10-K/A 1 may3109_10ka.htm MAY 31, 2009 FORM 10-K/A - AMENDMENT #1 may3109_10ka.htm
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 

FORM 10-K/A
(Amendment No. 1)

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

THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended May 31, 2009

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 registered
 
Title of each class
 
which registered
 
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
 
7.35% Collateral Trust Bonds, due 2026
 
NYSE
         

Securities registered pursuant to Section 12(g) of the Act: None

Indicate 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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨  No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§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 Act).  Yes ¨  No x

The Registrant is a tax-exempt cooperative and consequently is unable to issue any equity capital stock.

 
 

 

Explanatory Note


This Amendment No. 1 on Form 10-K/A (the “Amendment”) amends National Rural Utilities Cooperative Finance Corporation’s (the “Company”) Annual Report on Form 10-K for the fiscal year ended May 31, 2009 (the “Form 10-K”), as filed with the Securities and Exchange Commission on August 17, 2009, and is being filed solely to amend Item 7 of the Form 10-K to correct a typographical error in the date of the table on page 36 summarizing the Company’s secured debt or debt requiring collateral on deposit, the excess collateral pledged and unencumbered loans.  Specifically, the headings of the columns on such table should be 2009 and 2008 rather than 2008 and 2007, respectively.

As required by Rule 12b-15 under the Securities Exchange Act of 1934, as amended, we have (i) repeated the entire text of Item 7 of the Form 10-K in this Amendment and (ii) included new certifications of our principal executive officer and principal financial officer as exhibits to this Amendment.

Except as described above, no other changes have been made to the Form 10-K. This Amendment speaks as of the original filing date of the Form 10-K, does not reflect events that may have occurred subsequent to the original filing date and does not modify or update in any way disclosures made in the Form 10-K. 
 
        For convenience, the pages of Item 7 of this amended Form 10-K have been numbered to coincide with the Item 7 of the Form 10-K filed on August 17, 2009.

 

 
 
 

 


Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operations.

Unless stated otherwise, references to “we,” “our,” or “us” relate to the consolidation of National Rural Utilities Cooperative Finance Corporation ("National Rural"), Rural Telephone Finance Cooperative ("RTFC"), National Cooperative Services Corporation ("NCSC") and certain entities created and controlled by National Rural to hold foreclosed assets and accommodate loan securitization transactions.  The following discussion and analysis is designed to provide a better understanding of our consolidated financial condition and results of operations and as such should be read in conjunction with the consolidated financial statements, including the notes thereto. We refer to our 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 and is a tax-exempt entity under Section 501(c)(4) of the Internal Revenue Code.

RTFC is a private cooperative association created to provide and/or arrange financing for its rural telecommunications members and their affiliates.  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 also is a private 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.  NCSC is a taxable corporation.

Our primary objective as a cooperative is to provide financial products to our rural electric and telecommunications members at a low cost while maintaining sound financial results required for investment grade credit ratings on our debt instruments.  Our goal is not to maximize profit on loans to members, but to balance charging our members low rates on loans and maintaining the financial performance required to access the capital markets on behalf of our members.  Therefore, the rates we charge our borrowers reflect our funding costs plus a spread to cover our operating expenses and a provision for loan losses and to provide earnings sufficient to preserve interest coverage to meet our financial objectives.

We obtain funding from the capital markets, private placements of debt and our members.  We enter the capital markets, based on the combined strength of our members, to borrow the funds to fulfill our members’ financing requirements.  We regularly obtain funding in the capital markets by issuing:
·  
fixed-rate or variable-rate secured collateral trust bonds;
·  
fixed-rate or variable-rate unsecured medium-term notes including retail notes;
·  
commercial paper;
·  
bank bid note agreements; and
·  
fixed-rate subordinated deferrable debt.

We issue fixed-rate and variable-rate debt to private funding sources.  We also obtain debt financing from our members and other qualified investors through the direct sale of our commercial paper, daily liquidity fund and unsecured medium-term notes.

As a condition of membership, rural electric cooperatives were generally required to purchase membership subordinated certificates from us.  Members may be required to make an additional investment in us by purchasing loan or guarantee subordinated certificates as a condition for obtaining long-term loans or guarantees.  The membership subordinated certificates and the loan and guarantee subordinated certificates are unsecured and subordinate to our senior debt.

National Rural is required by District of Columbia cooperative law to have a mechanism to allocate our net income to our members.  We allocate our net income, excluding the non-cash effects of the accounting for derivative financial instruments and foreign currency translation, annually to a cooperative educational fund, a members' capital reserve and to members based on each member's patronage of our 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 its 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.

Our performance is closely tied to the performance of our member rural electric and telecommunications systems due to the near 100 percent concentration of our loan and guarantee portfolio in those industries.

 
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Financial Overview

In this section, we analyze our results of operations, financial condition, liquidity and market risk.  We also analyze trends and significant transactions completed in the years covered by this Form 10-K.

Results of Operations
We use a times interest earned ratio (“TIER”) instead of the dollar amount of net interest income or net income as our primary performance indicator, since net income can fluctuate as total loans outstanding and/or interest rates change.  TIER is a measure of our ability to cover the interest expense on our 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.  Adjusted net income is calculated by excluding the effect of derivatives 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 we make to our financial results for our own analysis and covenant compliance.

For the year ended May 31, 2009, we reported a net loss of $70 million, which resulted in a TIER calculation below 1.00 compared to a net income of $46 million and TIER of 1.05 for the prior year.  For the year ended May 31, 2009, we reported an adjusted net income of $86 million with an adjusted TIER of 1.10, compared with an adjusted net income of $138 million and adjusted TIER of 1.15 for the prior-year period.  The $116 million decrease in net income for the year ended May 31, 2009 compared with the prior-year period was primarily due to the $144 million increase in the provision for loan losses and the $61 million increase in the derivative forward value expense partially offset by the $86 million increase in derivative cash settlements.

Interest income of $1,071 million for the year ended May 31, 2009 increased two percent compared with the prior-year period.  During the year ended May 31, 2009, there was an increase of $1.3 billion or seven percent to the average balance of loans outstanding which was largely offset by a 25 basis point decline in the weighted-average yield earned on the loan portfolio as compared with the prior-year period.  The decline in the yield earned on the loan portfolio was the result of the lower interest rates earned on variable-rate loans.

Our interest expense was relatively unchanged for the year ended May 31, 2009 as compared with the prior-year period despite lower short-term interest rates.  The small increase in interest expense was the result of the following factors:

·  
The $2,707 million increase in average debt outstanding at May 31, 2009 compared with May 31, 2008.
·  
Higher interest rates on our collateral trust bonds.  In October 2008, we issued $1 billion of collateral trust bonds at a rate of 10.375 percent which was significantly higher than the $900 million five-year collateral trust bonds issued at a rate of 5.50 percent in June 2008 due to the severe credit environment in the fall of calendar year 2008.
·  
For a short period of time during the latter part of calendar year 2008, the cost of issuing commercial paper increased because of disruptions in the financial markets.

These factors were mostly offset by the following:
·  
The lower interest rate environment:  Lower interest rates on our variable-rate debt and commercial paper funding particularly in the latter half of the fiscal year.
·  
Lower cost funding from Federal Agricultural Mortgage Corporation (“Farmer Mac”):  Notes issued under note purchase agreements with Farmer Mac totaling $700 million at a blended spread over three-month LIBOR of 119 basis points and $500 million at a blended fixed rate of 3.871 percent between December 2008 and May 2009.
·  
Lower cost funding from the Rural Economic Development Loan and Grant (“REDLG”) program:  In September 2008,  $500 million was advanced to us under the REDLG program at an interest rate of 57.5 basis points above the comparable U.S. Treasury rate.
·  
Lower cost retail notes: Retail notes increased $783 million from May 31, 2008 to May 31, 2009. We issued retail notes at spread levels well below the indicative collateral trust bond funding levels with a weighted-average interest rate of 4.50 percent.

Our adjusted interest expense decreased by $82 million for the year ended May 31, 2009.  In addition to the factors above, the decrease in the adjusted interest expense was largely due to the $97 million payment to us, recorded as derivative cash settlements, for the termination of certain receive fixed, pay variable interest rate swaps during fiscal year 2009.

During fiscal year 2009, there was an increase of $144 million to the loan loss provision as compared with the prior-year period.  The increase to the loan loss provision during the year ended May 31, 2009 was due to the deterioration in the market value of collateral supporting impaired loans.  The fair value of the collateral was negatively affected by the limited access to

 
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and high cost of capital to support acquisitions of assets similar to the collateral supporting these impaired loans, which resulted in a compression of the earning multiple that potential buyers were willing to pay for such assets.  In addition, the current economic conditions caused consumers and businesses to reduce spending, which resulted in, at least for the short-term, reductions in the estimated earnings for companies whose stock is held as collateral for impaired loans.  This increase was partially offset by payments received on impaired loans, changes in estimates of future expected cash flows and the net decrease in our variable interest rates from May 31, 2008 to May 31, 2009 as described below.

The loan loss provision is affected by changes in the calculated impairment on our impaired loans due to changes in interest rates.  The impairment amount for certain loans is calculated by discounting future expected cash flows using the original contract interest rate on the loan, a portion of which is based on our variable interest rate.  Changes to our variable interest rates are based on the underlying cost of funding, competition and other factors.  Based on the current balance of impaired loans at May 31, 2009, an increase or decrease of 25 basis points to our short-term and long-term 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.  As of August 1, 2009, we had decreased our long-term variable interest rates by 45 basis points, resulting in a decrease to the calculated impairment on loans of $6 million.

Financial Condition
At May 31, 2009, total loans outstanding increased by $1,161 million or six percent as compared with May 31, 2008 due to a $929 million increase in power supply loans and a $292 million increase in distribution loans.  See further discussion of our loan portfolio in Financial Condition, Loan and Guarantee Portfolio Assessment.  We expect loan growth to remain relatively stable during fiscal year 2010.

Our loan growth has not been significantly affected by the slowdown in the economy since most of our members serve residential customers as opposed to industrial customers.  The current economic conditions reduced the competition for power supply loans from investment and commercial banks.  In addition, there is currently a need for utilities to improve their infrastructure, including base load generation, transmission and distribution plants, a significant portion of which is typically financed with borrowed capital.

The current difficult economic conditions have not resulted in a significant rise in delinquencies or defaults in our members’ receivables.  Calendar year 2008 data from member systems shows no significant increase in late payments or write-offs for the year ended December 31, 2008 compared to the prior calendar year.  The majority of the cooperatives' customers are residential, and electricity is considered an essential service, so we believe the impact of the recession on collections will likely be moderate.

Our total long-term and short-term debt outstanding increased by $1,087 million at May 31, 2009 as compared with the prior-year end.  During the year ended May 31, 2009, there was a need to issue debt required to fund new loan advances, as well as to refinance maturing debt.  During that period, we issued $5.8 billion of new term debt (collateral trust bonds, medium-term notes and private placement notes) to replace the $3.6 billion of debt that matured (mostly extendible collateral trust bonds).  Some of the debt issued during fiscal year 2009 was to prefund debt maturing in the first quarter of fiscal year 2010.  As part of our ongoing efforts to manage the liquidity risks associated with maturing debt, we regularly pre-fund large expected debt obligations prior to the maturity to ensure the availability of funds.

