10-K 1 may312008_10k.htm MAY 31, 2008 10-K may312008_10k.htm


 
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, 2008

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 telephone number, including area code, is 703-709-6700)



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


 
   
Name of each
     
Name of each
 
   
exchange on
     
exchange on
 
Title of each class
 
which listed
 
Title of each class
 
which listed
 
5.75% Collateral Trust Bonds, due 2008
 
NYSE
 
7.35% Collateral Trust Bonds, due 2026
 
NYSE
 
5.70% Collateral Trust Bonds, due 2010
 
NYSE
 
6.75% Subordinated Notes, due 2043
 
NYSE
 
7.20% Collateral Trust Bonds, due 2015
 
NYSE
 
6.10% Subordinated Notes, due 2044
 
NYSE
 
6.55% Collateral Trust Bonds, due 2018
 
NYSE
 
5.95% Subordinated Notes, due 2045
 
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 (Section 229.405 of this chapter) 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, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer ¨                    Accelerated filer ¨                     Non-accelerated filer x                   Smaller reporting company ¨

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 is a cooperative and consequently, does not issue any equity capital stock.


 
 

 


TABLE OF CONTENTS
Part No.
Item No.
 
Page
I.
 
1.
 
Business
1
 
         
General
1
 
         
Members
2
 
         
Distribution Systems
3
 
         
Power Supply Systems
3
 
         
Service Organizations and Associate Systems
4
 
         
Telecommunications Systems
4
 
       
Loan Programs
4
 
         
Interest Rates on Loans
5
 
         
National Rural 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
7
 
         
Guarantees of Long-Term Tax-Exempt Bonds
8
 
         
Guarantees of Tax Benefit Transfers
8
 
         
Letters of Credit
8
 
         
Other Guarantees
8
 
       
Disaster Recovery
9
 
       
Tax Status
9
 
       
Investment Policy
9
 
       
Employees
10
 
       
National Rural Lending Competition
10
 
       
Member Regulation and Competition
10
 
       
The RUS Program
12
 
   
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 Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of
   
       
Equity Securities
16
 
   
6.
 
Selected Financial Data
16
 
   
7.
 
Management's Discussion and Analysis of Financial Condition and Results of Operations
17
 
         
Business Overview
17
 
         
Critical Accounting Estimates
19
 
         
New Accounting Pronouncements
23
 
         
Results of Operations
24
 
         
Ratio of Earnings to Fixed Charges
33
 
         
Financial Condition
33
 
         
Off-Balance Sheet Obligations
41
 
         
Liquidity and Capital Resources
43
 
         
Market Risk
46
 
         
Non-GAAP Financial Measures
51
 
   
7A.
 
Quantitative and Qualitative Disclosures About Market Risk
55
 
   
8.
 
Financial Statements and Supplementary Data
55
 
   
9.
 
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
55
 
   
9A(T).
 
Controls and Procedures
55
 
   
9B.
 
Other Information
56
 
III.
 
10.
 
Directors, Executive Officers and Corporate Governance
57
 
   
11.
 
Executive Compensation
62
 
   
12.
 
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder
   
       
Matters
72
 
   
13.
 
Certain Relationships and Related Transactions, and Director Independence
72
 
   
14.
 
Principal Accountant Fees and Services
74
 
IV.
 
15.
 
Exhibits and Financial Statement Schedules
75
 
       
Signatures
78
 

 
 

 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Form 10-K contains forward-looking statements within the meaning of the Securities Act of 1933, as amended, and the Exchange Act of 1934, as amended.  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. All statements that address expectations or projections about the future, including statements about loan growth, the adequacy of the loan loss allowance, net income growth, leverage and debt to equity ratios, and borrower financial performance are forward-looking statements.  Although we believe that the expectations reflected in our forward-looking statements are based on reasonable assumptions, actual results and performance could differ materially from those set forth in the forward-looking statements.  Factors that could cause future results to vary from current expectations include, but are not limited to, general economic conditions, legislative changes, governmental monetary and fiscal policies, changes in tax policies, changes in interest rates, the interest expense, demand for our loan products, changes in the quality or composition of our loan and investment portfolios, changes in accounting principles, policies or guidelines, and other economic and governmental factors affecting our operations.  Some of these and other factors are discussed in our annual and quarterly reports previously filed with the Securities and Exchange Commission ("SEC").  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 ("National Rural" 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 National Rural 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.  National Rural 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.  National Rural also provides its members with credit enhancements in the form of letters of credit and guarantees of debt obligations.  National Rural is exempt from payment of federal income taxes under the provisions of Section 501(c)(4) of the Internal Revenue Code.  National Rural is a not-for-profit member-owned finance cooperative, thus its objective is not to maximize its net income, but to offer its members low cost financial products and services consistent with sound financial management.  National Rural’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 National Rural makes available, free of charge, as soon as reasonably practicable after the report is filed with the SEC.  Information posted on National Rural’s website is not incorporated by reference into this Form 10-K.

For financial statement purposes, the results of operations and financial condition of National Rural are consolidated with and include Rural Telephone Finance Cooperative ("RTFC") and National Cooperative Services Corporation ("NCSC").  Unless stated otherwise, references to the Company relate to the consolidation of National Rural, RTFC, NCSC and certain entities controlled by National Rural and created to hold foreclosed assets and effect loan securitization transactions.  National Rural also reports the operations for each of National Rural, RTFC and NCSC as separate segments.  See Note 17 to the consolidated financial statements for further information on the Company’s segment reporting.

RTFC is a private not-for-profit cooperative association originally incorporated in the state of South Dakota in 1987 and reincorporated in the District of Columbia in 2005.  The principal purpose of RTFC is to provide and arrange financing for its rural telecommunications members and their affiliates.  National Rural 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 National Rural a fee in exchange for which National Rural reimburses RTFC for loan losses.  RTFC is headquartered with National Rural in Herndon, Virginia.  RTFC is a taxable cooperative that pays income tax based on its net income, excluding net income allocated to its members, as allowed by law under Subchapter T of the Internal Revenue Code.

NCSC was incorporated in 1981 in the District of Columbia as a private non-profit 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 National Rural.  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 National Rural and distribution systems that are members of National Rural or are eligible for such membership.  National Rural is the primary source of funding to and manages the lending and financial affairs of NCSC through a management agreement which

 
1

 

is automatically renewable on an annual basis unless terminated by either party.  Under a guarantee agreement, NCSC pays National Rural a fee in exchange for which National Rural reimburses NCSC for loan losses, excluding losses in the consumer loan program.  NCSC is headquartered with National Rural in Herndon, Virginia.  NCSC is a taxable corporation.

Members
The Company's consolidated membership was 1,538 as of May 31, 2008 including 898 utility members, the majority of which are consumer-owned electric cooperatives, 511 telecommunications members, 66 service members and 63 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 National Rural, RTFC and NCSC have been eliminated in consolidation.

National Rural 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 wholly-owned or controlled by Class A or Class B members; and
·  
Class D - national associations of cooperatives.

Class A membership in National Rural is limited to cooperative or not-for-profit distribution systems that receive or are eligible to receive loans or other assistance from RUS.  The associates are not-for-profit 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 National Rural’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 telecommunications services to ultimate users.

Membership in NCSC is limited to National Rural and organizations that are Class A members of National Rural or are eligible to be Class A members of National Rural.

In many cases, the residential and commercial customers of National Rural’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.

 
2

 

Set forth below is a table showing by state or U.S. territory the total number of National Rural, RTFC and NCSC members, the percentage of total loans and the percentage of total loans and guarantees outstanding at May 31, 2008.

