10-K 1 may312011_10k.htm MAY 31, 2011 FORM 10-K may312011_10k.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

x     ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended May 31, 2011
       
OR
o     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
 
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.

 
 

 



TABLE OF CONTENTS
Part No.
Item No.
 
Page
I.
 
1.
 
Business
1
 
         
General
1
 
         
Our Business Development
2
 
         
Our Loan Programs
3
 
         
Guarantee Programs
11
 
         
Our Lending Competition
13
 
         
Our Regulation
15
 
         
Our Members
15
 
         
Corporate Governance
18
 
         
Rural Electric Industry
19
 
         
Rural Telecommunications Industry
22
 
         
Disaster Recovery
23
 
         
Tax Status
23
 
         
Allocation and Retirement of Patronage Capital
24
 
         
Investment Policy
25
 
         
Employees
25
 
   
1A.
 
Risk Factors
25
 
   
1B.
 
Unresolved Staff Comments
29
 
   
2.
 
Properties
29
 
   
3.
 
Legal Proceedings
29
 
   
4.
 
[Removed and Reserved]
30
 
II.
 
5.
 
Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of
   
       
Equity Securities
31
 
   
6.
 
Selected Financial Data
31
 
   
7.
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
32
 
         
Executive Summary
32
 
         
Critical Accounting Policies and Estimates
35
 
         
Results of Operations
38
 
         
Ratio of Earnings to Fixed Charges
45
 
         
Financial Condition
45
 
         
Off-Balance Sheet Obligations
54
 
         
Liquidity and Capital Resources
56
 
         
Market Risk
62
 
         
Non-GAAP Financial Measures
67
 
   
7A.
 
Quantitative and Qualitative Disclosures About Market Risk
71
 
   
8.
 
Financial Statements and Supplementary Data
71
 
   
9.
 
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
71
 
   
9A.
 
Controls and Procedures
71
 
   
9B.
 
Other Information
72
 
III.
 
10.
 
Directors, Executive Officers and Corporate Governance
73
 
   
11.
 
Executive Compensation
82
 
   
12.
 
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder
   
       
Matters
92
 
   
13.
 
Certain Relationships and Related Transactions, and Director Independence
92
 
   
14.
 
Principal Accounting Fees and Services
94
 
IV.
 
15.
 
Exhibits, Financial Statement Schedules
95
 
       
Signatures
98
 

 
 

 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Form 10-K contains forward-looking statements defined by the Securities Act of 1933, as amended, and the Exchange Act of 1934, as amended. Forward-looking statements, which are based on certain assumptions and describe our future plans, strategies and expectations, are generally identified by our use of words such as “intend,” “plan,” “may,” “should,” “will,” “project,” “estimate,” “anticipate,” “believe,” “expect,” “continue,” “potential,” “opportunity” and similar expressions, whether in the negative or affirmative. All statements about future expectations or projections, including statements about loan volume, the adequacy of the loan loss allowance, operating income and expenses, leverage and debt-to-equity ratios, borrower financial performance, impaired loans, and sources and uses of liquidity, are forward-looking statements. Although we believe that the expectations reflected in our forward-looking statements are based on reasonable assumptions, actual results and performance could materially differ. Factors that could cause future results to vary from current expectations include, but are not limited to, general economic conditions, legislative changes, governmental monetary and fiscal policies, changes in tax policies, changes in interest rates, demand for our loan products, lending competition, changes in the quality or composition of our loan and investment portfolios, changes in accounting principles, policies or guidelines, changes in our ability to access external financing, valuations of collateral supporting impaired loans, initial valuations of assets received in foreclosure, non-performance of counterparties to our derivative agreements and other economic and governmental factors affecting our operations. Some of these and other factors are discussed in our annual and quarterly reports previously filed with the Securities and Exchange Commission (“SEC”). Except as required by law, we undertake no obligation to update or publicly release any revisions to forward-looking statements to reflect events, circumstances or changes in expectations after the date on which the statement is made.

The information in this section should be read with our consolidated financial statements and related notes and the information contained elsewhere in this Form 10-K, including that set forth under Item 1A. Risk Factors and Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.


PART I

Item 1.
Business.

General

National Rural Utilities Cooperative Finance Corporation (“CFC”) is a member-owned cooperative association incorporated under the laws of the District of Columbia in April 1969. CFC’s principal purpose is to provide its members with financing to supplement the loan programs of the Rural Utilities Service (“RUS”) of the United States Department of Agriculture. CFC makes loans to its rural electric members so they can acquire, construct and operate electric distribution, generation, transmission and related facilities. CFC also provides its members with credit enhancements in the form of letters of credit and guarantees of debt obligations. As a cooperative, CFC is owned by and exclusively serves its membership, which consists solely of not-for-profit entities or subsidiaries or affiliates of not-for-profit entities. CFC is exempt from federal income taxes under Section 501(c)(4) of the Internal Revenue Code. As a member-owned cooperative, CFC has no publicly held equity securities outstanding. CFC funds its activities primarily through a combination of publicly and privately held debt securities and member investments. CFC’s objective is to offer its members cost-based financial products and services consistent with sound financial management and is not to maximize net income. As described under Allocation and Retirement of Patronage Capital on page 24, CFC allocates its net earnings, which consist of net income excluding the effect of certain non-cash accounting entries, annually to a cooperative educational fund, a members’ capital reserve and to members based on each member’s patronage of CFC’s loan programs during the year.

For financial statement purposes, CFC’s results of operations and financial condition are consolidated with and include Rural Telephone Finance Cooperative (“RTFC”) and National Cooperative Services Corporation (“NCSC”). Unless stated otherwise, references to “we,” “our” or “us” relate to the consolidation of CFC, RTFC, NCSC and certain entities created and controlled by CFC to hold foreclosed assets and to accommodate loan securitization transactions. The revenue, net profit or loss and total assets of CFC are presented as a reportable segment in Note 15, Segment Information, to the consolidated financial statements.

Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports are available, free of charge, at www.nrucfc.coop (under the link “Investor Relations/Financial Reporting”) as soon as reasonably practicable after they are electronically filed with or furnished to the SEC. These reports are also available free of charge on the SEC website at www.sec.gov. Information posted on our website is not incorporated by reference into this Form 10-K.

 
1

 

RTFC is a cooperative association originally incorporated in South Dakota in 1987 and reincorporated as a member-owned cooperative association in the District of Columbia in 2005. RTFC’s principal purpose is to provide and arrange financing for its rural telecommunications members and their affiliates. RTFC’s membership consists of a combination of not-for-profit entities and for-profit entities. CFC is the sole lender to and manages the lending activities of RTFC through a long-term management agreement. Under a guarantee agreement, RTFC pays CFC a fee and, in exchange, CFC reimburses RTFC for loan losses. RTFC is headquartered with CFC in Herndon, Virginia. RTFC is a taxable cooperative that pays income tax based on its net income, excluding patronage-sourced net earnings allocated to its patrons, as permitted under Subchapter T of the Internal Revenue Code.

NCSC was incorporated in 1981 in the District of Columbia as a member-owned cooperative association. The principal purpose of NCSC is to provide financing to members of CFC, entities eligible to be members of CFC and the for-profit and non-profit entities that are owned, operated or controlled by, or provide significant benefit to Class A, B and C members of CFC. NCSC’s membership consists of CFC and distribution systems that are members of CFC or are eligible for such membership. CFC is the primary source of funding to and manages the lending activities of NCSC through a management agreement that is automatically renewable on an annual basis unless terminated by either party. Under a guarantee agreement, NCSC pays CFC a fee and, in exchange, CFC reimburses NCSC for loan losses. NCSC is headquartered with CFC in Herndon, Virginia. NCSC is a taxable cooperative that, to date, has not allocated its patronage-sourced net earnings to members. Thus, NCSC pays income tax on the full amount of its net income.

Our Business Development

Our business strategy and policies are set by our Board of Directors and, in general, may be amended or revised from time to time by the Board of Directors. Over the past five years, we have undertaken the following initiatives as a result of the strategic planning of our Board of Directors: (i) focus on electric lending while strategically decreasing telecommunications exposures, (ii) obtain and diversify sources of funding to meet our capital needs, (iii) enhance market risk management and (iv) increase and retain investments by our members for longer periods.

Focus on Electric Lending
Over the past five years, we renewed our focus on lending to our electric systems while strategically decreasing our telecommunications exposure through RTFC. CFC’s primary focus is lending to its core distribution and power supply members that represent 92 percent of the outstanding loan portfolio at May 31, 2011, compared with RTFC loans outstanding that represent 4 percent of the total loan portfolio. Our electric cooperative borrowers have demonstrated stable operating performance and strong financial ratios, even during the recent economic downturn, as the majority of electric cooperatives’ customers are residential, for whom electricity is an essential service. Our electric cooperative members experience limited competition as they generally operate in exclusive territories, the majority of which are not rate regulated. Additionally, they have access to low-cost capital from the federal government in addition to our lending resources. In our 42-year history, we have had no net write-offs for distribution borrowers and $68 million in net write-offs for power supply borrowers. On the other hand, the telecommunications service providers, to which RTFC provides loans, have experienced fast-paced technological change, increasing competition and uncertainty with respect to their regulatory environment. For these reasons, RTFC became more selective as to the companies it finances and strategically exited or reduced its exposure to its larger borrowers. The telecommunications portfolio decreased by 60 percent over the last five years compared with a 14 percent increase to loans outstanding to CFC’s electric distribution and power supply borrowers.

Obtain Diverse Funding Sources
Diversifying our funding sources to expand beyond capital markets offerings of collateral trust bonds and medium-term notes and the sale of commercial paper was a primary initiative over the past five years. To help meet our capital needs, we expanded our funding programs to include the Guaranteed Underwriter program of the U.S. Department of Agriculture, as well as note purchase agreements and whole-loan sale programs with the Federal Agricultural Mortgage Corporation. From fiscal year 2006 to fiscal year 2011, we entered into four bond purchase agreements with the Federal Financing Bank totaling $3,500 million with a guarantee of repayment by RUS as part of the funding mechanism for the Rural Economic Development Loan and Grant program. At May 31, 2011, we had debt outstanding totaling $3,150 million under this program, with a remaining commitment of $350 million available. Currently, we have an application to RUS for an additional $500 million of RUS-guaranteed Federal Financing Bank loans authorized under this program. The guarantee fees paid to the government by CFC in connection with these borrowings are used to fund economic development programs administered by RUS in the rural areas served by electric cooperatives. Starting in fiscal year 2009, we entered into note purchase agreements with the Federal Agricultural Mortgage Corporation that totaled $2,400 million at May 31, 2009 and 2010. During fiscal year 2011, all note purchase agreements were consolidated into one agreement and the amount available increased $1,500 million. Under the

 
2

 

agreement we may borrow, repay and re-borrow funds up to $3,900 million at any time or from time to time through January 11, 2016 as market conditions permit. We may select a fixed rate or a variable rate at the time of each advance. Additionally, we developed a program to sell member systems’ distribution and power supply loans to the Federal Agricultural Mortgage Corporation to help manage single-obligor exposures within our loan portfolio, as an additional form of liquidity and to manage the level of our debt-to-equity ratio. During the fiscal years ended May 31, 2011, 2010 and 2008, we sold CFC distribution and power supply loans with outstanding principal balances totaling $327 million, $128 million and $74 million, respectively, at par to the Federal Agricultural Mortgage Corporation for cash. Prior to the end of fiscal year 2011 and soon after fiscal year end, we entered into agreements with two additional partners for the sale of our loans. See Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsLiquidity and Capital Resources for additional information regarding our funding sources.

Enhance Market Risk Management
In fiscal year 2011, we continued the practice of having regularly scheduled monthly Asset Liability Committee meetings to enhance the overall corporate monitoring of our funding activities. Our Asset Liability Committee was established in fiscal year 2009 and monitors our management of risks related to interest rates, counterparty credit and liquidity to ensure consistent access to funding that is in alignment with our strategic goals. The committee’s mandate is to review CFC’s liquidity, as well as the relationship of interest rates and tenor of our assets to our liabilities and, as a result, our spread between interest income and interest expense. Functional responsibilities of this committee include reviewing pricing and other funding decisions, investment decisions and trends in funding alternatives and risk exposure. Performance results and budget deviations also are reviewed. If necessary, the organization’s asset-liability strategy is reviewed for modification to react to the current market environment. At least monthly, the Asset Liability Committee reviews a complete interest rate risk analysis, reviews proposed modifications, if any, to our interest rate risk management strategy and considers adopting strategy changes. See Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsMarket Risk for additional information regarding our market risk management.

Increase Member Investments and Equity Retention
In fiscal year 2009, we developed a corporate objective to increase the investments of our members and our equity retention by implementing two primary initiatives: (i) offering of member capital securities, a 35-year unsecured and subordinated voluntary debt investment, to our members beginning in November 2008 and (ii) adjusting CFC’s patronage capital retirement practices in June 2009.

Member capital securities are unsecured obligations and are subordinate to all of our existing and future senior indebtedness and all of our existing and future subordinated indebtedness that may be held by or transferred to non-members, but rank on a parity to all other members’ subordinated certificates. Since fiscal year 2009, the initial year of the program, we have issued $398 million of member capital securities at a 35-year maturity that were callable at par by CFC starting five years from the date of issuance and anytime thereafter. The majority of member capital securities were issued with a 7.5 percent interest rate. Effective January 1, 2010, the fixed interest rate earned on our member capital securities changed from 7.5 percent to 5 percent. Since that time, an insignificant amount of member capital securities have been issued. For computing compliance with our revolving credit agreement covenants, we are required to adjust our leverage ratio by subtracting members’ subordinated certificates, including member capital securities, from total liabilities and adding this amount to total equity. The leverage and debt-to-equity ratios adjusted to treat members’ subordinated certificates as equity rather than debt reflect management’s perspective on our operations.

At the end of each fiscal year, CFC’s Board of Directors allocates its net earnings to members in the form of patronage capital and to board-approved reserves. CFC bases the amount of net earnings allocated to each member on the member’s patronage of CFC’s lending programs during the year. CFC’s Board of Directors historically votes to retire a portion of the prior year’s patronage capital allocation. In June 2009, CFC revised its guidelines to retire 50 percent of its prior year’s allocated net earnings and hold the remaining 50 percent for 25 years in order to further strengthen its equity position. CFC’s practice prior to June 2009 was to retire 70 percent of its prior year’s allocated net earnings and hold the remaining 30 percent for 15 years. For the years ended May 31, 2011, 2010 and 2009, the amount of allocated net earnings we retired was reduced by $18 million, $20 million and $17 million, respectively, as a result of the change in the retirement practices.

Our Loan Programs

CFC lends to its members and associates; RTFC lends to its members, organizations affiliated with its members and its associates; NCSC lends to its members and associates. The loans to the affiliated organizations may require a guarantee of repayment to NCSC from the CFC member cooperative with which it is affiliated.

 
3

 


The loans of CFC, RTFC and NCSC generally provide that an event of default has occurred if there is any material adverse change in the business condition, financial or otherwise, of the borrower. Our loan standards are generally comparable to those of RUS, and most members significantly exceed the financial tests set by both RUS and CFC.

CFC Loan Programs
Long-Term Loans
CFC’s long-term loans generally have the following characteristics:
·  
terms of up to 35 years on a senior secured basis;
·  
amortizing or bullet maturity loans with serial payment structures;
·  
the property, plant and equipment financed by and securing the long-term loan has a useful life equal to or in excess of the loan maturity;
·  
flexibility for the borrower to select a fixed interest rate for periods of one to 35 years or a variable rate; and
·  
the ability for the borrower to select various tranches with either a fixed or variable interest rate for each tranche.

Borrowers may select a fixed or a variable interest rate at the time of each advance on long-term loan facilities. When selecting a fixed rate, the member has the option to choose a fixed rate for a term of one year through the final maturity of the loan. When the selected fixed interest rate term expires, the borrower may select another fixed rate for a term of one year through the loan maturity or the current variable rate. Electric long-term fixed rates are set daily for new loan advances and loans that reprice. The long-term variable rate is set on the first day of each month. The fixed rate on each loan is determined on the day the loan is advanced or repriced based on the term selected.

To be in compliance with the covenants in the loan agreement and eligible for loan advances, distribution systems generally must maintain an average modified debt service coverage ratio, as defined in the loan agreement, of 1.35 or greater. Similarly, power supply systems generally must maintain an average modified debt service coverage ratio, as defined in the loan agreement, of 1.0 or greater. CFC may make long-term loans to distribution and power supply systems, on a case-by-case basis, that do not meet these general criteria.

Line of credit loans
Line of credit loans are generally unsecured. Line of credit loans are designed primarily to assist borrowers with liquidity and cash management and are generally advanced at variable interest rates. These variable interest rates may be set on the first day of each month or mid-month. Line of credit loans are typically revolving facilities and generally require the borrower to pay off the principal balance for at least five consecutive business days at least once during each 12-month period. Line of credit loans are also made available as interim financing when a member either receives RUS approval to obtain a loan and is awaiting its initial advance of funds or submits a loan application that is pending approval from RUS (sometimes referred to as “bridge loans”). RUS loan advances, if received, must be used to repay these interim facilities.

Syndicated line of credit loans
A syndicated loan is typically a large financing offered by a group of lenders who work together to provide funds for a single borrower. Syndicated loans are generally unsecured, floating-rate loans that can be provided on a revolving or term basis for tenors that range from several months to several years. Syndicated financing is arranged for borrowers on a case-by-case basis. CFC may act as lead lender, arranger and administrative agent for the syndicated facilities. CFC makes its best efforts to syndicate the loan requirements of  borrowers in good standing. The success of such efforts depends on the financial position and credit quality of the borrower as well as market conditions.

RTFC Loan Programs
At May 31, 2011 and 2010, 95 percent and 88 percent of RTFC loans, respectively, were outstanding to rural local exchange carriers. Most of these rural local exchange carriers evolved from solely being voice service providers to being providers of voice, data and, in many cases, video and wireless services. Rural local exchange carriers are generally characterized by the low population density of their service territories. Services are generally delivered over networks that include fiber optic cable and digital switching. There is generally a significant barrier to competitive entry.

The businesses to which the remaining RTFC loans have been made support the operations of the rural local exchange carriers and are owned, operated or controlled by rural local exchange carriers. Many such loans are supported by payment guarantees from the sponsoring rural local exchange carriers.

Long-Term Loans
RTFC makes long-term loans to rural telecommunications companies and their affiliates for the acquisition, construction or upgrade of wireline telecommunications systems, wireless telecommunications systems, fiber optic networks, cable television systems and other corporate purposes.