Total equity decreased $157 million from May 31, 2008 to May 31, 2009 primarily due to the board authorized patronage capital retirement totaling $85 million and the net loss of $70 million for the year ended May 31, 2009.  Total equity fluctuates based on the changes in earnings which are significantly affected by changes in the fair value of our derivative instruments.  The fair values of these derivative instruments are sensitive to changes in interest rates.  As a result, it is difficult to predict the future changes in equity due to the uncertainty of the movement in future interest rates.  In our internal analysis and for covenant compliance under our credit agreements, we adjust equity to exclude the non-cash effects of the accounting for derivative financial instruments and foreign currency translation.  In July 2009, National Rural’s board of directors authorized the retirement of allocated net earnings totaling $41 million, representing 50 percent of the fiscal year 2009 allocation.  This amount will be returned to members in cash at the end of September 2009.

Liquidity
After Lehman Brothers Holdings Inc. (“LBHI”) filed for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code in September 2008 and through the latter part of November 2008, there were significant disruptions in the capital markets that resulted in limited investor demand for corporate debt and a significant decrease in the investor demand for commercial paper investments with maturities of more than two weeks.  The majority of the investor demand for commercial paper during that time was for maturities of one week or less and the rates required to replace such funding were at significantly higher than historical spreads over the federal funds rate.  As a result, we had large volumes of commercial paper to roll over that were, on certain days during that period, at rates that were higher than normal.  During that time, we met our

 
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funding needs by issuing member and dealer commercial paper, collateral trust bonds, and through private placements of debt.  Those disruptions in the capital markets, while continuing, eased during the third and fourth quarters of fiscal year 2009.

We evaluate and make decisions about our daily cash needs early in the day to be certain we can meet our funding requirements.  On October 7, 2008, we were uncertain of our ability to issue the required amount of commercial paper for that day and drew down $418.5 million on our bank lines.  We repaid the $418.5 million borrowed under our revolving lines of credit on November 13, 2008.

As part of the effort to support the capital markets, on October 7, 2008, the Federal Reserve Board announced the creation of the Commercial Paper Funding Facility (“CPFF”), to provide a source of liquidity to highly-rated U.S. issuers of commercial paper through a special purpose vehicle that purchased three-month unsecured and asset-backed commercial paper directly from eligible issuers.  During the last half of November 2008, investors began to accept longer maturities in limited amounts, which allowed us to issue larger volumes of commercial paper on a daily basis.   On days during the second quarter of fiscal year 2009 when investor demand was concentrated at shorter-term maturities, and we preferred to issue longer-term commercial paper to maintain a certain percentage of the portfolio with longer maturities, we were able to issue commercial paper with 90-day maturities through the CPFF.  We did not issue any commercial paper through the CPFF during the third and fourth quarter of fiscal year 2009.  The $1 billion of commercial paper we issued through the CPFF in the second quarter of fiscal year 2009 matured in March 2009.  We have not issued additional commercial paper through the CPFF due to our ability to roll over maturing commercial paper with our existing investor base and finance our balance sheet growth with lower cost alternative sources of funding. We are still qualified to use the CPFF as the expiration date of the program was extended to February 1, 2010.  However, there is no intention at this time to use the more expensive funding through the CPFF since there is sufficient demand in the commercial paper market.

As with other companies, we were negatively affected by the severe credit crisis in the fall of 2008 as the demand in the capital markets for corporate debt was reduced and corporate debt that was issued was at historically high spreads over comparable U.S. Treasury rates.

After the LBHI bankruptcy, there was limited demand in the capital markets for corporate debt.  As a result, companies experienced difficulty issuing long-term debt, and for the companies that were able to issue long-term debt, the interest rate on the debt issued was at historically high spreads over comparable U.S. Treasury rates.  In October 2008, we issued $1 billion of ten-year collateral trust bonds to refinance maturing long-term debt and meet member loan growth demand.  This debt was issued with a coupon interest rate of 10.375 percent.  This interest rate represented a significant increase in the credit spread over Treasury rates compared with the $900 million 5.50 percent, five-year collateral trust bonds issued in June 2008.  We used other lower-cost funding sources during fiscal year 2009, as described in the Results of Operations section of this Financial Overview.

On March 13, 2009, we replaced our $1,500 million 364-day revolving credit agreement with a new $1,000 million 364-day revolving credit agreement.  Since the revolving credit lines are required to maintain backup liquidity on our commercial paper, we cannot issue as much commercial paper in the future because of the $500 million reduction in the facility.  We will issue long-term debt and swap the debt to a variable rate to make up for the reduction to commercial paper.  This is a more expensive form of funding.

As a result of the bankruptcy filing of LBHI, we terminated interest rate swaps with Lehman Brothers Special Financing (“LBSF”) as counterparty (with an LBHI guarantee) on September 26, 2008.  The payment due to us from LBSF of $26 million was recorded in derivative cash settlements representing the termination net settlement amount on that day, based on the terms of the contract.  On October 3, 2008, LBSF filed a petition under Chapter 11 of the U.S. Bankruptcy Code with the United States Bankruptcy Court for the Southern District of New York.  We have a claim of $26 million on the assets of both LBHI and LBSF.  We used market data that indicated values for LBHI bonds of 10 cents and 15 cents on the dollar as a proxy for the potential recovery from both LBHI and LBSF.  As a result, the receivable has been reduced to $7 million.  The amount recorded as a receivable does not reduce or limit our claim of $26 million against LBHI and LBSF.  The ultimate recovery will depend on the ability of LBHI and LBSF to maximize the value of assets through sale or assignment or the price that we can obtain through the sale of our claim.  As of July 24, 2009, market sales for similar claims against LBHI and LBSF were between 37 cents and 41 cents on the dollar.

At May 31, 2009, we had $2,288 million of commercial paper, daily liquidity fund, term loans, and bank bid notes and $2,580 million of medium-term notes, collateral trust bonds and long-term notes payable scheduled to mature during the next 12 months.  Members held commercial paper (including the daily liquidity fund) totaling $1,226 million or approximately 67 percent of the total commercial paper and daily liquidity fund outstanding at May 31, 2009.  Commercial paper issued through dealers and bank bid notes totaled $850 million and represented four percent of total debt outstanding at May 31, 2009.  We intend to maintain the balance of dealer commercial paper and bank bid notes at 15 percent or less of total debt

 
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outstanding during fiscal year 2010.  During the next 12 months, we plan to replace the maturing $2,580 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.  At May 31, 2009, we had $1.2 billion available under note purchase agreements with Farmer Mac, $625 million of which was advanced through August 2009.

We began offering member capital securities, unsecured and subordinate voluntary debt investments, to members in December 2008.  As of May 31, 2009, a total of $278 million of member capital securities had been sold.  Subsequent to our fiscal year-end, we met our target of issuing at least $300 million of member capital securities.  After the end of the fiscal year through August 7, 2009, an additional $53 million of member capital securities were sold bringing the total to $331 million.

At May 31, 2009 and 2008, we were the guarantor and liquidity provider for $643 million and $330 million, respectively of tax-exempt bonds issued for our member cooperatives.  During the year ended May 31, 2009, we were required to purchase $72 million of tax-exempt bonds pursuant to our obligation as liquidity provider.  As a result, we were required to hold the bonds until the remarketing agent was able to place them with third-party investors.  At May 31, 2009, all tax-exempt bonds we held during fiscal year 2009 had been redeemed or repurchased by third-party investors with no gain or loss on the transactions.

Critical Accounting Estimates

Our significant accounting principles, as described in Note 1, General Information and Accounting Polices, to the consolidated financial statements are essential in understanding the Management’s Discussion and Analysis of Financial Condition and Results of Operations.  Many of our significant accounting principles require complex judgments to estimate values of assets and liabilities.  We have procedures and processes to facilitate making these judgments.

We have identified the allowance for loan losses and the determination of fair value of certain items on our balance sheet as critical accounting policies because they require significant estimations and judgments by management.  The more judgmental estimates are summarized below.  We have identified and described the development of the variables most important in the estimation process.  In many cases, there are numerous alternative judgments that could be used in the process of determining the inputs to the model.  Where alternatives exist, we have used the factors that we believe represent the most reasonable value in developing the inputs.  Actual performance that differs from our estimates of the key variables could affect net income.  Separate from the possible future effect to net income from our model inputs, market sensitive assets and liabilities may change subsequent to the balance sheet date, often significantly, due to the nature and magnitude of future credit and market conditions.  Such credit and market conditions may change quickly and in unforeseen ways and the resulting volatility could have a significant, negative effect on future operating results.

Below is a description of the process used in determining the adequacy of the allowance for loan losses and the determination of fair value for certain items on our balance sheet.

Allowance for Loan Losses
At May 31, 2009 and 2008, our loan loss allowance totaled $623 million and $515 million, representing 3.09 percent and 2.71 percent 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.  We calculate the loss allowance on a quarterly basis.  The loan loss allowance is calculated by segmenting the portfolio into three categories of loans: impaired, high risk and general portfolio.  There are significant subjective assumptions and estimates used in calculating the amount of the loss allowance required by each of the three categories.  Different assumptions and estimates could also be reasonable.  Changes in these assumptions and estimates could have a material impact on our financial statements.

Impaired Loans
We calculate the impairment on loans based on GAAP.  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.  We review our portfolio to identify impairments at least quarterly.  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 us and the borrower, and
·  
estimates of the value of the borrower's assets that have been pledged as collateral to secure our loans.

 
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We calculate the impairment by comparing the future expected cash flow discounted at the interest rate on the loans at the time the loans became impaired, against our 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, 2009 and 2008, we reserved a total of $414 million and $331 million specifically against impaired loans totaling $1,056 million and $1,078 million, respectively, representing 39 percent and 31 percent, respectively, of total impaired loans.  The $414 million and $331 million specific reserves represented 66 percent and 64 percent of the total loan loss allowance at May 31, 2009 and 2008, respectively.  The original contract interest rate on a portion of the impaired loans at May 31, 2009 will vary with the changes in our variable interest rates.  Based on the current balance of impaired loans at May 31, 2009, a 25 basis point increase or decrease to our 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 our 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 Loans
We define a loan exposure as high risk when:
·  
the borrower has a history of late payments;
·  
the borrower's financial results do not satisfy loan financial covenants;
·  
the borrower contacts us to discuss pending financial difficulties; or
·  
for some other reason, we believe the borrower's financial results could deteriorate resulting in an elevated potential for loss.

Our corporate credit committee determines which loans to classify as high risk.  The committee meets at least quarterly to review all loan facilities with an internal risk rating above a certain level.

The corporate credit committee sets the required reserve for each borrower based on their facts and circumstances, such as:
·  
the borrower's financial condition;
·  
the borrower’s payment history;
·  
our estimate of the collateral value;
·  
pending litigation, if any; and
·  
other factors.