   
Number
     
Loan and
       
Number
     
Loan and
   
of
 
Loan
 
Guarantee
       
of
 
Loan
 
Guarantee
State/Territory
 
Members
 
%
 
%
   
State/Territory
 
Members
 
%
 
%
Alabama
   
30
     
2.18
%
   
2.43
%
   
Missouri
   
65
     
3.59
%
   
3.78
%
Alaska
   
30
     
1.96
%
   
1.86
%
   
Montana
   
40
     
0.70
%
   
0.71
%
American Samoa
   
1
     
-
     
-
     
Nebraska
   
40
     
0.10
%
   
0.09
%
Arizona
   
27
     
1.09
%
   
1.20
%
   
Nevada
   
7
     
0.82
%
   
0.80
%
Arkansas
   
30
     
2.74
%
   
2.64
%
   
New Hampshire
   
4
     
0.75
%
   
0.88
%
California
   
11
     
0.14
%
   
0.16
%
   
New Jersey
   
1
     
0.09
%
   
0.09
%
Colorado
   
39
     
4.95
%
   
4.96
%
   
New Mexico
   
25
     
0.19
%
   
0.19
%
Connecticut
   
1
     
1.05
%
   
1.00
%
   
New York
   
21
     
0.10
%
   
0.10
%
Delaware
   
1
     
0.20
%
   
0.19
%
   
North Carolina
   
42
     
2.56
%
   
2.93
%
District of Columbia
   
4
     
0.05
%
   
0.13
%
   
North Dakota
   
33
     
0.36
%
   
0.38
%
Florida
   
19
     
3.56
%
   
3.39
%
   
Ohio
   
42
     
2.39
%
   
2.31
%
Georgia
   
68
     
8.24
%
   
7.94
%
   
Oklahoma
   
49
     
2.54
%
   
2.41
%
Guam
   
1
     
-
     
-
     
Oregon
   
39
     
1.59
%
   
1.66
%
Hawaii
   
1
     
0.04
%
   
0.04
%
   
Pennsylvania
   
26
     
1.88
%
   
1.87
%
Idaho
   
17
     
0.83
%
   
0.80
%
   
South Carolina
   
38
     
2.55
%
   
2.45
%
Illinois
   
52
     
3.16
%
   
2.99
%
   
South Dakota
   
46
     
0.78
%
   
0.74
%
Indiana
   
52
     
2.79
%
   
2.64
%
   
Tennessee
   
29
     
0.57
%
   
0.54
%
Iowa
   
118
     
2.44
%
   
2.36
%
   
Texas
   
108
     
16.00
%
   
16.14
%
Kansas
   
49
     
4.62
%
   
4.68
%
   
Utah
   
11
     
3.00
%
   
2.91
%
Kentucky
   
33
     
1.91
%
   
2.33
%
   
Vermont
   
7
     
0.39
%
   
0.38
%
Louisiana
   
17
     
1.76
%
   
1.67
%
   
Virgin Islands
   
-
     
2.58
%
   
2.45
%
Maine
   
6
     
0.02
%
   
0.02
%
   
Virginia
   
27
     
1.24
%
   
1.19
%
Maryland
   
2
     
1.18
%
   
1.18
%
   
Washington
   
19
     
0.65
%
   
0.71
%
Massachusetts
   
1
     
-
     
-
     
West Virginia
   
4
     
0.03
%
   
0.03
%
Michigan
   
27
     
1.39
%
   
1.33
%
   
Wisconsin
   
62
     
2.02
%
   
1.92
%
Minnesota
   
74
     
3.45
%
   
3.28
%
   
Wyoming
   
15
     
0.70
%
   
0.73
%
Mississippi
   
27
     
2.08
%
   
2.39
%
   
Total
   
1,538
     
100.00
%
   
100.00
%

Distribution Systems
Distribution systems are utilities engaged in retail sales of electricity to consumers in their service areas.  Most distribution systems have all-requirements power purchase contracts with their power supply systems, which are owned and controlled by the member distribution systems.  Wholesale power for resale also comes from other sources, including power supply 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 61 operating power supply systems that have financing commitments from National Rural at December 31, 2007 (the most recent year for which data is available as of the date of filing this Form 10-K), 37 had generating capacity of at least 100 megawatts, 7 had less than 100 megawatts of generating capacity and 17 had no generating capacity.  The systems with no generating capacity generally operated transmission lines to

 
3

 

supply certain distribution systems.  Certain other power supply systems have been formed but do not yet own generating or transmission facilities or have financing commitments from National Rural.

Service Organizations and Associate Systems
Service organizations include 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 remainder 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 less than 15% of a local exchange telecommunications industry that provides service to over 172 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 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.

Loan Programs

Set forth below is a table showing the weighted average loans outstanding to borrowers and the weighted average interest rates thereon by loan program and by segment during fiscal years ended May 31:

   
2008
 
2007
   
Weighted average
 
Weighted average
 
Weighted average
 
Weighted average
   
loans outstanding
 
interest rate
 
loans outstanding
 
interest rate
(Dollar amounts in thousands)
                               
Total by loan type: (1)
                               
   Long-term fixed rate loans
 
$
14,573,227
   
6.05
%
 
$
14,323,272
   
5.87
%
   Long-term variable rate loans
   
1,170,017
   
6.94
%
   
1,433,484
   
7.58
%
   Loans guaranteed by RUS
   
252,788
   
5.49
%
   
258,407
   
5.59
%
   Short-term loans
   
1,310,313
   
5.89
%
   
1,028,585
   
7.06
%
   Non-performing loans
   
504,310
   
0.01
%
   
534,733
   
0.02
%
   Restructured loans
   
589,662
   
0.64
%
   
614,580
   
0.61
%
Total loans
 
$
18,400,317
   
5.81
%
 
$
18,193,061
   
5.79
%
                             
 Total by segment:
                           
   National Rural
 
$
16,167,441
   
5.85
%
 
$
15,803,285
   
5.80
%
   RTFC
   
1,791,100
   
4.97
%
   
1,993,672
   
5.30
%
   NCSC
   
441,776
   
7.68
%
   
396,104
   
8.00
%
   Total
   
$
18,400,317
   
5.81
%
 
$
18,193,061
   
5.79
%
(1) Loans are classified as long-term or short-term based on their original maturity.