 
4

 


RTFC’s long-term loans generally have the following characteristics:
·  
terms not exceeding 10 years on a senior secured basis;
·  
the property, plant and equipment financed by and securing the long-term loan has a useful life equal to or in excess of the loan maturity;
·  
flexibility for the borrower to select a fixed interest rate for periods from one year to the final loan maturity or a variable interest rate; and
·  
the ability for the borrower to select various tranches with either a fixed or variable interest rate for each tranche.

When a selected fixed interest rate term expires, the borrower may select another fixed-rate term or a variable rate. The fixed rate on a loan is determined on the day the loan is advanced or converted to a fixed rate based on the term selected. The long-term variable rate is set on the first day of each month.

To borrow from RTFC, a wireline telecommunications system generally must be able to demonstrate the ability to achieve and maintain an annual debt service coverage ratio and an annual times interest earned ratio (“TIER”) of 1.25 and 1.50, respectively. To borrow from RTFC, a cable television system, fiber optic network or wireless telecommunications system generally must be able to demonstrate the ability to achieve and maintain an annual debt service coverage ratio of 1.25.

Line of credit loans
Line of credit loans are generally unsecured. Line of credit loans are designed primarily to assist borrowers with liquidity and cash management and are generally advanced at variable interest rates. These variable interest rates may be set on the first day of each month or mid-month. Line of credit loans are typically revolving facilities and generally require the borrower to pay off the principal balance for at least five consecutive business days at least once during each 12-month period. Line of credit loans are also made available as interim financing, or bridge loans, when a member either receives RUS approval to obtain a loan and is awaiting its initial advance of funds or submits a loan application that is pending approval from RUS. RUS loan advances, if received, must be used to repay these interim facilities.

NCSC Loan Programs
Long-Term Loans
NCSC’s long-term loans generally have the following characteristics:
·  
terms of up to 35 years on a senior secured or unsecured basis;
·  
amortizing or bullet maturity loans with serial payment structures;
·  
the property, plant and equipment financed by and securing the long-term loan has a useful life equal to or in excess of the loan maturity;
·  
flexibility for the borrower to select a fixed interest rate for periods of one to 35 years or a variable rate; and
·  
the ability for the borrower to select various tranches with either a fixed or variable interest rate for each tranche.

NCSC allows borrowers to select a fixed interest rate or a variable interest at the time of each advance on long-term loan facilities. When selecting a fixed rate, the borrower has the option to choose a fixed rate for a term of one year through the final maturity of the loan. When the selected fixed interest rate term expires, the borrower may select another fixed rate for a term of one year through the loan maturity or the current variable rate. NCSC sets long-term fixed rates daily for new loan advances and loans that reprice. The long-term variable rate is set on the first day of each month. The fixed rate on a loan is determined on the day the loan is advanced or repriced based on the term selected.

Line of credit loans
Line of credit loans are generally unsecured. Line of credit loans are designed primarily to assist borrowers with liquidity and cash management and are generally advanced at variable interest rates. These variable interest rates may be set on the first day of each month or mid-month. Line of credit loans are typically revolving facilities and generally require the borrower to pay off the principal balance for at least five consecutive business days at least once during each 12-month period. Line of credit loans are also made available as interim financing, or bridge loans, when a member either receives RUS approval to obtain a loan and is awaiting its initial advance of funds or submits a loan application that is pending approval from RUS. RUS loan advances, if received, must be used to repay these interim facilities.

 
5

 


Interest Rates on Loans
As a member-owned cooperative finance company, we are a cost-based lender. Our interest rates are set primarily based on our cost of funding, general and administrative expenses, loan loss provision and to provide a reasonable level of earnings. Various standardized discounts may reduce the stated interest rates for Class A and Class B borrowers meeting certain criteria related to business type, performance, volume and whether they borrow only from us.

The table below shows the weighted-average loans outstanding to borrowers and the weighted-average yield earned by loan and borrower type during fiscal years ended May 31:

   
2011
   
2010
   
(dollar amounts in thousands)
 
Weighted-
average
loans outstanding
 
Weighted-
average
yield
   
Weighted-
average
loans outstanding
 
Weighted-
average
yield
   
Total by loan type:
                         
   Long-term fixed-rate loans
 
$
16,297,697}
 
5.55
%
$
15,456,301
 
5.81
%
   Long-term variable-rate loans
   
914,979}
 
4.98
   
1,609,562
 
4.68
 
   Line of credit loans
   
1,415,919}
 
3.13
   
1,652,154
 
3.39
 
   Restructured loans
   
487,570}
 
0.57
   
521,570
 
0.61
 
   Non-performing loans
   
242,890}
 
0.06
   
523,813
 
-
 
Total loans
 
$
19,359,055}
 
5.15
 
$
19,763,400
 
5.22
 
                       
 Total by borrower type:
                     
   CFC
 
$
17,787,856}
 
 5.15
%
$
17,681,663
 
5.29
%
   RTFC
   
1,107,287}
 
 4.98
   
1,718,100
 
4.21
 
   NCSC
   
463,912}
 
 5.68
   
363,637
 
6.61
 
Total
   
$
19,359,055}
 
 5.15
 
$
19,763,400
 
5.22
 

Credit Policies, Process and Monitoring
Loan Underwriting and Credit Monitoring
We have separate lending staff to underwrite distribution loans, power supply loans and telecommunications loans. Our borrowers contact the applicable lending staff to discuss the member’s need for funding. Our lending staff evaluates the borrower’s request to determine whether the requested credit represents an acceptable credit risk. When considering credit requests to borrowers with large single-obligor exposures we may use loan syndications to effectively manage portfolio risk related to credit concentrations. The lending staff evaluation of the proposed credit will include, but is not limited to:

·  
the size of the loan request;
·  
the intended use of proceeds;
·  
whether collateral is required and, if so, whether there is sufficient collateral;
·  
the member’s risk profile as measured by financial ratios and other risk characteristics; and
·  
other factors that might be applicable to the type of borrower or the specific loan request being considered.

If our lending staff determines that a credit is acceptable, the staff works with the borrower to structure a loan based on the various options we offer and prepares a credit recommendation for review by management in the lending group as discussed further below under Loan Approval.

Our Credit Risk Management group facilitates the activities of our internal credit review process, establishes credit policies and oversees our internal risk rating system. We maintain an internal risk rating system that produces a borrower rating and a facility rating. The borrower risk rating measures risk of default for each borrower based on both quantitative and qualitative measurements specific to the particular business line of the borrower. The facility risk rating measures risk of loss in the event of default for a particular facility based on the collateral or guarantee associated with the loan. Risk ratings are used to assess the credit quality of each of our borrowers and to establish credit limitations, and are factors in determining applicable credit approval levels.

 
6

 


Risk ratings for borrowers with outstanding and/or unadvanced loan or guarantee commitments are updated at least annually upon the receipt of audited financial information and are reviewed in connection with any new credit request. Annually, an outside banking consultant conducts a review of the accuracy of specific borrower risk ratings and the risk rating process and credit extension practices for compliance with policy and consistency in application. Such consultant provides recommendations to management and the Board of Directors for improvement, as well as progress on the resolution of items from prior reviews. Management is responsible for implementing the recommendations accepted by the Board of Directors. In addition, we compare our internal ratings to the publicly available ratings for our members that have public ratings.

Loan Approval
Our Board of Directors establishes our loan policies, which include a credit approval matrix. The credit approval matrix specifies the required level of approval applicable to any proposed loan based on factors such as the amount of the loan, the borrower risk rating, whether credit limitations are exceeded and whether the loan is to a member associated with one of our current directors. Through the approval matrix, the Board has delegated the authority to approve certain loans to the Chief Executive Officer, who has further delegated approval authority to the Corporate Credit Committee and management in the lending group while retaining sole authority to approve certain loans.

In order to maintain our ability to consider and approve loans and other extensions of credit on a timely basis, the Board of Directors has established a loan committee, made up of Board members, that it is authorized to approve loans that require Board approval in between regularly scheduled Board meetings.

Loans that require approval at a more senior level than management in the lending group are forwarded to the Corporate Credit Committee for consideration. The Corporate Credit Committee is a cross-functional group that includes staff with distribution, power supply and telecommunications lending experience, credit risk management experience, legal experience, accounting experience, regulatory experience and financial industry experience. This committee performs a vital role in maintaining a balance between the credit needs of the borrowers and the requirements for sound credit quality of our loan and guarantee portfolio. The Corporate Credit Committee monitors lending policies and practices and reviews extensions of credits requiring special attention. The Corporate Credit Committee also monitors selected rating changes, analyzes rating integrity and works to improve our internal risk rating system. Lending staff presents the credit recommendation and answers any questions posed by the committee. The Corporate Credit Committee then approves or rejects the loan. Loans that require Chief Executive Officer or Board approval are provided with documentation and a credit recommendation by management in the lending group and the Corporate Credit Committee. The Chief Executive Officer or Board of Directors (or the loan committee of the Board) reviews the credit recommendation, asks questions of staff if necessary and either approves or rejects the loan request.

Board policy requires that any exceptions to applicable credit limitations and any loan or extension of credit to a member that has a CFC director as one of its directors or officers must be approved by the Board of Directors or the loan committee of the Board, with the director associated with the member requesting the loan being recused from discussions and voting. Notwithstanding the foregoing, the Chief Executive Officer has the authority to approve emergency and certain other lines of credit, including circumstances where a director is either a director or officer of the member receiving such credit. Such lines of credit must meet specific qualifying criteria and must be underwritten in accordance with the prevailing standards and terms.

Non-performing loans
The Credit Risk Management group, on an ongoing basis, and the Corporate Credit Committee, on a quarterly basis, monitor all past due, non-accrual and restructured facilities that are not performing under their original terms. The Credit Risk Management group presents reports on such matters to the CFC Board of Directors. 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.

All loans are written off in the period that it becomes evident that collectability is highly unlikely; however, our efforts to recover all charged-off amounts may continue. Management makes a recommendation to the CFC Board or Directors as to the timing and amount of loan write-offs based on various factors, including, but not limited to, cash flow analysis and the fair value of the collateral securing the borrower's loans. The Board of Directors makes the final determination as to all loan write-offs.

 
7

 


Advances on Previously Approved Loan Facilities
Certain of our loan facilities allow our members to draw down the loan amount over a period of time. To advance an amount under an approved loan facility, a member must be in compliance with all terms and conditions of their facility. The majority of our loans allow us to deny an advance if there has been a material adverse change in the business condition, financial or otherwise, of the borrower since the time the facility was approved.

Covenant Compliance
Borrowers are required to maintain certain financial ratios. In addition, members with long-term loans outstanding are generally required to provide us with certain information and documentation on an annual basis, including, but not limited to, audited financial statements and a certificate of management confirming compliance with all covenants.

Loan Portfolio Performance
At May 31, 2011, there was one borrower not current with regard to its required loan payments. In general, our electric cooperative borrowers provide essential services and are insulated to some extent from the problems other companies may experience with regard to collection of amounts due during periods of recession. As a result, the difficult economic conditions experienced in recent years have not resulted in a significant rise in delinquencies or defaults in our borrowers’ receivables. For calendar year 2010, our electric member systems did not report a significant increase in late payments of utility bills from their member rate-payers or write-offs. Since the start of the financial crisis in September 2008, only one electric cooperative borrower has gone into payment default.

During the three-year period ended May 31, 2011, only five borrowers were in default of loan payments, four of which were telecommunications borrowers. During the past three years, we wrote off $360 million related to three of the telecommunications borrowers, including $354 million for Innovative Communication Corporation (“ICC”) during fiscal year 2011. Two smaller write-offs totaled $6 million in fiscal year 2009. There were no loan write-offs in fiscal year 2010. An electric distribution cooperative in payment default is in the process of developing geothermal generation capability and had non-performing loans outstanding of $31 million and $25 million at May 31, 2011 and 2010, respectively. This borrower filed for bankruptcy in September 2010. We had no other loans for which payments were more than 30 days delinquent at May 31, 2011. All loans classified as restructured are making payments as scheduled by the restructured agreements. See Note 3, Loans and Commitments, for additional information on our restructured and non-performing loans.

Our total loans outstanding increased by $298 million over the last three years ended May 31, 2011. The total loans outstanding increased by $1,161 million during fiscal year 2009 and decreased by $850 million and $13 million during fiscal years 2010 and 2011, respectively. The $13 million decrease in fiscal year 2011 was due to the $813 million decrease in RTFC loans outstanding, partially offset by the increases of $627 million and $173 million to loans outstanding to CFC and NCSC borrowers, respectively. The loans outstanding to CFC and NCSC borrowers increased due to a total of $1,109 million of loan advances used to refinance the debt of other lenders. This increase in loans outstanding was partly offset during fiscal year 2011 by distribution and power supply loans sold to the Federal Agricultural Mortgage Corporation totaling $327 million, of which $164 million were advanced at the time of sale, and by $75 million of loans prepaid at their repricing date. RTFC loans as a percentage of our total loan portfolio decreased from 9 percent at May 31, 2010 to 4 percent at May 31, 2011 as a result of the $536 million reduction in non-performing loans to ICC, and the prepayment of $204 million of telecommunications loans related to the acquisition of one of our borrowers.

Since we are limited to doing business with our members and associates, the growth in our loan portfolio is dependent on our members’ need for capital funding and the options available to them to obtain such funding. Thus, it is very difficult to predict, with any certainty, the amount of new loan advances that will occur over the next 12 to 18 months. This is especially true with the balance of line of credit loans, which are used by our members to manage liquidity or for interim financing in anticipation of obtaining long-term RUS loans. In many cases, these interim lines of credit carry relatively large balances.

 
8

 


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

(dollar amounts in thousands)
                                   
State/Territory
 
2011
   
2010
   
2009
   
State/Territory
 
2011
   
2010
   
2009
 
Alabama
$
442,174
 
$
400,037
 
$
430,065
   
Montana
$
115,407
 
$
128,037
 
$
128,563
 
Alaska
 
384,363
   
350,522
   
340,861
   
Nebraska
 
18,469
   
13,420
   
13,844
 
American Samoa
 
-
   
470
   
489
   
Nevada
 
168,411
   
158,137
   
171,754
 
Arizona
 
205,312
   
239,186
   
246,171
   
New Hampshire
 
103,658
   
120,968
   
132,741
 
Arkansas
 
544,876
   
558,493
   
615,429
   
New Jersey
 
15,843
   
18,090
   
18,806
 
California
 
25,002
   
27,588
   
37,270
   
New Mexico
 
88,071
   
27,791
   
32,254
 
Colorado
 
937,084
   
937,982
   
944,938
   
New York
 
20,852
   
16,560
   
14,523
 
Connecticut
 
200,000
   
200,000
   
200,000
   
North Carolina
 
508,617
   
392,872
   
468,240
 
Delaware
 
26,039
   
27,223
   
36,253
   
North Dakota
 
138,788
   
113,668
   
68,758
 
District of Columbia
8,826
   
9,069
   
9,298
   
Ohio
 
378,027
   
367,607
   
444,565
 
Florida
 
559,880
   
586,228
   
651,564
   
Oklahoma
 
529,591
   
520,302
   
500,189
 
Georgia
 
1,542,093
   
1,473,464
   
1,584,178
   
Oregon
 
309,006
   
300,871
   
303,926
 
Hawaii
 
7,214
   
9,229
   
6,443
   
Pennsylvania
 
400,330
   
379,504
   
375,549
 
Idaho
 
151,287
   
154,996
   
158,013
   
South Carolina
 
518,224
   
435,156
   
464,125
 
Illinois
 
715,296
   
728,541
   
661,632
   
South Dakota
 
169,122
   
153,815
   
142,582
 
Indiana
 
633,245
   
637,271
   
839,473
   
Tennessee
 
59,213
   
68,158
   
76,553
 
Iowa
 
419,769
   
557,553
   
493,722
   
Texas
 
3,512,178
   
3,114,889
   
3,332,283
 
Kansas
 
791,092
   
822,599
   
801,389
   
Utah
 
558,351
   
569,537
   
561,050
 
Kentucky
 
373,809
   
285,166
   
472,693
   
Vermont
 
59,269
   
66,049
   
79,131
 
Louisiana
 
287,826
   
334,339
   
388,490
   
Virgin Islands
 
-
   
536,026
   
523,758
 
Maine
 
7,933
   
11,416
   
4,093
   
Virginia
 
386,849
   
357,377
   
201,798
 
Maryland
 
203,973
   
223,779
   
216,468
   
Washington
 
167,533
   
182,471
   
161,099
 
Michigan
 
179,082
   
218,037
   
279,490
   
West Virginia
 
2,628
   
2,921
   
2,341
 
Minnesota
 
775,984
   
785,774
   
792,863
   
Wisconsin
 
414,891
   
418,361
   
418,898
 
Mississippi
 
378,518
   
400,138
   
422,625
   
Wyoming
 
109,436
   
115,759
   
121,011
 
Missouri
 
771,235
   
780,959
   
795,956
   
   Total
$
19,324,676
 
$
19,338,405
 
$
20,188,207
 

The service territories of our electric and telecommunications members and associates are located throughout the United States and its territories, including 49 states, the District of Columbia, American Samoa and Guam. Our members provide essential electric and telecommunications services to customers in rural areas covering approximately 70 percent of the land mass of the contiguous United States. Each system is separate from other systems and there is significant variance in the size of each system, thus each system’s capital requirements vary. At May 31, 2011, 2010 and 2009, loans outstanding to any one borrower did not exceed 2.6 percent, 2.7 percent and 2.6 percent, respectively, of total loans outstanding. At May 31, 2011, the top 10 borrowers held 17 percent of total loans outstanding compared with 18 percent of total loans outstanding at May 31, 2010 and 2009.

At May 31, 2011, 2010 and 2009, the largest concentration of loans to borrowers in any one state was in Texas, which had approximately 18 percent, 16 percent and 17 percent, respectively, of total loans outstanding. No other state had a loan concentration exceeding 8 percent at May 31, 2011, 2010 and 2009. Two primary factors contributed to Texas having the largest percentage of total loans outstanding compared with other states at May 31, 2011:
·  
Texas has the largest number of total borrowers compared with other states (see table on page 16); and
·  
Texas has the largest number of power supply systems (10 of our 71 power supply systems), which require significantly more capital than distribution systems and telecommunications systems.

