York, Ohio, Oregon, Pennsylvania, Rhode Island, Texas, and Virginia. Of the remaining states, 27 states were not actively pursuing restructuring, five states have delayed the restructuring process or the implementation of customer choice, and one state has suspended customer choice.

  

In the 17 states that were active in customer choice, CFC had a total of 244 electric members (183 distribution, 22 power supply and 39 associate) and $4,731 million of loans to electric systems in these states. In New York, where CFC has five electric members and $9 million of loans, cooperatives are not required to file competition plans with the state utility commission. CFC continues to believe that the distribution systems, which comprise the majority of CFC's membership and loan exposure, will not be materially impacted by a move to customer choice. The experience to date has been that, even in those states where customers have a choice of alternative energy suppliers, very few customers have switched from the traditional supplier.

  

In addition, in five of the 17 states actively operating under customer choice laws, co-ops have a choice whether to "opt in" to competition or retain a monopoly position with respect to energy sales. Those states are Illinois, New Jersey, Ohio, Oregon, and Texas. As of May 31, 2003, CFC had loans outstanding in the amount of $3,682 million in those states. Furthermore, even if customers choose to purchase energy from an alternative supplier, the distribution systems own the lines to the customer and it would not be feasible for a competitor to build a second line to serve the same customers in almost all situations. Therefore the distribution systems will still be charging a fee or access tariff for the service of delivering power regardless of who supplies the power.

  

The impact on power supply systems cannot be determined until final rules have been approved in each state with regard to stranded cost recovery.

   

While customer choice laws have been passed in the above states, there are many factors that may delay or influence the choices that customers have available to them and the timing of competition for cooperatives. One such factor will be the level of fees that systems will be allowed to charge other utilities for use of their transmission and distribution system. Other issues that may further delay competition include, but are not limited to, the following:

*

ability of cooperatives to "opt out" of the provisions of the customer choice laws in some states;

*

utilities in many states may still be regulated regarding rates on non-competitive services, such as distribution;

*

many states will still regulate the securities issued by utilities, including cooperatives;

*

FERC regulation of rates as well as terms and conditions of transmission service;

*

reconciling the differences between state laws, such that out-of-state utilities can compete with in-state utilities; and

*

the fact that few competitors have much interest in serving residential or rural customers.

    

In addition to customer choice laws, some state agencies regulate electric cooperatives with regard to rates and borrowing. There are 17 states that regulate the rates electric systems charge; of these states, three states have partial oversight authority over the cooperatives' rates, but not the specific authority to set rates, and seven states allow cooperatives the right to opt in or out of state regulation. There are 19 states that regulate electric systems regarding the issuance of long-term debt and there are two states that regulate the issuance of short-term debt. FERC also has jurisdiction to regulate rates, terms and conditions of service and securities by electric systems within its jurisdiction, which presently includes some cooperatives.

     

Telecommunications Systems

CFC member telecommunications systems are regulated at the state and federal levels. Most state regulatory bodies regulate local service rates, intrastate access rates and telecommunications company borrowing. The Federal Communications Commission ("FCC") regulates interstate access rates and the issuance of licenses required to operate certain types of telecom operations. Some member telecommunications systems have affiliated companies that are not regulated.

  

                 

11

    


   

The Telecommunications Act of 1996 (the "Telecom Act") created a framework for competition and deregulation in the local telecommunications market. The Telecom Act had four basic goals: competition, universal service, deregulation and fostering advanced telecommunications and information technologies. The Telecom Act seeks to achieve competition by requiring all carriers to interconnect with all others and by requiring LECs to provide competitors with total service resale, number portability, dialing parity, access to rights-of-way, reciprocal compensation, co-location, and unbundled access. Congress included provisions in the Telecom Act granting RLECs an exemption from the above requirements.

   

In cities, telecommunications competition is occurring. Despite the shakeout in the competitive LEC segment, facility and non-facility based competitors exist that are focused primarily on the large business user market. The RBOCs were motivated to cooperate with competitors in order to win approval to enter the long distance market in their service territories. Now, the RBOCs have gained authority to provide long distance service in all of their local markets and are less inclined to cooperate with competitors. AT&T and MCI are using the unbundled network element platform to compete with the RBOCs for residential customers, offering packages of local and long distance service.

  

Rural markets have been the last to see broad based local telecommunications service competition. Rural telecommunications companies that border metropolitan areas are experiencing competition for their largest business customers. Increasingly, rural telecommunications providers are entering nearby towns and cities as competitive LECs, leveraging their existing infrastructure.

   

In addition to competition, the Telecom Act also mandated a new universal telecommunications service support mechanism and required that it be: (1) sufficient to ensure that rural customers receive reasonably comparable rates and services when compared to urban customers; and (2) portable, that is available to all eligible providers. Congress stated its intent that implicit subsidies presently contained in the access charges local telecommunications companies levy on long distance carriers be eliminated and be made explicit in the new universal service support mechanism. Rules adopted by the FCC in 2000 have provided adequate levels of universal service support. This has been essential for RLECs, as other Commission rulings have reduced access charges which are a key RLEC revenue source. Numerous wireless carriers have entered rural markets as competitors to the LEC. By obtaining competitive eligible telecommunications carrier ("CETC") status from state regulators (as provided for in the Telecom Act), these wireless carriers are able to receive universal service funds ("USF") based on the incumbent LEC's costs. This has led to great concern for the sustainability of the fund. USF's current funding base of interstate telecommunications revenues is shrinking as long distance minutes-of-use go down due to wireless and email substitution. Uncontrolled growth of the fund would make the assessment rate unacceptably high. All industry segments agree that changes need to be made to USF. However, they are not all agreed on what those changes should be.

  

While uncertainty exists regarding USF, CFC does not anticipate that any potential revenue losses resulting from these changes will result in material losses on loans outstanding to rural telecommunications companies.

  

Most RLECs are expanding their offerings to customers. Without cable as a competitor in most rural areas, RLECs are rolling out digital video, high-speed data, and local and long distance voice service. Where they can leverage their infrastructure, they are competing with RBOCs and cable companies in neighboring towns. RLECs have generally been very successful competitors in these situations.

  

Deregulation thus far has not had much effect on LECs. The FCC has promulgated a series of rules to implement the Telecom Act, and eliminated very few existing regulatory requirements.

  

Another aspect of the Telecom Act dealt with advanced telecommunications and information technologies. In the late 1990s there was the concern that there was a growing "digital divide" between various groups and areas within the country. Legislators sought to provide broadband connectivity to all Americans through programs which provide funding to connect schools and libraries to the internet. RUS has issued rules liberalizing its lending criteria to facilitate provision of advanced telecommunications and information services in rural areas. Congress also created an RUS broadband loan program in 2002 and authorized $1.4 billion in fiscal year 2003 lending authority. It is anticipated that RUS will play a significant role in financing infrastructure to help provide rural Americans with access to these services. Given the increased availability of government financing for rural broadband, it is unlikely that CFC or any other supplemental lender will be participating in this financing to any significant degree.

                  

12

 


 

The RUS Program

    

Since the enactment of the Rural Electrification Act in 1936 (the "RE Act"), RUS has financed the construction of electric generating plants, transmission facilities and distribution systems in order to provide electricity to rural areas. Principally through the organization of systems under the RUS loan program in 48 states and U.S. territories, the percentage of farms and residences in rural areas of the United States receiving central station electric service increased from 11% in 1934 to almost 100% currently. Rural electric systems serve 12% of all consumers of electricity in the United States and its territories and account for approximately 8% of total sales of electricity and own about 5% of energy generation and generating capacity.

  

In 1949, the RE Act was amended to allow RUS to lend for the purpose of furnishing and improving rural telecommunications service. For fiscal year 2003, RUS has $495 million in lending authority for rural telephone systems and an additional $2,583 million for other telecommunications programs, including distance learning, broadband and local-to-local television.

   

The RE Act provides for RUS to make insured loans and to provide other forms of financial assistance to borrowers. RUS also provides financing at the Treasury rate. RUS is authorized to make direct loans, at below market rates, to systems which are eligible to borrow from it. RUS currently prices the majority of its insured loans to distribution systems based on a municipal government obligation index and prices hardship loans at a rate of 5%. RUS is also authorized to guarantee loans that have been used mainly to provide financing for construction of bulk power supply projects. Guaranteed loans bear interest at a rate agreed upon by the borrower and the lender (which generally has been the FFB). For telecommunications borrowers, RUS also provides financing through the RTB. The RTB is an instrumentality of the United States providing financing at rates reflecting its cost of capital and is managed by RUS. The RUS exercises financial and technical supervision over borrowers' operations. Its loans and guarantees are generally secured by a mortgage on substantially all of the system's property and revenues.

     

For the fiscal year ending September 30, 2004, both the House and Senate Appropriations Committees have approved RUS electric loan levels as follows: municipal rate loans of $1 billion, hardship loans of $240 million, treasury rate loans of $750 million, and loan guarantees of $2.1 billion. Electric funding levels for fiscal year 2003 were as follows: municipal rate loans of $100 million, hardship loans of $121 million, treasury rate loans of $1.1 billion, and loan guarantees of $2.7 billion.

    

Member Financial Data

      

Electric Systems

Distribution and power supply systems with long-term loans outstanding are required to submit to CFC annual financial information on Form 7 and Form 12 or FERC Form 1, respectively. The information presented on the Form 7, Form 12 and FERC Form 1 is more detailed information than is typically available in the audited financial statements. The following pages contain composite statements of revenues, expenses and patronage capital for the years ended December 31, 2002, 2001, 2000, 1999 and 1998 and the composite combined balance sheets at December 31, 2002, 2001, 2000, 1999 and 1998, based on the Form 7's, Form 12's and FERC Form 1's received from its members. As of August 18, 2003, CFC had received financial information from 808 distribution systems and 51 power supply systems.

       

While CFC had 826 distribution system members at May 31, 2003, 16 distribution systems were not required to report financial results on Form 7 because they did not have an outstanding balance of long-term loans at December 31, 2002 and two distribution systems did not file financial results on Form 7 with CFC.

     

Only 51 of the 72 total power supply systems reported December 31, 2002 financial results on Form 12 or FERC Form 1 to CFC. A total of 16 power supply systems did not report financial results because they did not have an outstanding balance of long-term loans at December 31, 2002. Two power supply systems merged with another and filed combined financial results on Form 12 or FERC Form 1. In addition, three power supply systems did not file financial results on Form 12 or FERC Form 1 with CFC.

       

Telecommunications Systems

On the following pages are tables providing composite statements of revenues and expenses from the telecommunications systems that were borrowers of CFC during the five years ended December 31, 2002. Members with long-term loans outstanding are generally required to submit annual data as of December 31 in the form of audited financial statements. As of August 18, 2003, CFC had received audited financial statements from 201 telecommunications systems.

 
                   

13

 

 


   

Only 229 of the 513 telecommunications system members at May 31, 2003 had long-term loans outstanding and therefore were required to submit audited financial statements to CFC at December 31, 2002. A total of five telecommunications system members have not yet filed audited financial statements with CFC, 21 telecommunications system members submitted consolidated audited financial statements and one system was excluded due to the size of the system resulting in a significant weighting of the composite results, even though its loans from CFC represented only 4% of the total telecommunications portfolio. In addition, one system, representing less than 2% of the total telecommunications portfolio, was excluded due to its Chapter 11 bankruptcy filing. The borrower is current on all debt service payments due to CFC. CFC expects the borrower's financial statements to change significantly upon its emergence from bankruptcy.

       

NOTE: The financial information submitted to CFC is subject to year-end audit adjustments by reporting borrowers and does not, with minor exceptions, take into account current data for certain systems that are not active CFC borrowers. CFC takes no responsibility for the accuracy or completeness of the member data. CFC's independent auditors have not examined any information contained in this section, and the number and geographical dispersion of the systems have made impractical an independent investigation by CFC of the statistical information.

                    

14

 


 

     

NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION

COMPOSITE STATEMENTS OF REVENUES, EXPENSES AND PATRONAGE CAPITAL

AS REPORTED TO CFC BY MEMBER DISTRIBUTION SYSTEMS

  

The following are unaudited figures that are based

upon Form 7 submitted to

CFC by Member Distribution Systems

  

Years ended December 31,

(Dollar amounts in thousands)

2002

2001

2000

1999

1998

Operating revenues and patronage capital

$

22,856,370

$

21,627,713

$

20,419,019

$

18,805,359

$

18,284,021

 

Operating deductions:

      Cost of power (1)

14,153,297

13,550,239

12,925,630

11,828,572

11,580,829

      Distribution expense (operations)

992,617

899,310

856,378

792,249

728,565

      Distribution expense (maintenance)

1,249,463

1,183,558

1,106,780

1,024,734

985,571

      Administrative and general expense (2)

2,266,334

2,144,824

1,972,220

1,864,344

1,735,074

      Depreciation and amortization expense

1,600,544

1,487,657

1,387,923

1,290,354

1,203,438

      Taxes

269,587

252,592

241,219

230,238

241,010

 

          Total

20,531,842

19,518,180

18,490,150

17,030,491

16,474,487

 

Utility operating margin

2,324,528

2,109,533

1,928,869

1,774,868

1,809,534

Non-operating margin

295,588

104,442

211,957

179,940

173,446

Power supply capital credits (3)

321,548

326,215

272,007

259,099

297,451

 

          Total

2,941,664

2,540,190

2,412,833

2,213,907

2,280,431

 

Interest on long-term debt (4)

1,151,978

1,194,016

1,150,231

1,024,369

980,863

Other deductions

74,769

74,854

84,049

50,523

49,628

 

          Total

1,226,747

1,268,870

1,234,280

1,074,892

1,030,491

 

Net margin and patronage capital

$

1,714,917

$

1,271,320

$

1,178,553

$

1,139,015

$

1,249,940

   

TIER (5)

2.48

2.05

2.01

2.11

2.35

DSC (6)

2.16

1.94

2.08

2.15

2.32

MDSC (7)

1.98

1.88

1.99

2.03

2.25

Number of systems included

808

811

812

811

820

(1)

Includes cost of purchased power, power production and transmission expense.

(2)

Includes sales expenses, consumer accounts and customer service and informational expense as well as other administrative and general expenses.

(3)

Represents net margin of power supply systems and other associated organizations allocated to their member distribution systems and added in determining net margin and patronage capital of distribution systems under RUS accounting practices. Cash distributions of this credit have rarely been made by the power supply systems and such other organizations to their members.

(4)

Interest on long-term debt is net of interest charged to construction. CFC believes that amounts incurred by distribution systems for interest charged to construction and allowance for funds used during construction are immaterial relative to their total interest on long-term debt and net margin and patronage capital.

(5)

The ratio of (x) interest on long-term debt (in each year including all interest charged to construction) and net margin and patronage capital to (y) interest on long-term debt (in each year including all interest charged to construction).

(6)

The ratio of (x) net margin and patronage capital plus interest on long-term debt (including all interest charged to construction) plus depreciation and amortization to (y) long-term debt service obligations.

(7)

The ratio of (x) operating margin and patronage capital plus interest on long-term debt (including all interest charged to construction) plus depreciation and amortization expense plus non-operating margin, interest plus cash received in respect of generation and transmission and other capital credits to (y) long-term debt service obligations.

                      

15

 


  

NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION

COMPOSITE COMBINED BALANCE SHEETS

AS REPORTED TO CFC BY MEMBER DISTRIBUTION SYSTEMS

 

The following are unaudited figures that are based

upon Form 7 submitted to

CFC by Member Distribution Systems

       

At December 31,

(Dollar amounts in thousands)

2002

2001

2000

1999

1998

Assets and other debits:

   Utility plant:

      Utility plant in service

$

51,732,230

$

48,895,933

$

45,985,367

$

43,023,535

$

40,387,723

      Construction work in progress

1,350,707

1,442,108

1,438,002

1,262,537

1,129,147

      Total utility plant

53,082,937

50,338,041

47,423,369

44,286,072

41,516,870

   Less: Accumulated provision for

                    depreciation and amortization

14,841,818

14,044,637

13,083,103

12,225,421

11,409,118

      Net utility plant

38,241,119

36,293,404

34,340,266

32,060,651

30,107,752

   Investment in associated organizations (1)

4,442,660

4,225,723

4,002,393

3,790,623

3,665,208

   Current and accrued assets

5,360,318

5,038,616

5,651,652

4,520,592

4,526,663

   Other property and investments

1,240,403

1,076,731

1,019,348

703,585

644,353

   Deferred debits

593,995

613,117

626,903

599,511

530,606

      Total assets and other debits

$

49,878,495

$

47,247,591

$

45,640,562

$

41,674,962

$

39,474,582

  

Liabilities and other credits:

   Net worth:

      Memberships

$

114,001

$

111,266

$

140,663

$

119,175

$

112,391

      Patronage capital and other equities (2)

20,459,062

19,642,036

18,538,088

17,542,625

16,710,886

      Total net worth

20,573,063

19,753,302

18,678,751

17,661,800

16,823,277

   Long-term debt (3)

23,345,933

21,943,560

21,326,555

19,308,152

18,343,340

   Current and accrued liabilities

4,440,751

4,095,900

4,280,010

433,687

3,098,525

   Deferred credits

974,414

952,642

892,001

3,429,173

884,595

   Miscellaneous operating services

544,334

502,187

463,245

842,150

324,845

      Total liabilities and other credits

$

49,878,495

$

47,247,591

$

45,640,562

$

41,674,962

$

39,474,582

 

Equity percentage (4)

41.2%

41.8%

40.9%

42.5%

42.6%

Number of systems included

808

811

812

811

820

(1)

Includes investments in service organizations, power supply capital credits and investments in CFC.

