10-Q 1 w46717e10-q.htm QUARTERLY REPORT e10-q

FORM 10-Q

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

        [X]                          QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended February 28, 2001

OR

         [  ]                         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d)

OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period From            To

Commission File Number 1-7102

NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION
(Exact name of registrant as specified in its charter)

     
DISTRICT OF COLUMBIA       52-0891669
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

Woodland Park, 2201 Cooperative Way, Herndon, VA 20171-3025
(Address of principal executive offices)

Registrant’s telephone number, including the area code (703) 709-6700

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   

Page 1 of 31


PART 1. FINANCIAL INFORMATION

Item 1. Financial Statements.

NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION

COMBINED BALANCE SHEETS

(Dollar Amounts in Thousands)

A S S E T S

                 
(Unaudited)
February 28, 2001 May 31, 2000


Cash and cash equivalents $ 196,780 $ 246,028
Debt service investments 26,875 22,968
Loans to members, net 19,307,859 16,449,753
Receivables 198,005 180,106
Fixed assets, net 46,433 43,672
Debt service reserve funds 86,198 98,870
Other assets 39,989 42,043


$ 19,902,139 $ 17,083,440


The accompanying notes are an integral part of these combined financial statements.

2


NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION

COMBINED BALANCE SHEETS

(Dollar Amounts in Thousands)

L I A B I L I T I E S    A N D    M E M B E R S’    E Q U I T Y

                     
(Unaudited)
February 28, 2001 May 31, 2000


Notes payable, due within one year $ 7,514,549 $ 4,252,166
Accounts payable 15,731 20,145
Accrued interest payable 119,310 125,708
Long-term debt 9,914,104 10,595,596
Other liabilities 2,359 8,191
Quarterly income capital securities 400,000 400,000
Members’ subordinated certificates:
    Membership subordinated certificates 641,985 641,985
    Loan and guarantee subordinated certificates 912,985 698,432


        Total members’ subordinated certificates 1,554,970 1,340,417
Members’ equity 381,116 341,217


Total members’ subordinated certificates and members’ equity 1,936,086 1,681,634


$ 19,902,139 $ 17,083,440


The accompanying notes are an integral part of these combined financial statements.

3


(UNAUDITED)

NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION

COMBINED STATEMENTS OF INCOME, EXPENSES AND NET MARGIN

(Dollar Amounts in Thousands)

For the Quarters and Nine Months Ended February 28, 2001 and February 29, 2000

                                     
Quarters Ended Nine Months Ended
February 28, February 29, February 28, February 29,
2001 2000 2001 2000




Operating income $ 354,692 $ 265,843 $ 1,043,231 $ 735,911
Less: cost of funds 290,425 224,145 849,293 620,146




Gross margin 64,267 41,698 193,938 115,765




Expenses:
General and administrative 7,348 6,070 19,265 17,203
Provision for loan losses 42,100 57,900 17,355




Total expenses 49,448 6,070 77,165 34,558




Operating margin 14,819 35,628 116,773 81,207
Extraordinary item 45 (286 )




Net margin $ 14,864 $ 35,628 $ 116,487 $ 81,207




The accompanying notes are an integral part of these combined financial statements.

4


(UNAUDITED)

NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION

COMBINED STATEMENTS OF CHANGES IN MEMBERS’ EQUITY

(Dollar Amounts in Thousands)

For the Quarters Ended February 28, 2001 and February 29, 2000

                                                   
Patronage Capital
Allocated

Education Unallocated General Reserve
Total Memberships Fund Margin Fund Other






Quarter ended February 28, 2001:
Balance at November 30, 2000 $ 366,273 $ 1,542 $ 903 $ 120,241 $ 500 $ 243,087
Net margin 14,864 14,864
Other (21 ) (1 ) (20 )






Balance at February 28, 2001 $ 381,116 $ 1,541 $ 883 $ 135,105 $ 500 $ 243,087






Quarter ended February 29, 2000:
Balance at November 30, 1999 $ 274,538 $ 1,530 $ 438 $ 47,868 $ 503 $ 224,199
Net margin 35,628 35,628
Other (38 ) 6 (42 ) (2 )






Balance at February 29, 2000 $ 310,128 $ 1,536 $ 396 $ 83,496 $ 503 $ 224,197






The accompanying notes are an integral part of these combined financial statements.

5


(UNAUDITED)

NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION

COMBINED STATEMENTS OF CHANGES IN MEMBERS’ EQUITY

(Dollar Amounts in Thousands)

For the Nine Months Ended February 28, 2001 and February 29, 2000
                                                   
Patronage Capital
Allocated

General
Education Unallocated Reserve
Total Memberships Fund Margin Fund Other






Nine months ended February 28, 2001:
Balance at May 31, 2000 $ 341,217 $ 1,538 $ 927 $ 18,618 $ 500 $ 319,634
Retirement of patronage capital (77,439 ) (77,439 )
Net margin 116,487 116,487
Other 851 3 (44 ) 892






Balance at February 28, 2001 $ 381,116 $ 1,541 $ 883 $ 135,105 $ 500 $ 243,087






Nine months ended February 29, 2000:
Balance at May 31, 1999 $ 294,953 $ 1,535 $ 543 $ 2,289 $ 503 $ 290,083
Retirement of patronage capital (66,445 ) (66,445 )
Net margin 81,207 81,207
Other 413 1 (147 ) 559






Balance at February 29, 2000 $ 310,128 $ 1,536 $ 396 $ 83,496 $ 503 $ 224,197






The accompanying notes are an integral part of these combined financial statements.

6


(UNAUDITED)

NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION

COMBINED STATEMENTS OF CASH FLOWS

(Dollar Amounts in Thousands)

For the Nine Months Ended February 28, 2001 and February 29, 2000
                     
2001 2000


CASH FLOWS FROM OPERATING ACTIVITIES:
Net margin $ 116,487 $ 81,207
Add (deduct):
Provision for loan losses 57,900 17,355
Depreciation 1,710 1,183
Amortization of deferred income (706 ) (1,752 )
Amortization of issuance costs and deferred charges 5,072 4,141
Receivables (24,843 ) (8,442 )
Accounts payable (4,413 ) (642 )
Accrued interest payable (6,398 ) 30,310
Other (23,249 ) (23,520 )


Net cash provided by operating activities 121,560 99,840


CASH FLOWS FROM INVESTING ACTIVITIES:
Advances made on loans (6,765,827 ) (5,506,571 )
Principal collected on loans 3,849,821 3,398,177
Investment in fixed assets (4,471 ) (5,189 )


Net cash used in investing activities (2,920,477 ) (2,113,583 )


CASH FLOWS FROM FINANCING ACTIVITIES:
Notes payable, net 2,346,440 (167,551 )
Debt service investments, net (3,907 ) (3,413 )
Proceeds from issuance of long-term debt 3,140,565 3,321,480
Payments for retirement of long-term debt (2,907,119 ) (1,107,391 )
Extraordinary loss on retirement of long-term debt (286 )
Proceeds from issuance of members’ subordinated certificates 222,588 83,777
Payments for retirement of members’ subordinated certificates 11,349 (26,872 )
Payments for retirement of patronage capital (59,961 ) (55,734 )


Net cash provided by financing activities 2,749,669 2,044,296


NET (DECREASE)/INCREASE IN CASH AND CASH EQUIVALENTS (49,248 ) 30,553
BEGINNING CASH AND CASH EQUIVALENTS 246,028 74,403


ENDING CASH AND CASH EQUIVALENTS $ 196,780 $ 104,956


Supplemental disclosure of cash flow information:
Cash paid during nine-month period for interest $ 865,374 $ 594,931


The accompanying notes are an integral part of these combined financial statements.

7


NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION

NOTES TO COMBINED FINANCIAL STATEMENTS

(1)      General Information and Accounting Policies

        (a) General Information

National Rural Utilities Cooperative Finance Corporation (“CFC”) is a private, not-for-profit cooperative association that provides supplemental financing and related financial service programs for the benefit of its members. Membership is limited to certain cooperatives, not-for-profit corporations, public bodies and related service organizations, as defined in CFC’s Bylaws. CFC is exempt from the payment of Federal income taxes under Section 501(c)(4) of the Internal Revenue Code.

CFC’s 1,048 members as of February 28, 2001 included 902 rural electric utility system members, virtually all of which are consumer-owned cooperatives, 73 service members and 73 associate members. The utility member systems included 832 distribution systems and 70 generation and transmission systems operating in 49 states and three U.S. territories.

Rural Telephone Finance Cooperative (“RTFC”) was incorporated as a private cooperative association in the State of South Dakota in September 1987. RTFC is a controlled affiliate of CFC and was created for the purpose of providing, securing and arranging financing for its rural telecommunications members and affiliates. RTFC’s results of operations and financial condition have been combined with those of CFC in the accompanying financial statements. As of February 28, 2001, RTFC had 515 members other than CFC. RTFC is a taxable entity under Subchapter T of the Internal Revenue Code and accordingly takes tax deductions for allocations of net margins to its patrons.

Guaranty Funding Corporation (“GFC”) was incorporated as a private cooperative in the State of South Dakota in December 1991. GFC operations ceased on January 31, 2001. GFC was a controlled affiliate of CFC and was created for the purpose of providing and servicing loans to its members to fund the refinancing of loans guaranteed by the Rural Utility Service (“RUS”). All loans held by GFC had been transferred by CFC. At January 31, 2001, GFC had loans outstanding to one borrower totaling $45 million. These loans were transferred back to CFC. The discontinuation of GFC activities will have no impact on the CFC and RTFC combined results of operations. All GFC loans were funded by loans from CFC to GFC. The shutdown of GFC will not have an impact on the CFC combined financial statements. The $45 million of loans outstanding were transferred from GFC to CFC upon dissolution. GFC’s net margin was derived primarily from the fees collected for trust service activities. CFC will now become the servicer for the grantor trusts.

In the opinion of management, the accompanying combined financial statements contain all adjustments (which consist only of normal recurring accruals) necessary to present fairly the combined financial position of CFC and RTFC as of February 28, 2001 (unaudited) and May 31, 2000, and the combined results of operations, cash flows and changes in members’ equity for the nine months ended February 28, 2001 (unaudited) and February 29, 2000 (unaudited).

The Notes to Combined Financial Statements for the years ended May 31, 2000 and 1999 should be read in conjunction with the accompanying financial statements. (See CFC’s Form 10-K for the year ended May 31, 2000, filed on August 29, 2000).