CFC, RTFC and NCSC each have policies limiting the amount of credit that can be extended to individual borrowers or a controlled group of borrowers. The credit limitation policies cap the total exposure and unsecured exposure to a borrower based on an assessment of the borrower’s risk profile, the type of facility and our internal risk rating system. As a member-owned cooperative lender, we balance the needs of our members 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, loan participations or loan sales to manage credit concentrations.

 
9

 


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 are approved but not yet closed and facilities that might not be drawn by the borrower, such as lines of credit and loan commitments for projects that may be delayed or eventually cancelled.

Unadvanced Loan Commitments
Unadvanced commitments represent approved and executed loan contracts for which the funds have not been advanced. At May 31, 2011, 2010 and 2009, we had the following amount of unadvanced commitments on loans to our borrowers.

(dollar amounts in thousands)
 
2011
 
% of
Total
   
2010
 
% of
Total
   
2009
 
% of
Total
 
Long-term
$
5,461,484}
 
39
%
$
5,154,990
 
36
%
$
5,609,977
 
41
%
Line of credit
 
8,609,191}
 
61
   
9,039,448
 
64
   
7,941,146
 
59
 
Total
$
14,070,675}
 
100
%
$
14,194,438
 
100
%
$
 13,551,123
 
100
%
                               
CFC
$
13,074,685}
 
93
%
$
13,248,732
 
93
%
$
12,804,021
 
95
%
RTFC
 
366,060}
 
3
   
441,719
 
3
   
457,022
 
3
 
NCSC
 
629,930}
 
4
   
503,987
 
4
   
290,080
 
2
 
Total
$
14,070,675}
 
100
%
$
14,194,438
 
100
%
$
13,551,123
 
100
%

A total of $999 million and $931 million of line of credit unadvanced commitments at May 31, 2011 and 2010, respectively, represented unadvanced commitments related to line of credit loans that are not subject to a material adverse change clause at the time of each loan advance. As such, we would be required to advance amounts on these committed facilities as long as the borrower is in compliance with the terms and conditions of the loan.

The remaining available amounts at May 31, 2011 and 2010 were generally subject to material adverse change clauses. Prior to making an advance on these facilities, we confirm that there has been no material adverse change in the business condition, financial or otherwise, of the borrower since the time the loan was approved and confirm that the borrower is currently in compliance with loan terms and conditions.

Unadvanced commitments related to line of credit loans are typically for periods not to exceed five years and are generally revolving facilities used for working capital and backup liquidity purposes. Historically, we have experienced a very low utilization rate on line of credit loan facilities, whether or not there is a material adverse change clause.

Since we generally do not charge a fee on the unadvanced portion of the majority of our loan facilities, our borrowers will typically request long-term facilities to cover maintenance and capital expenditure work plans for periods of up to five years and draw down on the facility over that time. In addition, borrowers will typically request an amount in excess of their immediate estimated loan requirements to avoid the expense related to seeking additional loan funding for unexpected items.

The above items all contribute to our expectation that a large portion of the unadvanced commitments reported at May 31, 2011 will expire without being utilized.

Conversion of Loans
A borrower may convert a long-term loan from a variable interest rate to a fixed interest rate at any time without a fee. Generally, a borrower may convert its long-term loan from a fixed rate to another fixed rate or to a variable rate at any time in exchange for a fee plus a make-whole premium, if applicable, based on current loan policies.

Prepayment of Loans
Generally, borrowers may prepay long-term fixed-rate loans at any time, subject to a prepayment fee and a make-whole premium, if applicable. Generally, long-term variable-rate loans may be prepaid at any time, subject to a prepayment fee. Line of credit loans may be prepaid at any time without a fee, unless the interest rate on the loan is fixed or based on a LIBOR index.

 
10

 


Loan Security
Long-term loans are typically senior secured on parity with other secured lenders (primarily RUS), if any, by all assets and revenue of the borrower, though utility mortgages are subject to standard liens such as those related to taxes, worker’s compensation awards, mechanics’ and similar liens, rights-of-way, governmental rights and judgment liens. We are able to obtain liens on parity with liens for the benefit of RUS even where the RUS loan was made earlier in time than ours because RUS’s form of mortgage expressly provides for other lenders such as us to have a parity lien position if the borrower satisfies certain conditions or obtains a written lien accommodation from RUS. When we make loans to borrowers that have existing loans from RUS, we generally require those borrowers either to obtain such a lien accommodation or to satisfy the conditions necessary for our loan to be secured on parity under the mortgage with the loan from RUS.

Our line of credit loans are generally unsecured. Line of credit loans are generally to provide a source of working capital, and thus it is market practice that line of credit loans are not secured.

The following tables summarize our secured and unsecured loans outstanding by loan and borrower type at May 31:

(dollar amounts in thousands)
 
2011
   
2010
 
Total by loan type:
 
Secured
 
%
   
Unsecured
 
%
   
Secured
 
%
   
Unsecured
 
%
 
 
Long-term fixed-rate loans
$
 15,583,068
 
 95
%
$
 821,872
 
 5
%
$
14,799,859}
 
96
%
$
613,128}
 
4
%
 
Long-term variable-rate loans
 1,207,580
 
 94
   
 70,811
 
 6
   
1,994,664}
 
95
   
94,165}
 
5
 
 
Loans guaranteed by RUS
 
 226,695
 
 100
   
 -
 
 -
   
237,356}
 
100
   
-}
 
 -
 
 
Line of credit loans
 
 107,193
 
 8
   
 1,307,457
 
 92
   
265,427}
 
17
   
1,333,806}
 
83
 
 
  Total loans
$
 17,124,536
 
 89
 
$
 2,200,140
 
 11
 
$
17,297,306}
 
89
 
$
2,041,099}
 
11
 
                                           
Total by borrower type:
                                       
 
CFC
$
 16,180,454
 
 90
%
$
 1,761,025
 
 10
%
$
15,585,788}
 
90
%
$
1,729,241}
 
10
%
 
RTFC
 
 628,020
 
 73
   
 231,102
 
 27
   
1,429,982}
 
86
   
241,911}
 
14
 
 
NCSC
 
 316,062
 
 60
   
 208,013
 
 40
   
281,536}
 
80
   
69,947}
 
20
 
 
  Total loans
$
 17,124,536
 
 89
 
$
 2,200,140
 
 11
 
$
17,297,306}
 
89
 
$
2,041,099}
 
11
 

Guarantee Programs

When we guarantee debt obligations for our members, we use the same credit policies and monitoring procedures for guarantees as for loans and commitments. If a member system defaults in its obligation to pay debt service, then we are obligated to pay any required amounts under our guarantees. Meeting our guarantee obligations satisfies the underlying obligation of our member systems and prevents the exercise of remedies by the guarantee beneficiary based upon a payment default by a member system. In general, the member system is required to repay, on demand, any amount advanced by us with interest, pursuant to the documents evidencing the member system’s reimbursement obligation. The following table provides a breakout of guarantees outstanding by type and member class at May 31:

(dollar amounts in thousands)
 
2011
     
2010
 
Total by guarantee type:
             
Long-term tax-exempt bonds
$
599,935}
   
$
601,625}
 
Indemnifications of tax benefit transfers
 
59,895}
     
69,982}
 
Letters of credit
 
327,201}
     
380,076}
 
Other guarantees
 
117,957}
     
119,426}
 
     Total
$
1,104,988}
   
$
1,171,109}
 

Total by member class:
                   
CFC:
 
2011
   
2010
 
   Distribution
$
217,099}
 
20
%
$
221,903}
 
19
%
   Power supply
 
817,618}
 
74
   
884,828}
 
75
 
   Statewide and associate
 
20,807}
 
2
   
22,032}
 
2
 
          CFC Total
 
1,055,524}
 
96
   
1,128,763}
 
96
 
RTFC
 
821}
 
-
   
636}
 
-
 
NCSC
 
48,643}
 
4
   
41,710}
 
4
 
          Total
$
1,104,988}
 
100
%
$
1,171,109}
 
100
%


 
11

 


Guarantees of Long-Term Tax-Exempt Bonds
We guarantee debt issued for our members’ construction or acquisition of pollution control, solid waste disposal, industrial development and electric distribution facilities. Governmental authorities issue such debt on a non-recourse basis to the government authority and the interest thereon is exempt from federal taxation. The proceeds of the offering are made available to the member system, which in turn is obligated to pay the governmental authority amounts sufficient to service the debt. The debt we guarantee may include short- and long-term obligations.

If a system defaults for failure to make the debt payments, we are obligated to pay, after available debt service reserve funds have been exhausted, scheduled debt service under our guarantee. Such payment will prevent the occurrence of an event of default that would otherwise permit acceleration of the bond issue. The system is required to repay, on demand, any amount that we advance pursuant to our guarantee plus interest on that advance. This repayment obligation, together with the interest thereon, is typically senior secured on a parity with other lenders (including, in most cases, RUS), by a lien on substantially all of the system’s assets. If the security instrument is a common mortgage with RUS, then in general, we may not exercise remedies for up to two years following default. However, if the debt is accelerated under the common mortgage because of a determination that the related interest is not tax-exempt, the system’s obligation to reimburse us for any guarantee payments will be treated as a long-term loan. The system is required to pay us initial and/or ongoing guarantee fees in connection with these transactions.

Certain guaranteed long-term debt bears interest at variable rates that are adjusted at intervals of one to 270 days, weekly, each five weeks or semi-annually to a level favorable to their resale or auction at par. If funding sources are available, the member who issued the debt may choose a fixed interest rate on the debt. When the variable rate is reset, holders of variable-rate debt have the right to tender the debt for purchase at par. In some transactions, we have committed to purchase this debt as liquidity provider if it cannot otherwise be remarketed. If we hold the securities, the cooperative pays interest to us at our short-term variable interest rate. At May 31, 2011 and 2010, we were the guarantor and liquidity provider for $524 million and $549 million, respectively, of tax-exempt bonds issued for our member cooperatives. During the years ended May 31, 2011 and 2010, we were not required to purchase any tax-exempt bonds pursuant to our obligation as liquidity provider.

Guarantees of Tax Benefit Transfers
We also have guaranteed members’ obligations to indemnify against loss of tax benefits in certain tax benefit transfers that occurred in 1981 and 1982. A member’s obligation to reimburse us for any guarantee payments would be treated as a long-term loan, secured on a parity with RUS by a first lien on substantially all of the member’s property to the extent of any cash received by the member at the outset of the transaction. The remainder would be treated as a line of credit loan secured by a subordinated mortgage on substantially all of the member’s property. Due to changes in federal tax law, no guarantees of this nature have been put in place since 1982.

Letters of Credit
In exchange for a fee, we issue irrevocable letters of credit to support members’ obligations to energy marketers, other third parties and to the Rural Business and Cooperative Development Service. Letters of credit may be on a secured or unsecured basis. Each letter of credit is supported by a reimbursement agreement with the member on whose behalf the letter of credit was issued. In the event a beneficiary draws on a letter of credit, the agreement generally requires the member to reimburse us within one year from the date of the draw, with interest accruing from that date at our line of credit variable interest rate.

Other Guarantees
We may provide other guarantees as requested by our members. These guarantees may be made on a secured or unsecured basis with guarantee fees set to cover our general and administrative expenses, a provision for losses and a reasonable margin.

 
12

 

Total guarantees outstanding by state and territory based on the location of the system’s headquarters, is summarized as follows at May 31:

(dollar amounts in thousands)
                                         
State/Territory
   
2011
     
2010
     
2009
   
State/Territory
   
2011
   
2010
   
2009
 
Alabama
 
$
195,124
   
$
198,018
   
$
198,506
   
Missouri
 
$
54,999
 
$
61,151
 
$
68,363
 
Alaska
   
6,757
     
3,884
     
3,860
   
Montana
   
88
   
71
   
12,772
 
American Samoa
   
1
     
1
     
-
   
Nebraska
   
7
   
11
   
7
 
Arizona
   
26,674
     
29,967
     
29,869
   
Nevada
   
51,099
   
47,018
   
37,452
 
Arkansas
   
2,425
     
4,309
     
6,166
   
New Hampshire
   
20,213
   
26,063
   
24,763
 
California
   
269
     
333
     
6,247
   
New Mexico
   
11,456
   
1,025
   
1,036
 
Colorado
   
51,239
     
51,964
     
52,690
   
New York
   
79
   
96
   
113
 
Delaware
   
8
     
12
     
8
   
North Carolina
   
100,699
   
105,871
   
105,905
 
District of Columbia
   
13,000
     
14,900
     
16,000
   
North Dakota
   
4,529
   
5,197
   
5,825
 
Florida
   
11,169
     
12,058
     
2,851
   
Ohio
   
3,004
   
4,005
   
7,000
 
Georgia
   
25,339
     
27,890
     
23,718
   
Oklahoma
   
823
   
800
   
764
 
Hawaii
   
1,300
     
1,300
     
1,300
   
Oregon
   
23,605
   
23,452
   
28,511
 
Idaho
   
-
     
-
     
3,173
   
Pennsylvania
   
11,593
   
12,622
   
18,747
 
Illinois
   
62,900
     
79,854
     
82,927
   
South Carolina
   
835
   
645
   
506
 
Indiana
   
24
     
19
     
23
   
South Dakota
   
8
   
24
   
19
 
Iowa
   
7,465
     
6,269
     
6,961
   
Tennessee
   
4,573
   
3,747
   
3,939
 
Kansas
   
37,664
     
39,632
     
41,318
   
Texas
   
182,836
   
219,754
   
216,443
 
Kentucky
   
67,932
     
82,562
     
91,741
   
Utah
   
-
   
-
   
6,961
 
Louisiana
   
244
     
407
     
501
   
Vermont
   
2,100
   
1,100
   
1,350
 
Maine
   
8
     
9
     
4
   
Virginia
   
2,213
   
2,552
   
2,874
 
Maryland
   
27,028
     
37,048
     
52,078
   
Washington
   
11
   
9
   
19,050
 
Michigan
   
2,132
     
5,131
     
5,236
   
Wisconsin
   
24,317
   
452
   
305
 
Minnesota
   
2,153
     
1,576
     
1,601
   
Wyoming
   
2
   
5
   
4,829
 
Mississippi
   
65,044
     
58,296
     
81,143
   
     Total
 
$
1,104,988
 
$
1,171,109
 
$
1,275,455
 

Our Lending Competition

Electric Lending
RUS is the largest lender to electric cooperatives. RUS provides long-term secured loans. CFC offers its members financial products and services that supplement and complement those of RUS and, therefore, CFC does not consider RUS to be a competitor. CFC competes with banks to make bridge loans that are needed by electric cooperatives in anticipation of obtaining long-term funding from RUS, the portion of a loan that RUS is unable to provide, and loans to members that have elected not to borrow from RUS. For the fiscal year ending September 30, 2011, authorized lending levels under the RUS electric loan program were $100 million for hardship loans and $6,500 million for loan guarantees.

Our main competitor is CoBank, ACB, a federally chartered instrumentality of the United States that is a member of the Farm Credit System. As a government-sponsored enterprise, CoBank, ACB, has the benefit of an implied government guarantee. In addition, members may obtain funding from commercial banks or may be large enough to directly access the capital markets for funding. As a result, we are competing with the pricing and funding options the member is able to obtain from these sources. We attempt to minimize the effect of competition by offering a variety of loan options and value-added services and by leveraging the working relationship we have developed with the majority of our members.

In order to meet the unique needs of our members, we offer options including credit support in the form of letters of credit and guarantees, large transaction management and loan sales to other financial institutions. Credit products are tailored to meet specific transaction structures and are often designed to cover gaps left by other lenders, such as bridge loans to long-term financing provided by RUS. CFC also offers certain risk mitigation products and interest rate discounts on secured, long-term loans for its members that meet certain criteria, including performance, volume, collateral and equity requirements.

CFC has established certain funds to benefit its members. Since 1981, CFC has set aside a portion of its annual margins in a cooperative educational fund to promote awareness and appreciation of the cooperative principles. As directed by CFC’s Board of Directors, the contributions to the funds are distributed through the electric cooperative statewide associations. Since 1986, CFC has supported its members’ efforts to protect their service territories from erosion or takeover by other utilities through assistance from the Cooperative System Integrity Fund. This program is funded through voluntary contributions from members, and amounts are distributed to applicants that establish that all or a significant portion of their consumers, services or facilities

 
13

 

face a hostile threat of acquisition or annexation by a competing entity, or that it faces a significant threat in its ability to continue to provide electric or other energy services to customers.

CFC also offers its members additional services to enhance member operations including:
·  
Return of net earnings through the retirement of patronage capital. The laws of the District of Columbia require CFC to allocate but not retire patronage capital. However, CFC maximizes members’ returns by retiring patronage capital to members to significantly reduce their effective cost of borrowing each year based on approval by its Board of Directors.

·  
CFC Paying Agent Service. CFC’s Paying Agent Service allows members to enhance their cash management abilities so that they can earn interest until the moment the money is needed to make loan payments, cover power bill costs or pay other ongoing costs.

·  
CFC Key Ratio Trend Analysis. CFC issues a report annually that provides members information about where their operations stand in relation to other electric systems or power suppliers of similar size, location and growth characteristics. The report provides a five-year review of rural electric trends in nine key planning areas and supports decision-making by our members’ managers and boards.

·  
CFC RateWatch™. This service allows members to monitor certain interest rates and alerts borrowers when fixed rates reach a maximum or minimum level specified by the borrower. Members can lock in a current interest rate for any term specified on expected future borrowings to mitigate risk, subject to certain fees. Borrowers with variable-rate loans are notified when fixed rates reach the selected level and have the option of converting at that time or of resetting CFC RateWatch at a new level. CFC offers this service free of charge.

·  
Regulatory support services. This service is available for members and includes, but is not limited to, assistance with rate design, expert testimony, cost-of-service analysis and strategic regulatory planning.

·  
Conferences, meetings and workshops. CFC produces a range of programs each year providing in-depth information and insight on utility and energy issues, financing and economic trends and outlooks, and management and leadership best practices. These programs also provide opportunities for members’ directors and employees to network with CFC staff and with their peers at other cooperatives, while simultaneously earning professional education credits.

·  
CFC Extranet. The CFC extranet provides borrowers with a convenient way to view their loan and investment history with CFC. In addition, the website provides useful financial tools for members to analyze various aspects of their businesses. Members also can make investments in CFC and request loan advances online.

Our rural electric borrowers are mostly private companies, thus the overall size of the rural electric lending market cannot be determined from public information. We estimate the size of the overall rural electric lending market from the annual financial and statistical reports filed with us by our members using calendar year data; however, there are certain limitations with regard to these estimates, including the following:
·  
while the underlying data included in the financial and statistical reports may be audited, the preparation of the financial and statistical reports is not audited;
·  
in some cases, not all members provide the annual financial and statistical reports on a timely basis to be included in summarized results; and
·  
the financial and statistical reports do not include indebtedness by lender other than RUS.