This is an objective and subjective exercise where the committee uses the available information to make its best estimate of the reserve.  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;
·  
bankruptcy of the borrower;
·  
payment default on our 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 12 to 24 months.  At May 31, 2009 and 2008, we reserved $11 million and $3 million against the $30 million and $8 million of exposure classified as high risk, representing coverage of 37 percent and 38 percent, respectively.  The $11 million and $3 million reserved for loans in the high risk category represented 2 percent and less than 1 percent of the total loan loss allowance at May 31, 2009 and 2008, respectively.

 
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General Portfolio
We determine the required loan loss allowance for the general portfolio by using our internal risk rating system, Standard & Poor’s historical default data on corporate bonds and our specific loss recovery data.  We use the following factors to determine the loan loss allowance for the general portfolio category:

·  
Internal risk ratings - We maintain risk ratings for each credit facility outstanding to our borrowers.  The ratings are updated at least annually and are based on the following:
-  
general financial condition of the borrower;
-  
our estimated value of the collateral securing our loans;
-  
our judgment of the borrower's management;
-  
our judgment of the borrower's competitive position within its service territory and industry;
-  
our estimate of potential impact of proposed regulation and litigation; and
-  
other factors specific to individual borrowers or classes of borrowers.
·  
Standard corporate bond default table - The table provides expected default rates based on rating level and the remaining maturity of the bond.  We use the standard default table for all corporate bonds published by Standard and Poor's Corporation to assist in estimating our reserve levels because we have limited history from which to develop loss expectations and because we have been unable to identify utility specific default rates.
·  
Recovery rates - Estimated recovery rates based on historical experience of loan balance at the time of default compared with the total loss on the loan to date.

We aggregate 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.  We correlate our internal risk ratings to the ratings used in the standard default table for borrowers with ratings from Standard and Poor’s Corporation and based on a standard matching used by banks.

At May 31, 2009 and 2008, we had a total of $18,858 million and $17,690 million of loans, respectively, in the general portfolio.  This total excludes $244 million and $250 million of loans at May 31, 2009 and 2008, respectively, that have a U.S. Government guarantee of all principal and interest payments.  We do not maintain a loan loss allowance on loans that are guaranteed by the U.S. Government.  At May 31, 2009 and 2008, we reserved a total of $162 million and $155 million, respectively, for loans in the general portfolio representing coverage of approximately one percent of the total loans for the general portfolio at both dates.

In addition to the general portfolio reserve requirement as calculated above, we maintain an unallocated reserve to cover the additional risk associated with large loan exposures and to cover economic and environmental factors that may be currently affecting 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 related to large loan exposures.  We set the exposure threshold at one percent of total loans and guarantees outstanding and provide coverage equal to one percent times the internal risk rating associated with the loan exposure.  We believe this reflects our assessment of the additional risk related to large loan exposures.  At May 31, 2009 and 2008, our single obligor reserve was $30 million and $23 million, respectively.

The second component of the unallocated reserve is an economic and environmental reserve to cover factors that we believe are currently affecting the financial results of borrowers, but are not reflected in our internal risk rating process and therefore present an increased risk of losses incurred as of the balance sheet date.  We use annual audited financial statements from our borrowers as part of our 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 we determine for the borrower.  This reserve component may be set at up to five percent of the amount of the calculated general reserve for each type of loan exposure.  Our 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, 2009, the corporate credit committee set the economic and environmental component of the unallocated reserve to be $6 million or four percent of the total general reserve, representing 3.5 percent of electric loans and five percent of telecommunications loans.  This amount took into consideration the effect on electric and telecommunications borrowers from (1) the current economic downturn, (2) the increase in the unemployment rate, (3) the decline in the housing market that has led to a significant increase in foreclosures and (4) specifically for telecommunications borrowers, reduced discretionary spending for telecommunications services, increased competition from wireless providers and continued loss of access lines among rural local exchange carriers.   At May 31, 2008, the economic and environmental component of the unallocated reserve was $3 million or two percent of the total general reserve.

 
24

 

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 our 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.

Fair Value
We have determined the accounting for certain items on our balance sheet at fair value to be a critical accounting policy because of the subjective nature and the requirement for management to make significant estimations in determining the amounts to be recorded.  Different assumptions and estimates could also be reasonable and changes in the assumptions used and estimates made could have a material effect on our financial statements.

The primary instruments recorded on our balance sheet at fair value are derivative financial instruments.  Because we generally do not apply hedge accounting to these instruments, the accounting guidance requires us to record all derivative instruments at fair value on the balance sheet with changes in fair value reported in earnings.  We record the change in the fair value of our derivatives for each reporting period in the derivative forward value line on the consolidated statements of operations.

Because there is not an active secondary market for the types of derivative instruments we use, we obtain market quotes from our dealer counterparties.  The market quotes are based on the expected future cash flow and estimated yield curves.  We perform our own analysis to confirm the values obtained from the counterparties.  The counterparties are estimating future interest rates as part of the quotes they provide to us.  We adjust all derivatives to fair value on a quarterly basis.  The fair value we record will change as estimates of future interest rates change.  To estimate the impact of changes to interest rates on the forward value of derivatives, we would need to estimate all changes to interest rates through the maturity of our outstanding derivatives.  We have derivatives in the current portfolio that do not mature until 2045.  Because many of the derivative instruments we use for risk management have such long-dated maturities, the valuation of these derivatives may require extrapolation of market data that is subject to significant judgment.  Accounting guidance on fair value requires that credit risk be considered in determining the market value of any asset or liability carried at fair value. We adjust the market values of our derivatives received from the counterparties based on our counterparties’ and our credit spreads observed in the credit default swap market.  The credit default swap levels represent the credit risk premium required by a market participant based on the available information related to the creditor.

In addition to the valuation associated with derivative financial instruments, we also periodically are required to record foreclosed assets at the lower of cost or fair value.  In many instances the valuation of these assets are judgmental and dependent upon comparisons to similar assets or estimations of future cash flows that are expected to be generated by the underlying foreclosed properties.  In both of these instances, management uses its best estimates, based upon available market data and/or projections of future cash flows.  However, because of the subjective nature of these estimates, other estimates could be reasonable and changes in the assumptions used and our estimates could have a material effect on our financial statements.

New Accounting Pronouncements

In May 2009, the FASB issued SFAS 165, Subsequent Events (“SFAS 165”) to establish a general standard of accounting for the disclosure of events that occur after the balance sheet date, but before financial statements are issued or are available to be issued.  SFAS 165 does not change the kinds of events that an entity must recognize or disclose in its financial statements. It does, however, require the disclosure of the date through which an entity has evaluated subsequent events and the basis for that date. This statement is effective on a prospective basis for interim or annual periods ending after June 15, 2009.  Our adoption of SFAS 165 in the first quarter of fiscal year 2010 is not expected to have a material impact on our financial position or results of operations.

In April 2009, FASB issued FSP SFAS 115-2 and SFAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments which amends the recognition guidance for other-than-temporary impairments (“OTTI”) of debt securities and expands the financial statement disclosures for OTTI on debt and equity securities.  Under this FSP, the difference between the amortized cost basis and fair value on debt securities that an entity intends to sell or would more-likely-than-not be required to sell before the expected recovery of the amortized cost basis is recorded in earnings. For available-for-sale and held-to-maturity debt securities that management has no intent to sell and believes that it is more-likely-than-not will not be required to be sold prior to recovery, only the credit loss component of the impairment is recognized in earnings, while the

 
25

 

rest of the fair value loss is recognized in accumulated other comprehensive income.  This FSP is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009.  Our adoption of this FSP in the first quarter of fiscal year 2010 is not expected to have a material impact on our financial position or results of operations.

In April 2009, FASB issued FSP SFAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly. The FSP reaffirms that fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions. The FSP also reaffirms the need to use judgment in determining if a formerly active market has become inactive and in determining fair values when the market has become inactive.  This FSP is effective for interim and annual reporting periods ending after June 15, 2009, and shall be applied prospectively. Early adoption is permitted for periods ending after March 15, 2009. Our adoption of this FSP in the first quarter of fiscal year 2010 is not expected to have a material impact on our financial position or results of operations.

In April 2009, FASB issued FSP SFAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments. The FSP requires disclosing qualitative and quantitative information about the fair value of all financial instruments on a quarterly basis, including methods and significant assumptions used to estimate fair value during the period. These disclosures were previously only done annually. The disclosures required by the FSP are effective for interim reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009.   Our adoption of this FSP in the first quarter of fiscal year 2010 is not expected to have a material impact on our financial position or results of operations.

In December 2007, the FASB issued SFAS 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB 51 (“SFAS 160”), to establish accounting and reporting standards for the noncontrolling interests in a subsidiary and for the deconsolidation of a subsidiary. It also amends certain consolidation procedures for consistency with the requirements of guidance covering 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.  SFAS 160 shall be applied prospectively as of the beginning of the fiscal year in which it is initially applied, except for the presentation and disclosure requirements. The presentation and disclosure requirements shall be applied retrospectively for all periods presented.

The principal effect of recasting the consolidated balance sheets upon the adoption of the new standard on June 1, 2009 is to move the noncontrolling interests from long-term liabilities to equity attributable to noncontrolling interests, thus increasing the total of consolidated equity by that amount.  The following table shows the expected effect of adopting SFAS 160 on the periods presented on the consolidated balance sheets as of May 31:

(dollar amounts in thousands)
 
2009
   
2008
Balance Sheet:
         
Total equity, as previously reported
$
508,938
 
$
665,965
Increase for SFAS 160 reclassification
         
of noncontrolling interests
 
10,162
   
14,247
Total equity, as adjusted
$
519,100
 
$
680,212
 
Additionally, the adoption of SFAS 160 requires that net income, as previously reported prior to the adoption of SFAS 160, be adjusted to include the net income attributable to the noncontrolling interests in the consolidated statement of earnings.  Thus, after the adoption of SFAS 160, consolidated net loss increases by $4 million for the year ended May 31, 2009 and net income decreases by $6 million for the year ended May 31, 2008.
 
Our adoption of SFAS 160 in the first quarter of fiscal year 2010 is not expected to have a material impact on our financial position or results of operations.

Results of Operations

Reclassifications of prior period amounts for fiscal years 2008 and 2007 have been made to conform to the current reporting format for the following two items.  Fees and other income totaling $18 million and $15 million for the years ended May 31, 2008 and 2007 have been reclassified from interest income to the fee and other income line of non-interest income on the consolidated statements of operations to conform with the May 31, 2009 presentation.  The loss on early extinguishment of debt and other expense totaling $6 million and $5 million for the years ended May 31, 2008 and 2007 have been reclassified from interest expense to those line items in non-interest expense on the consolidated statements of operations to conform with the May 31, 2009 presentation.

 
26

 

Fiscal Year 2009 versus 2008 Results
The following table presents the results of operations for the years ended May 31, 2009 and 2008.