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the assets, liabilities, revenues and expenses reported in the financial statements, as well as amounts included in the notes thereto, including discussion and disclosure of contingent liabilities. While CFC uses its best estimates and judgments based on the known facts at the date of the financial statements, actual results could differ from these estimates as future events occur.

CFC does not believe it is vulnerable to the risk of a near term severe impact as a result of any concentrations of its activities.

8


        (b) Principles of Combination

The accompanying financial statements include the combined accounts of CFC and RTFC, after elimination of all material intercompany accounts and transactions. CFC has a $1,000 membership interest in RTFC. CFC exercises control over RTFC through permanent majority representation on their Board of Directors. CFC manages the affairs of RTFC through a long-term management agreement. As of February 28, 2001, CFC had committed to lend RTFC up to $10 billion to fund loans to its members and their affiliates.

RTFC had outstanding loans and unadvanced loan commitments totaling $6,789 million and $4,994 million as of February 28, 2001 and May 31, 2000, respectively. RTFC’s net margin is allocated to RTFC’s borrowers. Summary financial information relating to RTFC is presented below:

                 
(Unaudited)
(Dollar amounts in thousands) February 28, 2001 May 31, 2000


Outstanding loans to members and their affiliates $ 5,284,968 $ 3,699,728
Total assets 5,755,698 3,975,990
Notes payable to CFC 5,263,312 3,679,822
Total liabilities 5,321,690 3,727,438
Members’ subordinated certificates 389,205 213,734
Members’ equity (1) 44,803 34,818
                         
(Unaudited)
For the nine months ended
February 28, February 29,
(Dollar amounts in thousands) 2001 2000


Operating income 312,101 170,069
Net margin (1) 2,903 2,592


(1)     The transfer of RTFC equity is governed by the South Dakota Cooperative Association Act, which provides that net margin shall be distributed and paid to patrons. However, reserves may be created and credited to patrons in proportion to total patronage. CFC has been the sole funding source for RTFC’s loans to its members. As CFC is not a borrower of RTFC and is not expected to be in the foreseeable future, RTFC’s net margin would not be available to CFC in the form of patronage capital.

Unless stated otherwise, references to CFC relate to CFC and RTFC on a combined basis.

        (c) Derivative Financial Instruments

CFC is neither a dealer nor a trader in derivative financial instruments. CFC uses interest rate and currency exchange agreements to manage its interest rate risk and foreign exchange risk. CFC accounts for these agreements on an accrual basis. CFC does not value the interest rate exchange agreements on its balance sheet, but values the underlying hedged debt at cost. CFC does not recognize a gain or loss on these agreements, but includes the difference between the interest rate paid and interest rate received in the overall cost of funding. In the event that an agreement was terminated early, CFC would record the fee paid or received due to the early termination as part of the overall cost of funding.

In June 1998, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 133, Accounting for Derivative Instruments and Hedging Activities. In June 1999, the FASB issued Statement No. 137, Accounting for Derivative Instruments and Hedging Activities —Deferral of the Effective Date of FASB Statement No. 133. In June 2000, the FASB issued Statement No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, an amendment of FASB Statement No. 133. Statement No. 133, as amended, establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded on the balance sheet as either an asset or liability measured at its fair value. The Statement requires that changes in the derivative instrument’s fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative instrument’s gains and losses to offset related results on the hedged item in the income statement or to be included in other comprehensive income, to the extent effective, and requires that a company formally document, designate, and assess the effectiveness of transactions that receive hedge accounting. The statement is effective for all fiscal years beginning after June 15, 2000. CFC will be required to implement this statement as of June 1, 2001. CFC has not yet quantified all effects of adopting Statement No. 133 on its financial statements.

9


(2)      Debt Service Account

A provision of the 1972 indenture between CFC and U.S. Bank Trust National Association as trustee requires monthly deposits into a debt service account held by the trustee, generally in amounts equal to one-twelfth of the total annual interest payments, annual sinking fund payments and the principal amount of bonds maturing within one year. These deposits may be invested in permitted investments, as defined in the indenture (generally bank certificates of deposit and prime-rated commercial paper).

On February 15, 1994, CFC completed a collateral trust bond indenture with U.S. Bank Trust National Association as trustee. This indenture does not require the maintenance of a debt service account. All collateral trust bonds issued since that date and all future collateral trust bonds will be issued under this new indenture.

(3)      Loans Pledged as Collateral to Secure Collateral Trust Bonds

As of February 28, 2001 and May 31, 2000, mortgage notes representing approximately $4,780 million and $3,484 million, respectively, related to outstanding long-term loans to members, were pledged as collateral to secure collateral trust bonds. Both the 1972 indenture and the 1994 indenture require that CFC pledge eligible mortgage notes (or other permitted assets) as collateral that at least equal the outstanding balance of collateral trust bonds. Under CFC’s revolving credit agreement (see footnote 6), CFC cannot pledge mortgage notes in excess of 150% of collateral trust bonds outstanding. Collateral trust bonds outstanding at February 28, 2001 and May 31, 2000 were $3,346 million and $3,351 million, respectively.

(4)      Allowance for Loan Losses

CFC maintains an allowance for loan losses at a level considered to be adequate in relation to the quality and size of its loan and guarantee portfolio. CFC makes regular additions to the allowance for loan losses. These additions are required to maintain the allowance at an adequate level based on the current year to date increase to loans outstanding and the estimated loan growth for the next twelve months. On a quarterly basis, CFC reviews the adequacy of the loan loss allowance and estimates the amount of future provisions that will be required to maintain the allowance at an adequate level based on estimated loan growth. The allowance is based on estimates, and accordingly, actual loan losses may differ from the allowance amount.

Activity in the allowance account is summarized as follows for the nine months ended February 28, 2001 and the year ended May 31, 2000.

                   
(Dollar amounts in thousands) February 28, 2001 May 31, 2000


Balance at beginning of year $ 228,292 $ 212,203
Provision for loan losses 57,900 17,355
Charge-offs (1,266 )


Balance at end of quarter $ 286,192 $ 228,292


Loan loss allowance as a percentage of:
Gross loans 1.46 % 1.37 %
Gross loans and guarantees 1.32 % 1.22 %
Total non-performing and restructured loans 19.85 % 39.94 %

(5)      Members’ Subordinated Certificates

Members’ subordinated certificates are subordinated obligations purchased by members as a condition of membership and in connection with CFC’s extension of long-term loans and guarantees. Those issued as a condition of membership (subscription capital term certificates) generally mature 100 years from issuance date and bear interest at 5% per annum. Those issued as a condition of receiving a loan or guarantee generally mature at the same time as the loan or guarantee or amortize proportionately based on the principal balance of the credit extended, and are non-interest bearing or bear interest at varying rates.

The proceeds from certain non-interest bearing subordinated certificates issued in connection with CFC’s guarantees of member’s tax-exempt bonds are pledged by CFC to the debt service reserve fund established in connection with the bond issue. Any earnings from the investment of the debt service reserve fund inure solely to the benefit of the member.

10


(6)      Credit Arrangements

As of February 28, 2001, CFC had three revolving credit agreements totaling $7,040 million. These revolving credit agreements are used principally to provide liquidity support for CFC’s outstanding commercial paper. In addition, these revolving credit agreements provide liquidity support for both the commercial paper issued by the National Cooperative Services Corporation (“NCSC”) and guaranteed by CFC, and the adjustable or floating rate bonds, which CFC has guaranteed and is standby purchaser for the benefit of its members.

Under a five-year agreement executed in November 1996, CFC can borrow $2,403 million until November 26, 2001. J.P. Morgan Securities Inc. and The Bank of Nova Scotia were Co-Syndication Agents, and Chase Manhattan Bank is the Administrative Agent for this agreement with 52 banks. Any amounts outstanding under the multi-year facility will be due on the maturity date. On August 10, 2000, a 364-day agreement for $4,087 million was executed with 34 banks including: Chase Manhattan Bank as Administrative Agent, Bank of America, N.A. as Syndication Agent, The Bank of Nova Scotia and Banc One, N.A. as Co-Documentation Agents and Chase Securities Inc. and Bank of America Securities LLC as Joint Lead Arrangers. A third revolving credit agreement for $550 million was also executed on August 10, 2000 with ten banks, including The Bank of Nova Scotia as Arranger and Administrative Agent and Banc One, N.A. as Documentation Agent. Both of the 364-day agreements have a revolving credit period that terminates on August 9, 2001 during which CFC can borrow and such borrowings may be converted to a one-year term loan at the end of the revolving credit period.

In connection with the five-year facility, CFC pays a per annum facility fee of .090 of 1%. The per annum facility fee for both agreements with a 364-day maturity is .085 of 1%. There is no commitment fee for any of the long-term revolving credit facilities; however, up front fees between .010 and .040 of 1% were paid to banks in the 364-day agreements based on their level of commitment. If CFC’s senior secured debt ratings decline below AA- or Aa3 and amounts outstanding exceed 50% of the total commitment, the facility fees may be replaced with a utilization fee of .125 of 1%. Generally, pricing options are the same under all three agreements and will be at one or more rates as defined in the agreements, as selected by CFC.

The multi-year revolving credit agreement requires CFC, among other things, to maintain members’ equity and members’ subordinated certificates of at least $1,418 million at May 31, 2000 (increased each fiscal year by 90% of net margin not distributed to members). The revolving credit agreements require CFC to achieve an average fixed charge coverage ratio over the six most recent fiscal quarters of at least 1.025 and prohibit the retirement of patronage capital unless CFC has achieved a fixed charge coverage ratio of at least 1.05 for the preceding fiscal year. The revolving credit agreements prohibit CFC from incurring senior debt in an amount in excess of ten times the sum of members’ equity, members’ subordinated certificates and quarterly income capital securities (“QUICS”). Senior debt includes guarantees; however, it excludes:

  guarantees to members where either the long-term unsecured debt of the member is rated at least BBB+ by Standard & Poor’s Corporation or Baa1 by Moody’s Investors Service;
  indebtedness incurred to fund RUS guaranteed loans; or
  the payment of principal and interest by the member on the guaranteed indebtedness if covered by insurance or reinsurance provided by an insurer having an insurance financial strength rating of AAA by Standard & Poor’s Corporation or a financial strength rating of Aaa by Moody’s Investors Service.