According to financial data provided to us by our 810 reporting distribution systems and 59 reporting power supply systems as of December 31, 2010, and our 808 reporting electric cooperative distribution systems and 56 reporting power supply systems as of December 31, 2009, long-term debt outstanding to CFC, RUS and other lenders in the electric cooperative industry by those entities was as follows:

(dollar amounts in thousands)
 
2010
       
2009
     
Total long-term debt reported by members
$
74,798,340
     
$
70,091,418
     
Less: long-term debt funded by RUS
 
(36,653,484
)
     
(36,032,467
)
   
Members’ non-RUS long-term debt
$
38,144,856
     
$
34,058,951
     

   
2010
 
% of Total
   
2009
 
% of Total
 
Long-term debt funded by CFC
$
16,998,173
 
45
%
$
15,905,971
 
47
%
Long-term debt funded by other lenders
 
21,146,683
 
55
   
18,152,980
 
53
 
Members’ non-RUS long-term debt
$
38,144,856
 
100
%
$
34,058,951
 
100
%

 
14

 


Members’ long-term debt funded by CFC is further summarized by type below at December 31:

(dollar amounts in thousands)
 
2010
 
% of Total
   
2009
 
% of Total
 
Distribution
$
13,373,765
 
79
%
$
12,704,496
 
80
%
Power supply
 
3,624,408
 
21
   
3,201,475
 
20
 
Long-term debt funded by CFC
$
16,998,173
 
100
%
$
15,905,971
 
100
%

We are not able to specifically identify the amount of debt our members have outstanding to CoBank, ACB, from either the annual financial and statistical reports filed with us or CoBank, ACB’s public disclosure, but we believe that CoBank, ACB, is the lender other than CFC and RUS with significant long-term debt outstanding to the rural electric cooperatives.

Telecommunications Lending
In 1949, the Rural Electrification Act was amended to allow lending for the establishment and improvement of rural telecommunications service. For fiscal year 2011, RUS has $690 million in annual lending authority for its traditional plant modernization and upgrade lending program of direct loans to rural telephone systems and $325 million of authority under the RUS broadband loan program that Congress created in 2002. In addition, the American Recovery and Reinvestment Act of 2009 provided RUS with $2,500 million of budget authority for loans and grants and the Department of Commerce’s National Telecommunications and Information Administration with $4,700 million in budget authority for grants to support the expansion of broadband service into unserved and underserved areas.

RTFC is not in direct competition with RUS, but rather competes with other lenders for supplemental lending and for the full lending requirement of the rural telecommunications companies that decide not to borrow from RUS or for projects not eligible for RUS financing. Given the increased availability of government financing for rural broadband, it is unlikely we will participate in this financing to any significant degree outside of incremental lending to existing rural local exchange carrier borrowers to provide broadband services to their customers or interim financing in connection with the federal funding programs.

RTFC’s competition includes commercial banks and CoBank, ACB. The competitive market for providing credit to the rural telecommunications industry is difficult to quantify. Many rural telecommunications companies are not borrowers of RUS or CoBank, ACB, and commercial banks generally do not publish information solely on their telecom portfolios. At December 31, 2010, RUS had approximately $3,760 million in long-term loans outstanding to telecommunications borrowers and $507 million in broadband loans. At December 31, 2010, RTFC had a total of $918 million in long-term loans outstanding to telecommunications borrowers.

Our Regulation

CFC, RTFC and NCSC are not subject to state or federal regulatory oversight or compliance with regard to lending. CFC, RTFC and NCSC are subject to state laws that pertain to the business conducted in each state, including but not limited to usury laws and laws governing mortgages.

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act, also known as the financial overhaul bill, was signed into law. The legislation strengthens the powers of regulators to monitor the financial industry and take action against failing companies that threaten the entire system. The law mandates numerous rulemakings that are expected to affect the financial industry in future periods. Of particular importance for our operations are the law’s provisions imposing new requirements on certain entities that use derivatives, including requirements for margin and clearing. The law calls for the specifics of these requirements to be set forth by certain regulatory agencies in rulemakings. These rulemakings have not been completed and final rules are not expected until at least the fall of 2011. We have submitted comments in connection with various rulemakings setting forth our belief, among others, that CFC should be exempt from the derivatives clearing and margin requirements of the Dodd-Frank Act.

Until final rules are issued, it is not clear to what extent CFC’s use of derivatives may be subject to additional requirements. Therefore, we cannot yet determine the full effect the law may have on us at this time. However, we anticipate that, if we are subject to the margin and clearing requirements of the Dodd-Frank Act, we may experience an increase in costs.

Our Members

At May 31, 2011, after taking into consideration systems that are members of both CFC and NCSC and eliminating memberships between CFC, RTFC and NCSC, our consolidated membership totaled 1,460 members and 262 associates.

 
15

 


The table below presents the total number of CFC, RTFC and NCSC members and associates and borrowers by state or U.S. territory and the percentage of total loans outstanding at May 31, 2011. The percentage of total loans is based on the aggregate principal balance of the loans outstanding.

State/Territory
 
Number
of
Members (1)
 
Number
of
Borrowers
 
Loan
Balance %
 
State/Territory
 
Number
of
Members (1)
 
Number
of
Borrowers
 
Loan
Balance %
 
Alabama
 
34
 
27
 
2.29
%
Missouri
 
76
 
49
 
3.99
%
Alaska
 
32
 
19
 
1.99
 
Montana
 
40
 
25
 
0.60
 
American Samoa
 
1
 
-
 
-
 
Nebraska
 
39
 
10
 
0.10
 
Arizona
 
28
 
12
 
1.06
 
Nevada
 
9
 
4
 
0.87
 
Arkansas
 
30
 
19
 
2.82
 
New Hampshire
 
4
 
1
 
0.54
 
California
 
12
 
5
 
0.13
 
New Jersey
 
2
 
2
 
0.08
 
Colorado
 
45
 
28
 
4.85
 
New Mexico
 
25
 
17
 
0.46
 
Connecticut
 
1
 
1
 
1.03
 
New York
 
21
 
7
 
0.11
 
Delaware
 
2
 
1
 
0.13
 
North Carolina
 
48
 
31
 
2.63
 
District of Columbia
6
 
2
 
0.04
 
North Dakota
 
38
 
13
 
0.72
 
Florida
 
23
 
16
 
2.90
 
Ohio
 
49
 
28
 
1.96
 
Georgia
 
76
 
47
 
7.98
 
Oklahoma
 
54
 
29
 
2.74
 
Guam
 
2
 
-
 
-
 
Oregon
 
44
 
23
 
1.60
 
Hawaii
 
1
 
1
 
0.04
 
Pennsylvania
 
31
 
16
 
2.07
 
Idaho
 
19
 
14
 
0.78
 
South Carolina
 
41
 
25
 
2.68
 
Illinois
 
59
 
30
 
3.70
 
South Dakota
 
50
 
33
 
0.88
 
Indiana
 
66
 
44
 
3.28
 
Tennessee
 
30
 
22
 
0.31
 
Iowa
 
123
 
49
 
2.17
 
Texas
 
120
 
74
 
18.17
 
Kansas
 
66
 
43
 
4.09
 
Utah
 
12
 
6
 
2.89
 
Kentucky
 
41
 
25
 
1.93
 
Vermont
 
8
 
6
 
0.31
 
Louisiana
 
19
 
11
 
1.49
 
Virginia
 
28
 
19
 
2.00
 
Maine
 
7
 
2
 
0.04
 
Washington
 
19
 
11
 
0.87
 
Maryland
 
3
 
3
 
1.06
 
West Virginia
 
4
 
2
 
0.01
 
Massachusetts
 
1
 
-
 
-
 
Wisconsin
 
69
 
26
 
2.14
 
Michigan
 
31
 
16
 
0.93
 
Wyoming
 
15
 
13
 
0.56
 
Minnesota
 
89
 
54
 
4.02
 
   Total
 
1,722
 
985
 
100
%
Mississippi
 
29
 
24
 
1.96
                 
(1) Includes associates.

CFC
Each of CFC’s distribution and power supply members received or is eligible to receive financing from RUS. One of the criteria for eligibility for RUS financing is a “rural area” test. Thus, as an entity that supplements RUS financing, CFC relies on the definition of “rural” as specified in the Rural Electrification Act, as amended in 2008. “Rural” is defined in the Rural Electrification Act as any area other than a city, town or unincorporated area that has a population of more than 20,000, or is an area within the service area of a borrower with an outstanding loan made under titles I though V of the Rural Electrification Act as of the date of enactment in 2008, regardless of population. The definition of “rural” under the act permits an area to be defined as “rural” regardless of the development of such area subsequent to the approval of the outstanding loan. Thus, if an RUS borrower met the “rural area” definition at the time of its first loan origination from RUS and continues to have outstanding RUS loans, RUS has the authority to continue lending to the entity regardless of subsequent population growth in its service territory. Similar to RUS, CFC establishes eligibility only at the time a system initially borrows from CFC, and that eligibility, as it relates to the “rural area” test, is based on a determination of whether the system borrowed or is eligible to borrow from RUS.

CFC’s Bylaws provide that cooperative or nonprofit corporations, public corporations, utility districts and other public bodies that received or are eligible to receive a loan or commitment for a loan from RUS or any successor agency (as well as subsidiaries, federations or statewide and regional associations that are wholly owned or controlled by such entities) are eligible for membership. Thus, those entities that received or qualify for financing from RUS are eligible to apply for membership and subsequently borrow from CFC regardless of whether there is an outstanding loan with RUS. There are no requirements to maintain membership, although the Board has the authority to suspend a member under certain circumstances. CFC has not suspended a member to date.

CFC has the following types of members, all of which are not-for-profit entities or subsidiaries or affiliates of not-for-profit entities. All electric members provide services to both residential and commercial customers.

 
16

 


Class A – Distribution Systems
Cooperative or nonprofit corporations, public corporations, utility districts and other public bodies, which received or are eligible to receive a loan or commitment for a loan from RUS or any successor agency, and that are engaged or planning to engage in furnishing utility services to their members and patrons for their use as ultimate consumers. The majority of our distribution system members are consumer-owned electric cooperatives. The remaining distribution systems are governmental entities, such as public power districts, public utility districts and tribal utility authorities.

Class B – Power Supply Systems
Cooperative or nonprofit corporations that are federations of Class A members or of other Class B members, or both, or that are owned and controlled by Class A members or by other Class B members, or both, and that are engaged or planning to engage in furnishing utility services primarily to Class A members or other Class B members. Our power supply system members are member-owned electric cooperatives.

Class C – Statewide and Regional Associations
Statewide and regional associations that are wholly owned or controlled by Class A members or Class B members, or both, or that are wholly owned subsidiaries of a CFC member, and that do not furnish utility services but supply other forms of service to their members.

Class D – National Associations of Cooperatives
National associations of cooperatives that are Class A, Class B and Class C members, provided said national associations have, at the time of admission to membership in CFC, members domiciled in at least 80 percent of the states in the United States. The National Rural Electric Cooperative Association is our sole Class D member.

Associates
Nonprofit groups or entities organized on a cooperative basis that are owned, controlled or operated by Class A, B, C or D members and are engaged in or plan to engage in furnishing non-electric services primarily for the benefit of the ultimate consumers of CFC members are eligible to be an associate of CFC.

CFC Class A, B, C and D members are eligible to vote on matters put to a vote of the membership. Associates are not eligible to vote on matters put to a vote of the membership.

At May 31, 2011, CFC’s membership included:
·  
834 Class A distribution systems;
·  
71 Class B power supply systems;
·  
66 Class C statewide and regional associations, including NCSC; and
·  
1 Class D national association of cooperatives.

In addition, CFC had 58 associates, including RTFC, at May 31, 2011.

RTFC
Membership in RTFC is limited to cooperative corporations, private corporations, public corporations, nonprofit corporations, utility districts and other public bodies that are approved by the RTFC Board of Directors and are actively borrowing or are eligible to borrow from RUS, and are engaged or planning to engage directly or indirectly in furnishing telecommunications services and holding companies, subsidiaries and other organizations that are owned, operated or controlled by one or more of such entities. RTFC members are eligible to vote at each meeting of the members. Entities approved by the RTFC Board of Directors that are owned, controlled or operated by members, or entities eligible to become members, are eligible to be an associate of RTFC. Associates are not eligible to vote at meetings of the members. All RTFC members provide services to both residential and commercial customers.

At May 31, 2011, RTFC’s membership included 489 members and five associates. CFC is not a member of RTFC. RTFC’s members and associates consist of 194 not-for-profit entities and 300 for-profit entities at May 31, 2011.

NCSC
Membership in NCSC is limited to organizations that are Class A members of CFC, or eligible for such membership, and CFC. At May 31, 2011, NCSC’s membership included 370 distribution systems and CFC. All of the NCSC distribution members are also CFC members.

 
17

 


In addition, NCSC had 200 associates at May 31, 2011. NCSC’s associates may include members of CFC, entities eligible to be members of CFC and entities that are owned, controlled or operated by or provide significant benefit to Class A, B and C members of CFC.

Corporate Governance

CFC
Pursuant to the CFC Bylaws, there are 11 districts, comprising of 10 districts for the general membership and one for the Class D membership. Pursuant to its bylaws, CFC holds an annual meeting of the members each calendar year. The Board of Directors also calls a separate meeting annually of the members in each of districts 1 to 10 for the purpose of electing a nominating committee, or electing directors or both. Each member is entitled to one vote and no more upon each matter submitted to a vote at all meetings of the members.

The business and affairs of CFC are governed by a board of up to 23 directors that exercises all of the powers of CFC except such as are by law, the Articles of Incorporation or the bylaws conferred upon or reserved to the members. The members are only entitled to vote for the election of nominating committees and directors and the removal of directors or officers, as well as amendments to the CFC Bylaws and such other matters as the Board of Directors determines appropriate to present to the members for a vote.

Each district is represented by two board members. In districts 1 to 10, one of the two positions on the Board of Directors in each district is held by a person who is a trustee or director of a member organization within the district and the other position is held by a person who is a manager of a member organization within the district. Additionally, two directors are designated by the Class D (District 11) member, the National Rural Electric Cooperative Association.

In addition to the 20 directors elected and two directors designated from the districts described above, if the Board of Directors in its discretion so determines, then there may be one additional at-large director elected to serve on the Board of Directors of CFC from time to time. The at-large director is elected by the members and serves on the Audit Committee. No person is eligible to become or remain the at-large director unless the person (i) is a trustee, director, manager, chief executive officer or chief financial officer of a member of CFC or holds a comparable position of a member of CFC, (ii) satisfies the applicable requirements of an Audit Committee financial expert and (iii) is otherwise independent in accordance with Rule 10A-3 under the Securities Exchange Act and under the New York Stock Exchange standards, which the Board of Directors adopted to evaluate the independence of our directors. Since March 2007, CFC has had such an at-large director on its Board of Directors.

Pursuant to the CFC Bylaws, the officers of CFC include a president, vice president, secretary-treasurer and such other officers as may be determined from time to time by the Board of Directors. The officers are elected annually by the Board of Directors at the first meeting of the Board of Directors held after each annual meeting. The president, vice president, and secretary-treasurer must be members of the Board of Directors.

CFC’s Board of Directors is responsible for the oversight and direction of risk management, while CFC’s management has primary responsibility for day-to-day management of the risks associated with CFC’s business. In fulfilling its risk management oversight duties, CFC’s Board of Directors receives periodic reports on business activities from executive management and from various operating groups and committees across the organization, including the Credit Risk Management group, Internal Audit group and the Corporate Compliance group, as well as the Asset Liability Committee, the Corporate Credit Committee and the Disclosure Committee. CFC’s Board of Directors also reviews CFC’s risk profile and management’s response to those risks throughout the year at its meetings. The Board of Directors establishes CFC’s loan policies and has established a loan committee of the Board comprising no fewer than 10 directors that reviews the performance of the loan portfolio in accordance with those policies. See Credit Policies, Process and Monitoring on page 6 for more information about the role of our Board of Directors in our lending business.

RTFC
The business affairs of RTFC are governed by a Board of no less than five and no more than 10 directors. Pursuant to the RTFC Bylaws, there are five districts for the membership, and no less than one director must be a director, trustee, officer or manager of a member in each of the five districts. Directors are elected at the annual meeting of the members. Each member is entitled to one vote and no more upon each matter submitted to a vote at all meetings of the members. There are no CFC directors, officers or employees that serve as a director for RTFC.

The RTFC Board of Directors established an Executive Committee of the Board of Directors pursuant to a written board policy that sets forth the delegations of responsibility, authorities and functions of the Executive Committee of the Board of

 
18

 

Directors. The board policy delegates to the Executive Committee the authority to advise and consult with the Chief Executive Officer with respect to the development of policies governing RTFC’s making of loans, guarantees and investments to or for the benefit of members.

The RTFC Board of Directors reserves the authority to approve certain loans and guarantees based on the loan amount, credit quality and other criteria established by the Board of Directors from time to time. During intervals between Board meetings, the Executive Committee may consider and approve financing arrangements that require approval by the full Board. The Board of Directors delegates to the Chief Executive Officer or to the Chief Executive Officer’s designee(s) the authority to approve certain financing arrangements up to certain dollar thresholds and with certain credit characteristics and also authorizes the Chief Executive Officer to establish an internal Corporate Credit Committee.

One of the loan policies established by RTFC’s Board of Directors sets forth the loan guidelines and credit products established to implement the corporate purpose and program objectives of RTFC. Loans and guarantees are made to members, affiliates of members and associates that meet applicable financial and feasibility criteria, security requirements and conditions as established for each type of loan pursuant to RTFC’s practices and procedures in effect at the time. A credit analysis is conducted by staff during the underwriting process for each application to determine if the applicant has the ability to meet its obligations and RTFC’s financial standards and if the proposed structure provides adequate security for each secured credit facility. RTFC’s Board of Directors delegates to the Chief Executive Officer or the Chief Executive Officer’s designee(s) the authority to implement this policy.

NCSC
The business affairs of the association are governed by a Board of 11 directors. Pursuant to the NCSC Bylaws, there are five districts for the general membership and one district for CFC. The five general membership districts are represented by two directors, one of which must be a director or trustee of a member and one of which must be a manager of a member. Directors are elected at the annual meeting of the members. Each member is entitled to one vote and no more upon each matter submitted to a vote at all meetings of the members. The membership of the sixth district, or CFC, nominates one director for election by the members.

