10-K 1 form10k53106.htm FORM 10-K - MAY 31, 2006 Form 10-K - May 31, 2006
 
 
 

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, 2006

  

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

 
7.30% Collateral Trust Bonds, due 2006  

NYSE

  7.35% Collateral Trust Bonds, due 2026  

NYSE

 
6.20% Collateral Trust Bonds, due 2008  

NYSE

  6.75% Subordinated Notes, due 2043  

NYSE

 
5.75% Collateral Trust Bonds, due 2008  

NYSE

  6.10% Subordinated Notes, due 2044  

NYSE

 
5.70% Collateral Trust Bonds, due 2010  

NYSE

  5.95% Subordinated Notes, due 2045  

NYSE

 
7.20% Collateral Trust Bonds, due 2015  

NYSE

  7.40% Quarterly Income Capital Securities, due 2050  

NYSE

 
6.55% Collateral Trust Bonds, due 2018  

NYSE

         
  
Indicated by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes X No __   

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes __ No X

  
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 III of this Form 10-K or any amendment to this Form 10-K. [ X ]
  
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one):
  
Large accelerated filer __           Accelerated filer __                       Non-accelerated filer X
  
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes           No X .
 
The Registrant has no stock.

TABLE OF CONTENTS

Part No.

Item No.

 

Page

I.

 

1.

  Business    
          General

1

 
          Members

2

 
          Distribution Systems

3

 
          Power Supply Systems

3

 
          Service Organizations and Associate Systems

3

 
          Telecommunications Systems

3

 
        Loan Programs

4

 
          Interest Rates on Loans

5

 
          CFC Loan Programs

5

 
          RTFC Loan Programs

6

 
          NCSC Loan Programs

6

 
          RUS Guaranteed Loans for Rural Electric Systems

7

 
          Conversion of Loans

7

 
          Prepayment of Loans

7

 
          Loan Security

7

 
        Guarantee Programs

8

 
          Guarantees of Long-Term Tax-Exempt Bonds

8

 
          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

10

 
        Employees

10

 
        CFC Lending Competition

10

 
        Member Regulation and Competition

10

 
        The RUS Program

13

 
   

1A.

  Risk Factors

13

 
   

1B.

  Unresolved Staff Comments

15

 
   

2.

  Properties

15

 
   

3.

  Legal Proceedings

15

 
   

4.

  Submission of Matters to a Vote of Security Holders

15

 

II.

 

5.

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

16

 
   

6.

  Selected Financial Data

16

 
   

7.

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

17

 
          Executive Summary

17

 
          Recent Events

19

 
          Critical Accounting Estimates

20

 
          Margin Analysis

23

 
          Ratio of Earnings to Fixed Charges

32

 
          Financial Condition

32

 
          Off-Balance Sheet Obligations

41

 
          Liquidity and Capital Resources

43

 
          Market Risk

45

 
          Non-GAAP Financial Measures

50

 
   

7A.

  Quantitative and Qualitative Disclosures About Market Risk

54

 
   

8.

  Financial Statements and Supplementary Data

54

 
   

9.

  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

54

 
   

9A.

  Controls and Procedures

54

 
   

9B.

  Other Information

55

 

III.

 

10.

  Directors and Executive Officers of the Registrant

56

 
   

11.

  Executive Compensation

60

 
   

12.

  Security Ownership of Certain Beneficial Owners and Management

63

 
   

13.

  Certain Relationships and Related Transactions

63

 
   

14.

  Principal Accountant Fees and Services

63

 

IV.

 

15.

  Exhibits and Financial Statement Schedules

64

 
        Signatures

66

 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 
This Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act of 1934, as amended, and as such may involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by these forward-looking statements. Forward-looking statements, which are based on certain assumptions and describe our future plans, strategies and expectations, are generally identified by our use of words such as "intend," "plan," "may," "should," "will," "project," "estimate," "anticipate," "believe," "expect," "continue," "potential," "opportunity," and similar expressions, whether in the negative or affirmative. Our ability to predict results is inherently uncertain. Although we believe that the expectations reflected in such forward-looking statements are based on reasonable assumptions, actual results and performance could differ materially from those set forth in the forward-looking statements. All statements that address expectations or projections about the future, including statements about loan growth, the adequacy of the loan loss allowance, net margin growth, leverage and debt to equity ratios, and borrower financial performance are forward-looking statements. All forward-looking statements speak only to events as of the date on which the statements are made. All subsequent written and oral forward-looking statements attributable to us or any person acting on our behalf are qualified by the cautionary statements in this section. Except as required by law, we undertake no obligation to update or publicly release any revisions to forward-looking statements to reflect events, circumstances or changes in expectations after the date on which the statement is made.
 
The information contained in this section should be read in conjunction with our consolidated financial statements and related notes and the information contained elsewhere in this Form 10-K, including that set forth under Item 1A, Risk Factors.
 

PART I

 
Item 1. Business.
 
General
National Rural Utilities Cooperative Finance Corporation ("CFC" or "the Company") is a private, not-for-profit cooperative association incorporated under the laws of the District of Columbia in April 1969. The principal purpose of CFC is to provide 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 makes loans 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 its members with credit enhancements in the form of letters of credit and guarantees of debt obligations. CFC is exempt from payment of federal income taxes under the provisions of Section 501(c)(4) of the Internal Revenue Code. CFC is a not-for-profit member-owned finance cooperative, thus its objective is not to maximize its net margins, but to offer its members the lowest cost financial products and services consistent with sound financial management. CFC's internet address is www.nrucfc.coop, where under "Investors," copies can be found of this annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments thereto, all of which CFC makes available as soon as reasonably practicable after the report is filed with the Securities and Exchange Commission. 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. In February 2005, RTFC reincorporated as a not-for-profit cooperative association in the District of Columbia. The principal purpose of RTFC is to provide and arrange financing for its rural telecommunications members and their affiliates. RTFC's results of operations and financial condition are consolidated with those of CFC in the accompanying financial statements. CFC is the sole lender to and manages the lending and financial affairs of RTFC through a long-term management agreement. Under a guarantee agreement, RTFC pays CFC a fee in exchange for which CFC reimburses RTFC for loan losses. RTFC is headquartered with CFC in Herndon, Virginia. RTFC is a taxable cooperative that pays income tax based on its net margins, excluding net margins allocated to its members, as allowed by law under Subchapter T of the Internal Revenue Code.
 
National Cooperative Services Corporation ("NCSC") was incorporated in 1981 in the District of Columbia as a private cooperative association. The principal purpose of NCSC is to provide financing to the for-profit and non-profit entities that are owned, operated or controlled by, or provide substantial benefit to, members of CFC. NCSC also markets, through its cooperative members, a consumer loan program for home improvements and an affinity credit card program. NCSC's membership consists of CFC and distribution systems that are members of CFC or are eligible for such membership. NCSC's results of operations and financial condition are consolidated with those of CFC in the accompanying financial statements. CFC is the primary source of funding to and manages the lending and financial affairs of NCSC through a management agreement which is automatically renewable on an annual basis unless terminated by either party. Under a guarantee agreement, NCSC pays CFC a fee in exchange for which CFC reimburses NCSC for loan losses, excluding losses in the consumer loan program. NCSC is headquartered with CFC in Herndon, Virginia. NCSC is a taxable corporation that pays income tax annually based on its net margins for the period.
   

1


Unless stated otherwise, references to the Company relate to the consolidation of CFC, RTFC, NCSC and certain entities controlled by CFC and created to hold foreclosed assets.

Members
The Company's consolidated membership was 1,547 as of May 31, 2006 including 898 utility members, the majority of which are consumer-owned electric cooperatives, 514 telecommunications members, 67 service members and 68 associates in 49 states, the District of Columbia and two U.S. territories. The utility members included 829 distribution systems and 69 generation and transmission ("power supply") systems. Memberships between CFC, RTFC and NCSC have been eliminated in consolidation.
 
CFC currently has four 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; and
* Class D - national associations of cooperatives.
   
In addition to its members, CFC has 68 associates that are 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. Associates are not entitled to vote at any meeting of the members and are not eligible to be represented on CFC's board of directors. All references to members within this document include members and associates.

Membership in RTFC is limited to commercial (for-profit) or cooperative (not-for-profit) telecommunications systems that receive or are eligible to receive loans or other assistance from RUS, and that are engaged (or plan to be engaged) in providing telecommunication services to ultimate users.
 
Membership in NCSC is limited to CFC and organizations that are Class A members of CFC or are eligible to be Class A members of CFC.
 
In many cases, the residential and commercial customers of CFC's electric members are also the customers of RTFC's telecommunications members, as the service territories of the electric and telecommunications members overlap in many of the rural areas of the United States.

Set forth below is a table showing by state or U.S. territory the total number of CFC, RTFC and NCSC members, the percentage of total loans and the percentage of total loans and guarantees outstanding at May 31, 2006.

   

Number

     

Loan and

       

Number

     

Loan and

 
   

of

 

Loan

 

Guarantee

       

of

 

Loan

 

Guarantee

 

State/Territory

 

Members

 

%

 

%

   

State/Territory

 

Members

 

%

 

%

 
Alabama    

30

     

1.94%

     

1.94%

      Missouri    

65

     

3.65%

      

3.93%

     
Alaska    

30

     

1.82%

     

1.73%

      Montana    

40

     

0.81%

     

0.76%

   
American Samoa    

1

     

0.01%

     

0.01%

      Nebraska    

40

     

0.08%

     

0.07%

   
Arizona    

26

     

0.93%

     

1.10%

      Nevada    

7

     

0.75%

     

0.71%

   
Arkansas    

30

     

2.99%

     

2.91%

      New Hampshire    

4

     

0.90%

     

0.90%

   
California    

11

     

0.13%

     

0.13%

      New Jersey    

1

     

0.10%

     

0.09%

   
Colorado    

40

     

4.77%

     

4.79%

      New Mexico    

25

     

0.20%

     

0.19%

   
Connecticut    

1

     

1.09%

     

1.03%

      New York    

21

     

0.12%

     

0.11%

   
Delaware    

1

     

0.13%

     

0.12%

      North Carolina    

44

     

2.84%

     

3.24%

   
District of Columbia    

4

     

0.05%

     

0.16%

      North Dakota    

35

     

0.42%

     

0.40%

   
Florida    

19

     

3.59%

     

3.91%

      Ohio    

42

     

2.24%

     

2.12%

   
Georgia    

67

     

8.48%

     

8.20%

      Oklahoma    

49

     

2.67%

     

2.54%

   
Guam    

1

     

-

     

-

      Oregon    

40

      

1.67%

     

1.70%

   
Hawaii    

1

     

0.04%

     

0.04%

      Pennsylvania    

26

     

2.39%

     

2.35%

   
Idaho    

17

     

0.90%

     

0.85%

      South Carolina    

38

     

2.73%

     

2.58%

   
Illinois    

52

     

2.77%

     

2.62%

      South Dakota    

46

     

0.92%

     

0.87%

   
Indiana    

53

     

2.36%

     

2.23%

      Tennessee    

30

     

0.61%

     

0.57%

   
Iowa    

118

     

2.55%

     

2.45%

      Texas    

111

     

15.67%

     

15.67%

   
Kansas    

49

     

3.23%

     

3.27%

      Utah    

11

     

3.16%

     

3.09%

   
Kentucky    

33

     

1.83%

     

2.35%

      Vermont    

7

     

0.45%

     

0.43%

   
Louisiana    

17

     

2.08%

     

1.99%

      Virgin Islands    

-

     

2.66%

     

2.51%

   
Maine    

6

     

0.06%

     

0.06%

      Virginia    

27

     

1.14%

     

1.10%

   
Maryland    

2

     

0.96%

     

1.04%

      Washington    

18

     

0.56%

     

0.53%

   
Massachusetts    

1

     

-

     

-

      West Virginia    

4

     

0.04%

     

0.04%

   
Michigan    

28

     

1.60%

     

1.52%

      Wisconsin    

62

     

1.90%

     

1.79%

   
Minnesota    

75

     

4.06%

     

4.22%

      Wyoming    

15

     

0.63%

     

0.65%

   
Mississippi    

26

     

2.32%

     

2.39%

      Total    

1,547

     

100.00%

     

100.00%

   
   

2


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. 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 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, 2004 (the latest information 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, 7 had less than 100 megawatts of generating capacity and 18 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.
 
Service Organizations and Associate Systems
Service organizations include the National Rural Electric Cooperative Association ("NRECA"), statewide and regional cooperative associations. NRECA represents cooperatives nationally.
  
Associates include organizations that are owned, controlled or operated by 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 many of the rural areas of the United States. These companies, which number approximately 1,300, are called independent because they are not affiliated with Verizon, AT&T or Qwest. Included in the 1,300 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. Approximately 20 of these commercial companies are publicly traded or issue bonds publicly.
  
Rural telecommunications companies (including all local exchange carriers ("LECs") other than Verizon, AT&T, Qwest, Cincinnati Bell and Embarq (formerly Sprint's local exchange properties)) comprise a relatively small sector (less than 15%) of a local exchange telecommunications industry that provides service to over 178 million access lines. These rural companies range in size from fewer than 100 customers to more than one million. Rural telecommunications companies' annual operating revenues range from less than $100,000 to well 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, internet protocol telephony and other advanced technologies.
   

3


Loan Programs
 
Set forth below is a table showing loans outstanding to borrowers and the weighted average interest rates thereon and loans committed but unadvanced to borrowers by loan program and by segment at May 31:

2006

2005

  

Loans outstanding and

     

Loans outstanding and

     
 

weighted average interest

 

Unadvanced

weighted average interest

 

Unadvanced

(Dollar amounts in thousands)

rates thereon

 

commitments(1)

 

rates thereon

 

commitments(1)

 
Total by loan type:                                                
     Long-term fixed rate loans

$

14,546,850

     

5.76%

   

$

-

   

$

12,724,758

     

5.52%

   

$

-

   
     Long-term variable rate loans  

2,524,722

     

4.78%

     

6,146,618

     

4,961,397

     

4.47%

     

5,537,121

   
     Loans guaranteed by RUS  

261,330

     

5.50%

     

591

     

258,493

     

5.16%

     

8,491

   
     Intermediate-term loans  

5,605

     

7.43%

     

21,741

     

10,328

     

5.91%

     

25,714

   
     Line of credit loans  

1,022,398

     

6.38%

     

6,610,963

     

1,017,092

     

4.75%

     

6,122,693

   
Total loans  

18,360,905

     

5.66%

     

12,779,913

     

18,972,068

     

5.19%

     

11,694,019

   
Less: Allowance for loan losses  

(611,443

)            

-

     

(589,749

)            

-

   
Net loans

$

17,749,462

           

$

12,779,913

   

$

18,382,319

           

$

11,694,019

   
                                                 
Total by segment:                                                
CFC:                                                
     Distribution

$

12,859,076

     

5.61%

   

$

8,905,434

   

$

12,728,866

     

5.05%

   

$

8,821,217

   
     Power supply  

2,810,663

     

5.97%

     

2,635,502

     

2,640,787

     

5.72%

     

2,059,350

   
     Statewide and associate  

124,633

     

6.72%

     

110,839

     

135,513

     

5.58%

     

124,539

   

          CFC total

 

15,794,372

     

5.68%

     

11,651,775

     

15,505,166

     

5.17%

     

11,005,106

   
RTFC  

2,162,464

     

5.26%

     

550,990

     

2,992,192

     

5.21%

     

518,514

   
NCSC  

404,069

     

6.84%

     

577,148

     

474,710

     

5.96%

     

170,399

   
Total

$

18,360,905

     

5.66%

   

$

12,779,913

   

$

18,972,068

     

5.19%

   

$

11,694,019

   
  
The following table summarizes non-performing and restructured loans outstanding and loans committed but unadvanced to those borrowers by loan program and by segment at May 31:
    
 

2006

 

2005

 
 

Loans outstanding and

     

Loans outstanding and

     
(Dollar amounts in thousands)

weighted average interest

 

Unadvanced

 

weighted average interest

 

Unadvanced

 
Non-performing loans:

rates thereon

 

commitments(1)

 

rates thereon

 

commitments(1)

RTFC:                                                
  Long-term fixed rate loans

$

212,984

     

-

   

$

-

   

$

213,092

     

-

   

$

-

   
  Long-term variable rate loans  

314,987

     

-

     

-

     

353,480

     

-

     

-

   
  Line of credit loans  

49,817

     

-

     

296

     

49,777

     

-

     

34,188

   
       Total RTFC loans  

577,788

     

-

     

296

     

616,349

     

-

     

34,188

   
NCSC:                                  

 

           
  Long-term fixed rate loans

 

81

     

-

     

-

     

277

     

-

     

-

   
       Total non-performing loans

$

577,869

     

-

   

$

296

   

$

616,626

     

-

   

$

34,188

   
                                                 
Restructured loans:                                                
CFC:                                                
  Long-term fixed rate loans

$

51,670

     

6.38%

   

$

15,242

   

$

-

     

-

   

$

-

   
  Long-term variable rate loans  

571,640

     

0.03%

     

200,000

     

593,584

     

-

     

200,000

   
  Line of credit loans  

258

     

6.75%

     

-

     

-

     

-

     

-

   
       Total CFC loans  

623,568

     

0.56%

     

215,242

     

593,584

     

-

     

200,000

   
RTFC:                                                
  Long-term fixed rate loans  

6,786

     

6.65%

     

-

     

7,342

     

6.65%

     

-

   
       Total restructured loans

$

630,354

     

0.62%

   

$

215,242

   

$

600,926

     

0.08%

   

$

200,000

   

   

                                               
(1) Unadvanced loan commitments are loans for which loan contracts have been approved and executed, but funds have not been advanced. Additional information may be required to assure that all conditions for advance of funds have been fully met and that there has been no material change in the member's condition as represented in the supporting documents. Since commitments may expire without being fully drawn upon and a significant amount of the commitments are for standby liquidity purposes, the total unadvanced loan 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.
 

4


Total loans outstanding by state or U.S. territory based on the location of the system's headquarters are summarized below at May 31:
    

(in thousands)              

State/Territory

 

2006

 

2005

 

2004

 

State/Territory

 

2006

 

2005

 

2004

 
Alabama

$

355,420

   

$

362,305

    $

373,978

      Montana    

$

147,731

   

$

164,715

   

$

179,570

   
Alaska  

333,716

     

330,827

     

370,528

      Nebraska      

14,149

     

15,635

     

14,975

   
American Samoa  

1,604

     

2,765

     

1,859

     

Nevada

     

137,701

     

141,571

     

147,868

   
Arizona  

169,754

     

165,664

     

201,548

     

New Hampshire

     

164,651

     

178,740

     

188,960

   
Arkansas  

549,552

     

555,055

     

552,971

     

New Jersey

     

18,211

     

19,438

     

19,576

   
California  

24,362

     

20,894

     

28,270

     

New Mexico

     

36,528

     

34,223

     

37,476

   
Colorado  

876,100

     

873,413

     

929,822

     

New York

     

21,782

     

19,621

     

20,270

   
Connecticut  

200,000

     

200,000

     

200,100

     

North Carolina

     

522,194

     

1,024,134

     

988,101

   
Delaware  

23,842

     

19,809

     

21,093

     

North Dakota

     

77,002

     

81,977

     

85,749

   
District of Columbia  

9,908

     

25,526

     

22,522

     

Ohio

     

410,346

     

415,227

     

407,850

   
Florida  

659,416

     

636,792

     

612,222

     

Oklahoma

     

490,351

     

492,462

     

482,824

   
Georgia  

1,557,675

     

1,573,770

     

1,555,763

     

Oregon

     

305,961

     

314,137

     

310,736

   
Hawaii  

7,500

     

7,834

     

41,120

     

Pennsylvania

     

438,914

     

265,930

     

284,644

   
Idaho  

165,035

     

170,820

     

175,827

     

South Carolina

     

501,990

     

525,285

     

576,822

   
Illinois  

509,391

     

543,196

     

589,870

     

South Dakota

     

169,335

     

173,074

     

180,518

   
Indiana  

432,953

     

373,185

     

354,512

     

Tennessee

     

111,043

     

125,688

     

117,857

   
Iowa  

468,236

     

492,095

     

1,090,224

     

Texas

     

2,877,586

     

2,904,185

     

3,545,604

   
Kansas  

593,670

     

539,392

     

542,033

     

Utah

     

580,472

     

547,288

     

558,692

   
Kentucky  

335,551

     

454,976

     

445,341

     

Vermont

     

81,761

     

87,595

     

84,510

   
Louisiana  

382,505

     

337,741

     

323,035

     

Virgin Islands

     

488,392

     

479,196

     

552,674

   
Maine  

11,737

     

12,954

     

39,159

     

Virginia

     

209,153

     

218,801

     

311,534

   
Maryland  

176,797

     

169,581

     

152,872

     

Washington

     

102,128

     

99,562

     

93,258

   
Massachussetts  

-

     

-

     

100

     

West Virginia

     

7,700

     

8,171

     

5,797

   
Michigan  

294,162

     

301,822

     

286,345

     

Wisconsin

     

348,351

     

339,207

     

334,039

   
Minnesota  

744,941

     

895,976

     

952,984

     

Wyoming

     

117,098

     

139,618

     

148,814

   
Mississippi  

426,634

     

426,895

     

313,904

     

Total

   

$

18,360,905

   

$

18,972,068

   

$

20,488,523

   
Missouri  

669,914

     

663,301

     

631,803

                                   
  
The Company'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, 2006, 2005 and 2004, loans outstanding to borrowers located in any one state or territory did not exceed 16%, 16% and 18%, 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 primarily based on its cost of funding, as well as general and administrative expenses, the loan loss provision and a reasonable net margin. Various discounts, which reduce the stated interest rates, are available to borrowers meeting certain criteria related to business type, performance, volume and whether they borrow exclusively from CFC. See Note 2 to the consolidated financial statements for the weighted average interest rates earned on all loans outstanding during the fiscal years ended May 31, 2006, 2005 and 2004.
  
CFC Loan Programs
Long-Term Loans
Long-term loans are generally for terms of up to 35 years and can be either amortizing or bullet loans with serial payment structures. These loans finance electric plant and equipment which typically have a useful life equal to or in excess of the loan maturity. 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 or repriced 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 generally 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, deliver to CFC annual audited financial statements and an annual compliance certificate and be in compliance with all other terms of the loan agreement. 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 criteria. During the five years ended May 31, 2006, 4% of the dollar amount of long-term loans approved was to borrowers that did not meet the minimum lending criteria.
 

5


Line of Credit Loans
Line of credit loans are generally 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 principal balance for five consecutive days during each 12-month period. 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.
  
Interim financing line of credit loans are also made available to CFC members that have a loan application pending with RUS and have received approval from RUS to obtain interim financing. CFC anticipates that advances under these interim facilities will be repaid with advances from RUS long-term loans.
   
RTFC Loan Programs
The RTFC loan portfolio is concentrated in the core rural local exchange carrier ("RLEC") segment of the telecommunications market. RLECs are characterized by the low population density of their service territories. Services are generally delivered over networks that include fiber optic cable and digital switching. There is generally a significant barrier to competitive entry.
 
The businesses to which the remaining RTFC 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.
  
Long-Term Loans
RTFC makes long-term loans to rural telecommunications companies and their affiliates for the acquisition, 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. Long-term fixed rates for telecommunications loans are set 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 RTFC, 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 RTFC, 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 RTFC obligations under the approved terms.
  
Intermediate-Term Loans and Line of Credit Loans
RTFC 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.
  
RTFC 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 principal 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 RTFC members that have a loan application pending with RUS 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 RTFC loan with advances from the RUS long-term loans.
 
NCSC Loan Programs
NCSC makes long-term and short-term loans to organizations affiliated with its members. Loans may be secured or unsecured. The loans to the affiliated organizations may have a guarantee of repayment to NCSC from the CFC member cooperative with which it is affiliated.
 