     
For the year ended May 31,
     
Increase/
   
(dollar amounts in thousands)
   
2009
     
2008
     
(Decrease)
   
Interest income
 
$
1,070,764
   
$
1,051,393
   
$
19,371
   
Interest expense
   
(935,021
)
   
(931,268
)
   
(3,753
)
 
     Net interest income
   
135,743
     
120,125
     
15,618
   
(Provision for) recovery of loan losses
   
(113,699
)
   
30,262
     
(143,961
)
 
Net interest income after (provision for) recovery of loan losses
   
22,044
     
150,387
     
(128,343
)
 
                           
Non-interest income:
                         
     Fee and other income
   
13,163
     
19,608
     
(6,445
)
 
     Derivative cash settlements
   
112,989
     
27,033
     
85,956
   
     Results of operations of foreclosed assets
   
3,774
     
7,528
     
(3,754
)
 
          Total non-interest income
   
129,926
     
54,169
     
75,757
   
                           
Non-interest (expense) income:
                         
     Salaries and employee benefits
   
(36,865
)
   
(36,428
)
   
(437
)
 
     Other general and administrative expenses
   
(23,977
)
   
(24,041
)
   
64
   
     (Provision for) recovery of guarantee liability
   
(1,615
)
   
3,104
     
(4,719
)
 
     Market adjustment on foreclosed assets
   
(8,014
)
   
(5,840
)
   
(2,174
)
 
     Derivative forward value
   
(160,017
)
   
(98,743
)
   
(61,274
)
 
     Loss on sale of loans
   
-
     
(676
)
   
676
   
     Loss on early extinguishment of debt
   
-
     
(5,509
)
   
5,509
   
     Other
   
(353
)
   
(112
)
   
(241
)
 
          Total non-interest expense
   
(230,841
)
   
(168,245
)
   
(62,596
)
 
                           
(Loss) income prior to income taxes and minority interest
   
(78,871
)
   
36,311
     
(115,182
)
 
                         
Income tax benefit
   
5,101
     
3,335
     
1,766
   
Minority interest, net of income taxes
   
3,900
     
6,099
     
(2,199
)
 
     Net (loss) income
 
$
(69,870
)
 
$
45,745
   
$
(115,615
)
 
                           
TIER (1)
   
-
     
1.05
           
Adjusted TIER (2)
     
1.10
     
1.15
           
(1) For the year ended May 31, 2009, earnings were insufficient to cover the fixed charges by $70 million.
(2) Adjusted to exclude the effect of the derivative forward value from net income, to include minority interest in net income and to include all derivative cash settlements in the interest expense.  See Non-GAAP Financial Measures for further explanation and a reconciliation of these adjustments.

The following tables provide a breakout of the average yield on loans, the average rate on debt and the change to interest income, interest expense and net interest income due to changes in average loan and debt volume versus changes to interest rates summarized by loan and debt type.  The following tables also include a breakout of the change to derivative cash settlements due to changes in the average notional amount of our derivative portfolio versus changes to the net difference between the average rate paid and the average rate received.  Management calculates an adjusted interest expense, which includes all derivative cash settlements in interest expense.  See Non-GAAP Financial Measures for further explanation of the adjustment we make in our financial analysis to include all derivative cash settlements in our interest expense.

Average balances and interest rates – Assets

   
Average volume
 
Interest income
 
Average yield
 
(dollar amounts in thousands)
 
2009
 
2008
 
2007
 
2009
 
2008
 
2007
 
2009
 
2008
 
2007
 
                                       
Long-term fixed-rate loans (1)
$
 15,052,425
$
14,782,141
$
14,542,951
$
890,367
$
872,488
$
   833,247
 
5.92
%
5.90
%
5.73
%
Long-term variable-rate loans (1)
2,255,538
 
1,803,553
 
2,086,792
 
    92,975
 
    86,787
 
114,786
 
4.12
 
4.81
 
5.50
 
Short-term loans (1)
 
1,895,563
 
1,310,313
 
1,028,585
 
  75,604
 
    77,145
 
72,632
 
3.99
 
5.89
 
7.06
 
Non-performing loans
495,014
 
504,310
 
534,701
 
-
 
-
 
-
 
-
 
-
 
-
 
   Total
 
19,698,540
 
18,400,317
 
18,193,029
 
1,058,946
 
1,036,420
 
1,020,665
 
5.38
 
5.63
 
5.61
 
Investments (2)
 
489,228
 
234,831
 
215,409
 
 5,683
 
      7,394
 
9,662
 
1.16
 
3.15
 
4.49
 
Fee income
 
-
 
-
 
-
 
    6,135
 
       7,579
 
9,323
 
-
 
-
 
-
 
   Total
$
20,187,768
$
18,635,148
$
18,408,438
$
1,070,764
$
1,051,393
$
1,039,650
 
5.30
%
   5.64
 %
   5.65
 %
                                       
(1) Interest income on loans to members.
(2) Interest income on the investment of excess cash, preferred stock and trading securities.

 
27

 

Average balances and interest rates – Liabilities

   
Average volume
 
Interest expense
 
Average cost
 
(dollar amounts in thousands)
 
2009
 
2008
 
2007
 
2009
 
2008
 
2007
 
2009
 
2008
 
2007
 
Commercial paper and bank bid
                                     
    notes (1)
$
3,188,189
$
2,719,598
$
3,170,196
$
58,688
$
122,786
$
178,687
 
1.84
%
4.51
%
5.64
%
Medium-term notes (1)
 
5,278,445
 
4,101,955
 
5,336,846
 
326,313
 
 330,193
 
363,760
 
6.18
 
8.05
 
6.82
 
Collateral trust bonds (1)
 
5,232,731
 
4,880,885
 
4,226,306
 
290,152
 
 243,579
 
218,523
 
5.54
 
4.99
 
5.17
 
Subordinated deferrable debt (1)
 
294,592
 
301,771
 
476,764
 
19,663
 
   19,663
 
33,089
 
6.67
 
6.52
 
6.94
 
Subordinated certificates (1)
 
1,428,083
 
1,326,216
 
1,317,373
 
55,330
 
   48,717
 
47,852
 
3.87
 
3.67
 
3.63
 
Long-term private debt (1)
 
3,595,048
 
2,980,097
 
2,499,501
 
164,306
 
151,694
 
130,568
 
4.57
 
5.09
 
5.22
 
    Total
 
19,017,088
 
16,310,522
 
17,026,986
 
914,452
 
  916,632
 
972,479
 
4.81
 
5.62
 
5.71
 
Debt issuance costs (2)
 
-
 
-
 
-
 
10,158
 
      9,605
 
12,328
 
-
 
-
 
-
 
Fee expense (3)
 
-
 
-
 
-
 
10,411
 
      5,031
 
        6,947
 
-
 
-
 
-
 
  Total
$
19,017,088
$
16,310,522
$
17,026,986
$
935,021
$
931,268
$
991,754
 
4.92
%
5.71
%
5.82
%
                                       
Derivative cash settlements (4)
$
12,764,394
$
13,055,651
$
12,631,758
$
112,989
$
27,033
$
86,442
 
0.89
%
0.21
%
0.68
%
Adjusted interest expense (5)
 
19,017,088
 
16,310,522
 
17,026,986
 
822,032
 
904,235
 
905,312
 
4.32
 
5.54
 
5.32
 
                                       
Net interest income/Net yield
           
$
 135,743
$
 120,125
$
 47,896
 
0.38
%
(0.07
)%
(0.17
)%
Adjusted net interest
                                     
income/Adjusted net yield (5)
             
 248,732
 
 147,158
 
 134,338
 
0.98
 
0.10
 
0.33
 
(1) Represents interest expense and the amortization of discounts on debt.
(2) Includes amortization of all deferred charges related to debt issuances, principally underwriter's fees, legal fees, printing costs and comfort letter fees. Amortization is calculated on the effective interest method.  Also includes issuance costs related to dealer commercial paper, which are recognized as incurred.
(3) Includes various fees related to funding activities, including fees paid to banks participating in our revolving credit agreements.  Fees are recognized as incurred or amortized on a straight-line basis over the life of the respective agreement.
(4) For derivative cash settlements, average volume represents the average notional amount of derivative contracts outstanding and the average cost represents the net difference between the average rate paid and the average rate received for cash settlements during the period.
(5) See Non-GAAP Financial Measures for further explanation of the adjustment we make in our financial analysis to include the derivative cash settlements in interest expense.

   
Analysis of changes in net interest income
 
   
2009 vs. 2008
   
2008 vs. 2007
 
   
Increase (decrease)
due to change in:
         
Increase (decrease)
due to change in:
       
(dollar amounts in thousands)
 
Average
volume (1)
   
Average
rate (2)
   
Net
change
   
Average
volume (1)
   
Average
rate (2)
   
Net
change
 
Increase (decrease) in interest income:
                                   
Long-term fixed-rate loans
$
15,952
 
$
1,927
 
$
17,879
 
$
13,705
 
$
25,536
 
$
39,241
 
Long-term variable-rate loans
 
21,750
   
(15,562
)
 
6,188
   
(15,580
)
 
(12,419
)
 
(27,999
)
Short-term loans
 
34,457
   
(35,998
)
 
(1,541
)
 
19,894
   
(15,381
)
 
4,513
 
   Total interest income on loans
 
72,159
   
(49,633
)
 
22,526
   
18,019
   
(2,264
)
 
15,755
 
Investments
 
8,010
   
(9,721
)
 
(1,711
)
 
871
   
(3,139
)
 
(2,268
)
Fee income
 
-
   
(1,444
)
 
(1,444
)
 
-
   
(1,744
)
 
(1,744
)
   Total interest income
$
80,169
 
$
(60,798
)
$
19,371
 
$
18,890
 
$
(7,147
)
$
11,743
 
                                     
Increase (decrease) in interest expense:
                                   
Commercial paper and bank bid notes
$
21,156
 
$
(85,254
)
$
(64,098
)
$
(25,398
)
$
(30,503
)
$
(55,901
)
Medium-term notes
 
94,703
   
(98,583
)
 
(3,880
)
 
(84,170
)
 
50,603
   
(33,567
)
Collateral trust bonds
 
17,559
   
29,014
   
46,573
   
33,845
   
(8,789
)
 
25,056
 
Subordinated deferrable debt
 
(468
)
 
468
   
-
   
(12,145
)
 
(1,281
)
 
(13,426
)
Subordinated certificates
 
3,742
   
2,871
   
6,613
   
321
   
544
   
865
 
Long-term private debt
 
31,303
   
(18,691
)
 
12,612
   
25,105
   
(3,979
)
 
21,126
 
   Total interest expense on debt
 
167,995
   
(170,175
)
 
(2,180
)
 
(62,442
)
 
6,595
   
(55,847
)
Debt issuance costs
 
-
   
553
   
553
   
-
   
(2,723
)
 
(2,723
)
Fee expense
 
-
   
5,380
   
5,380
   
-
   
(1,916
)
 
(1,916
)
   Total interest expense
 
167,995
   
(164,242
)
 
3,753
   
(62,442
)
 
1,956
   
(60,486
)
   Net interest income
$
(87,826
)
$
103,444
 
$
15,618
 
$
81,332
 
$
(9,103
)
$
72,229
 
                                     
  Derivative cash settlements (3)
$
(603
)
$
86,559
 
$
85,956
 
$
2,901
 
$
(62,310
)
$
(59,409
)
  Adjusted interest expense (4)
 
150,049
   
(232,252
)
 
(82,203
)
 
(38,094
)
 
37,017
   
(1,077
)
(1) Calculated using the following formula: (current period average balance – prior year period average balance) x prior year period average rate.
(2) Calculated using the following formula: (current period average rate – prior year period average rate) x current period average balance.
(3) For derivative cash settlements, variance due to average volume represents the change in derivative cash settlements from the change in average notional amount of derivative contracts outstanding.  Variance due to average rate represents the change in derivative cash settlements from a change in rates.  The change in rate represents the net difference between the average rate paid and the average rate received for cash settlements during the period.
(4) See Non-GAAP Financial Measures for further explanation of the adjustment we make in our financial analysis to include the derivative cash settlements in interest expense.