(2)

Includes non-refundable donations or contributions in cash, services or property from states, municipalities, other government agencies, individuals and others for construction purposes.

(3)

Principally debt to RUS and CFC. Includes $10,501,697, $9,794,118, $9,717,546, $8,342,631, and $7,481,368 for the years ended December 31, 2002, 2001, 2000, 1999, and 1998, respectively, due to CFC.

(4)

Determined by dividing total net worth by total assets and other debits.


                        

16

 


         

NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION

COMPOSITE STATEMENTS OF REVENUES, EXPENSES AND PATRONAGE CAPITAL

AS REPORTED TO CFC BY MEMBER POWER SUPPLY SYSTEMS

 

The following are unaudited figures that are based

upon Form 12 or FERC Form 1 submitted to

CFC by Member Power Supply Systems

  

Years ended December 31,

(Dollar amounts in thousands)

2002

2001

2000

1999

1998

Operating revenues and patronage capital

$

11,555,059

$

11,941,467

$

11,431,737

$

10,758,413

$

10,901,138

Operating deductions:

   Cost of power (1)

8,673,728

9,188,992

8,609,376

7,945,476

7,979,542

   Distribution expense (operations)

22,848

22,319

21,375

23,634

17,499

   Distribution expense (maintenance)

15,733

15,907

14,333

14,908

12,524

   Administrative and general expense (2)

461,984

439,032

433,616

414,362

406,441

   Depreciation and amortization expense

977,930

917,165

936,059

904,826

914,270

   Taxes (3)

21,493

26,877

82,297

68,681

69,095

 

      Total

10,173,716

10,610,292

10,097,056

9,371,887

9,399,371

 

Utility operating margin

1,381,343

1,331,175

1,334,681

1,386,526

1,501,767

Non-operating margin

224,104

249,256

303,513

258,186

577,842

Power supply capital credits (4)

39,653

44,506

49,077

44,180

56,646

  

      Total

1,645,100

1,624,937

1,687,271

1,688,892

2,136,255

   

Interest on long-term debt (5)

1,174,279

1,186,371

1,195,644

1,227,548

1,221,512

Other deductions

118,386

117,937

144,850

185,621

184,868

 

      Total

1,292,665

1,304,308

1,340,494

1,413,169

1,406,380

 

Net margin and patronage capital

$

352,435

$

320,629

$

346,777

$

275,723

$

729,875

  

TIER (6)

1.29

1.25

1.28

1.22

1.60

DSC (7)

0.97

0.99

1.16

1.15

1.45

Number of systems included

51

53

51

54

58

(1)

Includes cost of purchased power, power production and transmission expense.

(2)

Includes sales expenses and consumer accounts expense and consumer service and informational expense as well as other administrative and general expenses.

(3)

The significant decrease in 2001 was due to a $63 million deferred income tax credit caused by the change of one system's allocation of patronage capital from a historical book basis to a tax basis method.

(4)

Certain power supply systems purchase wholesale power from other power supply systems of which they are members. Power supply capital credits represent net margin of power supply systems allocated to member power supply systems on the books of the selling power supply systems. This item has been added in determining net margin and patronage capital of the purchasing power supply systems under RUS accounting practices. Cash distributions of this credit have rarely been made by the selling power supply systems to their members. This item also includes net margin of associated organizations allocated to power supply members and added in determining net margin and patronage capital of the member systems under RUS accounting practices.

(5)

Interest on long-term debt is net of interest charged to construction. Allowance for funds used during construction has been included in non-operating margin. According to unpublished information interest charged to construction and allowance for funds used during construction for CFC power supply members in the years 1998-2002 were as follows:

Allowance for Funds Used During

Interest Charged to Construction

Construction

Total

2002

$25,479

$15,009

$40,488

2001

39,140

21,851

60,991

2000

20,245

24,736

44,981

1999

10,073

13,604

23,677

1998

9,947

13,133

23,080

 (6)

The ratio of (x) interest on long-term debt (in each year including all interest charged to construction) and net margin and patronage capital to (y) interest on long-term debt (in each year including all interest charged at that time to construction). The TIER calculation for 1999 and 1998 includes the operating results of five systems, which failed to make debt service payments or are operating under a debt restructure agreement. The TIER calculation for 2000 and 2001 includes the operating results of one system and four systems, respectively, that did not borrow from CFC at that time. The TIER calculation for 2002 includes the operating results of 11 systems that do not currently borrow from CFC. Without these systems, the composite TIER would have been 1.29, 1.22, 1.29, 1.24 and 1.27 for the years ended December 31, 2002, 2001, 2000, 1999 and 1998, respectively.

(7)

The ratio of (x) net margin and patronage capital plus interest on long-term debt (including all interest charged to construction) plus depreciation and amortization to (y) long-term debt service obligations (including all interest charged to construction). The DSC calculation for 1999 and 1998 includes the operating results of five systems which failed to make debt service payments or are operating under a debt restructure agreement. The DSC calculation for 2000 and 2001 includes the operating results of one system and four systems, respectively, that did not borrow from CFC at that time. The DSC calculation for 2002 includes the operating results of 11 systems that do not currently borrow from CFC. Without these systems, the composite DSC would have been 1.14, 0.98, 1.19, 1.23 and 1.28 for the years ended December 31, 2002, 2001, 2000, 1999 and 1998, respectively.

 

                            

17

 

 


   

NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION

COMPOSITE COMBINED BALANCE SHEETS

AS REPORTED TO CFC BY MEMBER POWER SUPPLY SYSTEMS

 

The following are unaudited figures that are based

upon Form 12 or FERC Form 1 submitted to

CFC by Member Power Supply Systems

     

At December 31,

(Dollar amounts in thousands)

2002

2001

2000

1999

1998

Assets and other debits:

   Utility plant:

      Utility plant in service

$

35,116,374

$

32,687,748

$

31,970,487

$

31,140,658

$

31,141,532

      Construction work in progress

1,962,399

1,813,833

1,571,954

1,151,859

1,041,760

          Total utility plant

37,078,773

34,501,581

33,542,441

32,292,517

32,183,292

 

      Less: Accumulated provision for

                 depreciation and amortization

15,929,240

14,208,592

13,867,937

13,230,060

13,059,537

  

          Net utility plant

21,149,533

20,292,989

19,674,504

19,062,457

19,123,755

      Investments in associated

           organizations (1)

1,379,768

1,313,453

1,360,671

1,173,026

1,132,157

      Current and accrued assets

4,214,557

4,120,224

4,067,827

3,904,535

3,740,302

      Other property and investments

1,639,204

1,722,999

1,540,147

1,511,145

1,691,932

      Deferred debits

2,102,269

2,113,357

3,027,612

3,251,458

3,400,876

 

          Total assets and other debits

$

30,485,331

$

29,563,022

$

29,670,761

$

28,902,621

$

29,089,022

     

Liabilities and other credits:

   Net worth:

      Memberships

$

49,133

$

49,129

$

49,106

$

49,131

$

263

      Patronage capital and other equities (2)

3,942,442

3,575,050

3,498,360

3,175,374

(52,606

)

          Total net worth

3,991,575

3,624,179

3,547,466

3,224,505

(52,343

)

   Long-term debt (3)

20,159,824

19,935,286

19,051,276

19,591,883

23,389,067

   Current and accrued liabilities

3,070,276

2,878,459

3,186,042

2,328,504

1,877,320

   Deferred credits

1,556,459

1,509,021

1,565,294

1,338,343

1,296,308

   Miscellaneous operating reserves

1,707,197

1,616,077

2,320,683

2,419,386

2,578,670

   

          Total liabilities and other credits

$

30,485,331

$

29,563,022

$

29,670,761

$

28,902,621

$

29,089,022

Number of systems included

51

53

51

54

58

(1)

Includes investments in service organizations, power supply capital credits and investments in CFC.

(2)

The large increase in 1999 was due to the elimination of Cajun Electric Power Cooperative, which was liquidated after filing for bankruptcy. CFC had no credit exposure to Cajun.

(3)

Principally debt to RUS or debt guaranteed by RUS and loaned by FFB and includes $1,979,107, $2,048,767, $1,905,614, $1,761,847 and $1,652,943 as of December 31, 2002, 2001, 2000, 1999 and 1998, respectively, due to CFC.

                              

18

   


  

NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION

COMPOSITE STATEMENTS OF REVENUES AND EXPENSES

AS REPORTED TO CFC BY TELECOMMUNICATIONS SYSTEMS

  

The following are unaudited figures that are based

upon financial statements submitted to

CFC by Member Telecommunications Systems

   

   

Years ended December 31,

(Dollar amounts in thousands)

2002 (4) (5)

2001 (4)

2000 (3)

1999 (3)

1998

Operating revenues

$

4,765,679

$

4,503,614

$

4,879,808

$

3,908,496

$

2,535,461

Operating expenses (1)

3,364,102

3,030,570

3,509,779

3,003,530

1,846,215

Net income before interest,

     depreciation and taxes

1,401,577

1,473,044

1,370,029

904,966

689,246

Interest on long-term debt

477,587

568,829

430,825

221,103

140,436

Net income before depreciation and taxes

923,990

904,215

939,204

683,863

548,810

Depreciation and amortization expenses

719,204

797,665

675,757

410,805

279,277

Net income before taxes

204,786

106,550

263,447

273,058

269,533

Taxes

93,797

91,420

140,378

89,030

71,326

Net income

$

110,989

$

15,130

$

123,069

$

184,028

$

198,207

    

DSC (2)

1.43

1.59

1.79

2.30

2.14

Number of systems included

201

208

226

191

169

(1)

Includes sales expenses, consumer accounts and customer service and informational expense as well as other administrative and general expenses.

(2)

Debt service coverage ratio is the ratio of (x) net margin plus interest on long-term debt (including all interest charged to construction) plus depreciation and amortization to (y) long-term debt service obligations. During calendar year 2000, CFC closed two large loans to start-up companies for the purpose of acquiring local exchange properties from GTE (now Verizon). Due to significant expenses related to start-up and the transition of these operations, for the years ending 2002, 2001 and 2000 there were substantial transition related expenses reported by these two companies. These expenses were expected when the transactions were underwritten and are typical of such acquisition companies during their start-up mode. Excluding these two borrowers, the composite DSC was 1.71, 1.80 and 2.06 for the years ended December 31, 2002, 2001 and 2000, respectively.

(3)

For the years ended December 31, 2000 and 1999, some telecommunications members were acquired by Alltel Corporation, and CFC agreed to accept Alltel Corporation's financial statements rather than those of the acquired operating companies. Given Alltel Corporation's size, it is not included in the composite statistics.

(4)

During the year ended December 31, 2001, Citizens Communications Company became a telecommunications borrower. The December 31, 2002 and 2001 financial results for Citizens have been excluded from the information above because CFC believes that their inclusion would unduly skew these statistics. Loans to Citizens represent only 4% of the total telecommunications loan portfolio. Citizens' long-term debt has been rated Baa2 by Moody's Investors Service, BBB by Standard & Poor's Corporation and BBB by Fitch Ratings. For calendar year 2002, Citizens reported revenues of $2,669 million and a net loss of $683 million. The net loss was the result of a one-time $1,074 million impairment charge under SFAS 144. Citizens' debt service coverage ratio including and excluding this non-cash charge was 0.57 and 1.70, respectively. Had Citizens been included in the composite data above, the composite debt service coverage ratio would have been 0.99, including the non-cash impairment charge.

(5)

During the year ended December 31, 2002, two of CFC's large telecommunications borrowers recorded impairments to goodwill as a result of new accounting standards. These non-cash charges, which total $140.3 million are reflected in the 2002 composite DSC calculation. Exclusion of these charges would result in a composite DSC of 1.59. In addition, one of CFC's telecommunications borrowers, representing less than 2% of all telecommunications loans outstanding, has been excluded from the 2002 composite figures due to its Chapter 11 bankruptcy filing. CFC is being kept current on its loans to this borrower throughout the bankruptcy and expects to recover all principal and the contract yield on its loans to this borrower, all of which are senior secured. CFC expects the borrowers' financial statements to change significantly upon its emergence from bankruptcy.

 

                                

19

     


     

NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION

COMPOSITE COMBINED BALANCE SHEETS

AS REPORTED TO CFC BY TELECOMMUNICATIONS SYSTEMS

 

The following are unaudited figures that are based

upon financial statements submitted to

CFC by Member Telecommunications Systems

 

At December 31,

(Dollar amounts in thousands)

2002 (4) (5)

2001 (4)

2000 (3)

1999 (3)

1998

Assets and other debits:

     Cash and cash equivalents

$

655,500

$

653,628

$

639,882

$

646,409

$

401,507

     Current assets

970,994

909,931

1,372,186

1,029,905

590,248

     Plant, property and equipment

5,024,619

5,572,227

5,674,846

3,998,038

2,699,798

     Other non-current assets

4,331,119

4,728,130

4,957,209

2,505,597

1,456,301

          Total assets

$

10,982,232

$

11,863,916

$

12,644,123

$

8,179,949

$

5,147,854

Liabilities and equity:

     Current liabilities

$

935,367

$

945,181

$

1,225,408

$

898,080

$

586,176

     Affiliate debt

4,266

7,152

1,135

3,804

23,442

     Long-term debt (1)

6,844,587

7,156,808

6,960,293

4,309,996

2,686,987

     Other non-current liabilities

586,628

464,703

741,921

392,982

232,219

     Equity

2,611,384

3,290,072

3,715,366

2,575,087

1,619,030

          Total liabilities and equity

$

10,982,232

$

11,863,916

$

12,644,123

$

8,179,949

$

5,147,854

  

Equity percentage (2)

24%

28%

29%

32%

32%

Number of systems included

201

208

226

191

169

(1)

Includes current maturities.

(2)

Determined by dividing total net worth by total assets and other debits. During calendar year 2000, CFC closed two large loans to start-up companies for the purpose of acquiring local exchange properties from GTE (now Verizon). Due to significant expenses related to start-up and the transition of these operations, for the years ending 2001 and 2000 there were substantial operating losses reported by these two companies, which had a negative impact on their reported equity. For the years ended December 31, 2002, 2001 and 2000, the equity percentage would have been 27%, 30% and 32%, respectively, if the data for these two borrowers were excluded.

(3)

For the years ended December 31, 2000 and 1999, some telecommunications members were acquired by Alltel Corporation, and CFC agreed to accept Alltel Corporation's financial statements rather than those of the acquired operating companies. Given Alltel Corporation's size, it is not included in the composite statistics.

(4)

During the year ended December 31, 2001, Citizens Communications Company became a telecommunications borrower. The December 31, 2002 and 2001 financial results for Citizens have been excluded from the information above because CFC believes that their inclusion would unduly skew these statistics. Loans to Citizens represent only 4% of the telecommunications loan portfolio. Citizens' long-term debt has been rated Baa2 by Moody's Investors Service, BBB by Standard & Poor's Corporation and BBB by Fitch Ratings. At December 31, 2002, Citizens had total assets of $8.1 billion and equity of $1.2 billion. Had Citizens been included in the composite combined balance sheet data above, the composite equity percentage would have been 20%.

(5)

One of CFC's telecommunications borrowers, representing less than 2% of all telecommunications loans outstanding, has been excluded from the 2002 composite figures due to its Chapter 11 bankruptcy filing. CFC is being kept current on its loans to this borrower throughout the bankruptcy and expects to recover all principal and the contract yield on its loans to this borrower, all of which are senior secured. CFC expects the borrowers' financial statements to change significantly upon its emergence from bankruptcy.

                                  

20

   


      

Item 2.

Properties.

    

CFC owns and operates a headquarters facility in Fairfax County, Virginia. This facility consists of two six-story office buildings and two separate parking garages situated on ten acres of land. CFC also owns an additional two acres of unimproved land.

     

Item 3.

Legal Proceedings.

      

None.