The revolving credit agreements also restrict, with certain exceptions, the creation by CFC of liens on its assets and certain other conditions to borrowing. The agreements also prohibit CFC from pledging collateral in excess of 150% of the principal amount of collateral trust bonds outstanding. CFC may borrow under the agreements until the termination dates provided that CFC is in compliance with these financial covenants and is not in default under these agreements. Compliance with the financial covenants includes that CFC has no material contingent or other liability or material litigation not disclosed or reserved against in its most recent annual and quarterly financial statements. As of February 28, 2001 and May 31, 2000, CFC was in compliance with all covenants and conditions under its revolving credit agreements, and there were no borrowings outstanding under such agreements.

Based on the ability to borrow under the 364-day facilities, CFC classified $4,637 million and $5,493 million, respectively, of its notes payable outstanding as long-term debt at February 28, 2001 and May 31, 2000. CFC expects to maintain more than $4,637 million of notes payable outstanding during the next twelve months. If necessary, CFC can refinance such notes payable on a long-term basis by borrowing under the 364-day facilities, subject to the conditions therein.

11


(7)      Unadvanced Loan Commitments

As of February 28, 2001 and May 31, 2000, CFC had unadvanced loan commitments, summarized by type of loan.

                   
February 28, 2001 May 31, 2000


Long-term $ 7,715,412 $ 7,524,197
Intermediate-term 461,498 457,177
Short-term 4,521,656 4,403,987
Telecommunications 1,504,257 1,313,486


Total unadvanced loan commitments $ 14,202,823 $ 13,698,847


Unadvanced commitments include loans approved by CFC for which loan contracts have not yet been executed and for which loan contracts have been executed but funds have not been advanced. CFC may require additional information to assure itself that all conditions for advance of funds have been fully met and that there has been no material change in the member’s condition as represented in the documents supplied to CFC. Since commitments may expire without being fully drawn upon and a significant amount of the commitments are for standby liquidity purposes, the total unadvanced loan commitments do not necessarily represent future cash requirements. Collateral and security requirements for loan commitments are identical to those for advanced loans.

(8)      Retirement of Patronage Capital

CFC patronage capital in the amount of $77 million was retired in August 2000, representing 70% of the allocation for fiscal year 2000 and one-ninth of the total allocations for fiscal years 1991, 1992 and 1993. The $77 million includes $17 million retired to RTFC. RTFC retired $19 million in January 2001 representing 70% of its fiscal year 2000 allocation. Future retirements of patronage capital allocated to patrons may be made annually as determined by CFC’s and RTFC’s Boards of Directors with due regard for CFC’s and RTFC’s financial condition.

(9)      Guarantees

As of February 28, 2001 and May 31, 2000, CFC had guaranteed the following contractual obligations of its members.

                   
February 28, 2001 May 31, 2000


Long-term tax exempt bonds (1) $ 985,235 $ 1,024,340
Debt portions of leveraged lease transactions (2) 104,557 111,319
Indemnifications of tax benefit transfers (3) 238,025 259,223
Letters of credit (4) 359,565 275,995
Other guarantees (5) 396,232 274,325


Total $ 2,083,614 $ 1,945,202



(1)   CFC has unconditionally guaranteed to the holders or to trustees for the benefit of holders of these bonds the full principal, premium, if any, and interest on each bond when due. In the event of default by a system for nonpayment of debt service, CFC is obligated to pay any required amount under its guarantee to prevent the acceleration of the bond issue. The system is required to repay, on demand, any amount advanced by CFC and interest thereon pursuant to its guarantee. This repayment obligation is secured by a common mortgage with RUS on all of the system’s assets, but CFC may not exercise remedies thereunder for up to two years. However, if the debt is accelerated because of a determination that the interest thereon is not tax-exempt, the system’s obligation to reimburse CFC for any guarantee payments will be treated as a long-term loan. Of the amounts shown above, $891 million and $920 million as of February 28, 2001 and May 31, 2000, respectively, are adjustable or floating rate bonds. The floating interest rate on such bonds may be converted to a fixed rate as specified in the indenture for each bond offering. During the variable rate period (including at the time of conversion to a fixed rate), CFC has unconditionally agreed to purchase bonds tendered or called for redemption if the remarketing agents have not previously sold such bonds to other purchasers.
(2)   CFC has guaranteed debt issued by NCSC in connection with leveraged lease transactions. The amounts shown represent loans from NCSC to a trust for the benefit of an industrial or financial company for the purchase of a power plant or utility equipment that was subsequently leased to a CFC member. The loans are secured by the property leased and the owner’s rights as lessor.
(3)   CFC has unconditionally guaranteed to lessors certain indemnity payments, which may be required to be made by the lessees in connection with tax benefit transfers. The amounts shown represent CFC’s maximum potential liability at February 28, 2001 and May 31, 2000. However, the amounts of such guarantees vary over the lives of the leases. A member’s obligation to reimburse CFC for any guarantee payments would be treated as a long-term loan, secured pari passu 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 an intermediate-term loan secured by a subordinated mortgage on substantially all of the member’s property.
(4)   CFC issues irrevocable letters of credit to support members’ obligations to energy marketers, other third parties and to the Rural Business and Cooperative Development Service. Letters of credit are generally issued on an unsecured basis and with such issuance fees as may be

12


    determined from time to time. Each letter of credit issued by CFC is supported by a reimbursement agreement with the member on whose behalf the letter of credit was issued. In the event a beneficiary draws on a letter of credit, the agreement generally requires the member to reimburse CFC within one year from the date of the draw. Interest would accrue from the date of the draw at CFC’s variable rate of interest in effect on such date. The agreement also requires the member to pay, as applicable, a late payment charge and all costs of collection, including reasonable attorneys’ fees.
(5)   At February 28, 2001 and May 31, 2000, CFC had unconditionally guaranteed commercial paper issued by NCSC in the amount of $274 million and $171 million, respectively.

(10)      Derivative Financial Instruments

At February 28, 2001 and May 31, 2000, CFC was a party to interest rate exchange agreements with notional amounts totaling $6,396 million and $4,817 million, respectively. CFC uses interest rate exchange agreements as part of its overall interest rate matching strategy. Interest rate exchange agreements are used when they provide CFC a lower cost of funding or minimize interest rate risk. CFC will only enter into interest rate exchange agreements with highly rated financial institutions. At February 28, 2001 and May 31, 2000, CFC was using interest rate exchange agreements to fix the interest rate on $2,618 million and $2,461 million, respectively, of its variable rate commercial paper. Interest rate exchange agreements were used to swap fixed interest rates with variable interest rates on $525 million of collateral trust bonds as of February 28, 2001 and May 31, 2000. CFC was also using interest rate exchange agreements at both dates to minimize the variance between the three month LIBOR rate and CFC’s variable commercial paper rate totaling $3,253 million and $1,831 million at February 28, 2001 and May 31, 2000, respectively. All of CFC’s derivative financial instruments were held for purposes other than trading. CFC has not invested in derivative financial instruments for trading purposes in the past and does not anticipate doing so in the future.

The following table lists the notional principal amounts of CFC’s interest rate exchange agreements at February 28, 2001 and May 31, 2000.

                                                 
(Dollar amount in thousands)
Notional Principal Amount Notional Principal Amount


February 28, May 31, February 28, May 31,
2001 2000 2001 2000




June 2000 (2) $              — $ 675,000 October 2004 (3) $ 144,700 $ 150,700
July 2000 (2) 301,363 November 2004 (3) 118,000 122,000
August 2000 (3) 190,000 January 2005 (3) 8,000 8,000
September 2000 (3) 206,140 April 2005 (3) 97,820 97,820
September 2000 (2) 54,270 August 2005 (3) 475,000
October 2000 (3) 20,000 November 2005 (3) 274,313
January 2001 (3) 65,749 April 2006 (3) 100,000 100,000
January 2001 (2) 500,000 September 2007 (3) 78,900
February 2001 (3) 300,000 January 2008 (3) 14,000 14,000
June 2001 (2) 600,000 July 2008 (3) 40,400 40,400
July 2001 (2) 1,000,000 September 2008 (3) 64,320 66,410
September 2001 (3) 34,810 34,810 October 2008 (3) 33,512 33,512
February 2002 (2) 953,000 April 2009 (3) 29,700 29,700
May 2002 (2) 300,000 300,000 September 2010 (3) 43,000
August 2002 (2) 400,000 January 2012 (3) 13,000 13,000
January 2003 (3) 22,375 22,375 February 2012 (3) 8,500 9,000
February 2003 (1) 525,000 525,000 December 2013 (3) 173,300 173,300
April 2003 (3) 75,000 75,000 June 2018 (3) 5,000 5,000
June 2003 (3) 48,000 48,000 September 2020 (3) 43,000
August 2003 (3) 100,000 100,000 December 2026 (3) 48,185 48,185
September 2003 (3) 91,230 91,230 September 2028 (3) 117,100 118,440
October 2003 (3) 50,439 68,576 April 2029 (3) 66,000 66,000
November 2003 (3) 274,312 September 2030 (3) 43,000


September 2004 (3) 12,355 15,080 $ 6,396,271 $ 4,817,060



(1)   Under these agreements, CFC pays a variable rate of interest and receives a variable rate of interest.
(2)   Under these agreements, CFC pays a fixed rate of interest and receives a variable rate of interest.

13


(3)   Under these agreements, CFC pays a variable rate of interest and receives interest based on a fixed rate.

CFC does not value the interest rate exchange agreements on its balance sheet, but rather values the underlying hedged debt instruments at historical cost. All amounts that CFC pays and receives related to the interest rate exchange agreements and the underlying hedged debt instruments are included in CFC’s cost of funding for the period. In all interest rate exchange agreements, CFC receives the amount required to service the debt outstanding to its investors from the counterparty to the agreement. The estimated fair value of CFC’s interest rate exchange agreements is presented in the footnotes to the financial statements of CFC’s Form 10-K for the year ended May 31, 2000.

CFC closely matches the terms of its interest rate exchange agreements with the terms of the underlying debt instruments. Therefore, it is unlikely that CFC would prepay debt that is hedged or have hedged debt mature prior to the maturity of the interest rate exchange agreement. However, circumstances may arise that cause either CFC or the counterparty to the agreement to exit such agreement. In the event of such actions, CFC would record a gain or loss from the termination of the interest rate exchange agreement.

During the nine months ended February 28, 2001, CFC issued commercial paper to European investors in foreign currencies. The following chart provides details of the foreign currency swap that CFC had outstanding at February 28, 2001.