6


Lease and General Loan Program
NCSC provided financing for the purchase of utility plant and/or related equipment, in some cases by a third party in a sale/leaseback transaction. Collateral for these loans consists of a mortgage on the leased asset, utility plant and/or related equipment. NCSC no longer provides this type of financing.
 
Associate Member Loan Program
NCSC provides financing to for-profit or not-for-profit affiliated entities of member cooperatives for economic and community development purposes. Collateral for these loans consists of a first mortgage lien on the assets of the associate member and/or project. These loans are also generally guaranteed by the sponsoring cooperative.
 
RUS Guaranteed Loans for Rural Electric Systems
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. At May 31, 2006, CFC had $223 million of loans outstanding under this program. In addition, at May 31, 2006, CFC was holding certificates totaling $38 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. The fee on the conversion of a fixed interest rate to a variable interest rate is 25 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 repaid at any time without a premium, provided the loan has a variable interest rate.

Loan Security
Except when providing lines of credit and intermediate-term loans, the Company typically lends to its members on a senior secured basis. 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.

The following tables summarize the Company's secured and unsecured loans outstanding by loan program and by segment at May 31:

   

(Dollar amounts in thousands)  

2006

 

2005

Total by loan program:  

Secured

 

%

 

Unsecured

 

%

 

Secured

 

%

 

Unsecured

 

%

Long-term fixed rate loans

$

13,984,404

96%

$

562,446

4%

$

12,293,054

97%

$

431,704

3%

  Long-term variable rate loans  

2,414,737

 

96%

 

109,985

 

4%

 

4,701,660

 

95%

 

259,737

 

5%

  Loans guaranteed by RUS  

261,330

 

100%

 

-

 

-

 

258,493

 

100%

 

-

 

-

  lntermediate-term loans  

897

 

16%

 

4,708

 

84%

 

1,235

 

12%

 

9,093

 

88%

  Line of credit loans  

145,938

 

14%

 

876,460

 

86%

 

201,466

 

20%

 

815,626

 

80%

       Total loans

$

16,807,306

 

92%

$

1,553,599

 

8%

$

17,455,908

 

92%

$

1,516,160

 

8%

(Dollar amounts in thousands)  

2006

 

2005

Total by segment:  

Secured

 

%

 

Unsecured

 

%

 

Secured

 

%

 

Unsecured

 

%

  CFC

$

14,575,691

 

92%

$

1,218,681

 

8%

$

14,316,925

 

92%

$

1,188,241

 

8%

  RTFC  

1,921,635

 

89%

 

240,829

 

11%

 

2,747,845

 

92%

 

244,347

 

8%

  NCSC  

309,980

 

77%

 

94,089

 

23%

 

391,138

 

82%

 

83,572

 

18%

       Total loans

$

16,807,306

 

92%

$

1,553,599

 

8%

$

17,455,908

 

92%

$

1,516,160

 

8%

   

7


Guarantee Programs
 
The Company 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 at May 31:
   
(in thousands)

2006

 

2005

 

2004

 
Long-term tax-exempt bonds

$

607,655

   

$

738,385

   

$

780,940

   
Debt portions of leveraged lease transactions  

-

     

12,285

     

14,838

   
Indemnifications of tax benefit transfers  

123,544

     

141,996

     

159,745

   
Letters of credit  

272,450

     

196,597

     

307,518

   
Other guarantees  

75,331

     

68,489

     

68,258

   
     Total

$

1,078,980

   

$

1,157,752

   

$

1,331,299

   
   
Guarantees of Long-Term Tax-Exempt Bonds
The Company has guaranteed debt issued in connection with the construction or acquisition by its 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 the Company, may include short- and long-term obligations.
  
In the event of a default by a system for non-payment of debt service, the Company 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 the Company performs under its guarantee. The system is required to repay, on demand, any amount advanced by the Company pursuant to its guarantee. This repayment obligation is secured by a common mortgage with RUS on all the system's assets, but the Company 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 the Company for any guarantee payments will be treated as a long-term loan. The system is required to pay to the Company 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 the Company has committed to purchase debt so tendered if it cannot otherwise be remarketed. If the Company held the securities, the cooperative would pay interest to the Company at its intermediate-term loan rate. Since the inception of the program in the mid-1980s, all bonds have been successfully remarketed and thus, the Company has not been required to purchase any bonds.
 
Guarantees of Lease Transactions
Included in the Company's guarantees of lease transactions at May 31, 2005 and 2004 were CFC's guarantees of member's rent obligations to third parties. All obligations for this type of guarantee were released during the year ended May 31, 2006.
   
Guarantees of Tax Benefit Transfers
The Company 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 the Company 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 been put in place since 1982. The maturities for this type of guarantee run through 2015.
  
Letters of Credit
The Company 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 the Company within one year from the date of the draw, with interest accruing from such date at the Company's line of credit variable rate of interest.
 
Other Guarantees
The Company 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 the Company's general and administrative expenses, a provision for losses and a reasonable margin.
   

8


Members' interest expense for the years ended May 31, 2006, 2005 and 2004 on debt obligations guaranteed by the Company was approximately $20 million, $16 million and $13 million, respectively.
  
The following chart summarizes total guarantees by segment at May 31:
  

(Dollar amounts in thousands)     
CFC:

2006

 

2005

 

2004

 
     Distribution

$

70,166

     

7%

   

$

41,842

     

4%

   

$

60,672

     

5%

   
     Power supply  

921,930

     

85%

     

1,066,373

     

92%

     

1,130,379

     

85%

   
     Statewide and associate  

32,873

     

3%

     

41,642

     

3%

     

111,195

     

8%

   
          CFC Total  

1,024,969

     

95%

     

1,149,857

     

99%

     

1,302,246

     

98%

   
NCSC  

54,011

     

5%

     

7,895

     

1%

     

29,053

     

2%

   
          Total

$

1,078,980

     

100%

   

$

1,157,752

     

100%

   

$

1,331,299

     

100%

   
   
Total guarantees outstanding, by state and territory based on the location of the system's headquarters, are summarized as follows at May 31:
   
(in thousands)  

2006

   

2005

 

2004

     

2006

 

2005

 

2004

 
Alabama  

$

22,250

     

$

22,450

   

$

22,630

      Missouri    

$

93,074

   

$

104,218

   

$

113,186

   
Alaska    

1,800

       

3,320

     

3,320

      Montana      

145

     

-

     

-

   
Arizona    

43,699

       

45,869

     

46,865

      New Hampshire      

9,550

     

10,500

     

17,500

   
Arkansas    

15,921

       

19,776

     

23,537

      New Mexico      

1,016

     

1,000

     

1,000

   
Colorado    

55,131

       

55,744

     

56,518

      North Carolina      

107,817

     

100,854

     

100,350

   
District of Columbia    

21,428

       

30,248

     

100,000

      North Dakota      

-

     

-

     

20,000

   
Florida    

100,038

       

108,385

     

116,447

      Ohio      

2,000

     

1,000

     

-

   
Georgia    

35,283

       

-

     

-

      Oklahoma      

4,358

     

4,930

     

11,221

   
Idaho    

-

       

-

     

850

      Oregon      

24,922

     

24,880

     

23,520

   
Illinois    

225

       

633

     

6,218

      Pennsylvania      

18,307

     

21,021

     

21,900

   
Indiana    

911

       

95,900

     

107,997

      South Carolina      

50

     

-

     

-

   
Iowa    

8,517

       

5,708

     

4,885

      Tennessee      

295

     

295

     

295

   
Kansas    

42,561

       

35,632

     

37,200

      Texas      

167,881

     

143,682

     

147,347

   
Kentucky    

121,864

       

132,115

     

135,555

      Utah      

20,594

     

41,126

     

48,204

   
Louisiana    

4,778

       

4,728

     

4,728

      Vermont      

1,250

     

1,250

     

750

   
Maryland    

24,800

       

-

     

-

      Virginia      

4,133

     

3,603

     

4,065

   
Michigan    

1,163

       

1,207

     

1,148

      Washington      

250

     

-

     

-

   
Minnesota    

76,010

       

86,372

     

95,556

      Wisconsin      

322

     

274

     

1,403

   
Mississippi    

37,267

       

41,437

     

47,299

      Wyoming      

9,370

     

9,595

     

9,805

   
                                Total    

$

1,078,980

   

$

1,157,752

   

$

1,331,299

   
  
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 CFC owned backup systems as well as office space and related office equipment.
  
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 revoked 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 a taxable cooperative 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. RTFC pays income tax based on its net margins, excluding net margins allocated to its members. NCSC is a taxable corporation. NCSC pays income tax annually based on its net margin for the period.
 

9


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 highly-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, 2006, CFC had 210 employees, including financial and legal personnel, management specialists, credit analysts, accountants and support staff. CFC believes that its relations with its employees are good.
  
CFC Lending Competition
  
CFC competes with other lenders on price, the variety of financing options offered and additional services provided to its member/owners. CFC is primarily in competition with other banks for the business of its members. The primary bank competitor is CoBank, ACB ("CoBank"), a government sponsored entity and member of the Farm Credit System whose status as such gives it the ability to offer lower interest rates in select situations. However, there are some members that are large enough to obtain a credit rating and access the capital markets for funding. In these cases, CFC is competing with the pricing and funding options the member is able to obtain in the capital markets. CFC attempts to minimize the impact of competition by offering a variety of loan options and complimentary services and by leveraging the thirty-five year working relationship that it has with the majority of the members.
  
RUS is generally the members' first financing option as it is able to offer members interest rates that are generally lower than the rates CFC and the other banks are able to offer. Therefore, CFC and other banks compete for bridge loans in anticipation of long-term funding from RUS, the portion of a loan that RUS is not able to provide, loans to members that can not borrow from RUS and loans to members that have elected not to borrow from RUS.
  
According to December 31, 2004 financial data filed with CFC, the 810 reporting electric cooperative distribution and 59 reporting power supply systems had a total of $48 billion in long-term debt outstanding at December 31, 2004. RUS is the dominant lender to the electric cooperative industry with $27 billion or 56% of the total outstanding debt for the 869 systems reporting 2004 results to CFC. At December 31, 2004, CFC had a total of $16 billion of long-term exposure to its distribution and power supply member systems, including $15 billion of long-term loans and $1 billion of guarantees. CFC's $16 billion long-term exposure represented 33% of the total long-term debt to these electric systems. The remaining $5 billion or 11% was borrowed from other sources. (December 31, 2005 financial data filed with CFC by its borrowers was not available at the time of this filing, therefore competition data is based on December 31, 2004 financial data). At December 31, 2005, CFC had a total of $16 billion of long-term exposure to its distribution and power supply member systems, including $15 billion of long-term loans and $1 billion of guarantees.
  
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, 2005, RUS had a total of approximately $3.6 billion outstanding to telecommunications borrowers. The Rural Telephone Bank ("RTB") has been liquidated. This dissolution of the RTB resulted in the federal government retiring at par value approximately $1.5 billion in RTB stock held by rural telecommunication providers and transferring the RTB loan portfolio to RUS. RTFC is not in direct competition with RUS, but rather competes with other lenders for supplemental lending and for the full lending requirement of the rural telecommunications companies that have decided not to borrow from RUS or for projects not eligible for RUS financing. RTFC's competition includes commercial banks, CoBank and insurance companies. At December 31, 2005, RTFC had a total of $2.1 billion in long-term loans outstanding to telecommunications borrowers.
  
Member Regulation and Competition
  
Electric Systems
The trend toward retail electric competition has faltered. The electric utility industry has settled into a "hybrid" model in which there are significant differences in the regulatory approaches followed in different states and regions. At May 31, 2004 (the latest comprehensive information available), 16 states were in the process of moving toward customer choice. In these states, customer choice was either available to all or some customers or would soon be available. Those states were Connecticut, Delaware, Illinois, Maine, Maryland, Massachusetts, Michigan, New Hampshire, New Jersey, New York, Ohio, Oregon, Pennsylvania, Rhode Island, Texas and Virginia. However, several of these states are currently reconsidering their move toward customer choice. Of the remaining states, 27 states were not actively pursuing restructuring, five states had delayed the restructuring process or the implementation of customer choice, and two states (Arizona and California) had suspended customer choice.
  

10


In the 16 states where customer choice was or would be available, the Company had a total of 222 electric members (170 distribution, 20 power supply and 32 associates) and $5,062 million of loans to electric systems at May 31, 2006. In New York, where the Company has five electric members and $13 million of loans to electric systems, cooperatives are not required to file competition plans with the state utility commission. In Michigan, where the Company has 14 electric members and $264 million in loans, the starting date for customer choice has been delayed. The Company continues to believe that the distribution systems, which comprise the majority of its membership and loan exposure, will not be materially impacted by customer choice. In general, 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 16 states where customer choice was or would be available, co-ops may decide 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, 2006, CFC had loans outstanding in the amount of $3,838 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 of customer choice on power supply systems cannot be determined until final rules have been approved in each state and on the federal level.

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 16 states that regulate the rates electric systems charge; of these states, two states have partial oversight authority over the cooperatives' rates, but not the specific authority to set rates. Nine 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 both the issuance of short-term and long-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 only a few cooperatives.
 
With the enactment of the Energy Policy Act of 2005 in August 2005, the definition of a public utility has been modified to exclude cooperatives currently financed by RUS and non-RUS financed cooperatives provided that the non-RUS cooperatives have total sales less than four million Mwh. The Energy Policy Act of 2005 effectively provides a statutory exemption from FERC regulation for essentially all distribution cooperatives.
 
Telecommunications Systems
RTFC 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.
   
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. To achieve competition, the Act required all carriers to interconnect with all others and LECs to provide competitors with access to elements of their networks. Congress included provisions in the Telecom Act granting RLECs an exemption from the above unbundled network element requirements, absent a determination that it would be in the public interest.
 
Competition continues to be a significant factor in the telecommunications industry. An April 2006 FCC report on competition states that as of June 2005, competitive local exchange carriers ("CLECs") provided service to 34 million access lines - 19.1% of the nation's 178 million end-user switched access lines. Wireless carriers are providing service to 191 million mobile telephone service subscriptions - more than incumbent LEC ("ILECs") and CLECs combined. Non facilities-based CLECs took advantage of pro-competitive FCC rules that allowed CLECs to obtain all elements of the ILECs' networks necessary to conduct business at favorable rates. This is known as the unbundled network element platform ("UNE-P") and consisted of a combination of an unbundled loop, unbundled local circuit switching and shared transport.
   

11


A March 2004 court order forced the FCC to revisit its rules on UNE-P. In a decision favorable to the regional Bell companies, in December 2004 the FCC ruled that ILECs no longer had any obligation to provide CLECs with mass market local circuit switching and gave CLECs 12 months to transition existing customers off of unbundled local circuit switching. This ruling caused the UNE-P CLEC business model to collapse and created extreme hardship for many such CLECs. Over 50% of total CLEC lines as of June 2004 were provided through UNE-P. AT&T and MCI subsequently exited the residential CLEC market. Combined with the failure of the stand-alone long distance provider business model, AT&T and MCI sought merger partners. AT&T was merged into SBC and is now known as AT&T. MCI merged into Verizon.
  
RLECs generally were not subject to UNE-P based competition, since RLECs enjoyed an exemption contained in the Telecom Act. Rural telecommunications companies are experiencing competition, however. A survey of small rural telecommunications companies found that nearly all face at least one competitor in their markets. For the most part, local exchange competition has benefited RLECs by enabling them to enter nearby towns and cities as competitive LECs, leveraging their existing infrastructure and reputation for providing quality, modern telecommunications service.
   
In addition to competition, the Telecom Act also mandated a 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 FCC rulings have reduced access charges which are a key revenue source. Numerous wireless carriers have entered rural markets as competitors to the RLECs. By obtaining competitive eligible telecommunications carrier 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, email and voice over internet protocol substitution. Uncontrolled growth of the fund is making the rate assessed on all participants in the nationwide network unsustainably high. The second quarter 2006 assessment rate is 10.9%. All industry segments agree that changes need to be made regarding eligibility to receive and the funding mechanism for USF. However, they are not all in agreement on what those changes should be. The FCC has a proceeding open to review USF, and Congress is addressing it in several bills as part of its rewrite of the Telecom Act, which is now under way.
  
The FCC also has a proceeding open on intercarrier compensation - the most important components of which are access fees LECs charge to interexchange carriers that originate or terminate long distance traffic on LEC networks. While the large LECs (most of which now own long distance companies) would like to see these fees transition to zero, RLECs depend heavily on access charges and are active participants in the FCC proceeding. RLECs have come together with a unified proposal that would preserve some access fees and are promoting it with the FCC.
  
While uncertainty exists regarding USF and access, the Company 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 service offerings to customers. Without cable as a competitor in most rural areas, RLECs are introducing digital video, high-speed data, and local and long distance voice service. Where they can leverage their infrastructure, they are competing with Verizon, Qwest, AT&T, Embarq and cable companies in neighboring towns. RLECs have generally been very successful competitors in these situations.
  
Deregulation has not had much effect on LECs thus far. The FCC has promulgated a series of rules to implement the Telecom Act, and eliminated very few existing regulatory requirements. States continue to regulate RLECs extensively. A revised or totally rewritten Telecom Act would start a whole new round of regulatory proceedings.
  
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 $500 million in fiscal year 2006 lending authority. For fiscal year 2007, the Administration is proposing an additional $356 million.
  
Given the increased availability of government financing for rural broadband, it is unlikely that the Company 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 2006, RUS has $690 million in lending authority for rural telephone systems and an additional $558 million for other telecommunications programs, including distance learning and broadband.
   
The RE Act provides for RUS to make insured loans and to provide other forms of financial assistance to borrowers. RUS is authorized to make direct loans, at below market rates, to systems that qualify for the hardship program (5% interest rate) or the municipal rate program (based on a municipal government obligation index). RUS is also authorized to guarantee loans that are used mainly to provide financing for construction of power supply projects. Guaranteed loans bear interest at a rate agreed upon by the borrower and the lender (which generally has been the Federal Financing Bank ("FFB")). RUS also provides financing at the Treasury rate. 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, 2007, the House of Representatives has approved a total of $4.2 billion of RUS electric loan and guarantee levels as follows: municipal rate loans of $100 million, hardship loans of $100 million, treasury rate loans of $1 billion and loan guarantees of $3 billion. The Senate Appropriations Committee has approved a total of $6.3 billion for RUS electric loan and guarantee levels; all of this increase above the $4.2 billion provided by the House was for loan guarantees which the Senate bill sets at $5.1 billion. Fiscal year 2007 electric program levels set by the Senate bill for the municipal rate, treasury rate and hardship programs were the same as approved by the House. Differences between the House and Senate bills will be resolved as part of the appropriations process which ultimately results in an Appropriations Act. Electric funding levels for fiscal year 2006 were as follows: municipal rate loans of $100 million, hardship loans of $100 million, treasury rate loans of $1 billion, and loan guarantees of $2.7 billion.
   
Item 1A. Risk Factors
 
The Company's financial condition and results of operations are subject to various risks inherent in its business. The material risks and uncertainties that management believes affect CFC are described below. The risks and uncertainties described below are not the only ones facing CFC. Additional risks and uncertainties that management is not aware of, or that it currently deems immaterial, may also impair business operations. If any of the events or circumstances described in the following risks actually occur, our business, financial condition or results of operations could suffer. You should consider all of the following risks together with all of the other information in this Annual Report on Form 10-K.
  
The Company's ability to maintain and grow our business depends on access to external financing.
The Company depends on access to the capital markets to refinance its long-term and short-term debt, fund new loan advances and if necessary, to fulfill its obligations under its guarantee and repurchase agreements. At May 31, 2006, the Company had $3,355 million of commercial paper, daily liquidity fund and bank bid notes and $1,989 million of medium-term notes, collateral trust bonds, subordinated deferrable debt and long-term notes payable scheduled to mature during the next twelve months. There can be no assurance that the Company will be able to access the markets in the future at all or on terms that are acceptable to the Company. Downgrades to the Company's long-term debt ratings and/or commercial paper ratings or other events that may deny or limit the Company's access to the capital markets could negatively impact its operations. The Company has no control over certain items that are considered by the credit rating agencies as part of their analysis for the Company, such as the overall outlook for the electric and telecommunications industries.
  
Fluctuating interest rates could adversely affect our income, margin and cash flow.
The Company is exposed to interest rate risk in its core lending and borrowing activities. If the Company does not set interest rates on its loans at a level to cover its cost of funding, there would be an adverse affect on gross margin and net margin.
 
The Company provides its members with many options on its loans with regard to interest rates, the term for which the selected interest rate is in effect and the ability to prepay the loan. As a result there is a possibility of significant changes in the composition of the loan portfolio. If the Company is not able to adjust its outstanding debt portfolio to match the changes in the loan portfolio, there could be an adverse impact on gross margin and net margin.
 

13


In addition, the Company's calculated impairment on non-performing and restructured loans will increase as the Company's long-term variable and line of credit interest rates increase. Currently, an increase of 25 basis points to the Company's variable interest rates would result in an increase of $8 million to the calculated impairment.
  
Competition from other lenders could impair the Company's financial results.
The majority of the Company's members are eligible to borrow from RUS. The rates offered by RUS are generally lower than the rates that the Company and other lenders can offer. Thus the members' first financing option generally is to borrow funds under the RUS program. The RUS funding level is determined by the U.S. Congress each year. Increases to the amount of RUS funding could limit the amount of loan growth experienced by the Company.
  
The Company competes with other lenders for the portion of the loan commitment that RUS will not lend, for the loans to members that can not borrow from RUS or for loans to members that have elected not to borrow from RUS. If other lenders are more successful than the Company in the competition for this loan volume, it could have an adverse impact on the Company's financial results.
  
We may not recover the value of amounts that we lend.
CFC's allowance for loan losses is established through a provision charged to expense that represents management's best estimate of probable losses that have been incurred within the existing portfolio for loans. The level of the allowance reflects management's continuing evaluation of: industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions and unidentified losses and risks inherent in the current loan portfolio. The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires CFC to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of CFC's control, may require an increase in the allowance for loan losses. In addition, if charge-offs in future periods exceed the allowance for loan losses, CFC will need additional provisions to increase the allowance for loan losses. Any increases in the allowance for loan losses will result in a decrease in net margin, and may have a material adverse effect on CFC's financial results and credit ratings.
  
The Company has been and may in the future be in litigation with borrowers related to enforcement or collection actions pursuant to loan documents. In such cases, the borrower or others may assert counterclaims against the Company or initiate actions against the Company related to the loan documents. Unfavorable rulings in these cases which result in loan losses that exceed the related allowance could have a material adverse effect on our financial results and credit ratings.
  
Our ability to access the capital markets depends on our ability to maintain adjusted leverage and debt to equity ratios within a reasonable range of the current levels.
Maintenance of adjusted leverage and debt to equity ratios within a reasonable range of the current levels is important in relation to the Company's ability to access the capital markets. A significant increase in the adjusted leverage or debt to equity ratios could impair the Company's ability to access the capital markets, its ability to access the Company's revolving lines of credit and its ability to maintain preferred credit ratings. See "Non-GAAP Financial Measures" for further explanation and a reconciliation of adjusted ratios.
  
A decline in our credit rating could trigger payments under our derivative agreements.
If the Company's credit rating falls to the level specified in certain of its derivative agreements, the other counterparty may terminate the agreement. If the counterparty terminates the agreement, a net payment may be due from one counterparty to the other based on the fair value of the underlying derivative instrument. Based on the fair market value of its interest rate, cross currency and cross currency interest rate exchange agreements subject to rating triggers at May 31, 2006, the Company may be required to make a payment of up to $2 million if its senior unsecured ratings declined to Baa1 or BBB+, and up to $71 million if its senior unsecured ratings declined below Baa1 or BBB+. In calculating the required payments, the Company only considered agreements in which it would have been required to make a payment upon termination. In the event the Company is required to make a payment as a result of a rating trigger, it could have a material adverse impact on its financial results.
 