  

  

Item 4.

Submission of Matters to a Vote of Security Holders.

     

None.

                                   

21

 


         

PART II

      

Item 5. 

Market for Registrant's Common Equity and Related Stockholder Matters.

        
 Inapplicable. 

 

Item 6.

Selected Financial Data.

 

The following is a summary of selected financial data for each of the five years ended May 31, 2003.
      

 

(Dollar amounts in thousands)

2003

2002

2001

2000

1999

For the year ended May 31:

Operating income

$

1,070,875

$

1,186,533

$

1,388,295

$

1,020,998

$

792,052

Gross margin

140,028

300,695

270,456

159,674

127,943

Operating margin

15,153

63,834

132,766

115,333

76,439

Derivative cash settlements (A)

122,825

34,191

-

-

-

Derivative forward value (A)

757,212

41,878

-

-

-

Foreign currency adjustments (B)

(243,220

)

(61,030

)

-

-

-

Cumulative effect of change in

     accounting principle (A)

-

28,383

-

-

-

Net margin

$

651,970

$

107,256

$

132,766

$

115,333

$

76,439

Fixed charge coverage ratio (C)

1.70

1.09

1.12

1.13

1.12

Adjusted fixed charge coverage ratio (C)

1.17

1.12

1.12

1.13

1.12

As of May 31:

Assets

$

20,974,288

$

20,342,935

$

19,998,842

$

17,083,440

$

13,925,252

Long-term debt (D)

16,000,744

14,855,550

11,376,412

10,595,596

6,891,122

Subordinated deferrable debt

650,000

600,000

550,000

400,000

400,000

Members' subordinated certificates

1,708,297

1,691,970

1,581,860

1,340,417

1,239,816

Members' equity (A)

454,376

392,056

393,899

341,217

296,481

Total equity

930,836

328,731

393,899

341,217

296,481

Guarantees

$

1,903,556

$

2,056,385

$

2,217,559

$

1,945,202

$

1,893,197

Leverage ratio (E)

23.58

67.14

55.40

54.77

52.35

Adjusted leverage ratio (E)

6.63

7.18

7.72

8.10

7.10

Debt to equity ratio (E)

21.53

60.88

49.77

49.07

45.97

Adjusted debt to equity ratio (E)

4.96

5.40

6.05

6.46

5.52

(A)

Derivative cash settlements represent the net settlements due on interest rate and cross currency exchange agreements that do not qualify for hedge accounting for the years ended May 31, 2003 and 2002. In prior years this amount had been included in the cost of funds line on the combined statement of operations. The derivative forward value represents the present value of all future net settlements on agreements that do not qualify for hedge accounting based on the current estimate of future interest rates. The cumulative effect of change in accounting principle represents the forward value of interest rate and cross currency exchange agreements recorded as a transition adjustment upon adoption of SFAS 133. Members' equity represents total equity excluding foreign currency adjustments, derivative forward value, cumulative effect of change in accounting principle and accumulated other comprehensive income (see "Non-GAAP Financial Measures" in Management's Discussion and Analysis for further explanation of members' equity and a reconciliation to total equity).

(B)

Foreign currency adjustments represent the change on foreign denominated debt that is not related to a qualifying hedge under SFAS 133 during the period. The foreign denominated debt is revalued at each reporting date based on the current exchange rate. To the extent that the current exchange rate is different than the exchange rate at the time of issuance, there will be a change in the value of the foreign denominated debt. CFC enters into foreign currency exchange agreements at the time of each foreign denominated debt issuance to lock in the exchange rate for all principal and interest payments required through maturity.

(C)

The fixed charge coverage ratio is the same calculation as CFC's Times Interest Earned Ratio ("TIER") and the adjusted fixed charge coverage ratio is the same calculation as adjusted TIER. See "Non-GAAP Financial Measures" in Management's Discussion and Analysis for further explanation and a reconciliation of the adjustments CFC makes to its TIER calculation to exclude the impact of SFAS 133 and foreign currency adjustments.

(D)

Includes commercial paper reclassified as long-term debt in the amount of $3,951 million, $3,706 million, $4,638 million, $5,493 million and $2,403 million at May 31, 2003, 2002, 2001, 2000 and 1999, respectively, and excludes $2,911 million, $2,883 million, $4,388 million, $3,040 million and $983 million in long-term debt that comes due, matures and/or will be redeemed during fiscal years 2004, 2003, 2002, 2001 and 2000, respectively (see Note 4 to combined financial statements). Includes the long-term debt valuation allowance of $(1) million and $2 million and the foreign currency valuation account of $326 million and $(2) million at May 31, 2003 and 2002, respectively.

(E)

See "Non-GAAP Financial Measures" for further explanation of these calculations and a reconciliation of the adjustments CFC makes to its leverage and debt to equity ratio calculations.

                                    

22

  


   

Item 7.

Management's Discussion and Analysis of Financial Condition and Results of Operations.

   

This annual report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements may be identified by their use of words like "anticipates", "expects", "projects", "believes", "plans", "may", "intend", "should", "could", "will", "estimate", and other expressions that indicate future events and trends. All statements that address expectations or projections about the future, including statements about loan growth, the adequacy of the loan loss analysis, net margin growth, leverage and debt to adjusted equity ratios, and borrower financial performance are forward-looking statements.

  

Forward-looking statements are based on certain assumptions and expectations of future events that are subject to risks and uncertainties. Actual future results and trends may differ materially from historical results or those projected in any such forward-looking statements depending on a variety of factors, including but not limited to the following:

     
 *

Liquidity - CFC depends on access to the capital markets to refinance its long and short-term debt, fund new loan advances and if necessary, to fulfill its obligations under its guarantees and repurchase agreements. At May 31, 2003, CFC had $1,986 million of commercial paper, daily liquidity fund and bank bid notes and $2,911 million of medium-term notes and collateral trust bonds scheduled to mature during the next twelve months, excluding $150 million of foreign currency valuation related to medium-term notes. There is no guarantee that CFC will be able to access the markets in the future. CFC's long-term debt ratings were downgraded by three of the major credit rating agencies in fiscal year 2002 and Moody's Investors Service has CFC's ratings on negative outlook. Further downgrades or other events that may deny or limit CFC's access to the capital markets could negatively impact its operations. CFC has no control over certain items that are considered by the credit rating agencies as part of their analysis for CFC, such as the overall outlook for the electric and telecommunications industries.

    
 *

Restructured borrowers - Denton County Electric Cooperative, Inc. d/b/a CoServ Electric ("CoServ") has emerged from bankruptcy and the joint plans of liquidation and reorganization filed by CoServ and CFC are effective. However, the calculated impairment on the restructured loan would increase if CoServ were not able to perform as required by the joint plans of liquidation and reorganization.

       
 *

Credit concentration - CFC lends only into the rural electric and telephone industries and is subject to risks associated with those industries. Credit concentration is one of the risk factors considered by the rating agencies in the evaluation of CFC's credit rating. CFC's credit concentration to its ten largest borrowers could increase from the current 25% of total loans and guarantees outstanding, if:

   *

it were to extend additional loans to the current ten largest borrowers,

   *

its total loans outstanding were to decrease, with a disproportionately large share of the decrease to borrowers not in the current ten largest, or

   *

it were to advance new loans in excess of $100 million to one of the next group of borrowers below the ten largest.

       
 *

Loan loss allowance - Computation of the loan loss reserves is inherently based on subjective estimates. A loan write-off in excess of specific reserves for impaired borrowers or a large net loan write-off to a borrower that is currently performing would have a negative impact on the adequacy of the loan loss allowance and the net margin for the year due to an increased loan loss provision.

      
 *

Adjusted leverage and adjusted debt to equity ratios - If CFC were to experience significant loan growth over the next few years, as it did from fiscal year 1998 through fiscal year 2001, the adjusted leverage and adjusted debt to equity ratios would increase. The equity retention policies are tied to the growth in loans as members purchase subordinated certificates with the advance of loans. However, the required subordinated certificate purchase is not sufficient to allow equity retention in the amount required to continue to lower the adjusted leverage and adjusted debt to equity ratios. The increased loan volume would result in an increased gross margin, which could result in an increased allocation to the members' equity reserve, but not in an amount required to reduce the adjusted leverage and adjusted debt to equity ratios. See "Non-GAAP Financial Measures" for further explanation and a reconciliation of the adjustments to the leverage and debt to equity ratios.

      
 *

Tax exemption - Legislation that removes the federal tax exemption for 501(c)(4) social welfare corporations would have a negative impact on CFC's net margins. CFC's continued exemption depends on CFC conducting its business in accordance with its exemption from the Internal Revenue Service.

 

                                      

23

  

 


 

 *

Derivative accounting - The required accounting for derivative financial instruments has caused increased volatility in CFC's financial results. In addition, a standard market does not exist for CFC's derivative instruments, therefore the fair value of derivatives reported in CFC's financial statements is based on quotes obtained from CFC's counterparties. The market quotes provided by counterparties do not represent offers to trade at the quoted price.

    
 *

Foreign currency - The required accounting for foreign denominated debt has caused increased volatility in CFC's financial results. CFC is required to adjust the value of the foreign denominated debt on its combined balance sheet at each reporting date based on the then current foreign exchange rate.

    
 *

Rating triggers - There are rating triggers associated with $11,059 million notional amount of interest rate, cross currency and cross currency interest rate exchange agreements. The rating triggers are based on CFC's senior unsecured credit rating from Standard & Poor's Corporation and Moody's Investors Service. If the rating for either counterparty falls below the level specified in the agreement, the other counterparty may, but is not obligated to, terminate the agreement. If either counterparty terminates the agreement, a payment may be due from one counterparty to the other based on the fair value of the underlying derivative instrument. If CFC's rating from Moody's Investors Service falls to Baa1 or CFC's rating from Standard & Poor's Corporation falls to BBB+, the counterparties may terminate agreements with a total notional amount of $2,183 million. If CFC's rating from Moody's Investors Service falls below Baa1 or CFC's rating from Standard & Poor's Corporation falls below BBB+, the counterparties may terminate the agreements on the remaining total notional amount of $8,876 million. Based on the fair market value of its interest rate, cross currency and cross currency interest rate exchange agreements at May 31, 2003, CFC may be required to make a payment of up to $70 million if its senior unsecured ratings declined to Baa1 or BBB+ and up to $168 million if its senior unsecured ratings declined below Baa1 or BBB+. In calculating the required payments, CFC only considered agreements in which it would have been required to make a payment upon termination.

     
 *

Calculated impairment - CFC calculates loan impairments per the requirements of Statement of Financial Accounting Standards ("SFAS") 114, Accounting by Creditors for Impairment of a Loan - an Amendment of SFAS 5 and SFAS 15 and SFAS 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures - an Amendment of SFAS 114. This pronouncement states that the impairment is calculated based on a comparison of the present value of the expected future cash flows discounted at the original interest rate and/or the estimated fair value of the collateral securing the loan to the recorded investment in the loan. The interest rate in the original loan agreements between CFC and CoServ is a blend of the CFC long-term fixed rate for various maturity periods, the CFC long-term variable and line of credit interest rate. CFC periodically adjusts the long-term variable and line of credit interest rates to reflect the cost of variable rate and short-term debt. Thus, the original contract rate (weighted average of interest rates on all of the original loans to CoServ), will change as CFC adjusts its long-term variable and line of credit interest rates. CFC's long-term variable and line of credit interest rates are currently at historic low levels. CFC's calculated impairment on the restructured loan to CoServ will increase as CFC's long-term variable and line of credit interest rates increase. Currently, an increase of 25 basis points to CFC's variable interest rates results in an increase of $13 million to the calculated impairment.

 

The forward-looking statements are based on management's current views and assumptions regarding future events and operating performance. CFC undertakes no obligation to publicly update or revise any forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made.

     

The following discussion and analysis is designed to provide a better understanding of CFC's combined financial condition and results of operations and as such should be read in conjunction with the combined financial statements, including the notes thereto.

 

Overview

     

CFC was formed in 1969 by the rural electric cooperatives to provide them with a source of funds to supplement the financing provided by the Rural Utilities Service ("RUS"). CFC was organized as a cooperative in which each member (other than associate members) receives one vote. Under CFC's bylaws, the board of directors is composed of 22 individuals, 20 of whom must be either general managers or directors of member utility systems and 2 of whom are designated by the National Rural Electric Cooperative Association. CFC was granted tax-exempt status under Section 501(c)(4) of the Internal Revenue Code.

 

                                       

24

 

 


 

 

Rural Telephone Finance Cooperative ("RTFC") was incorporated as a private cooperative association in the state of South Dakota in September 1987 and was created for the purpose of providing and/or arranging financing for its rural telecommunications members and affiliates. CFC is the sole lender to and manages the affairs of RTFC through a long-term management agreement. RTFC's results of operations and financial condition have been combined with those of CFC in the accompanying financial statements (see Note 1(b) to the combined financial statements). RTFC is a class E member of CFC. RTFC is headquartered with CFC in Herndon, VA and is a taxable entity and takes tax deductions for allocations of net margins as allowed by law under Subchapter T of the Internal Revenue Code. CFC is not a member of RTFC and does not elect directors to the RTFC board. As of May 31, 2003, CFC had committed to lend RTFC up to $10 billion of which $5 billion was currently outstanding.

        

Unless stated otherwise, references to CFC relate to the consolidation of CFC and certain entities created and controlled by CFC to hold foreclosed assets, presented with RTFC on a combined basis. CFC established limited liability corporations and partnerships to hold foreclosed assets. CFC has full ownership and control of all such companies and thus consolidates their financial results

     

CFC's primary objective as a cooperative is to provide its members with the lowest possible loan and guarantee rates while maintaining sound financial results required to obtain high credit ratings on its debt instruments. Therefore, CFC marks up its funding costs only to the extent necessary to cover its operating expenses, a provision for loan losses and to provide a margin sufficient to preserve interest coverage in light of CFC's financing objectives. To the extent members contribute to CFC's base capital by purchasing subordinated certificates carrying below-market interest rates, CFC can offer proportionally lower interest rates on its loans to members.

     

CFC obtains its funding from the capital markets and its membership. CFC enters the capital markets, based on the combined strength of its members, to borrow the funds required to fulfill the financing requirements of its members. On a regular basis, CFC obtains debt financing in the capital markets by issuing fixed rate or variable rate secured collateral trust bonds, subordinated deferrable debt and fixed rate or variable rate unsecured medium-term notes, commercial paper and enters into bank bid note agreements. In addition, CFC obtains debt financing from its membership and other qualified investors through the direct sale of its commercial paper and medium-term notes.

      

Rural electric cooperatives that join CFC are required to purchase membership subordinated certificates from CFC as a condition of membership. In connection with any long-term loan or guarantee made by CFC to or on behalf of one of its members, CFC may require that the member make an additional investment in CFC by purchasing loan or guarantee subordinated certificates. Like the membership subordinated certificates, the loan and guarantee subordinated certificates are unsecured and subordinate to other senior debt of CFC.

  

CFC is required by the cooperative laws under which it is incorporated to have a mechanism to allocate its net margin to its members. CFC allocates its net margin before the effects of SFAS 133, Accounting for Derivative Instruments and Hedging Activities, and foreign currency adjustments, except for derivative cash settlements, annually to an education fund, a members' capital reserve and to members based on each member's participation in loan programs during the year. The membership, loan and guarantee subordinated certificates along with the education fund, members' capital reserve and unretired allocated margins provide CFC's base capitalization.

     

CFC's performance is closely tied to the performance of its member rural electric and telecommunications systems due to the near 100% concentration of its loan and guarantee portfolio in those industries.

     

Change of Auditors in Fiscal Year 2002

       

On April 16, 2002, CFC engaged Ernst & Young LLP to perform the May 31, 2002 year end audit, replacing former auditor Arthur Andersen LLP. On June 15, 2002, Arthur Andersen LLP was convicted of federal obstruction of justice charges arising from the government's investigation of its role as auditors for Enron Corp. Arthur Andersen LLP personnel who were involved with the Enron account had no involvement with the audit of CFC's financial statements for the fiscal year ended May 31, 2001.

       

Securities and Exchange Commission ("SEC") rules require CFC to include or incorporate by reference three years of audited financial statements in any prospectus filed by the company. Until CFC's audited financial statements for the fiscal year ended May 31, 2004 become available, the SEC's current rules would require CFC to present audited financial statements for fiscal year 2001 audited by Arthur Andersen LLP.