The NCSC Board of Directors established an Executive Committee of the Board of Directors pursuant to a written board policy that sets forth the delegations of responsibility, authorities and functions of the Executive Committee of the Board of Directors. The board policy delegates to the Executive Committee the authority to advise and consult with the Chief Executive Officer with respect to the development of policies governing NCSC’s making of loans, guarantees and investments to or for the benefit of members.

The NCSC Board of Directors has the authority to approve certain loans and guarantees based on the loan amount, credit quality and other criteria established by the Board of Directors from time to time. During intervals between Board meetings, the Executive Committee may consider and approve financing arrangements that require approval by the full Board. The Board of Directors delegates to the Chief Executive Officer or to the Chief Executive Officer’s designee(s) the authority to approve certain financing arrangements up to certain dollar thresholds and with certain credit characteristics and also authorizes the Chief Executive Officer to establish an internal Corporate Credit Committee.

One of the loan policies established by NCSC’s Board of Directors sets forth the loan guidelines and credit products established to implement the corporate purpose and program objectives of NCSC. Loans and guarantees are made to members, affiliates of members and associates that meet applicable financial and feasibility criteria, security requirements, and conditions as established for each type of loan pursuant to NCSC’s practices and procedures in effect at the time. A credit analysis is conducted by staff during the underwriting process for each application to determine if the applicant has the ability to meet its obligations and NCSC’s financial standards and if the proposed structure provides adequate security for each secured credit facility. NCSC’s Board of Directors has delegated to the Chief Executive Officer or the Chief Executive Officer’s designee(s) the authority to implement this policy.

Rural Electric Industry

Since the enactment of the Rural Electrification Act in 1936, RUS has financed the construction of electric generating plants, transmission facilities and distribution systems to provide electricity to rural areas. Principally through the creation of local electric cooperatives originally financed under the Rural Electrification Act loan program in 47 states and three U.S. territories, the percentage of farms and residences in rural areas of the United States receiving central station electric service increased from 11 percent in 1934 to almost 100 percent currently. According to 2009 data from the U.S. Energy Information Administration, rural electric systems serve approximately 13 percent of all consumers of electricity in the United States and its territories and serve about seven consumers per mile of line, compared with 35 customers per mile of line for investor-

 
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owned utilities. Rural electric systems account for approximately 11 percent of total sales of electricity and own about 5 percent of the nation’s electricity generating capacity.

RUS makes insured loans and loan guarantees and provides other forms of financial assistance to electric borrowers. RUS is authorized to make direct loans to systems that qualify for the hardship program (5 percent interest rate) or the municipal rate program (based on a municipal government obligation index). RUS is also authorized to guarantee loans that bear interest at a rate agreed upon by the borrower and the lender (which generally has been the Federal Financing Bank). RUS exercises financial and technical supervision over borrowers’ operations. Its loans and guarantees are secured by a mortgage or indenture on substantially all of the system’s assets and revenue.

Leading up to CFC’s formation in 1969, there was a growing need for capital for electric cooperatives to build new electric facilities due to growth in rural America. The electric cooperatives formed CFC so a source of financing would be available to them to supplement the RUS loan programs and to mitigate uncertainty related to government funding. Providing the electric cooperatives with financial products and services to supplement the RUS loan programs remains the purpose of CFC.

CFC aggregates the combined strength of the rural electric cooperatives to access the public capital markets and fill the need to provide supplemental funding to that of RUS. CFC is owned by its consumer-owned electric cooperative members. CFC works cooperatively with RUS; however, CFC is not a federal agency or a government-sponsored enterprise, and is not owned or controlled by any federal agency or government-sponsored enterprise. Our members are not required to have outstanding loans from RUS as a condition of borrowing from CFC. CFC supplements the RUS financing programs to meet the financial needs of its rural members by:

·  
providing bridge loans required by borrowers in anticipation of receiving RUS funding;
·  
providing financial products not otherwise available from RUS including lines of credit, letters of credit, guarantees on tax-exempt financing (usually for pollution-control equipment), weather-related disaster recovery lines of credit, unsecured loans, and investment products such as commercial paper and member capital securities;
·  
meeting the financing needs of those rural electric systems that repay or prepay their RUS loans and replace the government loans with private capital; and
·  
providing financing to RUS-eligible rural electric systems for facilities that are not eligible for financing from RUS. Examples of such facilities include electric utility facilities acquired by a cooperative from an investor-owned or municipal utility for service to an area that falls outside of an eligible rural area, as defined in the Rural Electrification Act. In other cases, an RUS-eligible system obtains CFC financing for non-electric facilities used by the cooperative to serve its rural members when such facilities are not eligible for RUS loans. More recently, RUS has instituted restrictions on financing for certain baseload generation facilities. A cooperative in the process of constructing such facilities will need financing to complete this work, and because of the recent change in RUS policy, it may not be able to obtain this additional funding from RUS.

Electric Systems and Associations
Distribution Systems
Distribution systems are utilities engaged in retail sales of electricity to residential and commercial consumers in their defined service areas generally on an exclusive basis using their distribution infrastructure including substations, wires and related support systems. Distribution systems are cooperatives owned by the customers they serve. Distribution systems vary in size from small systems that serve a few thousand customers to large systems that serve more than 200,000 customers. Thus, the amount of loan funding required by different distribution systems varies significantly. Distribution systems may service customers in more than one state.

Most distribution systems have all-requirements power purchase contracts with their power supply systems, which are owned and controlled by the member distribution systems. Wholesale power for resale also comes from other sources, including power supply contracts with government agencies, investor-owned utilities and other entities, and in some cases, the distribution systems own generating facilities.

Power Supply Systems
Power supply systems are utilities that purchase or generate electric power and provide it on a wholesale basis to distribution systems for delivery to the consumer. The distribution systems are the members of the power supply systems. The power supply systems vary in size from one with hundreds of megawatts of power generation capacity to systems that have no generating capacity, which generally operate transmission lines to supply certain distribution systems or manage power supply purchase arrangements for the benefit of their distribution system members. Certain other power supply systems have been formed but do not yet own generation or transmission facilities or have financing commitments from us. Thus, the amount of loan funding required by different power supply systems varies significantly. Power supply members may serve distribution systems located in more than one state.

 
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The wholesale power supply contracts with their distribution system members permit the power supply system, subject to regulatory approval in certain instances, to establish rates to produce revenue sufficient to meet the cost of operation and maintenance of all generation, transmission and related facilities and to pay the cost of any power and energy purchased for resale.

Statewide and Regional Associations
Each state may have an organization that represents and serves the distribution systems and power supply systems located in the state. Such statewide organizations provide training, as well as legislative, regulatory, media and related representation for the member distribution and power supply systems.

National Associations of Cooperatives
The National Rural Electric Cooperative Association represents cooperatives nationally. It provides training, sponsors regional and national meetings, and provides legislative, regulatory, media, and related representation for all rural electric cooperatives.

Electric Member Competition
The movement toward electric competition at the retail level has largely ceased. The electric utility industry has settled into a “hybrid” model in which there are significant differences in the retail regulatory approaches followed in different states and regions.

Customer choice regulation, where customers have a choice of alternative energy suppliers, has had little to no impact on distribution and power supply cooperatives, and we do not expect a material impact going forward. As of May 31, 2011, retail customer choice is active in 15 states. Those states are Connecticut, Delaware, Illinois, Maine, Maryland, Massachusetts, Michigan, New Hampshire, New Jersey, New York, Ohio, Oregon, Pennsylvania, Rhode Island and Texas. In general, even in those states, very few consumers served by CFC members have switched from the traditional supplier.

Many factors influence the choices customers have available to them and, therefore, mitigate the effect of customer choice and competition in areas served by cooperatives. These factors include, but are not limited to, the following:
·  
utilities in many states may still be regulated regarding rates on non-competitive services, such as distribution;
·  
20 states regulate the debt securities issued by utilities, including cooperatives, which could affect funding costs and, therefore, the electric rates charged to customers;
·  
Federal Energy Regulatory Commission regulation of rates as well as terms and conditions of transmission service;
·  
the fact that few competitors demonstrated much interest in providing electric energy to residential or rural customers; and
·  
distribution systems own the lines to the customer and it would not be feasible for a competitor to build a second line to serve the same customers in almost all situations. Therefore, the distribution systems still charge a fee or access tariff for the service of delivering power, regardless of who supplies the power.

Electric Member Regulation
There are 14 states that fully or partially regulate the rates electric cooperative systems charge. Those states are Arizona, Arkansas, Georgia, Hawaii, Kentucky, Louisiana, Maine, Maryland, New Mexico, New York, Utah, Vermont, Virginia and West Virginia. In these 14 states, we had 155 distribution members and 12 power supply members with a total of $4,069 million, or 21 percent, of loans outstanding at May 31, 2011, $2,034 million of which was to borrowers in Georgia and Utah that have partial oversight authority over the cooperatives’ rates, but not the specific authority to set rates. There are 11 states that allow cooperatives the right to opt in or out of state regulation. There are 20 states that regulate electric systems’ issuance of debt (although one of these states, New Mexico, does not regulate any loans to RUS borrowers). FERC also has jurisdiction to regulate transmission rates, wholesale rates, terms and conditions of service, and the issuance of securities by public utilities within its jurisdiction, which includes only a few cooperatives.

Our distribution and power supply members are subject to regulation by various federal, regional, state and local authorities with respect to the environmental effects of their operations, including air and water quality control, solid and hazardous waste disposal, and limitations on land use. At the federal level, the Environmental Protection Agency (“EPA”) has been pursuing an active regulatory agenda through a substantial number of significant rulemakings. Estimates indicate that regulations affecting cooling water intake structures, coal ash disposal, interstate transport of air pollutants and hazardous air pollutants, including mercury, could force the electric utility industry to retire or retrofit between 33,000 megawatts to 70,000 megawatts of generating capacity by 2015 at a significant cost. Additionally, earlier this year the EPA began the process of regulating greenhouse gas emissions from stationary sources, including power plants. This could force measures on the industry to reduce power plant greenhouse gas emissions, which would dramatically raise the cost of electricity generated from fossil fuel plants. While legislation has been introduced in the House and Senate to either pre-empt or delay the EPA’s

 
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efforts to regulate greenhouse gas emissions, its prospects for passage remain uncertain. While we cannot currently estimate projected expenditures related to these laws and regulations for our members, we believe the financial impact of these laws and regulations on our members will be passed through to their customers.

Rural Telecommunications Industry

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

Independent rural telecommunications companies provide service throughout many of the rural areas of the United States. These approximately 1,300 companies are called independent because they are not affiliated with Verizon or AT&T. Included in the 1,300 total are approximately 260 not-for-profit cooperative companies. A majority of the remainder of these independent rural telecommunications companies are privately held commercial companies. Less than 15 of these commercial companies are publicly traded or have issued bonds in the capital markets.

Rural telecommunications companies, excluding Verizon, AT&T and CenturyLink, provide service to less than 15 percent of the more than 120 million end-user switched access lines. These rural companies range in size from fewer than 100 customers to more than 5 million. Rural telecommunications companies’ annual operating revenue range from less than $0.1 million to more than $3,000 million. In addition to basic local exchange and access telecommunications service, most independents offer other communications services including wireless voice and data, cable television and high-speed Internet access. Most rural telecommunications companies’ networks incorporate digital switching, fiber optics, Internet protocol (IP) telephony and other advanced technologies.

Telecommunications Competition
The Telecommunications Act of 1996 created a framework for competition and deregulation in the local telecommunications market. As a result, competition continues to be a significant factor in the telecommunications industry. A January 2011 Federal Communications Commission (“FCC”) report on telecom competition states that as of December 2009, competitive local exchange carriers provided service to 21 million access lines, or approximately 17 percent of the nation’s 127 million end-user switched access lines. Wireless carriers are providing service to more than 300 million mobile telephone service subscriptions—more than local exchange carriers and competitive local exchange carriers combined. For the most part, local exchange competition has benefited rural local exchange carriers by enabling them to enter nearby towns and cities as competitive local exchange carriers, leveraging their existing infrastructure and reputation for providing high-quality, modern telecommunications service. Rural local exchange carriers enjoy an exemption from the Telecom Act requirement to provide competitors with access to their networks, absent a determination that it would be in the public interest to do so. Relatively few rural local exchange carriers have competitive local exchange carriers request access to their networks.

The national goal of universal service is accomplished through a support mechanism (the Universal Service Fund) that is required to be: (i) sufficient to ensure that rural customers receive reasonable rates and services compared with urban customers and (ii) portable; that is, available to all eligible providers. The Universal Service Fund provides support for rural local exchange carriers with costs significantly above the national average. In addition, implicit subsidies long contained in the access charges local telecommunications companies’ levy on long-distance carriers have been reduced. As these access charges have been reduced, rural local exchange carriers have been made whole by cost recovery provided by the Universal Service Fund. The Universal Service Fund is an important revenue source for most rural local exchange carriers.

The nexus between competition and universal service is the issue of competitor eligibility for universal service funding—the “portability” feature of the Universal Service Fund. As noted above, few wireline competitors attempted to enter rural markets. Numerous wireless carriers have extended their coverage areas into rural markets. By obtaining competitive eligible telecommunications carrier status from state and federal regulators (as provided for in the Telecom Act), these wireless carriers are able to receive universal service funds based on the incumbent local exchange carriers’ costs (the “identical support” rule). This has led to growth in claims on the fund and great concern for its sustainability. The Universal Service Fund’s current contribution base of interstate telecommunications revenue is shrinking as traditional long distance minutes-of-use decline due to wireless nationwide calling plans, e-mail and voice-over-Internet protocol substitution. Increased demand for funding from the Universal Service Fund has resulted in the rate assessed on all participants in the nationwide network (the “contribution factor”) to increase to 14.9 percent of interstate and international long distance revenue for the second quarter of calendar year 2011, compared with approximately 10.2 percent five years ago.

Telecommunications Regulation
Rural telecommunications systems generally are regulated at the state and federal levels. Most state commissions regulate local service rates, intrastate access rates and telecommunications company borrowing. The FCC regulates interstate access

 
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rates and the issuance of licenses required to operate certain types of telecom operations. Some rural telecommunications systems have affiliated companies that are not regulated.

Deregulation has not had a significant effect on the wireline local exchange carrier business segment thus far. The FCC continues to regulate wireline telephony under Title II of the Act. Internet, video, wireless and competitive local exchange services are much less regulated. However, in pursuit of its net neutrality policy, the FCC in December 2010 promulgated new “open Internet” rules related to service transparency, blocking and discrimination, which are applicable to certain broadband Internet access services. It has also been considering other potential new regulations that would apply to broadband communications after having previously considered broadband Internet services to be information service exempt from Title II regulation. Most rural local exchange carriers are expanding their service offerings to customers in less regulated business segments. With few competitors in the most rural parts of their service areas, rural local exchange carriers generally have been successful in these growth and diversification efforts.

In May 2008, the FCC ordered that payments to competitive eligible telecommunications carriers be capped. Total support for a competitive eligible telecommunications carrier is capped at what it was eligible to receive as of March 2009. In January 2008, the FCC began proceedings on universal service funding. These related proceedings addressed creation of separate funds for incumbents and competitive eligible telecommunications carriers, and a more refined and explicit need-based methodology for determining the amount of Universal Service Fund support an eligible carrier would receive. The FCC also has opened proceedings on intercarrier compensation—the most important components of which are access fees local exchange carriers charge to interexchange carriers that originate or terminate long-distance traffic on local exchange carriers’ networks. While the large local exchange carriers (most of which now own long-distance companies) would like to see these fees transition to zero, rural local exchange carriers depend heavily on access charges. The FCC’s Notice of Proposed Rulemaking, which was released on February 9, 2011, states that the FCC’s intent is to modernize the Universal Service Fund and intercarrier compensation rules including to provide support for broadband services utilizing recommendations from the aforementioned proceedings, and to establish policies that are “market-driven” with an implementation approach that is methodical and conducive to a non-disruptive transition. The FCC is now conducting a series of workshops on the proposed reforms that are designed to facilitate a process that is open to the public and incorporates input from principals throughout the industry. The rural telecommunications industry is actively participating in this process. At this stage, the outcome of the proposed rulemaking is unclear; however, the impending changes to the revenue mechanisms for rural telecommunications companies are not expected to result in our member rural local exchange carriers suffering revenue losses significant enough to cause material losses on our outstanding telecommunications loans.

Disaster Recovery

We have continued to use a comprehensive disaster recovery and business continuity plan since May of 2001. The plan includes a duplication of our production information systems at an offsite facility coupled with an extensive business recovery plan to use those remote systems. Our production data is replicated in real time to the recovery site 24 hours a day, seven days a week.

The plan also includes steps for each of our operating groups to conduct business with a view to minimizing disruption for our members and other parties with whom we do business. We conduct disaster recovery exercises twice a year that include both the information technology group and business areas. We contract with an external vendor for the facilities to house the backup systems that we own as well as office space and related office equipment. In fiscal year 2009, we moved our disaster recovery offsite facility from New Jersey to a location in western Virginia to allow for quicker access by employees to the site in the event of a disaster. We also implemented data duplication technology to provide backup to disks where backup data are also replicated to our disaster recovery site. In fiscal year 2010, we started a virtual recovery program to improve our remote access capabilities to address potential business disruptions such as weather-related events or pandemics.

Tax Status

In 1969, CFC obtained a ruling from the Internal Revenue Service recognizing CFC’s exemption from the payment of federal income taxes under Section 501(c)(4) of the Internal Revenue Code. Such exempt status could be revoked as a result of changes in legislation or in administrative policy or as a result of changes in CFC’s business.

In order for CFC to maintain its exemption under Section 501(c)(4) of the Internal Revenue Code, CFC must be “not organized for profit” and must be “operated exclusively for the promotion of social welfare” within the meaning of that section of the tax code. The Internal Revenue Service determined that CFC is an organization that is “operated exclusively for the promotion of social welfare” because the ultimate beneficiaries of its lending activities, like those of the RUS loan program, are the consumers of electricity produced by rural electric systems, the communities served by these systems and the nation as a whole.

 
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As an organization described under Section 501(c)(4) of the Internal Revenue Code, no part of CFC’s net earnings can inure to the benefit of any private shareholder or individual. This requirement is referred to as the private inurement prohibition and was added to Section 501(c)(4) of the Internal Revenue Code in 1996. A legislative exception allows organizations like CFC to continue to make allocations of net earnings to members in accordance with its cooperative status.