Our ability to comply with covenants related to our revolving credit agreements and debt indentures may affect our ability to obtain financing and maintain preferred rating levels on our debt.
The Company must maintain compliance with all covenants related to its revolving credit agreements, including the adjusted TIER, adjusted leverage and amount of loans pledged in order to have access to the funds available under the revolving lines of credit. See "Non-GAAP Financial Measures" for further explanation and a reconciliation of adjusted ratios. A restriction on access to the revolving lines of credit would impair the Company's ability to issue short-term debt, as it is required to maintain backup-liquidity to maintain preferred rating levels on its short-term debt.
  

14


If the Company does not maintain compliance with covenants on its collateral trust bond, medium-term note and subordinated deferrable debt indentures, the holders of such debt could declare an event of default and accelerate the repayment of the full amount of the outstanding debt principal prior to the stated maturity of such debt. Additionally, the Company could not issue new debt under such indentures. Such an event would require the Company to obtain new funding to repay the accelerated debt as a result of the covenant default and could have a material adverse impact on its financial results and credit ratings.
  
Our concentration of loans to borrowers within rural electric and telephone industries could impair our revenues if either or both of those industries were to experience economic difficulties.
Credit concentration is one of the risk factors considered by the rating agencies in the evaluation of the Company's credit rating. Substantially all of the Company's credit exposure is to the rural electric and telephone industries and is subject to risks associated with those industries.
  
The Company's credit concentration to its ten largest borrowers could increase from the current 18% of total loans and guarantees outstanding, if:
 
* it were to extend additional loans and/or guarantees to the current ten largest borrowers,
* its total loans and/or guarantees 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 large new loans and/or guarantees to one of the borrowers below the ten largest.
 
We could jeopardize our federal tax exemption if we fail to conduct our business in accordance with our exemption from the Internal Revenue Service.
Legislation that removes or imposes new conditions on the federal tax exemption for 501(c)(4) social welfare organizations could have a negative impact on the Company's net margins. CFC's continued exemption depends on it conducting its business in accordance with its 501(c)(4) status.
 
Item 1B. Unresolved Staff Comments
  
There are no material unresolved written comments that were received from the Securities and Exchange Commission's staff 180 days or more before the end of the Company's fiscal year related to the Company's periodic or current reports filed under the Securities and Exchange Act of 1934.
  
Item 2. Properties.
 
CFC leases office space that serves as its headquarters in Fairfax County, Virginia. CFC owned its headquarters facility until October 2005, when it sold the facility to an affiliate of Prentiss Properties Acquisition Partners, L.P. The headquarters facility sold by CFC consists of two six-story buildings and adjacent parking garages situated on ten acres of land and two acres of unimproved land adjacent to the office buildings. CFC has entered into a three-year lease with the new building owner for approximately one-third of the facility's office space. CFC has the option to extend the lease for two additional one-year terms.
  
Item 3. Legal Proceedings.
  
None.
  
Item 4. Submission of Matters to a Vote of Security Holders.
  
None.
   

15


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 the years ended May 31:

   

(Dollar amounts in thousands)  

2006

 

2005

 

2004

 

2003

 

2002

 
For the year ended May 31:                                          
Operating income  

$

1,007,912

   

$

1,030,853

   

$

1,009,856

   

$

1,075,310

   

$

1,193,597

   
Gross margin    

45,256

     

104,063

     

81,641

     

131,543

     

300,695

   
Derivative cash settlements (1)    

67,603

     

63,044

     

110,087

     

122,825

     

34,191

   
Derivative forward value (1)    

29,054

     

26,320

           

(229,132

)    

757,212

     

41,878

   
Foreign currency adjustments (2)    

(22,594

)    

(22,893

)

   

(65,310

)    

(243,220

)    

(61,030

)  
Operating margin (loss)    

62,580

     

127,032

     

(194,584

)    

651,970

     

78,873

   
Cumulative effect of change in                                          
     accounting principle (1) (3)    

-

     

-

     

22,369

     

-

     

28,383

   
Net margin (loss)  

$

95,746

   

$

122,974

   

$

(178,021

)  

$

651,970

   

$

107,256

   
Fixed charge coverage ratio (TIER) (4)(5)    

1.10

     

1.13

     

-

     

1.69

     

1.09

   
Adjusted fixed charge coverage ratio                                          
     (Adjusted TIER) (6)    

1.11

     

1.14

     

1.12

     

1.17

     

1.12

   
                                           
As of May 31:                                          
Loans to members  

$

18,360,905

   

$

18,972,068

   

$

20,488,523

   

$

19,484,341

   

$

20,047,109

   
Allowance for loan losses    

(611,443

)    

(589,749

)    

(573,939

)    

(511,463

)    

(478,342

)  
Assets    

19,179,621

     

20,060,314

     

21,455,457

     

21,139,039

     

20,466,523

   
Short-term debt (7)    

5,343,824

     

7,952,579

     

5,990,039

     

5,046,978

     

6,119,594

   
Long-term debt (8)    

10,642,028

     

8,701,955

     

12,009,182

     

12,050,119

     

11,149,925

   
Subordinated deferrable debt (9)    

486,440

     

685,000

     

550,000

     

650,000

     

600,000

   
Members' subordinated certificates    

1,427,960

     

1,490,750

     

1,665,158

     

1,708,297

     

1,691,970

   
Members' equity (1)    

545,351

     

523,583

     

483,126

     

454,376

     

392,056

   
Total equity    

787,976

     

768,761

     

695,734

     

930,836

     

328,731

   
Guarantees  

$

1,078,980

   

$

1,157,752

   

$

1,331,299

   

$

1,903,556

   

$

2,056,385

   
Leverage ratio (5)    

24.68

     

26.58

     

31.72

     

23.75

     

67.51

   
Adjusted leverage ratio (6)    

6.38

     

6.50

     

7.07

     

6.69

     

7.23

   
Debt to equity ratio (5)    

23.31

     

25.07

     

29.81

     

21.71

     

61.26

   
Adjusted debt to equity ratio (6)    

5.97

     

6.07

     

6.58

     

6.01

     

6.46

   

 

 
(1) Derivative cash settlements represent the net settlements received/paid on interest rate and cross currency exchange agreements that do not qualify for hedge accounting for the years ended May 31, 2006, 2005, 2004, 2003 and 2002. The derivative forward value represents the change in fair value on exchange agreements that do not qualify for hedge accounting, as well as amortization related to the long-term debt valuation allowance and related to the transition adjustment recorded as an other comprehensive loss on June 1, 2001. The cumulative effect of change in accounting principle in 2002 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 in 2002 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).
(2) 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.
(3) The cumulative effect of change in accounting principle in 2004 represents the impact of implementing Financial Accounting Standards Board Interpretation No. 46 (R), Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51, effective June 1, 2003.
(4) The fixed charge coverage ratio is the same calculation as CFC's Times Interest Earned Ratio ("TIER"). For the year ended May 31, 2004, CFC's earnings were insufficient to cover fixed charges by $200 million.
(5) See "Non-GAAP Financial Measures" in Management's Discussion and Analysis for the GAAP calculations of these ratios.
(6) Adjusted ratios include non-GAAP adjustments that CFC makes to financial measures in assessing its financial performance. See "Non-GAAP Financial Measures" in Management's Discussion and Analysis for further explanation of these calculations and a reconciliation of the adjustments.
(7) At May 31, 2006, includes $150 million in subordinated deferrable debt to be called in June 2006 and the foreign currency valuation account of $245 million, $40 million, $0, $150 million and $(1) million at May 31, 2006, 2005, 2004, 2003 and 2002, respectively.
(8)

 

Excludes $1,839 million, $3,591 million, $2,365 million, $2,911 million, and $ 2,883 million in long-term debt that comes due, matures and/or will be redeemed during fiscal years 2007, 2006, 2005, 2004, and 2003, respectively (see Note 4 to the consolidated financial statements). Includes the long-term debt valuation allowance of $(1) million and $2 million at May 31, 2003 and 2002, respectively, and the foreign currency valuation account of $221 million, $234 million, $176 million and $(2) million at May 31, 2005, 2004, 2003 and 2002, respectively.
(9) Amount outstanding at May 31, 2006 excludes $150 million to be called in June 2006 and reported in short-term debt.
   

16


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
   
Unless stated otherwise, references to the Company relate to the consolidation of National Rural Utilities Cooperative Finance Corporation ("CFC" or "the Company"), Rural Telephone Finance Cooperative ("RTFC"), National Cooperative Services Corporation ("NCSC") and certain entities controlled by CFC and created to hold foreclosed assets. The following discussion and analysis is designed to provide a better understanding of the Company's consolidated financial condition and results of operations and as such should be read in conjunction with the consolidated financial statements, including the notes thereto. CFC refers to its financial measures that are not in accordance with generally accepted accounting principles ("GAAP") as "adjusted" throughout this document. See "Non-GAAP Financial Measures" for further explanation.
  
Executive Summary
In this report, the Company will provide analysis on its results of operations, financial condition, liquidity and market risk. The Company will also provide analysis of trends and significant transactions completed in the period covered by the report.
  
CFC was formed in 1969 by the rural electric cooperatives to provide them with a source of financing to supplement the loan programs of the Rural Utilities Service ("RUS"). CFC was organized as a cooperative in which each member (other than associates) is entitled to one vote. Under CFC's bylaws, the board of directors is composed of 23 individuals, 20 of whom must be either general managers or directors of member systems, two of whom are designated by the National Rural Electric Cooperative Association and one at-large position who must satisfy the requirements of an audit committee financial expert as defined by Section 407 of the Sarbanes-Oxley Act of 2002 and must be a trustee, director, manager, Chief Executive Officer or Chief Financial Officer of a member. If the board of directors determines to fill the at-large seat, the candidates are nominated by the board of directors and the at-large director is elected by the membership. CFC was granted tax-exempt status under Section 501(c)(4) of the Internal Revenue Code.
  
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 their affiliates. In February 2005, RTFC reincorporated as a not-for-profit cooperative association in the District of Columbia. NCSC was incorporated in 1981 in the District of Columbia as a private cooperative association.
   
Business Overview
The Company'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 attain high credit ratings on its debt instruments. As a not-for profit, membership owned financial institution, the Company's goal is not to maximize its profit on loans to members, but rather to find a balance between charging its members the lowest possible rates on loans and maintaining the financial performance required to access the capital markets on behalf of its members. Thus, the Company 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 the Company's financing objectives.
  
At May 31, 2006, the Company's consolidated membership was 1,547, including 898 utility members, the majority of which are consumer-owned electric cooperatives, 514 telecommunications members, 67 service members and 68 associates in 49 states, the District of Columbia and two U.S. territories. The utility members included 829 distribution systems and 69 generation and transmission ("power supply") systems.
 
The Company makes long-term loans with maturities of up to 35 years to its members. The Company offers both variable and fixed rate options for various terms within the loan maturity and/or through the maturity of the loan. The Company also offers line of credit loans for periods of generally up to 5 years. The Company's long-term loans are typically secured by a mortgage on all assets and future revenues of the members. In cases where the member is also a borrower of RUS, the mortgage will be jointly held by the Company and RUS. The line of credit loans are typically unsecured. The Company will also guarantee the obligations of its members to third parties and will provide liquidity support to its members in the form of letters of credit.
  
CFC obtains its funding from the capital markets, private placement of debt 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, fixed rate subordinated deferrable debt, 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 private funding sources through the issuance of fixed rate notes. CFC also obtains debt financing from its membership and other qualified investors through the direct sale of its commercial paper, daily liquidity fund and unsecured medium-term notes.
 
Rural electric cooperatives that join CFC are generally 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 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. The membership subordinated certificates and the loan and guarantee subordinated certificates are unsecured and subordinate to other senior debt of CFC.
   

17


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 non-cash effects of Statement of Financial Accounting Standards ("SFAS") 133, Accounting for Derivative Instruments and Hedging Activities, as amended and SFAS 52, Foreign Currency Translation annually to an education fund, a members' capital reserve and to members based on each member's patronage of the loan programs during the year. RTFC annually allocates its net margin to its members based on each member's patronage of the loan programs during the year. NCSC does not allocate its net margin to its members.
  
The Company'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.
   
Financial Overview
Results of Operations
The Company uses a times interest earned ratio ("TIER") instead of the dollar amount of gross or net margin as its primary performance indicator, since its net margin in dollar terms is subject to fluctuation as interest rates change. TIER is a measure of the Company's ability to cover the interest expense on its debt obligations. TIER is calculated by dividing the sum of cost of funds and the net margin prior to the cumulative effect of change in accounting principle by the cost of funds.
 
For the year ended May 31, 2006, the Company reported a net margin of $96 million and TIER of 1.10, compared to a net margin of $123 million and TIER of 1.13 for the prior year. For the year ended May 31, 2006, the Company reported an adjusted net margin of $97 million and adjusted TIER of 1.11, compared to an adjusted net margin of $122 million and adjusted TIER of 1.14 for the prior year. See "Non-GAAP Financial Measures" for more information on the adjustments the Company makes to its financial results for the purposes of its own analysis and covenant compliance.
  
During the year ended May 31, 2006, the Company's earnings were significantly impacted by the level of loans on non-accrual status, the required loan loss provision and the sale of the headquarters facility. Holding loans on non-accrual status resulted in a reduction of $79 million to reported interest income for the year ended May 31, 2006. A loan loss provision of $23 million was required during the year ended May 31, 2006 to cover an increase in the calculated impairment on loans. The Company recognized a gain of $43 million from the sale of its headquarters facility during the year ended May 31, 2006.
 
In fiscal year 2007, the Company expects a reduction to the amount of loans on non-accrual status due to the anticipated resolution of certain problem loans. The reduction to the amount of loans on non-accrual status should result in an increase to the adjusted gross margin yield during fiscal year 2007. It is anticipated that the increases to the federal funds interest rate are nearing an end. Changes to the Company's variable interest rates should mirror changes to the federal funds rate. The calculated impairment on the Company's loans increases or decreases with the increases and decreases to the Company's variable interest rates. At May 31, 2006, an increase or decrease of 25 basis points to the Company's variable interest rates results in an increase or decrease of approximately $8 million to the calculated impairment on loans.
  
Financial Condition
During the year ended May 31, 2006, the Company's total loans outstanding decreased by $611 million. The decrease relates primarily to prepayments of RTFC telecommunication loans. RTFC loans outstanding decreased by $830 million and NCSC loans outstanding decreased by $71 million, while CFC loans increased by $290 million.
  
The Company expects that the balance of the loan portfolio will remain relatively stable during fiscal year 2007. Loans from the Federal Financing Bank ("FFB"), a division of the U.S. Treasury Department, with an RUS guarantee, represent a lower cost option for rural electric utilities compared to the Company. The Company anticipates that the majority of its electric loan growth will come from distribution system borrowers that have fully prepaid their RUS loans and choose not to return to the government loan program, from distribution system borrowers that do not want to wait the 12 to 24 months it may take RUS to process and fund the loan and from power supply systems. The Company anticipates that the RTFC loan balance will continue to decline due to long-term loan amortization and lower levels of capital expenditure requirements and asset acquisitions in the rural telecommunications marketplace.
  
During the year ended May 31, 2006, short-term debt decreased by $2,608 million and long-term debt increased by $1,940 million. Short-term debt decreased due to the maturity of collateral trust bonds and because CFC further reduced its reliance on the dealer commercial paper markets as a result of borrower loan repayments. In addition, the Company accessed two new private funding sources during the year ended May 31, 2006, notes to Federal Agricultural Mortgage Corporation ("Farmer Mac") and the FFB loan facilities with bond guarantee agreements with RUS as part of the funding mechanism for the Rural Economic Development Loan and Grant ("REDLG") program. Long-term debt increased due to these new private funding sources and the issuance of collateral trust bonds in May 2006 to refinance the bonds that matured during the year.
  
At May 31, 2006, the Company reported total equity of $788 million, an increase of $19 million from $769 million reported at May 31, 2005. Under GAAP, the Company's reported equity balance fluctuates based on the impact of future expected changes
   

18


to interest rates on the fair value of its interest rate exchange agreements and the impact of future expected currency exchange rates on its currency exchange agreements. As a result, it is difficult to predict the future changes in the Company's reported GAAP equity due to the uncertainty of the movement in future interest and currency exchange rates. In its internal analysis and for purposes of covenant compliance under its credit agreements, the Company adjusts equity to exclude the non-cash impacts of SFAS 133 and 52.
  
Liquidity
At May 31, 2006, the Company had $3,355 million of commercial paper, daily liquidity fund and bank bid notes and $1,989 million of medium-term notes, collateral trust bonds, subordinated deferrable debt and long-term notes payable scheduled to mature during the next twelve months. Members held commercial paper (including the daily liquidity fund) totaling $1,451 million or approximately 45% of the total commercial paper outstanding at May 31, 2006. Commercial paper issued through dealers and bank bid notes totaled $1,758 million and represented 10% of total debt outstanding at May 31, 2006. The Company intends to maintain the balance of dealer commercial paper and bank bid notes at 15% or less of total debt outstanding during fiscal year 2007. During the next twelve months, the Company plans to refinance the $1,989 million of medium-term notes, collateral trust bonds, subordinated deferrable debt and long-term notes payable and fund new loan growth by issuing a combination of commercial paper, medium-term notes, collateral trust bonds and other debt.
 
CFC uses internally generated member loan repayments, capital market debt issuance, private debt issuance, member investments, and net margins to fund its operations. In addition, the Company maintains both short-term and long-term bank lines in the form of revolving credit agreements with its bank group. Members pay a small membership fee and are typically required to purchase subordinated certificates as a condition to receiving a long-term loan advance and as a condition of membership. CFC has a need for funding to make loan advances to its members, to make interest payments on its public and private debt and to make payments of principal on its maturing debt. To facilitate open access to the capital markets, CFC is a regular issuer of debt in the capital markets, maintains strong credit ratings and has active shelf registrations on file with the Securities and Exchange Commission ("SEC") for each of its public debt instruments. CFC also has access to foreign debt markets with Euro medium-term note and commercial paper programs and an Australian medium-term note program.
  
During the year ended May 31, 2006, the Company drew down a total of $2 billion of funding as part of the REDLG program. As part of this program, the Company can borrow amounts from the FFB with a guarantee of repayment by the RUS. As a result of the RUS guarantee, these funds represent a lower cost compared to the Company's other forms of debt securities. At May 31, 2006, the Company had RUS approval to borrow an additional $500 million under the REDLG program and the Company anticipates borrowing this amount prior to the expiration of the commitment in July 2009.
   
Recent Events
On April 26, 2006, RTFC reached a settlement of loan litigation with Innovative Communication Corporation ("ICC"), its local exchange carrier subsidiary Virgin Islands Telephone Corporation d/b/a Innovative Telephone ("Vitelco"), Innovative Communication Company LLC, a Delaware limited liability company ("ICC-LLC)" and parent of Emerging Communication, Inc., a Delaware corporation and immediate parent of ICC ("Emcom"), their directors and Jeffrey Prosser ("Prosser"), individually. Under the settlement, RTFC obtained entry of judgments in the District Court for the District of the Virgin Islands against ICC for approximately $525 million and Prosser for approximately $100 million. RTFC also obtained dismissals with prejudice of all counterclaims, affirmative defenses and other lawsuits alleging wrongful acts by RTFC, certain of its officers, and CFC. Various parties also reached agreement for ICC to satisfy the RTFC judgments in the third quarter of calendar year 2006, subject to certain terms and conditions. In the event that does not occur, RTFC intends to pursue collection of the judgments.
  
On July 31, 2006, ICC-LLC, and Emcom each filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code in the United States District Court for the Virgin Islands, Division of St. Thomas and St. John, Bankruptcy Division, and Prosser, individually, filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the District of Virgin Islands. Each of the debtors is obligated to RTFC, for certain obligations of ICC, including court judgments, to RTFC.
  
In June 2006, the Company received $40 million as part of the court approved sale of the remaining operating assets of VarTec, Telecom, Inc. ("VarTec").
  
See further discussion of ICC and VarTec under the Non-performing Loans section of "Financial Condition."
   
Additionally, in June 2006, the Company redeemed the 7.625% subordinated deferrable debt securities due 2050 totaling $150 million. The Company redeemed these securities at par and recorded a charge of $5 million in cost of funds for the unamortized issuance costs.
  

19


Critical Accounting Estimates
  
Allowance for Loan Losses
At May 31, 2006 and 2005, the Company had a loan loss allowance that totaled $611 million and $590 million, representing 3.33% and 3.11% of total loans outstanding, respectively. Generally accepted accounting principles require loans receivable to be reported on the consolidated balance sheets at net realizable value. The net realizable value is the total principal amount of loans outstanding less an estimate of the probable losses inherent in the portfolio. The Company calculates its loss allowance on a quarterly basis. The loan loss allowance is calculated by segmenting the portfolio into three categories of loans: 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 the Company's financial statements.
  
Impaired Exposure
The Company calculates impairment on certain loans in accordance with SFAS 114, Accounting by Creditors for Impairment of a Loan - an Amendment of SFAS 5 and SFAS 15, as amended. 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. The Company reviews its portfolio to identify impairments at least on a quarterly basis. Factors considered in determining an impairment include, but are not limited to: the review of the borrower's audited financial statements and interim financial statements if available, the borrower's payment history, communication with the borrower, economic conditions in the borrower's service territory, pending legal action involving the borrower, restructure agreements between the borrower and the Company, and estimates of the value of the borrower's assets that have been pledged as collateral to secure the Company's loans. The Company calculates the impairment by comparing the future estimated cash flow, discounted at the original loan interest rate, against its 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, 2006 and 2005, the Company had a total of $447 million and $404 million reserved specifically against impaired exposure totaling $1,201 million and $1,208 million, respectively, representing 37% and 33% of the total impaired loan exposure. The $447 million and $404 million specific reserves represented 73% and 68% of the total loan loss allowance at May 31, 2006 and 2005, respectively. The calculated impairment at May 31, 2006 was higher than at May 31, 2005 due to higher interest rates on variable rate loans, offset by payments received on impaired loans. The original contract rate on a portion of the impaired loans at May 31, 2006 will vary with the changes in the Company's variable interest rates. Based on the current balance of impaired loans at May 31, 2006, a 25 basis point increase or decrease to the Company's variable interest rates would result in an increase or decrease, respectively, of approximately $8 million to the calculated impairment irrespective of a change in the credit fundamentals of the impaired borrower.
  
In calculating the impairment on a loan, the estimates of the expected future cash flow or collateral value are the key estimates made by management. Changes in the estimated future cash flow or collateral value 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 the Company'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 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 the Company to discuss pending financial difficulties or for some other reason the Company believes that the borrower's financial results could deteriorate resulting in an elevated potential for loss. The Company'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 at least quarterly to review 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, the Company'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, deterioration in financial condition, the borrower declaring bankruptcy, payment default on the Company's loans 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 12 to 24 months. At May 31, 2006 and 2005, the Company had reserved $2 million and $12 million against the $12 million and $68 million of exposure classified as high risk, representing coverage of 17% and 18%, respectively. The $2 million and $12 million reserve for loans in the high risk category represents less than 1% and 2%, respectively, of the total loan loss allowance at May 31, 2006 and 2005.
   

20


General Portfolio
The Company's methodology used to determine the required loan loss allowance for the general portfolio includes the use of an internal risk rating system, historical default data on corporate bonds and Company specific loss recovery data. The Company uses the following factors, in no particular order, to determine the level of the loan loss allowance for the general portfolio category:

* Internal risk ratings - the Company maintains risk ratings for each credit facility outstanding to its borrowers. The ratings are updated at least annually and are based on the following:
  * General financial condition of the borrower.
  * The Company's internal estimated value of the collateral securing its loans.
  * The Company's internal evaluation of the borrower's management.
  * The Company's internal evaluation of the borrower's competitive position within its service territory.
  * The Company'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. The Company uses the standard default table for all corporate bonds published by Standard and Poor's Corporation 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.