 
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
 
2008
 
2007
 
2006
 
State/Territory
 
2008
 
2007
 
2006
 
Alabama
$
414,961
   
$
347,723
   
$
355,420
     
Montana
$
133,655
   
$
132,603
   
$
147,731
   
Alaska
 
371,768
     
335,352
     
333,716
     
Nebraska
 
18,756
     
16,447
     
14,149
   
American Samoa
 
769
     
769
     
1,604
     
Nevada
 
155,625
     
147,401
     
137,701
   
Arizona
 
206,558
     
178,659
     
169,754
     
New Hampshire
 
143,417
     
149,496
     
164,651
   
Arkansas
 
522,018
     
518,273
     
549,552
     
New Jersey
 
17,747
     
18,217
     
18,211
   
California
 
25,968
     
27,283
     
24,362
     
New Mexico
 
36,636
     
32,344
     
36,528
   
Colorado
 
942,179
     
922,558
     
876,100
     
New York
 
19,735
     
19,844
     
21,782
   
Connecticut
 
200,000
     
200,000
     
200,000
     
North Carolina
 
487,249
     
519,214
     
522,194
   
Delaware
 
37,950
     
39,582
     
23,842
     
North Dakota
 
69,120
     
77,072
     
77,002
   
District of Columbia
 
9,514
     
9,717
     
9,908
     
Ohio
 
455,491
     
390,350
     
410,346
   
Florida
 
677,365
     
617,010
     
659,416
     
Oklahoma
 
483,623
     
480,536
     
490,351
   
Georgia
 
1,567,108
     
1,566,308
     
1,557,675
     
Oregon
 
303,166
     
305,506
     
305,961
   
Hawaii
 
6,804
     
7,157
     
7,500
     
Pennsylvania
 
357,337
     
376,193
     
438,914
   
Idaho
 
157,703
     
168,253
     
165,035
     
South Carolina
 
484,733
     
476,139
     
501,990
   
Illinois
 
600,571
     
543,389
     
509,391
     
South Dakota
 
147,916
     
161,247
     
169,335
   
Indiana
 
530,008
     
481,243
     
432,953
     
Tennessee
 
107,575
     
96,073
     
111,043
   
Iowa
 
465,056
     
482,513
     
468,236
     
Texas
 
3,044,117
     
2,618,010
     
2,877,586
   
Kansas
 
878,630
     
849,864
     
593,670
     
Utah
 
570,971
     
565,768
     
580,472
   
Kentucky
 
363,720
     
355,503
     
335,551
     
Vermont
 
74,957
     
75,905
     
81,761
   
Louisiana
 
333,984
     
320,765
     
382,505
     
Virgin Islands
 
491,706
     
492,795
     
488,392
   
Maine
 
4,566
     
9,884
     
11,737
     
Virginia
 
235,916
     
184,986
     
209,153
   
Maryland
 
224,754
     
206,491
     
176,797
     
Washington
 
122,674
     
110,907
     
102,128
   
Michigan
 
265,116
     
271,541
     
294,162
     
West Virginia
 
6,109
     
5,355
     
7,700
   
Minnesota
 
655,576
     
731,883
     
744,941
     
Wisconsin
 
384,748
     
369,427
     
348,351
   
Mississippi
 
395,423
     
366,989
     
426,634
     
Wyoming
 
133,087
     
117,374
     
117,098
   
Missouri
 
682,860
     
630,289
     
669,914
     
 Total
$
19,026,995
   
$
18,128,207
   
$
18,360,905
   
                                                     

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, 2008, 2007 and 2006, loans outstanding to borrowers located in any one state or territory did not exceed 16%, 15% and 16%, respectively, of total loans outstanding.

Interest Rates on Loans
National Rural’s goal as a not-for-profit cooperatively-owned finance company is to set rates at levels that will provide its members with low cost financing while maintaining sound financial results as required to obtain high credit ratings on its debt instruments.  National Rural 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 level of earnings.  Various discounts, which reduce the stated interest rates, are available to borrowers meeting certain criteria related to business type, performance, volume and whether National Rural is their sole mortgage holder.

National Rural 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 may select another fixed rate term or the variable rate.  National Rural 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.

In addition to National Rural’s customary loan standards, 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.  Similarly, power supply systems generally must maintain an average times interest earned ratio ("TIER") and MDSC, as defined in the loan agreement, of 1.0 or greater.  These are general guidelines only and National Rural has in the past and may in the future make long-term loans to distribution and power supply systems that do not meet these criteria.

 
5

 


Short-Term Loans
National Rural’s short-term loans are line of credit loans and generally are 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.

Interim financing line of credit loans are also made available to National Rural members that have a loan application pending with RUS and have received approval from RUS to obtain interim financing.  Advances under these interim facilities are made with the agreement that they 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.  Most of these RLECs have evolved from solely being voice service providers to being providers of voice, data and, often times, video and wireless services.  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 generally support 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 not exceeding 15 years.  Loans may be advanced at a fixed or variable interest rate.  Fixed rates are generally available for periods from one year to the final loan maturity.  Upon the expiration of the selected fixed interest rate term, the borrower may select another fixed rate term or a 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, experience of the management team 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.

Short-Term Loans
RTFC provides line of credit loans to telecommunications systems for periods generally not to exceed five years.  These line of credit loans are typically revolving facilities and generally require 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 rural utility members and 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 National Rural member cooperative with which it is affiliated.

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 is not a party to these lease agreements.  NCSC no longer provides new financing of this type.

 
6

 


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 generally 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
National Rural 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 National Rural.  Under this agreement, National Rural may make long-term secured loans to eligible members for periods of up to 35 years, at fixed or variable rates established by National Rural.  RUS guarantees the principal and interest payments on the notes evidencing such loans.  At May 31, 2008, National Rural had $215 million of loans outstanding under this program.  In addition, at May 31, 2008, National Rural was holding certificates totaling $35 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.  Such conversion will be effective on the first day of the following month. Generally, a borrower may convert from a fixed rate to another fixed rate or to 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 plus a make-whole premium, if applicable, per current loan policies.

Prepayment of Loans
Generally, 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 if in variable interest rate mode.

Loan Security
Except when providing short-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)
 
2008
 
2007
Total by loan program:
 
Secured
 
%
 
Unsecured
 
%
 
Secured
 
%
 
Unsecured
 
%
 
Long-term fixed rate loans
$
14,732,058
 
97%
$
472,556
 
3%
$
14,180,956
 
97%
$
482,384
 
3%
 
Long-term variable rate loans
 
1,728,803
 
92%
 
153,292
 
8%
 
1,865,821
 
94%
 
127,713
 
6%
 
Loans guaranteed by RUS
 
250,169
 
100%
 
-
 
-
 
255,903
 
100%
 
-
 
-
 
Short-term loans
 
165,226
 
10%
 
1,524,891
 
90%
 
191,231
 
16%
 
1,024,199
 
84%
 
  Total loans
$
16,876,256
 
89%
$
2,150,739
 
11%
$
16,493,911
 
91%
$
1,634,296
 
9%
                                   
Total by segment:
                               
 
National Rural
$
15,021,067
 
89%
$
1,865,340
 
11%
$
14,462,448
 
92%
$
1,342,842
 
8%
 
RTFC
 
1,497,487
 
87%
 
229,027
 
13%
 
1,630,079
 
88%
 
230,300
 
12%
 
NCSC
 
357,702
 
86%
 
56,372
 
14%
 
401,384
 
87%
 
61,154
 
13%
 
  Total loans
$
16,876,256
 
89%
$
2,150,739
 
11%
$
16,493,911
 
91%
$
1,634,296
 
9%

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)
2008
 
2007
   
Long-term tax-exempt bonds
$
498,495
   
$
526,185
         
Indemnifications of tax benefit transfers
 
94,821
     
107,741
         
Letters of credit
 
343,424
     
365,766
         
Other guarantees
 
100,400
     
74,682
         
     Total
$
1,037,140
   
$
1,074,374
         

Members' interest expense for the years ended May 31, 2008 and 2007 on debt obligations guaranteed by the Company was approximately $21 million and $20 million, respectively.

 
7

 

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 due to such non-payment by the system 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 on a pari passu basis with other lenders (including, in most cases, RUS), by a lien on substantially all of the system’s assets.  If the security instrument is a common mortgage with RUS, then in general, the Company may not exercise remedies thereunder for up to two years following default.  However, if the debt is accelerated under the common mortgage 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 short-term 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.  At May 31, 2008, the Company was the guarantor and liquidity provider for $330 million of tax-exempt bonds issued for its member cooperatives.  Additionally, National Rural was the guarantor, but not liquidity provider, for $155 million of tax-exempt bonds that were in the auction rate mode.

Guarantees of Tax Benefit Transfers
The Company also has 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 a short-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 may be issued on a secured or unsecured basis and with such issuance fees as may be determined from time to time.  Each letter of credit issued by National Rural 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 short-term 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.