 
28

 

Interest Income
The $19 million or two percent increase in interest income for the year ended May 31, 2009, as compared with the prior-year period was due to a $1.3 billion or seven percent increase in average loan volume largely offset by a 25 basis point decline in the average yield earned on the portfolio due to lower variable interest rates.

For the year ended May 31, 2009, we had a reduction to interest income of $56 million due to non-accrual loans compared with a reduction of $67 million for the prior-year period.  The effect on electric interest income of non-accrual loans was a reduction of $26 million for the year ended May 31, 2009, as compared with $34 million for the prior-year period.  The telecommunications interest income was reduced by $30 million for the year ended May 31, 2009 as compared with $33 million for the prior-year period as a result of non-accrual loans.  The effect of non-accrual loans on interest income is included in the rate variance in the table above.

Interest Expense
The $4 million or less than one percent increase in total interest expense for the year ended May 31, 2009 compared with the prior-year period was due to the higher level of debt outstanding to fund loan growth partially offset by the 79 basis point decline in the overall cost of our debt.  The decline in debt costs was primarily attributable to a decline in the cost of our short-term and variable-rate debt as a result of a lower interest rate environment compared with the prior-year period.  The growth in debt outstanding was primarily attributed to amounts borrowed under the REDLG program, notes payable issued to Farmer Mac and new issuances of collateral trust bonds since May 31, 2008.

The adjusted interest expense, which includes all derivative cash settlements, was $822 million for the year ended May 31, 2009 compared with $904 million for the prior-year period based on changes to interest expense noted above and derivative cash settlements described below.  See Non-GAAP Financial Measures for further explanation of the adjustment we make in our financial analysis to include all derivative cash settlements in interest expense.

Net Interest Income
The $16 million increase in net interest income for the year ended May 31, 2009 compared with the prior-year period was due to the increase in average loan volume and the 79 basis point decline in the overall cost of debt partially offset by additional debt required to fund the increase in loans and the 25 basis point decline in the yield of our loan portfolio.  The adjusted net interest income, which includes all derivative cash settlements, for the year ended May 31, 2009 was $249 million, an increase of $102 million from the prior-year period.  See Non-GAAP Financial Measures for further explanation of the adjustment we make in our financial analysis to include all derivative cash settlements in determining our adjusted interest expense which, in turn, affects adjusted net interest income.

Provision for Loan Loss
We recorded a loan loss provision of $114 million for the year ended May 31, 2009, compared with a $30 million recovery for the prior-year period.  The loan loss provision for the year ended May 31, 2009, was primarily due to a reduction in the fair value of the collateral supporting our exposure to Innovative Communication Corporation (“ICC”).  See Non-performing Loans in the Financial Condition section for additional discussion regarding this and other non-performing loans.  The fair value of the collateral was negatively affected by the limited access to and the high cost of capital to support acquisitions of assets similar to the collateral supporting our impaired loans, which resulted in a compression of the earning multiple that potential buyers are willing to pay for such assets.  In addition, the current economic conditions have caused consumers and businesses to reduce spending, which resulted in, at least for the short-term, reductions in the estimated earnings for companies.  The combination of these two factors, which began to affect market values after the LBHI bankruptcy, resulted in a decrease to the market value of companies similar to the collateral supporting our impaired loans and an increase in the required reserve for impaired loans.  The resulting increase in the loan loss provision was partly offset by payments received and changes in estimates of future expected cash flows for certain other impaired loans.  See further discussion in Allowance for Loan Losses in the Financial Condition section.

Non-interest Income
Non-interest income increased by $76 million for the year ended May 31, 2009, compared with the prior-year period primarily due to the increase in cash settlements on derivative financial instruments.  During the year ended May 31, 2009, we terminated certain receive fixed, pay variable interest rate swaps with notional amounts totaling $583 million that resulted in payments to us of $97 million which was recorded in the statement of operations as derivative cash settlements. Of the $583 million notional amount of derivative contracts terminated, we initiated the termination on $495 million, while the counterparty initiated the request to terminate $88 million (these swaps were terminated at par resulting in no cash payments or receipts).  As a result of these terminations, we recorded a charge to the derivative forward value line for the year ended May 31, 2009, to reduce the derivative asset by $97 million. The income recorded in cash settlements for the payments received and the charge to derivative forward value are offsetting, and therefore there is no effect on reported net income as a result of these transactions. While there was no effect on reported net income, adjusted net income and the related adjusted

 
29

 

equity increased by $97 million due to these transactions.  See Non-GAAP Financial Measures for further explanation of the adjustments we make in our financial analysis to net income and equity.

We terminated these derivative instruments primarily to increase our adjusted equity base for the fiscal year to partially offset losses from the quarter ended November 30, 2008 primarily due to the increase in the loan loss provision noted above.  Terminating these swaps also had the benefit of reducing our counterparty risk exposure on two out of the three counterparties to these instruments.  The economic effect of terminating these transactions was to accelerate into the current period the benefit we would have realized in future periods in the form of lower debt costs based upon expected future interest rates.

Cash settlements also include income of $7 million representing the estimated recovery for the $26 million due to us as a result of terminating interest rate swaps with LBSF.  The amount recorded as a receivable does not reduce or limit our claim of $26 million against LBHI and LBSF.  The ultimate recovery will depend on the ability of LBHI and LBSF to maximize the value of assets through sale or assignment or the price that we can obtain through the sale of our claim.  The cash settlements income described above was partially offset by the decrease in cash settlements as a result of lower short-term interest rates during the year ended May 31, 2009 compared with the year ended May 31, 2008 as we received a variable rate on the majority of our derivative contracts during both periods.  Additionally, the weighted-average rate received on pay fixed, receive variable interest rate swaps decreased from 2.64 percent for fiscal year 2008 to 0.62 percent for fiscal year 2009.

Non-interest Expense
Non-interest expense increased by $63 million for the year ended May 31, 2009 compared with the prior-year period primarily due to the $61 million increase in the derivative forward value expense explained below.  Additionally, we recorded a $2 million provision for guarantee liability for the year ended May 31, 2009 compared with a $3 million recovery of guarantee liability for the year ended May 31, 2008.  The increase to the provision for guarantee liability during the year ended May 31, 2009 was primarily due to the $238 million increase in guarantees outstanding. The $61 million increase in the derivative forward value expense during the year ended May 31, 2009 compared with the prior-year period is due to the reversal of the $97 million derivative asset related to terminated interest rate exchange agreements and changes in the estimate of future interest rates over the remaining life of the derivative contracts.

We recorded a decrease to the fair value of foreclosed assets of $8 million and $6 million for the years ended May 31, 2009 and 2008, respectively, based on decreasing collateral values.  The balance of foreclosed assets includes land development loans and limited partnership interests in certain real estate developments.  The reduction to the fair value of the collateral supporting these land development loans during the years ended May 31, 2009 and 2008 was primarily due to residential home market weakness which has caused lot sales to slow down.  Additionally, lower gas prices resulted in a decrease in the fair value of the underlying collateral in fiscal year 2009.

Minority Interest
During the year ended May 31, 2009, NCSC’s net loss exceeded its equity balance by $6 million primarily due to NCSC’s $12 million in derivative forward value losses during the period.  In accordance with consolidation accounting rules, National Rural is required to absorb the $6 million excess NCSC loss.  Minority interest for the year ended May 31, 2009, represents RTFC’s net loss of $1 million and $3 million of NCSC’s net loss of $9 million.  Minority interest for the year ended May 31, 2008 represents the total RTFC and NCSC net loss since NCSC losses did not exceed its equity during that period.

Net (Loss) Income
The change in the items described above resulted in a net loss of $70 million for the year ended May 31, 2009, compared to net income of $46 million for the prior-year period.  The adjusted net income, which excludes the effect of the derivative forward value and adds back minority interest, was $86 million, compared to $138 million for the prior-year period.  See Non-GAAP Financial Measures for further explanation of the adjustments we make in our financial analysis to net income.

 
30

 


Fiscal Year 2008 versus 2007 Results
The following table 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
 
$
1,051,393
   
$
1,039,650
   
$
11,743
   
Interest expense
   
(931,268
)
   
(991,754
)
   
60,486
   
     Net interest income
   
120,125
     
47,896
     
72,229
   
Recovery of loan losses
   
30,262
     
6,922
     
23,340
   
Net interest income after recovery of loan losses
   
150,387
     
54,818
     
95,569
   
                           
Non-interest income:
                         
     Fee and other income
   
19,608
     
16,106
     
3,502
   
     Derivative cash settlements
   
27,033
     
86,442
     
(59,409
)
 
     Results of operations of foreclosed assets
   
7,528
     
9,758
     
(2,230
)
 
          Total non-interest income
   
54,169
     
112,306
     
(58,137
)
 
                           
Non-interest (expense) income:
                         
     Salaries and employee benefits
   
(36,428
)
   
(33,817
)
   
(2,611
)
 
     Other general and administrative expenses
   
(24,041
)
   
(18,072
)
   
(5,969
)
 
     Recovery of guarantee liability
   
3,104
     
1,700
     
1,404
   
     Market adjustment on foreclosed assets
   
(5,840
)
   
-
     
(5,840
)
 
     Derivative forward value
   
(98,743
)
   
(79,281
)
   
(19,462
)
 
     Foreign currency adjustments
   
-
     
(14,554
)
   
14,554
   
     Loss on sale of loans
   
(676
)
   
(1,584
)
   
908
   
     Loss on early extinguishment of debt
   
(5,509
)
   
(4,806
)
   
(703
)
 
     Other
   
(112
)
   
(169
)
   
(57
)
 
          Total non-interest expense
   
(168,245
)
   
(150,583
)
   
(17,662
)
 
                           
Income prior to income taxes and minority interest
   
36,311
     
16,541
     
19,770
   
                         
Income tax benefit (expense)
   
3,335
     
(2,396
)
   
5,731
   
Minority interest, net of income taxes
   
6,099
     
(2,444
)
   
8,543
   
     Net income
 
$
45,745
   
$
11,701
   
$
34,044
   
                           
TIER
   
1.05
     
1.01
           
Adjusted TIER (1)
     
1.15
     
1.12
           
5(1) Adjusted to exclude the effect of the derivative forward value from net income, to include minority interest in net income and to include all derivative cash settlements in interest expense.  See Non-GAAP Financial Measures for further explanation and a reconciliation of these adjustments.