 

                                        

25

 


 

Critical Accounting Policies

       

Allowance for Loan Losses

At May 31, 2003 and 2002, CFC had a loan loss allowance that totaled $565 million and $507 million, representing 2.90% and 2.53% of total loans outstanding and 2.64% and 2.29% of total loans and guarantees outstanding, respectively. Generally accepted accounting principles require loans receivable to be reported on the combined balance sheet at net realizable value. The net realizable value is the total principal amount of loans outstanding less an estimate of the expected losses inherent in the portfolio. CFC calculates its loss allowance on a quarterly basis. The loan loss analysis segments the portfolio into three categories: impaired, high risk and general portfolio. There are significant subjective assumptions and estimates used in calculating the amount of the loss allowance required by each of the three categories. Different assumptions and estimates could also be reasonable. Changes in these assumptions and estimates could have a material impact on CFC's financial statements.

      

Impaired Exposure

CFC calculates impairment on certain loans in accordance with SFAS 114 and SFAS 118. SFAS 114 states that a loan is impaired when a creditor does not expect to collect all principal and interest due under the original terms of the loan. CFC reviews its portfolio to identify impairments on a quarterly basis. Factors considered in determining an impairment include, but are not limited to: the review of borrower audited financial statements and interim financial statements if available, borrower payment history, communication with borrower, economic conditions in borrower service territory, pending legal action involving the borrower, restructure agreements between borrower and CFC, and estimates of the value of the borrower's assets that have been pledged as collateral to secure CFC loans. CFC calculates the impairment by comparing the future estimated cash flow, discounted at the original loan interest rate, against CFC's current investment in the receivable. If the current investment in the receivable is greater than the net present value of the future payments discounted at the original contractual interest rate, the impairment is equal to that difference. If it is not possible to estimate the future cash flow associated with a loan, then the impairment calculation is based on the value of the collateral pledged as security for the loan. At May 31, 2003 and 2002, CFC had a total of $164 million and $202 million reserved specifically against impaired exposure totaling $629 million and $1,631 million, respectively, representing 29.03% and 39.84% of the total loan loss allowance. The $164 million and $202 million specific reserves represented 26.07% and 12.39% of the total impaired exposure at May 31, 2003 and 2002, respectively. The balance of impaired exposure outstanding decreased at May 31, 2003 due to the reclassification of the Deseret exposure to the general portfolio and to the receipt of assets as part of the CoServ bankruptcy settlement. The calculated impairment at May 31, 2003 was lower than at May 31, 2002 as a result of the Deseret reclassification, the receipt of assets as part of the CoServ bankruptcy settlement and due to lower interest rates on CFC variable rate loans. The original contract rate on CFC's impaired loans at May 31, 2003 will vary with the changes in CFC's variable interest rates. Based on the current balance of impaired loans at May 31, 2003, a 25 basis point increase or decrease to CFC variable interest rates will result in an increase or decrease, respectively, of approximately $13 million to the calculated impairment.

  

In calculating the impairment on a loan, the estimate of the expected future cash flow is the key estimate made by management. In all cases, the estimate is based on restructure agreements, borrower projected cash flow and past payment history. Changes in the estimated future cash flow would impact the amount of the calculated impairment. The change in cash flow required to make the change in the calculated impairment material will be different for each borrower and depend on the period covered, the original contract interest rate and the amount of the loan outstanding. Estimates are not used to determine CFC's investment in the receivables or the discount rate since, in all cases, they are the loan balance outstanding at the reporting date and the original loan interest rate.

     

High Risk Exposure

Loan and guarantee exposures considered to be high risk represent exposure in which the borrower has had a history of late payments, the borrower's financial results do not satisfy loan financial covenants, the borrower has contacted CFC to discuss pending financial difficulties or for some other reason CFC believes that without increased monitoring and special action on its part, the borrower's financial results could deteriorate resulting in an elevated potential for loss. CFC's corporate credit committee is responsible for determining which loans should be classified as high risk and the level of reserve required for each borrower. The committee meets once a month and reviews all loan facilities with an internal risk rating above a certain level. Once it is determined that exposure to a borrower should be classified as high risk, the committee sets the required reserve level based on the facts and circumstances for each borrower, such as the borrower's financial condition, payment history, CFC's estimate of the collateral value, pending litigation, if any, and other factors. This is an objective and subjective exercise in which the committee uses the available information to make its best estimate as to the level of loss allowance required. At any reporting date the reserve required could vary significantly depending on the facts and circumstances, which could include, but are not limited to: changes in collateral value, if the borrower declares bankruptcy and other factors. The borrowers in the high risk category will generally either move to the impaired category or back to the general portfolio within a period of twelve

                                           

26

 


   

months. At May 31, 2003 and 2002, CFC had allocated $87 million and $47 million of the loan loss allowance against the $871 million and $945 million of exposure classified as high risk, representing coverage of 9.99% and 4.97%, respectively. The $87 million and $47 million allocated to the high risk category represents 15.40% and 9.27%, respectively, of the total loan loss allowance at May 31, 2003 and 2002.

     

General Portfolio

In fiscal year 2003, CFC adopted a more objective methodology to determine the required loan loss allowance for the general portfolio as compared to a more subjective methodology used previously. CFC uses the following factors to determine the level of the loan loss allowance for the general portfolio category:

 *

Internal risk ratings - CFC maintains risk ratings for each of its borrowers. CFC adopted the risk rating methodology in fiscal year 2002. The ratings are updated at least annually and are based on the following:

   *

General financial condition of the borrower.

   *

CFC's internal estimated value of the collateral securing its loans.

   *

CFC's internal evaluation of the borrower's management.

   *

CFC's internal evaluation of the borrower's competitive position within its service territory.

   *

CFC's estimate of potential impact of proposed regulation and litigation.

   *

Other factors specific to individual borrowers or classes of borrowers.

 *

Standard corporate default table - The table provides expected default rates based on rating level and the remaining maturity of the bond. CFC uses the standard default table for all corporate bonds to assist in estimating its reserve levels.

 *

Recovery rates - Estimated recovery rates based on historical experience of loan balance at the time of default compared to the total loss on the loan to date.

   

CFC aggregates the loans in the general portfolio by borrower type (distribution, generation, telecommunications and associate member) and by internal risk rating within borrower type. CFC correlates its internal risk ratings to the ratings used in the standard default table based on a comparison of CFC's rating on borrowers that have a rating from the agencies and based on a standard matching used by banks.

           

In addition to the general portfolio reserve requirement as calculated above, CFC maintains an additional reserve for borrowers with a total exposure in excess of 1.5% of the total CFC exposure. The additional reserve is based on the amount of exposure in excess of 1.5% of the CFC total exposure and the borrower's internal risk rating. At May 31, 2003, CFC had a reserve of $31 million based on the additional risk related to large exposures. At May 31, 2002, CFC considered the additional risk related to large exposures in determining the level of the general reserve, however, no specific dollar amount was identified as there was at May 31, 2003.

              

At May 31, 2003 and 2002, CFC had a total of $17,718 million and $17,307 million of loans and $1,903 million and $1,977 million of guarantees, respectively, in the general portfolio. This total does not include $267 million and $243 million of loans at May 31, 2003 and 2002, respectively, that have a US Government guarantee of all principal and interest payments. CFC does not maintain a loan loss reserve on loans that are guaranteed by the US Government. CFC allocated a total of $314 million (including the $31 million described above) and $258 million of the loan loss allowance to the general portfolio at May 31, 2003 and 2002, respectively, representing coverage of 1.60% and 1.34% of the total exposure.

    

The methodology used in fiscal year 2002 considered many of the factors listed above, however the process of evaluating those factors was not as formalized as in fiscal year 2003 after the final adoption of the internal risk rating process. Overall, CFC believes the methodology used in fiscal year 2003 to be enhanced and less subjective than the methodology used in fiscal year 2002.

     

In fiscal years 2003, 2002 and 2001, CFC made provisions to the loan loss reserve totaling $68 million, $199 million and $105 million, respectively. The important factors affecting the provision for each year are listed below:

 *

Fiscal year 2003 provision of $68 million resulted from the following factors:

 

Impaired exposure decreased by $1,002 million and calculated impairment decreased by $38 million. Calculated impairment was impacted by decreases to CFC variable interest rates and reductions in total impaired exposure.

   *

High risk exposure decreased by $74 million and the CFC credit committee determined, based on facts and circumstances at that time, that a 10% reserve was required on the high risk exposure compared to a 5% reserve in 2002 which results in a net increase of $40 million to the reserve allocated to the high risk category.

   *

General portfolio exposure increased by $337 million and the new allowance methodology resulted in an increase to the reserve of $56 million representing 1.60% of total exposure versus 1.34% of total exposure in 2002.

   *

Net write-offs of $10 million during fiscal year 2003.

                                            

27

 


        
 *

Fiscal year 2002 provision of $199 million resulted from the following factors:

   *

Impaired exposure increased by $52 million and calculated impairments increased by $47 million. One impaired borrower defaulted on its restructure agreement and declared bankruptcy resulting in a higher calculated impairment as compared to fiscal year 2001.

   *

High risk exposure increased by $405 million. At year end it was estimated that a reserve of 5.00% was required on high risk exposure resulting in an increase of $26 million compared to 3.98% for fiscal year 2001.

   *

General portfolio exposure decreased by $316 million, however the reserve requirement based on the methodology in effect at that time required an increase to the general reserve of $102 million due to the downturn in the electric and telecommunications industries. The amount reserved against general portfolio exposure at May 31, 2002 represented 1.34% of exposure as compared to 0.79% of exposure at May 31, 2001.

   *

Net write-offs of $24 million during fiscal year 2002.

 *

Fiscal year 2001 provision of $105 million resulted from the following factors:

   *

Increase to impaired exposure of $919 million resulting in an increase to the calculated impairment of $70 million.

   *

High risk exposure increased by $129 million resulting in an increase of $11 million to the required reserve.

   *

General portfolio exposure increased by $2,138 million and the required reserve increased by $23 million. At May 31, 2001 the general reserve represented 0.79% of exposure as compared to 0.76% of exposure at May 31, 2000.

   *

Net write-offs of $1 million.

  

Senior management reviews and discusses the estimates and assumptions used in the allocation of the loan loss allowance to impaired loans, high risk loans and loans covered by the general portfolio, including high exposures related to single obligors, on a quarterly basis. Senior management discusses annual estimates with the board of directors and audit committee and reviews all loan loss related disclosures included in CFC's Form 10-Qs and Form 10-Ks filed with the SEC. Under current policy, CFC's board of directors is required to approve all loan write-offs.

       

Derivative Financial Instruments

In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS 133. SFAS 133, as amended, establishes accounting and reporting standards requiring that derivative instruments (including certain derivative instruments embedded in other contracts) be recorded in the combined balance sheet as either an asset or liability measured at fair value. The statement requires that changes in the derivative instrument's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative instrument's gains and losses to offset related results on the hedged item in the combined statement of operations or to be recorded as other comprehensive income, to the extent effective, and requires that a company formally document, designate, and assess the effectiveness of transactions that receive hedge accounting. CFC adopted this statement on June 1, 2001. CFC is neither a dealer nor trader in derivative financial instruments. CFC uses interest rate, cross currency and cross currency interest rate exchange agreements to manage its interest rate and foreign currency risk.

       

As a result of applying SFAS 133, CFC has recorded derivative assets of $1,160 million and $193 million, derivative liabilities of $355 million and $252 million, and a long-term debt valuation allowance that decreases long-term debt by $1 million and increases long-term debt by $2 million at May 31, 2003 and 2002, respectively. Accumulated other comprehensive losses related to derivatives from inception to date were $47 million and $73 million as of May 31, 2003 and 2002, respectively.

       

The impact of derivatives on CFC's combined statement of operations for the years ended May 31, 2003 and 2002 was a gain of $880 million and $104 million, respectively. The change in the forward value of derivatives for the years ended May 31, 2003 and 2002 were $757 million and $42 million which included amortization totaling $19 million and $21 million, respectively, related to the transition adjustment and long-term debt valuation allowance that was recorded when CFC implemented SFAS 133 on June 1, 2001. During the year ended May 31, 2002, CFC recorded a $28 million gain as a cumulative effect of change in accounting principle related to the fair value of derivatives on June 1, 2001, the date CFC adopted SFAS 133. In addition, $123 million and $34 million representing the net cash settlements received by CFC during the years ended May 31, 2003 and 2002, respectively, were recorded in the derivative cash settlements line item. These amounts relate to the interest rate and cross currency interest rate exchange agreements that do not qualify for hedge accounting under SFAS 133. These cash settlements were recorded in the cost of funds prior to fiscal year 2002, the year in which SFAS 133 was implemented.

  

                                         

28

       


  

  

CFC is required to determine the fair value of its derivative instruments. Because there is not an active secondary market for the types of derivative instruments it uses, CFC obtains market quotes from its dealer counterparties. The market quotes are based on the calculated net settlement for the period from the last payment date and the expected future cash flow based on estimated yield curves. CFC subtracts the accrued net settlement amount from the fair value quote, leaving the estimated forward value of the derivative. CFC records the accrual related to the net settlements in its derivative cash settlements line and records the forward value of the derivatives in the derivative forward value line for the majority of its derivatives or in the other comprehensive income account on the combined balance sheet for the derivatives that qualify for special hedge accounting. CFC is not making any material estimates in calculating the fair value of its derivatives. The counterparties are estimating future interest rates as part of the quotes they provide to CFC. CFC adjusts all derivatives to fair value on a quarterly basis. The fair value recorded by CFC will change as estimates of future interest rates change. CFC does not believe that volatility in the derivative forward value line on the combined statement of operations is material as it represents an estimated future value and not a cash impact for the current period.

   

The majority of CFC's derivatives do not qualify for special hedge accounting. To qualify for special hedge accounting, there must be a high correlation between the pay leg of the interest rate exchange agreement and the asset being hedged or between the receive leg of the interest rate exchange agreement and the liability being hedged. A large portion of CFC's interest rate exchange agreements use a 30-day composite commercial paper index as the receive leg, which would have to be highly correlated to CFC's own commercial paper rates to qualify for special hedge accounting. CFC sells commercial paper to its members as well as investors in the capital markets. CFC sets its rates daily based on its cash requirements. The correlation between the CFC commercial paper rates and the 30-day composite commercial paper index has not been high enough to qualify for special hedge accounting.

   

CFC does not plan to adjust its practice of using the 30-day composite commercial paper or a LIBOR index as the receive portion of its interest rate exchange agreements. CFC sets the variable interest rates on its loans based on the cost of its short-term debt, which is comprised of long-term debt due within one year and commercial paper. CFC believes that it is properly hedging its gross margin on loans by using the 30-day composite commercial paper or LIBOR index, which is the rate that is most closely related to the rates it charges on its own commercial paper. While the correlation is not sufficient to meet the high standards set in SFAS 133, CFC believes that it is effectively managing interest rate risk.

     

New Accounting Pronouncements

   

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51 ("FIN 46"). FIN 46 defines a variable interest entity as those that either have insufficient equity at risk to permit the entity to finance its activities without additional subordinated financial support from other parties or, as a group, its equity holders lack one or more characteristics of a controlling financial interest.

     

FIN 46 requires the consolidation of a variable interest entity by the party that is the primary beneficiary of the variable interest entity. An enterprise is considered a primary beneficiary if it absorbs a majority of the variable interest entity's expected losses, receives a majority of the entity's expected residual returns, or both, as a result of ownership, contractual or other financial interests in the entity. Currently, entities are generally consolidated by an enterprise when it has a controlling financial interest through ownership of a majority voting interest in the entity.

    

CFC believes it is the primary beneficiary of two variable interest entities, RTFC and NCSC, as a result of its exposure to absorbing a majority of their expected losses. Neither company has been consolidated with CFC under GAAP prior to FIN 46 since CFC has no direct financial ownership interest in either company. However, CFC is the sole lender to and manages the affairs of RTFC and NCSC through long-term management agreements. Under a guarantee agreement with RTFC, CFC maintains a loan loss reserve for RTFC. RTFC's results of operations and financial condition are currently combined with those of CFC.

  

Effective June 1, 2003, CFC and NCSC entered into a guarantee agreement under which CFC will indemnify NCSC against losses on loans that are directly funded by loans from CFC. Accordingly, NCSC will reduce its loss allowance to a level appropriate for its consumer loan program exposure.

    

CFC intends to implement FIN 46 effective  June 1, 2003 and believes that such implementation will result in the consolidation of National Cooperative Services Corporation ("NCSC'") and RTFC. Through May 31, 2003, the results of RTFC have been combined with CFC's. See Note 1(r) to the combined financial statements for additional information on NCSC.

 

                                          

29

    




   

CFC anticipates that the impact of adopting FIN 46 effective June 1, 2003, based on NCSC and RTFC balances at May 31, 2003, will be the following: an increase in total assets of approximately $361 million, an increase in total liabilities of approximately $365 million, an increase in NCSC and RTFC members' equity (minority interest) of approximately $16 million and a decrease in total equity of approximately $20 million. The impact on net margin for the year ended May 31, 2004 is not expected to be material. At May 31, 2003, CFC is exposed to loss in its relationship with NCSC to the extent of its net investment (loans receivable and guarantees of NCSC debt obligations less NCSC's investment in CFC) totaling approximately $677 million. At May 31, 2003, there is no additional exposure to loss on the relationship with RTFC due to the fact that RTFC financial results are combined with CFC. At May 31, 2003, CFC had a net investment in RTFC totaling $4,368 million.