The Company aggregates the loans in the general portfolio by borrower type (distribution, generation, telecommunications, associate and other member) and by internal risk rating within borrower type. The Company correlates its internal risk ratings to the ratings used in the standard default table based on a comparison of its rating on borrowers that have a rating from one or more of the recognized credit rating agencies and based on a standard matching used by banks.
  
In addition to the general portfolio reserve requirement as calculated above, the Company maintains an additional reserve for borrowers with a total exposure in excess of 1.5% of its total loans and guarantees outstanding. The additional reserve is based on the amount of exposure in excess of 1.5% of the Company's total exposure and the borrower's internal risk rating. At May 31, 2006 and 2005, respectively, the Company had a reserve of $3 million and $7 million based on the additional risk related to large exposures.
  
At May 31, 2006 and 2005, the Company had a total of $16,886 million and $17,437 million of loans, respectively, in the general portfolio. This total does not include $261 million and $258 million of loans at May 31, 2006 and 2005, respectively, that have a U.S. Government guarantee of all principal and interest payments. The Company does not maintain a loan loss allowance on loans that are guaranteed by the U.S. Government. The Company reserved a total of $162 million and $174 million (including the $3 million and $7 million described above) for loans in the general portfolio at May 31, 2006 and 2005, respectively, representing coverage of 0.96% and 1.00% of the total loans for the general portfolio.
  
In fiscal years 2006, 2005 and 2004, CFC made provisions to the loan loss reserve totaling $23 million, $16 million and $55 million, respectively.
 
Senior management reviews the estimates and assumptions used in the calculations of the loan loss allowance for impaired loans, high risk loans and loans covered by the general portfolio, including large exposures related to single obligors, on a quarterly basis. Senior management discusses estimates with the board of directors and audit committee and reviews all loan loss related disclosures included in the Company's Form 10-Qs and Form 10-Ks filed with the SEC.
  
Management makes recommendations regarding loans to be written off to the CFC board of directors. In making its recommendation to write off all or a portion of a loan balance, management considers various factors including cash flow analysis and collateral securing the borrower's loans.

Derivative Financial Instruments
In June 1998, the 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 consolidated balance sheets 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 consolidated statements 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. The Company is neither a dealer nor trader in derivative financial instruments. The Company uses interest rate, cross currency and cross currency interest rate exchange agreements to manage its interest rate and foreign currency risk.
   

21


The majority of the Company's derivatives do not qualify for hedge accounting. To qualify for 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 the Company'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 the Company's own commercial paper rates to qualify for hedge accounting. The Company sells commercial paper to its members as well as to investors in the capital markets. The Company sets its commercial paper rates daily based on its cash requirements. The correlation between the Company's commercial paper rates and the 30-day composite commercial paper index has not been consistently high enough to qualify for hedge accounting.
 
The Company 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. The Company 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. The Company believes that it is properly hedging its gross margin on loans by using the 30-day composite commercial paper or LIBOR index, which are the rates that are most closely related to the rates it pays on its own commercial paper. During certain periods, the correlation between the LIBOR rates or the 30-day composite commercial paper rate and the Company's 90-day and 30-day commercial paper rate has been higher than the required 90% to qualify for hedge accounting. However, the correlation is not consistently above the 90% threshold, therefore the interest rate exchange agreements that use the three-month LIBOR rate or 30-day composite commercial paper rate do not qualify for hedge accounting. For the purposes of its own analysis, the Company believes that the correlation is sufficiently high to consider these agreements effective economic hedges.
 
As a result of applying SFAS 133, the Company has recorded derivative assets of $579 million and $585 million and derivative liabilities of $85 million and $78 million at May 31, 2006 and 2005, respectively. From inception to date, accumulated other comprehensive income related to derivatives was $13 million and $16 million as of May 31, 2006 and 2005, respectively.
 
The impact of derivatives on the Company's consolidated statements of operations for the years ended May 31, 2006, 2005 and 2004 was a gain of $93 million, a gain of $81 million and loss of $128 million, respectively. The change in the fair value of derivatives for the years ended May 31, 2006, 2005 and 2004 was a gain of $29 million, a gain of $26 million and a loss of $229 million, respectively, recorded in the Company's derivative forward value. For the year ended May 31, 2004, the derivative forward value also includes amortization to expense of $1 million related to the long-term debt valuation allowance and for the years ended May 31, 2006, 2005 and 2004, it includes $0.4 million, $16 million and $17 million, respectively, related to the transition adjustment recorded as an other comprehensive loss on June 1, 2001, the date the Company implemented SFAS 133. In addition, income totaling $65 million, $55 million and $101 million was recorded for total net cash settlements received by the Company during the years ended May 31, 2006, 2005 and 2004, respectively, of which $68 million, $63 million and $110 million, respectively, relate to interest rate and cross currency interest rate exchange agreements that do not qualify for hedge accounting under SFAS 133 and were recorded in derivative cash settlements. The remaining expense of $3 million, $8 million and $9 million, respectively, relate to interest rate and cross currency interest rate exchange agreements that qualify for hedge accounting under SFAS 133 and were recorded in cost of funds.
 
The Company 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, the Company obtains market quotes from its dealer counterparties. The market quotes are based on the expected future cash flow and estimated yield curves. The Company performs its own analysis to confirm the values obtained from the counterparties. The Company records the change in the fair value of its derivatives for each reporting period in the derivative forward value line on the consolidated statements of operations for the majority of its derivatives or in the other comprehensive income account on the consolidated balance sheets for the derivatives that qualify for hedge accounting. The counterparties are estimating future interest rates as part of the quotes they provide to the Company. The Company adjusts all derivatives to fair value on a quarterly basis. The fair value recorded by the Company will change as estimates of future interest rates change. To estimate the impact of changes to interest rates on the forward value of derivatives, the Company would need to estimate all changes to interest rates through the maturity of its outstanding derivatives. The Company has derivatives in the current portfolio that do not mature until 2045. In addition, the Company excludes the changes to the fair value of derivatives from its internal analysis since they represent the net present value of all future estimated cash settlements. Thus, the Company does not estimate the impact of changes in future interest rates to the fair value of its derivatives. The Company does not believe that volatility in the derivative forward value line on the consolidated statements of operations is material as it represents an estimated future value and not a cash impact for the current period.
  
Cash settlements that the Company pays and receives for derivative instruments that do not qualify for hedge accounting are recorded in the cash settlements line in the consolidated statements of operations. Each 25 basis point increase or decrease to the 30-day composite commercial paper index, the three-month LIBOR rate and the six-month LIBOR rate would result in a $5 million increase or decrease in the Company's total cash settlements due to the composition of the portfolio at May 31, 2006. The Company's interest rate exchange agreements at May 31, 2006 include $7,350 million notional amount, or 59% of the total interest rate exchange agreements in which the Company pays a fixed interest rate and receives a variable interest rate. For the remaining $5,186 million notional amount, or 41% of the total interest rate exchange agreements at May 31, 2006, the Company
   

22


pays a variable interest rate and receives a fixed interest rate. Based on the interest rate exchange agreements in place at May 31, 2006, an increase to variable interest rates results in an increase to cash settlements due to CFC.
 
Margin Analysis
 
Results of Operations
 
Fiscal Year 2006 versus 2005 Results
The following chart presents the results for the year ended May 31, 2006 versus May 31, 2005.
   
   

For the year ended May 31,

     

(Dollar amounts in millions)
 


2006

 


2005

 

Increase/ (Decrease)

 
Operating income  

$

1,008

   

$

1,031

   

$

(23

)  
Cost of funds    

(963

)    

(927

)    

(36

)  
Gross margin    

45

     

104

     

(59

)  
Operating expenses:                          
General and administrative expenses    

(52

)    

(49

)    

(3

)  
Rental and other income    

2

     

6

     

(4

)  
Provision for loan losses    

(23

)    

(16

)    

(7

)  
Recovery of guarantee losses    

1

     

3

     

(2

)  
     Total operating expenses    

(72

)    

(56

)    

(16

)  
                           
Results of operations of foreclosed assets    

16

     

13

     

3

   
                           
Derivative and foreign currency adjustments:                          
Derivative cash settlements    

68

     

63

     

5

   
Derivative forward value    

29

     

26

     

3

   
Foreign currency adjustments    

(23

)    

(23

)    

-

   
     Total gain on derivative and foreign currency adjustments    

74

     

66

     

8

   
                           
     Operating margin    

63

     

127

     

(64

)  
Income tax expense    

(3

)    

(2

)    

(1

)  
Minority interest    

(7

)    

(2

)    

(5

)  
Gain on sale of building and land    

43

     

-

     

43

   
     Net margin  

$

96

   

$

123

   

$

(27

)  
                           
TIER    

1.10

     

1.13

           
Adjusted TIER (1)    

1.11

     

1.14

           

 

 
(1) Adjusted to exclude the impact of the derivative forward value, foreign currency adjustments and minority interest from net margin and to include all derivative cash settlements in the cost of funds. See "Non-GAAP Financial Measures" for further explanation and a reconciliation of these adjustments.
  
CFC's gross margin will increase or decrease due to changes in loan volume and the rate that it receives on its loans and pays on its sources of funding, respectively. CFC's loan volume substantially determines its funding needs. The following Volume Rate Variance Table provides a breakout of the change to operating income, cost of funds and gross margin due to changes in loan volume versus changes to interest rates. The analysis is consistent with the May 31, 2006 and 2005 consolidated statements of operations. For comparability purposes, average daily loan volume is used as the denominator in calculating operating income yield, cost of funds rates and gross margin spread.
  
Management calculates an adjusted gross margin, which includes all derivative cash settlements, in its cost of funds. The following table also includes a breakout of the change to derivative cash settlements due to changes in the average notional amount of its derivative portfolio versus changes to the net difference between the average rate paid and the average rate received. See "Non-GAAP Financial Measures" for further explanation of the adjustment the Company makes in its financial analysis to include all derivative cash settlements in its cost of funds.
   

23


Volume Rate Variance Table

(Dollar amounts in millions)

                     
 

For the year ended May 31,

                 
 

2006

 

2005

 

Change due to

 

Average
Loan
Balance


Income/
(Cost)



Rate

 

Average
Loan
Balance


Income/
(Cost)



Rate

 



Volume (1)



Rate (2)



Total

Operating income                                            

CFC

$

15,605

$

847

 

5.43

%  

$

15,494

$

737

 

4.76

%

 

$

5

 

$

105

 

$

110

 

RTFC

 

2,356

 

130

 

5.50

%    

3,863

 

266

 

6.88

%

   

(104

)  

(32

)  

(136

)

NCSC

 

444

 

31

 

7.08

%    

481

 

28

 

5.77

%

   

(2

)  

5

   

3

 

Total

$

18,405

$

1,008

 

5.48

%  

$

19,838

$

1,031

 

5.19

%

 

$

(101

)

$

78

 

$

(23

)
                                                   
Cost of funds                                                  

CFC

$

15,605

$

(814

)

(5.21

)%  

$

15,494

$

(647

)

(4.18

)%

 

$

(5

)

$

(162

)

$

(167

)

RTFC

 

2,356

 

(123

)

(5.21

)%    

3,863

 

(261

)

(6.75

)%

   

102

   

36

   

138

 

NCSC

 

444

 

(26

)

(5.92

)%    

481

 

(19

)

(3.90

)%

   

2

   

(9

)  

(7

)

Total

$

18,405

$

(963

)

(5.23

)%  

$

19,838

$

(927

)

(4.67

)%

 

$

99

 

$

(135

)

$

(36

)
                                                   
Gross margin                                                  

CFC

$

15,605

$

33

 

0.21

%  

$

15,494

$

90

 

0.58

%

 

$

-

 

$

(57

)

$

(57

)

RTFC

 

2,356

 

7

 

0.29

%    

3,863

 

5

 

0.13

%

   

(2

)  

4

   

2

 

NCSC

 

444

 

5

 

1.16

%    

481

 

9

 

1.87

%

   

-

   

(4

)  

(4

)

Total

$

18,405

$

45

 

0.25

%  

$

19,838

$

104

 

0.52

%

 

$

(2

)

$

(57

)

$

(59

)
                                                   
Derivative cash settlements (3)                                            

CFC

$

15,030

$

69

 

0.46

%  

$

15,103

$

65

 

0.43

%

 

$

-

 

$

4

 

$

4

 

NCSC

 

110

 

(1

)

(0.84

)%    

71

 

(2

)

(3.11

)%

   

(1

)  

2

   

1

 

Total

$

15,140

$

68

 

0.45

%  

$

15,174

$

63

 

0.42

%

 

$

(1

)

$

6

 

$

5

 
                                               
Adjusted cost of funds (4)                                              

Total

$

18,405

$

(895

)

(4.86

)%  

$

19,838

$

(864

)

(4.35

)%  

$

98

 

$

(129

)

$

(31

)

 

 
(1) Variance due to volume is calculated using the following formula: ((current average balance - prior year average balance) x prior year rate).
(2) Variance due to rate is calculated using the following formula: ((current rate - prior year rate) x current average balance).
(3) For derivative cash settlements, average loan balance represents the average notional amount of derivative contracts outstanding and the rate represents the net difference between the average rate paid and the average rate received for cash settlements during the period.
(4) See "Non-GAAP Financial Measures" for further explanation of the adjustment the Company makes in its financial analysis to include all derivative cash settlements in its cost of funds.
       
Operating Income
Total operating income reported on the consolidated statements of operations and shown in the chart above includes the following as a percentage of average loans outstanding:
   
   

For the year ended May 31,

     
   

2006

 

2005

     

(Dollar amounts in millions)
   


Amount

 


Rate

     


Amount

 


Rate

   

Increase/ (Decrease)

 
Interest income (1)  

$

971

 

5.28

%

 

$

968

 

4.88

%  

$

3

   
Investment income (2)    

10

 

0.05

%

   

3

 

0.01

%    

7

   
Conversion fees (3)    

14

 

0.08

%

   

18

 

0.09

%    

(4

)  
Make-whole and prepayment fees (4)    

5

 

0.03

%

   

36

 

0.18

%    

(31

)  
Commitment fees (5)    

4

 

0.02

%

   

2

 

0.01

%    

2

   
Guarantee fees (6)    

3

 

0.02

%

   

4

 

0.02

%    

(1

)  
Other fees (7)    

1

 

-

     

-

 

-

     

1

   
     Total operating income  

$

1,008

 

5.48

%

 

$

1,031

 

5.19

%  

$

(23

)  
___________________________________________
(1) Represents interest income on loans to members.
(2) Represents interest income on the investment of excess cash.
(3) Conversion fees are deferred and recognized using the interest method over the remaining term of the original loan interest rate pricing term, except for a small portion of the total fee charged to cover administrative costs related to the conversion which is recognized immediately.
(4) Make-whole and prepayment fees are charged for the early repayment of principal in full and recognized when collected.
(5) Commitment fees are charged only on RTFC loan commitments and in most cases are refundable on a prorata basis according to the amount of the loan commitment that is advanced. Such refundable fees are deferred and then recognized in full if the loan is not advanced prior to the expiration of the commitment.
(6) Guarantee fees are charged based on the amount, type and term of the guarantee. Guarantee fees are deferred and amortized using the straight-line method into operating income over the life of the guarantee.
(7) Other fees include late payment fees charged on late loan payments and recognized when collected and other fees associated with loan origination and the syndication of loans that are deferred and amortized using the straight-line method.
 

24


Total operating income for the year ended May 31, 2006 represented a decrease of $23 million or 2% from the prior year primarily due to the decrease in fee income. There were offsetting changes to operating income due to the increase to interest rates in the markets and to a lower loan volume. During the year ended May 31, 2006, the Company raised variable interest rates by between approximately 180 basis points and 190 basis points depending on the loan program, while fixed interest rates remained relatively stable. The increase to income as a result of higher variable interest rates was also offset by a reduction to operating income as a result of an increase to loans on non-accrual status. For the year ended May 31, 2006, the Company had a reduction to interest income of $79 million due to non-accrual loans, compared to a reduction of $51 million for the prior year period. The decrease in loan volume is due to the prepayment of RTFC loans during the year ended May 31, 2006.
 
Total fee and investment income earned during the year ended May 31, 2006 decreased $26 million from the prior year. The decrease to fee and investment income for the year ended May 31, 2006 was due to a reduction of $31 million in prepayment and make-whole fees, offset slightly by an increase of $7 million to investment income. During the year ended May 31, 2005, there were significant loan prepayments that generated a large amount of prepayment and make-whole fees. The large loan prepayments that occurred during fiscal year 2005 do not represent normal business activity and are not anticipated to occur in the future. The Company does not have a goal of maintaining an investment portfolio as part of the business plan to generate income, but rather the Company will invest excess cash on a short-term basis. Excess cash investments are typically the result of the Company prefunding debt maturities and due to commercial paper and medium-term note investments made late in the day by its members.
 
The $110 million increase in CFC operating income was due to the increase in interest rates partly offset by the impact of non-accrual loans. CFC operating income decreased $36 million for the year ended May 31, 2006 due to holding loans on non-accrual, compared to $27 million for the prior year period. The impact of non-accrual loans on operating income is included in the rate variance in the chart above. The $136 million decrease in RTFC operating income was due to loan prepayments and the impact of non-accrual loans. RTFC operating income decreased $43 million for the year ended May 31, 2006 due to holding loans on non-accrual, compared to $24 million in the prior year period.
  
Cost of Funds
Total cost of funds reported on the consolidated statements of operations and shown in the chart above includes the following:
  
   

For the year ended May 31,

     
   

2006

 

2005

     

(Dollar amounts in millions)
   


Amount

 


Rate

     


Amount

 


Rate

   

Increase/ (Decrease)

 
Interest expense (1)  

$

942

 

5.12

%

 

$

895   

 

4.51

%  

$

47

   
Debt issuance costs (2)    

10

 

0.05

%

   

12   

 

0.06

%    

(2

)  
Derivative cash settlements, net (3)    

3

 

0.02

%

   

8   

 

0.04

%    

(5

)  
Bank, dealer and trustee fees (4)    

9

 

0.05

%

   

11   

 

0.06

%    

(2

)  
Gain on extinguishment of debt (5)    

(2

)

(0.01

) %    

-   

 

-

     

(2

)  
Other fees (6)    

1

 

-

     

1   

 

-

     

-

   
Total cost of funds  

$

963

 

5.23

%

 

$

927   

 

4.67

%  

$

36

   
___________________________________
(1) Represents interest expense on all debt securities including members' subordinated certificates.
(2) Includes amortization of all deferred charges related to debt issuance, principally underwriter's fees, legal fees, printing costs and comfort letter fees. Amortization is calculated on the effective interest method.
(3) Represents the net cost related to swaps that qualify for hedge treatment plus the accrual from the date of the last settlement to the current period end.
(4) Includes various fees related to funding activities, including fees paid to banks participating in the Company's revolving credit agreements, fees paid to dealers related to commercial paper issuance and bond trustee fees. Fees are recognized as incurred or amortized on a straight line basis over the life of the respective agreement.
(5) Represents the gain on the early retirement of debt.
(6) Represents fees associated with NCSC's consumer loan program and other fees.
     
The $36 million increase to the cost of funds for the year ended May 31, 2006 was due to the increase to interest rates in the markets partly offset by lower loan volume and the $11 million decrease to total fees expensed by the Company during the year ended May 31, 2006 as compared to the prior year.
 
The adjusted cost of funds, which includes all derivative cash settlements for the year ended May 31, 2006 increased by $31 million compared to the prior year period due to the increase to cost of funds noted above partially offset by lower fees for swap terminations. See "Non-GAAP Financial Measures" for further explanation of the adjustment the Company makes in its financial analysis to include all derivative cash settlements in its cost of funds. Derivative cash settlements for the year ended May 31, 2006 includes $67 million received for derivative cash settlements from the Company's derivative counterparties and $1 million received from counterparties for the termination of interest rate exchange agreements used as funding for the loans that were prepaid during the period. The derivative cash settlements for the year ended May 31, 2005 includes $85 million of derivative cash settlements received by CFC offset by $22 million of fees paid by CFC for the termination of exchange agreements.
 

25


Gross Margin
The change in the line items described above resulted in a decrease in gross margin of $59 million for the year ended May 31, 2006 compared to the prior year period. The adjusted gross margin, which includes all derivative cash settlements, for the year ended May 31, 2006 was $113 million, a decrease of $54 million from the prior year period. See "Non-GAAP Financial Measures" for further explanation of the adjustment the Company makes in its financial analysis to include all derivative cash settlements in its cost of funds, and therefore gross margin.
  
Operating Expenses
General and administrative expenses were $52 million for the year ended May 31, 2006 compared to $49 million for the year ended May 31, 2005. General and administrative expenses represented 28 basis points of average loan volume for the year ended May 31, 2006 compared to 25 basis points for the prior year period.
   
The $4 million decrease to rental and other income for the year ended May 31, 2006 was due to the sale of CFC's headquarters facility in October 2005. Subsequent to the sale of the building, CFC is not collecting rental income as it is no longer a landlord for the facility.
   
The loan loss provision of $23 million for the year ended May 31, 2006 represented an increase of $7 million compared to the provision for loan losses of $16 million required for the prior year period. The $23 million loan loss provision for the year ended May 31, 2006 was the result of an increase in the calculated loan impairments offset by a decrease in the general reserve as a result of the decrease in the balance of loans outstanding at May 31, 2006 compared to the prior period end.
  
There was a recovery of $1 million from the guarantee liability in the year ended May 31, 2006 compared to $3 million in the prior year period. For the year ended May 31, 2006 and 2005, substantially all guarantees were issued by CFC.
  
Results of Operations of Foreclosed Assets
The Company recorded net income of $16 million and $13 million from the operation of foreclosed assets for the year ended May 31, 2006 and 2005. The results of operations of foreclosed assets for the year ended May 31, 2006 includes a gain of $4 million related to the sale of real estate assets in August 2005. At May 31, 2006, the remaining balance of foreclosed assets is comprised of notes receivable which the Company continues to service.
  
Derivative Cash Settlements
The increase in cash settlements for the year ended May 31, 2006 is primarily due to $1 million of termination fees received during the year ended May 31, 2006 compared to $22 million of termination fees paid during the year ended May 31, 2005 to unwind interest rate exchange agreements that were used as part of the funding for loans that were prepaid during the period. CFC is currently collecting more on its derivative contracts than it is paying.
   
Derivative Forward Value
During the year ended May 31, 2006, the derivative forward value represented an increase of $3 million compared to the prior year period. The increase in the derivative forward value is due to changes in the estimate of future interest rates over the remaining life of the derivative contracts. The derivative forward value for the year ended May 31, 2006 and 2005 also includes amortization of $0.4 million and $16 million, respectively, related to the transition adjustment recorded as an other comprehensive loss on June 1, 2001, the date the Company implemented SFAS 133. This adjustment will be amortized into earnings over the remaining life of the related derivative contracts.
   
The Company is required to record the fair value of derivatives on its consolidated balance sheets with changes in the fair value of derivatives that do not qualify for hedge accounting recorded in the consolidated statements of operations as a current period gain or loss. This change in fair value is recorded as the derivative forward value on the consolidated statements of operations. The derivative forward value does not represent a current period cash inflow or outflow, but represents the net present value of the estimated future cash settlements, which are based on the estimate of future interest rates over the remaining life of the derivative contract. The expected future interest rates change often, causing significant changes in the recorded fair value of derivatives and volatility in the reported estimated gain or loss on derivatives in the consolidated statements of operations. Recording the forward value of derivatives results in recording only a portion of the impact on the Company's operations due to future changes in interest rates. Under GAAP, the Company is required to recognize changes in the fair value of its derivatives as a result of changes to interest rates, but there are no provisions for recording changes in the fair value of its loans or debt outstanding as a result of changes to interest rates. As a finance company, the Company passes on its cost of funding through interest rates on loans to members. The Company has demonstrated the ability to pass on its cost of funding to its members through its ability to consistently earn an adjusted TIER equal to or in excess of the minimum 1.10 target. The Company has earned an adjusted TIER equal to or in excess of 1.10 in every year since 1981. See "Non-GAAP Financial Measures" for further explanation and a reconciliation of adjusted ratios.
   