                                         
(Currency amounts in thousands)
Type of Debt (1) Issue Date Maturity Date U.S. Dollars Foreign Currency (2) Rate






MTN February 24, 1999 February 24, 2006 $ 390,250 350,000 EU 1.115


(1)   MTN — CFC medium-term notes
(2)   EU — Euros

CFC entered into a swap to sell the amount of foreign currency received from the investor for U.S. dollars on the issuance date and to buy the amount of foreign currency required to repay the investor principal and interest due through or on the maturity date. By locking in the exchange rates at the time of issuance, CFC has eliminated the possibility of any currency gain or loss, which might otherwise have been produced by the foreign currency borrowing. CFC includes the difference between the amount of U.S. dollars received at issuance and the amount of U.S. dollars required to purchase the foreign currency at the interest payment dates and at maturity as interest expense.

Principal and interest is paid at maturity, which ranges from 1 day to 270 days on CFC commercial paper investments. Interest is paid annually on foreign currency denominated medium-term notes with maturities longer than one year. CFC considers the cost of all related foreign currency swaps as part of the total cost of debt issuance when deciding on whether to issue debt in the U.S. or foreign capital markets and whether to issue the debt denominated in U.S. dollars or foreign currencies.

(11)      Contingencies

(a) At February 28, 2001 and May 31, 2000, CFC had restructured loans in the amount of $552 million and $572 million, respectively, which were on an accrual status with respect to the recognition of interest income. CFC accrued a total of $23 million and $11 million of interest income on restructured loans during the nine months ended February 28, 2001 and February 29, 2000, respectively. At February 28, 2001, CFC had a total of $889 million of loans classified as non-perfoming, which were on non-accrual status with respect to the recognition of interest income. At May 31, 2000, CFC had no loans classified as non-performing.

(b) CFC classified $1,441 million and $572 million, respectively, of the amount described in footnote 11(a) as impaired with respect to the provisions of FASB Statements No. 114 and 118 at February 28, 2001 and May 31, 2000. CFC had allocated $155 million and $85 million of the loan loss allowance for such impaired loans at February 28, 2001 and May 31, 2000, respectively. The amount of loan loss allowance allocated for such loans was based on a comparison of the present value of the expected future cash flow associated with the loan and/or the estimated fair value of the collateral securing the loan to the recorded investment in the loan. CFC accrued interest income totaling $23 million and $11 million on loans classified as impaired during the nine months ended February 28, 2001 and February 29, 2000, respectively. The average recorded investment in

14


impaired loans for the nine months ended February 28, 2001 was $761 million compared to $578 million for the year ended May 31, 2000.

(c) Deseret Generation & Transmission Co-operative (“Deseret”) is a power supply member of CFC located in Utah. Deseret owns and operates the Bonanza generating plant (“Bonanza”) and owns a 25% interest in the Hunter generating plant along with a system of transmission lines. Deseret also owns and operates a coal mine through its Blue Mountain Energy subsidiary. Due to large anticipated increases in demand for electricity, the Bonanza site was designed for two plants and Deseret built the infrastructure to support two plants, although only one plant has been built to date. When the large increases in demand never materialized, Deseret was unable to make the debt payment obligations on the Bonanza plant and debt service payments to RUS. As a consequence, Deseret and its creditors entered into several restructuring agreements.

In 1991, Deseret and its creditors signed the Agreement Restructuring Obligations (“ARO”), which restructured Deseret’s obligations to CFC, RUS and certain other creditors. Deseret was unable to meet the payment schedule established by the ARO, which resulted in the agreement being amended by a second agreement. In 1996, Deseret and CFC entered into an Obligations Restructuring Agreement (“ORA”). Under the ORA, Deseret agreed to make quarterly minimum payments and to share excess cash flow with CFC through December 31, 2025, while CFC agreed to forbear from exercising any remedies. CFC continued to pay and perform on all of the obligations it had guaranteed for Deseret. In connection with the ORA, on October 16, 1996, CFC acquired all of Deseret’s indebtedness in the outstanding principal amount of $740 million from RUS for the sum of $239 million. The member systems of Deseret purchased from CFC, for $55 million, a participation interest in the RUS debt. The participation agreement allows the Deseret member distribution systems to put the participations back to CFC unconditionally on December 31, 2019.

Certain other creditors brought litigation regarding the CFC Deseret agreement. In December 1998, all parties to the litigation entered into a settlement arrangement. The settlement arrangement allowed CFC to effect the early redemption of the Bonanza Secured Lease Obligation Bonds, which were outstanding at an interest rate in excess of 9%. The settlement arrangement also resulted in an amendment of the Deseret cash flow payments in the final years of the agreement.

In March 1998, the cities of Riverside, California and Anaheim, California, brought Federal Energy Regulatory Commission (“FERC”) and civil actions against Deseret. All of these actions were dismissed in April 2000, with no material impact on Deseret’s ability to meet its annual payment requirements under the ORA.

At February 28, 2001 and May 31, 2000, CFC had the following exposure to Deseret.

                   
(Dollar amounts in thousands) February 28, 2001 May 31, 2000


Loans outstanding (1) $ 552,275 $ 571,579
Guarantees outstanding:
Tax benefit transfers 1,470 2,300
Mine equipment leases 42,381 46,795
Letters of credit 71,171 40,159


Total guarantees 115,022 89,254


Total exposure $ 667,297 $ 660,833



(1)   As of February 28, 2001, the loan balance of $552 million to Deseret is comprised of $177 million of cash flow shortfalls related to Deseret’s debt service and rental obligations guaranteed by CFC, $266 million related to the redemption of the Bonanza secured lease obligation bonds, $81 million related to the purchase of RUS loans, $18 million related to the original CFC loan to Deseret and $10 million related to the settlement of the foreclosure litigation.

Deseret has made all payments required by the ORA.  CFC received minimum cash flow payments totaling $31 million and excess cash payments totaling $10 million during the year ended May 31, 2000. During calendar year 2000, Deseret made quarterly payments totaling $38 million and excess cash payments totaling $27 million.

Based on its analysis, CFC believes that it has adequately reserved for any potential loss on its loans and guarantees to Deseret.

(d) At February 28, 2001, CFC had a total of $889 million in loans outstanding to Denton County Electric Cooperative, Inc., (d/b/a CoServ Electric), a large electric distribution cooperative representing 4.1% of CFC’s total

15


loans and guarantees outstanding. As of January 1, 2001, CFC classified all loans to CoServ Electric (“CoServ”) as non-performing and placed them on non-accrual status with respect to the recognition of interest income.

CoServ provides retail electric service to residential and business customers in an area where there has been significant residential and commercial growth in and adjacent to its current service territory over the last few years. CoServ adopted a strategy to provide a broad range of utility and other related services to consumers both in its service territory and the newly developing areas adjacent to its service territory. The non-electric services are generally provided through its controlled affiliates, which have been funded primarily through advances from CoServ, and include natural gas, home-security, cable television and a variety of telecommunications services. CoServ has also made substantial loans to and equity investments in residential and commercial real estate development projects. CFC loans to CoServ are secured primarily by assets and revenues of the electric distribution system. There is competition for substantially all services provided in the CoServ service territory.

On March 16, 2001, CFC and CoServ signed a master restructure agreement. The agreement restructures debt obligations of CoServ totaling $906 million over the next 35 years, $889 million of loans outstanding and $17 million of unpaid interest through the closing date. All obligations under the agreement are secured by a first priority lien on substantially all of the assets and revenues of CoServ and its major subsidiaries. Substantially all of the obligations are cross-collateralized and have cross-default provisions. CFC also agreed to lend additional amounts to CoServ to fulfill existing real estate commitments, to continue building out telecommunications infrastructure, as well as to provide the majority of future capital expenditure requirements for the electric distribution system. Based on the terms of the restructure agreement, CFC anticipates that the loan balance outstanding to CoServ will reach a maximum of just over $1 billion during CFC’s fiscal year 2002 and then begin to decline.

The key terms of the restructure agreement are as follows:

  Real estate projects — CFC will directly receive all payments of principal and interest from these project loans with the exception of an annual 12.5 basis point fee, based on the balance at the beginning of the year. Substantially all real estate obligations are scheduled to be repaid by 2010.
  Utility systems — CFC will receive quarterly payments for the next 35 years.
  Additional CFC loans — CFC agreed to make additional loans available to CoServ. These additional loans include a revolving line of credit and long-term loans. The advance of funds may be contingent upon certain conditions, including CoServ’s compliance with all conditions of the restructure agreement. The majority of these additional long-term loans to the utility systems will have 35-year maturities and will carry the then current CFC interest rates. The payments of principal and interest on these loans will be joint obligations of CoServ and its major subsidiaries in addition to the obligations described above.
  Asset dispositions — CoServ’s obligations to CFC will be reduced by the proceeds from the disposition of any assets by CoServ and its major subsidiaries.
  Deferred interest — CoServ will provide CFC with a $9 million note payable with a 35-year maturity and a standard CFC interest rate. This note payable is provided to CFC in return for deferring interest on all loans from the closing date through June 30, 2001.

CFC will keep the loans to CoServ on non-accrual status through May 31, 2001. The quarterly payments from CoServ will begin in September 2001. CFC will re-evaluate placing the loans on accrual status in fiscal year 2002 based on CoServ’s performance and the level of proceeds received from asset sales.

Based on the above restructured terms, estimated cashflow payments and asset sales by CoServ and the additional provision made to the loan loss reserve in the third quarter, CFC believes that it is adequately reserved against loss on its loans to CoServ.

(e) At February 28, 2001, two additional borrowers were in payment default to CFC on an unsecured loan totaling $1 million and a partially secured loan totaling $16 million. At May 31, 2000, no borrowers were in payment default.

(12)      Segment Information

CFC operates in two business segments – rural electric lending and rural telecommunications lending. Summary financial information relating to each segment is presented below.

16


The information reviewed by management on a regular basis is the combined financial statements and the stand-alone RTFC financial statements. The information presented below includes the stand-alone RTFC financial statements for the telecommunications systems, the combined financial statements as the total and the difference between the RTFC and the combined is presented for the electric systems. All activity is with electric or telecommunications systems.

RTFC is an associate member of CFC and CFC is the sole funding source for RTFC. RTFC borrows from CFC and then relends to the telecommunications systems. Included as part of the interest rate on the loans from CFC, RTFC pays an administrative fee to CFC for work performed by CFC staff. RTFC does not maintain a loan loss allowance, but CFC maintains a loss allowance on its loans to RTFC.

The following chart contains the income statement for the nine months ended February 28, 2001 and the total assets at February 28, 2001.