CFC believes its operations have not changed materially from those described to the Internal Revenue Service in its exemption filing. CFC reviews the impact on operations of any new activity or potential change in product offerings or business in general to determine whether such change in activity or operations would be inconsistent with its status as an organization described under Section 501(c)(4).

RTFC is a taxable cooperative under Subchapter T of the Internal Revenue Code and is not subject to income taxes on income from patronage sources that is allocated to its borrowers, as long as the allocation is properly noticed and at least 20 percent of the amount allocated is retired in cash prior to filing the applicable tax return. RTFC pays income tax based on its net income, excluding amounts allocated to its borrowers.

NCSC is a taxable cooperative that is subject to income tax annually based on its net income for the period. We believe that NCSC would qualify under Subchapter T of the Internal Revenue Code, and thus it would not be subject to income taxes on patronage-sourced net earnings allocated to its borrowers, as long as the allocation is properly noticed and at least 20 percent of the amount allocated is retired in cash prior to filing the applicable tax return. To date, NCSC’s Board of Directors has not allocated its patronage-sourced net earnings to borrowers, thus NCSC pays income tax on the full amount of its net income.

Allocation and Retirement of Patronage Capital

District of Columbia cooperative law requires cooperatives to allocate net earnings to patrons, to a general reserve in an amount sufficient to maintain a balance of at least 50 percent of paid-up capital, and to a cooperative educational fund, as well as permits additional allocations to board-approved reserves. District of Columbia cooperative law also requires that a coooperative’s net earnings be allocated to all patrons in proportion to their individual patronage and each patron’s allocation be distributed to the patron unless the patron agrees that the cooperative may retain its share as additional capital.

CFC
Annually, CFC’s Board of Directors allocates its net earnings to its patrons in the form of patronage capital, to a cooperative educational fund, to a general fund, if necessary, and to board-approved reserves. Net earnings are calculated by adjusting net income to exclude the non-cash effects of the accounting for derivative financial instruments and foreign currency translation. Negative net earnings, if any, are not allocated to members or to the reserves and do not affect amounts previously allocated as patronage capital or to the reserves. Net earnings may first be used to offset prior period losses, if any.

An allocation to the general fund is made, if necessary, to maintain the balance of the general fund at 50 percent of the membership fees collected. CFC’s bylaws require the allocation to the cooperative educational fund to be at least 0.25 percent of its net earnings. Funds from the cooperative educational fund are disbursed annually to statewide cooperative organizations to fund the teaching of cooperative principles and for other cooperative education programs.

Currently, CFC has one additional board-approved reserve, the members’ capital reserve. CFC’s Board of Directors determines the amount of net earnings that is allocated to the members’ capital reserve, if any. The members’ capital reserve represents net earnings that CFC holds to increase equity retention. The net earnings held in the members’ capital reserve have not been specifically allocated to members, but may be allocated to individual members in the future as patronage capital if authorized by CFC’s Board of Directors.

All remaining net earnings are allocated to CFC’s members in the form of patronage capital. The amount of net earnings allocated to each member is based on the members’ patronage of CFC’s lending programs during the year. No interest is earned by members on allocated patronage capital. There is no effect on CFC’s total equity as a result of allocating net earnings to members in the form of patronage capital or to board-approved reserves. CFC’s Board of Directors has voted annually to retire a portion of the patronage capital allocation. Upon retirement, patronage capital is paid out in cash to the members to whom it was allocated. CFC’s total equity is reduced by the amount of patronage capital retired to its members and by amounts disbursed from board-approved reserves.

Pursuant to CFC’s bylaws, CFC’s Board of Directors shall determine the method, basis, priority and order of retirement of amounts allocated. The current policy of the CFC Board of Directors is to retire 50 percent of the prior fiscal year’s allocated net earnings following the end of each fiscal year and to hold the remaining 50 percent for 25 years to fund operations. The amount and timing of future retirements remains subject to annual approval by CFC’s Board of Directors, and may be affected

 
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by CFC’s financial condition and other factors. CFC’s Board of Directors has the authority to change the current practice for allocating and retiring net earnings at any time, subject to applicable cooperative law.

RTFC
In accordance with District of Columbia cooperative law and its bylaws and board policies, RTFC allocates its net earnings to its patrons, a cooperative educational fund and a general reserve, if necessary. Negative net earnings, if any, are not allocated to members or to the reserves and do not affect amounts previously allocated as patronage capital or to the reserves. Net earnings may first be used to offset prior period losses, if any.

Pursuant to RTFC’s bylaws, RTFC’s Board of Directors shall determine the method, basis, priority and order of retirement of amounts allocated. RTFC’s bylaws require that it allocate at least 1 percent of net earnings to a cooperative educational fund. Funds from the cooperative educational fund are disbursed annually to fund the teaching of cooperative principles and for other cooperative education programs. An allocation to the general fund is made, if necessary, to maintain the balance of the general fund at 50 percent of the membership fees collected. The remainder is allocated to borrowers in proportion to their patronage. RTFC provides notice to its members of the amount allocated and retires 20 percent of the allocation for that year in cash prior to the filing of the applicable tax return. Any additional amounts are retired as determined by RTFC’s Board of Directors with due regard for RTFC’s financial condition. There is no effect on the balance of noncontrolling interest due to the allocation of net earnings to members or board-approved reserves. The retirement of amounts previously allocated to members or amounts disbursed from Board-approved reserves reduces the balance of noncontrolling interest.

NCSC
In accordance with District of Columbia cooperative law and its bylaws and board policies, NCSC allocates its net earnings to a cooperative educational fund, to a general fund, if necessary, and to board-approved reserves. Net earnings are calculated by adjusting net income to exclude the non-cash effects of the accounting for derivative financial instruments and foreign currency translation. Negative net earnings, if any, are not allocated to members or to the reserves and do not affect amounts previously allocated to the reserves. Net earnings may first be used to offset prior period losses, if any.

Pursuant to NCSC’s bylaws, the NCSC’s Board of Directors shall determine the method, basis, priority and order of amounts allocated and retired. An allocation to the general fund is made, if necessary, to maintain the balance of the general fund at 50 percent of the membership fees collected. NCSC’s bylaws require the allocation to the cooperative educational fund to be at least 0.25 percent of its net earnings. Funds from the cooperative educational fund are disbursed annually to fund the teaching of cooperative principles and for other cooperative education programs. To date, NCSC has not allocated net earnings to members. NCSC’s Board of Directors has retained prior net earnings as operating capital. The NCSC Board of Directors has the authority to determine if and when patronage-sourced net earnings will be allocated and retired. There is no effect on the balance of noncontrolling interest due to the allocation of net earnings to board-approved reserves. The amounts disbursed from board-approved reserves reduce the balance of noncontrolling interest.

Investment Policy

Surplus funds are invested based on policies adopted by our Board of Directors. Under present policy, surplus funds may be invested in direct obligations of, or guaranteed by, the United States or agencies thereof or other highly liquid investment- grade securities. Current investments may include highly rated securities such as commercial paper, obligations of foreign governments, Eurodollar deposits, bankers’ acceptances, bank letters of credit, certificates of deposit or working capital acceptances. The policy also permits investments in certain types of repurchase agreements with highly rated financial institutions, whereby the assets consist of eligible securities of a type listed above set aside in a segregated account. In addition, this policy permits investments in the Federal Agricultural Mortgage Corporation.

Employees

At May 31, 2011, we had 219 employees, including financial and legal personnel, management specialists, credit analysts, accountants and support staff. We believe that our relations with our employees are good.

Item 1A.
Risk Factors

Our financial condition, results of operations and liquidity are subject to various risks and uncertainties inherent in our business. The risks described below are the risks we consider to be material to our business. Other risks may prove to be material or important in the future. If any of the events or circumstances described in the following risks actually occur, our business, financial condition or results of operations could suffer adversely. You should consider all of the following risks together with all of the other information in this Annual Report on Form 10-K.

 
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Our business depends on access to external financing.
We depend on access to the capital markets and other sources of financing, such as our revolving credit agreements, new investment from our members, private debt issuances through the Federal Agricultural Mortgage Corporation, and funding from the Federal Financing Bank through the Rural Economic Development Loan and Grant program, to fund new loan advances and refinance our long-term and short-term debt and, if necessary, to fulfill our obligations under our guarantee and repurchase agreements. We cannot assure that we will be able to raise capital in the future at all or on terms that are acceptable to us. Market disruptions, downgrades to our long-term debt ratings and/or short-term debt ratings, adverse changes in our business or performance, downturns in the rural electric or rural telephone industries and other events over which we have no control may deny or limit our access to the capital markets and/or subject us to higher costs for such funding. Our access to other sources of funding also could be limited by the same factors, by adverse changes in the business or performance of our members, by the banks committed to our revolving credit agreements or the Federal Agricultural Mortgage Corporation, or by changes in federal law or the REDLG program.

Our funding needs are determined primarily by scheduled long and short-term debt maturities and the amount of our loan advances to our borrowers relative to the scheduled amortization of loans previously made by us. If we are unable to timely issue debt into the capital markets or obtain funding from other sources, we may not have the funds to meet all of our obligations as they become due.

Fluctuating interest rates could adversely affect our income, margin and cash flow.
We are a cost-based lender that sets our interest rates on loans based on our cost of funding. We set our line of credit interest rate and long-term variable interest rate monthly based on the cost of our underlying funding. We do not match fund the majority of our long-term fixed-rate loans with a specific debt issuance at the time the loans are advanced. Instead, long-term fixed-rate loans are aggregated until the volume reaches a level that will allow an economically efficient issuance of long-term debt to fund long-term fixed-rate loans. As such, we are exposed to interest rate risk on our long-term fixed-rate loans during the period from which we have set a fixed rate on the loan until the time we obtain the long-term funding for the loan from the market. At May 31, 2011, fixed-rate loans funded with variable-rate debt totaled $1,262 million, or 6 percent of total assets and total assets excluding derivative assets.

A decrease in long-term fixed interest rates provided by other lenders could result in an increase in prepayments on long-term fixed-rate loans scheduled to reprice. Borrowers are able to prepay the long-term fixed-rate loan without a make-whole fee at the time the fixed-rate term expires and the loan reprices. An increase in loan prepayments due to repricings could cause a decrease to earnings for the period of time it takes to use cash from such prepayments to repay maturing debt or make new loan advances. At May 31, 2011, $1,796 million of fixed-rate loans have a fixed-rate term scheduled to reprice during the next 12 months.

In addition, the calculated impairment on certain restructured loans will increase as our long-term variable and line of credit interest rates increase. Based on the current balance of impaired loans at May 31, 2011, an increase or decrease of 25 basis points to our variable interest rates results in an increase or decrease of approximately $9 million, respectively, to the calculated impairment on loans irrespective of a change in the credit fundamentals of the impaired borrower.

Competition from other lenders could impair our financial results.
We compete with other lenders for the portion of the rural utility loan demand for which RUS will not lend and for loans to members who have elected not to borrow from RUS. The primary competition for the non-RUS loan volume is from CoBank, ACB, a federally chartered instrumentality of the United States that is a member of the Farm Credit System. As a government-sponsored enterprise, CoBank, ACB, has the benefit of an implied government guarantee. Competition may limit our ability to raise rates to cover all increases in costs and may negatively impact net income. Raising our interest rates to cover increased costs could cause a reduction in new lending business.

Our elected directors also serve as officers or directors of certain of our individual member cooperatives, which may result in a potential conflict of interest with respect to loans, guarantees and extensions of credit that we may make to or on behalf of such member cooperatives.
In accordance with our charter documents and the purpose for which we were formed, we lend only to our members and associates. CFC’s directors are elected or appointed from our membership, with 10 director positions filled by directors of members, 10 director positions filled by general managers or chief executive officers of members, two positions appointed by the National Rural Electric Cooperative Association and one at-large position that must, among other things, be a director, financial officer, general manager or chief executive of one of our members. To address the conflict of interest inherent in our credit and lending activities with respect to any member that has one of its officers or directors sitting on CFC’s Board of Directors, all loans, guarantees and other extensions of credit to such member are required to be approved by a majority of CFC’s Board of Directors or a majority of the loan committee of CFC’s Board of Directors, with the interested director being

 
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recused from both the discussions and the vote on the approval of the proposed loan, guarantee or extension of credit. Notwithstanding the foregoing, the Chief Executive Officer has the authority to approve emergency and certain other lines of credit. All such loan requests are required to go through the same underwriting process and review as other loan requests before being submitted to the Board of Directors or loan committee for approval. Unlike FDIC-insured banking institutions, we are not subject to federal or state regulation, examination or oversight with regard to our lending activity.

We are subject to credit risks related to collecting the amounts owed to us on our outstanding loans. Increased credit risk related to our loans or actual losses that exceed our allowance for loan losses could impair our financial results.
Our allowance for loan losses is established through a provision charged to expense that represents management’s best estimate of probable losses that have been incurred within the existing loan portfolio. The level of the allowance reflects management’s continuing evaluation of credit risk related to industry concentrations; economic conditions; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions; and unidentified losses and risks inherent in the current loan portfolio. The determination of the appropriate level of the allowance for loan losses involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in the allowance for loan losses. In addition, if actual losses incurred exceed current estimates of probable losses included in the allowance for loan losses, we will need additional provisions to increase the allowance for loan losses. Any material increases in the allowance for loan losses will result in a decrease in net income, and may have a material adverse effect on our financial results.

We have been and may in the future be in litigation with borrowers related to enforcement or collection actions pursuant to loan documents. In such cases, the borrower or others may assert counterclaims against us or initiate actions against us related to the loan documents. Unfavorable rulings in these cases that result in loan losses that exceed the related allowance could have a material adverse effect on our financial results.

We own and operate assets and entities obtained through foreclosure and are subject to the same performance and financial risks as any other owner or operator of similar assets or businesses.
As the owner and operator of assets and entities obtained through foreclosure, we are subject to the same performance and financial risks as any other owner or operator of similar assets or entities. In particular, there is the risk that the value of the foreclosed assets or entities will deteriorate, negatively affecting our results of operations. We assess our portfolio of foreclosed assets for impairment periodically as required under generally accepted accounting principles in the United States. Impairment charges, if required, represent a reduction to earnings in the period of the charge. There may be substantial judgment used in the determination of whether such assets are impaired and in the calculation of the amount of the impairment. In addition, when foreclosed assets are sold to a third party, the sale price we receive may be below the amount previously recorded in our financial statements, which will result in a loss being recorded in the period of the sale.

The non-performance of counterparties to our derivative agreements could impair our financial results.
We use interest rate swaps to manage our interest rate risk. There is a risk that the counterparties to these agreements will not perform as agreed, which could adversely affect our results of operations. The non-performance of a counterparty on an agreement would result in the derivative no longer being an effective risk management tool, which could negatively affect our overall interest rate risk position. In addition, if a counterparty fails to perform on our derivative obligation, we could incur a financial loss to replace the derivative with another counterparty and/or a loss through the failure of the counterparty to pay us amounts owed.

At May 31, 2011, we were a party to derivative instruments with notional amounts totaling $10,940 million. At May 31, 2011, the highest concentration of total notional exposure to any one counterparty was 13 percent of total derivative instruments. Based on the fair market value of our derivative instruments at May 31, 2011, there were five counterparties that would be required to make payments to us totaling $62 million if all of our derivative instruments were terminated on that date. The largest amount owed to us by a single counterparty was $28 million, or 46 percent of the total payments owed to us at May 31, 2011.

A reduction in the credit ratings for our debt could adversely affect our liquidity and/or cost of debt.
Nationally recognized statistical rating organizations play an important role in determining, by means of the ratings they assign to issuers and their debt, the availability and cost of debt funding. We currently contract with two nationally recognized statistical rating organizations to receive ratings for our secured and unsecured debt and our commercial paper. Our credit ratings are important to our liquidity. In order to access the commercial paper markets at current levels, we believe that we need to maintain our current ratings for commercial paper of P1 from Moody’s Investors Service and A1 from Standard & Poor’s Corporation. Actions by governmental entities or others, additional losses from impaired loans and other factors could adversely affect the credit ratings on our debt. A reduction in our credit ratings could adversely affect our liquidity,

 
27

 

competitive position, or the supply or cost of debt financing available to us. A significant increase in our interest expense could cause us to sustain losses or impair our liquidity by requiring us to seek other sources of financing, which may be difficult to obtain.

A decline in our credit rating could trigger payments under our derivative agreements, which could impair our financial results.
We have certain interest rate swaps that contain credit risk-related contingent features referred to as rating triggers. Under certain rating triggers, if the credit rating for either counterparty falls to the level specified in the agreement, the other counterparty may, but is not obligated to, terminate the agreement. If either counterparty terminates the agreement, a net payment may be due from one counterparty to the other based on the fair value, excluding credit risk, of the underlying derivative instrument. These rating triggers are based on our senior unsecured credit rating from Moody’s Investors Service and Standard & Poor’s Corporation. Based on the fair market value of our interest rate exchange agreements subject to rating triggers at May 31, 2011, we may be required to make a payment of up to $114 million if our senior unsecured ratings from Moody’s Investors Service falls to or below Baa1 or from Standard & Poor’s Corporation falls to or below BBB+ and all agreements for which we owe amounts are terminated. In calculating the required payments, we only considered agreements that, when netted for each counterparty as allowed by the underlying master agreement, would require a payment upon termination. In the event that we are required to make a payment as a result of a rating trigger, it could have a material adverse impact on our financial results.

At May 31, 2011, our senior unsecured debt credit ratings from Moody’s Investors Service and Standard & Poor’s Corporation were A2 and A, respectively. While the rating triggers on our interest rate exchange agreements are not tied to the rating outlooks from Moody’s Investors Service and Standard & Poor’s Corporation, such rating outlooks may provide an indication of possible future movement in the ratings. At May 31, 2011, both Moody’s Investors Service and Standard & Poor’s Corporation had our ratings on stable outlook.

Our concentration of loans to borrowers within the rural electric industry could impair our revenue if that industry experiences economic difficulties.
At May 31, 2011, 93 percent of our total exposure was to rural electric cooperatives. Factors that have a negative impact on our member rural electric cooperatives’ financial results could also impair their ability to make payments on our loans. If our members’ financial results materially deteriorate, we could be required to increase our loan loss allowance through provisions for loan loss on our income statement that would reduce reported net income.