Interest Income
The $12 million or 1 percent increase in interest income for the year ended May 31, 2008 as compared with the prior-year period was due to the increase in National Rural and NCSC loan volume and long-term fixed-rate loans that repriced at higher interest rates partly offset by the decrease in RTFC loan volume and lower variable interest rates.  Interest rates for approximately $703 million of National Rural long-term fixed-rate loans were repriced in January 2008 with 85 percent selecting a new fixed rate.  The weighted-average interest rate of long-term loans subject to repricing in January 2008 was approximately 5.37 percent, which is lower than the National Rural fixed interest rates available to members at that time of between 5.65 percent and 7.25 percent (depending on the term selected).  The increase in interest income was offset by the impact of our decreasing variable interest rates by approximately 215 to 250 basis points, depending on the loan program, since May 31, 2007.

For the year ended May 31, 2008, we had a reduction to interest income of $67 million due to non-accrual loans compared with a reduction of $81 million for the prior year period.  The effect on electric interest income of non-accrual loans was a reduction of $34 million for the year ended May 31, 2008 as compared with $39 million for the prior year period.  The impact on RTFC interest income of non-accrual loans was a reduction of $33 million for the year ended May 31, 2008 as compared with $42 million for the prior year period.  The impact of non-accrual loans on interest income is included in the rate variance in the table on page 28.

 
31

 

Interest Expense
The $60 million or 6 percent decrease in total interest expense for the year ended May 31, 2008 as compared with the prior year period was due to lower interest expense on commercial paper and variable-rate long-term debt as a result of a 325 basis point decrease in the federal funds rate from the rate in effect at May 31, 2007.  The $500 million borrowed under the
REDLG program in August 2007 represents a lower cost compared with our other forms of long-term debt as a result of the guarantee of repayment by the RUS.  In addition, the $175 million of 7.40 percent subordinated deferrable debt redeemed in June 2007 resulted in a 39 basis point decrease in the weighted-average cost of subordinated deferrable debt.

The adjusted interest expense, which includes all derivative cash settlements, was consistent for the year ended May 31, 2008 with the prior-year period based on changes to interest expense noted above and derivative cash settlements described below.  See Non-GAAP Financial Measures for further explanation of the adjustment we make in our financial analysis to include all derivative cash settlements in our interest expense.

Net Interest Income
The change in the line items described above resulted in an increase in net interest income of $72 million for the year ended May 31, 2008 compared with the prior-year period.  The adjusted net interest income, which includes all derivative cash settlements, for the year ended May 31, 2008 was $147 million, an increase of $13 million from the prior year period.  See Non-GAAP Financial Measures for further explanation of the adjustment we make in our financial analysis to include all derivative cash settlements in our interest expense, and therefore net interest income.

Recovery of Loan Losses
The $30 million recovery of loan losses for the year ended May 31, 2008 resulted from the decrease in calculated impairments due to lower variable rates and payments received on impaired loans.

Non-interest Income
Non-interest income decreased by $58 million for the year ended May 31, 2008 compared with the prior year primarily due to decreases in cash settlements and income from the operations of foreclosed assets.  The $59 million decrease in cash settlements for the year ended May 31, 2008 from the prior year period is primarily due to a $31 million payment received during the prior year for the termination of two exchange agreements compared with $8 million paid during the year ended May 31, 2008 for the termination of three exchange agreements.  Additionally, cash settlements decreased for the year ended May 31, 2008 due to the 325 basis point decrease in the federal funds rate from May 31, 2007 to May 31, 2008 as we received a variable rate on 59 percent of our interest rate exchange agreements during fiscal year 2008 compared with 41 percent of our interest rate exchange agreements for which we pay a variable rate.  Income from the operation of foreclosed assets decreased by $2 million for the year ended May 31, 2008 compared with the prior year due to a lower outstanding balance in foreclosed assets.  At May 31, 2008, the foreclosed assets are comprised of real estate developer notes receivable and limited partnership interests in certain real estate developments.

Non-interest Expense
Non-interest expense increased by $18 million for the year ended May 31, 2008 compared with the prior year.

Salaries and employee benefits increased by $3 million for the year ended May 31, 2008 as compared with the prior year period primarily due to additional headcount and higher medical insurance rates.  We had 13 additional employee positions filled at May 31, 2008 as compared with the prior-year period end.

General and administrative expenses increased by $6 million for the year ended May 31, 2008 compared with the prior-year period because of increased expenditures for the acceleration of information systems projects and the write-off of site work expenses on property we had under contract, but the seller was unable to meet the conditions to close the sale.  Increased membership meeting expenses, marketing and audit fees also contributed to higher general and administrative expenses for the year ended May 31, 2008.

For the year ended May 31, 2008, we determined that there was a reduction of $6 million to the market value of the real estate developer notes receivable held as foreclosed assets.  The reduction to the market value was primarily as a result of the slowdown in lot sales due to residential home market weakness.

The $19 million decrease in the derivative forward value during the year ended May 31, 2008 compared with the prior year period was due to changes in the estimate of future interest rates over the remaining life of the derivative contracts.

There was no foreign denominated debt outstanding during the year ended May 31, 2008, therefore there was no foreign currency adjustments compared with $15 million in the prior year period.  When we issue debt in foreign currencies, we must adjust the value of the debt reported on the consolidated balance sheets for changes in foreign currency exchange rates since the date of

 
32

 

issuance.  To the extent that the current exchange rate is different than the exchange rate at the time of issuance, there will be a change in the value of the foreign denominated debt. The adjustment to the value of the debt is reported on the consolidated statements of operations as foreign currency adjustments.  At the time of issuance of all foreign denominated debt, we typically enter into a cross currency or cross currency interest rate exchange agreement to fix the exchange rate on all principal and interest payments through maturity.

In June 2007, we redeemed the $175 million of 7.40 percent subordinated deferrable debt at par and recorded a charge of $6 million as loss on the early extinguishment of debt for the unamortized issuance costs in the first quarter of fiscal year 2008.  There was a $5 million loss on the extinguishment of debt for the year ended May 31, 2007 due to the write-off of unamortized debt issuance costs associated with the early redemption of subordinated deferrable debt.

Minority Interest
Minority interest represents $0.3 million and $5.8 million of net loss for RTFC and NCSC, respectively, for the year ended May 31, 2008 compared with $0.1 million and $2.3 million of net income for RTFC and NCSC, respectively, for the prior year period.   The decrease in NCSC net income is primarily due to fluctuations in the fair value of its derivative instruments.

Net Income
The change in the line items described above resulted in an increase in net income of $34 million for the year ended May 31, 2008 from the prior year period.  The adjusted net income, which excludes the impact of the derivative forward value and foreign currency adjustments and adds back minority interest, was $138 million, compared with $108 million for the prior year period.  See Non-GAAP Financial Measures for further explanation of the adjustments we make in our financial analysis to net income.

Ratio of Earnings to Fixed Charges

The following table provides the calculation of the ratio of earnings to fixed charges.  For fiscal years prior to May 31, 2009, the ratio of earnings to fixed charges is the same calculation as TIER.  For the year ended May 31, 2009, the fixed charge coverage ratio includes capitalized interest in total fixed charges which is not included in our TIER calculation.  See Results of Operations for a discussion of TIER and adjustments that we make to the TIER calculation.

   
For the year ended May 31,
   
(dollar amounts in thousands)
 
2009
   
2008
   
2007
   
(Loss) income prior to cumulative effect of
                   
   change in accounting principle
$
(69,870
)
$
45,745
 
$
11,701
   
Add: fixed charges
 
935,194
   
931,268
   
991,754
   
Less: interest capitalized
 
(173
)
 
-
   
-
   
Earnings available for fixed charges
$
865,151
 
$
977,013
 
$
1,003,455
   
                     
Total fixed charges:
                   
Interest on all debt (including amortization of
                   
discount and issuance costs)
$
935,021
 
$
931,268
 
$
991,754
   
Interest capitalized
 
173
   
-
   
-
   
Total fixed charges
$
935,194
 
$
931,268
 
$
991,754
   
Ratio of earnings to fixed charges (1)
   
-
   
1.05
   
1.01
   
(1) For the year ended May 31, 2009, earnings were insufficient to cover the fixed charges by $70 million.

Financial Condition

Loan and Guarantee Portfolio Assessment
Loan Programs
Loans to members bear interest at rates we determine from time to time after considering our interest expense, operating expenses, provision for loan losses and the maintenance of reasonable earnings levels.  In keeping with the cooperative charter, our policy is to set interest rates at the lowest levels we consider to be consistent with sound financial management.

 
33

 

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

(dollar amounts in millions)
 
2009
   
2008
   
2007
   
2006
   
2005
 
Loans by type:
 
Amount
 
%
   
Amount
 
%
   
Amount
 
%
   
Amount
 
%
   
Amount
 
%
 
Long-term loans (1):
                                                 
Long-term fixed-rate loans
$
14,813
 
74
%
$
15,419
 
81
%
$
14,881
 
82
%
$
14,763
 
80
%
$
12,936
 
68
%
Long-term variable-rate loans
 
3,277
 
16
   
1,918
 
10
   
2,032
 
11
   
2,570
 
14
   
5,009
 
27
 
Total long-term loans
 
18,090
 
90
   
17,337
 
91
   
16,913
 
93
   
17,333
 
94
   
17,945
 
95
 
Short-term loans (2)
 
2,098
 
10
   
1,690
 
9
   
1,215
 
7
   
1,028
 
6
   
1,027
 
5
 
Total loans
$
20,188
 
100
%
$
19,027
 
100
%
$
18,128
 
100
%
$
18,361
 
100
%
$
18,972
 
100
%
                                                   
Loans by segment:
                                                 
National Rural:
                                                 
Distribution
$
13,730
 
68
%
$
13,438
 
71
%
$
12,828
 
71
%
$
12,859
 
70
%
$
12,729
 
67
%
Power supply
 
4,268
 
21
   
3,339
 
17
   
2,858
 
16
   
2,811
 
15
   
2,641
 
14
 
Statewide and associate
 
93
 
1
   
109
 
 1
   
119
 
1
   
 125
 
1
   
135
 
1
 
National Rural total
 
18,091
 
90
   
16,886
 
89
   
15,805
 
88
   
15,795
 
86
   
15,505
 
82
 
RTFC
 
1,680
 
 8
   
1,727
 
9
   
1,860
 
10
   
2,162
 
12
   
2,992
 
16
 
NCSC
 
417
 
2
   
414
 
2
   
463
 
2
   
404
 
2
   
475
 
2
 
Total
 
$
20,188
 
100
%
$
19,027
 
100
%
$
18,128
 
100
%
$
18,361
 
100
%
$
18,972
 
100
%
(1) Includes loans classified as restructured and non-performing and RUS guaranteed loans.
(2) Consists of secured and unsecured short-term loans, where the interest rate could be adjusted monthly or semi-monthly.