                           
(Dollar amounts in thousands) Electric Systems Telecommunications Systems Total Combined



Income statement:
Operating income $ 731,130 $ 312,101 $ 1,043,231
Cost of funds 540,546 308,747 849,293



Gross margin 190,584 3,354 193,938



Operating expenses 18,814 451 19,265
Loan loss provision 57,900 57,900



Total expenses 76,714 451 77,165



Net margin before extraordinary item 113,870 2,903 116,773
Extraordinary item (286 ) (286 )



Net margin $ 113,584 $ 2,903 $ 116,487



Assets:
Loans outstanding, net (1) $ 14,100,077 $ 5,207,782 $ 19,307,859
Other assets 123,550 470,730 594,280



Total assets $ 14,223,627 $ 5,678,512 $ 19,902,139




(1)   Net loans are calculated by prorating the loan loss allowance and subtracting this allowance from gross loans outstanding.

The following chart contains the income statement for the nine months ended February 29, 2000 and the total assets at February 29, 2000.

                           
(Dollar amounts in thousands) Electric Systems Telecommunications Systems Total Combined



Income statement:
Operating income $ 565,804 $ 170,107 $ 735,911
Cost of funds 452,988 167,158 620,146



Gross margin 112,816 2,949 115,765



Operating expenses 16,846 357 17,203
Loan loss provision 17,355 17,355



Total expenses 34,201 357 34,558



Operating margin 78,615 2,592 81,207
Net margin before extraordinary item



Net margin $ 78,615 $ 2,592 $ 81,207



Assets:
Loans outstanding, net (1) $ 12,210,667 $ 3,371,571 $ 15,582,238
Other assets 243,343 243,039 486,382



Total assets $ 12,454,010 $ 3,614,610 $ 16,068,620




(1)   Net loans are calculated by prorating the loan loss allowance and subtracting this allowance from gross loans outstanding.

17


Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations.
              (Dollar amounts in millions)

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

Financial Condition

At February 28, 2001, CFC had $19,902 in total assets, an increase of $2,819 or 17% over May 31, 2000. Net loans outstanding to members totaled $19,308 at February 28, 2001 an increase of $2,858 compared to a total of $16,450 at May 31, 2000. Net loans represented 97% and 96% of total assets at February 28, 2001 and May 31, 2000, respectively. The remaining assets, $594 and $633 at February 28, 2001 and May 31, 2000, respectively, consisted of other assets to support CFC’s operations. Except as required for the debt service account and unless excess cash is invested overnight, CFC does not generally use funds to invest in debt or equity securities.

The following chart provides a breakout of the loans outstanding by member class and loan program.

                           
February 28, 2001 May 31, 2000 Increase/ (Decrease)



Long-term loans:
Electric $ 11,045 $ 10,693 $ 352
Telephone 4,920 3,358 1,562



Total long-term loans 15,965 14,051 1,914
Intermediate-term loans:
Electric 292 343 (51 )
Telephone 14 12 2



Total intermediate-term loans 306 355 (49 )
Short-term loans:
Electric 1,381 1,281 100
Telephone 351 330 21



Total short-term loans 1,732 1,611 121
RUS guaranteed loans 150 89 61
Non-performing and restructured loans 1,441 572 869



Total loans 19,594 16,678 2,916
Loan loss allowance (286 ) (228 ) (58 )



Net loans $ 19,308 $ 16,450 $ 2,858



Percentage of loans with a fixed interest rate 51 % 53 %
Percentage of loans with a variable interest rate 49 % 47 %
Percentage of long-term loans 90 % 88 %
Percentage of short-term loans 10 % 12 %

The increase in loans outstanding resulted primarily from increased levels of lending to rural telecommunications systems for the acquisition of rural exchange assets. In addition, CFC loan advances have increased due to the following reasons: (1) the generally strong economy over the past few years, which has spurred construction and business development; (2) RUS waiting periods, which caused more borrowers to buyout their RUS debt and/or make greater use of CFC 100% loan funds; (3) a large number of systems have bought out their RUS debt over the last few years, requiring them to seek non-RUS financing; and (4) some borrowers have begun to expand and diversify their operations through acquisitions and mergers.

Long-term loans represented 90% and 88% of loans outstanding at February 28, 2001 and May 31, 2000, respectively. Long-term fixed rate loans represented 57% and 60% of total long-term loans at February 28, 2001 and May 31, 2000, respectively. Loans converting from a variable rate to a fixed rate for the nine months ended

18


February 28, 2001 totaled $1,197, which was offset by $235 of loans that converted from the fixed rate to the variable rate. For the nine months ended February 29, 2000, loans converting from a variable rate to a fixed rate totaled $14 which was offset by $6 of loans that converted from the fixed rate to the variable rate. This resulted in a net conversion of $962 from the variable rate to a fixed rate for the nine months ended February 28, 2001, compared to a net conversion of $8 for the nine months ended February 29, 2000.

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

                         
February 28, 2001 May 31, 2000 Increase/ (Decrease)



Long-term tax-exempt bonds $ 985 $ 1,025 $ (40 )
Debt portions of leveraged lease transactions 105 111 (6 )
Indemnifications of tax benefit transfers 238 259 (21 )
Letters of credit 360 276 84
Other guarantees 396 274 122



Total $ 2,084 $ 1,945 $ 139



The increase in total guarantees outstanding for the nine months ended February 28, 2001 was due primarily to the increases in letters of credit and other guarantees. The increase in other guarantees resulted from an increase to the balance of NCSC commercial paper guaranteed by CFC.

At February 28, 2001, CFC had unadvanced commitments totaling $14,203, an increase of $504 compared to the balance of $13,699 at May 31, 2000. Unadvanced commitments include loans approved by CFC for which loan contracts have not yet been executed or for which contracts have been executed, but funds have not been advanced. Approximately 40% and 37%, respectively, of the outstanding commitments at February 28, 2001 and May 31, 2000, were for short-term or line of credit loans. The majority of the short-term unadvanced commitments provide backup liquidity to CFC borrowers; therefore, CFC does not anticipate funding most of these commitments. To qualify for the advance of funds under all commitments, a borrower must assure CFC that there has been no material change since the loan was approved.

The following chart provides a breakout of debt outstanding.

                           
February 28, 2001 May 31, 2000 Increase/ (Decrease)



Notes payable:
Commercial paper (1) $ 8,551 $ 6,550 $ 2,001
Bank bid notes 500 155 345
Long-term debt with remaining maturities less than one year 3,101 3,040 61
Commercial paper reclassified as long-term (4,637 ) (5,493 ) 856



Total notes payable 7,515 4,252 3,263
Long-term debt:
Collateral trust bonds 3,246 3,251 (5 )
Medium-term notes 2,031 1,852 179
Commercial paper reclassified as long-term 4,637 5,493 (856 )



Total long-term debt 9,914 10,596 (682 )
QUICS 400 400



Total debt outstanding $ 17,829 $ 15,248 $ 2,581



Percentage of fixed rate debt (2) 45 % 50 %
Percentage of variable rate debt (3) 55 % 50 %
Percentage of long-term debt 58 % 72 %
Percentage of short-term debt 42 % 28 %


(1)   Includes $18 and $0 related to the daily liquidity fund at February 28, 2001 and May 31, 2000, respectively.
(2)   Includes fixed rate collateral trust bonds, medium-term notes and QUICS plus commercial paper with rates fixed through interest rate exchange agreements and less any fixed rate debt that has been swapped to variable.

19


(3)   The rate on commercial paper notes does not change once the note has been issued. However, the rates on new commercial paper notes change daily and commercial paper notes generally have maturities of less than 90 days. Therefore, commercial paper notes are considered to be variable rate debt by CFC. Also included are variable rate collateral trust bonds and medium-term notes.

Liabilities and members’ equity totaled $19,902 at February 28, 2001, an increase of $2,819 or 17% over the balance of $17,083 at May 31, 2000. The increase to total liabilities and members’ equity for the nine months ended February 28, 2001 was primarily due to increases in commercial paper required to fund the increase in loans outstanding. Total debt outstanding at February 28, 2001 was $17,829, an increase of $2,851 over the May 31, 2000 balance of $15,248.

The following chart provides a breakout of members’ subordinated certificates and members’ equity outstanding.

                           
February 28, 2001 May 31, 2000 Increase/ (Decrease)



Subordinated certificates:
Membership certificates $ 642 $ 642 $
Loan certificates 736 517 219
Guarantee certificates 177 182 (5 )



Total subordinated certificates $ 1,555 1,341 214
Members’ equity 381 341 40



Total equity and certificates $ 1,936 $ 1,682 $ 254





As a condition of becoming a CFC member, CFC requires the purchase of membership subordinated certificates. The majority of membership subordinated certificates outstanding and all new membership subordinated certificates have an original maturity of 100 years and pay interest at 5%. A small portion of membership subordinated certificates have an original maturity of 50 years and pay interest at a rate of 3%. Members are required to purchase subordinated certificates with each new loan and guarantee, depending on the borrower’s internal leverage ratio with CFC. Subordinated certificates are junior to all debt issued by CFC.

Applicants are required to pay a one-time fee to become a member. The fee varies from two hundred dollars to one thousand dollars depending on the membership class. CFC maintains the current year net margin as unallocated through the end of its fiscal year. At year-end, the net margin is allocated to the members in the form of patronage capital, to a members’ capital reserve and to the cooperative education fund. The net margin required to earn a 1.12 TIER is allocated back to the members. The net margin earned in excess of the amount required to earn a 1.12 TIER is allocated primarily to the members’ capital reserve, and a small portion is allocated to the cooperative education fund. The cooperative education fund is distributed annually to the cooperatives to assist in the teaching of cooperative principles. CFC immediately retires 70% of the net margin allocated for the prior year and holds the remaining 30% as allocated margins, which are currently retired after 15 years. All retirements of allocated margins are subject to approval by the Board of Directors. CFC does not pay interest on the allocated but unretired margins.

The increase to members’ subordinated certificates and members’ equity for the nine months ended February 28, 2001 is due to the issuance of new loan certificates related to loan advances and current year net margin offset by the retirement of patronage capital. During the nine months ended February 28, 2001, the loan subordinated certificates increased by 43% from $517 at May 31, 2000 to $736 at February 28, 2001. On August 31, 2000, CFC made a patronage capital retirement of $77, which represented 70% of the net margin allocated for fiscal year 2000 and one-ninth of the net margins for fiscal years 1991, 1992 and 1993.