The following chart summarizes total guarantees by segment at May 31:

(Dollar amounts in thousands)
National Rural:
2008
 
2007
   
   Distribution
$
184,459
     
18%
   
$
211,320
     
20%
                 
   Power supply
 
786,455
     
76%
     
797,009
     
74%
                 
   Statewide and associate
 
22,785
     
2%
     
25,359
     
2%
                 
          National Rural Total
 
993,699
     
96%
     
1,033,688
     
96%
                 
RTFC
 
260
     
-
     
-
     
-
                 
NCSC
 
43,181
     
4%
     
40,686
     
4%
                 
          Total
$
1,037,140
     
100%
   
$
1,074,374
     
100%
                 

 
8

 

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)
                               
State/Territory
 
2008
 
2007
 
2006
 
State/Territory
 
2008
 
2007
 
2006
   
 
Alabama
 
$
72,070
   
$
72,348
   
$
22,250
     
Montana
 
$
9,056
   
$
9,029
 
$
145
   
 
Alaska
   
1,900
     
1,900
     
1,800
     
Nebraska
   
4
     
6
   
-
   
 
Arizona
   
33,745
     
38,301
     
43,699
     
Nevada
   
5,400
     
5,400
   
-
   
 
Arkansas
   
8,008
     
12,027
     
15,921
     
New Hampshire
   
32,767
     
34,550
   
9,550
   
 
California
   
6,110
     
1,010
     
-
     
New Mexico
   
1,048
     
1,020
   
1,016
   
 
Colorado
   
53,467
     
54,236
     
55,131
     
North Carolina
   
99,729
     
100,630
   
107,817
   
 
District of Columbia
   
17,448
     
20,998
     
21,428
     
North Dakota
   
6,474
     
7,115
   
-
   
 
Florida
   
3,725
     
4,623
     
100,038
     
Ohio
   
8,000
     
5,500
   
2,000
   
 
Georgia
   
26,775
     
26,027
     
35,283
     
Oklahoma
   
754
     
3,056
   
4,358
   
 
Idaho
   
3,173
     
3,173
     
-
     
Oregon
   
29,034
     
29,439
   
24,922
   
 
Illinois
   
229
     
219
     
225
     
Pennsylvania
   
17,416
     
17,519
   
18,307
   
 
Indiana
   
13
     
7
     
911
     
South Carolina
   
6,300
     
7,819
   
50
   
 
Iowa
   
8,271
     
8,240
     
8,517
     
South Dakota
   
20
     
6
   
-
   
 
Kansas
   
60,797
     
55,472
     
42,561
     
Tennessee
   
1,460
     
296
   
295
   
 
Kentucky
   
102,423
     
124,013
     
121,864
     
Texas
   
194,214
     
152,307
   
167,881
   
 
Louisiana
   
389
     
4,733
     
4,778
     
Utah
   
13,495
     
17,193
   
20,594
   
 
Maine
   
2
     
1
     
-
     
Vermont
   
1,250
     
3,500
   
1,250
   
 
Maryland
   
11,725
     
25,266
     
24,800
     
Virginia
   
3,447
     
3,935
   
4,133
   
 
Michigan
   
2,232
     
2,123
     
1,163
     
Washington
   
19,050
     
23,171
   
250
   
 
Minnesota
   
3,025
     
10,585
     
76,010
     
Wisconsin
   
320
     
32
   
322
   
 
Mississippi
   
83,549
     
88,312
     
37,267
     
Wyoming
   
13,724
     
13,969
   
9,370
   
 
Missouri
   
75,102
     
85,268
     
93,074
     
Total
 
$
1,037,140
   
$
1,074,374
 
$
1,078,980
   

Disaster Recovery

The Company has had a comprehensive disaster recovery and business continuity plan in place since May of 2001.  The plan includes a duplication of the Company’s production information systems at an off-site facility coupled with an extensive business recovery plan to utilize those remote systems. The Company’s production data is replicated in real time to the recovery site 24 hours a day, 7 days a week.  The plan also includes steps for each of the Company’s operating groups to conduct business with a view to minimizing disruption for customers. The Company has conducted Disaster Recovery exercises twice a year that include both the information technology group and business areas. The Company contracts with an external vendor for the facilities to house the National Rural owned backup systems as well as office space and related office equipment.  Backup tapes are also stored at an off-site storage location managed by an external vendor.

Tax Status

In 1969, National Rural obtained a ruling from the Internal Revenue Service recognizing National Rural’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 National Rural’s business.  National Rural 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 to exclude from taxable income the amount of net income allocated to its members.  RTFC pays income tax based on its net income, excluding net income allocated to its members.  NCSC is a taxable corporation. NCSC pays income tax annually based on its net income for the period.


Investment Policy

Surplus funds are invested pursuant to policies adopted by National Rural’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 may 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.

 
9

 

Employees

At May 31, 2008, National Rural had 231 employees, including financial and legal personnel, management specialists, credit analysts, accountants and support staff.  National Rural believes that its relations with its employees are good.

National Rural Lending Competition

National Rural competes with other lenders on price, the variety of financing options offered and additional services provided to its member/owners.  National Rural is primarily in competition with other banks for the business of its members.  The primary bank competitor is CoBank, ACB ("CoBank"), a government sponsored enterprise and member of the Farm Credit System whose status as such gives it the ability to offer lower interest rates in many situations.  In addition, there are some members that are large enough to access the capital markets for funding.  In these cases, National Rural is competing with the pricing and funding options the member is able to obtain in the capital markets.  National Rural attempts to minimize the impact of competition by offering a variety of loan options and complimentary services and by leveraging the working relationship that it has developed with the majority of the members for more than 35 years.

RUS is generally the members' first financing option as it is able to offer members interest rates that are generally lower than the rates National Rural and the other banks are able to offer.  However, National Rural and other banks do 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 cannot borrow from RUS and loans to members that have elected not to borrow from RUS.

According to December 31, 2006 financial data (the latest full calendar year for which this data is available as of the date of filing this Form 10-K) provided to National Rural by its 811 reporting electric cooperative distribution and 57 reporting power supply systems, those entities had a total of $53 billion in long-term debt outstanding at December 31, 2006.  RUS is the dominant lender to the electric cooperative industry with $29 billion or 54% of the total outstanding debt for the 868 systems reporting 2006 results to National Rural.  At December 31, 2006, National Rural 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.  National Rural’s $16 billion long-term exposure represented 30% of the total long-term debt to these electric systems.  The remaining $9 billion or 16% was borrowed from other sources.

At December 31, 2007, 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, 2007, RUS had a total of approximately $3.7 billion outstanding to telecommunications borrowers.  The Rural Telephone Bank ("RTB") was fully liquidated in November 2007 which resulted in the transfer of 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, 2007, RTFC had a total of $1.7 billion in long-term loans outstanding to telecommunications borrowers.

Member Regulation and Competition

Electric Systems
The movement toward electric competition at the retail level has faltered, while the wholesale level has become largely competitive.  The electric utility industry has settled into a "hybrid" model in which there are significant differences in the retail regulatory approaches followed in different states and regions.  As of May 31, 2008, retail customer choice has been implemented in 15 states.  Those states are Arizona, Connecticut, Delaware, Illinois, Maine, Maryland, Massachusetts, Michigan, New Hampshire, New Jersey, New York, Ohio, Pennsylvania, Rhode Island, and Texas.  Of the remaining states, retail customer choice was not under consideration in 26 states, delayed in four states (Nevada, Oklahoma, Oregon, and West Virginia), repealed in four states (Arkansas, Montana, New Mexico, and Virginia), and suspended in one state (California).

In the 15 states where retail customer choice has been implemented, the Company had 158 distribution members and 19 power supply members with a total of $5,164 million of loans outstanding at May 31, 2008.  In New York, where the Company has four distribution members and $9 million of loans to electric systems, cooperatives are not required to file competition plans with the state utility commission.  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.

 
10

 

In addition, in four of the 15 states where retail customer choice has been implemented, cooperatives 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, and Texas.  As of May 31, 2008, National Rural had loans outstanding in the amount of $4,002 million in those states.  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.  Customer choice has had no impact on power supply cooperatives and the Company does not expect any impact.

Even in states where retail customer choice laws have been passed, 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 retail competition in areas served by cooperatives 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 demonstrated much interest in providing electric energy to residential or rural customers.