Foreign Currency Adjustment
The Company's foreign currency adjustment for the year ended May 31, 2006 did not fluctuate compared to the year ended May 31, 2005. Changes in the exchange rate between the U.S. dollar and Euro and the U.S. dollar and Australian dollar may cause the value
   

26


of foreign denominated debt outstanding to fluctuate. An increase in the value of the Euro or the Australian dollar versus the value of the U.S. dollar results in an increase in the recorded U.S. dollar value of foreign denominated debt and therefore a charge to expense on the consolidated statements of operations, while a decrease in exchange rates results in a reduction in the recorded U.S. dollar value of foreign denominated debt and income. The Company has entered into foreign currency exchange agreements to cover all of the cash flows associated with its foreign denominated debt. Changes in the value of the foreign currency exchange agreement will be approximately offset by changes in the value of the outstanding foreign denominated debt.
 
Operating Margin
The change in the line items described above resulted in a decrease in operating margin of $64 million for the year ended May 31, 2006 compared to the prior year period. The adjusted operating margin, which excludes derivative forward value and foreign currency adjustments, for the year ended May 31, 2006 was $57 million, compared to $124 million for the prior year period. See "Non-GAAP Financial Measures" for further explanation of the adjustment the Company makes in its financial analysis to exclude the derivative forward value and foreign currency adjustments in its adjusted operating margin.
 
Gain on Sale of Building and Land
On October 18, 2005, CFC sold its headquarters facility in Fairfax County, Virginia to an affiliate of Prentiss Properties Acquisition Partners, L.P. for $85 million. The assets had a net book value of $40 million, thus generating a total gain of $43 million during the year ended May 31, 2006, net of $2 million in closing and other related costs.
  
Net Margin
The change in the line items described above resulted in a decrease in net margin of $27 million for the year ended May 31, 2006 from the prior year period. The adjusted net margin, which excludes the impact of the derivative forward value and foreign currency adjustments and adds back minority interest, was $97 million, compared to $122 million for the prior year period. See "Non-GAAP Financial Measures" for further explanation of the adjustments the Company makes in its financial analysis to net margin. Adjusted net margin excluding the $43 million gain on the sale of the building and land for the year ended May 31, 2006 was $54 million, a decrease of $68 million from the prior year.
   
Fiscal Year 2005 versus 2004 Results
The following chart presents the results for the year ended May 31, 2005 versus May 31, 2004.
  
   

For the year ended May 31,

     

(Dollar amounts in millions)
 


2005

 


2004

 

Increase/ (Decrease)

 
Operating income  

$

1,031

   

$

1,010

   

$

21

   
Cost of funds    

(927

)    

(928

)

   

1

   
     Gross margin    

104

     

82

     

22

   
Operating expenses:                          
General and administrative expenses    

(49

)    

(47

)

   

(2

)  
Rental and other income    

6

     

6

     

-

   
Provision for loan losses    

(16

)    

(55

)

   

39

   
Recovery of guarantee losses    

3

     

1

     

2

   
     Total operating expenses    

(56

)    

(95

)

   

39

   
                           
Results of operations of foreclosed assets    

13

     

13

     

-

   
Impairment loss on foreclosed assets    

-

     

(11

)

   

11

   
     Total gain on foreclosed assets    

13

     

2

     

11

   
                           
Derivative and foreign currency adjustments:                          
Derivative cash settlements    

63

     

110

     

(47

)  
Derivative forward value    

26

     

(229

)

   

255

   
Foreign currency adjustments    

(23

)    

(65

)

   

42

   
     Total gain (loss) on derivative and foreign currency adjustments    

66

     

(184

)

   

250

   
                           
     Operating margin (loss)    

127

     

(195

)

   

322

   
Income tax expense    

(2

)    

(3

)

   

1

   
Minority interest    

(2

)    

(2

)

   

-

   
Cumulative effect of change in accounting principle    

-

     

22

     

(22

)  
     Net margin (loss)  

$

123

   

$

(178

)

 

$

301

   
                           
TIER (1)    

1.13

     

-

           
Adjusted TIER (2)    

1.14

     

1.12

           

   

27


 

 
(1) For the year ended May 31, 2004, the Company reported a net loss prior to the cumulative effect of change in accounting principle of $200 million, thus the TIER calculation results in a value below 1.00.
(2) Adjusted to exclude the impact of the derivative forward value, foreign currency adjustments and minority interest from net margin and to include all derivative cash settlements in the cost of funds. See "Non-GAAP Financial Measures" for further explanation and a reconciliation of these adjustments.

  
CFC's gross margin will increase or decrease due to changes in loan volume and the rate that it receives on its loans and pays on its sources of funding, respectively. CFC's loan volume substantially determines its funding needs. The following Volume Rate Variance Table provides a breakout of the change to operating income, cost of funds and gross margin due to changes in loan volume versus changes to interest rates. The analysis is consistent with the May 31, 2005 and 2004 consolidated statements of operations. For comparability purposes, average daily loan volume is used as the denominator in calculating operating income yield, cost of funds rates and gross margin spread.
 
Management calculates an adjusted gross margin, which includes all derivative cash settlements, in its cost of funds. The following table also includes a breakout of the change to derivative cash settlements due to changes in the average notional amount of its derivative portfolio versus changes to the net difference between the average rate paid and the average rate received. See "Non-GAAP Financial Measures" for further explanation of the adjustment the Company makes in its financial analysis to include all derivative cash settlements in its cost of funds.
 

Volume Rate Variance Table

(Dollar amounts in millions)

                     
 

For the year ended May 31,

                 
 

2005

 

2004

 

Change due to

 

Average
Loan
Balance


Income/
(Cost)



Rate

 

Average
Loan
Balance


Income/
(Cost)



Rate

 



Volume (1)



Rate (2)



Total

Operating Income

CFC

$

15,494

$

737

 

4.76

%  

$

14,982

$

674

 

4.50 

%

 

$

23

 

$

40 

 

$

63

 

RTFC

 

3,863

 

266

 

6.88

%    

4,809

 

308

 

6.40 

%

   

(60

)  

18 

   

(42

)

NCSC

 

481

 

28

 

5.77

%    

541

 

28

 

5.11 

%

   

(3

)  

   

-

 

Total

$

19,838

$

1,031

 

5.19

%  

$

20,332

$

1,010

 

4.97 

%

 

$

(40

)

$

61 

 

$

21 

 
                                                   
Cost of funds                                                  

CFC

$

15,494

$

(647

)

(4.18

)%  

$

14,982

$

(609

)

(4.06

)%

 

$

(21

)

$

(17

)

$

(38

)

RTFC

 

3,863

 

(261

)

(6.75

)%    

4,809

 

(301

)

(6.27

)%

   

59

   

(19

)  

40

 

NCSC

 

481

 

(19

)

(3.90

)%    

541

 

(18

)

(3.26

)%

   

2

   

(3

)  

(1

)

Total

$

19,838

$

(927

)

(4.67

)%  

$

20,332

$

(928

)

(4.57

)%

 

$

40

 

$

(39

)

$

1

 
                                                     
Gross margin                                                  

CFC

$

15,494

$

90

 

0.58

%  

$

14,982

$

65

 

0.44

%

 

$

2

 

$

23

 

$

25

 

RTFC

 

3,863

 

5

 

0.13

%    

4,809

 

7

 

0.13

%

   

(1

)  

(1

)  

(2

)

NCSC

 

481

 

9

 

1.87

%    

541

 

10

 

1.85

%

   

(1

)  

   

(1

)

Total

$

19,838

$

104

 

0.52

%  

$

20,332

$

82

 

0.40

%

 

$

-

 

$

22 

 

$

22

 
                                                   
Derivative Cash Settlements (3)                                            

CFC

$

15,103

$

65

 

0.43

%  

$

16,616

$

114

 

0.68

%

 

$

(11

)

$

(38

)

$

(49

)

NCSC

 

71

 

(2

)

(3.11

)%    

83

 

(4

)

(4.38

)%

   

1

   

1

   

2

 

Total

$

15,174

$

63

 

0.42

%  

$

16,699

$

110

 

0.66

%

 

$

(10

)

$

(37

)

$

(47

)
                                                   
Adjusted cost of funds (4)                                              

Total

$

19,838

$

(864

)

(4.35

)%  

$

20,332

$

(818

)

(4.03

)%  

$

30

 

$

(76

)

$

(46

)

 

   

(1)

Variance due to volume is calculated using the following formula: ((current average balance - prior year average balance) x prior year rate).

(2)

Variance due to rate is calculated using the following formula: ((current rate - prior year rate) x current average balance).

(3)

For derivative cash settlements, average loan balance represents the average notional amount of derivative contracts outstanding and the rate represents the net difference between the average rate paid and the average rate received for cash settlements during the period.

(4)

See "Non-GAAP Financial Measures" for further explanation of the adjustment the Company makes in its financial analysis to include all derivative cash settlements in its cost of funds.
  

28


Operating Income
Total operating income reported on the consolidated statements of operations and shown in the chart above includes the following:
   
   

For the year ended May 31,

     
   

2005

 

2004

     
(Dollar amounts in millions)    


Amount

 


Rate

     


Amount

 


Rate

   

Increase/ (Decrease)

 
Interest income (1)  

$

968

 

4.88

%

 

$

976

 

4.80

%  

$

(8

)  
Investment income (2)    

3

 

0.01

%

   

1

 

0.01

%    

2

   
Conversion fees (3)    

18

 

0.09

%

   

24

 

0.12

%    

(6

)  
Make-whole and prepayment fees (4)    

36

 

0.18

%

   

2

 

0.01

%    

34

   
Commitment fees (5)    

2

 

0.01

%

   

3

 

0.01

%    

(1

)  
Guarantee fees (6)    

4

 

0.02

%

   

3

 

0.01

%    

1

   
Other fees (7)    

-

 

-

     

1

 

0.01

%

   

(1

)  
Total operating income  

$

1,031

 

5.19

%

 

$

1,010

 

4.97

%  

$

21

   

 

 
(1) Represents interest income on loans to members.
(2) Represents interest income on the investment of cash.
(3) Conversion fees are deferred and recognized using the interest method over the remaining term of the original loan interest rate pricing term, except for a small portion of the total fee charged to cover administrative costs related to the conversion which is recognized immediately.
(4) Make-whole and prepayment fees are charged for the early repayment of principal in full and recognized when collected
(5) Commitment fees are charged only on RTFC loan commitments and in most cases are refundable on a prorata basis according to the amount of the loan commitment that is advanced. Such refundable fees are deferred and then recognized in full if the loan is not advanced prior to the expiration of the commitment.
(6) Guarantee fees are charged based on the amount, type and term of the guarantee. Guarantee fees are deferred and amortized using the straight-line method into operating income over the life of the guarantee.
(7) Other fees include late payment fees charged on late loan payments and recognized when collected and other fees associated with loan origination and the syndication of loans that are deferred and amortized using the straight-line method.
 
Total operating income for the year ended May 31, 2005 represented an increase of $21 million or 2% from the prior year primarily due to the increase in fee income. Interest income decreased $8 million due to the impact of loans on non-accrual and lower loan volume offset by the increase to interest rates in the markets. During the year ended May 31, 2005, the Company raised variable interest rates by between approximately 210 basis points and 235 basis points depending on the loan program, while fixed interest rates remained relatively stable. For the year ended May 31, 2005, the Company had a reduction to interest income of $51 million due to non-accrual loans, compared to a reduction of $23 million for the prior year. The decrease in loan volume is due to the prepayment of RTFC loans during the year ended May 31, 2005.
  
Total fee and investment income earned during the year ended May 31, 2005 increased $29 million from the prior year. The increase to fee and investment income for the year ended May 31, 2005 was primarily due to an increase of $34 million in prepayment and make-whole fees. During the year ended May 31, 2005, there were significant loan prepayments that generated a large amount of prepayment and make-whole fees. The large loan prepayments that occurred during fiscal year 2005 do not represent normal business activity and are not anticipated to occur in the future.
  
The $63 million increase in CFC operating income was due to the increase in interest rates partly offset by the impact of non-accrual loans. The impact of non-accrual loans at CFC was a decrease in operating income of $27 million for fiscal year 2005, compared to a decrease of $23 million for the prior year. The impact of non-accrual loans on operating income is included in the rate variance in the chart above. The $42 million decrease in RTFC operating income was due to loan prepayments and the impact of rising interest rates partially offset by the impact of non-accrual loans. The impact of non-accrual loans on RTFC operating income was a decrease of $24 million for fiscal year 2005, compared to no reduction in the prior year.
  
Cost of Funds 
Total cost of funds reported on the consolidated statements of operations and shown in the chart above includes the following:
  
   

For the year ended May 31,

     
   

2005

 

2004

     
(Dollar amounts in millions)    


Amount

 


Rate

     


Amount

 


Rate

   

Increase/ (Decrease)

 
Interest expense (1)  

$

895

 

4.51

%

 

$

891

 

4.38

%  

$

4

   
Debt issuance costs (2)    

12

 

0.06

%

   

12

 

0.06

%    

-

   
Derivative cash settlements, net (3)    

8

 

0.04

%

   

9

 

0.05

%    

(1

)  
Bank, dealer and trustee fees (4)    

11

 

0.06

%

   

9

 

0.05

%    

2

   
Loss on extinguishment of debt (5)    

-

 

-

     

6

 

0.03

%    

(6

)  
Other fees (6)    

1

 

-

     

1

 

-

     

-

   
Total cost of funds  

$

927

 

4.67

%

 

$

928

 

4.57

%  

$

(1

)  
   

29


 

 
(1) Represents interest expense on all debt securities including members' subordinated certificates.
(2) Includes amortization of all deferred charges related to debt issuance, principally underwriter's fees, legal fees, printing costs and comfort letter fees. Amortization is calculated on the effective interest method.
(3) Represents the net cost related to swaps that qualify for hedge treatment plus the accrual from the date of the last settlement to the current period end.
(4) Includes various fees related to funding activities, including fees paid to banks participating in the Company's revolving credit agreements, fees paid to dealers related to commercial paper issuance and bond trustee fees. Fees are recognized as incurred or amortized on a straight line basis over the life of the respective agreement.
(5) Represents the loss on the early retirement of debt.
(6) Represents fees associated with NCSC's consumer loan program and other fees.

The total cost of funding for the year ended May 31, 2005 was consistent with the prior year as the increase to interest rates in the markets was offset by lower loan volume and fee expenses. The adjusted cost of funds, which includes all derivative cash settlements, for fiscal year 2005 increased by $46 million compared to the prior year due to the decrease in derivative cash settlements. See "Non-GAAP Financial Measures" for further explanation of the adjustment the Company makes in its financial analysis to include all derivative cash settlements in its cost of funds. The $47 million decrease in derivative cash settlements includes $22 million of fees paid to counterparties for the termination of interest rate exchange agreements used as funding for the loans that were prepaid during the year ended May 31, 2005.

Gross Margin
The change in the line items described above resulted in an increase in gross margin of $22 million for the year ended May 31, 2005 compared to the prior year period. The adjusted gross margin, which includes all derivative cash settlements, for the year ended May 31, 2005 was $167 million, a decrease of $25 million from the prior year. See "Non-GAAP Financial Measures" for further explanation of the adjustment the Company makes in its financial analysis to include all derivative cash settlements in its cost of funds, and therefore gross margin.

Operating Expenses
General and administrative expenses for the year ended May 31, 2005 were $49 million compared to $47 million for the year ended May 31, 2004. General and administrative expenses represented 25 basis points of average loan volume for the year ended May 31, 2005, an increase of 2 basis points as compared to 23 basis points for the prior year period.
 
The loan loss provision of $16 million for the year ended May 31, 2005 represented a decrease of $39 million from the provision of $55 million for the prior year period. The Company's loan loss provision of $16 million at May 31, 2005 was due to an increase in the calculated impairments of $171 million offset by a decrease of $97 million for high risk loans and a reduction of $58 million to the allowance for all other loans. The increase to the calculated impairments was due to both an increase in the principal balance of loans classified as impaired and to an increase in the variable interest rates at May 31, 2005 as compared to the prior year. The decrease to the allowance for high risk loans was due to one borrower which moved from high risk to impaired due to ongoing litigation. The reduction to the allowance for all other loans was primarily due to a significant reduction in the balance of loans outstanding at May 31, 2005 as compared to the prior year. The $16 million loan loss provision was recorded at CFC during the year ended May 31, 2005. Under an agreement with RTFC and NCSC, CFC will reimburse both companies for loan losses, with the exception of the NCSC consumer loan and grant programs. There was no loan loss provision required at NCSC during the year ended May 31, 2005. The NCSC loan loss allowance decreased by approximately $1 million due to a decrease in the principal balance of NCSC consumer loans.
 
There was a recovery of $3 million from the guarantee liability in the year ended May 31, 2005 compared to $1 million in the year ended May 31, 2004. The recovery of $3 million during the year ended May 31, 2005 was due to a change in the maturity of a guaranteed bond due to a scheduled redemption in fiscal year 2006. At both May 31, 2005 and 2004, substantially all guarantees were issued by CFC.

Gain on Foreclosed Assets
The Company recorded net income of $13 million from the operation of foreclosed assets for the years ended May 31, 2005 and 2004. In addition, the Company recognized an impairment loss of $11 million to reflect the decrease in the fair value of certain foreclosed assets during the year ended May 31, 2004. The impairment loss recorded during the year ended May 31, 2005 was insignificant. It is not management's intent to hold and operate these assets, but to preserve the value for sale at the appropriate time.
 
Derivative Cash Settlements
The total cash settlements decreased for fiscal year 2005 as compared to the prior year due to a reduction in the amount of interest rate exchange agreements in place and to a reduction in the net difference between the average rates paid and received. In addition, a total of $22 million of termination fees were paid during fiscal year 2005 to unwind interest rate exchange agreements that were used as part of the funding for loans that were prepaid during the year. The total cash settlements received in fiscal year 2005, prior to the $22 million of termination fees, was $85 million, which is a reduction of $25 million from the prior year.
   

30


Derivative Forward Value
During the year ended May 31, 2005, derivative forward value increased $255 million compared to the prior year period. The increase in the derivative forward value is due to changes in the estimate of future interest rates over the remaining life of the derivative contracts. The derivative forward value for the years ended May 31, 2005 and 2004 also includes amortization of $16 million and $17 million, respectively, related to the transition adjustment recorded as an other comprehensive loss on June 1, 2001, the date the Company implemented SFAS 133. This adjustment will be amortized into earnings over the remaining life of the related derivative contracts.
  
The Company is required to record the fair value of derivatives on its consolidated balance sheets with changes in the fair value of derivatives that do not qualify for hedge accounting recorded in the consolidated statements of operations as a current period gain or loss. This change in fair value is recorded as the derivative forward value on the consolidated statements of operations. The derivative forward value does not represent a current period cash inflow or outflow, but represents the net present value of the estimated future cash settlements, which are based on the estimate of future interest rates over the remaining life of the derivative contract. The expected future interest rates change often, causing significant changes in the recorded fair value of derivatives and volatility in the reported estimated gain or loss on derivatives in the consolidated statements of operations. Recording the forward value of derivatives results in recording only a portion of the impact on the Company's operations due to future changes in interest rates. Under GAAP, the Company is required to recognize changes in the fair value of its derivatives as a result of expected changes in future interest rates, but there are no provisions for recording changes in the fair value of its loans or debt outstanding as a result of expected changes in future interest rates. As a finance company, the Company passes on its cost of funding through interest rates on loans to members. The Company has demonstrated the ability to pass on its cost of funding to its members through its ability to consistently earn an adjusted TIER in excess of the minimum 1.10 target. The Company has earned an adjusted TIER in excess of 1.10 in every year since 1981. See "Non-GAAP Financial Measures" for further explanation and a reconciliation of adjusted ratios.
  
Foreign Currency Adjustment
There was a decrease in the expense recorded as a foreign currency adjustment of $42 million for the year ended May 31, 2005 as compared to the year ended May 31, 2004 due to the change in currency exchange rates. Changes in the exchange rate between the U.S. dollar and Euro and the U.S. dollar and Australian dollar caused the value of foreign denominated debt outstanding to fluctuate. An increase in the value of the Euro or the Australian dollar versus the value of the U.S. dollar results in an increase in the recorded U.S. dollar value of foreign denominated debt and therefore a charge to expense on the consolidated statements of operations, while a decrease in exchange rates results in a reduction in the recorded U.S. dollar value of foreign denominated debt and income. The Company has entered into foreign currency exchange agreements to cover all of the cash flows associated with its foreign denominated debt. Changes in the value of the foreign currency exchange agreement will be approximately offset by changes in the value of the outstanding foreign denominated debt.
  
Operating Margin (Loss)
Operating margin for the year ended May 31, 2005 was $127 million, compared to a loss of $195 million for the prior year period. The significant increase in the operating margin for the year ended May 31, 2005 compared to the prior year period was primarily due to the $255 million increase in the estimated fair value of derivatives. The adjusted operating margin, which excludes derivative forward value and foreign currency adjustments, for the year ended May 31, 2005 was $124 million, compared to $99 million for the prior year period. See "Non-GAAP Financial Measures" for further explanation of the adjustment the Company makes in its financial analysis to exclude the derivative forward value and foreign currency adjustments in its adjusted operating margin. The adjusted operating margin increased due to the $39 million decrease in the provision for loan losses and the $11 million increase in the gain on foreclosed assets offset by the $25 million decrease in adjusted gross margin.
   
Cumulative Effect of Change in Accounting Principle
As a result of the implementation of Financial Accounting Standards Board ("FASB") Interpretation No. ("FIN") 46(R), Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51, effective June 1, 2003, CFC consolidated the financial results of NCSC and RTFC. The Company recorded a cumulative effect of change in accounting principle gain of $22 million on the consolidated statement of operations for the year ended May 31, 2004.
   
Net Margin (Loss)
Net margin for the year ended May 31, 2005 was $123 million, an increase of $301 million compared to a net loss of $178 million for the prior year period. The net margin for the year ended May 31, 2005 and the significant increase from the prior year period was primarily due to the $255 million increase in the estimated fair value of derivatives. The adjusted net margin, which excludes the impact of the derivative forward value, foreign currency adjustments and cumulative effect of change in accounting principle and adds back minority interest, was $122 million and $96 million for the year ended May 31, 2005 and 2004, respectively. See "Non-GAAP Financial Measures" for further explanation of the adjustments the Company makes in its financial analysis to net margin (loss).
   

31


Operating Results as a Percentage of Average Loans Outstanding
The following is a summary of the Company's operating results as a percentage of average loans outstanding for the fiscal years ended May 31, 2006, 2005 and 2004.
    