CFC’s leverage ratio increased to 8.35 during the nine months ended February 28, 2001, from 8.10 at May 31, 2000. The ratio is calculated by dividing debt and guarantees outstanding, excluding QUICS and all debt used to fund loans guaranteed by RUS, by the total of QUICS, members’ subordinated certificates and members’ equity. Members’ subordinated certificates and QUICS are treated as equity in the calculation of the leverage ratio. CFC will retain the flexibility to further amend its capital retention policies to retain members’ investments in CFC consistent with maintaining acceptable financial ratios. The increase in the leverage ratio was primarily due to an increase in loans outstanding to members financed by the issuance of short-term debt in the capital markets.

20


CFC’s debt to equity ratio increased to 6.64 at February 28, 2001 from 6.46 at May 31, 2000. The ratio is calculated by dividing debt outstanding, excluding QUICS and debt used to fund loans guaranteed by RUS, by the total of members’ subordinated certificates, members’ equity, the loan loss allowance and QUICS. The increase to the debt to equity ratio was primarily due to an increase in loans outstanding, which was financed by the issuance of short-term debt in the capital markets.

CFC’s leverage and debt to equity ratios have increased primarily due to the significant increase in loan volume. CFC’s management is committed to maintaining these ratios within a range required for a strong credit rating. CFC has implemented a new policy regarding the purchase of loan subordinated certificates. This policy requires members with a CFC debt to equity ratio in excess of the limit in the policy to purchase a non-amortizing/non-interest bearing subordinated certificate in the amount of 2% of the loan for distribution systems and 7% of the loan for power supply systems. CFC also created a members’ capital reserve, in which a portion of the net margin is held annually rather than allocating it back to the members. CFC has the ability to allocate the members’ capital reserve back to its members if necessary. CFC’s management will continue to monitor the leverage and debt to equity ratios. If required, additional policy changes will be made to maintain the ratios within an acceptable range.

Margin Analysis

CFC uses an interest coverage ratio instead of the dollar amount of gross or net margin as its primary performance indicator, since CFC’s net margin is subject to fluctuation as interest rates change. Management has established a 1.10 Times Interest Earned Ratio (“TIER”) as its minimum operating objective. TIER is a measure of CFC’s ability to cover the interest expense on funding. TIER is calculated by dividing the cost of funds and the net margin before extraordinary items by the cost of funds. CFC earned TIERs of 1.14 and 1.13 for the nine months ended February 28, 2001 and February 29, 2000, respectively. The following charts detail the results for nine months ended February 28, 2001 versus February 29, 2000.

                                                   
February 28, 2001 February 29, 2000 Increase / (Decrease)



Operating income $ 1,043 $ 736 $ 307
Cost of funds 849 620 229



Gross margin 194 116 78



General & administrative expenses 19 17 2
Loan loss provision 58 18 40



Total expenses 77 35 42



Operating margin 117 81 36
Extraordinary (loss) (1 ) (1 )



Net margin $ 116 $ 81 $ 35



TIER 1.14 1.13


The following chart shows net margins expressed as a percentage of average loans outstanding for the nine months ended February 28, 2001 versus February 29, 2000.

                             
February 28, 2001 February 29, 2000 Increase / (Decrease)



Operating income 7.49 % 6.65 % 0.84 %
Cost of funds 6.09 % 5.60 % 0.49 %



Gross margin 1.40 % 1.05 % 0.35 %



General & administrative expenses 0.14 % 0.16 % (0.02 )%
Loan loss provision 0.42 % 0.16 % 0.26 %



Total expenses 0.56 % 0.32 % 0.24 %



Operating margin 0.84 % 0.73 % 0.11 %
Extraordinary (loss)



Net margin 0.84 % 0.73 % 0.11 %



21


Net margins for the nine months ended February 28, 2001 represent a significant increase over the net margin for the nine months ended February 29, 2000. The increase to net margin as shown in the two charts above was due to increases in average loan volume and gross margin earned on loans. Average loan volume for the nine months ended February 28, 2001 was $18,634, an increase of $3,831 or 26% over the average loan volume for the prior year period. The reasons for the average loan volume increase include the two large telecommunications loans that were advanced in the quarter ended August 31, 2000 and loans advanced to distribution systems. The gross margin earned on loans for the nine months ended February 28, 2001 was 140 basis points, an increase of 35 basis points or 33% over the gross margin for the prior year period. CFC has increased the gross margin spread on its loans as part of the plan to increase the amount of equity accumulated and held. These two items are the primary reason for the significant increase in net margins for the nine months ended February 28, 2001.

Loan and Guarantee Portfolio Assessment

Portfolio Diversity

CFC and its combined affiliates make loans and provide financial guarantees to their qualified members. The combined memberships include rural electric distribution systems, rural electric power supply systems, statewide rural electric and telecommunication service organizations, associate organizations and telecommunication systems. The following chart summarizes loans and guarantees outstanding by member class at February 28, 2001 and May 31, 2000.

                                     
Loans and Guarantees by Member Class

February 28, 2001 May 31, 2000


Electric systems:
Distribution $ 11,434 53 % $ 10,487 56 %
Power supply 3,938 18 % 3,907 21 %
Service organizations 582 3 % 422 2 %
Associate members 439 2 % 107 1 %




Subtotal electric systems 16,393 76 % 14,923 80 %
Telecommunication systems 5,285 24 % 3,700 20 %




Total $ 21,678 100 % $ 18,623 100 %




The increase in loans and guarantees from May 31, 2000 to February 28, 2001 was due primarily to an increase in loans to telecommunications systems and secondarily due to an increase in loans and guarantees to distribution systems.

Credit Concentration

In addition to the geographic diversity of the portfolio, CFC limits its exposure to any one borrower or controlled group of borrowers. At February 28, 2001, the total exposure outstanding to any one borrower or controlled group did not exceed 4.1% of total loans and guarantees outstanding. At February 28, 2001 and May 31, 2000, CFC had $5,062 and $3,464, respectively, in loans outstanding, and $609 and $495, respectively, in guarantees outstanding to its largest 10 borrowers. The amounts outstanding to the largest 10 borrowers at February 28, 2001 and May 31, 2000, represented 26% and 21%, respectively, of total loans outstanding and 29% and 25%, respectively, of total guarantees outstanding. Total credit exposure to the largest 10 borrowers at February 28, 2001 and May 31, 2000, represented 26% and 21%, respectively. At February 28, 2001, the largest 10 borrowers included one associate member, two distribution systems, two power supply systems and five telecommunications systems compared to four distribution systems, three power supply systems and three telecommunications systems at May 31, 2000.

Credit Limitation

Under CFC’s policy, (1) a borrower’s total exposure is limited to 25% of CFC’s defined net worth, (2) a borrower’s unsecured loans are limited to 10% of CFC’s defined net worth, and (3) a borrower’s guarantees outstanding are limited to 10% of CFC’s defined net worth. CFC’s defined net worth is the total of members’ subordinated certificates issued and outstanding, members’ equity and the loan loss allowance. If a borrower submitting a new loan application has an exposure in excess of any one of the three tests, only the CFC Board

22


of Directors may approve the new loan application. CFC’s Board of Directors may approve a loan to a borrower with an exposure in excess of one or more of these tests after consideration of other factors, including the amount of the loan, the maturity of the loan, and the value of collateral held by CFC. At February 28, 2001, CFC’s defined net worth totaled $2,259, an increase of $349 or 18% compared to $1,910 at May 31, 2000. At February 28, 2001, the 25% limit on total exposure was $565, an increase of $87 from $478 at May 31, 2000 and the 10% limit on unsecured and guarantee exposure was $226, an increase of $35 from $191 at May 31, 2000. At February 28, 2001, there were six borrowers with total exposure greater than 25% of defined net worth and two borrowers with total guarantees outstanding in excess of 10% of defined net worth, compared to three borrowers with total exposure greater than 25% of defined net worth and one borrower with guarantees in excess of 10% of defined net worth at the prior year-end. The three new borrowers with total exposure in excess of 25% of defined net worth include two telecommunications systems that purchased local exchange systems. By policy, new loan applications from any borrower that has a total exposure in excess of the limit in any of the three categories may be approved only by CFC’s Board of Directors.

CFC anticipates that the total of members’ equity, members’ subordinated certificates and the loan loss allowance will increase by May 31, 2001. In addition, the total exposure to a few large borrowers may be reduced through the sale of loan participations. The combination of the increase to defined net worth and the decrease in exposure to a few large borrowers should reduce the number of borrowers that have total exposures in excess of the limit set by the policy.

Security Provisions

Except when providing lines of credit, CFC typically lends to its members on a secured basis. At February 28, 2001, a total of $1,812 of loans were unsecured representing 9% of total loans. At May 31, 2000, a total of $1,632 of loans was unsecured representing 10% of total loans. At February 28, 2001 and May 31, 2000, approximately $112 or 6% and $118 or 7%, respectively, of the unsecured loans represented obligations of distribution systems for the initial phase(s) of RUS note buyouts. Upon completion of a system’s buyout from RUS, CFC receives a first lien security on all assets and future revenues. The unsecured loans would represent 9% of total loans as of both February 28, 2001 and May 31, 2000 if these partial note buyout obligations were excluded. CFC’s long-term loans are typically secured pro-rata with any other secured lenders (primarily RUS) by all assets and future revenues of the borrower. Short-term loans are generally unsecured lines of credit. At February 28, 2001 and May 31, 2000, a total of $289 and $244, respectively, of guarantees were unsecured, representing 14% and 13%, respectively, of total guarantees. Guarantees are secured on a pro-rata basis with other secured creditors by all assets and future revenues of the borrower or by the underlying financed asset. In addition to the collateral received, CFC also requires that its borrowers set rates designed to achieve certain financial ratios. At February 28, 2001 and May 31, 2000, CFC had a total of $2,101 and $1,876, respectively, of unsecured loans and guarantees representing 10% and 10%, respectively, of total loans and guarantees.

Non-performing and Restructured Loans

CFC classifies a borrower as non-performing when any one of the following criteria are met:

  principal or interest payments on any loan to the borrower are past due 90 days or more,
  as a result of court proceedings, repayment under the original terms is not anticipated, or
  for some other reason, management does not expect the timely repayment of principal and interest.

Once a borrower is classified as non-performing, interest on its loans is recognized on a cash or accrual basis, to be determined on a case-by-case basis. Alternatively, CFC may choose to apply all cash received to the reduction of principal, thereby foregoing interest income recognition. At February 28, 2001 and May 31, 2000, there were $889 and $0, respectively, of loans classified as non-performing. At February 28, 2001, all loan classified as non-performing were on non-accrual status with respect to the recognition of interest income.