In addition to retail 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.  Those states are Arizona, Arkansas, Georgia, Hawaii, Kentucky, Louisiana, Maine, Maryland, Michigan, New Mexico, New York, Utah, Vermont, Virginia, West Virginia, and Wyoming.  Two of these states (Georgia and Utah) 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.  Those states are Alabama, Arizona, Colorado, Delaware, Georgia, Hawaii, Indiana, Kansas, Kentucky, Louisiana, Maine, Maryland, Massachusetts, New Hampshire, Rhode Island, Utah, Vermont, Virginia and Wyoming.  One of these states (Alabama) regulates both the issuance of short-term and long-term debt.  FERC also has jurisdiction to regulate transmission rates, wholesale rates, terms and conditions of service, and the issuance of securities by public utilities within its jurisdiction, which includes only a few cooperatives.

Telecommunications Systems
RTFC member telecommunications systems generally are regulated at the state and federal levels.  Most state commissions 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 Telecom 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 requirement to provide competitors with access to their networks, absent a determination that it would be in the public interest.

Competition continues to be a significant factor in the telecommunications industry.  A January 2007 FCC report on competition states that as of June 2006, competitive local exchange carriers ("CLECs") provided service to 30 million access lines - 17.4 % of the nation's 172 million end-user switched access lines.  Wireless carriers are providing service to 217.4 million mobile telephone service subscriptions - more than LECs and CLECs combined.    For the most part, local exchange competition has benefited RLECs by enabling them to enter nearby towns and cities as CLECs, 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 to date 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.  In addition, RLECs are experiencing some of the access line and access revenue losses experienced by the RBOCs.  However, growth in digital subscriber line service (DSL) has generally offset the revenue loss created by the decline of voice access lines.

 
11

 

Numerous wireless carriers have entered rural markets as competitors to the RLECs.  By obtaining competitive eligible telecommunications carrier (“CETC”) status from state regulators (as provided for in the Telecom Act), these wireless carriers are able to receive universal service funds ("USF") based on the incumbent LEC's costs (the “identical support” rule).  This has led to growth in claims on the fund and great concern for its sustainability.  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 demand for USF funding has resulted in the rate assessed on all participants in the nationwide network (the “contribution factor”) becoming unsustainably high.  The second quarter 2008 contribution factor is 11.3%.  Many in the industry agree that changes need to be made regarding eligibility and the funding mechanism for USF.  However, there is no agreement on what those changes should be.  In May 2008, the FCC ordered that payments to CETCs be capped.  Total support for a CETC will be capped at what they were eligible to receive in March 2008.  In January 2008 the FCC issued three notices of proposed rulemaking on universal service funding.  These related proceedings addressed creation of separate funds for incumbent and competitive ETCs, elimination of the “identical support” rule, and transitioning to a reverse auction regime for determining amounts of USF support an eligible carrier would receive.  RLECs universally supported the elimination of the identical support rule and opposed reverse auctions.  Positions on the creation of separate funds varied among RLECs.  Predictably, the wireless carriers supported reverse auctions, opposed elimination of the identical support rule and, as with the RLECs, took varying positions on creating separate universal service funds.

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.  No action has been taken in this proceeding and it is unlikely that the FCC will take any in the near future.

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.

As noted above, most RLECs are expanding their service offerings to customers.  Without competitors in the most rural parts of their service 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.

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 rural and urban 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. To date, RUS has obligated $1.53 billion in broadband loans.  Congress authorized $300 million in fiscal year 2008 lending authority.  The appropriation for fiscal year 2009 has been approved at $298 million.

Given the increased availability of government financing for rural broadband, it is unlikely that the Company will be participating in this financing to any significant degree outside of incremental lending to existing RLEC borrowers to provide broadband services to their customers.

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 creation of local electric cooperatives that were originally financed under the RE Act loan program in 47 states and two 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 electricity generating capacity.

In 1949, the RE Act was amended to allow lending for the purpose of furnishing and improving rural telecommunications service.  For fiscal year 2008, RUS has $690 million in lending authority for rural telephone systems and an additional $523 million for other telecommunications programs, including distance learning and broadband.

 
12

 

The RE Act provides for RUS to make insured loans and to provide other forms of financial assistance to electric borrowers.  However, RUS is currently not offering loans to finance the construction of new coal or nuclear baseload electric generation facilities. RUS is authorized to make direct loans 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 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, 2009, the President’s budget requests $100 million for hardship loans and $4 billion for loan guarantees with no requested budget for either municipal rate loans and treasury rate loans.  Electric funding levels for fiscal year 2008 were as follows: hardship loans of $100 million, and loan guarantees of $6.5 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 National Rural are described below.  The risks and uncertainties described below are not the only ones facing National Rural.  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, 2008, the Company had $3,150 million of commercial paper, daily liquidity fund and bank bid notes and $3,177 million of medium-term notes, collateral trust bonds and long-term notes payable scheduled to mature during the next twelve months.  At May 31, 2008, the Company was the guarantor and liquidity provider for $330 million of tax-exempt bonds issued for its member cooperatives.  Additionally, National Rural was the guarantor, but not liquidity provider, for $155 million of tax-exempt bonds that were in the auction rate mode.  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 effect on net interest income and net income.

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 net interest income and net income.

In addition, the Company's calculated impairment on non-performing and restructured loans will increase as the Company's long-term variable and short-term interest rates increase.  Based on the current balance of impaired loans at May 31, 2008, an increase or decrease of 25 basis points to the Company's variable interest rates results in an increase or decrease of approximately $9 million, respectively, to the calculated impairment on loans irrespective of a change in the credit fundamentals of the impaired borrower.

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 cannot 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.

 
13

 

We may not recover the value of amounts that we lend.
National Rural’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 loan portfolio.  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 involves a high degree of subjectivity and requires National Rural 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 National Rural’s control, may require an increase in the allowance for loan losses.  In addition, if actual losses incurred exceed current estimates of probable losses currently included in the allowance for loan losses, National Rural 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 income, and may have a material adverse effect on National Rural’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 the Company’s 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 market acceptable levels.
Maintenance of adjusted leverage and debt to equity ratios within a reasonable range of market acceptable levels is important in relation to the Company's ability to access the capital markets.  A significant increase above market acceptable levels 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 exchange agreements subject to rating triggers at May 31, 2008, the Company may be required to make a payment of up to $1 million if its senior unsecured ratings declined to Baa1 or BBB+, and up to $31 million if its senior unsecured ratings declined below Baa1 or BBB+.  In calculating the required payments, the Company only considered agreements which, when netted for each counterparty as allowed by the underlying master agreement, would require 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 and conditions 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.

If the Company does not maintain compliance with covenants and conditions 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.

 
14

 

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 income.  National Rural’s continued exemption depends on it conducting its business in accordance with its 501(c)(4) status.

Item 1B.                      Unresolved Staff Comments.

None.

Item 2.                      Properties.

National Rural leases office space that serves as its headquarters in Fairfax County, Virginia.  In October 2005, National Rural entered into a three-year lease with the building owner for approximately 107,228 square feet of the facility’s office, meeting and storage space.  In September 2007, the Company exercised the option to extend the lease for an additional one-year period.  The Company has the option to extend the lease for an additional one-year period in fiscal year 2009.  The terms of these extensions are similar to the initial three-year lease.  National Rural finalized a contract in May 2008 to purchase 42 acres of land located in Loudoun County, Virginia.  National Rural will use the purchased land in connection with its plans to construct a new headquarters facility.

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, Related Stockholder Matters and Issuer Purchases of Equity Securities.