   

Non-GAAP Financial Measures

   

CFC makes certain adjustments to financial measures in assessing its financial performance that are not in accordance with generally accepted accounting principles ("GAAP"). These non-GAAP adjustments fall primarily into two categories: (1) adjustments to exclude the impact of SFAS 133 and foreign currency adjustments, and (2) adjustments related to the calculation of leverage and debt to equity ratios.

     

Adjustments to Exclude the Impacts of Derivatives and Foreign Currency Adjustments

CFC's primary performance measure is the Times Interest Earned Ratio ("TIER"). TIER is calculated by adding the cost of funds to net margin prior to the cumulative effect of change in accounting principle and dividing that total by the cost of funds. The TIER is a measure of CFC's ability to cover interest expense requirements on its debt. CFC adjusts the TIER calculation to add the derivative cash settlements to the cost of funds and to remove the derivative forward value and foreign currency adjustments from net margin. Adding the cash settlements back to the cost of funds also has a corresponding effect on CFC's gross margin and operating margin. CFC makes these adjustments to its TIER calculation for the purpose of covenant compliance on its revolving credit agreements. CFC's goal is to maintain a minimum adjusted TIER of 1.10.

    

CFC's cost of funding is the primary factor used to set the interest rates on the loans to its members. CFC uses derivatives to manage interest rate and foreign currency exchange risk on its funding of the loan portfolio. The derivative cash settlements represent the amount that CFC receives from or pays to its counterparties based on the interest rate and foreign currency exchange indexes in its derivatives. CFC uses the adjusted cost of funding to set interest rates on loans to its members and believes that the cost of funds adjusted to include derivative cash settlements represents its total cost of funding for the period. CFC adjusts its cost of funds to include the derivative cash settlements for the purpose of covenant compliance on its revolving credit agreements. TIER calculated by adding the derivative cash settlements to the cost of funds reflects management's perspective on its operations and thus, CFC believes that it represents a useful financial measure for investors.

 

The derivative forward value and foreign currency adjustments do not represent cash inflow or outflow to CFC during the current period. The derivative forward value represents a present value estimate of the future cash inflows or outflows that will be recognized as net cash settlements for all periods through the maturity of its derivatives. Foreign currency adjustments represent the change in value of foreign denominated debt resulting from the change in foreign currency exchange rates during the current period. The derivative forward value and foreign currency adjustments do not represent cash inflows or outflows that affect CFC's current ability to cover its debt service obligations. The forward value calculation is based on future interest rate expectations that may change daily creating volatility in the estimated forward value. The change in foreign currency exchange rates adjusts the debt balance to the amount that would be due at the reporting date. At the issuance date, CFC enters into a foreign currency exchange agreement for all foreign denominated debt that effectively fixes the exchange rate for all interest and principal payments. For the purpose of making operating decisions, CFC subtracts the derivative forward value and foreign currency adjustments from its net margin when calculating TIER and for other net margin presentation purposes. The covenants in CFC's revolving credit agreements also exclude the effects of derivative forward value and foreign currency adjustments. In addition, since the derivative forward value and foreign currency adjustments do not represent current period cashflow, CFC does not allocate such funds to its members and thus excludes the derivative forward value and foreign currency adjustments from net margin when making certain presentations to its members and in calculating the amount of net margins to be allocated to its members. TIER calculated by excluding the derivative forward value and foreign currency adjustments from net margin reflects management's perspective on its operations and thus, CFC believes that it represents a useful financial measure for investors.

    

The implementation of SFAS 133 and foreign currency adjustments have also impacted CFC's total equity. The derivative forward value and foreign currency adjustments flow through the combined statement of operations as income or expense, increasing or decreasing the total net margin for the period. The total net margin or net loss for the period represents an increase or decrease, respectively, to total equity. As a result of implementing SFAS 133, CFC's total equity includes other

  
                                          

30

       


  

comprehensive income, which represents estimated unrecognized gains and losses on derivatives. The other comprehensive income component of equity does not flow through the combined statement of operations. As stated above, the derivative forward value and foreign currency adjustments do not represent current cash inflow or outflow. The other comprehensive income is also an estimate of future gains and losses and as such does not represent earnings that CFC can use to fund its loan portfolio. Financial measures calculated with members' equity, which is total equity excluding the impact of SFAS 133 and foreign currency adjustments, reflect management's perspective on its operations and thus, CFC believes that it represents a useful measure of CFC's financial condition and total capitalization.

  

The following chart provides a reconciliation between cost of funds, gross margin, operating margin, and net margin and these financial measures adjusted to exclude the impact of SFAS 133 and foreign currency adjustments for the years ended May 31, 2003 and 2002. No adjustment for SFAS 133 and foreign currency adjustments is necessary for periods prior to CFC's implementation of SFAS 133 in fiscal year 2002.

   

Year Ended May 31,

(Dollar amounts in thousands)

2003

2002

Cost of funds

$

930,847

$

885,838

Plus: Derivative cash settlements

(122,825

)

(34,191

)

Adjusted cost of funds

$

808,022

$

851,647

 

Gross margin

$

140,028

$

300,695

Plus: Derivative cash settlements

122,825

34,191

Adjusted gross margin

$

262,853

$

334,886

 

Operating margin

$

15,153

$

63,834

Plus: Derivative cash settlements

122,825

34,191

Adjusted operating margin

$

137,978

$

98,025

  

Net margin prior to cumulative

          effect of change in accounting principle

$

651,970

$

78,873

Less: Derivative forward value

(757,212

)

(41,878

)

          Foreign currency adjustments

243,220

61,030

Adjusted net margin

$

137,978

$

98,025

   

TIER using GAAP financial measures is calculated as follows:

        

Cost of funds + net margin prior to cumulative

TIER =

effect of change in accounting principle

 

Cost of funds

    

TIER adjusted to exclude the impact of SFAS 133 and foreign currency adjustments is calculated as follows:

   

Adjusted TIER =

Cost of funds + derivative cash settlements +

net margin prior to the cumulative effect of change in accounting

principle - derivative forward value - foreign currency adjustments

Cost of funds + derivative cash settlements

    

The following chart provides the TIER and adjusted TIER for the years ended May 31, 2003 and 2002.

 

Year Ended

May 31,

2003

2002

TIER

1.70

1.09

Adjusted TIER

1.17

1.12

                                          

31

      


     

Adjustments to the Calculation of Leverage and Debt to Equity

CFC calculates the leverage ratio by adding total liabilities to total guarantees and dividing by total equity. CFC calculates the debt to equity ratio by dividing total liabilities by total equity. CFC adjusts these ratios to subtract debt used to fund loans that are guaranteed by RUS, to subtract from total debt and add to total equity, debt with equity characteristics issued to its members and in the capital markets and to exclude the impact of SFAS 133 and foreign currency adjustments from its total liabilities and total equity. CFC also adjusts the debt to equity ratio to add the loan loss allowance to total equity.

  

CFC is an eligible lender under the RUS loan guarantee program. Loans issued under this program carry the US Government's guarantee of all interest and principal payments. Thus, CFC has little or no risk associated with the collection of principal and interest payments on these loans. Therefore, CFC believes that there is little or no risk related to the repayment of the liabilities used to fund RUS guaranteed loans and subtracts such liabilities from total liabilities for the purpose of calculating its leverage and debt to equity ratios. CFC adjusts its leverage ratio by subtracting liabilities used to fund RUS guaranteed loans from total liabilities for the purpose of covenant compliance on its revolving credit agreements. The leverage and debt to equity ratios adjusted to subtract debt used to fund RUS guaranteed loans from total liabilities reflects management's perspective on its operations and thus, CFC believes that these are useful financial measures for investors.

 

CFC requires that its members purchase subordinated certificates as a condition of membership and as a condition to obtaining a loan or guarantee. The subordinated certificates are accounted for as debt under GAAP. The subordinated certificates have long-dated maturities and pay no interest or pay interest that is below market and under certain conditions CFC is prohibited from making interest payments to members on the subordinated certificates. CFC adjusts its leverage ratio by subtracting members' subordinated certificates from total liabilities and adding it to total equity for the purpose of covenant compliance on its revolving credit agreements. The leverage and debt to equity ratios adjusted to treat members' subordinated certificates as equity rather than debt reflects management's perspective on its operations and thus, CFC believes that these are useful financial measures for investors.

  

CFC also sells subordinated deferrable debt in the capital markets with maturities of up to 49 years and the option to defer interest payments. The characteristics of subordination, deferrable interest and long-dated maturity are all equity characteristics. CFC adjusts its leverage ratio by subtracting subordinated deferrable debt from total liabilities and adding it to total equity for the purpose of covenant compliance on its revolving credit agreements. The leverage and debt to equity ratios adjusted to treat subordinated deferrable debt as equity rather than debt reflects management's perspective on its operations and thus, CFC believes that these are useful financial measures for investors.

   

As a result of implementing SFAS 133, CFC's combined balance sheet includes the fair value of its derivative instruments. As noted above, the amounts recorded are estimates of the future gains and losses that CFC may incur related to its derivatives. The amounts do not represent current cash flows and are not available to fund current operations. CFC adjusts its leverage ratio by excluding the impact of implementing SFAS 133 from liabilities and equity for the purpose of covenant compliance on its revolving credit agreements. The leverage and debt to equity ratios adjusted to exclude the impact of SFAS 133 from liabilities and equity reflects management's perspective on its operations and thus, CFC believes that these are useful financial measures for investors.

    

As a result of issuing foreign denominated debt and the implementation of SFAS 133 which discontinued the practice of recording the foreign denominated debt and the related currency exchange agreement as one transaction, CFC must adjust the value of such debt reported on the combined balance sheet for changes in foreign currency exchange rates since the date of issuance. At the time of issuance of all foreign denominated debt, CFC enters into a foreign currency exchange agreement to fix the exchange rate on all principal and interest payments through maturity. The adjustments to the value of the debt on the combined balance sheet are reported on the combined statement of operations. The adjusted debt value at the reporting date does not represent the amount that CFC will ultimately pay to retire the debt, unless the current exchange rate is equal to the exchange rate in the related foreign currency exchange agreement or the counterparty fails to honor its obligations under the agreement. CFC adjusts its leverage ratio by excluding the impact of foreign currency valuation adjustments from liabilities and equity for the purpose of covenant compliance on its revolving credit agreements. The leverage and debt to equity ratios adjusted to exclude the impact of foreign currency reflects management's perspective on its operations and thus, CFC believes that these are useful financial measures for investors.

   

CFC accumulates the loan loss allowance through the provision for loan losses on its combined statement of operations. Thus, the loan loss allowance represents net margins or equity that has been specifically allocated to cover losses in the loan portfolio. Including the loan loss allowance as part of equity in the debt to equity ratio reflects management's perspective on its operations and thus, CFC believes that it is a useful financial measure for investors.

                                             

32

 


   

The leverage and debt to equity ratios using GAAP financial measures are calculated as follows:

 

Leverage ratio =

Liabilities + guarantees outstanding

Total equity

       

Debt to equity ratio =

Liabilities

   

Total equity

    

The leverage and debt to equity ratios reflecting the adjustments noted above are calculated as follows:

  
 

Total liabilities - derivative liabilities - foreign currency valuation account -

 

debt used to fund loans guaranteed by RUS - subordinated deferrable debt -

Adjusted leverage ratio =

members' subordinated certificates +guarantees outstanding

Total equity - derivative forward value - cumulative effect of change in

accounting principle - foreign currency adjustments - accumulated other

comprehensive loss + members' subordinated certificates + subordinated

deferrable debt

        

Total liabilities - derivative liabilities - foreign currency valuation account -

   

debt used to fund loans guaranteed by RUS - subordinated deferrable debt -

Adjusted debt to equity ratio =

members' subordinated certificates

Total equity - derivative forward value - cumulative effect of change in

accounting principle - foreign currency adjustments - accumulated other

comprehensive loss + members' subordinated certificates + subordinated

deferrable debt + loan loss allowance

    

The following charts provide a reconciliation between the liabilities and equity used to calculate the leverage and debt to equity ratios and these financial measures reflecting the adjustments noted above, as well as the ratio calculations for the five years ended May 31, 2003.

        

Leverage Ratio:

May 31,

(Dollar amounts in thousands)

2003

2002

2001

2000

1999

Total Liabilities

$

20,043,452

$

20,014,204

$

19,604,943

$

16,742,223

$

13,628,771

   Less:

 

Derivative liabilities (1) (2)

(353,840

)

(254,143

)

-

-

-

Foreign currency valuation account (3)

(325,810

)

2,355

-

-

-

Debt used to fund loans guaranteed by RUS

(266,857

)

(242,574

)

(182,134

)

(89,153

)

(130,940

)

Subordinated deferrable debt

(650,000

)

(600,000

)

(550,000

)

(400,000

)

(400,000

)

Subordinated certificates

(1,708,297

)

(1,691,970

)

(1,581,860

)

(1,340,417

)

(1,239,816

)

Adjusted liabilities

$

16,738,648

$

17,227,872

$

17,290,949

$

14,912,653

$

11,858,015

       

Total Equity

$

930,836

$

328,731

$

393,899

$

341,217

$

296,481

   Less:

Prior year cumulative derivative forward value and

         foreign currency adjustments (2)(3)

(9,231

)

-

-

-

-

Current period derivative forward value (2)

(757,212

)

(70,261

)

-

-

-

Current period foreign currency adjustments (3)

243,220

61,030

-

-

-

Accumulated other comprehensive loss (2)

46,763

72,556

-

-

-

Members' equity

454,376

392,056

393,899

341,217

296,481

   Plus:

Subordinated certificates

1,708,297

1,691,970

1,581,860

1,340,417

1,239,816

Subordinated deferrable debt

650,000

600,000

550,000

400,000

400,000

Adjusted equity

$

2,812,673

$

2,684,026

$

2,525,759

$

2,081,634

$

1,936,297

 

Guarantees

$

1,903,556

$

2,056,385

$

2,217,559

$

1,945,202

$

1,893,197

 

Leverage ratio

23.58

67.14

55.40

54.77

52.35

Adjusted leverage ratio

6.63

7.18

7.72

8.10

7.10

   

(1) Includes the long-term debt valuation allowance of $(941) and $2,340 at May 31, 2003 and 2002, respectively.

(2) No adjustment for SFAS 133 is necessary for periods prior to CFC's implementation of SFAS 133 in fiscal year 2002.

(3) No adjustment for foreign currency is required prior to CFC's implementation of SFAS 133 in fiscal year 2002. Prior to that date, CFC was allowed under SFAS 52, to account for the foreign denominated debt and the related cross currency exchange agreement as one transaction in the cost of funds.

                                            

33

 


 

      

Debt to Equity Ratio:

May 31,

(Dollar amounts in thousands)

2003

2002

2001

2000

1999

Total Liabilities

$

20,043,452

$

20,014,204

$

19,604,943

$

16,742,223

$

13,628,771

   Less:

Derivative liabilities (1) (2)

(353,840

)

(254,143

)

-

-

-

Foreign currency valuation account (3)

(325,810

)

2,355

-

-

-

Debt used to fund loans guaranteed by RUS

(266,857

)

(242,574

)

(182,134

)

(89,153

)

(130,940

)

Subordinated deferrable debt

(650,000

)

(600,000

)

(550,000

)

(400,000

)

(400,000

)

Subordinated certificates

(1,708,297

)

(1,691,970

)

(1,581,860

)

(1,340,417

)

(1,239,816

)

Adjusted liabilities

$

16,738,648

$

17,227,872

$

17,290,949

$

14,912,653

$

11,858,015

  

Total Equity

$

930,836

$

328,731

$

393,899

$

341,217

$

296,481

   Less:

Prior year cumulative derivative forward value and

         foreign currency adjustments (2)(3)

(9,231)

-

-

-

-

Current period derivative forward value (2)

(757,212

)

(70,261

)

-

-

-

Current period foreign currency adjustments (3)

243,220

61,030

-

-

-

Accumulated other comprehensive loss (2)

46,763

72,556

-

-

-

Members' equity

454,376

392,056

393,899

341,217

296,481

   Plus:

Subordinated certificates

1,708,297

1,691,970

1,581,860

1,340,417

1,239,816

Subordinated deferrable debt

650,000

600,000

550,000

400,000

400,000

Loan loss allowance

565,058

506,742

331,997

228,292

212,203

Adjusted equity

$

3,377,731

$

3,190,768

$

2,857,756

$

2,309,926

$

2,148,500

   

Debt to equity ratio

21.53

60.88

49.77

49.07

45.97

Adjusted debt to equity ratio

4.96

5.40

6.05

6.46

5.52

     

(1) Includes the long-term debt valuation allowance of $(941) and $2,340 at May 31, 2003 and 2002, respectively.