Loans outstanding increased by six percent for the year ended May 31, 2009.  The primary reasons for the loan growth at National Rural were an increase in RUS note buyouts, funding of capital expenditures, bridge financing to fund projects before receipt of RUS funding and funding for renewable energy projects.

Loans that converted from a fixed rate to a variable rate totaled $856 million, which was partially offset by $205 million of loans converting from a variable rate to a fixed rate for the year ended May 31, 2009.  The significant shift in fixed-rate loans converting to variable rates was the result of extremely low variable rates because the Federal Reserve lowered the federal funds rate to historically low levels in the latter half of calendar year 2008.  For the year ended May 31, 2008, loans converting from a variable rate to fixed rate totaled $711 million, which was offset by $274 million of loans that converted from a fixed rate to a variable rate.

The following table summarizes loans and guarantees outstanding by segment at May 31:

                   
Increase/
 
(dollar amounts in thousands)
 
2009
     
2008
       
National Rural:
 
Amount
 
% of Total
     
Amount
 
% of Total
     
(Decrease)
 
   Distribution
$
13,994,595
 
65
%
 
$
13,622,829
 
68
%
 
$
371,766
 
   Power supply
 
5,213,868
 
24
     
4,125,567
 
20
     
 1,088,301
 
   Statewide and associate
 
116,203
 
1
     
131,710
 
1
     
 (15,507
)
          National Rural total
 
19,324,666
 
90
     
17,880,106
 
89
     
1,444,560
 
RTFC
 
1,680,654
 
8
     
1,726,774
 
9
     
   (46,120
)
NCSC
 
 458,342
 
2
     
457,255
 
2
     
1,087
 
          Total
$
21,463,662
 
100
%
 
$
20,064,135
 
100
%
 
$
1,399,527
 

The following table summarizes the loans and guarantees outstanding at RTFC as of May 31:

                   
Increase/
 
   
2009
     
2008
       
(dollar amounts in thousands)
 
Amount
 
% of Total
     
Amount
 
% of Total
     
(Decrease)
 
Rural local exchange carriers
$
1,476,402
 
88
%
 
$
1,518,197
 
88
%
 
$
(41,795
)
Cable television providers
 
152,326
 
9
     
153,539
 
9
     
(1,213
)
Fiber optic network providers
 
8,126
 
1
     
16,884
 
1
     
 (8,758
)
Competitive local exchange carriers
 
37,294
 
2
     
29,871
 
2
     
7,423
 
Wireless providers
 
3,924
 
-
     
4,579
 
-
     
(655
)
Other
 
2,582
 
-
     
3,704
 
-
     
(1,122
)
          Total
 
$
1,680,654
 
100
%
 
$
1,726,774
 
100
%
 
$
(46,120
)


 
34

 

Our members are widely dispersed throughout the United States and its territories, including 49 states, the District of Columbia and two U.S. territories.  At May 31, 2009, 2008 and 2007, loans and guarantees outstanding to members in any one state or territory did not exceed 17 percent, 17 percent and 15 percent, respectively, of total loans and guarantees outstanding.

Credit Concentration
National Rural, RTFC and NCSC each have policies that limit the amount of credit that can be extended to individual borrowers or a controlled group of borrowers.  The credit limitation policies set the limit on the total exposure and unsecured exposure to the borrower based on an assessment of the borrower's risk profile and our internal risk rating system.  As a member-owned cooperative, we balance the needs of our member/owners and the risk associated with concentrations of credit exposure.  The respective boards of directors must approve new credit requests from borrowers with total exposure or unsecured exposure in excess of the limits in the policies.  Management may use syndicated credit arrangements to minimize credit concentrations.

Total exposure, as defined by the policies, generally includes the following:
·  
loans outstanding, excluding loans guaranteed by RUS;
·  
our guarantees of the borrower's obligations;
·  
unadvanced loan commitments;
·  
borrower guarantees to us of another borrower's debt; and
·  
any other indebtedness with us, unless guaranteed by the U.S. Government.

The calculation of total exposure includes facilities that might not be drawn by the borrower, such as lines of credit and loan commitments for projects that may be delayed or cancelled.

At May 31, 2009 and 2008, the total exposure outstanding to any one borrower or controlled group did not exceed 2.4 percent and 2.7 percent, respectively, of total loans and guarantees outstanding.  At May 31, 2009, the ten largest borrowers included three distribution systems, six power supply systems and one telecommunications system. At May 31, 2008, the ten largest borrowers included five distribution systems, four power supply systems and one telecommunications system.  Over the past five years, our single obligor concentrations in the telecommunications portfolio have decreased resulting in outstanding loans at May 31, 2009 averaging $10 million per active, performing telecommunications borrower.  The following table shows the exposure to the ten largest borrowers as a percentage of total exposure by type and by segment at May 31:

  
  
2009
  
  
2008
   
Increase/
 
(dollar amounts in thousands)
 
 Amount
 
% of Total
   
Amount
 
% of Total
   
(Decrease)
 
Total by type:
                         
  Loans
$
 3,686,956
   
17
%
$
3,395,865
   
17
%
$
291,091
 
  Guarantees
 
 363,883
   
2
   
164,740
   
1
   
199,143
 
     Total credit exposure to ten largest borrowers
$
 4,050,839
   
19
%
$
3,560,605
   
18
%
$
490,234
 
                               
Total by segment:
                             
   National Rural
$
3,497,331
   
16
%
$
3,043,905
   
15
%
$
453,426
 
   RTFC
 
523,758
   
3
   
491,700
   
3
   
32,058
 
   NCSC
 
29,750
   
-
   
25,000
   
-
   
4,750
 
     Total credit exposure to ten largest borrowers
$
4,050,839
   
19
%
$
3,560,605
   
18
%
$
490,234
 


Security Provisions
Except when providing short-term loans, we typically lend to our members on a senior secured basis.  Long-term loans are typically secured on parity with other secured lenders (primarily RUS), if any, by all assets and revenues of the borrower with exceptions typical in utility mortgages.  Short-term loans are generally unsecured lines of credit.  Guarantee reimbursement obligations are typically secured on parity with other secured creditors by all assets and revenues of the borrower or by the underlying financed asset.  In addition to the collateral received, borrowers are also required to set rates charged to customers to achieve certain financial ratios.

 
35

 

The following table summarizes our unsecured credit exposure as a percentage of total exposure by type and by segment at May 31:

  
  
2009
  
  
2008
   
Increase/
 
(dollar amounts in thousands)
 
 Amount
 
% of Total
   
Amount
 
% of Total
   
(Decrease)
 
Total by type:
                         
  Loans
$
 2,831,111
   
13
%
$
2,150,739
   
10
%
$
680,372
 
  Guarantees
 
     347,325
   
2
   
235,816
   
1
   
111,500
 
     Total unsecured credit exposure
$
  3,178,436
   
15
%
$
2,386,555
   
11
%
$
791,881
 
                               
Total by segment:
                             
   National Rural
$
2,875,396
   
14
%
$
2,100,676
   
10
%
$
774,720
 
   RTFC
 
237,259
   
1
   
229,287
   
1
   
7,972
 
   NCSC
 
 65,781
   
-
   
56,592
   
-
   
9,189
 
     Total unsecured credit exposure
$
3,178,436
   
15
%
$
2,386,555
   
11
%
$
791,881
 

Pledging of Loans
We are required to pledge collateral equal to at least 100 percent of the outstanding balance of debt issued under the collateral trust bond indentures and the revolving debt issuance agreements with Farmer Mac.  We pledge distribution mortgage loans and permitted investments under our collateral trust bond indentures.  We pledge distribution and power supply mortgage loans under the debt issuance agreements with Farmer Mac, which permit up to 20 percent of loans pledged to be from power supply systems.  In addition, we are required to maintain collateral on deposit equal to at least 100 percent of the outstanding balance of debt under the REDLG program.  Distribution and power supply loans may be deposited for the REDLG program.

Although not required, we typically maintain pledged collateral and collateral on deposit in excess of the required 100 percent of the outstanding balance of debt issued.  However, our revolving credit agreements limit pledged collateral to 150 percent of the outstanding balance of debt issued.  The excess collateral ensures that required collateral levels are maintained and, when an opportunity exists, facilitates timely execution of debt issuances by limiting or eliminating the lead time required to gather collateral.  Collateral levels fluctuate because:
·  
distribution and power supply loans typically amortize, while the debt issued under the collateral trust bond indenture, the Farmer Mac debt issuance agreements and the REDLG program have bullet maturities;
·  
individual loans may become ineligible for various reasons, some of which may be temporary; and
·  
distribution and power supply borrowers have the ability to prepay their loans.

We may request the return of collateral pledged or held on deposit in excess of the 100 percent of the principal balance requirement or may move the collateral from one program to another to facilitate a new debt issuance, provided that all conditions of eligibility under the different programs are satisfied.

The following table summarizes our secured debt or debt requiring collateral on deposit, the excess collateral pledged and our unencumbered loans at May 31:

(dollar amounts in thousands)
 
2009
   
2008
 
Total loans to members
$
20,188,207
 
$
19,026,995
 
Less: Total secured debt or debt requiring
           
collateral on deposit
 
(9,390,000
)
 
(8,115,000
)
Less: Excess collateral pledged or on deposit
 
(2,566,723
)
 
(1,241,554
)
Unencumbered loans
$
8,231,484
 
$
9,670,441
 
             
Unencumbered loans as a percentage of total loans
 
41
%
 
51
%

Non-performing Loans
A borrower is classified as non-performing when any one of the following criteria is met:
·  
principal or interest payments on any loan to the borrower are past due 90 days or more;
·  
as a result of court proceedings, repayment on the original terms is not anticipated; or
·  
for some other reason, management does not expect the timely repayment of principal and interest.

Once a borrower is classified as non-performing, we typically place the loan on non-accrual status and reverse all accrued and unpaid interest back to the date of the last payment.  In certain circumstances, a performing restructured loan can also remain on non-accrual status (see Restructured Loans).  We generally apply all cash received during the non-accrual period to the reduction of principal, thereby foregoing interest income recognition.  At May 31, 2009, we had one non-performing loan outstanding in the amount of $524 million.  At May 31, 2008, we had non-performing loans of $507 million outstanding.  All loans classified as non-performing were on non-accrual status.

 
36

 

We monitor our borrowers’ performance and contact borrowers frequently when payments are delinquent.  The table below shows our delinquency rates for the past six years.  This table breaks out the delinquency rates including and excluding our loan to ICC.  The one loan to ICC drives the vast majority of our delinquent loans and we are in the process of foreclosing upon the collateral of this borrower.