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)
 
2008
 
2007
 
2006
 
2005
 
2004
   
For the year ended May 31:
                                           
Interest income
 
$
1,069,540
   
$
1,054,224
   
$
1,007,912
   
$
1,030,853
   
$
1,009,856
     
Net interest income
   
132,651
     
57,494
     
31,976
     
88,820
     
68,365
     
Derivative cash settlements (1)
   
27,033
     
86,442
     
80,883
     
78,287
     
123,363
     
Derivative forward value (1)
   
(98,743
)
   
(79,281
)
   
28,805
     
25,849
     
(228,840
)
   
Foreign currency adjustments (2)
   
-
     
(14,554
)
   
(22,594
)
   
(22,893
)
   
(65,310
)
   
Income (loss) prior to income taxes, minority
     interest and cumulative effect of change in
     accounting principle (3)
   
36,311
     
16,541
     
105,762
     
126,561
     
(194,292
)
   
Cumulative effect of change in
                                           
     accounting principle (4)
   
-
     
-
     
-
     
-
     
22,369
     
Net income (loss)
 
$
45,745
   
$
11,701
   
$
95,497
   
$
122,503
   
$
(177,729
)
   
Fixed charge coverage ratio (TIER) (5)(6)
   
1.05
     
1.01
     
1.10
     
1.13
     
-
     
Adjusted fixed charge coverage ratio
                                           
      (Adjusted TIER) (7)
   
1.15
     
1.12
     
1.11
     
1.14
     
1.12
     
                                             
As of May 31:
                                           
Loans to members (8)
 
$
19,029,040
   
$
18,131,873
   
$
18,363,954
   
$
18,974,108
   
$
20,490,021
     
Allowance for loan losses
   
   (514,906
)
   
(561,663
)
   
(611,443
)
   
(589,749
)
   
(573,939
)
   
Assets
   
19,379,381
     
18,575,181
     
19,179,621
     
20,060,314
     
21,455,443
     
Short-term debt (9)
   
6,327,453
     
4,427,123
     
5,343,824
     
7,952,579
     
5,990,039
     
Long-term debt (10)
   
10,173,587
     
11,295,219
     
10,642,028
     
8,701,955
     
12,009,182
     
Subordinated deferrable debt (11)
   
311,440
     
311,440
     
486,440
     
685,000
     
550,000
     
Members' subordinated certificates
   
1,406,779
     
1,381,447
     
1,427,960
     
1,490,750
     
1,665,158
     
Members' equity (1)
   
     613,082
     
566,286
     
545,351
     
523,583
     
483,126
     
Total equity
   
665,965
     
710,041
     
784,408
     
 764,934
     
 692,453
     
Guarantees
 
$
  1,037,140
   
$
1,074,374
   
$
1,078,980
   
$
1,157,752
   
$
1,331,299
     
Leverage ratio (6)
   
         29.64
     
26.64
     
24.80
     
26.71
     
31.88
     
Adjusted leverage ratio (7)
   
           7.50
     
6.81
     
6.38
     
6.50
     
7.07
     
Debt to equity ratio (6)
   
         28.08
     
25.13
     
23.42
     
25.20
     
29.95
     
Adjusted debt to equity ratio (7)
   
           7.06
     
6.37
     
5.97
     
6.07
     
6.58
     
     
(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.  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.  Members' equity represents total equity excluding foreign currency adjustments, derivative forward value 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 an exchange agreement that qualifies for hedge accounting 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.  National Rural 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) Includes $43 million gain on sale of building and land at May 31, 2006.
(4) 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.
(5) The fixed charge coverage ratio is the same calculation as National Rural’s Times Interest Earned Ratio ("TIER").  For the year ended May 31, 2004, National Rural’s earnings were insufficient to cover fixed charges by $200 million.
(6) See "Non-GAAP Financial Measures" in Management's Discussion and Analysis for the GAAP calculations of these ratios.
(7) Adjusted ratios include non-GAAP adjustments that National Rural 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.
(8) Certain reclassifications of prior year period amounts have been made to conform to the current reporting format.  See further explanation in Note 1(w) to the consolidated financial statements.
(9) Includes the foreign currency valuation account of $245 million and $40 million at May 31, 2006 and 2005, respectively.
(10) Excludes $3,177 million, $1,368 million, $1,839 million, $3,591 million, and $2,365 million in long-term debt that comes due, matures and/or will be redeemed during fiscal years 2009, 2008, 2007, 2006 and 2005, respectively (see Note 5 to the consolidated financial statements).  Includes the foreign currency valuation account of $221 million and $234 million at May 31, 2005 and 2004, respectively.
(11) Excludes $175 million called in June 2007 and $150 million called in June 2006 at May 31, 2007 and 2006, respectively, reported in short-term debt.


 
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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 ("National Rural" or "the Company"), Rural Telephone Finance Cooperative ("RTFC"), National Cooperative Services Corporation ("NCSC") and certain entities controlled by National Rural and created to hold foreclosed assets and effect loan securitization transactions.  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. National Rural 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 of why the Non-GAAP measures are useful and for a reconciliation to GAAP amounts.

Business Overview

National Rural was formed in 1969 by rural electric cooperatives to provide a source of financing to supplement the loan programs of the Rural Utilities Service ("RUS").  National Rural is organized as a cooperative in which each member (other than associates) is entitled to one vote.  Under National Rural’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.  In November 2006, the National Rural Board elected an at-large director that qualifies as a financial expert who serves on the audit committee.  The director took his seat on the board following the National Rural annual meeting in March 2007.  National Rural is a tax-exempt entity under Section 501(c)(4) of the Internal Revenue Code.

RTFC is a not-for-profit private cooperative association created for the purpose of providing and/or arranging financing for its rural telecommunications members and their affiliates.  NCSC also is a private non-profit cooperative association.  The principal purpose of NCSC is to provide financing to the for-profit or non-profit entities that are owned, operated or controlled by or provide substantial benefit to, members of National Rural.

The Company's primary objective as a cooperative is to provide its members with low 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 low 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 and a provision for loan losses and to provide earnings sufficient to preserve interest coverage in light of the Company's financing objectives.

At May 31, 2008, the Company's consolidated membership was 1,538 including 898 utility members, the majority of which are consumer-owned electric cooperatives, 511 telecommunications members, 66 service members and 63 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.

National Rural obtains its funding from the capital markets, private placement of debt and its membership.  National Rural 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, National Rural 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, National Rural obtains debt financing from private funding sources through the issuance of fixed rate and variable rate notes.  National Rural 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 National Rural are generally required to purchase membership subordinated certificates from National Rural as a condition of membership.  In connection with any long-term loan or guarantee made by National Rural on behalf of one of its members, National Rural may require that the member make an additional investment in National Rural 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 National Rural.

 
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National Rural is required by law to have a mechanism to allocate its net income to its members.  National Rural allocates its net income excluding 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 a cooperative educational 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 income to a cooperative educational fund and to its members based on each member's patronage of the loan programs during the year.  NCSC does not allocate its net income to its members, but does allocate a portion of its margins to a cooperative educational fund.

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 net interest income or net income as its primary performance indicator, since its net income in dollar terms is subject to fluctuation as total loans outstanding and/or 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 interest expense and the net income prior to the cumulative effect of change in accounting principle by the interest expense.

For the year ended May 31, 2008, the Company reported net income of $46 million and TIER of 1.05, compared to a net income of $12 million and TIER of 1.01 for the prior year.  For the year ended May 31, 2008, the Company reported an adjusted net income of $138 million and adjusted TIER of 1.15, compared to an adjusted net income of $108 million and adjusted TIER of 1.12 for the prior year.  The $34 million and $30 million increase in the net income and adjusted net income, respectively, for the year ended May 31, 2008 was primarily due to the $23 million increase in the recovery of loan losses resulting from the decrease in calculated impairments due to lower variable rates and payments received on impaired loans.  Adjusted net income is calculated by excluding the impact of derivatives and foreign currency adjustments and including minority interest.  Adjusted TIER is calculated by using adjusted net income and including all derivative cash settlements in the interest expense. 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, 2008, the Company's earnings were impacted by the level of loans on non-accrual status.  Holding loans on non-accrual status resulted in a reduction of $67 million to reported interest income for the year ended May 31, 2008.  During fiscal year 2009, the Company expects the outstanding balance of loans on non-accrual status to decrease due to principal repayments and the proceeds from asset sales.  In addition, it is expected that Denton County Electric Cooperative, Inc. d/b/a CoServ Electric (“CoServ”) will make scheduled quarterly payments totaling $28 million in fiscal year 2009, which will all be applied as a reduction to principal.