(2) No adjustment for SFAS 133 is necessary for periods prior to CFC's implementation of SFAS 133 in fiscal year 2002.

(3) No adjustment for foreign currency is required prior to CFC's implementation of SFAS 133 in fiscal year 2002. Prior to that date, CFC was allowed under SFAS 52, to account for the foreign denominated debt and the related cross currency exchange agreement as one transaction in the cost of funds.

   

Previously, we have described adjustments that CFC makes to its total outstanding debt and total equity. CFC also adjusts its total capitalization to exclude the impact of SFAS 133 and foreign currency adjustments from the total debt and total equity. Total capitalization includes notes payable, long-term debt, subordinated deferrable debt, members' subordinated certificates and total equity. Adjusted total capitalization excludes the derivative long-term debt valuation allowance and the foreign currency valuation account from total liabilities and excludes the impact of SFAS 133 and foreign currency adjustments from total equity. Total capitalization adjusted to exclude the impact of SFAS 133 and foreign currency adjustments reflects management's perspective on its operations and thus, CFC believes that it is a useful financial measure for investors. The following chart provides a reconciliation between total capitalization and adjusted total capitalization at May 31, 2003 and May 31, 2002. No adjustment for SFAS 133 and foreign currency adjustments is necessary for periods prior to CFC's implementation of SFAS 133 in fiscal year 2002.

 

    

(Dollar amounts in thousands)

May 31,  2003

May 31, 2002

Total capitalization

$

20,386,230

$

19,890,220

   Less:

Long-term debt valuation allowance

941

(2,340

)

Foreign currency valuation account

(325,810

)

2,355

Prior year cumulative derivative forward value and

       foreign currency adjustments

(9,231

)

-

Current period derivative forward value (1)

(757,212

)

(70,261

)

Current period foreign currency adjustments

243,220

61,030

Accumulated other comprehensive loss

46,763

72,556

Adjusted total capitalization

$

19,584,901

$

19,953,560

     

(1) Includes $28,383 related to the cumulative effect of change in accounting principle in fiscal year 2002.

       

Restatement

    
In the implementation of SFAS 133, CFC properly accounted for its cross currency and cross currency interest rate exchange agreements, but did not adjust its foreign denominated debt for changes in exchange rate from the date of issuance to the reporting date as required under SFAS 52. Prior to the adoption of SFAS 133, CFC was properly accounting for the foreign denominated debt and the related cross currency or cross currency interest rate exchange agreement by recording the debt at an amount that included the impact of the related exchange agreement and by offsetting the interest payments on the
                                                 

34

 


      
foreign denominated debt with the cash settlements on the exchange agreements in the cost of funds on the combined statement of operations. As a result of implementing SFAS 133, the fair value of all cross currency and cross currency interest rate exchange agreements were reported on the combined balance sheet as an asset or liability with the change in the fair value reported either in the combined statement of operations or in other comprehensive income. The separate reporting of the fair value of the exchange agreement required that the foreign denominated debt also be adjusted to fair value at each reporting date with the change in fair value reported in the combined statement of operations to reflect the change in exchange rate during the period. For the year ended May 31, 2002 and all quarterly reporting periods in fiscal years 2002 and 2003, CFC did not adjust the fair value of the foreign denominated debt on the combined balance sheet to reflect changes in the exchange rate during the period. CFC continued to record the foreign denominated debt on the combined balance sheet based on the exchange rate that was fixed at the time of issuance by the cross currency exchange agreements, which represents the amount that CFC will pay at maturity, unless the counterparty to the cross currency agreements defaults on its obligations. CFC has restated the May 31, 2002 year-end results as more fully described in Note 1(q) and the quarterly results in fiscal years 2002 and 2003 presented in Note 15 to the combined financial statements in this May 31, 2003 report on Form 10-K.
 

CFC has reviewed its disclosure controls related to the implementation of new accounting statements and is in the process of implementing changes to such controls in order to prevent and detect such items in the future.

 

Margin Analysis

 

CFC uses an interest coverage ratio instead of the dollar amount of gross or net margin as its primary performance indicator, since CFC's net margin in dollar terms is subject to fluctuation as interest rates change. Management has established a 1.10 adjusted TIER as its minimum operating objective. TIER is a measure of CFC's ability to cover the interest expense on funding. TIER is calculated by dividing the cost of funds and the net margin prior to the cumulative effect of change in accounting principle by the cost of funds. CFC's TIER for the years ended May 31, 2003, 2002 and 2001 was 1.70, 1.09 and 1.12, respectively. CFC adjusts TIER to exclude the derivative forward value and foreign currency adjustments from net margin and include the derivative cash settlements in the cost of funds. Adjusted TIER for the years ended May 31, 2003, 2002 and 2001 was 1.17, 1.12 and 1.12, respectively. See "Non-GAAP Financial Measures" for further explanation and a reconciliation of the adjustments CFC makes in its TIER calculation to exclude the impact of SFAS 133 and foreign currency adjustments.

     

Fiscal Year 2003 versus 2002 Results

The following chart presents the results for the year ended May 31, 2003 versus May 31, 2002.

   

For the year ended May 31,

Increase/

(Dollar amounts in millions)

2003

2002

(Decrease)

Operating income

$

1,071

$

1,187

$

(116

)

Cost of funds

931

886

45

   Gross margin

140

301

(161

)

Expenses:

General and administrative expenses

38

38

-

Provision for loan losses

68

199

(131

)

   Total expenses

106

237

(131

)

Results of operations of foreclosed assets

1

-

1

Impairment loss on foreclosed assets

(20

)

-

(20

)

   Subtotal foreclosed assets

(19

)

-

(19

)

   Operating margin

15

64

(49

)

    

Derivative cash settlements

123

34

89

Derivative forward value

757

42

715

Foreign currency adjustments

(243

)

(61

)

(182

)

Cumulative effect of change in accounting principle

-

28

(28

)

   Net margin

$

652

$

107

$

545

 

TIER

1.70

1.09

Adjusted TIER (1)

1.17

1.12

        

(1) Adjusted to exclude the derivative forward value and foreign currency adjustments from net margin and to include the derivative cash settlements in the cost of funds. See "Non-GAAP Financial Measures" for further explanation and a reconciliation of these adjustments.

                                                   

35

  


   

Net margin for the year ended May 31, 2003 was $652 million, an increase of $545 million or 509% over the $107 million earned the prior year. The net margin increase was primarily due to increases in the derivative cash settlements and forward value and a decrease in the provision for loan losses offset by a decrease in foreign currency adjustments and gross margin spread earned on loans.

   

Operating Income

The $116 million or 10% decrease in operating income for the year ended May 31, 2003 compared to the prior year was due to the decrease in the yield on average loans outstanding caused by lower interest rates. Average loan volume for the year ended May 31, 2003 was $19,846 million, an increase of $10 million, or less than 1%, over the average loan volume of $19,836 for the prior year. CFC's calculated average yield on its loan portfolio was 5.40% for the year ended May 31, 2003, a decrease of 0.58% from 5.98% for the prior year.

    

Cost of Funds

The total cost of funding for the year ended May 31, 2003 increased $45 million or 5% compared to the prior year. CFC's strategy of improving liquidity by replacing dealer commercial paper with medium-term notes and collateral trust bonds increased CFC's funding costs for the year ended May 31, 2003 compared to the prior year offsetting the impact of decreasing interest rates on short-term funding. CFC's calculated average cost of funding, which includes the cost of funds less the cash settlements divided by the average loan balance, was 4.07% for fiscal year 2003, a decrease from 4.29% for fiscal year 2002.

     

Gross Margin

The gross margin spread earned on loans for the year ended May 31, 2003 was 71 basis points, a decrease of 81 basis points, or 53%, compared to 152 basis points for the prior year. The gross margin spread earned on loans for the year ended May 31, 2003 adjusted to include derivative cash settlements was 133 basis points, representing a decrease of 36 basis points, or 21%, compared to the gross margin of 169 basis points for the prior year period. See the "Non-GAAP Financial Measures" section for further explanation of the adjustment CFC makes in its financial analysis to include the derivative cash settlements in its cost of funds, and therefore gross margin. The gross margin spread earned on loans for fiscal year 2003 decreased due to the increased cost associated with replacing dealer commercial paper with medium-term notes and collateral trust bonds offsetting the impact of decreasing interest rates on the gross margin earned on loans. CFC's goal as a not-for-profit, member-owned financial cooperative is to provide financial products to its members at the lowest rates possible after covering all expenses and maintaining a reasonable net margin. For the year ended May 31, 2003, CFC exceeded its minimum operating objective of a 1.10 adjusted TIER, therefore CFC did not pass the increase in its cost of funding on to its borrowers.

     

General and Administrative Expenses

General and administrative expenses for fiscal year 2003 were consistent with fiscal year 2002. The general and administrative expenses for fiscal year 2003 represented 0.19% of average loan volume, the same as the prior year.

      

Provision for Loan Losses

CFC considers various factors to determine the adequacy of the loan loss allowance in relation to the credit quality of its loan and guarantee portfolio. During the year ended May 31, 2003, CFC determined that a total of $68 million was required as an addition to the loan loss allowance based on the credit quality of CFC's loan and guarantee portfolio compared to $199 million for the prior year. The loan loss provision for the prior year was higher due to the default and subsequent impairment on the CoServ loan and to an increase in loans classified as high risk. The provision to the reserve for fiscal year 2003 represented 0.34% of average loan volume, a decrease from 1.00% for the prior year.

     

Results of Operations of and Impairment Loss on Foreclosed Assets

During the year ended May 31, 2003, entities controlled by CFC received real estate developer notes receivable, limited partnership interests in certain real estate developments, partnership interests in real estate properties and telecommunications assets from entities related to CoServ as part of the plan for CoServ to emerge from bankruptcy. Another borrower transferred real estate assets to an entity controlled by CFC in repayment of the loan as part of a settlement. CFC accounts for these assets on the combined balance sheets as foreclosed assets. CFC is operating certain real estate and telecommunications assets while attempting to sell these assets. The results of operations from foreclosed assets are shown on the combined statements of operations since the dates of foreclosure. For the year ending May 31, 2003, this amount was income of $1 million. CFC also recorded a $20 million impairment loss for the write down of certain foreclosed assets to their estimated fair value at May 31, 2003.

                                                     

36

 


   

Derivative Cash Settlements

The amounts that CFC pays and receives related to the cross currency interest rate and interest rate exchange agreements that do not qualify for special hedge accounting were recorded as derivative cash settlements for the years ended May 31, 2003 and 2002. The decreasing interest rate environment, change in foreign currency exchange rates and the composition of CFC's exchange agreement portfolio during the twelve months since May 31, 2002 resulted in an increase in the derivative cash settlements received of $89 million over the prior year.

     

Derivative Forward Value and Cumulative Effect of Change in Accounting Principle

The $715 million increase in the derivative forward value during the year ended May 31, 2003 is due to changes in the fair value quotes of the interest rate and cross currency interest rate exchange agreements estimated at May 31, 2003 as compared to the prior year. In most cases, variable interest rates have not increased as expected and in a decreasing interest rate environment, a rise in the fair value of fixed to variable exchange agreements usually occurs. CFC pays a variable rate and receives a fixed rate on the majority of its exchange agreements. At May 31, 2003, CFC's interest rate and cross currency interest rate exchange agreements include $8,484 million notional amount, or 51% of the total exchange agreements, in which CFC synthetically changed the interest rate on the debt securities from fixed to variable and $6,595 million notional amount, or 40% of the total exchange agreements, in which CFC synthetically changed the interest rate on the debt securities from variable to fixed. CFC pays a variable rate of interest and receives a variable rate of interest on the remaining exchange agreements. These types of exchange agreements have very little impact on the derivative forward value. Related to the adoption of SFAS 133 during the year ended May 31, 2002, CFC booked a $28 million gain as a cumulative effect of change in accounting principle on June 1, 2001.

      

Foreign Currency Adjustments

For the year ended May 31, 2003, CFC recorded a loss of $243 million related to foreign denominated debt that does not receive hedge treatment under SFAS 133. This was an increase from the loss of $61 million recorded for the prior year. The loss recorded is due to changes in the foreign exchange rate between the US dollar and the Euro. During fiscal year 2003, CFC had outstanding a total 1,350 million Euros. At each reporting date, CFC is required to record the dollar equivalent of foreign denominated debt on its combined balance sheet with any change from the prior period reported on the combined statement of operations. The increase to the loss recorded in fiscal year 2003 as compared to fiscal year 2002 was due to an increase in the average amount of Euro denominated debt outstanding and an increase in the value of the Euro against the dollar. For foreign denominated debt with related cross currency exchange agreements that qualify for hedge treatment under SFAS 133, the change in the value of the debt reported in the combined statement of operations is fully offset by the reclassification of an equal amount of the change in the fair value of the related hedge from accumulated other comprehensive loss, where the change in the fair value of the hedge was originally reported.

     

Fiscal Year 2002 versus 2001 Results

The following charts detail the results for the year ended May 31, 2002 versus May 31, 2001.

     

For the year ended May 31,

Increase/

(Dollar amounts in millions)

2002

2001

(Decrease)

Operating income

$

1,187

$

1,388

$

(201

)

Cost of funds

886

1,118

(232

)

   Gross margin

301

270

31

Expenses:

General and administrative expenses

38

32

6

Provision for loan losses

199

105

94

   Total expenses

237

137

100

   Operating margin

64

133

(69

)

    

Derivative cash settlements

34

-

34

Derivative forward value

42

-

42

Foreign currency adjustments

(61

)

-

(61

)

Cumulative effect of change in accounting principle

28

-

28

   Net margin

$

107

$

133

$

(26

)

    

TIER

1.09

1.12

Adjusted TIER (1)

1.12

1.12

       

(1) Fiscal year 2002 is adjusted to exclude the derivative forward value and foreign currency adjustments from net margin and include the derivative cash settlements in the cost of funds. See "Non-GAAP Financial Measures" for further explanation and a reconciliation of these adjustments.

                                                      

37

 


  

Net margin for the year ended May 31, 2002 was $107 million, a decrease of $26 million or 20% compared to the $133 million earned the prior year. Net margin decreased primarily due to an increase in the provision for loan losses and expense incurred due to foreign currency adjustments offset by increases due to the adoption of SFAS 133 and the increase in the gross margin spread earned on loans.

      

Operating Income

Operating income for the year ended May 31, 2002 was $1,187 million, a decrease of $201 million or 14% compared to the prior year. Operating income decreased due to reductions in interest rates offset by increases in average loan volume. Average loan volume increased by $969 million or 5% to an average loan balance of $19,836 million at May 31, 2002. The average interest rate on the portfolio for the year ended May 31, 2002 was 5.98%, a decrease of 1.38% from the 7.36% for the prior year.

      

Cost of Funds

The total cost of funding for the year ended May 31, 2002 was $886 million, a decrease of $232 million or 21% compared to the prior year amount of $1,118 million. The cost of funding decreased due to reductions in interest rates offset by increases in average loan volume outstanding and the reclassification of $34 million representing the amount that CFC pays and receives related to the interest rate exchange agreements that do not qualify for special hedge accounting from the cost of funds to a separate line in the combined statement of operations for the year ended May 31, 2002. Prior to the implementation of SFAS 133 on June 1, 2001, this amount was included in the cost of funds. The reduction to the total cost of funding for fiscal year 2002 as compared to fiscal year 2001 was due to the reduction to interest rates in the capital markets offset by an increase in the amount of debt outstanding. CFC's calculated average cost of funding, which includes the cost of funds less the cash settlements divided by the average loan balance, was 4.29% for fiscal year 2002, a decrease from 5.92% for fiscal year 2001.

     

Gross Margin

The gross margin earned on loans for fiscal year 2002 was $301 million, an increase of $31 million or 11% over the prior year amount of $270 million. The gross margin earned for fiscal year 2002 including the $34 million of net settlements received on derivatives totaled $335 million. The gross margin of $335 million represents 1.69% of average loan volume for the year, an increase from the 1.44% for the prior year. The reductions in short-term market interest rates during the year ended May 31, 2002 positively affected CFC's gross margin as the cost of funding decreased faster than interest rates on CFC's loans. Since CFC sets interest rates at the beginning of the month and CFC's rates are not tied to an index, CFC's rate reductions typically lag behind the market. CFC also increased the gross margin spread on its loans as part of the plan to increase the amount of equity accumulated and held.