Advances in technology may change the way electricity is generated and transmitted or the way telecommunications services are provided to businesses and consumers prior to the maturity of our loans to rural electric and telecommunications systems.
To the extent that advances in technology make our electric system members’ power supply, transmission and/or distribution facilities, or our telecommunications system members’ networks or services obsolete prior to the maturity of our loans, there could be an adverse impact on the ability of our members to repay such loans. This could lead to an increase in non-performing or restructured loans and an adverse impact on our results of operations.

Loss of our tax-exempt status could increase our tax liability.
CFC has been recognized by the Internal Revenue Service as an organization for which income is exempt from federal income taxation under Section 501(c)(4) of the Internal Revenue Code (other than any net income from an unrelated trade or business). In order to maintain CFC’s tax-exempt status, it must continue to operate exclusively for the promotion of social welfare by operating on a cooperative basis for the benefit of its members by providing them cost-based financial products and services consistent with sound financial management, and no part of CFC’s net earnings may inure to the benefit of any private shareholder or individual other than the allocation or return of net earnings or capital to its members in accordance with CFC’s current bylaws and incorporating statute.

If CFC were to lose its status as a 501(c)(4) organization, we believe that it would be subject to the tax rules generally applicable to cooperatives under Subchapter T of the Internal Revenue Code. As a Subchapter T cooperative, CFC would be allowed to allocate its patronage-sourced income to its members and take a deduction for the amount of such patronage dividends that are paid in cash or qualified written notices of allocation. However, CFC would be taxed as a regular corporation on any income in excess of allowed deductions, if any.

Our ability to comply with covenants related to our revolving credit agreements, debt indentures and debt agreements could affect our ability to retire patronage capital, may accelerate certain debt obligations and could affect our ability to obtain financing and maintain preferred rating levels on our debt.
We must maintain compliance with all covenants and conditions related to our revolving credit agreements and debt indentures.

 
28

 


We are required to maintain a minimum adjusted TIER for the six most recent fiscal quarters of 1.025, an adjusted leverage ratio of no more than 10-to-1 and we must maintain loans pledged as collateral for various debt issuances at or below 150 percent of the related secured debt outstanding as a condition to borrowing under our revolving credit agreements. Our revolving credit agreements also state that we must earn a minimum annual adjusted TIER of 1.05 in order to retire patronage capital to members. See Non-GAAP Financial Measures for further explanation and a reconciliation of our adjusted ratios.

If we are unable to borrow under the revolving credit agreements, our short-term debt ratings would most likely decline, and our ability to issue commercial paper could become significantly impaired. As a member-owned cooperative, all of our retained equity belongs to our members. As such, a restriction on the retirement of patronage capital in any year would result in a delay in the return of such amounts to the members until we earn an annual TIER of at least 1.05 and our board approves the retirement of the amounts allocated from the year in which retirement was restricted. A patronage capital retirement in any one year reduces the effective cost of borrowing for a member’s loan from CFC. Thus, if CFC does not retire patronage capital to its members, it results in a higher effective rate of borrowing from CFC for that year.

Pursuant to our collateral trust bond indentures, we are required (i) to maintain eligible collateral pledged at least equal to 100 percent of the principal amount of the bonds issued under the indenture, and (ii) to limit senior indebtedness to 20 times the sum of our members’ equity, subordinated deferrable debt and members’ subordinated certificates. Our medium-term note indentures also require us to comply with (ii) above.

If we are in default under our collateral trust bond or medium-term note indentures, the existing holders of our collateral trust bonds or medium-term notes have the right to accelerate the repayment of the full amount of the outstanding debt principal before the stated maturity of such debt. That acceleration of debt repayments poses a significant liquidity risk as we might not have enough cash or committed credit available to repay the debt. In addition, if we are not in compliance with the collateral trust bond and medium-term note covenants, we would be unable to issue new debt securities under such indentures. If we were unable to issue new collateral trust bonds and medium-term notes, our ability to fund new loan advances and refinance maturing debt would be impaired.

We are required to pledge eligible distribution system or power supply system loans as collateral equal to at least 100 percent of the outstanding balance of debt issued under a revolving note purchase agreement with the Federal Agricultural Mortgage Corporation. We are also required to maintain distribution and power supply loans as collateral on deposit equal to at least 100 percent of the outstanding balance of debt under the Guaranteed Underwriter program of the U.S. Department of Agriculture, which supports the Rural Economic Development Loan and Grant program. Collateral coverage under 100 percent for either of these debt programs constitutes an event of default, which if not cured within 30 days, could result in creditors accelerating the repayment of the outstanding debt principal before the stated maturity. This poses a liquidity risk of possibly not having enough cash or committed credit available to repay the debt. In addition, we would be unable to issue new debt securities under the applicable debt agreement, which could impair our ability to fund new loan advances and refinance maturing debt.

Item 1B.
Unresolved Staff Comments.

None.

Item 2.
Properties

CFC leases approximately 107,228 square feet of office, meeting and storage space that serves as its headquarters in Fairfax County, Virginia. This lease is scheduled to expire on October 17, 2011 and will not be renewed.

CFC purchased 42 acres of land located in Loudoun County, Virginia in May 2008. In June 2010, CFC entered into a definitive agreement for construction of a new headquarters facility using 16 of the 42 acres of land we own. The excess land is available if we need to expand in the future. Our new headquarters facility is scheduled for completion in the third quarter of calendar year 2011. Our new headquarters facility will be approximately 120,000 square feet and will be constructed at a cost not expected to exceed $39.5 million. We do not expect the change from leasing to owning our headquarters building to have a material impact on our operating results because the annual cost of operating, maintaining and depreciating the new building is expected to be less than the annual cost of the current lease.

Item 3.
Legal Proceedings.

From time to time, CFC is subject to certain legal proceedings and claims in the ordinary course of business, including litigation with borrowers related to enforcement or collection actions. In such cases, the borrower or others may assert counterclaims or initiate actions against us. Management presently believes that the ultimate outcome of these proceedings,

 
29

 

individually and in the aggregate, will not materially harm our financial position, liquidity, or results of operations. CFC establishes reserves for specific legal matters when it determines that the likelihood of an unfavorable outcome is probable and the loss is reasonably estimable. Accordingly, no reserve has been taken with respect to any legal proceedings at this time. Legal proceedings are, however, subject to inherent uncertainties, and unfavorable rulings could occur that could have individually or in aggregate, a material adverse effect on our business, financial condition, or operating results. Related to the ICC bankruptcy proceedings described on page 32 in the Executive Summary section of Management's Discussion and Analysis under Transfer of Control of ICC Operating Entities, ICC’s former indirect majority shareholder and former chairman, and related parties, continue to assert claims against CFC and certain of its officers and directors and other parties in various proceedings and forums. CFC anticipates that it will continue to be engaged in defense of those assertions on many fronts, as well as pursuing claims of its own.

Item 4.
[Removed and Reserved].

None.

 
30

 


PART II

Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Inapplicable.

Item 6.
Selected Financial Data.

The following is a summary of selected financial data for the years ended and as of May 31:

(dollar amounts in thousands)
                                         
For the year ended May 31:
   
2011
     
2010
     
2009
     
2008
     
2007
   
Interest income
 
$
1,008,911}
   
$
1,043,635}
   
$
1,070,764
   
$
1,051,393
   
$
1,039,650
   
Net interest income
   
167,831}
     
131,524}
     
135,743
     
120,125
     
47,896
   
Derivative (losses) gains (1)
   
(30,236)
     
(20,608)
     
(47,028
)
   
(71,710
)
   
7,161
   
Foreign currency adjustments (2)
   
-}
     
-
     
-
     
-
     
(14,554
)
 
Income (loss) prior to income taxes (3)
   
     152,542}
     
110,251}
     
(78,871
)
   
36,311
     
16,541
   
Net income (loss) (3)
   
151,215}
     
110,547}
     
(73,770
)
   
39,646
     
14,145
   
                                           
Fixed-charge coverage ratio (TIER) (4)(5)
   
1.18}
     
1.12}
     
-
     
1.04
     
1.01
   
Adjusted TIER (6)
   
1.21}
     
1.12}
     
1.10
     
1.15
     
1.12
   
 
                                         
As of May 31:
                                         
Loans to members
 
$
19,330,797}
   
$
19,342,704}
   
$
20,192,309
   
$
19,029,040
   
$
18,131,873
   
Allowance for loan losses
   
(161,177)
     
(592,764)
     
(622,960
)
   
   (514,906
)
   
(561,663
)
 
Assets
   
20,561,622}
     
20,143,215}
     
20,982,705
     
19,379,381
     
18,575,181
   
Short-term debt
   
5,842,924}
     
4,606,361}
     
4,867,864
     
6,327,453
     
4,427,123
   
Long-term debt (7)
   
11,293,249}
     
12,054,497}
     
12,720,055
     
10,173,587
     
11,295,219
   
Subordinated deferrable debt (8)
   
186,440}
     
311,440}
     
311,440
     
311,440
     
311,440
   
Members’ subordinated certificates  (9)
   
1,801,212}
     
1,810,715}
     
1,740,054
     
1,406,779
     
1,381,447
   
Members’ equity (10)
   
790,241}
     
669,355}
     
604,316
     
     613,082
     
566,286
   
Total equity
   
687,309}
     
586,767}
     
519,100
     
680,212
     
732,030
   
Guarantees
   
1,104,988}
     
1,171,109}
     
1,275,455
     
  1,037,140
     
1,074,374
   
                                           
Leverage ratio (5)
   
30.52}
     
35.33}
     
41.88
     
         29.01
     
25.84
   
Adjusted leverage ratio (6)
   
6.48}
     
6.34}
     
7.06
     
           7.48
     
6.82
   
Debt-to-equity ratio (5)
   
28.92}
     
33.33}
     
39.42
     
         27.49
     
24.37
   
Adjusted debt-to-equity ratio (6)
     
6.09}
     
5.93}
     
6.59
   
 
7.04
     
6.39
   
(1) Amount represents changes in the fair value of derivative instruments (forward value) along with realized gains and losses from cash settlements. Derivative cash settlements represent the net settlements received/paid on interest rate and cross currency exchange agreements that do not qualify for hedge accounting. The derivative forward value represents the change in fair value on exchange agreements that do not qualify for hedge accounting, as well as amortization related to the transition adjustment recorded as an other comprehensive loss on June 1, 2001.
(2) Foreign currency adjustments represent the change in value of foreign-denominated debt that is not related to an exchange agreement that qualifies for hedge accounting during the period and recorded in the statement of operations. The foreign-denominated debt is revalued at each reporting date based on the current exchange rate. If 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 debt is recorded in the foreign currency valuation account on the balance sheet. We enter into foreign currency exchange agreements at the time of each foreign-denominated debt issuance to lock in the exchange rate for all principal and interest payments required through maturity.
(3) Includes a one-time gain of $23 million from the proceeds of a settlement with CoBank, ACB, for the year ended May 31, 2010.
(4) For the years ended May 31, 2011, 2010 and 2009, the fixed-charge coverage ratio includes capitalized interest in total fixed charges, which is not included in our times interest earned ratio (“TIER”) calculation. For the years ended prior to May 31, 2009, the fixed-charge coverage ratio is the same calculation as our TIER as we did not have any capitalized interest during those periods. For the year ended May 31, 2009, earnings were insufficient to cover fixed charges by $74 million.
(5) See Non-GAAP Financial Measures in Management’s Discussion and Analysis for the GAAP calculations of these ratios.
(6) Adjusted ratios include non-GAAP adjustments that we make to financial measures in assessing our financial performance. See Non-GAAP Financial Measures in Management’s Discussion and Analysis for further explanation of these calculations and a reconciliation of the adjustments.
(7) Excludes $2,523 million, $2,312 million, $2,580 million, $3,177 million and $1,368 million in long-term debt that comes due, matures and/or will be redeemed during fiscal years 2012, 2011, 2010, 2009 and 2008, respectively (see Note 5 to the consolidated financial statements).
(8) Excludes $175 million called in June 2007 reported in short-term debt at May 31, 2007.
(9) Excludes $12 million of members’ subordinated certificates reported as short-term debt at May 31, 2011.
(10) Members’ equity represents total equity excluding foreign currency adjustments, derivative forward value, accumulated other comprehensive income and noncontrolling interest. See the Financial Condition/Liabilities and Equity section in Management’s Discussion and Analysis for further details of members’ equity and a reconciliation to total equity.

 
31

 


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

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 and the information contained elsewhere in this Form 10-K, including Part I, Item 1A. Risk Factors.

Unless stated otherwise, references to “we,” “our” or “us” relate to the consolidation of National Rural Utilities Cooperative Finance Corporation (“CFC”), Rural Telephone Finance Cooperative (“RTFC”), National Cooperative Services Corporation (“NCSC”) and certain entities created and controlled by CFC to hold foreclosed assets and to accommodate loan securitization transactions.

Executive Summary

Throughout this management discussion and analysis, we will refer to certain of our financial measures that are not in accordance with generally accepted accounting principles in the United States (“GAAP”) as “adjusted.” In our Executive Summary, our discussion focuses on the key metrics that we use to evaluate our business, which are adjusted times interest earned ratio (“TIER”) and adjusted debt-to-equity ratio. The most closely related GAAP measures are TIER and debt-to-equity ratio. We do not measure our performance or evaluate our business based on the GAAP measures, and the financial covenants in our revolving credit agreements and debt indentures are based on our adjusted measures rather than the related GAAP measures. The main adjustments we make to calculate the non-GAAP measures compared with the related GAAP measures are to adjust interest expense to include derivative cash settlements; to adjust net income, senior debt and total equity to exclude the non-cash adjustments from the accounting for derivative financial instruments; to exclude from senior debt the amount that funds loans guaranteed by the Rural Utilities Service (“RUS”), subordinated deferrable debt and members’ subordinated certificates; and to adjust total equity to include subordinated deferrable debt and members’ subordinated certificates. See Non-GAAP Financial Measures for further explanation of the adjustments we make to our financial results for our own analysis and covenant compliance and for a reconciliation to the related GAAP measures.

Our primary objective as a member-owned cooperative lender is to provide cost-based financial products to our rural electric and telecommunications members while maintaining sound financial results required for investment-grade credit ratings on our debt instruments. Our objective is not to maximize net income; therefore, the rates we charge our borrowers reflect our adjusted interest expense plus a spread to cover our operating expenses, a provision for loan losses and earnings sufficient to achieve interest coverage to meet our financial objectives. Our goal is to earn an annual minimum adjusted TIER of 1.10 and to achieve and maintain an adjusted debt-to-equity ratio of no greater than 6.00-to-1.

Lending Activity
The balance of loans outstanding remained relatively stable during the year ended May 31, 2011. During the year there were increases in loans outstanding to CFC and NCSC borrowers totaling $627 million and $173 million, respectively, and a decrease of $813 million in RTFC loans outstanding. The loans outstanding to CFC and NCSC borrowers increased due to a total of $1,109 million of loan advances used to refinance the debt of other lenders. This increase in loans outstanding was partly offset by distribution and power supply loans sold to the Federal Agricultural Mortgage Corporation totaling $327 million, of which $164 million were advanced at the time of sale, and by $75 million of loans prepaid at their repricing date. RTFC loans as a percentage of our total loan portfolio decreased from 9 percent at May 31, 2010 to 4 percent at May 31, 2011 as a result of the $536 million reduction in non-performing loans to Innovative Communication Corporation (“ICC”), as described below, and the prepayment of $204 million of telecommunications loans related to the acquisition of one of our borrowers.

During the period June 1, 2010 through May 31, 2011, $1,699 million of long-term fixed-rate loans were scheduled to reprice. Of that total, $1,338 million selected a new long-term fixed rate; $260 million selected the long-term variable rate; $26 million selected a new rate offered by the Federal Agricultural Mortgage Corporation and were sold by CFC to the Federal Agricultural Mortgage Corporation with CFC continuing to service the loans sold; and $75 million were prepaid in full.

Transfer of Control of ICC Operating Entities
During fiscal year 2011, a wholly-owned subsidiary of CFC, Caribbean Asset Holdings (“CAH”), obtained control of 100 percent of the equity interests of ICC’s United States Virgin Island (“USVI”), British Virgin Island and St. Maarten operating entities. RTFC was the primary secured lender to ICC, a diversified telecommunications company headquartered in St. Croix, USVI. The transfer of control of these entities from ICC to CAH was completed in two phases and was the result of ICC bankruptcy proceedings. RTFC assigned to CFC its rights with respect to the entities transferred as partial repayment of its

 
32

 

loan from CFC. As part of the transfer of control, we received entities with a fair value of $166 million and invested $88 million to pay down existing third party debt for a total investment of $254 million to foreclosed assets. Additionally, we recorded a $354 million charge-off of the ICC loan balance.  See further discussion in Note 4, Foreclosed Assets, to the consolidated financial statements.

Funding Activity
During the year ended May 31, 2011, our funding needs were primarily related to the refinancing of maturing debt since there was little change in our overall funding requirements due to a flat loan portfolio. However, during fiscal year 2011, we refinanced higher-cost debt with lower-cost debt. A higher utilization of our commercial paper issuance capacity was a key factor in our efforts to reduce our overall effective interest rate on borrowed funds during fiscal year 2011 as commercial paper is our lowest-cost source of debt funding. Our average balance of commercial paper, bid notes and daily liquidity fund outstanding increased to $2,767 million, or 15 percent of total average debt volume, compared with 11 percent of total average debt volume for the year ended May 31, 2010. The higher average balance of commercial paper was offset by a lower average balance of medium-term notes, which decreased to 21 percent of total average debt volume for the year ended May 31, 2011 from 24 percent for the prior-year period. As a result, short-term debt as a percentage of total debt increased to 17 percent at May 31, 2011 compared with 12 percent at May 31, 2010.

During the year ended May 31, 2011, our funding requirements were driven mainly by $907 million of maturing collateral trust bonds, the early redemption of $125 million of subordinated deferrable debt and medium-term note maturities that exceeded new issuances by $575 million. To refinance these debt obligations, we primarily issued a combination of commercial paper and $950 million of new collateral trust bonds. See further discussion of the decrease in interest expense during fiscal year 2011 as a result of refinancing debt maturities with lower-cost debt in the Financial Results section below.

In November 2010, we closed on a $500 million committed loan facility from the Federal Financing Bank with a guarantee of repayment by RUS as part of the funding mechanism for the Rural Economic Development Loan and Grant program. Under this facility, we are able to borrow funds up to the committed amount at rates ranging from 52.5 to 65 basis points over comparable maturity Treasury Bonds any time before October 15, 2013, with each advance having a final maturity not longer than 20 years from the advance date. In March 2011, we borrowed $150 million under this facility. On April 15, 2011, the President of the United States signed the Full-Year Continuing Appropriations Act for Fiscal Year 2011, which provided an additional $500 million under the Rural Economic Development Loan and Grant program. CFC has submitted an application to RUS for the $500 million, 20-year maturity RUS-guaranteed Federal Financing Bank loan authorized under this program. The amount approved for CFC by the federal government by its fiscal year ending September 30, 2011 could range between $0 and $500 million.