Loans classified as restructured are loans for which agreements have been executed that changed the original terms of the loan, generally a change to the originally scheduled cash flows. At February 28, 2001 and May 31, 2000, restructured loans totaled $552 and $572, respectively. At February 28, 2001 and May 31, 2000, all restructured loans were on accrual status with respect to the recognition of interest income at a rate of 7.0% and 3.9%, respectively. On June 1, 2000 and January 1, 2001, CFC increased the rate at which it accrues interest on restructured loans as a result of

23


excess cash payments received since the inception of the restructuring agreement. Subsequent to the end of the quarter, on March 16, 2001, CFC and CoServ signed an agreement restructuring all of CoServ’s obligations to CFC. (See footnote 11 to the combined financial statements for additional detail on the agreement).

Allowance for Loan Losses

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

Since its inception in 1969, CFC has charged-off loan balances in the total amount of $80 net of recoveries. Management believes that the allowance for loan losses is adequate to cover any portfolio losses that may occur.

The following chart presents a summary of the allowance for loan losses for the nine months ended February 28, 2001 and fiscal year ended May 31, 2000.

                 
February 28, 2001 May 31, 2000


Beginning balance $ 228 $ 212
Provision for loan losses 58 17
Charge-offs, net of recoveries (1 )


Ending balance $ 286 $ 228


As a percentage of gross loans 1.46 % 1.37 %
As a percentage of gross loans and guarantees 1.32 % 1.22 %
As a percentage of total non-performing and restructured loans 19.85 % 39.94 %

The loan loss allowance increased by $58 to a total of $286 for the nine months ended February 28, 2001 compared to $228 for the fiscal year ended May 31, 2000. The increase was required to provide for an increase to specific reserves and to provide adequate coverage on a loan portfolio that grew by $2,916 in the first nine months.

Asset/Liability Management

A key element of CFC’s funding operation is the monitoring and management of interest rate and liquidity risk. This process involves controlling asset and liability volumes, repricing terms and maturity schedules to stabilize gross operating margins and retain liquidity.

Matched Funding Policy

CFC measures the matching of funds to assets by comparing the amount of fixed rate assets repricing or amortizing to the total fixed rate debt maturing over the remaining period until maturity of the fixed rate loan portfolio and related funding. It is CFC’s policy to manage the match funding of asset and liability repricing terms within a range of 5% of total assets. At February 28, 2001, CFC had $8,681 of fixed rate assets amortizing or repricing funded by $7,466 of fixed rate liabilities maturing during the next 30 years and $1,089 of members’ equity and subordinated certificates, a portion of which does not have a scheduled maturity. The difference, $126 or 0.63% of total assets, represents the fixed rate assets in excess of the fixed rate debt maturing during the next 30 years. CFC funds variable rate assets which reprice monthly with short-term liabilities, primarily commercial paper and bank bid notes, both of which are issued primarily with original maturities under 90 days. CFC funds fixed rate loans with fixed rate collateral trust bonds, medium-term notes, QUICS, members’ subordinated certificates and members’ equity. With the exception of commercial paper and members’ subordinated certificates, which are generally issued with extended maturities at rates below CFC’s long-term cost of funding, CFC’s liabilities have average maturities that closely match the repricing terms of CFC’s fixed interest rate loans. CFC also uses commercial paper supported by interest rate exchange agreements to fund its portfolio of fixed rate loans.

Certain of CFC’s collateral trust bonds and medium-term notes were issued with early redemption provisions. To the extent borrowers are allowed to convert their fixed rate loans to a variable interest rate and to the extent it is beneficial, CFC takes advantage of these early redemption privileges. However, because conversions can take

24


place at different intervals from early redemptions, CFC charges conversion fees designed to compensate for any additional interest rate risk assumed by CFC.

CFC makes use of an interest rate analysis in the funding of its long-term fixed rate loan portfolio. The analysis compares the scheduled fixed rate loan amortizations and repricings against the scheduled fixed rate debt and members’ subordinated certificate amortizations to determine the fixed rate funding gap for each individual year and the portfolio as a whole. There are no scheduled maturities for the members’ equity, primarily unretired patronage capital allocations. The balance of members’ equity is assumed to remain relatively stable since annual retirements are approximately equal to the annual allocations of net margin. The non-amortizing members’ subordinated certificates either mature at the time of the related loan or guarantee or 100 years from issuance (50 years in the case of a small portion of certificates). Accordingly, it is assumed in the funding analysis that non-amortizing members’ subordinated certificates and members’ equity are first used to “fill” any fixed rate funding gaps. The remaining gap represents the amount of excess fixed rate assets amortizing or repricing in that year or the amount of fixed rate assets that are assumed funded by short-term variable rate debt, primarily commercial paper. The interest rate associated with the assets and debt maturing or equity and certificates is used to calculate a TIER for each year and the portfolio as a whole. The schedule allows CFC to analyze the impact on the overall TIER of issuing a certain amount of debt at a fixed rate for various maturities, prior to issuance of the debt. The following chart shows the scheduled amortization and maturity of fixed rate assets and liabilities outstanding at February 28, 2001.

INTEREST RATE GAP ANALYSIS
(Fixed Assets/Liabilities)
February 28, 2001

                                                             
Over 1 year Over 3 years Over 5 years Over 10 years
Less than but less than but less than but less than but less than Over
1 year 3 years 5 years 10 years 20 years 20 years Total







Assets:
Amortization and repricing $ 74 $ 1,641 $ 2,628 $ 2,355 $ 1,448 $ 535 $ 8,681







Total assets $ 74 $ 1,641 $ 2,628 $ 2,355 $ 1,448 $ 535 $ 8,681
Liabilities and equity:
Long-term debt $ 111 $ 1,761 $ 1,799 $ 2,716 $ 469 $ 610 $ 7,466
Members’ certificates and equity 5 36 35 109 855 49 1,089







Total liabilities and equity $ 116 $ 1,797 $ 1,834 $ 2,825 $ 1,324 $ 659 $ 8,555
Gap (1) $ 42 $ 156 $ (794 ) $ 470 $ (124 ) $ 124 $ (126 )
Cumulative gap $ 42 $ 198 $ 596 $ (126 ) $ (250 ) $ (126 )
Cumulative gap as a % of total assets 0.21 % 0.99 % (3.00 )% (0.63 )% (1.26 )% (0.63 )%


(1)   Loan amortization/repricing (over)/under debt maturities.

Derivative and Financial Instruments

At February 28, 2001 and May 31, 2000, CFC was a party to interest rate exchange agreements totaling $6,396 and $4,817, respectively. CFC uses interest rate exchange agreements as part of its overall interest rate matching strategy. Interest rate exchange agreements are used when they provide CFC a lower cost of funding or minimize interest rate risk. CFC will only enter into interest rate exchange agreements with highly rated financial institutions. CFC was using interest rate exchange agreements to fix the interest rate on $2,618 as of February 28, 2001 and $2,461 as of May 31, 2000 of its variable rate commercial paper. Interest rate exchange agreements were used to swap fixed interest rates with variable interest rates on $525 of collateral trust bonds as of February 28, 2001 and May 31, 2000. CFC was also using interest rate exchange agreements at both dates to minimize the variance between the three month LIBOR rate at which $3,253 of collateral trust bonds

25


and $1,831 of medium-term notes were issued and CFC’s variable commercial paper rate. All of CFC’s derivative financial instruments were held for purposes other than trading. CFC has not invested in derivative financial instruments for trading purposes in the past and does not anticipate doing so in the future.

During the nine months ended February 28, 2001, CFC issued commercial paper to European investors in a foreign currency. The following chart provides details of the foreign currency exchange agreements that CFC had outstanding at February 28, 2001.

                                         
(Currency amounts in thousands)
Type of Debt (1) Issue Date Maturity Date U.S. Dollars Foreign Currency (2) Rate






MTN February 24, 1999 February 24, 2006 $ 390 350 EU 1.115


(1)   MTN — CFC medium-term notes
(2)   EU — Euros

CFC enters into an exchange agreement to sell the amount of foreign currency received from the investor for U.S. dollars on the issuance date and to buy the amount of foreign currency required to repay the investor principal and interest due through or on the maturity date. By locking in the exchange rates at the time of issuance, CFC has eliminated the possibility of any currency gain or loss that might otherwise have been produced by the foreign currency borrowing. CFC includes the difference between the U.S. dollars received at issuance and the U.S. dollars required to purchase the foreign currency (at the interest payment dates and at maturity) as interest expense.

Market Risk

CFC’s primary market risk exposures are interest rate risk and liquidity risk. CFC is also exposed to counterparty risk as a result of entering into interest rate exchange agreements.

CFC does not match fund the majority of its fixed rate loans with a specific debt issuance at the time the loan is advanced. CFC aggregates fixed rate loans until the volume reaches a level that will allow an economically efficient issuance of debt. CFC uses fixed rate collateral trust bonds, medium-term notes, QUICS, members’ subordinated certificates, members’ equity and variable rate debt to fund fixed rate loans. CFC allows borrowers flexibility in the selection of the period for which a fixed interest rate will be in effect. Long-term loans typically have a 15 to 35 year maturity. Borrowers may select fixed interest rates for periods of one year through the life of the loan. To mitigate interest rate risk in the funding of fixed rate loans, CFC performs a monthly gap analysis. This gap analysis is a comparison of fixed rate assets repricing or maturing by year to fixed rate liabilities and equity maturing by year (see chart on page 27). The analysis indicates the total amount of fixed rate loans maturing by year and in aggregate that are assumed to be funded by variable rate debt. CFC’s funding objective is to limit the total amount of fixed rate loans that are funded by variable rate debt to 5% or less of total assets. At February 28, 2001 and May 31, 2000, fixed rate loans funded by variable rate debt represented 0.6% and 0.5%, respectively, of total assets.

Variable rate loans are priced monthly based on the cost of the debt used to fund the loans; therefore, the interest rate risk is minimal on these loans. CFC uses variable rate debt, non-interest bearing members’ subordinated certificates and members’ equity to fund variable rate loans. At February 28, 2001 and May 31, 2000, 49% and 47%, respectively, of loans carry a variable interest rate.