       

General and Administrative Expenses

General and administrative expenses for fiscal year 2002 totaled $38 million, an increase of $6 million or 19% from the prior year. These expenses increased due to the write-off of deferred expenses related to the construction of a third office building and the development of a risk transfer transaction, an increase in legal expenses, salaries, depreciation and amortization and expenses related to CFC's disaster recovery and business resumption plan. During fiscal year 2002, CFC's Board of Directors voted to cancel plans to construct a third building and also determined not to proceed with the risk transfer transaction. The general and administrative expenses for fiscal year 2002 represented 0.19% of average loan volume, an increase of 0.02% from the prior year.

   

Provision for Loan Losses

A total provision of $199 million was added to the loan loss reserve during the year ended May 31, 2002. The $199 million provision is an increase of $94 million or 90% over the amount added in the prior year. The provision to the reserve for fiscal year 2002 represented 1.00% of average loan volume, an increase from 0.56% for the prior year. The increased loan loss provision was required due to increased specific reserves for impaired borrowers, high concentration of total exposure to the largest ten borrowers and to market valuations in the telecommunications and electric utility industry.

     

Derivative Cash Settlements

The amounts that CFC pays and receives related to the interest rate, cross currency and cross currency interest rate exchange agreements that do not qualify for special hedge accounting were recorded in the derivative cash settlements for the year ended May 31, 2002. In fiscal years 2001 and 2000, prior to the implementation of SFAS 133, the net settlements for all interest rate, cross currency and cross currency interest rate exchange agreements were included in the cost of funds.

                                                       

38

  


      

Derivative Forward Value and Cumulative Effect of Change in Accounting Principle

Related to the adoption of SFAS 133, CFC booked a $28 million gain as a cumulative effect of change in accounting principle on June 1, 2001 and a $42 million gain as a derivative forward value adjustment for subsequent changes in the fair value of the derivatives during the year ended May 31, 2002. Thus, the net impact of the SFAS 133 adoption on CFC's net margin during this period excluding derivative cash settlements was an increase of $70 million.

     

Foreign Currency Adjustments

For the year ended May 31, 2002, CFC recorded a loss of $61 million related to foreign denominated debt that does not qualify for hedge treatment under SFAS 133. The loss recorded is due to changes in the foreign exchange rate between the US dollar and the Euro. CFC began fiscal year 2002 with a total of 350 million of Euro denominated debt. That balance increased to 1,350 million Euros at May 31, 2002. At each reporting date, CFC is required to record the dollar equivalent of the foreign denominated debt on its combined balance sheet with any change from the prior period reported on the combined statement of operations. At May 31, 2002, a total of 1,000 million Euros was related to hedges that did not qualify for special accounting treatment under SFAS 133, thus the change in the value was recorded on the combined statement of operations. At May 31, 2002, a total of 350 million Euros were related to an effective derivative hedge. For foreign denominated debt with related cross currency exchange agreements that qualify for hedge treatment under SFAS 133, the change in the value of the debt reported in the combined statement of operations is fully offset by the reclassification of an equal amount of the change in the fair value of the related hedge from accumulated other comprehensive loss, where the change in the fair value of the hedge was originally reported. Prior to fiscal year 2002 and the implementation of SFAS 133, CFC was netting all amounts related to the foreign denominated debt and the related foreign currency exchange agreement in the cost of funds on the combined statement of operations. This was the correct accounting prior to SFAS 133 and it represented the actual cost to CFC of both transactions.

 

Operating Results as a Percentage of Average Loans Outstanding

The following is a summary of CFC's operating results as a percentage of average loans outstanding for the fiscal years ended May 31, 2003, 2002 and 2001.

 

2003

2002

2001

Operating income

5.40

%

5.98

%

7.36

%

Cost of funds

4.69

%

4.46

%

5.92

%

   Gross margin

0.71

%

1.52

%

1.44

%

General and administrative expenses

0.19

%

0.19

%

0.17

%

Provision for loan losses

0.34

%

1.00

%

0.56

%

   Total expenses

0.53

%

1.19

%

0.73

%

Results of operations of foreclosed assets

-

-

-

Impairment loss on foreclosed assets

(0.10

)%

-

-

   Subtotal foreclosed assets

(0.10

)%

-

-

Operating margin

0.08

%

0.33

%

0.71

%

Derivative cash settlements

0.62

%

0.17

%

-

Derivative forward value

3.81

%

0.21

%

-

Foreign currency adjustments

(1.22

)%

(0.31

)%

-

Cumulative effect of change in accounting principle

-

0.14

%

-

  Net margin 

3.29

%

0.54

%

0.71

%

Adjusted gross margin (1)

1.33

%

1.69

%

N/A

Adjusted operating margin (1)

0.70

%

0.50

%

N/A

      

(1) Adjusted to include derivative cash settlements in the cost of funds. See "Non-GAAP Financial Measures" for further explanation and a reconciliation of these adjustments.

 

Liquidity and Capital Resources

      

Assets

At May 31, 2003, CFC had $20,974 million in total assets, an increase of $631 million, or 3%, from the balance of $20,343 million at May 31, 2002. Net loans outstanding to members totaled $18,919 million at May 31, 2003, a decrease of $621 million compared to a total of $19,540 million at May 31, 2002. Net loans represented 90% and 96% of total assets at May 31, 2003 and May 31, 2002, respectively. The remaining assets, $2,055 million and $803 million at May 31, 2003 and May 31, 2002, respectively, consisted of other assets to support CFC's operations, primarily cash and cash equivalents, derivative assets and foreclosed assets. Included in assets at May 31, 2003 and May 31, 2002 is $1,160 million and $193 million, respectively, of derivative assets representing the fair market value of its derivatives. Derivative assets increased by $967 million due to the decreasing interest rate environment. Foreclosed assets of $336 million at May 31, 2003 relate to assets received from borrowers as part of a bankruptcy settlement. Unless excess cash is invested overnight, CFC does not generally use funds to invest in debt or equity securities.

                                                         

39

      


 

Loans to Members

Net loan balances decreased by $621 million, or 3% from May 31, 2002 to May 31, 2003. Gross loans decreased by a total of $563 million, and the allowance for loan losses increased by $58 million, compared to the prior year. As a percentage of the portfolio, long-term loans represented 94% at May 31, 2003 (including secured long-term loans classified as restructured and nonperforming), compared to 93% at May 31, 2002. The remaining 6% and 7% at May 31, 2003 and 2002, respectively, consisted of secured and unsecured intermediate-term and line of credit loans.

  

Long-term fixed rate loans represented 68% and 60% of the total long-term loans at May 31, 2003 and 2002, respectively. Loans converting from a variable rate to a fixed rate for the year ended May 31, 2003 totaled $1,747 million, a decrease from the $2,179 million that converted during the year ended May 31, 2002. Offsetting the conversions to the fixed rate were $533 million and $363 million of loans that converted from the fixed rate to the variable rate for the years ended May 31, 2003 and 2002, respectively. This resulted in a net conversion of $1,214 million from the variable rate to a fixed rate for the year ended May 31, 2003 compared to a net conversion of $1,816 million for the year ended May 31, 2002. Approximately 64% or $12,426 million of total loans carried a fixed rate of interest at May 31, 2003 compared to 56% at May 31, 2002. All other loans, including $5,867 million and $7,320 million in long-term loans at May 31, 2003 and 2002, respectively, are subject to interest rate adjustment monthly or semi-monthly.

   

The decrease in total gross loans outstanding at May 31, 2003 was primarily due to a decrease of $391 million related to the repayment of nonperforming loans with cash received by CFC and foreclosed assets received by entities controlled by CFC as part of loan settlements, predominantly with CoServ. Additionally, intermediate-term loans decreased $132 million and short-term loans decreased $121 million offset by increases of $57 million in long-term loans and $24 million in RUS guaranteed loans. During fiscal year 2003, long-term electric advances totaled $1,306 million and telephone advances totaled $192 million. The electric long-term advances included $36 million for the purpose of repaying RUS loans, $1,231 million under the 100% and power vision programs, $11 million under the RUS concurrent loan program and $28 million under the RUS guaranteed loan program.

    

Loan and Guarantee Portfolio Assessment

Portfolio Diversity

CFC provides credit products (loans, financial guarantees and letters of credit) to its members. The combined memberships include rural electric distribution systems, rural electric power supply systems, telecommunication systems, statewide rural electric and telecommunication associations and associate organizations.

  

The following chart summarizes loans and guarantees outstanding by member class at May 31, 2003, 2002 and 2001.

        

(Dollar amounts in millions)

Loans and Guarantees by Member Class

 

2003

2002

2001

Electric systems:

  Distribution

$

11,488

54%

$

11,933

54%

$

11,599

53%

  Power supply

3,922

18%

3,928

18%

3,686

17%

  Statewide and associate

1,030

5%

1,162

5%

1,291

6%

       Subtotal electric systems

16,440

77%

17,023

77%

16,576

76%

Telecommunication systems

4,948

23%

5,080

23%

5,326

24%

Total

$

21,388

100%

$

22,103

100%

$

21,902

100%

 

CFC's members are widely dispersed throughout the United States and its territories, including 49 states, the District of Columbia, American Samoa, Guam and the U.S. Virgin Islands. At May 31, 2003, 2002 and 2001, no state or territory had over 17%, 20% and 19%, respectively, of total loans and guarantees outstanding.

         
Credit Concentration

In addition to the geographic diversity of the portfolio, CFC limits its exposure to any one borrower. At May 31, 2003, the total exposure outstanding to any one borrower or controlled group did not exceed 3.4% of total loans and guarantees outstanding compared to 4.6% at May 31, 2002. At May 31, 2003, CFC had $4,768 million in loans outstanding and $610 million in guarantees outstanding to its ten largest borrowers compared to $5,192 million in loans and $701 million in guarantees for the prior year. The amounts outstanding to the ten largest borrowers at May 31, 2003 represented 24% of total loans outstanding and 32% of total guarantees outstanding compared to 26% of total loans outstanding and 34% of total guarantees outstanding for the prior year. Total credit exposure to the ten largest borrowers was $5,378 million and $5,893 million and represented 25% and 27%, respectively, of total credit exposure at May 31, 2003 and 2002, respectively. At May 31, 2003 and 2002, the ten largest borrowers included two distribution systems, two power supply systems, one service organization and five telecommunications systems.

                                                            

40

        


 

Credit Limitation

In July 2002, CFC's Board of Directors approved a new credit limitation policy. The new policy sets the limit on CFC's total exposure and unsecured exposure to the borrower based on CFC's assessment of its risk profile. The new policy limits are more restrictive than the prior policy. The Board of Directors must approve new loan requests from a borrower with a total exposure or unsecured exposure in excess of the limits in the policy.

  

Total exposure, as defined by the policy, includes the following:

 *

loans outstanding, excluding loans guaranteed by RUS,

 *

CFC guarantees of the borrower's obligations,

 *

unadvanced loan commitments, and

 *

borrower guarantees to CFC of another member's debt.

  

During the period from the adoption of the policy to May 31, 2003, CFC's Board of Directors approved new loan and guarantee facilities totaling approximately $1 billion to 16 borrowers that had a total or unsecured exposure in excess of the limits set forth in the credit limitation policy. Loans approved totaling $640 million were refinancings or renewals of existing loans. Loans approved for three of these borrowers totaling $235 million were bridge loans that must be paid off once the borrowers obtain financing from RUS.

     

Security Provisions

Except when providing lines of credit and intermediate-term loans, CFC typically lends to its members on a senior secured basis. At May 31, 2003, a total of $1,696 million of loans were unsecured representing 9% of total loans. Approximately $233 million or 14% of the unsecured loans represent obligations of distribution borrowers for the initial phase(s) of RUS note buyouts. Upon completion of a borrower's buyout from RUS, CFC receives first lien security on all assets and revenues. The unsecured loans would represent 8% of total loans if these partial note buyout obligations were excluded. CFC's long-term loans are typically secured on a parity with other secured lenders (primarily RUS), if any, by all assets and revenues of the borrower with exceptions typical in utility mortgages. Short-term loans are generally unsecured lines of credit. At May 31, 2003, a total of $94 million of guarantee reimbursement obligations were unsecured, representing 5% of total guarantees. Guarantee reimbursement obligations are secured on a parity with other secured creditors by all assets and revenues of the borrower or by the underlying financed asset. At May 31, 2003, CFC had a total of $1,790 million of unsecured loans and guarantees, representing 8% of total loans and guarantees. At May 31, 2002, CFC had a total of $1,801 million of unsecured loans and guarantees, representing 8% of total loans and guarantees.

   

Portfolio Quality

Most CFC power supply borrowers sell the majority of their power under all-requirements power contracts to their member distribution systems. These contracts allow, subject to regulatory requirements and competitive constraints, for the recovery of all costs at the power supply level. Due to the contractual connection between the power supply and distribution systems, total combined system equity (power supply equity plus the equity at its affiliated distribution systems) has typically been maintained at the distribution level.

    

As with CFC, to the extent distribution systems can fund their assets with retained members' equity (i.e., unretired capital credits), overall funding costs for plant and equipment are reduced. Distribution systems can, in turn, pass these savings on to their member/consumers in the form of lower utility rates.

   

The effectiveness of the all-requirements power contract is dependent on the individual systems' right and ability (legal as well as economic) to establish rates to cover all costs. The boards of directors of most of CFC's power supply and distribution members have the authority to establish binding rates for their consumer members subject to state and federal regulations, as applicable. Some states regulate rate setting and can therefore override the system's internal rate-setting procedures.

   

For financial information on CFC's members, see pages 15 to 20.

  

Nonperforming and Restructured Loans

CFC classifies a borrower as nonperforming when any one of the following criteria are met:

*

principal or interest payments on any loan to the borrower are past due 90 days or more,

*

as a result of court proceedings, repayment on the original terms is not anticipated, or

*

for some other reason, management does not expect the timely repayment of principal and interest.

                                                           

41

          


   

Once a borrower is classified as nonperforming, interest on its loans is generally recognized on a cash basis. Alternatively, CFC may choose to apply all cash received to the reduction of principal, thereby foregoing interest income recognition. At May 31, 2003, CFC had no outstanding loans classified as nonperforming. At May 31, 2002, CFC had $1,011 million of loans classified as nonperforming. Of the nonperforming loans at May 31, 2002, $1,003 million was to CoServ. During the years ended May 31, 2003 and 2002, all loans classified as nonperforming were on non-accrual status with respect to the recognition of interest income.

 

At May 31, 2003 and 2002, CFC had a total of $628 million and $1,003 million, respectively, in loans outstanding to CoServ. At May 31, 2002, all loans to CoServ were classified as nonperforming as CoServ was in default under its loan agreements with CFC. Upon CoServ's emergence from bankruptcy on December 13, 2002, CFC reclassified the outstanding loan to CoServ from nonperforming to restructured and in the near term will maintain the restructured CoServ loan on non-accrual status. Total loans to CoServ at May 31, 2003 and 2002 represented 2.9% and 4.5%, respectively, of CFC's total loans and guarantees outstanding.

  

In June 2002, CoServ and CFC filed joint plans of liquidation and reorganization for each of CoServ's three business segments: real estate lending, telecommunications and electric distribution cooperative. The real estate plan became effective on October 11, 2002. On that date, CoServ transferred the real estate developer notes receivable, limited partnership interests in certain real estate developments and partnership interests in the real estate properties to entities controlled by CFC. The loan balance to CoServ was reduced by the fair value of the real estate assets received totaling $325 million and $27 million in cash. On December 13, 2002, CoServ emerged from bankruptcy and the electric plan and telecom plan became effective. On that date, CoServ transferred the telecommunications assets to entities controlled by CFC. The loan balance to CoServ was reduced by $39 million, the fair value of the telecommunications assets received less estimated costs to sell. CFC is accounting for the real estate and telecommunications assets received as foreclosed assets. CoServ will continue to operate as an electric distribution utility and will be required to make quarterly payments to CFC over the next 35 years. Under the electric plan, CFC may be obligated to provide up to $200 million of senior secured capital expenditure loans to CoServ over the next 10 years. If CoServ requests capital expenditure loans from CFC, the loans will be approved with the same standard terms that are offered to all electric distribution members.

   

Loans classified as restructured are loans for which agreements have been executed that changed the original terms of the loan, generally a change to the originally scheduled cash flows. At May 31, 2003 and 2002, restructured loans totaled $629 million and $540 million, respectively. Of the restructured loans at May 31, 2003, $628 million was to CoServ, as discussed above. Of the restructured loans at May 31, 2002, $534 million was to Deseret.