At May 31, 2011 and 2010, we had secured notes payable of $1,411 million and $1,587 million outstanding to the Federal Agricultural Mortgage Corporation under note purchase agreements totaling $3,900 million and $2,400 million, respectively. During fiscal year 2011, we entered into an agreement that increased the amount we can borrow under revolving note purchase agreements with the Federal Agricultural Mortgage Corporation by $1,500 million. Under the terms of our current note purchase agreement with the Federal Agricultural Mortgage Corporation, we can borrow up to $3,900 million, subject to market conditions for debt issued by the Federal Agricultural Mortgage Corporation, through January 11, 2016. At May 31, 2011 and through the filing date, we have $2,489 million available under this revolving note purchase agreement.

On March 21, 2011, we replaced the $967 million, five-year revolving credit agreement that terminated on March 22, 2011 with a new $1,125 million, three-year agreement that expires on March 21, 2014. As a result, the total committed credit available under our three current facilities is $3,545 million at May 31, 2011.

Financial Results
For the years ended May 31, 2011 and 2010, we reported net income of $151 million and $111 million, respectively, and TIER was 1.18  and 1.12, respectively. As previously mentioned, we use adjusted non-GAAP measures in our analysis to evaluate our performance and for covenant compliance.

We experienced an increase of $53 million, or 49 percent, to adjusted net interest income for the year ended May 31, 2011 compared with the prior-year period due to a decrease in interest expense that was greater than the decrease to interest income. The two primary factors driving the reduction to interest expense were the increased utilization of commercial paper in our overall funding mix and refinancing maturing term debt at lower interest rates. As a result, our adjusted interest expense fell from an average of $78 million per month for fiscal year 2010 to $71 million per month for fiscal year 2011. The average adjusted interest expense for the fourth quarter of fiscal year 2011 was even lower at $68 million per month.

The higher average balance of commercial paper outstanding and the decrease in the average balance of medium-term notes in our overall funding mix contributed to the overall decrease in interest expense during the year ended May 31, 2011

 
33

 

compared with the prior-year period. The average cost of commercial paper was 0.32 percent and 0.36 percent for the years ended May 31, 2011 and 2010, respectively, compared with the average cost of medium-term notes of 6.23 percent and 6.02 percent for the same periods, respectively. We also incurred additional interest expense during the prior-year period due to prefunding large debt maturities as we maintained commercial paper issuance capacity in reserve to address liquidity concerns in the market during that time.

The decrease in interest expense is also the result of refinancing term debt that matured or repriced during the year ended May 31, 2011 at lower interest rates. In November 2010, we refinanced $500 million of maturing 4.375 percent collateral trust bonds and the $125 million redemption of 6.75 percent subordinated deferrable debt with $650 million of new collateral trust bonds at an average interest rate of 1.54 percent. In January 2011, we repriced $750 million of long-term notes payable at an average effective rate of 1.73 percent, including gains from related treasury lock contracts where we qualified for hedge accounting treatment, compared with the effective interest rate of 5.20 percent prior to repricing. We estimate the transactions above resulted in combined savings of $22 million in interest expense during the year ended May 31, 2011, compared with the prior-year periods. On an annual basis, we estimate a $47 million reduction to interest expense as a result of these transactions.

For the year ended May 31, 2011, we recorded a recovery of loan losses totaling $83 million, an increase of $53 million over the recovery in the prior-year period. The recovery for the year ended May 31, 2011 was due to reductions in the allowance for loan losses held for the impaired and general loan portfolios of $47 million and $31 million, respectively, and a $5 million recovery of an amount previously written off for a telecommunications borrower in fiscal year 2008. The reduction to the loan loss allowance for impaired loans of $47 million was due to the change in fair value of collateral securing impaired loans of $26 million, as well as principal repayments on impaired loans that resulted in the remaining $21 million recovery from the loan loss reserve. The $31 million decrease in the reserve for the general portfolio was driven primarily by improvement in the borrowers’ average internal risk rating, as well as updated credit default information and a lower weighted average maturity for the loans in the general portfolio, partly offset by an increase in the general loan balance outstanding.

The change in the items described above resulted in adjusted net income of $175 million for the year ended May 31, 2011 compared with $108 million for the same prior-year period. Adjusted TIER for the years ended May 31, 2011 and 2010 was 1.21 and 1.12, respectively. The adjusted TIER for the year ended May 31, 2010 excluding $23 million of settlement proceeds was 1.09.

At May 31, 2011, our debt-to-equity ratio was 28.92-to-1 compared with 33.33-to-1 at May 31, 2010. As mentioned previously, we use adjusted non-GAAP measures in our own analysis to evaluate our performance and for covenant compliance. Our adjusted debt-to-equity ratio increased to 6.09-to-1 at May 31, 2011 compared with 5.93-to-1 at May 31, 2010. This increase was caused by the increase in adjusted liabilities of $456 million.

Outlook for the Next 12 Months
We anticipate a decline in outstanding loan volume over the next 12 months. This projected decrease is due to a number of expectations including (i) the maturity of a large telecommunications loan, (ii) anticipated loan sales, (iii) the repayment of a power supply bridge loan with proceeds from the advance of funds from RUS and (iv) a lower level of long-term loan advances, as we do not expect that the increase in loan advances during the year ended May 31, 2011, driven by refinancing members’ debt borrowed from other lenders, will continue in fiscal year 2012. As a result, scheduled long-term loan repayments are expected to be in excess of long-term loan advances. We recently expanded our loan product options by establishing two new programs to sell loans, in addition to the loan sale program we have with the Federal Agricultural Mortgage Corporation; therefore, we are projecting an increase in loan sales in fiscal year 2012. Management uses loan sales to manage credit concentrations, to manage the level of our debt-to-equity ratio and as an additional form of liquidity.

We estimate that our adjusted interest expense will continue to decline in fiscal year 2012, although at a slower pace than fiscal year 2011. Interest expense reductions are expected as a result of maintaining the current level of commercial paper in our funding mix, due to a full year of interest savings from refinancing debt at lower interest rates during fiscal year 2011 and due to an expected lower level of debt outstanding compared with the prior year. We do not anticipate a recovery of loan losses in fiscal year 2012 consistent with the $83 million recovery of loan losses in fiscal year 2011. As a result of anticipated reductions to loan volume, anticipation of a smaller recovery of loan losses and a slower pace of decline in adjusted interest expense, we believe our adjusted net income will be lower in fiscal year 2012 than in fiscal year 2011.

At May 31, 2011, we had long-term debt maturing in the next 12 months totaling $2,523 million. Almost 70 percent of this debt is scheduled to mature during the last quarter of fiscal year 2012, including a $1,500 million, 7.25 percent Series C medium-term note maturity scheduled for March 2012. On August 19, 2011, CFC redeemed $250 million of this amount at a premium. Both the premium and unamortized issuance costs of $9 million were recorded as a loss on extinguishment of debt during the first quarter of fiscal year 2012.

 
34

 

As a result, we anticipate that our funding needs will be limited until the second half of fiscal year 2012 when we expect to partly prefund the remaining March 2012 medium-term note maturity. Based on the expected reduction to outstanding loan balances, we do not anticipate that we will have to refinance the full amount of the remaining $1,250 million medium-term note maturity. We believe that our adjusted debt-to-equity ratio will fall below our target of 6.00-to-1 within the next 12 months as a result of the projected decrease in loan volume and an estimated slight increase to adjusted equity.

We believe there is sufficient liquidity from the combination of member loan repayments, capital markets issuance, member debt issuance and private placement of debt to the Federal Agricultural Mortgage Corporation and the Federal Financing Bank, as part of the funding mechanism for the Rural Economic Development Loan and Grant program, to satisfy our need for additional funding over the next 12 months.

Critical Accounting Policies and Estimates

Our significant accounting principles, as described in Note 1, General Information and Accounting Polices, to the consolidated financial statements are essential in understanding 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 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. These policies are summarized below and identify and describe 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 required for estimation. Where alternatives exist, we used the factors 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
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 maintain an allowance for loan losses at a level estimated by management to provide for probable losses inherent in the loan portfolio. The allowance for loan losses is reported separately on the consolidated balance sheet, and the provision for loan losses is reported as a separate line item on the consolidated statement of operations. At May 31, 2011 and 2010, our loan loss allowance totaled $161 million and $593 million, 0.83 percent and 3.07 percent of total loans outstanding, respectively.

There are significant subjective assumptions and estimates used in calculating the amount of the loss allowance required. We review the estimates and assumptions used in the calculations of the loan loss allowance on a quarterly basis. 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. The estimate of the allowance for loan losses is based on a review of the composition of the loan portfolio, past loss experience, specific problem loans, current economic conditions, available market data and/or projection of future cash flows and other pertinent factors that in management’s judgment may contribute to expected losses. The methodology used to calculate the loan loss allowance is summarized below.

The loan loss allowance is calculated by dividing the portfolio into two categories of loans:
(1)
the general portfolio which comprises loans that are performing according to the contractual agreements; and
(2)
the impaired portfolio which comprises loans that (i) are not currently performing or (ii) for various reasons we do not expect to collect all amounts as and when due and payable under the loan agreement or (iii) are performing according to a restructured loan agreement, but as a result of the troubled debt restructuring are required to be classified as impaired.

General Portfolio
The general portfolio of loans consists of all loans not specifically identified in the impaired category. We disaggregate the loans in the general portfolio by borrower type: CFC, RTFC and NCSC. We further disaggregate the CFC loan portfolio by member class: distribution, power supply and statewide and associates.

 
35

 

We use the following factors to determine the loan loss allowance for the general portfolio category:
·  
Internal risk ratings system. We maintain risk ratings for our borrowers that are updated at least annually and are based on the following:
-  
general financial condition of the borrower;
-  
our estimate of the adequacy of the collateral securing our loans;
-  
our judgment of the quality of the borrower’s management;
-  
our judgment of the borrower’s competitive position within its service territory and industry;
-  
our estimate of the potential impact of proposed regulation and litigation; and
-  
other factors specific to individual borrowers or classes of borrowers.
·  
Standard & Poor’s historical corporate bond default table. The table provides expected default rates for all corporate bonds based on rating level and the remaining maturity. We correlate our internal risk ratings to the ratings used in the corporate bond default table. We use the default table to assist in estimating our loan loss allowance because we have limited history from which to develop loss expectations.
·  
Recovery rates. Estimated recovery rates are based on our historical recovery experience by member class calculated by comparing loan balances at the time of default to the total loss recorded on the loan.

At May 31, 2011 and 2010, we had a total of $18,592 million and $18,037 million of loans, respectively, in the general portfolio. This total excludes $227 million and $237 million of loans at May 31, 2011 and 2010, 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, 2011 and 2010, we had a total loss allowance of $99 million and $125 million, respectively, for loans in the general portfolio representing coverage of 0.5 percent and 0.7 percent, respectively, of the total loans for the general portfolio.

In addition to the loan loss allowance for the general portfolio as calculated above, we maintain an unallocated reserve for the general portfolio. Our unallocated reserve has two components:

·  
A single-obligor reserve to cover the additional risk associated with large loan exposures. This unallocated reserve is based on our internal risk ratings and applied to exposures above an established threshold. At May 31, 2011 and 2010, our single-obligor reserve was $25 million and $28 million, respectively.
·  
An economic and environmental reserve to cover factors 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 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. Our Corporate Credit Committee makes a quarterly determination of the percentage to apply to loans in the general portfolio as an additional reserve. This reserve component may be set at up to 10 percent of the amount of the calculated general loan loss allowance for each type of loan exposure. At May 31, 2011, the Corporate Credit Committee set the economic and environmental component of the unallocated reserve to be $0.5 million, representing 7 percent of the general reserve held for telecommunications loans compared with $3 million at May 31, 2010 representing 2 percent of the general reserve held for CFC and NCSC loans and 7 percent of the general reserve held for RTFC loans. At May 31, 2010, the Corporate Credit Committee took into consideration the effect on our borrowers from (i) the economic downturn, (ii) the increase in the unemployment rate, (iii) the decline in the housing market that led to a significant increase in foreclosures and (iv) 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, 2011, the Corporate Credit Committee concluded that these factors continued to affect RTFC borrowers, but that CFC and NCSC borrowers were not significantly affected by the economic downturn and maintained or improved financial ratios. As a result, the Corporate Credit Committee reduced the unallocated reserve for CFC and NCSC loans to zero.

Impaired Loans
A loan is considered to be impaired when we do not expect to collect all principal and interest payments as scheduled by the original loan terms, other than an insignificant delay or an insignificant shortfall in amount. Factors considered in determining impairment may 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,


 
36

 

·  
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.

An impairment loss on a loan receivable is recognized as the difference between the recorded investment in the loan and the present value of the estimated future cash flows associated with the loan discounted at the effective interest rate on the loan at the time of impairment. If the current balance in the receivable is greater than the net present value of the future payments discounted at the effective interest rate at the time the loan became impaired, the impairment is equal to that difference and a portion of the loan loss allowance is specifically reserved based on the calculated impairment. If future cash flows cannot be estimated, the loan is collateral dependent or foreclosure is probable, the impairment is calculated based on the estimated fair value of the collateral securing the loan.

In calculating the impairment on a loan, the estimates of the expected future cash flows or collateral value are the key estimates made by management. Changes in the estimated future cash flows or collateral value affect the amount of the calculated impairment. The change in cash flows required to make the change in the calculated impairment material will be different for each borrower and depend on the period covered, the effective interest rate at the time the loan became impaired 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 loan at the time the loan became impaired.

At May 31, 2011 and 2010, respectively, there was a total specific loan loss allowance balance of $37 million and $437 million for impaired loans totaling $506 million and $1,064 million, representing 7 percent and 41 percent of total impaired loans. The $37 million and $437 million specific loan loss allowance balance represented 23 percent and 74 percent of the total loan loss allowance at May 31, 2011 and 2010, respectively. For certain impaired loans at May 31, 2011 and 2010, the effective interest rate at the time of impairment included a variable-rate component. As a result, the calculated impairment for these loans increases or decreases with changes in short-term and long-term variable interest rates. Based on the current balance of impaired loans at May 31, 2011, 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.

Our policy for recognizing interest income on impaired loans is determined on a case-by-case basis. An impaired loan to a borrower that is non-performing will typically be placed on non-accrual status and we will reverse all accrued and unpaid interest. We generally apply all cash received during the non-accrual period to the reduction of principal, thereby foregoing interest income recognition. Interest income may be recognized on an accrual basis for restructured impaired loans where the borrower is performing and is expected to continue to perform based on agreed-upon terms.

All loans are written off in the period that it becomes evident that collectability is highly unlikely; however, our efforts to recover all charged-off amounts may continue. The determination to write off all or a portion of a loan balance is made based on various factors on a case-by-case basis including, but not limited to, cash flow analysis and the fair value of collateral securing the borrower’s loans.

Fair Value
We 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. Derivative instruments must be recorded on the balance sheet as either an asset or liability measured at fair value. Since these instruments generally do not qualify for hedge accounting, the accounting standards require that we record all changes in fair value through earnings. We record the change in the fair value of derivatives instruments, along with realized gains and losses from cash settlements, in the derivative gain (losses) line item of the consolidated statement of operations each reporting period.

Since 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 estimate 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
 
37

 

derivatives, we would need to estimate all changes to interest rates through the maturity of our outstanding derivatives. The maturities of our derivatives in the current portfolio run through 2045. Since 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 standards on fair value require 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.

In addition to the valuation associated with derivative financial instruments, we also present foreclosed assets at fair value when initially recorded on the balance sheet. Subsequently, foreclosed assets are periodically reviewed for impairment. Our foreclosed assets do not meet the criteria to be classified as held for sale. If an impairment loss is recognized on our foreclosed assets, the adjusted carrying amount of the foreclosed assets becomes the new cost basis. Restoration of any recognized impairment loss is prohibited under GAAP, even when the fair value of the foreclosed assets increases subsequent to our recognition of impairment.

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.

Results of Operations

The following table presents the results of operations for the years ended May 31, 2011, 2010 and 2009.
 
     
For the years ended May 31,
   
Change from previous year
 
(dollar amounts in thousands)
   
2011
   
2010
 
2009
   
2011 vs. 2010
   
2010 vs.
2009
 
Interest income
 
$
1,008,911}
 
$
1,043,635
$
1,070,764
 
$
(34,724)
 
$
(27,129
)
Interest expense
   
  (841,080)
   
  (912,111)
 
(935,021
)
 
71,031}
   
22,910
 
     Net interest income
   
167,831}
   
131,524
 
135,743
   
36,307}
   
(4,219
)
Recovery of (provision for) loan losses
   
83,010}
   
30,415
 
(113,699
)
 
52,595}
   
144,114
 
Net interest income after recovery of (provision for) loan losses
 
250,841}
   
161,939
 
22,044
   
88,902}
   
139,895
 
                               
Non-interest income:
                             
     Fee and other income
   
23,646}
   
17,711
 
13,163
   
5,935}
   
4,548
 
     Settlement income
   
-}
   
22,953
 
-
   
(22,953)
   
22,953
 
     Derivative losses
   
(30,236)
   
(20,608)
 
(47,028
)
 
(9,628)
   
26,420
 
     Results of operations from foreclosed assets
 
(12,028)
   
1,122
 
3,774
   
(13,150)
   
(2,652
)
          Total non-interest income
   
(18,618)
   
21,178}
 
(30,091
)
 
(39,796)
   
51,269
 
                               
Non-interest expense:
                             
     Salaries and employee benefits
   
(42,856)
   
(39,113)
 
(36,865
)
 
(3,743)
   
(2,248
)
     Other general and administrative expenses
   
(28,591)
   
(31,839)
 
(23,977
)
 
3,248}
   
(7,862
)
     Recovery of (provision for) guarantee liability
 
673}
   
5,281
 
(1,615
)
 
(4,608)
   
6,896
 
     Fair value adjustment on foreclosed assets
   
(3,961)
   
(6,591)
 
(8,014
)
 
2,630}
   
1,423
 
     Loss on early extinguishment of debt
   
(3,928)
   
-}
 
-
   
(3,928)
   
-
 
     Other
   
(1,018)
   
(604)
 
(353
)
 
(414)