The reduction to the amount of loans on non-accrual status should contribute to an increase to the adjusted net interest income yield during fiscal year 2009.  Changes to the Company's variable interest rates will be based on the underlying cost of funding, competition and other factors.  The calculated impairment on the Company's loans increases or decreases with the increases and decreases to the Company's variable interest rates.  Based on the current balance of impaired loans at May 31, 2008, an increase or decrease of 25 basis points to the Company's variable interest rates results in an increase or decrease of approximately $9 million, respectively, to the calculated impairment on loans irrespective of a change in the credit fundamentals of the impaired borrower.

Financial Condition
At May 31, 2008, the Company's total loans outstanding increased by $899 million or 5% as compared to May 31, 2007.  At May 31, 2008, National Rural loans outstanding increased by $1,081 million, RTFC loans outstanding decreased by $134 million and NCSC loans outstanding decreased by $48 million compared to May 31, 2007.  National Rural loans outstanding increased due to net advances of $1,155 million offset by the sale of $74 million of National Rural distribution loans at par in loan securitization transactions during the year ended May 31, 2008.  National Rural expects to continue such loan sales on a periodic basis.  See further discussion of the Company’s loan portfolio in “Loan and Guarantee Portfolio Assessment”.

The Company expects that the balance of the loan portfolio will remain relatively stable during fiscal year 2009.  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 loans from 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 slowly decline due to long-term loan amortization, the strong liquidity position of rural

 
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telecommunications companies, a general slowdown in merger and acquisition activities and low demand for capital expenditure financing.

On December 26, 2007, the President of the United States signed the Appropriations Act for Fiscal Year 2008 which set the fiscal year 2008 RUS electric and telephone loan program levels.  Electric funding levels for fiscal year 2008 are $6.5 billion for FFB loans and $100 million for five percent loans.  Telephone funding levels for fiscal year 2008 are $145 million for five percent loans, $250 million for FFB loans, $295 million for treasury rate loans and $300 million for broadband loans.

During the year ended May 31, 2008, short-term debt increased by $1,900 million and long-term debt decreased by $1,122 million primarily due to an increase of $1,810 million to the amount of long-term debt that will mature in the next twelve months.  Holders of $2,140 million of the Company’s extendible debt elected not to extend the maturity of such debt during the year ended May 31, 2008.  As a result, $1,845 million of extendible debt was reclassified from long-term debt to short-term debt based on maturity dates ranging from August 2008 through February 2009.  The remaining $295 million of extendible debt will mature in fiscal year 2010.  Additionally, $500 million of secured notes payable was reclassified to short-term debt based on the July 2008 maturity of the debt.

Total equity decreased $44 million from May 31, 2007 to May 31, 2008 primarily due to the board authorized patronage capital retirement totaling $86 million offset by net income of $46 million for the year ended May 31, 2008.  Under GAAP, the Company's reported equity balance fluctuates based on the impact of future expected changes to interest rates on the fair value of its interest rate 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 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, 2008, the Company had $3,150 million of commercial paper, daily liquidity fund and bank bid notes and $3,177 million of medium-term notes, collateral trust bonds and long-term notes payable scheduled to mature during the next twelve months.  Members held commercial paper (including the daily liquidity fund) totaling $1,404 million or approximately 46% of the total commercial paper outstanding at May 31, 2008.  Commercial paper issued through dealers and bank bid notes totaled $1,612 million and represented 9% of total debt outstanding at May 31, 2008.  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 2009.  During the next twelve months, the Company plans to refinance the $3,177 million of medium-term notes, collateral trust bonds 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.

National Rural uses member loan repayments, capital market debt issuance, private debt issuance, member investments, and net income 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.  National Rural 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, National Rural is a regular issuer of debt, maintains strong credit ratings and has shelf registration statements on file with the Securities and Exchange Commission ("SEC").  The Company qualifies as a well-known seasoned issuer under the SEC rules.  Additionally, 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 and $2 billion of medium-term notes in the Australian market.

At May 31, 2008, the Company was the guarantor and liquidity provider for $330 million of tax-exempt bonds issued for its member cooperatives.  A total of $133 million of such tax-exempt bonds were in flexible and weekly mode, which reprice every seven to thirty-five days.  A total of $120 million of such tax-exempt bonds reprice semi-annually.  A total of $77 million of such bonds were in unit price mode and reprice approximately every 30 days.  National Rural has not been required to purchase any of the bonds in its role as liquidity provider.  In addition to these tax-exempt bonds, National Rural was the guarantor, but not liquidity provider, for $155 million of tax-exempt bonds that were in the auction rate mode.  National Rural has not been required to perform under the guarantee of its members’ tax-exempt bonds.

Critical Accounting Estimates

Allowance for Loan Losses
At May 31, 2008 and 2007, the Company had a loan loss allowance that totaled $515 million and $562 million, representing 2.71% and 3.10% of total loans outstanding, respectively.  GAAP requires 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

 
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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 other than an insignificant delay or an insignificant shortfall in amount.  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 interest rate on the loans at the time the loans became impaired, 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, 2008 and 2007, the Company had a total of $331 million and $397 million reserved specifically against impaired exposure totaling $1,078 million and $1,099 million, respectively, representing 31% and 36%, respectively, of the total impaired loan exposure.  The $331 million and $397 million specific reserves represented 64% and 71% of the total loan loss allowance at May 31, 2008 and 2007, respectively. The calculated impairment at May 31, 2008 was lower than at May 31, 2007 due to lower variable rates and payments received on impaired loans.  See further discussion under “Financial Condition”.  The original contract rate on a portion of the impaired loans at May 31, 2008 will vary with the changes in the Company's variable interest rates.  Based on the current balance of impaired loans at May 31, 2008, a 25 basis point increase or decrease to the Company's variable interest rates would result in an increase or decrease, respectively, of approximately $9 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, the investment is equal to the loan balance outstanding at the reporting date and the discount rate is equal to the interest rate on the loans at the time the loans became impaired.

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, 2008 and 2007, the Company had reserved $3 million and $3 million against the $8 million and $6 million of exposure classified as high risk, representing coverage of 38% and 50%, respectively.  The $3 million reserved for loans in the high risk category represented less than 1% of the total loan loss allowance at May 31, 2008 and 2007.

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 Standard & Poor’s default data on corporate bonds and Company specific loss

 
20

 

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:
o  
General financial condition of the borrower.
o  
The Company's internal estimated value of the collateral securing its loans.
o  
The Company's internal evaluation of the borrower's management.
o  
The Company's internal evaluation of the borrower's competitive position within its service territory.
o  
The Company's estimate of potential impact of proposed regulation and litigation.
o  
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, power supply, 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.

At May 31, 2008 and 2007, the Company had a total of $17,690 million and $16,768 million of loans, respectively, in the general portfolio.  This total does not include $250 million and $256 million of loans at May 31, 2008 and 2007, 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.  At May 31, 2008 and 2007, the Company reserved a total of $155 million and $159 million, respectively, for loans in the general portfolio representing coverage of approximately 1% of the total loans for the general portfolio at both dates.

In addition to the general portfolio reserve requirement as calculated above, the Company maintains an unallocated reserve to cover the additional risk associated with large loan exposures and to cover economic and environmental factors that may be currently impacting the financial results of borrowers, but have not shown up in the borrower’s annual audited financial statements.

The first component of the unallocated reserve is a single obligor reserve to cover the additional risk associated with the inherent risk related to large loan exposures.  The Company had previously set the exposure threshold at 1.5% of total loans and guarantees outstanding and provided coverage equal to 0.5% times the internal risk rating associated with the loan exposure.  During the third quarter of fiscal year 2008, the Company revised both the exposure threshold and the coverage percentage to better reflect the level of risk associated with the large loan exposures.  The exposure threshold was reduced from 1.5% to 1.0% to better match the top ten credit exposures.  The reserve coverage was increased to 1.0% of the internal risk rating times the exposure over the threshold, to better reflect the Company’s assessment of the additional risk related to large loan exposures.  At May 31, 2008 and 2007, the Company had a single obligor reserve of $23 million and $3 million, respectively.
 