(dollar amounts in thousands)
 
2004
   
2005
   
2006
   
2007
   
2008
   
2009
 
                                     
Total loans outstanding
$
20,488,523
 
$
18,972,068
 
$
18,360,905
 
$
18,128,207
 
$
19,026,995
 
$
20,188,207
 
Unpaid principal balance:
                                   
   Loans >60 and < 90
                                   
days past due
 
-
   
-
   
-
   
-
   
-
   
-
 
                                     
   Loans > 90 days past due
 
-
   
480,963
   
488,392
   
492,795
   
499,234
   
523,758
 
                                     
                                     
   ICC
 
-
   
479,196
   
488,392
   
492,795
   
491,706
   
523,758
 
                                     
Delinquency rates:
                                   
   Loans >60 and < 90 days
                                   
past due
 
0.00
%
 
0.00
%
 
0.00
%
 
0.00
%
 
0.00
%
 
0.00
%
   Loans > 90 days past due
 
0.00
   
2.54
   
2.66
   
2.72
   
2.62
   
2.59
 
                                     
Delinquency rates less ICC:
                                   
   Loans >60 and < 90 days
                                   
past due
 
0.00
%
 
0.00
%
 
0.00
%
 
0.00
%
 
0.00
%
 
0.00
%
   Loans > 90 days past due
 
0.00
   
0.01
   
0.00
   
0.00
   
0.04
   
0.00
 
                                     
Delinquency information:
                                   
     Loans >30
$
-
 
$
480,963
 
$
488,392
 
$
492,795
 
$
499,234
 
$
523,758
 
     Delinquency rate >30
 
0.00
%
 
2.54
%
 
2.66
%
 
2.72
%
 
2.62
%
 
2.59
%
                                     
Delinquency info less ICC:
                                   
     Loans >30
$
-
 
$
1,767
 
$
-
 
$
 -
 
$
7,528
 
$
 -
 
     Delinquency rate >30
 
0.00
%
 
0.01
%
 
0.00
%
 
0.00
%
 
0.04
%
 
0.00
%

At May 31, 2009 and 2008, non-performing loans include $524 million and $492 million, respectively, to ICC.  All loans to ICC have been on non-accrual status since February 1, 2005.  ICC has not made debt service payments to us since June 2005.  RTFC is the primary secured lender to ICC.

In February 2006, involuntary bankruptcy petitions were filed against ICC's indirect majority shareholder and former chairman, Jeffrey Prosser ("Prosser"), ICC's immediate parent, Emerging Communication, Inc. ("Emcom") and Emcom's parent, Innovative Communication Company LLC ("ICC-LLC"); and in April 2006, RTFC reached a settlement with ICC, Virgin Islands Telephone Corporation d/b/a Innovative Telephone ("Vitelco"), ICC-LLC, Emcom, their directors and Prosser, individually.  Under the settlement, RTFC obtained entry of judgments in the District Court of the Virgin Islands against ICC for approximately $525 million and Prosser for approximately $100 million.  RTFC also obtained dismissals with prejudice and releases of all counterclaims, affirmative defenses and other lawsuits alleging wrongful acts by RTFC, certain of its officers, and National Rural thereby resolving all the loan-related litigation in RTFC’s favor.  Regardless, Prosser and related parties continue to assert claims against National Rural and certain of its officers and directors and other parties in various proceedings and forums.  National Rural therefore anticipates that it will continue to be engaged in defense of those assertions on many fronts, as well as pursuing claims of its own.

ICC-LLC, Emcom and Prosser each have bankruptcy proceedings pending in the United States District Court for the Virgin Islands, Bankruptcy Division (the “Bankruptcy Court”).  A Chapter 11 trustee has been appointed for the ICC-LLC and Emcom estates; and a Chapter 7 trustee was appointed in Prosser’s individual case.  Prosser’s Chapter 7 trustee is in the process of marshaling Prosser’s non-exempt assets for disposition and eventual payment in respect of creditor claims.

On September 21, 2007, the Bankruptcy Court entered an order placing ICC in its own bankruptcy proceeding, and on October 3, 2007 appointed a trustee.  The Chapter 11 trustee of ICC has assumed ownership and control of ICC, including its subsidiaries, and has begun to marshal RTFC collateral and other assets for disposition, including property in Prosser’s possession or control, and eventual payment in respect of RTFC’s claims and the claims of other parties-in-interest.  Certain assets have been sold, including certain foreign companies, aircraft, and real estate.

On February 1, 2008, the Court approved a motion of the Chapter 11 trustee of ICC to sell substantially all of ICC’s assets, divided into three groups:  Group 1 consisting of ICC assets and stock in ICC subsidiaries operating in the U.S. Virgin Islands, the British Virgin Islands and St. Martin (the “Group 1 Assets”); Group 2 consisting of ICC assets and stock in ICC

 
37

 

subsidiaries operating in France and certain of its Caribbean territories and the Netherland Antilles (the “Group 2 Assets”); and Group 3 consisting of the newspaper and media operations of ICC (the “Group 3 Assets”).  The Group 2 Assets and Group 3 Assets were sold in December 2008 and May 2008, respectively, and in each case, the distribution of proceeds was approved by the Court and resulted in a net recovery to us.

On March 13, 2009, RTFC and the Trustee entered into a Purchase Agreement as part of a $250 million credit bid for the ICC Group 1 Assets.  The Purchase Agreement is conditional upon the approval of the bankruptcy court and applicable regulators.  On April 6, 2009, the Bankruptcy Judge approved, on an interim basis, the sale of the ICC Group 1 Assets to RTFC.  RTFC has begun the process of obtaining the applicable regulatory approvals.

In April 2009, RTFC acquired $85 million of Vitelco preferred stock and $12.5 million of accrued and unpaid dividends relating to such shares for a total purchase price of $30 million.  We believe that the acquisition of the preferred shareholders interests at a discount has improved our estimated recovery from the collateral.

For a more detailed description of the contingencies related to the non-performing loans outstanding to ICC, see Note 16 Restructured /Non-performing Loans and Contingencies, to the consolidated financial statements.  Based on its analysis, we believe that we have adequately reserved for our exposure to ICC at May 31, 2009.

Restructured Loans
When agreements are executed to change the original terms of a loan, generally a change to the originally scheduled cash flows, we classify the loan as restructured unless the new terms are deemed to be market terms.  We make a determination about the accrual of interest income for these loans on a loan-by-loan basis.  The initial decision is based on the terms of the restructure agreement and the anticipated performance of the borrower over the term of the agreement.  We will periodically review the decision whether or not to accrue interest income on restructured loans based on the borrower's past performance and current financial condition.

At May 31, 2009 and 2008, restructured loans totaled $538 million and $577 million, respectively.  A total of $491 million and $519 million of restructured loans were on non-accrual status at May 31, 2009 and 2008, respectively.

At May 31, 2009 and 2008, restructured loans outstanding to Denton County Electric Cooperative, d/b/a CoServ Electric ("CoServ") were $491 million and $519 million, respectively.  All restructured CoServ loans have been on non-accrual status since January 1, 2001.  In addition, $20 million was outstanding under the capital expenditure loan facility classified as a performing loan at both May 31, 2009 and 2008.  Total loans to CoServ at May 31, 2009 and 2008 represented 2.4 percent and 2.7 percent of our total loans and guarantees outstanding, respectively.

Under the terms of a bankruptcy settlement from 2002, National Rural restructured the loans to CoServ.  CoServ is scheduled to make quarterly payments to National Rural through December 2037.  As part of the restructuring, National Rural may be obligated to provide up to $204 million of senior secured capital expenditure loans to CoServ for electric distribution infrastructure through December 2012.  Under the facility, advances are limited to $46 million per year.  As of the date of this filing, there is $184 million available under this loan facility.  When CoServ requests capital expenditure loans from National Rural, these loans are made at the standard terms offered to all borrowers and require debt service payments in addition to the quarterly payments that CoServ is required to make to National Rural.  To date, CoServ has made all payments required under the restructure agreement and capital expenditure loan facility. Under the terms of the restructure agreement, CoServ has the option to prepay the loan for the lesser of their outstanding balance or $405 million plus an interest payment true up on or after December 13, 2008.  To date, National Rural has not received notice from CoServ that it intends to prepay the loan.  CoServ and National Rural have no claims related to any of the legal actions asserted before or during the bankruptcy proceedings.  National Rural's legal claim against CoServ is limited to CoServ's performance under the terms of the bankruptcy settlement.

Based on our analysis, we believe that we have adequately reserved for our exposure to CoServ at May 31, 2009.

At May 31, 2009 and 2008, we had a total of $42 million and $52 million, respectively, in restructured loans outstanding to Pioneer Electric Cooperative, Inc. ("Pioneer").  Pioneer is current with respect to all debt service payments at May 31, 2009 and all loans to Pioneer remain on accrual status.  National Rural is the principal creditor to Pioneer.

Based on our analysis, we believe that we have adequately reserved for our exposure to Pioneer at May 31, 2009.

Loan Impairment
On a quarterly basis, we review all non-performing and restructured borrowers, as well as certain additional borrowers selected

 
38

 

based on known facts and circumstances at the time of the review, to determine if the loans to the borrower are impaired and/or to update the impairment calculation.  We calculate a borrower’s impairment based on the expected future cash flow or the fair value of any collateral securing our loans to the borrower.  In some cases, to estimate future cash flow, certain assumptions are required regarding, but not limited to, the following:
·  
interest rates,
·  
court rulings,
·  
changes in collateral values,
·  
changes in economic conditions in the area in which the cooperative operates,
·  
changes to the industry in which the cooperative operates, and
·  
likelihood of repayment amount and timing.

As events related to the borrower take place and economic conditions and our assumptions change, the impairment calculations will change.  The loan loss allowance specifically reserved to cover the calculated impairments is adjusted on a quarterly basis based on the most current information available. At May 31, 2009 and 2008, impaired loans totaled $1,056 million and $1,078 million, respectively.  At May 31, 2009 and 2008, we specifically reserved a total of $414 million and $331 million, respectively, to cover impaired loans.

The following table presents a summary of non-performing and restructured loans as a percentage of total loans and total loans and guarantees outstanding at May 31:

(dollar amounts in thousands)
 
2009
     
2008
     
2007
     
2006
     
2005
 
Non-performing loans (1)
$
523,758
   
$
506,864
   
$
501,864
   
$
577,869
   
$
616,626
 
Percent of loans outstanding
 
2.59
%
   
2.67
%
   
2.77
%
   
3.15
%
   
3.25
%
Percent of loans and guarantees outstanding
 
2.44
     
2.52
     
2.61
     
2.97
     
3.06
 
                                       
Restructured loans
$
537,587
   
$
577,111
   
$
603,305
   
$
630,354
   
$
600,926
 
Percent of loans outstanding
 
2.66
%
   
3.03
%
   
3.33
%
   
3.43
%
   
3.17
%
Percent of loans and guarantees outstanding
 
2.50
     
2.88
     
3.14
     
3.24
     
2.99
 
                                       
Total non-performing and restructured loans
$
1,061,345
   
$
1,083,975
   
$
1,105,169
   
$