   

2006

 

2005

 

2004

 
Operating income    

5.48

%    

5.19

%    

4.97

%  
Cost of funds    

(5.23

)%    

(4.67

)%    

(4.57

)%  
     Gross margin    

0.25

%    

0.52

%    

0.40

%  
Operating expenses:                          
General and administrative expenses    

(0.28

)%    

(0.25

)%    

(0.23

)%  
Rental and other income    

0.01

%    

0.03

%    

0.03

%  
Provision for loan losses    

(0.13

)%    

(0.08

)%    

(0.27

)%  
Recovery of guarantee losses    

0.01

%    

0.02

 %    

-

   
     Total operating expenses    

(0.39

)%    

(0.28

)%    

(0.47

)%  
                           
Results of operations of foreclosed assets    

0.08

%    

0.07

%    

0.06

%  
Impairment loss on foreclosed assets    

-

     

-

     

(0.05

)%  
     Total gain on foreclosed assets    

0.08

%    

0.07

%    

0.01

%  
                           
Derivative cash settlements    

0.37

%    

0.32

%    

0.54

%  
Derivative forward value    

0.16

%    

0.13

%    

(1.12

)%  
Foreign currency adjustments    

(0.13

)%    

(0.12

)%    

(0.32

)%  

     Total gain (loss) on derivative and foreign currency
         adjustments

   

0.40

%    

0.33

%    

(0.90

) %  
                           

     Operating margin (loss)

   

0.34

%    

0.64

%    

(0.96

)%  
Income tax expense    

(0.01

)%    

(0.01

)%    

(0.02

)%  
Minority interest    

(0.04

)%    

(0.01

)%    

(0.01

)%  
Gain on sale of building and land    

0.23

%    

-

     

-

   
Cumulative effect of change in accounting principle    

-

     

-

     

0.11

%  
     Net margin (loss)    

0.52

%    

0.62

%    

(0.88

) %  
Adjusted gross margin (1)    

0.62

%    

0.84

%    

0.94

%  
Adjusted operating margin (2)    

0.31

%    

0.63

%    

0.48

%  

 

 
(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.
(2) Adjusted to exclude derivative forward value and foreign currency adjustments from the operating margin (loss). See "Non-GAAP Financial Measures" for further explanation and a reconciliation of these adjustments.
 
Ratio of Earnings to Fixed Charges
The following chart provides the calculation of the ratio of earnings to fixed charges for the years ended May 31, 2006, 2005 and 2004. The ratio of earnings to fixed charges is the same calculation as TIER. See the Results of Operations for discussion on TIER and adjustments that the Company makes to the TIER calculation.
   
(Dollar amounts in millions)    

2006

     

2005

     

2004

   
Margin (loss) prior to cumulative effect of                          
     change in accounting principle   $

96

    $

123

    $

(200

)  
     Add: fixed charges    

963

     

927

     

928

   
                           
Margins available for fixed charges   $

1,059

    $

1,050

    $

728

   
                           
Total fixed charges:                          
Interest on all debt (including amortization of                          
     discount and issuance costs)   $

963

    $

927

    $

928

   
                           
Ratio of margins to fixed charges (1)    

1.10

     

1.13

     

-

   

 

 
(1) For the year ended May 31, 2004, earnings were insufficient to cover fixed charges by $200 million.
  
Financial Condition
 
Loan and Guarantee Portfolio Assessment
Loan Programs
Loans to members bear interest at rates determined from time to time by the Company after considering its cost of funds, operating expenses, provision for loan losses and the maintenance of reasonable margin levels. In keeping with its not-for-profit, cooperative charter, the Company's policy is to set interest rates at the lowest levels it considers to be consistent with sound financial management.
   

32


The following chart summarizes loans by type and by segment at May 31:
   
 

Loans by Type

   
(Dollar amounts in millions)

2006

 

2005

     
Long-term loans (1):                                                
Long-term fixed rate loans

$

14,763

     

80%

   

$

12,936

     

68%

                   
Long-term variable rate loans  

2,570

     

14%

     

5,009

     

27%

                   
     Total long-term loans  

17,333

     

94%

     

17,945

     

95%

                   
Short-term loans (2)  

1,028

     

6%

     

1,027

     

5%

                   
     Total loans

$

18,361

     

100%

   

$

18,972

     

100%

                   
  
 

Loans by Segment

   
(Dollar amounts in millions)

2006

 

2005

     
CFC:                                                
Distribution

$

12,859

     

70%

   

$

12,729

     

67%

                   
Power supply  

2,811

     

15%

     

2,641

     

14%

                   
Statewide and associate  

125

     

1%

     

135

     

1%

                   
     CFC Total  

15,795

     

86%

     

15,505

     

82%

                   
RTFC  

2,162

     

12%

     

2,992

     

16%

                   
NCSC  

404

     

2%

     

475

     

2%

                   
     Total

$

18,361

     

100%

   

$

18,972

     

100%

                   
______________________________
(1) Includes loans classified as restructured and non-performing and RUS guaranteed loans.
(2) Consists of secured and unsecured intermediate-term and line of credit loans that are subject to interest rate adjustment monthly or semi-monthly.

  
The Company's loans outstanding have decreased $611 million or 3% during the year ended May 31, 2006 as a result of loan prepayments by RTFC borrowers. Long-term fixed rate loans at May 31, 2006 and 2005 represented 85% and 72%, respectively, of total long-term loans. Loans converting from a variable rate to a fixed rate for the year ended May 31, 2006 totaled $1,754 million, which was offset by $77 million of loans that converted from a fixed rate to a variable rate. This resulted in a net conversion of $1,677 million from a variable rate to a fixed rate for the year ended May 31, 2006. For the year ended May 31, 2005, loans converting from a fixed rate to a variable rate totaled $700 million, which was offset by $690 million of loans that converted from a variable rate to a fixed rate. This resulted in a net conversion of $10 million from a fixed rate to a variable rate for the year ended May 31, 2005.
  
The following chart summarizes loans and guarantees outstanding by segment at May 31:
  
(Dollar amounts in millions)

2006

 

2005

 

2004

 
CFC:                                                
     Distribution

$

12,929

     

67%

   

$

12,771

     

64%

   

$

12,597

     

58%

   
     Power supply  

3,733

     

19%

     

3,707

     

18%

     

3,815

     

18%

   
     Statewide and associate  

158

     

1%

     

177

     

1%

     

246

     

1%

   
          CFC Total  

16,820

     

87%

     

16,655

     

83%

     

16,658

     

77%

   
RTFC  

2,162

     

11%

     

2,992

     

15%

     

4,643

     

21%

   
NCSC  

458

     

2%

     

483

     

2%

     

519

     

2%

   
          Total

$

19,440

     

100%

   

$

20,130

     

100%

   

$

21,820

     

100%

   
  
The following table summarizes the RTFC segment loans and guarantees outstanding as of May 31:
  
(Dollar amounts in millions)  

2006

 

2005

 

2004

 
Rural local exchange carriers  

$

1,815

     

84%

   

$

2,358

     

79%

   

$

3,615

     

78%

   
Cable television providers    

179

     

8%

     

169

     

6%

     

176

     

4%

   
Long distance carriers    

89

     

5%

     

135

     

5%

     

340

     

7%

   
Fiber optic network providers    

41

     

2%

     

67

     

2%

     

168

     

4%

   
Competitive local exchange carriers    

28

     

1%

     

45

     

1%

     

62

     

1%

   
Wireless providers    

5

     

-

     

211

     

7%

     

267

     

6%

   
Other    

5

     

-

     

7

     

-

     

15

     

-

   
     Total  

$

2,162

     

100%

   

$

2,992

     

100%

   

$

4,643

     

100%

   
   
The Company's members are widely dispersed throughout the United States and its territories, including 49 states, the District of Columbia and two U.S. territories. At May 31, 2006, 2005 and 2004, loans and guarantees outstanding to members in any one state or territory did not exceed 16%, 16% and 17%, respectively, of total loans and guarantees outstanding.
   

33


Credit Concentration
CFC, RTFC and NCSC each have policies that limit the amount of credit that can be extended to individual borrowers or a controlled group of borrowers. The credit limitation policies set the limit on the total exposure and unsecured exposure to the borrower based on an assessment of the borrower's risk profile and the Company's internal risk rating system. As a member owned cooperative, the Company makes best efforts to balance meeting the needs of its member/owners and mitigating the risk associated with concentrations of credit exposure. The respective boards of directors must approve new credit requests from a borrower with a total exposure or unsecured exposure in excess of the limits in the policy. Management of credit concentrations may include the use of syndicated credit agreements.
   
The Company's credit limitation policy sets the limit on the total exposure and unsecured exposure to the borrower based on an assessment of the borrower's risk profile.
   
Total exposure, as defined by the policy, includes the following:

* loans outstanding, excluding loans guaranteed by RUS,

* the Company's guarantees of the borrower's obligations,

* unadvanced loan commitments, and

* borrower guarantees to the Company of another borrower's debt.

  
At May 31, 2006 and 2005, the total exposure outstanding to any one borrower or controlled group did not exceed 3.0% of total loans and guarantees outstanding. At May 31, 2006, the ten largest borrowers included four distribution systems, five power supply systems and one telecommunications system. At May 31, 2005, the ten largest borrowers included four distribution systems, three power supply systems and three telecommunications systems. The following chart shows the exposure to the ten largest borrowers as a percentage of total exposure at May 31:
    
   

2006

   

2005

 
(Dollar amounts in millions)  

Amount

 

% of Total

   

Amount

 

% of Total

 
Total by type:                    
Loans

$

3,140

 

17%

 

$

3,412

 

18%

 
  Guarantees  

267

 

25%

   

227

 

20%

 
     Total credit exposure

$

3,407

 

18%

 

$

3,639

 

18%

 
                     
Total by segment:                    
   CFC

$

2,856

 

17%

 

$

2,523

 

15%

 
   RTFC  

488

 

23%

   

1,096

 

37%

 
   NCSC  

63

 

14%

   

20

 

4%

 
Total credit exposure

$

3,407

 

18%

 

$

3,639

 

18%

 
      
Security Provisions
Except when providing lines of credit and intermediate-term loans, the Company typically lends to its members on a senior secured basis. 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. Guarantee reimbursement obligations are typically secured on a parity with other secured creditors by all assets and revenues of the borrower or by the underlying financed asset. In addition to the collateral received, borrowers are also required to set rates designed to achieve certain financial ratios.
  
The following table summarizes the Company's unsecured credit exposure by type and by segment at May 31:
 
   

2006

   

2005

         
(Dollar amounts in millions)  

Amount

 

% of Total

   

Amount

 

% of Total

         
Total by type:                            
Loans

$

1,554

 

8%

 

$

1,516

 

8%

         
  Guarantees  

144

 

13%

   

98

 

8%

         
     Total credit exposure

$

1,698

 

9%

 

$

1,614

 

8%

         
                             
Total by segment:                            
   CFC

$

1,358

 

8%

 

$

1,281

 

8%

         
   RTFC  

241

 

11%

   

244

 

8%

         
   NCSC  

99

 

22%

   

89

 

18%

         
Total credit exposure

$

1,698

 

9%

 

$

1,614

 

8%

         
 

34


Non-performing Loans
A borrower is classified as non-performing 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.
   
Once a borrower is classified as non-performing, CFC typically places the loan on non-accrual status and reverses all accrued and unpaid interest back to the date of the last payment. The Company generally applies all cash received during the non-accrual period to the reduction of principal, thereby foregoing interest income recognition. At May 31, 2006 and 2005, the Company had non-performing loans outstanding in the amount of $578 million and $617 million, respectively. All loans classified as non-performing were on a non-accrual status with respect to the recognition of interest income.
 
At May 31, 2006 and 2005, non-performing loans include $488 million and $475 million, respectively, to ICC. ICC is a diversified telecommunications company and RTFC borrower headquartered in St. Croix, United States Virgin Islands ("USVI"). Through its subsidiaries, ICC provides wire line local telephone service, long-distance telephone services, cable television service and/or wireless telephone service. All loans to ICC have been on non-accrual status since February 1, 2005. ICC has not made debt service payments to the Company since June 2005.
  
RTFC is the primary secured lender to ICC. RTFC's collateral for the loans includes (i) a series of mortgages, security agreements, financing statements, pledges and guaranties creating liens in favor of RTFC on substantially all of the assets and voting stock of ICC, (ii) a direct pledge of 100% of the voting stock of Vitelco, (iii) secured guaranties, mortgages and direct and indirect stock pledges encumbering the assets and ownership interests in substantially all of ICC's other operating subsidiaries and certain of its parent entities, including Emcom and ICC-LLC, and (iv) a personal guaranty of the loans from ICC's indirect majority shareholder and chairman, Prosser.
  
Beginning on June 1, 2004, RTFC filed a series of lawsuits against ICC, Prosser and others for failure to comply with the terms of ICC's loan agreement with RTFC dated August 27, 2001 as amended on April 4, 2003 (hereinafter, the "RTFC Lawsuits"). In response to the RTFC Lawsuits, ICC, Vitelco and Prosser denied liability and asserted claims, by way of counterclaim and by filing its own lawsuits against RTFC, CFC and certain of RTFC's officers, seeking various remedies, including reformation of the loan agreement, injunctive relief, and damages. The remedies were based on various theories including a claim that RTFC breached an alleged funding obligation for the settlement of litigation brought by Emcom shareholders (the "Greenlight Entities") against ICC-LLC, ICC and some of ICC's directors, and a claim that Emcom and ICC-LLC were entitled to contribution from RTFC and CFC in connection with judgments that the Greenlight Entities had been awarded (the "ICC Claims," together with the RTFC Lawsuits, the "Loan Litigation"). Venue of the Loan Litigation ultimately was fixed in the District Court for the District of the Virgin Islands.
  
On February 10, 2006, Greenlight filed petitions for involuntary bankruptcy against Prosser, Emcom and ICC-LLC in the United States Bankruptcy Court for the District of Delaware. RTFC has appeared in the proceedings as a party-in-interest in accordance with the provisions of the United States Bankruptcy Code. The alleged debtors have filed motions seeking change of venue and dismissal of the involuntary petitions. In addition, Emcom and ICC-LLC have moved to require Greenlight to post a bond to indemnify them for damages in the event the involuntary bankruptcy proceedings are dismissed. RTFC has filed responses seeking denial of all such motions.
  
On April 26, 2006, RTFC reached a settlement of the Loan Litigation with ICC, Vitelco, ICC-LLC, Emcom, their directors and Prosser, individually. Under the settlement, RTFC obtained entry of judgments in the District Court for the District of the Virgin Islands against ICC for approximately $525 million and Prosser for approximately $100 million. RTFC also obtained dismissals with prejudice of all counterclaims, affirmative defenses and other lawsuits alleging wrongful acts by RTFC, certain of its officers, and CFC. Various parties also reached agreement for ICC to satisfy the RTFC judgments in the third quarter of calendar year 2006, subject to certain terms and conditions. In the event that does not occur, RTFC intends to pursue collection of the judgments.
  
On July 31, 2006, ICC-LLC, and Emcom each filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code in the United States District Court for the Virgin Islands, Division of St. Thomas and St. John, Bankruptcy Division, and Prosser, individually, filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the District of Virgin Islands. Each of the debtors is obligated to RTFC, for certain obligations of ICC, including court judgments, to RTFC.
  
Based on its analysis, the Company believes that it is adequately reserved for its exposure to ICC at May 31, 2006.
   

35


Non-performing loans at May 31, 2006 and 2005 include a total of $90 million and $135 million, respectively, to VarTec. VarTec is a telecommunications company and RTFC borrower located in Dallas, Texas. RTFC is VarTec's principal senior secured creditor. At May 31, 2006 and 2005, all loans to VarTec were on non-accrual status, resulting in the application of all payments received against principal.
  
VarTec filed voluntary petitions under Chapter 11 of the United States Bankruptcy Code on November 1, 2004. On July 29, 2005, the court approved a sale of VarTec's remaining operating assets (the "Domestic Assets Sale"). In August 2005, RTFC received $32 million representing partial payment of proceeds from the Domestic Assets Sale. Final proceeds from the closing of the Domestic Assets Sale were received in June 2006 totaling $40 million. Pursuant to court order, all net proceeds of asset sales, including the Domestic Assets Sale, have been provisionally applied to RTFC's secured debt. The application is subject to third parties' rights, if any, superior to RTFC's rights and liens, and to further court order to require the return of such funds for use as cash collateral under the Bankruptcy Code. On June 19, 2006, the Chapter 11 proceedings were converted to Chapter 7 proceedings and a Chapter 7 trustee was appointed for each of the estates.
 
On June 10, 2005, the Official Committee of Unsecured Creditors (the "UCC") initiated an adversary proceeding in the United States Bankruptcy Court for the Northern District of Texas, Dallas Division. As a result of the conversion of the proceedings to Chapter 7, the UCC has been dissolved and the Chapter 7 trustee is now the plaintiff in the adversary proceedings. The adversary proceeding asserts the following claims: (i) that RTFC may have engaged in wrongful activities prior to the filing of the bankruptcy proceeding (e.g., RTFC had "control" over VarTec's affairs, RTFC exerted "financial leverage" over VarTec and is liable for VarTec's "deepening insolvency"); (ii) that RTFC's claims against VarTec should be equitably subordinated to the claims of other creditors because of the alleged wrongful activities; and (iii) that certain payments made by VarTec to RTFC and certain liens granted to RTFC are avoidable as preferences or fraudulent transfers or should otherwise be avoided and re-distributed for the benefit of VarTec's bankruptcy estates. The adversary proceeding identifies payments made by VarTec to RTFC of approximately $141 million, but does not specify damages sought. On December 16, 2005, the Court issued an order dismissing the "deepening insolvency" claim against RTFC. Trial, if necessary, on the merits of the remaining claims is currently scheduled for March 5, 2007. The trial date is subject to change.
 
On October 14, 2005, the Bankruptcy Court approved an administrative DIP facility from RTFC in the amount of $9 million, of which $9 million was outstanding as of May 31, 2006. The DIP facility was extended on March 17, 2006, but RTFC has no obligation to fund beyond those budgeted expenses which accrued prior to June 15, 2006. However, RTFC may consider providing the estate with further DIP funding to pursue the collection of various claims.
 
Based on its analysis, the Company believes that it is adequately reserved for its exposure to VarTec at May 31, 2006.
  
Restructured Loans
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. The Company will make a determination on each restructured loan with regard to the accrual of interest income on the loan. The initial decision is based on the terms of the restructure agreement and the anticipated performance of the borrower over the term of the agreement. The Company will periodically review the decision to accrue or not to accrue interest income on restructured loans based on the borrower's past performance and current financial condition.
  
At May 31, 2006 and 2005, restructured loans totaled $630 million and $601 million, respectively. A total of $569 million and $594 million of restructured loans were on non-accrual status with respect to the recognition of interest income at May 31, 2006 and 2005, respectively.
  
At May 31, 2006 and 2005, the Company had $569 million and $594 million, respectively, of loans outstanding to Denton County Electric Cooperative, Inc. d/b/a CoServ Electric ("CoServ"). All CoServ loans have been on non-accrual status since January 1, 2001. Total loans to CoServ at May 31, 2006 and 2005 represented 2.9% of the Company's total loans and guarantees outstanding.
   
To date, CoServ has made all required payments under the restructured loan. Under the agreement, CoServ will be required to make quarterly payments to CFC through 2037. Under the agreement, CFC may be obligated to provide up to $200 million of senior secured capital expenditure loans to CoServ for electric distribution infrastructure through 2012. If CoServ requests capital expenditure loans from CFC, these loans will be provided at the standard terms offered to all borrowers and will require debt service payments in addition to the quarterly payments that CoServ will make to CFC under its restructure agreement. To date, no amounts have been advanced to CoServ under this loan facility. Under the terms of the restructure agreement, CoServ has the option to prepay the restructured loan for $415 million plus an interest payment true up after December 13, 2007 and for $405 million plus an interest payment true up after December 13, 2008. If CoServ were to elect to prepay the restructured loan on December 13, 2007, it would be required to make a payment of $433 million to the Company, representing $415 million for the contractual prepayment plus $18 million of interest. Assuming that the Company continues to receive all required quarterly
  

36


payments from CoServ and applies all such payments to principal, the estimated loan balance would be $532 million at December 13, 2007. If CoServ were to elect to prepay the restructured loan on December 13, 2008, it would be required to make a payment of $423 million to the Company, representing $405 million for the contractual prepayment plus $18 million of interest. Assuming that the Company continues to receive all required quarterly payments from CoServ and applies all such payments to principal, the estimated loan balance would be $505 million at December 13, 2008.
  
Based on its analysis, the Company believes that it is adequately reserved for its exposure to CoServ at May 31, 2006.
   
Pioneer Electric Cooperative, Inc. ("Pioneer") is an electric distribution cooperative located in Greenville, Alabama. Pioneer had also invested in a propane gas operation, which it recently sold. Pioneer has experienced deterioration in its financial condition as a result of losses in the gas operation. At May 31, 2006, CFC had a total of $54 million in loans outstanding to Pioneer. Pioneer was current with respect to all debt service payments at May 31, 2006. CFC is the principal creditor to Pioneer.
   
On March 9, 2006, CFC and Pioneer agreed on the terms of a debt modification that resulted in the loans being classified as restructured. Under the amended agreement, CFC extended the maturity of the outstanding loans and granted a two-year deferral of principal payments. In addition, CFC agreed to make available a line of credit for general corporate purposes. The restructured loans are secured by first liens on substantially all of the assets and revenues of Pioneer. At this time, CFC plans to maintain the loans to Pioneer on accrual status.
   
Based on its analysis, the Company believes that it is adequately reserved for its exposure to Pioneer at May 31, 2006.
   
Loan Impairment
On a quarterly basis, the Company reviews all non-performing 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. The Company calculates an impairment for a borrower based on the expected future cash flow or the fair value of any collateral held by the Company as security for loans to the borrower. In some cases, to estimate future cash flow, certain assumptions are required regarding, but not limited to, the following:
  
* interest rates,
* court rulings,
* 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 the Company's assumptions change, the impairment calculations will change. The loan loss allowance specifically reserved to cover the calculated impairments is adjusted on a quarterly basis based on the most current information available. At May 31, 2006 and 2005, CFC had impaired loans totaling $1,201 million and $1,208 million, respectively. At May 31, 2006 and 2005, CFC had specifically reserved a total of $447 million and $404 million, respectively, to cover impaired loans.
  

NON-PERFORMING AND RESTRUCTURED LOANS

 

(Dollar amounts in millions)

May 31, 2006

 

May 31, 2005

 

May 31, 2004

 

Non-performing loans

$

578

$

617

$

341

Percent of loans outstanding

 

3.15

%    

3.25

%    

1.66

%  

Percent of loans and guarantees outstanding

 

2.97

%    

3.06

%    

1.57

%  

Restructured loans

$

630

   

$

601

   

$

618

   

Percent of loans outstanding

 

3.43

%    

3.17

%    

3.02

%  

Percent of loans and guarantees outstanding

 

3.24

%    

2.99

%    

2.83

%  
                         

Total non-performing and restructured loans

$

1,208

   

$

1,218

   

$

959

   

Percent of loans outstanding

 

6.58

%    

6.42

%    

4.68

%  

Percent of loans and guarantees outstanding

 

6.21

%    

6.05

%    

4.40

%  
   
Allowance for Loan Losses
The Company maintains an allowance for probable loan losses, which is reviewed quarterly by management for adequacy. The Company maintains an allowance for loan losses at a level estimated by management to provide adequately for probable losses inherent in the loan portfolio, which are estimated based upon a review of the loan portfolio, past loss experience, specific problem loans, economic conditions and other pertinent factors which, in management's judgment, deserve current recognition in estimating loan losses.
   

37


Management makes recommendations to the board of directors of CFC regarding write-offs of loan balances. In making its recommendation to write off all or a portion of a loan balance, management considers various factors including cash flow analysis and the collateral securing the borrower's loans. Since inception in 1969, write-offs totaled $150 million and recoveries totaled $33 million for a net loss amount of $117 million. In the past five fiscal years, write-offs totaled $51 million and recoveries totaled $16 million for a net loan loss of $35 million.
   
Management believes that the allowance for loan losses is adequate to cover estimated probable portfolio losses.
  