CFC faces liquidity risk in the funding of its variable rate loans and in being able to obtain the funds required to meet the loan requests of its members or conversely, having funds to repay debt obligations when they are due. CFC offers variable rate loans with maturities of up to 35 years. These loans are funded by variable rate commercial paper, bank bid notes, collateral trust bonds, medium-term notes, non-interest bearing members’ subordinated certificates and members’ equity. The average maturity of commercial paper and bank bid notes are typically 30 to 35 days. The collateral trust bonds and medium-term notes are issued for longer periods than commercial paper; however, the maturity for collateral trust bonds and medium-term notes is typically shorter than the maturity of the loans. Loan subordinated certificates are issued for the same period as the related loan. Thus, CFC is at risk if it is unable to continually rollover its commercial paper balance or issue other forms of variable rate debt to support its variable rate loans. To mitigate liquidity risk, CFC maintains back-up liquidity through

26


revolving credit agreements with domestic and foreign banks. At February 28, 2001 and May 31, 2000, CFC had a total of $7,040 and $5,493 in revolving credit agreements and bank lines of credit.

To facilitate entry into the debt markets, CFC maintains high credit ratings on all of its debt issuances from three credit rating agencies (see chart below). CFC also maintains shelf registrations with the SEC for its collateral trust bonds, medium-term notes, QUICS and member subordinated capital securities. At February 28, 2001 and May 31, 2000, CFC had active shelf registrations totaling $1,675 and $175, respectively, related to collateral trust bonds, $1,442 and $2,542, respectively, related to medium-term notes, $400 and $400, respectively, related to QUICS and members’ subordinated capital securities and $300 and $0, respectively, related to a daily liquidity fund. All of the registrations allow for issuance of the related debt at both variable and fixed interest rates. CFC also has commercial paper and medium-term note issuance programs in Europe. At February 28, 2001 and May 31, 2000, CFC had $125 and $0, respectively, of commercial paper and $1,010 of medium-term notes at both dates, outstanding to European investors. As of February 28, 2001, CFC had total issuance authority of $1,000 related to commercial paper and $4,000 related to medium-term notes under these programs in Europe.

CFC is exposed to counterparty risk related to the performance of the parties with which it has entered into interest rate exchange agreements and foreign currency exchange agreements. To mitigate this risk, CFC only enters into these agreements with highly rated counterparties. At February 28, 2001 and May 31, 2000, CFC was a party to $6,396 and $4,817, respectively, of interest rate exchange agreements and $390 and $438, respectively, of foreign currency exchange agreements. To date, CFC has not experienced a failure of a counterparty to perform as required under any of these agreements. At February 28, 2001, CFC’s interest rate exchange agreement and foreign currency exchange agreement counterparties had credit ratings ranging from A to AAA as assigned by Standard & Poor’s Corporation.

Credit Ratings

CFC’s long- and short-term debt and guarantees are rated by three of the major credit rating agencies: Moody’s Investors Service, Standard & Poor’s Corporation and Fitch Investors Service. The following table presents CFC’s credit ratings at February 28, 2001 and May 31, 2000.

             
Standard & Poor's
Moody's Investors Service Corporation Fitch Investors Service



Direct:
Collateral trust bonds Aa3 AA AA
Domestic and European medium-term notes A1 AA- AA-
QUICS A2 A A+
Domestic and European commercial paper P-1 A-1+ F-1+
Guarantees:
Leveraged lease debt A1 AA- AA-
Pooled bonds Aa3 AA- AA-
Other bonds A1 AA- AA-
Short-term P-1 A-1+ F-1+

The ratings listed above have the meaning as defined by each of the respective rating agencies, and they are not recommendations to buy, sell or hold securities. In addition, they are subject to revision or withdrawal at any time by the rating organizations.

27


Member Investments

At February 28, 2001 and May 31, 2000, CFC’s members provided 16% and 17% of total capitalization.

MEMBERSHIP CONTRIBUTIONS TO TOTAL CAPITALIZATION

                                   
February 28, 2001 % of Total (1) May 31, 2000 % of Total (1)




Commercial paper (2) $ 914 11 % $ 841 13 %
Medium-term notes 317 6 % 294 6 %
Members’ subordinated certificates 1,555 100 % 1,340 100 %
Members’ equity 381 100 % 341 100 %


Total $ 3,167 $ 2,816


Percentage of total capitalization 16% 17%



(1)   Represents the percentage of each line item outstanding to CFC members.
(2)   Includes $18 and $0 related to the Daily Liquidity Fund at February 28, 2001 and May 31, 2000, respectively.

The total amount of member investments increased slightly at February 28, 2001 compared to May 31, 2000. Total member investments, as a percentage of total capitalization decreased due to the increase in non-member debt required to fund the growth in loans outstanding. Total capitalization at February 28, 2001, was $19,765, an increase of $2,836 over the total capitalization of $16,929 at May 31, 2000. When the loan loss allowance is added to both membership contributions and total capitalization, the percentages of membership investments to total capitalization are 17% and 18% at February 28, 2001 and May 31, 2000, respectively.

Financial Outlook

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

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

  Interest rates – CFC interest rates generally move with rates in the capital markets. CFC includes an adder in its loan rate to generate a margin. The adder is a percentage of funding cost. If rates decrease the gross margins earned on loans outstanding may decrease as well.
  Loan funding – Risk associated with the funding of loans is discussed in detail in the market risk and matched funding sections of this management discussion and analysis.
  Borrowers – CFC’s borrowers are generally located in rural areas throughout the United States and its territories. The borrowers vary in size, management experience and the extent to which they have expanded into diversified activities outside of electric service or local exchange telephone service. CFC borrowers are concentrated in the electric utility and telecommunications industries. Problems in either industry could impact the borrowers’ ability to repay CFC loans.
  RUS approved loan and guarantee funding levels – Direct RUS loans and loans from the FFB with an RUS guarantee are the lowest cost option for CFC’s members. Further increases in RUS direct loan or loan guarantee levels may impact demand for loans from CFC.
  Continued performance of Deseret within the terms of the restructure agreement. At February 28, 2001, CFC had a total exposure of $667 to Deseret.
  The resolution of the CoServ exposure without a material loss. At February 28, 2001, CFC had a total exposure of $889 to CoServ.

28


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

Loans outstanding increased by $2,916 or an increase of 17% during the nine months ended February 28, 2001. CFC does not anticipate that this level of growth will continue over the final three months of the fiscal year. A large portion of the growth in the first nine months was due to unique one-time telecommunications transactions. In one of these transactions, CFC is planning to sell loan participations to reduce the total exposure within the guidelines of its credit limitation policy. RUS loan guarantee levels have been increased and CFC borrowers may use those funds as a first option.

Net margins increased by $35 or 43% during the nine months ended February 28, 2001, as compared to the prior year period. The rate of growth in net margins is expected to slow in the last three months of the year due to several factors. The Federal Reserve decreased interest rates by 100 basis points in January 2001 and more rate cuts are expected prior to the close of CFC’s fiscal year on May 31, 2001. As a result, CFC’s variable interest rates on loans to borrowers may decrease in the last quarter of the fiscal year. At February 28, 2001, a total of 49% of CFC’s outstanding loan portfolio had a variable interest rate.

As part of the restructuring of the loans to CoServ, CFC will advance additional amounts to CoServ and will keep all loans to CoServ on non-accrual status through May 31, 2001. Maintaining CoServ on non-accrual status results in a reduction to interest income of approximately $5 per month, based on current interest rates. If interest rates are reduced again prior to May 31, 2001, as expected, the monthly reduction to interest income will be less. In addition, based on CFC’s calculated impairment on the CoServ loans, the provision for the loan loss reserve in the third quarter was increased from the projected $5 to $42. Net margins for the nine months ended February 28, 2001, after the reduction to interest income from maintaining CoServ loans on non-accrual status and after the increased loan loss provision, were $116 an increase of $35 or 43% over the net margin for the comparable period in the prior year. Net margin for the fiscal year ending May 31, 2001 is projected to be $163 an increase of $48 or 42% over the prior year. The estimated fiscal year 2001 net margin earned by CFC is still well in excess of the prior year, but not as much in excess if the CoServ loans were performing according to the original terms of the loans. More detail on this borrower is located in footnote 11 to the February 28, 2001 financial statements.

The balance of the loan loss reserve increased by $58 or 25% during the nine months ended February 28, 2001. CFC had no loan write-offs during this period. The increase to the provision to the loss reserve was required to provide a specific reserve to the CoServ loans and to provide coverage to the remainder of the portfolio that increased by almost $3,000 during the year. At February 28, 2001 the loss reserve totaled $286 and represented 1.5% of total loans outstanding and 1.3% of total loans and guarantees. At February 28, 2001 CFC had set a side a total of $155 to the total loss reserve for impaired loans. It is anticipated that CFC will add $19 to the loss reserve in the fourth quarter, bringing the balance of the reserve to $305 at May 31, 2001. CFC has had a cumulative net write-off of $80 since its inception in 1969.

CFC’s leverage and debt to equity ratios have increased since May 31, 2000 due to loan growth and the annual payment of patronage capital retirements in August 2000. The leverage ratio increased from 8.10 to 8.35 and the debt to equity ratio increased from 6.46 to 6.64. CFC has targeted a leverage ratio of approximately 8.00. CFC expects the leverage and debt to equity ratios to decrease slightly over the next three months. As described above, loan growth is not expected to continue at the same level as over the first nine months and CFC is close to finalizing a syndication arrangement that, if successful, will result in the sale of a portion of one large telecommunications transaction. CFC has also made policy changes to increase the amount of members’ equity and certificates. The amount of loan certificate required to be purchased as a condition to receiving a loan has been increased for most borrowers and a portion of the net margins will be held as unallocated in the members’ capital reserve. The change to the amount of loan certificates purchased was implemented during the first six months of the year and the members’ capital reserve has been accumulating since November 1999. During the first nine months of the year, total equity and certificates outstanding increased by $254 or 15%.

29


PART II. OTHER INFORMATION

     
Item 1. Legal Proceedings.
    None.
Item 2. Changes in Securities.
    None.
Item 3. Defaults upon Senior Securities.
    None.
Item 4. Submission of Matters to a Vote of Security Holders.
    None.
Item 5. Other Information.
    None.
Item 6. Exhibits and Reports on Form 8-K.
    A. Exhibits.
      None.
    B. Reports on Form 8-K.
      Item 7 on January 23, 2001 — Amendment to Agency Agreement and Calculation Agent Agreement relating to the distribution of CFC’s Medium-Term Notes, Series C, within the United States.

30


Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

  NATIONAL RURAL UTILITIES COOPERATIVE
FINANCE CORPORATION



    /s/ Steven L. Lilly                                     
Chief Financial Officer

March 21, 2001



    /s/ Steven L. Slepian                                 
Controller (Principal Accounting Officer)

March 21, 2001

31