The second component of the unallocated reserve is an economic and environmental reserve to cover factors that the Company believes are currently impacting the financial results of borrowers, but are not reflected in the Company’s internal risk rating process and therefore present an increased risk of losses incurred as of the balance sheet date.  The Company uses annual audited financial statements from its borrowers as part of its internal risk rating process.  There could be a lag between the time that various environmental and economic factors occur and the time when these factors are reflected in the annual audited financial statements of the borrower and therefore the internal risk rating determined by the Company for the borrower.  This reserve component may be set at up to 5% of the amount of the calculated general reserve.  The Company’s corporate credit committee will make a quarterly determination of the percentage of general reserve to be held and the portions of the loan portfolio that the additional reserve percentage shall be applied.  At May 31, 2008, the corporate credit committee set the economic and environmental component of the unallocated reserve to be $3 million or 2% of the amount of the total general reserve.  This amount was set taking into consideration the impact on electric and telecommunications borrowers from (1) the current economic downturn, (2) the flooding in parts of the Midwest, (3) the decline in the housing market that has led to a significant increase in foreclosures, (4) the impact of rising food and gas prices on consumer spending and (5) the impact of rising fuel prices on electric utilities and the ability to pass on such costs.  There was no economic and environmental unallocated reserve at May 31, 2007 as the Company added this component to the unallocated reserve during the third quarter of fiscal year 2008.

 
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Senior management reviews the estimates and assumptions used in the calculations of the loan loss allowance for impaired loans, high risk loans, the general portfolio and the unallocated reserve 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 National Rural 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
The Company accounts for derivatives in accordance with 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.

Generally, 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.  At May 31, 2008 and 2007, the Company did not have any interest rate exchange agreements that were accounted for using 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 economically hedging its net interest income 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 $221 million and $223 million and derivative liabilities of $171 million and $72 million at May 31, 2008 and 2007, respectively.  From inception to date, accumulated other comprehensive income related to derivatives was $9 million and $12 million as of May 31, 2008 and 2007, respectively.
 
The impact of derivatives on the Company's consolidated statements of operations for the years ended May 31, 2008, 2007 and 2006 was a loss of $72 million, a gain of $7 million and a gain of $107 million, respectively.  The change in the fair value of derivatives for the years ended May 31, 2008, 2007 and 2006 was a loss of $99 million, a loss of $79 million and a gain of $29 million, respectively, recorded in the Company's derivative forward value.  For the years ended May 31, 2008, 2007 and 2006, the derivative forward value includes amortization income of $3 million and $0.8 million and amortization expense of $0.4 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 $27 million, $86 million and $79 million was recorded for total net cash settlements received by the Company during the years ended May 31, 2008, 2007 and 2006, respectively, of which $27 million, $86 million and $81 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 $2 million for the year ended May 31, 2006 relate to interest rate and cross currency interest rate exchange agreements that qualify for hedge accounting under SFAS 133 and were recorded in interest expense.
 
 
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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 meaningful in assessing its current financial condition 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 and the three-month LIBOR rate would result in a $6 million increase or decrease in the Company's net cash settlements due to the composition of the portfolio at May 31, 2008.  The Company's interest rate exchange agreements at May 31, 2008 include $7,660 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 $5,256 million notional amount, or 41% of the total interest rate exchange agreements at May 31, 2008, the Company pays a variable interest rate and receives a fixed interest rate. Based on the interest rate exchange agreements in place at May 31, 2008, an increase to variable interest rates results in an increase to cash settlements due to National Rural.

New Accounting Pronouncements

On June 1, 2007, the Company adopted SFAS 155, Accounting for Certain Hybrid Financial Instruments – an amendment of SFAS 133 and 140. SFAS 155 permits fair value measurement of any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. SFAS 155 also clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS 133.  It establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. SFAS 155 also clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives. SFAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006.  The Company’s adoption of SFAS 155 did not have a material impact on the Company's financial position or results of operations.

On June 1, 2007, the Company adopted SFAS 156, Accounting for Servicing of Financial Assets.  SFAS 156 requires the initial measurement of all separately recognized servicing assets and liabilities at fair value and permits, but does not require, the subsequent measurement of servicing assets and liabilities at fair value. SFAS 156 is effective as of the beginning of the first fiscal year that begins after September 15, 2006.  The Company’s adoption of SFAS 156 did not have a material impact on the Company's financial position or results of operations.

On June 1, 2007, the Company adopted Financial Accounting Standards Board (“FASB”) Interpretation No. (“FIN”) 48, Accounting for Uncertainty in Income Taxes, an interpretation of SFAS 109.  FIN 48 clarifies the accounting for income taxes by prescribing a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.  FIN 48 is effective for fiscal years beginning after December 15, 2006.  The Company’s adoption of FIN 48 did not have a material impact on the Company's financial position or results of operations.

In September 2006, the FASB issued SFAS 157, Fair Value Measurements. SFAS 157 defines fair value, sets out a framework for measuring fair value and expands on required disclosures about fair value measurement.  SFAS 157 is effective as of the beginning of the first fiscal year that begins after November 15, 2007. The Company's adoption of SFAS 157 as of June 1, 2008 is not expected to have a material impact on the Company's financial position or results of operations.

In February 2007, the FASB issued SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities. The fair value option established by SFAS 159 permits entities to choose to measure eligible financial instruments at fair value. The unrealized gains and losses on items for which the fair value option has been elected should be reported in earnings. The decision to elect the fair value option is determined on an instrument by instrument basis and is irrevocable. Assets and

 
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liabilities measured at fair value pursuant to the fair value option should be reported separately in the balance sheet from those instruments measured using other measurement attributes. SFAS 159 is effective as of the beginning of the first fiscal year that begins after November 15, 2007.  As part of the Company's adoption of SFAS 159 as of June 1, 2008, it has not elected the option to measure eligible financial instruments at fair value and therefore the adoption of SFAS 159 is not expected to have a material impact on the Company's financial position or results of operations.

In December 2007, the FASB issued SFAS 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of Accounting Research Bulletin (“ARB”) 51, Consolidated Financial Statements, to establish accounting and reporting standards for the noncontrolling interests in a subsidiary and for the deconsolidation of a subsidiary. It also amends certain of ARB 51’s consolidation procedures for consistency with the requirements of SFAS 141, Business Combinations.  Noncontrolling interests shall be reclassified to equity, consolidated net income shall be adjusted to include net income attributable to noncontrolling interests and consolidated comprehensive income shall be adjusted to include comprehensive income attributable to the noncontrolling interests.  This statement is effective for fiscal years beginning on or after December 15, 2008.  The Company’s adoption of SFAS 160 on June 1, 2009 is not expected to have a material impact on the Company’s financial position or results of operations.

In March 2008, the FASB issued SFAS 161, Disclosures about Derivative Instruments and Hedging Activities. This statement requires enhanced disclosures about an entity’s derivative and hedging activities.  The statement is effective for fiscal years beginning after November 15, 2008.  The Company’s adoption of SFAS 161 on June 1, 2009 is not expected to have a material impact on the Company’s financial position or results of operations.
 
Results of Operations
 
Fiscal Year 2008 versus 2007 Results
The following chart presents the results of operations for the year ended May 31, 2008 versus May 31, 2007.

   
For the year ended May 31,
 
Increase/
 
(Dollar amounts in thousands)
 
2008
 
2007
 
(Decrease)
 
Interest income
 
$
1,069,540
   
$
1,054,224
   
$
15,316
   
Interest expense
   
(936,889
)
   
(996,730
)
   
59,841
   
     Net interest income
   
132,651