Activity in the allowance for loan losses is summarized below for the years ended May 31:
 
 

For the year ended May 31,

 

(Dollar amounts in millions)

 

2006

     

2005

     

2004

   

Beginning balance

$

590

   

$

574

   

$

511

   

Provision for loan losses

 

23

     

16

     

55

   

Change due to consolidation (1)

 

-

     

-

     

6

   

Net (write-offs) recoveries

 

(2

)

   

-

     

2

   

Ending balance

$

611

   

$

590

   

$

574

   

 

                       

Loan loss allowance by segment:

                       

     CFC

$

610

   

$

589

   

$

572

   

     NCSC

 

1

     

1

     

2

   

     Total

$

611

   

$

590

   

$

574

   
                         

As a percentage of total loans outstanding

 

3.33

%    

3.11

%    

2.80

%  

As a percentage of total non-performing loans outstanding

 

105.71

%    

95.62

%    

168.33

%  

As a percentage of total restructured loans outstanding

 

96.98

%    

98.17

%    

92.88

%  

 

 
(1) Represents the impact of consolidating NCSC including the increase to CFC's loan loss allowance recorded as a cumulative effect of change in accounting principle and the balance of NCSC's loan loss allowance on June 1, 2003.
 
CFC has agreed to indemnify RTFC and NCSC for loan losses, with the exception of the NCSC consumer loans that are covered by the NCSC loan loss allowance. Therefore, there is no loan loss allowance required at RTFC and only a small loan loss allowance is required at NCSC to cover the exposure to consumer loans.
   
The Company's loan loss allowance increased $21 million from May 31, 2005 to May 31, 2006. Within CFC's loan loss allowance at May 31, 2006 as compared to the prior year end, there was an increase in the calculated impairments of $43 million offset by a decrease of $10 million for high risk loans and $12 million to the allowance for all other loans. The increase to the calculated impairments was primarily due to an increase in the variable interest rates at May 31, 2006 as compared to May 31, 2005. The reduction to the allowance for all other loans was due to a decrease in the balance of loans outstanding at May 31, 2006 as compared to May 31, 2005.
  
Liabilities, Minority Interest and Equity
 
Outstanding Debt
The following chart provides a breakout of debt outstanding at May 31:
  


(Dollar amounts in millions)


2006

 


2005

 

Increase/
(Decrease)

 
Short-term debt:                         
     Commercial paper (1)

$

3,255

    

$

4,261

   

$

(1,006

)  
     Bank bid notes  

100

     

100

     

-

   
     Long-term debt with remaining maturities less than one year  

1,594

     

3,551

     

(1,957

)  
     Foreign currency valuation account  

245

     

40

     

205

   
     Subordinated deferrable debt with remaining maturities less than one year  

150

     

-

     

150

   
Total short-term debt  

5,344

     

7,952

     

(2,608

)  
Long-term debt:                  
     Collateral trust bonds  

3,847

     

2,946

     

901

   
     Notes payable  

2,575

     

91

     

2,484

   
     Medium-term notes  

4,220

     

5,444

     

(1,224

)  
     Foreign currency valuation account  

-

     

221

     

(221

)  
Total long-term debt  

10,642

     

8,702

     

1,940

   
Subordinated deferrable debt  

486

     

685

     

(199

)  
Members' subordinated certificates:                  
     Membership certificates  

651

     

663

     

(12

)  
     Loan certificates  

641

     

679

     

(38

)  
     Guarantee certificates  

136

     

149

     

(13

)  
Total members' subordinated certificates  

1,428

     

1,491

     

(63

)  
                         
Total debt outstanding

$

17,900

 

$

18,830

   

$

(930

)  

   

38


 

2006

 

2005

       
Percentage of fixed rate debt (2)  

83%

     

67%

       
Percentage of variable rate debt (3)  

17%

     

33%

           
Percentage of long-term debt  

70%

     

58%

           
Percentage of short-term debt  

30%

     

42%

         

 

 
(1) Includes $267 million and $271 million related to the daily liquidity fund at May 31, 2006 and 2005, respectively.
(2) Includes variable rate debt that has been swapped to a fixed rate less any fixed rate debt that has been swapped to a variable rate.
(3) The rate on commercial paper notes does not change once the note has been issued. However, the rates on new commercial paper notes change daily and commercial paper notes generally have maturities of less than 90 days. Therefore, commercial paper notes are considered to be variable rate debt. Also includes fixed rate debt that has been swapped to a variable rate less any variable rate debt that has been swapped to a fixed rate.
 
Other information with regard to short-term debt at May 31 is as follows:
 
(Dollar amounts in thousands)  

2006

     

2005

     

2004

 
Weighted average maturity outstanding at year-end:                      
Short-term debt (1)  

26 days

     

22 days

     

20 days

 
Long-term debt maturing within one year  

203 days

     

294 days

     

162 days

 
Total  

92 days

     

145 days

     

76 days

 
Average amount outstanding during the year:                      
Short-term debt (1)

$

3,204,852

   

$

4,355,579

   

$

3,173,167

 
Long-term debt maturing within one year  

3,502,026

     

1,834,883

     

2,913,723

 
Total  

6,706,878

     

6,190,462

     

6,086,890

 
Maximum amount outstanding at any month-end during the year:                      
Short-term debt (1)  

4,208,796

     

4,816,367

     

3,758,428

 
Long-term debt maturing within one year  

4,031,102

     

3,591,374

     

3,427,560

 

 

 
(1) Includes the daily liquidity fund and bank bid notes and does not include long-term debt due in less than one year.
    
Total debt outstanding at May 31, 2006 decreased as compared to May 31, 2005 due primarily to decreases of $611 million to loans outstanding and $158 million to cash and cash equivalents. The decrease to loan volume reduces the amount of debt required to fund loans. During the year ended May 31, 2006, CFC used cash to pay down short-term debt. Short-term debt decreased due to the maturity of $2,449 million of collateral trust bonds during the year ended May 31, 2006. In addition, CFC further reduced its reliance on the dealer commercial paper markets, reducing the amounts outstanding from $2,873 million at prior year-end to $1,658 million at May 31, 2006. The reduction to dealer commercial paper is a result of borrower loan repayments and the Company's two new private funding sources, $500 million of notes to Farmer Mac and the advance of $2 billion on FFB loan facilities with bond guarantee agreements with RUS as part of the funding mechanism for the REDLG program. Long-term debt increased due to these new private funding sources and due to the issuance of $1,000 million in extendible floating rate collateral trust bonds which were used to refinance a portion of the collateral trust bonds which matured during the year.
  
In December 2005, CFC repurchased $37 million of the 5.95% subordinated deferrable debt securities due 2045 and $12 million of the 6.10% subordinated deferrable debt securities due 2044. CFC recognized a net gain of $2 million on the early redemption of the subordinated deferrable debt securities. The net gain on the redemption was comprised of a gain of $3 million as the securities were redeemed below their par value, offset by the write-off of $1 million of unamortized issurance costs recorded in cost of funds. Subsequent to the end of the year on June 15, 2006, the Company redeemed the 7.625% subordinated deferrable debt securities due 2050 totaling $150 million. The Company redeemed these securities at par and recorded a charge of $5 million in cost of funds for the unamortized issuance costs.
   
At May 31, 2006 and 2005, the Company had a total of $960 million and $1,366 million, respectively, of foreign denominated debt. As a result of issuing debt in foreign currencies, the Company must adjust the value of the debt reported on the consolidated balance sheets for changes in foreign currency exchange rates since the date of issuance. 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. The adjustment to the value of the debt for the current period is reported on the consolidated statements of operations as foreign currency adjustments. At the time of issuance of all foreign denominated debt, the Company enters into a cross currency or cross currency interest rate exchange agreement to fix the exchange rate on all principal and interest payments through maturity. At May 31, 2006 and 2005, the reported amount of foreign denominated debt includes a valuation adjustment of $245 million and $261 million, respectively due to changes in the value of the Euro and Australian dollar versus the U.S. dollar since the time the debt was issued.
   
The decrease to members' subordinated certificates of $63 million for the year ended May 31, 2006 is primarily due to $133 million applied toward loan prepayments, amortization and maturities and a $13 million reduction to a borrower's unissued membership certificates offset by the purchase of $83 million of new certificates.
  

39


Minority Interest
Minority interest on the consolidated balance sheets at May 31, 2006 was $22 million, an increase of $3 million from the balance of $19 million at May 31, 2005. During the years ended May 31, 2006, 2005 and 2004 the balance of minority interest has been adjusted by minority interest net margins less the offset of unretired RTFC patronage capital against loans outstanding to certain impaired and high risk borrowers and the retirement of patronage capital to RTFC members in January of each fiscal year.
  
Equity
The following chart provides a breakout of the equity balances at May 31:
  


(in millions)


2006

 


2005

 

Increase/
(Decrease)

 
Membership fees

$

1

   

$

1

   

$

-

   
Education fund  

1

     

1

     

-

   
Members' capital reserve  

157

     

164

     

(7

)  
Allocated net margin  

386

     

358

     

28

   
     Total members' equity  

545

     

524

     

21

   
Prior years cumulative derivative forward                        
          value and foreign currency adjustments  

229

     

225

     

4

   
Current period derivative forward value (1)  

23

     

27

     

(4

)  
Current period foreign currency adjustments  

(22

)    

(23

)    

1

   
Total retained equity  

775

     

753

     

22

   
Accumulated other comprehensive income  

13

     

16

     

(3

)  
Total equity

$

788

   

$

769

   

$

19

   

 

 
(1) Represents the derivative forward value (gain) loss recorded by CFC for the period.
 
Applicants are required to pay a one-time fee to become a member. The fee varies from two hundred dollars to one thousand dollars depending on the membership class. CFC is required by the District of Columbia cooperative law to have a methodology to allocate its net margin to its members. CFC maintains the current year net margin as unallocated through the end of its fiscal year. At that time, CFC's board of directors allocates its net margin to its members in the form of patronage capital and to board approved reserves. Currently, CFC has two such board approved reserves, the education fund and the members' capital reserve. CFC adjusts the net margin it allocates to its members and board approved reserves to exclude the non-cash impacts of SFAS 133 and 52. CFC allocates a small portion, less than 1%, of adjusted net margin annually to the education fund as required by cooperative law. Funds from the education fund are disbursed annually to the statewide cooperative organizations to fund the teaching of cooperative principles in the service territories of the cooperatives in each state. The board of directors determines the amount of adjusted net margin that is allocated to the members' capital reserve, if any. The members' capital reserve represents margins that are held by CFC to increase equity retention. The margins held in the members' capital reserve have not been specifically allocated to any member, but may be allocated to individual members in the future as patronage capital if authorized by CFC's board of directors. All remaining adjusted net margin is allocated to CFC's members in the form of patronage capital. CFC bases the amount of adjusted net margin allocated to each member on the members' patronage of the CFC lending programs in the year that the adjusted net margin was earned. There is no impact on CFC's total equity as a result of allocating margins to members in the form of patronage capital or to board approved reserves. CFC annually retires a portion of the patronage capital allocated to members in prior years. CFC's total equity is reduced by the amount of patronage capital retired to its members and by amounts disbursed from board approved reserves.
   
At May 31, 2006, equity totaled $788 million, an increase of $19 million from May 31, 2005. During the year ended May 31, 2006, CFC retired $71 million of patronage capital to its members, patronage capital totaling $2 million was applied against the outstanding loan balance of an impaired borrower and a reduction to accumulated other comprehensive income related to derivatives of $3 million which was offset by net margin of $96 million.
  
Contractual Obligations
The following table summarizes the long-term contractual obligations at May 31, 2006 and the scheduled reductions by fiscal year.
   
(in millions)                        

More than 5

   

Instrument

   

2007

 

2008

 

2009

 

2010

 

2011

 

Years

 

Total

 
Short-term debt (1)    

$

1,989

   

$

-

   

$

-

   

$

-

   

$

-

   

$

-

   

$

1,989

 
Long-term debt      

-

     

2,140

     

1,018

     

1,488

     

511

     

5,485

     

10,642

 
Subordinated deferrable debt      

-

     

-

     

-

     

-

     

-

     

486

     

486

 
Members' subordinated certificates (2)      

19

     

12

     

19

     

5

     

14

     

1,051

     

1,120

 
Operating leases (3)      

3

     

3

     

1

     

-

     

-

     

-

     

7

 
Contractual interest on long-term debt (4)      

1,485

     

568

     

502

     

426

     

386

     

4,741

     

8,108

 
Total contractual obligations    

$

3,496

   

$

2,723

   

$

1,540

   

$

1,919

   

$

911

   

$

11,763

   

$

22,352

 

  

40


 

 
(1) Includes principal payments for subordinated deferrable debt to be called in June 2006 and long-term debt due in less than one year.
(2) Excludes loan subordinated certificates totaling $308 million that amortize annually based on the outstanding balance of the related loan. There are many items that impact the amortization of a loan, such as loan conversions, loan repricing at the end of an interest rate term, prepayments, etc, thus an amortization schedule cannot be maintained for these certificates. Over the past three years, annual amortization on these certificates has averaged $27 million. In fiscal year 2006, amortization represented 8% of amortizing loan subordinated certificates outstanding.
(3) Represents the payment obligation related to the Company's three-year lease of office space for its headquarters facility.
(4) Represents the interest obligation on the Company's debt based on terms and conditions at May 31, 2006.
   
Off-Balance Sheet Obligations
Guarantees
The following chart provides a breakout of guarantees outstanding by type and by segment at May 31:
         

Increase/

 
(in millions)

2006

 

2005

 

(Decrease)

 
Total by type:                        
Long-term tax-exempt bonds

$

608

   

$

738

   

$

(130

)  
Debt portions of leveraged lease transactions  

-

     

12

     

(12

)  
Indemnifications of tax benefit transfers  

124

     

142

     

(18

)  
Letters of credit  

272

     

197

     

75

   
Other guarantees  

75

     

69

     

6

   

     Total

$

1,079

   

$

1,158

   

$

(79

)  
                          
Total by segment:                        
CFC

 $

1,025

   

 $

1,150

   

 $

(125

)  
NCSC  

54

     

8

     

46

   
     Total

 $

1,079

   

 $

1,158

   

 $

(79

)  
   
The decrease in total guarantees outstanding at May 31, 2006 compared to May 31, 2005 was due primarily to a $92 million prepayment and normal amortization on long-term tax-exempt bonds, the release of the obligation under the remaining leveraged lease transaction and normal amortization on tax benefit transfers offset by new letters of credit totaling $49 million to NCSC borrowers.
  
At May 31, 2006 and 2005, the Company had recorded a guarantee liability totaling $17 million and $16 million, respectively, which represents the contingent and non-contingent exposure related to guarantees of members' debt obligations.
  
The following table summarizes the off-balance sheet obligations at May 31, 2006 and the related principal amortization and maturities by fiscal year.
  
(in millions)      

Principal Amortization and Maturities

 
   

Outstanding

                     

Remaining

 

 

 

Balance

 

2007

 

2008

 

2009

 

2010

 

2011

 

Years

 
Guarantees (1)  

$  1,079

 

$  230

 

$  80

 

$  76

 

$  66

 

$  151

 

$  476

 

 

   
(1) On a total of $572 million of tax-exempt bonds, CFC has unconditionally agreed to purchase bonds tendered or called for redemption at any time if the remarketing agents have not sold such bonds to other purchasers.

  
Contingent Off-Balance Sheet Obligations
Unadvanced Loan Commitments
At May 31, 2006, the Company had unadvanced loan commitments totaling $12,780 million, a decrease of $1,086 million compared to the balance of $11,694 million at May 31, 2005. Unadvanced commitments are loans for which loan contracts have been approved and executed, but funds have not been advanced. The majority of the short-term unadvanced commitments provide backup liquidity to the Company's borrowers; therefore, it does not anticipate funding most of these commitments. Approximately 52% of the outstanding commitments at May 31, 2006 and 2005 were for short-term or line of credit loans. Substantially all above mentioned credit commitments contain material adverse change clauses, thus for a borrower to qualify for the advance of funds, the Company must be satisfied that there has been no material change since the loan was approved.
  
Unadvanced loan commitments do not represent off-balance sheet liabilities and have not been included in the chart summarizing off-balance sheet obligations above. The Company has no obligation to advance amounts to a borrower that does not meet the minimum conditions as determined by CFC's credit underwriting policy in effect at the time the loan was approved. If there has been a material adverse change in the borrower's financial condition or the borrower has not satisfied other terms in the agreement, the Company is not required to advance funds. Therefore, unadvanced commitments are classified as contingent liabilities.
   

41


Ratio Analysis
Leverage Ratio
The leverage ratio is calculated by dividing the sum of total liabilities and guarantees outstanding by total equity. Based on this formula, the leverage ratio at May 31, 2006 was 24.68, a decrease from 26.58 at May 31, 2005. The decrease in the leverage ratio is due to an increase of $19 million in total equity, a decrease of $903 million to total liabilities and a decrease of $79 million in guarantees as discussed under the Liabilities, Minority Interest and Equity section and the Off-Balance Sheet Obligations section of "Financial Condition".
  
For the purpose of covenant compliance on its revolving credit agreements and for internal management purposes, the leverage ratio calculation is adjusted to exclude derivative liabilities, debt used to fund RUS guaranteed loans, the foreign currency valuation account, subordinated deferrable debt and subordinated certificates from liabilities, uses members' equity rather than total equity and adds subordinated deferrable debt, subordinated certificates and minority interest to arrive at adjusted equity. At May 31, 2006 and 2005, the adjusted leverage ratio was 6.38 and 6.50, respectively. See "Non-GAAP Financial Measures" for further explanation and a reconciliation of the adjustments the Company makes in its leverage ratio calculation.
 
The decrease in the adjusted leverage ratio is due to a decrease in adjusted liabilities of $785 million and a decrease of $79 million in guarantees offset by the decrease of $86 million in adjusted equity. The decrease in adjusted liabilities is primarily due to a net decrease of $802 million in short-term and long-term debt excluding the foreign currency valuation account and subordinated deferrable debt to be called in June 2006. The decrease to adjusted equity is primarily due to the $71 million retirement of allocated margins and decreases of $49 million in subordinated deferrable debt and $63 million in members subordinated certificates offset by adjusted net margin totaling $97 million. In addition to the adjustments made to the leverage ratio in the "Non-GAAP Financial Measures" section, guarantees to member systems that have an investment grade rating from Moody's Investors Service and Standard & Poor's Corporation are excluded from the calculation of the leverage ratio under the terms of the revolving credit agreements.
  
Debt to Equity Ratio
The debt to equity ratio is calculated by dividing the sum of total liabilities outstanding by total equity. The debt to equity ratio, based on this formula at May 31, 2006 was 23.31 a decrease from 25.07 at May 31, 2005. The decrease in the debt to equity ratio is due to the increase of $19 million to total equity and the decrease of $903 million to total liabilities as discussed under the Liabilities, Minority Interest and Equity section of "Financial Condition".
   
For internal management purposes, the debt to equity ratio calculation is adjusted to exclude derivative liabilities, debt used to fund RUS guaranteed loans, the foreign currency valuation account, subordinated deferrable debt and subordinated certificates from liabilities, uses members' equity rather than total equity and adds subordinated deferrable debt, subordinated certificates and minority interest to arrive at adjusted equity. At May 31, 2006 and 2005, the adjusted debt to equity ratio was 5.97 and 6.07, respectively. See "Non-GAAP Financial Measures" for further explanation and a reconciliation of the adjustments made to the debt to equity ratio calculation. The decrease in the adjusted debt to equity ratio is due to the decrease of $785 million in adjusted liabilities offset by the decrease of $86 million in adjusted equity.
  
Credit Ratings
The Company's long- and short-term debt and guarantees are rated by three of the major credit rating agencies, Moody's Investors Service, Standard & Poor's Corporation and Fitch Ratings. The following table presents the Company's credit ratings at May 31, 2006.
 
 

Moody's Investors

 

Standard & Poor's

     
 

Service

 

Corporation

 

Fitch Ratings

 
Direct:                        
Senior secured debt   A1   A+       A+  
Senior unsecured debt   A2   A       A  
Subordinated deferrable debt   A3   BBB+       A-  
Commercial paper   P-1   A-1       F-1  
                         
Guarantees:            
Leveraged lease debt   A2   A       A  
Pooled bonds   A1   A       A  
Other bonds   A2   A       A  
Short-term   P-1   A-1       F-1  
  
The ratings listed above have the meaning as defined by each of the respective rating agencies, are not recommendations to buy, sell or hold securities and are subject to revision or withdrawal at any time by the rating organizations.
   
Standard & Poor's Corporation, Moody's Investors Service, and Fitch Ratings have the Company's ratings on stable outlook.
   

42


Liquidity and Capital Resources
The following section will discuss the Company's sources and uses of liquidity. The Company's primary sources of liquidity include capital market debt issuance, private debt issuance, member loan principal repayments, member loan interest payments, a revolving bank line facility and member investments. The Company's primary uses of liquidity include loan advances, interest payments on debt, principal repayments on debt and patronage capital retirements. The Company feels that its sources of liquidity are adequate to cover the uses of liquidity.
   
Sources of Liquidity
Capital Market Debt Issuance
At May 31, 2006, the Company had effective registration statements covering $1,075 million of collateral trust bonds, $3,948 million of medium-term notes and $165 million of subordinated deferrable debt. The Company has Board authorization to issue up to $1 billion of commercial paper and $4 billion of medium-term notes in the European market of which $1 billion and $3.6 billion, respectively, was remaining at May 31, 2006. The Company has Board authorization to issue $1.5 billion of medium-term notes in the Australian market of which $1.2 billion was remaining at May 31, 2006. In addition, the Company has a commercial paper program under which it sells commercial paper to investors in the capital markets. The amount of commercial paper that can be sold is limited to the amount of backup liquidity available under the Company's revolving credit agreement.
   
Private Debt Issuance
The Company has made use of two sources of private debt issuance during fiscal year 2006. In July 2005, the Company issued $500 million of notes to Farmer Mac due in 2008 and secured such issuance with the pledge of loans to distribution systems as collateral. The Company is also authorized to borrow up to $2.5 billion under FFB loan facilities with bond guarantee agreements with RUS as part of the funding mechanism for the REDLG program. At May 31, 2006, the Company had a total of $2 billion of funding outstanding as part of the REDLG program, with remaining authority to borrow an additional $500 million.
   
Member Loan Repayments
There has been significant prepayment activity over the past two fiscal years in the telecommunications loan programs. It is not anticipated that there will be significant loan prepayments over the next few years. Amortization of long-term loans in each of the five fiscal years following May 31, 2006 and thereafter are as follows:
   
(in millions)  

Amortization (1)

   
  2007  

 $

801

     
  2008     

834

     
  2009     

789

     
  2010    

817

     
  2011    

795

     
  Thereafter    

12,769

     

 

 
(1) Represents scheduled amortization based on current rates without consideration for loans that reprice. Excludes non-performing loans for which the scheduled amortization cannot be estimated.
 
Member Loan Interest Payments
During the year ended May 31, 2006, interest income on the loan portfolio was $971 million, representing an average yield of 5.28% as compared to 4.88% and 4.80% for the years ended May 31, 2005 and 2004, respectively. At May 31, 2006, 80% of the total loans outstanding had a fixed rate of interest and 20% of loans outstanding had a variable rate of interest. At May 31, 2006, a total of 6% of loans outstanding were on a non-accrual basis with respect to the recognition of interest income.
   
Bank Revolving Credit Facility
The following is a summary of the Company's revolving credit agreements at May 31:
 


(Dollar amounts in millions)
   


2006

   


2005

   

Termination
Date

   

Facility fee per annum (1)

   
364-day agreement (2)  

$

1,025

 

$

-

   

March 21, 2007

   

0.05 of 1%

   
                             
Five-year agreement    

1,025

   

-

   

March 22, 2011

   

0.06 of 1%

   
                             
Five-year agreement    

1,975

   

1,975

   

March 23, 2010

   

0.09 of 1%

   
                             
Three-year agreement    

-

   

1,740

   

March 30, 2007

   

0.10 of 1%

   
                             
364-day agreement (2)    

-

   

1,285

   

March 22, 2006

   

0.07 of 1%

   
                             
     Total  

$

4,025

 

$

5,000

               

 

 
(1) Facility fee determined by CFC's senior unsecured credit ratings based on the pricing schedules put in place at the initiation of the related agreement.
(2) Any amount outstanding under these agreements may be converted to a one-year term loan at the end of the revolving credit periods. If converted to a term loan, the fee on the outstanding principal amount of the term loan is 0.10 of 1% per annum.