   

In February 2003, CFC reclassified the $536 million of loans then outstanding to Deseret from restructured to performing based on Desert's performance to date and expected future performance under the restructure agreement signed in October 1996. As of May 31, 2003, a total of $529 million of loans were outstanding to Deseret under the restructure agreement signed in October 1996. Under this agreement, Deseret is required to make quarterly payments to CFC through 2025. In addition, on an annual basis, CFC receives 80% of the excess cash generated by Deseret during the calendar year (excess cash is calculated based on a formula in the restructure agreement). Deseret has made all minimum payments as required and has made excess cash payments to CFC totaling $134 million or approximately $22 million per year. From January 1, 2001 to February 28, 2003, CFC accrued interest on the Deseret restructured loan at a rate of 7%. On February 28, 2003, when CFC reclassified Deseret's restructured loan to performing, CFC reduced the accrual rate to 5%. CFC keeps 75% of excess cash payments it receives from Deseret to apply against accrued interest and reduce the principal balance. The remaining 25% is applied against the loans made to Deseret member distribution systems to finance their purchase of a participation in the CFC loan to Deseret until paid in full. Once a participation loan has been repaid, CFC retains that portion of the excess payment to apply against the Deseret loan. CFC received excess cash flow totaling $10 million from Deseret during fiscal year 2003. As of May 31, 2003, CFC has no net write-off on its loans to Deseret. If CFC had known that Deseret was going to generate excess cash flow and make payments to CFC as it has done since 1996, CFC would not have accounted for the Deseret restructuring as a troubled debt restructuring.

  

On a quarterly basis, CFC reviews all nonperforming and restructured borrowers, as well as some additional borrowers, to determine if the loans to the borrower are impaired and/or to update the impairment calculation. CFC calculates an impairment for a borrower based on the expected future cash flow or the fair value of any collateral held by CFC as security for loan(s) to the borrower. In some cases, to estimate future cash flow, CFC is required to make certain assumptions regarding but not limited to the following:

*

changes to interest rates,

*

court rulings,

                                                                 

42

            


*

changes in collateral values,

*

changes in economic conditions in the area in which the cooperative operates, and

*

changes to the industry in which the cooperative operates.

      
As events related to the borrower take place and economic conditions and CFC's assumptions change, the impairment calculations will change. CFC adjusts the amount of its loan loss allowance specifically reserved to cover the calculated impairments on a quarterly basis based on the most current information available. At May 31, 2003 and 2002, CFC had specifically reserved a total of $164 million and $202 million, respectively, to cover impaired loans.
       

Based on its analysis, CFC believes that it is adequately reserved against loss on its restructured and nonperforming loans.

    

NONPERFORMING AND RESTRUCTURED LOANS

        

As of May 31,

(Dollar amounts in millions)

2003

2002

2001

Nonperforming loans

$

-

$

1,011

$

1

Percent of loans and guarantees outstanding

0.00%

4.57%

0.00%

 

Restructured loans

$

629

$

540

$

1,465

Percent of loans and guarantees outstanding

2.94%

2.44%

6.69%

 

Total nonperforming and restructured loans

$

629

$

1,551

$

1,466

Percent of loans and guarantees outstanding

2.94%

7.02%

6.69%

   

Allowance for Loan Losses

CFC maintains an allowance for probable loan losses, which is periodically reviewed by management for adequacy. In performing this assessment, management considers various factors including an analysis of the financial strength of CFC's borrowers, delinquencies, loan charge-off history, underlying collateral, and the effect of economic and industry conditions on its borrowers.

   

During the year ended May 31, 2003, CFC wrote off a total of $11 million in loans to 5 borrowers and recovered $1 million of amounts previously written off. During the year ended May 31, 2002, CFC wrote off a total of $34 million in loans to four borrowers and recovered a total of $10 million of amounts previously written off.

   

Since inception in 1969, CFC has recorded charge-offs totaling $145 million and recoveries totaling $29 million for a net loan loss amount of $116 million. In the past five fiscal years, CFC has recorded charge-offs totaling $110 million and recoveries totaling $24 million for a net loan loss of $86 million.

   

The following chart presents a summary of the allowance for loan losses at May 31, 2003, 2002 and 2001.


(Dollar amounts in millions)

2003

2002

2001

Beginning balance

$

507

$

332

$

228

Provision for loan losses

68

199

105

Charge-offs, net

(10

)

(24

)

(1

)

Ending balance

$

565

$

507

$

332

    

As a percentage of total loans outstanding

2.90%

2.53%

1.69%

As a percentage of total loans and guarantees outstanding

2.64%

2.29%

1.52%

As a percentage of total nonperforming and restructured loans outstanding

89.78%

32.69%

22.65%

    

CFC made the large increase to the reserve in fiscal year 2002 to provide for larger specific reserves on impaired loans and to reflect its concentration of credit in the ten largest borrowers and the market valuation of utility and telecommunications assets.

 

Liabilities and Equity

CFC obtains funding in the capital markets through the issuance of commercial paper, medium-term notes, collateral trust bonds and subordinated deferrable debt which make up a large portion of the liabilities on the combined balance sheet. The increase to total liabilities and equity at May 31, 2003 was due to a $1,145 million increase in long-term debt, a $602 million increase to equity, a $103 million increase in derivative liabilities, a $50 million increase in subordinated deferrable debt, a $16 million increase in member's subordinated certificates and a $33 million increase in accrued interest payable and other liabilities offset by a $1,318 million decrease in notes payable outstanding. The $602 million increase to equity was due to

 

                                                                 

43

               


 

an increase of $540 million related to the change in the fair value of CFC's derivative instruments and foreign currency adjustments and an increase of $137 million to adjusted net margin (see the "Non-GAAP Financial Measures" section for further explanation of the adjustments CFC makes to net margin) offset by a decrease of $75 million for the retirement of patronage capital. Total debt outstanding at May 31, 2003 was $19,455 million, a decrease of $106 million compared to the May 31, 2002 balance of $19,561 million.
       

Notes Payable

Notes payable, which consists of commercial paper, daily liquidity fund, bank bid notes and long-term debt due within one year, totaled $1,096 million, a decrease of $1,318 million from the prior year. The decrease was primarily due to the $1,316 million decrease in commercial paper and the $245 million increase in the amount of short-term debt supported by revolving credit agreements and reclassified as long-term offset by a $150 million increase to the foreign currency valuation account, a $66 million increase to the daily liquidity fund and a $28 million increase in long-term debt maturing within one year. The foreign currency valuation account reflects the adjustment to CFC's foreign denominated medium-term notes based on current foreign currency exchange rates. At May 31, 2003, CFC's short-term debt consisted of $820 million in dealer commercial paper, $930 million in commercial paper issued to CFC's members, $26 million in commercial paper issued to certain nonmembers, $100 million in bank bid notes, $111 million in the daily liquidity fund, $2,911 million in collateral trust bonds and medium-term notes that mature within one year and $150 million foreign currency valuation account. CFC reclassifies a portion of its short-term debt as long-term, based on the ability (subject to certain conditions) to borrow under its revolving credit agreements. CFC reclassified $3,951 million and $3,706 million of short-term debt as long-term at May 31, 2003 and 2002, respectively.

   

Other information with regard to notes payable due within one year at May 31, is as follows:

  

(Dollar amounts in thousands)

2003

2002

2001

Weighted average maturity of notes outstanding at year-end:

   Notes payable (1)

18 days

24 days

28 days

   Long-term debt maturing within one year

195 days

163 days

185 days

     Total

123 days

89 days

93 days

Average amount outstanding during the year (2):

   Notes payable (1)

$

2,971,540

$

4,933,166

$

8,595,668

   Long-term debt maturing within one year

2,707,410

3,742,451

3,090,812

     Total

5,678,950

8,675,617

11,686,480

Maximum amount outstanding at any month-end during the year (2):

   Notes payable (1)

3,681,822

6,943,445

10,169,473

   Long-term debt maturing within one year

3,453,567

4,364,230

4,388,504

      

(1) Includes the daily liquidity fund and bank bid notes and does not include long-term debt due in less than one year.

(2) Prior to reclassification to long-term debt and the foreign currency valuation account.

   

Commercial Paper

At May 31, 2003 and 2002, CFC had $1,776 million and $3,092 million, respectively, outstanding in commercial paper with a weighted average maturity of 19 days and 25 days. Commercial paper notes are issued with maturities up to 270 days and are senior unsecured obligations of CFC. Commercial paper sold directly by CFC and outstanding to CFC's members and others totaled $956 million and $930 million at May 31, 2003 and 2002, respectively. Commercial paper sold through dealers totaled $820 million and $2,162 million at May 31, 2003 and 2002, respectively. CFC has a program to issue commercial paper in Europe, but had no amounts outstanding at May 31, 2003, compared to $85 million at May 31, 2002. The commercial paper sold in Europe may be denominated in foreign currencies. At May 31, 2003 and 2002, there were no amounts outstanding denominated in foreign currencies. CFC also issues extendable commercial notes with a stated maturity of 90 days, and CFC has the option to extend the maturity to 390 days. At May 31, 2003, there were no extendable commercial paper notes outstanding, compared to $105 million at May 31, 2002. The decrease to the total amount of commercial paper outstanding at May 31, 2003, as compared to the prior year, was due to the decrease to loans outstanding and the increase to long-term debt outstanding. In fiscal year 2003, CFC limited its issuance of commercial paper to 15% or less of total debt outstanding, to reduce the dependency on its ability to continually roll over a large balance of commercial paper funding.

    

Bank Bid Notes

CFC obtains funds from various banking institutions under bank bid note arrangements, similar to bank lines of credit. The notes are issued for terms up to three months and are unsecured obligations of CFC. At May 31, 2003 and 2002, CFC had $100 million outstanding in bank bid notes and these notes had a weighted average maturity of 17 days and 20 days, respectively.

 

                                                                

44

              


  

Daily Liquidity Fund

CFC's daily liquidity fund, consisting of funds invested by CFC's members, totaled $111 million as of May 31, 2003 compared to $45 million at May 31, 2002. These funds are available on demand by the member investor, not subject to stated maturity dates, and the notes are unsecured obligations of CFC.

 

Long-Term Debt

During fiscal year 2003, long-term debt outstanding increased by $1,145 million compared to the prior year-end. The increase in long-term debt outstanding was due primarily to increases of $1,199 million in collateral trust bonds, an increase of $245 million to the amount of short-term debt supported by the revolving credit agreements and reclassified as long-term debt, offset by decreases of $296 million to medium-term notes and $3 million to the long-term debt valuation allowance. CFC issued more long-term debt during fiscal year 2003 to reduce the amount of commercial paper funding that had to be continually rolled over.

   

Collateral Trust Bonds

At May 31, 2003, CFC had $6,293 million in fixed rate collateral trust bonds outstanding. Collateral trust bonds are issued for terms of two years to 30 years. Under its collateral trust bond indentures, CFC must pledge as collateral cash, permitted investments or eligible mortgage notes from its distribution system borrowers, evidencing loans at least equal in principal amount to the outstanding principal amount of collateral trust bonds. At May 31, 2003, CFC had pledged $6,664 million in mortgage notes, $224 million of RUS guaranteed loans qualifying as permitted investments and $2 million in cash. During fiscal year 2003, CFC issued a total of $1,500 million in collateral trust bonds. On February 7, 2003, CFC issued $400 million of floating rate bonds due 2005, $600 million of 3% collateral trust bonds due 2006 and $500 million of 3.875% collateral trust bonds due 2008. Virtually all collateral trust bonds were offered to investors in underwritten public offerings. A total of $300 million of collateral trust bonds are scheduled to mature during fiscal year 2004 and are reported as notes payable due within one year.

  

Medium-Term Notes

At May 31, 2003, CFC had $8,819 million outstanding in medium-term notes. Medium-term notes are senior unsecured obligations of CFC and are issued for terms of nine months to 30 years. Medium-term notes outstanding to CFC's members totaled $296 million at May 31, 2003. The remaining $8,523 million were sold through dealers to investors including $1,637 million in the European markets. At May 31, 2003, a total of 1,350 million of Euro denominated medium-term notes were issued. At the time the Euro denominated debt was issued, CFC also entered into cross currency and cross currency interest rate exchange agreements to fix the exchange rate on all principal and interest payments due through maturity. At May 31, 2003, CFC's foreign currency valuation account was $326 million to adjust the Euro denominated medium-term notes for the change in exchange rates from the date the Euro denominated medium-term notes were issued to the reporting date. A total of $2,611 million of medium-term notes are scheduled to mature during fiscal year 2004, excluding $150 million of foreign currency valuation related to these medium-term notes. On August 29, 2002, CFC issued $1,250 million of 5.75% global unsecured notes due 2009 denominated in U.S. dollars to investors in the United States, Europe and Asia. The proceeds from these notes were used to repay commercial paper obligations maturing in September 2002 in line with CFC's goal to reduce reliance on dealer commercial paper.

   

Subordinated Deferrable Debt

At May 31, 2003, CFC had $650 million outstanding in subordinated deferrable debt. Subordinated deferrable debt represents quarterly income capital securities and subordinated notes that are unsecured obligations of CFC, subordinate and junior in right of payment to senior debt and the debt obligations guaranteed by CFC, but senior to subordinated certificates. Subordinated deferrable debt has been issued for periods of up to 49 years. CFC has the right at any time and from time to time during the term of the subordinated deferrable debt to suspend interest payments for a period not exceeding 20 consecutive quarters. CFC has the right to call the subordinated deferrable debt any time after five years, at par. To date, CFC has not exercised its option to suspend interest payments. On March 28, 2003, CFC effected the early redemption of the 7.65% quarterly income capital securities totaling $75 million issued in September 1997. CFC redeemed these securities at par, and recorded $2 million in cost of funds for the unamortized issuance costs. Subordinated deferrable debt increased due to the $125 million issuance of 6.75% subordinated notes due 2043 issued in February 2003.

                                                                  

45

                


    

Subordinated Certificates

Subordinated certificates include both membership subordinated certificates and loan and guarantee subordinated certificates, all of which are subordinate to other CFC debt. At May 31, 2003 and 2002, membership subordinated certificates totaled $644 million and $641 million, respectively. These certificates generally mature in 100 years and pay interest at 5% per annum. At May 31, 2003, loan and guarantee subordinated certificates totaled $1,064 million and carried a weighted average interest rate of 1.47% compared to $1,051 million with a weighted average interest rate of 1.40% at May 31, 2002. Loan subordinated certificates increased by $21 million and guarantee subordinated certificates decreased by $7 million from May 31, 2002 to May 31, 2003. The loan and guarantee certificates are long-term instruments, which may amortize at a rate equivalent to that of the loan or guarantee to which they relate. On a combined basis, subordinated certificates carried a weighted average interest rate of 2.76% compared to a rate of 2.73% for the prior year. Loan and guarantee subordinated certificates may be required to be purchased in conjunction with the receipt of a loan or credit enhancement based on the member's leverage ratio (total debt and credit enhancements from CFC divided by total equity investments in CFC). Members that have a leverage ratio with CFC in excess of a level in the policy are required to purchase additional subordinated certificates as a condition to receiving a loan or credit enhancement. CFC paid a total of $47 million in interest to holders of subordinated certificates during fiscal year 2003 compared to a total of $44 million for the prior year.

    

Equity

Under current policy, CFC returns 70% of the allocated margins in the next fiscal year, with the remaining 30% to be held and then retired at a future date (currently 15 years), as permitted by CFC's contractual obligations and to the extent that the board of directors in its discretion determines that the financial condition of CFC will not be impaired as a result. During the next six years, CFC plans to retire the unretired allocations representing allocated margins for fiscal years 1991, 1992 and 1993, all of which had been allocated under a previous retirement policy. The unretired allocations do not earn interest and are junior to all debt instruments, including subordinated certificates. On September 3, 2002, CFC's Board of Directors authorized the retirement of $74 million of allocated margins, which included $18 million to RTFC. On January 16, 2003, RTFC retired $19 million of allocated margins which represented 70% of its fiscal year 2002 margin, including the allocation from CFC.

 

At May 31, 2003, CFC had $454 million in retained equity excluding the derivative forward value and foreign currency adjustments, which included $1 million of membership fees, $2 million for the education fund, $90 million of members' capital reserve and $361 million of allocated but unretired allocations to members, compared to a total of $352 million for the prior year.

   

Contractual Obligations

The following table summarizes CFC's contractual obligations at May 31, 2003 and the related principal amortization and maturities by fiscal year:

     

Principal Amortization and Maturities

(Dollar amounts in millions)

Outstanding

Remaining

Instrument

Balance

2004

2005

2006

2007

2008

Years

Notes payable (1)

$

4,898

$

4,898

$

-

$

-

$

-

$

-

$

-

Long-term debt (2)

11,875

-

2,292

2,939

1,094

814

4,736

Subordinated deferrable debt

650

-

-

-

-

-

650

Members' subordinated certificates (3)

1,061

13

9

45

17