  

43


Up-front fees of between 0.05 and 0.13 of 1% were paid to the banks based on their commitment level to the five-year agreements in place at May 31, 2006, totaling in aggregate $3 million, which will be amortized on a straight-line basis over the life of the agreements. No upfront fees were paid to the banks for their commitment to the 364-day facility. Each agreement contains a provision under which if borrowings exceed 50% of total commitments, a utilization fee must be paid on the outstanding balance. The utilization fees are 0.05 of 1% for the five-year agreement terminating on March 22, 2011 and the 364-day agreement and 0.10 of 1% for the five-year agreement terminating on March 23, 2010 outstanding at May 31, 2006.
    
Effective May 31, 2006 and 2005, the Company was in compliance with all covenants and conditions under its revolving credit agreements in place at that time and there were no borrowings outstanding under such agreements.
    
For the purpose of calculating the required financial covenants contained in its revolving credit agreements, the Company adjusts net margin, senior debt and total equity to exclude the non-cash adjustments related to SFAS 133 and 52. The adjusted times interest earned ratio ("TIER"), as defined by the agreements, represents the cost of funds adjusted to include the derivative cash settlements, plus minority interest net margin, plus net margin prior to the cumulative effect of change in accounting principle and dividing that total by the cost of funds adjusted to include the derivative cash settlements. In addition to the non-cash adjustments related to SFAS 133 and 52, senior debt also excludes RUS guaranteed loans, subordinated deferrable debt, members' subordinated certificates and minority interest. Total equity is adjusted to include subordinated deferrable debt, members' subordinated certificates and minority interest. Senior debt includes guarantees; however, it excludes:
* guarantees for members where the long-term unsecured debt of the member is rated at least BBB+ by Standard & Poor's Corporation or Baa1 by Moody's Investors Service;
* indebtedness incurred to fund RUS guaranteed loans; and
* the payment of principal and interest by the member on the guaranteed indebtedness if covered by insurance or reinsurance provided by an insurer having an insurance financial strength rating of AAA by Standard & Poor's Corporation or a financial strength rating of Aaa by Moody's Investors Service.
  
The following represents the Company's required and actual financial ratios under the revolving credit agreements at or for the year ended May 31:
 
   

Requirement

 

2006

 

2005

 
               
Minimum average adjusted TIER over the six most recent fiscal quarters  

1.025

 

1.11

 

1.08

 
               
Minimum adjusted TIER at fiscal year end (1)  

1.05

 

1.11

 

1.14

 
               
Maximum ratio of senior debt to total equity  

10.00

 

6.26

 

6.30

 

 

               
(1) The Company must meet this requirement in order to retire patronage capital.
 
The revolving credit agreements do not contain a material adverse change clause or ratings triggers that limit the banks' obligations to fund under the terms of the agreements, but CFC must be in compliance with their other requirements, including financial ratios, in order to draw down on the facilities.
 
Member Investments
At May 31, 2006 and 2005, members funded 19.2% and 17.7%, respectively, of total assets as follows:
 
 

2006

 

2005

 
(Dollar amounts in millions)

Amount

 

% of Total (1)

 

Amount

 

% of Total (1)

Change

Commercial paper (2)

$

1,451

     

45%

   

$

1,260

     

30%     

$

191

Medium-term notes  

255

     

4%

     

275

     

4%     

 

(20)

Members' subordinated certificates  

1,428

     

100%

     

1,491

     

100%     

 

(63)

Members' equity (3)  

545

     

100%

     

524

     

100%     

 

21 

Total

$

3,679

           

$

3,550

       

$

129

Percentage of total assets  

19.2

%            

17.7

%

         
Percentage of total assets less derivative assets (3)  

19.8

%            

18.2

%

         

 

   
(1) Represents the percentage of each line item outstanding to CFC members.
(2) Includes $267 million and $271 million related to the daily liquidity fund at May 31, 2006 and 2005, respectively.
(3) See "Non-GAAP Financial Measures" for further explanation and a reconciliation of the adjustments made to total capitalization and a breakout of members' equity.
 
Uses of Liquidity
Loan Advances
Loan advances would come from new loans approved to members and from the unadvanced portion of loans that were approved prior to May 31, 2006. At May 31, 2006, the Company had unadvanced loan commitments totaling $12,780 million. The Company does not expect to advance the full amount of the unadvanced commitments at May 31, 2006. Unadvanced
   

44


commitments generally expire within five years of the first advance on a loan and the majority of short-term unadvanced commitments are used as backup liquidity for member operations. Approximately 52% of the outstanding commitments at May 31, 2006 were for short-term or line of credit loans. The Company anticipates that over the next twelve months, loan advances will be approximately equal to the scheduled loan repayments.
   
Interest Expense on Debt
For the year ended May 31, 2006, interest expense on debt was $942 million, representing 5.12% of the average loan volume for which the debt was used as funding. The interest expense on debt represented 4.51% and 4.38% of the average loan volume for which the debt was used as funding for the years ended May 31, 2005 and 2004, respectively. At May 31, 2006, a total of 83% of outstanding debt had a fixed interest rate and 17% of outstanding debt had a variable interest rate.
  
Principal Repayments on Long-term Debt
The principal amount of medium-term notes, collateral trust bonds, long-term notes payable, subordinated deferrable debt and membership subordinated certificates maturing in each of the five fiscal years following May 31, 2006 and thereafter is as follows:
 
 

Amount

 

Weighted Average

   
(Dollar amounts in millions)

Maturing

 

Interest Rate

   
2007 (1)

$

2,008

      6.18%      
2008  

2,152

      4.72%      
2009  

1,037

      5.08%      
2010  

1,493

      5.69%      
2011  

525

      4.44%      
Thereafter  

7,022

      6.07%      
Total (2)

$

14,237

      5.71%      

 

                 
(1) For the amount scheduled to mature in fiscal year 2007, $1,989 million has been presented as long-term debt due in one year under short-term debt and $19 million is presented in membership subordinated certificates.
(2) Excludes loan subordinated certificates totaling $308 million that amortize annually based on the outstanding balance of the related loan. There are many items that impact the amortization of a loan, such as loan conversions, loan repricing at the end of an interest rate term, prepayments, etc, thus an amortization schedule cannot be maintained for these certificates. Over the past three years, annual amortization on these certificates has averaged $27 million. In fiscal year 2006, amortization represented 8% of amortizing loan subordinated certificates outstanding.
 
Patronage Capital Retirements
The Company has made annual retirements of its allocated patronage capital in 26 of the last 27 years. In July 2006, the CFC board of directors approved the allocation of a total of $102 million from fiscal year 2006 net margin and the members' capital reserve to the CFC members. CFC is scheduled to make a cash payment of $84 million to its members as retirement of 70% of the amount allocated for fiscal year 2006 and 1/9th of the amount allocated for fiscal years 1991, 1992 and 1993.
   
Market Risk
  
The Company's primary market risks are interest rate risk and liquidity risk. The Company is also exposed to counterparty risk as a result of entering into interest rate, cross currency and cross currency interest rate exchange agreements.
   
Interest Rate Risk
The interest rate risk exposure is related to the funding of the fixed rate loan portfolio. The Company does not match fund the majority of its fixed rate loans with a specific debt issuance at the time the loan is advanced. The Company aggregates fixed rate loans until the volume reaches a level that will allow an economically efficient issuance of debt. The Company uses fixed rate collateral trust bonds, medium-term notes, subordinated deferrable debt, members' subordinated certificates, members' equity and variable rate debt to fund fixed rate loans. The Company allows borrowers flexibility in the selection of the period for which a fixed interest rate will be in effect. Long-term loans typically have 15 to 35 year maturities. Borrowers may select fixed interest rates for periods of one year through the life of the loan. To mitigate interest rate risk in the funding of fixed rate loans, the Company performs a monthly gap analysis, a comparison of fixed rate assets repricing or maturing by year to fixed rate liabilities and members' equity maturing by year (see chart on page 46). The interest rate risk is deemed minimal on variable rate loans, since the loans may be repriced either monthly or semi-monthly to reflect the cost of the debt used to fund the loans. At May 31, 2006 and 2005, 20% and 32%, respectively, of loans carried variable interest rates.
  
Matched Funding Policy
The Company measures the matching of funds to assets by comparing the amount of fixed rate assets repricing or amortizing to the total fixed rate debt maturing over the remaining maturity of the fixed rate loan portfolio. It is the Company's funding objective to manage the matched funding of asset and liability repricing terms within a range of 3% of total assets excluding derivative assets. At May 31, 2006, the Company had $14,557 million of fixed rate assets amortizing or repricing, funded by $12,751 million of fixed rate liabilities maturing during the next 30 years and $2,002 million of members' equity and members' subordinated certificates, a portion of which does not have a scheduled maturity. The difference of $196 million, or 1.02% of
  

45


total assets and 1.05% of total assets excluding derivative assets, represents the fixed rate debt and equity in excess of the fixed rate assets maturing during the next 30 years. Fixed rate loans are funded with fixed rate collateral trust bonds, medium-term notes, long-term notes payable, subordinated deferrable debt, members' subordinated certificates and members' equity. With the exception of members' subordinated certificates, which are generally issued at rates below the Company's long-term cost of funding and with extended maturities, and commercial paper, the Company's liabilities have average maturities that closely match the repricing terms (but not the maturities) of its fixed interest rate loans. The Company also uses commercial paper supported by interest rate exchange agreements to fund its portfolio of fixed rate loans. Variable rate assets which reprice monthly are funded with short-term liabilities, primarily commercial paper, collateral trust bonds, long-term notes payable and medium-term notes issued with a fixed rate and swapped to a variable rate, medium-term notes issued at a variable rate, subordinated certificates, members' equity and bank bid notes.
  
Certain of the Company's collateral trust bonds, subordinated deferrable debt and medium-term notes were issued with early redemption provisions. To the extent borrowers are allowed to convert their fixed rate loans to a variable interest rate and to the extent it is beneficial, the Company takes advantage of these early redemption provisions. However, because conversions and prepayments can take place at different intervals from early redemptions, the Company charges conversion fees designed to compensate for any additional interest rate risk it assumes.
  
The Company makes use of an interest rate gap analysis in the funding of its long-term fixed rate loan portfolio. The analysis compares the scheduled fixed rate loan amortizations and repricings against the scheduled fixed rate debt and members' subordinated certificate amortizations to determine the fixed rate funding gap for each individual year and the portfolio as a whole. There are no scheduled maturities for the members' equity, primarily unretired patronage capital allocations. The non-amortizing members' subordinated certificates either mature at the time of the related loan or guarantee or 100 years from issuance (50 years in the case of a small portion of certificates). Accordingly, it is assumed in the funding analysis that non-amortizing members' subordinated certificates and members' equity are first used to "fill" any fixed rate funding gaps. The remaining gap represents the amount of excess fixed rate funding due in that year or the amount of fixed rate assets that are assumed to be funded by short-term variable rate debt, primarily commercial paper. The interest rate associated with the assets and debt maturing or members' equity and members' certificates is used to calculate an adjusted TIER for each year and for the portfolio as a whole. The schedule allows the Company to analyze the impact on the overall adjusted TIER of issuing a certain amount of debt at a fixed rate for various maturities, prior to issuance of the debt. See "Non-GAAP Financial Measures" for further explanation and a reconciliation of the adjustments to TIER.
  
The following chart shows the scheduled amortization and repricing of fixed rate assets and liabilities outstanding at May 31, 2006.
   

INTEREST RATE GAP ANALYSIS

(Fixed Rate Assets/Liabilities)

As of May 31, 2006

   
     

Over 1

 

Over 3

 

Over 5

 

Over 10

       
     

year but

 

years but

 

years but

 

years but

       
 

1 year

 

3 years

 

5 years

 

10 years

 

20 years

 

Over 20

   
(Dollar amounts in millions)

or less

 

or less

 

or less

 

or less

 

or less

 

years

 

Total

Assets:                                                      
     Amortization and repricing

$

1,858

   

$

3,182

   

$

2,361

   

$

3,736

   

$

2,463

   

$

957

   

$

14,557

 
          Total assets

$

1,858

   

$

3,182

   

$

2,361

   

$

3,736

   

$

2,463

   

$

957

   

$

14,557

 
                                                       
Liabilities and members' equity:                                                      
     Long-term debt

$

2,075

   

$

3,146

   

$

2,485

   

$

3,396

   

$

1,156

   

$

493

   

$

12,751

 
     Subordinated certificates  

49

     

66

     

54

     

93

     

883

     

161

     

1,306

 
     Members' equity (1)  

150

     

28

     

25

     

112

     

78

     

303

     

696

 
          Total liabilities and members' equity

$

2,274

   

$

3,240

   

$

2,564

   

$

3,601

   

$

2,117

   

$

957

   

$

14,753

 
                                                       
Gap (2)

$

(416

)  

$

(58

)  

$

(203

)  

$

135

   

$

346

   

$

-

   

$

(196

)
Cumulative gap

$

(416

)  

$

(474

)  

$

(677

)  

$

(542

)  

$

(196

)  

$

(196

)        
Cumulative gap as a % of total assets  

(2.17

)%    

(2.47

)%

   

(3.53

)%    

(2.83

)%    

(1.02

)%    

(1.02

)%        
Cumulative gap as a % of adjusted total assets (3)

(2.24

)%    

(2.55

)%

   

(3.64

)%    

(2.91

)%    

(1.05

)%    

(1.05

)%        

 

 

(1)

Includes the portion of the loan loss allowance and subordinated deferrable debt allocated to fund fixed rate assets. See "Non-GAAP Financial Measures" for further explanation of why CFC uses members' equity in its analysis of the funding of its loan portfolio.

(2)

Assets less liabilities and members' equity.

(3)

Adjusted total assets represents total assets in the consolidated balance sheets less derivative assets.
 
Use of Derivatives
At May 31, 2006 and 2005, the Company was a party to interest rate exchange agreements with a total notional amount of $12,536 million and $13,693 million, respectively. The Company uses interest rate exchange agreements as part of its overall interest rate matching strategy. Interest rate exchange agreements are used when they provide a lower cost of funding or minimize interest rate risk. The Company will enter into interest rate exchange agreements only with highly rated financial
 

46


institutions. CFC was using interest rate exchange agreements to synthetically change the interest rate from a variable rate to a fixed rate on $7,350 million as of May 31, 2006 and $6,643 million as of May 31, 2005 of debt used to fund long-term fixed rate loans. Interest rate exchange agreements were used to synthetically change the interest rates from fixed to variable on $5,186 million and $7,050 million of long-term debt as of May 31, 2006 and 2005, respectively. The Company has not invested in derivative financial instruments for trading purposes in the past and does not anticipate doing so in the future.
   
As of May 31, 2006 and 2005, the Company was a party to cross currency and cross currency interest rate exchange agreements with a total notional amount of $716 million and $1,106 million, respectively, related to medium-term notes denominated in foreign currencies. Cross currency and cross currency interest rate exchange agreements with a total notional amount of $434 million and $824 million, respectively, at May 31, 2006 and 2005 in which the Company receives Euros and pays U.S. dollars, and $282 million at May 31, 2006 and 2005 in which the Company receives Australian dollars and pays U.S. dollars, are used to synthetically change the foreign denominated debt to U.S. dollar denominated debt. In addition, $716 million of the cross currency interest rate exchange agreements at May 31, 2006 and 2005 synthetically change the interest rate from the fixed rate on the foreign denominated debt to variable rate U.S. denominated debt or from a variable rate on the foreign denominated debt to a U.S. denominated variable rate.
   
The Company enters into an exchange agreement to sell the amount of foreign currency received from the investor for U.S. dollars on the issuance date and to buy the amount of foreign currency required to repay the investor principal and interest due through or on the maturity date. By locking in the exchange rates at the time of issuance, the Company has eliminated the possibility of any currency gain or loss (except in the case of the Company or a counterparty default or unwind of the transaction) which might otherwise have been produced by the foreign currency borrowing.
 
Liquidity Risk
The Company faces liquidity risk in the funding of its loan portfolio. The Company offers long-term loans with maturities of up to 35 years and line of credit loans that are generally required to be paid down annually. On long-term loans, the Company offers a variety of interest rate options including the ability to fix the interest rate for terms of one year through maturity. At May 31, 2006, the Company has a total of $1,989 million of long-term debt maturing during the next twelve months. The Company funds the loan portfolio with a variety of debt instruments and its members' equity. The Company typically does not match fund each of its loans with a debt instrument of similar final maturity. Debt instruments such as subordinated certificates have maturities that vary from the term of the associated loan or guarantee to 100 years and subordinated deferrable debt has been issued with maturities of up to 49 years. The Company may issue collateral trust bonds and medium-term notes for periods of up to 30 years, but typically issues such debt instruments with maturities of 2, 3, 5, 7 and 10 years. Debt instruments such as commercial paper and bank bid notes typically have maturities of 90 days or less. Therefore, the Company is at risk if it is not able to issue new debt instruments to replace debt that matures prior to the maturity of the loans for which they are used as funding. Factors that mitigate liquidity risk include the Company maintenance of back-up liquidity through revolving credit agreements with domestic and foreign banks and a large volume of scheduled principal repayments received on an annual basis. At May 31, 2006 and 2005, the Company had a total of $4.025 billion and $5 billion in revolving credit agreements and bank lines of credit. In addition, the Company limits the amount of dealer commercial paper and bank bid notes used in the funding of loans. The Company's objective is to maintain the amount of dealer commercial paper and bank bid notes used to 15% or less of total debt outstanding. At May 31, 2006 and 2005, there was a total of $1,758 million and $2,973 million, respectively, of dealer commercial paper and bank bid notes outstanding, representing 10% and 16%, respectively, of the Company's total debt outstanding.
  
Counterparty Risk
The Company is exposed to counterparty risk related to the performance of the parties with which it has entered into interest rate, cross currency and cross currency interest rate exchange agreements. To mitigate this risk, the Company only enters into these agreements with financial institutions with investment grade ratings. At May 31, 2006 and 2005, the Company was a party to interest rate exchange agreements with notional amounts totaling $12,536 million and $13,693 million and cross currency and cross currency interest rate exchange agreements with notional amounts totaling $716 million and $1,106 million, respectively. To date, the Company has not experienced a failure of a counterparty to perform as required under any of these agreements. At the time counterparties are selected to participate in the Company's exchange agreements, the counterparty must be a participant in one of its revolving credit agreements. At May 31, 2006, the Company's interest rate, cross currency and cross currency interest rate exchange agreement counterparties had credit ratings ranging from AAA to A- as assigned by Standard & Poor's Corporation.
 
The Company currently uses two types of interest rate exchange agreements: (1) the Company pays a fixed rate and receives a variable rate and (2) the Company pays a variable rate and receives a fixed rate. The following chart provides a breakout of the interest rate exchange agreements at May 31, 2006 by type of agreement.
  

(Dollar amounts in millions)  

Notional Amount

 

Average Rate Paid

 

Average Rate Received

 
Pay fixed / receive variable  

$

7,350

     

4.11

%

   

5.21

%  
Pay variable / receive fixed    

5,186

     

6.76

%

   

6.59

%  
Total  

$

12,536

     

5.20

%

   

5.78

%  
   

47


Foreign Currency Risk
The Company may issue commercial paper, medium-term notes or bonds denominated in foreign currencies. For any such obligation issued, the Company expects to enter into a cross currency or cross currency interest rate exchange agreement with a highly-rated counterparty. At May 31, 2006, the Company had a total of $434 million and $282 million of medium-term notes denominated in Euros and Australian dollars, respectively, for which cross currency and cross currency interest rate exchange agreements were in place obligating the Company to pay interest and principal in U.S. dollars based on an exchange rate fixed at the date of issuance. At May 31, 2005, CFC had $824 million and $282 million of medium-term notes denominated in Euros and Australian dollars, respectively. The Company's foreign currency valuation account, which represents the change in the foreign exchange rate from the date of issuance to the reporting date, increased the debt balance by $245 million and $261 million at May 31, 2006 and 2005, respectively. The change in the value of the foreign denominated debt is reported in the consolidated statements of operations as foreign currency adjustments. The change in the fair value of cross currency exchange agreements that qualify for hedge accounting is initially recorded to accumulated other comprehensive income and then reclassified to foreign currency adjustments. The change in the fair value of the foreign denominated debt and the change in the fair value of the related cross currency and cross currency interest rate exchange agreements are approximately the same amount and offsetting in the consolidated statements of operations. The change in the fair value of the cross currency and interest rate exchange agreements that do not qualify for hedge accounting is recorded to the derivative forward value line.
  
Rating Triggers
The Company has certain interest rate, cross currency, and cross currency interest rate exchange agreements that contain a condition that will allow one counterparty to terminate the agreement if the credit rating of the other counterparty drops to a certain level. This condition is commonly called a rating trigger. Under the rating trigger, if the credit rating for either counterparty falls to 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 net payment may be due from one counterparty to the other based on the fair value of the underlying derivative instrument. Rating triggers are not separate financial instruments and are not separate derivatives under SFAS 133. The Company's rating triggers are based on its senior unsecured credit rating from Standard & Poor's Corporation and Moody's Investors Service. At May 31, 2006, there are rating triggers associated with $10,005 million notional amount of interest rate, cross currency and cross currency interest rate exchange agreements. If the Company's rating from Moody's Investors Service falls to Baa1 or the Company's rating from Standard & Poor's Corporation falls to BBB+, the counterparties may terminate agreements with a total notional amount of $1,097 million. If the Company's rating from Moody's Investors Service falls below Baa1 or the Company's rating from Standard & Poor's Corporation falls below BBB+, the counterparties may terminate the agreements on the remaining total notional amount of $8,908 million.
  
At May 31, 2006, the Company 's exchange agreements subject to rating triggers had a derivative fair value of $45 million, comprised of $47 million that would be due to the Company and $2 million that the Company would have to pay if all interest rate, cross currency and cross currency interest rate exchange agreements with a rating trigger at the level of BBB+ or Baa1 and above were to be terminated, and a derivative fair value of $322 million, comprised of $393 million that would be due to the Company and $71 million that the Company would have to pay if all interest rate, cross currency and cross currency interest rate exchange agreements with a rating trigger below the level of BBB+ or Baa1 were to be terminated. See chart on page 42 for CFC's senior unsecured credit ratings as of May 31, 2006.
 
For additional information of risks related to the Company's business, see Item 1A "Risk Factors".
  

48


Financial Instruments and Derivatives
All financial instruments to which the Company was a party at May 31, 2006 were entered into or contracted for purposes other than trading. The following table provides the significant balances and contract terms related to the financial instruments at May 31, 2006.
 
         

Principal Amortization and Maturities

(Dollar amounts in millions)

Outstanding

                         

Remaining

 

Instrument

 

Balance

 

Fair Value

 

2007

 

2008

 

2009

 

2010

 

2011

 

Years

Investments

$

2

   

$

2

   

$

2

   

$

-

   

$

-

   

$

-

   

$

-

 

$

-

 
     Average rate  

4.83

%

           

4.83

%

   

-

     

-

     

-

     

-

   

-

 
Long-term fixed rate loans (1)  

14,491

     

12,115

     

670

     

693

     

664

     

674

     

674

   

11,116

 
     Average rate  

5.85

%

           

5.64

%

   

5.65

%

   

5.67

%

   

5.75

%

   

5.81

%

 

5.89

%
Long-term variable rate loans (2)  

1,645

     

1,645

     

122

     

129

     

110

     

127

     

105

   

1,052

 
     Average rate (3)  

7.35

%

           

-

     

-